The electricity distribution sector in Ontario: the slow road to consolidation

November 2013 | SPECIAL REPORT: ENERGY & NATURAL RESOURCES

Financier Worldwide Magazine

In 1998, the introduction of Ontario’s Energy Competition Act (ECA) and Electricity Act (EA) signalled the start of the restructuring of Ontario’s electricity sector, bringing to Canada the wave of liberalisation of electricity markets that had commenced in the UK in the 1990s. As part of this restructuring, Ontario’s electricity distribution sector would be transformed as well.

Prior to the restructuring of the sector, more than 300 distribution utilities functioned as municipal departments, known as public utility commissions or hydro-electric utility commission. The rates and terms of service of such utilities were regulated by the provincially owned monopoly transmitter/generator/system operator Ontario Hydro, which would be unbundled (but not privatised) pursuant to the ECA. Transmission assets and distribution assets in the rural areas were transferred to a new entity named Hydro One Inc.

The EA required that distribution utilities be transformed into corporations under the Ontario Business Corporations Act (OBCA). Shares of these new corporations (Local Distribution Companies, or ‘LDCs’) could continue to be held by the municipalities. But, to achieve efficiencies and economies of scale, they could also be sold to others, or the corporations could be merged. Pursuant to the ECA, regulation of electrical utilities was transferred to the Ontario Energy Board (OEB).

The number of LDCs was reduced considerably as a result initially of a government policy of amalgamation of municipalities, and subsequently acquisitions by Hydro One Inc. and amalgamations of the utilities themselves. Municipal amalgamation necessitated the amalgamation of LDCs resulting in the first phase of distribution sector consolidations. The second phase of distribution sector consolidations were a result of the acquisition of a large number of smaller utilities by Hydro One. As a result of these developments, the number of LDCs was reduced to approximately 120 by the mid-2000s. Further consolidation of municipal utilities has continued in fits and starts since 2005 due to factors that include: (i) desire by the municipal shareholders to ‘monetise’ the value of its shares in the distributor; (ii) increasing efficiencies and economies of scale; (iii) increasing financial returns; and (iv) addressing the increasing regulatory burden of rate filings and compliance with OEB codes.

As a result of this continuing consolidation, the number of distributors has been reduced to less than 80.

Private sector participants

Based on their historical foundation, most of the province’s distribution utilities are still owned by Ontario’s provincial and municipal governments. For example, Hydro One, owned by the Ontario government, maintains ownership over three distribution utilities including Hydro One Networks, Hydro One Brampton and Hydro One Remote Communities. Further, most of Ontario’s LDCs are either wholly owned by a single municipality or jointly owned by a number of municipalities.

FortisOntario remains the single private sector majority LDC owner in Ontario. FortisOntario maintains 100 percent ownership over three smaller utilities in Ontario and also holds minority interests in a number of other LDCs.

Other private sector participants in the distribution market include pension plans. For these market participants, electricity distributors represent attractive investment opportunities since they are a regulated industry with stable rates-of-return. For example, in 2001, Borealis Infrastructure, an affiliate of Ontario Municipal Employees Retirement System, purchased a 10 percent stake in Enersource, the distributor for the large suburban municipality outside of Toronto.

Tax considerations

Overview

The tax regime in respect of electricity distributors in Ontario includes three separate considerations: the Canadian federal Income Tax Act exempts municipally owned corporations from the payment of corporate income tax; however, the EA requires that municipally owned LDCs pay ‘payments-in-lieu of corporate taxes’ (PILs); and where electricity distribution assets or shares are sold, such transfer is subject to transfer tax equal to 33 percent of the fair market value of such assets or shares, resulting in a substantial obstacle to such transactions. An exemption is available where such assets or shares are purchase by another municipally or provincially owned corporation.

The Income Tax Act

Under the Income Tax Act, a municipally owned LDC may be exempt from income tax in a taxation year. In order to fall under the exemption, the LDC must satisfy an ownership test and a test in respect of its income-producing activities. In order to fulfill the ownership test, one or more Canadian municipalities must own not less than 90 percent of the LDC’s capital. In determining share ownership of the LDC, options and rights to acquire shares in the corporation may also be considered. To fulfill the test in respect of income-producing activities, an LDC is required to restrict its income producing activities to within the geographical boundaries of its municipal shareholders. There may be some flexibility in this determination. For example, up to 10 percent of an LDC’s activities for a taxation year may come from outside the geographical boundaries specified. Further, certain types of income may be excluded from the determination. These tests are also applicable under the Ontario Corporations Tax Act in order to determine whether an LDC would be exempt from paying income tax for a taxation year.

Payments-in-lieu of corporate taxes

If an LDC that is exempt from tax under the federal Income Tax Act and the Ontario Corporations Tax Act for a taxation year loses its tax exempt status, it will have to pay a PILs proxy tax. For example, if a private investor acquires more than 10 percent in the capital of the LDC and it no longer meets the ownership, it will be subject to PILs. The amount of PILs is calculated on the deemed disposition of all the LDC’s property at fair market value. The amount by which the proceeds from the deemed disposition exceed the cost of the property will be the amount subject to PILs.

Transfer tax

Under the EA, a vendor LDC or shareholder pays a 33 percent tax on any actual or deemed transfer of interest in real or personal property used in connection with generating, transmitting, distributing or retailing electricity, as well as shares that derive their value from such activities. This tax is payable by the LDC as long as a municipal shareholder maintains a direct or indirect ownership interest in the corporation.

Exemptions are available to such liability where the purchaser is a municipality or a municipally owned corporation, or a provincially owned corporation (i.e., Hydro One Inc.).

The transfer tax constitutes a significant roadblock to private sector investment in the distribution sector.

Report of the Ontario Distribution Sector Review Panel

In April 2012, the Ontario Minister of Energy established the Ontario Distribution Sector Panel (the ‘Panel’) to provide expert advice to the government on how to improve efficiencies in the sector with the aim of reducing the financial cost of electricity distribution for electricity consumers. In its review, the Panel reported that fragmentation in the Ontario distribution system in delivering electricity was costing consumers more than it should. Some reasons for the higher costs were higher per capital costs for operations, maintenance and administration among smaller LDCs and duplication of equipment and facilities among neighboring LDCs. The Panel considered that the current distribution system was a product of history, and a new model, including greater consolidation among LDCs, would drive greater efficiencies and value for consumers.

The Panel shared certain case studies showing consolidations that resulted in significant cost savings and efficiencies. For example, Veridian Connections was created through consolidation of distribution utilities in the medium-sized communities of Pickering, Ajax and Clarington. Within its first three years of operation, the LDC reported savings of 13 percent in its operations, maintenance and administration costs. Similarly, Powerstream was the result of a voluntary merger of distribution utilities in suburban Markham and Vaughn and the acquisition of Richmond Hill’s LDC, resulting in approximately $6.9m in cost savings.

The Panel’s report also emphasised the benefits of attracting new financing in a sector that required significant investment in upgrades in order to maintain safety and reliability of distribution assets. The report cited the PILs and transfer taxes as barriers to attracting private investment for the distribution sector.

As part of its recommended solutions to address these issues, the Panel encouraged the Ontario government to give “clear, unambiguous direction to lead and engage in fair, market-value based discussions with LDCs to create new regional distributors” as a result of voluntary consolidation among distributors. The target result of such direction was to create “shoulder-to-shoulder consolidation of the industry”, which would be created voluntarily initially, but on a mandatory basis if sufficient mergers and acquisitions did not occur within a certain timeframe.

The Panel also recommended discussions between Ontario with the federal government on a tax agreement that would facilitate the removal of the transfer tax.

Models for consolidation

The Panel explored various models of consolidation for LDCs.

Strategic investment. One approach to consolidation was a strategic investment as exemplified by the Town of Collingwood in its agreement to sell half the shares in its LDC (Collus Power) to PowerStream. The transaction created a unique structure by which economies of scale and synergies between the two entities could be achieved while maintaining the municipality’s interests in its LDC.

Merger. Alternatively, a merger between LDCs may be an option for consolidation. For example, in July 2000, three LDCs owned by ERTH Corporation merged under a single entity, Erie Thames Powerlines. A key focus under this model is communication between various stakeholders of the LDCs to ensure that the desired synergies and economies of scale are achieved.

Sale/auction. Finally, as seen in the recent example of the sale of Norfolk Hydro to Hydro One, municipalities may invite bids for the sale of their utilities in order to provide their constituents with better value. Norfolk County invited bids for sale of Norfolk Hydro in late 2012 and eventually sold the utility for $93m to Hydro One earlier this year. While there may be value for consumers in reduced local rates as a result of such transactions, the purchasing entity may need to increase rates and costs to consumers across the province in order to finance the purchase of LDCs through these auction processes.

Reaction to Panel Report

Many LDCs and municipalities strongly disagreed with the Panel’s recommendations, arguing among other points, that size did not in and of itself result in efficiencies and lower costs. As a result, the Minister of Energy subsequently distanced himself from some of the Panel’s findings, in particular the requirement for mandatory consolidation.

Conclusion

The electricity distribution sector has continued to evolve in order to meet the ongoing challenges posed by corporatisation and regulatory pressures on its activities.

Recent recommendations by the Ontario Distribution Sector Review Panel may indicate that greater consolidation in the industry would provide practical solutions to meet the pressures faced by LDCs in Ontario. However, the reaction of municipal shareholders and existing LDCs indicates that further consolidation must be balanced with a recognition of the importance of local presence and control of LDCs. Further review of the appropriate model for such consolidations may be required in order to determine the best fit for each LDC and shareholder considering this option. The role of private participants in this evolution remains to be seen.

Ron W. Clark is a partner and Aisha Ramkrishnan is an articling student at Aird & Berlis LLP. Mr Clark can be contacted on +1 (416) 865 7701 or by email: rclark@airdberlis.com.

Ron W. Clark and Aisha Ramkrishnan

Aird & Berlis LLP