Ontario Energy Board s (OEB S) Response to the. International Accounting Standards Board s. Request for Information on Rate Regulation

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5 Ontario Energy Board s (OEB S) Response to the International Accounting Standards Board s Request for Information on Rate Regulation Question 1: For the types of rate regulation that you think would be useful for us to consider in the Discussion Paper (or would not be useful to consider, if applicable), what types of goods or services are subject to the rate regulation being described? In providing this information, please also tell us: a) whether you are a rate-regulator, a financial statements preparer, auditor, user or other (please specify); b) what jurisdiction the rate regulation that you are describing is in; c) whether that jurisdiction is a recent adopter of IFRS; and d) whether the main suppliers of the rate-regulated goods or services (ie the rateregulated entities), including your company if applicable, are predominantly private-sector entities, government entities or closely related to the rate regulator. Responses to Question 1: The Ontario Energy Board ( OEB ) is the rate-regulator of electricity and natural gas in the province of Ontario, Canada. The types of goods or services that are subject to the OEB s rate regulation are the generation (certain prescribed assets), transmission, and distribution of electricity and the distribution and storage of natural gas. As the economic rate regulator of these monopolistic goods and services provided by regulated utilities, the OEB is a key user of the utilities financial statements. The Canadian Accounting Standards Board ( AcSB ) and the Canadian Public Sector Accounting Board ( PSAB ) specify the accounting standards that apply in Canada. The AcSB requires all Publicly Accountable Enterprises to apply IFRS as their financial reporting standard. Publicly Accountable Enterprises include reporting issuers or entities that list their debt or equity securities on a public exchange such as the Toronto Stock Exchange. The PSAB requires that all Government Business Enterprises ( GBEs ) also apply IFRS. Rate regulated utilities owned by the government (federal, provincial and municipal) are considered to be GBEs and are required to adopt IFRS. The entities that the OEB regulates are primarily GBEs in the electricity sector and private entities in the gas sector. 1

6 The effective date for adoption of IFRS in Canada was January 1, However, four extensions to the mandatory IFRS adoption have been granted by the AcSB to rateregulated entities. The current extension date granted is to January 1, To date, only a few rate-regulated companies in Ontario have adopted IFRS. There are certain rate-regulated entities including two large gas utilities and the largest municipally owned distributor in Ontario that have been granted approval by the OEB to use US GAAP for regulatory rate-making and reporting purposes. These entities have received permission from the Ontario Securities Commission to use US GAAP for financial reporting purposes effective January 1, 2012 through to December 31, Further, the two large electricity utilities (one a generator and the other a transmitter/distributor) that are owned by Government of Ontario are required to use US GAAP effective January 1, 2012 through a regulation that was issued by the government. IFRS may not be required by the AcSB or the PSAB for rate-regulated enterprises for whom some other standard may apply. For example, private enterprises that are not owned by the government and not listed on a public exchange may choose to use Accounting Standards for Private Enterprises (ASPE), which is similar to Canadian GAAP, for financial reporting purposes. An Ontario utility has received approval by the OEB to use ASPE for regulatory rate-making and reporting purposes. Its parent company operating in another province has reviewed approval from its regulator to use US GAAP. Question 2: What are the objectives of the rate regulation and how do they influence the interaction between the rate regulator, the rate-regulated entity and customers? In providing this information, please tell us: a) what are the high-level objectives of the rate regulation (for example, to restrict prices or to influence the levels of supply and demand or to restrict or encourage competition); and b) how these objectives are reflected in the nature of the rate-setting mechanism? For example, to what extent: i. is the rate-setting mechanism designed to give the rate-regulated entity a fair rate of return (for example, a cost-plus mechanism) or is the focus more on reducing the cost to customers (for example, a price-cap or other incentive-based mechanism); ii. are there incentives to meet targets that are not directly related to the cost-rate relationship (for example, efficiency, service levels, infrastructure investment, increased supply capacity or reliability, use of alternative resources or reduction in customer demand or usage); 2

7 iii. iv. does the rate regulation fix the price per unit or does it provide some flexibility for the entity to set prices (for example, through price ranges or caps, based on either unit prices or total revenue or total profitability); and are there other aspects of the rate-setting mechanism that reflect any specific objectives not envisaged above? Responses to Question 2: Response to 2 (a): The OEB has regulatory oversight of Ontario s natural gas and electricity sectors. As an adjudicative tribunal, the OEB carries out many of its regulatory functions through public hearings. The OEB also carries out some of its responsibilities through the creation and enforcement of rules for the natural gas sector and codes for the electricity sector, as well as through the issuance of policies and guidelines to inform and guide participants in both of those sectors. All of the OEB s adjudicative and policy work are conducted through open and transparent processes, with a focus on long-term outcomes, reasoned decisions and practical solutions. The OEB performs its mandate under a statutory framework in the Ontario Energy Board Act, 1998, which sets out a number of objectives to guide the OEB s work. Objectives relating to pricing, energy conservation, reliability and quality of service, and the maintenance of a financially viable industry are common to both sectors. Competition, the rational development and expansion of infrastructure, and communication and consumer education are additional objectives in relation to natural gas. Additional objectives in relation to electricity are economic efficiency and costeffectiveness, smart grid implementation and the use of renewable energy sources. The details of the OEB objectives are provided in Appendix A. Response to 2 (b) (i): Electricity Distribution The OEB regulates the rates of the 77 local electricity distributors that operate Ontario s local electricity delivery networks. These networks are essential to the seamless delivery of electricity from generators to end users. The OEB has employed incentive regulation ( IR ), including formula-based and costbased rate-setting. Under this approach, the OEB uses one-year forecasted cost and revenue information to determine a base revenue requirement (i.e., total costs) and the base rates that are set to recover that revenue requirement. The revenue requirement approved includes a rate of return approved by the OEB based on a fair return standard. In subsequent years, those base rates are adjusted annually according to an OEBapproved formula that includes components for inflation and the OEB s expectations of 3

8 efficiency and productivity gains. The structure of the IR framework is an inflation minus X-factor price-cap form of rate adjustment mechanism, which is intended to incent innovation and efficiency. The X-factors for individual distributors consist of an empirically derived industry productivity trend and differentiated stretch factors. At the conclusion of the IR term, distributors file applications to rebase their rates under cost of service and the updated base rates become the starting point for the subsequent IR term. The IR framework for electricity distributors includes off-ramp. If in any year during the IR term, a distributor has an actual Return on Equity ( RoE ) that is more than 300 basis points above or below the OEB approved RoE, the off-ramp provision of the IR framework is triggered. If the off-ramp provision is triggered, a regulatory review may be initiated to review the distributor s performance. Any such review would be prospective in nature and could result in modifications to the IR plan, a termination of the IR plan or the continuation of the IR plan. A Z-factor provision is also included to address extraordinary events that may occur during the term. Electricity Distribution Beginning 2014 The OEB on October 18, 2012 released its Report on a Renewed Regulatory Framework for Electricity ( RRFE ). In the RRFE Report, the OEB noted that its approach to rate-setting must continue to support a sustainable, financially viable and reliable electricity system. The OEB stated that it must do so in a manner that is responsive to customers concerns about affordability, by promoting increased efficiency which in turn can lower costs and provide for more predictable rates. It must also do so in a manner that better accommodates differing circumstances of distributors (for example, with respect to customer expectations, asset profile and investment needs) and facilitates the cost-effective and efficient achievement of expected performance outcomes. The OEB also noted that the rate regime must recognize the inter-connected nature of the electricity system in Ontario, promote ongoing productivity improvements, encourage innovation, and support efficient regulation. This new framework will still be based on incentive regulation but options will be available to distributors. For example, a Custom option will be available to distributors to propose a rate-setting mechanism that accommodates the distributor s circumstances, while still meeting the OEB s expecting outcomes and just and reasonable rates. Natural Gas Distribution In contrast to electricity distribution, the OEB regulates only three natural gas distribution companies; two very large distributors (Union Gas Limited and Enbridge Gas Distribution Inc.) and one small distributor. Similar to the electricity sector, the OEB used a one-year forecast of cost and revenue information to determine a base revenue requirement and the base rates are set to recover that revenue requirement ( including a rate of return). The key difference from electricity rate regulation is that the OEB does not have a generic policy framework for gas IR. Instead, each distributor brought forth an 4

9 application to the OEB proposing how they would like to design their IR framework which would be applied beginning in This resulted in slightly different IR frameworks for Union and Enbridge. For the period , Union s and Enbridge s IR frameworks included an inflation minus X-factor (productivity factor) annual rate adjustment. The IR plan also included Z- factor provisions (similar to electricity distributors), Y-factor provisions (pass-through items), and an earnings-sharing mechanism ( ESM ) with ratepayers if actual earnings are more than 200 and 100 basis points (above the OEB-approved RoE) for Union and Enbridge, respectively. At the conclusion of the IR term, natural gas distributors file applications to rebase their rates and the new base rates set the starting point for the subsequent IR term. Response to 2 (b) (ii): Financial Incentives A financial incentive is built into the incentive regulation plan formula for electricity distributors. Rates are adjusted by inflation less a productivity factor that is established by the OEB. The productivity expectations are lower for distributor with the best cost efficiency. The IR plan allows distributors to earn in excess of the regulated return if efficiency improvements exceed the productivity expectations established by the OEB. Furthermore, the OEB s expectations for productivity improvements are lower for those distributors with the best cost efficiency performance. Financial incentives similarly exist in the two gas distribution incentive regulation plans. An earnings sharing mechanism is in place to share with customers a percentage of any earnings that exceed a certain level. Conservation & Demand Management ( CDM ) and Demand Side Management ( DSM ) The OEB has implemented specific financial incentives for electricity and gas utilities in relation to their achievement of conservation and demand management results. The incentive payment is made on the basis of the company s achieved verified results in meeting specific targets. For gas utilities, the DSM targets are negotiated in settlement agreements with interested stakeholders and approved by the OEB. For electricity utilities, CDM targets are a condition of licence. Financial Penalties For electric and gas utilities, potential financial penalties are associated with enforceable provisions. Where the OEB is satisfied that a utility has contravened an enforceable provision, the OEB may make an order requiring a utility to pay an administrative penalty. Appropriate compliance processes are in place and followed prior to a penalty being levied on a company. 5

10 Response to 2 (b) (iii): In almost all cases, the rate regulation results in an approved rate order that must be applied for the services provided by the electricity and natural gas utilities. However, there are a few exceptions where the OEB provides some flexibility to the utility to set an appropriate price for a given service. In the gas sector, for example, Union offers some transportation and storage service to natural gas shippers/retailers. For Short- Term Storage and Balancing Services, the OEB sets an approved maximum rate that can be charged and allows Union to negotiate the actual price charged with customers seeking the service. Response to 2 (b) (iv): None Question 3: What sort of rights or obligations does the regulation create? In providing this information, please consider: a) whether the rate-regulated entity has an exclusive right to operate in the market; b) if the entity s right to operate in the market is established by licence: i. is there a cost to acquire the licence; and ii. can the licence be revoked, renewed or transferred; c) how competition is excluded or encouraged; d) how the rights and obligations are expressed, for example, as a cap on the rate of return, as the right to recover entity-specific costs, as a right to recover an allowed level of costs (whether or not incurred by the entity), or as a right to recover specific types of costs without limit if and when incurred; and e) whether the entity can choose to stop providing the goods or services that are subject to rate regulation and, if so: i. how is this achieved; and ii. what are the consequences for the entity? 6

11 Responses to Question 3: (general followed by specific responses to questions) The following is a summary of the OEB s regulatory mandate which serves to establish rights and obligations with respect to the goods and services in the energy sector. Natural gas rates and facilities: The OEB approves the rates that can be charged for monopoly natural gas distribution and transmission services. Through this ratesetting process, the OEB also regulates the demand-side management activities of natural gas distributors. The OEB also has authority to set natural gas commodity prices and approve municipal franchise agreements relating to the supply of natural gas in municipalities. Mergers and acquisitions by natural gas distributors and transmitters are also subject to OEB approval, as are larger natural gas infrastructure (pipelines) projects. Electricity rates and fees: The OEB approves the rates that can be charged for monopoly electricity distribution and transmission services. The OEB sets electricity commodity prices, as well as payments ( prices ) for the output of certain prescribed generation facilities operated by Ontario Power Generation Inc. (OPG), the largest electricity producer in the province. Electricity system planning and facilities: The OEB has authority to mandate and approve electricity distribution and transmission system plans to facilitate renewable electricity generation connection and smart grid development. Mergers and acquisitions by electricity distributors and transmitters are subject to OEB approval, as are larger electricity transmission line projects. Licensing of electricity and natural gas participants: Through the licensing function, the OEB regulates the conduct of all participants in the electricity sector and the activities of marketers that sell natural gas to low-volume consumers. Through the licensing process, the OEB also sets the conservation and demand management targets to be met by electricity distributors. Electricity and natural gas conservation programs: The OEB objectives include the promotion of energy conservation. The OEB approves conservation targets for distributors and monitors and reports on the results. Retail electricity and natural gas markets: The OEB s regulation of the competitive retail market sector includes establishing rules to govern the conduct and business practices of electricity retailers and natural gas marketers, particularly in relation to low-volume consumers in keeping with enhanced consumer protection objectives inherent in the Energy Consumer Protection Act. Wholesale electricity market: The OEB s oversight of the wholesale electricity market includes the authority to review amendments to the market rules and of electric reliability standards. The OEB s mandate also includes the responsibility of the Market Surveillance Panel, which monitors the wholesale market and has authority to investigate activities related to that market or the conduct of wholesale market participants. 7

12 Response to 3 (a): Electricity utilities have service areas that are approved by the OEB as part of the distributor s licence. Natural gas utilities must obtain a certificate of public convenience and necessity ( Certificate ) for each municipality where they supply natural gas to a person. Neither gas nor electricity transmitters have approved service territories or Certificates for transmission services. As a practical matter, however, the natural gas utilities have Certificates for all municipalities through which their transmission pass, as they also provide distribution services in those municipalities. With respect to natural gas storage, the OEB must designate an area for gas storage, and then authorize a utility to store in this designated area before gas can be injected into storage. The only rate regulation of electricity generation in the province is with respect to the majority of OPG s assets. OPG s facilities are located in several parts of the province, and it does not have a service territory since it supplies electricity to the province-wide grid. Response to 3 (b): The OEB licenses all electricity distributors, transmitters, retailers, marketers, wholesalers and generators in the province. Only distributors, transmitters, and most of OPG s generation assets are rate regulated. The initial fee for a licence is $1000, plus an annual fee of $800. Licences can be revoked by the OEB if the provisions of the licence are not followed. Licences can be renewed by the OEB, and they can be transferred with leave of the OEB. The OEB also has the power to issue an emergency interim licence to a party to undertake any of the activities for which a licence is required. This power is used to allow a third party to operate the facilities of a licence holder where that licence holder is no longer able to do so to the OEB s satisfaction. The OEB does not have any licensing powers with respect to the sale, storage, distribution or transmission of gas, but it does approve franchise agreements for the distribution of natural gas. As described above, the OEB does authorize a utility to inject natural gas into a designated storage facility, although this is not formally a licence. Response to 3 (c): Exclusion of Competition The distribution and transmission / transportation of electricity and natural gas are naturally monopolistic. The construction of parallel infrastructure to deliver electricity / gas to customers is not economically efficient. Therefore, there are natural barriers to competition in these areas of the market. 8

13 Competition in the distribution of electricity is restricted through the OEB s licensing practices. The licence granted to electricity distributors sets out the geographic area in which the distributor is licensed to serve electricity customers. If a licensed distributor wishes to serve a customer in another distributor s service area, it must initiate a Service Area Amendment ( SAA ) proceeding with the OEB to decide whether a service area should be expanded / retracted. SAA proceedings typically occur when a new development (residential development, industrial plant, etc.) is being built on the border of neighbouring distributors. The OEB also effectively excludes competition in the distribution of natural gas through its approval of Certificates of Public Convenience & Necessity ( Certificates ) and Franchise Agreements for the gas distributors. The areas that gas distributors have the right to serve are based on the Certificates which are issued by the OEB. In addition, Franchise Agreements set out the terms, conditions, and period of time for which the distributor has the right to construct and operate works for the distribution of natural gas and the right to extend and add to the works in a given municipality. Franchises are agreements entered into between the utility and the municipality (and are approved by the OEB). Encouragement of Competition - Competition in the Supply and Retailing of Electricity and Marketing of Natural Gas Ontario s electricity and natural gas sectors have competition in the supply and retailing of the commodity. In the electricity sector, a pool market system is in place. The prices of the pool electricity are based on frequent auctions (hourly) between generators who wish to supply electricity into the pool, and this electricity market is overseen by the Independent Electricity System Operator (IESO). Customers obtain their supply of electricity by either signing a contract with an electricity retailer, or through the standard supply service provided as a default by their distributor. Customers can also opt to be a wholesale market participant and settle for their supply of electricity directly with the IESO, an option generally only selected by large consumers. Low volume consumers on the standard supply service are charged for electricity based on a Regulated Price Plan ( RPP ). The RPP prices are set by the OEB. Electricity retailers are not rate-regulated by the OEB but they must have a licence approved by the OEB to retail electricity in the province. There are also certain code requirements applicable to electricity retailers that must be followed. The OEB s compliance process ensures that retailers are complying with the applicable requirements. In the natural gas sector, customers have the option of paying their distributor directly for the commodity (known as system supply customers) or can sign a long-term contract with a natural gas marketer (known as retail customers). For system supply customers, the gas distributor procures natural gas supplies (and related transportation service) for its customers in accordance with its OEB-approved gas supply plan. Gas distributors pass on the market price of natural gas to its customers (with no markup). 9

14 Gas marketers are not rate-regulated by the OEB but they must have a licence approved by the OEB to market natural gas in the province. There are also certain code requirements applicable to natural gas marketers that must be followed. Forbearance of Rate-Regulation In exceptional circumstances, the OEB has determined that it would forebear from rateregulating certain activities that were once rate-regulated where it finds that there exists competition sufficient to protect the public interest. An example of this was the OEB s decision in the Natural Gas Electricity Interface Review proceeding. The OEB determined that Ontario storage operators compete in a geographic market that includes Michigan and parts of Illinois, Indiana, New York and Pennsylvania. The OEB found that the market for natural gas storage is competitive and that neither Union nor Enbridge has market power. As such, the OEB no longer regulates the prices charged for certain storage services. Affiliate Relationships Code The OEB has Affiliate Relationship Codes ( ARC ) for both electricity distributors and transmitters and for natural gas utilities. The ARCs set out the standards and conditions governing the relationship between electricity / gas utilities and their respective affiliated companies. One objective of the ARCs is to prevent a utility from cross-subsidizing affiliate activities, which are competitive. Cross subsidies could create a competitive advantage. Response 3 (d): Electricity and gas distributors can recover their prudently incurred costs and fair rate of return (approved RoE) as determined by OEB. A fair rate of return allows the distributors shareholders to be compensated for the risks involved in operating the utility. It also ensures that continued capital investment can be attracted or borrowed in order to maintain sustainable electricity and gas sectors in the province. A utility that earns less than the regulated return approved by the OEB in its revenue requirement cannot seek to recover the difference. With the OEB s incentive regulation approach, a utility that earns in excess of the approved regulated return keeps the additional earnings, though for natural gas when earnings reach a certain level, a percentage of any additional earnings is shared with customers. There is an off-ramp provision built into the IR plans for the electricity distributors and Enbridge Gas Distribution. If actual earnings are above or below an established threshold, a regulatory review is triggered. For both the electricity and gas distributors, certain cost / revenue items are subject to deferral or variance account treatment. The associated rights and obligations are discussed in response to Question 4. Response 3 (e): Please see response to Question 4 (c) below. 10

15 Question 4 For the rights and obligations identified in response to Question 3, how does the rate-regulated entity enforce its rights, or how does the rate regulator enforce the settlement of the rate-regulated entity s obligations? In providing this information, please tell us: a) does the rate regulation provide for retrospective recovery or reversal of under- or over-recoveries of allowable costs? If so, how is this achieved, for example through cash payments or other asset transfers to or from parties outside the rate-regulated entity (such as individual customers or groups of customers, the rate regulator or the government); b) are the rights and obligations separable from the business; and what happens to the rights or obligations when the entity ceases to provide the rateregulated goods or services? Responses to Question 4: Response to 4 (a): Under rate regulation, the prices or rates are considered just and reasonable because they provide a rate regulated utility the opportunity to recover the costs it has appropriately incurred in providing monopoly services (e.g., delivery of electricity or natural gas), and because customers are protected from paying higher prices or rates for these services than otherwise would occur in the absence of competition. The OEB has established rights and obligations for the utilities and their customers when it determines fair and reasonable prices/rates for the services offered by utilities. The regulator accomplishes this by determining the amount of revenue the utility needs to cover its operating expenses, depreciation, cost of capital including a return (via a method known as the rate base treatment) and the associated income taxes. Regulatory deferral and variance accounts are part of this regulatory framework that underpins fair and reasonable rates. Consequently, deferral and variance accounts are part of the regulatory formula, and as such, they are generally accepted regulatory tools designed to allow a utility to recover prudently incurred costs and earn a fair return and to ensure the utility s customers pay no more than is required for receiving the service. Rate regulation allows a utility to defer its incurred costs or earned revenues in deferral or variance accounts in one accounting period to be recovered or refunded in a subsequent accounting period(s). In the energy sector in North America, this accounting 11

16 practice was prevalent for many years even before its formalization in 1982 in Accounting Standard Code 980 (formally Statement of Financial Accounting Standards No. 71). The ratemaking actions of the rate regulator establish a cause and effect as to the timing of when the deferred amounts are recovered from or refunded to a utility s customers. This in turn directly impacts the utility s revenues/expenses (statement of comprehensive income), capital assets/obligations (statement of financial position) and cash flows (statement of cash flows) in a particular accounting period. In the regulatory framework, the ratemaking actions and decisions of a regulator provide rights and obligations to both the utility and its customers in terms of when deferred amounts are included in the rates charged to the utility s customers. Regulatory accounting does not just have an impact on the utilities revenues/expenses. Another component with respect to the deferral of amounts affecting regulated entities is the deferred impacts on capital assets (i.e., items of property, plant and equipment). The energy sector is a very capital intensive industry which requires material cash outlays for continuous spending on refurbishments and replacements of existing systems, expansions and new infrastructures, new innovations (e.g., conservation and demand management programs) and technological advancements (e.g., smart metering, renewable energy and smart grid). The OEB determines the timing of the capital assets inclusion in rates through the rate base treatment which provides for the recovery of depreciation expenses, cost of capital including a return on equity and the associated income taxes. The OEB has approved advanced funding in the rates of utilities prior to their completion of new initiatives, such as smart meters and renewable energy connections (for new assets installed to accommodate renewable generation connect to utility s distribution system). In addition, the OEB has prescribed capital asset-based deferral accounts for smart meters, renewable energy connections and smart grid. These capital assets are not included in a utility s rate base until they are reviewed and approved as prudently incurred costs by the OEB. The associated deferred current period costs (operations, maintenance, administrative and depreciation expenses) also recorded in associated deferral accounts are approved concurrent with the associated capital assets in deferral accounts. In some cases where the OEB has determined certain costs were not prudent, cost recoveries were disallowed. On July 31, 2009, the OEB issued its Report of the Board on Electricity Distributors Deferral and Variance Account Review Initiative to more clearly define regulatory policies and procedures, to reduce the risk and uncertainty associated with the recovery of deferral or variance account balances, and to meet statutory requirements. The OEB has established review processes for the timely review and clearance of electricity deferral and variance account balances in two groups, as follows: Group 1 comprises several OEB-authorized generic variance accounts for the pass-through of costs (e.g., electricity commodity and transmission services) from third party service providers (e.g. Ontario s Independent Electricity System Operator) to electricity distributors and ultimately to their customers. The passthrough of these costs (with no added profit margin) to customers impacts the 12

17 cash flows, but not the profit or loss of distributors. These account balances do not require a review for prudence prior to disposition, and are approved and included in the annual rate orders of distributors. This systematic approach mitigates inter-generational inequities and eliminates the accumulation of large account balances while also enhancing the utilities ability to manage their cash flows. Group 2 comprises several OEB-authorized generic deferral/variance accounts in relation to the utilities operations that are reviewed in cost of service applications since these applications facilitate detailed reviews for prudence required for these accounts. The deferral of these costs/revenues impact the profit or loss, the capital assets or obligations and cash flows of distributors. The approved account balances are included in the rates in the rate orders of distributors. In addition, a distributor may file an application to recover non-typical or extraordinary event costs, which are permitted by the OEB as Z-factor adjustments under the incentive regulation plan, recorded in a specified deferral account. These costs include weather related storm damages and changes in income tax rates arising from new legislation. The utility tracks these costs in a deferral account. In the case of storm damages, the request for the associated cost recovery must satisfy the criteria of causation, materiality, and prudence. The amount must have been prudently incurred and represented the most cost-effective option (not necessarily least initial cost) for ratepayers. The OEB uses an accounting order, as a regulatory instrument, in establishing the accounting details including accounting entries for the deferral and variance accounts that may be unique to a utility and approved in the utility s rate proceeding. The accounting order is intended to reflect the OEB s decision for the regulatory accounting requirements and establishes rights and obligations for the utility. In the natural gas sector, there are specific OEB decisions and orders or similar policy guidelines including the quarterly or annual reviews to clear natural gas pass-through costs recorded in a variance account. For example, the OEB s rate regulation provides a true-up mechanism to clear the differences between forecasted and actual amounts related to the cost of natural gas delivered to customers. To accomplish this, the OEB has established a purchase gas variance account ( PGVA ) for the natural gas utilities to record the difference between the actual price of gas (including upstream transportation) and the forecast utility price charged to customers in rates. Lastly, the approval of the deferral and variance account balances results in the recovery/refund through rate orders issued by the OEB to the utilities. The recovery/refund is allocated to different groups of customers based on factors approved by the OEB. 13

18 Response to 4 (b): The regulated entity s business cannot be carried out by another entity including an affiliated entity of the regulated entity. Enforceable requirements included in the legislation, licence, orders, codes or rules require utilities to fulfil their obligations which are not separable from the utility business. For example, the licences for electricity distributors in Ontario specify terms and conditions with which a distributor ( the licensee ) has an obligation to comply. Failure to do so could result in administrative penalties. Response to 4 (c): A utility may cease operations as a legal entity through a change in ownership as a result of a merger, amalgamation, acquisition or divestiture (MAAD). However, the OEB has the legislative authority that requires its approval of all MAADs in the rate regulated electricity sector. As a result, the rights and obligations of a predecessor utility are continued in a new successor utility when the OEB approves a MAAD application, and through the terms and conditions in a new licence. In addition, this regulatory process ensures that the rights and obligations of electricity customers in the affected service area are protected through the continuation of delivery services and authorized rates. In the past 15 years, this has been a common occurrence due to the going consolidation of the electricity sector in Ontario. The number of regulated gas utilities has remained unchanged for many decades. In the extreme circumstance if an entity s licence is revoked, the rights and obligations are expected to be transferred to a successor utility. In this circumstance, the OEB has the legislative authority that allows it to appoint an interim utility operator to continue the operations of the service area of a particular utility due to, for example, its bankruptcy or inability to provide adequate delivery service. Question 5 How does the rate regulation ensure the recovery or reversal of under- or overrecoveries of allowable costs (ie variance amounts) (if applicable)? Are these mechanisms effective in recovering or reversing those amounts within the targeted time frame? In providing this information, please tell us: a) what is the mechanism for tracking the recovery or reversal of such variance amounts; b) how does the rate-setting mechanism adjust for unexpected changes in demand for the rate-regulated goods or services; 14

19 c) has there been a recent trend whereby the balances of the variance amounts have been increasing? If so: i. is this caused by an increase or a decrease in the demand of the rateregulated goods or services; ii. has the trend resulted in a net debit position (ie under-recovery of costs) or a net credit position (ie over-recovery of costs); and iii. what are the main components of the variance amounts (ie what are the main categories of cost or income variances)? Responses to Question 5: Response to 5 (a): The OEB has reporting requirements in place for rate regulated utilities including the quarterly and annual reporting of deferral and variance account balances. These regulatory account balances are also reported in the utilities financial statements reported to the OEB. The balances in these accounts are monitored by the OEB as part of its statutory requirement to ensure the timely consideration of the accumulated account balances detailed in response to 4 a). The two charts below provide summaries of Ontario s electricity and natural gas utilities regulatory deferral and variance account balances for year-end

20 The recoveries/refunds arising from the approval of deferral and variance account balances are included in the rate orders issued by the OEB to the utilities. The rate orders have designated rate riders to recover / refund the approved balances over a specified period (i.e., up to the expiry date set for the rate rider). As an example of a tracking mechanism, the approved deferral and variance balances of electricity utilities are tracked in a special tracking of recovery/refund account. At the end of the rate rider(s) period, the net of the approved deferral and variance account balances and the recovered/refunded amounts may result in a residual debit or credit balance, which utilities are allowed to recover but required to refund to their customers. This tracking mechanism ensures that the utilities have rights/obligations to recover/refund the full amount of their approved account balances. In addition, there are other tracking mechanisms that allow the residual balances to be carried forward in the specified regulatory account for subsequent review and approval. An example of this is the gas utilities PGVA which permits the residual amount from a prior period to be rolled up in the new balance arising in a subsequent period. Response to 5 (b): As part of a cost of service rate application, the OEB approves rates which have been designed from the forecast of both costs and sales volumes (i.e. demand) for the utility. A revenue requirement is determined from the forecast costs, and the rates are 16

21 designed to recover these costs based on the forecast of sales volumes. The rate of return included in the revenue requirement for the utility is expected to take into account the normal risk of fluctuating demand. There are unique circumstances that may arise where a utility loses a large use of energy customer (e.g., due plant closure of a large pulp and paper company or automotive manufacturer) resulting in a material loss of demand. In such a case, a utility has options to request a resetting of its rates to address the unexpected loss in demand to ensure that it continues to recover prudently incurred costs. An off-ramp could also be triggered if the requirements are met. The off-ramp is symmetrical and as such, a utility that either under-earns or over-earns by a certain margin due to, among other things, high growth demand, could be subject to a regulatory review. The OEB has also established a specific variance account (Loss Revenue Adjustment Mechanism) to capture decreases in revenue due to the loss of demand arising from conservation and demand management programs in the electricity and gas sectors. The variance account captures revenue losses arising from lower demand due to successful conservation/demand programs that are recoverable through this variance account in the future. With respect to the recovery/refund of deferral and variance account balances, even if there are unexpected changes in demand, as discussed in 5 a), there are tracking mechanisms to ensure that the full amount of approved account balances are either recovered or refunded. Responses to 5 (c) (i), (ii) and (iii): There is a recent trend whereby the debit balances in the variance amounts have increased. However, this is not attributable to changes in demand, but rather due to cost increases attributable to new initiatives. In 2006, the Ontario government initiated a smart meter multi-year conversion program for electricity customers. The overall costs for the installation of about 4.7 million smart meters over several years were recorded in OEB approved deferral accounts. As a result of the Green Energy and Economy Act, 2008, utilities have obligations to connect sources of renewable energy to their electrical system, and as such, have incurred additional costs for renewable generation connections which are recorded in deferral accounts or allowed in their revised rates. 17

22 Appendix A Electricity Objectives: The Ontario Energy Board Act states that the OEB, in carrying out its responsibilities under this or any other Act in relation to electricity, shall be guided by the following objectives: a) To protect the interests of consumers with respect to prices and the adequacy, reliability and quality of electricity service. b) To promote economic efficiency and cost effectiveness in the generation, transmission, distribution, sale and demand management of electricity and to facilitate the maintenance of a financially viable electricity industry. c) To promote electricity conservation and demand management in a manner consistent with the policies of the Government of Ontario, including having regard to the consumer s economic circumstances. d) To facilitate the implementation of a smart grid in Ontario. e) To promote the use and generation of electricity from renewable energy sources in a manner consistent with the policies of the Government of Ontario, including the timely expansion or reinforcement of transmission systems and distribution systems to accommodate the connection of renewable energy generation facilities. Natural Gas Objectives: The Ontario Energy Board Act states that the OEB, in carrying out its responsibilities under this or any other Act in relation to gas, shall be guided by the following objectives: a) To facilitate competition in the sale of gas to users. b) To protect the interests of consumers with respect to prices and the reliability and quality of gas service. c) To facilitate rational expansion of transmission and distribution systems. d) To facilitate rational development and safe operation of gas storage. e) To promote energy conservation and energy efficiency in accordance with the policies of the Government of Ontario, including having regard to the consumer s economic circumstances. f) To facilitate the maintenance of a financially viable gas industry for the transmission, distribution and storage of gas. g) To promote communication within the gas industry and the education of consumers. 18