ENERGY MARKETS B U L L E T I N

ENERGY MARKETS B U L L E T I N JANUARY 14, 2004 ELECTRICITY CONSERVATION AND SUPPLY TASK FORCE REPORT THE NEW BLUEPRINT FOR ONTARIO S ELECTRICITY SECTOR? BORDEN LADNER GERVAIS LLP

ELECTRICITY CONSERVATION AND SUPPLY TASK FORCE REPORT THE NEW BLUEPRINT FOR ONTARIO S ELECTRICITY SECTOR? Introduction Dwight Duncan, the Ontario Minister of Energy, earlier today released the report (the Report ) of the Electricity Conservation & Supply Task Force (the Task Force ) entitled Tough Choices: Addressing Ontario s Power Needs. In releasing the Report, Minister Duncan stated that the Report reinforces that we need to make dramatic changes to the sector and provides a foundation for setting a new direction and developing a responsible and sustainable policy for Ontario s electricity sector. The Government will introduce a new vision for Ontario s electricity sector this Spring through a number of legislative initiatives. The Task Force has undertaken a major review of difficult issues in a short period of time and has delivered a concise and clear summary of the issues which the Government has committed to address. The issues are multifaceted and will not only require legislation but are effectively calling for a stronger role by the Government and its various agencies in both the short term and long term. In addition to legislation and a sustained leadership role by the Government, the Government will have to establish the key priorities for moving forward as well as determining how financial liquidity and stability can be provided to allow some of the key identified stakeholders the ability to meet those priorities. It is however very encouraging to see that the Minister has committed to make those changes to better serve the needs of Ontarians. If the recommendations are to be implemented, either new legislation will be required or the Energy Competition Act, 1998 will require significant revision. The next few months will provide an important opportunity for all stakeholders to assist the Government in developing a workable plan with short, medium and long term targets that will preserve Ontario s competitiveness while reflecting the true cost of power and providing stable, reliable and environmentally beneficial supply. BORDEN LADNER GERVAIS LLP Page 2

Overview The Task Force was appointed by the Ontario Government at the end of June 2003 to develop recommendations which would promote conservation, enhance the reliability of the transmission grid and foster the development of new generation. 1 The Task Force recommends some fundamental changes to Ontario s electricity sector, concluding that the market approach adopted in the late 1990s needs substantial enhancement if it is to deliver the new generation and conservation Ontario needs, within the timeframes we need them. The Task Force identified the following four fundamental changes in the energy sector since the prior Government adopted the Energy Competition Act in 1998: The collapse of merchant generation and related energy trading markets following the demise of Enron and other energy traders; The Liberal Government s commitment to phase out coal-fired generation by 2007; The new Government s commitment to keep all Ontario Power Generation generation assets in public ownership; and The increased level and volatility of natural gas prices. The Task Force concluded that these factors and others have necessitated a reworking of the prior Government s plan to base Ontario s electricity sector on a largely market-driven model with light-handed regulation by an independent regulator and minimal intervention by the provincial Government. Based on the input it received from various sources, the Task Force concluded that there was support for an electricity sector that is based on competitive principles. The Task Force believed that there is general agreement that the old Ontario Hydro monopoly should not be recreated and that consumers understand that artificially low prices subsidized by the Government constitute a major disincentive to both new generation supply and conservation efforts. If the Report s principal recommendations are adopted, significant new legislation and the creation or designation of a new power procurement agency will be required. 1 The Task Force was composed of representatives from a broad spectrum of stakeholders including the Association of Major Power Consumers of Ontario, the Association of Power Producers of Ontario, the Electricity Distributors Association, the Power Workers Union, the Ministry of Energy, representatives of the two Government owned utilities, Hydro One and Ontario Power Generation ( OPG ), the Independent Electricity Market Operator ( IMO ) and several private sector representatives. The former Conservative Government appointed the Task Force; the Liberal Government that took office in Ontario in October 2003 asked the Task Force to continue its work. The Report notes that not all members of the Task Force agreed with all recommendations. BORDEN LADNER GERVAIS LLP Page 3

Summary of Principal Recommendations The Report underlines the need for new investment in the Ontario electricity sector but identified a wide range of barriers to investment that need to be addressed. The Task Force concluded that relying on market signals alone is simply too risky an approach to take given the potential consequences of failing to achieve the needed early investments in new supply and conservation. The Task Force seeks to find a middle ground between a pure market model and the central planning of the old Ontario Hydro monopoly model. A key focus for the Task Force was the need to develop a plan that works for all electricity consumers. A. Consumer Impacts The Task Force believes it is important to make the electricity sector work for consumers and made the following recommendations from the perspective of consumers: Standard supply service 2 or default supply should be available at stable prices determined by the Ontario Energy Board ( OEB ) that reflect the true cost of power. All consumers should have access to contracting with energy retailers and wholesalers. The OEB will be mandated to develop new mechanisms for setting default supply prices in future. Spot-markets should not be the primary basis for establishing electricity prices for most Ontario consumers. The OEB should consider establishing a price which blends a number of supply sources including: (i) the cost of power from OPG s existing generating facilities; (ii) long-term contracts; (iii) shorter term contracts; and (iv) the spot market. OPG s existing nuclear and hydraulic generation facilities would be categorized as heritage power. Prices from such assets, which have low marginal operating costs, could reflect their actual cost to produce power rather than a market-based price. Default supply prices should be established so that such arrangements do not unduly impede retail competition. A comprehensive and coordinated approach to providing consumers with information concerning the electricity market and how they can control their energy costs is necessary. 2 The OEB has used the term Standard Supply Service; the Report refers instead to default supply. BORDEN LADNER GERVAIS LLP Page 4

To permit consumers to see the benefit of adjusting their consumption, rates should be structured for default supply customers that reflect differences in power prices between peak and off-peak periods. The OEB should ensure a greater accountability among Hydro One and local distribution companies ( LDCs ). The Report s recommendations concerning default supply pricing and maintaining a retail market may prove difficult to reconcile. It is not clear what factors the OEB might use to establish the default supply price. Previously, the attractiveness of a retail offering had been based on the stability and predictability provided by fixed prices offered by retailers even if those prices were somewhat higher than the default supply price based on a more volatile spot-market price. The Report does not address how these somewhat disparate recommendations will be implemented; the Government or the OEB will have to respond to that challenge. B. Encouraging Conservation A major focus of the Report is the need for measures that will promote conservation. The Task Force makes the following recommendations on conservation and demand management: Ontario should create a conservation culture and the Government should develop a long-term and comprehensive conservation strategy with clear targets for conservation. The IMO should introduce changes necessary to facilitate demand response in the wholesale energy market including: allowing demand response capacity to be bid into any capacity market on the same basis as supply capacity. consumers should be encouraged to shift consumption from peak periods to off-peak periods through differentiated prices and incentives for the use of smart meters. Retailers, energy service companies and LDCs should be given benefit sharing opportunities to encourage investment and marketing of new technologies and services that help to reduce consumption and shift consumption to off-peak hours. LDCs and transmitters should be compensated through rates for investment in demand side management based on the natural gas industry model. LDCs should evaluate proposed conservation initiatives on an equal basis with new supply options and distribution investments. The private sector should be recognized by the OEB as an alternative to LDCs in the delivery of conservation measures. BORDEN LADNER GERVAIS LLP Page 5

Government should enhance conservation through tax incentives, development of energy efficiency standards and reduction of Government electricity consumption. The Task Force recommends the creation of a conservation champion to coordinate conservation activities and to serve as the focal point for a conservation culture in Ontario. The report suggests that the OEB or possibly another organization could fulfil this role. The Task Force supports the OEB initiative which is to report in the spring of 2004 on the appropriate organization and funding of conservation in Ontario. C. Ensuring Adequate Supply The Report concludes that Ontario urgently needs investment in new generation and recognizes the difficulties that the private sector has encountered in committing to new generation initiatives in Ontario. The Task Force notes that the concept of merchant generation, under which new generating facilities would be built without long-term power purchase agreements but relying instead on sales into a wholesale market, has not worked to create new generation facilities in Ontario. The Task Force also notes that the meltdown in U.S. energy markets with the insolvency of many energy traders has resulted in a lack of creditworthy counterparties who would commit as purchasers to buy power under long-term power purchase or tolling agreements. The Report concludes that the spot-market cannot be the primary mechanism for attracting investment in new supply to the Ontario market. The Task Force suggests that a number of transitional measures are required in the near term which must be designed to support the development of a well functioning contract-based market over the longer term. The Task Force believes that Ontario should move toward a market model based on longer term contracts among multiple buyers and multiple sellers. However, the Task Force recognizes that a number of immediate steps need to be taken to address short-term supply needs. The Task Force s principal recommendations to ensure new supply are as follows: The Ontario Government should provide guidance to the IMO on the desirable composition of supply and demand in the Ontario electricity system. Rather than the marketplace determining what types of generation should be built, the Task Force is staking out a role for the provincial Government to determine what type of generation should be built in Ontario, what environmental criteria it must meet, what the supply needs are on a regional basis across the province and how imports will be factored into the supply mix. The IMO should be charged with developing a long-term integrated system plan within the context of the Ontario Government policy direction. The plan would reflect consultation with the Government, the OEB and a broad spectrum of investors and customers in order to guide development of supply and demand resources. BORDEN LADNER GERVAIS LLP Page 6

The IMO will be required to determine adequate reserve margins for Ontario consistent with international standards for adequacy and reliability with authority to implement and maintain those reliability requirements. On a transitional basis, the Task Force recommends the establishment of an agency that would enter into a portfolio of long-term, short-term and medium-term contracts with generators to supply Ontario s needs. The agency would have the ability to recover the costs associated with this new generation supply from customers. The agency would contract for supply through an open competitive process under procedures established by the Ontario Energy Board. The portfolio of contracts would reflect the Government s guidance on desired supply mix. The Task Force is clearly leaving to the Government, rather than to the marketplace or to a regulator such as the OEB, the decision as to the generation fuel mix which is most suitable for Ontario. The Task Force suggests that the IMO could possibly be this new procurement agency but recognizes that other alternatives are also feasible. To achieve the longer term objective of a portfolio of contracts involving multiple buyers and multiple sellers, the Task Force recommends that the market be developed around a number of load serving entities which would take on the responsibility for acquiring electricity for customers who do not deal directly with a supplier. The Task Force envisions that six to eight load serving entities would be needed to serve the province and that LDCs, wholesalers and retailers could fulfil this role. The specifics of how this approach would work and how load serving entities would be constituted have not been fully developed by the Task Force. The Report does not address the need to repair the damage caused by the Energy Pricing, Conservation and Supply Act, 2002 ( Bill 210 ) to the creditworthiness of LDCs in order for them to have the necessary financial capability to commit to large long term power purchase arrangements. In a recommendation that seems to address concerns raised by existing private generators and investors, the Task Force recommends that existing contracts and more recent investments should not be penalized through the contract market that would be developed. The spot-market would continue to operate, but only as a balancing market. The day-ahead market and futures market should be developed by the IMO. The IMO should be required to project supply and demand trends for 25 years rather than the current 10 year outlook it publishes as well as its 18 month forecast. BORDEN LADNER GERVAIS LLP Page 7

The Task Force recommends streamlining and shortening the timeframe for siting and approvals for new generation and transmission projects. The Task Force recommends the creation of a further task force to review Ontario regulatory and approval processes in order to ensure that Ontario s practices match best practices elsewhere. The Task Force recommends that a number of initiatives be adopted which will promote appropriate investment in distributed generation. 3 The Task Force recommends that the Government move quickly to implement its Renewable Portfolio Standard whereby the Government has targeted that by 2007 an additional 5% (and by 2010 10%) of the province s power will come from renewable resources. The Task Force recommends that the Government must maintain its existing coal-fire generation units until adequate new supplies and demand reduction measures are in place. In order to implement its decision to close down coal-fire generation, the Government should quickly develop alternatives including clean coal technologies if the latter are feasible within the target emissions levels. Transmission should be considered as an enabler of generation rather than a barrier. The OEB should issue guidelines that facilitate grid connection for distributed generation. It is clear that the Task Force believes that Government should determine which generation technologies it wishes to support and then develop the necessary framework to ensure new supply is built. D. Enhancing the Responsiveness and Reliability of the Ontario Transmission Grid The Task Force does not believe that a merchant transmission model based on congestion-based price differences provides adequate planning or incentives to build the transmission grid that Ontario needs. In essence, the Task Force is taking the view that the model espoused by the Market Design Committee for incenting new transmission is not feasible. The Task Force recommends that: The transmission grid should be treated as essential public infrastructure with the OEB determining when expansion and improvement is necessary to serve the public interest. Customers would pay for such expansion and improvements through the transmission rates set by the OEB. 3 Distributed generation is defined by the Task Force to mean electricity generating capacity located close to the customers it serves. The Task Force makes a number of recommendations that would facilitate development of distributed generation facilities including a broadening of the definition of distributed generation investment for purposes of the Ontario Tax Incentive Program. BORDEN LADNER GERVAIS LLP Page 8

Ontario should recognize that it is part of the north-eastern regional market and continue to work with neighbouring jurisdictions to eliminate barriers to trade in electricity and ancillary services. Ontario must continue to participate in the interconnected north-eastern market in order to assist in providing reliable and affordable power in Ontario. The OEB should set and enforce transmission and distribution reliability and service standards. This recommendation seems to restate the OEB s existing role in this area. The Task Force recommends that within the context of its integrated system plan, Hydro One should develop a comprehensive long-term transmission development plan after broad consultation. The plan should be a 10 year plan with annual updates and address system needs in a proactive manner. E. More Effective Institutions The Task Force recommends that the respective roles and responsibilities of the key Government and industry players, namely, the Ontario Government, OEB, IMO, OPG, Hydro One and LDCs should be clearly and distinctly spelled out. The Government should continue to support research and innovation. The Government, industry, educational institutions, employees and their associations should work together to ensure there are skilled workers for the electricity sector. The provincial Government and the federal Government should work together to ensure streamlined federal and provincial regulation. The Government should ensure that all ministries and agencies recognize the importance of promoting conservation and developing new generation and transmission resources. Ontario should expand its electricity trade capabilities with neighbouring jurisdictions but maintain its independence to set policy. F. Addressing the Future Role of Ontario Power Generation ( OPG ) The Task Force considered the role of OPG in the Ontario electricity marketplace and the concerns that its dominant position was a barrier to new investment and competition. The Ontario Government recently appointed former federal cabinet minister John Manley to report by March 15, 2004 on the role of OPG, its future structure, corporate governance and senior management structure and the potential refurbishing of Pickering A Units 1, 2 and 3. While recognizing the role of the OPG Review Committee, the Task Force made the following recommendations about OPG: BORDEN LADNER GERVAIS LLP Page 9

If OPG is to remain the dominant generator, it should be limited to an investor of last resort role for projects that the private sector could otherwise undertake economically. OPG should partner with private investors to further develop its existing facilities where practical and economic. The Market Power Mitigation Agreement which contemplated reduction in the size of OPG will need to be replaced. Since the Government has committed to ongoing public ownership of OPG s existing assets, it will be necessary to develop another mechanism to address concerns over OPG market power. The Task Force suggests that long-term regulated contracts for heritage power could be used as a basis to reduce price volatility for all consumers. The OPG water power and nuclear assets would generate heritage power which could be charged out to consumers at their cost. The Government needs to re-examine its approach to stranded debt in light of the need to replace the Market Power Mitigation Agreement. The impact on customers who have been anticipating receiving the Market Power Mitigation Agreement rebate is not specifically addressed in the recommendations of the Task Force. The Government has to recognize the important role that OPG s existing assets play in Ontario s electricity supply mix. The Government must take into account the impact its decisions may have about nuclear, coal and hydro assets on the availability of supply and the cost of power. The Task Force notes that its action plan provides a diverse supply mix that is likely to include new renewables, natural gas-fired generation, water power and nuclear power. While the Task Force does not take a position on the appropriate mix for Ontario, it does recognize the importance that nuclear plants have played in providing base load power. Next Steps The Ontario Government will need to decide what elements of the Report it will adopt. The Report presents a high-level view of the most pressing issues in the Ontario electricity sector. Detailed legislation and IMO and OEB initiatives will be necessary. Some of the major issues which will need to be addressed include the following: The creation of a new contracting entity will raise issues concerning its financing, its mandate, its governance, structure and, most critically, its credit worthiness. In order to be able to support financing for investment in new generation and conservation measures, the procurement agency must have the ability to meet the rigorous financial requirements that counterparties will insist upon. BORDEN LADNER GERVAIS LLP Page 10

The concept of load serving entities cannot become a reality unless the Government decides to undo the damage caused to LDCs by Bill 210. The Report is silent on the many issues which currently face LDC s and leaves to others to develop the steps necessary to re-establish retail competition. The Ontario electricity sector will continue to be the subject of major changes as the new Government wrestles with the many challenges the Task Force has so ably identified. Our Energy Markets Group would be pleased to assist you with any matter raised in the Report with you further. If you have any questions please contact either Linda Bertoldi at 416-367- 6647) or Mark Rodger at 416-367-6190. This publication has been prepared as a service to clients and friends of Borden Ladner Gervais LLP and other persons involved in energy markets. It is not intended to be an exhaustive statement of law or an opinion on any subject. If you have specific areas of concern or require further details we would be pleased to elaborate on any of the matters set out above. Please contact: Linda L. Bertoldi Tel: (416) 367-6647 Email: lbertoldi@blgcanada.com Co-Chair, Energy Markets Law Group Rick F. Coburn Tel: (416) 367-6038 Email: rcoburn@blgcanada.com Bruce Fowler Tel: (416) 367-6194 Email: bfowler@blgcanada.com W. Paul McCarten Tel: (416) 367-6230 Email: pmccarten@blgcanada.com Michael Shadbolt Tel: (416) 367-6172 Email: mshadbolt@blgcanada.com Christine E. Long Tel: (416) 367-6683 Email: clong@blgcanada.com J. Mark Rodger Tel: (416) 367-6190 Email: mrodger@blgcanada.com Co-Chair, Energy Markets Law Group Stephen J. Fyfe Tel: (416) 367-6650 Email: sfyfe@blgcanada.com Shane Freitag Tel: (416) 367-6137 Email: sfreitag@blgcanada.com James C. Sidlofsky Tel: (416) 367-6277 Email: jsidlofsky@blgcanada.com Richard J. Morelli Tel: (416) 367-6197 Email: rmorelli@blgcanada.com William R. McLean Tel: (416) 367-6021 Email: wmclean@blgcanada.com BORDEN LADNER GERVAIS LLP Page 11

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