EDITOR’S INTRODUCTION

From time to time the ERQ publishes reports that will be of interest to our readers. We often provide an independent review of those reports. The first one appeared in 2019 and consisted of report on the status of energy storage in both Canada and the United States. That report was authored by two law firms, one in Canada and another in the United States.^[1]

More recently the ERQ analyzed a report published by KPMG regarding cloud computing.^[2] That report, sponsored jointly by the Canadian Gas Association and the Canadian Electricity Association, argued that utilities should be able to include the expenses relating to cloud computing in rate base or through an accounting process that would result in a similar cost recovery.

The Report addressed in this article was prepared by the Charles River, consulting firm in Boston, at the request of the Independent Electricity System Operator (IESO). The IESO in turn was responding to a request of the Minister of Energy pursuant to a Directive issued in November 2019.^[3]

This Directive followed by almost a year a Directive by the same Minister directing the IESO to terminate a number of wind and solar contracts.^[4] Pursuant to that directive the IESO terminated three wind contracts which in total accounted for 90 MW and 752 solar contracts accounting for 333 MW. An earlier ERQ article outlines those developments in detail.^[5]

The most recent Directive asks the IESO to review the existing contracts and identify changes that might result in cost savings. As indicated, the IESO turned to Charles River. That Report can be accessed by readers here. Charles River made a number of recommendations. They are assessed by Ron Clark, a well-known Toronto energy lawyer, in the following Commentary. A few months after the Charles River Report was released, a presentation was made jointly by the IESO and Charles River. That presentation can be found here. The most interesting aspect of that presentation was the acknowledgment by the IESO that it had no mandate from the government to enact any of the Charles River recommendations.

COMMENTARY

As indicated, the Generation Contract Review report was prepared in response to a directive issued by the Ontario Minister of Energy to the IESO to retain an expert “to undertake a targeted review of existing generation contracts to identify opportunities to lower electricity costs within such generation contracts.” The Directive was issued in connection with the Premier Ford’s pledge^[6] to reduce electricity bills by 12 per cent (beyond the 25 per cent reduction promised by the Liberals, as described below).

In connection with the Report, the IESO consulted with stakeholders, including by sending letters to all contracted generators that hold larger contracts or a larger portfolio of contracts, requesting identification of viable cost-lowering opportunities.^[7]

Between 2008 and 2016, consumers in Ontario saw significant increases on their electricity bills.^[8] Residential electricity prices increased by 71 per cent during this period.^[9] An important factor in these increases was attributable to long term generation contracts (many entered into without competition), the phase-out of coal energy, and a growing electricity supply and exporting electricity at a loss.^[10]

Under the Ontario Fair Hydro Plan Act (the “Fair Hydro Plan”),^[11] introduced by then Ontario Premier Kathleen Wynne, on March 2, 2017,^[12] consumer electricity bills were to be reduced by 25 per cent. However, electricity generators would still need to be paid. In order to fund this shortfall, a trust created by Ontario Power Generation Inc. borrowed the money at market rates of interest. The Financial Accountability Office of Ontario, an officer of the Provincial Legislative Assembly, estimated that the Fair Hydro Plan would cost the Province $45 billion over 29 years while providing savings of about $24 billion to eligible ratepayers^[13] and questioned the accounting practices used in its creation.^[14]

In legislation introduced on March 21, 2019, Premier Ford’s Conservatives adopted legislation such that funding obligations in the Fair Hydro Plan moved from the IESO to the Province, shifting the obligation from the ratepayer to the taxpayer.^[15]

Magnitude of Payments

Between 2005 and 2016, at the direction of the Ontario government, the Ontario Power Authority (and later the IESO) entered into over 30,000 Renewable Energy Supply (RES), Renewable Energy Standard Offer Program (RESOP), Feed-in Tariff (FIT), microFIT and Large Renewable Procurement (LRP) contracts representing over 7,000 MW of additional contracted capacity.^[16]

Payments by the IESO to generators under major contracts (excluding the Bruce Power Refurbishment Agreement) amount to approximately $7 billion, or 32 per cent of total annual costs of the Ontario electricity system.^[17]

AVAILABLE OPTIONS TO LOWER COSTS

Three Options

The IESO’s consultant (Charles River Associates) examined three options with respect to the IESO’s generation contract:

• The “buy-out” consists of a lump sum payment by the IESO to a contracted generator for the anticipated, future net revenue and terminating the contract.
• The “buy-down” option consists of the IESO paying a lump-sum for a reduction of the contracted generator’s projected future contract payments while leaving the contract in place.
• Finally, “blend and extend” means the term of the existing contracts would be extended (e.g. 25 or 30 years, instead of the current 20-year term) in return for lowering the rates paid to the generator under the contract.

“Buy-Out” Option

Under the buy-out option, following the termination of the IESO contract, the facility owner would then be free to make decisions on the future of the facility, such as operating the facility as a merchant generator, permanently shutting it down or selling it.

To finance the buy-out, the IESO would need to borrow funds (on behalf of ratepayers) and would repay the loan over time through charges to ratepayers. The potential savings to the ratepayer would come from the anticipated difference between the IESO’s borrowing costs and the contract generator’s cost of capital on the stream of future cash flows.

“Buy-Down” Option

The “buy-down” option is similar to the buy-out option in that the IESO would need to finance a lump-sum payment to the generator in lieu the IESO’s obligation to make future payments to the generator. However, it is different in that the contract remains in place and the generator must continue to provide electricity generation under the contract’s provisions for the remainder of the term. In other words, instead of “buy now, pay later,” it is “pay now, get electricity later.”

“Blend and Extend”

Underlying the “blend and extend” option is the assumption that, once the contract expires, the contracted facility can continue to operate at a lower cost and thus accept a lower price under the contract. By, in effect, moving forward a portion of the lower costs post-termination (contract payments during the remainder of the contract terms can be reduced) at the cost of higher prices (than would have applied otherwise) during the extension period (after the current termination date).

According to the report, this opportunity is better suited for contracts that are set to expire in the near term, as the value of blending the expected lower prices in the extended term gets increasingly diluted over longer periods of existing term.

Other Savings Opportunities

The report also considered various other opportunities to lower IESO contract payments. These included monetizing “environmental attributes” (akin to carbon credits), enhanced dispatch agreements with generators under Non-Utility Generator (NUG) contracts (legacy contracts that were entered into by Ontario Hydro and are currently managed by the Ontario Electricity Financial Corporation), gas distribution & management (GD&M) services (related to certain contracts with gas-fired generators), and various contract-specific opportunities.

Assessment

Buy-Out and Buy-Down Options

According the to the IESO’s consultant,^[18] both the buy-out and buy-down options have similarities, in that savings are based on the lower interest rates available to the IESO (or the Province) compared with generators’ borrowing rates.

For the buy-out option, the amount of this savings opportunity would also depend on any differences in assumptions placed on the value of the facility without an IESO contract. In the case of gas-fired generation facilities, the certainty provided by that contract is essential. Without a contract, the risk that some or all of these plants would not be available when needed would be significant. The consultant’s report notes “Absent a robust and proven capacity market mechanism…the risks of extensive facility shutdowns are likely to be unacceptable to the IESO.”^[19] Thus, the buy-out option is not practicable in respect of gas-fired facilities and is examined further only in the context of contracts for renewable generation.

As noted above, in the context of the buy-down option, the contract (and the generator’s obligation under it) remain in place. Therefore, in the context of the gas-fired contracts, the buy-down option would remain viable (at least as far as gas-fired capacity continuing to be available).

As with the termination of any futures or hedging contract, one party (in this case the IESO) would be the “winner” if electricity prices drop (as compared with the forecast prices used to determine the buy-out amount). The other party (the generator) would be the “winner” if prices increase.

The buy-down option does not place this market risk on either party as the contract is left in place and it does not rely on forecasted future market revenues in the same way as the buy-out option. However, this does not take into account the risk that remains with the contract in place (i.e that the contract price will be “in the money” or “out of the money”). In other words, if the contract price is higher than the market price over time, the IESO will be seen to have “overpaid,” and vice versa.

Thus, the buy-down option relies solely on differences in sovereign vs. private sector borrowing rates for savings in contract payments. There is a long history of debate in the public-private partnerships sector about whether the “delegated” risks of private sector procurement outweigh the higher borrowing costs. Suffice it to say, there is a reason why the private sector pays higher interest rates and it has to do with the risk it takes on.

Figure 1 summarizes potential savings of the buy-out and buy-down options for certain categories of IESO generation contracts.

In a base-case scenario, the net present value of the net savings from the buy-down option ranges from $303 to $443 million over the term of the program (in the chart, aggregating wind and solar with gas-fired contracts). However, it would require over $2.1 billion of new debt to be taken on by the Province or one of its agencies to pay out generators.

Figure 1^[20]

“Blend and Extend”

Because of generator’s higher financing costs, depriving generators of future revenues to pay them more in the near term would mean that the IESO would, in effect, have to bear those higher financing costs. Thus, this option, while pushing down costs initially, would result in higher overall payments for ratepayers.

Other Savings Opportunities

For opportunities other than the buy-out and buy-down options and blend and extend, there were not compelling opportunities for savings in the near term. For environmental attributes, markets are neither sufficiently liquid nor certain. For NUG contracts, most of these have already been renegotiated to obtain desired savings. GD&M services generally work well as they are. Finally, contract-specific opportunities may exist, but by their very nature they will require discrete sets of negotiations over time to realize value.

Contract Terminations

Appendix 4 to the Report deals with contract termination.^[21] Can the IESO simply terminate the generation contracts, thus avoiding continuing payments to generators? Yes, but the price would be steep.

In July of 2018, the IESO exercised its termination right for over 750 renewable energy contracts. However, with few exceptions, these rights were exercised prior to “notice to proceed” or “NTP” (in the case of Feed-In Tariff (FIT) Contracts) or commercial operation (in the case of Large Renewable Procurement (LRP) contracts). NTP (for FIT) and commercial operation (for LRP) are milestones under the contract prior to which IESO liability is limited to pre-construction costs. Thus, the generator is incented to limit its construction and other expenditures prior to this milestone.

However, the vast majority of the projects developed pursuant to IESO contracts have passed the NTP milestone and reached commercial operation. Termination by the IESO after such milestones have been achieved would amount to a breach of contract, giving rise to IESO liability to the generator for damages, negating any cost savings associated with avoiding future payments to the generator under the contract for the remainder of the term.

COMMENTS AND CONCLUSIONS

Can the provincial government simply pass legislation terminating the contracts and depriving generators of a remedy? Interestingly, the IESO report (as made public) does not mention this as an option. However, this possibility has its own hazards. The contracts generally contain a “discriminatory action” clause that provide that, in the event of governmental action that deprives generators of payments, the generator is to be kept whole, again negating any savings resulting from avoiding future payments.

As noted in the report, “Once a project is operational, in the earlier years of a facility’s life there is often little (if any) costs to be saved by unilaterally terminating the contract, after taking into account incurred costs and the break fees that would normally be incurred in an early termination.”^[22] Such a calculation would also, in broad terms, apply to discriminatory action by legislation.

The consultant’s report to the IESO was issued before the COVID-19 pandemic had begun to wreak destruction on the economy, people’s health and electricity consumption patterns. One suspects that, given the likely reduction in energy consumption for the foreseeable future, generators would be even more reluctant to barter away or otherwise sell their rights to receive payments under the IESO’s contracts. Thus, the buy-out and buy-down options could very well be even more expensive than forecast in the report.

In any case, even using the pre-COVID figures, it is clear that efforts to reduce current electricity costs would have severe costs in the long term, often outweighing the short-term benefits.

*Ron Clark is a partner with Aird & Berlis LLP in Toronto, Canada. Ron’s energy law practice involves counselling stakeholder groups, retailers, distributors and generators on legislative and policy matters relating to electricity markets. Ron has been retained in connection with power procurement arrangements, development of generation and cogeneration facilities and the Ontario government’s clean energy supply and renewable energy supply RFPs and contracts. Ron has a background in public international law and previously served as a diplomat with the Canadian Department of Foreign Affairs, with postings in Ottawa and Brussels. He is a co-author of Ontario Energy Law: Electricity (co-authored with Fred D. Cass and Scott A. Stoll), LexisNexis Canada, December 2012 and author of Regulation and Governance of Municipally-Owned Corporations in Ontario, LexisNexis Canada, January 2019. Ron is admitted to the bar in New York and Ontario. He received an LL.M. in International Legal Studies from New York University, an LL.B. from Osgoode Hall Law School and a B.A. in Political Science from Carleton University.

1. Paul Kraske et al., “Electric Storage in North America” (2019) 7:1 Energy Regulation Q 55.
2. KPMG, “Capitalizing the Cloud” (March 2020), online (pdf ): Energy Regulation Quarterly <www.energyregulationquarterly.ca/wp-content/uploads/2020/04/CEA_CGA_-Capitalizing-the-Cloud-Report-EN_04.23.20.pdf>.
3. OIC 1499/2019, online: Ontario <www.ontario.ca/orders-in-council/oc-14992019>; See also Directive dated November 6, 2019 to the IESO to undertake a targeted review of existing generation contracts for viable cost-lowering opportunities, online: Ontario <www.ontario.ca/page/ministers-directive-order-council-14992019>.
4. OIC 1003/2018, online: Ontario <www.ontario.ca/page/ministers-directive-order-council-10032018>.
5. Gordon Kaiser, “Ontario Cancels Wind and Solar Contracts” (2018) 6:3 Energy Regulation Q 17.
6. Ted Raymond, “Ford renews promise to lower hydro rates despite upcoming hike”, CTV News (24 October 2019) online: <ottawa.ctvnews.ca/ford-renews-promise-to-lower-hydro-rates-despite-upcoming-hike-1.4653526>.
7. IESO, “Contract Review Directive Report” (28 February 2020) at 12, online (pdf): <www.ieso.ca/-/media/Files/IESO/Document-Library/contract-review/Contract-Review-Directive-Report.pdf?la=en>.
8. Taylor Jackson et al., “Evaluating Electricity Price Growth in Ontario” (20 July 2017) at 2, online (pdf): Frasier Institute <www.fraserinstitute.org/sites/default/files/evaluating-electicity-price-growth-in-ontario.pdf>.
9. Ibid.
10. Ibid.
11. Ontario Fair Hydro Plan Act, 2017, SO 2017, c 16, Schedule 1.
12. Office of the Premier, Statement, “Premier’s Statement on Ontario’s Fair Hydro Plan” (2 March 2017), online: Newsroom Ontario <news.ontario.ca/en/statement/43892/premiers-statement-on-ontarios-fair-hydro-plan>.
13. Financial Accountability Office of Ontario, An Assessment of the Fiscal Impact of the Province’s Fair Hydro Plan, by Matt Gurnham & Matthew Stephenson, (Toronto: Queen’s Printer for Ontario, 2017) at 1, online (pdf): Financial Accountability Office of Ontario<www.fao-on.org/web/default/files/publications/Fair%20Hydro/Fair%20Hydro%20Plan.pdf>.
14. Ibid.
15. Fixing the Hydro Mess Act, 2019, SO 2019, c 6.
16. IESO, supra note 7 at 6.
17. Ibid at 11.
18. Ibid at Appendix 2; See also Charles River Associates, “Independent Electricity System Operator Contract Savings Review” (27 February 2020), online (pdf): IESO <www.ieso.ca/-/media/Files/IESO/Document-Library/contract-review/Appendix2-CRA-Third-Party-Report.pdf?la=en>.
19. Charles River Associates, supra note 18 at 16.
20. IESO, supra note 7 at 19.
21. Ibid at Appendix 4; See also Elliot Smith, “Review of Generation Contracts Directive dated October 25, 2019 (the “Directive”)” (24 February 2020), online (pdf): IESO <www.ieso.ca/-/media/Files/IESO/Document-Library/contract-review/Appendix4Memo-from-Osler-Hoskin-Harcourt-to-IESO.pdf?la=en>.
22. Ibid at 14.