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A formula for smoothing rising Ontario hydro bills

Guy Holburn is Suncor chair in Energy Policy and director, Ivey Energy Policy and Management Centre, Ivey Business School; Adam Fremeth is assistant professor, Ivey Business School; Margaret Loudermilk is research director, Ivey Energy Policy and Management Centre; Brandon Schaufele is assistant professor, Ivey Business School.

Public angst about rising electricity bills in Ontario has intensified recently as the cost of new investment in generation capacity becomes clear. Over the past decade, the government has contracted for more than 20,000 megawatts of generation capacity, including natural gas and refurbished nuclear plants as well as renewables, contributing to a near doubling of regulated electricity rates for residential consumers.

There is a policy solution that is economically rational, equitable to consumers and simple to implement. The government could smooth the costs of contracted generation capacity over a longer period of time than is currently planned, reducing consumer bills in the short to medium term in return for slightly higher bills in the long term.

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The economic rationale for this smoothing policy is that the useful productive lives of contracted generation assets are in many cases longer than the durations of the contracts. For instance, wind-power contracts are structured for 20 years, even though wind turbines may be expected to operate for 30 years or longer, assuming periodic maintenance and refurbishment is undertaken. Natural-gas-generation contracts are generally for 20-year periods, though in the United States, many gas plants continue to operate beyond 40 years. Under 20-year contracts generator capital costs are amortized too quickly relative to their useful life, leading to higher annual capital charges than would be the case if the amortization period was extended to the full life span. The amount consumers pay today could thus be reduced by stretching capital amortization periods to match the expected productive lives of the assets. In this way, the costs of generation charged to households would more closely reflect the true economic costs of the assets.

There are two broad approaches for the government to accomplish this in Ontario.

First, the government could offer generators with existing contracts the opportunity to bid for new contracts that would supersede their current ones, stipulating that (a) the time horizon for a new contract must extend beyond the current one, and (b) the new purchase price for electricity over the duration of the new contract must be lower than the original contracted rate. If the generator and government reach an agreement on new terms, the new contract would replace the original one. Otherwise, the original contract would remain in force.

From the generator's perspective, this provides an opportunity to lengthen the time horizon of financial returns on their investment, and to increase today's expected net present value of the project. From the government's perspective, generation costs would be smoothed over a longer period of time as determined by individual generators on a case-by-case basis, lowering average electricity bills in the short to medium term. Importantly, since the government need not accept all new generator contract proposals (due to the possibility that future demand for electricity will decrease), this process would create bidding competition between generators – competitive pressures that could lead to lower average power-purchase rates in new long-term contracts.

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An alternative approach is for the government to subsidize in the short to medium term a portion of annual contracted payments under original contractual terms, and to reduce hydro bills by the corresponding amount. The subsidy each year would equal the difference in annual amortization currently charged (based on the contract duration) and the annual amortization amount calculated using the productive life of the asset. Interest rates on government debt (which would fund the short-term subsidy) are currently at historic lows, making this a relatively cost-effective strategy.

In both approaches, the quid pro quo is that consumers would pay more for electricity in the future to reflect the longer amortization period, specifically during the years beyond the end of the original contract and up to the useful life of the generation assets.

What's the bottom line? Calculations completed by the Ivey Energy Policy and Management Centre estimate the potential savings could be large. Preliminary modelling, relying on publicly available data and a host of simplifying assumptions, suggests that a smoothing policy could reduce contracted generation charges by up to $1.7-billion in 2018, equivalent to 8 per cent of total electricity system costs. The magnitude of this annual reduction diminishes gradually over time, and after 2030 bills are forecast to be slightly higher for several years than they would have been without smoothing.

While financial engineering is not a long-term policy solution for ensuring an efficient and reliable generation sector, it would ease the transition for households and businesses in the province over the coming decade.

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