IPO just the start of Hydro One changes

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Holding court in a sunny office high atop the TD Canada Trust tower in Toronto's banking district, Ed Clark is the very picture of corporate sagacity. Yet since retiring as CEO of TD last year, he has spent much of his time doing a very unbankerly thing—helping a bunch of politicians untie a Gordian knot.

As an unpaid adviser to Premier Kathleen Wynne, Clark thumbed through a folder of Ontario's assets, looking for candidates that could be sold off so the province can invest in the sort of things governments do: Build schools, hospitals and transit lines, and address issues like income inequality, about which Clark says he cares deeply. That scrutiny led Clark to Hydro One, the $6.5-billion-a-year monopoly that operates the province's transmission corridors and also sells power directly to about 1.2 million customers.

To Clark, continued public ownership of a utility made no sense at a time when competition for scarce government resources is intense and demographics are driving up health-care and other social-service costs. "If you can only borrow so much money and you [need to] be building a hospital or a school, are you going to not build that hospital or school so that you can supply solar panels to a consumer? I mean, that's nutso."

Wynne decided to embrace Clark's advice, flicking the "on" switch on the sale of 15% of Hydro One. The $20.50 shares began trading in early November, and the oversubscribed offering promptly deposited $1.66 billion into provincial coffers.

That moment marked a historic reversal of political polarity. In 1906, Adam Beck, a Conservative MPP, persuaded Queen's Park to keep control of the emerging electricity grid out of the hands of rapacious monopolists. Famously promising "power at cost," Beck created the Hydro-Electric Power Commission of Ontario (later Ontario Hydro), which gradually took over nascent municipal utilities and transmission networks, and systematically brought electricity to the province's remote regions.

Ontario's Liberal government believes it must now put control over the grid back into private hands as a means of serving the public weal. "No one's trying to make money from this thing," Clark claims, referring to critics' charge that the change is driven by Bay Street. "They're trying to do the right thing for the province." But Ontario's spotty record in privatization is weighing on the public's mind, according to polling. "We're cognizant that we're in a learning process about why privatizations so often get messed up," Clark says. "What you're doing, which is completely normal in the private sector, is abnormal to the [public sector]."

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Over the years, Adam Beck's baby gradually grew into a headstrong adult that was too powerful for Queen's Park's liking. The idea of selling the massive utility was first bruited by Bob Rae's NDP government in 1993. Bay Street sat up straight at the news: "I can guarantee you that every single investment bank is looking at it," venture capitalist Andy Sarlos later said, "and lining up their clients."

In 1999, the Mike Harris Tories separated Hydro into segments including a generation company (Ontario Power Generation) and a transmission company, now called Hydro One. A proposed Hydro One IPO died on the vine in 2002, but in 2004 the McGuinty Liberal government introduced a measure of competition, with the new Ontario Power Authority assessing demand and acquiring new generating capacity from private suppliers. Queen's Park stopped short of selling Hydro's major generating stations, although Harris turned over the operation of the Bruce Nuclear station to a consortium whose largest partners are TransCanada Corp. and Borealis, the infrastructure arm of OMERS, an Ontario public service pension fund.

The larger of Hydro One's two businesses is delivering wholesale power, via heavy-duty transmission corridors, to municipal electrical utilities, ranging in size from Toronto Hydro on down. Hydro One also directly supplies power to its own retail customers, primarily rural residents not served by a municipal utility.

After the Harris restructuring, Hydro One started absorbing municipal distribution companies, acquiring 88 over 15 years. Prior to the breakup, the province had 306 local distribution companies; at the time of the IPO, it had just 72, with Hydro One Networks the largest of the lot (Toronto Hydro is a distant second).

Unsurprisingly, Hydro One's balance-sheet growth has been robust: It invests about $1.5 billion in capital expenditures each year. The utility's net income has clipped along at a 9.7% compounded annual growth rate since the end of the last recession.

Those impressive returns are separate from the charges paid by provincial ratepayers to retire the "stranded debt" left behind by Ontario Hydro's nuclear-power building binge, which still accounts for a hefty chunk of the government's payables. According to a provincial electricity financing agency, the debt retirement charges on utility bills have cut the stranded debt from $19.4 billion, in 1999, to $9.8 billion as of March, 2014.

The debt points up how Ontario's nuclear-heavy electricity sector bears little resemblance to many other jurisdictions, whether in Canada or elsewhere. British Columbia and Quebec, both blessed with cheap, abundant hydro power, have kept their electricity sectors public, while some other provinces have long since put power wholly or largely in private hands: Nova Scotia (Emera), Newfoundland (Fortis) and Alberta (TransAlta, which later sold its transmission business to create AltaLink). In the United States, electricity is supplied by both giant government agencies, like the Tennessee Valley Authority, and publicly traded companies. In Europe, the predominant players, including France's state-controlled EDF and Germany's publicly traded E.ON, straddle national borders. E.ON, boasting 58,000 employees, could likely swallow Hydro One without breaking stride.

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Not long before she won a majority in June, 2014, Wynne named Clark to head an advisory council with a mandate to look at the future of three prominent government assets: the Liquor Control Board of Ontario, Ontario Power Generation and Hydro One. Unlike previous privatization campaigns, the Liberals were motivated more by a craving for cash than ideological fervour. The Liberals, after all, had to confront an accumulated provincial debt of about $300 billion, giving Ontario the dubious distinction of being, by one reckoning, the world's largest "sub-sovereign" borrower. Something had to be done to mollify the debt-rating agencies.

As companies like Emera show, private investors have been buying up public utilities for years. But such income-generating assets have become especially prized by giant institutional investors as low interest rates and slow growth became the new normal. As Jim Leech, the former CEO of the Ontario Teachers' Pension Plan, observes, such investments are excellent proxies for long-term government bonds because they provide cash flow and are hedged against inflation.

Ontario's experience with privatization has been a mixed bag. Everyone in the Greater Toronto Area knows the sorry tale of how the Harris government sold Highway 407, a toll road, at fire-sale prices. Since 2003, the Liberals have opted for a privatization-lite approach, bringing in private firms and capital to build and maintain public facilities—everything from transit lines to hospitals and courthouses—on a fee-for-service model, while retaining ownership. Yet according to a scathing 2014 report from Ontario's Auditor-General, the province has spent $8 billion more than it would have had it built things on its own.

No doubt Wynne thought Ed Clark, expert in both government and finance, was as good a bet as anyone to improve on that spotty record. Clark, who has a doctorate in economics from Harvard and describes himself as a socially progressive executive, worked in senior bureaucrat posts in Ottawa (including on Pierre Trudeau's National Energy Program) before jumping to the private sector. At TD, he presided over a push to boost customer service and oversaw the acquisition of distressed U.S. banks—a move that propelled TD, once the smallest of the Big Five banks, into a neck-and-neck competition for first place with RBC.

In its initial fall, 2014, report, Clark and his advisory council veered away from calling for a full sell-off of Hydro One, recommending instead that the government cleave off the local distribution business and merge it with one or more Toronto-area utilities, while also bringing in private investors to the merged entity. By spring, 2015, however, Clark's committee "significantly revise[d]" its advice, calling on the province to sell off a majority interest in Hydro One.

What changed? In a word, Buffett.

Warren Buffett, in recent years, has become enamoured with energy. Last year, his Berkshire Hathaway Energy snapped up AltaLink, which had taken over TransAlta's transmission network in 2002. Berkshire paid $3.1 billion—a price that, unusually for a Buffett company, was on the high side. With that takeover, AltaLink became an asset in a vast energy division that operates 375,000 kilometres of transmission corridors in North America and boasts $83.4 billion (U.S.) in assets. Not coincidentally, the architect of the deal was Greg Abel, the Canadian-born Berkshire executive who is on the short-short list to some day succeed the Oracle of Omaha.

The stateside gas and electric utility sector has been frothy with steep-premium M&A activity in the past year, following Leech's dictum that investors seek out the sector's long-term stability and steady cash generation.

Buffett may bring a special buzz to the market, but Canadian investors have in fact long played in the private transmission sector. The business has always been part of the DNA of the Brascan/Brookfield empire. In the past six years, OMERS's Borealis wing has made acquisitions in the sector in the U.S., Finland, and Sweden.

For prospective Hydro One investors, however, the other salient recent deal besides Buffett's took place in September, when Emera paid $10.4 billion (U.S.) to take over TECO Energy, a utility with operations across Florida and New Mexico. While Emera paid a rich price, the deal doubles the company's asset base; Emera told investors it will boost earnings per share by 10% within three years.

David McFadden, a counsel at Gowlings specializing in energy and infrastructure (and a former Tory MPP), believes that Hydro One could some day look and behave like Emera and Fortis, another acquisitive utility with its roots in public ownership.

Emera (where officials declined to be interviewed) became the privatized incarnation of Nova Scotia Power in 1992. The $3-billion-a-year company has been on a tear in recent years, snapping up smaller utilities in the U.S. and the Caribbean, investing in clean-energy schemes like tidal power, and developing a transmission corridor that will link Labrador's hydro dams to consumers in Atlantic Canada and beyond. "I would not be surprised to see Hydro One go down this road as well," says Rob Hope, an energy infrastructure analyst with Macquarie Group who watches the Canadian market. Since going private, both Fortis and Emera have delivered steadily increasing dividends to their shareholders. Emera's first dividend payment in 1992 was pegged at 18.75 cents per share; today, that figure has jumped to 47.5 cents. (Hydro One has proposed an initial dividend of 21 cents per share.)

That the sale of the first tranche of Hydro One shares was oversubscribed probably indicates that investors are banking on the scenario foreseen by Hope. The government hasn't been forthcoming about the timing of the subsequent issues, likely for tactical reasons.

The share sale, according to government estimates, will yield about $9 billion. Of that, $5 billion will chop that stranded debt. Residential customers will stop seeing a debt-retirement charge on their bills after this year; business customers, however, will still get dinged. The remaining $4 billion will go into the so-called Trillium Trust, an account with funds earmarked for infrastructure like transit. Clark's council estimated the market value of 100% of Hydro One to be in the $13 billion-to-$15 billion range. (The underwriting syndicate, led by Scotiabank and RBC, earned a reported $30 million.) The market-value figures could creep up if Hydro One's share price rises and the government and its investment bankers time the subsequent release of stock so it can share in the capital gain created by increased stock prices and pent-up demand.

Other observers are dubious about the projected numbers. The province's Financial Accountability Office, in a report made public days before the IPO, calculated the market value to be in the $11 billion-to-$14.3 billion range, so a sale of 60% would produce a smaller windfall of $6.8 billion to $8.9 billion. Of that, the watchdog concluded, about $3.3 billion to $5.8 billion would go to infrastructure. (The Financial Accountability Office, however, couldn't access all documents pertaining to the deal.)

The Accountability Office and other critics also fretted about the impact of the sale on provincial income. Hydro One sends about $700 million in income to provincial coffers each year. That number is less than 1% of Ontario's total revenue, but it is not chesterfield change, either. By selling that first 15%, Queen's Park will lose an estimated $84 million this year, taking account of both lower interest payments on Hydro One's debt and foregone dividend income, according to an analysis done for the Canadian Union of Public Employees by economist Douglas Peters, who concluded it's "not appropriate" to sell Hydro One.

Once the entire 60% is divested, the net loss to the treasury will jump to almost $340 million annually, according to the analysis. "There was no business case for privatization and I found that startling," argues CUPE economist Toby Sanger, who points out that governments can still finance large-scale infrastructure projects the old-fashioned way, since interest rates are historically low. "It suggests they quickly caved in to pressure, either politically or from Bay Street."

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While parlous provincial finances are the justification for the privatization, the issue of public-sector entitlement is in the air. Hydro One is notorious for having more than half of its 7,800 workers on the so-called Sunshine List of public employees earning more than $100,000, with pensions to match, and for its indifferent treatment of retail customers.

The workforce won stock-based compensation as part of a new collective agreement. But some are wondering whether they'll be on the payroll to collect the payout. Mayo Schmidt, the new CEO, has a reputation as a job slasher: The American-born executive turned around, and then privatized, the Saskatchewan Wheat Pool (renamed Viterra) before selling it to Glencore International PLC in 2012. Clark predicts that under Schmidt, who will earn as much as $4 million annually after his first year, and chair David Denison, former head of the Canada Pension Plan Investment Board, Hydro One will see improved productivity, stronger cash flow and disciplined management. Neither Schmidt nor the new CFO, Michael Vels, a Maple Leaf Foods alumnus hired in July, comes from Ontario's electricity sector, which of course means they don't know much about electricity. The fact that Hydro One's former CEO, Carmine Marcello, is staying on (with a base salary of $525,000 a year) as an adviser to Schmidt and Vels underscores their lack of technical know-how in an engineering-driven organization.

But being outsiders also means they aren't steeped in the utility's bureaucratic culture. And they do know plenty about mergers and acquisitions. Clark, however, won't make predictions about potential expansion. "Let's talk about that three or four years from now," he says. First, he adds, Hydro One has to "earn the right if [it] wants to play elsewhere." (Schmidt and Denison declined interviews.)

If Hydro One employees are worrying about their jobs, the company's customers are wondering whether improved service will indeed become job one, as Clark intimates (even as Schmidt reduces overhead), and whether rates will go up. In the run-up to the sale, opposition parties raised the spectre of rising rates as an argument against privatization.

Yet rates were going up well before the privatization began, in part because of subsidies to renewable energy producers such as wind and solar farms. Both advocates of the deal and regulatory experts dismiss price-hike fears as "misinformed," pointing out that the province's regulator, the Ontario Energy Board (OEB), doesn't set rates based on ownership. The OEB, in fact, has long regulated private natural gas distributors without incident. "The owner is not relevant," says David McFadden. Even environmentalists like Jack Gibbons, chair of the Ontario Clean Air Alliance, agree. "There's no reason to believe that private [ownership] will lead to higher rates."

Others say the Liberals' partial privatization may actually prevent Schmidt from making the necessary changes. University of British Columbia business professor Anthony Boardman has studied the performance of former Canadian Crown corporations, post-privatization. In the first two or three years, these giants show improved profitability because they shed jobs, he found, but they only later generate real growth through acquisitions or geographic expansion.

But, Boardman adds, the most successful privatized Crown corporations are those that have completely cut the apron strings. In his view, Queen's Park is trying to have it both ways, holding on to an ownership stake that will make it the largest single shareholder even if the government doesn't retain formal control. (The governance agreement also precludes moving the head office outside Ontario; likewise the sale of regulated assets.) "I'm not a big fan of a mixed entity like this," says Boardman, adding that the government's continued presence as a shareholder "creates ambiguity for the managers. It's a potential problem."

Clark dismisses such arguments, saying he's confident that Denison and Schmidt will rebuff any government meddling. "Investors won't invest in this company if they believe the government will continue to micromanage," he says. "[The government has] stepped away and said to David Denison, 'You're going to deal with these issues.'" Notably, as head of the CPPIB, Denison had to resist political pressure to direct the fund's billions toward or away from certain asset classes.

Clark says he's never been fond of "ideological" positions, such as the necessity of a 100% privatization. "A world where everything is black or white is where you don't get a lot of things done," he says. "To me, ideology is simply a lazy way of making decisions."

Whether Ontario will continue to own part of Hydro One in perpetuity is, of course, a matter of speculation, and Clark won't go there. But the narrative arc of most Canadian privatization deals, including far more controversial ones, suggests that the 40% stake is merely a way station on the long road to a complete sell-off.

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All the muscular talk about managerial independence and robust regulation won't be sufficient to ensure that Hydro One shakes off its monopolistic instincts. As Clark and the provincial policy-makers who worked on this file know, the utility needs rivals to ensure that it's not gouging when its officials submit rate applications to the OEB. "There's no question it would be easy to fall into a culture that says, you don't have any choice," says Clark. "I think that's absolutely the risk."

The province's solution to this problem involved cleaving off Hydro One's Brampton local utility, which produced a $600-million windfall for provincial coffers, and merging it with a consortium comprised of three other Toronto-area utilities—Enersource, PowerStream and Horizon. "The idea is to create a really viable competitor," says Clark.

Gowlings partner Ian Mondrow, a former adviser to the OEB, explains that, with the creation of the new utility, the OEB will be overseeing three large, independent utilities (Toronto Hydro being the third), which means it will have more comparative data in hand while setting rates. "From a regulatory point of view," he says, "it will be cleaner."

What's more, it seems that the post-IPO Hydro One won't be encouraged to continue gobbling up local utilities—or, at least, not yet. Rather, McFadden says, the consolidation around Toronto sets the stage for not just more mergers, but for an influx of private capital as new investors acquire stakes in local utilities. To grease the wheels, Queen's Park has slashed the transfer tax on the sale of companies in the sector for the next three years.

Both Fortis and Epcor, Edmonton's municipal utility, have been poking around Ontario, looking for acquisitions, while other investors, including pension funds and Berkshire Hathaway Energy, are also said to be scouting deals. "There are a massive number of groups talking about consolidation right now," McFadden says. "It's all happening below the surface." Epcor spokesperson Tim LeRiche confirms that the company, which has expanded to Saskatchewan and Arizona, is searching for opportunities in Ontario.

McFadden speculates that the Hydro One IPO will also prompt other Ontario utilities to either sell shares on the public markets or invite in private equity partners, such as the infrastructure arms of large public-sector pension plans (OMERS, the most obvious candidate, declined to be interviewed). At the top of the list is Toronto Hydro, which remains a wholly owned subsidiary of the City of Toronto. "Yes, [a Toronto Hydro IPO] is talked about," McFadden says.

"It's not for me to tell [Toronto mayor] John Tory what to do," Clark demurs. But, he adds, "I definitely think it's a prime candidate. If I were John Tory, I would be looking hard at whether that's a sensible thing to do."

The upshot, McFadden predicts, is that Ontario's fragmented distribution sector will consolidate into six to eight large utilities owned either entirely or in part by private investors. Only then should Schmidt's downsized Hydro One turn its attention to an Emera-style border-crossing acquisition run.

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Almost everyone involved in the Hydro One privatization—boosters and critics alike—assumes that transmission/distribution utilities offer an almost foolproof form of investment stability. Even conservation campaigns meant to encourage end-users to reduce their electricity consumption don't blow back on investors, because regulators offer gas and electric utilities attractive financial incentives to promote energy-saving technologies.

But what if the business isn't the safe harbour everyone assumes it to be? Greenpeace energy analyst Keith Stewart says the industry today resembles the telephone sector at that pregnant moment a generation ago before deregulation, cellphones and the Internet came along. He says that on a global level the transmission industry is beginning to evolve from the old hub-and-spoke structure—a handful of large generating stations feeding power through high voltage lines to local distributors—into a decentralized "smart grid" system in which energy flows to the grid from many small or intermittent sources: solar and wind farms, homes fitted with photovoltaic roof panels, and other renewable generators. "We're going to fundamentally change how that system is governed," Stewart says. "The grid won't work the same way as it has for the last 50 years and those who think it will, will lose a lot of money." Clark agrees that the next decade will see revolutionary changes.

Ontario's move to phase out its coal-fired generating plants—completed in 2014—has been accompanied by a rapid deployment of renewable energy suppliers and smart-meter technology. With a growing number of homeowners and commercial property owners installing low-cost rooftop solar panels that feed power into the local grid, the transmission system won't be called on to transport as much power as it once did. Ontario's peak summer loads, Stewart says, have actually fallen in recent years because all the solar energy now being generated on thousands of rooftops has supplemented traditional generation sources.

Ian Mondrow points out that other disruptive technologies, such as electricity storage and electric vehicles, will accelerate the transformation and invite in non-traditional players, like Google, which has a renewable power division.

In fact, in a recent lobbying document, the U.S. electricity industry describes the potential hit to transmission revenues as "a death spiral." With more power from small, far-flung sources circulating in local grids, less power will flow through the heavy-duty long-distance transmission lines. That spells lower toll revenues and even the spectre of stranded transmission assets—that is, high-voltage corridors that no longer connect to operating generators. "One of the challenges is how we manage that transition and change the way we charge for electricity," says Stewart.

Andrew Weisel, a U.S. utilities analyst at Macquarie, also notes that Europe's giant utilities—some of them public, others not—are well ahead of North America's in adapting to these technological changes, thanks to policy incentives meant to spur the development of renewable generation. As in Ontario and elsewhere, the shift to clean energy has driven up consumer power rates. Consequently, Weisel observes, some European regulators have actually moved to squeeze regulated rates of return for power companies as a means of offsetting the rising cost of clean generation to customers.

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With the first chapter of the IPO complete, Clark finds himself thinking about his days running a bank that had to distinguish itself in an industry that offered little in the way of differentiation, much less competition. The subject came up regularly as Clark and Denison huddled over the future of a utility that will have to become a lot less complacent before Schmidt et al. can begin to think about pursuing an Emera-style expansion strategy.

Clark, however, is no fan of slash-and-burn turnarounds—"it always blows up in your face"—and he also understands that things can go south. Other utility privatizations have backfired politically thanks to rising rates and deteriorating service. "[Hydro One] cannot earn the right to play in this marketplace unless it puts the customer first," he says. "For now, Hydro One has to prove that it can play the game dramatically better than it has played until now."