Moody’s says immediate rating actions not anticipated
Toronto, November 19, 2002 — When originally conceived in 1996, the restructuring of the Ontario electricity market was expected to bring to ratepayers the benefits of a competitive marketplace — expanded generation capability, a choice of suppliers and lower prices.
However, since the market opening in May 2002, the provincial government has expressed a good deal of dissatisfaction with the short-term results particularly with the impact on prices at the retail level.
In response to rising prices, the government has announced a plan that would essentially freeze the retail price of energy at 4.3 cents per kilowatt hour until at least 2006.
This plan is far ranging and is to include initiatives focused on increasing generation supply and fostering conservation at the same time as providing longer term price stability.
This newly evolving environment prompted Moody’s Investors Service to assess the impact of the component pieces of the government’s plan to assure that the possible end results are not contrary to the existing rating levels assigned to the various companies involved in the industry.
The credit ratings agency provided comments which attempt to explain its understanding of the plan, its thoughts on how the plan could impact the various market participants, and how it may react to additional future changes in market conditions that could impact the bondholder’s position.
At the heart of the government’s plan is its intention to limit the impact of industry restructuring on the volatility of prices paid by all retail customers. This is to be accomplished by fixing the rate paid by end users at 4.3 cents per kilowatt-hour of usage as of the date of market opening.
This will require refunds to be paid and bill credits to be issued to users. Although the general outline of the government’s plan are known through its announcements of last week, it is anticipated that the complete details will only be known when a bill is introduced for the Ontario legislature’s review and approval. This will likely occur quickly, Moody’s commented.
At the same time that the retail price of supply is being frozen, the government has left the wholesale generation market untouched. Prices are expected to fluctuate based on availability of generation capacity and the level of demand.
The Independent Electricity Market Operator (IMO) will continue to buy power from the generators. In turn the IMO will sell to the end use customer with the local electricity distribution company (LDC) performing the billing and collection function as before.
Other highlights of the plan include a cap on the price that customers pay for the delivery of electricity at current rates, a review of other charges including the fixed monthly charge that customers currently pay for use of the distribution network and the intention, if feasible, to accelerate payments directed towards the reduction of stranded cost debt.
Effect of the plan on retailers
It is difficult to imagine that those companies engaged in direct retail sale of supply to customers continue to have a viable business plan. By fixing the retail rate for a period of almost 4 years, the government has eliminated both the uncertainty on the consumer’s pocketbook of any future rate increases and the incentive to seek an alternative supplier other than the local distribution company.
Effect of the plan on the local distribution companies
The principal impact of the plan from the debt holders perspective is the effect on cash flows.
1. Essentially the government is ordering a rate rollback of supply costs to the level of April 30, 2002. Following market opening, the price of power rose from 4.3 cents per kilowatt hour to an average cost of 8.3 cents in September. The refunds and credits associated with this decision are not anticipated to have any additional impact on the working capital needs of the LDCs as the government is expected to provide the companies with the level of cash necessary for the transactions before checks are written or bill credits are applied. For those LDCs who have chosen to operate over the last six months by billing their customers for a fixed monthly price, this decision actually provides for an acceleration of payment for the deferred costs of supply in excess of the 4.3 cents that were incurred.
2. With delivery rates capped at current levels, earnings and cash flow support could be impacted because of the elimination of the final price increase that was expected as part of the three year rate phase-in plan that was adopted by the Ontario Energy Board in 2000. While Moody’s believes the loss of these revenues is challenging, it does not believe that the financial consequence will be similar for all LDCs across the board. For some of the smaller companies or those that had factored a larger revenue increase into the later years of the original transition plan, the inability to raise rates may have a significant effect on financial performance. For others, such as Hydro One, Moody’s believes that a focus on productivity and employee efficiency can offset much of the impact which will be further mitigated by the natural growth in the business.
Effect of the plan on the generators
1. The introduction and timing of the plan clearly indicates the level of dissatisfaction the government has with the performance of its wholly owned entity Ontario Power Generation (OPG). Moody’s believes that concern for the escalating costs and possible delays in returning the Pickering A nuclear facility to operational status was sufficiently great that, when viewed in the additional context of the reliability of OPG’s fossil unit performance, the government assigned a high probability to customers experiencing substantial power price costs in the summer of 2003. Without significantly more interest being shown by potential third-party generators in building in Ontario, Moody’s anticipates that the government would prefer to remain in control of OPG’s existing generation portfolio as a means to assure that the province could retain direct influence in determining power prices.
2. As a matter of public policy, the government has decided to allow the wholesale power market to price energy according to the laws of supply and demand. Moody’s believes this approach is being taken in the expectation that a competitive environment is most attractive to potential providers of additional generation capability. Over the long term, attracting additional generation to Ontario can accomplish two important goals. The performance of other suppliers can act as benchmarks from which to judge the performance of OPG and the existence of additional generation will put downward pressure on the price of electricity in the wholesale market, all other things being equal. Unfortunately, the historic fits and starts of market restructuring and now the government’s intervention in the retail market will undoubtedly raise the spectre of additional interventions in the future and perhaps give potential operators further cause to look elsewhere for opportunity.
3. The IMO will continue to buy power at the price set by wholesale market economics. In so far as it must pay for power above the 4.3 cents it will receive from its end use customers, it must call on the province or its credit to provide the additional cash to pay the generators. Moody’s notes that while the required subsidy could add to the province’s debt burden, we do not, at this time, anticipate that any such additions would be material to the province’s credit rating.
4. Direct customers of the generators have the option to retain their bi-lateral agreements or reprice them down to the 4.3 cent level. It is our understanding that the government will be making the generators whole on any renegotiated contracts and providing the cash in advance of any refund or bill credit need.
5. The government is expected to provide tax incentives to encourage the building of additional generation and to support the expansion of non-traditional generation sources such as wind power and other green technologies.
Effect of the plan on transmission providers
1. In addition to the impact the plan has on its distribution business, Hydro One is also affected by the plan’s cap on the cost of delivery, of which the cost of transmission is a part. In so far as any planned rate increases were anticipated by management, the cash flow impact of those increases must now be offset by focusing on expense control, improving operational performance, and seeking out capital efficiencies, Moody’s said.
2. The government is still seeking a potential strategic partner for Hydro One. Moody’s anticipates that the uncertainty associated with the long-term market structure in Ontario and the increasing possibility of political intervention will work both to lengthen the period of negotiations for the sale and to raise questions in the mind of potential purchasers of the company’s ultimate value.
While Moody’s does not believe that the province’s plan, in its current form, represents an immediate impact on credit quality, the business environment facing all participants in the electric power market in Ontario is decidedly fluid. For one, the plan could change prior to being submitted to the legislature; changing further as it progresses to law. For another, elections could occur within the next 18 months and if party change cannot be ruled out then neither can further changes to the structure of the power market. In between these two events lies the government’s review of its mandate to the Ontario Energy Board.
As the political consequences of rising energy prices in Ontario have played out, the government has criticized the OEB for not doing enough to shield rate-payers from the increased costs.
Currently the Energy Minister has been charged with reviewing, and presumably recommending changes to, the approach the OEB has taken to implement market restructuring. This task has become somewhat easier given the chairman of the last five years has recently resigned.
Since the government’s action has been couched in terms of the ongoing effect on rate-payers, our greatest concern surrounds any action the OEB may take that substantially changes the financial profile of the industry.
In this regard, the most sensitive issues that could affect the bondholder’s position are changes in cash flows associated with reduced tariff rates or allowed rates of return, a reassessment of an appropriate capital structure profile, or deferrals to the timely recovery of legitimate business expenses.
A decision is expected in the first quarter of 2003 and the impact of any changes to the affected companies’ prospective credit profile will be assessed at that time.
Source: Moody’s Investors Service