Every week in the news it is possible to read an article that relates to the electric power industry. Edison’s incandescent lamp in 1879 gave birth to a commodity few can function without. The demand has risen exponentially over the past decades. The problem is that the supply has not kept pace.

Short term administration and political involvement have inhibited the invisible hand of the competitive market place. Perceptions of reality have been skewed, and the costs of reconciling the problematic industry are astronomical. For the people of Ontario however, the cost of not improving the industry is immensely higher.

This report is the result of research into the restructuring of Ontario’s electric market and the economic impact resulting from it. The premise of the report expands on three issues; a failing system, the unrealistic price cap, and the black out of August 14th, 2003.

The report links the structural change hypothesis and the spill over effect of declining income levels to the uncertainty within the electric market and its impact on Ontario’s future economic trends.

CONCEPTION AND HISTORY OF COMMERCIAL ELECTRICITY
In 1844 the first telegraph wires were strung between Washington and Baltimore and by 1861 a web of lines crossed the US. In 1879, Edison’s incandescent lamp gave birth to the establishment of the electric power industry. The construction of the Pearl Street Generation Station in NY commenced to meet the demand for electricity. Linemen were needed from all across the country to erect transmission and distribution lines. They would risk their lives on the high lines a hard 12 hours a day, 7 days a week in all weather conditions for $8.00 a week. There were no safety standards and no apprenticeship training for this extremely challenging work. The death rate for lineman was 1 of 2 hired, twice the national average for all other industries combined.

In Ontario, the single largest electricity company in the industry is Hydro One, the former Ontario Hydro. Founded in 1906 by Adam Beck, the Hydro Electric Power Commission of Ontario was originally only a transmission company that owned the power lines but purchased the power from privately owned independent industries. They soon monopolized the entire Ontario transmission and generation market as well as a substantial distribution share. Unlike crown corporations or private companies, OH had no regulatory board and no shareholders to be accountable to. By the 1950’s they ran out of rivers to tap for hydro-electric generation and began building fossil fuel and nuclear generators.

Policy makers finally came to regard monopolistic firms as inefficient. Changes in technology, such as demand side generation encouraged the initiative that a market driven electric energy sector would be preferred over the existing regulated model. The invisible hand of the market would provide competitive pricing and an increased awareness of the industries development requirements.

Ontario Hydro was a provincially owned monopoly, vertically integrated to include distribution, transmission and generation. Prior to the restructuring of the industry, there were also approximately 300 local distribution companies (LDC’s) own by municipalities. The consumers paid one bundled fixed rate per kilowatt hour that encompassed all costs.

By 1999, Ontario Hydro had accumulated a provincially guaranteed debt of over $38 billion, $20 billion higher than total assets. This debt was primarily due to major cost overruns from poor project management of the nuclear generators. To compensate for excessive spending, Ontario Hydro increased rates in the early 1990’s by 30%. The government reacted to the public protest by implementing a price freeze in 1993 which remained in effect until the market opened.

The Electricity Act passed in 1998 regulates emission limits in the US causing an increase in the demand for the generation of a low emission power supply. In order to conform to Act, US companies either needs new generation facilities or they must import from Ontario. This increases the need for inter-ties in the transmission circuits between Ontario and the US. The Kyoto Protocol calls for a reduction in fossil fuel emissions. Improvements to the environment means improved electrical system in two possible means;

1. Supply. An increase in the supply of low emissions electricity.
2. Demand. A change in demand will come from an increase in energy efficiency

ECONOMIC
In an open market, the price of a commodity is determined by the economic forces of supply and demand. Electricity is particularly unique in that the commodity can not be stored in inventory reserves to aid in smoothing the extremes. There is a definite ceiling on the supply or capacity at any given time. As customer demand approaches that ceiling, the price of electricity will rise as those customers are willing to compete for the scarce commodity. However, as the demand falls away from the ceiling, the price will fall as suppliers must compete to sell their surplus electricity in the shrinking marketplace.

The alternative way of avoiding price spikes is to reduce demand. Ontario does not want another economic slowdown therefore; the only way to reduce demand will be through innovated energy efficiency and increasing electric productivity.

Higher electricity prices also encourage the implementation of renewable energy technology for generation. The price caps imposed on rates reduce the incentive to invest in energy efficiency and conservation. There is no motivation for energy intensive businesses to upgrade their older equipment.

ENVIRONMENTAL /TECHNOLOGICAL
System Reliability
The ability to match supply with demand is one component of a reliable electric system. The other is obviously the plant or infrastructure itself. The transmission system in Ontario, and similarly the distribution system maintained by Hydro One, have not kept current and are deteriorating. Much of the province’s system was installed in the 1960’s with some dating back into the 40’s. There is a maintenance deficit caused primarily from prolonged price freezing. The Ontario government’s freeze from 1993 to 2001 severely reduced capital and maintenance budgets. These rate freezes were imposed as a political response to public anger at double digit rate increases that were necessary to keep current with rising costs. The cure then was much worse than the disease. Ontario Hydro’s debt grew at an astronomical rate as did the maintenance deficit. Public debt to fund electricity system improvements is not positively accepted by the public and therefore not a politically accepted option. Political pressure will prevent Hydro One from borrowing funds for expansion projects.

Many of the expansion plans Hydro One would pursue, such as upgrading connection capacity with neighbouring jurisdictions, can not be funded from the regulated rate base in accordance with the OEB guidelines. Many of the projects forecast long term profitability; however, the company is governed by short term political considerations. The electricity industry is too complex to be avoiding long term investments.

Export/Import capacity
Ontario has historically been a net exporter of electric power. US power companies spend billions importing electricity and are projected to continue at an increasing level. US companies must meet regulated emissions limits. Purchasing low emission generated electricity will offset their heavy reliance on fossil fuel generation.

Ontario offers profitable opportunities for private sector investment in electricity generation but the uncertainty over the rules are deterring investment. There are only two new private generation projects for the deficient market; the TransAlta Corp’s 575MW plant in Sarnia and the Brascan Corp’s 45MW generator in Wawa.

Another important aspect is import capacity. Storms such as the Ice Storm in 98 are reality indicators that Ontario requires import capability in case of system failure. Furthermore, Ontario should be able to capitalize on low price surplus power from the US.

Either factor requires significant increases to the inter-tie connections, which are the physical links, between Ontario, Manitoba, Quebec, New York, Minnesota and Michigan. Currently the inter-tie capacity is at only 15% of the peak demand. During the summer of 2002, the province was importing approximately 4000MW and required 4273MW. The data used to calculate this percentage is severely skewed by the extreme peaks encountered; however, the capacity is not be enough to fully participate in an open US market.

Environmental Quality
Continuous improvement of environmental performance in the industry is an economic incentive as well as a social benefit.

Fossil fuel generation accounts for approximately 20% of the power in Ontario, but the workers at these facilities make up a significantly higher percentage. It doesn’t make economic sense to close down these facilities, or convert them to natural gas. New technological advances in emission reduction have introduced leading edge “clean coal” plants. Using Selective Catalytic Reduction technology, these facilities transform the coal into a gas state that is then burned for generation reducing over 90% of the previously emitted sulphur dioxide, nitrogen oxides and other particulate pollutants.

Natural gas is already a low emission fuel source. Converting the generators to natural gas would be an investment in access of $5 billion without adding any additional capacity to the electric system. Further more, the cost of natural gas is rising and it is estimated that there is less then 30 years supply of natural gas remaining. North American coal reserves are expected to last over 300 years.

Emissions can be reduced via supply of low emission power or from a decrease in demand so that the fossil fuel generating plants will be used less often to handle excess peak loads. Nuclear power has none of the greenhouse gas emissions regulated in the Kyoto Protocol. Energy efficiency programs will stimulate economic cyclical activity in Ontario which will ultimately create more employment.

There have been huge technological gains in the industry over the last two decades. Advances in hydraulics and electronics have transformed a once very labour intense industry into one that is very technical. The workforce needed to evolve with the environment. The new technology was opposed at first. It was viewed as replacing workers and a waste of money. The use of fibre optics in junction with hydraulic equipment allowed for taller aerial devices and greater lifting capacity. One truck was able to do the work of two. Remote switches that were electronically controlled at the operations control room reduced the need for physically opening and closing line switches. This is a significant time saver as driving time is a factor as the switches may be miles apart. Although this equipment required fewer workers with one skill set, it requires more workers of other skill sets. Technology is no longer perceived as threatening job security unless the workers are unwilling to update their skills. It is allowing the workforce to work smarter, safer and with less effort.

THE IMPACT OF THE PRICE CAP
The Ontario electricity market opened for competition on May 1, 2002, after multiple set backs. The wholesale market spot price is set by the marginal supplier every five minutes to respond to the changing levels of supply and demand.

When the market opened, the weighted average wholesale price was 3.01 cents/kWh. As the temperature increased, consumption increased and by July the average price was over 6 cents/kWh. Due to the price spikes, the highest recorded market price occurred on September 3 at $1.03/kWh.

Despite warnings and attempts to educate the consumers on market activity and the theory behind the competitive model, the public continued to consume and criticize. On December 9, 2002, the Electric Pricing, Conservation and Supply Act, 2002 was ratified. This act lowered and froze the low volume retail rate at 4.3 cents/kWh and gave retroactive rebates back until market opening. The rate freeze was due to remain in effect until 2006. The 4.3 cent cap was clearly unreasonable. The weighted average price from market opening to that time was 6.2 cents, which would have been a more sensible approach if applying a price cap.

There are three primary negative outcomes resulting from the restriction of rates and restructuring:

1. extensive financial burden on the province
2. reduced incentive to conserve consumption
3. reduced incentive for investment

FINANCIAL BURDEN
The imbalance between the market supply and demand will continue to increase the prices and ultimately the contributions required from the provincial government. The cost in the one year since market opening is $1.6 billion. These funds represent the opportunity cost of money re-allocation from education and health care or from increased taxes.

CONSUMPTION
The rate cap is intensifying the imbalance by inhibiting the invisible hand of the marketplace. As the demand for a commodity increases, the quantity produced also increases. When the supply is unable to match the demand, the commodity becomes relatively scarce and the forces of competition put upward pressure on the price. A higher price causes less quantity to be demanded and therefore causes the price to decrease until the market reaches equilibrium. Faced with increased electric bills, the consumer would reduce consumption. As a result of the price cap, the commodity is now perfectly demand inelastic; it is completely unresponsive to changes in actual price level.

A typical result of a perfectly inelastic demand curve would be increased wholesale prices. Because the consumer will continue consumption regardless of the commodity’s price it is open to wholesale price abuse. This creates a situation where more than half of Ontario’s electric demand is not responding to increased prices therefore requiring an increased amount of generation capacity to meet the demand.

INVESTMENT
Uncertainty is the greatest fear in a capitalist economy. The absence of proficient governance is creating uncertainty in a desperate industry. Bottom line is if companies do not forecast a return greater than the associated risk, they will not invest. The price cap is set below marginal returns for generation, so there is no incentive for private investment to generate the supply of electricity.

For Ontario, the situation only gets darker. Ontario will face capacity shortfalls in the future, especially in extreme weather. In March 2003, the IMO reported that only 25% of the planned generation was under construction. Since the market opening virtually all has been delayed or cancelled.

Compounded to the fact that there has been virtually no additional generation in the past decades, the Independent Market Operator (IMO) estimates that 20% of our current capacity will be either retired from service or require substantial refurbishment over the next 10 years and another 20% in the subsequent 5 years. Almost all generation capacity will be retired or require substantial refurbishment over the next 30 years.

To further discourage investment in the province’s capacity, the government is considering major transmission expansions. This will allow for the importing of electricity from Manitoba and Quebec. This is another example of a short term solution, or band-aid, for the lack of Ontario’s internal supply. Even these short term options will take years to complete if they even begin. This is another example of how government intervention policies do not address the root problem. They are foregoing long term, proactive stability and reacting to consequences on an ad hoc basis for short term public favour.

BLACKOUTS
The Canadian Centre for the Advancement of Energy Markets (CAEM) tracks the progress towards retail energy competition. The report is issued twice per year and is called the Retail Energy Deregulation Index (RED Index). Ontario had an impressive 45 out of a possible 100 points by mid 2002, which ranked Ontario in 11th place within North America. One year later, Ontario is now at the bottom tied with California for 29th.

Two years ago it would be hard to believe that the once benchmarked electric grid could be subject to power shortage blackouts. Shortly after 4pm during the afternoon of Thursday, August 14, 2003, Ontario, along with 8 additional states in the Northeast, lost the ability to supply electrical service to their customers.

Anderson Economic Group summarizes the economic effects in their report. Unfortunately Canada is only mentioned as also being effected. The data applies to actual US impact. A brief summary of the report follows:

The report from AEG compared the impact of the blackout to two other significant economic events; the 1998 GM strike and the 2002 Port Shutdown. They indicate the 2003 blackout was approximately four times as damaging as the port shutdown and twice as damaging as the GM strike.

The report further indicates that the loss is about 1/10th of 1% of the total US $10.7 trillion GDP. This means that the blackout will hurt growth for about two quarters, but will not trigger a recession.

Statistics Canada quantifies the impact much heavier than expected. Over-all output declined 0.7% in August. They report that the last time the economy suffered such a setback was September 11th. The output of the federal government fell 5.1%, manufacturing fell 0.6%, rail transportation fell 1.7% and trucking fell 3%.

In wake of the blackout, despite the nominal effect in the US, the Department of Energy is implementing strategies to insure reliability.

The uncertainty over the threat of further blackouts will have colossal effect on Ontario’s output. Manufacturing firms are all ready discouraged from operating in Ontario due to the relatively high Canadian dollar and the progressive over compensation of low-skilled workers brought on from the monopolization of labour. The instability of electric supply will be an important future consideration for facility location. As the cost of low-skilled labour increases, firms become more capital intense. Automation becomes relatively less expensive and a more feasible means of increasing output. The productivity gains are achieved via continuous flow of highly specialized and synchronized operations. This equipment in addition to being very costly is also extremely dependent on a continual supply of electricity. Any anomalous in the supply can be detrimental. Down time alone is astronomical. Automated firms run their equipment through the night, most equipment must be manually restarted if interrupted therefore increasing down time. Heavily automated milling machines often have dissimilar residual forces when their supply of power stops. This force causes extensive damage to the product and the machines. Any firm that is considering investing in automated capital is going to want a consistent, secure energy supply. If Ontario’s electric system is a disproportionate risk, existing firms will re-locate and prospective firms will set up elsewhere.

Firms re-locating will cause a decrease in labour demand represented by a shift in the labour demand curve downward and to the left. A large majority of the employees that would lose their jobs are union workers. There will be a decline of non-union wages resulting from the spill over effect from these displaced union workers entering into non-union markets. This increase in the supply of labour would result in rising structural unemployment. This would further decrease the standard of living in Ontario as consumption of goods would fall with the declining income levels. The provincial tax base would shrink as would health care and education. Ontario would become increasingly less productive in the global competitive environment.

CONCLUSION
Edison would be amazed at what he has created. The electric industry has had a very eventful past and there is no doubt it will have an equally eventful future.

Price stability is a major issue. In open markets, commodity prices are determined by the economic pressures of supply and demand. Electricity’s pricing is particularly volatile as it has a precise ceiling on capacity, furthermore, lacking the ability to store commodity surplus. There are three ways of correcting this problem. Increase the supply; decrease the demand, or both.

The ability to match supply with demand is only one element of a reliable system. As with any business, resources can not run at maximum capacity without maintenance and further capital investment; focusing primarily on short term gains while neglecting long term planning is poor business management.

Without further long term investment into the electric system, future blackouts are highly probable if not inevitable. Blackouts have had a will continue to have an impact on Ontario’s aggregate output. Without some radical improvements, the future of Ontario’s economy may become unplugged.

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