DBRS Publishes Study: Ontario Electricity Industry’s Long-Term Outlook – Rising Political Risk

DBRS has today published the industry study “Ontario Electricity Industry’s Long-Term Outlook: Rising Political Risk.”

RISING POLITICAL PRESSURE COULD INCREASE CREDIT RISK GOING FORWARD
After years of a relatively stable political and regulatory environment, the utility sector in Ontario could face growing challenges. As generation costs potentially rise above and ultimately test the political ceiling (10% increase of the total bill annually), it may be difficult for the utilities to pass these costs onto the ratepayers. As a result, the following are possible negative outcomes: (1) a rate freeze whereby incremental costs are not recovered or (2) costs that could only be recovered over a long period of time. In either event, profitability for the regulated utilities would be impacted and could result in a negative rating action.

BILL 210 (2002 RATE FREEZE), DÉJÀ VU
Given the direction of the energy policies in Ontario, a similar outcome to Bill 210 could occur as ratepayers finally see the price tag of green energy initiatives. In 2002, upon market opening, power prices increased sharply in Ontario as a result of record demand and high fuel costs. In response to the high power price, the provincial government legislated Bill 210, which received the Royal Assent in late 2002, freezing electricity rates. As a result of heightened political risk and its implication on the credit quality of DBRS-rated electricity companies based in Ontario, DBRS placed eight companies “Under Review with Negative Implication” at the time.

SUFFICIENT SUPPLY BUT NO PROTECTION FOR RATEPAYERS
Contrary to the power cost increases of the early 2000s, which was driven by limited generation capacity and rising demand, the future rise in costs will be associated with green energy initiatives. Furthermore, the future environment is expected to be well supplied and more than sufficient to meet future energy needs. Over the past ten years, total generation capacity has increased sharply by 30% to over 36,000 MW, while demand has dropped by 7% to approximately 141 TWh.

GREEN COSTS GREEN
The current green policy initiatives could create the perfect storm, if the following occurs: (1) continued changes in generation mix toward more expensive green energy sources; (2) after the shutdown in coal-fired generation in 2014, the marginal cost of electricity is expected to continue to be largely based on natural gas prices, even if natural gas prices rise dramatically; (3) unplanned nuclear outages; and (4) the expiration of the Ontario Clean Energy Benefit in 2015, unless the government decides to extend the credit. The combination of these events could test the political will to pass on the rising costs to ratepayers and potentially result in credit deterioration.

THE PROBABILITY OF A PERFECT STORM IS LOW BUT INCREASING
DBRS is concerned about a potential perfect storm in the combination of the following:
(1) Coal-fired generation being shut-down by 2014;
(2) Increasing weather-sensitive, high-cost renewable energy (e.g., wind);
(3) Natural gas price recovery; and
(4) Other variables, such as the expiration of the Ontario Clean Energy Benefit.

However, DBRS expects regulated businesses, including transmission and distribution utilities, as well as non-regulated generating businesses (under longer-term power contracts with the Ontario Power Authority (OPA; rated A (high)) to continue to generate relatively stable earnings and cash flow in the foreseeable future.

(1) Power costs expected to increase as low-cost coal-fired generation to be phased out by 2014.
With a greater emphasis on environmentally friendly electricity generation, Ontario’s Long-Term Energy Plan will phase out coal-fired electricity generation in favour of natural gas and renewable energy generation projects, such as wind projects. Although renewable energy is considered to be more environmentally friendly than coal-fired generation, it comes at the expense of higher power costs. The average fuel cost of electricity produced by a coal power plant is typically around 3 cents per kWh, while electricity from wind and solar generation costs more than 10 cents per kWh. The replacement of coal plants will pressure the Province of Ontario (the Province; rated AA (low)) to become more heavily reliant on more costly energy sources.

(2) Wind, solar and biomass generation is expensive and less reliable.
Wind, solar and biomass power plants have relatively low capacity utilization rates and cannot always be relied upon when needed. As a result, they require backup generation capacity, as well as contracts that are significantly above market, which in some cases may be more than ten times higher than the spot market on average. This places additional pressure on costs. Furthermore, wind power generators typically produce the majority of electricity load during the early morning hours, which is when electricity demand and prices are low.

(3) Potential natural gas price recovery could contribute to higher power costs.
DBRS expects natural gas fundamentals to gradually improve and restore the demand/supply imbalance in the medium term, as evidenced by a significant decline in the natural gas active rig count in key plays, such as Haynesville and Marcellus, as well as continued switching to natural gas from coal to generate electricity.

Upon the shutdown of the coal plants, natural gas power plants will account for the majority of intermediate and peaking capacity. As a result, natural gas-fired generation will drive marginal pricing during most of the peak hours.

Capital investment in power generation is generally considered sunk costs. Once a plant is commissioned, the marginal cost of producing an additional kWh of electricity generally determines its dispatch and fuel costs make up the majority of the marginal costs. As a result, the marginal price will be at the mercy of natural gas prices. Should natural gas prices recover from the current unsustainably low levels, fuel costs will increase.

Consumer bills could increase by approximately 10% and 15% should natural gas prices reach $6 per mcf. It could prove difficult for the industry to pass these incremental costs on to the consumer over a short period of time. This analysis is based on the assumption that 50% of generation is non-regulated and non-contracted, and on a heat conversion rate (from natural gas to electricity) of 8,000 British thermal units (BTU), where the marginal cost will double to 4.8 cents per kWh (8,000 BTU x $6 per mcf) from 2.4 cents per kWh (8,000 BTU x $3 per mcf).

(4) Other variables.
Other plausible events that could put additional pressure on electricity prices include the following:
(a) Nuclear outages: Candu nuclear reactors used in all of nuclear plants in Ontario could be affected by prolonged outages, for example from a deterioration of pressure tubes, which could lead to them being replaced before their 25 years of useful life and result in a full plant shut down for a period of more than two years for repairs. This would lead to a further decline in supply from nuclear generation, increasing reliance on other fuel-type generation, such as natural gas and renewables.
(b) Low hydrology: Low water levels due to drought conditions would contribute to reduced production of low-cost hydro generation.
(c) Ontario Clean Energy Benefit: The Ontario Clean Energy Benefit (OCEB) is expected to expire in 2015. The OCEB currently reduces the electricity bills of families, farms and small businesses by 10% for the first 3,000 kilowatt hours (kWh) used.

A PERFECT STORM OF EVENTS COULD RESULT IN POLITICAL INTERVENTION
The Ontario electricity industry will become more heavily reliant on natural gas and renewable energies once all of the coal-fired generation plants in Ontario are shut down by 2014. DBRS expects that natural gas fundamentals will gradually improve and restore the demand/supply balance in the medium term, recovering from the current bottom-of-cycle natural gas pricing conditions. The combination of the natural gas price recovery and rising above-market renewable energy contracts will likely increase power costs, putting pressure on the industry’s ability to pass through their deemed cost, including power purchased costs, on a timely basis. Unlike coal contracts, gas power generators have difficulty finding counterparties to enter into long-term fixed-price gas purchase contracts to hedge fuel risk. This may create volatility in pricing that could limit the industry’s ability to pass costs on to the consumer should high natural gas prices occur. Given political intervention, it may be difficult for the industry to pass these costs on to the consumer should total bills exceed 10% on an annual basis.

Notes:
The applicable methodology is Rating Companies in the North American Energy Utilities (Electric and Natural Gas) Industry (May 2011), which can be found on our website under Methodologies.