Powerful Reforms:

Worth A Look, Crown Corporations, Frontier Centre

Canadians accustomed to cheap, reliable electricity are facing higher energy costs and, in some parts, an increased likelihood of blackouts. Much of Canada's electrical power industry shows arterial sclerosis with inadequate investment, fewer exports and increased import competition from high-cost sources in the United States. Canada's power industry needs a good dose of liberalization, as successfully adopted in the European Union, but most of our provincial politicians are too reluctant to give up their monopoly fiefdoms.

Here's a puzzle. Why aren't huge investments taking place right now in Canada's power industry, where costs of production are much lower than in the United States? It would not take long for a smart entrepreneur to figure out that Canada, with cheaper sources of supply, could export electricity to the United States and earn huge margins on exported electricity.

Such is not the case. Instead, investment by electrical utilities, most of which are government-operated, represents a declining share of the economy's activity. In 1995, capital stock in the electric power industry was almost 19% of GDP, falling to 12% by 2005. The 2005 investment expenditure of $11.4-billion barely covered its capital depreciation of $7.4-billion, adding little to the current capital stock of $173-billion. Overall, Canadian production of electrical power declined from 585 million to 569 million megawatt hours by 2003. Exports declined from 51 million MWh to 31 million MWh and imports rose from 15 to 24 million MWh in the same period.

A recent U.S. study identified Ontario as one of three locations with the most inadequate transmission facilities (the other two being Connecticut and southern California). On a North American map, Ontario's land mass certainly shows up as blight when it comes to mismanagement. If this is not enough to convince you that Canada's electrical industry is ailing, just look at its lack of profitability and its cash flows, which are inadequate for investment. According to a report by Statistics Canada last year, the 2003 pretax return on assets was 6% for Canada's electrical utilities, insufficient to cover its cost of capital and risks. The highest return on assets was 9.7% in privatized Alberta, followed by 7.7% in nationalized Quebec. Ontario eked out a pretax return on assets of only 2.9% – meaning that the government would be better off to buy back the previous Ontario Hydro's massive stranded debt than to invest more money in power. In Manitoba and New Brunswick, utilities are actually losing money after subtracting taxes and interest costs from their profits.

The culprit in this poor performance is not management or workers. Instead, most governments are at fault for relying on outdated modes of regulation that protect power companies from competition. This is in sharp contrast to the regulation of telecommunications, which was once dominated by provincial telephone companies, such as Alberta Government Telephones and BC Tel. Today, most provinces have given up ownership of provincial telecommunication companies (except for Crown-corp.-loving Saskatchewan), resulting in a more innovative and inexpensive communications industry with major players like Bell, Rogers, Telus, MTS and Videotron. If the regulatory environment for the telecommunications industry can be liberalized, why not power? The Europeans provide an answer to this question: They have been able to beat back national interests via EU directives that remove barriers to trade in electricity markets. Their power reforms have significantly improved the industry's performance through liberalization (not necessarily privatization).

Instead of relying on monopoly power companies, providing little choice to consumers and virtually no cross-border trade, the EU in the 1990s increased competition by unbundling generation, transmission and distribution services, while allowing for regulated third-party access and cross-border trade. Since 1997, European real prices have declined 30% for small-business users, 15% for households and less than 10% for large users.

The United States has also been liberalizing markets, knocking down state boundaries in favour of more integrated markets. A recent OECD study found that liberalization of electricity markets in the United States have benefited all sectors of the economy by as much as 1% to 3% of GDP, with the EU reforms providing even larger benefits equal to 2% to 3.5% of GDP.

As Ulrik Stridbaek of the International Energy Agency points out, the most important benefit has been better integration of power supply from nuclear, coal, gas, wind and other sources of energy, since suppliers could more easily enter markets with different products and requirements. Such innovation is a casualty of the more rigid approach in many Canadian provinces with near-monopoly government-owned companies. This is the same lesson Canadians learned after the communications industry was liberalized from provincial protection.

Governments still play an important role in regulation: Consumer interests have to be protected and the power grid properly co-ordinated by an independent operator. Environmental policies still need to be led by governments by creating incentives to reduce pollution. However, the key is to allow for more competition among suppliers and what better way to achieve this than by allowing for greater third-party access and interprovincial ownership of power companies that can trade electricity across provincial boundaries? Small provincial utilities, such as in the Atlantic region, should be merged to improve their capacity to innovate, as well as to achieve better economies of scale.

The electricity industry needs a reform shock. The provinces are responsible for getting the ball rolling.

Jack M. Mintz is Professor of Business Economics, J. L. Rotman School of Management, University of Toronto and fellow-in-residence at the C. D. Howe Institute.