Glimpse into Why Municipalities Sell Their Regulated Electric Utilities

I have been lucky enough to work on several successful merger and acquisitions for a few electric utilities in Ontario, and here are some key reason why municipalities ultimately sell.

Quick history lesson

It should be noted that the Ontario Government de-regulated the energy industry over 20 years ago, and one of the key components was the breaking up Ontario Hydro (transmission, distribution and generation) into hundreds of electric distribution utilities and Ontario Power Generation, among technology assets.

From a municipal perspective, this process was on the tail end of “Who Does What” process that the Ontario government embarked on. As they downloaded additional responsibilities and costs, they also handed them the value of these local electric utilities.

At the time, I was working as a Political staffer at the Municipality of Metropolitan Toronto, and it was obvious to me that the Ontario government never properly received their appreciation from municipalities for handing over $ billions in assets.

But the province was doing something different. They had found a way to effectively privatize the distribution assets, so no more over-expenditures would occur on their watch, and they simultaneously found a way for these municipally-owned utilities to begin to repay the stranded debt after decades of over-expenditures in nuclear energy assets, among others.

Municipalities had very quickly figured out that they were holding a cash cow that could be manipulated for years to come for additional municipal revenues through dividends and over-priced debt notes- but I’m getting ahead of myself.

The beginning

Initially, as I scoured the province looking for possible sellers of their utilities to Hydro One, I learned some valuable lessons.

It took municipalities a few years to really figure out what is was that they had in their utilities. Initially, there were municipal leaders who were convinced that by them holding the assets, they were some how protecting the rate payers better than if it were in non-municipal ownership. It’s an interesting notion considering 99% of them took every possible increase in rates they could… There was certainly a disconnect with what the utilities were doing and what municipalities expected, but as long as dividends were available, it clouded their direction.

There were a few municipal owners that tried their best to run the utilities as non-profit entities, but very quickly figured out that the regulation process would render their utility worthless without an aggressive capital campaign.

There were about 90 utilities, mainly small rural, that were acquired by Hydro One in the first two years of de-regulation, and there were several community mergers of similar-sized utilities.

There were very different reasons why municipalities sold in the early years vs the last 5, and I’ll explain the difference and where we are now.

Initially, about 100 small rural municipalities understood two key factors. One, running utilities was not in their core-competency, and two, their small rural towns needed some cash or certainly didn’t want the financial burden of running the utility. It was seen as a risk. As I understood it, some utilities needed to be rebuilt from ground up, and the risks would have been great for small towns.

It was after the dust had settled and brought total number of utilities to under 100, that utility execs started to figure out how to game the regulatory system to earn more money, and municipalities figured out that utilities could provide critical dividends and streams of cash, when required.

While dividends have been set at ~ 9% of sunk equity, two things started to happen to increase overall cash to shareholders. One, they started to find ways to increase capital spend per customer in somewhat redundant infrastructure, and two, they found ways of borrowing lines of credit from their shareholder at much higher rates than from traditional banks, thus generating greater return for lending their cash to get around only 40% of invested capital being equity.

Before I get into why municipalities sell their utilities in the last 5 years, let me explain the political dynamics that prevent them from achieving more mergers with their neighbours.

As you can appreciate, these municipalities are run by politicians who are elected by their local citizens. They run campaigns every 4 years, and in the great words of former US Speaker of House of Representatives, Tip O’Neill, “all politics is local”.

One observation to keep in mind is that the smaller the community, the greater the risks in keeping and managing their utility well. As well, the smaller the community, the more powerful the Mayor compared to other municipally-elected politicians.

It’s just politics, but you can probably appreciate that once you’re in office, you’re not just competing for the next election, you’re indirectly being measured against what your political neighbours are doing, and how you measure up against them.

Why is this relevant?

If you wanted to take advantage of synergies by merging local utilities, you do not want to be the minority partner with your neighbour. The optics look like you sold out to your bigger neighbour. Thus few mergers were successful between small town communities. There are exceptions, but it’s not the rule, and you can point to other dynamics that were catalysts to those deals.

If mergers were really the answer to generating synergies and economies of scale and value to rate payers, then why haven’t more occurred?

To be successful in a merger of relative equals, politically, the answer is to bring each shareholder into minority ownership and avoid any one majority shareholder. That would mean a min of 3 merged entities, and since no one wants to be the minority in the first deal, you need to accomplish this deal in real time among few parties.

Larger communities have accomplished this, and arguably because they had the resources and political prowess to whether the stormy process of valuations and negotiations compared the the limited resources of other towns. I would even argue that the lack of political will prevents synergistic deals from occuring.

To add to the challenges of operating these utilities as a smaller less efficient size is the attitude of utility board members collecting their per dium, and utility c-level protecting their jobs.

Let’s answer the question first of why smaller utilities aren’t sold of late.

I have prepared the environmental scans of targets for acquisition, and they generally include the need of cash by the municipal shareholder. We look out and see the fiscal challenges hitting the town or in some cases hitting the utility. We walk in and we pitch to be the solution and acquire the utility for a significant price, and more times than not, the municipal leadership debates the fact that they need funds and argues that they are more than fine to continue without a sale. I have a handful of examples where these municipalities recognized their financial burden years later.

So for anyone thinking that municipal shareholders will sell their utility because you offer a bag of money, that’s not going to get them to sell…

In fact, I had Mayors and Staff ask if we can keep the cash from the sale away from the council because they would spend it all at once.

So what has been successful for them to sell?

In my experience, and referring back to the political side of the equation, most of these municipalities want economic development growth.

The larger the town the greater the economic development opportunity to justify selling their utility. I recall walking into one municipality and offering a small investment that came with 20 jobs. They effectively laughed us out of the office.

Politicians win elections by solving problems. If their utility isn’t a problem, then what do you think you’re going to solve by selling it.

You need to understand the broader financial issues, and post- Great Recession, it’s all about jobs and investments!

Hydro One had the advantage of needing to rebuild dozens and dozens of operations facilities. Why ever would you re-build them in non-service territory municipalities. You use your facilities that you’re going to build anyways, and you leverage to bring economic development to buy utilities.

As an example, Alectra offered the green technology centre to sweeten its merger with Guelph Hydro.

At this moment in time, municipal shareholders are competing for jobs and investments with their neighbouring communities, and leveraging jobs is critical to any deal. But don’t kid yourself that you’re going to buy it for anything less than top dollar.

If I were at the largest utility in Ontario, I would seriously consider breaking up downtown Toronto headquarters into several key locations around Ontario as leverage to acquire utilities. Certainly expending resources in a city that is out of your service territory, serves no benefit to your current rate payers.

There are more deals to be done in Ontario, and what’s required is for utility shareholders to not only appreciate what is required in order to acquire them, but to develop a robust plan to convert them into growth platforms to increase share of wallet with customers.

At the moment, wires businesses in Ontario seems to run the businesses that were created 100 years ago, not what the customers need today. But I digress…