Alternative Bid: The Monopoly / Competition Interface

1. Alternative Bid:The Monopoly / Competition Interface Presentation to Queen’s University Economics of Regulation Class March 25, 2010 David M. Brown

2. Introduction and Overview • This presentation deals with the “alternative bid” or “contestability” features of one of the OEB’s Codes – the DSC. • It’s a very interesting case study in regulatory policy and involves some fundamental notions in the economics of regulation. • These include: • The natural monopoly market failure • The boundary between the natural monopoly and the rest of the world that it serves. • The “make-or-buy decision”

3. Introduction and Overview • What is Alternative Bid? • When a customer wants to connect to a utility he or she may have a choice of either asking the utility to construct the connection infrastructure, or hiring his/her own contractors. • In other words, the customer may own the ”make-or-buy” decision • The Regulator sets the rules around alternative bid. • Key interests are at stake, as is the nature of the way the utility will grow.

4. Introduction and Overview • Here’s an outline of where we will go: • Background on the electricity sector • The natural monopoly market failure • Growth in a Distribution Utility – an Alternative Bid • Alternative bid provisions of the DSC • The dispute between ECAO and Hydro One • Resolving the dispute – what do we want alternative bid framework to do?

5. The Electricity Sector

6. The Electricity Sector

8. The Electricity Sector • The four parts shown in the previous page exist under any market structure – competition or vertically integrated utility. • The two potentially competitive sectors bracket the two natural monopoly sectors. • Another view:

9. An Electricity Grid

10. The Electricity Sector • This view of an electricity system highlights the transmission grid and the loads (distribution utilities, industrials) and generators connected to it. One gigantic machine. • Transmission is networked; distribution is very radial. • Both are considered natural monopolies • Meaning: declining average costs as output increases; high fixed relative to variable costs

11. Sources • For Figure 1: William W. Hogan A Competitive Electricity Market Model Harvard KSG Hogan website, October 9, 1993 • For Figure 20: William W. Hogan Competitive Electricity Market Design: A Wholesale Primer Harvard KSG Hogan website, December 17, 1998

12. Natural monopoly • It is least cost, most efficient to have one provider of the natural monopoly service. • A market characterized by natural monopoly may fail absent some form of intervention. • What do we mean by “market failure”? • Private agents acting in their own bests interests lead to an outcome that is socially disadvantageous or inefficient.

13. Natural Monopoly Market Failure • What might this market failure look like in the distribution context?

15. Natural Monopoly Market Failure • These utilities haven’t always looked like this – they had do grow – some still are, some may not be. • If rival firms were competing to grow the distribution service: • Rushing to hook up most desirable, creditworthy customers • Avoiding customers who may look less desirable • Loss of economies of density • Analogy: wiring your new house

16. Natural Monopoly Market Failure • Consolidation of sector would likely occur • In a static setting (Kingston Hydro): • High degree of mistrust between customers subject to unregulated monopoly • Utility owners would be wary of the political activities of customers aimed at limiting their market power. Customers lobbying politicians might not give adequate thought to allowing the utility to recover sunk costs. • Outcomes will depend on legal framework.

17. Natural Monopoly Market Failure • Utility should expand in a rational manner • Its pricing should cover all costs. • Regulation may be a good way of achieving this balance • But replacing the market with a court-like process is very costly as well.

18. Alternative Bid • The Alternative Bid provisions of our Distribution System Code (DSC) govern some aspects of the utility’s growth process. • Distribution is very radial – growth occurs as new customers want to connect. • [Although green energy era is changing this] • To understand alternative bid we have to briefly describe the connections process:

19. Connections Process • Suppose a new subdivision is going in and the developer want to get electricity connected. • Distributor studies the situation and makes offer to connect. • Cost of connection will be borne by developer • Utility does “economic evaluation”: • PV(Connection Costs) <> PV(Rate Revenue) • If greater than, developer must pay capital contribution • Requirement for capital contribution triggers alternative bid provisions of code.

20. Connections Process • Alternative Bid: Who owns the “make or buy decision” • If capital contribution is required the customer can compare the utility’s offer to that of an alternative contractor • If capital contribution is not required the utility can choose to do the connection itself (“make”) or contract out the work (“buy”). • The alternative bid rules in the DSC specify what parts of an expansion project are actually “subject to alternative bid” • These rules are the source of controversy. • The utility and its unions want a narrow definition • Customers and non-utility electrical contractors want a broad definition.

21. Existing DSC Provisions • 3.2.14 Where the distributor requires a capital contribution from the customer, the distributor shall allow the customer to obtain and use alternative bids for the contestable work. The distributor shall require the customer to use a qualified contractor for the contestable work. • 3.2.15 The following work shall be uncontestable: • (a) the preliminary planning, design and engineering specifications of the work required for the distribution system expansion and connection (specifications shall be made in accordance with the distributor’s design and technical standards and specifications); and • (b) work involving existing distributor assets.

22. The ECAO - Hydro One Dispute • The hot market right now in utility construction is in expansions expansions that will enable the connection of renewable energy. • Clear creek project – HI alleges that contractor was interspacing new, higher poles between existing H1 poles. • H1 made them stop and announced new rules for alternative bid work…including a 5 m clearance around existing H1 poles. • This meant that non-utility contractors would lose a lot of business. • They complained to the OEB. • A lengthy dispute resolution process unfolded.

23. The ECAO - Hydro One Dispute • Senior Management decided that the Code neded to be revised. I was asked to steer the project along: • What might basic economics have to say about alternative bid provisions? • The “make or buy decision”: • Suppose a company needs a particular input to its productive process – should it make it or buy it? In other words what are the boundaries of the firm in that regard? • Some considerations: • Economies of scale: Can the company fully exploit economies of scale in producing this input? Perhaps competitive firms that specialize in this activity can, whreas the company itself cannot.

24. The ECAO - Hydro One Dispute • Some considerations (cont.): • Economies of scale: Ontario’s distributors range greatly in size: from Hydro One, Toronto Hydro, down to Innisfil Hydro. The potential to exploit economies of scale will range greatly as well. Hints at a need for flexibility. • Incentives – buying from a specialist company – more likely to be a profit seeking residual claimant. For an electrical contractor – electrical construction is their business • For Hydro One, construction is a division of the whole utility – not a residual claimant. Besides the overall utility may be cost-of-service regulated.

25. Principles that Alternative Bid Provisions should support • Maximize the social net benefits of the utility: • The utility should be exploit economies of scale and density; should be planned to grow in a “right-sized” manner. This principle points more to the planning activity than construction itself. Construction is not a natural monopoly. • Minimize the cost of service provisions: allow economies of scale to be exploited where they are found. Hints at need for flexibility – differing treatment. • Timely completion of projects – argues for allowing wide participation – supportive of alternative bid.

26. Our first attempt • On the work: Allow anything but physical contact to be Subject to Alternative Bid (SAB) unless the utility decides that a project requiring physical contact should be SAB. • This element of discretion would allow the Innisfils to have flexibility, but the Hydro Ones to maintain the control they want. • On the planning: planning is at the heart of the natural monopoly – keep it Not Subject to Alternative Bid (NSAB). • On ownership – alternative bid provisions apply only if the utility will own the assets after completion. But cannot bind the customer. Therefore bind the utility to oblige customer to transfer assets once completed.

27. Concerns over conflicts of interest • Work on expansions that is in close proximity to existing utility lines may require de-energizations or temporary customer disconnections • Utilities and alternative bid contractors may not agree on how this work should be done • Alternative contractor may not be sensitive to the external effect his/her work has on other customers (a mini market failure) • Whereas the utility has on-going relationships with all its customers – may better understand the effects of a de-energization. • So contractor might say – de-energize from Monday to Friday whereas utility would plan to do the work on Sunday – paying double time to its union workers.

28. Next attempt • As before but any work that requires de-energization is NSAB unless the utility decides otherwise. • We took this proposal to senior management. • They felt it gave too much discretion to the utilities – these provisions would be abused in order to keep the alternative contractors out of the business. • Letter from CEO of ECAO arrives to our Chair. (quote from letter). • I assured them that our upcoming consultative meeting with ECAO official, their lawyer, and actual contractors would be productive

29. Meeting with ECAO • De-energization: its not the work related to de-energization that matters. Once the line is de-energized anyone can do the work • It’s the decision to de-energize that matters. This decision must be controlled by the utility. • Planning: both sides have a role – the planning sections must sculpt out these two roles. • The contractor has to plan its work, obviously • The utility has to plan how the facility will be used – how it will meet the needs of future potential customers.

30. Proposed Code Amendments • 3.2.15 Planning and the development of specifications for the design, engineering and layout of an expansion are not subject to alternative bid. • 3.2.15A Work that requires physical contact with the distributor’s existing distribution system is not subject to alternative bid unless the distributor decides in any given case to allow such work to be subject to alternative bid. • 3.2.15B Despite any other provision of this Code, decisions related to the temporary de-energization of any portion of the distributor’s existing distribution system are the sole responsibility of the distributor. Where the temporary de-energization is required in relation to work that is being done under alternative bid, the distributor shall apply the same protocols and procedures to the de-energization as it would if the customer had not selected the alternative bid option.

31. Comments due April 1 • You can follow how this consultation unfolds at www.oeb.gov.on.ca • The case number of the file is eb-2010-0038 • Go to website, choose “industry” • Top right “webpage content search” enter “alternative bid”