Current Issues

Commodity Payment Default Risk and Ontario’s Electricity Distributors

Local Distribution Companies (LDCs) are responsible for delivering a commodity: electricity. The Ontario Energy Board (OEB) has explicitly stated that in order to fulfill their legislated role of providing impartial access to their wire systems (commodity delivery network) for suppliers and consumers, distributors should bear “no significant” financial risk associated with the commodity.

Much like a courier company, distributors are responsible for (and get paid a fee for) delivering a product. The OEB, through a regulatory decision rendered in 1999, made it clear that, just like courier companies, distributors are not supposed to have any financial interest in the cost of the product they deliver.

However, current market rules and codes impose an obligation on Local Distribution Companies (LDCs) to pay the Independent Electricity System Operator (IESO) monthly invoice, which includes commodity and other charges not related to distribution, before distributors receive full payment from end-users.

The financial risks arise from the fact that distributors (whose distribution fees only represent approximately 20% of consumers’ monthly electricity bills) are required to guarantee payment to the Independent Electricity System Operator (IESO) for the remaining 80% of the bill. These non-distribution components of the bill are related to:

The price of the electricity commodity (which goes to generators, including OPG);
The price of transmitting electricity (which goes to the transmitter, Hydro One);
The price of running the electricity market (which goes to the IESO); and
The price of servicing the debt left over from the old Ontario Hydro (which goes to the Ontario Electricity Financing Corporation).

Consequently, the IESO, transmitters and generators are fully indemnified by LDCs. Distributors are ‘bridge-financing’ the period between their payment to the IESO and the point at which they are fully reimbursed by end-users through the billing process. In this context, payment default of the bill by an end-user is a significant negative event for LDCs.

Since market opening, the Electricity Distributors Association (EDA) has advocated for the removal of the commodity risk facing distributors.

In May 2002, the EDA Board of Directors passed a motion seeking the elimination of the commodity underwriting role of distributors by converting the 100% payment obligation to the Independent Electricity System Operator (IESO) into a “pay-what-you’ve collected” policy.

Formerly, municipal utilities were able to register property liens to secure against account defaults (under the Public Utilities Act). However, legislation and Ontario Energy Board (OEB) codes have removed this right. During market opening and fluctuating energy rates, LDCs saw their creditworthiness being negatively impacted by this issue.

Since the establishment of the market rules and codes there has been on-going concern within the sector regarding payment defaults by large customers, and the financial impact that this can have on LDCs who are given no choice but to shoulder this risk.

The EDA believes that this long-standing commodity risk issue needs to be addressed. Distributors should only pay to the IESO what they have collected, consistent with their role as pass-through agents.

LDCs at Risk: Impact of Customer Deposit Policies and Payment Default

When the issue of commodity risk was raised with the IESO in the past, the IESO indicated that distributors should reduce their risk by implementing appropriate prudential requirements with their electricity customers.

Many distributors responded by revising their deposit policies to help lessen the financial impact that defaults were having on the utilities.

Then, in 2003, the OEB initiated a review of customer deposit policies with a view to create consistency across the province. The review resulted in an amendment to the Distribution System Code (DSC) in February 2004 which required the distributor to return deposits when a customer demonstrated good payment history over 1 year in the case of a residential customer, 5 years in the case of non-residential customers under 50 kW, and 7 years in the case of non-residential customers over 50 kW. The deposit would be reinstated if the customer received more than one disconnection notice.

The issue for distributors remains that many large customers give no indication of impending bankruptcy and after a customer demonstrates financial problems, the customer is often not in a position to provide a deposit. A distributor can attempt to reduce their exposure, but the customer may already be in arrears and face difficulties in settling their accounts.

The current market rules and codes require distributors to absorb the immediate financial loss caused by any commodity payment default by an end-user, and bring an application to the OEB to seek approval to retroactively recover the defaulted amounts.

The capacity of a distribution company to absorb the immediate financial impact of a payment default depends on the size of the default and the credit capacity of the LDC.

In certain conceivable circumstances - e.g. in the event of a default of a large industrial customer, or in the event of the default of an electricity retailer, either of which can represent as much as 30% or more of the total wholesale electricity bill for some LDCs - absorbing the initial impact of the default could eliminate the distributor’s ability to meet its obligation to pay the IESO invoice, and have dire financial repercussions for the utility. Even under less severe circumstances, the realization of commodity payment default risk has the real potential to diminish a distributor’s ability to provide stable financing to its distribution business.

To recover losses caused by commodity payment default, LDCs must submit an application to the OEB and demonstrate that prudence was exercised in securing themselves against the risk of payment default from the end-user in question.

LDCs and the Issue of Bridge Financing

The EDA recognizes that some of the concerns raised in 2002 have been addressed though market changes. The IESO has made changes that have reduced LDC prudential obligations. Additionally, the initial market design, which required the difference between the stable commodity price paid by consumers and market prices carried by LDCs to be put in a variance account, has been addressed by shifting the obligation to the Ontario Power Authority (OPA).

Ontario’s Market Rules (Chapter 9, subsection 6.11.1) require market participants to pay the full amount of the IESO invoice on the payment date. That typically involves the LDC paying the full net amount of the IESO invoice prior to receiving payment from their customers through the retail settlement process.

This occurs as a result of differences between wholesale and retail settlement timeframes. The lag between monthly wholesale settlement and the corresponding retail settlement can vary, depending on the LDC’s customer billing period (e.g., weekly, monthly, bi-monthly, quarterly), which is determined at the discretion of individual distributors. As a result, LDCs provide bridge financing covering the differences between wholesale and retail billing and collection timeframes.

While wholesale settlements occur on a monthly basis, electricity is consumed when it is produced, creating a lag between consumption and payment for that consumption. Also, it is impossible to recover the electricity consumed if a consumer does not pay. Therefore, to ensure the creditworthiness of the wholesale market and protect against payment defaults, the IESO requires market participants (e.g., LDCs, grid-connected industrial users, generators, etc.) to provide security in the form of a prudential support obligation to the IESO to demonstrate their ability to meet the financial obligations arising from their real-time market transactions (i.e., electricity withdrawals).

The Need for Amendments to the Market Rules

The critical issue for distributors comes from the current Market Rules that requires market participants to pay the full amount of their IESO invoice on the payment date. To alleviate LDC commodity risk the rule should be amended to allow LDCs to pay the IESO only what they have collected from their customers rather than the full amount of their IESO invoice. This recommendation was submitted by LDCs to the IESO in 2002, but not adopted because the Technical Panel did not agree that the suggested rule change was the appropriate method to resolve the problem. It was also not supported by the generators (or the majority of market participants), as this would delay payment to generators. There was a concern that it may cause a potential negative impact on attracting much needed new private generation into the Ontario electricity market.

To address the concerns on the “pay what is collected” approach, the rules should be changed on how customer payment defaults of large LDC-served consumers are recovered.

The Market Rules give the IESO the authority to impose default levies on all market participants in the case of a payment default (i.e., the cost of market participant payment default is socialized broadly across all market participants). For example, if an industrial user directly connected to the transmission grid defaults on its IESO payment and the cost of this default is not covered by the user’s prudential support, the cost will be borne by all market participants (including LDCs) through an IESO imposed default levy. However, if that same industrial user is served by an LDC the costs of default will be borne by the LDC’s ratepayers and will require Board approval of the LDC’s application to recover the default from ratepayers (i.e., the cost is socialized narrowly across an individual LDC’s ratepayers). Thus, the socialization of default recovery is a function of a user’s point of connection (grid v. distributor).

This is not a fair or efficient mechanism for recovering payment defaults. A small LDC with a large industrial customer defaulting could impose significant financing costs on a LDC, compromising its ability to financing its distribution business, and require significant rate increases on the LDC’s limited number of remaining ratepayers. The preferred alternative option is to broadly socialize the costs of commodity payment defaults by all large customers through the IESO default levy, facilitating faster recovery and mitigating rate increases.

This inconsistency between the wholesale and retail markets, where the IESO recovers a large default from the entire Ontario electricity market while an LDC would recover a default of the same magnitude from only its customers, is an issue of inequity and cross-subsidization.

Working Capital Allowance

The need for ‘bridge financing’ the period between an LDC’s payment to the IESO and the collection from the LDC’s customers has an impact on the distributor’s cash flow stability. A key component of the working capital that LDCs use for cash flow stability is the amount required for IESO payments which are largely driven by the cost of power. Regulators generally recognise the need for working capital as the cash needed to support expense outlays due to the timing difference between receipt of revenues from customers and payments of funds to vendors and other suppliers. In the OEB’s 2006 Electricity Distribution Rate (EDR) model, the working capital allowance (calculated as a maximum of 15% of cost of power plus controllable expenses as working capital allowance) is used to calculate the rate base.

Recently, as a part of the OEB’s process for determination of the Cost of Capital (OEB Staff Discussion Paper of July 2006), OEB staff proposed an option that short-term debt needed to finance working capital, be deemed to be 8% of rate base. Should the working capital allowance of LDCs, as suggested in the staff proposal, be limited to only 8% of rate base (as opposed to the current practice of including a maximum of 15% of cost of power plus controllable expenses as working capital allowance), it would result in a reduction in the revenue requirements for LDCs and have an impact on cash flow stability. As noted earlier, LDCs use their working capital to ‘bridge finance’ the period between their payments to the IESO and the point at which they are fully reimbursed by end-users through the billing process.

The Need to Address LDC Commodity Risk Issues

Commodity risk, or the risk associated with the commodity portion of the end-user default risk, continues to have several negative impacts on distributors. First, carrying the financial burden requires more working capital. Basically, distributors assume the role of banker/underwriter for the entire electricity market, providing 100% upfront financing of the cash flows for all participants in the electricity market (generators, the transmitter, retailers, the IESO, and the OEFC).

More importantly, as the “banker/underwriter”, electricity distributors carry all the risk of payment default, and are forced to absorb all non-payments of consumers or retailers. These have the potential to be extremely significant, and have exponentially increased the amount of financial risk carried by distributors.

Commodity risk for distributors has the potential to negatively impact LDC efforts to provide an essential service—high quality, reliable electricity distribution. It also has the potential to divert resources away from many important activities, such as conservation, demand management and the installation of new smart meters, for which distributors have assumed a leading role.