ENSURING THE SUCCESSFUL PRIVATIZATION OF ONTARIO HYDRO

The road to privatization is a road travelled frequently these days, but as cases in jurisdictions such as California (electricity) and the United Kingdom (telecom) illustrate, the ride on that road is not always a smooth one. Privatization, and managing it successfully, has taken on added importance for residents of several Canadian provinces, especially Ontario, where generating, distributing and marketing electricity are gradually being assumed by the private sector. In this article, the authors outline a road map for the successful privatization of Ontario Hydro, and lay down guidelines that both entrepreneurs and consumers can follow.

Rolling blackouts in California have drawn attention to Ontario’s plans to privatize the production and distribution of electricity. The failure of privatization in California makes it all the more important for Ontario to understand what went wrong there, and why others (such as British Airways and British Telecom, for example) succeeded. This article describes the best practices in privatization, and provides lessons for both the Ontario government and the parties who would manage the privately owned corporations. For government, we recommend a controlled deregulation over time that would enable Ontario Hydro to adjust to market dynamics and avoid the California situation. For potential investors, we offer new ideas and business models to capitalize on the opportunities the opening of this market will provide.

PRIVATIZATION AND DEREGULATION: PURPOSE

In the early 1980s, the British government began to sell off many state-owned enterprises (SOEs), in the process popularizing the concepts of privatization and deregulation. Over one decade, the Thatcher government privatized state jewels such as British Petroleum, British Steel, British Telecom, British Gas and British Airways. The success of these privatizations led to a rush to privatize state-owned enterprises around the world. By 1999, it was estimated that privatization was generating some $160 billion (all currency in U.S. dollars) in revenue (Meridien, T., Management Review, 88(6), 16-23).

There is a misconception that privatization should only be carried out in developing or emerging economies. The British example shows that this is not true. Closer to home, it is also possible to see that there are numerous industries in Canada, and Ontario in particular, that could be privatized.

The best practices perspective is crucial not only for the privatization of Ontario Hydro, but also for health care, education, the distribution of alcohol, rail transportation, the building and operation of prisons, and of highways. Organizations in these industries, or the services they provide, in some way define what is Canadian. For example, publicly funded health care and education are cornerstones of our social policy. Nevertheless, there is evidence that privatization, if done correctly, can improve the quality of service or decrease the costs of providing it. While society may not be ready to privatize certain services or institutions, it is likely that they could be improved if privately run. It may be that the only way to gain popular support for privatizing these services is to heavily regulate and protect them.

For example, one of the major criticisms of privatization is that huge job losses result once the former SOE has rationalized operations. However, researchers have found that while this is true in the short term (due to the difficulty many SOE employees have in embracing the new organizational culture), in the long term, more jobs are created by new entrants and the incumbent firm’s growth. Also, employment in a privatized industry can be encouraged through the limited-term provision of grants or tax incentives.

SUCCESSFUL PRIVATIZATION: LIMITED DEREGULATION AND MANAGERIAL ACTION

Government

In the Academy of Management Executive, Robert Grosse and Juan Yanes suggest some goals that governments often hope to achieve by privatizing an SOE (Grosse, R., and Yanes, J., Academy of Management Executive, 12(2), 51-63). While all of their goals apply to the privatization of Ontario Hydro, three of them are especially meaningful for consumers and potential investors:

1. Improve the quality of the activity being undertaken (e.g., provision of telephone service, operation of a commercial bank, production and sale of a natural resource), by putting it in the hands of market-focused managers.

2. Demonstrate that the government is serious about promoting the role of the private sector (and often about allowing foreign investors to participate in these economic activities, as well as about deregulating markets).

3. Eliminate losing businesses from the government sector, thus helping to reduce the drain on the national treasury and perhaps external debt as well.

Essentially, a government will privatize an SOE to improve its performance and profitability. Gradual, limited deregulation is designed to encourage the development of a market that may not have existed due to the SOE’s monopoly. Governments should thus create an environment in which the former SOE faces competition that leads to better service for its constituents. The Ontario electricity market is an industry that was ripe for privatization. It was not seen as an institution integral to Ontario’s culture or identity. Hence, the public outcry has not been as emotional as the one against the privatization of certain healthcare activities.

SOEs are often characterized as being less efficient and providing poorer service than privately run firms: “The management team of an SOE reckons that the government will bail it out of a crisis situation, that it can have access to the government’s bottomless kitty and that the firm is not exposed to the discipline of the marketplace” (Ghosh, S., Journal of General Management, 20(1), 72-81). Such a disastrous performance is common among SOEs, since most are complacent and unresponsive due to their monopoly positions. Large, inefficient bureaucracies grow within them, and they survive by virtue of their government’s protection. Certainly, this seems to have been the case with Ontario Hydro. Despite the fact that it was exempt from corporate taxes, the utility was still unprofitable in the 1990s. It was only the provincial government’s unconditional guarantees that enabled it to maintain a decent credit risk rating.

By 1997, Ontario Hydro had accumulated over $35 billion in debt. Not only did this force the company to set aside most of its revenue to service this massive debt, it also severely constrained it in raising more funds. This was a particularly bad situation since its two main nuclear generation plants required several billion dollars in repairs and upgrades. The only option was to shut down portions of the plants.

Economists from the World Bank and International Monetary Fund believe that the privatization of state-owned enterprises is a critical step in economic reform, often making mass privatization a condition for further economic aid packages to emerging regions. The academic community also generally accepts the notion that privatizing an SOE will improve its performance. There are, of course, caveats: The firm must become market-oriented and focus on efficiencies and innovation. The privatization process itself is crucial, particularly with regard to the regulatory changes that accompany it, and the regulatory structure that oversees it.

An SOE will likely be unprepared for the onslaught of competition, and it may require certain protection while it builds the capabilities it needs to survive. One of the main criticisms of the California situation is that certain aspects of the industry were deregulated too quickly, leaving the industry unable to cope with the rapid escalation of energy prices. On the other hand, some aspects were deregulated too slowly, preventing the necessary increases in electricity prices. This perspective emphasizes that it can be very difficult to privatize successfully. Often, the goals of privatization are never realized and the former SOE is outperformed by new competitors.

Management

Academics suggest that one of the major weaknesses of a privatized SOE is its management and operations. Due to their monopoly, SOEs are intrinsically unresponsive to market forces. The mental models, routines, organizational practices and structures of a privatized SOE have to be completely reformed to meet the needs of the market. A newly privatized firm should change what, how and for whom it produces. It may change the core technology it uses and the marketing strategy it follows. Strategically, it should follow a new set of goals, a new mission, and ensure that everyone in the organization follows the new vision by, in turn, following new forms of authority. Essentially, the SOE becomes a new firm. The changes it must undergo to develop a market-oriented mindset involve a “change in the organization’s core form” and corporate culture (Haveman, H. A., Administrative Science Quarterly, 37(1), 48). When Ontario Hydro was restructured in 1998, the Ontario government retained ownership over the newly created holding company, Hydro One Inc. The company was divided into six subsidiaries. Although not required to pay income tax after April 1, 1999, the firm was required to pay fees to the Ontario Energy Financial Corporation (a provincial agency). Figure One presents the organizational structure of Hydro One after the restructuring of Ontario Hydro (www.hydroone.com/corporate/).

The new Hydro One would be a much leaner entity, with emphasis on key operating units. The structure of Hydro One also somewhat reflects the structure of the industry and the potential lines of business that will be created in the open market.

BUSINESS OPPORTUNITIES

As noted above, one of the keys to a successful privatization is the opening of an industry to competition. When the Ontario electricity market is privatized, there will be numerous opportunities for entrepreneurs and investors. New technologies make the generation of electricity far safer, more efficient, and available to more organizations than ever. Technologies like fuel cells and micro-generation plants, business models like gas generation, co-generation or local service, or macro-level generation through new services like General Electric’s web site are some of the opportunities (www.gepower.com/). At GE’s site, a customer can use GE Capital to rent or buy (to their specifications) generators as small as 12 kilowatts to complete hydro electric power plants. As it notes in its on-line brochure: “GE Hydro has already invested a considerable amount of its own money and expertise in a number of schemes worldwide, to develop them from greenfield sites to completion often as full or partial owners/operators” (Source: www.gepower.com/hydro/english/products/gebroch.pdf). However, there are two concerns that threaten to compromise these opportunities, the power grid and the concept of stranded debt.

The power grid

A particular fear associated with the privatization of Ontario Hydro concerns monopoly pricing for the distribution of generated electricity. Although the generation and distribution of electricity will be open to competition, realistically there will be extensive competition only in generation. An effective distribution-network infrastructure is extremely difficult and expensive to build. Hydro One will retain ownership of the grid, and is required to allow other producers to use its grid to distribute their electricity. However, there are risks that Hydro One could abuse its monopoly and charge higher than “market-determined” rates, or limit the timing or amounts of power that it will allow across the grid. Hence, ongoing government regulation to ensure the fair use of this asset is needed. It is unlikely that Canada’s Competition Bureau will be able to exercise the necessary continual oversight, and so an agency will have to be created, with the power and budget to prevent non-competitive behaviour. The Ontario Energy Board drafted a code called “Affiliate Relationships Code for Electricity Distributors and Transmitters,” which governs the actions of all the Hydro One subsidiaries that are intended to perform this function.

The grid itself offers opportunities for technological advancement and entrepreneurs. Every home and business in Ontario is connected to the grid. These connections represent potential links to telephone, television and Internet access providers. The technology may presently, or in the near future, exist whereby these services could be offered through one portal. If Hydro One alone, and/or local distribution corporations, controls this access, potential competitors will be shut out.

Stranded debt

Ontario Hydro had billions of dollars of assets that were in various states of use and decay. To finance their acquisitions and operations, billions of dollars of debt were accrued. When Hydro One was formed, the book value of the assets and liabilities it assumed was $8.6 billion. In short, Ontario Hydro may have a negative net worth. This huge negative net worth is referred to in the literature as “stranded debt.” A key point is that new competitors, not suffering from such a debt of the past, could under-price a privatized Ontario Hydro.

Ontario Hydro’s so-called stranded debt will still have to be paid, even though the assets may not generate any profit. In order for these assets to be sold, a corporation might require a payment of perhaps as much as $20-$30 billion to cover this stranded debt. However, with the creation of Hydro One, the government of Ontario assumed most of Ontario Hydro’s debt. In return, Hydro One issued nearly $5 billion in corporate bonds to cover the liabilities the province did not assume. According to the 1999 Hydro One annual report: “OEFC has stranded debt. Stranded debt is defined as debt that the successor corporations could not service as commercial entities in a competitive market. The Province has stated that it will dedicate certain of its revenue streams from the restructured electricity industry (e.g., payments in lieu of corporate taxes made by Hydro One, OPG and local distribution utilities) to service stranded debt. The Province anticipates that these dedicated revenue streams will service the majority of the stranded debt, with the balance serviced through a competition transition charge to be reflected in customers’ electricity bills. The precise amount of any competition transition charge will reflect actual price and cost performance in the new competitive market. Hydro One has no obligation to pay, does not guarantee, and is not otherwise responsible for any stranded debt.”

Thus, to cover the costs of its debt, Hydro One will still have to charge rates that would be higher than those of new competitors. Alternatively, there will be a tax of some sort, whether on electricity consumption or on a broader base, such as income. Due to this huge debt, the savings promised to the consumer are unlikely to be seen for many years, unless the province plans to sell the assets or a competitor is able to sell power for less. For example, the nuclear power plant located near Kincardine, Ontario, was recently leased to British Energy. The new operators invested heavily and got two of the four reactors that were shut down back online. But, will this competition lead to lower prices?

BEST PRACTICES FOR MANAGERS: SCENARIO PLANNING

When an industry is controlled by government, it is often privatized and structured well beyond the control of those who may wish to participate in the market created. Such is the situation with Ontario Hydro. Due to the indecision about stranded debt and the uncertainty as to whether some of Ontario Hydro’s assets will be privatized, the government’s actions are unknown. It is there f o re impossible for a new entrant to reasonably estimate its potential revenues, costs and the costs of its competitors. In particular, it is impossible for that new entrant to predict the costs of a competitor who may acquire the assets of Ontario Hydro. Those costs will depend upon how much it pays for the assets; however, due to the stranded debt, no one knows the true value of those assets. The whole industry structure will depend upon whether and how these assets are privatized. Depending on whether the government requires the purchaser to cover the debt or pay extra for the debt it assumed, or whether the province looks to the public to cover the stranded debt, the cost and revenue structure for the whole industry will be different. The nature and authority of the government regulations in place after the privatization will also have a major impact on how the industry develops. Thus, the best practice for firms looking to enter this market is to ensure superior due diligence.

The market will be structured differently, depending on the scenarios outlined above. A potential entrant would be wise to understand its business model in light of the potential scenarios, and evaluate its likelihood of success in relation to the likelihood of each scenario unfolding. Ultimately, this is a high-risk venture, and the returns will have to be high as well. It is likely that hurdle rates for these investments will be greater than a 20-percent ROI and that they will take a long time to materialize. Any scenario will have to involve varying levels of government intervention, and calculate the effects of such involvement on market growth, entry and exit barriers and revenue streams.

THE SOLUTION?

Clearly, electricity generation in Ontario is in poor shape. The status quo is not an option without the risk of higher taxes, increased user rates, a meltdown at one of the nuclear plants, or a combination of all three. Privatization is necessary. However, we have suggested that privatization alone has risks that make it a very difficult trick to pull off. And as the California situation shows, the cure can be worse than the disease.

In suggesting best practices for privatization, we have explicitly recommended government involvement through limited-term regulation of the industry. We have also discussed the importance of the development of a market-oriented mindset within the management and organizational structure of the newly privatized firm. Finally, we have suggested many new lines of business that may result from the opening of the market. We have stressed that the success of this industry is also contingent on the actions of the government in relation to the stranded debt. As well, investors/businesses must understand the government’s actions clearly and have well-planned scenarios in hand.

For some Canadians, privatization may convey an image of greed. However, there are many examples where privatization has improved the lives of consumers around the world. The trick is that privatization is not a “one size fits all” solution. Embedded in the concept is a wide variety of regulatory processes and adjustments in corporate culture that are unique to each society and each type of activity.

Nevertheless, there are some basic principles that, if followed, will lead to a smoother transition. If privatization is to succeed, society must be patient and flexible. It is possible to privatize and deregulate the Ontario electricity market without corruption, huge rate hikes and disruptions. Of course, we must also be willing to create a level playing field for new competitors and maintain a regulatory structure that has the authority to respond to a large range of scenarios, any one of which may unexpectedly appear.

About the Author

David Conklin is a Professor at the Richard Ivey School of Business. His teaching and research focus on the economic, political, social and technological forces that impact businesses and….Read David Conklin's full bio

About the Author

Trevor Hunter is Associate Professor of Management, King’s University College, London, Ontario.

About the Author

Trevor Hunter is Associate Professor of Management, King’s University College, London, Ontario.