ELECTRICITY RESTRUCTURING

Observations on Canadian Electricity Trends and Issues

The electric power industry in North America has been undergoing substantial change as many jurisdictions have introduced competition in generation and provide access to wholesale markets and some retail markets. However, the pace of restructuring varies across regions and the extent to which restructuring will occur is uncertain. A key concern is the impact on electricity prices. Volatile oil and especially natural gas prices during the past two years have also been cause for uncertainty about electricity prices, because of the increasing use of gas in power generation. Given these concerns, this report has provided a detailed analysis of Canadian electricity markets, which has led to the following observations.

Electricity Supply
Overall, Canadian electricity markets appear to be adequately supplied. Alberta has experienced relatively tight supply situations, particularly during periods of peak demand. However, recent announcements suggest that power developers are planning to make new supplies available over the next one to five years.

Across the country, with a few notable exceptions, new generation projects in the near term are expected to be gas-fired. These plans were, for the most part, made before the recent escalation in natural gas prices. Depending on the duration of higher gas prices, there could well be a shift toward other forms of electricity generation. In recent months, there have been announcements of new coal- fired generation projects in Alberta, which has abundant and inexpensive coal. Higher prices tend to make wind energy and other renewable technologies more feasible.

The nature of gas-fired generation plants allows them to be built closer to load centres. Although not a focus of this report, this could be an important consideration in provinces where the current coal and hydroelectric generation facilities are located far from markets, thus requiring the construction of transmission capacity (e.g., Alberta, Saskatchewan, Manitoba and Québec). A related matter is future trends in distributed generation; locating generation at industrial sites, for example, could reduce the need for both long-distance transmission and distribution facilities.

Convergence
Convergence of the natural gas and electricity markets is an outcome of the increasing use of gas in power generation. An important aspect is that gas prices and power prices have become closely related. Convergence is demonstrated by some recent trends: high natural gas prices throughout the U.S. affecting overall Canadian electricity export revenues; the price of natural gas influencing electricity prices in the Power Pool of Alberta; and electricity demand in California contributing to relatively high prices for B.C. gas exports.

The Role of Electricity Exports and Market Integration
A number of provinces have surplus energy available for export, and the country continues to be a net exporter of electricity. Exports comprised about nine percent of domestic generation in 2000.

Some Canadian entities have been granted wholesale trader status by FERC by satisfying the reciprocity requirements of open access under FERC Order 888. To further facilitate Canadian exportersÕ access to U.S. markets, and to facilitate access to U.S. supplies by Canadians, the transmission companies in several provinces are considering membership in RTOs. By consolidating the operations of a number of transmission systems into one independent entity, which would establish a standard tariff, RTOs further the objective of opening access to transmission. Canadian entities are not subject to FERC regulation, but due to the integrated nature of the North American transmission system, it appears that Canadian involvement in RTO formation could be potentially beneficial to all market participants, provided proper approaches for jointly overseeing a cross-border RTO are adopted.

Directionally, the formation of RTOs could lead to more north-south trade and increased integration of the U.S. and Canadian electricity markets. To the extent Canadian competitiveness can be maintained, higher export revenue would result. Market integration could also result in upward price pressure in some provinces.

Although market integration may be facilitated by access to current transmission facilities (as expected by the RTO initiative), persistent price differentials between regions with competitive wholesale markets may indicate that new transmission facilities are required.

Restructuring of Electricity Markets
The unbundling of generation, transmission and distribution services is occurring at an uneven pace across the country. Alberta completed its five-year program, introducing full retail access in January 2001, after implementing wholesale access in January 1996. Ontario plans to implement full retail access in May 2002.

At this time, there are no definitive plans to introduce full retail access in the other provinces; the reasons for this vary. In many provinces, it appears that, with the historical record of relatively low and stable prices and the prospect that this will continue to prevail in the near term, there is limited incentive to change the current regulated regime. However, a number of provinces currently provide, or plan to provide, whole-sale access.

A prime motivation seems to be to satisfy the reciprocity requirements of FERC Order 888.

Two main objectives of restructuring are lower prices and more customer choice. Increased competition might be expected to result in lower prices. However, there may also be higher costs associated with the increased risk faced in a competitive market environment, as compared with a regulated environment.

An example would be the increased cost of capital faced by electricity suppliers.

There is substantial debate about whether restructuring will ultimately result in higher or lower prices; however, it is clear that, in any given region, the design of the restructuring program and the supply and demand situation will be important factors in establishing the eventual outcome.

Electricity Prices
Volatile energy prices do not necessarily mean volatile electricity prices. In all provinces, with the recent exception of Alberta, consumer prices have been generally stable, or have increased by relatively small amounts, over the past several years. This stability is largely the outcome of the provincial regulatory regimes which establish prices on a cost-of-service basis and, in some provinces, the implementation of price freezes. Prices tend to be lower in provinces that generate most of their electricity from hydro resources (e.g., B.C., Manitoba and Québec). A comparison with residential electricity prices in other countries suggests that Canadian prices are among the lowest of the industrialized countries.

Continuing to establish electricity prices on the basis of regulated costs would be a departure from the pricing of other energy commodities, which is based on domestic and international market forces.

To the extent there is a difference between the regulated cost and the market value of electricity, as measured, for example, by the prices of competitive fuels in the same market area or electricity prices in adjacent market areas, electricity consumers and producers may not receive the appropriate price signals for decision-making. A regulated price that is set below market value could result in too much consumption and/or insufficient production, and a price that is set above market value would have the opposite effects.

Growing reliance on market forces in other sectors of the economy and in other electric power jurisdictions in North America is causing Canadian provinces to consider adopting market-based structures.

However, the record of low electricity prices provided, for the most part, by provincially-owned utilities under the traditional structure, and the recent experience with price volatility in California, have caused most provinces to move cautiously toward developing comprehensive restructuring plans.