20 June 2008 / le 20 juin 2008
Submitted by/Soumis par : Kent Kirkpatrick, City Manager/Directeur des services municipaux
Contact Person/Personne ressource : Gerry Mahoney, Manager of Treasury,
Gestionnaire, trésorière
Financial
Services/Services financiers
(613) 580-2424
x 21310, gerry.mahoney@ottawa.ca
SUBJECT:
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OBJET :
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ÉVALUATION DE LA STRATÉGIE COMMERCIALE D’HYDRO oTTAWA |
It is recommended that Council:
1. Endorse the Strategic Directions and
Financial Outlook 2008 - 2012 prepared by Hydro Ottawa Holding Inc. (HOHI).
2. Direct Hydro Ottawa to report back to
Council annually on the implementation of its growth strategy and seek approval
of specific initiatives where required,
in accordance with the Shareholder Declaration;
3. Direct HOHI to target dividends at the
greater of 60% of its annual net income or $14 million provided that the
company is in compliance with the Ontario Business Corporations Act, relevant
Ontario Energy Board guidelines, is not in breach of any covenants on its bond
or credit facility obligations, and does not negatively impact its credit
rating as a result of the dividend payment;
4. Direct the City Manager to work with Hydro Ottawa to assess the synergies, costs savings and other benefits that would result from having street lighting services provided to the City by Hydro Ottawa, and to report back to Council within six months; and
5. Direct the City Manager to continue to
monitor the policy and regulatory environment surrounding the provincial
Transfer Tax on Municipal Electricity Property and the Payments In Lieu of
Corporate Taxes regime and report back to Council on any significant changes.
Il est recommandé que le Conseil :
1.
adopte les orientations stratégiques
et les perspectives financières de 2008-2012 préparées par la Société de
portefeuille Hydro Ottawa inc.;
2. enjoigne Hydro Ottawa de faire rapport au Conseil chaque année en ce qui concerne le déploiment de sa stratégie de croissance et d’obtenir l’approbation d’initiatives précises, le cas échéant, conformément à la Déclaration de l’actionnaire;
3. enjoigne la Société de portefeuille Hydro Ottawa inc. de cibler des dividendes d’au plus 60 % de son revenu annuel net ou de 14 millions de dollars pourvu que la compagnie se conforme à la Loi sur les sociétés par actions et aux lignes directrices pertinentes de la Commission de l’énergie de l’Ontario, qu’elle n’enfreigne aucune clause relative à ses obligations ou à ses obligations de facilité de crédit, et qu’aucune répercussion négative ne soit entraînée relativement à sa cote de solvabilité qui découlerait du paiement de dividendes;
4. enjoigne le directeur municipal de collaborer avec Hydro Ottawa afin d’évaluer les synergies, les économies de coûts et autres avantages qui résulteraient du fait qu’Hydro Ottawa fournit des services d’éclairage de rue à la Ville d’Ottawa, et de faire rapport dans les six mois;
5. enjoigne le directeur municipal de continuer à surveiller la politique et le milieu de la réglementation entourant l’impôt provincial sur les transferts en matière de biens municipaux relatifs à l’électricité et le régime de paiements versés en remplacement d’impôt sur les sociétés, et de faire rapport au Conseil concernant tout changement important.
On October 24, 2007 Hydro Ottawa Holdings Inc. (HOHI) presented an overview of its 2008 to 2012 Growth Strategy and Financial Outlook to City Council. Council deferred consideration of that strategy to its meeting of November 14, 2007.
At the November meeting Council requested a more detailed analysis of the strategy and deferred any decision on changes to the dividend policy subject to receipt of the analysis of the growth strategy. At the Council meeting of January 23, 2008, Council noted that HOHI was working with City staff to examine the value creation opportunities arising from the HOHI Growth Strategy and directed staff to provide a more complete analysis for Council's consideration. The purpose of this report is to provide that analysis. A brief summary of the contents of HOHI’s growth strategy is provided below.
HOHI was created in November 2000
as a result of the amalgamation of the municipalities of the former Region of
Ottawa-Carleton and the restructuring of the Ontario electricity sector due to
the Electricity Act (1998), which required all hydro utilities to
operate as business corporations. The objectives of HOHI, as set out in the
company’s first Annual Report (2001), are to increase the value of the Hydro
Ottawa asset for its shareholder, the City of Ottawa; deliver efficient and
effective service to its customers; and grow competitive businesses that
maximize the value of existing assets and core competencies.
Hydro Ottawa Holding Inc. is comprised of Energy Ottawa Inc. (EO), which owns three hydro generation facilities and an interest in another generation facility, and Hydro Ottawa Limited (HOL), which is a regulated electricity distribution company operating in the City and the Village of Casselman. A third line of business, Telecom Ottawa Holding Inc. has recently been sold. All of the analysis provided in the report is based on estimates for 2008 to 2012 and excludes any special dividend that the City may receive from the sale of Telecom Ottawa.
Since its creation in November 2000, the accumulated shareholder’s value of HOHI, defined as equity retained within the company plus accumulated dividends paid to date, has increased by approximately $100 million, projected to reach $140 million by the end of 2008.
HOL is a regulated business with a good growth and a low risk profile. A recent report by Pacific Economics Group indicates that HOL is a leader among top Ontario Local Distribution Companies (LDCs) in terms of operations, maintenance and administration costs (OM&A). The completion of the company’s 2008 rate application provides assurance that reasonable and prudent costs will be recovered in rates. The company is projected to earn a return on equity close to the regulated rate, and is expected to operate at 59% debt to capital level structure, slightly below regulated target levels.
HOL and EO are considered to be attractive investments that are expected to generate growing earnings to HOHI and growing dividends to the City through the forecast period. The risk profile of these two businesses appears consistent with their peers.
As articulated by its Board and management, HOHI’s
growth strategy involves expanding the company’s hydroelectric and other
renewable generation capacity, expanding its distribution business beyond its
current service territory, and building on the company’s existing core
strengths to diversify its business lines, focusing on business opportunities
that are compatible, low risk, and offer stable long-term returns. This may involve strategic acquisitions and
partnerships to acquire scale, expertise, or markets, and discontinuation of
business lines as appropriate to ensure profitability and compatibility with
the company's risk profile. HOHI’s
Board and Management believe that the strategic growth plan provides a stable,
low risk and growing return on the City’s investment.
HOHI proposes a targeted and phased approach, building
on successes to continue to expand and diversify. It also proposes to expand the current range of collaboration
between the City and HOHI to achieve synergies and cost savings, with the
utility proposing to provide services such as street lighting and water
meter-to-cash services that are currently provided to other municipalities by
their local electrical utilities.
HOHI’s five year growth strategy as presented, excluding scenario 4 as explained below, forecasts growth in value of $135-165 million in equity over the 5 year plan and is projected to yield $71-74 million in dividends to the City based on the City receiving the greater of $14 million or 60% of forecasted annual net income. These projections see an increase in net income of between $117-127 million over the 5 year plan.
It should be noted that while the planning horizon is for a 5-year period, both electrical distribution and generation assets are considered long-term infrastructure investments. By their nature, these investments often require up front capital investments which earn low-risk, predictable returns over a time horizon of 10-30 years. These asset classes are favoured by investors with long term obligations, such as pension funds, and insurance companies. HOHI’s current dividend policy calls for the declaration of dividends in the amount of 60% of prior fiscal year Net Income, meaning that growth in Net Income results in corresponding growth in dividend potential.
For the purposes of analysis, the five-year growth plan presented by HOHI can be divided into four different scenarios. These are summarized below.
The first scenario, presented in the growth strategy, is basically a status quo scenario which forecasts annual net income growth of 10% over the forecast period.
The second scenario includes growth initiatives of sub-metering, street lighting and water billing. These initiatives are expected to increase average annual net income by 12% over the forecast period with further growth occurring in later years as the projects mature, although the estimates are subject to change as these initiatives are at preliminary stages. These growth initiatives are examples of opportunities that exist to leverage key capabilities of the HOHI group of companies, including infrastructure asset management, customer relationship management and billing services. Other opportunities may be identified that are similar in nature, scale, benefits and investment. HOHI has the credit capacity to support the capital required to undertake these initiatives based on the information available at this time.
The third scenario expands the initiatives contained in Scenario 2 and includes expansion of Energy Ottawa’s hydroelectric generation assets. Scenario 3 is projected to increase average annual net income by 15% over the forecast period however the cash flow and net income from generation expansion could become more significant in the years beyond 2012. Financing for this scenario would be provided partially from project financing and HOHI’s existing credit facilities.
The fourth scenario advanced by HOHI involves the expansion of its distribution business through potential merger or acquisition between HOL and another municipal electricity utility or utilities in Ontario. This would provide an opportunity for HOL to participate in growth markets outside of the Ottawa area, thus diversifying its business and geographical base. In addition, merger synergies could be achieved through increased scale (spreading overhead costs over a larger base of operations), cost reductions, and improved purchasing of power.
For illustrative purposes, an LDC approximately half the size of HOL was considered in this scenario. This could provide HOHI average annual net income growth of approximately 17% in the forecast period, depending on the size of the merged partner. The existing regulatory framework for HOL would allow the merged entity to retain the cost savings benefits from any merger for five years following which the new cost structure would be taken into consideration in setting its electricity rates, thus the benefits would be passed on to ratepayers in the City, in the form of reduced electricity distribution rates. Additional acquisitions could further enhance growth.
A summary of the forecasted benefit of each scenario along with the estimated Capital Investment required, is presented in the following table.
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Average Annual Net Income Growth (2008 to 2012) |
Capital Investment Required ($million) |
Risk to Net Income |
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1. Status quo |
10% |
Status Quo |
Low |
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2. Sub-metering , street lighting and billing plus #1 |
12% |
$30 |
Low |
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3. Increased generation plus #2 |
15% |
$100 |
Low |
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4. Merger with other LDC’s plus #3 |
17% |
TBD |
TBD |
CIBC World Markets (CIBC) was engaged by the City of Ottawa to provide an expert, independent analysis of HOHI's five-year growth strategy. CIBC worked with Genuity Capital Markets who were the financial advisors to HOHI in the preparation of their Growth Strategy. The analysis focused on the expected dividends to the City, the financeability and risks inherent in the strategy as well as a review of certain monetization alternatives available to the City.
Some significant outcomes from the strategy along with some observations are as follows:
· Shareholder value is expected to grow by $135-165 million over the 2008 to 2012 period.
· The forecast annual dividend of $14 million for the years 2008 and 2009 results in a dividend payout ratio of 76% in 2008 and 62% in 2009. This is higher than other similar utilities however HOHI has the ability to make these payments within its available credit facilities. If projected earnings growth is achieved then the dividend payout ratio will normalize to 60% by 2010.
· Hydro Ottawa Limited and Energy Ottawa Inc. are attractive investments which are expected to provide growing earnings to HOHI and increasing dividends to the City
· The Strategy identifies a number of growth initiatives, which are estimated to require approximately $130 million in additional capital over the next four years.
· The financing requirements contemplated in the Strategy, including any requirements to make dividend payments, can be met through unused capacity in existing credit facilities.
· Sustainment of existing distribution and generation infrastructure have not been compromised to fund growth initiatives.
The assessment of the Growth Strategy by CIBC concludes that the net income forecasted and the forecasted dividends under each of the growth scenarios appears reasonable and can be financed though HOHI’s existing credit facilities. The Strategy as it relates to HOL is consistent with the risks and returns of comparable companies. Similarly, as the Growth Strategy relates to EO it appears reasonable and does not expose the overall dividend stream to undue risk and is expected to be financed in a manner consistent with its peers. HOL is amongst the lowest cost local distribution companies in Ontario.
The risks of the growth not meeting the estimates contained in the base case scenario 1 are moderate to low. HOHI has a consistent performance in maintaining a leading operating, maintenance and administrative cost structure. Milder weather could reduce volumes, while missed productivity targets and higher than expected bad debt expense are also not recoverable from ratepayers that could impact earnings.
The growth initiatives contained in scenario 2 have various risk assessments. Two pilot sub-metering projects (the installation of meters on individual units in multi-tenant buildings) are underway, but forecasts are subject to change as the competitive environment is unclear and market penetration rates and installation costs may vary from this strategy. The risks associated with HOHI assuming responsibility for street lighting and water billing are considered low based on the business case that street lighting would be negotiated on a cost plus basis, and there are synergies with existing electricity billing and water billing operations. The risks associated with scenario 3 are also considered low, as Energy Ottawa’s business model requires projects to be supported by long term (i.e. 20 year) Power Purchase Agreements with stable pricing.
Risks associated with a possible merger with
another local distribution company were not specifically addressed in this
report as a specific transaction has not yet been identified. Instead CIBC used the results of other LDC
mergers as a possible representation of what results could be expected.
Council approved a Shareholder Declaration in
August 2004 that gives HOHI the ability to undertake all of the actions
contemplated in the Growth Strategy including acquiring significant interest in
generation facilities without requiring Council’s express consent to undertake
any of the actions contemplated. While
HOHI does not legally have to obtain Council consent to proceed with the
various initiatives identified in the strategy, it is the intent of HOHI to
keep Council informed of progress on the implementation of the strategy and any
significant developments. If however
HOHI contemplates a merger with another LDC, then the consent of Council would
be required.
HOHI Strategy Compared to Other Alternatives
Leaving aside significant public policy considerations related to public versus private ownership of the utility, the major financial constraint to considering alternatives to retaining ownership in HOHI is the Provincial transfer tax. Since October 2001, municipal electrical utilities in Ontario have been paying Payments in Lieu of taxes (PILs), which are meant to be the equivalent of corporate income taxes. These PILs are paid to the province and are used to pay the stranded debt, which was previously accumulated by Ontario Hydro. Stranded debt is debt that no longer has an income stream to pay for it, as the asset it purchased may no longer be producing or may no longer be owned by Ontario Hydro’s successors.
In addition to the yearly PILs the municipal electrical utilities are paying, Section 94 (1) of the Electricity Act, 1998 and Ontario Regulation 124/99 imposes a Transfer Tax on Municipal Electricity Property. If a non-governmental entity were to acquire an ownership interest of 10% or more in a municipal electrical utility, the resulting corporation would be subject to corporate taxes and the Province would lose a portion of corporate income taxes to the federal government, thereby reducing their ability to pay off the stranded Ontario Hydro debt. As a result the Province requires a portion of the net proceeds of any sale of a municipal electrical company to the private sector to be paid to the province in the form of a transfer tax. Although there are a number of specific adjustments to the calculation of the amount to be paid for any specific transfer, the basic rate is 33% of the fair market value of the assets being transferred less any PIL payments already made.
As the transfer tax obligation decreases as PIL payments are made to the province, it is estimated that HOL will satisfy the transfer tax obligation by 2015. There is also the possibility that the Province may at some point alter or cancel the Transfer Tax. At present an exemption exists for transactions between municipal electric utilities where definitive agreements are reached before October 1, 2008. This exemption is designed to encourage consolidation among municipal electric utilities; as such amalgamations should provide efficiency improvements for operating, maintenance and administrative costs (OM& A) of 10% to 30%.
In CIBC’s view, HOL and EO are saleable assets and would be very attractive investments to public investors, strategic and financial buyers. If the transfer tax was eliminated this could put the City in a position to realize an additional return on the sale of the utility.
The City could potentially realize gross proceeds of $750 to $860 million prior to any transfer tax, company debt repayment, and transaction expenses. In comparing the potential return to the City under the sale option CIBC established this range based on a value assessment of HOL and EO using various approaches:
· An analysis of comparable companies applying a range of possible values based on trading multiples of various Canadian and U.S. distribution companies;
· Valuations and multiples applied in recent Canadian municipal electrical utility transactions;
· Discounted cash flow analysis and an ability to pay analysis that assessed the maximum value that a prospective strategic buyer could pay.
For comparative purposes CIBC prepared an analysis of the potential long-term returns which could be available if the City disposed of its interest in HOHI and invested the proceeds in:
· A portfolio of Government of Canada bonds;
· With the City’s Endowment Fund based on its current asset allocation; or,
· In a portfolio of utility stocks which approximates a similar risk and earnings growth profile as HOHI.
CIBC included investing the funds from the sale of HOHI in the City’s Endowment Fund, as the regulations governing the fund allows for “Only the proceeds of the sale by the City of its securities in a corporation incorporated under section 142 of the Electricity Act, 1998” to be used to make the investments in the fund. The Province broadened the scope of eligible investments specifically for these funds in late 2005 to include Canadian equities and Canadian corporate bonds. This would allow the City to establish within the Endowment Fund a portfolio consisting of Canadian electrical utility equities. As of 30 April 2008 the Fund is invested approximately 16% in short-term money market investments, 37% longer-term fixed income investments and 47% in Canadian equities.
CIBC applied historical rates of returns to the existing City portfolio to estimate the value in 2012 but actual results will vary. It should be noted that this analysis is based on returns experienced during a particularity strong period of the equity cycle. CIBC also evaluated the potential returns of a model Canadian utilities portfolio which would approximate the same business and risk profile as HOHI. It should be noted that a portfolio containing the utility stocks selected by CIBC, could be acquired under current regulations in the Endowment Fund.
A summary of the CIBC comparisons is provided below:
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Hold and Grow* ($ millions) |
Options if Sold
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Reinvested in
Gov’t Bonds ($ millions) |
Reinvested in
Endowment Fund ($ millions) |
Reinvested in
Utility Stocks ($ millions) |
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2008-2012 |
$71-$74 |
$52-$65 |
$56-$71 |
$62-$78 |
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Equity Value Comparison (2008) |
$505-$645 |
$290-$360 |
$290-$360 |
$290-$360 |
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Estimated Equity Value (2012) |
$640-$810 |
$290-$360 |
$365-$455 |
$400-$500 |
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Change in Value |
$135-$165 |
-- |
$75-$95 |
$110-$140 |
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Estimated transfer tax |
NA |
$210-$250 |
$210-$250 |
$210-$250 |
* Does not include scenario 4.
CIBC also evaluated a possible lease structure, which would extend the impact of the transfer tax and would provide a stable stream of income to the City. A lease structure would typically involve:
· Existing HOL assets would be leased to a private sector lessee over ten years or longer;
· Future capital expenditures in HOL are financed by the lessee;
· Lessor (HOHI) continues to pay the PILs;
· At the end of the lease, the lessee has the right but not the obligation to acquire the leased assets at fair market value which is determined at the beginning of the lease. If the purchase option is not exercised the lessor may be required to purchase the assets purchased by the utility during the term of the lease;
· Excess working capital would be given to the lessor at the start of the lease (possibly as a dividend);
· Present value of lease payments cannot exceed 90% of market value of assets; and,
· The term of the lease cannot exceed 85% of the life of the assets.
A lease alternative was not considered
attractive for the City since the City’s investment is reduced by the transfer
tax and on-going PILs and the market value of the assets is fixed at the start
of the lease but only paid on termination of the lease and may not reflect any
growth in value over this time period.
At this time the outright disposal of the City’s interests in HOHI is also unattractive since it would result in a significant transfer tax payment.
The Growth Strategy proposed by HOHI provides forecasted net income and dividends under each of the growth scenarios which appear reasonable and can be financed though HOHI’s existing credit facilities. The Strategy as it relates to HOL and EO is consistent with the risks and returns of comparable companies and does not expose the overall dividend stream to undue risk.
Given the current transfer tax regime, the City’s investment in Hydro Ottawa represents the best mix of value creation and return on investment.
The public consultation process is not applicable to the review of HOHI’s Strategic Direction and Financial Outlook and the review of monetization alternatives at this time. Should conditions favourable to consideration of alternatives to Council retaining it’s holding in HOHI materialize, then public consultations may be desirable.
Under the existing framework dividends of $14 million from Hydro Ottawa
are included in the operating budget and are used for general city operating
requirements. Should favourable
conditions materialize to a possible non-taxable disposal of its interest in
HOHI then it would be appropriate to examine various alternatives, which may
provide greater monetary returns than retaining its existing ownership.
This report will be considered by Council.