Bay Street and the Hydro One Sale

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Of the many options available to the Ontario government to finance its $130 billion infrastructure plan, selling 60% of Hydro One is pretty much the worst.

Of the many options available to the Ontario government to finance its $130 billion infrastructure plan, selling 60% of Hydro One is pretty much the worst.

It is becoming increasingly clear that the Ontario government is making a serious mistake in its plan to sell off a majority interest in Hydro One. According to a report from Ontario’s new Financial Accountability Officer, the province will be in even worse financial shape after the planned sale of 60 per cent of Hydro One than it is now.

Even former TD Bank CEO Ed Clark, the driving force behind the sale, readily admits that there will be significant forgone revenue from the sale of Hydro One down the road. But he, like Ontario Premier Kathleen Wynne, dismisses this on the grounds that the  partial sale of Hydro One is needed to help pay for Ontario’s plan to spend $130.5 billion over 10 years on transit, bridges, highways and other infrastructure.

Unfortunately, while it is undoubtedly true that the planned investments in Ontario infrastructure are badly needed, it is also true that of the various options available to the province to pay for its ten-year, $130.5 billion infrastructure investment, selling 60% of Hydro One is pretty much the worst option.

So why is the Ontario government selling off one if its most valuable assets in what seems like a clear cut case of “short-term gain for long-term pain”?

The sell-off of Hydro One is yet another chapter in the ongoing saga of an Ontario government mesmerized by private sector promises that a healthy dose of private sector, market “discipline” will somehow translate into the public good.

The names are familiar: eHealth, Ornge, the Mississauga and Oakville private gas plants, and public-private hospitals and transit – to name just a few.

The problem? Each and everyone turned out to be a train wreck of truly monumental proportions.

And now Hydro One.

Why the province will be financially worse off with the Hydro One sale

In a rigorous report released last week, the province’s new Financial Accountability Officer (FAO) made a convincing case that Ontario will be worse off financially – and less able to finance infrastructure – with the 60% sale of Hydro One.

Why is this?

In comparing the different options the province has at its disposal to finance its $130 billion infrastructure investment over the next ten years, it is useful to separate out the first 4 years during which the province will be booking the proceeds of the Hydro One sale (15% each year) from the years after that.

Starting with the first four years, of the roughly $9 billion expected to be raised by privatizing 60% of Hydro One, $5 billion would go to pay off hydro debt and the other $4 billion would be earmarked for infrastructure.

These are ballpark numbers but the best-guess estimate of the FAO would seem to confirm this range even if the majority of the funds actually allocated to the Trillium Trust (the legal mechanism established to hold proceeds from Ontario government asset sales) aren’t proceeds from the IPO strictly speaking but emanate from complex financial engineering associated with the sale in the form of “deferred tax assets” (don’t ask).

According to the Financial Accountability Officer’s report:

“The province’s net debt would initially be reduced, but will eventually be higher than it would have been without the sale…”

“Assuming the province sells 15 per cent of Hydro One in 2015-16, Ontario’s net debt would initially be reduced by $2.4 billion to $3.9 billion. However, net debt would eventually increase as a result of the partial sale as the costs of forgone revenues from Hydro One begin to exceed the initial fiscal benefits.”

So in the first year the province is definitely in a better financial situation to make the infrastructure investments because of the one-time windfall from the “deferred tax assets”. However, in the years following this windfall, selling the utility to private investors will end up costing the provincial treasury more than the sale proceeds taken in.

That’s because Hydro One is consistently profitable returning roughly $750 million a year in total profits all of which presently go to the provincial treasury. Once the province sells 60% of its equity in Hydro One, its dividend from the company will fall to roughly $300 million annually – a $450 million reduction.

As well, the utility now provides the province with what are called “payments in lieu” of taxes which are currently worth $100 million annually to the Treasury.  While the company will eventually pay a portion of this in Corporate Income Tax, it will not start paying corporate tax until 2020 at the earliest.

There are far better ways to fund Ontario’s infrastructure program

So if the longer-term consequence of selling off 60% of Hydro One in order to fund transit and other infrastructure is to put Ontario in a worse financial situation than it would be without the sale, what are the other options to fund the government’s worthwhile $130 billion infrastructure program?

First, the Trudeau Liberals campaigned relentlessly on a promise to significantly increase infrastructure spending — admirably going so far as to say that it will run deficits for the next three years to pay for it. In fact, it pledged to deliver $60 billion more in infrastructure spending than the Conservatives over 10 years to the provinces and municipalities. That’s exactly the same period that Wynne wants to spend $130 billion on Ontario infrastructure.

If the province gets a share roughly equivalent to its proportion of Canada’s population (just under 40 per cent), Ontario should end up with something like $23 billion in additional federal infrastructure funds over ten years. In just the first 4 years – the period that Ontario would be selling off Hydro One and booking the proceeds – that would mean over $9 billion more for Ontario infrastructure compared to just $4 billion from the sale of Hydro One.

With the likelihood of that kind of federal infrastructure funding coming Ontario’s way, the argument that selling off a money-making utility like Hydro One is crucial to funding the province’s need for increased infrastructure, simply doesn’t hold water.

Second, the government should re-consider its wrong-headed (and very expensive) approach to financing infrastructure through public-private partnerships (P3’s) thereby getting a much bigger bang for its infrastructure buck. And it might start that re-evaluation by taking another look at the scathing Ontario Auditor General’s report from late last year which thoroughly criticized Queen’s Park for overpaying billions on 74 Ontario P3 projects.

The 2014 Ontario Auditor-General’s report on P3’s, which the Toronto Star has rightly characterized as taking “a wrecking ball to the Liberals’ use of private money to bankroll new hospitals and transit”, found that there was no evidence in support of paying the private sector $8 billion (yes, $8 billion!) more to build 74 infrastructure projects than it would have cost the Ontario Government to build them itself.

$6.5 billion of those extra $8 billion in costs were a result of higher private sector borrowing costs. Most of the rest of the $1.5 billion in extra costs were “transaction” costs (legal fees, consulting fees, etc.) which end up in the pockets of corporate lawyers, investment bankers and engineering consulting firms.

The argument put forward by pro-P3 players such as Bert Clark, son of privatization guru Ed Clark and head of Infrastructure Ontario (IO), is that P3 contracts provide an incentive for the various private-sector players in large infrastructure projects to keep costs down.

But the truth of the matter is that there is absolutely no reason why the government can’t borrow directly at the much lower government interest rates while at the same time using Infrastructure Ontario’s P3-style contracts including all the same incentives to the private-sector contractors who do the actual construction whether the financing is public or private. And nothing prevents the high-powered folks  at Infrastructure Ontario from directly tendering large, traditionally (i.e. publically) financed infrastructure projects.

According to U of T Professor Matti Siemiatycki, one of the foremost experts on the Ontario government’s experiment with P3’s:

“Why can’t Infrastructure Ontario manage traditional jobs? Then you remove that potential view that public-private partnerships are the only game in town and you open up their set of skills to traditional build projects. Why can’t we structure traditional projects a bit more like P3s in terms of who’s managing the projects?”

Why not, indeed? With this approach you get the best of both worlds – private sector type incentives and low government borrowing costs! The much lower borrowing costs and the reduced transactions costs (legal fees, etc.), could save Ontario billions and reduce the need for a Hydro One sale.

Third, the Ontario government could be just a little bit flexible in its drive to balance the budget by the 2017-18 fiscal year. Putting off balancing the provincial budget for a couple of years would allow it to borrow a few billion dollars more at the current record low interest rates to partially pay for its infrastructure program.

After all, the Trudeau Liberals won an election running on “a modest short-term deficit” of less than $10 billion for each of the first three years of its mandate and then a balanced budget by the 2019-2020 fiscal year. Based on the Trudeau experience, pushing back the date for a balanced budget in Ontario a couple of years and borrowing a few billion dollars to help pay for its infrastructure program, might even be a political winner for Premier Wynne!

Who really benefits from the Hydro One privatization?

If the privatization of Hydro One is just about the worst way to pay for the Liberal government’s $130 billion infrastructure program and ordinary Ontario tax payers are going to be worse off as a result of the Hydro One privatization, who exactly is benefiting from the privatization?

A whole range of Bay St. players, it turns out. Here are some of the key ones.

For starters, in putting together their recommendations to sell off Hydro One, the “government” task force headed by former TD Bank CEO Ed Clark paid $6.8 million for consulting services to blue-chip consultants KPMG, McKinsey, Deloitte, PricewaterhouseCoopers as well as speech-writing firm Feschuk.Reid.

The lead underwriters for the Hydro One IPO are Scotiabank and RBC Capital Markets. Underwriters are the firms that work with the “issuer” (Hydro One) to determine the offering price  of its securities, and who then sell the shares to investors via their distribution networks.  It is common for large IPO’s to be sold by a much bigger syndicate of underwriters behind the leads and Hydro One is no exception. Amongst the foreign banks included in the Hydro One IPO underwriting syndicate are Goldman Sachs Canada and Barclays. All of the big Canadian banks are also represented in the syndicate.

The fees for the underwriters are one per cent for institutional investors (pension funds, life insurance companies, etc.) and three per cent for retail investors (individuals).

Of the shares sold in the Hydro One IPO, retail investors ended up purchasing roughly 40 per cent, more than the 25 per cent that was initially set aside for them. The rest goes to institutional buyers. Because the retail portion is higher than originally projected, Hydro One will have to pay its underwriters more in fees than planned.

Bay St. insiders say that wealthy clients were being herded by their investment advisers to get aboard the Hydro One IPO because of the three per cent sales commission that such orders attract. Again, institutional orders come with a one per cent commission so the higher the proportion of retail investors, the more money made by Scotia Bank, RBC Capital Markets and the other underwriters in the syndicate.

The sales commissions are calculated on the sale of 81.1 million shares, priced at $20.50 each for total of $1.66 billion.  Scotia Bank and RBC Capital Markets have an option to purchase an additional 8.15 million shares, which would bring proceeds from the IPO to a total of $1.83 billion.

The importance of the Hydro One IPO to Bay St. can be seen by the fact that the last time the Canadian markets saw such a large IPO was in March 2000, when Sun Life raised $1.8 billion on its initial offering.

Hydro One’s lead law firm in the IPO is Bay St. stalwart Osler, Hoskin & Harcourt LLP while the lead firm representing the underwriters is Blake, Cassels & Graydon, another big Bay St. law firm. Such firms commonly charge $600-$700/hr. for their partners’ services. Sometimes more.

As to the compensation of senior executives, new Hydro One CEO Mayo Schmidt will have a base salary of $850,000, with potential bonuses of up to $3.15-million for a total annual compensation package of $4 million. CFO Michael Vels will make $500,000, with up to $1-million in bonuses.

By comparison, former CEO Carmine Marcello made $745,208.25 last year in pay and benefits while Hydro One was still a Crown Corporation.

And on and on it goes…..

Lesson learned? Probably not.

The real tragedy of the Hydro One sale is that we’ve been down this road before – pretty much the same Bay Street players, providing pretty much the same inappropriate privatization advice, to the benefit of pretty much the same private interests.

In the past 6 years alone, one Ontario Auditor-General report after another has documented the Ontario government’s privatization disasters. These include (but are not limited to): eHealth (2009), ORNGE (2012), the Oakville and Mississauga gas plants (2013), the P3 (AFP) infrastructure program (2014), and winter road maintenance (2015).

The lesson the province should have learned long ago? Simple. The private sector isn’t the public sector and assuming that the logic of the market will somehow magically translate into the public good is painfully naïve.

And expensive for the people of Ontario. Very expensive.
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