The privatization of Toronto Hydro would change its operation dramatically in a number of ways. These changes will be examined in the subsequent sections, where it will be seen that they are likely to be for the worse for the people of Toronto. They would result in higher prices and curtailed service. What this section will do is assume that Toronto Hydro was privatized on January 1, 2001 and its operations under Bill 35 are exactly the same as its operation under city ownership, as described in the previous section.
In other words, instead of receiving the interest and dividends in Table II, the city receives the proceeds from its sale, while the private owner receives the annual earnings before interest and taxes (EBIT) and pays the interest and taxes. That is, the private owner would receive the $179.2 in EBIT in Table II. Consistent with the above assumption, it is also assumed that the city receives the $1,700 million book value from the sale.
The city might receive more than $1,700 million and thereby profit from the sale of Toronto Hydro. However, the higher the sale price, the higher the rates the private owner can expect to charge, so that a higher sale price is unlikely to benefit the people of Toronto.(13)
However, there is a danger that the squeeze on local government by the provincial government might persuade city officials to use the sale of Toronto Hydro at the highest possible price as an indirect means to raise tax revenue to finance the cost of city services. The higher the price at which Toronto Hydro is sold, the higher the price that must be paid for electricity.
The city could take the $1,700 million proceeds from the sale and use it for some combination of paying down its debt, reducing taxes and improving city services. It would then give up the annual income generated by Toronto Hydro. That income would be $134 million in 2001 (the $179.2 EBIT less the taxes paid), and it is likely to rise at an annual rate of about 2 per cent thereafter.
The expenditure of the $1,700 million for the above purposes over a short period of time is unlikely to be in the best interests of the people of Toronto. A better use of the money would be the city services that can be purchased in the long run with an annual income from the ownership of Toronto Hydro that starts at $134 million and grows at an annual rate of about 2 per cent. The short-term expenditure of the $1,700 million might be justified if the city were desperate for funds, the availability of other sources of funds was limited, and the province could be expected to soon expropriate the $1,700 million.
Instead of spending the $1,700 million proceeds from the sale of Toronto Hydro over a short period of time, the city could invest it in a mutual fund with the objective of generating the same annual income as the ownership of Toronto Hydro could be expected to provide. That comparison favours continued city ownership for two reasons. First, in negotiating with the provincial government and other organizations to fund some desired activity, the city can be told: “You have plenty of money, $1,700 million to be exact. Use that money.” The other reason for continued city ownership, even if it succeeds in not spending the fund is that the income from the ownership of Toronto Hydro is far less risky than the mutual fund income.(14)
To match the income from the ownership of Toronto Hydro, the city could invest 65% of the $1,700 million proceeds from its sale in bonds and 35% in a portfolio of shares. By investing in A level corporate bonds, they could earn the 6.8 per cent on bonds allowed by the OEB under city ownership, and a stock portfolio could be selected on which the expected return is about 10%, what the city is allowed in Table II.
The A level corporate bonds are risky in that they carry some risk of default and interest rates fluctuate. Most important, they are subject to inflation rate risk. Even with the low rate of inflation that we are experiencing currently, the real purchasing power of the principal and of the interest falls over time. A period of high inflation over a decade or so would reduce the real value of the bonds to close to zero. The city now has a debt of about one billion dollars, so that the imputed interest on the Toronto Hydro bonds would be about equal to the interest on the city debt if the long and short position in bonds remained in balance. Doubt about the ability of the city to keep the interest and principal on the two positions in balance would make it advisable to have the city place Toronto Hydro’s debt on the market and use the proceeds to pay off its own debt. The city would then be left with the ownership equity in Toronto Hydro.
The alternative to the ownership equity in Toronto Hydro is the return on a stock portfolio that of course is highly uncertain. In any one year, it could earn as much as 20 per cent, and it could decline in value by that amount.
Figure I reproduces charts prepared by the Canadian Institute of Actuaries on the nominal and real annual returns from 1926 to 1998 on representative portfolios of Canadian and U.S. stocks. The U.S. market has done quite well in recent years, but the charts make clear the high long-run volatility of stock market returns in both markets. The market volatility in the first four months of 2000 is further evidence on the subject.
In contrast, it is difficult to imagine a safer investment than Toronto Hydro for the people of Toronto. The rate of profit on the investment in Toronto Hydro can be expected to fluctuate very little from one year to the next and in the long run. One possible source of uncertainty is the volume of electricity sold, but the electricity consumed in the city is very stable, and in the long run it can be expected to grow at a moderate stable rate. The rate of profit Toronto Hydro is allowed to earn by the Ontario Energy Board (OEB) may fluctuate due to changes in interest rates and other economic conditions. But these fluctuations are nothing compared to the gyrations in the stock market.
Furthermore, for the people of Toronto, the return on city ownership is even more stable than the return to the city. When the return the city earns on its investment in Toronto Hydro in dividends and growth goes down, the price paid by the people for electricity also goes down, and vice versa.(15) Hence, what the people lose as owners, they gain as consumers and vice versa. By contrast, with a privatized Toronto Hydro, when the return on the stock portfolio goes down, the price charged for electricity may go up, and when the portfolio return goes up, the price of electricity may go down. The ownership of Toronto Hydro is a far safer investment than its replacement with a stock portfolio.
What then is the advantage of private ownership? The only case that might conceivably be made for private ownership is that it is more efficient and it will result in lower prices for the distribution of electricity. The lower average price, it might be argued, would offset the higher risk in electricity price fluctuations to consumers and in portfolio return to the city under private ownership. However, we will see in the next two sections that private ownership would not only be more risky, but the case for greater efficiency is weak to non-existent, and in various ways it would raise the distribution cost of electricity materially.
- Regardless of ownership, Toronto Hydro will be a regulated monopoly with respect to distribution, and other things remaining the same, the rates charged by Toronto Hydro will vary with the “rate base” which is the cost of its assets.
- In the recent past, funds invested in the stock market have grown at a high rate. However, you can’t have your cake and eat it too. The high growth rates are achieved with little or nothing of the profit paid in dividends, and only the dividends can be spent on city services. An RBC Dominion study that argued the merits of privatizing Edmonton Power Company, claimed that the dividend on the portfolio made possible by the sale would be greater than the dividend from ownership. However, under the total return projections for the portfolio, the projected dividend growth would bankrupt the portfolio. See “An Examination of the Comparative Financial Consequences of Owning and Selling Epcor for the people of Edmonton,” cited in Appendix 2.
- This is perfectly clear for the TTC, the school boards and other city-owned users of electricity. What the city gains in higher rates to these city-owned operations, it gives up in their higher costs. The same is true of the people of Toronto who own Toronto Hydro through the city.