Hydro One: Re-Energizing with Microgrids
By: Jonathan Copeland & Gazal Grewal
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
For most provinces in Canada, citizens typically focus on healthcare, jobs, or taxes as their most important provincial concern. However, this is not the case in Ontario. In recent years, Ontarians have been confronted with the highest electricity rates in Canada. This highly-charged issue has put the public spotlight on those involved in Ontario’s electric ecosystem, with one firm in particular embroiled in a continuous heat of controversy: Hydro One. In order to address concerns regarding an aging power grid and growing risks, Hydro One needs to pursue an innovative strategy shift.
Shocking Prices, Crumbling Infrastructure, and Incoming Storms
Responsible for electricity transmission and distribution across 68 per cent of Ontario’s population, Hydro One owns the energy grid that supplies electricity used for daily functions. It purchases electricity from power generation companies like Ontario Power Generation and transmits the electricity through high voltage lines before distributing the electricity to its consumers. As such, it must maintain its assets regularly to offset depreciation in the grid. However, maintenance costs are expensive. Hydro One invested C$1.7 billion in capital projects in 2016, representing 26 per cent of revenues. 67 per cent of these investments were directed toward sustaining operations. Even with the large amount of investment, Hydro One is still plagued by issues of low reliability. Compared to 2010, power outages in 2014 were 24 per cent more frequent and 30 per cent longer because of aging equipment and damage from insufficient management of trees near power lines. In an effort to replace its deteriorating infrastructure, Hydro One is looking to commit C$6.4 billion over the next five years.
However, Hydro One lacks the flexibility to set its own prices to fund these investments. Prices are instead set by the Ontario Energy Board, a governmental regulator that determines hydro rates by setting prices at a level that would allow Hydro One to make a profit margin on top of its investment and demand projections. The inherent problem with this type of traditional electrical utility business model is that it incentivizes utility giants like Hydro One to increase infrastructure investments to grow its bottom line. Innovative solutions that have the potential to decrease infrastructure costs and increase sustainability are not intrinsically incentivized under the current business model, and may even face resistance. However, with escalating electricity prices reaching a tipping point in the public’s consciousness, the government-controlled Ontario Energy Board is facing immense political pressure to freeze hydro rates. Consequently, the Ontario Energy Board has mandated Hydro One to reduce infrastructure investment by C$126 million in 2017 and C$122 million in 2018. With the Ontario Energy Board’s firm control over Hydro One’s ability to generate revenue, Hydro One must look to alternative business models to improve reliability without neglecting its aging infrastructure.
The costs associated with deteriorating infrastructure come from decreased reliability in energy distribution and transmission and increased operating costs. These issues are exacerbated during periods of extreme weather. For example, Toronto’s massive ice storm in 2013 resulted in C$12.9 million in total additional costs for the local distribution company in the area. The frequency of extreme weather events in the province, including floods and severe winter storms, is expected to increase in the future, and is already drawing concern from the government regarding its consequences on infrastructure. Hydro One is vulnerable to the same issues, and may see strain on its system going forward from scenarios such as physical damage to power lines during storms and unanticipated increases in consumption. Increased strain on the aging grid will lead to an increasing number of blackouts that Ontario residents have already been experiencing.
Ontario Energy Use
Losing power has even greater economic consequences to manufacturers, making them an attractive candidate for a new solution. During the 2003 blackout in Ontario, residential users had power returned to them in one day, but businesses faced power restrictions for more than a week. This resulted in the loss of 18.9 million employment hours and C$2.3 billion in manufacturing shipment. Accounting for 19 per cent of all energy consumption in Ontario, manufacturing facilities represent a significant portion of the consumer energy market in Ontario. While Hydro One historically benefitted from a monopoly, it risks losing valuable industrial consumers who may opt to switch to more reliable power generation methods off of the grid. With advancements in power technologies, it is becoming increasingly feasible for the dynamic of power management to shift from utility companies to the hands of consumers. There is a precedent for companies that are already exploring alternative methods of energy storage. One such example is Ford’s partnership with Detroit Edison to install a 500 KW solar microgrid at its Michigan Assembly Plant.
The problem for Hydro One is clear: funding for infrastructure investment must be found to protect the main grid from being vulnerable to costly blackouts. However, with prices being capped by the Ontario Energy Board, Hydro One must find another way to finance the cost of maintaining its existing infrastructure. As such, the company must learn to adapt to the shifting industry landscape and focus on a long-term strategy that maintains its influence in emerging models.
Microgrids: A Forward-Thinking Solution
Microgrids have the potential to fundamentally change the way society thinks about electricity – transforming power consumers into power producers. Simply put, microgrids are small power grids, localized so that they can operate autonomously to the main grid. Microgrids can be powered using a wide range of sources such as distributed generators, batteries, and more popularly, with renewable resources like solar. They usually function alongside the main grid, giving users the benefits of having electricity transmitted in parallel from two sources, which essentially acts as an extra lifeline. The ability for microgrids to disconnect from the main grid has become increasingly vital as it allows the decentralized electricity system to continue generating power even if an extreme weather event takes down the main grid. Traditionally, diesel generators have been used for backup power, but these generators quickly become useless in the event of any extreme weather disaster as fuel needs to be replenished. In such situations, solar panels offer a much more viable solution. However, absent a microgrid, solar panels shut off with the rest of the grid, rendering them useless when they could be providing the highest value. With a microgrid, the solar panels can store power in high-capacity capacitors in a secure location.
In an effort to improve the resiliency of the electric grid and further integrate renewable energy sources, microgrid adoption has seen a remarkable uptake in the Northeastern United States following the devastation of Hurricane Sandy in 2012. Overall, the United States currently has 1,600 MW of microgrid power in deployment. Using New York state capacity as a proxy, Ontario’s output capacity for solar energy is estimated to be around 350 billion MWh annually. The province, however, is currently only producing 460,000 MWh annually. As a result, there is plenty of opportunity to introduce microgrids in the form of solar panels in Ontario. Compared to residential applications, industrial and institutional applications are an attractive area for microgrid application, where the cost of power failure is much more detrimental.
One of the great barriers of microgrid adoption to date has been the high levels of regulation in Ontario. Furthermore, operational challenges in microgrid capacity constraints, forecasting capabilities, and quantifying benefits make it difficult for companies to rationalize the investment. With Hydro One’s competencies in field operations, asset management, and regulatory relations, they are well-positioned to partner with current microgrid providers to rapidly scale commercial microgrid deployment. By entering into the microgrids business, Hydro One can tactically begin its transformation from a heavy utility giant reliant on heavy infrastructure investments into a nimbler supplier that can sustainably survive into the future.
The Deal
Hydro One should partner with an existing microgrid implementation firm, such as Siemens, to implement commercial microgrids for large energy-consuming companies that have factories in Ontario, such as Ford’s Oakville Assembly Plant. All three firms will share the investment to build these microgrids, but Hydro One will retain ownership over the microgrid as well as the responsibility of maintaining the infrastructure. In return, industrial companies with installed microgrids will pay Hydro One a slightly higher premium of two per cent for their electricity consumption. Structuring such a three-way deal is difficult, as it requires all three parties to come out of the equation better economically than had they decided to operate alone. This is how each counterparty benefits:
Industrial Companies – i.e. Ford
While residential consumers of electricity might find a blackout to be merely a nuisance, commercial companies that rely on electricity to power their factories’ throughput can incur much larger economic costs. For example, if Ford’s Oakville Assembly plant lost one day of productivity, it directly results in C$18 million in lost potential revenue. With the likelihood of inclement weather causing power outages increasing in the future, this is an ongoing concern. Large-scale manufacturing companies clearly have the incentive to upgrade to a more reliable dual-pronged power source that utilizes both the main grid and their own microgrids.
Commercial companies will also save costs through the ability to smooth their power consumption from the main grid. During peak consumption times, large consumers of electricity must pay Global Adjustment (GA) charges issued by the province’s power generation facilities. Power generated during these peaks are extremely costly to power generation companies and GA charges are an attempt to reduce the heavy strains during these times. By drawing on both the microgrid and the main grid, Ford can avoid GA charges by relying more heavily on its own microgrid during peak hours before smoothing out demand during baseload hours. GA charges often contribute to the largest proportion of an industrial consumer’s energy bill, amounting to C$500,000 per MW. For Ford’s Oakville Assembly Plant, paying a two-per-cent premium for electricity from microgrid facilities installed on site, would only increase electricity costs by C$336,000 per year. With carbon pricing’s imminent implementation, there are additional savings that Ford could gain by upgrading to a renewable energy source.
Microgrid Implementation Companies – i.e. Siemens
Although Hydro One possesses vast experience with field operations in relations to the main grid, it does not possess the equipment to implement microgrids on its own. Siemens Energy is a power generation and distribution company that has already made an attempt to enter the microgrid industry by selling and deploying microgrid power generation solutions to institutional users in Ontario. Recently, the company secured a successful arrangement with Algonquin College that has already generated a positive return on investment.
Successfully installing a microgrid facility can take upwards of five years, with costs that are likely projected to be around C$1 billion. The cost of solar panels and batteries needed for the microgrid will likely average out to C$5.8 million. Combining the shared expertise of Siemens microgrids and Hydro One’s understanding of the main grid can substantially lower the likelihood of cost overruns and speed up implementation to only two years. The microgrid industry is still nascent in Ontario; Siemens would leverage an early-mover’s advantage by partnering with Hydro One to scale up quickly and establish itself as a main player. Siemens also benefits by sharing the risk with Hydro One, so that it does not have to incur heavy upfront investment on its own.
The Traditional Utility Company – Hydro One
According to the MaRS Advanced Energy Centre’s [Micro]grids Today report, the high levels of provincial legislation and regulatory framework in Ontario are the greatest barrier to microgrid adoption. Hydro One, still 49.9-per-cent owned by the government, would have a much clearer understanding of how to navigate the regulatory controls, an advantage that Siemens does not possess. In addition, as microgrids still function in accordance with the main grid, having Hydro One operate both grids will allow for a more optimal flow of energy through a centralized control room.
Hydro One benefits from this arrangement in multiple ways. While it may seem like Hydro One would be cannibalizing sales by encouraging companies to wane their demand on the main grid, Hydro One would be proactively positioning itself to capture the new market in microgrids. This innovation will likely propagate with or without Hydro One’s support.
Hydro One’s traditional utility business model is no longer working. By stressing less on infrastructure and more on reliability, Hydro One will be positioned more sustainably for the future. This may seem like a very long-term view, but it is important to note that utility companies often hold very long-term decision-making frames, often up to 30 years. As such, it is important to adapt early to a shifting landscape. In the short-term, Hydro One will benefit by keeping its clients and earning more short-term cash flows. In the long term, Hydro One must decrease the reliance on the main grid which will help decrease the investment needed to maintain it.
Conclusion
Over the past century, electrical utility companies presiding in the industry were protected in an enviable position that guaranteed comfortable, consistent returns on investment. Today, those cozy returns are no longer as comfortable. Regulatory constraints and changing industry dynamics have put electrical utility companies in a precarious position. On one hand, the advancements made in renewables and energy storage can provide a more sustainable source of revenue. However, these technologies also enable private consumers, residential and commercial alike, to shift their position in the market from electricity consumers to electricity producers. The challenge for electrical utility companies moving forward is adapting to this shifting landscape in a way that preserves their long-term survival without impeding environmental and sustainable progress.