BC's billion-dollar power play

March 5, 2001

BC's billion-dollar power play
The electricity crises in California and Alberta put Michael Costello and BC Hydro in the right place at the right time. But will the good times last?

By Peter Verburg

With all the bad news coming out of California and Alberta, you'd think Armageddon was just around the corner. In January, Californians got stuck in elevators, and bank machines seized up as rolling blackouts hit the state, its utility companies on the verge of bankruptcy because of soaring electricity costs. In Alberta, the lights are still on, but consumers are paying heavily for the privilege. Calgary homeowners opened their January utility bills and discovered the price of electricity had nearly doubled in the space of a month. And the nightmare has only just begun. When power-hungry air conditioners are flicked on this summer, residents of sunny California will face the prospect of catastrophic blackouts that will short-circuit Silicon Valley and bring factories to a standstill. Fallout from the outages could ripple through the North American economy.

Just about everyone is fretting about an energy crisis. Everyone but Michael Costello, the president and chief executive of BC Hydro. All he sees is one hell of an opportunity to make money. BC Hydro, a Crown-owned utility, occupies the northwest corner of a huge power grid that covers the western half of Canada and the US. It's a great position to be in as energy-starved Alberta and California struggle with mismanaged deregulation that has sent power prices through the roof. In the fiscal year ending March 31, BC Hydro expects to generate about $5 billion in gross revenue selling power to its neighbors -- a fivefold increase over last year -- and approximately $1 billion in net income, most of which will flow into BC government coffers. Costello, a career civil servant, is happy to boast about the province's good fortune. "It's been quite a year," he says. "We're very proud of these results and proud of the incredible effort of our 5,600 employees."

Cynics would say it's just dumb luck. BC Hydro generates about 80% of its electricity at dams on the Peace and Columbia rivers and, as everyone knows, water running downhill is both benign and cheap. The utility can produce one megawatt-hour of electricity -- enough to light 1,000 homes -- for about $5.50. During peak hours, the spot price of electricity on the Western grid has recently spiked as high as $1,500 per megawatt-hour. That's a nice spread if you've got spare juice to sell.

The beauty of a hydroelectric facility is that you can store generating capacity by trapping water in reservoirs. By contrast, Alberta's coal-fired thermal generators can't be turned off. Costello has exploited this difference by slowing down his hydro generators at night and importing power from Alberta and the US when demand is low and electrons are cheap. The next morning, when demand kicks in and California or Alberta must import power from BC, Costello releases the water stored behind his dams and makes the generators perform double duty. He then sells power on the wholesale market for up to five or six times what he paid to import electricity the night before. By timing its generation for peak periods and buying wholesale in the wee hours of the morning, BC Hydro is able to make a tidy profit -- in effect transferring wealth from capitalist Alberta to socialist BC.

BC Hydro isn't the only company profiting from the energy shortage, but the utility and its sole shareholder, the provincial government, are by far the biggest beneficiaries. Without BC Hydro's record revenues, the spendthrifts in the province's NDP government would be running a deficit this year. The managers at BC Hydro are also sitting pretty. Costello and the utility's chair, Brian Smith, each pocketed a $100,000 bonus last year. And with so much money in the bank, Costello is able to flirt with some unconventional schemes, committing 10% of new-generation spending to "green" projects, such as solar and wind energy, and millions more to restoring salmon streams and building hiking trails. Why not? Costello figures the good times will last another few years.

He may be California dreamin'. For one thing, a sizable chunk of Costello's windfall profits are only theoretical at this point. BC Hydro is owed more than $300 million by California power companies. The state's biggest utilities, Pacific Gas and Electric Co. and Southern California Edison, are drowning in billions of dollars of debt and have warned they may not be able to meet their contractual obligations. That could reduce BC Hydro's earnings. Calgary-based TransAlta Corp., which has also sold power into California from its coal-fired plant in Washington state, took a $43-million writedown in the fourth quarter over concerns it wouldn't be paid. Another problem: BC Hydro could soon face its own power shortage. This winter has been unusually dry, resulting in the lowest snowpack in a decade. That means less water flowing into dam reservoirs and reduced power generating capacity. In fact, the situation may be worse than the utility is letting on. An industry source says that since December, BC's power exports have dramatically declined; on most days the utility is importing electricity even during peak hours.

Despite these looming pitfalls for BC Hydro, it's clear the energy supply crunch in California and Alberta isn't going away until new power plants are built -- and that will take at least two or three years. That means electricity prices will stay in the stratosphere, and the threat of blackouts will continue, especially during the summer, when loads are highest. According to one report, California's electricity shortfall could reach 6,800 megawatts this summer if temperatures are above normal. That's only slightly less than the daily power requirement for the whole of Alberta. One energy analyst says the peak "Mid-Columbia" price, the wholesale rate set at the Washington-Oregon border, could climb from $500 in mid-February to a staggering $15,000. Talk about a recipe for disaster.

Ironically, the root of this energy crunch was an attempt by governments to lower power prices by introducing competition to the industry. The principle behind deregulation is sound: when power distributors are forced to compete for customers, prices should drop. Margaret Thatcher proved it when she deregulated Britain's electrical market in 1990. The US Consumers Union produced a study in 1997 showing that deregulation in Britain reduced power costs and resulted in significant efficiency gains.

But this scheme works only when there's enough electricity to go around. As with any other commodity, if supplies are tight, prices will go up. When Alberta and California blazed North America's deregulation trail in the mid-1990s, there was uncertainty about how the competitive process would unfold. Utilities were reluctant to build new generating plants because it was unclear how they would recoup their huge capital investments in a deregulated environment. As a result, no large-scale power plants have been built in Alberta or California for more than a decade.

The freeze on new generation coincided with an economic boom in California's high-tech industry and Alberta's oil patch. There has been a phenomenal 24% rise in electricity consumption in California since 1995. In Silicon Valley, summertime demand is expected to grow another 5% this year. One expert has noted that some Internet Web-hosting centres use as much electricity as eight 40-storey office buildings. Similarly, the surplus of power enjoyed by Alberta in the mid-1990s was soaked up by rapid population growth and new developments in high tech, the petrochemical industry and the oil sands. The province's demand for power has grown by 4% per year over the past decade. In short, Alberta and California are victims of their own success. Growth in consumption has exhausted supplies.

Among US states, California is hardly alone. A robust economy, central air-conditioning (half of US homes now have it) and a proliferation of microwave ovens, computers and other high-tech toys have caused summertime electricity demand across the US to surge by almost 25% since 1990. Over the same period, new generating capacity is up a mere 6.4%, according to the US Department of Energy. Once again, the principal culprit appears to be uncertainty surrounding deregulation. Approximately half of US states have initiated some form of competition in the electricity market, delaying the addition of new generating capacity. Interestingly, Texas has taken steps to avoid a power shortage by requiring utilities to build an excess of capacity into the system before it introduces competition.

Most of Canada, meanwhile, has stuck with the status quo. Ontario and New Brunswick are the only other provinces to take significant strides toward deregulation, and because of the crisis unfolding in Alberta, Ontario's plans are now on hold. It's probably no coincidence that low electricity rates are the norm across the country. Ontario had a recent market price of 5.8¢ per kilowatt-hour. BC's was at 3.4¢. The one exception is Alberta, where electricity was recently priced at 13¢ per kilowatt-hour. The cost of electricity is higher still in some American states. Californians pay 24.2¢ per kilowatt-hour.

The folly of Alberta's deregulation process is shocking when you consider that, a decade ago, the province enjoyed some of the lowest electricity rates on the continent -- a mere 2.5¢ per kilowatt-hour. Approximately 75% of Alberta's power is generated in coal-fired plants, and the province has huge, shallow deposits of thermal coal, enough to supply power internally for some 800 years. Coal has a bad reputation as a dirty fuel but, using modern technology, it causes no more pollution (other than carbon dioxide) than natural gas. What's more, coal-fired electricity can be generated for about 0.5¢ per kilowatt-hour, compared with 8¢ using gas. (The record price of natural gas this winter is the other reason electricity is so expensive. About 25% of Alberta's power is generated in gas turbines.)

On most days, Alberta still has a slight surplus of power, but supplies are extremely tight. A shortfall occurs whenever a generator goes down or demand is higher than normal. In the old days, before wholesale power trade between Canada and the US, the shortfall could have been covered by imports from BC at a reasonable price. But not anymore. With electrons racing around the Western grid and finding their way to the highest bidder, California's problems have essentially spilled over into Alberta. The province's utilities now have an incentive to export electricity from Alberta to the US, where it fetches a much higher dollar during peak hours.

You can see the impact of wholesale competition and high gas prices on Alberta's power pool prices, which have climbed steadily from an average of $14.42 per megawatt-hour in 1996 to $133.22 in 2000. Power prices in Alberta haven't reached the stratospheric levels of the US grid, but only because exports from Alberta are limited by the province's transmission system. If the Mid-Columbia price soars to $15,000 a megawatt-hour this year, Alberta's prices could reach $1,000.

All of this explains why Michael Costello is in such high spirits. BC Hydro is a protected monopoly with cheap power, it sits atop a densely populated American coastline that's jazzed for juice, and it acts as a power broker between Alberta and the rest of the Western grid. Alberta has no major supply lines into the US and only a small link to Saskatchewan, so it's forced to move power through BC. The electricity trade is like a big chess game -- and for most of the past year, Costello has held all the best pieces.

It's a nice change of pace for the once scandal-plagued BC Hydro, and for Costello himself. Costello was the deputy finance minister of Saskatchewan in the 1980s, during the controversial rein of Conservative Premier Grant Devine. He later held the same job in Victoria under Glen Clark, just prior to the NDP's notorious "fudge-it budget" scandal. Costello left finance to run BC Hydro in 1996, after the utility's then-president John Sheehan was forced from the job in a conflict-of-interest scandal. (He later sued for wrongful dismissal and won.) Sheehan's wife had acquired shares in a company that was involved in a joint venture with BC Hydro in Pakistan. Oh well. The utility's sullied reputation is easily forgotten when it's pumping out billion-dollar profits.

BC Hydro's spectacular financial results aren't purely a consequence of being in the right place at the right time. Costello deserves some credit for guiding the utility into a position that allowed it to capitalize on the current energy shortage. In 1996, when Costello took over, BC Hydro generated $51 million in revenue selling surplus electricity at the Canada-US border. He immediately sought permission from the US Federal Energy Regulatory Commission to begin buying and selling electricity on the wholesale market. A licence was granted the following year. With that, BC Hydro could strategically import power directly from US producers at night -- when it's dirt cheap -- and store water that would have been used to generate electricity. After the sun came up, the stored water was unleashed, creating surplus power that could be sold at a favorable margin. This practice is known as "time shifting."

In the first six months of this fiscal year, the utility paid an average of $91 per megawatt-hour to buy electricity off the wholesale market when demand was weak. It then turned around and sold power back into the grid at an average price of $172 per megawatt-hour. In December, Alberta and California paid up to $500 per megawatt-hour importing power from BC. "Couple our storage capacity with competitive power markets and the incredible volatility in those markets and you see the opportunity," says Costello. Indeed, with an expected $5 billion in gross trading revenue this year, BC Hydro's import-export business has risen by a staggering 9,700% in just five years.

In its last annual report, the utility made a big deal about how clean its hydro energy is compared to the thermal plants run by other Canadian utilities, such as Alberta's TransAlta. But over the past year, BC Hydro has imported close to 3,000 megawatts of electricity a day from Alberta's carbon dioxide-emitting coal-fired generators. (It seems even the green-friendly NDP doesn't mind a bit of pollution if it can make a fast buck.) Thanks to the lucrative power trade, the provincial government was able to collect $343 million in dividends from BC Hydro last year and $276 million in "water rentals" -- payment for simply using the resource. Every year, the government siphons off 85% of the utility's net income. Since taking office in 1991, the NDP has sucked about $4.7 billion out of BC Hydro in dividends and water rentals.

A sizable portion of those profits should have been left with BC Hydro so it could prepare for the province's long-term energy needs, argues Vancouver energy lawyer David Austin. He says the provincial government is busy "looting the store" to cover its budgetary deficit, when it should be allowing BC Hydro to pay down debt and invest in new generating capacity. The utility hasn't built a major power station for over a decade. Austin argues the only reason BC hasn't already run into an electricity shortfall like Alberta's is that the government has brought economic growth to a virtual standstill over the past nine years. Also, the province has benefited from higher-than-normal levels of snow and rain over the past half decade, raising reservoir levels. If that's the case, a lack of snowfall this winter could create problems for BC Hydro. According to the BC environment ministry, this has been the driest winter in more than a decade. Even before the winter began, BC's reservoirs were low. In November, the utility reported that its hydro generation had declined over the previous six months because of a 14% reduction in the level of water inflows into its reservoirs. In a dry cycle, Austin says BC could find itself in the same position as Alberta and be forced to go cap-in-hand to buy power from others. The utility's only big non-hydro operation is a 900-megawatt gas-fired Burrard plant in the Lower Mainland, and it's going flat out. "Burrard is only 31% efficient," says Austin. "It's an old piece of junk."

Costello isn't concerned. He points out that BC Hydro has proposed a small gas-fired turbine for Vancouver Island, and says the province won't need new generation until 2005. As for the low snowpack, he says: "All that translates into is an absence of any surplus hydro power to sell into external markets." In fact, BC Hydro recently became a net importer of electricity. It's only because of "time shifting" that the utility is able to mask its power deficit and generate such massive profits. However, if reservoir levels get low enough, BC Hydro could find itself with tight supply during peak hours and be forced to buy electricity on the spot market paying Mid-Columbia prices. That's risky, given the utility's $7.1 billion in long-term debt. Its debt-to-equity ratio, at 3:1, is high -- twice the norm for utility companies.

These are issues the BC Liberals will be forced to deal with if they oust the NDP in this spring's provincial election, as polls predict. One thing the new government should do, says Austin, is privatize BC Hydro's high-voltage transmission network. Such a move would be welcomed by BC's small band of Independent Power Producers (IPPs) and Alberta's electricity distributors, who are frustrated by BC Hydro's monopoly over the wires. The IPPs are being bullied by the Crown-owned utility, according to Austin. Powerex, the export arm of BC Hydro, has been offering to buy electricity from small producers for one-tenth the going market price and, since BC Hydro owns the wires, the IPPs have little choice but to accept. Meanwhile, the Power Pool of Alberta, the provincial agency responsible for the power grid, produced a report showing that, in its role as gatekeeper, BC Hydro was interfering with electricity trades between Washington and Alberta. The federal Competition Bureau is looking into the matter. If BC Hydro wants unfettered access to the wholesale market, it should not abuse its monopoly power.

Whatever happens, Costello can count on continuing high electricity prices. The energy shortage in California will be difficult to overcome, despite some 40 new power facilities proposed for the state. Past attempts to add new generation have been hampered by strict environmental controls. It takes two years just to get a siting permit in the state for a gas-fired plant. As a result, California is relying on neighboring states to fill the gap, but they don't have a lot of extra power to sell.

There's also the little matter of payment. When California deregulated its power industry, it froze electricity rates paid by consumers, but forced utilities to buy on the Western grid at whatever price the market would bear. When a heat wave hit last summer and the wholesale price soared, the utilities were forced to buy power at $1,650 a megawatt-hour and sell it to consumers at a ridiculously low $81. That's why they're teetering on the brink of bankruptcy. Costello says that, as long as the state's utilities can provide letters of credit or make other special financial arrangements, he'll continue to zap electricity across the border.

Meanwhile, now that the rules of deregulation have been sorted out in Alberta, several utilities are planning new generation. TransAlta, Edmonton-based Epcor and Calgary's Enmax Corp. have proposed new or expanded coal-fired plants, totaling some 1,700 megawatts of new capacity. Unfortunately, coal-fired plants are big, require a lot of up-front capital and take a long time to build. The new generation units won't be running until 2005. Alberta will get new gas-fired turbines before then but, since natural gas supplies are expected to remain tight, they might not relieve the price pressure. In all, 4,000 megawatts of new electrical capacity is planned for the province over the next decade, a 50% increase over current levels. But until those new electrons are streaming down power lines, Albertans will pay the highest electricity rates in the country. Consumers will simply have to adjust to the new environment by using less electricity.

That's already happening. In mid-February, the day after Alberta Premier Ralph Klein called a provincial election, french-fry processing company Lamb Weston Inc. announced it would indefinitely postpone a $50-million upgrade of its plant in Lethbridge, Alta., due to high electricity costs. The news came as a blow to the Klein Tories, who are already smarting from criticism that they bungled deregulation. The Opposition Liberal Party claims the soaring power costs will suck billions out of the provincial economy over the next five years. Klein is trying to deflect the criticism by dipping into Alberta's soaring oil revenue and handing out billions in energy rebates to consumers.

The energy shortage will undoubtedly be the dominant issue during Alberta's monthlong election campaign. For industrial consumers and residential ratepayers on fixed incomes, a doubling of electricity prices in one month has come as a huge shock. "The Tories are sensitive to the fact that they've blown it for the province," says the director of one Alberta utility. "We'll be on the verge of crisis for the next few years." Nevertheless, given Klein's solid track record on almost every other matter, he's likely to pull off a third consecutive majority.

It's a circus alright. BC Hydro's Michael Costello should enjoy it while he can. His own dark days might not be far off.