THE NEW REGULATORY FRAMEWORK IN QUÉBEC

 Notes for an Address
By
Jean A. GuérinChairman of the Régie de l'énergie

Second Annual Conference of
The Canadian Electricity Association and
The Canadian Gas Association
 February 12, 1998

Ladies and Gentlemen:

I would like to thank The Canadian Electricity Association and The Canadian Gas Association for giving me the opportunity to address the representatives of the electricity and natural-gas industries. This conference, which brings us together annually, has, this year, as its central theme the convergence of natural gas and electricity. I feel it is a privilege to speak to such a prestigious audience and I hope that it will be an opportunity for you to become more familiar with the Régie de l’énergie.

As you are all undoubtedly aware, the Régie de l'énergie is a brand-new agency. It was created on June 2, 1997, after having long been hoped for by most interveners involved in the Québec energy industry. Its creation is a result of one of the main recommendations of the Consultation Panel for the Public Energy Debate, as well as of a major commitment regarding energy policy published by the Québec government in the fall of 1996.

There have been great expectations for this agency since the moment we first started talking about it. This is why I feel it is important to describe to you the role this regulatory body is meant to play. Indeed, it is a role that will allow it to face the challenges of the new energy market, which is characterized by trade liberalization, increasing energy-market integration and convergence. First of all, I would like to take a few minutes to summarize recent developments which have marked the North American energy industry and to stress the economic importance that this sector has in Québec. Following this, I will present the powers and functions of the Régie, as well as a summary of the main activities it will undertake this year.

1. THE CONTEXT

You are surely aware of the profound changes which have taken place in the North-American market in the last few years, not only in the energy field, but also in several of the larger economic sectors, such as transportation and communication.

In the United States, the liberalization of the natural-gas market began in 1978. It ended in 1993 with the complete liberalization of well-head prices. In the petroleum sector, the American government began to deregulate prices at the end of the 1970's. In the electricity sector, the liberalization of wholesale markets has, for all practical intents and purposes, been completed since the adoption of Orders 888 and 889 of the Federal Energy Regulatory Commission, commonly known as the FERC.

Electricity has come to be seen more and more as a "commodity" which is subject to the same market forces as any other merchandise, whether it be grain, petroleum or natural gas. Since April 1996, we can indeed trade electricity options and term contracts on the New York Mercantile Exchange (NYMEX), with prices quoted in dollars and cents per megawatt hour. In fact, what is happening today in the electricity industry is what happened a few years ago in the area of natural gas.

However, this movement towards liberalization is not the only phenomenon that has rocked the energy market in the United States. Now that all energy forms have been deregulated, or are on the road to being so, we are faced more and more often with a convergence between them, this being particularly true for natural gas and electricity.

This phenomenon of convergence is comparable to the one that has already taken place in the telecommunications field, where television stations, telephone, cable and computer companies have begun to merge certain of their activities in order to offer consumers the possibility of one-stop shopping that provides access to a multitude of services. Thus, the corresponding movement towards liberalization in the energy field has resulted, in certain cases, in mergers and in joint ventures between electricity, natural gas and petroleum companies, all in an attempt to give their customers multi-energy services which meet their many and varied needs.

These various stages of deregulation in the energy field have had direct repercussions on Canadian industry.

The Canadian petroleum industry has been subject to international prices since 1985, and petroleum products have generally been sold in a free market where prices are dictated by market forces.

In the natural-gas sector, the liberalization of production and trade took place at the end of 1985. This deregulation has led to a substantial drop in the price of the commodity. It has also enabled the producer to choose from a vast array of suppliers. Transmission and distribution activities, however, have continued to be regulated, largely because these activities constitute natural monopolies. For obvious economic reasons, it is not possible generally to allow the duplication of such infrastructures on the same territory without compromising efficiency gains that result from exclusive franchises rights.

For its part, the electricity sector has felt the effects of the opening up of American markets. The provinces must meet a certain number of conditions if they want to take full advantage of the immense market represented by the American electricity trade. Among these conditions, we might mention that American firms must be offered a certain form of reciprocity so that they might benefit from conditions similar to those which the Canadian firms would like to be able to take advantage of in the United States.

Incidentally, Alberta and British Columbia have already undertaken certain initiatives with the goal of taking full advantage of this new market, and the Ontario government recently announced that it will make certain adjustments to its legislation as of 1998 in order to pave the way for the emergence of a truly competitive market in the year 2000.

A similar movement towards the opening up of markets has been observed on the part of Canadian federal authorities since 1995, when the National Energy Board began to grant electricity-export permits to companies other than public electricity utilities, especially to electricity and natural-gas marketers.

This movement in favour of the opening up of wholesale electricity markets should eventually take concrete form in the granting of a wheeling service linking the various Canadian provinces. As a matter of fact, the provinces and the federal government should be ratifying Chapter 12 of the internal trade agreement over the next few months, thus making it possible for public utilities to offer other provinces open access to electricity-transmission services.

Québec, for its part, has complied with the FERC requirements for reciprocity by approving transmission rates and opening up Hydro-Québec's network and wholesale market to American companies. In order to respect the new ground rules laid down by the North- American industry and to offer its wholesale customers open access to transmission service, Hydro-Québec has separated its transmission activities from its other activities. This change has been implemented through the creation of an independent business unit, Trans Énergie, which concentrates solely on the firm's transmission activities. Furthermore, Hydro-Québec Energy Services (U.S.), a fully owned subsidiary, was granted by the FERC, on November 12 of last year, a permit to sell electricity at U.S. market-based prices.

2. THE ENERGY MARKET IN QUÉBEC

The liberalization of American electricity markets can represent an excellent growth opportunity for Québec producers. There are two main reasons why it is advisable to seriously examine this opportunity:

· First, the energy market in Québec seems to have reached a certain maturity. Indeed the make up of Québec’s energy balance has remained relatively stable over the last ten years. Energy specialists are predicting that there will only be moderate growth in energy demand over the next few years, with an annual increase of approximately 1.5%.

· The second reason motivating Québec is related to the size of this sector of our economy. The energy sources that are regulated or within the jurisdiction of the Régie, namely electricity, natural gas, and petroleum products, make up 97% of Québec’s overall energy consumption, with electricity representing 41%, natural gas 16%, and petroleum products 40%. In 1995, these sources accounted for sales in the order of $16 billion, including $8 billion for electricity, $1 billion for natural gas and $7 billion for gasoline and diesel fuel.

The share of the energy sector in Québec’s gross domestic product (GDP) reached 4.5% in 1995. In the same year, capital spending in the energy sector was more than $3 billion, representing close to 13% of total investments in Québec. There were 45,000 jobs in the electricity, natural gas, oil and coal sectors, of which 23,300 were in electricity, 20,300 in oil and 1,400 in natural gas.

These figures aside, I feel it is important to give you a brief description of the market structure of each energy sector.

In the electricity sector, Hydro-Québec controls more than 91% of the province’s generating capacity, which reached 40,400 MW on January 1, 1997, with the remaining 8.5% (3,860 MW) coming from private producers, such as Alcan. The total available production is approximately 200 billion kWh, of which 97% was hydro-electric in origin. Finally, Hydro-Québec distributes 97% of the electricity consumed. The rest of the distribution is assumed by municipal grids, including 9 municipal grids and a regional electricity cooperative.

In the natural-gas sector, Gaz Métropolitain has exclusive distribution rights for almost all of the Province of Québec, with the exception of the Outaouais region, where the rights belong to Gazifère Inc. Gaz Métropolitain annually distributes 221 Bcf of natural gas compared to 7 Bcf for Gazifère.

Concerning the petroleum-product industry, there are approximately 4,700 service stations in Québec. These stations sold more than 7 billion litres of gasoline and diesel fuel in a competitive and dynamic market. Independent distributors represent approximately 27% of the Québec market whereas the major companies, such as Imperial Esso, Shell Canada, Petro Canada, Ultramar Canada and Irving Oil Limited control 73% of the same market.

Finally, it is worth noting that Québec is not exempt from the North American tendency towards convergence. Indeed, Hydro-Québec has now 41% of the capital stock of Noverco Inc., which in turn owns 80% of the shares of the distributor, Gaz Métropolitain. In addition, Hydro-Québec has concluded a strategic alliance with Enron Capital and Trade Resources Canada Corp. with an eye to facilitating the market implementation of its energy services. Through its participation in Noverco, Hydro-Québec has also formed a partnership with IPL Energy Inc. and Gaz de France to develop the sales of its energy services on the North American market. As part of this transaction, IPL Energy has bought an equity interest of 32% in Noverco Inc. whereas Noverco has acquired 8% of the capital of IPL Energy with an additional 2% option.

As for Gaz Métropolitain, it owns 50% of TransQuébec and Maritimes (TQM) and 100% of a natural-gas distributor in New England, Vermont Gas Systems Inc. Many other company alliances and mergers have been observed over the last two years in the energy sector.

3. THE RÉGIE DE L’ÉNERGIE: POWERS AND FUNCTIONS

According to the very terms of the Act respecting the Régie de l’énergie, the objective of this quasi judicial agency is to promote "the satisfaction of energy needs through sustainable development". Towards this end, the Régie must take into account economic, social and environmental concerns, as well as individual and collective equity. It must likewise foster the conciliation of the public interest, consumer protection and the fair treatment of distributors.

The Régie will be independent from a budgetary standpoint and will be financed by fees and annual duties paid by the distributors under its jurisdiction. This duty will be calculated in accordance with the services provided to the clientele in question, according to the "user-pay" principle.

The efficiency, equity and transparency of the Régie's regulatory process are guaranteed by formal rules of procedure. These rules are to specify, most notably, the conditions and criteria which will be applied to reimburse, when necessary, expenses incurred by individuals and groups who will intervene before the Régie.

Moreover, the Régie intends to take every necessary step to make the regulatory procedure as flexible and light as possible. It will promote consultation and collaboration among all interested parties, encourage the holding of preparatory meetings and the reaching of negotiated settlements, all with a view to reducing the costs of regulation as much as possible.

Lastly, both its constitutive law and its operating procedure give the Régie the advantage of an independent status which ensures its future credibility. This condition of independence is the bulwark of its authority. It ensures compliance with its decisions by the various stakeholders concerned, both in Québec and abroad. As it so happens, in a decision rendered on May 9, 1997, the FERC granted Hydro-Québec a permit to act as a wholesale power marketer in the United States, basing its decision, among other things, on the competence and independence of the Régie de l'énergie.

In all of its interventions, the Régie will especially have to be sure that its decisions respect the requirements of other public institutions, such as those of our environmental agency, the BAPE. On the other hand, when the Régie has given the go-ahead for the building of certain facilities which are part of the resource plan of a distributor, the BAPE will not have to re-examine whether the project can be justified from an energy standpoint. This approach will contribute to a reduction of the regulatory requirements which can be applied to these enterprises.

Let us examine how the Régie will specifically fulfil its mandate in each of these industrial sectors. We will begin with natural gas.

In Québec, the Régie du gaz naturel was closely involved with the liberalization of the natural -gas trade. It is worth noting, for example, the importance of decisions, such as that concerning the integration of buy-sell transactions into Gaz Métropolitain rates, rendered in 1988, and another concerning customer buy-sell transactions, rendered in 1994. Today, approximately 80% of natural-gas purchases, that is 170 Bcf, is carried out directly by the customer with the supplier of his choice, without any involvement on the part of the distributor.

It is also worth mentioning for system gas customers, who represent 20% of sales volume, the introduction of an automatic prospective adjustment mechanism which applies to the price of the gas commodity. This innovative approach attempts to make full use of mechanisms now available on the markets, such as monthly and annual price indexes and swap contracts, instead of traditional regulatory approaches. Since the introduction of this mechanism at the end of 1994, no more hearings have been required to set the price of gas supply because the rate is now determined entirely by information or price signals provided by the market. Any discrepancy between the billing and purchase prices is itself recovered by the same automatic mechanism. The Régie now only monitors on a monthly basis the application of the whole procedure. Finally, a similar mechanism has been adopted for inventory price adjustments that come with any change in the price of gas supply.

It is likewise worth mentioning the Régie’s decision of last December concerning the revision of cost-of-service allocation methodologies pertaining to, among other things, transmission services used by interruptible customers. The effect of this decision was to grant these customers a credit equivalent to the storage-avoided costs that the distributor do not have to assume in order to serve its firm service customers. Finally, on January 30, the Régie recently ruled on the implementation of unbundled rates and services by Gaz Métropolitain in its franchises. It will now be possible for an industrial customer to choose from a wide range of services offered by the distributor or to buy transmission or storage capacity on his own in order to bring gas to the Gaz Métropolitain franchise. This decisive change has occurred in response to needs expressed by customers and to new market contexts and opportunities.

The Régie de l’énergie will continue to set or modify rates as did the Régie du Gaz naturel. The Act respecting the Régie de l’énergie introduces, moreover, two new elements. In the future, when the Régie sets a rate, it must "determine measures and incentives for improved distributor performance and increased satisfaction of consumer needs". Numerous regulatory approaches of this type have already been conducted in Québec, Canada and the United States. The Régie will ensure the implementation of mechanisms adapted to each distributor.

Furthermore, natural-gas distributors must submit, for approval by the Régie, a resource plan proposing strategies to balance supply and demand. The Régie will examine these plans using an integrated-resource-planning approach, thus taking into account the impact of these projects on the environment. When necessary, these approaches must take into account the introduction of competition into certain industry segments.

With regard to electricity, the Régie is taking over from the Government as concerns the approval of Hydro-Québec’s rates. The approach, however, will be somewhat different. When setting electricity rates, the Régie must establish a rate base for each of Hydro-Québec’s regulated business units. It must likewise approve the different components of the cost of service, determine a reasonable rate of return on its rate base, and so on.

The setting of rates and conditions for the supply and transmission of electricity by Hydro-Québec will be conducted through a series of rigorous public hearings which will allow all interested parties to be heard.

The Régie has decision-making authority in matters of rate scheduling. This authority will be applicable to the level and structure of rates and to commercial programs. The Régie will likewise authorize electricity exports outside of Québec, as well as electricity purchase and exchange contracts as it deems to be appropriate.

As previously mentioned, the Régie will also set the rates and conditions for electricity transmission, for which assets reach a total of more than $17 billion. This element is essential to Québec’s participation in the deregulated electricity market of U.S. north-east.

In the same way and for the same reasons as for natural-gas distributors, Hydro Québec must submit its resource plan to the Régie. This plan must include strategies to balance supply and demand, taking into account economic, social and environmental concerns as well as risks inherent in the chosen sources of supply.

The Act respecting the Régie de l’énergie confirms, moreover, that Hydro-Québec has exclusive electricity-distribution rights throughout the Province of Québec, excluding areas that are served by distributors operating private or municipal electric power systems. The latter distributors will remain subject to the Act respecting municipal and private electric power systems and, therefore, will not be within the Régie’s jurisdiction with respect to rate setting.

Before ending this brief overview of the main changes introduced by the Act respecting the Régie de l’énergie, I would like to mention the powers that the Régie has with regard to petroleum products and steam. Sections 55 to 58, which have been in force since last November 1, now enable the Régie to exercise its powers of monitoring, inspection and inquiry concerning the sale or distribution of petroleum products.

The Régie recently established a telephone information service and also draws up a weekly survey of the prices charged by gasoline and diesel-fuel retailers all across Québec. During the recent electric-power failures in our province, the Régie’s summary was drawn up daily in the affected regions to ensure that there were no abusive business practices during this particularly difficult period.

In virtue of Section 59, which became effective yesterday, February 11, the Régie must hold public hearings in order to determine the operating costs per litre that gasoline retailers must bear and to assess the expediency of excluding or including this amount in the total costs borne by retailers in the various regions of Québec.

Finally, the Régie must examine all complaints addressed by gas or electricity consumers about the implementation of a rate or service. To meet legal requirements, distributors are now obliged to establish an internal complaint procedure and submit it to the Régie for approval. Residential, commercial or industrial consumers who disagree with a distributor’s decision can now apply to the Régie. The Régie’s objective in this matter will be to standardize the procedure for the examination of gas and electricity consumers’ complaints.

4. THE RÉGIE’S ACTION PLAN AS OF FEBRUARY 11, 1998

The standardized examination procedure for gas and electricity consumers’ complaints came into force yesterday, February 11, 1998. The Régie will ensure that all requests are treated diligently and fairly.

According to Order in Council 1351-97, passed last October 15 by the Government of Québec, paragraph 1 of section 167 of the Act also came into force yesterday. Under this clause, the Régie, within six months of this date, shall advise the government on Hydro-Québec’s proposal concerning a procedure for the determination and implementation of rates for the supply of electric power.

This proposal, stated in Hydro-Québec’s strategic plan, consists in determining the energy production price ("P") by taking Hydro-Québec’s general rate for large power customers, also known as the "L rate", and subtracting the cost of transmitting this energy to various markets ("T").

P = L - T

The Régie will hold public hearings in the next few months in order to hear the various stakeholders’ statements on Hydro-Québec’s proposal.

Following these hearings, the Régie will present recommendations to the Government focusing on the most appropriate method to regulate Hydro-Québec’s production activities. The Government will then determine whether Hydro-Québec’s production sector, which has corresponding assets in the order of $28 billion, will be regulated according to the traditional cost-of-service approach or a price-cap approach.

The Régie likewise intends to establish the regulatory principles governing electricity rate determination, then initiate, in the spring, transmission and distribution rate case hearings. In the fall of this year, the Régie intends to begin establishing the rate base for electricity distribution as well as the separation of regulated activities from non-regulated ones.

With respect to wind energy, the Régie, at the request of the Minister of State for Natural Resources, will hold public hearings this spring to determine the price and the total share that this energy form should represent in Hydro-Québec’s resource portfolio. The Régie will give its advice on this matter to the Government at the beginning of the summer.

Finally, the Régie has begun to put together a task force which will be mandated to discuss, with the main intervenors of the energy sector, the elements that should be included in the resource plans of distributors and the conditions involved in the implementation of integrated resource planning (IRP) in the new Québec energy context.

In the natural-gas sector, the Régie will soon begin examining Gaz Métropolitain’s rate request, which should comprise proposals concerning incentive regulations and rate schedules for unbundled services. These new services will come into force in November of this year and will represent one more step towards restructuring and the introduction of competition in certain market segments.

In the case of Gazifère Inc., the Régie intends to revise the cost allocation methodologies of this distributor.

Finally, the Régie will hold public hearings in June to determine the operating costs that a gasoline retailer must bear.

With respect to this market, it is worth noting that it is not the role of the Régie to regulate the gasoline market but rather to protect the interests of consumers and distributors by promoting the free movement of market forces. If a retailer believes that he has been a victim of excessive and unreasonable practices on the part of a competitor, he can take the matter to court. The judge will have to take into account the Régie’s ruling on the necessary and reasonable operating costs of an efficient retailer.

5. REGULATION, COMPETITION AND CONVERGENCE

Creating the Régie de l’énergie at a time when everyone is speaking of market liberalization and deregulation might, at first glance, seem to be a case of going against the flow. It must, however, be recalled that the Government of Québec had two main objectives in creating the Régie de l’énergie:

- First, to ensure that there is level playing field in terms of the regulatory treatment of natural-gas and electricity distributors;

- Second, as concerns the determination of electricity rates, to adopt a transparent, fair, independant and impartial decision-making process in which the participation of the various intervenors of our society will help protect their interests as well as serving the general public interest.

The Régie de l’énergie will regulate natural monopolies, such as energy transmission and distribution, in areas where there are no viable market alternatives. Furthermore, the Régie will encourage the free play of market forces wherever possible. It will thereby reconcile the public interest , that of consumers and that of distributors while taking into account economic, social and environmental concerns.

Where a market is dynamic and efficient, the Régie can ease up regulations and, if appropriate, simply provide monitoring or supervision.

Thus, with regard to petroleum products, the law gives the Régie the power to monitor prices and to determine the operating margin of gasoline retailers. It is worth noting, nonetheless, that the Régie must likewise assess the expediency of excluding the amount from or include it in the costs that retailers must bear. This decision will be made after inquiries and public hearings which will help the Regie to determine the degree to which the free market meets the interests of the public, consumers and petroleum-product distributors.

Furthermore, with respect to the determination of the rates of natural-gas and electricity distributors, the Régie will foster incentive measures or mechanisms to encourage distributors to improve their performance and help consumers meet their needs. These measures will obviously take into account the strong competition that exists in Québec’s heating market between natural gas and electricity.

As previously mentioned in the discussion of unbundled services, the Régie, in a recent decision, increased the range of choices that consumers now have concerning, for example, transmission services. Consumers can now buy these services from either a distributor or a supplier on the market, while still benefiting from the same options with respect to the distributor’s other services.

With regard to the restructuring of the electricity market, on May 1, 1997, the Québec Government opened up Hydro-Québec’s transmission grid and wholesale market to American companies. This opening up of the market has consequently given the Régie an even more important role in the supervision of access conditions to the transmission grid and in the determination of the rate schedules of the grid.

As concerns the regulation of electricity generation, following the advice that the Régie will submit to the Government of Québec in August, 1998 and based on the decision that the government will make concerning this advice, there will either be heavy regulation of electricity-generation activities conducted by the Régie or very little. In the latter case, more place will be left to market forces. And, in any case, it will always be the Régie’s goal to promote a smooth and efficient functioning of the market without making the regulatory framework heavier.

Finally, the globalization and liberalization of markets is increasing competition in several, previously closed market segments. Given this state of affairs, companies are attempting to improve their competitive position, reduce their operating costs and provide multi-energy services by initiating alliances, partnerships, acquisitions and mergers. This tendency towards convergence is particularly evident in the natural-gas and electricity sectors.

It is still too early to measure the full impact of this convergence phenomenon on service quality, prices and the service options available to consumers. In the end, it will be the consumers themselves who will decide whether or not the convergence of products, services and investments is economically viable.

The Régie, like other regulatory boards, can only observe this tendency and ensure that the rules of healthy competition are respected in the best interests of consumers, distributors and the general public.

Thank you for listening.