Guiding and Controlling Ontario's Future Water and Wastewater Services:
User Pay and Full Cost Pricing,
Independent Economic Regulation, and
Strengthened Environmental Law Enforcement

By
Thomas Adams

Borealis Research Association

Submission to the Walkerton Inquiry
on behalf of Energy Probe Research Foundation

April 2001

Revised June 2001

Table of Contents

1. Introduction
2. Applying the Principles of User Pay and Full Cost Pricing to Water
3. Independent Economic Regulation of Water Utilities
   • Natural Monopolies And Public Utilities in Water Services
   • Applying Ontario's Successful Experience With Economic Regulation of Natural Gas to Water
     • Case Study on Public Regulation as a Superior Social Control Alternative to Public Ownership: Ontario's Natural Gas Industry Vs. Ontario Hydro
     • Case Study on Accountability: OEB Treatment of an Enbridge Deferred Tax Issue Prior to Bill 35
   • Principles to Guide Public Regulation of Water Utilities
   • Choice of Regulatory Instruments
   • How Might a Future Ontario Water Board Work?
   • Changes to The OEB's Mandate in 1998
4. Strengthening Environmental Law Enforcement
   • Ontario's Environmental Law Enforcement Rollercoaster
   • Enforcement Case Studies
     • Kingston
     • Hamilton
     • Deloro
   • Improving the Effectiveness of Government Environmental Enforcement
5. Conclusions
6. Notes

In many communities in Ontario today, a large portion of the cash cost of water service is externalized to provincial taxpayers through capital facility grants.⁽¹⁾ Our waste water disposal practices across the province have allowed significant costs to be externalized to the environment and users of the environment, through polluting waste water emissions. As a consequence, water prices in Ontario do not reflect the value of the resources consumed in providing the service.

Underpricing of water leads to excess consumption. The OECD quotes figures for Ontario showing that the gap between marginal cost and prices for municipal water supply has led to consumption exceeding efficient levels by an average of 50%.⁽²⁾ In an analysis of fresh water issues conducted for the UN Commission on Sustainable Development, the federal government notes that each Canadian consumes on average 326 litres per day, twice the European average.⁽³⁾

The proposal to apply user pay and full cost pricing principles to water has been controversial. For example, during the 1997 debate over Bill 107 that transferred ownership of water facilities from the province to municipalities, Janet May representing Toronto Environmental Alliance, opposed full cost pricing stating, "To Ontarians, water is a right, not a privilege." The grounding for her opposition to full-cost pricing: "because we need water to survive."⁽⁴⁾

Many official bodies have recommended the implementation of full-cost pricing or at least progress toward that goal. This report provides but a drop from the lake full of recommendations in favour of full-cost pricing.

An OECD report recommends, "Ideally, water pricing should cover both the fixed and variable cost of supplying water, the environmental costs of its extraction, and the associated rent."⁽⁵⁾

The National Round Table on the Economy and the Environment stated:

The challenges outlined in the previous chapter could be addressed by moving toward full cost, user pay, direct customer charges for water and wastewater services. Such a pricing system would help attract the capital needed to maintain and augment Canada's water infrastructure. Moreover, by paying directly for water service, consumers would create the revenue flow to retire the debt incurred in retrofitting existing infrastructure and building new infrastructure. New environmental and economic opportunities would follow.⁽⁶⁾

An inquiry conducted on behalf of the government of Canada noted:

We should point out that the federal government has already endorsed the 'user pay' principle in its 1978 statement on water policy and in an international statement on this matter issued by the Organization for Economic Cooperation and Development (The Polluter Pays Principle, 1975)...A suitable price can serve several useful purposes:

• It will create incentives to avoid waste and to use water efficiently, thus contributing to water conservation.
• By reducing the water needed and the waste disposal capacity, it will reduce infrastructure costs.
• The resulting lower demand will reduce environmental pressures on water resources.
• By demonstrating users' willingness to pay for water, prices help allocate supplies among the uses and users so that the highest value is generated from limited resources.
• Pricing will generate revenue to cover the cost of water supply and waste disposal systems.
• Suitable pricing can ensure that the cost of water service is equitably borne by the beneficiaries according to the benefits they receive.

These advantages have convinced us that the pricing of water supplies should be a fundamental part of federal water policy. We therefore recommend: (10.2) The federal government should encourage water conservation and demand management practices by explicitly endorsing the principle that beneficiaries should pay for water and wastewater services by means of appropriate prices.⁽⁷⁾

A report on water pricing sponsored by the Ontario Sewer and Watermain Contractors Association (OSWCA) with the support of the Association of Municipalities of Ontario with funding from OSWCA, Environment Canada and the MOE concluded:

The time has arrived in Ontario to implement the user pay principle and to increase water rates significantly. The revenues that this will create must remain with the industry to finance needed investments.⁽⁸⁾

A report conducted for the MOE by Peat Marwick concluded:

There is justification, in terms of the user pay principle and the principle of social opportunity cost pricing, for the pricing of both raw water and effluents in Ontario.⁽⁹⁾

A report of the Premier's Council on Health, Well-being, and Social Justice concluded in 1993:

Implement full cost accounting for water supplies, price water to reflect its real costs (thereby reducing demand) and reinvest the resulting water revenues/infrastructure savings in programs to improve water quality.⁽¹⁰⁾ (Parentheses as per the original.)

The MOE's Municipal/Industrial Strategy for Abatement (MISA) MISA Advisory Committee recommended:

Provincial authorities should move now to adopt and implement a Municipal Water Conservation Plan for Ontario. The plan would be fully implemented over a 10 to 15 year period and would be similar to those currently in place in California and other American States. At the root of the plan should be the conservation of water and the requirement that the user pay the full cost of service.⁽¹¹⁾

The issues has also surfaced in submissions to the Walkerton Inquiry. Appendix B Section 4 of Pollution Probe's report provides some information on the extent of full-cost pricing in some OECD countries. Pollution Probe's study for the Walkerton Inquiry states:

The move towards full cost pricing of water today could well be the most important decision taken to communicate to consumers the true value of our precious water resources as well as to raise the revenues needed to ensure the long-term integrity and sustainability of our water services.

Nicholas D'Ombrain's report, which envisages continued government subsidies, also provides qualified support for movement toward full-cost pricing. The report notes:

To the extent that full-cost pricing promotes public safety by improving access to capital to build and renovate facilities, owners should be moving in that direction."⁽¹²⁾

Sancton and Janik raise the issue of full cost pricing as an alternative to continuous demands on the province for subsidies but do not reach a conclusion on whether this approach should be adopted.⁽¹³⁾

The degraded condition of the water service system in many Ontario communities might have been predicted by recognizing that political priorities determine rates and the capital to be invested. From a political perspective, it may be difficult to justify raising prices. Restructuring the rate regime for water so that reasonable costs for an acceptable standard of service can be reliably recovered from its users would make the sector self-sustaining.

Given the extensive subsidization of water services, particularly in smaller communities, and the historic practices of permitting damaging sewage pollution, the principle of user pay will be costly to consumers. Low income households living in some communities are particularly exposed.⁽¹⁴⁾ Where society favors subsidies to ensure that all citizens have access to service, government should subsidize resource users with direct payments, untied to the level of consumption, rather than subsidies that lower the apparent cost of the resource. Relative to subsidies in kind paid by taxpayers, direct payments to users combined with user pay promotes transparency, accountability, and efficiency.⁽¹⁵⁾

Provincial funding currently earmarked to support water infrastructure could instead be granted directly to low income consumers. For example, Superbuild's current capital spending of $240 million over two years would translate into two annual support payments of $1000 for 120,000 families. Water support payments might be administered as a provincial income tax credit.

Direct payments to users is a common policy approach. For example, the federal heating assistance plan announced in the 2000 budget update has a similar structure, providing $125 per individual or $250 per family to help low- and modest-income families with heating costs.

Figuring out how exactly to apply the principle of user pay in a situation where a variety of users share a system, particularly a system with high fixed costs and relatively low short run variable costs, is inherently complex. Some users may have been on the system for a long time and made contributions in their historic rates to some of the capital needs of the system whereas other users may be new. Some users may emit effluents to the sewage system with contamination characteristics different than the norm. Some users may make volumetric demands of the system at times coincident with system peak usage whereas others may make their demand outside the times of peak system usage. Some users will make large volumetric demands and others little. A regulatory mechanism is required to deal with these issues, the design of which we turn to next.

Establish a mechanism, based on an existing agency such as the Ontario Municipal Board, to review and regulate water and wastewater rate setting and the overall performance of waste and wastewater utilities.⁽¹⁶⁾

• "subadditivity" of cost, where a single firm is able to provide the service at lower total cost than two or more firms
• necessity of the service to the user
• a low price elasticity of demand, where the price elasticity is the ratio of the change in usage of a commodity for a given change in its price, meaning that consumers will continue to buy at inflated prices
• high fixed and low variable cost structure where production and consumption are synchronous, thereby preventing reselling and enabling discriminatory pricing
• costs that vary by time of use and where consumer demand is episodic
• the service in question requires contiguous service zones and territorial integrity.⁽¹⁷⁾

The business of providing water service to consumers requires many individual components. Many of the components of services are naturally competitive, others fit into a grey area of potential competition, and a few elements of service are more strict natural monopolies. Practices in Ontario's gas sector have shown that constructing distribution facilities and reading meters are examples of operations that can be readily contracted competitively. Examples of water-related

services that might be suited for competitive procurement if the market for such services is sufficiently mature includes emergency services, billing and customer care, operating treatment works or sewage treatment plants, and some engineering services. One area where an irreducible natural monopoly appears to exist is the capital tied up in physical piping system.

While firms subject to competitive pressures are likely to price their products for services at marginal costs, in the water business pricing at the short run marginal cost would raise insufficient revenue to support the business.

Uncontrolled, profit-maximizing natural monopoly utilities are potentially injurious to the public interest. Unopposed by competitive pressures, a monopolist could maximize its profits by curtailing the supply of its service and discriminating between customers on the basis of their price elasticity, so that those with the fewest alternatives and ability to pay are charged most.

Should a competing supplier arise able to serve existing customers, where new and incumbent providers are unable to differentiate their product through customer service quality, both producers, facing high fixed but low marginal costs, might engage in price cutting so severe as to undermine the ability of both firms to recover their capital. Alternatively, competing suppliers might have strong enough monopoly powers to transfer the cost impacts of lower throughput volumes onto customers. In either case, the societal costs of providing the service would not be minimized.

2. "Bundling": The gas industry, since commodity deregulation began in 1985, has become profoundly structurally unbundled.⁽¹⁸⁾ Until 1998, Ontario's electricity was structural bundled in the "Hydro family" of Ontario Hydro and the municipal utilities it controlled. The only extent to which water services are unbundled today derive from those few instances of contracting-out operations.

3. Economic regulation: All the natural monopoly components of the gas system were subject to public rate regulation by a legally independent tribunal until 1998, whereas electricity rates were unregulated until 1993 and regulated by cabinet from 1993 thereafter. Water rates are usually controlled by municipal councils.

From a public interest perspective, Ontario's natural gas sector has been highly successful. The industry's public safety record is very good. Distribution rates are stable and relatively low by comparison with other North American gas utilities. Access to gas is now provided to virtually all parts of the province where it can be economically justified. The environmental concerns associated with natural gas are relatively modest compared to those associated with most other energy commodities. Natural gas service in Ontario is supplied without taxpayer liabilities.

Starting in 1985, commodity competition has been introduced and has flourished, with a significant majority of all gas sold in Ontario now provided by non-utility suppliers. Ontario has been the world leader in natural gas deregulation since 1985. The flexibility of the regulatory regime was demonstrated by the fact that until 1998, the OEB successfully facilitated competition in the purchase and sale of commodity gas - a role never envisioned by the original drafters of the legislation - although its authority to do so was moot. Such a broad consensus of interested parties supported the move to competition that the OEB successfully directed the development of new approaches to commodity pricing and procurement. All gas is now sold in Ontario for market prices. Since 1985, the savings to Ontario consumers due to deregulation have been significant. Deregulation has also helped strengthen the security of supply since in the event of supply shortfalls consumers automatically receive powerful price signals to conserve.

From a public interest perspective, Ontario's electricity sector has been successful in some respects but very unsuccessful in others. Power system reliability in Ontario is high and electricity service is broadly available. However, Ontario Hydro was among the top two polluters in Canada in the categories of SOX, NOX, carbon dioxide, and tritium. Electricity prices are high by national comparison. Prices are set arbitrarily and have never reflected demand/supply relationships. In the event of shortage, consumers do not receive conservation signals except by public appeals for reduced usage. By official estimate, Ontario's power system has imposed liabilities against the public purse of $38.1 billion, offest by assets worth only $17.2 billion. Major capital projects were historically mismanaged. For example, the Darlington nuclear power project was completed 270% over budget in inflation-adjusted terms, 10 years late, and suffering from serious design flaws that caused extensive downtime during its first several years of operations. Despite these deficiencies, none of the responsible officials was ever fired or even publicly reprimanded. Ontario Hydro and its predecessor, the Hydro Electric Power Commission of Ontario, have been the subject of special legislative reviews, standing committees, select committees, Royal commissions, task forces, and official expert review panels since the 1920s.

One way to compare the public interest success of gas service and regulation compared to both Ontario's water and electricity sectors is the relatively low level of public concern, media attention, and political acrimony about gas. The only significant attention to gas matters in the last ten years has focussed on the practices of some gas marketers and the December 2000 gas commodity price spike. Public discussions around Ontario's water and electricity sectors are much more intense and complicated.

Government ownership of industrial enterprises makes the ownership interests of citizens and taxpayers dilute. Dilute ownership leaves management effectively in control. The unfortunate consequences of leaving decision making authority in the hands of such unattended management is demonstrated by Ontario Hydro's ultimate fate. Although Ontario Hydro always received clean audit opinions and issued unwavering public reassurances, in 1998 the government effectively (and correctly) declared Ontario Hydro bankrupt.

Continuous regulatory oversight has meant that Ontario's natural-gas monopolies have consistently been more open with information than was Ontario Hydro, despite the fact that Ontario Hydro was subject to Ontario's Freedom of Information and Protection of Privacy Act, while the natural-gas monopolies were not.

Regulation also made the private gas utilities more sensitive to public-interest concerns than the publicly owned Ontario Hydro. In response to regulatory decisions accepting some public-interest arguments (but contrary to Energy Probe's recommendations), Ontario's natural-gas monopolies have instituted "Demand-Side Management" programs designed to decrease their gas sales to their customers. The major utilities have convened multi-stakeholder consultative processes that have managed those programs in a manner that is generally acceptable to a wide range of stakeholders. Neither Ontario Hydro nor its successor companies has maintained such programs or processes.

A comparative analysis of the benefits of private ownership and public regulation of energy utilities, compared to public ownership was undertaken in 1992 by Dr. Mervin Daub, Professor of Business at Queen's and at the time a member of the Ontario Energy Board. Daub's analysis provides several insights relevant to the Walkerton Inquiry. He made a case that public regulation and privatization of Ontario Hydro would provide a superior form of social control than is available through public ownership. He argued that his recommended combination of regulation and privatization would not require recourse to taxpayers for future costs since private investors would be responsible for future liabilities. He argued that politicization of decision making could be eliminated and that more intense scrutiny could be applied by professional regulators with a narrow mandate than by politicians with broader interests and responsibilities. He argued that there is a basic governance problem with the old Ontario Hydro by pointing out, "Several small hands touching an elephant irregularly will not likely change its course, especially when it has learned that in important respects it is really free to do more or less as it wishes." He also noted, "There is an abundance of historical evidence that the government has not always resisted this temptation to 'close the distance' between Hydro and itself, whether because of strong direct interest-group lobbying representation, or for its own reasons." In contrast, he observed that gas regulation was conducted at regular intervals in public hearings, the public is invited to participate, decisions with reasons were issued, and the whole process was open to scrutiny. "As a result, it is likely that there is less capriciousness about the political interference with the gas industry than there is in the case of electricity." One of Daub's conclusions, which is reminiscent of problems in Ontario's water supply, was that "the social control of Hydro that does exist is too diverse to be effective."⁽¹⁹⁾

In electricity and water, public ownership in Ontario has proven inconsistent with public control. Ontario's successful experience with private ownership and public regulation of natural gas delivery provides a successful model to emulate in water.

In 1997, the rules began to change when the Board ruled that ancillary activities, such as the water heater rental business, should be costed at fully allocated cost, effectively ending access to free overheads paid for by gas ratepayers and requiring the water heater business to recover its own overheads.⁽²⁰⁾ Enbridge's response to the 1997 decision was to bring an application to separate most of its ancillary businesses from the regulated utility. Water heater rentals was by far the largest of these ancillary businesses.

Enbridge's separation application was subject to full due process as required under the old OEB Act. There were 16 intervenors (including such interests as users of all sizes, gas marketers, and other utilities), formal written interrogatories, cross examination of witnesses in a public hearing, written arguments - in chief from the utility, in rebuttal from intervenors, and in reply from the utility - and a decision with reasons from the Board.

The main issue in the separation application was who should bear the responsibility for the related deferred taxes. Enbridge argued that the firm was using the Board-approved tax accounting methodology, many gas distribution ratepayers had benefited from low water heater rental rates due to the tax treatment, and that therefore Enbridge should be allowed to recover $126 million from gas distribution ratepayers over a reasonable period. Consumer representatives argued that Enbridge never had permission to accumulate deferred taxes on ancillary programs for later recovery from ratepayers and that shareholders had benefited (earning a return on the capital spent on ancillary businesses) from the rate-making treatment for income taxes. Energy Probe argued that the costs should be split between shareholders and ratepayers because on one hand the company should have advised, but did not advise, the Board and the public of the accumulating tax liability issue as it arose, but on the other hand, the company was following a much earlier decision of the Board favouring deferred taxation, albeit in a different context.

The Board ruled that Enbridge had no authority to apply the tax treatment approved for utility operations to ancillary businesses, that it was Enbridge's responsibility to inform the Board of this issue, and that therefore the $126 million was the shareholders' responsibility. It did, however, authorize the company to recover up to $50 million from ratepayers as the related taxes become due, in recognition of the benefits to ratepayers (mainly the effect of higher load factors from year-round water heating on asset utilization) over the years.⁽²¹⁾

Enbridge made an application to the Lieutenant-Governor-In-Council (LGIC) to have the issue re-heard by the Board. Energy Probe's counsel wrote to the LGIC stating:

Producing fair and appropriate regulation of energy monopolies is very demanding work. If the LGIC interferes with the Board's decision making authority and independence, we would anticipate a deluge of appeals to fly to the LGIC. Energy Probe suggests that the interests of gas ratepayers, industry investors and the public wold be greatly harmed if the complex tradeoffs sometimes required were removed from the Board, where in the main these matters have been admirably discharged, and moved to a political process ill adapted for the task.⁽²²⁾

The LGIC took no public action in response to Enbridge's request.

Enbridge has brought the decision to judicial review, to be heard June 19, 2001.^(22B)

In the end, Enbridge shareholders incurred a tax liability of approximately $76 million.

The Enbridge water heater deferred tax liability case illustrates a number of important characteristics of Ontario's former regulatory regime.

Utility shareholders can suffer repercussions if they exploit loopholes that appear in bad regulatory decisions, like the original decision allowing the flowing through of tax benefits without accounting for resulting liabilities. In effect, utility shareholders, like all other parties affected by regulatory decisions, have an interest in the integrity of the regulatory process.

Utility shareholders can also suffer repercussions if their utility fails to deal fairly and fully disclose all relevant information. The Enbridge deferred tax case demonstrates an instance where, in hind sight, it is clear that the private monopoly was not willing enough to argue for self-interested proposals. Management apparently judged that the regulator's overall pleasure was more important to the company's short term well-being than winning every argument that should logically have gone the company's way. This understandable but corrupting phenomenon is the exact opposite of the much-discussed phenomenon of "regulatory capture," where regulators gradually come to think like those they regulate.

Private utility operators have strong incentives to ensure that their actions bear close scrutiny. If they don't, they can be penalized by the regulator. Shareholders have a direct interest in ensuring that utility management successfully anticipates the regulatory process.

Economic regulation is a weak substitute to competition and should only be used when and where competitive alternatives are unavailable. Although economic regulation of monopolies is necessary, its limitations - such as discouragement to efficiencies, weak ability to successfully innovate, and encouragement to excess investment - have been documented extensively by Averch and Johnson⁽²³⁾ and many others. As much as feasible, those components of the water system suited for competition should be competitively organized.

Economic regulation in water services should focus its attention primarily on the irreducible natural monopoly in physical infrastructure of the utility system referred to previously. To be able to attract sufficient capital to meet the needs of our currently substandard water infrastructure, substantial rate increases will be necessary. Investors will need reason to be confident that rates can be sustained to allow investments to earn a fair rate of return over the long term.

As previously noted, applying the apparently simple principle of user pay to water service can be complex. While economic regulation should be guided by public interest criteria, it should be recognized that the public interest in the circumstances that are likely to arise is far from self defining. While the legal mandate of the regulator should set out public interest purposes, these purposes should be very general. Examples of purposes that might be considered include protecting the long term interests of consumers by ensuring just and reasonable rates, fairly allocating costs among consumers, ensuring the long term financial integrity of the system, facilitating rational investment, and promoting transparency to the public.

Due process, as set out in the Statutory Power and Proceeds Act, should apply to economic regulation. The case for due process does not hinge on a claim that due process generates perfect decisions. The strength of due process lies in its ability to test the strength of positions under disclosure and cross examination, to protect the rights of affected parties to be heard, to make regulators accountable, and to ultimately result in decisions that are respected by producers and consumers. If the courts respect the expertise of the regulatory board and due process has been observed, regulatory decisions are likely to be respected by the courts, as has been the experience with Ontario Energy Board.

Macaulay and Sprague note that administrative tribunals prevent "arbitrary executive action."

Perhaps the most important characteristic of the administrative arena is that issues are consistently resolved in the public interest. Notwithstanding that an issue is raised by one party with a particular interest in the outcome, when the merits of that issue come before the administrative decision makers, the final decision should accord with the statutory mandate to pursue the public interest.⁽²⁴⁾

Ontario's gas experience suggests that regulation with due process is highly cost effective and beneficial to the public interest. Over the last four main rates cases adjudicated in the legal regime that prevailed before the revision of the OEB Act, the direct hearing costs borne by the utility ratepayers were recovered about 13 times over from cost reductions ordered by the Board. While a full consideration of the cost effectiveness of regulation would have to take account of indirect costs related to internal overheads of the regulated firm borne by consumers, it appears safe to say that the previous regulatory structure was beneficial to consumers.

Enbridge Consumers Gas Ratepayer Savings Due to Regulation - 1996 Through 1999

The economic interests of water utilities, which an economic regulator oversees, naturally conflict with other public interests. Environmental standards, environmental law enforcement, economic development criteria, and labour interests are all examples of factors that naturally pull in the opposite direction of short term cost minimization. Producers and consumers need to know that their concerns can be fairly considered. To be fully effective and legitimate, economic regulators should be as independent as possible from all potentially conflicting interests.

Economic regulators should be subject to judicial review. As noted by Macaulay and Sprague, "One of the reasons for the growth in the number of administrative tribunals is the availability of the supervisory role of judicial review of tribunal decisions to ensure adherence to principles of procedural fairness and natural justice."⁽²⁵⁾ Access to judicial review protects the rights of regulatory litigants by strengthening the accountability of the tribunal and ensuring that due process is protected. Energy Probe's direct experience with judicial review is defensive (in 1991 Energy Probe successfully defended a regulatory decision that supported our right to present evidence to an Environmental Assessment panel against an application to throw our evidence out). However, the tribunals' reluctance to face judicial review appear to have assisted Energy Probe in making its issues heard.⁽²⁶⁾

Regulatory processes should require full disclosure of relevant information. Although the definition of what information is relevant should be left up to the regulator, it should be recognized that regulated firms allowed some substantial guarantee of cost recovery have limited claim to commercial confidentiality and competitive advantage.

The rules of standing should ensure that all affected parties have access to the process. The academic literature and regulatory practice recognizes that effective adjudication requires a balance in the presentation of various points of view.⁽²⁷⁾

The principle of standing can be actualized by allowing public interest intervenors, who might not otherwise have the means to participate, an opportunity to recover costs through a costs process based on principles imported from civil litigation. In several Canadian jurisdictions, legislators have recognized the need to encourage public participation in regulatory proceedings by granting regulatory bodies the power to award costs. For example, the Utilities Commission Act, B.C. and the Ontario Energy Board Act, 1998, the Nova Scotia Gas Distribution Act, s. 31 contain cost award provisions. Regulators in Manitoba and Alberta have similar provisions. Several regulators have put these provisions into practice through rules that provide public interest intervenors an opportunity to recover from the regulated entity or entities reasonably incurred costs of intervening in a regulatory proceeding if the interventions are deemed by the regulator to have been conducted in a responsible fashion and to have been of assistance to the tribunal. The decisions to provide such awards historically arose from a recognition that regulators must make decisions in the public interest and in order to determine the public interest the regulator must hear, take into account, and weigh a wide variety of opinions including those of individuals and public interest groups. In its E.B.O. 116 Report of the Board (1985), the Ontario Energy Board recognized that the awarding of costs to intervenors was in the interest of encouraging public participation.

Consistent with the user pay principle, reasonable utility, board and intervenor costs should be recovered from consumers of the regulated service. This application of the user pay principle has recently been recognized in Ontario with the passage of regulation O.R. 529/99 which provides for the Ontario Energy Board to assess its costs against the regulated entities it oversees. Regulated entities adjust their cost of service to reflect these regulatory costs and recover them from consumers.

Regulators should not attempt to prejudge the efficient basket of assets for a particular regulated business. While economies of scope between potable water service and waste water service are apparent, it may be that a more efficient arrangement is to have potable water and waste water services provided by separate firms. A food or beverage company might see brand advantages in being a potable water supplier but not a waste water service provider. Utility owners should have the freedom and incentive to assemble and change their business to maximize efficiency.

The proper functioning of government is undermined when it has conflicting interests, such as when governments regulate themselves. The greater the separation between the government regulator and the utility which it regulates, the more likely the regulator will act independently. If regulation is to be imposed on government-owned utilities, extra attention to regulatory independence would be necessary. At least some level of regulation by state utility commission of publicly owned water systems exists in several US states, including Maine, Montana, New Jersey, Rhode Island, and West Virginia.⁽²⁸⁾ From a regulatory perspective, the public interest would benefit from water utility privatization because privatization structurally eliminates conflicting interests in regulation and provides regulatory accountability through potential financial penalties administered to investors. Even if utilities are not government-owned but remain government-funded, the independence of any regulatory effort could be impaired.

The criticisms have also encouraged the development of a range of incentive or performance-based regulatory instruments. The leading jurisdiction innovating regulatory incentive instruments has been the U.K., where the economist Stephen Littlechild developed a regulatory instrument called RPI-X and directed its successful implementation.⁽²⁹⁾ This paper considers how the concepts behind RPI-X might be applied to Ontario's water sector without addressing other forms of incentive regulation.

RPI-X, also known as price cap regulation, is a formulaic approach to rate making where rates, rather than profits, are subject to direct regulation. Rates are based on the retail price index less some efficiency factor (which can be negative or positive) for some predetermined review interval, following which the performance of the firm is evaluated and the formula is reset. To ensure that profits are not realized by cutting service quality, comprehensive service quality standards are imposed. For example, water, gas and electric companies in the U.K. pay penalties directly to affected consumers for service interruptions and failure to make appointments on time. In addition, regulated firms have been subject to very strict incentives to minimize disconnections of service for non-payment, incentives so effective that, relative to the level of disconnections that prevailed during the period of government operation of utilities, by 1998 disconnections were nearly eliminated. In November 1998, the UK government introduced legislation to end disconnections for non-payment for homes, schools and hospitals.

RPI-X is effectively cost of service and rate of return regulation with a time lag. The incentive benefits of RPI-X result from the time lag between formula changes. To be financially sustainable in the long term, the formula must be set such that utilities are able to sustain their capital. If the regulator is effective in setting rates at the minimum level consistent with utility's financial integrity, over the long term consumers realize the efficiency benefits incentivized by the time lag.

A regulatory strategy that appears attractive for dealing with Ontario's water sector deficiencies is to initially focus on cost of service and rate of return regulation and gradually make a transition to price cap regulation. The benefit of adopting cost of service and rate of return regulation initially would be to encourage investment, to ensure transparency, and to allow regulatory practice to mature in a new sector. Once good operations have been demonstrated, encouraging efficiency can become a higher priority. The regulator can enhance efficiency by shifting toward price caps and increasing the regulatory lag. Under this proposed regime, the level of regulatory effort and resources should decline over time.

The government has demonstrated on several occasions that the ultimate decision making authority resides with cabinet rather than the Board. For example, in May 2000, during a hearing on an electricity transmission rate issue, the energy minister gave a speech publicly directing the OEB to find in favour of some industrial interests in the proceeding. The Board's decision was consistent with the Minister direction.⁽³⁰⁾ In June 2000, the energy minister issued a directive to the OEB ordering a review of a previous distribution rate decision and realigning the purposes of the OEB as set down in the legislation. In the same month, the minister also tabled legislation - Bill 100 -- which would have postponed the implementation of distribution rate increases until after the next election.⁽³¹⁾ Also in June 2000, the Cabinet adopted regulation 00/365 that amended the mandate of the OEB as set down in the legislation. Regulation 00/365, which was adopted during the consideration of an application by the government-owned transmission utility Hydro One for an expansion of its system, reduces the scope of OEB oversight of such plans. The validity of Regulation 00/365 is currently be considered by the courts. In March 2001, the Ontario Cabinet passed regulation 01/61 under the Municipal Act abrogating Section 4.4.18 of the report of the OEB in the "2000 Model Franchise Agreement" that granted municipalities the right to levy fees on utilities to recover reasonable costs incurred by the municipalities in providing services related to utility construction activities.

Due process has been undermined and OEB decisions are no longer binding. Independent utility regulation -- historically a source of significant benefits for Ontario gas consumers and essential for encouraging adequate gas infrastructure investment -- has now been lost. The long term impacts on the investment climate in Ontario's energy sector remain to be seen.

ONTARIO'S ENVIRONMENTAL LAW ENFORCEMENT ROLLERCOASTER

The Ministry of Environment's Investigations and Enforcement Branch (IEB) was formed in 1985. It was mandated to be responsible for enforcement of all environmental legislation for the Ministry.

Tracking the Ontario government's law enforcement record is complicated by changes in reporting conventions and disclosure policies. The purpose of the following data is to try to illustrate the general underlying trends in intensity of enforcement activity.

Data set on environmental enforcement activity in Ontario - 1986-2000⁽³²⁾

These data sets show that the activity level of the IEB increased until 1992, declined from the period 1993-1997, and then increased in the period 1998-2000. It also appears that activity levels started to decline before staffing levels declined.

In the period from 1985 until 1991, the IEB successfully demonstrated the enforceability of our environmental laws on a large scale. However, under administrations of different political colours enforcement has been allowed to wane. Structural change - creating an Ontario Environmental Protection Agency - would help depoliticize enforcement.

The rollercoaster pattern of enforcement activity appears not to be attributable to the funding available to IEB.⁽³³⁾ Rather, the pattern seems to be attributable to changing attitudes toward enforcement. In 1999, near the all-time low of enforcement activity, a spokesperson for the MOE told the Toronto Star that ministry officials were working with companies to try to resolve pollution problems and that "The goal is pollution prevention."⁽³⁴⁾ The MOE's renewed commitment to enforcement since 1999 may have been encouraged by the rise of citizen-based enforcement initiatives and their success in protecting the environment.

Mr. Merrit (for MOE): That's correct.⁽³⁵⁾

Abatement staff often see polluters as "clients" and primarily rely on cordial, sometimes cozy, relationships to accomplish objectives.

Chapman: Oh, I see, I see, but isn't it common that the Ministry of the Environment does refer to the regulated municipality or the industry as their client?

Mr. Erv McIntyre (for MOE): Yeah, I believe so.⁽³⁶⁾

There is even some suggestion created by the testimony that the MOE saw those subject to enforcement processes as "clients."

Mr. Muldoon: My simple question is who is the client?

Mr. Merritt (for MOE): The -- and that was a particularly -- particular challenge for the Minister to -- to, in fact, identify the -- the client. In this context, it was -- it was an encouragement to -- to be more externally focussed rather than internally focussed, but the client was very broad here, the client for our particular Ministry, perhaps unlike many other ministries, ranged from -- from the environment as a whole all the way through to -- to individuals that phoned our office with -- with questions and concerns and -- and, even in the reverse sense, the people we were -- we were bringing forward through the enforcement process in some respects were our client.⁽³⁷⁾

An independent environmental police agency would help to mitigate existing law enforcement problems. If the IEB was re-created as an independent police agency, as other policing agencies in Ontario are currently structured, the Province would be ensuring that environmental laws are enforced with the same commitment and independence we rely on for serving and protecting other important public law enforcement interests. MOE Abatement staff receive thousands of "Occurrence Reports" each year. Abatement staff have a role in determining which reports will be investigated by IEB. Accordingly, thousands of occurrences each year are not forwarded to IEB to determine the grounds for investigation. An independent environmental police agency would receive all occurrence reports and decide on the need for proceeding with an investigation.

The enforcement of environmental laws is not on an equal footing with the way criminal code violations are policed in the sense that other officials in the same ministry may be supporting some activity that may be in violation. Even when the IEB gets an opportunity to investigate, its investigations can conflict with regional office Abatement staff. Subsequently, investigations may be impeded or ended. Information most critical to an investigation may not be the nature or extent of pollution violations but whether or not Abatement staff have approved or been informed of but failed to control particular polluting activities.

If an independent environmental policing agency is empowered with the responsibility for reviewing occurrence reports and determining the grounds for an official investigation, it will increase the arm's length between the police and the abatement regulator. The merits of an investigation should be left to the determination of the investigative wing of government and the Crown Attorney's office and out of contact from any government officials that see polluters as clients.

A police agency of any kind must be structured in a manner that ensures its independence and limits the defences of "officially induced error" and "abuse of process" from shielding those who would otherwise be charged. Measured against this test, the current IEB structure is potentially problematic. An independent environmental police agency, responsible for investigating occurrences and deciding on the appropriateness of charges, will reduce the likelihood of conflicts and improve the abilities of the environmental police to do their job well.

Many other environmental groups not active in environmental law enforcement have focussed their attention narrowly on the question of resources available to the entire Ministry of Environment. This concern has also been expressed by the official opposition, who during the last election promised 100 new investigator positions in the event that it formed the government.

While legitimate environmental protection activities must be adequately resourced, judging from the level of fines, it appears that in the period 1996-1998 the resources, measured by total staff, available for environmental law enforcement were not being used effectively. The historical record shows that the decline in enforcement activity started in the mid 1990s prior to significant cuts at the MOE. Hiring more investigators without strengthening the underlying foundation of the investigative apparatus would be unlikely to meaningfully enhance Ontario's natural environment.

The proposed reporting arrangement for the Ontario Environmental Protection Agency would correspond to the current arrangement for the MOE's Legal Services Branch whose members are seconded to the MOE from the Attorney General's office.⁽³⁸⁾

1. Sancton, Andrew and Teresa Janik. 2001. Provincial-local Relations and Drinking Water in Ontario. Toronto: Walkerton Inquiry. February.

2. OECD. 2000. Economic Surveys: Canada. P. 130.

3. Government of Canada. 1998. Canada and Freshwater - Experiences and Practices. P. 3.

4. Ontario Legislative Assembly. 1997. Hansard: Standing Committee on Resources Development, April 15. Pp. 1130 and 1140.

5. OECD. 2000. Economic Surveys: Canada. P. 130.

6. National Round Table on the Economy and the Environment. 1996. State of the Debate on Environment and the Economy: Water and Wastewater Services in Canada. Ottawa. P. 11.

7. Pearse, P.H., F. Bertrand, J.W. MacLaren. 1985. Currents of Change: Final Report, Inquiry on Federal Water Policy. Ottawa. September. P. 98-99.

8. Fortin, M, B Mitchell. 1990. Water and Wastewater Charges: The User Pay Principle. OSWCA, Mississauga. October. P. iii.

9. Peat Marwick and Partners. 1988. Design Factors and Data Requirement for Water Withdrawal Pricing and Effluent Charges. Policy and Planning Branch, MOE. Toronto. April.

10. Premier's Council on Health, Well-being, and Social Justice. 1993. Our Environment Our Health: Report of the Review Committee on Goal 3. Toronto. January. P. 32.

11. MISA Advisory Committee. 1991. Water Conservation in Ontario: Implementing the User Pay System to Finance a Cleaner Environment. MOE, Toronto. May. P. iv

12. D'Ombrain, Nicholas. 2001. Machinery of Government for Safe Drinking Water in Ontario. Walkerton Inquiry: Toronto. para. 467.

13. Sancton, Andrew and Teresa Janik. 2001. Provincial-Local Relations and Drinking Water in Ontario. Walkerton Inquiry: Toronto. p. 28.

14. According to the MOE, there are large and small communities that are facing "severe problems." See the Inquiry transcript, April 12, p. 188, ll. 15-23.

15. Less efficient arrangements have been tried in other commodities and jurisdictions to deal with the infrastructure costs challenges presented by low density systems. Ontario's regulatory regime for natural gas distribution, although it maintains full cost pricing in aggregate, effectively requires significant urban to rural transfers of wealth due to the adoption of franchise-wide "postage stamp" rates for distribution services and permitting system expansion to serve customers that are not cost effective at existing rates. Ontario's full-time rural residential electricity customers have always enjoyed explicit subsidies from provincial taxpayers and urban electricity consumers through a program called Rural Rate Assistance. During the 1990's, the State of Victoria in Australia privatized its state-owned electricity distribution sector. To subsidize rural dwellers, the government packaged high cost rural and low cost urban franchise areas together to create regional utilities.

16. Fortin, M, B Mitchell. 1990. Water and Wastewater Charges: The User Pay Principle. OSWCA, Mississauga. October. P. iii.

17. James C. Bonbright, Albert L. Danielsen and David R Kamerschen, 1988, Principles of Public Utility Rates, Second Edition, Arlington: Public Utilities Reports, pp. 8-10.

18. Consumers in Ontario are dependent on a chain of gas producers, exchange operators, marketers, long distance pipelines, storage operators, and distributors who are usually separate companies.

19. Daub, M.1992. "Regulation of Private Enterprise vs. Direct Control of Crown Corporations: A Comparison of Gas and Electricity in Ontario." Working Paper 92-08, Queen's School of Business. Also filed as Exhibit 758 in the Environmental Assessment Board's hearing on Ontario Hydro's Demand/Supply Plan (October 1992).

20. Ontario Energy Board, E.B.R.O. 495.

21. Ontario Energy Board, EBO 179-14/15, March 31, 1999.

22. Correspondence: M. Mattson to LGIC, June 2, 1999.

22B. The April version of this report incorrectly stated that Enbridge did not proceed with judicial review.

23. Averch, Harvey, and Leland Johnson. 1962. Behaviour of the Firm Under Regulatory Constraint. American Economic Review. December, 52:1053-69.

24. "Robert W. Macaulay,Q.C., James L.H. Sprague, Practice and Procedure Before Administrative Tribunals, Volume 1, Carswell.

25. Robert W. Macaulay,Q.C., James L.H. Sprague, Practice and Procedure Before Administrative Tribunals, Volume 1, Carswell.

26. In recommending the advantages of making regulators subject to judicial review, I recognize that I am contracting the advice of some eminent legal scholars, including Harry Arthurs, former dean of Osgoode Hall and President of York University. In his paper "Protecting Against Judicial Review" (1983, 43 Rev. du Barreau 277) Arthurs argues that administrative tribunals need to be democratized and to have the freedom to make decisions without threat of intervention from the courts. Arguing that "one man's due process is another's red tape," he argues that administrative tribunals, staffed by experts and attuned to policy and practical matters, are better placed to make nuanced public interest decisions than the courts. Arthurs's purpose in advocating against judicial review is that legislatures that craft the mandate of tribunals, and to whose will tribunals may be more attuned than courts, are better placed to protect the interests of "unorganized ordinary citizens." He says "judicial review proceedings disfavour the poor and the powerless." Energy Probe, which appears to fit within the categories Arthurs claims to speak for, has had the opposite experience.

27. Robert W. Macaulay,Q.C., James L.H. Sprague, Practice and Procedure Before Administrative Tribunals, Volume 3, Carswell.

28. Beecher, Janice, Richard Dreese and John Standford. 1995. Regulatory Implications of Water and Wastewater Utility Privatization. Columbus: National Regulatory Research Institute. July. P.133.

29. One example of Professor Littlechild's work in this area is "Economic Regulation of Privatized Water Authorities: A Report Submitted to the Department of the Environment", January 25, 1986.

30. Wilson, Jim. Minister of Energy Science and Technology. 2000. [on line] [quoted April 19, 2001.] Speech to the 9^th Annual Gas Fair and Power 2000 Conference. May 15. <http://www.est.gov.on.ca/english/ar/sp_000515.html> In the speech, he said "I've listened concerns that gross load billing would make most self-generation projects uneconomic" and that this was an outcome "we want to avoid." He went on, "The issue is currently before the Ontario Energy Board, and I'm confident that the OEB, as our independent regulator, will come up with a decision that protects the best interests of customers and advances competition." Some industrial interests preferred a rate design that could improve the cost-effectiveness of self-generation projects by shifting sunk transmission costs to customers who do not have access to self-generation. The mechanism for cost shifting is called net load billing.

31. Bill 100 was withdrawn in November 2000.

32. For the period 1986 to 1991, data on convictions and the number of people and companies charged is taken from "Offences against the Environment-1991" published by MOE. Note that 1986-1989 are fiscal years and 1989 and forward are calendar years. For the 1989 to 1991, the counts laid is taken from "Environmental enforcement statistics" by Len Griffiths and John Nicholson, published in Hazardous Material Management, April/May 1999. The remaining data is taken from MOE filings with the Inquiry, April 17, 2001.

33. D'Ombrian, Nicholas, 2001. Machinery of Government for Safe Drinking Water in Ontario. Paragraph 96. This reference relies on government submissions to the Inquiry filed by Smith Lyons.

34. McAndrew, Brian, 1999."Water polluters not being punished." Toronto Star, March 1, p. A1.

35. Walkerton Inquiry Transcript, 2001. April 12, p. 197.

36. Walkerton Inquiry Transcript, 2001. March 7, p. 198.

37. Walkerton Inquiry Transcript, 2001. March 7, p. 158.

38. Walkerton Inquiry Transcript, 2001. April 12, p. 191.

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