Beutel Goodman Speaker Series: In Conversation with Hydro One

24 November 2023

Part of the Beutel Goodman Speaker Series, this fireside chat featured Chris Lopez, EVP, Chief Financial and Regulatory Officer at Hydro One, alongside Sue McNamara, Senior Vice President and Head of Credit, Fixed Income at Beutel Goodman.

An important holding in our fixed income portfolios for years, Hydro One is Ontario’s largest electricity transmission and distribution service provider, serving approximately 1.5 million customers across the province.

In this conversation, Chris and Sue discussed some of the challenges of operating as a large utility operator in Canada, how the company is positioning itself for the energy transition, as well as its sustainable finance program.

This recording took place on November 17, 2023. The following transcript is edited for clarity.

Note: The information in this transcript and recording is not intended, and should not be relied upon, to provide legal, financial, accounting, tax, investment or other advice. This is not an invitation to purchase or trade any securities. Beutel, Goodman & Company Ltd. does not endorse or recommend any referenced securities.

Sue McNamara: Good afternoon, everyone. I’d like to start by acknowledging that the land we are on is the traditional territory of many nations, including the Mississaugas of the Credit, the Anishnabe, the Chippewa, the Haudenosaunee and the Wendat peoples and is now the home to many diverse First Nations, Inuit and Metis peoples.

We also acknowledge that Toronto is covered by Treaty 13 with the Mississaugas of the Credit and the Williams Treaties signed with multiple Mississaugas and Chippewa bands.

I’d like to thank you, everyone, for joining us this afternoon for the Beutel Goodman Speaker Series in conversation with Hydro One. I’m Sue McNamara, Senior Vice President, Fixed Income and Head of Responsible Investing here at Beutel Goodman, and I’m joined today by Hydro One’s Executive Vice President, Chief Financial and Regulatory Officer, Chris Lopez. Chris is an industry leading CFO with more than 23 years of progressive experience in the utilities industry in Canada, the United States and Australia, and has overseen significant improvements in equity and bond investor confidence, share price and performance, as well as productivity savings at Hydo One. Hi, Chris. Thanks for joining us today.

Chris Lopez: Hi Sue, and thanks for having me. Pleased to be here.

Sue McNamara: Great. So, kicking off … Hydro One is a core holding for us in our fixed income portfolios and has been for many years. The company is Ontario’s largest electricity transmission and distribution service provider and serves approximately 1.5 million customers across the province. We view Hydro One as the benchmark utility bond in Canada and it will continue to be a core fixed income holding for us for a long period of time. As bondholders, we tend to focus more on risk. We are not the most positive people in the room. We’re usually the ones with the dark clouds over our head. We are focused on the risk and the downside; we really have no other upside other than to get our principal back at maturity and collect coupons along the way. So, for us, in this context, we think that boring is beautiful and Hydro One is something that I think exemplifies that for us right now. But I will say that in the past, Hydro One has flirted with expansion in the U.S., but for the last several years has returned to a “Made-in-Ontario” strategy that’s focused on growing the rate base, tuck-in acquisitions, reliability and safety.

Can you discuss Hydro One’s strategy and growth opportunities?

Chris Lopez: Thanks, Sue. Absolutely. Your statement of boring is beautiful, I like that too. As an accountant and finance executive, we are multiple things to multiple stakeholders. But on the financial side, I do think of us as fairly boring and fairly straightforward. And hopefully we don’t revisit the period of 2018, which wasn’t a financial situation, it was more driven by politics. So, on the strategy side, what are we focused on? You’re absolutely correct, we are entirely focused on operations within Ontario. So, we don’t look outside Ontario, and every now and again, we’ll get a phone call. We stay alert and aware of what’s going on in the industry across North America. More from a technology perspective, but not from an investing perspective. Like I said, [we are] entirely based in Ontario, transmission and distribution, entirely rate regulated, or at least 99%. That is not going to change for the foreseeable future. There is a bright-line test at S&P, and we’re fully aware of that, that goes to 10%. That really says that 90% of your FFO [funds from operations] must come from regulated T and D [transmission & distribution]. We’ll never get close to that number. And the 1% that comes today is really a small business called Acronym that we have. It’s a telecommunications business that we must hold to provide services to transmission. So, what is the strategy? The strategy is focused on Ontario, focused on our customers, and focused on supporting economic growth through transmission and distribution within the province. So, it will stay that way. We’re not going to move away from that. It really also keeps us highly aligned to the Government of Ontario. Part of the reason why we ended up in a challenge in 2018 is we actually lost that connection. Now we focus on — what are the policies of Ontario, what is good for Ontario, what is good for the electric industry, and how do we align those two in the best way we can. And that’s worked out to Hydro One’s benefit and to the benefit of all Ontarians and customers that we have today. I’ll just remind your viewers, we supply 1.5 million customers on the distribution network. But on the transmission network, we supply all Ontarians. We’ll do it through other intermediaries. But today it’s 1500 direct and 14 million plus indirect.

Sue McNamara: Okay, that’s great. Maybe we’re just going to switch and talk about sustainable finance for a moment. In January of this year, Hydro One issued more than $1 billion of bonds from its new sustainable bond framework. The framework combines the use of proceeds from both green and social projects. Here at Beutel Goodman, we have a fairly robust process for reviewing labelled bonds, and we look to follow the ICMA, International Capital Markets Association’s sustainable bond principles regarding the use of proceeds, the reporting, and the verification. Additionally, we look favorably upon a company having a second party opinion on their framework, which is what you had. So, looking at your sustainable bond framework, maybe if we could just start on the green side.

Can you go over some of the projects that you would be looking at to finance out of the sustainable bond?

Chris Lopez: Sure. As a reminder, we call it the Sustainable Financing Framework, which encompasses, as you just said, green and social. So, I’ll start on the green side, which is going to be, quite frankly, the biggest piece. So really, what is it about being, as we call ourselves, an enabler of the energy transition in Ontario through transmission and distribution infrastructure. The energy complex or electricity complex in Ontario today is over 90% decarbonized. That’s the energy going through the system. As it gets built out, we expect that it will stay there. It could fluctuate up and down a little bit through the transition, but we would expect it to be, in the long term, highly decarbonized, like 90% plus over the longer term. And what does that mean? It means we can transition energy consumed in Ontario. Today, it’s only 16% of the energy in Ontario coming from electricity, and the plan is to get it up to somewhere around 50%. But that really means displacing things like natural gas and liquid fuels in some manner. So, that’s really what that’s about. What I would say is we’ll continue to focus on doing that. The framework itself is entirely highly aligned to the United Nations Sustainable Development Goals.

And the key one that your viewers will be interested in, the European taxonomy called for less than 100 grams of CO2 per kilowatt hour. Ontario for the last five years has been at 24.6. It will fluctuate a little bit, but it’s about a quarter of what the EU taxonomy calls for, so that will nearly always comply. When we talk about green projects, what’s in there? Any project to do with clean energy, energy efficiency, clean transportation, biodiversity conservation, climate change, adaptation, which is becoming a larger one, by the way. So that’s the green side. And we would expect that the majority of our bonds would qualify through the green side of that program for the foreseeable future. And really, that is any investment in Ontario’s low carbon energy mix. So, what do we do today? You’ll see us reinvesting in the existing grid or expanding it. And that’s really where most of the green investments will come. I can touch on social if you want, or we can go there if you have another question.

Sue McNamara: No, I really do want to focus on the social aspect. I think it is really one of the unique attributes of the sustainable bond framework. So, just to give a quick background for the audience, the social part of Hydro One’s bond framework is focusing on procuring business from Indigenous businesses, as well as expanding infrastructure to remote communities.

You have an Indigenous relations policy that’s publicly available on your website, and the company supports the United Nations Declaration on the Rights of Indigenous People. So, maybe if you want to just expand upon that?

Chris Lopez: Absolutely. So eligible in the framework, there’s a few more categories, and I’ll just list them out. So, on the social project side, you have the social economic advancement of Indigenous peoples. That will be the majority. It’s really committing, and we have committed to more than 5% of our addressable spend with Indigenous First Nations. We’re actually there today, but as the program grows, it will grow with it. The second area would be access to essential services for underserved communities, things like the electrical grid enablement. That could be for First Nations, but it could also be for remote locations in Ontario. And the same is true for high-speed broadband internet. So, it covers Indigenous, but it also covers those that are underserved and have lower reliability today than, say, you have in a city area. So, they’re the major pieces. It is unique, as you said, it has two aspects to it on the Indigenous side. The first one is that commitment to spend amounts that I just disclosed. The other part would be our partnerships with First Nations going forward. So, if we do a new transmission line today, what we have committed to doing is offering a 50% equity investment in the transmission line component of the project.

But we go further than that. The addressable spend gets included because what we do is we set up remote locations; First Nation corporations that can supply maintenance services to the business, such as vegetation management, cutting trees down. So, they’ll do that from remote locations. What that involves usually is us co-investing with them for a period, three to five years while they build up that skill set within that remote location. So, that’s how we’re driving some of that procurement spend. And then the bigger benefit, and I’m happy to go further on that one, is our partnership with First Nations on the growth side.

Sue McNamara: Sure. Feel free to expand there.

Chris Lopez: Okay, so how that’s working is there have been twelve [large transmission lines] allocated over the last, say, six years. One line went to Fortis up in the far north, and one line went to a partnership between NextEra and Enbridge, called NextBridge, up around the top of the Lake Superior area. Hydro One took a good look at that and said, okay, what is our role in the province? We were very well connected in the southern part of the province, but are we going to involve First Nations? And then looking at it even further and saying, what role could we play in advancing reconciliation? What we came up with, after a deep look at that, was the two goals that we said already, one about procurement, and the other part about investing. And the conclusion was really clear — you will not build any contiguous infrastructure across Canada, and it might even be across North America, very soon without Indigenous First Nations being involved. And when you’ve talked about reconciliation and the treaties that Canada has, it is unique. It did talk about self determination and being able to have an equal say.

So, what we came up with was that we’re willing to go for the contiguous piece that’s on their properties up to 50%. And really we said 50% is a straight offer, and that’s what people have come for in Indigenous First Nations. What it did was it satisfied the need that they want self determination. They want to be able to say that on that line, they have a say in how it’s built, how it’s maintained, and how the land will be looked after over the life of that asset. Previously, what companies were doing, and Hydro One was one of those, is we would offer less than 50%, maybe 30%, maybe 20%, or we’d offer them shares. And that’s not what they wanted. Once we went to 50%, it really did accelerate development in this province. I’ll give you a couple of good examples. Waasigan is the biggest one, a $1.2 billion project up in the far northwest of the province. That’s going to open up that Ring of Fire. That is a partnership with nine First Nations. And really what happens in that partnership is they bring their own equity. We’ll get the debt onto the project, but they bring their own equity. It’s all financed. The equity is financed at roughly the cost of Hydro One debt. Because we can step back into the project if they can’t pay, and we’re happy to buy the project at one time, we would never want to, but if they couldn’t pay, that’s what would occur. That really means that they’re able to finance the equity component at about our cost of debt, say, 4%, and they’re able to get the equity return at about 9%. That spread of 5% really does promote development in the First Nations locations in the far north. The province of Ontario loves it, the federal government loves it, and we can get projects built quicker and faster. So Waasigan is a good example. The other one’s Chatham to Lakeshore, which is in the southern part of the province. We’ve been able to build that line. It’ll now come online at the end of 2024. That one’s only $253 million, but it’s through a very populous area. We’re able to build that line one year quicker than we originally planned, and we’ve just reduced the budget by 5%. So, in a time of high inflation, people can’t get things built, Hydro One has been able to come through that and build it faster at a lower cost.

And that really is in large part due to that partnership with First Nations. And on Waasigan, it’s going to be something similar, because we did face some initial pushback from a group called Neighbors on the Line, and it was really a small group that were quite wealthy, and they said, look, I don’t want the line as close to my property as it was, but we could bring First Nations into the discussion to say, we’ve looked at all this, and as stewards of the land, that is the best design that we can see. And the other designs that you’re recommending would cause more harm to the land over time, more harm to animals and so on. So having them as true partners is not only the right thing to do, but it’s also the right economic thing to do.

Sue McNamara: That’s a great story, and I hope continued success on all the new transmission projects that you’re going to develop in partnership. I guess just switching on to the regulatory side, similar to our equity colleagues, we believe that cash flow is king. And for Hydro One, a key element to that cash flow stability is the regulatory environment. So, you’ve been very successful in getting approval for the milestone joint rate application with the Ontario Energy Board (OEB). So that covers your transmission and distribution. Businesses that used to be separate and are now together under one construct. And I think for bondholders, the way we look at it, too, is we believe that the regulatory compact not only ensures that rates are fair and reasonable for the ratepayers, but the second element that I think gets a little bit less attention is that it pretty much has to ensure that utilities are kept on a sound financial footing and that solidifies the safe-haven position of utilities in the bond market.

Maybe just for our investors on the line, if you can expand on the JRAP that you received, as well as your five-year investment plan?

Chris Lopez: Sure. So, the JRAP stands for joint rate application. I get asked the question all the time. And really what that is about is we do the distribution and the transmission application at the same time. So previously they were on different timelines, but what that meant was any common costs between the two business of transmission and distribution. So, corporate costs would get tested twice in the same period, and they might end up with different decisions, which they didn’t like. So, they said, look, let’s do it all at the same time, which we do love. What it does is it gives us certainty, and bondholders certainty over a five-year period. And then we can manage the corporate or shared costs and the cost of each business unit across a five-year period, which is important to the regulator under what’s called the incentive rate making. So, they incent us to do better, in which case the ratepayer will benefit in the rate period if we earn more than 100 bps over [the allowed ROE], and beyond the rate period if we hold rates flat. And I’ll talk a little bit about that, about how we maintain our relationship with the OEB.

But what’s in the joint rate application? You’re correct, Sue, It’s transmission and distribution for the next five years. It’s mostly maintenance of the system. About 70 to 80% of the investment is maintenance, about 20% is growth. Why is there any growth in there? It’s known growth at the time you do the application. Any growth that comes after the application or is related to a change in policy from the government. A new transmission line is a good example of that. The partnerships will have their own license anyway — they’re outside of the joint rate application. Why is that important? It’s a new innovation that the OEB and Hydro One came up with in this last application. Previously you’re given an envelope, and if new growth came in, you had to cut maintenance to fund the growth. That’s how it worked. Today they are completely separate beasts. To the extent growth is known, it’s approved in that process. If it’s unknown, it goes outside. And therefore, we can maintain the system to the intention that we had at the time. Why did we do that? Well, with energy transition coming, we knew without maintaining the system, you couldn’t make the investments necessary in the future to deliver the benefits that we said.

So that was an innovation. It provides growth of I would say it’s 6% rate base growth. It used to be 4.5%, 5%. Now we’re up to 6%. So, you’ve already seen an increase in investment, 6% earnings and 6% dividend. And our dividend growth rate was 6% this year. It’s all underpinned by our capital structure, which is 60% debt, 40% equity. We don’t stretch that, so we stay at that rate. So that’s where it is. Those other items on growth that I talked about earlier, Sue, are not included in that guidance. As they get approved, like Waasigan, we just submitted it — we didn’t change our guidance — we’ve identified how much it will be. When it’s approved, if it has an impact on guidance, we’ll update it. Now, what we said openly is it does not change the range that we have today, which is 5-7%. It takes you closer to the 7% mark, but it doesn’t take you through that mark. So that’s the joint rate application — very pleased with that outcome. What I’ll also say, and it gets into the second question about [our] relationship with the OEB and what we can expect going forward.

So, in the past, we’ve had some decisions we didn’t agree with. The one that’s probably most known is the deferred tax asset decision. Just quickly for everybody, it goes back to the time when Hydro One became public. In the initial public offering, the shareholders paid a departure tax, about $2.4 billion. And under the regulatory construct, benefits follow cost. If an investor paid for it, they should get the benefit. And that was a poor-quality decision I would say that led to a decision that tried to take some of that benefit for ratepayers. We appealed it all the way to the highest court in Ontario, and we won. And then we’ve got that repaid back to Hydro One. Now, decisions like that can happen. What I’m really pleased to say is that the regulatory process withstood a difference of opinion. We went through the whole process and it was in the hundreds of millions of dollars, by the way, but it was rectified to the right decision. So, I’m pleased for bondholders, for shareholders, for all stakeholders. What else could I point to with the OEB? It’s very constructive. The JRAP is a great example of that.

The joint rate application was settled. It didn’t go to a hearing. It was the first settlement of that size. The settlement was $18 billion over five years, breaks out to about $5 billion in OM&A [Operations, Maintenance and Administrative costs], and $13 billion in CapEx. Throughout that process, inflation took off. I’m sure everyone’s had that experience. So, in 2021 we had submitted the application. By the early 2022 period, inflation was much higher than we thought. We pulled the application and updated the inflation factors. It resulted in our ask going from $17 billion to $18 billion. Now, the OEB at the time was not happy with us, but here’s the strength of the relationship. Once we got to the settlement process, it was approved in full. We also had the benefit, I’ll say this Sue, of Janet Yellen, the U.S. Treasury Secretary testifying before Congress just the day before our settlement started and saying we couldn’t see inflation at this rate. And my point was, when we started, if Janet couldn’t see it, then what hope do we have? So, we got away with that one. But it was fully approved. No concern there.

Earlier this year, S&P took action on a small group of LDCs [local distribution companies] in Ontario. And really their contention was regulatory lag. We don’t really have regulatory lag in Ontario, but what they were pointing to was that when rates were fixed, they were fixed at a time that meant that they didn’t get full recovery of, say, input costs. And one of those input costs was transmission. So, what happened? I’ll tell you how quickly this happened. I got a call from the ministry to say, is this real or not? My honest opinion was, it’s not real and it can be fixed quite quickly with the OEB, which is the regulator. So, between the OEB, the ministry and ourselves, we were able to change the way we approved rates. So, transmission rates are now approved a couple of months earlier than distribution. So, they can put those inputs into the distribution rates and they get full recovery within the year. So that issue has gone away. And S&P acknowledged that happened very quickly. So that’s a really good example of that close relationship.

And then the final one, I’d say is that we are talking now about what the future holds. So, with this five-year rate case, all of that is behind us. And we’re saying when you’re going to go through an energy transition period, the growth has already picked up. We’ve seen that. We talked a little bit about the action from S&P, about credit metrics and so on, and I said, well, that one wasn’t real and we can deal with that one. It is true that as you go through a higher growth period, the construct you have today is going to need to be altered or enhanced to accommodate a higher growth rate. What do I mean by that? At 60/40 you could be an A-rated utility maintaining that if you’re growing at 4 to 6%. We’re starting to go just past that — we’ve got a very strong balance sheet, so no problem. But the LDCs don’t have that and as you go up to eights, nines and possibly into the low double-digit area, you’re going to need to revisit equity thickness or some form of return on your work in progress. So, we get paid interest during construction today — you’re going to need more than that in the future if you’re going to maintain growth rates of 10%. How can you see that? In that 60% debt structure they have? Really what that’s made up of is 56% long-term debt in rate base and 4% of assets under construction. Well, that assets under construction piece is growing quickly. It’s going from four to six to eight — it’ll get to more. So, we’re having that conversation now. The OEB is open to it. Nobody’s got a gun to each other’s head. There’s plenty of time to sort it out. And we’ve said, look, take the time to sort it out and we will work with you. We don’t need it for the next five years, but others might. How do we do it in a transitional way? I don’t think we’ll keep it forever, but you might need it for 10-15 years.

The last thing I will point to, a couple of very small ones, the formulaic ROE [return on equity]. You know your regulator is doing something well when other regulators copy them. And a good example of that is the Alberta Utilities Commission just recently. They’ve actually transferred the formulaic method of doing ROEs to Alberta. The number is almost identical. It’s in the low nines right now. The only difference they have is they’re going to update the ROE every year, which could be good or bad.

I think it’s a good thing because what it does is it floats with whatever’s happening in interest rates. So, it actually provides more real term support. For us, we know it and it’s fixed for five years. That would be the only difference that I can see. And recently we were called on to take over a small LDC. A lot of the callers today could probably afford it, especially if you have a property in Toronto. It was about $2 million. It was that small, 1200 customers. But that again gives us credibility with the OEB, they need someone to come in there and fix it and keep operating it. So, they asked us to do that and we just announced a full deal to purchase it. Very small, not material, but another good example of how we’re working very closely to get these kind of things done.

Sue McNamara: That’s great, that’s a great explanation. Thank you. Just switching now. We did kind of reference it a little bit — going back to those dark days of two provincial elections ago, Hydro One was on the front pages. It was front and center as an election issue. It resulted in several management changes. It resulted in the Hydro One Accountability Act, parts of that which referred to executive compensation did sunset this year. But a key focus for bondholders is that Hydro One is allowed to operate as a standalone entity without material influence from the province. I would argue that’s probably key for equity holders as well. So, I know the relationship is a lot better.

Could you give a few comments on how the relationship is with the province?

Chris Lopez: Sure. I think your key point was around equity and debt holders being very aligned. I would say that’s true, Sue just on the total level of risk. This is a unique space and Hydro One is probably a unique company in that it is extremely low risk and the bond holders and equity holders are very well aligned. And in fact, I probably missed this before — there are a number of investment companies out there that hold our bonds and our equity for the same reasons. To be honest, when we did the sustainable financing framework, believe it or not, I think the bond holders were much more sophisticated and were able to move in and out of Hydro One bonds and call them sustainable. The difference was equity holders couldn’t. And once we had the sustainable financing framework, they were able to point to that and say it is sustainable. Now it can go into an equity sustainable fund. So, that was a big difference. On the bond side, it didn’t make much difference, three to four points off the financing rate.

So, moving to the province. With that in mind, that everybody’s well aligned, really what we learned in 2018 is, and it’s not a matter of ownership, they own 47% of us. But we saw in Nova Scotia, where the government owned nothing, they can still have a big impact on your regulatory outcomes, on the stability of the company and the risk profile. So, it’s just good business to be very aware of the policy that’s in play with the parties that are currently governing, but not only the governing parties, but even the ones that might come into government. So how do we stay aligned. And for us, really, the main thing is looking at their policy, which in Ontario is we’re open for business and we’re driving economic development. And I’ll be really clear, this government, the provincial government, you might recall when they first came in, weren’t focused on green or decarbonizing. They did realize fairly quickly that in attracting new investment to the province, that was actually a prime benefit, you could come onto the Ontario grid very quickly and you could be 100% decarbonized or 90% very quickly. So, they realized that’s true. Now, I would still say this. Their number one objective is powering the Ontario economy. If green makes sense, they will make sure that that’s part of it, and that’s where we come in. So, we’ve aligned our investment, how we support customers, all of those key metrics towards those key policies. And when I said it’s not just provincial, it’s the federal government and the provincial government. So, the federal government is the Liberal government here at the moment. They are left leaning and Ontario is right leaning, but they are totally aligned on the green economy and being open for business, but more the green economy. At the federal level, it’s ideological, I’d argue, and at the provincial level, it’s business. But the two work together extremely well. We meet with federal ministers, provincial ministers, deputy ministers. I’m actually in Ottawa next week with meetings for Tuesday, Wednesday, and we stay aligned across the board. And that’s why we’re able to get these nine and ten transmission lines on the books and we’re able to get them done faster, and we’re able to have an impact on things like Volkswagen coming to the province, Stellantis — we’re involved in those team Ontario discussions and getting them connected to energy quickly, so they give you the credibility to work with government in the future. So that’s what we’re doing. We’re doing it across the board. So, we’re fairly comfortable that we will be successful going forward. And we’re fairly focused on maintaining those relationships, not just with those in power today, but those that could come afterwards — how we make sure that that all stays aligned.

Sue McNamara: Great. Just moving on to the energy transition. When I think about net zero by 2050 and how we get there, and especially in the electricity industry, where this is going to require significant amounts of investment and really just change even the way that we use electricity. If our EVs are charging all night, if possibly we’re running homes off electricity instead of natural gas, I mean, not only does it change the load, it changes peaking times, and probably we don’t even have peaking times anymore because we just use electricity all the time. And I guess one of the concerns I have, it’s probably not now, but kind of looking further out, is all of the investments you’re going to have to make to reinforce the grid, which are reasonable investments that will have to be made. But how do you also manage that rate shock for the consumers? Because we’ve seen it in Nova Scotia, where you’ve referenced it, we’re seeing some issues arising in Alberta — how do you kind of manage that rate shock? I guess work with the regulator, work with the government, so that there is that sense from the consumer that we are not going to freeze in the dark, but there is a cost.

Chris Lopez: Yeah, you definitely won’t freeze, but you’re correct that the cost is there. I’ll acknowledge this. I think that where we are today and getting to 2050, the view is that you can decarbonize and the cost or the percentage of your income going to the energy wallet is going to be roughly the same. So, we can end up in a good place by 2050. And that really is taking your electricity bill, your gas bill and your liquid fuel bill today, and you’ll have a bigger percentage on electricity, less on liquid fuels and natural gas, but you’ll have a better carbon footprint. And we think they can be done at roughly the same cost. That’s all good and well, but how do you go from where you are today to that point? That’s the challenge, because you’re going to have two systems in play. It’s fine to get to the endpoint and say, now I have one system, it’s all good, but you’re going to have to have two systems operating over the next 15, 20, 25 years. So that’s the challenge, Sue, and we are actively working with federal and provincial governments on how to do that.

It is absolutely going to require some form of support. There’s no world where that does not happen. We’re lucky in Ontario today, you actually have a mechanism, it’s called distributor rate protection. So basically for residential customers, it can’t go above the rate of inflation. What that would mean is automatically any additional increases would flow to the tax base in Ontario. The amount on your bill is going to get large, though, if that’s the mechanism they use. So, we just need to stay ahead of that, ensure the government understands where we’re headed. You’re correct, it’s not near term — you’re talking more in the 2030s period. In this period, it’s quite low. If I look at just the Hydro One piece, the transmission part of the bill is 7%. If I include distribution, we make up about 30% of the bill. So, our part is low. Our increases over the next five years are less than inflation definitely, but they’re in that 1% to 3% range. That’s our portion. When you think about generation, that could be quicker. The other part I would say is Ontario is in a better place because we’ve already decarbonized the existing grid. The challenges that you’re going to see in other parts of the utility space is they have to decarbonize existing generation.

That’s what Alberta is going through. That’s what you’re seeing Nova Scotia, you’re seeing it all over the U.S. So, that first shock, Ontario went through that, believe it or not, back in beginning of last decade, the back end of the 2000 period and we had pushback and then a chunk of that value was put on the tax base already. Ontario has gone through that and our bills are some of the lowest in North America. The average in North America will go up dramatically in that first phase. So, we’re watching carefully how that works, how it happens, what government responses are. Ontario is in a very good place. Where we are today, it’s a great place to be. We can focus more on that 2030 plus period, but it’s still going to happen. That transition will still come at a cost.

Sue McNamara: So, staying on the topic of climate change, it’s pretty hard to ignore right now. We had one of the hottest summers on record globally and in Canada. We had significant issues from wildfires. And you did touch on to a certain extent with S&P’s actions on Fortis where they put the company on negative outlook, partly in relation to the fact that they felt that where Fortis operated was susceptible to wildfire risk.

When you’re looking at Hydro One, how do you ensure resiliency and reliability of the line amidst increased climate risk and physical risk?

Chris Lopez: Yeah, I think that gets back to that conversation we had a little earlier about adaptability in the social sustainable financing framework. And I do think mitigation and adaptation is going to form a bigger piece because I think the idea that we’ll get to net zero, we’re all striving for that. But even with that net zero, you’re still going to see an increase in these events. That’s a fairly common understanding now. So, what do we focus on? First one would be what investments can we make to reduce that risk? Number two, what can we do to reduce times to restore power? So, they’re using technology to assess where things are, assess where they’ve gone off. Do we have battery backup? We didn’t have that before, but we’re now able to use batteries to reinforce distribution lines, especially in remote locations, so their downtime can be halved. For example, we have early warning systems, so we’ve got a really advanced warning system that tells us where storms are going to hit. And we’ve put trucks and equipment out in those areas before the storm hits. And it just means that we’re ready to go once it goes through.

So that kind of change in how we do things reduces the impact to consumers and customers and reduces any negative blowback. Now, wildfires will still be there. What I will say for those that went to EEI [Edison Electric Institute annual conference] , Fitch put out a really good report. It was out of the U.S. and talked about wildfire risk across North America, which is very prevalent on the West Coast; it went through all the large fires that we all know about. When you go to the East Coast, as well as Ontario, Chicago, it was actually very low. And that’s what we’ve seen. It’s actually been very low so far. It’ll increase, but it’s been very low. And what that means is the reason why S&P took action, specifically on the West Coast, was based on that. On the East Coast, what they said was, you need to have a severe fire risk, which we don’t have, but if you have that, then you must have a public safety shut off policy. Now, we don’t have the public safety shut off policy, but we don’t have the high wildfire risk. So, for us, our experience so far on wildfires this year, it was slightly above the average, but by the end of the year, it’s come back to average.

We’ll continue to focus on abatement. So, we’ve cleared more trees away from our lines. If a line does get impacted, Sue, it’s more remote. We don’t see the wildfires going across large areas like you see in the West Coast. And there’s two reasons for that. You either have very hilly terrain, mountainous terrain, where the heat goes up the hill very quickly, and then it’s unstoppable, or you have the desert, which pushes the wind across, which is what you saw in California. We don’t have either of those. So, when we’ve seen wildfires, they’ve been contained to a smaller location. They haven’t gone over these large swaths of land that you’ve seen elsewhere. But we are doing some work just to make everyone aware of it, with the Ontario Ministry of Natural Resources and Forestry to look at forest fires and emergency service response. We do help them when a fire comes close to our lines, we’ll help them do back breaks and things like that — it’s in both our best interests to look at that. If it does occur — here’s the positive part — in Ontario to this point, we have an insurance program, and where possible, we’ll insure risks. Normally that’s buildings, stations, and within a thousand meters or feet of those buildings. So, what does that mean? Your lines are not insured, but wherever a line has been damaged, they haven’t been damaged by fire, but they have been damaged by storms. That is fully recoverable in rates from the ratepayer. So, best example I can give you of that one is the derecho that happened late last year. That was that severe storm that went all the way up towards Ottawa. We suffered about $100 million of damage in that one, and that was all allowable in rates. So, you capitalize it and you recover it over a long period of time, the asset life. So fully recoverable today, fully tested by the OEB when you do your rate application. So, we’re fairly confident you’re in a good place today and the regulatory construct is supportive.

Sue McNamara: Okay, just maybe wrapping up with one last question. As a bond holder, I sometimes feel like we’re kind of the poor relatives to equity holders, as most companies seem to be focused on dividend growth and earnings growth, and even in some of the worst-case scenarios, that gets funded by debt. So, I would say, though, that Hydro One has fostered a strong relationship with both its bond holders and its equity holders.

How do you balance the needs of both of your stakeholders, and how does that get incorporated into your capital allocation plan?

Chris Lopez: Yeah, so if I talk about capital allocation first, really, the big majority of our capital allocation plan is organic. So, it’s basically that joint rate application or new transmission lines. We’ve got one small project to support the government: rural broadband, which has the same return and risk profile as our distribution business. The reason for that, they’re just hanging telecommunications equipment on our distribution line. So, it’s identical risk for us. And then the final one is if we bought local LDCs and we’ve got a very good track record of integrating those and getting them back into one times rate base. So think of us as being one times rate based. We don’t have different levels of risk profile. What does that mean? We’re going to maintain 60% debt 40% equity. It’s very clear. We tell all of our investors that. Why would it change in the short term? It might change while you’re constructing assets, and we’re speaking to the OEB about that, that 60/40 debt equity structure applies when the asset is in service. The way the OEB wants to work is that while you’re constructing the asset, they want to give you cost of debt, which means that your debt goes up a little bit. That’s my discussion with them, is that you may have to pay a bit more than cost of debt for that to work in the future.

I’ll come back to equity and debt holders being very well aligned. Our capital allocation process inside the company doesn’t have different risk profiles. It’s all one times rate based. It’s all based on the OEB construct. So, there is no need for us to trade that away. We’ll stay fixed. What that really means is, we’ll stay and defend the A rating that we have today. The OEB knows that, the government knows that. They’re very aware of it. When S&P took action, like I said, they called us straight away to ask what our opinion was. So, it shows you their intention. As you know, I’m not conflicted. I’m very pleased to say that the risk profile of equity and debt is very close. And the construct that we’re working in in Ontario matches that risk profile very well.

Sue McNamara: Well, that is great to hear, and that’s probably a great place to finish. So mindful of time, I think we’ll wrap the conversation up here. At the risk of betraying all the grey hair I have, I’ve covered Hydro One since their inaugural debt deal in 2000, and it has been a very long, but also a very fruitful relationship. And I would actually say partnership. So, we’d like to thank you, Chris, for joining us today to help us through this deep dive of Hydro One, and also to highlight a little bit on how we invest on the bond side.

We would also like to thank all the attendees today. For those of you who may have any additional questions, we would ask that you please reach out to your Beutel Goodman representative and we will get back to you. So, thank you very much and happy Friday.

Chris Lopez: Thank you, Sue.

Beutel, Goodman & Company Ltd.

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