A District Energy System (“DES”), also referred to as a Neighbourhood Energy Utility, is an energy distribution system that delivers thermal energy (in the form of hot water, steam or chilled water) from a central plant to a building or series of buildings or units. A DES can incorporate a variety of energy sources, including natural gas, electricity, geothermal, biomass or waste heat from a manufacturing process. DES are becoming more common in British Columbia as a result of public interest in energy efficiency and low-carbon or renewable energy, as well as government requirements to reduce GHG emissions. In British Columbia, the construction of DES assets, and the rates charged by the owner of a DES for thermal energy, is generally subject to regulation by the B.C. Utilities Commission under the Utilities Commission Act if the thermal energy is to be provided to “the public or a corporation for compensation”.
What are some examples of a DES?
There are various models of a DES. Examples include:
- The developer model: It is commonplace for developers to install piping in a development sufficient to service all tenants or strata owners. Sometimes this infrastructure is simply turned over to the local government. However, a developer might choose to install a central generating plant as well as the downstream delivery infrastructure (i.e. create a DES), and hold/transfer/sell it to a special purpose corporate vehicle (Utility Co.). The Utility Co. can then charge long-term tenants, strata councils or strata owners a rate for the provision of thermal energy from the DES. End users (i.e. DES customers) will have to cover a portion of the cost of the central plant through rates charged over time, but each end user avoids the cost of installing and maintaining individual heating appliances. Customers may be willing to pay, and the regulator may accept Utility Co. charging, a premium for a reduced carbon energy source.
- The institutional model: Institutions with existing excess capacity in a central plant, or with plans to install or expand a central plant, may consider selling thermal energy to other surrounding buildings or tenants. This provides a contribution to offset fixed costs of the central plant. At the same time, the low marginal costs associated with generating additional heat at the central plant may make it possible to sell surplus thermal energy at a lower cost than the customer could achieve by obtaining energy from major public utilities.
- Traditional public utility model: Large public utilities such as natural gas distribution utilities may also undertake DES independently, partner with DES proponents, purchase DES assets from developers and others, or provide operating services on contract.
- The local government model: Local governments may own and operate a DES. Municipally-owned utilities are not subject to regulation by the B.C. Utilities Commission, and may set their own rates for thermal energy.
When is a DES regulated by the B.C. Utilities Commission?
While there are exceptions and complexities under the Utilities Commission Act as to when an entity is subject to regulation by the B.C. Utilities Commission, a general rule is that a privately owned DES serving another corporation (including a strata corporation) or the public for compensation is a “public utility” subject to B.C. Utilities Commission regulation. As noted above, municipally-owned utilities are a notable exception and have their own regulatory framework.
What does it mean, in practice, to be regulated as a public utility?
Public utility regulation may invoke the image of a traditional large natural gas or electricity utility with extensive regulatory requirements. However, while it is true that a DES is subject to the same basic regulatory model as a large utility, the B.C. Utilities Commission’s general approach to regulating small utilities has thus far been pragmatic. In short, the requirements imposed tend to recognize the small scale of these operations.
At a high level, there are two basic approvals required for a regulated DES:
- Constructing and operating the regulated DES requires a Certificate of Public Convenience and Necessity (CPCN). This is a general public interest approval granted by the B.C. Utilities Commission. At a high-level, the proponent of a DES would be expected to establish that it is capable of carrying out the project and providing service to customers in a cost-effective manner.
- The B.C. Utilities Commission must also approve rates before the DES can provide service to customers. Rates are generally set at a level to recover the forecast operating costs, depreciation expense on capital assets, and debt costs of the DES as well as a rate of return on equity. The B.C. Utilities Commission might look to set different utility rates for different types or classes of customers (e.g. commercial, residential). The B.C. Utilities Commission would set the rate of return on equity with reference to evidence on business risk and comparable investments.
Once the rates and allowed return on equity are in place, the rates may remain in place for lengthy periods of time, or could be subject to periodic (e.g. annual or biannual) reviews by the B.C. Utilities Commission. Whether the rates stay in place longer than one or two years between rate reviews by the B.C. Utilities Commission will depend on whether customers, the Utility Co. and, ultimately, the B.C. Utilities Commission, believe the rates being charged continue to be just and reasonable in light of changing circumstances.
Barring unusual circumstances, all of these processes could be expected to be conducted in writing. The time frame for review of smaller applications is typically within 90-120 days from filing, but the B.C. Utilities Commission is generally sensitive to reasonable commercial requirements that necessitate a faster turn-around.
How is the rate of return on the owner’s capital investment determined?
The B.C. Utilities Commission determines the owner’s return on investment by setting rates that account for:
- a forecast of prudently incurred operating costs (with no mark-up), depreciation expense on capital, and all reasonable debt financing costs;
- a capital structure (i.e. ratio of debt to equity) determined by the B.C. Utilities Commission for rate-setting purposes; and
- a Commission-determined rate of return on equity invested in undepreciated capital assets and ongoing capital improvements that reflects the unique business risk of the DES Utility Co. and is sufficient to attract capital.
In practice, the rate of return on equity is set by reference to a company-specific risk premium on the benchmark return on equity for B.C., which is the rate of return afforded to Terasen Gas Inc., the largest investor-owned utility in the Province. Currently, Terasen Gas Inc. has a regulatory capital structure of 40 per cent equity and 60 per cent debt and earns a regulated after tax equity return of 9.5 per cent (rates are grossed up to generate a return of 9.5 per cent for the shareholder after accounting for tax payable by the utility). Smaller utilities with higher business risk may have larger equity components in their capital structures and/or a higher return on equity. The capital structure and rate of return on equity earned by Terasen Gas Inc. (i.e. the benchmark) changes from time to time as circumstances require, and the rate of return for
other utilities in the Province change with it. Rates may be structured to levelize the impact of depreciating capital assets over time.
Regulated public utility rates are designed to provide the utility with an opportunity to recover forecast operating and capital depreciation expenses, plus a regulated rate of return on the undepreciated capital invested that reflects the business risk inherent in the operation. The regulatory processes and approvals required to construct and operate a DES are relatively few in number, and have generally been tailored to accommodate small public utilities.
Fasken Martineau is an international business law and litigation firm with over 650 lawyers in offices in Canada, the United Kingdom, France and South Africa. Christopher R. Bystrom practices in the firm’s Litigation and Dispute Resolution Group with a focus on public utility and energy-related matters, and Matthew Ghikas is a partner in the firm’s Litigation and Dispute Resolution Group who specializes in the regulation of energy utilities, insurance companies, and transportation companies.