You need to read the article attached and respond to these questions:? 1. What are Hydro Ones business strategic objectives? 2.

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R E V : J A N U A R Y 1 8 , 2 0 1 2

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Post-Doctoral Fellow Anette Mikes prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2008, 2012 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1 -800-545- 7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

A N E T T E M I K E S

Enterprise Risk Management at Hydro One (A)

The Toronto skyline glittered in the early gloom of winter as chief executive Laura Formusa returned to her glass-walled office. She knew that the winter season presented Hydro One with its most severe challenges. It had to deliver electricity safely and reliably to 92 municipal utilities, 113 large industrial customers and 1.3 million households in the Province of Ontario while snow, freezing rains and severe winds gusting up to 100 km/hr continually threatened its aging transmission and distribution system. Just last weekend Hydro One’s award-winning restoration crews had worked around the clock to restore power to 90,000 customers affected by a winter storm.

Formusa glanced at her watch. She had ten minutes to review a headline news update, sent by chief risk officer John Fraser, in advance of the 30 minute semi-annual review with him of Hydro One’s risk profile. Formusa, a 30-year veteran of Hydro One and the company’s former general counsel, had been appointed chief executive officer only a few days ago, on 8 December 2006. The company’s strategy (posing objectives such as 90% customer satisfaction across the board) had not changed substantially in the last five years. However, she felt that the risks threatening the achievement of the strategic plan had been shifting, to the extent that she had to ask herself – was the strategy tenable?

Company History, Operations and Strategy

Founded in 1906, Hydro One’s predecessor, Ontario Hydro generated electric power at Niagara

Falls for distribution to municipal utilities.1 Over time the company had built five coal-fired, 68 hydro-electric and five nuclear power stations, and increased its power generation and transmission capacity to 30,000 megawatts, making Ontario an exporter of electricity to other provinces and the United States. However, by the end of the century it became clear that Ontario’s aging electricity system needed a major transformation.

In 1998, the Ontario government deregulated the province’s electric power industry. It restructured Ontario Hydro into two separate organizations: a power generation utility and a combined transmission/delivery “poles-and-wires” business to be called Hydro One. Headquartered in Toronto, Hydro One consisted of three businesses—transmission, distribution, and telecommunications, with the first two accounting for 99% of revenue.

1 Aabo, T., Fraser, J., Simkins, B. (2005), ‘The Rise and Evolution of the Chief Risk Officer: Enterprise Risk Management at Hydro One’ Journal of Applied Corporate Finance, Volume 17, Number 3, pp. 62-74.

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Sir Graham Day, a renowned Canadian-born businessman who played an instrumental role in privatizing Britain’s utility sector under Margaret Thatcher’s government, chaired the Hydro One board. The board had a mandate to prepare Hydro One to become a public company through an IPO that would raise an estimated C$5.5 billion for upgrading Ontario’s transmission infrastructure and for paying down the C$4.5 billion debt due to the government. The board appointed the senior management team, headed by chief executive Eleanor Clitheroe, a high-profile Canadian businesswoman. In preparation for the IPO, Hydro One’s management team embraced new business practices and a cultural change featuring a new consumer-focused service ethos, cost cutting,2 enterprise risk management, performance management, and strategic planning. In April 2002, Hydro One prepared an IPO prospectus and began a series of investor presentations. The transformation of Hydro One, however, had raised media and political controversy. Publicity about the private-sector- level salaries of the management team led to a fall-out between the government and the board. The board resigned and ultimately, the replacement board ousted the chief executive.3 A trade union went to court and obtained a ruling that created a legal barrier to the privatization. The government did not appeal, and Hydro One canceled the IPO two weeks before the planned date.

Once the public controversy died down, the new board appointed Australian energy executive Tom Parkinson as CEO. Under his leadership, Hydro One continued to follow Clitheroe’s value creation strategy including the implementation of enterprise risk management, a risk-based investment planning system, and a balanced scorecard that featured a strong emphasis on customer service.

Hydro One’s rates had to be approved periodically by the Ontario Energy Board, established under legislation. In 2002, unusually hot weather conditions in spring and summer increased energy cost pressures on customers. The Ontario Energy Board mandated lower distribution rates for Hydro One, effectively capping the distribution revenues at about C$4 billion for the next five years. (See summary financial statements in Exhibit 1.) To allow continuing investment in the maintenance and upgrade of its transmission system in this constrained environment, Hydro One launched an efficiency and cost-cutting initiative that led to the departure of 140 staff and a hiring freeze. Rating agencies Standard and Poor’s, Moody’s and Dominion recognized the improvements in Hydro One’s financial profile, and upgraded the company’s long term debt to A, A2 and A (high), respectively. But in 2005, 800 professional employees went on an 18-week strike to protest a proposed decrease of benefits to new employees in their union, arising from the cost cutting measures.

The government of Ontario favored conservation initiatives, and was rigorously phasing out coal- fired power stations throughout the province. The ruling party’s re-election campaign in the forthcoming election year featured energy savings and environmental conservation. Should the party be re-elected, and pursue initiatives to reduce electricity consumption in Ontario, Hydro One would be expected to lead these initiatives despite their adverse impact on the company’s revenues and earnings. Formusa wondered whether Hydro One could deliver on the government’s conservation goals without compromising its commercial viability. Hydro One had to manage a complex web of conflicting interests—the multiple agendas of government ministers, regulators, consumers, environmental groups, and capital market debt holders who had recently subscribed to the company’s C$1billion bond issue (not guaranteed by the Province).

2 An early retirement scheme in 2000 led to the departure of 1,300 long-serving employees, 20% of the company’s staff. The company rebalanced its workforce by the addition of just 126 people and spending C$4.4-million per annum in outsourcing costs.

3 “An apology for Eleanor Clitheroe”. Canadian Business, 9-22 October 2006, pp. 80-89.

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Hydro One’s power transmission capacity, however, remained stretched. Summer heat waves led to record levels of power demand from the company’s aging assets. Hydro One had plans to invest more than C$600 million into the maintenance and growth of its asset base, the largest expansion in 20 years. Yet soaring demand for transmission and distribution systems from China, which was opening new coal-fired power stations at a rate of one per week, had reduced the company’s bargaining power with suppliers who were now quoting longer and longer lead times for crucial equipment.

Despite the government’s advocacy of conservation, cheap electricity encouraged Canadian consumers to increase their purchases of plasma TVs, air conditioners and other energy-intensive consumer devices. (See trends in Ontario’s electricity generation and usage in Exhibit 2.) To cope with the increased demand on its aging assets, Hydro One launched an active conservation and demand management program. In one initiative, it became the first electricity company in the world to provide customers with free PowerCost Monitors,TM which gave consumers a quick and easy way of seeing their real-time spending on electricity. The 2006 pilot study of five hundred Ontario homeowners showed that real time electricity monitors helped them reduce their consumption of electricity by up to 8%.

Hydro One’s customer-focused strategy contributed to increases of customer satisfaction ratings of large transmission and local distribution company customers from 42% in 2002, to 86% in 2006. Residential customer satisfaction remained consistently strong around 82%. The company’s maintenance team regularly received industry awards for rapid restoration of damaged transmission infrastructure during extreme winter weather emergencies.

Upon her appointment4, Laura Formusa took stock of the company’s status quo:

Turning the company's attention outward to the customer had been a huge change for us. We always knew about our customers’ needs, and we always thought we knew the best thing for them. But with the change in our focus in addressing their needs, customer satisfaction has, in some areas, doubled.

Our operating costs, however, remain high, and with the work force reductions under the previous CEOs and the 18-week strike, we lost some of the heart and soul of our employees. We now have a workforce that's not entirely engaged. We also have some reputational risk arising from the departures of the previous CEOs.

Formusa endorsed the vision in a Strategic Plan to make Hydro One the best transmission and distribution business in North America. It would achieve this vision by having the best safety record in the world, top quartile transmission and distribution reliability, 90% customer satisfaction across all segments, top quartile employee productivity, operating efficiency, and an “A” credit rating.5 Formusa also intended to reach out and negotiate a long-term deal with the unions.

4 The previous chief executive left under a cloud of media furor, after he had been accused by Ontario’s auditor general for putting $45,000 in business expenses on his secretary’s corporate credit card, and then approving her claim himself. (Source: Toronto Star, 9 December 2006.)

5 “Five Year Vision”, company document.

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Enterprise Risk Management

The Toronto Stock Exchange was one of the first exchanges that required listed companies to implement high-level, strategic risk management. Pioneering Canadian companies, such as the Royal Bank of Canada, Sun Life and Hydro One developed enterprise risk management in response to this corporate governance requirement.6 New policies were changing the energy industry, bringing to the fore new threats and opportunities: climate change and carbon legislation; the deregulation of electricity markets, and the greater adoption of renewable technologies. Chief risk officer John Fraser advocated: “if a company does not have risk management, it would be like driving a car without brakes.”7

Hydro One had introduced a three-phase enterprise risk management program. In Phase One, employees participated in a series of workshops to develop a collective understanding of the company’s key strategic objectives and the risks that threaten their achievement. In Phase Two the chief risk officer conducted a series of one-to-one interviews twice a year with senior managers to review the corporate risk profile. In Phase Three, conducted during the annual planning process, Hydro One allocated resources to prioritized investment project proposals based on the risks identified.

Phase 1: Risk Workshops and the Delphi Method

Fraser believed that enterprise risk management started with top management agreeing about strategic objectives, then developing a shared understanding of the principal risks faced by the organization. Fraser acknowledged that his role was to raise questions during interactive risk workshops:

Enterprise risk management is a contact sport. Success comes from making contact with people. Magic occurs in risk workshops. People enjoy them. Some say, “I have always worried about this topic, and now I am less worried, because I see that someone else is dealing with it, or I have learned it is a low probability event.” Other people said, “I could put forward my point and get people to agree that it is something we should be spending more time on, because it is a high risk.”

Prior to a risk workshop, the risk team informally polled managers and drew up a generic list of 60–70 potential risks or threats to the business or the project being discussed. They e-mailed the list to the participating management team asking them to choose the ten most critical risks facing their business or project. Based on these choices, and, if needed, some additional interviews and focus groups, the risk management team narrowed the list to 8–10 risks. A risk officer then started the half- day risk assessment workshop with the presentation of the shortlisted risks, and asked participants to confirm whether these were in fact the most important risks or whether any others should be discussed in detail instead. Then participants talked over the risks, one at a time, and voted on their relative significance.

6 According to one widespread definition, embraced by many Canadian boards, enterprise risk management is “the discipline by which an entity assesses, controls, measures and monitors risk from all sources for the purpose of increasing the entity’s short- and long-term value to its stakeholders. (Source: “Risky business”, CA magazine, May 2005.)

7 Source: “Risky business”, CA magazine, May 2005.

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The meetings used the Delphi-method for voting, which involved a combination of facilitated discussions and iterative anonymous voting technology. The management team assessed each risk by asking, “Which of our stated business objectives are most threatened by that risk and to what degree?” It measured impact for each strategic objective on a five-point scale: Minor (1), Moderate (2), Major (3), Severe (4), and Worst Case (5). For example, an oil spill could be assessed as threatening several objectives—financial, environmental and reputational (see Exhibit 3). Fraser explained:

Let’s assume we had an environmental spill of 10,000 liters of oil. We ask people to vote on a scale of one to five as to the consequences if our controls didn’t work. A financial person could use the financial scale by stating, “the last time we had an oil spill, it cost $10 million to clean up; I call it a 4.” The environmental specialist could assess its impact by saying, “this could cause a significant local off-site impact, I am going to vote a 3.” The head of public relations says “if it gets reported in the local press, the Toronto Star, I would call it a 3. If the spill gets into the waterways, it would get covered by the national press, and then I’m going to vote a 4.” Each person in the room identifies a different impact, based on his or her area of

expertise. It brings a lot of clarity.8

The first vote on the perceived impact of the risk under consideration often showed wide dispersion. The team continued to discuss the causes and consequences of the particular risk. The length of the discussion typically depended on the dispersion of votes in the first voting session. At some point, the team voted again. Usually they needed no more than three voting rounds to agree on the assessment of a particular risk, or in the absence of alignment, a clearly documented cause of disagreement.

For all risks deemed to be Major (3), Severe (4), or Worst Case (5), managers identified the worst credible outcome that could occur within a 2-3 year time frame if certain key controls failed.9 In this way, the group assessed the magnitude of a given risk, its probability of occurrence over the next 2-3 years, and the strength of existing controls. (Exhibits 4 and 5 show the scales used for the assessment of probabilities and control strength.) The group then discussed preliminary action plans and assigned a manager to be the “risk-owner,” typically the project manager or the business’ CEO, with

responsibility to develop concrete action plans to mitigate the risk.10 While the ERM policy was that “risk management is everyone’s responsibility, from the Board of Directors to individual employees,” the risk owner had primary responsibility for deciding whether to accept and live with the risk or to

take specific steps to deal with it within a formal risk mitigating process.11

Once the management team had assessed risks and controls, the risk officers prepared a risk map—a two-dimensional rank-ordered chart of “residual risks.” (Exhibit 6 shows an example of an impact-probability risk map.) Fraser acknowledged that the risk assessment process was subjective, not “scientific.” He liked to quote the physicist Niels Bohr, “prediction is very difficult, especially about the future.” Fraser used the risk meetings to collect and synthesize expert opinions from all areas of the business.

8 Interview with John Fraser, May 7, 2008.

9 As defined, worst credible outcomes differed both from “inherent magnitudes”, which assumed that all controls failed or were absent, and “residual magnitudes”, which assumed that all key controls were in place and functioning.

10 Aabo et al., 2005, p. 65.

11 Ibid., p. 67.

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One risk officer described the prevalence of the risk assessment meetings:

Our original ambitious plan was to do twelve risk assessments a year. The senior executive team embraced the approach so enthusiastically that one year we did 60 different risk assessment workshops. My role was to help executives tell their bosses about the risks they faced and how they were mitigating those risks. We helped them make judgments about the

adequacy of the mitigating actions proposed and taken.12

Fraser was also head of internal audit. He maintained a strict distinction between auditing and risk management activities, treating the latter as a “separate product line”: “Risk management staff do not attend internal audit meetings and the information from a risk management meeting is not available to internal audit staff without written authorization from a vice president. I want a complete separation between risk management and internal audit so that people can speak extremely

candidly at the risk management workshops.”13

Phase 2. Reviewing the Corporate Risk Profile

Twice a year, in January and July, Fraser and his team prepared a Corporate Risk Profile report for the executive team. He also presented the report in person to the Audit Committee. The Corporate Risk Profile summarized the principal risks facing the organization. Fraser did a series of interviews with the top 30 to 40 executives and consulted other sources, such as annual business plans and risk workshops. The profile reflected the managerial assessments of previously identified risks and emerging risks that had been identified in workshops, media scans, or other sources since the last

report.14 An extract from the July 2006 Corporate Risk Profile is shown in Figure A. (For a history of the risk profile trends refer to Exhibit 7.)

12 Interview with Rob Quail, May 7, 2008.

13 “Q&A with Hydro One’s Chief Risk Officer.” Compliance Week, January 25, 2005.

14 Aabo et al. (2005), p.69.

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Figure A Corporate Risk Profile, July 2006

Risk Source

Risk Rating

January 2005

Risk Rating

January 2006

Risk Rating

July 2006

Trend from

July 2006

Adequate Electricity Supply High Very High Very High

Performance, Productivity and People

(“Getting the Work Done”) Medium- High Very High Very High

Government Policy Uncertainty High High Very High

Regulatory Uncertainty Very High Very High High

Employee Accidents Very High High High

Capacity of Transmission Network Medium Medium-

High High

Condition of Transmission Network Medium Medium-

High Medium- High

Condition of Distribution Assets High Medium- High Medium

Customer Expectations High Medium- High Medium

Environment Medium Medium Medium

Information Technology Low Medium Medium

Source: Adapted from company document.

Prior to the interviews Fraser sent each manager a two-page list of headline news from the past six months, and the summary of the previous corporate risk profile. (Exhibit 8 presents the media update used for the December 2006 interview series.) Fraser described the risk review meetings as follows:

I take the one-page strategic objectives, the news update and the summary of the previous risk assessments to all interviews, so the context is clearly set. Then I pull out the empty risk profile template and ask what had changed, what is new. The risk assessments could change because of the mitigation steps taken, or because of external changes in the environment. Some people grab the template and start filling it out on the spot. Others will literally shut their eyes, put their feet up on the desk and tell me what is worrying them.15

The ERM process stressed the importance of the half-yearly monitoring and review of risks, because risks did not remain static. In order to make sure that the objectives-impacts matrix remained relevant, senior managers, who had accountability for the particular objectives, reviewed and approved the scales annually. The CFO reviewed the financial scale, the chief regulatory officer reviewed the regulatory scale, and so on.

15 Interview with John Fraser, 7 May 2008

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Phase 3. Risk-based Investment Appraisal and Planning

In the final phase of the ERM process senior management set priorities for the maintenance and building programs based on the risks identified. Hydro One managed a portfolio of fixed assets with lifetimes of 30-70 years. It spent about C$ 1bn per annum on new physical capital. The investment planning department and the risk management team jointly developed a risk-based approach for allocating resources. They evaluated each investment proposal in terms of cost and the severity of the risk that the program aimed to mitigate. They calculated a “bang for the buck” index to show the risk reduction per dollar spent, and ranked the investment programs accordingly. Where the cumulative expenditures reached the level of available resources, they determined the planned work for the year.

Engineers made the initial risk assessments, making use of the tools of risk assessment they received from the investment planning department: the program-specific objective-impact matrix and the probability scale. An additional risk map template assigned an overall risk score to each combination of impact and probability assessment. The investment planning department also acted as an independent mezzanine evaluator, relentlessly challenging and querying the risk and cost assessments, as the engineers prepared the investment proposals for presentation to senior management.

Fraser argued that looking at the investment proposals from a risk management viewpoint gave high visibility and scrutiny to capital expenditure planning, and reassured top management that in a resource-constrained environment Hydro One was making the right investment decisions:

You cannot just make up a “mitigated risk score”. Every year we hold a two-day planning meeting with the senior management team. They review and challenge the investment proposals ranked by the “bang for the buck” index. The engineers have to defend each project proposal in front of senior managers and their peers who challenge them on their mitigated risk score and how much money they plan to spend. This allows management to identify activities that could be stopped, deferred or changed, and to release valuable resources for higher priorities. The process ensures that projects addressing the highest risks have the highest priority.

The Meeting

Laura Formusa closed the headline news update and looked up from her desk as John Fraser entered. After the initial pleasantries Fraser handed over the corporate risk profile template and a brief summary of the risk updates he has collected from interviewing other managers. (See interview summaries in Exhibit 9.)

Formusa quickly leafed through the interview summaries. Then she glanced at the corporate risk profile template in front of her and began:

Let me see what I can add from where I sit. Like most industries, we have not been hiring but down-sizing for many, many years. The work load has now exploded, and more than 20% of our employees will be eligible for retirement in two years’ time. “Getting the work done” is more difficult. I am reaching out to the union that was out on strike to begin a new relationship. I want to enter into a five-year deal with them. It would be unprecedented, but I need the union to work with us to address the challenges we are facing. The demographics are against us. In Canada we do not have enough of a workforce waiting for us. Where is it going

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Enterprise Risk Management at Hydro One (A) 109-001

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to come from? It has to come from tapping new resources, both inside and outside the country.

Safety is our number one objective. I make it part of every management team meeting: whenever we talk about safety, we feel it's our highest risk. It is not enough to make sure we have the tools and the equipment. We have to make people think safety every minute of every day. We also have to deal with the spending controls issue. In order to meet the expectations of the Provincial Auditor General, we must put in place more formalized procedures.

The risks related to the “Capacity of Transmission Network” should be “very high” rather than “high,” as the situation is getting more risky. This year’s record demand for power shows a strong need for more capacity. As for the condition of the transmission network, I think risks are increasing due to some premature equipment failures we have experienced, despite plans in place to upgrade key transmission stations. However, the condition of distribution assets is stable, due to our good storm restoration plans and the monies we have spent on refurbishments.

Going forward, I expect growing Government uncertainty due to the impending election in October 2007, and some continued confusion over the roles of the several government electricity agencies.

Residential customers are still a challenge, we need to improve satisfaction. The media is always a concern because of reputation risk—we have been in the media too much for the wrong reasons.

The environment is getting to be a bigger issue for the industry as a whole. Time-of-use rates might be the next step in the energy conservation agenda: the smart meter going hand in hand with smart pricing. The question is: are people going to modify their behavior? Are they going to do their dishes at 11:00 at night when the rate goes down? Are they going to use less power? The danger is they are going to choose not to. And all of a sudden a person who had a $100 per month bill is going to see $200. When those rates go in, people are going to be screaming dissatisfaction to the government.

Finally, now that we also started to implement SAP, I feel that I.T. risks are increasing, and this should be rated Medium/High rather than

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