Gazifere Fair Return and Capital
Structure
Professor Laurence Booth
CIT Chair in Structured Finance
Rotman School of Management
BOOTH Gazifere 2010
Key Issues before the Regie

Has Gazifere’s business risk increased since
its last hearing in1998?

Is the 75% ROE adjustment to forecast
changes in the long Canada bond yield still
appropriate?

What is a fair and reasonable ROE for
Gazifere and what is a reasonable range for
the estimate?
BOOTH Gazifere 2010
Gazifere’s Business Risk

McShane and Booth agreement that risk has a
short and long run dimension

Short run: return on capital
– McShane: ability to earn a “compensatory return”
– Booth not earning the allowed ROE
– Whether the allowed ROE is fair and reasonable or
“compensatory” is regulatory risk not business risk
– Quantitative assessment

Long run: return of capital
– The ability to recover the investment in rate base
– Viability of the natural gas market in Quebec
– Qualitative assessment
BOOTH Gazifere 2010
Gazifere
ROE Performance
GI-31 Doc 1.1 & GI32 Doc 1.5
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Allowed
BOOTH Gazifere 2010
Actual
Short Run Risk



Gazifere has over earned its ROE by an
average of 0.96% per year since 1998 (GI-31);
No trend in over-earning
“Gazifere has not gone back.... to establish
the drivers for deviations from the allowed
return” (GI-31)
– Clearly Gazifere thinks its short run risk is
not material?


2005 deviation due to bad debt expense form
two large industrial customers (Booth
IR#11)
2007-9 uptick due to performance based
regulation: PBR is not a risk as company
simply earns more than the allowed ROE
BOOTH Gazifere 2010
Gaz Metro Allowed vs Actual ROE
15
14
13
12
11
10
9
8
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Allowed
Incentive
Actual
Gaz Metro has sometimes failed to earn its full PBR
but still over earned its allowed ROE
BOOTH Gazifere 2010
Gazifere Revenue Composition



1999 2003 2006 2009
19,748 22,633 28,438 32,077
2,539 2,562 2,818 2,968
14
14
13
12
Residential
Commercial
Industrial
Gazifere Revenue Composition
GI-3- Doc 1
0.60
0.50
0.40
0.30
0.20
0.10
0.00
1999
2000
2001
2002
2003
RES
BOOTH Gazifere 2010
2004
COMM
2005
IND
2006
2007
2008
2009
Natural Gas Competitiveness

Development of natural gas from shale has
created a disconnect from the price of oil
– 1999 price advantage was 24% for residential
and a disadvantage of 8% for commercial
– 2009 residential advantage increased to 50%
and commercial 53%

Quebec has abundant electricity
– 1999 price advantage of natural gas was 24%
for residential and 57% for commercial
– 2009 this advantage had dropped to 15-27%
for residential and 33% for commercial
BOOTH Gazifere 2010
Business Risk Summary




Demonstrated ability to earn allowed ROE
Protective regulatory environment where
PBR has increased over-earning
Large increase in customer base as natural
gas has a competitive advantage over both
oil and electricity for residential and
commercial consumers
Drop off in industrial customers,
particularly interruptible reduces forecast
risk and possibility of bad debt losses
similar to 2005
Overall no sign of any increase in business
risk, more likely a reduction
BOOTH Gazifere 2010
Regie Gaz Metro Decision
BOOTH Gazifere 2010
Financial



US emerging from a brutal recession, Canada from
a mild recession
Cause was the failure of the US financial system
that spread contagion around the world
Catalyst: Failure of Lehman Brothers September 14,
2008
– Domino effect around the world as banks focused on
survival




Hoarded cash
Reduced lending
Sold off securities to bolster capital
Reduced principal trading in debt markets: reduced
liquidity in secondary markets
BOOTH Gazifere 2010
Stock Market Collapse
Index or Exchange
United States Composite
(US Dollar)
Japan Composite (US
Dollar)
United Kingdom
Composite (US Dollar)
Canada Composite (US
Dollar)
Germany Composite (US
Dollar)
Hong Kong Composite
(US Dollar)
Spain Composite (US
Dollar)
Switzerland Composite
(US Dollar)
Last Trade
Date
213.40
10/24/2008
82.39
10/24/2008
149.79
10/24/2008
278.25
10/24/2008
218.89
10/24/2008
186.44
10/24/2008
388.93
10/24/2008
374.65
10/24/2008
1Day
Change
-7.52
1 Day
%
-3.40%
1 Month
%
-27.53%
6 Month
%
-37.17%
YTD %
-2.74
-3.21%
-22.00%
-32.07%
-35.54%
-11.63
-7.21%
-35.44%
-48.66%
-52.51%
3,441
-4.74
-1.67%
-40.46%
-48.15%
-49.61%
1,636
-14.62
-6.26%
-39.40%
-51.88%
-56.28%
1,426
-10.10
-5.14%
-31.80%
-51.39%
-57.97%
1,361
-26.01
-6.27%
-34.22%
-50.24%
-51.93%
1,146
-10.44
-2.71%
-22.21%
-32.06%
-34.35%
1,111
-40.46%
2006 $b
Value
18,039
4,422
Real Economy can not flourish if the financial system is
broken:
1)
Credit crunch
2)
Real economy stops spending
3)
Sharp recession started 2008Q4 in Canada
BOOTH Gazifere 2010
BOOTH Gazifere 2010
CP
BA
Money market now back to normal in Canada
3/4/2010
1/4/2010
11/4/2009
9/4/2009
7/4/2009
5/4/2009
3/4/2009
1/4/2009
11/4/2008
9/4/2008
7/4/2008
5/4/2008
3/4/2008
1/4/2008
11/4/2007
9/4/2007
7/4/2007
5/4/2007
3/4/2007
1/4/2007
11/4/2006
9/4/2006
7/4/2006
5/4/2006
3/4/2006
1/4/2006
Short Term Credit Spreads
Money Market Spreads
(CansimV121812,V121778,V121796)
300
250
200
150
100
50
0
Overnight Rate
(cansim V39079)
10
9
8
7
6
5
4
3
2
1
12/1/2009
12/1/2008
12/1/2007
12/1/2006
12/1/2005
12/1/2004
12/1/2003
12/1/2002
12/1/2001
12/1/2000
12/1/1999
12/1/1998
12/1/1997
12/1/1996
12/1/1995
12/1/1994
12/1/1993
12/1/1992
0
Bank of Canada has increased the overnight rate twice since
May to remove some of the stimulus as economy has regained
most of the jobs lost during the recession
BOOTH Gazifere 2010
Yields since January 2008
9
Gaz Metro hearing August 2009
8
7
6
5
4
BBB
A
AA
8/1/2010
7/1/2010
6/1/2010
5/1/2010
4/1/2010
3/1/2010
2/1/2010
1/1/2010
12/1/2009
11/1/2009
9/1/2009
10/1/2009
8/1/2009
7/1/2009
6/1/2009
5/1/2009
4/1/2009
3/1/2009
2/1/2009
1/1/2009
12/1/2008
11/1/2008
10/1/2008
9/1/2008
8/1/2008
7/1/2008
6/1/2008
5/1/2008
4/1/2008
3/1/2008
2/1/2008
3
Canada
LTC Yields fell, Corporate debt yields increased but now back to precrisis levels
McShane recommends a 50% adjustment to Corporate bond yields,
This means about the same allowed ROE as start of 2008
Recently both Corporates and Canada yields have fallen unlike in the
financial crisis
BOOTH Gazifere 2010
Default Spreads Since Dec 1979
500
450
400
350
300
250
200
150
100
50
AA
A
BBB
Spreads still high relative to where we are in the recovery,
perhaps 0.50% too high or long Canada’s 0.50% too low
BOOTH Gazifere 2010
12/31/2009
12/31/2007
12/31/2005
12/31/2003
12/31/2001
12/31/1999
12/31/1997
12/31/1995
12/31/1993
12/31/1991
12/31/1989
12/31/1987
12/31/1985
12/31/1983
12/31/1981
12/31/1979
0
Conclusion


LTC Yields remain the only long term
opportunity cost or fair rate of return in the
capital market
LTC yields expected to increase to 4.5% for
2011,
– 3.93% at time of testimony
– 3.53% currently
– More risk of lower LTC yields than higher for
2011


Corporate yields have followed long Canada
yields down the last five months, AA spreads
constant, A spreads minor pick up.
Market is still “jittery”
BOOTH Gazifere 2010
Risk Premium Models

Explicit Risk premium model
– CAPM
– Primary reliance by NEB (RH-1-2008)
– Primary reliance by Regie
K  R F  MRP * 
Time Value of
Money
BOOTH Gazifere 2010
Market Risk
Premium * “beta”
BOOTH Gazifere 2010
Annual Rate of Return Estimates 1926-2009
U.S.
CANADA
S&P
Long US
Excess
Equities
Treasury
Return
AM
11.80
5.77
6.03
GM
9.77
5.40
OLS
11.09
5.11
Volatility1
20.48
9.15
TSE Equities
Long
Excess
Canadas
Return
11.39
6.43
4.96
4.37
9.69
6.08
3.61
5.98
10.42
5.80
4.62
18.96
8.87
Arithmetic is simple average; geometric is compound and OLS is the least squares estimate.
Approximately Geometric Mean = Arithmetic Mean - .5*variance
For example, US variance is about 4%, so AM and GM diverge by about 2%
BOOTH Gazifere 2010
Fernandez Survey May 2009
1) MRP higher in Canada than US
2) Median Canadian MRP is 5.1%
BOOTH Gazifere 2010
If the Regie randomly asked a Canadian finance professor what
the MRP is, the answer would almost certainly be 5.0% or 6.0%
BOOTH Gazifere 2010
BOOTH Gazifere 2010
-0.100
BOOTH Gazifere 2010
Utility beta
Utility (No TAU)
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Relative Risk (BETA)
Average Utility Betas
0.600
0.500
0.400
0.300
0.200
0.100
0.000
Stock Performance over Last
Year: Emera
BOOTH Gazifere 2010
Stock Performance over Last
Year: Fortis
BOOTH Gazifere 2010
Stock Performance over Last
Year: GMLP
BOOTH Gazifere 2010
Fair ROE

LTC Yield:
Market Risk Premium:
Beta:
Issue costs:

Recommended Benchmark ROE: 7.75%

Financial Crisis adjustment:
Gazifere addition:
Recommended ROE:






4.50%
5.0-6.0%
0.45-0.55
0.50%
0.50%
0.25%
8.50%
Since June LTC Yields have dropped but
spreads have widened
BOOTH Gazifere 2010
2009 Reviews
AUC November 2009
OEB (August 2009)
BOOTH Gazifere 2010
Analyst Views
Matt Aikman McQuarrie May 2008 to CAMPUT
BOOTH Gazifere 2010
ROE Formula Reviews






OEB 2003 (2004 Decision)
AUC (AEUB) 2003 for 2004
BCUC 2007 changes (100% adjustment to
Canada yields changed to 75%)
NEB 2001 confirmation in TCPL Mainline
declined to hear ROE evidence in 2004
Regie 2007 Gaz Metro decision
Ms. McShane recommended a 75% ROE
adjustment to long Canada yield changes as
late as 2007 in an Ontario Power Generation
hearing
BOOTH Gazifere 2010
New ROE formula proposals

McShane
– assume NEB correct in 1994
– adjusts for 50% of long term Canada (LTC) and
“spread” in A bond yield changes
– collapses to change by 50% of the change in A
bond yields
ROE  12 . 25 %  0 . 50 * ( LTC  9 . 25 %)  0 . 50 * ( Spread  0 . 71 %)

Booth
– assume NEB correct in 2000
– adjusts for 75% of change in LTC yields
– adjusts for 50% of the change in A spreads
ROE  9 . 90  . 75 * ( LTC  6 . 12 %)  0 . 50 * ( Spread  0 . 94 %)
BOOTH Gazifere 2010
ROE Adjustment Formula
ROE Formula
13
12.5
12
11.5
11
10.5
10
9.5
9
8.5
8
1995
1996
1997
1998
1999
2000
NEB
2001
2002
McShane
2003
2004
Booth1
2005
2006
2007
2008
2009
Booth2
McShane assumes NEB got it right for 199f and wrong
from thereafter
Booth 1 &2 assumes NEB got it right in 2001 or 2004 and
uses spread change to capture the “crisis” premium
BOOTH Gazifere 2010
2010
Gazifere

Assume Regie got it right in 1998
– adjust by 75% of LTC change
– adjust by 50% of spread change
ROE  10 . 0 %  0 . 75 * ( LTC  5 . 70 %)  0 . 50 * ( spread  0 . 99 %)

For 2011
– LTC is 4.50%
– Utility spread 1.30%




LTC causes 0.75*1.2% or -0.90%
Spread causes 0.50* 0.30 or +0.15
Overall 9.25%
Update
– LTC forecast yields lower (-0.15%)
– spreads wider
(+0.10%)
BOOTH Gazifere 2010
US Data

Moody’s
–
–
–
–
25% regulation
25% ability to earn the allowed ROE
10% diversification
40% financials: the numbers
“Moody’s views the regulatory risk of US utilities as being higher in most cases than that of utilities located in some other developed
countries, including Japan, Australia and Canada. The difference in risk reflects our view that individual state regulation is less predictable
than national regulation; a highly fragmented market in the US results in stronger competition in wholesale power markets; US fuel and
power markets are more volatile; there is a low likelihood of extraordinary political action to support a failing company in the US; holding
company structures limit regulatory oversight; and overlapping and unclear regulatory jurisdictions characterize the US market. As a result
no US utilities, except for transmission companies subject to federal regulation, score higher than a single A in this factor.”
“as is characteristic of the US, the ability to recover costs and earn returns
is less certain and subject to public and sometimes political scrutiny.”
BOOTH Gazifere 2010
US Utility Bond Ratings
Description is of business risk rating for each rating class
BOOTH Gazifere 2010
Newfoundland Power Decision
BOOTH Gazifere 2010
BCUC Decision
BOOTH Gazifere 2010
Ms McShane’s Use of Analyst
Growth Forecasts
BOOTH Gazifere 2010
Optimism Bias



Analyst are over optimistic and gradually
zero in on the right numbers as they get
guidance from companies
Academic research that analysts are biased
McKinsey (consultants)
– S&P500earnings growth has been 100% too
optimistic: 10-12% vs 6%

Ms McShane’s US sample
–
–
–
–
Historic & forecast GDP growth
Historic dividend growth:
Historic earnings growth:
Forecast analyst growth:
BOOTH Gazifere 2010
5.0%
2.5%
4.0%
5.9%
Ms McShane’s Risk Assessment
for Gazifere



She assumes Gazifere
would be a BBB utility
and estiamtes the risk
premium for US BBB’s
relative to her low risk
US utilities
US utilities are large
risky utilities
Gazifere is a small low
risk utility
BOOTH Gazifere 2010
Fair ROE

LTC Yield:
Market Risk Premium:
Beta:
Issue costs:

Recommended Benchmark ROE: 7.75%

Financial Crisis adjustment:
Gazifere addition:
Recommended ROE:
Suggested New ROE Formula:







4.50%
5.0-6.0%
0.45-0.55
0.50%
0.50%
0.25%
8.50%
9.25%
Since June LTC Yields have dropped but
spreads have widened
BOOTH Gazifere 2010