EVIDENCE OF
Laurence D. Booth
BEFORE THE
Regie de L’Energie du Quebec
R-3662-2008
June 2008

Q. PLEASE DESCRIBE YOUR NAMES, QUALIFICATIONS AND EXPERIENCE.
A.
Laurence Booth is a professor of finance and finance area co-ordinator in the
Rotman School of Management at the University of Toronto, where he holds the CIT
Chair in Structured Finance. A detailed resume is filed as Appendix A to this testimony.
Dr. Booth filed testimony before the Regie last year in Gaz Metro`s last general rates application (GRA). He has also filed testimony before the Regie on several other occasions as well as before most of the public utilities across Canada. Further information and copies of working papers by Dr. Booth can be can be downloaded from his web site at the University of Toronto at http://www.rotman.utoronto.ca/~booth.
Q. WHAT ARE THE ISSUES INVOLVED IN THIS APPLICATION?
A.
Gaz Metro is defining the difference between the long Canada bond yield and that on its own long term bonds to be a credit spread. At the time of last years GRA this spread was (August, 3, 2007) 105 basis points comprised of a long Canada bond yield of
4.40% and a yield on Gaz Metro`s bonds of 5.45%. However, Gaz Metro indicates that the spread has (March 28, 2008) increased to 178 basis points comprised of a long
Canada bond yield of 3.95% and a Gaz Metro bond yield of 5.73%. Gaz Metro feels that because its ROE is linked to the long Canada bond yield, its allowed ROE will fall even though the bond markets are indicating, through the credit spread, that its bonds are more risky. As a result Gaz Metro is asking the Regie to suspend the application of its formula ROE and grant it the same 9.05% ROE as last year. Additionally Gaz Metro is asking the Regie to change its 0.30% issue cost, or financial flexibility, adjustment and increase it to 0.50% in line with my use last year. These two adjustments would then allow Gaz Metro a 9.25% ROE, significantly higher than would result from the application of the Regie’s ROE formula.
2

Q. WHAT IS THE PURPOSE OF YOUR TESTIMONY?
A. The Industrial Gas Users Association (IGUA) has asked me to provide an independent assessment of the evidence presented by Gaz Metro and specifically to answer two questions:
1) Is Gaz Metro correct in stating that the recent increase in credit spreads justifies an increase in Gaz Metro’s allowed ROE over what the Regie’s formula would allow?
2) Is it appropriate to increase the financial flexibility or issue cost allowance from the 0.30% allowed by the Regie to 0.50% as I recommended last year.
To answer these questions in Section 2 I will first briefly discuss the major financial events since last August and then how credit spreads fit in. In Section 2, I will then discuss issue costs and fair ROEs.
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Q. WHAT ARE THE MOST IMPORTANT RECENT FINANCIAL AND
ECONOMIC EVENTS?
A. Gaz Metro is correct in that last year’s GRA was heard just before some dramatic events unfolded in the US and Canadian capital markets. At the time of last year’s GRA the Bank of Canada had recently increased its target overnight rate to 4.50%, since the major fear was that the Canadian economy was over-heating. This tighter monetary policy continued throughout 2007 into the start of December 2007 when the target overnight rate was cut from 4.5% to 4.25%. The reason for the change in monetary policy was the financial problems stemming from the sub-prime crisis in the United
States and its spill-over into Canada. The crisis actually started in the US at the end of
2006 as US house prices peaked and started to fall, but it wasn’t until July 2007 with the failure of two hedge funds managed by Bear Sterns that investors realised that it was spreading beyond the mortgage markets. The reason for this is that faced with declining house prices, purchasers were increasingly drawn into mortgages by some or all of the following:
•
•
•
Teaser low interest rates for short periods of time;
No down payment;
No verification of income
The fact that often the mortgage originator did not keep the mortgage, but sold it off to others, primarily hedge funds and asset backed commercial paper issuers, meant that the normal checks in the lending process broke down and the quality of these “subprime” mortgages was far worse than anticipated.
The crisis broke in August 2007 when funds that had issued commercial paper to invest in mortgage related assets could not roll over the commercial paper as investors bolted from anything associated with sub-prime US mortgage debt. In Canada this lead to the
Montreal Accord as about $32 billion in asset backed commercial paper was essentially frozen and turned into long term notes. However, in the US the real damage became
4

apparent as Citigroup and Merril Lynch wrote off tens of billions of losses and sought emergency equity infusions from offshore sovereign wealth funds, and the Fed had to put together a “rescue package” on March 16, 2008 to get JP Morgan to buy Bear Sterns for $2 a share, when Bear was selling for $155 the previous summer.
1
The result in the US has been fear of any sort of credit risk and a rush to quality as lenders have belatedly increased credit standards. Further home owners are believed to be using credit cards and other forms of debt to stay in their houses and lenders are bracing for a rash of delinquencies on home equity loans and credit card loans as well as on mortgages. In response the Federal Reserve has dramatically cut interest rates, bailed out Bear Sterns and made repurchase agreements more widely available in the financial system in an attempt to stop the credit crisis from tipping the US into a full blown recession.
These US problems have percolated into Canada directly through losses at CIBC and the National Bank on asset backed commercial paper and indirectly through heightened credit standards and the fear of a US recession. The following graph indicates the impact the credit squeeze has had on lenders. It graphs the spread between the 91 day
Treasury bill yield and that on 90 day commercial paper. Only the very safest of issuers can borrow on the basis of a promise to repay in 90 days, so normally the spreads over
Government of Canada treasury bills is a tiny 0.1-0.2% on an annual basis. On August
15, 2007 this promptly jumped to 0.57% and then the next day to over 1.0% and has been at historically high levels ever since.
1 At least $300 billion in sub prime mortgages have been written off so far and estimates of actual losses now go as high as $500 billion, prompting some to believe that the crisis has far from passed.
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Commercial Paper Spread
2
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
Whether the US is in a recession at the moment will not be known for some time, but the leading indicators in both the US and Canada have both turned down and it will take some time for the monetary stimulus to work through the economy. As a result the current outlook is for sub-par economic growth, probably marginally below 2.0% through 2008, with a pickup back to trend for 2009 as more normal markets reassert themselves. Without question last year’s GRA for Gaz Metro was at the top of the business cycle and we are now in a downswing as the next cycle starts.
Leading Indicators: US and Canada
2.00
1.50
1.00
0.50
0.00
n-
00
Ja
-0.50
Ma y-
00
Se p-
00
Ja n-
01
Ma y-
01
Se p-
01
Ja n-
02
Ma y-
02
S ep-
02
Ja n-
03
Ma y-
03
Se p-
03
Ja n-0
4
Ma y-
04
Se p-0
4
Ja n-0
5
Ma y-
05
Se p-
05
Ja n-
06
Ma y-
06
Se p-
06
Ja n-
07
Ma y-
07
Se p-
07
Ja n-
08
-1.00
Canada % US %
However, of major importance is that the “storm” seems to have passed in the financial markets or at least stabilized. The trend in commercial paper spreads is definitely
6

downward, punctuated with some significant reversals as panicky investors react to more write-offs among predominantly US financial institutions.
Q. WHAT HAS HAPPENED TO INTEREST RATES?
A.
Schedule 1 provides data on the full range of interest rates across the broad maturity spectrum as of June 12, 2008 and at the time of my testimony last year. Last year I indicated that Canada was “late” in the business cycle and that interest rates were essentially flat across the whole maturity spectrum. In contrast, currently interest rates for long maturity instruments are now much higher than they are at the short end of the maturity spectrum; this is referred to as a ‘normal’ or positively sloped yield curve. The change in the shape of the yield curve from last year to this reflects the change in the stage in the business cycle.
The following figure charts the history of short and long term interest rates together with inflation since 1961.
Interest Rates and Inflation
20.00
18.00
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
"1
96
1"
"19
65
"
"1
96
9"
"19
73
"
"19
77
"
"19
81
"
"19
85
"
"1
98
9"
"19
93
"
"1
99
7"
"2
00
1"
"2
00
5"
T.Bills
Ca nada s CP I
It is clear that short term Treasury bill yields have continued their long decline from their peaks in 1981 as inflation has receded. This long run decline has been punctuated by periods when Treasury bill yields have increased to support the dollar (1996) or fight
7

a too vigorous economy (late 1980’s, late 1990’s, and mid 2000’s). In each of these latter cases when the yield curve inverted or became very flat, a slow down in the economy followed as higher short term interest rates slowed down consumer demand. In contrast, long-term rates have continued their gradual year over year decline without these peaks. This is because long-term bond investors look not just at the next 91 days, but far off into the future. As such, long-term bond yields reflect the longterm future of the Canadian economy, while T-Bill yields reflect shortterm expectations.
The message is simply that the current shape of the yield curve reflects the change in monetary policy from fighting inflation (last year) to stimulating the economy to head off a slow down or recession this year. In dropping its target overnight rate from 4.5% at the start of December 2007 to the current 3.5%, the Bank of Canada has brought down the whole short end of the yield curve to stimulate the economy and prevent it from following the US lead into recession. In this I think it will be successful, much as it was in 2001/2. However, of importance is that while short term interest rates have dropped by over 150 basis points long term rates have only dropped by 30-40 basis points.
Given the current state of the economy I would judge there to be room for some more minor interest rate cuts in Canada with larger cuts possible in the US, where I think there are still serious problems. I don’t expect much movement in the 91 day Treasury bill yield for the next six months, but after then I expect it to trend back to the 3% -
3.50% level. However, the over ten year bond yield is not so affected by current short term rates or current monetary policy and I expect it to increase gradually. As a result, I am currently using a forecast long Canada rate of 4.75% for my fair ROE estimates compared with the 5.0% I was using last year.
The message is that I would expect the decline in forecast interest rates affecting Gaz
Metro’s ROE to be moderate compared to the actual drops at the time they prepared
8

their testimony. Further, the decline is well within the limits normally used by witnesses for the ROE formula to operate before it is reviewed.
2
Q. HOW DOES THIS RELATE TO GAZ METRO’S ANALYSIS?
A.
Gaz Metro believes that the current decline in interest rates should not be used to lower its allowed ROE through the Regie’s formula adjustment. However, it is quite clear that the change in interest rates from last year is perfectly normal: it happens every time the economy and financial system works through the business cycle. Last year we were at the top of the cycle and the yield curve was flat, this year we are starting a new cycle and are in a slow down with a normal yield curve. Since the National Energy
Board started using its ROE formula in 1994 we have been through this process at least once, if not twice, before and the NEB has not changed its formula and repeatedly found the results to be fair and reasonable. Further, the Regie’s formula ROE as well as that of the Ontario Energy Board both went through the period 2001-3 when yield spreads were similarly large without any adjustment. Consequently, I see nothing unusual in what has happened over the last year that might cause the ROE formula to become unfair or unreasonable.
Q. CAN YOU DISCUSS THE CREDIT SPREAD?
A.
Yes, this is the other side of the behaviour of the yield curve. In the following graph is the spread on BBB bonds relative to the aggregate ROE of Corporate Canada as calculated by Statistics Canada.
2 In its decision D-99-11 approving Gaz Metro’s current ROE adjustment mechanism, the Régie ruled that the mechanism should be reviewed should long-term Canada bonds yields increase above a rate of 8% over a period of 6 consecutive months. Similarly, in a current Ontario Power
Generation hearing, the financial witness on behalf of OPG, Ms. McShane uses a 3-8% band for the forecast long Canada bond yield within which the ROE formula adjustment should operate.
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Corporate ROE and BBB Spread
400
350
300
250
200
150
100
50
BBB Spread
0
19
80
19
82
198
4
19
86
19
88
199
0
ROE
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
8.00
6.00
4.00
2.00
0.00
16.00
14.00
12.00
10.00
What is absolutely clear is that as aggregate profitability declines, spreads on the lowest investment grade bonds (BBB) increase as fears of default increase and liquidity dries up. The most obvious example is in the severe recession of the early 1990s as Canada adjusted to free trade with the US. At that time the aggregate ROE was barely 2.0% while BBB spreads averaged 350 basis points. As profitability recovered spreads fell, until the slowdown of the early 2000’s when they again increased. Finally, we can see the very good economy of the last few years and the very low spreads that resulted.
It is an entirely predictable pattern that at the top of the business cycle we see thinner spreads of corporate bond yields over long Canadas, just as the Bank of Canada starts pushing up short term interest rates to slow down the economy. Then as the slowdown bites, the yield curve reverts to normal and the spread between corporate and government bond yields widens until the recovery is clearly underway.
This process can perhaps be seen more clearly in the following graph of yield spreads, where the spread data is on a finer frequency: monthly and then weekly.
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A and BBB Spreads
500
450
400
350
300
250
200
150
100
50
0
A BBB
From this we can see that BBB spreads over Canadas were actually much higher during the recession of the early 1990s and peaked at over 450 basis points. Similarly in the slowdown of the early 2,000’s BBB spreads were over 300 basis points and this cycle they seem to have peaked at 296 basis points in April, as since then they have retreated by about 25 basis points. It seems that the bond market, like the paper market, is predicting that the worst of this cycle is already over.
It is clear that the yield spread between long and short term government bonds and government and corporate bonds are important signals indicating the stage of the business cycle. I have used this data in the past and expect to do so in the future however it has little to do with changes in the risk of a company or the fair return on equity.
Q. WHAT DO SPREADS HAVE TO SAY ABOUT BUSINESS RISK
A. First, is has to be understood that what Gaz Metro calls a credit spread is also simply called a yield spread, since it involves more than the evaluation of credit. The yield spread (R-r) between Corporate and Canada bonds can be decomposed as follows:
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where
1) The first term is the compensation for expected rescheduling or default, which is the probability ( π ) times the promised (1+R) minus actual proceeds ( β ).
2) The second term ( γ ) reflects the higher transactions costs and lower liquidity of Corporate versus Canada bonds;
3) The last term reflects a risk premium should one exist, which is the amount at risk times the market price of risk ( φ -1 ).
Gaz Metro refers to an Elton et al (2001) study which also refers to a tax premium. This exists in the US due to the different tax status between state municipal bonds and US
Treasuries arising out of the US constitution.
3 However, they fail to point out that there is also a liquidity premium, which Elton et al did not analyse since it was not the subject of their research.
4
Yield spreads then increase as the probability of a bad event increases and there is more loss when it does. This is the first term and indicates that there is a positive spread even if there is no risk premium. Similarly, there is a positive spread even if there is no risk at all, if corporate bonds are less liquid and therefore more difficult to trade out of should you so wish. Finally, there is a risk premium if the bonds have systematic risk so that the losses are related to market movements.
Proving the existence of a risk premium in corporate bonds has proven incredibly difficult. The academic finance profession is divided on whether a risk premium should exist, since losses on corporate bonds generally occur in strong markets as interest rates increase whereas equities perform well and vice versa. This interest rate effect means that bonds have significant systematic risk when the equity markets are driven by
3 Elton et al mention a liquidity premium in footnote 248, but this was not the subject of their
4 research.
Gaz Metros answer to IR 5.5 indicates that Elton et al refer to liquidity effects in footnote 248
12

interest rate factors. For example, in Appendix F Schedule 5 of my testimony last year I showed the following graph of government bond betas.
Bond Betas
0.8
0.6
0.4
0.2
-0.2
-0.4
0
US Canada
In the 1980’s-1990s Government of Canada and US Treasury bonds had significant systematic risk. This was because capital markets were dominated by the twin problems of government debt and deficits. However, as these problems receded and inflation came down the general equity markets have not had as much exposure to interest rates and the systematic risk of government bonds has all but disappeared. Consequently, I have consistently stated that there were significant risk premiums in government bonds until the start of this decade, but they are now minimal.
Corporate bonds then have this general interest rate exposure plus default risk exposure. I believe that corporate bonds had equivalent, if not more, beta risk than government bonds in the 1980-1990’s, but doubt that they have significant risk premiums now. The main problem is that estimating the risk premium, that is, the third term in the previous equation, is closely related to the first. As a result in practice it is extremely difficult to separate the two.
13

Further Gaz Metro ignores the significant problems that liquidity differences introduce.
Liquidity is the ability to realise value in money and captures the ability and cost of trading. Liquidity or transactions costs are time varying and extremely difficult to estimate in a time series. However, the effects can be very large.
Amihud and Mendelson 5 in a study of the US government securities markets noted that the bid-ask spread, that is the buy and sell prices, for a US$1 million transaction in US
Treasury Bills was 1/128th of a point plus a brokerage fee of $12.5–25 per million. In contrast, a similar-sized transaction in Treasury Notes had a 1/32 spread plus a brokerage fee of $78.125 per million. The discounted value of these future differential transactions cost is then impounded in market prices to cause liquidity or transactions cost spreads between different US government securities, where there is no default or rescheduling risk at all.
These differential liquidity spreads between different US government bonds also exist in Canada, where the Bank of Canada has taken great efforts to preserve the liquidity of
“on the run” or benchmark bonds in the face of declining levels of outstanding
Government of Canada debt, since they are important indicators for the whole economy. These efforts consist of buying up illiquid non-benchmark bonds and issuing more benchmark bonds, otherwise their liquidity would fall. The following table illustrates the turnover or liquidity of different classes of Canadian bonds
5 Y Amihud and H. Mendelson, 1991, Liquidity, maturity and the yields on government securities, Journal of Finance 46, 1411-25.
14

Notably about 25% of government bonds turn over versus 2.3% of provincial bonds and only 1.6% of corporate bonds. The fact is that corporate bonds are highly illiquid so that a significant part of the yield spread may represent a liquidity premium. This is because every class of bonds issued by a firm is unique with different covenant provisions etc, and there are so many different companies issuing debt. In contrast, usually there are only one or two classes of common shares outstanding for an individual firm. As a result $50 million of outstanding equity is usually much more liquid than $50 million of corporate debt.
Q. WHY IS THIS IMPORTANT AT THE MOMENT?
A.
Because since the credit crunch began last August we have been in the middle of a liquidity crisis. In August $32 billion of asset backed commercial paper in Canada was frozen and could not be traded. These short terms notes have subsequently had to be restructured as long term notes, since the market disappeared as there was no liquidity.
Notably as shown earlier the spread between commercial paper and treasury bills has dramatically increased and yet there has been no increase in risk to these premier
Canadian companies. Similarly central banks around the world have resorted to unprecedented measures to maintain liquidity. The US Federal Reserve, for example, has extended repurchase agreements to non-bank financial institutions. This allows them to swap illiquid securities for US treasury securities that can then be sold to
15

ensure that they do not get caught in a liquidity squeeze, similar to that which brought down Bear Sterns.
In my judgment as well as being a normal cyclical flight to quality that always occurs at this stage of the business cycle, we currently have a liquidity crisis overlaid on top. This is because this cycle the problems have emanated from the financial system (sub-prime) and not the real economy. Further these effects do not work equally between the equity and bond markets. The bond markets are overwhelmingly an institutional market dominated by life insurance companies and pension funds, which both have a natural demand for long lived fixed income investments. In contrast, the equity markets still have a very large retail component as well as a broader array of institutions. This preferred habitat model of the bond market means that equity and bond markets often react differently to the same economic factors.
Q. IS IT THE LONG TERM BOND RATE THAT IS IMPORTANT FOR GAZ
METRO?
A.
The company doesn’t think so. On Page 24 of its Annual Report Gaz Metro has the following discussion:
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What Gaz Metro thinks is relevant is the five year Canada bond yield and not the long term bond yield. This is because Gas Metro LP pays out such a large fraction of its distributable cash as a dividend that it has limited growth prospects and a relatively low duration for a utility. What is clear from this data is that Gaz Metro’s investors are looking for a yield of 1.67-3.34% over the five year Canada yield, which at the moment is about 3.50%. This would put the fair ROE for Gaz Metro as significantly lower than my fair ROE recommendation last year of 8.0% and much lower than the allowed ROE of 9.05%. However, the important point is that the long term default spread is not the valid spread for Gaz Metro it should be the mid term spread, which is generally slightly smaller.
Q. WHAT ARE YOUR CONCLUSIONS ABOUT THE RELEVANCE OF THE
YIELD SPREAD?
A.
It is my judgement that:
1) Interest rates on government and corporate debt are behaving exactly as one would expect at this stage of the business cycle, that is:
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a.
The yield curve has reverted to normal b.
Yield spreads on corporate debt have widened;
2) This behaviour has happened at least once if not twice while ROE adjustment formula have been at work and at no time have they caused any adjustments to the formula;
3) There is no objective evidence that there has been a significant increase in the risk premium, should one exist, in corporate bond yields;
4) Even if corporate bond yields do have an increased risk premium, there is no evidence that: a.
equity markets have reacted in a similar way or b.
the correct reference point for Gaz Metro is the long term rather than the mid term spread.
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Q. WHAT ARE ISSUE COSTS
A. In last year’s GRA I recommended a 0.50% financial flexibility allowance on top of my direct estimate of the investor’s required or fair rate of return. Such an allowance is technically needed to convert a return on the market value of a firm’s securities to an
ROE on the book value of stockholder’s equity. For example suppose we have a simple perpetuity and a utility has a book value of $100 and an equity cost and fair ROE of
10%, then its market value would also be $100. That is,
V
=
ROE * RATE BASE
Equity cos t
=
0 .
10 * 100
0 .
1
=
$ 100
In a frictionless market where the firm is always expected to earn the investor’s required rate of return or equity cost, its stock price would always trade at book value.
This is why a market to book ratio of 1.0 for a rate of return regulated utility quite generally indicates fair regulation.
However, if the firm then raises $100 in new equity and incurs 10% flotation or issue costs, then it would only add $90 to rate base and it would then have $190 in rate base earning 10%. The result is that its market value would fall to
V
=
0 .
10 * 190
0 .
1
=
$ 190
Given that the firm value was $100 and it then raised a further $100 from investors, its market value has fallen by $10 million due to the non-recovery of these issue costs.
There are two approaches to solve this problem. The first and most obvious is to allow the firm to recover the $10 in issue costs directly in its revenue requirement. However, this creates inter generational equity problems, in that the equity funds are used to provide service for many years in the future and are not a charge for current service. As
19

a result, normally utilities are not allowed to recover issue costs directly in the revenue requirement. The alternative is to “gross up” the investors’ fair return and apply a larger ROE to the rate base to ensure that the share price stays at the level that the shareholder contributed to the firm before the subtraction of issue costs.
In our example we have a simple problem, we have to solve the following:
Netfunds * ROE
=
Value * K where K is the investor’s required rate of return. This simply says that the net funds raised, and allowed in the rate base, has to earn an ROE that delivers the same value that investors have placed on the firm in terms of the funds invested. Solving for ROE gives
ROE
=
Value
Netfunds
* K
=
( 1
K
−
F )
Where F is the flotation cost allowance, which in our example is 10%, or alternatively net funds raised are 90% of the value invested in the firm. In this way the 10% investor opportunity cost is grossed up by dividing by one minus the flotation cost allowance to get 11.11%. In this example the fair ROE allowed the regulated firm has to be increased by 1.11%.
Several important points flow from this example, to allow a flotation cost/issue cost/financial flexibility allowance:
1) The actual costs can not otherwise be allowed in the rate base or revenue requirement, otherwise there is double counting;
2) Some of the costs are tax deductible so an adjustment has to be made to put them on an after-tax basis;
3) Since the costs are applied to the total shareholder’s equity, the flotation cost needs to be downward adjusted to account for equity that has been raised without such costs, such as retained earnings, the exercise of executive stock
20

options and equity that has been otherwise raised than by a seasoned equity offering.
4) Since 10% is an extreme upward estimate for these costs after adjustments for
1)-3) have been made; the average stock price should always exceed the book value by a nominal amount, say 5-10%.
For example, if a firm has a 50% dividend payout, with a 5% dividend yield and 5% expected growth, with no equity raised other than by new offerings or retained earnings, with 5% underwriter commissions we would use the following variation as an approximation
ROE
= d
P ( 1
−
F )
+ g
or
ROE
=
0 .
05
0 .
95
+
0 .
5
=
10 .
26 %
So instead of 1.11% the issue cost allowance is only 0.26%. This amount would then be even smaller for Crown Corporations.
Q. WHY DO YOU HAVE PROBLEMS WITH GAZ METRO HAVING 0.50%
ISSUE COSTS WHEN YOU USE THAT NUMBER?
A. As the previous discussion indicates the correct approach requires that you track all the sources of equity and the costs attached to every issue. My late colleague Dr.
Berkowitz and I have been in hearings where the calculations got extremely tedious as we recommended 15-25 basis points and the opposing company witness asked for much more and tried to track all the sources of shareholder’s equity. In the end it got so tedious and of marginal value that a sort of consensus emerged to use 0.50% and then get on with more important issues. What is important is that the overall ROE is fair and reasonable and that the stock is fairly valued, not that particular components of the calculation are individually correct. In this respect I am distressed that Gaz Metro would take my 0.50% flotation cost allowance out of context without mentioning that
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my recommended ROE last year of 8.0% is significantly lower than that actually allowed by the Regie of 9.05%. In my judgment the Regie’s allowed ROE is generous and at the top end of a fair and reasonable ROE range.
Q. HOW DO YOU KNOW THE ALLOWED ROE IS MORE THAN FAIR?
A. For one Gaz Metro continues to over-earn. In answer to IR #1.1 from IGUA Gaz
Metro provided the following allowed versus earned ROE data. Notably in 2007 Gaz
Metro over-earned by 1.17%, including its performance incentive of 0.84%. There is no indication of any inability on the part of Gaz Metro to earn its allowed ROE, and no sign of any increase in risk. This is confirmed by Gaz Metro itself where, in a presentation provided in response to IGUA 2.3, it simply says “2007 fiscal year was a good one for
Gaz Metro,” and pointed specifically to “improvements on the regulatory front” for its distribution assets. I would imagine that the “improvements” referred to are at least in part attributable to the 0.25% additional risk premium awarded by the Regie.
Allowed vs Actual ROE
15
14
10
9
8
7
13
12
11
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
Allowed Actual
Gaz Metro also currently has the highest allowed ROE of any regulated Canadian utility other than Pacific Northern Gas. As I discussed last year PNG is by far the riskiest utility in Canada and has consistently failed to earn its allowed ROE, so PNG is not a reasonable basis for comparison. For 2008 Terasen Gas is allowed 8.62%, Enbridge
Gas Distribution 8.39%, Union Gas 8.54%, Atco Gas 8.75% and TQM, the pipeline that serves Gaz Metro 8.78% Given that these utilities are have less common equity than Gaz
22

Metro and that risk adjustments are usually made through the common equity ratio and not the allowed ROE, it is puzzling that Gaz Metro has the highest ROE by a significant margin. I am therefore not surprised that Gaz Metro would describe 2007 as a “good” year.
Finally, I should point out again that a flotation/issue cost allowance is needed to get the stock price marginally above book value, so that the company nets out book value and there is no dilution to the common shareholders. In answer to IGUA IR 9.3 Gaz
Metro indicated that the price or market to book ratio for GMLP has ranged between 2.1 and 2.7. GMLP assets includes assets other than the regulated gas distribution assets in
Quebec, however, this data indicates that the possibility of “equity” being raised that dilutes the firm is miniscule. As a result, conceptually there is no need for any flotation/issue cost allowance as by implication the ROE is well above the investor’s required rate of return already and no “gross up” is needed.
For all of the reasons above I recommend that the Regie simply decide whether the overall ROE awarded Gaz Metro last year through its formula adjustment mechanism remains fair or not. If it decides that it is no longer fair, I would urge it to reconsider the whole fair ROE not base its decision by looking at one very minor component of the
ROE calculation. By doing so it runs the risk of making iterative changes that cause the resulting ROE to be out of line with a fair and reasonable ROE and what is being awarded other similar utilities across Canada.
23

Schedule 1
Overnight money market rates
Benchmark bonds
Canada 91 day Treasury Bill yield
Canada Six month Treasury Bills
Canada One year Treasury Bills
Canada Long term (30 year)
Canada Real return bonds
Marketable Bond Average yields
Canada 1-3 year
Canada 5-10
Other
US
US
Five year Treasuries
Long term (30 year)
3.63
3.80
4.16
1.66
3.31
3.45
3.71
4.17
3.00
2.75
3.04
3.27
3.28
3.37
3.49
3.26
3.98
Source: Bank of Canada’s web site at http://bankofcanada.ca/en/securities.htm, for June 12-20, 2007 &
Weekly Financial Statistics June 10, 2008. hbdocs - 4493021v1
4.66
4.64
4.55
2.15
4.69
4.68
4.65
4.50
4.25
4.36
4.54
4.74
4.68
4.70
4.66
4.94
4.97
24