August 7, 2007
File no: R-3630-2007
IGUA’S response to Information Request #1 by Gaz-Métro to IGUA
INFORMATION REQUEST #1 FROM G AZ MÉTRO, LIMITED PARTNERSHIP (”GAZ MÉTRO”) TO
IGUA CONCERNING THE EVIDENCE PRODUCED BY DR. L AURENCE D. B OOTH
1) Reference: Schedules 1 – 24 appended to Evidence of Laurence D. Booth
Question:
1.1 Please provide electronic versions (in MS Excel or a comparable electronic
format) of Schedules 1-24 appended to Dr. Booth’s testimony. Include all
underlying data and calculations associated with these schedules with sources
clearly noted and all formulas included.
2) Reference: Tables and charts (or Schedules) in Evidence of Laurence D. Booth on
pages 17, 41, 47, 48 and 49
Question:
2.1 Please provide electronic versions (in MS Excel or a comparable electronic
format) of the tables and schedules appearing on pages 17, 41, 47, 48 and 49 of
Dr. Booth’s testimony. Include all underlying data and calculations associated
with these tables and schedules with sources clearly noted and all formulas
included.
Provided in answer to IR1
3) Reference: Evidence of Laurence D. Booth, page 3, lines 1 – 3
“Using the traditional risk premium tests I would judge that utilities have a relative risk
rating of 45-55% of the overall market. Given that I make risk adjustments through
the common equity ratio I would use a value of 0.50 for Gaz Métro.”
Question:
3.1 Given Dr. Booth’s estimate of a 0.50 beta for Gaz Métro, please provide a list
of all business risk factors that are not mitigated by regulatory protection that
cause Gaz Métro’s returns to covary with the market at large.
It is Dr. Booth’s judgment that it is not business risk factors that are the primary cause of
the 0.50 beta estimate. This estimate is caused primarily by investment factors, such as
changes in interest rates.
4) Reference: Evidence of Laurence D. Booth, page 5, lines 15-16
“This 7.3% dividend yield may be ‘contaminated’ by GMPL’s other businesses, but
most of them are also regulated.”
Questions:
4.1 Would Dr. Booth agree that Vermont Gas Systems is a wholly owned
subsidiary of Gaz Métro’s wholly owned subsidiary Northern New England
Energy Corporation?
4.2 Would Dr. Booth agree that Vermont Gas Systems has a 55% deemed equity
thickness for the 2007 fiscal year?
4.3 Would Dr. Booth agree that Vermont Gas Systems has an allowed ROE of
10.5% for the 2007 fiscal year?
4.4 Would Dr. Booth agree that Gaz Métro owns 38.3% of the Portland Natural
Gas Transmission System (PNGTS) pipeline?
4.5 Would Dr. Booth agree that PNGTS’ rates are currently set using a pre-tax rate
of return of 12.33%?
4.6 Would Dr. Booth agree that Gaz Métro’s allowed pre-tax return (including
incentives) in 2002 – 2006 were as follows:
2002 9.69%
2003 10.34%
2004 10.96%
2005 11.64%
2006 9.33%
2007 9.57%
4.7 Would Dr. Booth agree that Green Mountain Power is a wholly owned
subsidiary of Gaz Métro’s wholly owned subsidiary Northern New England
Energy Corporation?
4.8 Would Dr. Booth agree that Green Mountain Power currently has an allowed
ROE of 10.25%?
4.1-4.8 Dr. Booth has no reason to disagree with the answers to these self asked
questions, but they are not part of his testimony. What is part of his testimony is that
GMLP’s « core business » according to its annual report is the distribution of natural gas
and this business is regulated on a rate of return basis.
5) Reference: Evidence of Laurence D. Booth, page 33, line 10 to page 34, line 23
Questions:
5.1 Dr. Booth does not mention competition risk in his discussion of short, medium
and long term risk. Does Dr. Booth recognize competition as a risk facing
regulated utilities?
5.2 If the answer to a) is yes, please explain how regulation mitigates competition
risk.
5.1 Competition can sometimes impact on a regulated utility but unlike in the US in
Canada it is very rare as generally regulatory boards protect ‘their” utility and award it an
effective geographical monopoly. Of course in the truest sense all companies compete
with all other companies for the consumer dollar; this shows up in electricity versus
natural gas competition in Quebec in certain sectors. However, the only direct
competition that Dr. Booth is aware of is Alliance vs the TransCanada Mainline, and
even here Alliance is currently full, so that there is no significant effective capacity with
which it can compete in the immediate future.
5.2 Not relevant
6) Reference: Evidence of Laurence D. Booth, page 37, line 15-16
“and increased its allowed depreciation rate to keep the stranded asset risk
constant.”
Question:
6.1 Please provide the statement by the NEB (and identify the source of the
statement) that is consistent with this statement in Dr. Booth’s testimony.
In RH-4 2001 the National Energy Board addressed the question of whether changes in
the depreciation rate changed the TCPL Mainline’s business risk, it stated (page 28):
“Depreciation
The Board views the issues of cost of capital and depreciation as being related, but as
addressing different factors. The primary goal of a depreciation rate is to reflect the
assessment of the economic life of an asset. Business risk, which is a key determinant
of cost of capital, addresses the probability that the utility may not be able to recover its
prudently incurred costs over the economic life of the asset, whatever that economic life
may be.
In RH-1-2001, the Board approved a modest increase in the Mainline’s composite
depreciation rate. This increase, however, did not materially change the assessed
economic life of the Mainline and, in the Board’s view, its impact on business risk and
cost of capital is negligible.”
In RH-2-2004 the NEB indicated (as stated by Dr. Carpenter in his answer 9.1a )
“The NEB explains that: (1) depreciation rates should be set to reflect current estimates
of economic life, (2) “the assessment of cost of capital should assume that the depreciation
rates reflect the best assessment of economic life of” the underlying assets, (3) the “potential
that a company’s tolls may not incorporate sufficiently high depreciation rates because
competitive factors would prevent such rates from being charged…if significant, is appropriately
compensated through the cost of capital”, and (4) “resetting depreciation rates to reflect a new
best estimate of economic life does not, by itself, reduce business risk”
.
Clearly depreciation rates are set to reflect the economic life of a pipeline and thus the
risk of stranded assets. If the NEB had not altered the Mainline’s depreciation rate to
reflect this supply risk its business risk would have changed.”
7) Reference: Evidence of Laurence D. Booth, page 37, lines 15-16
“The BCUC marginally changed its ROE formula when it increased Terasen Gas’s
common equity ratio to 35%.”
Questions:
7.1 Please confirm that Dr. Booth recommended a 7.75% ROE for Terasen Gas for
2006 in his written testimony in the BCUC proceeding “In The Matter Of
Terasen Gas Inc. And Terasen Gas (Vancouver Island) Inc. Application To
Determine The Appropriate Return On Equity And Capital Structure And To
Review And Revise The Automatic Adjustment Mechanism.”
7.2 Please confirm that had the BCUC not revised the formula it uses to determine
Terasen’s allowed ROE in that proceeding, Terasen’s allowed ROE would have
been 8.29% for 2006.
7.3 Please confirm that the BCUC did revise the formula it uses to determine
Terasen’s allowed ROE in that proceeding, and as a result Terasen’s allowed
ROE for 2006 increased to 8.80%.
7.4 Please also confirm that the BCUC revised the formula is uses to determine
Terasen Gas Vancouver Island’s allowed ROE to increase its 2006 allowed
ROE from 8.79% to 9.50%.
7.1
Confirmed
7.2
Confirmed
7.3
Confirmed the BCUC switched its adjustment to 75% of forecast long Canada
interest rate changes from 100% to bring it into line with other jurisdictions. Dr.
Booth recommended this change.
7.4
The BCUC has one formula and the TGVI allowed ROE is keyed off this formula.
Dr. Booth did not present evidence on TGVI.
8) Reference: Evidence of Laurence D. Booth, page 24, lines 8-10
“Since business risk is the primary determinant of capital structure, it is to be
expected that a board will change an allowed capital structure relatively infrequently
in response to significant changes in business risk.”
Questions:
8.1 Please confirm that in 2001 Dr. Booth recommended a 30% deemed common
equity ratio for the TransCanada Mainline.
8.2 Please confirm that in Decision RH-4-2001, the NEB approved an increase in
the TransCanada Mainline deemed common equity ratio from 30% to 33%.
8.3 Please confirm that in 2004 Dr. Booth recommended a 33% deemed common
equity ratio for the TransCanada Mainline.
8.4 Please confirm that in Decision RH-2-2004, the NEB approved an increase in
the TransCanada Mainline deemed common equity ratio from 33% to 36%.
8.5 Please confirm that according to Schedule 15 attached to Dr. Booth’s evidence
in this proceeding, the TransCanada Mainline earned its allowed return in all
but one year during 1990 – 2005.
8.1-5 Confirmed. Dr. Booth recommended that the TransCanada Mainline’s capital
structure be maintained. However, the Board felt that the introduction of Alliance, when
combined with increased longer term supply risk, increased the Mainline’s business risk.
The Board did not feel that the short run ability of the Mainline to earn its allowed ROE
had suffered as the data in Schedule 15 confirms.
As the Board stated in RH4-2001 (page 28)
“Overall, the Board concludes that the level of business risk facing the Mainline has
increased since 1994, although it remains low. The increased business risk primarily
reflects an increase in the risk resulting from pipe-on-pipe competition and increased
supply risk. Other sources of risk have not changed materially.”
This change is specific to the Mainline and has no impact on Gaz Metro.
9) Reference: Evidence of Laurence D. Booth, page 24, lines 8-10
“Since business risk is the primary determinant of capital structure, it is to be
expected that a board will change an allowed capital structure relatively infrequently
in response to significant changes in business risk.”
Questions:
9.1 Please confirm that in 2005 Dr. Booth recommended a 33% common equity
ratio for Terasen Gas Inc.
9.2 Please confirm that in Order No. G-14-06, the BCUC approved an increase in
Terasen Gas Inc.’s common equity ration from 33% to 35%.
9.3 Please confirm that according to Schedule 16 attached to Dr. Booth’s evidence
in this proceeding, Terasen earned its allowed return in all but three years
during 1992 – 2004.
9.1-2 Confirmed that Dr. Booth recommended that Terasen Gas’s common equity ratio
should remain at 33% and it was increased to 35%. This was partly due to the lack of
preferred shares. As the BCUC states (Decision March 2, 2006 page 32)
“As indicated in the above table, all the other major gas distribution utilities have
preferred shares in their capital structures. Since 1994 the allowed common equity of
TGI has been 33 percent. In 1999 preferred shares were redeemed that accounted for
9.4 percent of the capital structure. The preferred shares of ATCO Gas, Enbridge, and
Union are perpetual preferred shares. The Commission Panel accepts the evidence of
TGI that it does not have a credit rating high enough to enable it to issue perpetual
preferred shares (T3: 267). Therefore, the Commission Panel concludes that the
preferred shares of ATCO Gas, Enbridge and Union need to be considered when
comparing the capital structures of those utilities with TGI.”
And again page 36
“The Commission Panel concludes that the appropriate capital structure range for
consideration of TGI is in the range of 35 percent to 38 percent and that given the effect
of deferral accounts in reducing the risk of TGI, the appropriate equity component for
TGI is 35 percent. Given the preferred shares in the capital structure of all other
Canadian gas distribution utilities, (italics and bold added) the equity component of
TGI will remain the lowest in Canada for gas distribution utilities.”
This change is specific to Terasen Gas and has no impact on Gaz Metro.
9.3 Confirmed that a natural gas utility, similar to Gaz Metro, has very low risk and can
earn its allowed rate of return on 33% common equity.
10) Reference: Evidence of Laurence D. Booth, page 24, lines 8 -10
“Since business risk is the primary determinant of capital structure, it is to be
expected that a board will change an allowed capital structure relatively infrequently
in response to significant changes in business risk.”
Question:
10.1 Please confirm that the following table comparing Dr. Booth’s
recommendations for allowed equity thickness before the EUB in 2003 and the
EUB’s decisions on allowed equity thickness in Decision 2004-052 is correct:
Company Dr. Booth’s Recommended
Equity Thickness
EUB Approved Equity
Thickness
ATCO TFO 30% 33.0%
AltaLink 32% 35.0%
EPCOR TFO 30% 35.0%
NGTL 33% 35.0%
ATCO Electric Disco 35% 37.0%
FortisAlberta (Aquila) 35% 37.0%
ATCO Gas 35% 38.0%
ENMAX DISCO 35% 39.0%
EPCOR DISCO 35% 39.0%
AltaGas 35% 41.0%
ATCO Pipelines 36-42% 43.0%
No.
The comparisons are incorrect. Dr. Booth did not make specific recommendations for
individual companies he made general recommendations as follows (page 15 of
Appendix A of his Alberta Generic Testimony)
“Consequently, I recommend the following common equity ratios:
Lowest risk: Electricity transmission assets, for example AltaLink, 30%
Very low risk: Gas transmission assets, for example NGTL, 33%
Average risk: Gas and Electric LDCs, for example, ATCO Gas 35%
10 Absent
the merchant function the allowed common equity ratio can be reduced to at least the 33% of Terasen Gas. If
the revenue requirement is recovered through a fixed delivery charge the allowed common equity ratio can be the same
30% I deem appropriate for the transmission wires and pipes.
Above average risk: ATCO Pipelines 36-42%, (depends on 2004 EUB decision)”
Some of the comparisons above indicate companies that Dr. Booth did not provide
testimony on and they also include municipally owned utilities that do not pay income
taxes that again Dr. Booth did not make recommendations on, but the AEUB allowed an
additional 2% to their common equity ratio. Further the recommendations were
conditional on proceedings that were scheduled to come before the Board, such as that on
intra Alberta pipeline competition.
11) Reference: Evidence of Laurence D. Booth, page 24, lines 8 -10
“Since business risk is the primary determinant of capital structure, it is to be
expected that a board will change an allowed capital structure relatively infrequently
in response to significant changes in business risk.”
Questions:
11.1 Please confirm that in 2006 Dr. Booth recommended a 35% common equity
ratio for Enbridge Gas Distribution Inc. as “reasonable if not generous.”
July 12, 2007
11.2 Please confirm that on July 5, 2007 in Docket No. EB-2006-0034, the OEB
approved an increase in Enbridge Gas Distribution Inc.’s common equity ratio
from 35% to 36%.
11.1 Confirmed that Dr. Booth recommended the continuation of Union Gas’s 35%
common equity ratio.
11.2 Confirmed but a material fact is ignored. The OEB approved a black box settlement
that included as part of it an increase in the common equity ratio to 36%.
Settlements by their nature are supposed to be without prejudice, since the tradeoffs that
generated particular values are unknown. All we know is that the OEB considered the
package fair and reasonable.
12) Reference: Evidence of Laurence D. Booth, page 35, lines 24-26
“Further it was my judgement that none of the Alberta utilities were as risky as Pacific
Northern Gas (PNG) with a 36% common equity ratio or Gaz Métropolitain (GMI)
with a 38.5% common equity ratio, where I regarded those two as the riskiest
regulated utilities in Canada.”
Question:
12.1 Please provide excerpts from all written testimony and all transcripts from
regulatory proceedings where Dr. Booth has discussed the risk or relative risk
of Gaz Métro.
The only area where Dr. Booth has discussed Gaz Metro is included within his
testimony. This passage itself is extracted from his 2003 Alberta generic testimony. Dr
Booth is unaware of any questions ever being directed at him in any hearing related to
Gaz Metro.
13) Reference: Evidence of Laurence D. Booth, page 35, lines 24 -26
“Further it was my judgement that none of the Alberta utilities were as risky as Pacific
Northern Gas (PNG) with a 36% common equity ratio or Gaz Métropolitain (GMI)
with a 38.5% common equity ratio, where I regarded those two as the riskiest
regulated utilities in Canada.”
Questions:
13.1 Please confirm whether Dr. Booth stated in written testimony before the EUB in
September 2003, “In my judgement, none of the Alberta utilities are as risky as
Pacific Northern Gas (PNG) or Gaz Métropolitain (GMI).”
13.2 Please confirm whether Dr. Booth stated in written testimony before the OEB in
November 2006, “It was, and remains, my judgement that none of the Alberta
utilities were as risky as Pacific Northern Gas (PNG) with a 36% common
equity ratio or Gaz Métropolitain (GMI) with a 38.5% common equity ratio,
where I continue to regard these two as the riskiest regulated utilities in
Canada.”
13.3 Please confirm that Dr. Booth’s opinion continues to be that Gaz Métro is one
of the two riskiest utilities in Canada.
13.4 If Dr. Booth cannot confirm this, please explain why his opinion appears to
have changed since he filed testimony before the OEB in November 2006.
13.5 Please confirm whether it is Dr. Booth’s understanding that Gaz Métro has had
a 38.5% equity thickness and a formula-based ROE since October 1999.
13.6 Please confirm whether it is Dr. Booth’s understanding that Gaz Métro has had
a weather normalization mechanism since 1979.
13.7 Please confirm whether it is Dr. Booth’s understanding that Gaz Métro has
operated under a performance based rates (PBR) plan since October 2000.
13.8 Please indicate whether to Dr. Booth’s knowledge there have been changes
since 1999 in his assessment that the “size and diversity of the Québec
economy and the fact that Gaz Métro serves 97% of the province dramatically
reduces its risk.” (Evidence of Laurence D. Booth, page 39, lines 25-27) If
there have been changes in this assessment, please identify them with
specificity.
13.1 Confirmed the passage in Dr. Booth’s current GMI testimony specifically refers to
his Alberta generic testimony!
13.2 Confirmed the OEB passage similarly relates to the risk ranking in Dr. Booth’s
testimony before the Alberta EUB, so of course they are the same.
13.3 Confirmed in terms of the utilities that Dr. Booth has provided testimony on. In
terms of underlying business risk, as Dr. Booth notes in his current testimony, Gaz Metro
would be regarded as above average risk for a Canadian utility, but it also it has greater
regulatory protection and a higher common equity component as he notes in his overall
summary
“Overall I would judge that the greater regulatory protection to have equalized the risk of
Gaz Metro with other gas distribution utilities, so it can be allowed the same ROE.”
13.4
Dr. Booth’s opinion has not changed. In fact it is exactly the same.
13.5
It is Dr. Booth’s understanding that
“the Regie has established that the rate of return on the rate base is to be fixed using an
adjusted capital structure of which partner’s deemed equity is in the order of 46%,
including 38.5% that is compensated as common shares of a company and 7.5% as if it
were preferred shares.” (Gaz Metro 2006 Annual Report, page 38)
It is Dr. Booth’s understanding from Dr. Chretien’s report (page 5) the present formula
for the ROE was adopted in 1999.
13.6 It is Dr. Booth’s understanding that Gaz Metro currently has a weather
normalisation deferral account. Dr. Booth can not confirm that this deferral account has
remained unchanged since 1979.
13.7 Yes.
13.8 Dr. Booth would not judge any changes to be material. Changes in these factors
occur only slowly over time.
14) Reference: Evidence of Laurence D. Booth, page 37, lines 20 -21
“The important point is that almost all the boards across Canada that have looked at
their ROE adjustment formula have reaffirmed the fact that they are fair and
reasonable.”
Questions:
14.1 Please identify all proceedings where boards in Canada have evaluated their
existing ROE adjustment formulas and reaffirmed that they are fair and
reasonable. Please identify the board, the docket and/or decision number, and
the date of the relevant decision.
14.2 Please identify all proceedings where boards in Canada have evaluated their
existing ROE adjustment formulas and made changes to either allowed ROEs
as determined by the formula or the ROE adjustment formula.
14.1 & 14.2 Please see Dr. Carpenter’s answer to information request 2.1b. Dr. Booth
agrees with Dr. Carpenter’s description of changes to formula allowed ROEs.
15) Reference: Evidence of Laurence D. Booth, page 42, lines 9 -10
“This gleeful announcement to investors hardly indicates that PBR is a risk factor for
Gaz Métro.”
Question:
15.1 Please provide excerpts from all written testimony and all transcripts from
regulatory proceedings where Dr. Booth has discussed the effects of incentive
regulation on risk.
The impact of PBR has been greatest in BC where the BCUC moved its utilities on to
PBR ahead of most other jurisdictions notably Ontario, where they are only now moving
to PBR. The following comments relate to Professor Booth’s testimony. He does not
keep transcripts of the hearings, but to the best of his knowledge PBR was not seriously
discussed in any of the hearings.
The following passage relates to Dr. Booth’s FortisBC testimony (January 2005)
Q.
HAVE YOU TAKEN INTO ACCOUNT THE EFFECTS OF
PERFORMANCE BASED REGULATION ON FORTISBC?
A.
Yes. FortisBC has been under performance based regulation (PBR) for almost ten
years, which is why it has fewer deferral accounts than other utilities. The essence of
PBR is to ensure that costs, that can be controlled by the utility are as low as possible, the
utility is allowed to share in cost savings. Under traditional cost of service regulation the
utility is assumed to operate efficiently, but since lower costs get passed on in a lower
revenue requirement there is little “in it” for the shareholders to lower costs. In contrast
under PBR rates are set for a base year and then in subsequent years, rates are subject to
an inflation adjustment less a productivity factor, which in the case of FortisBC has been
1.0-2.0%.
This general PBR model has been modified in the case of FortisBC, since only some
costs have been subject to PBR. The three main categorise are:
1)
Flow through costs such as extraordinary operations and maintenance costs and
capital expenditures, transmission expenses, water fees, taxes, etc, which are all
flowed through directly to rate payers. Hence the shareholders are not at risk for
these costs.
2)
Power purchase costs, which are also mainly flowed through to ratepayers, except
that FortisBC gets 35% of the savings up to $1million and 25% thereafter.
3)
Shared operating expenses such as operating and maintenance expenses and
miscellaneous costs are then shared 50:50 between ratepayers and FortisBC.
The above brief description of PBR should be contrasted with the more traditional model
of a forward test year, where the utility is held responsible for all deviations from
forecast. There are two main differences. First, in a forward test year model the
benchmark is increased each year based on the company’s forecast, as adjusted in a rate
hearing or settlement. In contrast, under PBR the benchmark is the “base year” adjusted
for inflation and the productivity factor, so that in real terms the benchmark is ratcheted
down each year.1 Second, in a forward test year model the company is 100% exposed to
1
In practise this is moderated by a true up after a pre-specified period.
higher than expected costs, whereas under FortisBC’s PBR it is a 50:50 sharing, so its
exposure is limited.
Q.
DOESN’T THIS EXPOSURE MAKE FORTISBC RISKIER?
A.
Not necessarily. The PBR mainly applies to O&M expenses which are largely
under the control of the company, so that the risk depends on how much “fat” was in the
system during the base year. Further the 50:50 sharing reduces the risk, as does the
existence of the truing-up date and the exception to “extra-ordinary” O&M expenses.
FortisBC accurately describes the effect of the PBR system as
“Furthermore, in a PBR framework the shareholder is able to enhance its returns
by achieving certain defined performance, reliability and safety criteria.”
That is, the main impact of PBR is to incent the company to operate more efficiently and
earn a higher ROE, not to expose it to material risk.
An example of this is found in the performance of the main gas transmission pipelines
regulated by the National Energy Board. In Schedule 6 is the allowed versus actual ROE
for the TransCanada Mainline (TCPL), Foothills, the TCPL BC System (formerly Alberta
Natural Gas or ANG) and Trans Quebec and Maritimes Pipeline (TQM). Foothills and
ANG are regulated on a full cost of service basis, where their rates are continually trued
up, so that all costs are passed on to rate payers. As a result they exactly earn their
allowed ROE. The only exception to this was for ANG where some merger expenses
were absorbed on its acquisition by TCPL.
In contrast, TCPL and TQM are on a forward test year plus deferral accounts basis,
where they consistently over earn their allowed ROE. TQM has done this every year
since at least 1990, while TCPL under earned in one year as a result of some fuel cost
disallowances by the NEB. On average being exposed to the forecasting risk of a forward
test year has been worth 25-37 basis points for TCPL and TQM versus the no risk cost of
service regulation of Foothills. In any dictionary risk means to incur the possibility of
harm, it is difficult to see how being on a forward test year and being exposed to
forecasting risk has harmed either TCPL or TQM.
A further example is for the companies in Schedule 7. This data is for the two big gas
utilities regulated by the Ontario Energy Board and Nova Gas Transmission (NGTL)
regulated by the Alberta EUB. Enbridge Gas Distribution (Consumers Gas) has over
earned on a weather adjusted basis every single year and Union almost every single year
since 1990. In their case being exposed to forecasting risk means that they over-earn on
average 78-110 basis points a year. Finally, there is the data for NGTL, where the
allowed data is that for NGTL where known or that for Foothills when NGTL operating
under negotiated settlements. What is important here is that while under negotiated
settlements NGTL has routinely earned 1.50-2.0% more then the equivalent allowed
ROE for Foothills.
The upshot of the data in schedules 6 and 7 is that we have to be very careful in defining
risk. Consider two situations, in case 1 you get $10 for sure, whereas in case 2 you either
get $10 or $20 with equal probability. Clearly in case 2 you are exposed to “risk” in the
sense that you don’t know which of the two outcomes will happen. However, no-one
would chose case 1 over case 2, since you are never worse off with 2 than 1 and half the
time you are better off. This example highlights a situation of “stochastic dominance” and
the fact that variability does not always mean risk.
In my judgment utilities are almost always better off in a “risky” situation that involves
their forecasting their costs, since they have control over these costs and in practise use
this to enhance their actual ROEs. Further, negotiated settlements may have reduced
hearing costs, but in my judgment they also work to the advantage of the utility, since the
settlements frequently involve an asymmetry of information between the utility and the
interveners that is not subject to cross examination. The persistent over-earning by
regulated utilities subject to forecasting “risk” is clear evidence of this.
Q.
HAS FORTISBC PERSISTENTLY OVEREARNED?
A.
Yes. In answer to BCOAPO IR #91.2 Fortis BC provided actual versus allowed
ROE for regulated operations back to 1986. The following graph summarises this data:
Actual vs Allowed FortisBC ROE
16
%
14
12
10
8
6
Actual
Allowed
4
2
19
98
20
00
20
02
20
04
19
96
19
86
19
88
19
90
19
92
19
94
0
The company clearly believes that this sort of data is important since similar data was
also provided in a presentation to DBRS in October 2004 with the sub heading “a
consistent history of earning the regulated ROE.” My only qualification is that the correct
sub heading should have been “over earning.” However, the most important insight is the
very limited variability in the actual ROE around the regulated ROE until 1996, when
FortisBC moved to a PBR mechanism. After 1996 the actual ROE clearly moves above
the allowed ROE indicating “over earning,” except for 2002 when the failure to earn the
allowed ROE was due to integration expenses and software write-offs.2 From 1996-2004
the average ROE exceeded the allowed by 0.56% and if 2002 is ignored the excess
increases to 0.78%. It is difficult to see from the above graph that being under PBR has
hurt the shareholders of FortisBC. Consequently, I see no reason for adding a bonus to
the ROE for a system that already effectively enhances the company’s ROE and does not
increase its risk.
In the case of Dr. Booth’s Terasen Gas testimony (October 2005)
Q.
2
HOW DO THESE COMMENTS APPLY TO TERASEN?
Hence the request for a deferral account.
A.
I have already indicated the significant amount of regulatory protection afforded
Terasen through deferral accounts. The BCUC has recognised the value of this protection
through its 33% allowed common equity ratio, which is marginally lower than the 35%
allowed the big Ontario LDCs. Of note is that approximately 60% of Industrial customers
arrange for their own gas supply, while approximately 75% of large volume commercial
customers do so. As Terasen notes in its 2004 Annual Information Form (AIF)
“Customers arranging their own supply in fact reduce the credit risk to Terasen.” Also the
BCUC is generally regarded as a progressive regulator in encouraging the use of
incentive or performance based regulation. The essence of these PBR measures is for
50:50 sharing of earnings above and below the allowed ROE, which effectively reduces
Terasen’s earnings exposure, since it is only exposed to 50% of the variability instead of
100%.
The following graph indicates Terasen’s allowed and actual (post sharing) ROE since
1995 when the adjustment formula went into effect and the company started operating
under PBR. Of note is that Terasen has consistently exceeded its allowed ROE, even
under the effects of PBR. The graph indicates the degree of regulatory protection
afforded Terasen and the obvious fact the incentive based PBR essentially works to
increase Terasen’s earnings and not to expose it to any additional risks. This is why
DBRS describes the regulatory environment in BC as “supportive,” and in this case they
are referring to supportive of the bond rating, that is good for bond holders and credit
risk.
ACTUAL vs ALLOWED ROE
13
12
11
10
9
8
7
1995
1996
1997
1998
1999
Allowed
2000
2001
2002
2003
2004
Post
The only “blip” in Terasen’s performance came in 1998 when it failed to earn its allowed
ROE. . In answer to JIESC-BCOAPO-CEC 7.1 Terasen indicated that the reason for this
was employee severance payments resulting from a major reorganisation, which were not
covered by its PBR settlement. These expenses are not normal operating expenses and do
not reflect on Terasen’s going forward ability to earn its allowed ROE. The above data
clearly indicate Terasen’s low risk nature.
In Dr. Booth’s Union Gas testimony (April 2006) he stated
Q
DOES THE MOVE TOWARDS PERFORMANCE BASED REGULATION
INCREASE UNION’S RISK?
A.
No.
I am aware of the Board’s intention to move to multi year incentive
regulation with rebasing through periodic rate reviews, but in my judgment this has no
impact on Union’s risk. Union operated under PBR from 2001-2003 and in these years it
over-earned by 1.50%, 2.41% and 2.13%, which is above Union’s long run tendency to
over-earn. Further Terasen Gas has been on a PBR mechanism for sometime and
continues to earn in excess of its allowed ROE.
In Dr. Booth’s EGDI testimony (November 2006) he stated
I am also aware of the Board’s intention to move to multi year incentive regulation with
rebasing through periodic rate reviews, but in my judgment this has no impact on EGDI’s
risk. EGDI has operated under PBR before, while Terasen Gas has been on a PBR
mechanism for sometime and continues to earn in excess of its allowed ROE. I see PBR
as a mechanism for allowing a utility to over earn while flowing some of the benefits
though to ratepayers. I do not see it as a mechanism that materially affects the risk of the
utility
16) Reference: Evidence of Laurence D. Booth, page 42, lines 9 -10
“This gleeful announcement to investors hardly indicates that PBR is a risk factor for
Gaz Métro.”
Question:
16.1 Please provide all scholarly articles, regulatory decisions, or other materials
that support the notion that moving from cost of service regulation to multi year
PBR regulation has no impact on a utility’s business risk.
Dr. Booth is not aware of any scholarly articles that have analysed the impact of PBR on
Canadian utilities, since it is a recent phenomenon and its impact is restricted to a small
minority of utilities. However, he would agree with Dr. Chretien that it reduces the risk of
the utility, whether its impact is of the order of 0.50% on the ROE as he recommends is
doubtful.
17) Reference: Evidence of Laurence D. Booth, page 41, lines 19 -21
“In this sense PBR has had the same effect on Gaz Metro as it has had on Fortis BC
and Terasen Gas: it has allowed them to over-earn the fair ROE.”
Question:
17.1 Please explain how it would be easier for a regulated utility to achieve its
allowed rate of return (before any incentive rate of return) under Gaz Métro’s
PBR than under a traditional cost of service regime.
17.1 The utility controls its expenditures, in the sense that it can time them to meet
particular targets, particularly in terms of O&M. The observed empirical results are thus
that PBR serves to increase the earned ROE.
Dr. Booth is concerned that PBR generates short term gains that eventually results in a
rebasing of expenditures and resulting « give back ».
18) Reference: Evidence of Laurence D. Booth, page 42, lines 13 -15
“This is a substantive difference from US utilities where it seems that rate hearings
are less frequent, there is less use of deferral accounts and interventions are less
common.”
Question:
18.1 Given Dr. Booth’s comparison of Canadian and US LDCs and his estimate of
Gaz Métro’s beta, what is Dr. Booth’s estimate of US Utility Beta?
18.1 Dr. Booth does not normally incorporate US utility betas into his testimony.
However, in response to Dr. Carpenter’s statement s before the OEB in Enbridge Gas
Distribution’s recent hearing (February 2007) he did draft the following comments for use
in direct examination.
Q
In Mr. Carpenter’s direct examination he discussed your evidence and EGDI’s
business risks, do you have any comments on that new evidence?
A.
Yes it would have been nice to have been able to ask information requests
on Mr. Carpenters’ beta estimates and other new evidence that he provided. However the
first thing I should mention is that he criticised my conclusion that EGDI has little or no
business risk by providing some beta estimates for US gas utilities. However, these beta
estimates do not estimate business risk; they estimate the sum total of business risk,
financial risk and investment risk so observing beta estimates can not directly tell us
anything about business risk.
The second thing I should mention is that I did pull off the data for the nine
companies he mentioned and estimated their betas using data back to 1973 where
available. The most recent beta estimates for the nine are as follows:
AGL
ATMOS
0.3752 0.43706
laclede
NJ Resources
Northwest Piedmont SJ Inds
0.4869 0.02442 0.14216 0.32988 0.30892
0.791724 0.812343 0.828952
Southwest WGL
0.2316 0.26856
0.67481 0.714053 0.776618 0.769632 0.743863
The first row is the beta estimate and the second if you weight the estimate 1/3 the actual
estimate and 2/3 with 1.0 which obviously increases them all. For convenience I graph
the average of all nine estimated from five years of data going back to January 1973.
There are several obvious conclusions from the graph:
1)
2)
3)
There is no tendency of these betas to revert to 1.0 so weighting
them with the overall market’s average beta of 1.0 makes no
sense. This just confirms the well known result that utility betas
tend to revert to their long run average value not 1.0
Betas for these US gas utilities have been declining over time;
Recent estimates of average values of 0.30 are consistent with my
recent estimates of 0.45-0.55 given the fact that these utilities as
Dr. Carpenter points out do not have the same level of financial
leverage as Canadian utilities.
0.75618
Dec-05
Dec-03
Dec-01
Dec-99
Dec-97
Dec-95
Dec-93
Dec-91
Dec-89
Dec-87
Dec-85
Dec-83
Dec-81
Dec-79
Dec-77
Average Betas for Mr. Carpenter' s US Gas Utiltiies
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
19) Reference: Evidence of Laurence D. Booth, page 2, lines 25-27
“Further, Gaz Métro benefits from relatively generous performance based regulation
(PBR) so that together I judge them to have equalized the overall risk to
shareholders as compared to the Ontario LDCs implying a similar fair ROE.”
Questions:
19.1 Please provide all support for Dr. Booth’s opinion that Gaz Métro’s PBR is
“relatively generous.”
19.2 Please identify the years during which Enbridge Gas Distribution Inc. and
Union Gas operated under PBR.
19.3 Please compare Gaz Métro’s performance under PBR with that of Enbridge
Gas Distribution Inc. and Union Gas. Please make specific reference to the
allowed vs. actual ROE data Dr. Booth employed for Gaz Metro on page 41 of
his testimony, and for Enbridge Gas Distribution Inc. and Union Gas in
Schedule 16 attached to his testimony.
19.1 The fact that Gaz Metro’s expert financial witness, Dr. Chretien thinks that it is so
generous that he reduces his recommended ROE by 0.50% is the most obvious sign.
19.2 & 19.3 Please see Dr. Booth’s answer to 15.1
20) Reference: Evidence of Laurence D. Booth, page 3, lines 9-13
“In my judgement current formula allowed ROEs are excessive across Canada and
have failed to recognize that the use of an adjustment mechanism has lowered the
investment risk attached to Canadian utilities and converted their equity into a form
of floating rate preferred share, where observed yields are significantly lower than
current allowed ROEs.”
Questions:
20.1 Please comment on whether in Dr. Booth’s opinion the predictability of formula
allowed ROEs outweighs the necessity of an adequate return to attract capital.
20.2 Please identify any regulatory decision that has determined that it is
appropriate to lower allowed returns ROEs to account for the fact that they
have been made more predictable by using a formula-based approach.
20.1
Of course not. The crucial question is whether the resulting allowed ROE is fair
and reasonable. In Dr. Booth’s judgment the Regie’s adjustment mechanism
gives generous returns even given the greater predictability that flows from the
formula adjustment.
20.2
Dr. Booth is not aware of any. Most boards have simply reaffirmed the general
validity of their formula allowed ROEs without going into substantial reasoning.
21) Reference: Evidence of Laurence D. Booth, page 3, lines 14-17
“It is the generosity of current allowed ROEs that has caused utility assets to be
valued so significantly above their book values. The evidence from takeovers of
Canadian utilities indicates that they are very attractive investments since the
takeovers are uniformly at significant premiums to book value.”
Question:
21.1 Please reconcile Dr. Booth’s statement with the following opinion expressed by
the BCUC on page 52 of BCUC Commission Order No. G-14-06 (its March 2,
2006 Decision on Terasen’s Return on Equity and Capital Structure):
“The Commission Panel agrees with the AEUB that acquisition premiums may
result from a number of strategic factors which are unrelated to the
establishment of a fair return for a benchmark low-risk utility.”
21.1 Dr. Booth disagrees with this statement and their interpretation of the AEUB
decision, as it is inconsistent with effective utility regulation. If a utility always earns its
allowed ROE, and that is always expected to be fair, then there are no strategic factors
unless the utility becomes part of a holding company and services are transferred at
non-arms length prices, which should not happen in a regulated utility
Dr. Booth also notes the decision of the Alberta EUB in its generic cost of capital hearing
(July 2004)
Market-to-Book Ratios and Acquisition Premiums
The Board notes the evidence, including that of AltaGas3 and Calgary/CAPP 4 that the
equity of utilities that earn a large portion of their earnings based on regulated formulas
in other Canadian jurisdictions tends to trade at market-to-book ratios well above 1.0,
albeit at premiums less than the average market premium.
The Board also notes that there have been a number of acquisitions of Alberta utilities in
recent years, at prices that significantly exceeded book value. For example, in 2000,
Aquila acquired TransAlta Corporation’s distribution and retail businesses at a total price
of 1.5 times book value. Book value was forecast to be $472 million at time of close,
resulting in a forecast premium of $238 million.5 Aquila subsequently sold TransAlta’s
former retail business to EPCOR Energy Services (Alberta) Inc. for $110 million,
including a premium of $99 million.6
As well, in 2004, Fortis purchased Aquila for a premium of $215 million above the book
value of $601 million.7
3
AltaGas Argument, page 24
4
Exhibit 016-11(b), Written Evidence of J.D. McCormick, page 5
5
Decision 2000-41, page 3
6
Decision 2000-71, page 3
7
Decision 2004-035, page 18
Similarly, with respect to the AltaLink acquisition of TransAlta Corporation’s
transmission assets, the Board notes Mr. McCormick’s8 evidence that a premium of $200
million was paid to acquire a rate base of approximately $644 million.
The Board agrees with the Applicants that there are a number of factors impacting
market-to-book ratios of utility holding companies and that one has to be cautious
making inferences regarding the regulated utilities. The Board also agrees that there may
be strategic factors affecting the price that is paid to acquire a utility.
For example, NGTL submitted that its parent did not acquire a further interest in the
Foothills pipeline, paying 1.6 times book value, for the opportunity to earn a return at the
NEB formula rate; rather, the investment was made in an effort to increase the probability
that TCPL will participate in a Northern pipeline project. The Board also recognizes that,
in some cases, a premium might be paid for regulated assets in anticipation of significant
future growth in rate base, to achieve geographic diversification or to obtain a foothold in
a new market. However, parties are also aware of the constraints placed on regulated
utilities with respect to affiliate transactions, particularly those with unregulated affiliates.
In the absence of such strategic factors, the Board would not expect a prudent investor to
pay a significant premium unless the currently awarded returns are higher than that
required by the market. The Board acknowledges the views of some parties that payment
of a premium over book value for a regulated utility indicates that the recent ROE awards
may have been higher than required by the market. The Board is not aware of the
strategic factors that may have affected the price paid to acquire Alberta utilities in recent
years. Nevertheless, the experience regarding the market-to-book values of utilities and
the experience regarding the acquisition of Alberta utilities in recent years gives the
Board some comfort that its recent ROE awards have not been too low.
Further in this regard, the Board notes AltaLink’s testimony, in response to examination
by the Chairman,9 that AltaLink’s decision to purchase TransAlta’s transmission business
considered Board awards for transmission entities of 9.75% ROE on a capital structure
including 35% equity.
Directionally, the Board concludes that the experience regarding the market-to-book
ratios of utilities and the experience regarding the acquisition of Alberta utilities in
recent years is relevant and supports continuation of an ROE at or below the Board’s
CAPM estimate. (italics and bolded added)
8
Exhibit 016-11(b) Evidence of J.D. McCormick, pages 39-40
9
Transcript, Volume 15, pages 2004-2006
22) Reference: Evidence of Laurence D. Booth, pages 3 and 37
Preamble:
“In my judgement current formula allowed ROEs are excessive across Canada and
have failed to recognize that the use of an adjustment mechanism has lowered the
investment risk attached to Canadian utilities and converted their equity into a form
of floating rate preferred share, where observed yields are significantly lower than
current allowed ROEs.”
“I therefore find it difficult to imagine that the Regie’s adjustment formula does not
also continue to give fair and reasonable estimates of the ROE.”
Question:
22.1 Please indicate if Dr. Booth favours an automatic adjustment formula for the rate of
return, and, if so, where in his evidence the formula he proposes is to be found.
22.2 Dr. Booth was asked to recommend a fair ROE for Gaz Metro. He has frequently
stated in other hearings that he believes that automatic adjustment mechanisms have
basically “got it right” in terms of the general level of ROEs, albeit at generous levels.
Dr. Booth believes that the formula allowed ROE granted Gaz Metro is generous and is
near the top end of a range of reasonableness.
23) Reference: Evidence of Laurence D. Booth, pages 4 and 5
Preamble:
Concerning the use of Gaz Métro’s distribution rate as an estimate of the rate of return
required by investors.
Questions:
23.1 Please confirm that the bond maturity yield represents the expectations of investors
on coupons and on bond futures capital gain while the return on the distribution side
represents past distributions (paid out over the past year).
23.2 Please calculate the annualized capital gain earned by an investor who purchased
a Gaz Métro security in 1993 for resale in December 2006.
23.3 Please indicate if the capital gain calculated represents a non-negligible portion of
the return for an investor who has purchased Gaz Métro units. Please indicate if Dr.
Booth believes that investors with rational expectations have integrated this capital gain
into the return they expect to earn.
23.1 Bonds issued at par have no expected future capital gains. Such gains and losses
only come about due to unexpected changes in interest rates as a result we can
use the yield on a par issue Government of Canada bond as an estimate of the
investors’ expected rate of return. This is also why we use them as a base for the
fair ROE in the CAPM. For non-par bonds there is a built in capital gain or loss as
the bond is redeemed at par. In the case of GMLP, Gaz Metro’s policy is to pay out
nearly all of its income. This is equivalent to a par bond and as such capital gains
should only come from changes in interest rates or required rates of return.
23.2 In 1993 the average yield on a Government of Canada bond was 7.85% and in
2006 it was 4.29%, so investors reaped unexpected capital gains due to the
decline in interest rates. The same is true of investors in GMLP partnership units,
but such unexpected capital gains have no bearing on the expected rate of return.
In the case of GMLP the units increased in value from $13.125 in December 1993
to approximately $16 at the end of 2006 for a compound capital gain of 1.5%, this
is similar to the unexpected gain on long Canada bonds and would not indicate that
this was expected or should necessarily be added to the dividend yield component
in the estimation of an expected rate of return.
23.3 Relative to the current dividend yield of 7.3% the realized capital gain of 1.5% is
marginally significant, but not excessively so. No rational investor would
incorporate this into the expectation of future capital gains. To do so would fly in
the face of the known interest rate changes that generated it and the fact that
GMLP is an income stock.
24) Reference: Evidence of Laurence D. Booth, pages 6-17
Preamble:
Concerning economic and financial prospects.
Questions:
24.1 Please elaborate on the relevance of examining macroeconomic and accounting
data ending in 2006 (see Schedule 1, for example) to establish a reliable economic and
financial picture for 2008.
24.2 Please specify the academic literature which demonstrates that the macroeconomic
and accounting data used make it possible to predict stock performance in Canada and
the US.
24.3 Please elaborate on the reasons why Dr. Booth does not suggest incorporating the
macroeconomic and accounting variables used within the formula for establishing yield
rates in order to improve the results.
24.4 Please explain the concept of myopia and confirm that the validity of the CAPM on
a period by period basis relies on the presence of a form of myopia. Please explain if the
CAPM on this basis is still theoretically valid if the macroeconomic and accounting
variables used actually make it possible to predict the prospects on investment
opportunities.
24.5 Please describe the conclusions to be found in the academic literature on the
reliability of economists’ forecasts.
24.1 There is inertia built into the economy which is why almost all macroeconomic
models incorporate distributed lag functions and exhibit serial correlation. Most interest
rate models for example exhibit serial correlation with mean reversion. The classic
example is the Vasicek model discussed by Dr. Chretien and the fact that Dr. Chretien
wants to rebase the ROE formula using an historic average long Candaa yield. .
Consequently where we are is critical for understanding where we can go. Dr Booth
believes that this is so obvious it doesn’t need further stating.
24.2 Dr. Booth’s testimony does not discuss stock market prediction and such
propositions play no part in his recommendations.
24.3 Good question, while it is possible to use a mean reverting process to forecast
interest rates Dr. Booth prefers the market’s judgment as reflected in current rates and
his judgment as to the state of the economy and where interest rates are likely to go.
24.4 Dr. Booth thinks what the question is referring to are myopic utility functions, such
as a time separable logarithmic utility function, whereby changes in the future
opportunity set play no role in the current portfolio decision. Jan Mossin, The Theory of
Financial Markets, Prentice Hall, 1973, developed the concept of myopia and its
implication for asset pricing were expounded in two classic papers.
Stapleton and Subrahmanyam show that a multi-period CAPM only results in a discrete
time model if there are no changes in the opportunity set and investors have negative
exponential utility functions. This causes the capital gain to be completely predictable
and each period’s cash flows are discounted back using the CAPM fair rate of return.
While these theoretical results are interesting they are mainly of concern in advanced
finance courses. For example, the last time Dr. Booth taught the Ph.d financial theory
course at U of T these topics figured prominently and the course outline can be
downloaded from http://www.rotman.utoronto.ca/~booth/ under the teaching button and
MGT3030. However, the CAPM is now more normally developed based on the
distributional properties of security returns and the desire to reduce risk through
diversification. Consequently the CAPM can be developed in a multi-period setting under
general utility functions and the concept of myopia has been relegated to a theoretical
backwater.
24.5 Dr. Booth does not make any use of economist’s forecasts so researching this
literature is of no value. However, the fact that they exist indicates that they add value.
Otherwise since they are costly to produce they would have long since gone out of
business. Economic forecasts are like mutual funds, theoretical economists can not
explain why they exist, but they do. Layman, on the other hand, have no such trouble.
25) Reference: Evidence of Laurence D. Booth, pages 11-12
Preamble:
Concerning long term interest rate forecasting.
Questions:
25.1 With reference to the statement that “long-term rates have continued their gradual
year over year decline without these peaks,” please justify this affirmation with respect to
the data presented in Schedule 1 on long term rates.
25.2 With reference to the statement that “long-term bond yields reflect the long-term
future of the Canadian economy, while T-bill yields reflect short-term expectations,”
please explain the Pure Expectation Theory of interest rates and discuss the empiric
validity of this theory. Please confirm that there exist interest rate theories according to
which the above affirmation is not valid.
25.3 With reference to the forecast of a 5% long-term rate, please point out and supply
all analysis used to arrive at this figure.
25.4 With reference to the forecast of a 5% long-term rate, please indicate if an objective
reliability standard, such as a statistical standard deviation, or a subjective one, such as
a qualitative assessment, was established for this forecast. If so, please supply this
reliability standard. If not, please supply a range of long-term forecasts for a 90%
confidence level.
25.1 The Schedule 1 data is averages for the year which smooths out volatility, it is
more obvious if you look at the graph in Schedule 3.
25.2 The pure expectations theory posits that long run rates are simply a geometric
average of the future short term rates. It is the basis of most interest rate models. The
pure expectations theorem has been adjusted by some to include liquidity premiums and
maturity matching strategies, resulting in what are normally called biased expectations
models. For example, we would expect the average yield curve to be flat if the pure
expectations theorem held, but in practice it is upward sloping which is what it is called a
normal yield curve. This empirical observation is why many, including Dr. Booth, believe
in liquidity or risk premiums embedded in the yield curve. However, the use of the yield
curve to gauge the path of future interest rates results from either the biased or pure
expectations theorem. Dr. Booth does not use any of these models and sees no point in
surveying a huge literature in finance.
25.3 This is a judgment call by Dr. Booth based on his assessment of the state of the
economy. Notably since this testimony was filed the Bank of Canada increased its over
night rate by 0.25% and indicated there was more to come.
25.4 This question is confusing no confidence interval was used to come up with the
best estimate of the forecast long Canada rate. As indicated in 25.3 this is Dr. Booth’s
best estimate and consistent with the path the Canadian economy is taking. If external
verification is needed what follows is the interest rate forecast provided by the Royal
Bank of Canada that is freely available at
http://www.rbc.com/economics/market/pdf/fcst.pdf. The Royal sees long term rates
increasing to 5.45% over the next year.
26) Reference: Evidence of Laurence D. Booth, page 17
Preamble:
First table on page 17
Question:
26.1
Please explain the significant differences between the average and the median reported
in this table.
The distribution of the earned ROEs is not symmetric, they are highly skewed
27) Reference: Evidence of Laurence D. Booth, page 19
Preamble:
“However, when the commodity is an intangible service that cannot be resold or
arbitraged away, like a distribution company, there is no feasible competition.
Consequently they have market power.”
Questions:
27.1 Please confirm that the use of Gaz Métro’s distribution service is dependent on the
consumption by Gaz Métro’s clientele of an energy source, natural gas in this case,
which is itself in competition with other energy sources, constituting an energy market
over which Gaz Métro does not have significant control (except for certain specific
applications).
27.2 Please confirm that if the demand for this particular energy source is on the
decrease as a result of competition on the energy market then the service which Gaz
Métro offers and for which it has a regulated monopoly, i.e. natural gas distribution, will
also diminish.
27.1
This is obviously true
27.2 Not necessarily. While the demand for natural gas per customer may decline (as
it has) increasing numbers of customers may cause aggregate demand to increase.
Hence, actual demand and throughout depends on the size, diversity and growth of the
provincial economy, as well as the impact of competing fuel sources.
28) Reference: Evidence of Laurence D. Booth, page 22
Preamble:
Missing formula.
Questions:
28.1 Please supply the missing formula.
There is no missing formula in the document that Dr. Booth filed? The formula at the top
of page 22 is the financial leverage as follows:
ROE ROI (ROI R d (1 T )) D S
29) Reference: Evidence of Laurence D. Booth, page 37
Preamble:
Concerning the statement, “The important point is that almost all the boards across
Canada that have looked at their ROE adjustment formula have reaffirmed the fact
that they are fair and reasonable.”
Questions:
29.1
Please identify the decisions or the boards in Canada which have compared their
adjustment formula to other available proposed formulas and have concluded that their
adjustment formula should be maintained without modification.
29.2 Please identify the decisions in which Canadian boards have been exposed to the
evidence which has developed over the last 20 years on the empiric problems of CAPM
in explaining yields.
29.1 See the answer to IR 14. As far as Dr. Booth is aware since their original inception
boards have simply assessed whether their formula allowed ROE was continuing to give
fair and reasonable results. With the exception of the BCUC which changed the
adjustment from 100% to 75% of the change in the forecast long Canada yield they have
all agreed that they do. Dr. Booth is unaware of any witness proposing an alternative
adjustment mechanism, although this was proposed in 1993/4 when first the BCUC and
then the NEB looked at the issue.
29.2 In every hearing Dr. Booth has been a part of someone has discussed the empirical
problems with validating the CAPM. Generally the issues flow from who the company
witness is. Before the NEB, AEUB and OEB Drs Kolbe and Vilbert have used some
variation of the empirical CAPM where arbitrary constants are added to the risk free rate
to increase the intercept and flatten the slope of the CAPM. Before the BCUC and OEB
Ms. McShane has placed more weight on alternative models. Dr. Booth is not aware of
any board specifically putting any weight on asset pricing model alternatives to the
CAPM, since apart from the above they have not been proposed. To the contrary the
Alberta EUB in 2003 specifically used the CAPM in setting the fair ROE for its generic
formula.
30) Reference: Evidence of Laurence D. Booth, page 46
Preamble:
Concerning the statement, “Why the CAPM is so widely used is because it is intuitively
correct. It captures two of the major laws of finance: the time value of money and the risk
value of money. I will discuss the third major law of finance, the tax value of
money, later.”
Questions:
30.1 Please identify balance models of financial assets which are not intuitively correct
because they do not capture the two major laws of finance which the CAPM captures.
30.2 Please indicate if balance models of financial assets exist which capture the three
major laws of finance discussed. If so, please identify these models and indicate if they
are even more intuitively correct than the CAPM.
30.1 & 30.2 This question is hard to understand. Dr. Booth believes there is a translation
error, but he will try to answer it anyway.
The Fama-French model is not intuitively correct, since it is a straight empirical model
and the result of data snooping with no theoretical basis. It’s only possible base is the
inter-temporal asset pricing model of Merton (1971) or the arbitrage pricing model of
Ross (1977) that suggest that other factors might be possible in either a multi-period
model or an arbitrage free economy. However, neither of these models suggest market
to book or size as risk factors. The after tax CAPM of Brennan and the dividend model of
Litzenberger capture the three laws of finance as suggested by Dr. Booth and generate
before-personal tax expected rates of return. However, Dr. Booth uses none of these
models in his testimony.
31) Reference: Evidence of Laurence D. Booth, page 46
Preamble:
Concerning the statement, “As long as the market risk premium is approximately
correct the estimate will be in the right ball park. Where the CAPM gets controversial
is in the beta coefficient since risk is constantly changing so too are beta coefficients,
which makes testing the model difficult.”
Questions:
31.1 Please explain how to check if the market risk premium is approximately correct.
31.2 Please specify why there would be little controversy with respect to the market risk
premium according to Dr. Booth.
31.3 Please confirm that a central implication of CAPM is that the market portfolio be on
the boundary of mean-variance efficiency with respect to returns. Please indicate if tests
of the CAPM exist testing this implication for which the beta coefficients do not need to
be known.
31.1 You bench mark it against historic averages in the country that you are concerned
with, other companies with similar institutional arrangements and theoretical models
based on utility theory and risk aversion. All of which Dr. Booth does in his testimony.
31.2 Estimates of the market risk premium lie in a relatively narrow range. For example,
as discussed in Appendix D to his testimony the market risk premium (MRP) is
theoretically determined as:
MRP 
2
where  is the price of risk and 2 is the variance of the annual rate of return. Over
long periods of time approximately = 1.5 to 1.6 so when the capital market was very
risky with a standard deviation of the annual rate of return of 20% the market risk
premium was 6.0-6.4%. More recently with the standard deviation much lower at 16%
the market risk premium was 3.8-4.1%. This range compares to the historic average in
Canada of approximately 5.0% so the range of possible market risk premiums is
bounded by the perceived risk in the capital market.
31.3 Tests of the CAPM are not part of Dr. Booth’s testimony and nowhere does he use
efficient set theory. However the Roll critique indicates that under certain assumptions
there are three possible tests of the CAPM: The market portfolio is mean variance
efficient; betas are a sufficient statistic for estimating risk premiums and Jensen’s alpha
is equal to zero. However, you need the full variance-covariance matrix to derive the
efficient frontier and test the efficiency of the market portfolio and if you can do this you
can estimate betas.
32) Reference: Evidence of Laurence D. Booth, page 46
Preamble:
Concerning the statement, “However these tests suffered from two major problems,
which have never been overcome.”
Questions:
32.1 Please explain why CAPM tests on the stock exchange use treasury bond yield as
the risk-free rate, even though it be “only appropriate for very short (91 days)
investments.”
32.2 If the simple use of a long-term rate allowed adjustment for the documented bias in
the first tests, please indicate why this problem was never overcome.
32.3 Please identify the scientific articles or supply the studies and research which
demonstrate that the use of a long term rate allows adjustment for the documented bias
which emerged in the first tests.
32.4 Please indicate if CAPM tests exist in which it is not necessary to observe the riskfree rate and which therefore are not subject to the first major problem discussed.
32.5 Please explain why the second problem, related to the beta estimates, was never
overcome considering the existence of CAPM tests which did not require the betas to be
known.
32.6 Apart from the two major problems discussed, please identify the other CAPM
problems which have been documented since the first tests.
32.1 Dr. Booth assumes that tests use the T Bill yield over 30 days since the tests are
run over 30 day holding periods.
32.2 The use of a 30 year long Canada bond yield as the risk free rate requires a 30
year holding period which dramatically shrinks the number of observations and the
literature is dominated by applied statisticians who like lots of observations and focus
more on methodology than getting the right number.
32.3 There can be no scientific tests for the reason given in 32.2. However, the fact that
a normal yield curve is upward sloping indicates that the yield on the long Canada bond
lies above the yield on treasury bills. This causes the intercept on the empirical CAPM to
increase and the slope to decrease since the market risk premium is smaller. From the
data in Schedule E1 to Dr. Booth’s testimony this adjustment is worth approximately
1.25% added to the risk free rate. The fact that no-one in business uses the CAPM with
a treasury bill yield for valuation purposes validates the model.
32.4 Black’s (JB 1971) zero beta model estimates the effective risk free rate as the
return on a security that has minimum variance and zero correlation with the market
portfolio. At one point, time series of the return on the zero beta portfolio were available
to test this model, just as the size and market to book factors are available to test the
three factor model. However, Dr. Booth is not aware that the return on the zero beta
portfolio is currently available
32.5 As Dr. Booth indicated earlier tests of the efficiency of the market portfolio in
practice need the same data as is needed to estimate betas.
32.6 There have been countless empirical tests that claim that there are anomalies, but
Dr. Booth believes that they are the result of data snooping. The main anomalies focus
on variables that include price. This is consistent with Fama and French’s (JPE 1986)
observation of negative serial correlation over long horizons or over-reaction.
33) Reference: Evidence of Laurence D. Booth, page 50
Preamble:
Concerning the statement, “It is my judgement that betas tend to revert to their long run
average levels: for the market as a whole this is 1.0, but for regulated firms from
Schedule 18, this is about 0.5-0.6.”
Questions:
33.1 Please explain why betas estimated over a long period are not introduced given Dr.
Booth’s judgement that the betas’ long run average levels are more reliable and that the
beta levels estimated over a five year period are too influenced by abnormal events such
as the Internet bubble.
33.2 With reference to Gaz Métro’s beta estimated at 0.5, please point out and supply all
analysis carried out to arrive at this figure. In particular, please justify why a value of 0.5
was retained instead of another value between 0.5 and 0.6.
33.3 With reference to Gaz Métro’s beta estimated at 0.5, please indicate if an objective
reliability standard, such as a statistical standard deviation, or a subjective one, such as
a qualitative assessment, was established for this value. If so, please supply this
reliability standard. If not, please indicate why the reliability of the estimate has not been
examined. If possible, please supply a range of beta values for a confidence level of
90%.
33.1 They are, just look at the figures in Schedules 18 and 20 which track betas over
very long time periods. The average depends on the sample period which is why Dr.
Booth produced a range of 0.50-0.60.
33.2 Dr. Booth’s analysis indicates that Gaz Metros’ risk is similar to that of any other
Canadian utility since regulation and financial structure offset business risk. This is why
adjustment mechanisms used across Canada give such similar results and why the
BCUC adjusted theirs, as the results were out of line with other utilities. On page 54 Dr.
Booth believes that a reasonable estimate is 0.50, where the range for average betas
since 1980 on page 47 has been -0.09- 0.55. This estimate reflects the recent bubble
period passing out of the estimation window. Estimates from the 1960’s and 1970s while
include in a long run average reflect a period when utilities were under pressure due to
high periods of inflation, regulatory lag and the risks of the merchant function. They
would thus over-estimate the current risk and beta estimates for a Canadian utility.
33.3 Dr. Booth does not believe in confidence intervals, since they are a function of the
sample period. Generally the standard error is the standard deviation of the underlying
variable divided by the square root of the number of observations. Statisticians believe
that the standard error goes down as you increase the number of observations so the
estimate gets better. They thus want more observations. Anyone who knows even
limited economics knows that the only way to do this is to go back in time and take in
observations that may or may not reflect current conditions. This means that the
estimates often get worse not better.
34) Reference: Evidence of Laurence D. Booth, pages 53 and 54
Preamble:
Concerning the statement, “most of the decline in the market risk premium has been
caused not by a decline in equity returns but an increase in bond market returns,
commensurate with their increased risk,” and the statement, “it is clear that bond betas
increased dramatically until the mid 1990s when they peaked at over 0.50.”
Questions:
34.1 Please confirm that CAPM theory requires a market risk premium found based on a
risk-free rate.
34.2 Please explain the relevance of using long term Canada Savings Bonds as a riskfree asset when Dr. Booth’s testimony argues that they are not risk free and that their
risk would even have increased since 1956.
34.1 Correct but the problem is that there are a limitless number of risk-free rates
depending on the investor’s holding period. For example when T Bill yields were at 1.5%
two years ago this did not reflect the risk-free rate for an investment project with a thirty
year life. It simply reflected the fact that the Bank of Canada was stimulating the
economy and pushing down short yields. A 30 day treasury bill yield is only risk-free over
a 30 day horizon, since investors with a longer horizon have to reinvest at the end of 30
days. It is thus irrelevant for almost all corporate finance decisions. It is only useful for
asset pricing people who are fixated on 30 day investment horizons and need lots of
data to get any statistical power for their tests.
34.2 This is the conventional practice in valuation, since they reflect interest rate and
inflationary expectations over the investment horizon. They thus avoid many of the
standard pitfalls in valuation. Dr. Booth, like every other expert financial witness in
Canada, also uses the long Canada yield since this is the practice before regulatory
boards for the reasons given in 34.1.
35) Référence: Evidence of Laurence D. Booth, page 54
Preamble:
Concerning the statement, “I currently estimate the market risk premium at 5.0%.”
Questions:
35.1 With reference to the market risk premium estimated at 5.0%, please point out and
supply all analysis carried out to arrive at this precise figure.
35.2 With reference to the market risk premium estimated at 5.0%, please indicate if an
objective reliability standard, such as a statistical standard deviation, or a subjective one,
such as a qualitative assessment, was established for this value. If so, please supply this
reliability standard. If not, please indicate why the reliability of the estimate has not been
examined. If possible, please supply a range of values for the market risk premium for a
level of confidence of 90%.
35.1 and 35.2. Please refer to Dr. Booth’s answers to 33.
36) Reference: Evidence of Laurence D. Booth, pages 54-56
Preamble:
With respect to the two-factor risk premium model.
Questions:
36.1 Please point out and supply all analysis carried out to examine the validity of the
two-factor model for explaining Canadian and US market risk premiums.
36.2 Please identify the academic articles which propose and test this model on the
Canadian and US markets.
36.3 Please confirm that on March 2, 2006, the British Columbia Utilities Commission
concluded that “Dr. Booth’s two-factor model is not helpful in assisting the Commission
Panel in determining an appropriate Market Risk Premium.“
36.1 The theoretical justification would be Ross’s arbitrage model or Merton’s intertemporal CAPM or any other generic factor model., that is the same literature that
justifies Dr. Chretien’s use of the Fama-French model.
36.2
Interest rate risk was a natural factor to consider after the development of
Black’s two factor model, one classic paper is Sweeney and Varga “Pricing Interest Rate
Risk: Evidence from the Stock Market,” Journal of Finance, June 1986 says
36.3 That was the decision of the BCUC but Dr. Booth has presented this model
before other boards without eliciting any negative reaction. The reason being that
interest rate risk is a primary factor in the risk of investing in utilities.
37) Reference: Evidence of Laurence D. Booth, pages 54-56
Preamble:
Concerning the two-factor risk premium model.
Questions:
37.1 Please confirm that the “classic” CAPM presented can be written as follows: MRP R
K F



5 . 0 , where 0.5 is the beta with respect to the market.
37.2 Please confirm that the two-factor model presented can be written as follows: 23 . 1
5 . 0 ) 23 . 1 ( 5 . 0 23 . 1 








MRP R K F , where 0.5 is the beta with respect to the
market and also the “gamma” with respect to the interest rate factor, and where 1.23% is
the average deviation between long term rates and treasury bond rates.
37.3 Please confirm that with a bit of algebra, it is possible to rewrite the two-factor
model, cancelling the 1.23 as follows: MRP R K F 



5.0.
37.4 Please confirm that the two-factor model presented is mathematically equivalent to
the “classic” CAPM presented.
37.5 Please justify the relevance of examining a two-factor model which is equal to the
“classic” CAPM by mathematical construction and will therefore necessarily give the
same rate of return estimate. Please elaborate on the relevance of according equal
weight to two models when they are in fact equivalent.
37.6 Please indicate if you have tested the soundness of these two models on securities
or security portfolios. If so, please produce the results of these tests.
37.1-37.6 The translation of these questions produced questions that are difficult to
answer. In particular the algebra did not translate. Dr. Booth will try to answer all these
questions as he understands them.
First the traditional CAPM is
E ( R j ) RC ( E( R M ) Rc ) j
where the long Canada yield is subscripted c. the two factor model is
E(R j ) RT (E(RM ) RT )j (E(Rc RT )
where T subscripts the treasury bill yield and expected returns are a function of the short
term treasury bill yield and two factors one comprising market risk and the other interest
rate risk.
The CAPM and two factor models can be rearranged as
E (R j ) RC (1 ) E (RM )j
And
E ( R j ) RT (1 ) E( RM ) j ( E ( Rc )
If beta =gamma=0.50 in both models then they give identical estimates as the treasury
Bill yield drops out. However from the data in Schedules 21, 23 and 24 this is not always
the case. To take an extreme case of gamma =1, for the two factor model the estimate
becomes
E ( R j ) E( RM ) j E ( Rc )(1 ) ( Rc RT )
This is then only equal to the CAPM if there is no term premium in which case there is
no interest rate risk or interest rate risk is not priced. In this case, the two-factor is not
relevant anyway. The following table gives the expected rate of return from both models
as gamma varies and all the other parameters are as in Dr. Booth’s testimony.
gamma
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
CAPM
7.5
7.5
7.5
7.5
7.5
7.5
7.5
7.5
7.5
7.5
7.5
2 factor
6.885
7.008
7.131
7.254
7.377
7.5
7.623
7.746
7.869
7.992
8.115
Dr. Booth developed this model in response to other expert (company) witnesses who
argued that utilities needed to have much larger ROEs due to their interest rate risk and
estimated the interest rate risk premium from realised excess returns on bonds over
treasury bills over the last 25 years or so. During this period interest rates have fallen
and this realised excess return has been approximately 4.7% as bonds earned 11.47%
and T Bills 6.75%. As a result, this earned interest rate risk premium ex post was very
large.
Dr. Booth tests the reasonableness of a model in part based on the reasonableness of
its results and is happy that the two factor model gives the same general estimate as the
classic CAPM when you use reasonable market parameters.
38) Reference: Evidence of Laurence D. Booth, page 59
Preamble:
Concerning the statement, “There have been two major approaches to explaining the
puzzle.“
Questions:
38.1 Please identify all of the approaches considered to arrive at this conclusion.
38.2 Please explain why all of the approaches identified above are not major
approaches in the eyes of Dr. Booth.
38.3 Please confirm that the academic literature has shown that the risk premium puzzle
also exists in various countries, suggesting a defect in the standard economic model
rather than a defect in the historical data used to measure risk premium.
38.4 Please confrim that several explanations exist for the premium risk puzzle which do
not throw into question the historic risk premium.
38.5 Please confirm that the historic risk premium which is the basis of the literature on
the risk premium puzzle generally uses a treasury bond as the risk-free asset.
38.1 In terms of estimating the market risk premium the two approaches considered
by Dr. Booth are the only ones that he is aware of. In terms of theoretical work most of
the literature focuses on the time separability of the multi-period utility function of the
representative agent and the introduction of additional sources of risk such as cash flow
risk and/or housing risk.
38.2 Dr. Booth’s evidence is concerned with the estimation of the fair ROE, not the
resolution of interesting theoretical propositions. He leaves the latter to his advanced
financial theory courses and does not want to try the Regie’s patience by discussing it in
this hearing.
38.3 No. The US market risk premium is generally larger than that found in other
mature capital market oriented countries with similar institutional arrangements, such as
the UK and Canada..
38.4
See the answer to 38.1
38.5 The risk premium puzzle in the US exists whether or not the risk premium is
measured over bonds or bills. It is true that part of the risk premium puzzle is also
sometimes referred to as a risk-free rate puzzle by economist who do not seem to
understand that when interest rates increase realized returns on bonds go down. Dr.
Booth cites some of this literature in his testimony.
39) Reference : Evidence of Laurence D. Booth, pages 61-66 of the evidence and
Annex C
Preamble:
Concerning estimates using the standard discounted cash flow method.
Questions:
39.1 With reference to different estimates of the risk premium using the standard
discounted cash flow method, please indicate if an objective reliability standard, such as
a statistical deviation standard, was used for these estimates. If so, please supply this
reliability standard. If not, please indicate why the reliability of the estimate has not been
examined. If possible, please supply a range of values for each estimate for a
confidence level of 90%.
39.2 With reference to different estimates for the dividend rate and the dividend growth
rate used for the standard discounted cash flow method, please indicate if an objective
reliability standard, such as a statistical deviation standard, was established for these
estimates. If so, please supply the reliability standard. If not, please indicate why the
reliability of the estimate has not been examined. If possible, please supply a range of
values for each estimate for a confidence level of 90%,
39.3 Please elaborate on the risks of using the standard discounted cash flow method to
calculate return rates, particularly given the sensitivity of the estimates with respect to
hypotheses on dividend growth.
39.4 Considering the National Energy Board’s “concerns related to the absence of
methods for measuring objectively the expectations of investors with respect to dividend
growth,” (Decision R-H2-94, p. 6), please explain how Dr. Booth’s methods for
determining dividend growth are objective.
39.5 Please confirm that Dr. Booth does not propose to use the standard discounted
cash flow method as the basis for a Gaz Métro calculation formula.
39.1 The estimates are the best estimates from the data. With a single set of data
points it is not possible to set confidence intervals or do the requested tests.
39.2
Please see the answer to 39.1
39.3 The risks are similar to the risks of any estimation technique. Of importance is
that the DCF model is the standard model used in the US and the basis for the FERC’s
regulation of interstate pipelines and electricity companies.
39.4 Dr. Booth’s direct DCF estimates come from a sample of US not Canadian
companies. There are greater problems in finding pure play utilities in Canada which is a
major reason why DCF estimates are not popular.
39.5 Dr. Booth uses DCF techniques as a check on the reasonableness of his overall
estimates. His recommendations are only indirectly influenced by them
40) Reference: Evidence of Laurence D. Booth, pages 69-70 of the evidence and
Annex D
Preamble:
Concerning premium risk reduction due to globalization.
Questions:
40.1 Concerning the example on risk premium reduction due to globalization presented
in pages 5-6 of Annex D, please confirm that the market risk premium is 5.16% in this
example for a Canadian investor in a segmented market.
40.2 Concerning the example of premium risk reduction due to globalization presented in
pages 5-6 of Annex D, please confirm that the market risk premium is 5.82% in this
example for a North American investor in an integrated market where the correlation is
0.85.
40.3 Concerning the example of premium risk reduction due to globalization presented in
pages 5-6 of Annex D, please confirm the exactness of the statement, “As might be
expected by merging the US and Canadian markets, with a constant market price of risk
the new market risk premium is between the US 6.55% and the Canadian 5.16%.”
40.1
Confirmed
40.2
Confirmed
40.3 Confirmed. However, note there was typo in the standard deviation of the US
market. On page 5 it was reported as 20.31%, this is the estimate as of 2005. The most
recent estimate contained in Appendix F is 20.07% which was used in the estimates. If
20.31% is used the integrated market risk premium is marginally higher.
41) Reference: Evidence of Laurence D. Booth, page 70
Preamble:
Concerning the statement, “The objective of regulation is to treat investors fairly. This is
accomplished by awarding a fair return such that the share price should only increase by
the amount of earnings within the firm and not paid out as dividend. If a utility paid out
100% of its earnings as dividend, the share price should approximate its book value, as
long as it continues to be awarded its fair return.”
Questions:
41.1 Please confirm that there are almost no companies in the composite S&P/TSX
index which are traded at or below their book value.
41.2 Please identify all the reasons why Canadian companies generally are traded
above their book value.
41.3 For each reason, please explain why it does not apply to utilities.
41.4 Please confirm that utilities generally are traded in multiples with respect to lower
book values than companies in other sectors.
41.5 Please confirm that the reduction in Gaz Métro’s rate of return for the distribution
rate (about 7.5%) should have the impact, according to Dr. Booth, of making Gaz
Métro’s quoted market price go down to a book value of $7.90, thus falling to a market
price less than half of its current price. If so, please explain how this decline would then
treat Gaz Métro’s investors fairly. If not, please explain why the price would not decline
to the book value.
41.6 If Gaz Métro’s price were to drop to half of its value in order to be traded at a
multiple of one with respect to its book value, please confirm that the return on
distribution side would double to approximately 15%. If so, please explain if the
distribution side return of 15% then represents a fair and reasonable return for Gaz
Métro. If not, please elaborate on the value which the distribution side return would take
as soon as Gaz Métro’s price were to fall by half.
41.1 This cannot be confirmed as Dr. Booth has not collected this data. Further the
market to book ratio is only relevant for regulated firms as their revenues and profits are
based on it whereas for competitive firms they are not. Hence the market to book ratio
for a competitive firm has little relevance.
41.2 The biggest ones are the exercise of market power and that assets are not
recorded on their balance sheet. For example R&D and brand names are the biggest
assets for most firms particularly as we move into a knowledge economy and these
assets are not recorded.
41.3 Utilities are regulated, do not do much R&D and their brand names count for
little. The Consumers Gas Company changed its name to Enbridge Gas Distribution and
it had very little impact.
41.4 Yes you would expect this since they are regulated and do not have any brand
names and do very little R&D.
41.5 This is the problem of regulatory lag. When allowed returns are not cut in line
with market interest rates and the stock price goes up, company analysts then say it is
unfair to cut the allowed return since the price will fall. On the other hand company
witnesses like Dr Kolbe (in his book Kolbe et al) were telling regulators to increase
allowed ROEs when market to book ratios were below 1.0, since this indicated they were
being treated unfairly. The result is regulatory asymmetry to the shareholder’s gain. It is
the job of the regulator to set the fair ROE and let the stock market take care of pricing
the stock.
41.6 No. GMLP’s ROE includes non-regulated earnings as well as possibly an income
tax component, so its ROE is much greater than the regulated ROE. E-trade records
GMLP’s ROE at 15.92% as of September 2006. further a drop in the allowed ROE if
followed by a proportional drop in the market price, which is what would happen if GMLP
were a perpetuity and paid out all it earnings, would have no impact on the dividend
yield.
42) Reference: Evidence of Laurence D. Booth, page 10 of Annex E
Preamble:
Missing formulas
Question:
42.1 Please supply the missing formulas.
42.1 There are no missing formulae in Dr. Booth’s submission, but from the question he
assumes that the following got lot in translation:
E ( R j ) R F MRPj
E ( RC ) RF MRP 
C
or
E ( R j ) E ( RC ) MRP( j 
C)
43) Référence : Evidence of Laurence D. Booth, graph on page 62 and Schedules
26-28, 31-32 of the evidence, Schedules 2-4 of Annex B, Schedules 3-4 of Annex C,
Schedules 1-4 of Annex D, Schedules 1-8 of Annex E and Schedules 1-7 of Annex
F.
Question:
43.1 Please supply an electronic version, in MS Excel files, of the graph and schedules
refered to above. Please include all of the underlying data as well as their sources.
43.1 See the answer to IR #1
44) Reference: Dr. Booth’s Information Request #1 on Dr. Chretien’s Evidence
Preamble:
IR #10: “Please indicate and provide any Canadian decision by a regulator that has
explcicitly accepted a US sample of regulated firms as a suitable proxy for setting the
allowed ROE or capital structure for a Canadian gas LSC.”
Question:
44.1 Please confirm that Dr. Booth was recently interviewed by a consultant who has
studied, in particular, the issue of Canadian and US capital market integration. If so,
please indicate the conclusions of that consultant’s report and please file the report.
Please also indicate who had ordered the study and in what context.
44.1 Dr. Booth fails to see any connection between this question and an information
request of Dr. Carpenter. Further he is constantly being interviewed by consultants as
well as the media, so this questions has to be much more precise. He is not aware of
any consultant asking him questions about capital market integration.
45) Reference: Dr. Booth’s Information Request #1 on Dr. Chretien’s Evidence
Preamble:
IR #24: “Please confirm that Dr. Chretien’s risk measures place US LDCs as riskier
than Canadian ones, so that they should have higher allowed ROEs than Canadian
LDCs, if not why not.”
Question:
45.1 Please confirm that Dr. Booth was recently interviewed by a consultant who has
studied, in particular, the issue of Canadian and US capital market integration. If so,
please indicate the conclusions of that consultant’s report and please file the report.
Please also indicate who had ordered the study and in what context.
45.1
See the answer to 44.
46) Reference: Evidence of Laurence D. Booth, page 32
Preamble:
“If risk is the possibility of incurring harm or a loss the insight from the data in
Schedules 15 and 16 is that regulated utilities in Canada have very little risk”.
Question:
46.1 Please indicate if Dr. Booth considers that risk must be measured taking into
account the frequency with which a utility does not attain the return it is authorized to or
is this affirmation only a hypothesis.
46.1 Short term business risk is measured by the ability of a utility to earn its
allowed ROE. Long-term business risk depends on strategic considerations such
as the risk of stranded assets.