August 7, 2007
File no: R-3630-2007
IGUA’S response to Information Request #1 by the Régie to IGUA
August 7, 2007
File #: R-3630-2007
Information Request #1 by the Régie to IGUA
Page 1 of 3
INFORMATION REQUEST #1 FROM THE RÉGIE DE L’ÉNERGIE (“LA RÉGIE” ) ON SUBJECTS
RELATING TO THE HEARING REGARDING A REQUEST TO MODIFY G AZ M ÉTRO, LIMITED
PARTNERSHIP (“GAZ MÉTRO” ) RATES STARTING O CTOBER 1, 2007
1. Reference: Fair Return for Gaz Métro, Evidence of Laurence Booth, July 2007,
Preamble:
Fama-French model.
Questions:
1.1 What is your opinion with respect to applying the Fama-French model in the context
of a regulated company.
Dr. Booth believes that the Fama-French model is not accepted widely enough to be used
in a current regulatory hearing.
The Fama-French model is one variation on a general class of factor models. The genesis
of all these models is Ross’s arbitrage pricing theory (APT) that indicated that in an
arbitrage free capital market under quite loose conditions expected returns would be
linearly related to the risk premiums on externally specified risk factors. The Achilles
heel to these models is the specification of the factors.
Roll and Ross (JF 1980) specified the APT in terms of macro-economic variables such as
industrial production, changes in expected and unexpected inflation and default and yield
premia, whereas others have used factor analysis to see what factors returns “load on.”.
However, William Sharpe, inventor of the CAPM, for which he received a Nobel prize,
responded that such APT models could always be given a multi-beta interpretation
consistent with the CAPM.
This literature then died down as the focus moved to explaining anomalies that could not
be explained by the CAPM. Many of these anomalies revolved around the fact that
“high” priced firms subsequently earned lower rates of return. Anomalies such as the PE
effect, the dividend yield effect, the over-reaction effect all involve the firm’s existing
price. Another anomaly was the size effect, that institutions tend to be restricted to
investing in large cap stocks and thus their expected rates of return tend to be lower since
their prices have been bid up. In contrast, small cap stocks tend to be neglected by large
institutions and there is less public information on them, so they tend to earn higher rates
of return. The Fama-French model codifies these anomalies as risk factors, since in
addition to the market return they add a size factor and a factor that includes the market
price (the inverse of the market to book ratio).
Professor Fama is the “high prince” of market efficiency and many have interpreted the
Fama-French model as a way of interpreting anomalies to market efficiency as “risk
factors” consistent with market efficiency. The Fama-French model is thus very
controversial amongst finance academics. Those who do not accept the (University of)
Chicago view of market efficiency simply see the Fama-French model as an example of
“data snooping,” that is, they have spun the security return tapes enough times to find
factors that work in explaining returns. Others who do not accept the extreme Chicago
view on market efficiency see these same factors as evidence of market inefficiency.
The problem is that there are only limited economic foundations for two of the three risk
factors in the Fama-French model. The size variable very much depends on very small
firms during the sample period, while the impact of the market to book ratio is the
opposite to what intuition indicates. The normal intuition is that firms with high market to
book ratios, like Google, are riskier because the high valuation reflects the existence of
future excess profits, which by their nature are risky due to competition. In contrast firms
with low market to book ratios, like utilities, are less risky since there are no excess
profits to be competed away. Instead the Fama-French model implies that firms with high
market to book ratios are lower risk, while utilities with low market to books are high
risk, which doesn’t make any sense. Until there is a well-accepted economic foundation
for the Fama-French factors, Dr. Booth believes it is a classic case of fitting an ad-hoc
model to the data without any justification. Further, since the Fama-French model was
developed there has emerged a growth industry in factor models as factors such as
momentum, skewness and liquidity have all been put forward as “risk” factors.
In Dr. Booth’s judgment these factor models are at too primitive a stage to be used in
regulatory hearing and to the best of his knowledge none has ever been accepted or even
presented before in a Canadian regulatory environment.
However, the Regie should be aware of some of the implications of Dr. Chretien’s work
using the Fama-French multi-factor model.


In his three Canadian indexes, both for the Dow Jones Canada Gas
Distribution index and the Datastream index, Enbridge is the most important
component since these indexes are weighted by their market value. This is
why the correlation with Enbridge is so high. Apart from this high correlation,
the other Canadian utilities clearly have the best correlation with his sample of
Canadian utilities. In contrast, the correlation with the US indexes is so low
that for some of them they could in reality be zero. This confirms the
importance of risk measures relative to a Canadian market index and that the
only sample that is relevant is the sample of Canadian utilities.
In Dr. Chretien’s Fama-French estimates in Table 2 (page 39) the beta
coefficient on the market for his Canadian utility sample is 0.484, which
approximately confirms the lower end of Dr. Booth’s beta range of 0.45. In
his adjusted CAPM estimates in Table 3 on page 48 the beta estimates for the
Canadian samples are 0.560, which confirms the high end of Dr. Booth’s beta



range of 0.55. Without accepting his models, Dr. Chretien’s statistical work
approximately confirms the range of Dr. booth’s own estimates for Canadian
utilities of 0.45-0.55.
The risk premiums from Dr. Chretien’s Fama-French estimates for his
Canadian utility sample is 4.232%, which is HALF his estimates for the US
sample confirming again the low risk nature of Canadian utility holding
companies relative to those in the US and the inadvisability of using evidence
from the US for Canadian companies. If this risk premium is added to the
4.3% forecast long Canada rate and 0.30% added for issues costs then the
resulting estimate of 8.83% is only 0.28% higher than the Regie’s formula
allowed ROE.
In Dr. Chretien’s adjusted CAPM the risk premium for the Canadian utilities
in Table 3 is 4.884%, which with a 4.3% long Canada rate and 0.30% for
issue costs gives an ROE of 9.48%. However, this only comes about due to a
1.39% “error” correction, so without this the estimate is 8.09% lower than the
Regie’s formula allows. Of note is that the “error” correction is essentially an
adjustment for the fact that realised returns have been higher than expected
due to interest rate declines in Canada. Whether this has any relevance for
future returns is doubtful.
To be consistent with his empirical testing and estimates, both Dr. Chretien’s
Fama-French and Adjusted CAPM models should be used with the treasury
bill or short term interest rate as the risk-free rate. Instead Dr. Chretien
estimates the parameters using the short-term rate and then applies the models
using his modified risk-free rate, based on long Canada yields. This is clearly
a contradiction. Since long Canada yields are normally higher than the short
term rate Dr. Chretien essentially double counts the adjustment to the CAPM
and artificially inflates his estimates.
These comments on Dr. Chretien’s implementation of the Fama-French and Adjusted
CAPM models simply highlight the problems in using these novel models. The fact is
that the practise of finance is to use a CAPM with the long Canada bond yield as the riskfree rate and an adjusted beta as the risk coefficient. These adjustments along with a
market risk premium of 5.0% are used daily by the large investment banks in Canada in
valuing firms in research reports, since they have stood the test of time. In contrast, the
Fama-French and adjusted CAPM models so far have not.
2. References: i) Exhibit Gaz Métro-7, Document 8, pages 24 et 25.
ii) Exhibit Gaz Métro-7, Document 8.20, page 1.
Preamble:
Modified risk-free rate proposed by Gaz Métro
Questions:
2.1 What is your opinion about Dr. Chrétien’s proposal which recommends establishing
the mean level of long term rates at 6.41% instead of 5.76% in order to better reflect the
average conditions of 30 Canadian year rates in the formula for setting the risk-free rate.
2.2 Please make the link between the risk-free rate anchorage point to a given year and
the effect on the return on shareholders’ equity of a regulated company.
2.1
Dr. Booth has no problem with a recalibration of the adjustment mechanism. This
can be based on any interest rate as long as the resulting estimate of the ROE is
fair. Since the Regie considered the results of the adjustment model fair in 1999,
any new model has to be consistent with this decision. Otherwise, explicitly the
Regie’s 1999 decision is thought to be unfair. For example, in document Gaz
Metro 7 10.1 the fair ROE for 1998, and what it would be now, was described as
follows:
Risk free rate:
Risk premium (0.55 beta*market risk premium of 6.5%)
Issue costs
Fair ROE in 1999
Change in risk free rate (5.76-4.30)
Change in fair ROE 75% of change in risk-free rate
Fair ROE
5.76%
3.58%
0.30%
9.64%
-1.46%
-1.09%
8.55%
If Dr. Chretien’s recommendation for the risk-free rate is accepted then the risk
premium for 1999 has to be altered accordingly, so that the fair ROE in 1999 is
still 9.64%:
1999 Modified Risk free rate:
75% of 1999 rate of 5.76%:
25% of long run rate of 6.41%:
Risk premium
Issue costs
Fair ROE in 1999
Current modified risk-free rate:
75% of current rate of 4.30%:
25% of long run rate of 6.41%:
Risk premium
Issue costs
Fair ROE
5.92%
4.32%
1.60%
3.42%
0.30%
9.64%
4.83
3.23%
1.60%
3.42%
0.30%
8.55%
In this way the smaller risk premium for 1999 of 3.42% is consistent with the
motivation of the adjustment mechanism that the size of the market risk premium
varies inversely with the level of interest rates. As a result, the 0.65% higher riskfree rate of 6.41% is offset by a 0.65% smaller risk premium of 3.42%, but the
fair ROE remains that set by the Regie in 1999 of 9.64%
If this adjustment to Dr. Chretien’s formula is made, the recommendation for the
fair ROE for 2008 would be identical between the Regie’s existing formula and
that proposed by Dr. Chretien. However, what Dr. Chretien seems to have in mind
is the simple proposition that the Regie’s fair ROE in 1999 was too low and he
seems to envisage using the same risk premium of 3.58% (+ issue costs) the Regie
found to be fair in 1999 combined with his higher (modified) risk free rate. My
understanding is that Dr. Chretien envisages the following:1
1999 Modified Risk free rate:
75% of 1999 rate of 5.76%:
25% of long run rate of 6.41%:
Risk premium
Issue costs
Fair ROE in 1999
Current modified risk-free rate:
75% of current rate of 4.30%:
25% of long run rate of 6.41%:
Risk premium
Issue costs
Fair ROE
5.92%
4.32%
1.60%
3.58%
0.30%
9.80%
4.83
3.23%
1.60%
3.58%
0.30%
8.71%
Note that the fair ROE for both 1999 and now is higher by 0.16% as a result of
Dr. Chretien’s modified risk-free rate. The fact is that his change to the Regie’s
formula has nothing to do with interest rate modelling, instead it is simply a way
of increasing the formula ROE by 0.16%.
2.2
1
In any risk-based model the “anchor” is the current risk-free rate. This holds
whether the risk-based model is the CAPM, a multi-factor model or the arbitrage
pricing model. This is because we are explicitly breaking the fair rate of return
into time and risk value of money components. Consequently the use of anything
other than the current risk-free rate is extremely difficult to understand. As is
explained in answer to 2.1 it is always possible to substitute a “modified” risk-free
rate, for the current risk-free rate, in a formula adjustment for the fair ROE, as
long as the risk premium is adjusted accordingly. If the risk premium is not
adjusted, as it is not in Dr. Chretien’s model, the resulting ROE estimate will not
be fair. However, why anyone would want to use such a modified risk-free rate
model is difficult to understand.
This is based on his explicit examples in footnotes 18& 19 on page 25 of his testimony.
In Dr. Booth’s judgment the use of this modified risk-free rate by Dr. Chretien
results from a misunderstanding on his part as to why adjustment mechanisms
have been adopted. In his testimony Dr Chretien refers to “interest rate
modeling” and the fact that “The Regie has (indirectly) selected an average
towards which the expected long-term risk-free rate must converge that equals the
expected risk-free rate for 1999.” This interpretation is totally incorrect. Even if
we accept his interpretation of the adjustment mechanism, there is nothing that
causes the long-term risk-free rate to converge to anything. However, of more
importance is that regulatory boards have not based the adoption of ROE
adjustment mechanisms on any interest rate modelling.
Dr. Booth participated in the original BCUC and NEB hearings that resulted in
the adoption of their adjustment mechanisms, as well the initial applications in
Ontario and Manitoba. In all cases the focus was on how the risk premium varied
with the level of interest rates. The specific empirical regularity that justified this
was the observation that risk premiums varied inversely with the level of interest
rates. In the period of high interest rates in the late 1970’s into the mid 1990s
utility risk premiums were very “low” and they subsequently increased as interest
rates came down. As Dr. Booth discusses in his Appendix F bond market risk was
very high at this time, so that utility risk premiums over long bond yields should
have been very low. Consequently Dr. Booth judges both the economic and
regulatory foundations for the adjustment mechanism to be the inverse
relationship between interest rates and risk premiums. The use of ROE adjustment
models doesn’t have anything to do with modified risk-free rates or interest rate
modeling as envisaged by Dr. Chretien. This is a strange interpretation.
3. Reference: Fair return for Gaz Métro, Evidence of Laurence Booth, July 2007,
page 43.
Preamble:
“In this case the BCUC felt that Terasen’s RSAM deferral 2 account was worth 0-3% on
its common equity ratio. However, Gaz Metro is also deemed a 7.5% preferred equity
ratio for a total equity ratio of 46% one of the largest of any Canadian utility since
almost all Canadian utilities have been retiring their preferred shares. This is because of
recent accounting changes that cause debt like preferred shares with hard retractions to
be treated like debt for reporting purposes regardless of their legal characteristics. With
a 46% equity ratio Gaz Metro has a very large offset to any remaining risk differences
between it and the two large Ontario Gas LDCs.”
Questions:
3.1 Please elaborate further on what treatment the Régie should consider for preferred
shares.
===========================================================
This depends entirely on what sort of preferred shares the Regie deems for Gaz Metro.
Regulated utilities have used preferred shares since they were equity for reporting
purposes but acted like debt. In this way they increased coverage ratios and acted as
intermediate financing to help firms gain access when their coverage ratios may
otherwise have restricted access. However, if the preferred shares are structured like debt
where they are paid off in a short time period (5 years or so) then for reporting purposes
they are now treated like debt. These accounting changes and the repeal of the PUITTA,
which rebated the income tax paid ahead of preferred shares, reduced their attractiveness
so that most utilities have been redeeming their preferred shares and replacing them
mainly with debt.
Since Gaz Metro finances with first mortgage bonds and faces no access problems in
terms of having to maintain a particular interest coverage ratio to issue debt, there is no
reason for the preferred shares. Consequently Dr. Booth would recommend that they be
treated as debt.
4. Reference: Fair return for Gaz Métro, Evidence of Laurence Booth, July 2007,
pages 3, 6, 7 and 70.
Preamble:
page 3 “The generosity of the current allowed ROE to Gaz Metro is also indicated by the
fact that on October 10, 2006 GMi sold 2,9133,753 units of Gaz Metro for $17.16 a unit
and recognized a gain of $16.70 million on the $50 million in proceeds. Again, this sale
was at a significant premium to book value indicating that the allowed ROE is above the
investor’s required rate of return or fair ROE.”
pages 6 and 7 “Further as of September 2006 the book value of GMLP was $7.87 so at
$16.84 GMLP was selling for over 2X book value. I will discuss the importance of market
to book ratios as signals to regulators of the fair ROE later, but the fact that GMLP is
selling at such a premium to book value indicates that the return earned by GMLP is in
excess of what 1 investors require. From this market data on GMLP it is clear that the
fair ROE is significantly less than the 10.19% estimate of Dr. Chretien on behalf of Gaz
Metro.”
page 70 “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 retained within the firm and not paid out as a dividend. If a utility paid out
100% of its earnings as a dividend, the share price should approximate its book value, as
long as it continues to be awarded its fair return. »
Questions:
4.1 Could you please be more precise as to your opinion, in the reference on page 70,
with respect to the link you establish between the company’s distribution policy, the
share or unit price and the book value.
4.2 Please elaborate as to the conclusions you present in the references on pages 3, 6 and
7.
4.1
If investors capitalize a utility with $11, but $1 is taken in investment banking
fees and issue costs etc so that $10 is in the rate base, and the opportunity cost is
10% then they expect to earn $1.1 on the $11 investment or 11% on the $10 net to
the company. If this fair treatment is expected to continue forever, then the stock
would sell at a market to book of 1.1X. In this way a market to book of 1.1X
reflects the dilution or issue costs that are incurred to raise capital. Absent any
such costs the market to book would be 1.0.
If the fair ROE then drops to 8%, but the regulator does not respond, assuming
again that this is expected to continue forever, the stock price would increase to
$13.75 and the market to book ratio becomes 1.375 indicating that the allowed
ROE is excessive and should fall. Consequently effective regulation implies that
the market to book ratio should be a small premium over 1.0. Of course the
regulator cannot control market prices, but a persistent pattern of a utility’s stock
price being significantly in excess of 1.0 indicates that allowed ROEs are
generous and should be cut. As the Alberta EUB said (Decision U99099, Vol 1,
page 303)
“The Board would be derelict in its statutory responsibilities to recognize market
capitalization ratios that are derived from a market value capitalization that
deviates from the intrinsic long-run value of the regulated firm.”
The EUB recognized that market values should be close to book values. This
proposition is clear when 100% of earnings are paid out as dividends, since the
stock can be simply valued as a perpetuity, since there is no growth. Slightly more
assumptions have to be made to get the same result when a significant amount of
earnings are reinvested within the firm. However, the general result still holds that
market to book ratios for regulated firms indicate how satisfied investors are with
the allowed ROE. In this sense it parallels results for the bond market where
bonds selling at a premium to par value (market to book above 1.0) indicate that
interest rates (fair returns) have fallen. These general ideas were expounded by
Dr. Booth in an article in the NRRI Bulletin, “The Importance of Market to Book
Ratios in Regulation, which is attached as Booth NRRI paper 1997.pdf
4.2
Dr. Booth believes that the fact that GMLP units sell significantly above book
value indicates that the ROE earned by GMIP is higher than a fair ROE. Similarly
the sale of utility assets at well above book value to other utilities indicates that
their allowed ROEs are generous. Dr. Booth also notes that GMIP’s ROE seems
to contain an income tax component which inflates the ROE above the regulated
level.
4.3
5. Reference: Fair Return for Gaz Métro, Evidence of Laurence Booth, July
2007,
Appendix E, Schedule 1, page 14 and Appendix F, Schedules 1 and 2.
Preamble:
Data series and sources
Questions:
5.1 Please file in Excel format the data series as well as their sources.
This is contained as Booth-Regie 1.xls