Cost of Capital
Professor Laurence Booth
CIT Chair in Structured Finance
Rotman School of Management
BOOTH GMI 2009
Key Issues before the Regie
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Has Gaz Metro’s business risk increased
since 2007 when the Regie increased its
allowed ROE due to increased business
risk?
Has Gaz Metro’s fair ROE increased?
– What has been the impact of the financial
crisis of 2008-9
– Is it legitimate to continue to base the fair
ROE on long term Canada (LTC) bond yields?
– How do you interpret “A” and Gaz Metro’s
bond spreads over LTC yields?
– Have Canadian LDCs experienced any
problems accessing capital in 2008-9?
What are the implications, if any, of the
NEB’s TQM Decision using ATWACC
BOOTH GMI 2009
Gaz Metro’s Business Risk
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Short run
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Long run
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TransCanada Mainline and TQM
– Has Gaz metro earned its allowed ROE?
– What is the record of Canadian utilities?
– Is there any change in the risk that Gaz Metro may
not be able to recover the capital invested in its
operations?
– Viability of the natural gas market in Quebec
– NEB regards TQM as integrated into the Mainline
– Load on the Mainline has dropped due to declining
productivity in WCSB and increasing intra Alberta
demand
– NEB has allowed the Mainline’s common equity ratio
to increase from 30% to 40% since 2002 to reflect this
increased longer term risk
BOOTH GMI 2009
Gaz Metro
Gaz Metro Allowed vs Actual ROE
15
14
13
12
11
10
9
8
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Allowed
Incentive
Actual
So far no indication of any inability by
Gaz Metro to earn its allowed ROE
BOOTH GMI 2009
Revenue Breakdown Gaz Metro
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
1997
1998
1999
2000
2001
2002
2003
D!
2004
D3
2005
2006
2007
2008
2009
D4+D5
Gradually falling importance of industrial revenues
Increased commercial
BOOTH GMI 2009
2010
No indication of a deterioration in the
competitive position of natural gas
BOOTH GMI 2009
Natural gas seems to be becoming more
competitive with fuel oil for industrial customers
BOOTH GMI 2009
Absolute cost of natural gas has come
down: wells are being shut in in Alberta
BOOTH GMI 2009
Relevance of TQM Decision?
NGTL Throughput Forecast
12
10
8
6
4
2
0
2008/09 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20
Empress
McNeil
ABC
Other
Alberta
Increasing intra-Alberta demand and flat supply
from WCSB
BOOTH GMI 2009
Throughput: Mainline vs TQM
% of 2001 throughput
120.00%
100.00%
80.00%
60.00%
40.00%
20.00%
20
01
/0
20 2
02
/0
20 3
03
/0
20 4
04
/0
20 5
05
/0
20 6
06
/0
20 7
07
/0
20 8
08
/0
20 9
09
/1
20 0
10
/1
20 1
11
/1
20 2
12
/1
20 3
13
/1
20 4
14
/1
20 5
15
/1
20 6
16
/1
20 7
17
/1
20 8
18
/1
20 9
19
/2
20 0
20
/2
20 1
21
/2
20 2
22
/2
20 3
23
/2
20 4
24
/2
5
0.00%
Mainline %
TQM Base
TQM High
TQM Low
TQM throughput forecast to be stable: increasing supplies
from Dawn Hub
NEB disregarded this as TQM integrated with the Mainline.
BOOTH GMI 2009
Financial
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US economy has been in recession for the last 18
months as result of losses on sub-prime mortgages
Canada was largely immune from this:
– TSX hit record highs in July 2008
– CDN$ stayed over $1 US through Summer 2008
– Bank of Canada had begin lowering interest rates to
stimulate the economy
Catalyst: Failure of Lehman Brothers September 14,
2008
– Domino effect around the world as banks focused on
survival:
v
v
v
v
Hoarded cash
Reduced lending
Sold of securities to bolster capital
Reduced principal trading in debt markets: reduced
liquidity
BOOTH GMI 2009
BOOTH GMI 2009
CP
BA
Money market now back to normal in Canada
7/1/2009
6/17/2009
6/3/2009
5/20/2009
5/6/2009
4/22/2009
4/8/2009
3/25/2009
3/11/2009
2/25/2009
2/11/2009
1/28/2009
1/14/2009
12/31/2008
12/17/2008
12/3/2008
11/19/2008
11/5/2008
10/22/2008
10/8/2008
9/24/2008
9/10/2008
8/27/2008
8/13/2008
7/30/2008
7/16/2008
7/2/2008
Short Term Credit Spreads
Money Market Spreads
300
250
200
150
100
50
0
Stock Market Collapse
Index or Exchange
United States Composite
(US Dollar)
Japan Composite (US
Dollar)
United Kingdom
Composite (US Dollar)
Canada Composite (US
Dollar)
Germany Composite (US
Dollar)
Hong Kong Composite
(US Dollar)
Spain Composite (US
Dollar)
Switzerland Composite
(US Dollar)
Last Trade
Date
213.40
10/24/2008
82.39
10/24/2008
149.79
10/24/2008
278.25
10/24/2008
218.89
10/24/2008
186.44
10/24/2008
388.93
10/24/2008
374.65
10/24/2008
1Day
Change
-7.52
1 Day
%
-3.40%
1 Month
%
-27.53%
6 Month
%
-37.17%
YTD %
-2.74
-3.21%
-22.00%
-32.07%
-35.54%
-11.63
-7.21%
-35.44%
-48.66%
-52.51%
3,441
-4.74
-1.67%
-40.46%
-48.15%
-49.61%
1,636
-14.62
-6.26%
-39.40%
-51.88%
-56.28%
1,426
-10.10
-5.14%
-31.80%
-51.39%
-57.97%
1,361
-26.01
-6.27%
-34.22%
-50.24%
-51.93%
1,146
-10.44
-2.71%
-22.21%
-32.06%
-34.35%
1,111
-40.46%
2006 $b
Value
18,039
4,422
Real Economy can not flourish if the financial system is
broken:
1)
Credit crunch: banks hoard cash
2)
Real economy stops spending
3)
Sharp recession started 2008Q4 in Canada
BOOTH GMI 2009
BOOTH GMI 2009
BBB
A
CAN
LTC Yields fell, Corporate debt yields increased
2/25/2009
6/9/2008
9/20/2007
1/2/2007
4/14/2006
7/27/2005
11/8/2004
2/19/2004
6/3/2003
9/13/2002
12/26/2001
4/9/2001
7/20/2000
11/2/1999
2/12/1999
5/27/1998
9/8/1997
12/19/1996
4/2/1996
7/14/1995
10/26/1994
2/7/1994
5/20/1993
9/1/1992
12/13/1991
3/27/1991
7/9/1990
10/19/1989
1/31/1989
5/13/1988
Yields
15
13
11
9
7
5
3
BOOTH GMI 2009
11/20/2008
11/20/2007
11/20/2006
11/20/2005
11/20/2004
11/20/2003
11/20/2002
11/20/2001
11/20/2000
11/20/1999
11/20/1998
11/20/1997
11/20/1996
11/20/1995
11/20/1994
11/20/1993
11/20/1992
11/20/1991
REAL BOND YIELD
5.50
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
Real Canada bond yield increased: no sign of a rush
into long Canada bonds
BOOTH GMI 2009
Drop in LTC yield was caused by:
* Fear of a Great Depression 2 and deflation
* Current inflation rate: 0.5% will rise to 2% in 2010/11
2009-05
2008M11
2008M5
2007M11
2007M5
2006M11
2006M05
2005M11
2005M05
2004M11
2004M05
2003M11
2003M05
2002M11
2002M05
2001M11
2001M05
2000M11
2000M05
1999M11
1999M05
1998M11
1998M05
1997M11
1997M05
1996M11
1996M05
1995M11
1995M05
1994M11
1994M05
1993M11
1993M05
1992M11
1992M05
1991M11
Break-Even Inflation Rate (BEIR)
6
5
4
3
2
1
0
1935
1937
1939
1941
1943
1945
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
Dr. Vilbert’s 1.0% Spread
Premium Add on to the LTC Yield
BondBetas
0.8
0.6
0.4
0.2
0
-0.2
-0.4
US
BOOTH GMI 2009
Canada
Conclusion
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LTC Yields remain the only opportunity cost
or expected rate of return in the capital
market
The real yield increased indicating no “rush
to quality in LTC bonds”
Drop in nominal yield reflected lower
expected inflation
I expect LTC yields to increase to 4.5-4.75%
over 2010, (currently 4.0%)
The rush to quality occurs in short term
bonds:
– T Bill yields went negative in the US
– Currently 0.26% in Canada
BOOTH GMI 2009
BOOTH GMI 2009
A
BBB
11/25/2008
4/3/2008
8/13/2007
12/20/2006
4/28/2006
9/6/2005
1/13/2005
5/24/2004
10/1/2003
2/7/2003
6/18/2002
10/25/2001
3/5/2001
7/12/2000
11/19/1999
3/30/1999
8/6/1998
12/15/1997
4/23/1997
8/30/1996
1/9/1996
5/18/1995
9/26/1994
2/2/1994
6/11/1993
10/20/1992
2/27/1992
7/8/1991
11/14/1990
3/23/1990
8/1/1989
12/8/1988
4/18/1988
A and BBB Spreads
500
450
400
350
300
250
200
150
100
50
0
5.477% is not an unfair or unreasonable debt cost
BOOTH GMI 2009
BOOTH GMI 2009
Forecast Test Year
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MVIX: Volatility of the Canadian equity
market has declined precipitously
TSX is up 40% since March lows and
recently was above 11,000
“A” spreads now close to normal cyclical
levels
Economy recovering
Has this affected the equity cost going
forward and should it affect the ROE
mechanism?
BOOTH GMI 2009
Risk Premium Models
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Explicit Risk premium model
– CAPM
– Primary reliance by NEB (RH-1-2008)
– NEB rejected ECAPM since it is based on
empirical work using Treasury Bill yields as
the risk free rate and (Dr. Vilbert) produces
Nonsense results
K  RF  MRP * 
Time Value of
Money
BOOTH GMI 2009
Market Risk
Premium * “beta”
BOOTH GMI 2009
Annual Returns 1926-2008
Annual Rate of Return Estimates 1926-2008
U.S.
CANADA
S&P
Long US
Excess
TSE
Long
Excess
Equities
Treasury
Return
Equities
Canadas
Return
AM
11.66
6.05
5.61
11.10
6.56
4.54
GM
9.61
5.67
3.94
9.41
6.21
3.20
OLS
11.13
5.06
6.07
10.44
5.74
4.70
Volatility1
20.56
9.19
18.90
8.84
Arithmetic is simple average; geometric is compound and OLS is the least squares estimate.
Approximately Geometric Mean = Arithmetic Mean - .5*variance
For example, US variance is about 4%, so AM and GM diverge by about 2%
BOOTH GMI 2009
Fernandez Survey May 2009
1) US MRP is higher than in Canada
2) Median Canadian MRP is 5.1%,
1) Dr. Booth uses 5.0%
2) Dr. Vilbert uses 7.75%
BOOTH GMI 2009
If the Regie randomly asked a Canadian finance professor what
the MRP is, the answer would almost certainly be 5.0% or 6.0%
BOOTH GMI 2009
-0.100
BOOTH GMI 2009
Utility beta
Utility (No TAU)
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Relative Risk (BETA)
Average Utility Betas
0.600
0.500
0.400
0.300
0.200
0.100
0.000
Stock Performance over Last
Year
BOOTH GMI 2009
Stock Performance over Last
Year
BOOTH GMI 2009
Stock Performance over Last
Year
BOOTH GMI 2009
Stock Performance over Last
Year
BOOTH GMI 2009
Stock Performance over Last
Year
BOOTH GMI 2009
Stock Performance over Last
Year
BOOTH GMI 2009
BOOTH GMI 2009
Fair ROE
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LTC Yield:
Market Risk Premium:
Beta:
Raw Estimate:
4.50%
5.0%
0.5
7.0%
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Issue costs:
0.50%
Margin of Error
(6% MRP & beta of 0.50 = 0.50%): 0.25%
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Recommended ROE:
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BOOTH GMI 2009
7.75%
ATWACC
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After tax weighted average cost of capital
ATWACC  Equity cos t *
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EquityValu e
Debt
 Aftertaxde bt cos t *
Totalvalue
Totalvalue
Dr. Kolbe assumes ATWACC constant and uses
it to get utility ROE. All else constant if M/B>1
the result is a higher ROE
Normally high M/B indicates the ROE is too
high, ATWACC reverse this by claiming that
financial risk is higher!
BOOTH GMI 2009
ATWACC
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NEB TQM Decision (RH-1-2008)
NEB used Dr. Vilbert’s base CAPM estimate of
7.4%
Dr. Vilbert now increases this estimate:
– Market Risk Premium +2%
– Spread adjustment to LTC Yield +1%
BOOTH GMI 2009
BOOTH GMI 2009
Dr Kolbe
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Takes Dr. Vilbert’s 7.25% and increases it
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At TQM’s 6.4% ATWACC
–
–
–
–
BOOTH GMI 2009
+0.25% for higher risk
+0.10% for embedded cost of debt
+0.15% for issue costs
Note this is applied to total rate base
Traditional Methodology
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7.75% ATWACC means 12.39% ROE on
current deemed common equity of 38.5%
Dr. Vilbert’s direct estimates of the equity
cost estimates are similar to mine
How does a reasonable equity cost estimate
become an unreasonable ROE
recommendation of 12.39%?
BOOTH GMI 2009
Answer: :Leverage Adjustments
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Dr. Kolbe assumes that the ATWACC is
constant so that if the M/B ratio >1, the
utility cost of capital with book weights has
to have a higher ROE to get the same
ATWACC as with market value weights
Suppose the regulator lowers the utility’s
risk
– market value goes up and ROE should be
lowered
– ATWACC places higher weight on equity sot
eh ATWACC increases keeping the ROE
higher than a fair return
– Produces the exact opposite result from that
which you would expect
BOOTH GMI 2009
NEB vs Alberta EUB
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“the Board considers that beta and the cost of equity do not change to the extent necessary for an
ATWACC, determined from market capitalization weights, to remain constant when applied to
the book capitalization for a pure play regulated utility. The increase required to the cost of
equity to achieve a constant ATWACC would be excessive and violate the fair return standard.”
1
2
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NEB simply used an ATWACC of 6.4%. They
said nothing about a constant ATWACC or Dr.
Kolbe’s leverage adjustments
– Consistent with 9.7% ROE on 40% Common
equity
– 40% common equity is the same as the
TransCanada Mainline
BOOTH GMI 2009
Financing
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No bond rating downgrades of Canadian
utilities over the last year
– Newfoundland Power just got upgraded two
notches and it has an RTOE formula
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Significant new financing by major utilities
during last year’s crisis: TransCanada,
Enbridge and Fortis
No dividend cuts by significant Canadian
utilities
AltaGas just been sold for a 45% premium
over its market price
Canadian Utilities remain financial sound
with no market access problems
No indication that the Regie’s ROE formula
is unfair.
BOOTH GMI 2009