BEFORE THE
RÉGIE DE L’ÉNERGIE
GAZ MÉTRO
R-3690-2009
Direct Evidence of
Michael Gorman
Filed July 14, 2009
On behalf of
The Canadian Industrial Gas Users Association
(IGUA)
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Summary
1.
ATWACC suffers from material empirical deficiencies and
should be rejected.
2.
The ATWACC will introduce significantly more cost of service
volatility and rate instability to utility rate setting. This cost of
service instability will be detrimental to both customers and
investors.
3.
Traditional methods of setting a utility rate of return have
resulted in significant investment, have fairly compensated
investors and have maintained utilities’ financial integrity.
4.
The ATWACC does not comply with the Québec regulatory
standards and Régie rules for Rate Fixing and Modification.
5.
Gaz Métro does not have greater business risk than U.S.
LDCs.

S&P, DBRS, and Scotia Capital all find that Gaz Métro
has “Low” business risk.
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I. ATWACC Empirical Deficiencies

No proof that financial risk is measured by market
participant using market value capital structure
information. To the contrary, significant proof book that
value capital structure data is used to measure financial
risk.

Dr. Vilbert used Gaz Métro income tax rate for all sample
companies rather than each company’s actual tax rate.
As a result, he has erroneously estimated the sample
group’s ATWACC.

ATWACC will not produce reliable results.

ATWACC is driven by market-to-book ratio variations to
capital balances. The market-to-book ratio adjustment is
flawed and produces unreliable results.
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Financial Risk

The ATWACC is based on the premise that financial
risk is derived from market value capital structure
weights (Kolbe at 27, Vilbert at 8).

Virtually all credit and equity analyst reports on
utilities provide investors financial risk data on book
value information.

Scotia Capital Gaz Métro Document 1

CIBC World Markets Gaz Métro Document 12

Standard & Poor’s Gaz Métro Document 10

DBRS Gaz Métro Document 9
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ATWACC and Tax Rate

ATWACC theory states that all companies will use debt capital to
maximize the tax shield value of debt.

Tax shield is created by converting the cost of debt to its after-tax
cost (debt interest * (1 – tax rate))



Dr. Vilbert incorrectly used Gaz Métro’s income tax rate (30.2%)
to estimate each company’s ATWACC.
U.S. LDCs have composite state and federal income tax rates
much greater than 30.2%.

State tax rate varies from 0% to more than 5%.

Federal tax rate: 35%.

Composite U.S. income tax rate ranges from 35% to around
40%.
Since Dr. Vilbert understated the sample group companies’
composite income tax rate, he incorrectly calculated and
overstated the sample’s ATWACC.
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Dr. Kolbe’s ATWACC
Adjustments Are Flawed

Interest expense adjustment based on debt
interest “rate” and not interest “expense”

Flotation return on equity and ATWACC
adder – contradicts ATWACC principle –
inflates ATWACC
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ATWACC is Not Reliable

ATWACC would be developed in each rate
case based on updated market valuation of
capital component costs, and market capital
costs for all components of overall rate of
return.

In contrast, traditional rate of return locks in
all components of rate of return except
return on equity.

ATWACC will not meet standard of
competitive rates and financial integrity.
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Exhibit MPG-1
Gaz Métro
After-Tax Weighted Average Cost of Capital (ATWACC) Volatility
Book Value Capital Structure
Year 0
Line
Description
Amount
(1)
Year 1
Weighted
Cost
(4)
After-Tax
Weighted
Cost
(5)
Weight
(2)
Cost
(3)
50%
10.00%
5.00%
5.00%
$
100
7.00%
3.50%
2.45%
$
8.50%
7.45%
$
1
Common Equity
$
100
2
Variable Rate Debt
$
100
50%
3
Total Capital
$
200
100%
4
Earnings Interest Coverage
5
Tax Rate
Amount
(6)
Weight
(7)
Cost
(8)
Year 2
Weighted
Cost
(9)
After-Tax
Weighted
Cost
(10)
Amount
(11)
After-Tax
Weighted
Cost
(15)
Weight
(12)
Cost
(13)
50%
11.25%
5.63%
5.63%
8.25%
4.13%
2.89%
9.75%
8.51%
50%
9.75%
4.88%
4.88%
$
100
100
50%
6.75%
3.38%
2.36%
$
100
50%
200
100%
8.25%
7.24%
$
200
100%
1.43x
Weighted
Cost
(14)
1.44x
1.36x
30%
Market Value Capital Structure
Year 0
Line
Description
Amount
(1)
Year 1
Weighted
Cost
(4)
After-Tax
Weighted
Cost
(5)
Weight
(2)
Cost
(3)
50%
10.00%
5.00%
5.00%
$
150
7.00%
3.50%
2.45%
$
8.50%
7.45%
$
6
Common Equity
$
100
7
Variable Rate Debt
$
100
50%
8
Total Capital
$
200
100%
9
Earnings Interest Coverage
1.43x
Equity Market/Book Ratio
1.00
10
Amount
(6)
Weight
(7)
Cost
(8)
Year 2
Weighted
Cost
(9)
After-Tax
Weighted
Cost
(10)
Amount
(11)
After-Tax
Weighted
Cost
(15)
Weight
(12)
Cost
(13)
43%
11.25%
4.82%
4.82%
8.25%
4.71%
3.30%
9.54%
8.12%
60%
9.75%
5.85%
5.85%
$
75
100
40%
6.75%
2.70%
1.89%
$
100
57%
250
100%
8.55%
7.74%
$
175
100%
8
Weighted
Cost
(14)
2.17x
1.02x
1.50
0.75
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ATWACC is Based on a Market-to-Book
Adjustment to Capital Component Balances

Market value capital structure weights used to derive
ATWACC rate of return are derived on Dr. Vilbert’s Tables
MJV-3 and MJV-14.

Dr. Vilbert lists the M/B ratio adjustments he uses to derive
the capital structure weights on those tables.

Dr. Kolbe does not believe a market/book ratio adjustment
helps to ensure the rate of return meets investors’ return
requirements. (Appendix E at E-16, E-23).

Dr. Kolbe concludes that the market-to-book ratio
adjustment is derived from stock market price data that is
not completely understood. (E-23).

The ATWACC capital structure is based on stock market
prices, the same data that is not completely understood,
and which forms the basis for Dr. Kolbe to reject the M/B
ratio adjustment.
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II. Rate Instability

ATWACC will subject rates to significantly more volatility.

ATWACC put the entire rate of return “in the market” in each rate case.

Traditional rate of return methodology locks-in (hedges) all rate of return
components except return on equity.

ATWACC volatility will be detrimental to both investors and ratepayers.

Investor earnings, cash flow uncertainty

Credit coverage uncertainty

Ratepayers’ rate volatility
10
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Exhibit MPG-2
Page 1 of 2
Gaz Métro
Market Value Common Equity Ratio
(Canadian Utilities)
Line
Company
DCF
Capital
Structure
2008
2007
2006
2005
2004
5-Year
Average
(1)
(2)
(3)
(4)
(5)
(6)
(7)
1
2
3
4
5
Canadian Utilities
Emera, Inc.
Enbridge, Inc.
Fortis, Inc.
TransCanada Corp.
56%
47%
54%
40%
51%
55%
49%
55%
41%
53%
59%
52%
59%
41%
57%
59%
57%
60%
46%
57%
60%
52%
58%
47%
55%
51%
51%
56%
38%
50%
57%
52%
58%
43%
54%
6
Average
49%
51%
53%
56%
55%
49%
53%
Source:
Workpaper #1 to Table No. MJV-4.
11
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III. Traditional Rate of Return Methods Have Supported
Utility Plant Investments, Financial Integrity
and Have Fairly Compensated Investors


Gaz Métro’s rate base has grown by 29% since 1999. (Carpenter
Direct Evidence at 29).
Credit rating – strong
Investment grade (S&P, A+; DBRS, A; Scotia Capital, A)

Canadian and U.S. LDC Stock
a)
b)
Market Valuation Factors (Exhibit MPG-3):

Market/book ratio

Price/earnings ratio

Price/cash flow ratio
Dividend Metrics (Exhibit MPG-4):

Yield ratio

Payout ratio

Dividend/book ratio
12
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Exhibit MPG-3
Page 1 of 4
Gaz Métro
Market Valuation Factors
Line
1
2
3
Line
4
5
6
Line
7
8
9
Utility
Canadian Utilities
U.S. Gas LDC
U.S. Pure Play LDC
Utility
Canadian Utilities
U.S. Gas LDC
U.S. Pure Play LDC
Utility
Canadian Utilities
U.S. Gas LDC
U.S. Pure Play LDC
Market/Book Ratio
2006
2007
2004
2005
1.97
1.83
1.86
2.34
1.82
1.84
2.16
1.78
1.89
1.72
1.62
1.77
2004
Price/Earnings Ratio
2005
2006
2007
2008
15.05
16.58
16.54
19.21
16.80
16.90
18.07
16.39
16.03
13.89
14.60
15.77
2004
Price/Cash Flow Ratio
2005
2006
2007
2008
7.74
8.73
8.67
8.57
8.24
8.41
7.28
7.45
7.98
13
2.49
1.93
2.03
20.14
17.54
16.95
9.36
8.69
8.66
8.17
8.34
8.36
2008
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Exhibit MPG-4
Page 1 of 4
Gaz Métro
Dividend Metrics
Line
Utility
2004
2005
Dividend Yield
2006
2007
2008
1
2
3
Canadian Utilities
U.S. Gas LDC
U.S. Pure Play
LDC
3.66%
3.90%
3.86%
3.11%
3.95%
3.85%
2.96%
3.52%
3.42%
3.31%
3.85%
3.67%
3.92%
4.52%
4.03%
Dividend Payout
2005
2006
2007
2008
Line
Utility
2004
4
5
6
Canadian Utilities
U.S. Gas LDC
U.S. Pure Play
LDC
55.24%
64.86%
64.02%
Line
Utility
2004
7
8
9
Canadian Utilities
U.S. Gas LDC
U.S. Pure Play
LDC
7.11%
7.12%
7.22%
59.13%
65.86%
64.48%
59.58%
61.76%
57.58%
59.55%
62.26%
58.23%
Dividend/Book Ratio
2005
2006
2007
7.12%
7.07%
7.12%
14
7.22%
6.77%
6.94%
7.03%
6.72%
6.93%
55.40%
62.00%
61.11%
2008
6.63%
6.70%
6.88%
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IV. Regié Oversight
(An Act Respecting the Regié de l’energie,
R.S. Q. Chapter R-6.01)
Québec Regulatory Standards
 Ensure that financial ratios are maintained. (49.5)
 Ensure that the rates and other conditions for the provision of the
service are fair and reasonable. (49.7)
 The fair value of the assets of the electric power carrier or a natural
gas distributor shall be determined on the basis of the original cost,
less depreciation. (50)
 No electric power transmission tariff or natural gas transmission or
delivery tariff may impose higher rates or more onerous conditions
than are necessary to cover capital and operating costs, to maintain
the stability of the electric power carrier or a natural gas distributor
and the normal development of a transmission or distribution system
or to provide a reasonable return on the rate base. (51)
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The ATWACC Does Not Comply
With the Régie’s Rules

Financial Ratios



Book Value Capital Structure

Manage capital costs

Credit analyst benchmarks/credit reviews help to confirm
appropriate target
Market Value – ATWACC

Ratios based on market not management decisions

Transparency of management objectives significantly less clear

ATWACC can be managed to maximize returns to shareholders
rather than maintain financial integrity
Fair value assets – original cost less depreciation


ATWACC based on asset’s market value (Kolbe at 27, and Vilbert
at 16)
Higher rates (ROE 12.4% vs. 9.0% - 10.0%) (Kolbe at 56)
16
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V. Gaz Métro’s Business Risk

Standard & Poor’s




Supportive regulation underpins the gas distribution business’
dominant market position and provides operational consistency.
GMLP benefits from a performance-based regulatory arrangement
with incentives on some operations.
DBRS

Low risk gas distribution activities provide financial stability

Strong operating cash flow finances capital expenditures and
distributions

Supportive regulatory environments
Scotia Capital

Generally timely commodity price recapture in customer rates, and
the reasonable assurance of full recovery of prudently incurred
capital and operating costs.
17
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Dr. Carpenter – Unique Business Risk

Unique Gaz Métro Risk

Lower residential penetration rate

Stronger competition from electricity and fuel oil

Large industrial load

All of these factors are considered by S&P, DBRS,
and Scotia Capital.

Unlike Dr. Carpenter, the credit analysts find Gaz
Métro’s: (1) business risk is “low,” (2) regulation is
supportive and comparable to other Canadian
utilities, and (3) regulatory mechanisms help ensure
it will earn its authorized return on equity.
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Dr. Carpenter – Long-Term Risk
Greater Than U.S. LDCs (at 55)

Dr. Carpenter

Industrial load

Competition

Lower regulatory risk

Contradicts his general conclusion that Canadian regulatory practices
produce more stable returns than U.S. regulations (Carpenter at 42-44)
– frequent rate cases, prominent use of deferral accounts

Attachment B. Regulatory lag still a risk of recovering costs


Decoupling

Weather normalization

Gas cost adjustment
U.S. regulation still exposes investors to more earning volatility
19
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