Société en commandite Gaz Métro
Cause tarifaire 2010, R-3690-2009
Appendix C to the Written Evidence of Aaron M. Engen
Fixed Returns on Equity
Q1.
Certain of the pipeline projects you refer to in Table 4 use or propose to use rate
methodologies which include a fixed return on equity over an extended period of
time. Do investors require a higher return on capital where returns are fixed over
some period of the investment as compared to returns which float as is the case
under the Régie Formula?
A1.
Whether a higher return on capital is required for accepting a fixed return depends on
market conditions at the time of pricing. If the yield curve is upward sloping investors
should demand a premium for taking a fixed return. If the yield curve is inverted, that is,
downward sloping, they should accept a discount for taking a fixed return. A normal
state for the Government of Canada yield curve is a positive slope.
Q2.
Is determining the premium (or discount) for taking a fixed return on capital simply
then a matter of comparing short-term and long-term rates?
A2.
No, because short-term rates are not relevant under the circumstances. Although easy to
calculate and simple to understand, the required “spread” for taking a fixed return on
capital is not merely the difference between short-term and long-term rates. Because the
Régie Formula sets allowed ROEs based largely on 10-year bond rates (not short-term
rates) and because the Régie Formula resets allowed ROEs annually, the calculation of
applicable premiums (or discounts) must be determined by comparing 10-year rates, reset
annually (similar to the reset mechanism in the Régie Formula) with fixed rates set for
the applicable fixed return period.
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Original : 2009.05.04
Gaz Métro - 7, Document 12
Annexe C (6 pages)
Appendix C to the Written Evidence of Aaron M. Engen
Short-term rates simply do not matter. As a result, spreads between short-term and longterm rates are irrelevant when considering applicable premiums (or discounts) for taking
fixed returns on capital in the context of a comparison with returns which would be
generated under the Régie Formula.
Q3.
Can the premium (or discount) for taking a fixed return on capital be measured?
A3.
Yes, although it can only reasonably be done through the swap market. A financial
model that prices and values constant maturity swaps (“CMS”) can be used since CMS
most closely reflect allowed ROE outcomes under the Régie Formula to the extent the
formula is reset annually and is based largely on 10-year Government of Canada bond
yields.
Q4.
What is a CMS?
A4.
A CMS is a variation of a standard single currency interest rate swap. Like standard
single currency swaps, there is both a fixed and a floating rate involved. Unlike a
standard swap which typically uses short-term indices such as Bankers’ Acceptances or
the LIBOR, CMS use floating rate indices which are typically long-term. For the
purposes of my evidence, 10-year Canadian dollar swap rates, reset annually, were used
as the floating rate index.
Quotes on CMS can be obtained from any major investment bank. For the purposes of
my evidence, I relied on quotes provided by BMO Capital Markets’ Financial Products
Group.
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Appendix C to the Written Evidence of Aaron M. Engen
Q5.
Is there a more direct approach to measuring the premium (or discount) for taking
a fixed return on capital?
A5.
A more directly comparable approach could be to use a constant maturity Government of
Canada bond pricing model but the available data and market demand do not support
such models in Canada or elsewhere. CMS are a reasonable proxy for the potentially
better, but unavailable, constant maturity bond financial structure.
Q6.
Please describe the methodology used by BMO Capital Markets to arrive at an
appropriate premium for locking-in returns on capital.
A6.
BMO Capital Markets used a proprietary CMS pricing model to solve for fixed rates.
The difference between model derived fixed rates and first period floating rates
represented the premium (or discount) implied by the model for taking a fixed rate over a
resetting floating rate. The BMO Capital Markets model is consistent with other models
used by major banks to price similar scenarios.
Model outcomes are heavily influenced by the shape of the yield curve or more
specifically the forward curve for 10-year swap rates. Other important influences include
the volatility of 10-year swap rates, absolute levels of swap rates, the duration of the
floating rate index and reset frequency.
Q7.
What would have been the lock-in premiums at the time returns on capital were
negotiated for the Alliance Pipeline, Southern Lights and the Alliance Pipeline
Taylor expansion?
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Appendix C to the Written Evidence of Aaron M. Engen
A7.
Alliance Pipeline:
Using a September 30, 1996 lock-in date and a 15-year locked-in return commencing on
December 1, 2000, the appropriate lock-in premium would be in the range of 28 – 38 bps.
Southern Lights:
Using a July 1, 2006 lock-in date and a 15-year locked-in return commencing on July 1,
2010, the appropriate lock-in premium would be in the range of 9 – 19 bps.
Alliance Pipeline - Taylor Expansion:
Using a September 30, 2007 lock-in date and a 7-year locked-in return commencing on
Nov. 1, 2008, the appropriate lock-in premium would be in the range of 17 – 27 bps.
Q8.
What would lock-in premiums look like in a more current market?
A8.
As of early December 2007, the lock-in premium for various key terms would be:
•
5-year fixed rate vs. 10-year swap rate, reset annually: 11 – 16 bps
•
15-year fixed rate vs. 10-year swap rate, reset annually: 14 – 19 bps
•
20-year fixed rate vs. 10-year swap rate, reset annually: 8 – 13 bps
These lock-in premiums reflect spreads at which BMO Capital Markets would have been
prepared to enter into such swap transactions with the additional inclusion of applicable
transaction fees.
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Appendix C to the Written Evidence of Aaron M. Engen
Q9.
The lock-in premiums you have calculated are over a year old. Please explain why
you are not providing lock-in premiums at a point in time closer to the date this
evidence is being filed.
A9.
The estimates calculated as of December 2007 were based on then current data in
rationale and liquid markets, acknowledging that CMS pricing and trading in Canada is
historically relatively illiquid. Since then 10-year Government of Canada bond rates
have declined over 100 bps and the Government of Canada yield curve has shifted lower
and steepened materially.
This magnitude of change would normally warrant an update. Due, however, to the
global credit and liquidity crisis, CMS modeling is not presently commercially feasible.
At present, only standard (vanilla) financial securities/instruments are capable of being
priced and traded, and even those are subject to severe liquidity constraints in Canada.
Further, while theoretical estimates are possible in today’s market, it would not be
reasonable to utilize model output derived from a statistically abnormal period.
Q10. What would the average lock-in premium be over the 10-year period leading up to
December 2007 for a 15-year transaction?
A10.
The average lock-in premium over the 10–year period would be in the range of 20 - 30
bps. The results ranged from a high of 88 bps to a low of -7 bps .
Q11. How did BMO Capital Markets determine the average premium (or discount)?
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Appendix C to the Written Evidence of Aaron M. Engen
A11.
BMO Capital Markets priced CMS for the past 10 years using end of calendar quarter
observations. The same approach was used to determine applicable quarterly spreads as
was used with the point in time lock-in premium determinations for the current market
and for the various pipeline projects at the time they were negotiated.
Q12. Do you have any concerns regarding the accuracy of the data provided by BMO
Capital Markets?
A12.
The input data (bond yields and swap spreads) were provided by a recognized reliable
third party source and are readily available from several sources including financial
brokers and financial information providers (for example, Bloomberg and Reuters). The
financial model used has been internally vetted for accuracy. I would expect minor
variations among investment banks views based on differences in models, methodologies,
and inputs.
Q13. Are any adjustments required to convert the lock-in premiums obtained from your
debt capital market analysis to required premiums for fixing returns on equity
rather than accepting floating rates of return on equity under the Régie Formula?
A13.
There are, although I was not asked to, nor have I undertaken such an analysis. Dr.
Kolbe addresses that matter in his evidence.
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