Société en commandite Gaz Métro
Cause tarifaire 2010, R-3690-2009
Appendix F:
Written Reply Evidence of A. Lawrence Kolbe
Original : 2009.07.27
Gaz Métro - 7, Document 16
(24 pages)
NATIONAL ENERGY BOARD
IN THE MATTER OF the National Energy Board Act and the
Regulations made thereunder;
AND IN THE MATTER OF an Application by Trans Québec &
Maritimes Pipeline Inc. for orders pursuant to Part I and Part IV of the
National Energy Board Act.
WRITTEN REPLY EVIDENCE
OF
A. LAWRENCE KOLBE
FOR
TRANS QUÉBEC & MARITIMES PIPELINE INC.
The Brattle Group
44 Brattle Street
Cambridge, MA 02138
September 2008
2
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
Table of Contents
I.
INTRODUCTION AND SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
II.
ON WHAT SHOULD ECONOMIC EVIDENCE RELY? . . . . . . . . . . . . . . . . . . . . . . . . 9
III.
INTEREST TAX SHIELDS FOR COMPETITIVE COMPANIES . . . . . . . . . . . . . . . . 13
IV.
OTHER ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
GUIDE TO LOCATIONS OF POINTS ALREADY ADDRESSED IN PREVIOUS PROCEEDINGS . . . . . 24
3
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
I.
INTRODUCTION AND SUMMARY
2
Q1.
Please state your name and address for the record.
3
A1.
My name is A. Lawrence Kolbe. My business address is The Brattle Group, 44 Brattle
4
Street, Cambridge, Massachusetts, 02138.
5
Q2.
Did you provide written evidence earlier in this proceeding?
6
A2.
Yes.
7
Q3.
What is the purpose of your reply evidence?
8
A3.
I have been asked by TransQuébec and Maritimes Pipeline (“TQM,” or the “Company”)
9
to review the Evidence of Laurence D. Booth on behalf of the Canadian Association of
10
Petroleum Producers (CAPP) and the Industrial Gas Users Association (IGUA) (“Booth
11
Evidence”), and, if necessary, to comment on the parts of it that address the written
12
evidence of Dr. Michael J. Vilbert and myself. I have also been asked to review certain
13
CAPP responses to TQM Information Requests (“IRs”) that were directed to Dr. Booth.
14
However, to explain my approach to these tasks, I first need to supply some context.
15
Q4.
Please do so.
16
A4.
Over the course of a series of previous proceedings, twice before this Board and elsewhere
17
as well, my recommendations have relied on the modern economic understanding of how
18
capital structure affects the cost of capital. Dr. Booth has submitted evidence in opposition
19
to this approach. I in turn have replied in some detail as to why I believe Dr. Booth’s
4
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
evidence in opposition to be invalid. However, Dr. Booth’s evidence in the next
2
proceeding has never addressed the economic logic of the points I have made in my reply
3
in the previous proceeding.1 Instead, the points from the previous proceeding are repeated
4
with minor variations. If my present reply were simply to make the same responses to
5
those points that I have made previously, the Board would be left with little new
6
information on which to base its decisions.
7
To try to break out of this circle, this time TQM directed IRs to Dr. Booth that
8
stated my previous replies to points that appear again in his TQM evidence, and that asked
9
explicitly for Dr. Booth’s response to those previous replies.2 TQM also followed up on
10
the initial round of answers with additional IRs in round two.3 As a result of this process,
11
I believe the basic points of dispute between Dr. Booth and myself are considerably more
12
clear than in previous proceedings.
13
Q5.
Based on this context, what does your reply evidence do?
14
A5.
Here I focus on the content and implications of the IRs, not to the points repeated again in
15
Dr. Booth’s evidence itself. My responses to the points made in his TQM evidence are
16
readily discernable from my responses to those same points in his evidence in previous
1
To demonstrate this point, I am appending to my present reply evidence (in a separate document) Dr.
Booth’s evidence and my reply evidence on these topics from the last two such proceedings, for the
TransCanada Mainline in RH-2-2004, Phase II, before the Board and for Union Gas, EB-2005-0520,
before the Ontario Energy Board. While the exact words and some of the detailed issues evolve
somewhat from proceeding to proceeding, the basic points of dispute over capital structure principles
and their implications for rate regulation appear over and over.
2
These consist of Questions 1.87 to 1.94 in TQM’s first set of IRs to CAPP (hereafter, “IRs 1.87 to
1.94”).
3
These consist of Questions 2.19 to 2.24 in TQM’s second set of IRs to CAPP (hereafter, IRs 2.19 to
2.24)
5
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
proceedings, which are reproduced in the appendices to this reply evidence.4 A table at the
2
end of this reply provides a guide to the page numbers of Dr. Booth’s previous and current
3
evidence that raise specific issues, and the pages of my previous reply evidence that
4
respond to each.5
5
Q6.
Please summarize your reply evidence.
6
A6.
Only four additional issues need to be addressed in this reply.
7
Value of Reference to the Economic Literature: The response to IR 1.89 argues
8
that there “has been no substantial research in the area [of capital structure since 1977] and
9
nothing of interest to a regulator.” Other parts of the responses are critical of the numerous
10
references to the capital structure literature in my evidence. However, I am recommending
11
that the Board approach the treatment of capital structure in setting a fair return with an
12
enhanced awareness of the modern research on capital structure. In that context, the
13
modern literature is directly relevant. Capital structure decisions and their implications for
14
firm value and risk have been the subject of a great deal of well-respected economic
15
research in the past three decades. That research has extended and tested the original and
16
fundamental insights of Professors Modigliani and Miller in important ways, and those
4
For example, Dr. Booth has long used a numerical example to criticize my recommendations, and I have
long explained why his example is not in accord with the relevant economic principles and flatly
misstates my recommendations. This numerical example appears again in his TQM evidence. (See the
response to IR 1.94, parts (a) and (b).) My latest response to the example on its own terms, explaining
its economic errors and its misstatements of my recommendations, may be found in Appendix R-1 of
my Reply Evidence for Union Gas, which in turn is Appendix R-Kolbe2 to this TQM reply evidence.
5
Please also recall that I addressed the use of the market-to-book ratio in Appendix E of my direct
evidence in the present proceeding. Nothing in Dr. Booth’s evidence concerning market-to-book ratios
changes my conclusions in this regard, although there is one new comment in the IR responses that I
address below.
6
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
results underlie my evidence. When parties disagree about the capital structure principles
2
to apply, I would submit that reference to the economic literature is not only permissible,
3
but also informative and directly relevant. I would respectfully submit that it is Dr.
4
Booth’s approach to the economic literature, not mine, that is likely to be less helpful to
5
a regulatory body trying to decide how to grant a fair overall return.
6
Whether Unregulated Shareholders Keep the Tax Benefits of Debt: The IR
7
responses make clear that the Dr. Booth’s position that unregulated shareholders keep the
8
tax benefits of debt is based in part on a distinction between real-world industries and
9
textbook simplifications. Also, the response to IR 2.20 states in part, “the point of the
10
statement in Dr. Booth’s evidence is simply to show why there is an incentive for holding
11
companies to shift the value of the interest tax shields from their utility subs to the parent.”
12
This discussion thus is related to Dr. Booth’s discussion of “double leverage,” i.e., the
13
issuance of debt by a subsidiary whose parent also issues debt. There are four problems
14
with Dr. Booth’s views on this issue:
15
16
17
18
19
20
21
•
There has never been a dispute that debt conveys some net tax advantage, and that
rate-regulated companies are able to take more advantage of it than most firms.
The dispute concerns (1) how much incremental growth does debt’s net advantage
exhibit when firms add incremental debt after reaching the normal range of capital
structures in their industry (recent research shows that the answer is, “little or
none”), and (2) does competition bring unregulated prices down in a way that
passes debt’s tax advantage through to unregulated firms’ customers?
22
23
24
•
While the real world is not in competitive equilibrium, it would be unreasonable
to assume that real-world prices leave the entire tax advantage to debt in the hands
of unregulated shareholders.
25
26
27
•
My procedures focus on getting the regulated firm’s ATWACC right, whether by
adjustments to the return on equity, the deemed equity ratio, or both. As long as
that is done, the issue of “double leverage” is irrelevant.
28
29
•
If the debate about who keeps the tax shields in unregulated firms is intended to
shed light on motivations, it is illogical and uninformative. First, the managers of
7
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
2
3
4
5
6
7
8
9
regulated companies have an economic incentive to get higher rates and their
customers have an economic incentive to get lower rates, whether the companies
are stand-alone or subsidiaries of other companies, and whether shareholders or
customers benefit from the debt tax shields in unregulated markets. Second,
beyond this obvious fact, speculations about managers’ motives cannot be resolved
either from the arguments made by Dr. Booth or from factors that can be
objectively observed, and it in any case would be fallacious to reject the logic of
an analysis because of claimed “bad” motivations on the part of the person
performing it.
10
Whether Capital Structure Analysis Is Irrelevant If the Company Is of Low
11
Risk: IR 2.22 states that Dr. Booth needs to make no capital structure adjustments because
12
TQM’s risks are so low that such adjustments would make only “a minor” difference.
13
Below, I show this assertion to be factually incorrect, using Dr. Booth’s equity return and
14
deemed equity ratio recommendations for TQM.
15
Whether it Is Inconsistent to Reject the Market-to-Book Test but Accept
16
Market Values for Capital Structure Analysis: IR 1.94 suggests that it is inconsistent
17
of me to hold that we do not understand stock prices well enough to rely on the market-to-
18
book test, while still accepting market values for capital structure analyses. However, there
19
is no inconsistency. The market-to-book test is valid, even under otherwise ideal
20
conditions, only if a particular model of how stock prices are set is correct, and history is
21
inconsistent with that model’s being correct. But the fact that a higher market-value debt
22
ratio increases the risk of equity does not depend on how asset values are actually set in the
23
market. Indeed, recent experience in the housing market illustrates that financial risk due
24
to a high market-value debt ratio is plainly of as much concern in a housing price “bubble”
25
as when prices are closer to their longer-run, fundamental value, whatever that might be.
26
Q7.
How is the remainder of your evidence organized?
8
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
Section II addresses the type of evidence and analysis on which an economic expert witness
A7.
2
should rely when preparing evidence in a regulatory proceeding. Section III addresses Dr.
3
Booth’s views on whether the corporate tax shields created by debt are passed through to
4
customers in competitive industries, and if not, what that means in a regulatory context.
5
Section IV addresses other points raised in the IR responses. The appendices containing
6
Dr. Booth’s and my evidence from the RH-2-2004, Phase II proceeding and the Ontario
7
Energy Board’s Union Gas proceeding, EB-2005-0520, are in a separate document.
8
II.
ON WHAT SHOULD ECONOMIC EVIDENCE RELY?
9
Q8.
What views do the IR responses express on the type of evidence an economic expert
10
11
should use in a regulatory proceeding?
A8.
The IR responses are critical of my use of references to the academic literature on capital
structure. In confirming that Dr. Booth’s evidence6
12
13
14
15
16
in its review of the literature on the weighted-average cost of capital and
leverage adjustments cites no paper written in the last quarter-century, with
the exception of a citation to a 1991 textbook in a section that cites a 1974
paper
the IR response states that7
17
18
19
20
21
22
23
There has been no substantial research in the area since then and nothing
of interest to a regulator. ... Testimony is not the same as writing journal
articles and including a large number of references serves no purpose.
Except for hearings in which Dr. Kolbe and Vilbert are involved, Dr. Booth
has never seen any requests for academic articles or academic corroboration
of obvious facts. ... As the information request notes Dr. Booth has
6
IR 1.89, question parts (a) and (b)
7
IR 1.89, responses to parts (a), (b), (d) and (e).
9
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
2
3
4
5
6
7
8
9
10
contributed to this literature and is fully aware of what it says and what it
does not. ... However, bombarding the Board with testimony replete with
multiple references serves little purpose, particularly since it would dilute
the importance of the classic papers Dr. Booth does cite. It would be easy
for Dr. Booth to add many more references but that adds little additional
value. ... Dr. Booth sees no need to counter comments that he believes
have no substance. Further, Dr. Booth finds it somewhat strange that
non-academics are trying to be more academic than an academic. He
believes that the objective of providing testimony is to inform the Board;
not write a paper for an academic audience, he does enough of that as it is.
11
The point is reinforced in response to IR 2.21, which explicitly declines to provide
12
two papers on capital structure written by Dr. Booth himself and explicitly cited in the
13
response to IR 1.89 because
14
15
16
17
18
19
20
21
22
As Dr. Booth indicated in his original answer, he does not believe that
providing a list of academic references to a board is of any significant
value. If need be Dr. Booth can fill pages with references beyond the
classic ones. ... Of course [the Board, not Dr. Booth, will be the judge of
what information it finds helpful], but that is why Dr. Booth does not file
voluminous lists of academic references. Since he first testified in 1985, he
has rarely seen large numbers of academic papers referenced, except in
hearings in which Drs Kolbe and Vilbert participate. The implication is
that there is little value to the exercise.
23
Q9.
Why does your evidence refer to so many academic articles?
24
A9.
I am recommending that the Board approach the treatment of capital structure in setting a
25
fair overall return with an enhanced awareness of the modern research on capital structure.
26
In that context, the modern literature is directly relevant. With all respect to Dr. Booth, I
27
believe that the last 30 years of economic research have profound implications for how
28
regulatory bodies should treat capital structure decisions. Capital structure decisions and
29
their implications for firm value and risk have been the subject of a great deal of well-
30
respected economic research in this period. That research has extended and tested the
31
original and fundamental insights of Professors Modigliani and Miller in important ways,
10
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
and those results underlie my evidence. I would refer the reader to Appendix C, Section
2
I, of my direct evidence for more detailed discussion of this point.8
3
Q10. How can regulators who are not economists be sure your conclusions fairly reflect the
4
5
current state of the research?
A10.
If I have improperly cited the current state of the economic literature and its implications,
6
witnesses for other parties can refer to the articles I have overlooked or misinterpreted and
7
explain my errors, which I can either accept or dispute in reply evidence. That has not
8
happened to date.
9
Q11. Are there other sources of support for an economic expert’s recommendations than
10
11
reference to the literature?
A11.
Certainly. For example, the expert can explain the principles using everyday examples, as
12
I have attempted to do with my example of home mortgages.9 The expert can also cite
13
decisions by regulatory bodies, although care must be taken in the use to which an
14
economic expert puts such citations. This is the approach relied on in Dr. Booth’s
15
responses to IRs 1.93, 2.22 and 2.23, citing the U99099 decision by the Alberta Energy and
16
Utilities Board (“EUB”).
8
If it’s relevant, I would also note that like Dr. Booth, I have a certain amount of experience in regulatory
proceedings, stretching back somewhat further than his. The only instance in which I have previously
encountered expert witnesses who explicitly reject references to recent economic research as irrelevant
is before regulatory commissions who have directed that certain procedures always be used (for
example, in calculation of the cost of equity). I cannot recall ever encountering an academic who does
so, aside from Dr. Booth.
9
See my direct evidence, Appendix B.
11
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
Q12. Do you have a response to the economics of the EUB’s U99099 decision?
2
A12.
Yes, I provided it with my direct evidence, in Appendix E. (This is where my discussion
3
of the market-to-book test is, for example.) I have been unable to find a response in either
4
Dr. Booth’s evidence or his IR responses to the economic content in my Appendix E.
5
Q13. Do you have any other comments regarding Dr. Booth’s reliance on the EUB
6
7
decision?
A13.
Yes, I would just note that if regulatory decisions are a relevant standard, there are many
8
that Dr. Booth does not cite that might also be seen as relevant. Foremost would be this
9
Board’s decision in RH-2-2004, Phase II, which stated at p. 54 an acceptance “that
10
ATWACC-based methodologies have theoretical merit.” Also, at p. 55 the decision says,
11
“The Board accepts that, over a certain range, the ATWACC curve may be flat or virtually
12
flat.” The decision goes on to discuss the Board’s reservations about the ATWACC
13
evidence in that proceeding, which I have attempted to address in Section IV of my direct
14
evidence. Additionally, many regulatory jurisdictions outside of North America, which
15
instituted regulatory procedures much later than in North America and with the advantage
16
of access to more recent economic research, make use of the weighted-average cost of
17
capital as the primary standard for the fair return.10
18
Q14. Please sum up.
19
A14.
20
If the parties in a regulatory proceeding generally agree on the economic principles that
should be used to address a particular question, such as how to quantify the effect of capital
10
See TQM’s response to NEB IR 5.1.
12
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
structure on the cost of capital or how to estimate the cost of equity, reference to the
2
economic literature may well be unnecessary. But when the parties disagree, I would
3
submit that reference to the economic literature is not only permissible, but also
4
informative and directly relevant. A reasoned debate over the economic principles to be
5
applied is enhanced by explicit reference to economic research, in my view. I would
6
respectfully submit that it is Dr. Booth’s approach to the economic literature, not mine, that
7
is likely to be less helpful to a regulatory body seeking to determine the fair overall return
8
on capital.
9
10
III.
INTEREST TAX SHIELDS FOR COMPETITIVE COMPANIES
Q15. What does Dr. Booth’s evidence say about who keeps the benefits of the interest tax
11
12
shields on corporate debt?
A15.
Dr. Booth has long maintained that11
13
14
15
16
17
18
…there is a built-in tax advantage to any corporation using debt financing.
This tax advantage goes to the shareholders of unregulated firms and to the
customers of regulated firms, since the use of debt reduces the firm’s
revenue requirement. As will be discussed later, this asymmetry in benefits
for the regulated firm is a motivating factor behind regulated companies
continually striving to increase their equity ratios.
19
This statement is puzzling, because issuance of debt is an easily copied competitive
20
strategy. If there is a material tax advantage to debt, it will reduce the costs of companies
21
in competitive industries, and competition will then drive down their prices. This price
22
reduction will pass the tax advantage of debt through to the customers of competitive
11
Response to IR 1.87, parts a and b. Quotation originally from the (TQM) Booth Evidence, p. 28
(emphases in the original).
13
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
industries, just as Dr. Booth says happens in regulated industries (a statement on which we
2
agree).
3
Q16. Do the IR responses clarify this issue?
4
A16.
In part. The response to IR 1.87, part (e) deepened the puzzle, because it stated that
5
whether competitive companies’ shareholders get to keep the tax advantage or not was “an
6
irrelevance”, which appeared to be inconsistent with the emphasis given the statement in
7
the above quotation. The second round of IRs clarified matters.
8
Part of the explanation is that Dr. Booth appears to be drawing a distinction
9
between companies in the less-than-perfectly competitive real world and the textbook
10
model of competitive equilibrium.12 This issue also appears to be related to Dr. Booth’s
11
discussion of “double leverage” on p. 35 of his direct evidence:
12
13
14
15
16
17
18
19
20
21
22
As indicated above, if there is a tax advantage to using debt, then
competitive firms will use debt. However, for ROE regulated utilities this
tax advantage flows through to the consumer as a lower tax charge in the
revenue requirement. As a result there is no advantage to the utility using
debt. However, for utilities owned by UHCs the situation is worse, since
the parent has an incentive to finance the utility with as much equity as
possible, so that the tax advantages to debt are shifted to the parent. In this
way it is the UHCs shareholders that get the tax advantages instead of the
utility ratepayers. This is often called the “double leverage” problem,
where the utility assets support debt at both the utility level and then again
at the parent level.
23
However, the main part of the explanation appears to be that Dr. Booth is making
a statement about motivations, not the actual outcome:13
24
12
See particularly the response to IR 2.19, part (b), which clarifies parts of the response to IR 1.87.
13
IR 2.20, part (c).
14
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
2
3
4
5
6
7
8
Further, the point of the statement in Dr. Booth’s evidence is simply to
show why there is an incentive for holding companies to shift the value of
the interest tax shields from their utility subs to the parent. If debt has no
value impact, as Dr. Kolbe claims, then TQM’s debt ratio should be an
irrelevance to him. The fact that Dr. Kolbe is so vociferous in his
argument, while advocating such an enormous increase in TQM’s common
equity ratio, is consistent with this tax shield transfer argument.
Q17. Now that the issues have been clarified, do you have new comments on Dr. Booth’s
9
10
evidence in this area?
A17.
Yes, four.
11
First, the response to IR 2.19 argues at length that there is a net corporate tax
12
advantage to debt for most companies, or at least that many managers believe there is.14
13
However, the fact that there is a net tax advantage in most industries in going from no debt
14
to debt in the industry’s middle range of capital structures has never been in dispute in this
15
proceeding. See, for example, Section IV.B (particularly Figures 4 and 5) of my direct
16
evidence, which makes this point explicitly. The question is not whether most firms get
17
an advantage from the use of some debt, nor whether rate regulated companies get more
18
advantage than most and should use more debt than most other firms. Of course they do,
19
and of course they should. Instead, the two issues actually in dispute are:
20
21
22
•
How much does that advantage change in response to an increment to the debt ratio
once companies are somewhere within the middle range of capital structures for the
given industry? The answer to that question is, “hardly at all.”15
14
In doing so, it cites extensively to an article from the recent academic literature on capital structure.
15
In this regard, please recall also that Figures 4 and 5 of my direct evidence actually overstate the net
impact the tax advantage of debt can have. (See Appendix C, Section II of my direct evidence for
calculation of the maximum possible net tax advantage to debt.) Also, please recall that within the
middle range of capital structures, the addition of debt might as well convey a slight net disadvantage
as a slight net advantage.
15
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
2
3
4
5
6
•
Are unregulated firms somehow immune from competition that lowers prices and
eliminates debt’s advantage, so their shareholders get to keep it, or do the firms’
managers have to issue debt and get the typical advantage in their industry just to
stay competitive, so that it is passed through to customers in lower prices? The
fundamental answer to that question, as will be seen shortly, is that it is indeed “an
irrelevance.”
7
Second, it is of course true that the real world is not in competitive equilibrium, and
8
that actual prices will typically not equal equilibrium costs (including any reduction in
9
those costs due to the tax advantage of debt). Nonetheless, the corporate tax savings due
10
to the use of debt will tend to reduce real-world prices, just like any other easily copied
11
cost-saving strategy, thereby tending to pass the advantage through to customers on
12
average. In workably competitive markets, this will be true whether corporate managers
13
think in these terms or not. It would certainly not be reasonable to assume that real-world
14
prices instead always leave the tax advantage in shareholders’ hands.
15
Third, my evidence focuses on determining the combination of return on equity and
16
deemed equity ratio that gets the right ATWACC for TQM. As long as that is done,
17
TQM’s overall return is completely independent of the particular value for the deemed
18
equity ratio. Therefore, the implications of TQM’s overall return for the parent’s “debt
19
capacity” (and hence the value of the parent’s interest tax shields) is independent of the
20
particular value for the deemed equity ratio, also. The “double leverage” issue is simply
21
irrelevant if you focus on the ATWACC.
22
Q18. What is your final comment now that Dr. Booth’s views have been clarified?
23
A18.
Dr. Booth’s statements as to the implications of the tax shield on debt for the motivations
24
of the managers of rate regulated companies, and possibly for that of expert witnesses as
25
well, are neither logical nor informative, for two reasons.
16
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
One, the mechanism by which the Board currently sets rates involves a deemed
2
equity ratio. Higher deemed equity ratios mean higher returns for a rate-regulated
3
company, absent market conditions or other factors that prevent the company from earning
4
those returns. One need not rely on a theory of tax advantage transfer to ascertain that
5
managers of rate-regulated companies have an economic incentive to seek higher deemed
6
equity ratios and higher rates of return on equity. In the same vein, those companies’
7
customers have an economic incentive to seek lower deemed equity ratios and lower rates
8
of return on equity.16 These opposing incentives exist regardless of whether shareholders
9
or customers keep the tax advantage of debt in unregulated firms, and regardless of whether
10
the regulated company is a subsidiary or stands alone. The issue of who keeps the interest
11
tax shields under competition is simply irrelevant to the companies’ and the customers’
12
basic economic incentives.
13
Two, speculation about parties’ motivations is logically irrelevant, also. I would
14
submit that it is impossible, either from the arguments made by Dr. Booth or from factors
15
that can be objectively observed, to determine whether any particular party is acting
16
opportunistically or with complete sincerity. Moreover, it is a well-known logical fallacy
17
to conclude that characteristics such as “bad motivations,” even if they were somehow
18
unambiguously determined to be present, imply that an analysis is incorrect.17
16
Of course, if the low returns go on too long, there can be long-run costs to customers from
underinvestment, if a rate-regulated company becomes convinced that a fair return will not be
forthcoming in a particular regulatory jurisdiction. See Section II of my direct evidence.
17
The fallacy may be described as follows:
An ad hominem argument ... consists of replying to an argument or factual claim by attacking
or appealing to a characteristic or belief of the person making the argument or claim, rather
than by addressing the substance of the argument or producing evidence against the claim. ...
(continued...)
17
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
In sum, for all of the above reasons, I would echo the language of the response to
2
IR 1.87, part (e), to say that the issue of who keeps the tax advantages of debt in an
3
unregulated firm is indeed “an irrelevance.”
4
IV.
OTHER ISSUES
5
Q19. What other issues do the IR responses raise?
6
A19.
There are two worth explicit mention:18
7
8
•
Does the fact that a company’s risks are low make adjustments for capital structure
differences irrelevant?
9
10
•
Is it inconsistent to reject the market-to-book ratio test while accepting market
values in capital structure calculations?
11
The answer to both questions is, “no.”
12
Q20. How does the first issue arise?
13
A20.
14
15
16
17
18
The response to IR 2.22, part (a), states that
Dr. Booth believes that the use of debt by Canadian utilities does not have
a material impact on their risk, since the use of deferral accounts means that
there is very little risk in the first place. As a result, there is only a minor
increase in equity market risk and the cost of equity for Canadian utility
investors.
17
(...continued)
It is also used when an opponent is unable to find fault with an argument, yet for various
reasons, the opponent disagrees with it. (http://en.wikipedia.org/wiki/Ad_hominem)
18
My failure explicitly to discuss a particular statement in the IR responses does not necessarily indicate
that I agree with it.
18
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
Q21. Is this correct?
2
A21.
No, the response is simply wrong. The underlying economics still exist for companies with
3
low business risk, and they make a material difference even at the very low returns
4
recommended by Dr. Booth. To show this, Table R-1 accept Dr. Booth’s 7.75 percent
5
recommended return on equity and asks:
6
7
8
•
What ATWACC does this imply at (1) the average market-value capital structure
of Dr. Vilbert’s Canadian sample, and at (2) Dr. Booth’s recommended 32 percent
deemed equity ratio?
9
10
•
How much difference from Dr. Booth’s return on equity would those ATWACCs
imply for the cost of equity at TQM’s requested 40 percent deemed equity ratio?
11
12
13
•
How much difference would those ATWACCs imply between the appropriate
deemed equity ratio at a return on equity of 7.75 percent and TQM’s requested 40
percent?
19
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
Table R-1. Sensitivity of Dr. Booth’s Recommendations
to Alternative Capital Structures
Canadian Sample
Market Value
Equity Ratio
Booth Deemed
Equity Ratio
Equity Ratio
Booth Cost of Equity
TQM Cost of Debt
TQM Tax Rate
Implied ATWACC
51%
7.75%
5.5%
31.9%
5.8%
32%
7.75%
5.5%
31.9%
5.0%
Implied ROE at 40%
Equity Ratio
8.9%
7.0% [6]
Difference from Booth
Cost of Equity
1.1%
-0.8% [7]
Implied Deemed Equity
Ratio at 7.75% ROE
51%
32% [8]
Difference from 40%
Deemed Equity Ratio
Requested by TQM
11%
-8% [9]
[1]
[2]
[3]
[4]
[5]
Notes:
[1]: 1st Column, Exhibit MJV-11; 2nd Column, Evidence of Dr. Booth
[2]: Evidence of Dr. Booth
[3], [4]: Exhibit MJV-12
[5]: [1]*[2] + (1-[1])*[3]*(1-[4])
[6]: ([5] - (1-[1])*[3]*(1-[4])) / [1]
[7]: [6] - [1]
[8]: ([5] - [3]*(1-[4])) / ([2] - [3]*(1-[4]))
= [1] here, since that is the starting point for the ATWACC in [5]
[9]: [8] - [1]
1
Q22. Please explain the calculations in Table R-1.
2
A22.
The two columns represent two possible capital structures, the market-value capital
3
structure of Dr. Vilbert’s Canadian sample (which has the lowest market-value equity ratio
4
of his sample groups) and Dr. Booth’s recommended 32 percent deemed equity ratio.
20
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
These equity ratios appear in row [1]. Row [2] is Dr. Booth’s recommended return on
2
equity. At TQM’s cost of debt (row [3]) and tax rate (row [4]), the implied ATWACCs
3
are either 5.8 percent or 5.0 percent (row [5]).
4
5
The IR response asserts that modern capital structure principles are irrelevant
because TQM’s risks are so low. But rows [6] through [9] show this is wrong.
6
First consider rows [6] and [7]. If the 7.75 percent were a market-value estimate
7
of the cost of equity at the Canadian sample’s capital structure, the cost of equity at
8
TQM’s requested 40 percent deemed equity ratio would be 8.9 percent, a full 1.1
9
percentage points higher. If Dr. Booth had estimated the 7.75 percent return on equity
10
from a sample of companies with a market-value capital structure of 32 percent equity, the
11
corresponding cost of equity at TQM’s requested 40 percent deemed equity ratio would
12
have been 7.0 percent, a full 0.8 percentage points lower. These are material differences
13
in a regulated company’s cost of equity.
14
Rows [8] and [9] make the same point in a different way. The deemed equity ratio
15
that corresponds to a cost of equity of 7.75 percent and the ATWACCs in row [5] is, of
16
course, the deemed equity ratio used to calculate those ATWACCs with that cost of equity
17
in the first place. Therefore, the deemed equity ratio that should apply if the 7.75 percent
18
were estimated from a sample with a market-value capital structure of 51 percent and the
19
return on equity were set at 7.75 percent is 51 percent. The same logic holds if the market-
20
value capital structure underlying the 7.75 percent were 32 percent equity. These are,
21
respectively, 11 and 8 percentage points away from TQM’s requested 40 percent, which
22
again are material differences in a regulatory setting.
21
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
Thus, notwithstanding Dr. Booth’s view that TQM is of extremely low risk, there
2
is still very much a need to apply the capital structure principles that underlie my evidence,
3
since they still make a material difference.
4
Q23. How does the other issue, the consistency of your views regarding of market values
5
6
in analyzing capital structures and the market-to-book test, arise?
A23.
7
8
9
10
The response to IR 1.94, part (c), states,
... Further Dr. Booth notes that while Dr. Kolbe has recanted on his views
that markets are efficient enough that we can pay attention to market to
book ratios as signals of excessively high or low allowed ROEs, he still
feels that markets are efficient in their leverage adjustments.
11
Q24. Is there an inconsistency between your rejection of the market-to-book ratio test and
12
your acceptance of market values for purposes of calculating the ATWACC and
13
adjusting for financial risk?
14
A24.
No. Please refer to my discussion of the market-to-book ratio test in Appendix E to my
15
direct evidence, Section III. Even for a pure-play utility regulated on a book-value rate
16
base in equilibrium, the market-to-book ratio test requires that a particular model of stock
17
prices correctly describe how the market price is actually determined. Yet the stock-market
18
“bubbles” of October 1987 and the turn of the century demonstrate that this model cannot
19
be correct.19
19
Please also note that the IR’s statement not withstanding, this is not a conclusion about market
efficiency. A test of market efficiency is a joint test of (a) efficiency and (b) the model you postulate
underlies market prices. The market may be fully efficient, just based on a different pricing model than
the simple discounted cash flow model required for the market-to-book test to work.
22
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
1
In contrast, the principles involving the effect of leverage on equity risk rely on no
2
particular model of value. Even in a “bubble” (and maybe especially in a bubble, given
3
recent experience in the housing market), greater use of debt increases equity risk. It does
4
not matter why housing prices are as high as they are, someone with a mortgage equal to
5
90 percent of the current value of their home faces more risk than someone with a
6
mortgage equal to 50 percent of the current value of their home.
7
Thus, the market-to-book ratio test does not work even in principle unless stock
8
values are fully described by a simple discounted cash flow model. The dependence of
9
equity risk on the market-value capital structure is valid regardless of the “true” model that
10
determines asset prices.20 There is no inconsistency in saying we do not understand stock
11
prices well enough to rely on the market-to-book test, while recognizing that an increase
12
in the market-value debt ratio increases equity’s risk.
13
Q25. Does this complete your reply evidence?
A25.
20
Yes.
Of course, the precise equation for the relationship between the risk of equity and the market-value
proportion of debt is subject to uncertainty, and the equation varies depending on whether the company
is within the middle range of capital structures or outside this range. (See Appendix C, Part I, of my
direct evidence, for my analysis of which equation is consistent with the evidence on corporate
behavior.) But the existence of such a relationship is not challenged by our failure to understand fully
the process by which stock prices are determined.
23
WRITTEN REPLY EVIDENCE OF
A. LAWRENCE KOLBE
GUIDE TO LOCATIONS OF POINTS ALREADY ADDRESSED IN PREVIOUS PROCEEDINGS
(Appendices to Kolbe Written Reply Evidence Contain the Evidence Itself)
TransCanada Mainline
(RH2-2004, PHASE II)
Topic of Kolbe Reply Evidence
1) ATWACC A TOOL, NOT AN
OUTCOME
Written Reply
of
Dr. Kolbe
Evidence of
Dr. Booth (Appendix D)
Union Gas
(EB-2005-0520)
TQM
Evidence of
Dr. Booth
Written
Reply of Dr.
Kolbe
Evidence of
Dr. Booth
(Appendix B)
pp. 9-10
pp. 4, 28
pp. 3-4, 64,
70
pp. 2-4
pp. ii, 79, 104
pp. 62-76, 8790
pp. 4-12
pp. 70-81, 83- pp. 11-12,
89, 96
Appendix R-A
3) INADEQUATE REVIEW OF CAPITAL
STRUCTURE LITERATURE
pp. 81-87
pp. 13-16
pp. 89-95
pp. 12-16
pp. 20-26
4) RELIANCE ON SELECTED
REGULATORY DECISIONS RATHER
THAN CAPITAL STRUCTURE
LITERATURE
pp. 3,74-76,
78-80
pp. 17-19
pp. ii, 2, 82,
88, 97, 100,
104
pp. 16-17
pp. 1,15,20,28
pp. 83-85
pp. 19-20
pp. 93-94
pp. 18-19
p. 25
6) INCORRECT CLAIM THAT MY
EQUATION FOR THE INTERACTION
BETWEEN THE COST OF EQUITY
AND CAPITAL STRUCTURE
PRODUCES THE HIGHEST POSSIBLE
CHANGES
pp. 85-86, 89
pp. 21-22
pp. 93-94
pp. 19-20
pp. 18, 24, 25,
27
7) INCORRECT IMPLICATION THAT MY
PROCEDURES IGNORE NON-TAX
COSTS TO DEBT
pp. 16-17
pp. 22-24
p. 23
pp. 21-22
p. 25
8) CHARACTERIZATION OF THE WAY
REGULATION WORKS
INCONSISTENT WITH THE EVIDENCE
p. 79
pp. 24-26
p. 87
pp. 22-24
pp. 11-13
9) FINANCIAL RISK DEPENDENT ON
MARKET VALUES, NOT BOOK
VALUES
pp. 15-17, 81
pp. 26-30
pp. 21-23,
87-89
pp. 24-30
p. 19
10) MY PROCEDURES TO CALCULATE
APPROPRIATE DEEMED EQUITY
RATIOS ARE REASONABLE
pp. 89-91
pp. 30-31
pp. 98-100
pp. 30-31
p. 28
2) FLAWED NUMERICAL EXAMPLE
5) INCORRECT CLAIM THAT MY
EVIDENCE RELIES ON THE 1977
MILLER MODEL
24
pp. 3-7, 8-14,
16, 20-23