DECISION
QUEBEC
RÉGIE DE L’ÉNERGIE
D-2007-116
R-3630-2007
October 15, 2007
PRESENT:
Richard Carrier, B. Sc. (Econ.), M.A. (Econ.)
Gilles Boulianne, B. Sc. (Econ.)
Richard Lassonde
Commissioners
Gaz Métro Limited Partnership (Gaz Métro)
Applicant
and
Interveners whose names appear on the following page
Decision
Application to modify the tariffs of Gaz Métro Limited
Partnership effective October 1, 2007
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4.
TOPICS ADDRESSED IN HEARING
4.1 RATE OF RETURN
4.1.1 MODELS USED
The experts heard used different approaches and models to estimate the rate of return on the
shareholder’s equity of Gaz Métro.
The IGUA’s expert, Dr Booth, uses the traditional capital asset pricing model (CAPM) and a
two-factor model involving the market risk premium and the risk premium for Canada longterm bonds1. Gaz Métro’s expert, Dr Chrétien, applies the Fama-French model to portfolios
of corporate securities that have similar characteristics to those of a benchmark distributor.
He also uses a modified CAPM2.
The CAPM is represented by the following equation:
K = Rf + β*(Rm - Rf)
This equation represents the rate of return (K) an investor expects to earn on an investment
in a security having a certain risk. The expected return for that security equals the return that
could be earned on a risk-free investment (Rf) plus a risk premium. The premium for the
security evaluated is proportional to the market risk (Rm - Rf) that is estimated using the
return (Rm) earned on a diversified portfolio of securities. The relationship between the
market risk and the risk associated with the security is expressed by the beta (β) factor.
The Fama-French model used by Dr Chrétien has been developed since 1993 and is
increasingly used in finance. Based on the evidence, however, its use in regulatory milieus to
fix the return of a public utility is a first in Canada and has only been used once in the
United States3.
Even though the two models differ, the objective of both is to estimate the return an investor
expects to earn on an investment in securities having a certain risk. The main difference
1
2
3
Exhibit C-8.10-ACIG, Evidence of Laurence D. Booth, July 2007, pages 54 and 55
Exhibit B-4-Gaz Métro-7, document 8, page 44
Exhibit B-11-Gaz Métro-7, document 8.4, page 1
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between the two approaches is in the method used to express that risk. In the Fama-French
model, the security’s risk is based on three explicative variables, i.e. the market, value and
size risk premiums, and not on a single variable, i.e. the market risk premium, as is the case
in the CAPM. Moreover, the model proposed by Dr Chrétien is based on a different
evaluation of the risk-free rate (Rf) than that normally used with the CAPM. Dr Chrétien
proposes the following equation:
K = Rfadj + β(market) * λ (market) + β(size) * λ (size) + β(value) * λ (value)
Dr Chrétien states that the Fama-French model emulates the market returns better than the
CAPM. He says that is verifiable particularly for securities having a lower than average risk
and for “value” securities, regardless of the market considered, i.e. in North America and in
other international markets. Dr Booth says that model is very controversial in finance and
submits various articles published in specialized literature to support his opinion4.
The Régie does not retain the Fama-French model for establishing the rate of return in
this decision. The application of that model to regulated enterprises has not been sufficiently
examined to date to be used as a basis for fixing the rate of return of a distributor. Based on
the evidence, regulatory application has only been discussed in a very few specialized
literature articles.
Nevertheless, the evidence submitted by Dr Chrétien shows the model’s ability to produce
meaningful robust statistical results to explain the returns earned in the past by corporate
portfolios, mainly in the gas distribution industry. Dr Booth states that the statistical
performance of the model is not the primary factor to consider. Instead, the model’s
consistency with fundamental finance principles should be examined, in particular in terms
of analysis of the risk factors that may influence the return on securities. In the Régie’s
view, a more in-depth analysis of these issues is required before recognizing and applying
the Fama-French model for determining a reasonable rate of return.
Based on the evidence, the Régie also notes, among other things, the inherent difficulty in
developing series of data over a sufficiently long period of time and the inclusion in the
reference portfolios of enterprises whose activities sometimes go significantly beyond
distribution or “regulated” activities. The Régie also questions the inclusion of income trusts
in the portfolios retained and the possible impact thereof on the estimate of the value risk
factor. Lastly, the Régie questions the possible circularity phenomenon that may result from
using portfolios of regulated enterprises to estimate the size and value parameters. While a
4
Exhibits C-8.30, C-8.31 and C-8.32-ACIG, Answers to commitment number 2.
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number of these difficulties may also apply with the CAPM, it appears they may be more
acute in the Fama French model because of the nature of the explicative factors considered.
With respect to the modified CAPM used as a complement by Dr Chrétien and the multifactor model used by Dr Booth, the Régie only uses the information provided by the results
presented to validate its assessment of the rate of return.
For these reasons, the Régie mainly retains the CAPM for its decision. It is the approach
retained by the Régie in its past decisions and the most common approach in Canada. This
model is recognized or used in finance milieus and by most experts who testify before
regulatory bodies. However, the use of this model involves substantial difficulties that the
Régie addresses in greater detail in the following sections.
4.1.2 MARKET RISK PREMIUM
The CAPM requires establishing the market risk premium used to fix the premium of a
benchmark enterprise or distributor.
Dr Chrétien presents a market risk premium of 6.43%, which is based on average returns
obtained using the arithmetic average from 1951 for the Canadian market and from 1927 for
the American market5. To do this, he uses the weightings retained by the Régie in Decision
D-99-1506, i.e. 60% for Canadian data and 40% for American data. He also justifies taking
the American data into account by the increasingly greater integration of the two
economies7.
Dr Booth says the integration of the two economies should reduce, not increase, the risk
premiums. He refers to various Canadian and American data in his testimony, but gives
special weight to Canadian data. He also mentions the need to look at data for shorter
periods as well as data over long periods of time. Dr Booth presents estimates for the periods
starting in 1926 and in 1957 by using the arithmetic and geometric averages and the ordinary
least squares analysis method. He recommends a market risk premium of 5.0%.
Based on the evidence in the application, the Régie estimates the market risk premium using
the same weightings for Canadian and American data as in 1999. In its view, the opening up
of markets offers investors various investment alternatives that it is necessary to reflect in
5
6
7
Exhibit B-11-Gaz Métro-7, document 8.1, page 2
Decision D-99-150, application R-3428-99, page 10
Exhibit B-11-Gaz Métro-7, documents 8.27 and 8.30
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establishing a reasonable rate of return.
The Régie also maintains the establishment of the market risk premium on the basis of the
arithmetic average of market returns. However, the choice of reference periods for
establishing the risk premium raises certain issues. In effect, the average may be
substantially different depending on the starting year and the series of data retained.
In particular, since 1999, the statistics show a significant decrease in the average returns,
notably on the averages for shorter periods. The drop in securities values in 2001 and 2002
partially explains this phenomenon.
In this context, the Régie places greater importance than before on the long period averages.
Based on the evidence in the application, the Régie establishes the market risk
premium in a range varying from 5.40% to 5.90%.
4.1.3 RISK OF BENCHMARK DISTRIBUTOR
Dr Booth and Dr Chrétien then estimate the risk of a benchmark distributor, i.e. a public
utility with a low risk. A benchmark distributor’s risk is measured by the beta factor, which
represents the risk differential between the benchmark distributor and the market in general.
The establishment of a beta factor is one of the biggest difficulties in applying the CAPM.
These difficulties involve establishing reference portfolios that are representative of the risk
of regulated enterprises and getting valid series of data to make a robust estimate.
Dr Booth points out the problems related to the impact of including data of a few large
enterprises in the samples, such as the heavy weighting of Nortel in the TSX index a few
years ago. He states that the resulting bias is significant when estimating the betas of all
regulated enterprises if the betas of those large enterprises differ significantly from the norm.
He presents various estimates based on recent data, but says it is necessary to use judgement
and proposes establishing the beta of a benchmark distributor based on the historical
average, which he estimates to be between 0.45 and 0.55.
Dr Chrétien presents a beta of 0.53 based on various reference portfolios used in connection
with the application of the Fama-French model.
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He also presents a modified beta of 0.588 in applying the modified CAPM. The objective of
the modified beta is to take account of the empirical research showing the trend of betas to
converge towards one (1). On the other hand, Dr Booth says the betas of regulated
enterprises converge towards the average of the betas of their group and not towards one (1).
After review, the Régie maintains the position expressed in Decision D-2003-93 to the effect
that the betas of regulated utilities converge towards their own average and not towards the
market average, which by definition, equals one (1)9.
Even though it is a determining factor in the application of the CAPM, it remains difficult to
objectively infer the value of the beta based on the market data for the enterprises retained in
the samples. Based on the evidence in the application, the Régie establishes the beta of a
benchmark distributor in a range of 0.50 to 0.55.
4.1.4 RISK-FREE RATE
The CAPM requires establishing a risk-free rate to which is added the enterprise’s risk
premium. The risk-free rate used is normally the rate for Government of Canada 30-year
bonds established based on the specialized publication of Consensus Economics Inc.
Dr Chrétien proposes an improvement to the approach used in 1999, called the modified
risk-free rate. He submits the use of the projected reference year rate as the basis for
establishing the reference return is arbitrary in that the rate for the year in question is not
representative of the average of those rates over a long period. As the risk premium is
established using long period averages, he recommends using the long period average of
Government of Canada bonds with a term of more than ten (10) years to establish the
reference return and then adjust the resulting risk premium for the 2008 year based on the
elasticity factor of 75-25 as established in the 1999 Decision. By retaining the 6.41% rate
proposed by Dr Chrétien and the 4.78% risk-free rate in the application, the resulting
adjustment of Gaz Métro’s risk premium would be approximately 41 basis points.
Dr Booth submits that it is not appropriate to correct the 1999 risk premium using a modified
risk-free rate because the fair and reasonable rate of return allowed by the Régie in 1999 was
based on an assessment that took account of all the information available at the time. He is
not aware of any other regulatory body that has used the modified risk-free rate concept. He
recommends the Régie continue to use the unmodified risk-free rate for establishing a
8
9
Exhibit B-4-Gaz Métro-7, document 8, page 53
Application R-3492-2002, phase 1, Decision D-2003-93, page 73
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reasonable return but that, in its assessment of the risk premium, it take account of all the
relevant factors on the basis of the evidence before it, including, among others, the
relationship between the risk premium and the rate on long-term bonds.
The Régie finds that the positions expressed by the two experts are not irreconcilable.
According to the Régie, the application of the CAPM involves an additional difficulty when
the evaluation of the return occurs in a period when current government bond rates are
substantially different from the average long period rate. As the risk premium is calculated
over long periods and represents the difference between the arithmetic average of the market
returns and the government bond returns, that premium is therefore basically representative
of the conditions that prevailed over that period. An adjustment is therefore required in the
Régie’s assessment when the conditions of the bond market depart from that average.
In short, Dr Chrétien proposes an explicit adjustment of the risk-free rate in such a case
whereas Dr Booth relies on the judgement of the experts and the regulator. In the Régie’s
view, the modified risk-free rate approach is an interesting means of facilitating the
application of the CAPM.
The Régie feels this initial discussion of the issue merits further review. However, the
discussion would not significantly change the reasonable rate of return to which the
shareholder is entitled. Unless explicitly treated as Dr Chrétien proposes, the problem has to
be taken into account in the assessment of the facts as Dr Booth says. In this application,
the Régie increases the results produced by the CAPM by 40 basis points.
4.1.5 OTHER MARKET ACCESS COSTS
The issue and other costs of accessing the markets were not reviewed in detail in this
application. They are 0.30% for the enterprise in Dr Chrétien’s evidence and 0.50% in Dr
Booth’s. The Régie maintains Gaz Métro’s issue and other costs of accessing markets at
30 basis points as established in Decision D-99-11.
4.1.6 GAZ MÉTRO’S RISK
There was ample evidence of Gaz Métro’s risk compared to the risk of a benchmark
distributor and the evolution thereof since 1999.
In Dr Carpenter’s opinion, that risk has increased since 1999 notably on account of the
substantial increase and greater volatility of natural gas prices. He also says the enterprise’s
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risk is increased by the performance incentive mechanism introduced in 2001. He concludes
that Gaz Métro has a greater risk than a benchmark distributor and that an increase of 50
basis points is justified.
Dr Booth states that Gaz Métro’s business risk is greater than its peers because of the
composition of its clientele. However, he states that a higher capitalization ratio and greater
risk coverage through numerous deferral accounts offsets the business risk, with the result
that the enterprise’s overall risk is in the average.
Another IGUA witness states that the risk related to the composition of the clientele has
lessened since 1999. He also states that the performance incentive mechanism does not
increase the enterprise’s risk at all and provides an opportunity to earn a higher return, if
justified by performance, and provides various protective measures that make it comparable
to a cost-based regime.
Based on the evidence in the application, the Régie feels the enterprise’s overall risk has
increased since 1999. The Régie bases this conclusion on the much higher average supply
price and the impact of that increase, particularly with respect to the competitive position in
relation to fuel oil and electricity10. The Régie is concerned about the loss of industrial
volumes and the relative stagnation of total sales since 1999. The Régie also notes the
greater volatility of supply prices. However, this is partially compensated by the utilization
of derivatives in connection with an approach the broad parameters of which have been
authorized beforehand by the regulator.
In the Régie’s view, the enterprise’s risk has not increased significantly because of the
introduction of the performance incentive mechanism. The mechanism has been adjusted
twice since 2001. While it is premature to judge the impact of the changes made to the
regime in 2007, the opportunity of taking account of the enterprise’s required revenue each
year for fixing the tariffs is maintained, which is similar in this regard to traditional costbased regimes.
The Régie evaluates the enterprise’s overall risk as higher than average but takes account in
its assessment of the greater coverage of those risks through deferral accounts and a slightly
higher capitalization ratio than average.
In the Régie’s view, the enterprise’s risk has increased since 1999 and is greater than a
benchmark distributor. Based on the evidence in the application, the Régie feels the
10
Exhibit B-16-Gaz Métro-2, document 2, page 3
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greater risk justifies setting the risk premium in the order of 25 to 35 basis points
higher than a benchmark distributor.
4.1.7 RESULTS OF CAPM
Taking account of all the preceding conclusions with respect to the application of the
CAPM, the resulting return for the distributor would be in a range varying from 8.43% to
9.08%.
4.1.8 AUTOMATIC RISK PREMIUM ADJUSTMENT FORMULA
Based on the evidence, the simple update, with no other adjustment, of the enterprise’s risk
premium using the automatic rate of return adjustment formula in force since 1999 would
produce a rate of return on shareholder’s equity of 8.91%.
4.1.9 OTHER MODELS
As previously mentioned, the Régie uses the information provided by the results of the
modified CAPM used by Dr Chrétien and the multi-factor model used by Dr Booth to
validate its assessment of the rate of return.
4.1.10 COMPARISON WITH AMERICAN DISTRIBUTORS
During the hearing, comparisons of the returns allowed Canadian regulated utilities with
their American counterparts were heard at length. Management representatives of both Gaz
Métro and IGUA explained the related issues for the industry in general to the Régie.
In this application, the Régie decides the reasonable rate of return applicable to Gaz Métro’s
shareholder. It does not decide on the current debate within the industry. However, it
indicates the factors that had an influence on its assessment.
In the Régie’s view, even though rates of return allowed in the United States are clearly
higher on average than those allowed in Canada, the evidence does not make it possible to
conclude there is any prejudice to or unfair treatment of the distributor. The applicant has
not demonstrated that the opportunities offered on the American market are comparable, in
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particular in terms of risk. On the one hand, Dr Chrétien’s evidence shows that the risk
premiums associated with the portfolios of American enterprises were higher in the past than
those of portfolios of Canadian enterprises11. On the other hand, Dr Carpenter’s evidence
does not convincingly establish that the enterprise’s risks are comparable to the risks of the
American enterprises used in comparison. The evidence does not make it possible to
compare the overall differences that may exist in the institutional, economic and financial
contexts of the two countries and their impact on the opportunities they provide for
investors.
Mention was made of the results of the Concentric Energy Advisors study commissioned by
the Ontario Energy Board in 2006. The study refers to, among other things, the fact the
returns allowed in Ontario and the United States reversed starting in 1997, i.e. since the
introduction of the automatic rate of return adjustment formulae based on the variation in the
long-term bond rates. These observations will merit further discussion in the future by the
proponents of each contention.
4.1.11 CONCLUSION
Under the terms of its empowering legislation, the Régie must determine the reasonable
return on the distributor’s rate base.
This hearing reviewed a new approach for establishing the return on the shareholder’s
equity, i.e. the Fama-French approach, incorporating additional explicative factors to take
account of the impacts of size and value in the assessment of the risk premium. The new
approach is not retained for purposes of this decision because of the lack of work or
research, in both academic and regulatory milieus, supporting its use for fixing the rate of
return of a regulated enterprise. The Régie retains the results produced by the Capital Asset
Pricing Model (CAPM) as a reference basis.
However, this hearing raised certain issues relating to the objective application of the CAPM
for determining a reasonable rate of return in the present context. In its opinion, the Régie
indicates the nature of those issues for which more elaborate evidence would be useful for
the future. Lastly, it presents the content of its conclusions on the application of the CAPM.
The Régie uses the results of the other risk premium-type models as information.
11
Exhibit B-4-Gaz Métro-7, document 8, page 40
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Given the results of the CAPM, the result the automatic adjustment formula in force since
1999 would have produced and the Régie’s conclusions about the distributor’s greater risk
since 1999, the Régie considers it is reasonable to place the return allowed the enterprise at
the high end of the range of the results produced by the CAPM.
Based on the evidence in the application and for all the reasons given, the Régie fixes
the return on the shareholder’s equity of Gaz Métro at 9.05% effective October 1, 2007
on the basis of a risk-free rate of 4.78%, which corresponds to an implicit risk
premium of 4.27%.
Furthermore, on the basis of an equity ratio of 38.5% and the debt cost presented in
the application, the Régie establishes the average cost of capital on the rate base at
7.68% and the prospective cost of capital at 6.69%.
The Régie also renews, effective for the 2009 fiscal year, the automatic rate of return
adjustment formula on the terms and conditions established in Decision D-99-11.
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