Proposal to Provide Consulting Services
to FCEI, UMQ, OC and possibly others
in the Matter of the HQD Phase 2 Rate Hearing
Submitted by
Lawrence Kryzanowski, Ph.D.
Ned Goodman Chair in Investment Finance
John Molson School of Business, Concordia University
Gordon S. Roberts, Ph.D.
CIBC Professor of Financial Services
Schulich School of Business, York University
September 29, 2003
Rationale
Geoffroy Groleau’s emails of September 7 and 22, 2003, and related telephone
conversations, lead to a mandate to examine three related questions:
1. What are the advantages of using the prospective, as opposed to historical, cost of
debt in determining a rate at which to capitalize financing costs related to the
construction of fixed assets when the construction phase exceeds one year?
2. What is the appropriate carrying charge for deferral accounts?
3. What are the advantages of employing a cost of debt that includes both short- and
long-term maturities in estimating the revenue requirement, and what is the
conceptually correct method of implementing such an approach?
We address these issues in three steps. First, we develop a conceptual framework for the cost
of debt for HQD. Second, we use the framework to develop recommendations to the Regie
and to critique the evidence submitted by HQD. Third, we develop some measures of the
approximate cost savings for ratepayers that could be obtained by implementing our
recommendations.
Overview of proposed evidence
Under the stand-alone principle of regulation, HQD’s costs should reflect the costs that would
be faced if it were an independent company doing business in the base year. In our evidence
in Phase I we applied this principle in setting the capital structure of HQD at a level different
from that allowed for other entities of HQ, for example, TransEnergie. We further applied the
principle in determining a recommended return on equity for the base year as opposed to a
historical cost.
1
1.
Conceptual framework
In the proposed evidence, we develop a conceptual framework for the cost of debt for HQD as
a stand-alone company doing business in the base year. This would require a projection of the
asset and liability structures that such a company would have and then determining the costs.
Specific issues to be addressed include:
• For the purposes of the conceptual framework only:
o Assets should be determined by separating out the distribution assets of HQ
and by comparisons with other relevant entities.
o Given the assets, the matching principle requires that the maturity and currency
of the liabilities be matched to those features of the assets.
o Cost of debt should reflect the prospective costs of short- and long-term
maturities chosen to match the assets.
o The cost of debt in determining the revenue requirement should be the
prospective cost of total debt with the mix of maturities and currencies set to
reflect HQD’s business. This means more short-term debt and less foreign
debt. To the extent that foreign debt is employed and is not offset by foreign
revenues, the FX risk of the foreign debt should be hedged under the matching
principle.
• Prospective costs should be used, and not historical costs in order to avoid subsidies
and to provide correct incentives for management consistent with market discipline
under the stand-alone principle.
• The carrying charge of capital utilized by or obtained from an investment or activity,
such as a deferral account, that has a life and risk level that is lower than that for the
“average” capital investment that is undertaken by HQD should be lower than the
approved rate of return on rate base for HQD.
2.
•
•
•
3.
Recommendations and critique of HQD evidence
For this proceeding only, we take the maturity and currency-denomination structure of
HQD’s debt as given for the purposes of developing our recommendations and for our
critique of HQD’s evidence.
The prospective cost of debt should be used in capitalizing construction costs for
construction that exceeds a year, such as interest charges incurred during construction.
Should the Regie decide to continue the present practice, this should be regarded as
strictly for administrative convenience.
The carrying charge of deferral accounts for or to HQD should depend on the life and
risk of the account. The carrying charge should range between the short-term rate to
HQD (as proxied, for example, by the Bank Rate plus an appropriate premium) and
the approved rate of return on rate base for HQD.
Estimated cost savings to ratepayers of implementing recommendations
This section will illustrate the order of magnitude of the cost savings obtainable from
implementing our recommendations.
2
Cost
The total estimated cost for the services of the two experts is $52,000 (i.e., 160 hours prior to
any contingency at $325 per hour) plus GST and PST for Dr. L. Kryzanowski and GST for
Dr. G. Roberts. Based on past experience with regulatory hearings, the experts retain the right
to bill actual hours expended on this mandate. Hearing-related expenses for travel,
accommodation, and so forth will be in addition to the cost of the services of the two experts.
Timing
Timing delays will need to be negotiated. For example, 4 to 5 weeks will be required between
the finalization of the mandate and the deposit of our evidence. Thus, the finalization of the
mandate and its terms needs to occur without any undue delay.
3