FAIR RETURN AND CAPITAL STRUCTURE
FOR TRANSÉNERGIE
EVIDENCE OF
Laurence D. Booth
Michael K. Berkowitz
BEFORE THE
Régie de l’énergie du Québec
November 2000
TABLE OF CONTENTS
Page
1.0
INTRODUCTION
1
2.0
THE REGULATORY FRAMEWORK
4
3.0
BUSINESS AND FINANCIAL RISK
13
4.0
ECONOMIC AND FINANCIAL OUTLOOK
22
5.0
THE RISK OF A REGULATED UTILITY
33
6.0
FAIR ROE ESTIMATES
39
APPENDIX A:
ABBREVIATED RESUMES
APPENDIX B:
CRITIQUE OF OTHER EVIDENCE
APPENDIX C:
INSTRUMENTAL MODEL FOR ESTIMATING BETA
APPENDIX D:
MULTI-FACTOR MODEL
APPENDIX E:
ESTIMATION OF THE MARKET RISK PREMIUM
APPENDIX F:
U.S. RISK PREMIUM EVIDENCE
1
1.0
INTRODUCTION
2
Q.
PLEASE DESCRIBE YOUR NAMES, QUALIFICATIONS AND EXPERIENCE.
5
A.
Laurence Booth is a professor of finance and finance area co-ordinator in the Rotman School
6
of Management at the University of Toronto, where he holds the Newcourt Chair in Structured
7
Finance. Michael Berkowitz is a professor of economics and finance, holding a cross appointment in
8
both the Department of Economics and the Rotman School of Management at the University of
9
Toronto. Professor Berkowitz is the chair designate of the Department of Economics and Director of
3
4
10
the Financial Economics Program.
11
12
Professors Booth and Berkowitz have both presented testimony on the capital structure and fair rate of
13
return for regulated utilities before most of the major regulatory boards in Canada, including the CRTC,
14
the National Energy Board, and the public utility ‘boards’ in Alberta, British Columbia, Manitoba,
15
Quebec and Ontario. Their testimony has been presented on behalf of a wide range of organisations
16
including, but not limited to, the Province of Ontario, the Consumers Association of Canada, the
17
Consumer Advocate of the Province of Newfoundland, the National Anti-Poverty Organisation
18
(NAPO), the Canadian Association of Petroleum Producers (CAPP), the Industrial Gas Users
19
Association (IGUA) and the Industrial Power Consumers Association of Alberta (IPCAA).
20
21
Detailed resumes are included as Appendix A.
22
Q.
WHAT IS THE PURPOSE OF YOUR TESTIMONY?
25
A.
The Québec Association of Industrial Electricity Users (AQCIE), the Québec Forestry Industry
26
Association (AIFQ) and the Association of Private Electricity Producers (AQPER) have asked us to
27
provide an independent assessment of the fair rate of return on common equity and the appropriate
23
24
1
1
capital structure for TransÉnergie. We have also been asked to comment on various financial issues and
2
to critique the evidence provided by the company witness, Dr. Roger Morin, (Appendix B).
3
4
We last appeared before the Regie in 1996 presenting similar evidence on GMI. Since then major
5
changes have occurred in the capital markets that have forced us to modify our basic testimony. In
6
particular, several companies have disappeared. The merging of the eastern regional Telcos into Aliant
7
Telecom and the merger of BC Tel with Telus into BCT.Telus Communications has deprived us of a
8
significant part of our “pure play” regulated sample. This has removed a significant fraction of the pure
9
regulated utility sample that we relied on to draw inferences for pipelines, Telcos and gas and electric
10
companies. As a result, we have discontinued both our discounted cash flow (DCF) and our preferred
11
stock risk premium testimony.1 The latter is no longer feasible, whereas the former is now subject to
12
significantly greater estimation risk.
13
14
To compensate for the loss of these models we have developed a new multi-factor model to
15
complement our standard CAPM based risk premium model. Further, the increasing globalization of
16
capital markets and the development of innovative financing vehicles to circumvent portfolio restrictions
17
in tax deferred savings plans has lead us to examine in more detail the statistical evidence on the US
18
market risk premium.
19
20
Q
WHAT OVER-RIDING PRINCIPLES HAVE GUIDED YOUR TESTIMONY?
21
22
A.
In our judgement capital structure decisions should be “long lived” as they are primarily a function
23
of the business risk of the firm. In particular, it is not standard practise to change equity ratios on an
24
ongoing basis. The fair ROE, in contrast, constantly changes with capital market conditions.
25
Consequently, we would recommend that the Régie sets TransÉnergie’s allowed ROE in the future
1
By agreement between the parties in 1996 we did not present our normal testimony focussing instead on
our risk premium evidence.
2
1
based on a formula adjustment based on its ROE determination in this hearing. We would recommend
2
adopting a similar formula to that chosen by the National Energy Board, the BC Utilities Commission,
3
the Manitoba PUB and the Ontario Energy Board. This approach fixes the allowed ROE and then
4
alters it each year in line with changes in the long Canada rate. The actual implementation differs slightly
5
from jurisdiction to jurisdiction, but we would have no objections to changing the allowed ROE by 75%
6
of the change in the long Canada rate as projected from the Consensus Economics forecast of ten year
7
Canadas for the test year. Although such an approach is primarily an administrative convenience with
8
little grounding in financial theory, it seems to have worked quite well in practise.
9
10
Q.
WHAT ARE YOUR CONCLUSIONS?
A.
The major conclusions of our analysis are:
11
12
13
14
!
A fair return on equity of 8.25% is appropriate for transmission assets for 2001. This is
slightly under a 300 basis points risk premium over current long Canadas and a 225
basis point risk premium over our forecast long Canada rate of 6.00%;
!
Since the transmission assets are the lowest risk part of the electricity business, we
recommend a common equity ratio of 30%, the same as that of mainline gas
transmission assets;
!
The excellent job done by Mr. Paul Martin in solving the endemic deficit problems of
the federal government has reduced the significant risk premium that was embedded in
long term Canada bonds, reducing the market risk premium to 4.5%, and
!
Canada is poised for at least another year of good economic growth, combined with
relatively low inflation. Although the risk of an economic slowdown is increasing, from
our analysis of current capital market conditions, it is our judgement that the
Transmission assets have sufficient financial flexibility with a 8.25% ROE on a 30%
equity component to provide service.
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
3
1
2.0
THE REGULATORY FRAMEWORK
2
3
Q.
WHAT DO YOU UNDERSTAND TO BE THE CONCEPTUAL FOUNDATIONS
FOR A FAIR RATE OF RETURN?
4
5
6
A.
Electricity transmission operations continue to be rate of return regulated because they are a
7
classic example of a natural monopoly. This is due to the technological nature of the production
8
process, in that the costs are primarily fixed. As a result, average cost falls with output as larger and
9
larger volumes are spread over relatively fixed costs. A declining average cost business eliminates
10
competitors as a dominant firm with increasing market share emerges, until there is effectively only one
11
producer in the market. Even if competition initially exists in a market, competitive pressures to increase
12
the scale of operations and decrease average costs results in a monopoly provider. This is particularly
13
true when the commodity produced is a service and not a manufactured good that can be resold in a
14
different market. In these situations of natural monopoly there is very little countervailing pressure to the
15
activities of the monopolist.
16
17
For these reasons fixed cost “service” providers are usually subject to government regulation. The
18
presumption is that without such regulation the activities and prices of the natural monopolist would be
19
unreasonable. In this respect it is important to note that it is regulation that follows the underlying
20
economics, not vice versa. This economic imperative is reflected in the statutes under which regulated
21
companies operate and the general approach to regulation, where firms are regulated to mimic the
22
actions of a competitive firm and yet reap the scale economies of the natural monopolist. It is
23
also implicit in the above that regulated firms have to be monitored otherwise they will use their natural
24
market power to the benefit of their shareholders and not consumers.
25
26
The litmus test for the competitive firm is then the absence of monopoly profits. Conversely, the
27
regulated firm only earns normal profits and the equity holders a fair return on their investment. Although
4
1
legal statutes differ marginally from one jurisdiction to another, they are similar to the regulations by
2
which the Supreme Court of Canada came to determine a fair rate of return. In BC Electric Railway
3
Co Ltd., vs the Public Utilities Commission of BC et al ([1960] S.C.R. 837), the Supreme Court of
4
Canada had to interpret the following statute:
5
6
7
8
9
10
11
(a)
The Commission shall consider all matters which it deems proper as affecting the rate:
(b)
The Commission shall have due regard, among other things, to the protection of the
public interest from rates that are excessive as being more than a fair and reasonable charge for
services of the nature and quality furnished by the public utility; and to giving to the public utility
a fair and reasonable return upon the appraised value of the property of the public utility used,
or prudently and reasonably acquired, to enable the public utility to furnish the service:
12
13
This statute articulated the "fair and reasonable" standard in terms of rates, and that the regulatory body
14
should consider all matters that determine whether or not the resulting charges are "fair and reasonable."
15
To an economist "fair and reasonable" means minimum long run average cost, since these are the only
16
costs which satisfy the economic imperative for regulation and by definition do not include unreasonable
17
and unfair cost allocations. The statute also articulated the “prudently and reasonably acquired” test in
18
terms of the assets included in the rate base.
19
20
In the BC Electric decision the Supreme Court of Canada adopted Mr. Justice Lamont's definition of a
21
fair rate of return as enunciated in the Northwestern Utilities Limited v. City of Edmonton ([1929]
22
S.C.R. 186) decision that:
23
24
25
26
27
"By a fair return is meant that the company will be allowed as large a return on the
capital invested in its enterprise (which will be net to the company) as it would receive if
it were investing the same amount in other securities possessing an attractiveness
stability and certainty to that of the company's enterprise."
28
29
Mr. Justice Lamont's definition embodies what a financial economist would call a risk adjusted rate of
30
return or "opportunity cost."
31
5
1
Since regulated utilities finance their net fixed assets by raising very large amounts of financial capital, it
2
is very important that once that capital has been raised that the investors are treated fairly. This is
3
because the capital is "sunk" and can not be easily taken out of the enterprise once invested. This is
4
why equity investors should be allowed to earn a rate of return equivalent to what they could earn
5
elsewhere. To do otherwise would be to unfairly enrich either the shareholders or customers of the
6
company.
7
8
Of note is that Mr. Justice Lamont's definition includes three critical components:
9
10
11
(1)
The fair return should be on the "capital invested in the enterprise (which will
be net to the company)"
12
13
This means that the return should be applied to the capital actually “invested” in the company, or the
14
“book value” of the assets, and not their market value. The reason for this is that the latter (market
15
values) changes as a result of the regulatory decision and has little connection with the actual capital
16
invested in the firm. As a result, Mr. Justice Lamont’s definition is normally interpreted as the original
17
historic cost rate base. Only this represents the actual money invested in the regulated utility.
18
19
(2)
"other securities"
20
21
Mr. Justice Lamont specifically states that the alternative investment should be other securities, and not
22
the book value investment of other companies. This was a natural outgrowth of the Northwestern
23
Utilities Limited decision that was concerned with the authority of the Board to change the allowed
24
rate of return to reflect "changed conditions in the money market." In 1929 the term "money market"
25
had a broader interpretation than its current use; "capital market" would be closer to today's
26
terminology.
27
28
The motivation for the definition was clearly the desire to change the allowed rate of return to reflect the
6
1
changes in "market opportunities." This is equivalent to the standard economic definition of a market
2
opportunity cost. The return should be equivalent to what the stockholders could get if they took their
3
utility investment (at book value) and invested it elsewhere. Clearly this utility investment can only be
4
invested at market prices, since the utility investor can not invest elsewhere at book value! Hence, the
5
opportunity cost has to be measured with respect to market rates of return. In particular, there is no
6
basis for allowing a utility investor a return equivalent to the accounting rate of return earned elsewhere.
7
8
(3)
"attractiveness, stability and certainty"
9
10
These words clearly articulate what a financial economist would call a risk adjusted rate of return. Even
11
in 1929 it was obvious that investors required higher rates of return on risky investments, than on
12
relatively less risky ones.
13
14
Further, we can find no economic or legal basis for arbitrarily increasing the investor's opportunity cost
15
by "targeting" a particular market to book ratio or a particular interest coverage ratio. In Federal
16
Power Commission et al v. Hope Natural Gas Co. [320 US 591, 1944], the United States
17
Supreme Court decided that a fair return
18
19
20
"should be sufficient to assure confidence in the financial integrity of the enterprise so as to
maintain its credit and to attract capital."
21
22
Financial integrity is critical for a corporation. Since the equity holders have made a “sunk” investment,
23
it is possible for subsequent regulated decisions to deprive the stockholders of a reasonable return and
24
thus make it very difficult to access the market for new capital. Financial integrity is thus equivalent to
25
the ability to attract capital and fair treatment to investors. The investor's "market opportunity cost"
26
accomplishes these additional objectives, since by definition the opportunity cost is the rate that the
27
investor can earn elsewhere. Thus it is a rate that attracts capital, and if the company can attract capital
28
on reasonable terms it can maintain its financial integrity.
7
1
Nowhere in the theory of regulation is there any presumption that a regulated firm has to maintain a
2
particular credit rating. “Credit” is not the same thing as a credit rating. Credit just means the ability to
3
raise financing to undertake the ongoing activities of the company. The upshot of these remarks is that
4
we implement Mr. Justice Lamont’s definition of a fair rate of return by estimating the market based
5
investor opportunity cost 2. We do not add any “bells and whistles” to the market based opportunity
6
cost that have no legal or economic justification.
7
8
Finally, most statutes allow the regulatory authority to examine all factors that enter into the rates to
9
ensure that the rates are “fair and reasonable.” This includes the firm’s capital structure decision, since
10
this has a very direct and obvious impact on the overall revenue requirement. To allow the regulated
11
utility to freely determine its capital structure will inevitably lead to rates that are unfair and
12
unreasonable, otherwise the management of the regulated firm is not fulfilling its fiduciary duties to act in
13
the best interests of its stockholders.
14
15
Q.
WHAT RISKS DO INVESTORS FACE IN INVESTING IN UTILITIES?
16
17
A.
Investors are interested in the rate of return on the market value of their investment. This
18
investment can be represented conceptually by the standard discounted cash flow model,
19
P0 =
20
ROE * BVPS * (1 − b)
(K − g)
21
22
where P0 is the stock price, ROE the accounting return on equity, BVPS the book value per share, b
23
the retention rate (how much of the firm’s earnings are ploughed back in investment) and K and g are
24
the investor’s required rate of return, or cost of equity capital, and expected growth rate respectively.
25
2
We can find no legal or economic basis for so called “comparable earnings” testimony that looks at the
accounting ROEs of a sample of arbitrarily selected firms.
8
1
Of the different sources of risk, we normally focus on the firm’s business risk, its financial risk, and its
2
investment risk. For regulated utilities we also add a fourth dimension, namely its regulatory risk. In
3
terms of the above equation what the firm actually earns, its return on equity (ROE), captures the
4
business, financial and regulatory risk, which together we term income risk, whereas all the other factors
5
are reflected in investment risk, which is the way in which investors react to the income risk and other
6
macroeconomic variables.
7
8
Business risk is the risk that originates from the firm’s underlying “real” operations. These risks are the
9
typical risks stemming from uncertainty in the demand for the firm’s product resulting, for example, from
10
changes in the economy, the actions of competitors, and the possibility of product obsolescence. This
11
demand uncertainty is compounded by the method of production used by the firm and the uncertainty in
12
the firm’s cost structure, caused, for example, by uncertain input costs, like those for labour or critical
13
raw or semi-manufactured materials. Business risk, to a greater or lesser degree, is borne by all the
14
investors in the firm. In terms of the firm's income statement, business risk is the risk involved in the
15
firm's earnings before interest and taxes (EBIT). It is the EBIT which is available to pay the claims that
16
arise from all the invested capital of the firm, that is, the preferred and common equity, the long term
17
debt, and any short term debt such as debt currently due, bank debt and commercial paper.
18
19
If the firm has no debt or preferred shares, the common stock holders “own” the EBIT, after payment
20
of corporate taxes, which is the firm’s net income. This amount divided by the funds committed by the
21
equity holders (shareholder’s equity) is defined to be the firm's return on invested capital or ROI, and
22
reflects the firm's operating performance, independent of financing effects. For 100% equity financed
23
firms, this ROI is also their return on equity (ROE), since by definition the entire capital investment has
24
been provided by the equity holders. The uncertainty attached to the ROI therefore reflects all the risks
25
prior to the effects of the firm’s financing and is commonly used to measure the business risk of the firm.
26
27
As the firm reduces the amount of equity financing and replaces it with debt or preferred shares, two
9
1
effects are at work: first the earnings to the common stock holder are reduced as interest and preferred
2
dividends are deducted from EBIT and, second the reduced earnings are spread over a smaller
3
investment. The result of these two effects is called financial leverage. The basic equation is as follows:
4
ROE = ROI + ( ROI − R D (1 − T )) D S
5
6
7
where D, and S are the amounts of debt, and equity respectively. If the firm has no debt financing (D/S
8
=0), the return to the common stockholders (ROE) is the same as the return on investment (ROI). In
9
this case, the equity holders are only exposed to business risk. As the debt equity ratio increases, the
10
spread between what the firm earns and its borrowing costs ( RD ) is magnified. This magnification is
11
called financial leverage and measures the financial risk of the firm.
12
13
The common stockholders in valuing the firm are concerned about the total “income” risk they have to
14
bear, which is the variability in the ROE. This reflects both the underlying business risk as well as the
15
added financial risk. If the firm operates in a highly risky business, the normal advice is to primarily
16
finance with equity, otherwise the resulting increase in financial risk might force the firm into serious
17
financial problems. Conversely, if there is very little business risk, as is the case with regulated utilities,
18
the firm can afford to carry large amounts of debt financing, since there is very little risk to magnify in
19
the first place.
20
21
This means that a regulatory board has a variety of tools to manage the regulated firm’s risk. The first is
22
that in can set up deferral accounts to capture different components of business risk. The essence of
23
deferral accounts is simply to capture forecasting errors. For example, if operations and maintenance
24
expense is 2% higher than forecast, rather than have the utility’s stockholders “eat” the extra costs in
25
terms of a lower earned rate of return, the board can simply have the extra costs captured in a deferral
26
account and then charged to the following years’ ratepayers. In this way “ratepayers” bear the risk.
27
10
1
Different boards have a different attitude towards deferral accounts, which reflects one of two facts: 1)
2
the stability of the ratepayer group 2) the desire to hold management accountable for the utility’s costs.
3
If the ratepayer group changes dramatically over time, deferral accounts can end up having a future
4
group pay the cost over-runs that are not part of their “fair and reasonable” costs. However, deferral
5
accounts are very useful when management can not control or accurately forecast costs and the
6
ratepayer group is fairly stable. In contrast, non-regulated firms can not normally go back and ask their
7
customers to pay extra for services already been paid for!
8
9
A second tool is for the regulator to alter the amount of debt financing. If the regulator feels that the
10
firm’s business risk has increased (decreased) it can reduce (increase) the amount of debt financing so
11
that the total risk to the common stockholder is the same. Both of Canada’s national regulators, the
12
National Energy Board and the CRTC, have recognized this. When the CRTC opened up Canada’s
13
telecommunications market to long distance competition it specifically increased the allowed common
14
equity component of the Telcos to 55% to offset the increased business risk. Similarly, when the NEB
15
decided to go to a formula based approach for the return on equity it reviewed all the capital structure
16
ratios for the major oil and gas pipelines and set different equity ratios for the firms that it believed faced
17
different business risks. TransCanada, for example, was allowed 30% common equity, since it
18
predominantly had mainline transmission operations, while Westcoast with its greater proportion of
19
gathering lines was allowed 35%. Once the financial risk had offset the different business risks, the
20
NEB was able to award them all the same return on equity.
21
22
The third tool available for the regulator is to directly alter the allowed rate of return, so that the
23
stockholder only earns a rate of return commensurate with the risks undertaken. The CRTC, for
24
example, has historically allowed Northwestel 0.75% more than the other Telcos primarily due to the
25
“ruggedness” of its operating region.
26
27
Q.
WHICH TOOLS DO YOU ADVOCATE THE RÉGIE USING?
11
1
2
A.
Generally, the revenues of the regulated firm are so large that setting up deferral accounts for
3
many hard to control items imposes negligible risk on the customers and significant reductions in risk for
4
the regulated firm. As a result, deferral accounts are often a “win-win” for both ratepayers and
5
shareholders. However, we would not advocate their use where management can influence the costs.
6
The problem with deferral accounts is simply that there will still be differences in risks across firms even
7
after their prudent use.
8
9
With a choice between capital structure versus ROE adjustments, our preference is to adjust capital
10
structures, since the market seems to consider any changes in the allowed capital structure to be a more
11
permanent change, while it expects the ROE to change with capital market conditions. Since business
12
risk is the primary determinant of capital structure, it is to be expected that a board will change an
13
allowed capital structure relatively infrequently in response to changes in business risk. A second reason
14
is that fixing capital structures reduces the amount of testimony that a board hears and as a result
15
regulatory costs. A board can then set the allowed equity ratios relatively infrequently and hold a
16
generic ROE hearing or use an adjustment mechanism to set the ROE.
17
18
It is our understanding that the use of deferral accounts and equity ratios to adjust for differences in
19
business risk is relatively more common in Canada than the US. This normally comes up in the
20
qualitative discussions by the bond rating agencies in comparing companies operating in different
21
jurisdictions. The result is to make it difficult to compare firms operating in different jurisdictions. Within
22
Canada, BC Gas Utility, for example, has a weather normalisation account, whereas Consumers Gas
23
does not. As a result, the impact of weather variations on gas consumption and earned returns is
24
different between these two companies, even though they are both local gas distribution companies. For
25
the same reason it is extremely hazardous trying to make comparisons between firms in the U.S. and
26
Canada. This is particularly true for integrated electric companies, since they often have different risk
27
profiles, depending on whether generation is predominantly from coal, nuclear, hydro or co-generation.
28
Different mixes of generation, distribution and transmission then further compound the different
12
1
approaches to regulation.
13
1
3.0
BUSINESS AND FINANCIAL RISK
2
3
Q.
PLEASE DISCUSS THE RISKS OF TRANSÉNERGIE
4
5
A.
In 1997 Hydro-Quebec obtained a FERC power marketing license enabling it to access U.S.
6
markets. In return, Hydro-Quebec had to grant U.S. utilities reciprocal (wholesale) access within the
7
province. To achieve this, the company separated its transmission operations from its electricity
8
generation, distribution and marketing activities. The result was a new division of Hydro-Quebec called
9
TransÉnergie.
10
11
TransÉnergie now offers access to its system capacity to all those who want to use it for their power
12
transfers. The mission of the new division is:3
13
14
•
to transmit electricity and market transmission in accordance with the requisite quality standards
15
and in compliance with current regulations, while ensuring the durability and optimum growth of
16
our assets, from a perspective of sustainable development;
17
18
•
to market products and services in areas related to energy transmission; and
•
to control the generation and transmission system under its responsibility, at the best possible
19
20
21
cost and in accordance with quality, reliability and safety standards and open access
22
regulations.
23
24
According to Merrill Lynch, Hydro-Quebec did not give up very much in opening its market to outside
3
http:/www.hydroquebec.com/transenergie/en/profil/missions/index.html/
14
1
competition4, since in particular, it will be difficult for U.S. electric utilities to compete with its low cost
2
hydro based energy, particularly when one considers that electricity rates in the U.S. Northeast average
3
US 9¢ - US 11¢ per kWh. 5
4
5
According to Hydro-Quebec’s 1999 Annual Report, growing demand for electricity, spurred by a
6
healthy Quebec economy, was responsible for 37% of the rise in revenue from Quebec electricity sales
7
in 1999. Demand was strongest in the industrial sector with the pulp and paper industry accounting for
8
much of the increase in industrial demand growth. Overall, growing demand boosted revenues across
9
the industrial sector by $56 million in 1999. At the same time, overall sales in the residential and farm
10
sector and the general and institutional sector climbed by $11 million and $30 million, respectively. The
11
stronger demand in these sectors was fuelled by the economic upturn in Quebec which spurred
12
employment, consumption and housing construction within the province.6
13
14
The graphs of real provincial GDP growth and electricity demand within Quebec are presented in
15
Schedules 1-1 to 1-4. Schedule 1-1 shows that overall electricity demand is strongly related to
16
economic growth within the province over the 1982-99 period. The correlation is almost 60%. At the
17
same time, Schedules 1-2 to 1-4 show the relationship between provincial GDP growth and electricity
18
demand in the industrial, residential and commercial sectors where the correlations are 48%, 10% and
19
50%, respectively. With steady provincial economic growth of 2.3% forecast for 20017, this suggests
20
continued growth in electricity demand for the test period.
21
The opening of wholesale markets to competition led to a climb in short-term electricity sales outside of
4
Merrill Lynch, “Opinion Regarding Hydro Quebec’s Theoretical Borrowing Costs in the Absence of a
Government Guarantee”, HQT-8, Document 2, August 2000.
5
This compares to the Company’s cost per net generated kWh of electricity in 1999 of 5.01¢ ($C) as
reported by Dominion Bond Rating Service, August 2000, HQT-8, Document 3.2.
6
Hydro Quebec Annual Report 1999, p. 49.
7
Hydro Quebec, Financial Profile 1999-2002, p. 6.
15
1
the province in 1999. At year end, these sales amounted to $624 million, or almost 7% of total sales,
2
for a revenue increase of 49% over 1998.8 Long term sales were virtually at the same level as 1998.
3
According to the Company, as many of these long term contracts expire by the end of 2002, this will
4
free up quantities of energy that the Corporation can resell at favourable prices in short-term
5
transactions outside Quebec or use to satisfy growing domestic demand.9
6
7
Hydro Quebec’s targeted expansion is 20 Twh, or a 12% increase in new sales in all markets by 2002.
8
To reach this goal, the company is focussing on selling more power throughout the U.S. and Canada.
9
Hydro Quebec is expanding its marketing presence in the U.S. as new opportunities arise through
10
deregulation. According to Duff & Phelps Credit Co., this is a wise strategy, as peak load demands are
11
increasing in the U.S., and Hydro Quebec is the lowest cost provider in its chosen regions.10
12
Q.
WHAT ARE THE KEY FEATURES OF TRANSÉNERGIE’S SYSTEM?
15
A.
The key features of the TransÉnergie transmission system are that the postage stamp tariff that
16
ensures all Quebec residents pay the same cost of transmission regardless of location, while rates for
17
hookup by generators will be distance sensitive to ensure locational efficiency. The postage stamp tariff
18
is set to recover all the common transmission costs, which apart from the direct costs of the system also
19
includes line losses.
13
14
20
21
As Dr. Morin points out in his evidence, to the extent that TransÉnergie’s costs are largely passed on to
22
Disco and rolled into Disco’s costs of service for rate-making purposes, the company is relatively
8
Hydro Quebec Annual Report 1999, p. 50.
9
Hydro Quebec Annual Report 1999, p. 51.
10
Duff & Phelps Credit Rating Co, October 1999, HQT-8, Document 3.4, p. 2. The comparative marketing
advantage provided Hydro Quebec by its low-cost power is also recognized by Moody’s ( Moody’s Investor
Service, April 2000, HQT-8, Document 3.1, p. 4.)
16
1
shielded from the fate of Disco’s sales volume and is “relatively assured of recovering its costs and a
2
fair return on capital investment.”11
3
4
TransÉnergie estimates its costs and then bills Hydro-Quebec to recover those costs on a fixed basis.
5
TransÉnergie’s proposed cost structure for 2001 is as follows:
6
$ mm
1,445,750
447,813
184,100
317,998
288,947
2,684,608
7
Capital cost
Depreciation & Amortisation
Taxes
Direct expenses
Other
Total
8
9
10
11
12
13
%
53.8
16.7
6.9
11.8
10.8
14
15
Fixed costs include the return to investors, depreciation and amortisation and taxes. In total they
16
amount to 77.4% of the revenue requirement. Forecasting risk involved in these items is minimal. Even
17
for the remaining operating expenses there are minimal forecasting risks.
18
19
As discussed earlier the fixed nature of TransÉnergie’s costs, combined with the service nature of the
20
commodity, make it a natural monopoly. This lowers its risks and makes cost forecasting relatively
21
easy. TransÉnergie’s forecast costs are covered by an annual payment from its parent. As a result,
22
TransÉnergie is almost certain to recover from Hydro-Quebec the funds required to meet all of its
23
forecasted expenditures. Consequently, TransÉnergie should earn as close to a guaranteed
24
return on equity as it is possible to earn.
25
26
The only risk that an “investor” in TransÉnergie would then face is that the allowed return would
27
fluctuate with capital market conditions. For example, if the Régie adopted an ROE adjustment
28
mechanism, this effectively converts an investment in TransÉnergie into a floating rate preferred share. It
11
R.A. Morin, Fair Return on Common Equity for TransÉnergie, April 2000, HQT-9, Document 1.
17
1
is a preferred share, since the payments to the owner are through a dividend and would thus benefit
2
from the inter-corporate tax exemption on dividend income. It is floating rate, since the ROE would
3
float annually with the long Canada bond yield. In our judgement most of the risk of investing in
4
TransÉnergie is effectively investment risk.
5
6
The observation that TransÉnergie is guaranteed a revenue requirement to cover forecast costs and is
7
only exposed to some minor short run forecasting risk in its operating expenses points to some obvious
8
Canadian comparables. In our judgement, TransÉnergie’s risks are similar to those of TransCanada
9
Pipelines, where revenues are likewise largely recovered through fixed demand charges.
10
11
Q.
WHAT ARE THE CAPITAL STRUCTURES OF OTHER REGULATED
CANADIAN COMPANIES?
12
13
14
A.
In Schedule 2 are the capital structures of the major utilities and utility holding companies with
15
their associated bond ratings. The first page of Schedule 2 provides the common equity ratios for the
16
seven gas local distribution companies (LDC), which range from Union Gas’s 30.2% to Gaz Metro’s
17
41.2%. However, Gaz Metro is a limited partnership and has preferred equity imputed for rate making
18
purposes so 41.2% overstates its common equity ratio. All of the gas LDCs have an A bond rating,
19
except for PNG12 which is the smallest gas LDC with shareholder’s equity of only $64 million and
20
Consumers Gas, which is Canada’s largest gas LDC, with shareholders equity of $1,331 million and an
21
A(High) bond rating.
22
23
Page 2 of Schedule 2 provides the bond ratings for the pipelines, electric LDCs and Canadian Utilities,
24
which is a diversified regulated company. It is more difficult to evaluate these capital structure ratios,
25
since several of these companies are among the largest companies in Canada and are holding
12
PNG is sometimes classified as a gas pipeline. It was recently downgraded due to uncertainty over future
deliveries by a critical Methanex plant in Kitimat.
18
1
companies for a large array of other mostly regulated companies. This can be seen by observing that
2
TransAlta Inc, for example, has minority interest of $804 million and stockholder’s equity of $1,625
3
million, indicating that they are consolidating some very large companies for whom they do not have
4
100% ownership. TransAlta Utilities has a marginally lower common equity ratio at 43.0% The three
5
pipelines have common equity ratios ranging from Westcoast’s 25.7% to Nova Gas Transmission’s
6
31.6%. The four electric LDCs have common equity ratios ranging from Nova Scotia Power’s 35.2%
7
to TransAlta Utilties’s 43%. Canadian Unities has 35.2% common equity, reflecting both its power
8
generation and gas LDC operations. Similar to the gas LDCs, all the pipelines and utilities in Schedule 2
9
have A ratings except West Kootenay, a small electricity company in BC with only $119 mm in
10
stockholder’s equity and Alliance pipeline, which is projected by DBRS to have 70% debt financing for
11
2001 with a BBB (High) bond rating.
12
13
Page 3 of Schedule 1 provides similar data for the Telcos. Interpretation of this data is somewhat more
14
complicated due to the recent consolidation in the industry with Aliant Telecom and the new Telus
15
emerging as dominant players, as well as write offs following the move to price cap regulation.
16
However, note that the common equity ratios are substantially higher than for the pipelines and utilities
17
with the modal group clustered around 50% which is consistent with the allowed common equity ratio
18
of 55%. Similar to the other regulated firms, the bond ratings in the DBRS report are generally A with
19
the only exception Island Tel, which only has shareholders equity of $61 million. The three largest
20
Telcos, Bell Canada, Telus and BC Tel all have A(High) ratings similar to the largest Gas LDC,
21
Consumers Gas, and the two largest power generation companies (TransAlta and Canadian Utilities).
22
The only exception to the “largest equals A(high)” tendency is for the pipelines, where TransCanada
23
has been downgraded to A(low) primarily due to problems in its non-regulated businesses.
24
25
Q.
DO YOU HAVE ANY OTHER DATA ON ELECTRIC COMPANIES?
A.
Yes, the Dominion Bond Rating Service (DBRS) completed a major industry study earlier this
26
27
19
1
year.13 This study incorporates a detailed risk analysis of the government and investor owned electricity
2
companies from the point of view of the debt market investor. In Schedule 3 are the main financial
3
ratios reported by DBRS for the five year period 1994-1998. The ratios are for the five investor owned
4
utilities: West Kootenay Power (WKP), ATCO Electric, TransAlta, Great Lakes Power (GLP) and
5
Nova Scotia Power (NSP).
6
7
The first data is simply electricity sales in millions of kWhs, keeping in mind that these utilities are of
8
different sizes. Even though sales do not directly correspond to generation, it is clear that TransAlta is
9
the giant of the investor-owned industry in Canada; ATCO and Nova Scotia Power are next at about
10
one-third TransAlta’s size, followed by the two smaller companies, West Kootenay and Great Lakes
11
Power.
12
13
In terms of financial structure we would expect TAU to have the greatest debt ratio, simply because
14
size is a factor in financial market access. However, Nova Scotia Power with 68-69% debt financing is
15
consistently the most indebted followed by ATCO and WKP with TAU using relatively less debt. This
16
shows up in the two coverage ratios reported by DBRS. In the fixed charge coverage ratio (includes
17
preferred dividends) ATCO, TAU and WKP consistently have the highest coverage ratio. For the
18
EBITDA14 coverage ATCO and TAU are ahead of the other electric companies.
19
20
This financial strength is also reflected in page 2 of Schedule 3. It is very well to look at coverages, but
21
debt investors are primarily interested in the ability of the firm to generate cash to pay off their debt. On
22
this score, ATCO and TAU have the greatest cash flow to total debt ratios. TAU consistently
23
generates 25% of its total debt each year in cash flow and ATCO recently is not far behind with 19%.
24
In contrast, the other electrics languish at barely above 10%. Internally generated funds (cash flow)
25
represented over twice TAU’s 1998 capital expenditures (capex). In this respect, TAU, ATCO and
13
14
Dominion Bond Rating Service, Electric Utility Industry Study, 2000.
EBITDA is earnings before interest, tax, depreciation and amortisation.
20
1
NSP have all demonstrated strong ability to fund capex internally, reducing their need to access
2
financial markets.
3
4
For the public sector electric companies, the financial ratios are almost meaningless, since every public
5
sector electric utility borrows either under a provincial guarantee or the debt is issued directly by the
6
province.15 As a result, investors look directly to the provincial credit rating to assess access and cost
7
and pay little if any attention to the capital structure ratios of the utility. This can be assessed by looking
8
at Schedule 4, which has the capital structure ratios and credit ratings for the publicly owned electric
9
companies. Note that Ontario Hydro has an equity ratio of -11.3%, ie., it has negative book equity,
10
while New Brunswick Power has an equity ratio of 0.1%. Neither of these ratios have any financial
11
meaning. Even the ratios that look “reasonable” are not economically determined. They largely reflect
12
the expansion of the electric system and the need to retain earnings within the utility rather than pay it
13
out to the province. In the future equity ratios will probably decrease since the overall Canadian system
14
is mature. Schedule 4 indicates that cash flow generated by the utility exceeds the respective capital
15
expenditures for every utility. Left to themselves without the need to pay a provincial dividend, every
16
publicly owned electric company in Canada16 could fully fund its capital expenditures internally.
17
18
Q.
WHAT WOULD YOU RECOMMEND AS AN EQUITY RATIO FOR
19
TRANSÉNERGIE?
20
21
A. In our judgement the electricity industry in Canada in general is relatively mature. However, in
22
Québec there is more growth than elsewhere as the cash flow/capex ratio of the last nine years
23
indicates.
24
25
26
Cash Flow/Capex
1998
1997
1996
1995
1994
1993
1992
1991
15
The only exception is Edmonton Power, which is not a provincial crown corporation.
16
With the possible recent exception of Manitoba Hydro.
21
1990
1
2
Québec
1.11
Canada average 1.84
1.48
1.96
0.99
1.62
0.63
1.20
0.59
1.04
0.47
0.59
0.43
0.51
0.40
0.45
0.41
0.42
3
4
The importance of the above data is that it indicates that from 1996-1998 there was little system
5
expansion, most of the big growth coming in the earlier years. With lower growth for the system as a
6
whole there is less pressure on the transmission system and less need for external financing. This in turn
7
reduces the need for financial flexibility.
8
9
In our judgement, the risk for average Canadian transmission assets is very, very, low. In Québec the
10
risk associated with transmission assets is also quite low. Although additional reinforcement to the
11
system is required following the ice storm to increase reliability, additional investment is necessary for
12
the purpose of increasing exports and imports and this investment is dictated by the generation division
13
of Hydro Quebec who bears the risk of buying transmission through long term contract. In this respect
14
we feel that the system is comparable to the mainline gas transmission assets of TransCanada, where
15
the system is similarly mature, but there is still some growth in pipeline capacity. For this reason we
16
recommend that TransÉnergie’s transmission system have a 30% common equity ratio. This is the same
17
common equity ratio that the National Energy Board allows TransCanada. In our view the requested
18
common equity ratio of 32.5% is marginally conservative.
22
1
4.0
ECONOMIC AND FINANCIAL OUTLOOK
2
3
Q.
WHAT IS YOUR OUTLOOK FOR ECONOMIC GROWTH IN CANADA?
4
5
A.
Schedule 5 provides basic macroeconomic data for the last twenty years to add some
6
perspective to current economic conditions. The Canadian economy surged forward in 1999 at an
7
annual rate of 4.5% and has exceeded that, growing at 4.9% in the first quarter of this year. Real
8
consumer spending is up one percentage point over last year to a 4% annual rate in the first quarter,
9
sparked by strong full-time job creation and federal/provincial personal tax cuts. Canada’s current
10
account balance swung into a record quarterly surplus of C$19.4 billion (annually) in the first quarter,
11
buoyed by a widespread upturn in exports and lower deficits on direct investment income and travel.
12
13
The general view is that there will continue to be strong growth in the Canadian economy in 2001 though
14
export demand is likely to weaken with a slowdown in the U.S. economy. Two factors are responsible
15
for this view. First, although real interest rates have risen in both Canada and the U.S., they remain well
16
below levels that have triggered recessions in the past. Second, fiscal surpluses at the Federal level and
17
in most provinces will help to increase disposable incomes.
18
19
Solid output gains were recorded across a wide range of goods and services leading to a rise of 0.3% in
20
real GDP in July. Retail volumes rose 1.5% spurred by aggressive incentives by auto dealers and
21
business services advanced 1.2% during the month as a result of strong sales of computer services.
22
Rebounding from a strike, construction rose 0.7% in July while manufacturing output climbed 0.4%, led
23
by electrical and electronic products, transportation equipment and furniture.
24
25
The strengthening real economy has shown up in tighter labour market conditions, with September
26
showing another 0.4% more jobs.17 On a year over year basis, the unemployment rate fell to 6.8% in
17
Statistics Canada, Canadian Statistics, Economic Indicators, http:/www.statcan.ca
23
1
September, down .3% from August, and the lowest level since Statistics Canada’s current labour force
2
survey began in 1976.
3
4
The signs appear to point toward the transition from very strong economic growth to more sustainable
5
expansion of the Canadian economy. According to TD Economics, the ability of the government to
6
maintain a low inflationary environment may be the most powerful argument for achieving sustainable
7
economic growth. In addition, the real interest rate which is a useful indicator of future economic activity
8
is presently at around 4%. In contrast, the real interest rate was at 8% prior to the last two economic
9
recessions in Canada.18
10
11
Canada’s fiscal news continues to be bright. Ottawa is now reporting a $12.3 billion surplus for fiscal
12
2000, $9.3 billion higher than projected in the February budget. The federal government has been able
13
to lower its debt/GDP ratio from a 71.2% peak in FY95/96 to 58.9% last March. According to
14
Scotiabank, increased debt repayment this year could “leapfrog the federal government towards its
15
medium-term target of a 50% debt/GDP ratio.”19 With the unemployment rate at an “all time” low, the
16
prognosis for the future is that the economy will slow down, but continue to grow well above the average
17
rate of 2.0% over the 1990-98 period. As a result, we tend to agree with the Consensus Economics
18
forecast that real growth will slacken somewhat to 3.4% in 2001.20
19
20
In a recent speech, U.S. Federal Reserve Chairman Alan Greenspan stated that he believed the desired
21
“soft landing” had likely been achieved. He cited past increases in interest rates and a waning wealth
22
effect stemming from softer equity markets, as well as the “tax effects” of risky debt levels and higher
23
energy costs, as reasons why he expects the slowdown in consumer spending to persist. He also noted
18
TD Economics, TD Quarterly Economic Forecast, June 22, 2000.
19
Scotiabank Group, Global Economic Research, Fiscal Pulse, September 2000.
20
Consensus Economics Inc., October 2000 .
24
1
that the stock of consumer durables was historically high suggesting the lengthy economic expansion had
2
exhausted pent-up demand. The Fed’s outlook calls for moderate expansion in the years ahead, 3¼ - 3
3
¾% in 2001.21
4
Q.
WHAT IS YOUR OUTLOOK FOR INFLATION?
7
A.
The recent tightening of labour markets together with a year long rally in commodity prices has
8
raised concerns about possible inflationary pressures emerging. While oil prices led the way, significant
9
price increases were also realized in aluminum, copper and nickel prices. The rally in commodity prices
10
involved widespread increases in primary sector output which demonstrated confidence that the growth
11
in demand is sufficient to support additional supply. Although non-energy prices remained relatively
12
stable, the increase in energy costs was sufficient for year-over-year inflation to match a four year high of
13
2.6% in September. Excluding the energy component, the underlying CPI rose by only 1.7% from a
14
year ago.
5
6
15
16
Schedule 6 shows the change in the CPI and the rate of wage settlements since 1978. In the recent
17
business cycle, inflation reached its low point in 1994 when the CPI was close to zero and wage
18
increases almost non-existent. Since that time the consumer price index has remained broadly in the
19
middle of the Governor of the Bank of Canada’s 1-3% range. However, wage settlements have
20
increased gradually every year since 1994 as the economy has gradually absorbed the slack in the
21
labour market.
22
23
The graph shows that prior to 1981, inflation and wage settlements were increasing rapidly, until the
24
Bank of Canada engineered a recession in 1982-3 to bring inflation under control. Similarly, in the late
25
1980's there was a gradual increase in inflation and wage settlements that peaked about 1991 as again
21
Testimony of Chairman Alan Greenspan, The Federal Reserve Report on Monetary Policy Before the
Committee on Banking, Housing, and Urban Affairs, U.S. Senate, July 20, 2000.
25
1
the Bank of Canada engineered a recession to bring down the rate of inflation. Although the absolute
2
rate of inflation has been brought down considerably from these earlier periods, the same pattern of
3
increasing inflation from 1994-1999 is evident as in the earlier periods of 1986-1990 and 1976-1982. In
4
each case, interest rate increases slowed down the economy and with it the rate of inflation.
5
6
This same pattern of increasing interest rates is also evident at the current point in time. For this reason
7
we do not expect inflation to accelerate significantly. Our projection for 2001 is 2.4%, the same as the
8
Consensus Economics (October 2000) forecast. We believe that the Governor of the Bank of Canada
9
has invested too much capital and inflicted too much harm on the Canadian economy to let inflation again
10
become the serious problem that it was in the 1970's and late 1980's. This is why we believe that the
11
inflation rate will stay within the “operating” range of 1.0% - 3.0%.
12
13
Schedule 7 shows that the long term Canada real bond yielded 3.52% on October 26, 2000 or about
14
210 basis points below the equivalent nominal bond. The real bond guarantees the investor protection
15
from inflation, whereas the nominal bond has built into the yield compensation for both the expected rate
16
of inflation and a real yield. As a result, the spread between the nominal and real rate can be taken as
17
one estimate of the market’s forecast of the long run inflation rate. Hence the market appears to be
18
betting on the Bank of Canada keeping inflation within the 1.0-3.0% range as well.
19
Q.
WHAT ARE YOUR INTEREST RATE PROJECTIONS?
22
A.
Schedule 7 provides data on the full range of interest rates across the full maturity spectrum as
23
of October 26, 2000. What is evident is that interest rates are pretty much flat regardless of the maturity
24
of the instrument; this is what is commonly referred to as a “flat” yield curve. This is in contrast to our
25
1996 testimony before the Régie when 91-day Treasury bill yields were at 4.60% and long Canadas
26
were 8.20% At that time, long Canada yields were significantly higher than Treasury bill yields, a
27
situation known as a “normal” yield curve. This different shape of the yield curve has well known
20
21
26
1
implications for where the economy is likely headed.
2
3
From Schedule 8 it is clear that the short term Treasury bill yield bottomed out in 1997 as the
4
Bank of Canada stopped providing monetary stimulus to the economy. Since that time short term rates
5
have tended to increase. In contrast, long term rates have continued their gradual year over year decline
6
to 1999, as long term bond investors have been looking not just at the next 91 days, but far off into the
7
future. As such, long term bond yields reflect the long term future of the Canadian economy while T-Bill
8
yields reflect short term expectations.
9
10
What is important to note from Schedule 8 is that the only times that the Treasury bill yield has exceeded
11
that on the long Canada yield were in 1980-1982 and 1989-1991. In both cases, the Bank of Canada
12
was trying to engineer a slow down in the economy, due to its fears of accelerating inflation. However,
13
while the current shape of the yield curve is similar to that in 1980 and 1988, immediately prior to the
14
yield curve inversion, we expect, for the reasons cited earlier, that the Bank will successfully steer the
15
economy into a “soft” landing and avoid a recession.
16
17
Another way of looking at the impact of the Bank of Canada’s monetary policy is to recognise that
18
monetary policy works through both interest rates and the exchange rate: higher interest rates and a
19
stronger dollar together slow down the economy. To examine both of these effects the Bank of Canada
20
maintains a “monetary conditions index,” which is reproduced in the graph in Schedule 9. Again the
21
dramatic changes of 1981-82 and 1988-1991 are evident, as is the recent tightening. However, despite
22
the recent increases in interest rates, the Canadian dollar remains weak and overall monetary policy does
23
not seem to be so overly restrictive as to precipitate a recession.
24
25
This view is reinforced by the observation that the long awaited slowdown in the U.S. economy finally
26
appears to be taking shape. As the year progresses, economic expansion in the US will continue to lose
27
momentum in response to both past increases in short term interest rates and a cooling stock market,
27
1
which somewhat dampens consumer spending. Nonetheless, the U.S. economy still has considerable
2
momentum and we expect the Fed to raise short term interest rates by another 50 basis points in 2001.
3
At the same time, strong economic growth over the next few quarters, together with a tightening labour
4
market and higher wage settlements, will cause the Bank of Canada to match the increases in U.S. rates.
5
28
1
The Consensus Economics (October 2000) forecast for 10-year Canada bonds is 6.00%.22 This
2
forecast is consistent with the current shape of the yield curve and our estimation of where the economy
3
is in the business cycle. While the spread between 10-year and long term Canada bonds at the moment
4
is about -14 basis points23, in our judgement this discount partly reflects a lack of supply of long term
5
Canadas, since the yield curve is otherwise flat. Given this observation and our expectation of further
6
moderate increases in interest rates, we base our estimates on a long Canada bond yield of 6.00%
7
in 2001.
8
9
Q.
WHAT HAS BEEN THE RECENT STATE OF CANADIAN CAPITAL
MARKETS?
10
11
12
A.
Since the onset of the last recession, capital markets have been dominated by federal and
13
provincial government financing. Their importance, however, has been receding. Overall government
14
“lending,” representing the aggregate of all levels of government, was running at the rate of over minus
15
$50 billion during 1992 and 1993 or 7.3% of GDP.24 Government net lending subsequently almost
16
halved to a rate of minus $32 billion in 1995 and halved again to minus $14.4 billion in 1996. To put it
17
another way, the net lending as a percentage of GDP was running at -8.0% of GDP in 1992, that is,
18
governments were borrowing eight cents out of every dollar of “economic activity” to finance their
19
operations. Schedule 10 shows the net lending as a percent of GDP.
20
21
The disastrous consequences of fiscal policy starting in the early 1970s is obvious. However, it is equally
22
clear that since 1992 all layers of government have made serious efforts to restore some sanity to their
22
The forecast for 10-year bonds 3 months hence is 6.0% while the forecast 12 months ahead is 5.9%. The
average of these forecasts is 6.0%.
23
National Post, October 12, 2000.
24
Government financing is recorded as “net lending,” even though the negative sign indicates government
borrowing.
29
1
finances. By 1997 lending had become genuine lending, that is debt repayment, as in aggregate,
2
governments were in surplus for the first time in twenty three years. In 1999 all layers of government in
3
aggregate ran a surplus of $26 billion as tax revenues soared and expenditures on welfare,
4
unemployment, etc., declined along with the unemployment rate. This amounted to 2.75% of GDP, the
5
biggest surplus in 48 years.
6
7
The decline in government “lending” has opened up room for private sector borrowing as corporations
8
have returned to the equity and bond markets, following the strengthening of corporate balance sheets.
9
Fuelled by healthy consumer spending, corporate profits have rebounded from the extreme cyclical lows
10
of 1992-1994, when after-tax profits almost disappeared. Pre-tax corporate profits as a percentage of
11
GDP have now reached the cyclical highs of 1988-1989, i.e. the levels reached immediately prior to the
12
last recession.
13
14
The increase in corporate profits has fuelled momentum in the stock market and resulted in record levels
15
for the TSE300 index, as the average price-earnings multiple reached 34X in October. This is a level not
16
reached before, except during 1992-3 when sky high multiples were reached due to the absence of
17
earnings, rather than high prices. As of September 25, the TSE300 recorded a year to date gain of
18
25%. Fuelled by strong gains in Nortel Networks and BCE, the upswing this year is, however, more
19
broadly based than just these two stocks, with 9 of the 14 TSE sub-sectors showing year to date
20
increases of greater than 10%. The remainder of the year should see continued market volatility as the
21
debate over the high flying technology stocks in general and Nortel in particular heats up.
22
23
Capital markets remain attractive for issuers. In 1999, $5.74 billion in corporate debt was raised. This
24
was down from the cyclical peak in 1997 when $8.022 billion was raised. As the economy reaches its
25
peak, the bond market begins to fear a recession causing widening spreads. One indication of this is the
26
graph in Schedule 11, which shows the spread between BBB corporate and Canada yields. The record
27
high of almost 350 basis was set in 1993 in the depths of the recession, while the low in this business
30
1
cycle was set in 1997 at just over 100 basis points. Since 1997 spreads have widened to over 200 basis
2
points, which in part reflects the drop off in Canada yields at the long end of the yield curve.
3
Parenthetically, this 200 basis point credit spread is about at the level seen immediately prior to the last
4
recession.
5
Q.
HOW DOES THE STATE OF THE ECONOMY AFFECT CORPORATE PROFITS ?
7
A.
Pre-tax corporate profits have significantly rebounded as the economy has strengthened.
8
Currently they are running at just over 10% of GDP, a little below the highs of the last business cycle of
9
12.71% in 1988. In Schedule 12 are the earnings of the firms in the TSE300 Index, where each firm’s
10
earnings per share are averaged according to their weights in the TSE300 index. This data tells a slightly
11
different story: aggregate TSE300 earnings in 1999 were 210, which were approximately at the level of
12
1994 and down from their 1995 high, although still well above the recession years, when TSE300
13
earnings were almost non-existent.25
6
14
15
A final way of assessing corporate profitability is to look at the aggregate data maintained by Statistics
16
Canada (Quarterly Financial Statistics for Enterprises). Statistics Canada started reporting quarterly
17
return on equity data in 1980, when the average ROE was 15.05%. The subsequent trend in ROE is
18
graphed in Schedule 13. Note that “Corporate Canada’s ROE” declined during the 1982 recession and
19
then hovered around the 10% level during the growth oriented 1980's, before peaking in 1988 at
20
12.21%. During the 1992 recession the aggregate ROE of Corporate Canada dropped to 0.2%, before
21
recovering to the 1995-8 range of 8.0-9.0%.26 In broadest terms, this aggregate ROE data tells the
22
same story as the TSE300 earnings data and before that the pretax profits data: profitability has
23
recovered from the dismal levels of the recession, but has still not completely reached the levels
24
expected of a “top” in the business cycle.
25
Note that these earnings are actual nominal earnings, they are not standardized by dividing by GDP or
book equity. As a result, comparisons across time are affected by increased investment in book equity as well as
inflation. They also do not include the earnings of private corporations or foreign subsidiaries in Canada.
26
Data for 1999 is not yet available.
31
1
2
Some expert witnesses in the past have argued that regulated firms should be allowed a return equivalent
3
to what other companies are earning on their book investments. We are dubious about such a
4
proposition, since the selection of firms is largely a matter of judgement with enormous potential for
5
abuse, and the average return of any sample of firms over some arbitrary time period is only loosely, if at
6
all, related to a fair rate of return. However, the data on overall corporate ROEs indicates that
7
Corporate Canada has earned just above 6% over the last ten years, even if we ignore the recession
8
years and focus only on what other competitive firms are currently earning, the data would suggest 8.0-
9
10.0% as a fair ROE.
10
Q.
DO YOU HAVE ANY OTHER RETURN ON EQUITY DATA?
13
A.
The StatsCanada ROE data gave the performance of Corporate Canada as a whole, but only on
14
an aggregate basis. Schedule 14, page 1, shows the ROEs for a 153 firm sample of firms that we
15
collected for our Instrumental Beta Model (Appendix C). The firms consist of those firms in the Financial
16
Post data bank with both complete stock market and financial statement data over the sample period.
17
The sample is broadly based with firms from all of the major sectors, and based on earnings before
18
extraordinary items, had an average ROE of only 4.83% over the 1990-99 period.
11
12
19
20
The advantage of our sample of firms over the average Corporate Canada ROE published by Statistics
21
Canada is that we can sort the firms according to their TSE sub-sectors, and thereby analyse the
22
differential impact of the business cycle. For example, the consumer goods subsector of the 25 firms in
23
our sample had a mean return on equity of 5.79%, the 19 firms in the merchandising sector had a mean
24
return on equity of 5.51% and the 23 industrial product firms had a mean return on equity of 6.06%.
25
However, some of these 153 firms suffered severe losses over the last business cycle, and plausibly,
26
these losses should not be allowed to contaminate an understanding of underlying profitability expected
27
from continuing operations. To adjust for this, those firms with standard deviations of their ROE
28
exceeding 30% were eliminated. Page 2 of Schedule 14 shows that the mean return of the remaining
29
133 firms increases to 7.23%. The 23 consumer product firms had a mean return of 8.08%, the 18
32
1
merchandisers had a mean return of 7.74% and the 22 industrials product firms earned on average
2
6.13% for the 1990-99 period.
3
4
It is also interesting to compare the earned returns of the regulated companies with the other firms in the
5
sample. What stands out is that the returns in the regulated sector are at the extreme end of the
6
distribution relative to the other sectors. The regulated utility companies had a mean return of 12.04%
7
over the 1990-99 period. Schedule 15 shows the return distribution for the 16 regulated firms in our
8
sample. The risk-return principle would suggest that the high return earned in this sector is necessary to
9
offset the high risk facing these firms. However, as Schedule 15 shows, the average standard deviation
10
of returns for the regulated group is only 3.66% and once BCE is removed, it falls to 2.89%. This is well
11
below the average standard deviation of ROEs of the non-ROE regulated sectors of the Canadian
12
economy. From this we conclude that regulated firms have on average earned higher ROEs than justified
13
by their low level of risk and well above the average Canadian firm of about 8.0%.
14
15
In order to see where the regulated firms fit into the distribution of unregulated firms, which comprise the
16
usual sample of firms in comparable earnings analyses, we examined the distribution of the 69 firm
17
unregulated subsample that survived to 1999. The firms were ranked from lowest to highest by the
18
standard deviation of their ROE. This distribution is presented in Schedule 16. The column "Sample
19
ROE" is the mean ROE for the sample created by consecutively adding the next highest risk company to
20
the previous portfolio. For convenience the data is presented in the graph in Schedule 17. Note that as
21
progressively more risky firms are added to the sample the average ROE falls. The regression line is
22
added to the graph to make this relationship clear: average ROE and average risk are negatively
23
correlated in this sample.
24
Q.
OVERALL WHERE ARE WE IN THE BUSINESS CYCLE?
27
A.
We are well into the later stages of the current economic cycle. It may seem a bit like taking
28
away the food before the party’s over, but the U.S. is deep into an extended boom and there are distinct
29
signs of overheating in the economy. Whether the economy slows down significantly is largely a question
25
26
33
1
of whether the Bank of Canada feels that the signals that “mirror” the late 1980's justify a recession,
2
when the absolute levels, particularly of inflation, are relatively low. In our judgement, there is every
3
indication that the Bank of Canada will be able to head off inflation and that it is unwilling to put the
4
Canadian economy into recession, just because inflation exceeds 2%. As a result, we remain upbeat
5
about the short run prospects of the economy. We expect at least another year of good economic
6
growth with low inflation and good corporate profits. As a result, the markets will remain receptive to
7
normal credit worthy companies for both debt and equity financing. There are no indications of any
8
access problems for at least two years.
34
5.0
THE RISK OF A REGULATED UTILITY
Q.
HOW DO YOU ASSESS THE RISK OF A REGULATED UTILITY?
5
A.
Schedules 14-16 provided the average variability and mean ROEs for the 153 Canadian firms
6
used in Appendix C for our “Instrumental Variables” beta model. The variability is measured as the
7
standard deviation in the accounting ROE over the period 1990-1999. The average standard deviation
8
of the 69 firm sample was about 9%, even this estimate is low since all firms with a standard deviation
9
over 30% were eliminated to create the sample. As a result, the standard deviation of a typical firm’s
1
2
3
4
10
ROE is much greater than the average. However, the higher standard deviations of the unregulated firms
11
are clearly affected by a few huge writeoffs for some firms during the deep recessionary years 1991-
12
1994. In contrast, the average “regulated” firm's standard deviation of ROE was less than 3.66%,
13
depending on whether or not BCE is included or excluded. However, the industry characterisations here
14
refer to the common descriptions of the holding companies. Most of the variation in the ROE for these
15
“regulated” companies came from their non-regulated activities.
16
17
Schedule 15 breaks down the variability in the ROE of sixteen “regulated” companies. Of the 16
18
regulated firms, half have standard deviations less than 2.2%. Moreover of the 8 ‘riskier’ firms, three
19
were "pipeline" companies; three firms, TransAlta, BCE and Bruncor, have had poor experiences with
20
non-regulated operations, while BC Gas was for a time unregulated and very highly leveraged. It is our
21
judgement that a parent company of a typical regulated utility has a standard deviation of its accounting
22
ROE well below 2.5%, while an undiversified regulated subsidiary has a standard deviation of its ROE
23
well below this level. From this, it is relatively straightforward to conclude that returns in the regulated
24
sector were no more than about 30% as variable as those of unregulated firms after the effects of
25
unusual writeoffs are removed.
26
27
Within this risk spectrum, it is interesting that some of the least risky regulated firms have been Island
28
Tel, Quebec Tel, Maritime Electric and Pacific Northern Gas. Each of these companies is not only
29
among the smallest firms in their sector, but also are the closest to pure play regulated operations. The
35
1
average standard deviation for the ROE of these four firms is 1.36%, which is one eighth that of the
2
unregulated firm sample.27 Finally, it should be noted that much of the “risk” involved in these regulated
3
firms has simply come from variation in their allowed ROEs, unlike the unregulated firms it has not come
4
from competitors or business risk in the “market.”
5
6
However, this risk assessment is based on the variability of the firm's accounting earnings, what we
7
referred to as total income risk. What investors are interested in is the risk of the securities they hold,
8
which includes investment risk as well as income risk. Moreover, since investors rarely hold single
9
investments, they are interested in the overall portfolio risk of an investment. This observation means that
10
the correct measure of risk is the incremental risk of holding a stock in a diversified portfolio. This
11
measure of risk is called the security's beta coefficient.
12
13
Schedule B1 of Appendix B provides a table of beta coefficients for most of the regulated firms which
14
approach “pure” regulated companies. The average industry betas for each of the 5-year periods ending
15
1994 through 1999 are:
16
Average Beta Estimates
17
18
19
1994
1995
1996
1997
1998
1999
20
Telcos
0.563
0.465
0.552
0.552
0.808
0.777
21
Gas/Electrics
0.482
0.563
0.525
0.47
0.529
0.368
22
Pipelines
0.485
0.529
0.462
0.437
0.523
0.330
23
24
The average beta for the market as a whole is 1.0, so these beta estimates indicate that regulated firms in
25
general are regarded as on average 33-80% as risky as the overall market. This risk assessment is
26
higher than that obtained by examining the variability of accounting ROEs alone, reflecting the fact that
27
some of the risk of investing in utilities is investment risk, independent of the income risk. This risk is
27
This is operational risk, ie., fluctuations in the ROE. There are still longer term or strategic risks that can
affect the viability of the firm.
36
1
particularly evident for the Telcos where investors have switched to a forward focus in valuation and
2
away from current income, as the Telcos have been largely deregulated.
3
4
Another way of looking at market risk is to look at the beta of the TSE sub indexes. The great
5
advantage of the sub index betas is that they include more companies than the individual estimates. This
6
is particularly important due to the fact that a large number of regulated firms, like Consumers Gas,
7
Maritime Electric, Island Tel etc, have disappeared through corporate reorganisation. Although, this
8
means that their individual company betas have also disappeared, it does not mean that their economic
9
impact has disappeared. Consumers Gas now shows up as part of IPL, Island Tel as Aliant etc, as such
10
their economic impact will still show up in the sub index betas of their parents. However, there are two
11
disadvantages: the first is that the sub index betas include companies like BCE, and as a result reflect
12
more non-regulated activities; the second is that the sub indexes are weighted according to the TSE
13
weights for each company. As a result, BCE is weighted very heavily in both the Telco and utility sub-
14
indexes. We would expect these estimates to exceed the pure play utility beta estimates.
15
16
The most recent Telco, Gas and Electric (Gasel), overall utility and pipeline subindex average betas are
17
as follows:
18
19
20
21
22
23
24
25
26
27
1992
1993
1994
1995
1996
1997
1998
1999
GASEL
0.366
0.476
0.532
0.509
0.526
0.500
0.492
0.449
TELCO
0.413
0.463
0.549
0.528
0.538
0.627
0.704
0.864
PIPELINE
0.814
0.603
0.513
0.526
0.533
0.508
0.402
0.332
UTILITY
0.42
0.483
0.542
0.534
0.544
0.609
0.759
0.882
28
29
By and large the sub index betas tell the same story as the individual company betas, but there are some
30
slight differences. A simple average weights all the companies the same, regardless of the fact that
31
Canadian Utilities market value significantly exceeds that of Fortis. As a result, the sub-index average
32
beta of 0.449 exceeds the simple average from Schedule B3 of 0.368. Similarly, if we look at the Telco
33
average, we see that BCE is the high value at 1.24, this drags up the Telco sub index much more than
37
1
the simple average in Schedule B3, since BCE (prior to the Nortel spinoff) had such a huge market
2
valuation.
3
4
We should also remember that beta estimates the way in which a stock’s return varies with the market
5
over an estimation period. By convention, betas are estimated over a five year period. This means that if
6
a critical event happens during the estimation period, then the beta estimate will pick it up. However,
7
once the event “passes out” of the five year estimation window, the impact of the event will disappear
8
from the beta. For example, the graph in Schedule 18 gives the beta estimates for the sub indexes going
9
back to the 1963-1967 estimation period. Note that the beta estimates were trending to a common
10
average; then in 1987, the pipeline beta increased and the others decreased. This lasted for five years
11
until they again came together. This behaviour was the effect of the stock market crash of October
12
1987, which stayed in the estimation period for five years. Since the crash was so large (22% price
13
drop) whatever happened to an individual stock in October 1987 had a large impact on its beta estimate
14
until October 1992.
15
16
Since October 1992, the betas of all regulated firms were almost identical until the last eighteen months
17
or so, when the Pipeline and Gasel index beta dropped significantly whereas the Telco and utility index
18
increased significantly. In both cases the changes have been largely driven by the behaviour of a few
19
firms. In the case of the pipeline sub index, the collapsing share price of TransCanada Pipelines, against
20
a generally strong equity market, has caused the pipeline beta to fall. In particular, the December 1999
21
pipeline beta value reflects the collapsing TransCanada stock price when it cut its dividend. Similarly, the
22
surging “Utility” and “Telco” betas reflect the surging investment value of Nortel which has pulled up the
23
value of both BCE and the whole TSE300 index. As a result, BCE’s beta has increased significantly.
24
For the last year plus, BCE/Nortel has almost been the Canadian equity market, which is why its beta is
25
close to one.
26
27
Clearly, in estimating beta, much depends on what has happened over the estimation period. Betas do
28
change as a result of particular events and once these events have passed, they move back to their
29
“normal” level, which is why some people “adjust” betas. The conceptual argument is that if we have an
38
1
expectation that the true beta is say 0.5 and we estimate an actual beta of 0.2, then the estimated beta is
2
probably biased low. In this case, we average the estimate of 0.2 with our “prior” belief that the beta
3
should have been 0.5. Since the average beta for the whole market is 1.0, Merril Lynch and others
4
routinely average estimated betas with one to get “adjusted” betas. This practise is appropriate for the
5
average stock, where our prior belief is that the true beta is one. It is totally inappropriate for utilities,
6
since out prior belief in this case is that the beta is much lower than one.
7
8
In Appendix B we show that Canadian betas have adjusted towards an estimated value of 0.582. This is
9
based on the classic paper by Marshall Blume who first estimated the regression tendency of betas.
10
More recently, Gombola and Kahl 28 have shown that utility betas tend to regress towards their long run
11
average value. This makes intuitive sense, if you observe a beta value of 0.2 for a utility, you are going to
12
average this “low” estimate with your prior belief that utility betas should be around 0.50, not that they
13
are around one. We have not had to adjust betas for some time, since the estimated betas have recently
14
been in their normal range. However, we believe that recent Gasel betas in the range 0.368-0.449 are
15
too low to reflect the current investment risk of investing in gas and electric company shares. If these
16
estimates are weighted 50:50 with the regression tendency estimate of 0.582 we would get an
17
approximate range of 0.48-0.52 or an average of 0.50.
18
Q.
HAVE YOU ANY DIRECT EVIDENCE ON THE BETA ESTIMATES?
21
A.
Yes. An alternative way of estimating the beta for illiquid and non-traded firms is through the use
22
of a set of explanatory variables to estimate a beta estimation model for traded firms. Once estimated the
23
model can then be applied to the data for the non-traded firm. This is what we refer to as the
24
Instrumental Variables Model. Appendix C explains in greater detail how our model is estimated. The
25
model was developed to estimate the risk of non-traded companies like Edmonton Power, Centra Gas
26
Manitoba and NOVA Gas Transmission. At the same time, it can be used for thinly traded companies,
27
like Island Telephone, and Pacific Northern Gas, as well as for firms that have undergone major
19
20
28
M.J. Gombola and D.R. Kahl, 1990, “Time Series Processes of Utility Betas: Implications for Forecasting
Systematic Risk”, Financial Management, Autumn, pp 84-93.
39
1
corporate reorganizations, like Interprovincial Pipelines.
2
3
Our third regression model presented in Schedule C2 is the most parsimonious in its use of data,
4
requiring only total asset growth and the debt/equity ratio. From Schedules C3 and C4, it also appears
5
that the third model has equally strong predictive ability as the other two models so this model is chosen
6
for forecasting the beta of TransÉnergie . Using Hydro-Quebec’s historic transmission assets to
7
estimate the total asset growth variable and a 30% equity ratio, the beta estimate is approximately .57.
8
However, since the model was estimated using a sample of integrated gas/electrics and not a
9
transmission facility operator, the (negative) coefficient associated with the gas/electric dummy variable is
10
too low to represent the lower risk of the transmission facilities. Therefore, it is reasonable that the beta
11
for TransÉnergie would be approximately 0.5.
12
Q.
CAN YOU SUMMARISE YOUR RISK ASSESSMENT?
15
A.
Yes. Examining the variability in the accounting rates of return, which measure the income risk of
16
utilities, our assessment is that regulated utility operations are no more than about 13% as risky as a
17
typical competitive firm. However, investors are concerned about investment risk, more than income
18
risk, since the income is not all paid out to them as a dividend, and they are more concerned about how
19
the stock price behaves. When we assess this market or beta risk, our assessment is that regulated utility
20
operations are about 50% as risky based on market beta estimates. In considering electricity risks, it is
21
our judgement that the basic risk ranking runs (lowest to highest) Transco-Disco-Genco, where Genco
22
risk depends on the particular type of generating assets. We would therefore recommend a 30%
23
common equity ratio for transmission operations, and are currently recommending 35% for distribution
24
assets, where the actual rate here depends largely on commodity unbundling. These common equity
25
differences then mean that the same allowed return can then be awarded, based on a beta of 50%.
13
14
40
1
6.0
FAIR ROE ESTIMATES
2
Q.
WHAT IS YOUR RISK PREMIUM OVER BOND ESTIMATE?
5
A.
The standard method for assessing the degree of risk to determine a relative risk premium is to
6
calculate a company's beta coefficient ($) and then use the formula:
3
4
7
K = RF + [ MRP] * β
8
9
where Rf is the risk free government of Canada bond yield, MRP is the market risk premium and β is
10
the beta coefficient. This leads to a three step procedure for estimating the fair rate of return. First,
11
estimate the market risk premium. Second, estimate the relative risk, or beta. Finally, estimate the risk
12
free rate. The three pieces of information are then combined to estimate the overall fair rate of return.
13
14
The analysis in Appendix E estimates the Canadian market risk premium of equities over long term
15
bonds using Canadian data. This data suggests that the Canadian market risk premium of equities over
16
long term bonds is about 4.0%. From our previous discussion of the risk of TransÉnergie at a 30%
17
common equity ratio the beta estimate is 0.50. This would imply a risk premium of 2.00%. Adding this
18
risk premium to the long Canada forecast of 6.00% produces a risk premium over bonds of 8.00%. If
19
the Régie accepts TransÉnergie’s 32.5% allowed common equity component our beta estimate would
20
shrink marginally, by about 10 basis points, and we would recommend a 7.90% allowed ROE.
21
22
Q.
DO YOU HAVE ANY CONCERNS ABOUT YOUR 4% MARKET RISK PREMIUM
ESTIMATE?
23
24
25
A.
Yes. Appendix E simply estimates the difference between the return on long Canada bonds and a
26
broad equity index (TSE300) and explains what has generated those returns. There are two problems
27
with this. First, the estimates are inherently backward looking. Second, there is nothing magical about
28
basing a risk premium over the long Canada bond yield. In fact, there is no reason to believe that a risk
41
1
premium over long Canadas is stable, since it depends on the assumption that the riskiness of equities
2
versus the long Canada bond is also stable. Both of these assumptions are problematic, which is why we
3
have always used judgement in interpreting the statistical evidence.
4
5
Q.
CAN YOU DISCUSS THE RELATIVE RISKINESS OF EQUITIES VERSUS LONG
CANADA BONDS?
6
7
8
A.
Appendix E discusses this in detail, but in our judgement the riskiness of the equity market is
9
relatively stable. In fact, going back as far as 1871, there is substantial evidence that the real return on
10
U.S. equities has been constant at around 9.0%.29 However, there is no support for the assumption that
11
either bond market risk or average bond market returns have been constant . As Appendix E shows,
12
from 1924-1956, there was very little movement in nominal interest rates, as monetary policy (moving
13
interest rates to control the economy) was subordinate to fiscal policy (controlling government spending
14
to control the economy). As a result, the standard deviation of annual bond market returns was only
15
5.20%. In contrast from 1956-1999, monetary policy became progressively more important and interest
16
rates much more volatile. As a result, the standard deviation of the returns from holding the long Canada
17
bond increased to 10.79%. Effectively bond market risk doubled, while equity market risk was
18
much the same. This alone would lead to a conclusion that the equity risk premium over long Canada
19
bonds should be smaller than historically.
20
21
However, what is crucial for the investor is whether this risk is diversifiable. That is, is the bond market
22
beta positive? In Appendix F we show that bond market betas in both the U.S. and Canada have been
23
very large, particularly during the period since 1991. What this tells us is that both the bond market and
24
the equity market have been partly moved by a common factor: interest rates. This is why adding long
25
Canada bonds to an equity portfolio during the 1990's did not reduce portfolio risk to the extent that it
26
did in the 1950's. It also explains why adding an average risk premium to a long Canada yield that had
27
increased substantially due to this risk produces excessive estimates of the fair rate of return.
29
See Laurence Booth, “Estimating the Equity Risk Premium and Equity Costs: New Ways of Looking at
Old Data”, Journal of Applied Corporate Finance, Spring 1999.
42
1
Essentially, with the long Canada bond being unarguably riskier, we are estimating the market risk
2
premium as the expected return difference between two risky securities. For example, if both the long
3
Canada bond and an equity security are priced by the Capital Asset Pricing Model, the fair rate of return
4
expected by an investor on each security is as follows:
5
K j = R F + MRPβ j
6
KC = RF + MRPβC
7
where for any particular security, j, and the long Canada bond, C, the return is expected to be equal to
8
the risk free (RF) rate plus the market risk premium (MRP) times each’s beta coefficient. The risk
9
premium of the security over the long Canada bond is then simply
10
K j − KC = MRP (
11
j
− βC )
12
What this means is that even if an individual security is no riskier than historically, its risk premium over
13
long Canada bonds will change if the riskiness of the long Canada bond changes.
14
15
In Appendix F, we show how the beta on the long Canada bond was close to zero until the estimation
16
period 1987-1991; since then it has been positive, peaking in 1995-6 at about 0.60. It is this increase in
17
bond market risk that has caused risk premiums to shrink throughout the 1990's. It is critical to
18
understand that lower risk premiums over long Canada bonds are not because equities were
19
less risky; it was because the bond market was much more risky! In fact, it is quite clear that with a
20
Canada bond beta of say 0.60, a low risk utility with a similar beta might not require any risk premium
21
over the long Canada bond yield at all. This conclusion would be reinforced by the observation that the
22
Canada bond income (interest) is fully taxed, whereas the utility income would predominantly come as
23
dividend income, which is preferred by every single taxable investor in Canada.
24
25
Q,
WHAT HAS BEEN CAUSING THE RISK IN THE CANADA BOND MARKET?
26
43
1
A.
In Schedule 19 are the results of a regression analysis of the real Canada bond yield against
2
various independent variables. The real Canada yield is defined as the nominal yield reported by the
3
Canadian Institute of Actuaries minus the average CPI rate of inflation, calculated as the average of the
4
current, past and forward year rate of inflation. The regression model explains 86% of the variation in
5
real Canada yields, and four variables are highly significant. The two “dummy” variables represent unique
6
periods of intervention in the financial markets. Dum1 is for the years from 1940-1951, which were the
7
"war" years, when interest rates were controlled. The coefficient indicates that government controls
8
reduced real Canada yields by about 5.4% below where they would otherwise have been. Similarly,
9
Dum2 is for the years 1972-1980, which were the oil crisis years, when huge amounts of "petrodollars"
10
were recycled from the suddenly rich OPEC countries back to western capital markets, where they
11
essentially depressed real yields. The sign on Dum2 indicates that, but for this recycling, real yields
12
would have been about 3.7% higher. These dummy variables are included because during these two
13
periods real yields were known to be depressed by special “international” factors.
14
15
The remaining two independent variables capture the risk and endemic problem of financing government
16
expenditures. Risk is the standard deviation of the return on the Scotia Capital long bond index over the
17
preceding ten years. In earlier periods when monetary policy was not used, interest rates barely moved
18
and the returns on long Canada bonds were very stable and risk very low. Through time this risk has
19
increased. The coefficient on the bond risk variable indicates that for every 1% increase in volatility, real
20
Canada yields increased by about 29 basis points. That is, the effective doubling of the variability in
21
bond returns between the two periods 1924-1956 and 1957-1995 has been associated with almost a
22
150 basis point increase in real Canada yields between these two periods. This is the extra risk premium
23
required by current investors to compensate for the higher risk in long Canada bonds. Absent any
24
increase in equity market risk, the result is a 150 basis point reduction in the market risk
25
premium between the two periods.
26
27
The deficit variable is the total amount of government lending (from all levels of government) as a
28
percentage of the gross domestic product. As governments increasingly ran deficits, this figure became a
29
very large negative number, indicating increased government borrowing. For 1996, the number was 44
1
1.8%, down from the record peacetime high of -7.3% set in 1993, indicating that government net
2
borrowing was 1.8% of GDP. For 1997, this deficit turned into a surplus, which has increased every
3
year since. The coefficient in the model indicates that for every 1% increase in the aggregate government
4
deficit, real Canada yields have increased by about 25 basis points. That is, increased government
5
borrowing by competing for funds, has driven up real interest rates. Conversely, the 2.75% budgetary
6
surplus for 1999 lowered real Canada yields by 66 basis points, compared to what they would have
7
been with a balanced budget. It is this very surplus that is also reducing the supply of long Canada bonds
8
and driving their prices up and yields down. The result is the drop off in long Canada bond yields at the
9
long end of the yield curve.
10
11
The effect of increased interest rate risk and government “over borrowing” are clearly two sides of the
12
same coin. Their effect was to crowd the bond market with risky long Canada bonds that could only be
13
sold at premium interest rates, frequently to non-residents. This driving up of Canada bond yields
14
reduced the spread between Canada bond yields and equity required rates of return and hence the
15
market risk premium. It is this deficit and risk phenomenon in the government bond market that created
16
the narrowing market risk premium in the 1990's and the large Canada bond betas in the mid 1990's.
17
18
Q.
WHY WOULDN'T EQUITY SECURITIES BE AFFECTED TO THE SAME DEGREE
BY THE FACTORS THAT HAVE MADE DEBT SECURITIES RISKY?
19
20
21
A.
Equity securities have been affected by government financing problems and changing monetary
22
policy has affected the entire capital market. However, debt securities involve a fixed amount of income
23
to be received over a long period of time. The value of this income is much more sensitive to changes in
24
interest rates simply because it is fixed. Equity securities, on the other hand, represent a claim on the
25
earning power of the firm, and to the extent that the firm can adjust to changed economic conditions,
26
they represent a partial hedge against these changes.
27
28
The equity securities of regulated firms, in particular, offer much more protection against interest rate
29
volatility than do nominal Canada bonds. This is particularly true for companies subject to frequent rate
45
1
review, or who have their ROE fixed by an automatic adjustment mechanism. For these firms, regulation
2
reduces the interest rate risk relative to that embedded in long Canada bonds. If an investor buys shares
3
in a regulated firm and interest rates increase, the income of the regulated firm will also tend to increase.
4
However, the investor in long Canada bonds is stuck with a fixed claim and no compensation for
5
increasing interest rates. All equity securities offer some protection against these types of changes. This is
6
partly why Schedule E2 shows that the variability of equity returns has actually decreased, while for
7
bonds it has increased. As a result, there is no reason to believe that the return on equities, in general,
8
has necessarily increased by the same amount as that on long Canadas in response to this increased
9
interest rate risk. In contrast to equities in general, there is evidence that the return on utilities has
10
decreased because a major component of their risk, interest rate risk or regulatory lag, has
11
been removed.
12
13
It is also relevant that the increased borrowing requirement by all levels of government has been met in
14
the fixed income markets, that is by issuing bonds and treasury bills. This has significantly raised real
15
yields in these markets. This borrowing has affected other sectors of the capital market indirectly, since
16
funds have been redirected from other markets. However, there is no reason to believe that this indirect
17
impact is of the same order of magnitude as its direct impact on the fixed income market.
18
Q.
WHAT IS THE PROBLEM WITH HISTORIC ESTIMATES?
21
A.
The data from Appendix E is drawn from the historic experience of the Canadian capital
22
markets. The statistical evidence is clear cut in terms of the level of the Canadian market risk premium
23
and the relative returns on common equities and bonds. However, there are two general problems. First,
24
expectations may not be realised. For example, it may be that the Canadian market has simply
25
underperformed for the last seventy four years. This is believable for short time periods or, for example,
26
the last ten or fifteen years, but is difficult to believe for extended time periods. This is why we look at
27
the full time period for our risk premium estimates. The second problem is adjusting the estimates for
28
structural changes in the capital market. Any statistician can calculate the average equity and bond
29
market return, for example, from the CIA data, but it requires some professional expertise to extract
19
20
46
1
from the data an understanding of what has generated those returns and, for example, to analyse any
2
structural changes that have affected the returns, and to estimate the market risk premium.
3
4
Q.
CAN YOU GIVE AN EXAMPLE OF A STRUCTURAL CHANGE AND HOW IT
AFFECTS THE MARKET RISK PREMIUM?
5
6
7
A.
8
taking into account the structural changes in the Canada bond market that have occurred over the last
9
seventy four years, any estimates of the market risk premium over long Canada bonds would be
10
The obvious one is our prior discussion of the changes in the government bond market. Without
hopelessly biased.
11
Q.
ARE THERE ANY OTHER MAJOR CHANGES?
14
A.
Yes. Twenty years ago, the world was characterized by currency restrictions, investment
15
controls and very limited international investing opportunities. Since that time most currencies have
16
become freely convertible, most investment restrictions have been removed and there has been an
17
increase in the coverage of international stocks among investment advisors. This latter coverage has been
18
enhanced by international collaboration among investment banks and the growth of some major
19
international investment banks. For example, since the time of our last evidence, Merrill Lynch has
20
moved back into Canada with a major retail presence through the purchase of Midland Walwyn. This
21
purchase of a retail outlet in Canada has increased the information flow on foreign securities as well as
22
reducing some risks. Rather than buying securities directly in the foreign market and relying solely on
23
foreign securities laws, the purchase through a “domestic” broker with international coverage, like Merrill
24
Lynch, buys the “protection” of the brokerage house as well.
12
13
25
26
Canadian stocks will always be the cornerstone of portfolios held by Canadian investors for several
27
reasons. First, most investment portfolios are for retirement purposes and will normally involve Canadian
28
dollar living expenses. Consequently, foreign stocks are inherently riskier, since they involve additional
29
foreign exchange risk. Second, the direct purchase of foreign securities involves relying on foreign
47
1
securities law, since the Ontario Securities Commission, for example, only regulates information flows to
2
securities sold to residents of Ontario. Third, the purchase of foreign securities is generally more
3
expensive, since transactions costs, brokerage fees etc, are generally higher since trades frequently go
4
through a domestic and a foreign broker. Fourth, evaluating foreign securities is inherently more complex
5
since accounting standards differ across countries: one dollar earnings per share or a 10% return on
6
equity can mean a variety of different things, depending on whether it is for a German, American or
7
Canadian company. 30 As a result, it is very difficult to work out whether Manulife, for example, is more
8
profitable than Metropolitan Life.31 Finally, there are a variety of legal and tax impediments to foreign
9
investing. Tax sheltered plans like RRSPs and RRSP eligible mutual funds face foreign investment
10
restrictions based on the book value of the investment portfolio. Although it is possible to get around
11
these restrictions by sophisticated derivatives strategies, this is only possible at the mutual fund level, and
12
even there the performance of the fund is reduced by the fees attached to creating and managing the
13
derivatives portfolio.
14
15
All of the above barriers are getting smaller. Cross listing of securities, the creations of ADRs (American
16
Depository Receipts), multilateral jurisdictional disclosure (MJDS) in terms of issuance procedures, the
17
normalisation of international accounting standards, and the acceptance of foreign disclosure rules for
18
domestic sale of securities have all served to weaken the barriers to international investment. However,
19
other tax restrictions remain, and are unlikely to be reduced any time soon, since they are frequently
20
enshrined in bilateral tax treaties that take years to negotiate.
21
22
What this means is that Canadian investors have increasingly been looking to foreign securities markets
23
to fill in the “holes” in their Canadian stock portfolios. As is well known, the TSE300 is heavily weighted
24
towards resource stocks (and more recently technology stocks through Nortel) , which reflects their
30
For example in Manulife’s initial public offering in the fall of 1999, its Canadian dollar earnings. according
to Canadian generally accepted accounting principles (GAAP) were about 50% higher than its Canadian dollar
earnings calculated according to U.S. GAAP.
31
This difference in GAAP also explains why U.S. return on equity data can not be easily compared with
that for Canadian companies, unless there is a reconciliation for the differences in GAAP. This is rarely, if ever, done
by witnesses presenting foreign ROE data.
48
1
importance in the Canadian economy, and is correspondingly under-weighted in other areas. Canadian
2
investors therefore should seek out the stocks for which there are no good domestic substitutes. It
3
makes more sense to buy an AOL-Time Warner than an Enron. This is because we have some
4
Canadian pipeline stocks, but we have relatively few internet stocks of the “calibre” of AOL-Time
5
Warner. When we add in tax preferences, Canadian investors should be investing in the tax advantaged
6
stocks of firms that represent economic activity not available in Canada.32
7
Q.
WHAT TYPE OF TAX IMPEDIMENTS AND ADVANTAGES ARE THERE?
10
A.
The chief ones are with-holding taxes and the impact of the dividend tax credit system. As
11
investment income flows across national boundaries there are usually taxes levied “at the border” in lieu
12
of the income taxes that would have been paid if the foreign investor had been a resident. These with-
13
holding taxes differ according to the bilateral tax treaty and whether the income is dividends or interest.
14
As a result, it makes sense for foreign investors to buy capital gains, rather than dividend oriented
15
stocks. This conclusion is particularly relevant for Canadians, since the federal government allows a
16
dividend tax credit for dividends paid by Canadian companies to partially compensate for the double
17
taxation of equity income at both the corporate and individual level.
8
9
18
19
The impact of taxes and the degree to which foreign stocks are substitutes for Canadian ones has a
20
direct impact on utilities. Why would a Canadian investor, for example, buy shares in a U.S. utility, when
21
they can buy shares in a Canadian one, be protected by Canadian disclosure rules, make direct
22
comparisons of its financial statements with other Canadian firms and receive a significant tax advantage
23
as well? In our view the continued relaxation of international investment barriers will lead to the
24
diversification of Canadian investment portfolios, but this will not lead to significant selling pressure on
25
tax advantaged Canadian stocks, like utilities, that already exist around the world in most foreign
26
securities markets. As a result, we see almost no impact of international diversification trends for the
32
These arguments were first made by Laurence Booth, “The Dividend Tax Credit and Canadian Ownership
Objectives” Canadian Journal of Economics, May 1987.
49
1
utility and pipeline sector’s fair ROE. These are quintessential domestic stocks.
50
Q.
WILL THE OVERALL MARKET RISK PREMIUM BE AFFECTED?
3
A.
As markets become internationalised there are several effects at work. First, all stocks become
4
less risky. This is because purely domestic factors get diversified away in an international portfolio. As a
5
result, the total market risk is much smaller.33 This means, for example, that if a cabinet minister resigns in
6
disgrace in the UK and the UK market is off 3%, an internationally diversified portfolio would be much
7
less affected. This is a domestic risk that would be priced in a domestic portfolio, but not an
8
internationally diversified portfolio. In the limit, as portfolios become internationally diversified, they
9
become much less risky. As a result, holding everything else constant, the market risk premium for an
10
internationally diversified portfolio is much smaller than for the same securities held by their respective
11
domestic investors alone.
1
2
12
13
This is the reason why financial theory tells us that investors should diversify internationally. The basis for
14
this result is not that returns are higher, since these returns are determined by investors buying the shares,
15
but that the risks are lower. The action of investors diversifying internationally will push up share prices,
16
so that equilibrium expected returns are lower.
17
18
It is important to note that financial theory indicates that risk premiums decline as portfolios are
19
internationally diversified. In particular, as Canadians diversify abroad there is no reason to believe that
20
the Canadian risk premium will increase. In fact, this is flatly contradicted by financial theory. First, the
21
overall level of the “market risk premium” will decrease and second the correct beta coefficient will
22
probably decrease as well.
23
24
It should also be pointed out that the evidence on the realised U.S. market risk premium will be a biased
25
high estimate of the future market risk premium. This is because U.S. investors will no longer have to
26
bear a large part of the U.S. market risk, since part of it is unique to the U.S. and will be diversified
33
B. Solnik, “The Advantages of International Diversification”, Financial Analyst’s Journal, July-August
1974, showed that an internationally diversified portfolio was about half as risky as a simple U.S. diversified
portfolio.
51
1
away in an internationally diversified portfolio. As a result, they will be willing to pay higher prices for
2
U.S. stocks and earn lower expected returns in the future driving down the market risk premium.
3
Because capital markets are becoming more diversified internationally, it
follows that the market risk premium in the future will be lower than any of the
historic estimates from different national markets.
4
5
6
7
8
The second problem is that the risk for an individual security is its beta coefficient times the market risk
9
premium. Financial theory and common sense tells us that the market risk premium will decline, but it can
10
not indicate how betas will change, since they depend crucially on the correlation between the security’s
11
return and that on the market. We would expect this to go down as well, but in pathological cases it
12
could go up. For the above reasons it runs counter to financial theory to increase the Canadian market
13
risk premium to account for the gains that Canadians realise by investing internationally.
14
Q.
IS THERE ANY VALUE AT ALL TO LOOKING AT U.S. DATA?
17
A.
Yes. The Canadian data reflects one “realisation” of what has happened over the last seventy
18
four years. Unfortunately, unlike a physics experiment, we can not rerun the economy again to see what
19
other risk premiums might have emerged. This limitation is partially removed by looking at the U.S. as a
20
guide to see whether or not the Canadian estimates are reasonable. In Appendix F are estimates of the
21
U.S. market risk premium and some simple comparisons with Canada. From 1926-1999, the U.S.
22
market risk premium, measured by annual arithmetic returns, was about 2.0% higher than in Canada
23
(7.74% versus 5.61%). This simple statistic leads many to assume that U.S. risk premiums are higher
24
and that the Canadian economy has underperformed its U.S. counterpart. However, this is not
25
necessarily correct.
15
16
26
27
For one thing, the U.S. data starts in 1926 since the original intent was to start a business cycle prior to
28
the great crash of 1929. It thus deliberately includes the great run up of the stock market prior to the
52
1
crash and is therefore biased towards a higher average return on equity. 34 It is as if we deliberately start
2
the series in the year when the market earns a very high return, say 40%. By including this high return in
3
every subsequent average, all the estimates are then biased high. More to the point and contrary to
4
popular belief, over the period 1926-1999 the U.S. market was riskier than the Canadian market
5
(standard deviation of returns of 20.14% compared to 18.76%).
6
7
Appendix F also shows that U.S. interest rates have behaved much the same as Canadian rates.
8
Between 1926-1999 the standard deviation of the returns on U.S. Treasuries (long bonds) increased
9
from 4.93% to 11.37%, whereas the corresponding increase in Canada was from 5.41% to 10.94%.
10
Similarly, in both markets the risk attached to common stocks declined, in the U.S. from 24.88% to
11
16.21% and in Canada from 22.09% to 16.20%. In both cases, the major reason for the decline in risk
12
was simply removing the effects of the Great Crash of 1929.
13
14
The reaction to this increased bond market risk has been much the same in the U.S. as in Canada, but a
15
little moderated since they have not had to use interest rates to protect their currency value to the same
16
extent. Schedule F3 shows, the U.S. market risk premium has declined from 1.13-3.32% as compared
17
to 2.31-5.06% for Canada. Schedule F3 also shows the reasons for this decline. In the U.S. decreased
18
equity returns have accounted for -2.13-0.04% and increased bond returns for 3.26-3.71%. In Canada,
19
decreased equity returns have accounted for -1.50-1.13% and increased bond returns for 3.54-3.93%.
20
Essentially, in neither market is there significant evidence of decreased equity returns, in fact in the US
21
there are indications of increased equity returns. In contrast, there is evidence for an obvious and large
22
increase in bond market returns.
23
24
The data in Schedule F3 provides little support for the argument that the Canadian market risk premium
25
is biased low due to significant under-performance of the Canadian equity market. If in the 1956-1999
26
period Canadian equity returns had matched those of the 1926-1956 period, the market risk premium
34
The same comments apply to the Canadian start date that seems to mimic that in the US. See Laurence
Booth, Estimating the Equity Risk Premium and Equity Costs: New Ways of Looking at Old Data,” Journal of
Applied Corporate Finance, Winter, 1999.
53
1
would still have only been 4.62%, 2.88% or 1.09% depending on whether you use the arithmetic,
2
geometric or least squares estimates. The bulk of the decline in the market risk premium in both the U.S.
3
and Canada has been caused by increased bond returns. This is an undeniable result of increased
4
interest rate volatility, consequent on more developed fixed income markets and monetary policy.
5
6
Q.
DO YOU TAKE THE U.S. EVIDENCE INTO ACCOUNT IN YOUR MARKET RISK
PREMIUM ESTIMATES?
7
8
9
A.
Yes we do. We do not increase our market risk premium estimates due to the globalisaton of
10
international investment, since that phenomenon should lower not increase risk premiums. Instead, we
11
believe that the market risk premium has increased since the early 1990's because the federal
12
government has its deficit problems under control and the real Canada yield has fallen. Further, there is
13
some evidence that the equity return in Canada could be marginally understated. For example, in
14
Schedule F2 the average arithmetic mean return in Canada has gone from 0.50% less than in the U.S. to
15
2.02% less than in the U.S. It is not an accident that this has occurred in a period of increasing Canadian
16
tax preferences to hold Canadian equities, but some part of this may be due to a marginal under-
17
performance of the equity market in Canada. For both of these reasons, we are increasing the direct
18
estimate of the Canadian market risk premium in Appendix E of 4.0% to our current estimate of 4.50%.
19
This is at least 1.0% more than the actual statistical evidence of the data since 1956 would indicate is
20
warranted. It reflects our observation that the federal government has gotten its finances under control
21
and that the risk premium over current long Canada yields should be greater than the realised average
22
since 1956. The 50 basis point increase in the market risk premium translates into an extra 25 basis
23
points in ROE with a 30% common equity ratio.
24
Q.
DO YOU HAVE ANY OTHER ESTIMATES?
27
A.
In the past we provided a risk premium over preferreds estimate which was dependent on a
28
publication by a major Canadian investment dealer. We are no longer able to receive regular copies of
29
this publication. More importantly, that evidence was based on a sample of six Canadian Telcos,
25
26
54
1
assuming that they were rate of return regulated monopolists. To the extent that the Telcos are no longer
2
rate of return regulated, and they have merged to reduce the size of the sample, updating the evidence
3
would have been of questionable value. Similar comments apply to our Discounted Cash Flow
4
testimony, which were mainly based on the six pure play Telcos.
5
6
To compensate for the loss of our DCF and risk premium over preferreds estimates, we have developed
7
a “multi-factor” model. This model has been the subject of intense academic research over the last ten
8
years to determine whether or not the simple CAPM risk premium model is valid or whether other
9
factors, aside from the market risk premium, are also priced. The multi-factor model has gained support
10
as financial research recognised that there is a size effect in the capital markets as well as a stress
11
phenomenon.
12
13
Essentially, small stocks seem to earn rates of return higher than those predicted by the CAPM.
14
Similarly, stocks trading on high book to market ratios face stress from possible bankruptcy or takeover
15
and also seem to be riskier than the CAPM predicts. Incorporating these two additional factors seems to
16
better explain overall security returns. The economic rationale is that small securities have a liquidity
17
problem in that large institutions are unwilling to buy them since they can not easily trade out of their
18
position. As a result, there is an “artificial” reduction in demand, prices are lower and returns higher. The
19
book to market ratio captures a longer term risk than the month to month trading risk captured in betas.
20
A firm with a high book to market ratio may have poor investment opportunities, little or no competitive
21
advantage in the marketplace, or inefficient management resulting in possible financial distress. These
22
tend to be longer term risk factors. As a result, investors will expect higher rates of return.
23
Q.
HAVE YOU ESTIMATED A MULTI-FACTOR MODEL?
26
A.
Yes. Appendix D describes the development and estimation of a model based on three separate
27
factors, each of which contribute to the overall equity return. The three factors which have been widely
28
used in the finance literature are the market return, size of the firm and the book/market ratio. The
29
market return factor captures the usual compensation for the systematic relationship between the firm
24
25
55
1
and the market. The size factor, as measured by the market value of the firm’s equity, is intended to
2
capture the risk associated with size. It is well documented that investment portfolios comprised of
3
smaller firms, all else equal, have earned returns in excess of the return required as a result of the usual
4
risk measures. This so called ‘small firm effect’ which has spurred the influx of small-cap and micro-cap
5
mutual funds in the last decade. Finally, the third factor, the book/market ratio captures the value versus
6
growth aspects of firms. Firms with high book/market ratios are being undervalued by the market
7
relative to the book value of their assets. Low book/market ratio firms are persistently strong performers
8
while the economic performance of high book/market firms is persistently weak.
9
10
Based upon our forecasts of the long Canada bond rate and market risk premium, Schedules D5 and
11
D6 present the application of the model. For the sample of gas/electric companies, the model provides
12
an estimated return on equity of approximately 7.16%-7.49% The coefficient of the market risk
13
premium, or beta, for the gas/electrics is about 0.46 which is consistent with the estimate we adopt for a
14
generic electric utility. The overall estimate for the Canadian utility sample cost of equity is about
15
7.54%-7.67% suggesting that the model is quite robust across estimates for the different utility sectors.
16
Q.
PLEASE SUMMARISE YOUR TESTIMONY.
19
A.
Our testimony is based on two risk premium models, the classic CAPM and the newer multi-
20
factor model, a careful analysis of current economic conditions, and the risk return relationship in both
21
the U.S. and Canada. We no longer have the benefit of averaging over four different estimation
22
techniques, which is partly why our discussion of risk premium models is so extensive.
17
18
23
24
The methods provided the following estimates:
25
26
CAPM Risk Premium Model:
8.25 %
27
Multi-factor Risk Premium Model: 7.16 - 7.67 %
28
29
where the estimates assume our 30% common equity recommendation. Of the two estimates we put
56
1
most weight on the conventional CAPM based risk premium model. Overall, we believe that investors
2
expect returns in the range 7.45-8.25% for equity securities of similar risk to electricity transmission
3
operations. This is a real return of about 5.45-6.25%, given forecast inflation of just over 2.0%. This
4
compares to the historic average real return on equities as a whole of just under 9.0% (Schedule E2.
5
12.11%-3.17%), which reflects the low risk nature of transmission operations. Hence, this return is
6
completely consistent with seventy four years of equity market history in Canada.
7
Q.
IS THIS YOUR RECOMMENDED ALLOWED RETURN?
10
A.
Competitive firms issuing common equity in the capital market will have to earn slightly more
11
than the investor’s required rate of return in order to recover the issuing and out of pocket costs incurred
12
to raise the capital. These costs are generally of the order of 15 basis points. In addition, there is
13
significant uncertainty as to the trend in interest rates and whether or not a soft landing will actually be
14
achieved. As a result, we recommend an ROE of 8.25% for TransÉnergie.
8
9
15
Q.
HOW DOES THIS RISK PREMIUM COMPARE WITH OTHER AWARDS?
18
A.
It is currently difficult to make comparisons, since many regulated companies are now on
19
automatic adjustment mechanisms, implying that their allowed returns are determined without reference
20
to any testimony. The precedent was the British Columbia Utilities Commission (BCUC) decision in
21
June 1994 which put its three companies (BC Gas, West Kootenay Power and PNG) on a 3.00% risk
22
premium on a forecast long Canada yield of 7.75%. That BCUC decision also determined that the
23
allowed return should vary on a one-to-one basis with any changes in the forecast long Canada yield.
24
In its 1999 Decision, the BCUC set the equity risk premium for a low risk benchmark utility at 3.00%
25
plus an additional 50 basis points to cover the risk of dilution and the cost of new share issues in ordinary
26
circumstances if the forecast Canada yield is 6.0% or below. At the same time, for forecasted long
27
Canada yields greater than 6.0%, the allowed return of 9.5% would be adjusted by 80% of the
28
difference in forecast yields. In March 1995, the National Energy Board put the major pipelines on a
29
3.00% risk premium over a forecast long Canada yield of 9.25%, but decided that the allowed return
16
17
57
1
would vary by 75% of any subsequent change in the long Canada yield. The Public Utility Board of
2
Manitoba then decided in May 1995 that Centra Gas Manitoba would also have a 3.00% risk premium
3
over a forecast long Canada yield of 9.12%, with an 80% adjustment to any subsequent change in the
4
long Canada yield. Finally, the Ontario Energy Board has allowed Consumers Gas a 3.40% risk
5
premium at a 7.25% long Canada yield with a 75% adjustment to any change in the long Canada yield.35
6
7
In all of the above cases, except the OEB’s, the regulatory board has determined that the “going in” risk
8
premium for the utility should be 300 basis points. Any changes in the risk premium have then come
9
about purely as a result of a mechanical adjustment formula, designed as an administrative convenience
10
to avoid repetitive rate hearings.
11
12
In the case of the National Energy Board’s formula, the risk premium at a forecast long Canada yield of
13
6.00% is:
14
3.00% + 0.25 * (9.25-6.00) = 3.81%
15
16
17
Hence, the allowed ROE for NEB mainline pipelines at a 6.00% long Canada yield is for 9.81% on a
18
30% common equity component.
19
20
In our judgement, the use of an automatic adjustment mechanism is an administrative convenience.
21
However, the decline in real Canada yields over the last several years, that has caused our market risk
22
premium estimate to increase has, by coincidence, produced the same sort of result as that produced by
23
the automatic adjustment mechanisms, since inflation has not materially changed over this period.
24
Although in our judgement these mechanisms produce an overestimation of the fair rate of return, we
25
view the NEB automatic adjustment mechanisms as corroborating the main thrust of our testimony that
26
an ROE of 8.25% for TransÉnergie on a 30% common equity component is fair.
35
The actual allowed ROE for 1997/8 was 10.30% .
58
SCHEDULE 1
Page 1 of 4
OVERALL ELECTRICITY DEMAND GROWTH
0.1
0.08
Growth (%)
0.06
0.04
0.02
0
-0.02
-0.04
1982
1984
1983
1986
1985
1988
1987
1990
1989
1992
1991
Year
OVERALL ELECTRICITY DEMAND
REAL QUEBEC GDP
59
1994
1993
1996
1995
1998
1997
1999
SCHEDULE 1
Page 2 of 4
INDUSTRIAL ELECTRICITY DEMAND GROWTH
0.25
0.2
Growth (%)
0.15
0.1
0.05
0
-0.05
-0.1
1982
1984
1983
1986
1985
1988
1987
1990
1989
1992
1991
Year
INDUSTRIAL ELECTRICITY DEMAND
REAL QUEBEC GDP
60
1994
1993
1996
1995
1998
1997
1999
SCHEDULE 1
Page 3 of 4
RESIDENTIAL ELECTRICITY DEMAND GROWTH
0.15
Growth (%)
0.1
0.05
0
-0.05
-0.1
1982
1984
1983
1986
1985
1988
1987
1990
1989
1992
1991
RESIDENTIAL DEMAND
Year GROWTH
REAL QUEBEC GDP
61
1994
1993
1996
1995
1998
1997
1999
SCHEDULE 1
Page 4 of 4
COMMERCIAL ELECTRICITY DEMAND GROWTH
0.15
Growth (%)
0.1
0.05
0
-0.05
1982
1984
1983
1986
1985
1988
1987
1990
1989
1992
1991
Year
COMMERCIAL DEMAND GROWTH
REAL QUEBEC GDP
62
1994
1993
1996
1995
1998
1997
1999
SCHEDULE 2
Page 1 of 3
RECENT CAPITAL STRUCTURE RATIOS
DBRS
RATING
DEBT
SHORT LONG
EQUITY
PREFS
COMMON
%
$
BC GAS UTILITY
(August 2000)
A
15.8
47.4
4.0
32.8
618
CONSUMERS GAS
(March 2000)
A(high)
12.6
46.2
7.4
33.8
1331
CENTRA MANITOBA
(March 1999)
A
19.8
44.3
.
35.1
117
19.2
44.1
3.5
33.2
64
PACIFIC NORTHERN
(June 2000)
BB (high)
UNION GAS
(June 2000)
A
15.9 50.5
3.3
30.2
957
GAZ METRO2
(January 2000)
A
2.9
-
41.2
797
1.
2.
55.9
Debt preferred shares classed as debt.
Gaz Metro is a partnership not an incorporated company.
Numbers may not add to 100% due to rounding, all estimates as close to December 1999.
63
SCHEDULE 2
Page 2 of 3
RECENT CAPITAL STRUCTURE RATIOS
DBRS
RATING
TRANSCANADA PIPE
(JUNE 2000)
DEBT
SHORT LONG
A(Low) 5.2
61.7
EQUITY
PREFS COMMON
%
$
7.9
65.6
25.1
5,334
8.7
25.7
2,561
31.6
1,688
WESTCOAST ENERGY
(June 2000)
A(Low)
NOVA GAS
(June 1999)
A
11.8
56.5
NEWFLND POWER
(March 2000)
A
4.1
50.4
1.8
43.7
243
WEST KOOTENAY
(December 1999)
BBB(HIGH)
20.5
39.0
-
40.7
119
TRANSALTA INC
(August 1999)
A(High)
8.7
36.7
8.0
46.6
1,625
TRANSALTA UTILITIES
(July, 1999)
AA(LOW)
11.2
37.1
8.8
43.0
1,313
CANADIAN UTILITIES
(August 2000)
A(High)
4.4
51.2
9.2
35.2
1,419
NOVA SCOTIA POWER
A(Low)
9.2
47.0
8.6
35.2
943
A(Low)0.0
67.5
-
32.4
169
30.0
774
(February 2000)
TRANSQUÉBEC & MARITIME
(June 2000)
ALLIANCE2
1.
BBB(HIGH)
-
70.0
TransCanada, Westcoast and TransAlta Inc all have minority interest, only in the case of
64
TransAlta Inc does it clearly affect the common equity ratio. NGT is owned by TransCanada, the common
equity is DBRS’s interpretation of the ownership structure in common share equivalents.
2.
Projected for 2001
Numbers may not add to 100% due to rounding, all estimates as close to December 1999.
65
SCHEDULE 2
Page 3 of 3
RECENT CAPITAL STRUCTURE RATIOS
DBRS
RATING
DEBT
SHORT LONG
EQUITY
PREFS
COMMON
%
TELUS (BC)
(July 1999)
A(HIGH)
ISLAND TEL
(August, 2000)
$
11.0
27.8
5.0
56.2
1,556
BBB(HIGH)
6.9
40.1
-
53.0
61
MT&T
(July 2000)
A
8.4
58.0
-
33.6
267
MANITOBA TEL
(June 2000)
A(Low)
2.7
32.4
19.7
45.3
428
NB TEL
(JULY 1999)
A
5.7
44.9
-
49.4
319
NEWTEL COMM
(JULY 2000)
A(LOW)
9.0
42.5
-
48.5
237
QUEBEC TEL
(July 2000)
A(LOW)
12.7
36.5
-
50.8
181
TELUS
(June 2000)
A(HIGH)
9.7
20.9
-
69.4
2,005
BELL CANADA
(August 2000)
A(HIGH)
6.2
43.9
4.2
45.6
8,046
ALIANT
(August 2000)
A(Low)
7.4
44.4
-
48.2
1,141
66
Numbers may not add to 100% due to rounding, all estimates as close to December 1999.
67
SCHEDULE 3
Page 1 of 2
FINANCIAL RATIOS
Electricity Sales(mmkWhs) 1998
1997
1996
1995
1994
2,617
9,790
27,672
2,378
9,772
2,628
9,687
28,463
2,313
9,516
2,759
9,351
27,844
2,270
9,146
2,623
8,493
28,380
2,125
9,035
2,611
8,206
27,450
2,064
8,966
Debt in capital structure
1998
1997
1996
1995
1994
West Kootenay
ATCO Electric
TransAlta
Great Lakes
Nova Scotia Power
61.3
55.2
48.1
34.6
68.2
59.1
58.7
49.6
32.8
68.8
58.9
60.8
47.9
32.4
69.0
57.0
63.8
52.9
61.5
68.7
58.4
66.8
50.0
61.6
69.2
EBITDA Coverage
1998
1997
1996
1995
1994
West Kootenay
ATCO Electric
TransAlta
Great Lakes
Nova Scotia Power
3.03
4.46
5.66
2.95
2.67
3.68
4.17
5.15
3.30
2.52
3.60
3.95
5.74
3.14
2.28
3.41
4.00
5.34
3.32
2.25
2.83
4.00
5.28
2.77
2.05
Fixed Charge Coverage
1998
1997
1996
1995
1994
West Kootenay
ATCO Electric
TransAlta
Great Lakes
Nova Scotia Power
2.22
2.41
2.91
1.44
1.69
2.70
2.22
2.78
2.06
1.65
2.71
2.03
2.99
2.20
1.41
2.47
2.00
2.66
2.19
1.28
2.04
1.96
2.49
1.94
1.21
West Kootenay
ATCO Electric
TransAlta
Great Lakes
Nova Scotia Power
68
Source: DBRS, Canadian Electric Utility Industry Study, 2000.
69
SCHEDULE 3
Page 2 of 2
FINANCIAL RATIOS
Cash flow to Total Debt
1998
1997
1996
1995
1994
West Kootenay
ATCO Electric
TransAlta
Great Lakes
Nova Scotia Power
0.11
0.19
0.25
0.07
0.11
0.13
0.17
0.26
0.12
0.11
0.14
0.16
0.28
0.11
0.11
0.17
0.14
0.25
0.08
0.08
0.20
0.13
0.25
0.09
0.09
Cash flow to Capex
1998
1997
1996
1995
1994
West Kootenay
ATCO Electric
TransAlta
Great Lakes
Nova Scotia Power
0.60
1.84
2.09
0.95
1.70
0.87
1.71
1.96
1.79
2.23
0.85
1.63
1.92
3.58
2.28
0.79
1.65
2.70
3.18
1.73
0.93
1.90
2.93
3.03
1.73
Operating Margins
1998
1997
1996
1995
1994
West Kootenay
ATCO Electric
TransAlta
Great Lakes
Nova Scotia Power
23.6
43.4
42.9
14.4
34.7
26.6
42.5
43.3
28.2
35.4
26.3
43.0
45.6
38.3
34.3
24.4
43.3
45.6
38.2
32.8
20.3
45.0
45.2
35.9
32.1
ROE
1998
1997
1996
1995
1994
West Kootenay
ATCO Electric
TransAlta
Great Lakes
Nova Scotia Power
10.3
12.2
12.7
0.7
11.3
12.5
11.7
13.1
2.1
12.0
12.7
10.8
14.1
5.4
10.0
11.9
12.5
12.9
14.4
8.8
10.1
12.9
12.4
11.8
8.8
70
Source: DBRS, Canadian Electric Utility Industry Study, 2000.
71
SCHEDULE 4
Public Sector Canadian Electric Companies
Short Long Equity
%
Equity Cash flow/capex
($millions)
B.C. Hydro
AA(Low)
15.3
69.8
14.8
1,312
2.18
Edmonton Power
A(Low)
9.5
47.9
42.7
679
2.38
Saskatchewan Power A(Low)
2.2
56.8
41.1
1,140
2.28
Manitoba Hydro
4.0
85.0
11.0
666
0.98
92.2
-11.3
-3,166
3.33
70.5
24.8
13,288
1.11
A
Ontario Hydro A(High)
Hydro Quebec A(Low)
18.1
4.7
N.B Power
A
9.1
90.8
0.1
2
3.80
Nfld & Lab Power
BBB
10.6
54.8
34.7
592
3.11
48.4
46.0
Churchill Falls A(Low)
Note:
5.6
336
16.93
Each utilities debt is either guaranteed by the province or issued directly by it, except for Edmonton Power.
Source: DBRS, Canadian Electric Utility Industry Study, 2000.
72
SCHEDULE 5
MACROECONOMIC DATA
GDP
UNEMP T BILL
LONG EXCHANGE PROFITS
GROWTH RATE YIELD CANADAS
RATE
%GDP
AVG
ROE
1980
1.38
7.5
12.68
12.34
.855
12.18
15.04
1981
3.05
7.6
17.78
14.99
.834
9.86
11.70
1982
-2.94
11.0
13.83
14.38
.810
6.94
6.79
1983
2.75
11.9
9.32
11.77
.811
8.85
9.34
1984
5.67
11.3
11.10
12.75
.772
10.07
10.53
1985
5.40
10.5
9.46
11.11
.733
10.15
10.47
1986
2.64
9.6
8.99
9.54
.720
8.72
9.49
1987
4.10
8.9
8.17
9.93
.754
10.26
11.19
1988
4.86
7.8
9.42
10.23
.812
10.47
12.71
1989
2.54
7.5
12.02
9.92
.845
8.96
10.88
1990
0.27
8.1
12.81
10.85
.857
6.49
5.68
1991
-1.87
10.4
8.83
9.81
.873
4.70
2.00
1992
0.91
11.3
6.51
8.77
.828
4.58
0.18
1993
2.30
11.2
4.93
7.85
.775
5.52
3.64
1994
4.73
10.4
5.42
8.58
.732
8.35
7.20
1995
2.77
9.5
6.98
8.36
.729
9.33
8.04
1996
1.70
9.7
4.31
7.54
.733
9.51
8.09
1997
3.95
9.2
3.21
6.47
.722
9.85
8.90
73
1998
3.10
8.3
4.74
5.45
.674
9.03
7.89
1999
4.19
7.8
4.67
5.58
.673
10.68
N/A
74
SCHEDULE 6
Inflation Indicators
14.00
12.00
%
10.00
8.00
6.00
4.00
2.00
0.00
"1978"
"1982"
"1986"
CPI
75
"1990"
WAGESETS
"1994"
"1998"
SCHEDULE 7
CANADA BOND YIELDS
Benchmark bonds
Canada
91 day Treasury Bill yield
5.62
Canada
Canada
Canada
Canada
Canada
Canada
Canada
Six month Treasury Bills
One year Treasury Bills
Two year notes
Three year notes
Five year bonds
Ten year bonds
Long term bonds
5.73
5.82
5.74
5.83
5.79
5.75
5.62
Canada
Real return bonds
3.52
Marketable Bond Average yields
Canada
Canada
Canada
Canada
1-3 year
3-5 year
5-10
Over tens
5.79
5.83
5.81
5.81
Source: Bank of Canada Web page. Canada as of October 26, 2000.
76
SCHEDULE 8
T.BillandLongCanadaYields
20.00
15.00
%
10.00
5.00
0.00
"1971"
"1975"
"1979"
"1983"
T.Bills
77
"1987"
Canadas
"1991"
"1995"
"1999"
78
2000
1998
1997
1996
1995
1993
1992
1991
1990
1988
1987
1986
1985
1983
1982
1981
1980
SCHEDULE 9
Monetary Conditions Index
20
15
10
5
0
-5
-10
DULE
% of GDP
GovernmentNetLending
6
4
2
0
-2
-4
-6
-8
-10
"1950" "1956" "1962" "1968" "1974" "1980" "1986" "1992" "1998"
79
SCHE
10
SCHEDULE 11
Spread in Basis Points BBB Yields minus Canadas
400
350
300
250
200
150
100
50
0
1977
1980
1983
1986
1989
80
1992
1995
1998
SCHEDULE 12
TSE Earnings Adjusted to the Index
Metals & Minerals
Gold & Silver
Oil & Gas
Paper & Forest
products
Consumer Products
Industrial Products
Real
Estate/Construction
Transportation
Pipelines
Utilities
Communications/Media
Merchandising
Financial Services
Conglomerates
TSE300
1990
270
106
129
98
1991
57
-101
-8
-449
1992
-38
-46
-130
-536
1993
-34
135
80
-135
1994
30
240
175
-5
1995
330
186
144
629
1996
196
155
171
306
1997
164
-400
260
-171
1998
118
-300
19
25
1999
32
-69
42
1
308
96
-1317
241
-130
87
317
-44
-1247
224
-15
-2914
388
112
6
1345
265
8
91
187
-14
404
216
9
976
105
160
488
58
149
476
265
187
192
-128
302
271
202
-938
272
269
-9
97
260
23
77
-450
450
236
-39
114
106
-378
21
-1652
180
137
86
156
160
-105
35
196
323
151
135
132
311
288
195
232
323
214
183
253
378
231
342
156
385
236
334
53
468
-44
245
802
383
301
505
226
583
706
293
-260
349
102
985
285
551
667
228
539
309
527
267
63
576
547
210
Source: December issues of successive TSE Monthly Review.
81
SCHEDULE 13
Corporate Canada's ROE
16.00
14.00
12.00
%
10.00
8.00
6.00
4.00
2.00
0.00
1980
1983
1986
1989
82
1992
1995
1998
SCHEDULE 14
Page 1 of 2
MEAN RETURNS ACROSS INDUSTRIES
1990-99
NUMBER
OF FIRMS
INDUSTRY
MEAN ROE
METALS & MINERALS
14
-1.00
GOLD
2
-5.97
OILS
17
1.26
PAPER & FOREST
8
2.19
CONSUMER PRODUCTS
25
5.79
INDUSTRIAL PRODUCTS
23
6.06
CONSTRUCTION
5
-8.82
TRANSPORTATION
3
12.05
PIPELINES
4
11.05
TELCOS
7
12.52
GAS & ELECTRICS
5
11.83
COMMUNICATIONS
7
0.83
MERCHANDISING
19
5.51
FINANCIAL SERVICES
7
10.94
MANAGEMENT COMPANIES
7
6.44
153
4.83
MEAN
83
SCHEDULE 14
Page 2 of 2
MEAN RETURNS ACROSS INDUSTRIES
1990-99
(FIRMS WITH STD ROE LESS THAN 30% )
NUMBER
OF FIRMS
INDUSTRY
MEAN ROE
METALS & MINERALS
9
2.86
GOLD
1
4.37
OILS
15
2.99
PAPER & FOREST
7
3.58
CONSUMER PRODUCTS
23
8.08
INDUSTRIAL PRODUCTS
22
6.13
CONSTRUCTION
2
9.35
TRANSPORTATION
3
12.05
PIPELINES
4
11.05
TELCOS
7
12.52
GAS & ELECTRICS
5
11.83
COMMUNICATIONS
4
5.70
MERCHANDISING
18
7.74
FINANCIAL SERVICES
7
10.94
MANAGEMENT COMPANIES
6
6.99
133
7.23
MEAN
84
85
SCHEDULE 15
MEAN ROE AND STANDARD DEVIATION OF ROE
(REGULATED UTILITY SAMPLE)
MEAN ROE
1990-99
STD ROE
1990-99
QUEBEC TELEPHONE
13.70
0.55
CANADIAN UTILITIES
13.77
1.07
MARITIME ELECTRIC*
13.06
1.45
PACIFIC NORTHERN GAS
12.90
1.64
BC TELEPHONE*
11.78
1.73
FORTIS INC.
10.72
1.74
ISLAND TELEPHONE*
12.66
1.78
NEWTEL ENT.*
10.54
2.23
TRANSALTA CORPORATION
11.01
3.41
MARITIME T&T*
11.53
3.55
BRUNCOR INC.*
12.16
4.31
BC GAS INC.
11.21
4.38
TRANS MOUNTAIN PIPE LINE*
12.99
4.54
TRANSCANADA PIPELINES
11.12
5.01
WESTCOAST ENERGY
8.37
6.00
BCE INC
15.14
15.19
MEAN
12.04
3.66
MEAN (BCE EXCLUDED)
11.83
2.89
* No longer traded.
86
SCHEDULE 16
SAMPLE ROE VS. STANDARD DEVIATION OF ROE
(UNREGULATED SAMPLE - SURVIVING FIRMS)
Firm
MEAN ROE
SAMPLE ROE
STDROE
1990-99
1990-99
1990-99
1 BANK OF MONTREAL
0.151
0.151
0.011
2 ANDRES WINES
0.109
0.130
0.016
3 ULSTER PETRO
0.040
0.100
0.018
4 LOBLAW COS
0.128
0.107
0.021
5 LEON'S FURNITURE
0.153
0.116
0.026
6 BANK OF NOVA SCOTIA
0.149
0.122
0.029
7 CANADIAN MARCONI
0.059
0.113
0.034
8 DOVER IND
0.098
0.111
0.036
9 BOMBARDIER INC
0.150
0.115
0.036
10 MDS HEALTH GROUP
0.104
0.114
0.039
11 PANCANADIAN PETRO
0.113
0.114
0.040
12 CANADIAN TIRE
0.097
0.112
0.042
13 IMASCO LTD
0.150
0.115
0.047
14 WAJAX LTD
0.055
0.111
0.048
15 GREYVEST FIN SVC
0.082
0.109
0.048
16 CARA OPERATIONS
0.136
0.111
0.049
17 IPSCO INC
0.091
0.110
0.050
18 TRIMAC
0.101
0.109
0.054
19 AGRA
0.021
0.104
0.054
20 UNICAN SECURITY SYSTEMS
0.117
0.105
0.054
21 IMPERIAL OIL
0.079
0.104
0.055
22 CDN IMP BANK OF COMM
0.118
0.105
0.056
23 HUDSON'S BAY CO
0.056
0.102
0.056
24 MELCOR DEVELOP
0.101
0.102
0.059
25 ALCAN
0.047
0.100
0.060
26 DU PONT CANADA
0.169
0.103
0.060
27 ROTHMANS INC
0.364
0.112
0.062
28 NORANDA INC
0.044
0.110
0.062
29 MOFFAT COMM
0.116
0.110
0.065
30 FINNING LTD
0.091
0.110
0.067
31 BUDD CANADA
0.056
0.108
0.068
0.139
0.144
0.045
0.052
0.109
0.110
0.108
0.106
0.068
0.070
0.070
0.072
32
33
34
35
ROYAL BANK
TORONTO DOM BANK
BRASCAN
RIO ALGOM
87
36 SHELL CANADA
37 REITMANS
0.098
0.106
0.106
0.106
0.074
0.075
-0.014
0.103
0.077
39 SEARS CANADA
0.041
0.101
0.080
40 TOTAL PETRO
-0.000
0.099
0.081
41 CDN OCCIDENTAL PETRO
0.066
0.098
0.084
42 TECK CORP
0.044
0.097
0.084
43 RANGER OIL
-0.004
0.094
0.087
44 ST LAWRENCE CEMENT
0.052
0.093
0.088
45 SLATER STEEL
0.018
0.092
0.089
46 COMINCO LTD
0.024
0.090
0.090
47 SCHNEIDER CORP
0.070
0.090
0.096
48 WESTON, GEORGE LTD
0.128
0.091
0.096
49 CORBY DIS
0.228
0.093
0.099
50 TOROMONT IND
0.233
0.096
0.102
51 IRWIN TOY
0.040
0.095
0.115
52 TORSTAR CORP
0.090
0.095
0.115
53 SEAGRAMS
0.129
0.096
0.120
54 HARRIS STEEL
0.167
0.097
0.123
55 STELCO
-0.009
0.095
0.131
56 MOLSON COS
0.063
0.095
0.134
57 ALGOMA CENTRAL RR
0.148
0.095
0.140
58 NORTHERN TELECOM
0.095
0.095
0.141
59 WESTFIELD MINERALS
-0.022
0.093
0.144
60 ROLLAND INC
0.056
0.093
0.147
61 DONOHUE RES
0.124
0.093
0.155
62 EMCO
-0.025
0.091
0.168
63 DOMTAR
0.015
0.090
0.179
64 ABITIBI-PRICE
-0.024
0.088
0.180
65 IVACO LTD
-0.031
0.087
0.203
66 MOORE CORP
0.003
0.085
0.226
67 SPAR AEROSPACE
0.023
0.084
0.242
68 NUMAC OIL & GAS
-0.093
0.082
0.244
69 GENDIS
0.040
0.081
0.26
38 BECKER MILK
88
SCHEDULE 17
SAMPLE MEAN ROE VS. STD. DEVIATION OF ROE
UNREGULATED SAMPLE - SURVIVING SAMPLE
0.16
0.15
SAMPLE MEAN ROE
0.14
0.13
0.12
0.11
0.10
0.09
0.08
0.07
0.00
0.05
0.10
0.15
STANDARD DEVIATION OF ROE
STDROE > .30 EXCLUDED
89
0.20
0.25
0.30
SCHEDULE 18
Sub-Index Betas
1.600
1.400
1.200
1.000
0.800
0.600
0.400
0.200
Gasel
Telco
90
95
84
73
0.000
Pipes
Utility
91
SCHEDULE 19
FACTORS INFLUENCING THE REAL CANADA YIELD
Dependent variable:
Long Canada yield minus the average CPI inflation rate for the past , current and
forward year.
Independent variables:
Coefficient
Constant:
T-Statistic
1.237
Risk: standard deviation of return on
Scotia Capital long bond index for prior ten years.
0.296
5.52
Deficit: aggregate government lending
as a % of GDP.
-0.241
-6.78
Dum1: dummy variable for years 1940-51
-5.364
-11.62
Dum2: dummy variable for years 1972-80
-3.678
- 8.19
Adjusted R2 of the regression
85.7%
Sixty four years of data 1936-1999
92
Appendix A
L. D. BOOTH
Joseph L. Rotman Centre for Management
University of Toronto
105 St. George St,
Toronto, Ontario M5S 3E6
(416) 978-6311
Dr. Booth is currently Professor of Finance and the Newcourt Chair in Structured Finance in the
Rotman School of Management at the University of Toronto. He received his doctorate from the School
of Business at Indiana University in 1978, where he also received his MBA and his MA in economics.
He received a first class honours degree from the London School of Economics in 1971.
Dr. Booth's current teaching interests are in corporate finance and mergers and acquisitions. An award
winning teacher, he has taught MBA courses in corporate financing, financial management, international
finance, mergers and acquisitions, managerial economics, and macroeconomics. He has also taught in
RSM’s executive MBA and Ph.D programs. Professor Booth has taught executive seminars on the
money and foreign exchange markets, business valuation, innovations in the capital markets, and
financial risk management. For 1988-90 he was a director of the Financial Management Association,
and from 1987 until 1991 was the area co-ordinator for finance at the University of Toronto, a position
that he has held again since 1993. He is on the editorial board of several academic journals and is an
active researcher.
Dr. Booth's consulting activities have been quite varied with assignments from several government
departments, including Treasury and Economics (Ontario), and Consumer and Corporate Relations,
Finance and Industry Canada (Federal), as well as private corporations. Professor Booth has appeared
as an expert witness before the Ontario Securities Commission, the Ontario Energy Board, and the
CRTC. Additionally with Professor Berkowitz he has appeared before the CRTC, the National Energy
Board, the Ontario Energy Board, the Public Utilities Commission of British Columbia, the Alberta
Energy and Utilities Board and the Public Utilities Board of Manitoba. He is regularly quoted in the
media and has been asked to give guest lectures before a variety of professional associations including
most recently the Canadian Institute of Actuaries and the Canadian Institute of Chartered Business
Valuators.
A full CV and copies of relevant papers can be downloaded from his web page at
http://mgmt.utoronto.ca/~booth
1
MICHAEL K. BERKOWITZ
Department of Economics
University of Toronto
150 St. George Street
Toronto, Ontario M5S 3G7
Telephone/Fax (416) 978-2678
Dr. Berkowitz is Professor of Economics and Finance in the Department of Economics and the
Rotman School of Management at the University of Toronto and president of M.K. Berkowitz &
Associates. He is currently the director of the MA Program in Financial Economics and past Associate
Dean of the Faculty of Arts & Science at the University of Toronto. In July 2001, he will begin a five year
term as Chairman of the Department of Economics. Dr. Berkowitz received his Ph.D. from the State
University of New York at Buffalo in 1976. His thesis was titled "Pricing and Production Decisions of
Regulated Public Utilities".
Dr. Berkowitz has taught courses at the graduate and undergraduate levels in Security Analysis and
Portfolio Management, Corporate Finance, Financial Economics, Energy and Resource Economics,
Managerial Economics, Economics of Natural Resources, Accounting, Micro-Economics, and Investments.
His research interests are in corporate capital structure and incentive mechanisms for mutual fund managers.
His research on mutual fund performance has been published in academic journals and was also highlighted
in the Globe and Mail, Canadian Business Magazine and The Canadian Investment Review. For the
last two years, he participated in the weekly Toronto Star's Choice Portfolio series as an expert in mutual
funds. Dr. Berkowitz has been awarded a major three year grant by the Social Science and Humanities
Research Council on a project entitled, "An Analysis of Management Compensation on the Performance
of Mutual Fund Managers."
Dr. Berkowitz's consulting activities have been varied, ranging from the economic analysis of
competition in rail transport to cost of capital issues. He has appeared as an expert witness before the
Ontario Select Committee on Energy, the CRTC, the Ontario Energy Board, the Public Utilities
Commission of Manitoba, the British Columbia Public Utility Commission, the National Energy Board, the
Alberta Energy Utilities Board and the Regie du Gaz Naturel. He has also appeared as an expert witness
on inside trading before the Ontario Court's Provincial Division and has been called upon to provide asset
valuation expertise in a number of cases. His consulting assignments have been with Scotia Securities,
Consumer and Corporate Affairs Canada, the Consumer Advocates's Office of Newfoundland, Economic
Council of Canada, Royal Commission on Passenger Transportation, Energy, Mines and Resources
Canada, Union Gas, Canadian Association of Petroleum Producers, Slater Steel, Industrial Power
Consumers Association of Alberta, Industrial Gas Users Association, National Anti-Poverty Association,
Consumers Association of Canada, Telesat Canada among others.
Relevant research publications include:
“Common Risk Factors in Explaining Canadian Equity Returns”, W/P UT-ECIBA-BERK-00-01,
2
September 2000.
“Investor Risk Evaluation in the Determination of Management Incentives in the Mutual Fund Industry”,
with Y. Kotowitz, Journal of Financial Markets, 2000, pp. 365-387.
“Measuring Fund Performance”, Adviser’s Guide to Financial Research, MacLean-Hunter, 1999,
pp.35-42.
“Investment Management Services”, Canadian Investment Review, with Y. Kotowitz
Vol. 11, No. 1, pp 42-48, Winter 1998.
"Ex Post Production Flexibility, Asset Specificity and Financial Structure", with V. Aivazian,
Journal of Accounting, Auditing, and Finance, Winter 1998, pp. 1-20.
"Estimating the Market Risk for Non-Traded Securities: An Application to Canadian Public Utilities,
International Review of Financial Analysis, 1998, Vol. 7, No. 2, pp 171-179.
"Incentives and Efficiency in the Market for Management Services: A Study of Canadian Mutual Funds",
with Y. Kotowitz, Canadian Journal of Economics, Vol 26, November 1993, pp. 850-866.
"Promotions as Work Incentives", with Y. Kotowitz, Economic Inquiry, Vol. 31, July 1993, pp. 342353.
"Precommitment and Financial Structure: An Analysis of the Effect of Taxes", with V. Aivazian,
Economica, Vol. 59, February 1992, pp. 93-106.
"The Market for Investment Management Services: Is it Rational?", with Y. Kotowitz, Canadian
Investment Review, Vol. IV, No. 1, Spring 1991, pp.69-76.
"Disaggregate Analysis of the Demand for Gasoline," Canadian Journal of Economics, with N. Gallini,
E. Miller, and R. Wolfe, Vol. 23, No. 2, May 1990, pp.253-275.
"Forecasting Vehicle Holdings and Usage with a Disaggregate Choice Model," with N. Gallini, E. Miller,
and R. Wolfe, Journal of Forecasting, Vol. 6, No. 4, Oct-Dec 1987, pp. 249-269
"A Disaggregate Model of Residential Heating Mode Choice: A Multinomial Probit Modelling Approach",
with G.H. Haines, Journal of Applied Economics, Vol. 19, No. 5, May 1987, pp. 581-596.
"The Relationship Between Attributes, Relative Preferences, and Market Share: The Case of Solar Energy
in Canada", with G.H. Haines, Journal of Consumer Research, Vol. 11, No. 3, December 1984,
pp. 754-762.
"Vehicle Ownership and Usage in Canada: Data Issues and Collection", with R.A. Wolfe, E.J. Miller, R.
Rideout and N. Gallini, Transportation Forum, Vol. 1-2, September 1984, pp. 40-48.
“Forecasting Future Canadian Residential Heating Demand: An Illustration of Forecasting with Aggregate
and Disaggregate Data," with G. H. Haines, Journal of Forecasting, Vol. 3, No. 2, April-June
1984, pp. 217-227.
"Financing and Investment Behavior of the Regulated Firm Under Uncertainty", with E. Cosgrove, in
Economic Analysis of Telecommunications: Theory and Applications, L. Courville,A. de
Fontenay, and R. Dobell (eds.), North Holland, 1983, pp.383-396.
"Patent Policy in an Open Economy", with Y. Kotowitz, Canadian Journal of Economics, Vol. 15, No. l,
February 1982, pp. 1-l7.
"Predicting Demand for Residential Solar Heating: An Attribute Approach", with G.H. Haines,
Management Science, Vol. 28, No. 7, July 1982, pp. 717-727.
"A Multi Attribute Analysis of Consumer Attitudes Toward Alternative Space Heating Modes", with G.
3
Haines, in Consumers and Energy Conservation, edit by J.D. Claxton, et al., Praeger Press,
1981, pp. 108-114.
"A Review of Canadian and U.S. Solar Energy Policies", Canadian Public Policy-Analyse de Politiques,
2, Spring 1979, pp. 257-62.
"Incentive Schemes for Encouraging Solar Heating Applications in Canada", Journal of Business
Administration, Vol. 10, Nos. 1 and 2, Fall 1978/ Spring 1979, pp. 373-82.
"Power Grid Economics in a Peak-Load Pricing Framework", Canadian Journal of Economics, X,
No. 4, November 1977, pp. 621-36.
"A Note on Production Inefficiency in the Peak-Load Pricing Model", co-author F.C. Jen, Southern
Economic Journal, 44, No. 2, October 1977, pp. 374-79.
Relevant technical reports include:
"The Potential for Competition in Rail Carriage", report submitted to the Royal Commission on National
Passenger Transportation, July 1991.
"The Hidden Costs of Electricity Usage in Ontario", report submitted to Ontario Select Committee on
Energy, April 1986.
"Advertising Pre-clearance: Assessment of Alternatives", report submitted to Consumer and Corporate
Affairs Canada, March 1986.
"The Organization and Control of Public Corporations", report submitted to Economic Council of Canada,
March 1985.
Rate of return testimony before the CRTC, PUB Manitoba, British Columbia Utility Commission,
Alberta Energy Utilities Board, Ontario Energy Board and Regie du Gaz Naturel. Companies include Bell
Canada, BC Tel, AGT, Consumers Gas, Union Gas, Island Tel, MT&T, NB Tel, Newfoundland Tel,
Centra Gas Manitoba, Centra Gas Ontario, Nova Gas Transmission, Northwestel, Ontario Hydro, Pacific
Northern Gas, BC Gas, West Kootenay Power, TransCanada Pipelines, Westcoast Energy, Trans
Mountain Pipelines, Trans Northern Pipelines, Foothills Pipelines, Alberta Natural Gas, Interprovincial Pipe
Lines, Trans Quebec & Maritimes, Gaz Metropolitain, TransAlta, Edmonton Power and ATCO Electric.
Web page: http://www.economics.utoronto.ca/berk/
4
SCHEDULE B3
CANADIAN INSTITUTE OF ACTUARIES DATA USED TO UPDATE
HATCH AND WHITE SERIES
COMMON CANADA
MARKET
CANADA
LONG
RISK
INDEX
BONDS
PREMIUM
1988
11.08
10.45
0.64
1989
21.37
16.29
5.08
1990
-14.80
3.34
-18.14
1991
12.02
24.43
-12.41
1992
-1.43
13.07
-14.51
1993
32.55
22.88
9.67
1994
-0.18
-10.46
10.28
1995
14.53
26.28
-11.75
1996
28.35
14.29
14.05
1997
14.98
17.45
-2.47
1998
-1.58
14.13
-15.72
1999
31.71
-7.15
38.86
ARITH. MEAN
.30
GEOM. MEAN
-.87
SCHEDULE B4
CANADA MINUS U.S T.BILL YIELDS
1952.01-2000.06
700
600
500
400
300
200
100
Basis Points
0
-100
-200
-300
-400
1952:01
1956:01
1954:01
1960:01
1958:01
1964:01
1962:01
1968:01
1966:01
1972:01
1970:01
1976:01
1974:01
1980:01
1978:01
Time Period
1984:01
1982:01
1988:01
1986:01
1992:01
1990:01
1996:01
1994:01
2000:01
1998:01
SCHEDULE C1
DEFINITION OF VARIABLES USED IN INSTRUMENTAL MODEL
DE= Debt/equity ratio.
STDEPS= Std. deviation of firm's earnings per share.
STDROE= Std. deviation of firm's return on equity.
EBETA= Earnings (accounting) beta.
TAGRTH= Growth in total assets.
DGASEL= Dummy variable for gas and electric utilities.
DTEL= Dummy variable for telcos.
DPIPE= Dummy variable for pipelines.
D1= Dummy variable for mining companies.
D2= Dummy variable for oil & gas producers.
D3= Dummy variable for paper & forest products.
D4= Dummy variable for consumer products.
D5= Dummy variable for industrial products.
D6= Dummy variable for construction & development.
D7= Dummy variable for transportation companies.
D8= Dummy variable for communications.
D9= Dummy variable for merchandising companies.
D10= Dummy variable for banks and trust companies.
6
7
T-statistics in parentheses.
9
SCHEDULE C3
PREDICTED BETAS FOR UTILITY SAMPLE
PREDICTED BETA USING:
EQUATION
EQUATION
EQUATION
MBETA
NO. 1
NO. 2
NO. 3
BC GAS INC.
0.454
0.724
0.731
0.724
BC TELEPHONE
0.529
0.482
0.486
0.474
BCE INC.
0.554
0.486
0.467
0.512
BRUNCOR INC.
0.405
0.505
0.502
0.491
CANADIAN UTILITIES
0.579
0.497
0.497
0.474
FORTIS INC.
0.492
0.506
0.504
0.497
ISLAND TEL
0.536
0.511
0.517
0.497
MARITIME ELECTRIC
0.616
0.438
0.435
0.470
MARITIME T&T
0.447
0.487
0.494
0.506
NEWTEL ENT.
0.466
0.518
0.522
0.513
PACIFIC NORTHERN GAS
0.548
0.619
0.635
0.616
QUEBEC TELEPHONE
0.515
0.463
0.470
0.460
TRANS MOUNTAIN PIPE LINE
0.681
0.542
0.531
0.547
TRANSALTA UTILITIES
0.450
0.453
0.444
0.446
TRANSCANADA PIPELINES
0.683
0.672
0.682
0.703
WESTCOAST ENERGY
0.568
0.718
0.720
0.682
0.533
0.539
0.540
0.538
0.019
0.021
0.017
MEAN
THIEHL'S INEQUALITY
10
SCHEDULE C4
PREDICTED BETAS FOR CONSUMER PRODUCTS SAMPLE
PREDICTED BETA USING:
EQUATION
EQUATION
EQUATION
MBETA
NO. 1
NO. 2
NO. 3
ANDRES WINES
0.606
0.618
0.627
0.593
BC SUGAR
0.773
0.707
0.696
0.649
BUDD CANADA
0.700
0.552
0.548
0.553
CANADA MALTING
0.388
0.638
0.659
0.625
CANBRA FOODS
0.549
0.591
0.568
0.577
CONSUMERS PKG.
0.963
0.757
0.678
0.759
CORBY DIST.
0.404
0.573
0.575
0.575
CORPORATE FOODS
0.616
0.666
0.677
0.676
DOMINION TEXTILE
0.789
0.660
0.658
0.666
DOVER IND.
0.421
0.607
0.612
0.588
FORD MOTOR CO.
0.349
0.419
0.521
0.592
HAYES-DANA
0.664
0.653
0.651
0.596
IMASCO LTD.
0.739
0.827
0.866
0.877
IRWIN TOY
0.859
0.611
0.604
0.645
LABATT
0.670
0.727
0.741
0.698
MDS HEALTH GROUP
0.728
0.793
0.800
0.779
MOLSON COS.
0.747
0.634
0.640
0.655
NOMA IND.
1.429
0.684
0.635
0.689
PEERLESS CARPET
0.491
0.722
0.673
0.727
ROTHMANS
0.628
0.520
0.485
0.524
SCHNEIDER CORP.
0.474
0.611
0.627
0.631
SCOTT PAPER
0.748
0.758
0.772
0.675
SEAGRAMS
0.921
0.635
0.663
0.660
UAP INC.
0.526
0.705
0.718
0.661
0.674
0.653
0.654
0.653
0.047
0.054
0.048
MEAN
THIEHL'S INEQUALITY
11
Schedule D1
Summary Statistics for Explanatory Variables
(204 observations, January 1982-December 1998)
Name
Mean
Std. Dev.
t(mn)
RM
.954
4.51
3.02
RF
.677
.282
34.37
Correlations
RM-RF
SMB
RM-RF
.277
4.51
0.89
1.00
SMB
.435
3.14
1.98
.034
1.00
HML
.160
3.90
0.59
.015
-.059
Note: t(mn) is the t-statistic associated with the mean value.
7
HML
1.00
Schedule D2
Multifactor Model Estimates for Individual Utilities
Coefficient of
Firm
BCE INC.
BC GAS
BC TELEPHONE
BRUNCOR INC
CANADIAN UTILITIES
FORTIS
ISLAND TELEPHONE
MARITIME T&T
NEWTEL ENT.
PACIFIC NORTHERN GAS
QUEBEC TELEPHONE
TRANSALTA UTILITIES
TRANS MOUNTAIN PIPE
TRANSCANADA PIPE
WESTCOAST ENERGY
HML
-0.017*
-0.054*
0.116*
0.096*
0.146
0.119
-0.389
0.101*
0.129*
-0.062*
-0.096*
0.165
-0.077*
0.060*
0.132
RM-RF
0.631
0.412
0.616
0.538
0.510
0.423
0.736
0.522
0.478
0.506
0.590
0.458
0.591
0.654
0.517
SMB
-0.294
-0.093*
-0.204
-0.036*
-0.215
-0.039*
-0.089*
-0.265
-0.231
-0.054*
-0.309
-0.318
-0.045*
-0.222
-0.178
Constant
0.008
0.005*
0.007
0.005*
0.006
0.005
0.018
0.007
0.007
0.007
0.011
0.004*
0.005*
0.001*
0.002*
TELCO MEAN
GAS-ELECTRIC MEAN
PIPELINE MEAN
OVERALL MEAN
-0.008
0.094
0.014
0.025
0.587
0.451
0.567
0.545
-0.204
-0.166
-0.125
-0.173
0.009
0.005
0.004
0.007
* Not significant at 90% level.
8
Schedule F1
Annual Rate of Return Estimates 1926-1999
U.S.
CANADA
S&P
Long US
Excess
TSE
Long
Excess
Equities
Treasury
Return
Equities
Canadas
Return
AM
13.28
5.54
7.74
11.89
6.28
5.61
GM
11.34
5.15
6.19
10.25
5.91
4.34
OLS
11.09
4.36
6.73
10.49
5.01
5.48
Volatility1
20.14
9.37
18.76
9.20
1. Volatility is the standard deviation of the returns over the whole period.
Schedule F2
Equities Over Long Term Bonds in the U.S. & Canada
S&P500
U.S.
Excess
TSE
Long
Excess
Equities
Treasuries
Return
Equities
Canadas
Return
AM
13.05
3.38
9.67
12.55
4.00
8.55
GM
10.11
3.27
6.84
10.30
3.87
6.42
OLS
8.97
3.48
5.52
8.90
3.99
4.90
Volatility1
24.88
4.93
22.09
5.41
AM
13.44
7.09
6.35
11.41
7.93
3.49
GM
12.24
6.53
5.71
10.22
7.41
2.81
OLS
11.05
6.99
4.06
10.40
7.81
2.59
Volatility
16.21
11.37
16.20
10.94
1926-1956
1957-1999
1. Volatility is the standard deviation of the returns over the whole period.
Schedule F3
Factors Determining the Decline in the Market Risk Premium
(Between 1926-56 & 1957-99)
Decline in
Equity
Bond
Decline in
Equity
Bond
U.S. Risk
Returns
Returns
Canadian
Returns
Returns
Premium
Risk
Premium
AM
3.32
-0.39
3.71
5.06
1.13
3.93
GM
1.13
-2.13
3.26
3.61
0.07
3.54
OLS
1.45
-2.05
3.52
2.31
-1.50
3.82