PRESENTATION TO THE
REGIE DE L'ÉNERGIE
FILE R-3492-2002
By: Dr. Lawrence Kryzanowski
Dr. Gordon Roberts
March 13, 2002
Part II
RATE OF RETURN ON
COMMON EQUITY OR ROE
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We rely primarily on the Equity risk
premium test
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Under this method, the recommended ROE
is the risk-free rate estimate + the risk
premium estimate
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When using historical data, we deal with three
important issues:
• First, what is the proper annual average?
- If returns were IID or identically and independently distributed
over time, and horizon was 1 year, then it would be the
arithmetic mean
- Unfortunately, returns are not IID due to mean
reversion/aversion and regime shifts, & horizons are long-term;
yesterday we heard “market volatility is not constant”
- Thus, a weighted-average of the geometric and arithmetic
means, which places more weight on the geometric mean, is
more appropriate
- To be conservative, we use an equal-weighted average of these
two types of means
• “In practice, two combinations of risk -free rates and
equity-risk premia are seen: (1) long-term risk -free
rates plus geometric means or (2) short-term risk -free
rates plus arithmetic means. Nothing in the theory of
the CAPM dictates the use of these parameters; they are
artifacts of practice. A recent survey of leading
American corporations and financial institutions
suggests greater use of the geometric-mean/long-term
risk -free rate approach.”
• This recent study is: R. F. Bruner, K.M. Eades, R.S.
Harris and R. Higgins, Best practices in estimating the
cost of capital: Survey and synthesis, Financial
Practice and Education (Spring/Summer 1998).
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Second, what is the proper time period?
• Again, if returns are IID, then longer time periods are
better since the precision of the estimate increases with
more data points
• When returns are not IID, the use of a long time period
gives equal weight to observations from a regime that is
no longer valid as it does to observations from a regime
that is currently valid
• When returns are for a market proxy whose
construction is not consistent over time, this also argues
in favor of using a shorter time -period
• We conclude that the time period since 1956 is best for
Canada but we also utilize both longer and shorter time
periods
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Third, realized and expected risk premiums can
differ
• Many studies show that the historical realized risk
premium exceeds the risk premium that was expected
over that period for both Canada and the US
• Equity investors realized more than they expected while
bond investors realized less than they expected
• Thus, the use of historical estimates generates an
upwardly biased estimate of expected or going-forward
risk premia
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We estimate an equity market risk premium of
4.70%
• To emphasize the conservative nature of this estimate,
please note that it is near the highest weighted risk
premium of 4.76% reported in our Schedule 8, and does
not reflect the large negative risk premium for 2002
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We use a DCF test using historical and future
estimates of dividend growth at the market level to
check the reasonableness of our estimate
• We again conclude that our estimate is conservatively
high
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We use various other estimates to determine
where our estimate falls in the possible range of
values. These include:
• Expected risk premia estimates of various academics and
practitioners – almost all of these are below our 4.7%
• Surveys of Canadian investment professionals (Mercer; Watson
Wyatt, 5.5%, 6%, 7.8%, 7.9%) that imply at most a 3% risk
premium over long Canada bonds which is considerably lower
than our 4.7% estimate
• These sources strongly suggest that future equity risk premia will
be lower than in the past, & may even be nil or negative. In other
words, there has been a regime shift downwards in the risk
premium
• The US equity risk premium experience also suggests that our
estimate is generous
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We provide numerous fundamental changes that
imply a decreasing equity risk premium, such as:
• Marked reduction in trade costs over the last century,
which has lowered the equity risk premium by about
1%
• Achievement of market diversification at lower cost
through the development of various index products
• Fuller and less costly diversification of domestic market
risk through international diversification
• However, we make no adjustment to our market risk
premium estimate for these fundamental changes
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We estimate the relative investment
riskiness or beta of HQ DIST at 0.5
• We conclude that this estimate is conservatively
high since:
- The trend in utility betas is downwards to zero ? Not
upwards towards 1
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By multiplying our market risk premium estimate
of 4.70% by our estimate of HQ DIST's beta of
0.5, we obtain the own risk premium for HQ of
2.35%
We add 10 basis points to compensate for
potential equity issuance costs
This yields our return on equity recommendation
for HQ DIST of 8.45%
This is 245 basis points over our long Canada
forecast of 6.0%
CRITIQUE OF THE EVIDENCE
SUBMITTED BY DR. MORIN
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Beta estimation problems:
• Beta estimation problem #1 – Use of Value
Line Betas
• If the betas of Canadian utilities have been
moving towards 1 at a reversion rate of onethird as Dr. Morin has argued over the years,
how come the rolling five-year average beta is
moving towards zero and not 1 for our sample
of utilities?
• Dr. Morin misinterprets the 1986 study by
Kryzanowski and Jalilvand. Like the study by Gombola
& Kahl, this study provides support for the regression
tendency of utility betas to regress toward the grand
utility mean and not towards the market average of 1
• Thus, since Dr. Morin basically uses the sample
average utility beta as his estimate of the beta for HQ
DIST, no further adjustment is required
• Unadjusting his adjusted betas yields a beta estimate of
0.51, which is almost identical to ours
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Beta estimation problem #2 – Further
upward beta adjustment via the ECAPM
We show that the further adjusted beta
becomes 0.75 by placing a 75% weight on
Dr. Morin's adjusted beta of 0.67 & the
remaining weight on the market beta of 1
Thus, a raw beta of 0.51 becomes 0.67 after
round-one adjustments, and becomes 0.75
after round-two adjustments
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Not only is the ECAPM devoid of any theoretical
basis as is generally the case for financial models
but Dr. Morin provides no peer -reviewed support
for its empirical validity or use in practice
The ECAPM allegedly adjusts for early findings
that the estimated risk-free rate exceeds its
realized value when its realized value is proxied
by the Treasury Bill rate. However, regulatory rate
setting uses the higher long Canada rate
Thus, how many times do we need to adjust for
the same problem?
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Beta estimation problem #3 – No downward beta
adjustment when using the US market risk premium
It is well known in finance that different beta estimates are
obtained using different market proxies
Our evidence shows that the beta of interlisted Canadian
utilities using the U.S. index is lower than that using the
Canadian index
Thus, when using the higher US equity risk premium, Dr.
Morin should have used a lower beta
In integrated markets, such as for the interlisted shares of
Hydro if it was a public company, the same firm has the
same return in both markets
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Market risk premium estimation problems
• Market risk premium problem #1 – Dr. Morin
only uses historical arithmetic mean returns
- Counter to the underlined IR response by Dr. Morin,
many textbooks on finance & scientific journals
advocate a major or exclusive role for the geometric
mean in computing the costs of capital
- Dr. Morin gives the geometric mean no role; we
give it an equal role
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Market risk premium problem #2- Choice
of return series for determining the market
risk premium
If Dr. Morin believes that the longest time
period is best, why did he not extend the
time periods of some known studies either
forward or backward in time when such was
possible?
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We document the impact of extending the
series & for the correction of apparent
calculation errors on his estimates
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We also calculate the sizeable impact from
adding 2002 realized returns to his
estimates
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Two of the 6 studies used in his estimation of the market
risk premium use a DCF analysis
His DCF analyses on Canadian and U.S. markets are
extremely unreliable for such reasons such as:
• His constant growth discounted dividend valuation model
assumes that the growth of dividends, earnings, book value
& stock prices are identical and constant forever
• Although the growth of earnings and dividends are assumed
to be equal for this model to be valid, he obtains, for
example, his estimate of the growth rate for Canadian
dividends of 10.3% by averaging the projected dividend
growth rate of 5.4% with the projected earnings growth rate
of 15.1%. We do not consider 5.4% and 15.1% to be
approximately equal!
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If the long-run annual rate of inflation is assumed to be 3%, then
Dr. Morin is estimating that his sample of Canadian firms is
expected to grow forever at an annual rate of 7.3%
These forever dividend and earnings growth rates greatly exceed
expectations for the growth rate in the Canadian economy
Dr. Morin's 5-year expected growth rate makes no adjustment
for the historic low in the earnings of Corporate Canada in 2001.
High 5-year growth rates from a low base are seldom good as
forever forecasts
Dr. Morin's analysis makes no adjustment for the known upward
bias in bottom-up analyst forecasts. This bias can be as high as
20% for the next year's earnings forecast, & the inflated
forecasts tend to grow for more distant forecasts
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Market risk premium problem #3 – Use of DCF
estimates of fair return as check of ROE
recommendations
• Circularity is a particular problem for DCF use for
individual firms in regulated industries; analysts base their
expectations on the rate of return allowed by regulatory
bodies
• The DCF model assumes that returns are set competitively.
We provide evidence that such is not the case, since
investors have reaped annual free lunches form their utility
investments in Canada
• Furthermore, the 2001 study by Richard Bernstein and Lisa
Kirscher finds that the S&P Utility Index outperformed the
Nasdaq index since the inception of Nasdaq in 1971; a
higher annual return while incurring less risk
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Comparison of the recommended rates of return
against those generated using adjustments
formulas
• The formulas embody the risk -free and the required risk
premium deemed appropriate by various regulators for
determining the rate of return on equity for an average
utility
• Using our forecasted rate of 6% in five adjustments
formulas produces an average risk premium of 363
basis points with a relatively narrow range of 345 to
381 basis points
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The resulting average rate of return on equity of 9.62% is
lower than Dr. Morin's recommendation of 10.5 to 11%
and higher than our recommendation of 8.45%
However, the average recommended ROE drawn from
these regulatory formulas is a generous upper bound
This average return needs to be adjusted downwards to,
first, reflect the relatively lower risk of HQ DIST, &
second to reflect the fact that these formula were set in a
higher risk premium regime. Our evidence presents a large
body of argument showing that the equity risk premium is
expected to be considerably lower in the future than it was
in the past
COMMENTS BY WARREN BUFFET
ABOUT DERIVATIVES
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DERIVATIVE INSTUMENTS WERE
“FINANCIAL WEAPONS OF MASS
DESTRUCTION”
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THEY “POSED A “POTENTIALLY
LETHAL” THREAT TO THE ECONOMY
UNDERLYING REASON
§
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REFLECTED HIS FRUSTRATION AT
BEING UNABLE TO EXTRACT
BERKSHIRE FROM GENERAL RE
SECURITIES
LATTER HAS PORTFOLIO OF
“EXOTIC” PRODUCTS THAT WAS
PROVING IMPOSSIBLE TO UNWIND
QUICKLY
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VERY LONG DATED PRODUCTS WITH
TERMS IN EXCESS OF 10 YEARS
IN COMPARISON TO AVERAGE 5
YEAR TERM OF CREDIT
DERIVATIVES
WITH TOTAL RETURN
CHARACTERISTICS
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E.G., SECURITIES WHOSE
PERFORMANCE LINKED TO 30-YEAR
YIELD CURVE & OTHER VOLATILE
BENCHMARKS
CREDIT DERIVATIVES MARKET
§
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RELATIVELY SMALL
REGULATORS OCCASIONALLY
EXPRESS PUBLIC CONCERN ABOUT:
• LACK OF TRANSPARENCY IN THIS
MARKET
• INABILITY TO MEASURE EXPOSURE
ACCURATELY