Perspective on Canadian Gas Pipeline ROEs
February 2008
Scope
This document outlines key facts and views regarding return on equity (ROEs) on Transmission
Pipelines in Canada, with a specific focus on gas pipelines. It has been prepared by the
Canadian Energy Pipeline Association (CEPA) to support engagement and discussion of ROE
issues amongst CEPA members who are operating natural gas transmission systems and with
associated policy makers, regulators and stakeholders.
2
Summary
Several Canadian regulatory jurisdictions have in existence similar formulas to determine
allowed rates of return on common equity (ROEs) for utility and pipeline assets. While there is
merit (eg. efficiency, link to debt markets) in using a formula approach to ROE, the ROEs that
result from the current formulas are too low, causing unfair returns.
This paper, which is
focused on ROEs for natural gas transmission pipelines, provides the facts supporting this
position, and other background information to generate discussion on this topic.
The background information provided includes the legal obligation for regulators to provide fair
returns on invested capital, the methods that can be used to estimate an appropriate ROE, and
the ROE formulas currently in place.
The following facts are presented to support the position that gas pipeline ROEs are too low:
•
U.S. and Canadian gas pipelines had similar ROEs at the time ROE formulas came into
use, but now U.S. gas pipelines have much higher ROEs, despite a relative increase in
the business risk of Canadian gas pipelines;
•
U.S. local gas distribution companies (LDCs) had similar ROEs at the time ROE
formulas came into use, and now U.S. LDCs have much higher ROEs despite being less
risky;
•
ROEs contractually negotiated for Canadian pipelines are consistently higher, and the
difference is likely greater than can be accounted for by additional risks inherent to
negotiated settlements;
•
Analysis of Canadian stock market data shows that investors expect higher returns; and
•
Since the ROE formulas were originally adopted, capital markets have changed in ways
that have led investors to require higher equity returns than those resulting from singlevariable ROE formulas.
To assist the discussion, this paper also addresses some common challenges to the assertion
that ROEs are too low.
CEPA intends this paper to be complementary to a paper issued by the Canadian Gas
Association (CGA) in May 2007. The CGA’s paper addresses ROEs from the perspective of
3
natural gas LDCs. CGA members also have formula-generated ROEs, and suffer from unfair
rates of return as a result.
Background
Who is the Canadian Energy Pipeline Association (CEPA)?
CEPA represents Canada's energy transmission pipeline companies. Its members transport
97% of Canada's daily crude oil and natural gas production from producing regions to markets
throughout Canada and the U.S. CEPA members operate over $20 billion in assets and project
$1 billion per year of capital investments over the next 2 decades. Collectively, total assets are
projected to double over the next 15 years in order to meet the needs of energy producers and
consumers.
In order to ensure that the Canadian gas pipeline industry continues to be
maintained and expanded to meet these needs, sufficient returns are required on capital
invested.
The Fair Return Standard
Regulators allow the recovery of all prudently incurred and reasonable costs required to provide
service. These costs include the cost of capital employed, for which regulators are required to
provide a fair return.
The “fair return standard” is based on court rulings on cost of capital
matters, and has three elements. A return is fair if 1) it enables the utility to attract capital on
reasonable terms, 2) maintains the financial integrity of the regulated entity, and 3) is
comparable to the returns available to enterprises of similar risk.
The fair return standard is not only a legal requirement but it is also based on sound economic
theory. It ensures that necessary regulated systems remain financially healthy and that its
investors are compensated appropriately and equitably.
The first two parts of the fair return standard, capital attraction and financial integrity, are related
but distinct tests. The capital attraction standard ensures the regulated entity can attract the
capital it requires to grow and maintain its system. The financial integrity standard requires that
the return allowed be sufficient to assure confidence in the financial soundness of the regulated
4
entity. In approving a cost of capital, regulators must consider the financial soundness of the
regulated entity and the risk that it could be unable to attract capital on reasonable terms. This
should have nothing to do with the ownership of the regulated entity. The company which owns
the regulated entity may be stronger or weaker financially, and may have more or less difficulty
raising capital than the regulated entity would. To address this, regulators follow the “standalone principle” whereby cost of capital decisions are made for the regulated entity as if it were
a stand alone company. i In other words, the regulator asks how financially sound the regulated
entity is and whether it could raise capital on its own; the financial soundness and ability of the
parent company to raise capital are irrelevant.
The third part of the fair return standard, that the return be comparable to that of entities with
similar risk, has clearly not been met in recent decisions. Too often regulators have used
differences between comparators as reasons not to compare rather than as considerations in
how to compare. Regulators have rejected comparison to US pipelines, ii oil pipelines, iii or to
pipelines who have negotiated their rates through settlement agreements. iv
There are few
sources for comparators, and it is circular to compare to other pipelines whose returns are also
based on an ROE generated the same way. Thus, where differences exist, the onus is on
regulators to exercise reasoned judgment and consider differences while making comparisons.
Otherwise, the fair return standard, which legally requires comparisons, is not met.
The fair return standard applies to the overall cost of capital, comprised of the cost of debt and
the cost of equity. This paper focuses on ROE because debt rates are rarely contentious,
equity ratios have been deemed by Canadian regulators based on individual business risks, and
since ROEs are set by formulas which apply to many pipelines.
Methods of Estimating an Appropriate ROE
Setting an appropriate ROE is a challenge that requires regulators to not only understand and
measure risk, but to put a price on risk differences based on an understanding of how risk is
being priced in the capital market. Academics do not agree on a single method or test to
determine an appropriate ROE. They have a number of methods to estimate the cost of capital,
each with its own underlying theory and its own unique shortcomings.
Estimating an
appropriate ROE with any of these methods involves the challenge of gathering an appropriate
sample. While the results of all methods have been considered by regulators in the past, the
5
most recent EUB and NEB decisions have relied primarily or solely on Equity Risk Premium
(ERP) based methods. v, vi
The methods of estimating cost of capital fall in three broad categories: the Comparable
Earnings (CE), Discounted Cash Flow (DCF), and Equity Risk Premium methods. The CE
method compares the actual ROEs earned by companies with comparable risk. While this
method relies on accounting data which can be affected by accounting concepts such as
accruals and gains and losses on sales, it is a straight-forward application of the comparable
return standard.
The DCF method is universally accepted in the U.S. and universally given little or no weight in
Canada recently. It is based on the constant dividend growth model and the theory that the
appropriate cost of equity is the risk-adjusted discount rate applied to dividends to obtain the
current value of a stock. The formula is;
Price =
Next Year' s Expected per unit Dividends
ROE - Growth Rate
This formula is then rearranged to back-out an estimate of the ROE from data on the current
stock price, expected dividends, and the projected growth rate. After selecting a sample, the
main challenge of this method is determining estimates of future growth rates. These estimates
normally rely on economic growth forecasts and dividend growth forecasts published by equity
analysts. One advantage of this method is that investors and investment analysts routinely use
the formula above in making valuations. The DCF method is also a forward-looking test, unlike
most other tests.
The ERP method determines an ROE as the sum of a risk-free rate of return plus a risk
premium. The theory is that the risk-free rate of return compensates investors for the time value
of money while the risk premium compensates for any additional amount of risk. The Capital
Asset Pricing Model (CAPM) is the traditional ERP model, and is represented by the following
formula:
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ROE = RF + β × MRP
where RF is the risk-free rate of return, MRP is the market risk premium which is the marketdetermined price for the average amount of risk, and β is the entity’s risk relative to the average
market risk. The unique challenge with this CAPM method is estimating β and the MRP through
statistical analysis of stock market data.
A relatively new ERP method is the Fama-French model. It is based on evidence that the
CAPM model underestimates the return on equity for low beta stocks and for high value stocks
(stock with a low market to book ratio). vii These biases of the CAPM model would cause an
underestimation of the appropriate ROE for a Canadian gas pipeline. To correct for these
biases in the CAPM model, the Fama-French model adds variables for company size and
company value to the traditional CAPM model. The formula for this method is;
ROE - RF = α + β1SMB + β 2 HML + ε
where
ƒ
α is the abnormal returns of the company’s stock;
ƒ
SMB is the size factor (small market capitalization returns minus big market
capitalization returns);
ƒ
HML is the book-to-market factor (high B/M returns minus low B/M returns);
ƒ
β1 and β2 are the respective sensitivities of stock to the SMB and HML risk factors;
and
ƒ
ε is the diversifiable or firm specific risk.
Another approach to estimating cost of equity that can be combined with these methods is the
After-Tax Weighted Average Cost of Capital (ATWACC) method. It is based on the premise
that the overall after tax cost of capital is constant over a wide range of capital structures.
Based on this premise, either an ATWACC should be approved by the regulator or ROE and
capital structure should be considered together, not in isolation, to result in a fair return.
ATWACC’s are a real-world measure, since businesses consider whether the ATWACC of a
project is above or below a hurdle rate of return when considering whether or not to proceed
with that project.
7
There are many methods and variations of methods which can be used to estimate the cost of
capital. However, when parties prepare evidence for a cost of capital proceeding, they typically
present a method that has been accepted in the past. If new methods are disregarded because
they are new, regulators will end up with a very narrow, and possibly outdated view when
evaluating cost of capital evidence.
Current ROE Formulas
The British Columbia Public Utilities Commission (BCUC) was the first Canadian regulator to
establish a formula ROE and was followed by the NEB and three other provincial regulators.
These regulators use virtually identical ERP-based formulas to set approved ROEs each year
by adjusting the previous year’s ROE by a proportion of the change in the forecast long-term
Government of Canada bond yields (a measure of the risk-free rate of return). The table below
provides the results of these formulas in 2007 and 2008, which are very similar, and average
8.51% in 2007 and 8.78% in 2008.
Approved Formula ROEs
Jurisdiction
National Energy Board
Alberta Energy and Utilities Board
British Columbia Utilities Commission
Ontario Energy Board
Enbridge
Union
Québec régie de l'énergie for Gaz Métro
Formula
Implemented
1995
2004
1994
1997
1997
1999
2007 ROE
2008 ROE
8.46%
8.51%
8.37%
8.41%
8.54%
8.76%
8.71%
8.75%
8.62%
not available
not available
9.05%
As bond yields have dropped, so have the formula generated ROEs. The ROE in the 1995
base year of the NEB Formula was 12.25%, and has fallen by 379 basis points relative to 2007.
The ROE awarded for the 2004 base year of the EUB formula was 9.60%, and has fallen by 109
basis points relative to 2007.
8
Growing Gap Relative to U.S. ROEs
Formula ROEs have dropped in Canada, while gas pipeline ROEs approved by the U.S.
Federal Energy Regulatory Commission (FERC) have not, as shown below.
NEB Formula vs U.S. Gas Pipelines
ROE
NEB Formula ROE
US ROEs (FERC Approved Litigated Cases)
US ROEs (FERC Approved Settlement Cases)
15%
14%
13%
12.25%
12%
11.25%
11%
10.67%
10.21%
9.90%
10%
9.53%
9.61%
9.58%
9.56%
9.79%
9.46%
8.88%
9%
8.71%
8.46%
8%
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Source: FERC Decisions
Over this time period, Canadian pipelines have faced increasing risks as they have entered a
competitive age and faced increased supply risk, while U.S. gas pipelines have not faced such
structural changes. In any event, it would be difficult to argue that U.S. gas pipelines have
experienced an increase in relative risk since 1995.
U.S. gas pipeline ROEs are relevant for comparison.
Markets continue to globalize, and
investors can now switch their investments between Canada and the U.S. as easily as switching
between sectors within the same country. There are also no material differences in fiscal or
monetary policy to affect comparability. In other words, higher ROEs are easily available to
Canadian investors who invest in U.S. gas pipelines instead of Canadian gas pipelines.
Comparison to U.S. regulated entities is logical since they a have similar regulatory model.
9
Whether subject to Canadian or U.S. FERC regulation, a gas pipeline faces the same long term
risk of failing to recover the capital invested.
As mentioned, the FERC uses the DCF methodology to set approved ROEs for gas pipelines.
Like all methods, the DCF method includes the challenge of finding an appropriate comparator
group. Recent merger and acquisition activity in the U.S. had limited the DCF sample, or “proxy
group.”
As a result, the FERC began adding LDCs to its proxy group, and making ROE
adjustments to account for the greater risk of pipelines relative to LDCs.
The FERC recently
issued a Policy Statement proposing that pipelines organized as Master Limited Partnerships
(“MLPs”) be included in the proxy group to increase its size. viii
Based on research by the
Interstate Gas Association of America, including MLPs in the sample should tend to increase
the ROEs that result from the DCF test. ix
The NEB formula ROE has also dropped significantly in relation to the ROEs of U.S. gas and
electric LDCs. A recent Concentric Energy Advisors report prepared for the OEB concluded
that there are no significant differences that would lead to a difference in investor required
returns for Canadian and U.S. LDCs. x By extension it can be concluded that U.S. LDCs are
less risky than Canadian gas pipelines, since gas pipelines have no franchises and greater
supply, market and competitive risk. The figure below shows that the NEB formula return has
dropped significantly and is now below the ROEs awarded to U.S. gas and electric LDCs.
10
NEB Formula vs U.S. Gas & Electric LDCs ROE
NEB Formula ROE
U.S. Gas & Electric LDCs
16%
15%
14%
13%
12.25%
12%
11.25%
11%
10.67%
10.21%
9.90%
10%
9.79%
9.61%
9.58%
9.53%
9.56%
9%
9.46%
8.88%
8.71%
8%
1994
8.46%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Source: Public Utilities Fortnightly
A gap has clearly grown between Canadian and U.S. ROEs, which cannot be explained by
changes in relative risk.
Gap Relative to Negotiated Canadian ROEs
Pipelines and their customers often negotiate an explicit ROE for a new or an existing pipeline.
These ROEs are invariably higher than the formula ROEs at the time. The ROE negotiated in a
single settlement reflects a negotiated trade-off between ROE and other risk factors. However,
the fact that all settled ROEs are significantly higher than the alternative formula ROE suggests
that pipelines and their customers are able to agree that formula ROEs do not appropriately
reflect the cost of equity capital.
It is worth noting that for U.S. gas pipelines, the ROEs
determined in litigated cases and settlements are very similar, as shown above.
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While Canadian pipelines may accept increases in short-term risk in some settlements, this
cannot explain a 200 to 400 basis point premium over the formula ROE. The following table
shows some negotiated ROEs. ROEs established as a premium to the NEB formula would be
reset upon a change in the NEB formula. Note that several of these examples are for oil
pipelines, where transportation costs have historically been small in relation to the value of the
commodity in comparison to gas pipelines, and where settlements have been more prevalent.
Pipeline/Pipeline Project
Alliance (2000 to 2014)
M&NP (2007 settlement)
Trans Mountain
(2006 to 2010 Settlement)
Alberta Clipper
Line 4 Extension
Mackenzie Valley
Southern Lights
ROE
11.25%
13%
10.75%
NEB Formula ROE + 225 Basis Points
NEB Formula ROE + 225 Basis Points
NEB Formula ROE + 221 Basis Points
12%
The evidence suggests that in Canada, formula returns are a floor for negotiations, and not a
level that parties consider a reasonable benchmark. As a result, they affect the returns that are
negotiated, as the fall-back to settlement.
Analysis of Canadian Stock Market Data
CEPA retained Dr. Stephen Gaske, a cost of capital expert, to conduct an ERP-based analysis
as a further indication of whether current formula-based ROEs are reasonable. His analysis,
appended to this paper, is a straightforward analysis of two samples of Canadian stocks. His
Energy Transportation Sample (consisting of Emera, Enbridge, Fortis, TransCanada, Canadian
Utilities, Westcoast and Terasen while still public) has an average equity risk premium over the
past 23 years of 7.6%, which results in an 11.88% ROE when added to current long term bond
yield. In his opinion, this result appears more reasonable than the ROEs currently produced by
Canadian ROE formulas. Dr. Gaske also evaluates equity risk premiums over time, and finds
that the moving averages for both samples have been increasing.
These results support
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CEPA’s position that the current formula-based ROEs are too low, and that it is time to open up
broader discussion on this topic.
Changes in Financial Markets
The ROE required to meet the fair return standard depends on the price investors put on
differences in risk and the accessibility of capital, which are determined in competitive capital
markets.
Its determination is too complex to be captured by any single-variable formula.
Capital markets have changed significantly since ROE formulas were established, increasing
the returns required by investors.
This is visible in the following figure which shows an
increasing spread between earnings yields and long-term bond yields since ROE formulas
came into use. xi
Earnings Yield - Government Bond Yield Spread
S&P 500 Earnings Yield less U.S. 10-Yr. Treasury Bond Yield
S&P/TSX Comp. Earnings Yield less Cdn. 10-Yr. Canada Bond Yield
6.0%
4.0%
2.0%
0.0%
-2.0%
-4.0%
-6.0%
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Not only have capital markets changed in ways not captured by ROE formulas, but the one
variable they do rely on may no longer be a good measure of the risk-free rate of return. Since
the federal government has been reducing the amount of federal debt, and the supply of long
13
term government bonds has decreased while the economy has been growing, the price of
bonds has increased and bond yields have been reduced.
Thus, improved government
finances have artificially reduced pipeline ROEs.
The following figures show the decline in bond yields and the current low spread between 10
and 30 year bond yields.
10 & 30 Year Canadian Bond Yield
10 Year
30 Year
9.0%
8.0%
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
14
10-30 Year Canadian Bond Yield Spread
(Basis Points)
60
50
40
30
20
10
0
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
-10
-20
-30
It would be a coincidence if a single variable formula set as long as 13 years ago generated a
reasonable ROE today. It is equally unlikely that a reasonable return result could be set for the
year 2021 with a formula determined today.
Potential Questions
In order to advance discussion on this topic, this section addresses some questions that may be
raised in response to this paper.
Why have gas pipelines not applied for higher ROEs if they are too low?
Each company has its own motivations, but there are some common reasons. ROE litigation is
costly and contentious, and the evidentiary standard may be high given the subjective nature of
the matter. Settlements are typically preferred if they result in an increase in ROE relative to the
formula result. Settlements allow pipelines and their customers to collaborate on other matters
instead of opposing each other in lengthy, adversarial proceedings.
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Why does investment continue if the ROE is too low?
As long as a gas pipeline operates, its owners will continually invest to maintain safe operations.
Investments are also made to serve new customers. These are long term investments, and are
made with the expectation that the returns will be fair over the life of the asset. Expansions and
extensions are also required in order to avoid bypass by a competing pipeline, which would
undermine the value of the initial investment.
Without an improvement in formula-based returns, Canadian pipeline infrastructure investment
is being put at risk, along with the development of Canada’s natural resources. If investors
begin to lose faith that a regulator will award reasonable returns, they will be less likely to invest
in that jurisdiction. It could take many years of corrected action by regulators before investors
regain confidence, during which economic development could be impeded.
Why are entities earning formula ROEs purchased for more than book value if ROEs are too
low?
Recent purchases above book value have suggested to some that formula-based returns are
higher than the cost of capital to investors.
Apart from the fact that book values are an
accounting construct, there are a number of other reasons investors would pay more than book
value for an asset. A few examples are creative financing, expectations of higher returns (either
by regulatory change or settlement/incentives), and strategic value. There have also been
cases where, in hindsight, too much has been paid for a regulated asset. xii
Why are stock prices and credit ratings unharmed if ROEs are too low?
There is no gas pipeline in Canada which trades on the stock market as a “pure play” gas
pipeline.
They are all held by parent companies with other assets or include other non-
regulated assets. Considering the stock prices and debt ratings of a parent company is not
consistent with the stand-alone principle described above. While some regulated entities may
be rated by credit ratings agencies, these ratings are affected by the credit quality of the parent
organization.
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Further, there is evidence that the investment community is concerned about the ROEs
awarded to gas pipelines, as described in the NEB’s 2007 Hydrocarbon Transportation System
Assessment:
Many analysts expressed support for a formulaic approach to determining ROEs
because of the transparency, stability and predictability that this method
provides. However, a number expressed the view that the ROE resulting from the
formula was too low, and contend that they are much lower than regulated ROEs
in the U.S. and U.K. While views ranged widely on this issue, some felt that the
typically lower ROEs in Canada were not justified by the differences in risk for
Canadian companies compared to FERC-regulated pipelines. Some parties
suggested it was time for the Board to revisit the ROE Formula. xiii
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Conclusion
Canadian gas pipelines are being awarded formula ROEs that result in unfairly low returns.
U.S. gas pipelines and LDCs, and Canadian pipelines who settle their returns, have ROEs 200
to 400 basis points higher than formula ROEs. Dr Gaske’s conclusion is within this range,
based on a simple ERP-based statistical analysis of utility index data. It is no surprise that
formulas are unable to track the dynamics of a capital market, which incorporates the
expectations of investors based upon all available information.
The time has come for
stakeholders to engage in discussion on this matter, and to consider the potential
consequences of awarding low ROEs for energy infrastructure.
Endnotes
i
The EUB describes the stand alone principle as follows: “The Board accepts that the underpinning of the standalone principle is that the regulated utility should not be subsidizing its non-utility operations or operations of
members of its corporate family, neither should the non-regulated activities subsidize the utility operations” EUB
Decision 2003-061, AltaLink Management Ltd. and TransAlta Utilities Corporation Transmission Tariff for May 1,
2002 – April 30, 2004 TransAlta Utilities Corporation Transmission Tariff for January 1, 2002 – April 30, 2002 August
3, 2003, p 83.
ii
See for instance, NEB Reasons for Decision RH-2-2004 Phase II. TransCanada Pipelines Cost of Capital pp. 7071. April 2005; EUB Decision 2004-052 Generic Cost of Capital p.26. July 2, 2004.
iii
NEB Reasons for Decision RH-2-2004 Phase II. TransCanada Pipelines Cost of Capital pp. 68-69. April 2005.
iv
NEB Reasons for Decision RH-2-2004 Phase II. TransCanada Pipelines Cost of Capital pp. 68. April 2005
EUB Decision 2004-052 Generic Cost of Capital p.27. July 2, 2004
v
The NEB used to consider the DCF and CE methods, but in the early 1990s shifted to giving most or all weight on
the results of the ERP method. The NEB primarily considered a Comparable Earnings evaluation of Canadian
industrials in RH-1-78 and RH-1-79. In RH-4-81, RH-3-82, and RH-2-83, the NEB made ROE determinations based
“on its consideration of all of the evidence presented” which included multiple estimation methods. Decision RH-1-84
states “The Board is of the view that the determination of an appropriate rate of return on equity involves the use of
methods that are subject to the exercise of judgment.” The Board made similar comments in RH-2-85, RH-3-86, and
RH-1-88 Part II. In the RH-2-89 decision the Board found that the results of DCF test “should be given weight in
assessing a fair rate of return on equity” despite “limitations of the approach.” In the early 1990’s the Board placed
the primary weight on the ERP method and placed less weight on the CE and DCF methods (decisions RH-1-91 and
RH-2-92). In RH-4-93 the Board put “little or no weight” on the results of the CE and DCF methods, stating that
“these tests may prove useful under different economic conditions.” In the last NEB ROE decision, RH-2-94, the
Board “decided to give primary weight to the results of the equity risk premium test.”
vi
The EUB once gave some weight to the results of the DCF test, but most recently placed no weight on the results of
the DCF test. From 1990 to 1994, the EUB gave less weight to the results of the DCF method than the ERP method.
For instance Decision E94060 states "The Board has in the past found that none of the methods advocated by the
expert witnesses necessarily yields or provides a precise measurement of the fair rate of return on equity. However,
the Board considers the results of each method helpful in its deliberations…The Board has taken note of the caution
expressed by each of the expert witnesses respecting the use of the DCF method in today’s economic environment.
The Board accepts that less weight should be placed on the absolute results of the DCF method under current
economic conditions.” The EUB moved from “less weight” to “little weight” on DCF results in Decision U96001, also
because of the effects economic conditions at the time may have had on the results of the DCF test. In the Board’s
Generic Cost of Capital Decision (Decision 2004-052), the results of the DCF test were given no weight, as the Board
was convinced by interveners that “the analysts’ earnings forecasts used in the development of the DCF estimates
have been biased high.”
vii
Eugene F. Fama and Kenneth R. French, “The Capital Asset Pricing Model: Theory and Evidence” Journal of
Economic Perspectives, Volume 18, Number 3, Summer 2004, Pages 43-44.
viii
FERC, Proposed Policy Statement on Composition of Proxy Groups for Determining Gas and Oil Pipeline Return
on Equity, Issued July 19, 2007.
ix
Smead, Richard G of Navigant Consulting Inc. paper prepared for the Interstate Natural Gas Association of
America, “Allowed Returns on Equity in the Interstate Gas Pipeline Industry: Issues and Options Regarding the FERC
DCF Approach,” August 24, 2006.
x
Concentric Energy Advisors, A Comparative Analysis of Returns on Equity of Natural Gas Utilities, prepared for the
Ontario Energy Board, pp. 3, 57, 58.
xi
The Earnings Yield is earnings in the stock market divided by the sum of stock prices. This measure can be
compared to the yield on debt.
xii
On August 2, 2005 Kinder Morgan announced that it had agreed to acquire Terasen for US$5.6 billion or 2.6x
estimated 2005 book value per share. Since then, Kinder Morgan has moved aggressively to divest non-core assets
19
acquired in the Terasen Inc. transaction. On February 26, 2007, it announced that it has agreed to sell Terasen Gas
Inc. to Fortis Inc. for C$3.7 billion and on March 5, 2007, Kinder Morgan announced that it has agreed to sell the
Corridor Pipeline and the $1.8 billion expansion of that pipeline to Inter Pipeline Fund for $760 million and $300
million of assumed debt relating to the expansion.. On April 30, 2007, Kinder Morgan Energy Partners completed the
purchase of the Trans Mountain Pipeline system from Kinder Morgan for US$550 million plus US$450 million of
assumed debt. In its Form 10-Q filing for the period ending March 31, 2007, Kinder Morgan Inc. announced that it
has recorded a goodwill impairment charge of US$377.1 million relating to the Trans Mountain transaction. This
charge is in addition to the US$650.5 million impairment charge recorded in its Form 10-K filing, resulting from the
Terasen Inc. - Fortis Inc. transaction.
xiii
NEB, Canadian Hydrocarbon Transportation System: Transportation Assessment, July 2007, p. 40.
20
Appendix
Risk Premium Analysis
Dr. Stephen Gaske
Canadian regulators currently set the rate of return on common equity for regulated pipelines by
using “equity risk premium” formula ROEs calculated each year by adding a percentage of the
change in yields on Bank of Canada bonds to the previous year’s ROE. The risk premium
approach explicitly recognizes that pipeline equity is riskier than long term Bank of Canada
bonds, and therefore that the expected return on equity should be higher in the pipeline industry
than the yield on Bank of Canada bonds. Although there is no doubt about the need for a risk
premium, the difficult problem for a regulator is to determine the size of the premium that is
required in order for a pipeline to attract capital on reasonable terms. However, just as bond
yields change from year to year, the required level of the premium also changes continually in
response to (i) changes in the financial market in general, and (ii) to changes in the risks of
pipelines in particular.
The formula currently used to estimate ROEs can generally be written:
ROE in Year 2 = ROE in Year 1 + 75% of the change in the forecast bond yield
This formula mechanically adjusts the allowed ROE in response to changes in interest rates.
The allowed ROE moves up and down at 75% of the change in the forecast bond yield. As a
result, the size of the risk premium is adjusted each year by an amount equal to -25% of the
change in the bond yield. The mechanical adjustment in the size of the risk premium is
designed to make a rough adjustment for changes in the financial market in general by
assuming that the risk premium is greater when interest rates are relatively low and that a
smaller risk premium is required when interest rates are relatively high. While this might be a
reasonable representation of how the required risk premium is likely to react in the short run to
changes in financial market conditions (for which changes in the interest rate is intended to be a
rough proxy), there is nothing in this formula that allows the risk premium to adjust in the long
run if the relative risks of pipelines change over time. Consequently, it may be necessary to recalibrate the formula periodically.
To test whether the current formula is reasonably accurate, and to determine whether the
required risk premium may have changed significantly through the years, this analysis reviews
bond yields and market returns on utility common equity for various time periods during the 51
year period 1956-2006. Market returns on common equity were evaluated with two indices:
1. The S&P/TSX Capped Utilities Index (S&P/TSX Utility Sample), for which data are
available for the 1956-2006 time period. The S&P/TSX Utility Sample currently consists
of Algonquin Power Income Fund, ATCO Ltd., Canadian Utilities Limited, Emera Inc.,
Energy Savings Income Fund, EPCOR Power L.P., Fortis Inc., Northland Power Income
Fund, TransAlta Corp., and TransAlta L.P.
2. A sample with a focus on corporations with pipeline or other energy transportation
assets (Energy Transportation Sample). The Energy Transportation Sample is a better
proxy for gas pipelines since it does not include less relevant utility companies (those
that are primarily energy retailers or power producers), and includes pipeline companies
not includes in the S&P/TSX Utility Sample (Enbridge, TransCanada, and, for years in
which they were traded, Westcoast and Terasen). Therefore the Energy Transportation
Sample consists of Emera, Enbridge, Fortis, TransCanada, Canadian Utilities,
Westcoast and Terasen. Data for this sample is only available starting in 1983.
The “Total Returns” used in these two indices are calculated each year by dividing the dividends
plus changes in stock price during the year, by the stock price at the beginning of the year.
Both indices are constructed using the assumption that all dividends are reinvested in the
company.
Risk premiums were calculated each year by subtracting the Bank of Canada bond yield from
the Total Return experienced by each stock sample.
The Energy Transportation Sample experienced an average risk premium of 7.6 percent
between 1983 and 2006. The S&P/TSX Utility Sample experienced an average risk premium of
5.12 percent over the period 1956-2006, and 9.53 percent over the period 1983-2006. These
results are shown in Exhibit 1, and summarized in the Table below:
Average Total Returns and Risk Premiums
1983-2006
Average
1956-2006
Average
Long Term
Canada
Bond Yield
7.95%
7.68%
Energy Transportation Sample
Total
Risk
Return
Premium
15.55%
7.60%
S&P/TSX Utility Sample
Total
Risk
Return
Premium
17.48%
9.53%
not available
12.79%
not available
5.12%
When evaluating pipelines, the Energy Transportation Sample should be a better indicator of
required returns than a broader sample. Consequently, the 7.6 percent average risk premium
for pipelines should be a better estimate of the required risk premium than risk premiums
calculated for the S&P/TSX Utility Sample. Adding the 4.28 percent bond yield from 2006 to the
7.6 percent risk premium would produce an allowed rate of return of 11.88 percent. This is
hardly an excessive rate of return, and appears to be far more reasonable than the ROEs
currently resulting from Canadian ROE formulas.
Analysis of both indices suggests the required risk premium has increased significantly since
the 1990’s. The chart below shows the moving averages of the risk premiums for both indices,
which have increased while the yield on long term bonds has decreased.
Changes in Average Risk Premium
and Interest Rate
1990-2006
18.00%
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
0.00%
-2.00%
-4.00%
Yield on Long-Term Canada Bond
Energy Transportation Sample Premium, 10-year moving average
S&P/TSX Utility Sample Premium, 35-year moving average
Exhibit 1
Total Returns and Risk Premiums
Year
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
AVERAGE:
1983-2006
1956-2006
Yield on LongTerm Canada
Bond
3.63%
4.11%
4.15%
5.08%
5.19%
5.05%
5.11%
5.09%
5.18%
5.21%
5.69%
5.94%
6.75%
7.58%
7.91%
6.95%
7.23%
7.56%
8.90%
9.04%
9.18%
8.70%
9.27%
10.21%
12.48%
15.22%
14.26%
11.79%
12.75%
11.04%
9.52%
9.95%
10.22%
9.92%
10.85%
9.76%
8.77%
7.85%
8.63%
8.28%
7.50%
6.42%
5.47%
5.69%
5.89%
5.78%
5.66%
5.28%
5.08%
4.39%
4.28%
7.95%
7.68%
Energy Transportation Sample
10-Yr.
Moving
Average
Annual
Risk
Return
Premium
Premium
25.63%
5.46%
18.95%
-3.48%
9.97%
7.87%
18.44%
6.35%
3.90%
-0.52%
31.45%
-2.65%
14.77%
30.69%
48.56%
4.07%
-24.02%
57.96%
14.68%
13.79%
27.71%
14.99%
32.08%
16.64%
13.84%
-7.29%
7.91%
-13.00%
0.02%
-2.35%
8.52%
-4.50%
-5.86%
-9.29%
23.60%
-11.28%
6.49%
23.19%
42.14%
-1.40%
-29.71%
52.07%
8.90%
8.13%
22.43%
9.91%
27.69%
12.36%
15.55%
7.60%
-1.20%
-0.23%
-0.62%
-0.77%
2.85%
7.07%
7.16%
3.34%
8.99%
10.47%
12.21%
12.10%
14.21%
16.33%
15.25%
S&P/TSX Utility Sample
Annual
Return
0.17%
-3.43%
9.81%
0.21%
26.81%
19.17%
-0.72%
6.19%
21.59%
4.23%
-13.17%
5.07%
7.41%
-8.62%
23.34%
4.29%
-0.44%
-4.14%
14.38%
5.75%
15.02%
19.00%
27.28%
12.61%
5.74%
-0.55%
35.90%
40.97%
24.31%
10.04%
11.48%
1.07%
5.63%
22.07%
0.58%
27.02%
-2.24%
23.52%
-6.04%
18.44%
32.68%
37.33%
36.55%
72.34%
18.70%
-25.19%
-3.86%
22.92%
18.01%
25.78%
7.36%
Risk
Premium
-3.46%
-7.54%
5.66%
-4.87%
21.62%
14.12%
-5.83%
1.10%
16.41%
-0.98%
-18.86%
-0.87%
0.66%
-16.20%
15.43%
-2.66%
-7.67%
-11.70%
5.48%
-3.29%
5.84%
10.30%
18.01%
2.40%
-6.74%
-15.77%
21.64%
29.18%
11.56%
-1.00%
1.96%
-8.88%
-4.59%
12.15%
-10.27%
17.26%
-11.01%
15.67%
-14.67%
10.16%
25.18%
30.91%
31.08%
66.65%
12.81%
-30.97%
-9.52%
17.64%
12.93%
21.39%
3.08%
17.48%
12.79%
9.53%
5.12%
35-Yr. Moving
Average
Premium
1.78%
2.37%
2.27%
2.56%
2.28%
1.95%
2.27%
3.32%
4.17%
5.61%
6.00%
5.66%
5.41%
5.90%
6.73%
6.90%
7.06%