The National Energy Board (NEB) has charted a new course for cost of capital determination. In a decision released on March 19, 2009 regarding the 2007 and 2008 cost of capital of Trans Québec & Maritimes Pipeline Inc. (TQM), Decision RH-1-2008 (TQM Decision), the NEB departed from its long-standing, formulaic methodology and adopted a market-based approach for TQM, based on an After Tax Weighted Average Cost of Capital (ATWACC) methodology. Stikeman Elliott acted as counsel to TQM.
The TQM Decision has potentially significant ramifications for other pipelines regulated by the NEB and for the returns allowed to other regulated utilities in Canada.
Cost of capital - background
Regulation is a surrogate for competition in the determination of the price that a regulated utility may charge for its services. The major elements of that price are (1) operating, maintenance and administrative expenses, (2) depreciation (return of capital) and (3) cost of capital - the return on the capital (equity and debt) invested in utility assets that provide service. The cost of capital is the largest component of the utility revenue requirement that is included in utility tolls charged to customers.
In the context of transmission pipelines, where the prices of natural gas and oil are determined in the marketplace and pipelines are purely transporters rather than merchants, the ultimate effect of the transportation cost is borne by the producers of the commodity. Simplistically, if the transportation tolls go up, the netback to the commodity producer goes down and vice versa. Cost of capital is therefore a very contentious issue between the pipeline owners and the shippers that use them. The obligation of pipeline management is to seek a return for utility shareholders that is commensurate with the returns available from investments of similar risk. The interests of customers lie in minimization of the tolls paid for safe, efficient transportation service.
The task of the regulator, in this case the NEB, is to determine the fair return, which has been judicially defined (as the "fair return standard") to mean a return that is commensurate with returns available from investments of similar risk, that maintains the financial integrity of the regulated enterprise, and that permits attraction of incremental capital on reasonable terms and conditions.
Historical cost of capital determination
The NEB has historically determined cost of capital for the pipelines it regulates by first setting a deemed capital structure or equity/debt ratio (e.g. 30% equity and 70% debt), then determining the rate of return on equity (ROE) to be applied to the deemed equity. In the past, the deemed equity has been set at a level that the NEB considered reflective of the business risks of the pipeline. The ROE has been set on an equity risk premium (ERP) basis (to reflect the premium required to entice investors to invest in utility equity, rather than in long-term government bonds), adjusted annually using a formula (ROE Formula) that was established in 1995 in the NEB Multi-Pipeline Cost of Capital Decision RH-2-94 (RH-2-94 Decision). The cost of equity (ROE x deemed equity) plus the cost of debt (actual costs, if prudently incurred) must together result in an overall cost of capital that meets the fair return standard.
The RH-2-94 Decision established deemed capital structures for pipelines within NEB jurisdiction, and stated that it would consider reassessment only in the event of significant changes in business risk, in corporate structure or in corporate fundamentals. The ROE Formula adjusted the ROE annually, based on forecast changes in long Canada bond interest rates, removing the need for frequent cost of capital applications. The NEB also stated that it did not expect to reassess the ROE for at least three years.
In 2001, TransCanada PipeLines Limited (TransCanada) challenged both the capital structure and the ROE applied to its Mainline. The NEB RH-4-2001 Decision in June 2002 declined to adopt an ATWACC approach, increased the Mainline deemed equity by 3% but declined to change the ROE Formula. The decision was upheld on review and subsequently by the Federal Court of Appeal.
The 2009 TQM Decision was the first time that the 1995 ROE Formula had been challenged since 2001.
The TQM Decision
TQM operates NEB-regulated natural gas transportation facilities in Québec on behalf of its owners, Gas Métro Limited Partnership and TransCanada. TQM receives all of its gas through its interconnection with the TransCanada Mainline, and its tolls are included in Mainline tolls as "transmission by others."
The ROE for TQM had been determined by the NEB using the 1995 ROE Formula. In the RH-1-2008 application, TQM relied on changes in financial markets and economic conditions since 1995 to seek review and variance of the RH-2-94 Decision and the determination of an overall fair return on capital through an increase in deemed equity and ROE, or through an ATWACC methodology.
In the TQM Decision, the NEB decided to depart from the traditional methodology and adopted an ATWACC approach on the basis that it most accurately reflected the way investors in pipelines and companies as a whole make decisions with respect to investing capital. This was the first time that an ATWACC methodology has been fully accepted by a North American utility regulator.
Having regard to its philosophy that pipeline companies should be regulated on a goal-oriented basis, the NEB set TQM's cost of capital on an ATWACC basis without specifying a capital structure. This was intended to give TQM the ability to determine its optimal capital structure and choose specific financial instruments without regulatory oversight. The approved TQM ATWACC includes the market cost of debt, rather than the actual cost of debt. Transitional provisions were not deemed necessary, since virtually all of TQM's debt would be reaching maturity in the near future.
The NEB awarded TQM a 6.4% ATWACC for each of 2007 and 2008, finding that it met the three components of the fair return standard (comparable investment, financial integrity, capital attraction). Expressed in ATWACC terms, the approved TQM return before the RH-1-2008 application was 5.5%. In the lexicon of the traditional methodology, TQM was moved from ROE Formula (8.46% in 2007 and 8.71% in 2008) on 30% equity to the equivalent of 9.7% on 40% equity (or 11.2% on 32%).
Significantly, the NEB also accepted the evidence of TQM that (i) Canadian and U.S. financial markets are integrated and, as a result, Canadian pipelines compete for capital with their U.S. counterparts; (ii) U.S. pipelines serve as comparables to Canadian pipelines; and (iii) U.S. local distribution companies serve as comparables to Canadian pipelines such as TQM.
What does this mean for other regulated utilities?
The TQM Decision has not been appealed. There is wide anticipation that it will have far-reaching effects on the regulatory determination of cost of capital in Canada. While the NEB was not the first to adopt a formulaic approach (the British Columbia Utility Commission did that), most other regulators in Canada chose the formula route after the federal regulator did so. The NEB move to a different (ATWACC) methodology, its acceptance of a market-based approach, including comparability of U.S. evidence, and the level of the return allowed to TQM are all precedential decisions that will have to be considered and weighed by other regulators. The NEB itself has already solicited comments (due May 25) on whether an open review of the RH-2-94 Decision should be conducted.