THE PUBLIC UTILITIES BOARD, ALBERTA

Transcription

1 THE PUBLIC UTILITIES BOARD, ALBERTA re: NOVA CORPORATION OF ALBERTA In the matter of a complaint by the Canadian Association of Petroleum Producers that the rates, tolls or charges for customers of the Alberta Gas Transmission Division of NOVA Corporation of Alberta for the calendar year 1993 are not just and reasonable. BEFORE: N. W. MacDonald T. D. Hetherington, Q. C. T. C. Roberts Presiding Member Member Member FILE

2 PUBLIC UTILITIES BOARD. Alberta TABLE OF CONTENTS TITLE PAGE... 1 TABLE OF CONTENTS... 2 APPEARANCES... 4 WITNESSES... 5 ABBREVIATIONS INTRODUCTION BACKGROUND MANNER OF DETERMINING JUST AND REASONABLE TOLLS BUSINESS RISK CAPITAL STRUCTURE COST OF PREFUNDED DEBT COST OF UNFUNDED DEBT COST OF LONG TERM DEBT COST OF PREFERRED EQUITY COST OF COMMON EQUITY COVERAGE RATIOS STANDBY FACILITY CHARGES METHOD OF COST RECOVERY ORDER Page August

3 TABLE OF CONTENTS APPENDICES 1 CAPITAL STRUCTURE, INTEREST AND FIXED CHARGE COVERAGES AND TRANSPORTATION UNIT COST... 1 page 2 REVIEW OF INTEREST AND FIXED CHARGE COVERAGES... 1 page 3 TCPL CAPITAL STRUCTURE, INTEREST AND FIXED CHARGE COVERAGES... 1 page 4 AGTD/NON-AGTD PRE-TAX INTEREST COVERAGE... 1 page

4 APPEARANCES For the Canadian Association of Petroleum Producers (CAPP) : Mr. C. K. Yates Milner Fenerty For NOVA Corporation of Alberta (NOVA) : Mr. H. D. Williamson, Q.C. Howard Mackie : Mr. J. Lutes McCarthy Tetrault For Alberta Natural Gas Company Ltd. : Ms. A. G. Menzies For Alberta Petroleum Marketing Commission : Ms. W. M. Moreland For Alberta and Southern Gas Company Ltd. : Mr. A. Blackie For CanAm Energy Inc. : Mr. E. M. Small For Hillary & Associates Inc. : Mr. R. B. Hillary For Imperial Oil Resources : Mr. R. R. Moore For the Northeast Group and Northern Natural Gas Company : Mr. L. G. Keough For Pan-Alberta Gas Ltd. : Mr. J. St. Louis For ProGas Limited : Ms. M. A. K. Muir For Western Gas Marketing Limited : Mr. D. I. D. McLean

5 0 PUBLIC UTILITIES BOARD, Alberta WITNESSES For NOVA Corporation of Alberta (Alberta Gas Transmission Division) Company Panel (Panel 1) : Mr. Bruce W. Simpson President : Mr. Robert W. Schmidt Vice President Regulatory Affairs : Mr. Richard C. Milner Vice President, Finance Expert Witness (Panel 2) : Mrs. M. Theresa McLeod Senior Vice President and Member of the Board of Directors Scotia McLeod Inc. Expert Witness (Panel 3) : Dr. Robert E. Evans Consultant Economic Research Associates Limited For Canadian Association of Petroleum Producers Expert Witness (Panel 1) : Dr. William R. Waters Consultant William R. Waters Ltd.

6 rn PUBLIC UTILITIES BOARD, Alberta WITNESSES Financial Markets Panel (Panel 2) : Mr. Kenneth D. Heulitt Director, Short-Term Investments and Borrowings Amoco Canada Petroleum Company Ltd. : Dr. John F. Kyle Vice President, Treasurer Imperial Oil Limited : Mr. Keith B. Munnoch Treasurer Shell Canada Limited : Mr. Dan B. Macnamara Vice President, Natural Gas CAPP Policy Panel (Panel 3) : Mr. S. Barry Jackson President Chief Operating Officer Northstar Energy Corporation Chairman, Natural Gas Committee CAPP : Mr. Irvine J. Koop President and Chief Executive Officer of Westcoast Petroleum Ltd. Chairman, CAPP : Mr. Dan B. Macnamara Vice President, Natural Gas CAPP

7 0 PUBLIC UTILITIES BOARD, Alberta AFUDC AGTD AGTL AGTL Act Board CAPP CD CU DCF ERCB ERP IRR NEB NOVA NOVA Act ProGas PUB Act TCPL TransAlta TSE Westcoast Allowance for Funds Used During Construction Alberta Gas Transmission Division of NOVA Corporation of Alberta Alberta Gas Trunk Line Company Alberta Gas Trunk Line Company Act Public Utilities Board Canadian Association of Petroleum Producers Contract Demand Canadian Utilities Limited Discounted Cash Flow Energy Resources Conservation Board Equity Risk Premium Investors' Required Rate of Return National Energy Board NOVA Corporation of Alberta NOVA Corporation of Alberta Act ProGas Limited Public Utilities Board Act TransCanada PipeLines Limited TransAlta Utilities Corporation Toronto Stock Exchange Westcoast Energy Inc.

8 1. INTRODUCTION Pursuant to Section 37(2) of the NOVA Corporation of Alberta Act, R.S.A. 1980, c. N-12, as amended (NOVA Act), the Public Utilities Board (the Board) received a complaint (the Complaint), dated December 22, 1992, from the Canadian Association of Petroleum Producers (CAPP) that the rates, tolls or charges effective January 1, 1993 are unjust and unreasonable. The Complaint was filed following NOVA Corporation of Alberta (NOVA) correspondence dated December 2, 1992 which advised all of its customers and interested parties of the transportation rates to be charged by the Alberta Gas Transmission Division (AGTD) of NOVA effective January 1, a Included in the Complaint was an application from CAPP that, pursuant to Section 52 of the Public Utilities Board Act, c. P-37, R. S.A. 1980, as amended (PUB Act), the Board establish interim rates for AGTD effective January 1, 1993 and that such rates continue in effect until the Board makes its final order after the matters have been heard and determined. CAPP requested that the Board establish interim rates for AGTD at a level which reflects a common equity rate of return of 11.25% on a common equity ratio of 25%. Notice of the hearing of the Complaint was published and served in accordance with the Board's instructions. The Board considers Notice of the hearing to be adequate.

9 1. INTRODUCTION The Board held a pre-hearing conference in Calgary with respect to the complaint on January 26, at that time. CAPP withdrew its application for interim rates CAPP, at the time of filing of its evidence, requested that the Board vary the rates fixed by AGTD for 1993 to reflect a common equity rate of return of 11% on a common equity ratio of 25%. The main hearing of the Complaint took place in Calgary from June 21, 1993 to * Written June 25, NOVA and CAPP were the only registered parties who took an active role in cross examination at the public hearing portion of the proceeding. Argument was received from NOVA, CAPP and ProGas Limited (ProGas) on or about July 9, Written Reply was received from NOVA and CAPP on or about July 23, 1993.

10 2. BACKGROUND In 1954, through the provisions of the Alberta Gas Trunk Line Company Act, the Government of Alberta established the Alberta Gas Trunk Line Company (AGTL). AGTL later became NOVA Corporation of Alberta. The Alberta Gas Transmission Division of NOVA is hereinafter referred to as AGTD. The current legislation governing NOVA is the NOVA Act. NOVA is authorized by Section 37(1) of the NOVA Act to set tolls and other charges on its system, a to adjust rates and methods of depreciation, and to determine a rate base and rate of return thereon. conditions of service for its system. Section 39(1) authorizes NOVA to prescribe terms and In place of full regulation of NOVA'S operations, the NOVA Act provides for interested parties to file a complaint against NOVA with respect to either rates and tolls or terms and conditions of service. The jurisdiction to resolve a written complaint respecting rates and tolls rests with the Board. Any order issued by the Board varying a rate, toll or other charge fixed or varied by NOVA would remain in effect for a maximum period of 12 months, in accordance with Section 37(3) of the NOVA Act. Jurisdiction to decide upon written complaints regarding terms or conditions of service rests with the Energy Resources Conservation Board (ERCB).

11 e PUBLIC UTILITIES BOARD, Alberta 2. BACKGROUND A complaint respecting the rate of return on NOVA's gas transmission division was filed in July 1970 and the Board rendered Decision dated May 25, 1971 respecting that matter. Between September 1971 and December 1, 1977, NOVA, through negotiations with its major contract customers fixed or varied its rate of return on rate base on four different occasions. In 1978, as a result of inability to reach agreement, NOVA's customers filed complaints with the Board respecting NOVA's rate of return on rate base for the gas transmission division. The Board rendered Decision E78221 dated December 21, 1978 with respect to that complaint. 0 The Board also rendered two Decisions in the period respecting income tax treatment of capital cost allowance. In these Decisions the Board considered that taxable income should be calculated on a "flow through'' basis claiming maximum capital cost allowance. These Decisions were appealed to the Alberta Court of Appeal and then to the Supreme Court of Canada. The courts upheld the Board's Decisions. Since the 1978 rate of return Decision NOVA's rate of return on its gas transmission division rate base has been fixed or varied by NOVA on twelve occasions through negotiations with an industry committee consisting of Alberta gas producers. Another complaint respecting the rate of return on NOVA's gas transmission e October 26, 1992 fixing the rate of return on common equity at 12.5% on a division was filed in December The Board rendered Decision E92086 dated

12 2. BACKGROUND deemed common equity component of capital structure of 32% for transportation rates effective from January 1, 1992 to December 31, The current Complaint reads as follows: "CAPP hereby complains to the Board that the rates, tolls or charges fixed by NOVA for the calendar year 1993 are not just and reasonable. This complaint is made in respect to the capital structure, the cost rates of the various components of that capital structure, and other financial matters which impact on the tolls charged by NOVA for transportation of gas through its facilities. More specifically, but not so as to limit the generality of the complaint, CAPP complains that the rate of return on common equity of percent and the deemed common equity component of the capital structure of 32 percent are both excessive in At the pre-hearing conference held on January 26, 1993, with the concurrence of all parties, the foregoing Complaint was further delineated into the following issues with specific reference to AGTD: (1) What is the appropriate capital structure for NOVA, including the common equity ratio and an appropriate level for such ratio; (2) What is the appropriate cost factor of each component of the capital structure, including the return on common equity; (3) Without restricting the generality of the foregoing, the effect of corporate diversification by NOVA outside the traditional utility area ; and

13 2. BACKGROUND (4) What is the appropriate method for recovery of costs of the elements of the capital structure, inasmuch as such costs may vary from time to time or be affected by the corporate diversification of NOVA. CAPP explained the reason for the Complaint with respect to 1993 rates as follows : "While CAPP was pleased that the results of the 1992 proceeding were directionally correct, it still takes the view that the tolls of the AGTD are excessive. As indicated later in this evidence various relevant events and developments that have taken place since the 1992 hearing corroborate certain positions that were taken by the complainants in that proceeding but were not accepted by the Board. There have also been several changes in circumstances and new facts that suggest reductions in the level of deemed common equity and the rate of return on that common equity are warranted, CAPP has sought to resolve the issues through negotiation with NOVA, but has been unsuccessful. The failure of negotiations caused CAPP to file its complaint. l1 (Exhibit 25, Evidence of CAPP, pp.3-4) In this Decision the Board will set out its findings respecting the foregoing issues as they relate to 1993.

14 3. MANNER OF DETERMINING JUST AND REASONABLE TOLLS The NOVA Act, Section 37(2), provides as follows: " (2) On complaint in writing of an interested party, the Public Utilities Board may, or on the direction of the Lieutenant Governor in Council shall, after notice to and hearing of the parties interested, determine the justness and reasonableness of the rates, tolls or other charges fixed or varied by Nova and by order in writing may vary or confirm the rates, tolls or other charges." Unlike the PUB Act and the Gas Utilities Act, the NOVA statute is silent as to the factors to be considered by the Board in assessing the justness and reasonableness of AGTD's The Board's 1978 determination on the appropriate treatment of income tax by the AGTD was appealed to the Court of Appeal and then to the Supreme Court of Canada. In Alberta Gas Trunk Line Company Limited vs. Amoco Petroleum Corporation (1980 3WWR 1, 13) Mr. Justice Clement of the Court of Appeal reviewed the legislation and concluded as follows: Ifwith all this, it is not to be taken that the legislature intended that the Board should not follow well established concepts and methods, but should devise for the exercise of its jurisdiction under the AGTL ACT some different precepts and principles. It would be unreasonable to come to such conclusion.11 The Board, in accordance with such well established concepts and methods, has in previous Decisions determined that AGTD should be allowed to earn a fair return on its rate base on a stand alone basis.

15 3. MANNER OF DETERMINING JUST AND REASONABLE TOLLS In Decision E92086 dated October 26, 1992, the Board recognized that NOVA is not a pure utility operation and that NOVA'S non-agtd operations include diversified activities with dissimilar business risks to those of AGTD. Accordingly, the Board considered that the components of AGTDts capital structure and the cost factor for each component should be determined on a stand alone basis consistent with its business risk and its ability to attract capital on reasonable terms. The Board notes that the amount of the AGTD rate base has been agreed upon by the parties and is not an issue before the Board in e Accordingly, the Board has proceeded on the assumption that the rate base has been determined substantially in accordance with well established regulatory concepts and methods. With respect to fair return, the Board considers that the stand alone principle requires the fixing of an appropriate capital structure for AGTD in the light of its business risk and financial circumstances and the determination of stand alone cost rates for each of the components of the capital structure.

16 3. MANNER OF DETERMINING JUST AND REASONABLE TOLLS While endorsing the stand alone principle, the Board also stated in Decision E92086 that inquiry into non utility operations would be relevant to ensure that the following criteria are being satisfied: (1) The financial integrity of NOVA is not being threatened in a way that will result in cessation of safety or service provided by AGTD. (2) The AGTD customers are not subsidizing the non-agtd operation of NOVA. The Board notes that as long as AGTD remains consolidated with NOVA'S chemical and other operations, NOVA, AGTD1s customers and the Board (when m called upon by complaint) will be required to face the contentious issue of whether or not the corporate diversification of NOVA has placed additional financing and/or other costs on AGTD1s operations. The Board also notes this is the second year in a row that a complaint has been lodged respecting AGTD's rates, tolls or charges. The Board remains available to resolve such complaints, however, the Board is hopeful that NOVA and its customers can, in future years, arrive at mutually beneficial negotiated rates, tolls or charges on the basis of the principles determined and established by the Board in this Decision and in Decision E92086.

17 4. BUSINESS RISK In addition to AGTD, NOVA carries on a number of activities including investments in both pipelines and chemicals. Parties to the 1993 proceeding agreed that the principal matter before the Board is the determination of an appropriate capital structure for AGTD and cost rates for each component of AGTD's capital structure on a stand alone basis. The determination of an appropriate capital structure and cost of capital for AGTD involves an assessment of AGTD1s investment risk. Generally, e investment risk is the risk of a market security as appraised by investors. Investment risk is in turn a function of the business risk and financial risk faced by the business entity issuing the securities. Dr. Evans, for NOVA, explains business risks thus: "Business risks are all of the physical, economic, political, competitive and regulatory risks to which the income-earning potential of the business assets are exposed. The notion of business risk is associated with the left side of the balance sheet -- the assets -- and is independent of the manner in which the assets are financed." (Exhibit 7, Vol. 2, Tab 4, p.5) In contrast to business risks Dr. Evans explains financial risks to be those "... associated with the way in which the assets of a corporation are financed... i. e., the right side of the balance sheet. These risks may be measured by reference to other balance sheet or income statement data." (Exhibit 7, Vol. 2, Tab 4, p.5)

18 * 4. PUBLIC UTILITIES BOARD, Alberta BUSINESS RISK Therefore, financial risk arises from the capital structure used to finance the assets of the corporation. Dr. Evans stated that the greater the proportion of debt to total capital on the balance sheet, the greater the financial risk. Dr. Waters noted that investment risk resulting from the use of financial leverage (i.e. use of debt and preferred fixed cost capital) is simply a multiple of the fundamental business risk of the enterprise. (Exhibit 25, p. 29) The level of a corporation's business risk determines the extent to which it can increase its financial risk, so that the overall investment risk is in the range accepted by the equity and bond markets. Financial risk is increased by lowering the amount of common equity in the capital structure thereby increasing the amount of fixed cost debt and preferred capital, the cost of which must be paid out each year. For example, a corporation with a high business risk will only be able to utilize a small proportion of debt (i.e. low financial risk) in order to produce an overall investment risk acceptable to the equity and bond markets. Similarly, a corporation with a low business risk will be able to utilize a large proportion of debt (i.e. high financial risk) in order to produce an overall investment risk acceptable to the equity and bond markets. The investment risk of most utilities would increase more slowly than that of unregulated companies if the common equity component of their capital structure was reduced. Utility earnings are insulated from increases/decreases in the rate on long term debt issues or refinancings in a risingldeclining interest rate environment. The long term debt rate approved for recovery by regulators

19 4. BUSINESS RISK would normally match interest rate increases/decreases aside from regulatory lag or an incorrect forecast for a given test year. Unregulated companies are not as insulated from increasedldecreased debt costs and the variability of their earnings is increased by the variability of debt cost rates. In the case of AGTD, cost recoveries would exactly match long term debt costs with only a one month lag. In this section the Board will examine issues raised by parties with respect to the business risk of AGTD. The issues relating to capital structure and resulting financial risks of AGTD will be dealt with in the next section. a NOVA noted that all of the expert rate of return witnesses agreed that there had been no material change in AGTD's business risk since Decision E92086, but suggested that the importance of some evidence which indicated that AGTD was riskier than TCPL was not fully recognized in that Decision. CAPP submitted that the Board should recognize in this Decision that AGTD was the least risky of all pipelines including TCPL. Factors which contribute to AGTD's total business risk are grouped under the risk of annual cost recovery, regulatory risk and risk of long term cost recovery and are described below. (a) Risk of Annual Cost Recovery CAPP submitted that AGTD recovers its actual cost of service, including return on common equity, through its cost of service tolls Any differences between

20 4. BUSINESS RISK the tolls that are estimated and the costs that are actually incurred by AGTD are recovered in the following month through the Monthly Billing Adjustment. CAPP noted that the Board found in Decision E92086 that AGTD is different from other utilities since it is not subject to forecasting risk and is not at risk for weather variations. CAPP submitted that AGTD was provided with a greater assurance of annual cost recovery than TCPL which is regulated by the National Energy Board (NEB) on a forward test year basis. CAPP noted that TCPL does have a large portion of its cost of service subject to deferral accounts, however, TCPL is at risk for recovery of amounts in the deferral accounts for at least a one-year period. CAPP noted that although disallowance is rare, the issue is risk rather than the actuality of ultimate recovery. 0 ProGas submitted the following: If...the manner in which AGTD recovers costs from shippers involves very little risk as the current structure ensures complete cost recovery on a monthly basis. l1 (Argument, p. 1) CAPP also considered that business risks arising from AGTD1s tariff were significantly less than those of TCPL particularly in the areas of force majeure, interruptions and curtailments, bad debts, billing and payment and liability for failure to provide service. CAPP noted that the NOVA tariff does not under any circumstance of force majeure suspend or relieve shippers from the obligation to pay any minimum charge, demand charge, basic charge, surcharge, or any other amount payable to NOVA (Exhibit 11, Article 12.3, p. 161). In reply NOVA noted that in cases

21 a PUBLIC UTILITIES BOARD, Alberta 4. BUSINESS RISK where TCPL has provided a demand charge credit to shippers because TCPL failed to deliver due to force majeure, the demand charge credits have been recovered via a deferral account. CAPP noted that the NOVA tariff gives NOVA the power to interrupt service at its sole discretion and without notice for ''unforeseen cir~umstances~~ with shippers obligated to continue to pay. In reply NOVA noted that the TCPL tariff specifically provides that TCPL is excused from its obligation to serve when it makes repairs or alterations to machinery. CAPP noted that the NOVA tariff allows NOVA to recover bad debts from a tollpayers. NOVA considered that the risk that the NEB "would disallow TCPL's normal course bad debts, accounted for in a deferral account, is not materially different from the risk that an AGTD customer would complain about the inclusion of normal course bad debts in the cost of service". (Reply, Tab 2, p.4) CAPP noted that Article 5 of the NOVA tariff allowed NOVA to suspend service until a customer pays a disputed bill in full and that the customer's obligation to pay is not relieved by the suspension of service. NOVA noted that, in the event of a billing dispute, the TCPL tariff allows suspension of service if a shipper does not pay any undisputed amounts and post a surety bond satisfactory to TCPL guaranteeing payment of the amount ultimately found due.

22 4. BUSINESS RISK CAPP noted that Article 13 of the NOVA tariff states that NOVA has no liability in respect of its failure to provide service for any reason other than its wilful default. NOVA considered that TCPL, due to its force majeure provision, was in the same substantive position as AGTD. NOVA did not dispute the contention that AGTD faces little risk with regard to recovery of annual cost of service under the existing regulatory framework. NOVA submitted that effectively its cost recovery and tariff risks were not significantly different from those of TCPL. forward test year and deferral accounts, NOVA noted that with a fixed TCPL had earned more than its a approved rate in each year since NOVA considered the longer-run risks and experienced returns of AGTD and TCPL are more important to investors than the subtle differences in tariff mechanism and short-run cost recovery. (b) Regulatory Risk NOVA submitted that investors lllook through" the tariff mechanism to the fundamental risks of the business and recognize that the current method of regulation of AGTD may change. NOVA considered that investors have long-term vision and recognize that existing tariffs may not apply if economic circumstances related to the fundamental risks of the business dictate changes to the method of regulation. CAPP submitted that even if the present method of regulation were to change, the alternative would be along the lines of NEB regulation of TCPL

23 4. BUSINESS RISK (c) Risk of Long Term Cost Recovery Long term cost recovery risk is a function of the security of production and delivery of natural gas to the markets served by AGTD. The greater the assurance or security of production and delivery to markets, the lesser the risk that AGTD may not recover its return of and return on capital invested in plant facilities, in the long term. In its 1992 evidence NOVA submitted that AGTD faced higher business risks than in 1978 and in support of this contention alluded to changes in several production and market structure risks. These comparisons were provided in order to give an indication of the trend in business risk faced by AGTD. NOVA considered that there had been no material change in business risk since its 1992 evidence was presented. (c) (i) Production Risks NOVA submitted that in Decision E92086 the Board did not fully recognize the long-run, fundamental risks associated with AGTD1s investments to maintain system deliverability. NOVA considered that the 1992 experience of significant peak day deliverability shortfalls and the recent demands by shippers for contract demand ( CD ) relief highlighted the longer-run risks of this issue. Concerns regarding producers1 peak day supply deliverability may cause end use markets to become less reliant on Alberta suppliers thereby impacting on the long term viability of investment. AGTD1s NOVA considered that implementation of its CD relief proposal would result in significantly reduced terms associated with receipt point CDs and

24 0 PUBLIC UTILITIES BOARD, Alberta 4. BUSINESS RISK increased risk of non-renewals thereby reducing the level of assurance that AGTD's total cost of facilities will be recovered. NOVA considered that its risks would be increased by its agreement to reduce the risks of the customers who benefited from the reduction in contract terms. CAPP noted that the CD relief proposal applied only to renewals and not to delivery capacity or new connections. CAPP considered that most of the capacity subject to CD relief was older capacity which, at least notionally, had been paid out, or capacity that NOVA has designed out because of its view of deliverability in a particular area. CAPP submitted that NOVA'S risk of cost recovery would not increase if the CD relief proposal was implemented since it was only a reallocation of cost as among AGTD users. ProGas submitted the following: "Implementation of AGTD's phased-in contract relief program which allows certain shippers, who were required to accept long term contracts prior to 1 November 1989, to adjust the term of their receipt point contract demands does not increase the level of risk to AGTD. The contract relief program introduced by AGTD does not alter the all events cost recovery toll structure. It merely results in a reallocation of costs among shippers based on contractual volume. " (Argument, pp.i-2) CAPP considered that NOVA controls the basis on which it provides service since it has no statutory obligation to serve, and any common law obligation to serve that may exist is subject to the provisions of the NOVA Act which gives NOVA much more latitude and discretion than other utilities

25 4. BUSINESS RISK (Argument p.24). In contrast, the NEB can require the pipeline it regulates to provide service. NOVA countered that NOVA'S refusal to provide service for any reason is a term or condition of service which is subject to complaint under Section 40 of the NOVA Act. CAPP considered that AGTD faced a lower risk of stranded investment than TCPL or Westcoast Energy Inc. (Westcoast). CAPP considered that as long as Alberta gas reserves remain, AGTD would be shipping them to some market and as reserves deplete AGTD was "designing those facilities outf1. CAPP noted that AGTD designed to its view of deliverability and would not put facilities in place to meet contract obligations where deliverability is in decline, thereby reducing the risk of stranded investment. In reply argument, CAPP submitted that under the NOVA Act, NOVA could increase its depreciation rates if it feared an increased risk of stranded investment and noted that NOVA had not done so. (c) (ii) Market Risks NOVA considered that increases in the export portion of its gas transportation had increased its market risks. CAPP considered that greater diversity of NOVA'S markets reduced its risk. CAPP submitted that AGTD is at minimal risk from non renewal of transportation contracts given the diversity of markets served by AGTD. Further, even if certain customers cease to use the system, the cost of service will be spread over the remaining shippers under the current method of regulation. CAPP also submitted the following:

26 0 4. BUSINESS RISK "In our environment where prices are set in the marketplace, Alberta gas will sell at the market-clearing price, and if not in one particular location, it will be in another. This lessens the risk of gas not moving out of Alberta.?? (Tr. p.666, ) Board Findings The Board considers that AGTD faces virtually no risk or regulatory lag with regard to recovery of its annual cost of service because the actual cost of service is recovered monthly through its cost of service tolls. Any differences between estimated tolls and the costs actually incurred by AGTD are recovered in the following month through the Monthly Billing Adjustment. (Exhibit 11, p. 7) In this respect AGTD is different from other utilities under the Board's jurisdiction whose costs and revenues are subject to forecasting risk. Forecasting risk includes the risk of weather variation as well as the risk of actual costs and revenues being higher or lower than forecasts. These utilities may therefore be considered to have a greater potential for earnings variation, both on the upside as well as on the downside, compared to AGTD and are therefore more risky than AGTD with respect to the risk of annual cost recovery. This greater risk of other utilities under the Board's jurisdiction is supported by the historical data provided on Exhibit 41 wherein the coefficient of variation of achieved return on common equity for Alberta Power Limited is 18%; for Canadian Western Natural Gas Company Limited is 22%; for Northwestern Utilities Limited is 26%; and for TransAlta Utilities Corporation * (TransAlta) is 9% over the period 1981 to 1991 compared to 7% for AGTD over the period 1981 to The Board notes that with the implementation of the

27 0 4. BUSINESS RISK Board's approved method of cost recovery (Section 13), the coefficient of variation of rate of return on achieved common equity for AGTD for 1993 and onwards will likely remain the lowest of any utility under the Board's jurisdiction since AGTD will have little or no variation between the allowed and achieved rate of return on common equity. Variation in AGTD's rate of return on common equity over time will arise mainly from changes in the Board allowed or the industry negotiated rate of return on common equity. The Board notes that TCPL is regulated by the NEB on a forecast test year basis with some 85% of TCPL's cost of service subject to deferral accounts. 0 (Ref. NR.CAPP-57.5) The deferral accounts operate on the basis that variations of actual costs from estimated costs are recorded in the accounts and brought forward at the next toll case for disposition by the NEB. The Board agrees with CAPP that, although disallowance is rare and past successful recovery important, the issue is risk of future non-recovery. The Board agrees with CAPP that the provisions of the NOVA Tariff (Exhibit 11) and the TCPL Tariff (Exhibit 12) appear to provide NOVA with less exposure to loss than TCPL in the areas of force majeure, interruptions and curtailments, bad debts and liability for failure to provide service. Once again the issue is risk of future non-recovery rather than the past recovery of loss. On balance, the Board concludes that AGTD faces less risk than TCPL with respect to annual cost recovery.

28 4. BUSINESS RISK With respect to regulatory risk, the Board is not aware of any impending change that could have a significant effect on AGTD's method of regulation. The Board concludes that the probability of any change in the current method of regulation for AGTD that would increase AGTD's business risks significantly, is relatively low. For example, if AGTD were in the future to be regulated on a forecast test year basis, the extent of the increase in AGTD's business risks due to the risk of annual cost recovery would likely be limited to a level of risk of annual cost recovery similar to that being experienced by other utilities under the Board's jurisdiction. * gathering With respect to long term production risk, the Board notes that AGTD is a and transmission system. Receipt-related facilities are required to connect some 825 receipt points to the transmission system. Approximately 50% of new capital expenditures and over 60% of rate base investment is associated with receipt-related facilities. (Tr. p.288) The Board agrees with NOVA that AGTD's exposure to production risk likely exceeds that of TCPL which is essentially a main line transmission system. The Board recognizes that AGTD has no statutory obligation to serve all customers and that the exposure to production risk is minimized through the use of stringent economic tests and contract requirements before making investments in receipt-related meter stations and laterals. However, the Board concludes that the dispersion of facilities required to gather the gas and the less concentrated intermediate and main transmission facilities combined with the requirement continually invest in facilities to maintain deliverability results in AGTD facing

29 a PUBLIC UTILITIES BOARD, Alberta 4. BUSINESS RISK a greater risk of stranded investment due to the depletion of Alberta natural gas reserves than does TCPL. The Board does not agree with CAPP that AGTD is necessarily less risky than TCPL and Westcoast due to the basis on which service and new facilities are provided. The Board notes that AGTD1s annual facilities plan (Exhibit 9, Vol. 3C) is subject to regulatory review by the ERCB and TCPL and Westcoast facility additions are subject to regulatory review by the NEB. With respect to long term market risks, NOVA submitted that increased diversification of markets shared by gas producers has resulted in increased risk for AGTD. The Board notes that, in 1992, exports represented 55% of marketable gas deliveries. CAPP asserted that diversification of the markets available to Alberta gas producers clearly contributes more to the utilization of AGTD1s single business, being transportation of gas, than if there was only access to one market. The Board agrees with CAPP that AGTD faces less market risk than TCPL as a result of the increased diversification of markets. With respect to other longer term risks, the Board notes AGTD's proposal for CD relief and the shortening of the length of contracts. The Board is not persuaded that this proposal will increase the business risk of AGTD since it does not apply to new connections and considering that all costs will still be recovered through a reallocation of costs from large aggregators to the balance of the users on the system. With respect to the increased risk of non-renewals, 0 the Board notes NOVA'S statement in its February 26, 1993 Annual Information

30 a PUBLIC UTILITIES BOARD, Alberta 4. BUSINESS RISK Form, "The non-renewal of a transportation contract does not have a financial impact on NOVA because the cost-of-service of the Pipeline System is allocated to the remaining contracts." (Ref. Exhibit 7, Vol. 1, Tab 9, p. 6) On balance, the Board concludes that AGTD is likely to face approximately the same risk as TCPL with respect to long term cost recovery. The Board observes that the bond rating agencies did not identify any long term risks of cost recovery in the bond rating reports marked as Exhibits in this proceeding. While long term risks are no doubt considered by investors, a definitive explanation of potential long term risks (including a discussion of e materiality) does not appear to be readily available to potential AGTD investors. Taking all of the foregoing into account the Board concludes for the purposes of this Decision that, AGTD's business risk is very low. The Board concludes, after weighing the evidence before it, that AGTD's business risk is considerably lower than other utilities regulated by the Board and marginally lower than TCPL.

31 5. CAPITAL STRUCTURE In the previous section the Board concluded that AGTD's business risk is very low. As mentioned previously, the level of a corporation's business risk determines the extent to which it can increase its financial risk while still maintaining an overall investment risk that will enable it to attract capital from the market on reasonable terms and conditions. In this section the Board will examine issues raised by parties with respect to AGTDts financial risks. * ratio. One of the principal issues in these proceedings is the determination of an appropriate capital structure for AGTD, including an appropriate common equity AGTD's financial risk will arise from the capital structure to be determined for AGTD. In his book, "Utilities' Cost of Capital1' (Public Utility Reports Inc. 1984), Dr. R. G. Morin defines financial risk as follows: "Financial risk stems from the method used by the firm to finance its investments and is reflected in its capital structure. It refers to the additional variability imparted to income available to common shareholders by the employment of fixed cost financing, that is, debt and preferred stock capital. Although the use of fixed cost capital can offer financial advantages through the possibility of leverage of earnings, it creates additional risk due to the fixed contractual obligations associated with such capital. Debt and preferred stock carry fixed charge burdens which must be supported by the company's earnings before any return can be made available to the common shareholder. The greater the percentage of fixed charges to the total income of the company, the greater the financial risk. The use of fixed cost financing introduces additional variability into the pattern of net earnings over and above that already conferred by business risk, and may even introduce the possibility of default and bankruptcy in unusual cases. I' (p.32)

32 5. CAPITAL STRUCTURE The primary elements of capital structure are debt, preferred equity and common equity. Generally, the greater the proportion of debt and preferred equity to total capital, the greater the financial risk. Dr. Evans noted that preferred equity involves less financial risk than debt. (Tr. p.510, ) Since AGTD, as a division of NOVA, does not issue securities directly to the market, NOVA deemed a capital structure and common equity ratio for AGTD for NOVA proposed that the deemed common equity ratio be set at 34.0% at a common equity rate of return of 12.75% for The total equity ratio proposed was about 39.3%, including a preferred equity component of 5.29%. NOVA submitted that its proposed capital structure for AGTD would be consistent with AGTD1s business risks and Decision E92086, wherein the Board determined that AGTD1s total equity should be in the range of 35% to 40%. NOVA indicated its proposal would enable AGTD to raise its significant capital requirements on reasonable terms. Mrs. McLeod supported NOVA1s proposed capital structure by reference to the capital structure of a group of ten regulated utilities which showed average preferred and common equity ratios of 13.8% and 34.3%, respectively or 6.6% and 34.3%, respectively when the retractable preferred shares of Canadian Utilities Limited ( CU) and TransAlta are excluded. Dr. Evans supported NOVA1s proposal on the basis of his judgement respecting the comparative business risks of AGTD and his determination that it was consistent with 0 Decision E92086.

33 a PUBLIC UTILITIES BOARD, Alberta 5. CAPITAL STRUCTURE With respect to the coverage ratios for AGTD that result from its proposals [interest coverage of 2.08 (pre-tax) and 1.76 (after-tax) and fixed charge coverage of 1.92 (pre-tax) and 1.66 (after-tax)], NOVA submitted: "In our view, AGTD requires a 40% total equity level with pre-tax interest coverage of approximately two times. (Exhibit 7, Volume 2, Tab 3, page 4) Dr. Waters for CAPP recommended that AGTD1s deemed common equity ratio be set at a level which is both consistent with the very low risks of AGTD and the amounts of common equity which will actually be available to support AGTD. On this basis Dr. Waters considered that a common equity ratio of 25% at a rate of return on common equity of 11% would provide AGTD on a stand alone basis with a AA bond rating. At his recommended levels, Dr. Waters calculated interest coverage of 1.7 (pre-tax) and 1.5 (after-tax) and fixed charge coverage of 1.6 (pre-tax) and 1.4 (after-tax). (Waters' Evidence, p.45, Table C) Dr. Waters also made the conditional recommendation that if the Board should conclude that a total equity ratio of more than his recommended 30.29% (including 5.29% preferred equity) were appropriate, then the additional equity should consist solely of preferred shares. This would minimize the revenue associated with a particular total equity ratio since the before tax cost of preferred share financing is considerably lower than that of common equity. Dr. Waters noted that over the 11 year period ending in 1992 the respective average before and after tax interest coverage ratios for NOVA were 1.7 and 1.4 times and therefore less than AGTD's 2.2 and 1.8 times. In

34 5. CAPITAL STRUCTURE addition, Dr. Waters considered that the interest coverage ratios of 3.4 and 7.3 for 2 Canadian and a median of 5.2 for 27 non-canadian chemical companies over the period from 1974 to 1991 (Dr. Waters' Evidence, Tables 20A-20D) exceeded those apparently achieved and prospectively achievable by the comparable NOVA segment. Dr. Waters considered that : "Since NOVA's non-agtd operations have been comprised primarily of high risk petrochemical and, until 1991, petroleum related operations, the ratios of this segment should have been much higher than those of the AGTD in order for the risks of the two segments to have been even somewhat similar". (Dr. Waters' Evidence p.4o) "The significance is that NOVA's chemical division will impact adversely on NOVA's overall credit worthiness, and hence on the cost rate it will be required to pay on AGTD-related debt for the foreseeable future. This conclusion follows from the observation that, even with much higher interest coverage ratios than NOVA's, the chemical industry's creditworthiness, as inferred from the bond ratings of the companies included in my analysis, are generally inferior to those of utilities". (Dr. Waters' Evidence p.42) Dr. Waters also considered that the non-agtd investments of NOVA are undercapitalized in terms of equity financing and therefore the deemed common equity actually available to support AGTD would be reflected by a 25% common equity ratio. (Exhibit 25, Dr. Waters' Evidence, Appendix XVII) NOVA, noting the benchmark equity ratio for an A credit rating of 40%, considered that the equity ratio included common equity and preferred equity. CAPP considered that the preferred shares of companies like TCPL, CU and TransAlta should be treated as debt-like in the calculation of total equity since they were "nothing more than a high cost form of fixed-rate financing". CAPP considered the fact that preferred shares are used infrequently by companies (unless a favorable tax position can be achieved) supported that conclusion

35 5. CAPITAL STRUCTURE CAPP noted an NEB decision wherein preferred shares were treated as debt-like and a DBRS note that they should be considered similar to debt. CAPP also noted that CU and TransAlta, each with about 40% total equity not including "debt-like" preferred shares, were both rated in the AA category. Board Findings In fixing a capital structure and cost rates, the Board must ensure that the resulting return meets the fairness standard of being commensurate with returns on investments in other enterprises having corresponding risks and is sufficient to maintain the financial integrity of the The Board agrees with Dr. Evans that there are a number of combinations of capital structure ratios and cost rates which would produce a fair return. The Board also generally agrees with Dr. Evans that an appropriate method of arriving at the fair return is to determine a capital structure which reflects the business risk of the stand alone operation and then apply to that a rate of return on common equity which reflects the financial risk implicit in the capital structure. (Tr. p.503, 1.17 to p.504, 1.16) However, the Board considers that the combined effect of the capital structure ratios and rate of return on common equity affects coverage ratios, bond ratings and the overall financeability of AGTD. Provided the fair return standard is met, the Board agrees with CAPP that the selected capital structure and cost rates should "Maintain the financeability of AGTD at the lowest overall before-tax cost rate that will allow funds to be raised on reasonable terms and

36 5. CAPITAL STRUCTURE conditions1'. (Argument, p.6) For the above reasons, the Board considers it appropriate to examine a range of reasonable capital structure ratios together with a range of reasonable rates of return on common equity to ensure that the selected capital structure and selected rate of return on common equity meets the fair return standard and achieves the desired coverage ratios and bond ratings to maintain AGTD as a high-quality credit. The Board in Decision E92086 concluded that a range of total equity between 35% and 40% was reasonable for a low business risk pipeline company such as AGTD. The Board in Decision E92086 determined AGTD's common equity ratio to be 32% and AGTD's total equity ratio to be 37.5%. The Board notes that the level of a corporation's determines the minimum amount of common equity business risk generally required in the capital structure to provide a common equity investment risk acceptable to the high quality common equity market and a fixed cost coverage acceptable to the high grade bond and preferred equity markets. The Board also notes that the level of a corporation's business risk generally determines the minimum amount of total equity (i.e. preferred and common) required to provide an interest coverage acceptable to the high grade bond market. In view of the Board's findings in Section 4 (Business Risk) that AGTD has a very low business risk, the Board considers that AGTD would rank at the low

37 5. CAPITAL STRUCTURE end of a reasonable range of common equity ratios that would be applicable to stable low risk pipelines and utilities. The Board considers that AGTD's low business risk enables AGTD to have a lower common equity ratio (i.e. high financial risk) and still provide an investment risk acceptable to the high quality equity market. The Board observes that the common equity ratio for APL is 31.1%; for CWNG is 34.1%; for NUL is 34.2%; for TransAlta is 36.4%, resulting in an average of 34% for large utilities under the Board's jurisdiction. (NOVA Argument, Tab 2, p.24) The Board also observes the following common equity ratios determined by the NEB for gas transmission pipelines under its jurisdiction. NEB Common Preferred Company Decision Date Year Equity Equity Total 8 % % TCPL RH-2-92 Feb Westcoast RH-3-92 Mar TQM RH-4-92 Dec ANG RHW-1-92 Sep Average The Board considers that AGTD's common equity ratio should be lower than the 34% average common equity ratio of the higher business risk large utilities under the Board's jurisdiction. The Board also considers that AGTD's common equity ratio should be lower than the 35% common equity ratio of the higher business risk Westcoast and slightly lower or approximately the same as the 308 common equity ratio of TCPL which has a slightly higher business risk than AGTD

38 5. CAPITAL STRUCTURE On balance, and upon considering all of the foregoing, the Board considers that a common equity ratio of approximately 30% would be consistent with AGTD1s low business risk and produce a common equity investment risk acceptable to the high quality common equity market. The Board notes that, with a preferred share ratio of 5.26%, AGTD1s total equity ratio would then be approximately 35.26%. The Board notes that TCPL has a preferred share ratio of 9.37% and a total equity ratio of 39.37%. The Board also notes that TCPL1s higher preferred share ratio results in a slightly lower financial risk for TCPL compared to AGTD. TCPL1s slightly lower financial risk combined with its slightly higher business risk than AGTD results in comparable investment risks for TCPL and AGTD. However, before reducing AGTD's common equity ratio from 32% to 30%, the Board, in Section 11, will review the coverage ratios that result from a common equity ratio in the range of 30% to 32% and a total equity ratio in the range of 35.26% to 37.26% with the common equity rate of return range determined in Section 10.