IN THE MATTER OF AND DECISION. July 29, Before:

Transcription

1 IN THE MATTER OF PACIFIC NORTHERN GAS LTD. AND AN APPLICATION TO RECAPITALIZE UNDER AN INCOME TRUST OWNERSHIP STRUCTURE DECISION July 29, 2004 Before: L.A. Boychuk, Panel Chair and Commissioner N.F. Nicholls, Commissioner R.J. Milbourne, Commissioner

2 TABLE OF CONTENTS Page No. 1.0 BACKGROUND Income Trusts in General Background to and PNG s Interest in the Recapitalization Proposal OVERVIEW OF THE RECAPITALIZATION APPLICATION Steps to be Taken to Recapitalize PNG Ownership Structure Comparisons Specific Approvals Sought Benefits of the Recapitalization Application CONSIDERATION OF PNG S RECAPITALIZATION APPLICATION Method of Setting PNGL s Rates Deemed Regulatory Structure Key Aspects of the Application Consideration of the Deeming Requests PNG s Position Views of Other Parties Regulatory Precedents Commission Panel Analysis Public Interest Considerations Financability and Business Risk Financing Terms Realizing the Benefits of the Recapitalization Application CONCLUSION 29 ORDER NO. G-70-04

3 1.0 BACKGROUND Pacific Northern Gas Ltd. ( PNG, PNG-West ), Pacific Northern Gas (N.E.) Ltd. [ PNG(NE) ], and Pacific Northern Gas Transition Ltd. ( PNGT ), collectively referred to as PNG or the Applicants, applied to the Commission on January 30, 2004 for certain approvals and Orders to enable PNG to complete a corporate reorganization and to recapitalize its balance sheet under an income trust ownership structure (Ex. B-5). Revisions to the numerical information provided under Tabs 5-10 of the application were filed April 9, 2004 and marked as Exhibit B-39. A revision to Tab Application page 24 was filed April 13, 2004 and marked as Exhibit B-42. Collectively, Exhibits B-5, B-39, and B-42 are referred to as the Recapitalization Application or the RA in this Decision. Under the proposed recapitalization, the PNG Income Trust would become the sole shareholder and owner of an amalgamated PNG, PNG(NE) and PNGT which would become one corporation under the name Pacific Northern Gas Ltd. ( PNGL ). PNGL, the operating company, would continue to be regulated by the Commission. PNGT has been incorporated for the purpose of facilitating this recapitalization. The Commission agreed to review the Recapitalization Application in conjunction with, and essentially as a second phase of, the Hearing to consider PNG s Revenue Requirements Application. This second phase of the Hearing occurred on April 13 and 14 in Vancouver and a common Exhibit List was established for both phases (see Appendix C to the 2004 Revenue Requirements Decision). Argument and Reply with respect to the Recapitalization Application also occurred as part of the Argument and Reply for the Revenue Requirements Application. 1.1 Income Trusts in General PNG provided extensive general information on income trusts at Tab 1 of the Recapitalization Application, including the following statements: an income trust is a hybrid investment vehicle combining equity and debt designed to distribute cash flow from an underlying business to investors in a tax effective manner; income trusts can own securities (debt and equity) issued by an underlying business and, as such, they receive cash distributions based on the cash flow generated by the underlying business; the underlying business in an income trust pays substantially all of its cash flow by way of interest and dividends on the shareholder notes and common shares held by the income trust, subject to retention of a prudent level of cash reserves; any cash paid by the operating entity to the income trust is then distributed to the unit holders of the trust on either a monthly or quarterly basis. 1

4 2 PNG noted as well that the income trust market began in the mid-1980s with the establishment of oil and gas royalty trusts comprising mature, producing, oil and gas properties, which paid out their royalties to investors. Enerplus Royalty Trust was the first income trust established in Since then the number of income trusts has grown substantially and the number of business interests establishing income trusts has broadened. The income trust market has evolved from purely oil-and-gas-based underlying assets to other energy-related underlying assets, to real estate assets, to diversified business assets. The income trust market has continued to grow and diversify over the last five years and, at the time of the PNG filing, consisted of 134 entities with an aggregate market capitalization of over $82 billion, representing approximately 7 percent of the Canadian equity markets (RA, Tab 1, para.7, p. 2). 1.2 Background to and PNG s Interest in the Recapitalization Proposal In the Recapitalization Application (RA, Tab Application, Part I), and also in the opening statement of PNG s president at the start of the second phase of the Hearing (T3: ), PNG provided a historical perspective to the development of PNG s recapitalization proposal as summarized below. PNG is a publicly traded company financed by a combination of common and preferred shares listed on the Toronto Stock Exchange and by third party secured debt. This secured debt was issued pursuant to a Trust Deed dated April 15, 1982 which has been amended several times through supplemental indentures (RA, Tab Application, para. 4, p. 2). In May 2000 Methanex Corporation ( Methanex ), PNG s largest industrial customer, gave notice that it was shutting down its methanol plant for a minimum period of 12 months commencing on July 1, 2000 and indicated that there might be a permanent closure if it did not obtain an appropriate load retention rate from PNG. As a result, PNG suspended payment of common dividends in mid Exacerbating the situation was the then unprecedented rise in gas prices in late 2000 and early Residential rates on the PNG-West system rose to prices in excess of the equivalent cost of electricity. The debt rating of PNG s third party secured debt was reduced over the 2000 to 2001 period in two stages by three full grade levels, from BBB(high), an investment grade, to BB(high), which is below investment grade. In response to the liquidity problems brought about by the closure of the methanol plant, PNG suspended payment of common share dividends in mid At the end of 2000, PNG completed a major internal reorganization to

5 3 substantially reduce its operating costs, reducing staff by approximately 40 percent and carrying out other changes within the Company. Methanex restarted the methanol plant in July 2001, but Skeena Cellulose, then PNG s second largest industrial customer, went into bankruptcy protection in September 2001 and shut down its pulp mill operations at Prince Rupert. British Columbia Hydro and Power Authority ( BC Hydro ), however, operated its power generation facility in Prince Rupert for several months in 2001, which helped to offset the loss in revenue from Skeena Cellulose (T3: 372). With Methanex restarted, PNG was able to arrange financing of $12 million at the end of 2001 to repay a $12 million debenture that was coming due in mid However, the terms of that financing required PNG to make monthly payments of principal and interest at much less favourable terms than previous long-term financing. In late March 2002, PNG and Methanex signed a Memorandum of Agreement for a new contract at $0.50 per gigajoule demand toll over seven years, from November 2002 through October During 2002, high natural gas rates caused residential and commercial customers to use considerably less gas than that included in the revenue requirements Decision for that year, thereby eroding earnings. In late 2002, PNG was able to arrange financing of $15 million of long-term debt, which among other things was used to finance a special dividend of $2.75 per share to bring PNG s common equity more in line with the 36 percent common equity allowed for regulatory purposes and to essentially compensate shareholders for the dividends not received during the two and a half year period when dividends were suspended (T3: 373). By the end of 2002, PNG had successfully reorganized to reduce capital and operating costs, refinanced its Series 2002 Debentures and executed a new seven-year agreement with Methanex all of which largely enabled the reinstatement of regular quarterly common share dividends in the first quarter of A Special Committee of PNG s Board of Directors was struck in November 2002 to review the overall strategic direction of PNG and, in particular, to investigate and pursue recapitalization initiatives to improve PNG s access to capital and to work with management to consider options available to the company to add value for both the shareholders and the customers (T3: 374). It was noted that PNG s actual common equity exceeds the deemed common equity allowed by the Commission in PNG s rates and that PNG has to refinance approximately $48 million of third party longterm debt over the next ten years. The Special Committee, PNG management and PNG s financial

6 4 advisors concluded in early 2003 that the best option available to the company in these circumstances was to recapitalize PNG under an income trust ownership structure (T3: 374; RA, Tab Application, paras , p. 5). In early 2003, PNG negotiated a new operating line of credit with another Canadian Chartered bank limited to the collateral value of PNG s inventories and accounts receivable. On November 17, 2003, the Dominion Bond Rating Services ( DBRS ) upgraded PNG s third party secured debt rating to BBB(low), which is considered to be investment grade. DBRS cited the medium term firm demand charge contract with Methanex and a more flexible operating line of credit as the major factors for the upgrade. On December 18, 2003, Westcoast Energy Inc., a business unit of Duke Energy Corporation ( Duke Energy ), completed the sale of its PNG share ownership to a company controlled by Tricor Pacific Capital Inc. ( Tricor ), a British Columbia private equity investment firm (RA, Tab Application, para. 23, p.6). During much of 2003 PNG management had been focused on bringing about the Tricor purchase of the Duke Energy shares and reaching an agreement with its third party secured debt holders on a redemption plan that would facilitate recapitalization of PNG under an income trust ownership structure. PNG reached agreement with the debt holders on a redemption plan in October 2003 (T3: 376). PNG filed its 2004 Revenue Requirements Application on November 28, 2003 and filed its Recapitalization Application on January 30, On February 17, 2004 PNG entered into the Memorandum of Agreement ( MOA ) with West Fraser Mills Ltd. ( West Fraser ), another of its industrial customers, for a new ten-year contract for firm transportation service. 2.0 OVERVIEW OF THE RECAPITALIZATION APPLICATION PNG advised that the proposed income trust, to be called the PNG Income Trust, would qualify as a mutual fund trust under the Income Tax Act of Canada. If approved, PNG and its wholly owned subsidiary PNG(NE), would be amalgamated with PNGT, as one corporation PNGL. The existing three divisions (PNG-West, Tumbler Ridge and Fort St. John/Dawson Creek), would be maintained for rate determination purposes (RA, Tab Application, para. 69, p. 28). The amalgamated PNGL would continue to own and operate all of the existing natural gas transmission and distribution assets owned by PNG and PNG(NE), and would continue to be regulated by the Commission. PNG Income Trust would become the new direct owner of the amalgamated PNGL in place of the common shareholders and the common shareholders of PNG would become unit holders of the PNG Income Trust, along with new investors pursuant to an initial public offering ( IPO ) of PNG Income Trust units.

7 5 The PNG Income Trust would not be involved in the ownership or operation of PNGL s utility business except in its capacity as the sole shareholder of PNGL. PNG expects that the trustees of the PNG Income Trust and the members of the Board of Directors of the amalgamated PNGL would be the same individuals (RA, Tab Application, para. 40, p. 14). PNG believes that the proposed recapitalization under an income trust ownership structure would not affect PNG s gas pipeline operations, since the operating company, PNGL, would continue to have the same assets and personnel as PNG has today, and would continue to be regulated by the Commission. 2.1 Steps to be Taken to Recapitalize PNG At Tab 3 of the Recapitalization Application, PNG sets out the steps involved to recapitalize PNG under an income trust ownership structure. These steps are further described in PNG s Argument at pages While Tab 3 provides for 5 steps, PNG s Argument describes 6 steps. Steps 1 through 3 would be undertaken simultaneously through a Plan of Arrangement under the B.C. Business Corporations Act, subject to approval of PNG s shareholders and then the B.C. Supreme Court. Following completion of Steps 1 through 3, the structure required to carry out the IPO would be in place. Steps 4 through 6 would then take place. The steps are as follows: Step 1 Steps 2 Step 3 Step 4 Step 5 PNGT will issue common shares and shareholder notes to the existing PNG common shareholders in exchange for all of their outstanding PNG common shares. The PNG Income Trust will issue trust units to the previous shareholders of PNG in exchange for their common shares and shareholders notes of PNGT. PNG, PNG(NE) and PNGT will be amalgamated to form [PNGL] and, following the amalgamation, the PNG Income Trust will hold all of the shareholders notes and common shares of [PNGL]. The PNG Income Trust will issue additional units of the PNG Income Trust for cash to new investors through IPO of PNG Income Trust units. The PNG Income Trust will use most of the proceeds of its initial IPO of trust units, estimated to be approximately $48 million, to purchase additional common shares and shareholders notes from [PNGL].

8 6 Step 6 PNG will use the cash received from the sale of the additional common shares and shareholder notes to the PNG Income Trust to redeem a portion of PNG s existing third party long-term debt (approximately $36 million) and to redeem PNG s existing preferred shares (approximately $5 million). The balance of the $48 million will be used to pay all of the transaction costs of the recapitalization, including approximately $4 million of third party debt early redemption fees. As a result of this process, the PNG Income Trust would hold all of the common shares of PNGL and all of the new shareholder notes and would be entitled to receive dividends paid on the common shares of PNGL and interest on the shareholder notes (BCUC IR No. 1, p. 2). 2.2 Ownership Structure Comparisons PNG provided the following schematic outline of the current corporate structure and the proposed income trust structure (RA, Tab Application, para. 34, p. 12):

9 7 As noted above, the PNG Income Trust would become the new owner of the amalgamated PNGL in place of the common shareholders, who would become unit holders of the PNG Income Trust. The PNG Income Trust would issue additional units to new investors through an IPO, the proceeds of which would be invested in additional common shares and shareholder notes as well as used to redeem the existing preferred shares of PNG and approximately 40 percent of PNG s current third party debt. PNG has entered into an agreement in principle with its current third party secured debt holders to amend the Trust Deed to this effect as set out at Tab 2 of the Recapitalization Application. PNG s new capital structure would be made up of the remaining third party secured debt, the shareholder notes and common share equity. The following table, extracted from Exhibit B-41, summarizes the typical financial structure of the entities involved, based on PNG-West: Pacific Northern Gas Ltd. (West Division) 2004 Capital Structures Pro Forma As Is Public Ownership IT Ownership Deemed IT Ownership Actual Short-term Debt 5.56% 7.00% 5.56% Third Party Long-term Debt 54.76% 57.00% 31.93% Preferred Shares 3.69% - - Shareholder Notes % Common Equity 36.00% 36.00% 12.50% Total 100% 100% 100% PNG summarized the expected terms of the shareholder notes in a draft term sheet set out at Tab 4 of the Recapitalization Application. The shareholder notes are to be subordinated to all third party secured debt and trade creditors, and would allow PNGL to defer interest payments under certain circumstances for a limited term. The rate on the shareholder notes would be fixed through the 40-year term to maturity and would be approximately 12 percent per annum subject to market conditions at the time of issue.

10 8 The interest on the third party secured debt and the shareholder notes would be deductible by PNGL in the determination of its taxable income, which is expected to be close to zero as a result of these interest deductions (RA, Tab Application, para. 37, p. 13). PNG requested DBRS to review its rating of PNG s third party secured debt on a prospective basis. DBRS reviewed an earlier draft of the Recapitalization Application and other financial information and indicated that the recapitalization of PNG would be a positive consideration though it would not necessarily result in an immediate change to PNG s current debt rating (RA, Tab Application, para. 44, p. 14). PNG estimates that its shareholders would incur total costs in the range of $10 million to recapitalize PNG under an income trust ownership structure. This amount includes an underwriting commission of approximately 6 percent, third party secured debt restructuring costs, legal and other transaction costs (RA, Tab Application, para. 43, p. 14). PNG confirmed that its shareholders are prepared to pay all of the costs of the recapitalization, including third party secured debt restructuring costs, and if the need arose to convert back to a corporate structure, for whatever reason, the shareholder would bear all those costs as well (T3: 485; RA, Tab Application, para. 32, p. 11). 2.3 Specific Approvals Sought The various approvals sought by PNG under the Utilities Commission Act ( the Act or UCA ) are outlined at Tab Application, Part VI of the Recapitalization Application and include: the redemption of a portion of its existing third party debt and all of its issued and outstanding preferred shares, pursuant to s. 50(3)(a) of the Act; the acquisition by PNGT of all of the issued and outstanding common shares of PNG pursuant to s. 54(5), (7) and (8) of the Act; the issue of shareholder notes and common shares by amalgamated PNGL to the PNG Income Trust pursuant to s. 50(2) of the Act; the acquisition by the PNG Income Trust of all of the issued and outstanding common shares of the amalgamated PNGL pursuant to s. 54(5), (7) and (8) of the Act; and a Commission report and findings related to the proposed amalgamation of PNG, PNG(NE) and PNGT to form PNGL to be submitted, if the findings are favourable, to the Lieutenant Governor in Council for its consent under s. 53 of the Act.

11 9 As discussed below, the Applicants are also seeking confirmation from the Commission that the annual revenue requirement for each operating Division [of PNGL] will be determined on the same basis as it is currently done for PNG and PNG(NE), namely on the basis of ratemaking principles outlined in Part IV of the Recapitalization Application (RA, Tab Application, para. 52, p. 16). During the proceedings and in Reply Argument PNG explained that this confirmation is essential to the success of the recapitalization of PNG under an income trust ownership structure to ensure that the cash available for distribution to unit holders will be sufficient to induce current shareholders of PNG to approve a conversion (PNG Reply Argument, para. 19, p. 11). Accordingly, the Applicants request that the Commission, pursuant to s. 50(7) and s. 54(9), attach conditions to the requested approvals to the effect that: the future rates for the customers of PNG s three Divisions shall be determined on the basis of the ratemaking principles set out in Part IV of the Application, including the applied-for deemed capital structure; all costs including depreciation rates and income taxes will be forecast and recovered in all Divisions revenue requirements in accordance with existing Commission practices; and no costs related to the recapitalization, including costs associated with the proposed debt redemption and the initial issue of shareholder notes and trust units be recovered through customer rates (RA, Tab Application, para. 69, pp. 28-9). With respect to the proposed amalgamation, the Commission must either form the opinion that it would be beneficial in the public interest or dismiss the application [UCA, s. 53(5)]. With respect to the proposed redemption and issue of securities, the Commission may give its approval subject to conditions and requirements considered necessary or desirable in the public interest [UCA, s. 50(7)]. And, with respect to the proposed acquisition of a reviewable interest, the Commission is guided by s. 54(9) of the Act which states: 54(9) The commission may give its approval under this section subject to conditions and requirements it considers necessary or desirable in the public interest, but the commission must not give its approval under this section unless it considers that the public utility and the users of the service of the public utility will not be detrimentally affected. The onus is on the Applicants to provide the Commission with the legal and evidentiary basis that would enable the Panel to exercise its statutory discretion, as provided in the relevant sections of the Act, in the manner requested by the Applicants.

12 Benefits of the Recapitalization Application PNG s Position PNG believes that there would be numerous benefits to both ratepayers and shareholders as a result of the recapitalization under an income trust ownership structure. These benefits are summarized in the Recapitalization Application, Part V, at pages 25 to 27, in testimony by PNG at pages 377 to 380 of the Transcript and in its Argument at page 15. PNG submits (at para. 42, p. 15, of its Argument), that the recapitalization of PNG under an income trust ownership structure will: (i) provide [PNGL] with improved access to capital markets on better terms and conditions than under the status quo case; (ii) permit [PNGL], through its improved access to capital, to meet its obligations to re-finance on reasonable terms, the amortization and redemption of approximately $48.2 million of PNG s current third party long-term debt coming due between 2004 and 2013; (iii) enable [PNGL] to obtain an adequate bank operating line of credit which will allow it to properly finance: day to day operating requirements; regulatory deferrals; unanticipated contingencies such as line break repairs; and an appropriate natural gas commodity hedging program; and (iv) allow [PNGL] to finance the draw down of deferred income taxes which will enable it to provide customers with stable and lower rates compared to rates under the status quo case. PNG believes that PNGL would have more financial flexibility than PNG has today, with a reduced chance of defaulting under its third party secured debt based on the expected terms of the shareholder notes and less leverage resulting from the redemption of a significant portion of PNG s current third party secured debt (RA, Tab Application, para. 39, p. 13). PNG states that the [r]efinancing is expected to be relatively easier and over time, long-term debt costs should be lower than under the status quo resulting in lower customer rates (BCUC IR No. 2, Q. 9, pp. 1-2 and T4: ). One of PNG s financial advisors suggested that on a relative basis... in the proposal the rates would be lower than without the proposal and explained that as the debt is refinanced, you refinance it at a lower rate, and that s when you get the benefit of the lower rate (T4: 590). PNG explained that the more debt that is on the financial statements, the more bargaining position the individual entities that we go to to refinance will have and that if it wasn t for this large principal payment issue every year, if all we had to do was service the interest, we would have a lot more flexibility to negotiate (T4: 491-2).

13 11 The projected major benefit to ratepayers, according to PNG, relates to the draw down of deferred income taxes. PNG suggests that the improved flexibility to finance PNG in the income trust ownership structure would allow for the gradual draw down of the deferred income tax balances, i.e. it provides PNG with the ability to draw down the deferred income tax balances in each of the Divisions and return them to customers through reduced rates. The PNG-West Division currently has approximately $14.5 million of deferred income taxes that are deemed by the Commission to be zero cost capital, financing the PNG-West Division rate base. The corresponding balances for the Fort St. John/Dawson Creek and Tumbler Ridge Divisions are $553,000 and $415,000, respectively. The portion of the deferred income taxes to be credited to the annual revenue requirements would be determined by the Commission each year based on the overall objective of stabilizing, and in some cases reducing, customers rates. PNG provided a summary of the expected Gross Margin Comparisons under the status quo and Income Trust ownership structures on a pro forma basis for the period 2004 to 2008 (RA, Tab Application, p. 24, as updated by Ex. B-42). It indicated gross margin savings over 2005 to 2008 of $6.1 million attributed to the recapitalization, largely as a result of the draw down of deferred income taxes PNG suggests that its customers should also anticipate improved stability within the Utility, since the increased liquidity will provide flexibility for PNG to manage its cash working capital requirements for unanticipated gas price spikes and other large expenditures, such as repairing line breaks on an emergency basis. Views of Others In its Argument, the BC Old Age Pensioners Organization et al. ( BCOAPO ) concluded that the benefits to ratepayers from the proposed recapitalization were very limited compared to the much more significant benefits to unit holders of the PNG Income Trust (BCOAPO Argument, pp ). BCOAPO suggests that the only substantial benefit is the amortization of deferred income taxes. According to BCOAPO, the other potential ratepayer benefits are more amorphous including benefits associated with easier refinancing and lower long-term debt over time than under the status quo. BCOAPO considers that the possible service enhancements for ratepayers are fairly minimal and that there is only a nebulous possibility of other benefits, i.e. resulting from PNGL or the PNG Income Trust engaging in other activities to create economies of scale and associated benefits for ratepayers (T4: 595, 635).

14 12 BCOAPO further questioned whether increasing PNG s common equity percentage was a better deal for PNG s ratepayers in the long run as opposed to the Recapitalization Application (BCOAPO Argument, p. 16). West Fraser submits that [t]he conversion to an Income Trust Structure may be beneficial for PNG and its ratepayers (West Fraser Argument, p. 12). West Fraser suggests that its MOA is helpful in support of the PNG Income Trust by generating a steady flow of income, but notes that any benefits to ratepayers will not be shared with its Eurocan mill as a result of the MOA. During the proceeding, PNG provided copies of letters of support (Ex. B-36) from each of four municipalities within its service territory: Fort St. John, Prince Rupert, Terrace and Kitimat. No other parties commented on or provided submissions concerning the Recapitalization Application. 3.0 CONSIDERATION OF PNG S RECAPITALIZATION APPLICATION 3.1 Method of Setting PNGL s Rates Although the recapitalization of PNG under an income trust ownership structure is technically complex and ultimately requires several specific approvals from the Commission, from PNG s perspective it is simply seeking, for regulatory purposes, a continuation of the status quo. PNG proposes that [PNGL s] future rates be established using all the same ratemaking principles and mechanisms that are now in place for the determination of just and reasonable rates for each of the PNG-West, Fort St. John/Dawson Creek and Tumbler Ridge Divisions. PNG explained that the income derived from this method of rate setting provides the cash flow to the PNG Income Trust and will effectively determine the cash available for distribution by the PNG Income Trust to its unit holders, as the available cash will be equal to the amount of revenue that PNG receives from its customers, based on Commission approved rates, less the sum of, among other things, i) operating, maintenance, administrative and general expenses; ii) property, other taxes and corporate income taxes, including large corporation capital tax; iii) gas supply costs; iv) funds required for capital expenditures; and v) debt service charges on its third party secured debt and operating line of credit (RA, Tab Application, paras. 45 and 46, p. 15).

15 13 According to PNG, simply stated, the Applicants are requesting Commission confirmation that the annual revenue requirement for each operating Division will be determined on the same basis as is currently done (RA, Tab Application, para. 52, p. 16). PNG states that continuation of the historical ratemaking principles is essential to the success of the recapitalization of PNG under an income trust ownership structure (RA, Tab Application, para. 47, p. 15). It is only on this basis that, in the opinion of PNG s financial advisors, PNG and the PNG Income Trust will be able to successfully complete the transactions contemplated above, including the IPO of PNG Income Trust units (PNG Argument, para. 48, p.20). PNG advises that the models prepared by the financial advisors are predicated on the rates that are currently in effect and how they are currently determined, and that s the main crux underpinning the potential success of the IPO (T4: 605). PNG, therefore, is seeking, as a critical aspect of its applied-for approvals, confirmation related to the manner by which PNGL would be regulated by the Commission. In seeking this confirmation from the Commission, the PNG witnesses acknowledge that this Commission Panel cannot bind future Commission Panels. PNG states that the regulatory risk for investors would not be significantly changed since [PNGL] is always at risk for the future determinations of the Commission (T: ). PNG submits, however, that [t]he success of the PNG recapitalization proposal depends entirely on the investors in the PNG Income Trust units having assurances as to how [PNGL s] future rates will be determined. PNG suggests that investors understand that regulatory principles may change over time and that while a decision of this panel of the Commission is not binding on a future Commission panel, the general practice of the Commission has been to follow its decisions unless there are compelling reasons to change past practices (PNG Argument, para. 67, p. 27). While PNG acknowledges that this Commission Panel cannot bind future Commission panels, PNG is nevertheless seeking a determination for the setting of future rates beyond the test year, and appears to suggest that the Commission s decision in this case would essentially set a precedent from which a future panel would require compelling reasons to depart Deemed Regulatory Structure The application of historical ratemaking principles requested by PNG requires a significant amount of deeming with respect to the revenue requirement formula and the determination of PNGL s rates.

16 14 PNG is requesting that the Commission deem a capital structure for PNGL that would include 57 percent of longterm debt, 7 percent of short-term debt and 36 percent common equity. The existing 3.69 percent component of preferred shares would be redeemed. The deemed common equity percentage would be open to review over time based on changed risk profiles. PNG also proposes that the return on PNGL s deemed common equity component continue to be set at the low risk benchmark utility level, plus 75 basis points for PNG-West and Tumbler Ridge Divisions and, plus 50 basis points for the Fort St. John/Dawson Creek Division. PNG further proposes that the cost rate for its deemed longterm debt be deemed to be the average rate of the remaining outstanding long-term debt. PNG proposes a change in the way PNGL would determine the long-term and short-term debt components of the deemed capital structure. PNG submits that with the redemption of PNG s preferred shares, it would be reasonable to increase the deemed short-term debt component of its capital structure to 7 percent and to deem the long-term debt component at a level 2 percent higher than its current actual level (RA, Tab Application, para. 50, p. 16). Notwithstanding that the recapitalization would essentially minimize or eliminate the corporate taxes payable by PNGL, which would remain a taxable and reporting entity, PNG further proposes that an income tax component for each operating Division s revenue requirement be calculated using the existing flow through income tax calculation and the deemed capital structure, in the same way as is presently being done for regulatory ratemaking purposes. Essentially, PNG is asking the Commission to deem an element of PNGL s cost of service that is equivalent to the income taxes payable as if the recapitalization had not been effected. The full details of the proposed deemed rate setting structure and the confirmations requested of the Commission are outlined in Part IV of the Recapitalization Application at pages 15 to Key Aspects of the Application In his opening statement at the commencement of the hearing in Vancouver, Mr. Dyce stated: The key to the recapitalization is in the hands of the Commission Panel. PNG has asked the Commission to continue to set customer rates based on current regulatory practices. The substantial amount of financial analysis that has been put into the assessment of the recapitalization plan has been based on customer rates continuing to be determined by the Commission using the same regulatory construct as has been in place since the inception of PNG (T3: ).

17 15 While PNG stated in the Recapitalization Application and maintained throughout the proceeding that it is simply seeking Commission confirmation that PNGL will continue to be regulated as PNG is currently, it became clear during the proceeding and in PNG s Argument that this is the critical aspect of the Recapitalization Application. In fact, PNG has characterized the requested confirmations as conditions to be imposed on the applied-for approvals, many of the details of which have not yet been determined and which depend upon the requested confirmation being granted by the Commission. In particular, a draft of the IPO prospectus has not been prepared, and while a term sheet of the agreement in principle with PNG s bondholders has been provided, drafting of the definitive agreement is in process but not yet complete. PNG explained that these matters, as well as other matters related to the structuring of cash distributions and borrowing policies, are all pending Commission approval of the recapitalization (BCOAPO IR No. 1, Q. 41, 42 and 117). In fact, PNG suggested in Argument that the Commission s decision on this Recapitalization Application need only confirm that the Commission will issue its Orders (granting approvals under sections 50 and 54 of the Act) subject to [a further] condition that PNG will provide the Commission with the details of each of the transactions at such time as it files a copy of the Plan of Arrangement and Preliminary prospectus with the Commission, consistent with the terms set out in the Recapitalization Application (PNG Argument, para. 68, p. 27). PNG has suggested that it is seeking the same regulatory construct and the application of historical ratemaking principles. However, PNG is asking the Commission to deem aspects of the cost of service formula in a manner and combination that is significantly different from the Commission s past practice in respect of similarly regulated utilities in British Columbia or apparently, based on the evidence before it, any like regulatory body in Canada. BCOAPO recognized this in Argument, noting that the Recapitalization Application proposes a major and, for a regulated utility, unprecedented change and requires BCUC regulation of the utility on the basis of a deemed capital structure significantly different from what would be its actual capital structure (BCOAPO Argument, p. 9). The key aspects of PNG s request are also identified in an investment analyst s report filed as Exhibit A-31 discussed with PNG s witnesses during the proceeding (T3: 497; T4: ). At pages 5-6 of that report, the analyst commented that there are a number of issues that must be considered by the regulator and likely result in a material risk that the application is not approved as filed. First, she noted the question of whether deemed taxes should be collected from ratepayers when corporate taxes will no longer by paid by the regulated utility due to the difference between actual capital structure and the deemed structure outlined in the application and,

18 16 second, whether it is in the public interest to have a deemed capital structure that is substantially different than the actual capital structure of the utility Consideration of the Deeming Requests PNG s Position PNG submits that the use of the deemed capital structure to fix its rates is appropriate for two reasons. First, such a capital structure will result in lower rates for ratepayers and, second, the deemed capital structure ratemaking model has a long regulatory history and is therefore understandable and acceptable to the financial community that follows gas utilities like PNG (PNG Argument, para. 51, p. 21). PNG states that when the Commission deems, for rate purposes, a capital structure with a common equity component less than the actual common equity component, it prevents the utility from recovering its actual income taxes payable. According to PNG, no one would suggest that the Commission does not have the authority to deem such a capital structure as part of the Commission s statutory obligation to fix just and reasonable rates. However, as a matter of principle, PNG suggests that if the Commission can deem the common equity component (and associated income tax expense) below the actual common equity ratio, then it can also deem the common equity component of the capital structure (and associated income tax expense) above the actual common equity ratio. Again the regulatory principle that applies, according to PNG, is whether, in deeming a common equity ratio above (or below) the actual ratio, the Commission is acting in the public interest and determining just and reasonable rates (BCUC IR No. 2, Q. 14; Ex. B-49, PNG Argument, para. 54, pp ). PNG notes that it is not uncommon for regulators, including the Commission, to deem capital structures for ratemaking purposes that are different from the actual capital structure of the regulated entity. Indeed, PNG suggests that the Commission has done precisely this for many years in the case of PNG, where its common equity ratio has exceeded 36 percent but rates have been set on the basis of a deemed 36 percent equity ratio. With respect to the income tax proposal, PNG states that the continued recovery of an income tax component in PNG s post recapitalization deemed cost of service will provide the needed cash flow from PNG s utility operations to pay its shareholder note interest obligations and dividends on the common shares held by the PNG Income Trust (PNG Argument, para. 52, p. 21). PNG suggests that [i]f it is accepted that the recovery of an income tax component in rates simply provides the investors with their required before tax return sufficient to induce them to make their investment then that principle applies regardless of the legal structure and notes that [i]n PNG s case the holders of the PNG Income Trust units will be taxable investors. PNG suggests that in both the case of a limited partnership structure and in this case, with a trust structure, the inclusion of an income

19 17 tax provision in the costs of service provides the investor with a before tax rate of return which is necessary to induce the investors to invest their capital. PNG further suggests that the inclusion of an income tax component in its rates in the income trust scenario will result in rates which are equal to, or somewhat less than, the just and reasonable rates which will apply in the status quo case (PNG Argument, paras. 55 and 56, p. 24). PNG notes that the utility will remain a taxable entity and that while the tax liability of PNGL will be lowered under the income trust structure, taxes will be paid by the unit holders on distributions from the PNG Income Trust as interest income. In fact, PNG states that the unit holders will pay more taxes on the distributions than are currently paid by shareholders. PNG maintains that if taxes are not included in the calculation of the rates as proposed (i.e. on a deemed capital structure and deemed taxable status), the cash available for distribution to unit holders will not be sufficient to induce current shareholders of PNG to approve a conversion and that the status quo, therefore, would remain a superior alternative for shareholder value. Without this result, PNG notes that the benefits to customers of the recapitalization would not be obtained (PNG Reply Argument, paras.18 and 19, p ) Views of Other Parties As noted in section 3.1.2, BCOAPO states that the Recapitalization Application proposes a major and, for a regulated utility, unprecedented change in PNG s capital structure and that the proposal requires BCUC regulation of the utility on the basis of a deemed capital structure significantly different from what would be its actual capital structure. BCOAPO submits that given that PNG is the first regulated utility to apply to convert from a traditional capital structure to an income trust [ownership structure], PNG owes the Commission and intervenors a much higher standard of proof than what has been adduced on the record to date to suggest that the proposal is in the public interest and that the users of the service of the public utility will not be detrimentally affected (BCOAPO Argument, p. 15). BCOAPO submits that PNG has not provided sufficient evidence to meet the requirements of the Act and further, that there are just too many questions left open to give BCOAPO and the Commission the confidence that this proposal really is in the best interest of the utility and its ratepayers. BCOAPO suggests that the unit holders of the income trust will be able to take advantage of ratepayers paying in their rates the level of income taxes presently collected in the rates by the utility while the utility is projected to pay close to zero income taxes (BCOAPO Argument, p. 11, with reference to RA, para. 37, p. 13). BCOAPO notes PNG s statement (Mr. Johnstone) that the elimination of corporate income taxes is a permanent issue as opposed to a short-term issue (T4: 596). According to BCOAPO, PNG s proposal is that under the income trust, PNG will continue to collect corporate income taxes from its ratepayers, not pay it, but distribute the savings

20 18 to unit holders and BCOAPO further suggests that this is a direct transfer of millions of dollars from ratepayers to unit holders (BCOAPO Argument, p. 12) Regulatory Precedents The Commission asked PNG to provide regulatory precedents and regulatory principles to support is Recapitalization Application and the proposed income tax treatment. PNG reproduced in its Argument the full text of its response to BCUC IR No. 2, Q. 14 (Ex. B-12) which, among other things, simply listed a number of cases where regulators have allowed the recovery of an income tax component in the cost of service in circumstances where the regulated utility is not taxable, including: - BCUC Plateau Pipe Line Ltd. (June 2001) - Quebec Regie Gaz Metropolitan Inc. (December 1990) - National Energy Board Trans Quebec and Metropolitan Inc. Maritime Pipelines (numerous decisions) - National Energy Board Alliance Pipelines L.P. (GH-3-97) - National Energy Board Maritimes and Northeast Pipelines (RH ) PNG states that this list is not exhaustive but that it includes a representative number of decisions where regulatory tribunals have included an income tax component in the cost of service where there was no expectation on the part of the regulator that the taxes would be actually paid by the regulated entity, but rather by the beneficiaries. PNG suggests that it is the practice of Canadian regulators to include an income tax component in the cost of service of a regulated utility, determined on a stand-alone basis, in circumstances where the corporation may not actually be paying income taxes. During the hearing, Commission counsel discussed with PNG s witnesses a number of the precedents including the Commission s June 26, 2001 Decision related to the Plateau Pipe Line Ltd. ( Plateau ) application for permanent tolls for the Taylor to Kamloops Pipeline ( Plateau decision ). It was acknowledged that the Commission s Plateau decision permitted the inclusion in rates of an allowance for income taxes, even though the assets were owned by a limited partnership and the ultimate owner was the Pembina Pipeline Income Fund. And, it was acknowledged, that while there was a discussion in the decision of whether or not income taxes should be allocated on a normalized deferred or flow-through basis, there was no discussion in the decision of whether or not those taxes should actually be collected at all (T3: 520).

21 19 A recent decision of the Alberta Energy and Utilities Board ( EUB ) was not mentioned in PNG s information response but was raised by Commission counsel at the hearing. In the EUB Decision (August 3, 2003) concerning the Transmission Tariff for AltaLink Management Ltd. and TransAlta Utilities Corporation ( AltaLink case ), AltaLink applied for an income tax component in its revenue requirement. It submitted that such costs must be acknowledged by the EUB and approved as an appropriate and fundamental part of its revenue requirement notwithstanding that AltaLink LP is a limited partnership whose only limited partner, AILP, is itself a limited partnership, neither of which is subject to the payment of income taxes (p. 77). The EUB noted that under existing law, a partnership is not subject to the payment of income taxes arising from income generated by the partnership s business activities. Rather, the earnings from those business activities are allocated to its individual partners in proportion to their partnership interests. AltaLink argued that the stand-alone principle of regulation requires the acceptance of the assumption that AILP is a taxable corporate entity in the Province of Alberta, despite the fact that as a partnership it is not subject to taxation. According to AltaLink, this means that the ratepayers must provide an income tax component consistent with the tax liability that arises from the regulated income stream irrespective of the entity or entities that actually incurs the tax liability. In that case, a number of intervenors took issue with AltaLink s position suggesting, for example, that income tax expense is similar to any other cost associated with the operation of the utility and that if there was no reasonable expectation that it would be incurred, then it should not be borne in customer rates (p. 81) It was argued that either forecast taxes that are actually going to be paid directly by the utility are recoverable or the forecast actual corporate income tax expense of the partners is recoverable. The EUB noted that in Alberta s cost of service jurisdiction where revenue and costs are forecast on a prospective basis, there must be a reasonable expectation that the quantum of costs, which are approved, would likely be incurred. The EUB suggested that the calculation of an income tax component of revenue requirement should be determined on the same basis as other costs, that is, the utility is treated as a separate entity for regulatory purposes and it is the costs related to that utility s operations that are examined and approved on a prospective basis. On the evidence before it, the EUB accepted that the partners are taxable entities in Canada and assumed that there is a reasonable expectation that income taxes in the range approved will be incurred and paid by the partners, with one exception. The EUB conditionally approved a deemed income tax allowance for the other partners ( eligible partners ) as part of the revenue requirement (p. 84), subject to the filing of further information related to the capital structure of the limited partners investment in the utility partnership. In its January 27, 2004 Compliance with Board Directions in Decision , the EUB approved the use of deemed income tax allowance treatment for the eligible partners when establishing AltaLink s final transmission tariff for the fiscal years in issue (p. 24).

22 20 Commission counsel discussed the AltaLink case with PNG s witnesses at the hearing suggesting that the EUB had recently declined to include an allowance for income taxes in the rates of AltaLink to the extent that the EUB could not be sure that those taxes would ever be paid. Mr. Teitge indicated that PNG is aware of the decision and noted that the decision is subject to reconsideration and review and that, as he understands it, the limited partnership units in AltaLink are all now held by taxable corporations (T3: ). PNG also referred to the establishment of Gaz Metropolitain Inc. as a limited partnership and the deemed elements of the regulation of that utility by the Quebec Regie as a close parallel to the Recapitalization Application. In its Final Argument, PNG took issue with Commission counsel s suggestion in cross-examination that there was a distinction to be made in the Plateau Pipeline Ltd. and Gaz Metropolitain Inc. cases compared to PNG, because Plateau and Gaz Metropolitain Inc. were limited partnerships rather than income trusts (T: ). PNG submits that this is a distinction without a difference (PNG Argument, para. 55, p. 23). The Commission also asked PNG to provide evidence that the structures and methodologies proposed by PNG to be approved by the Commission on a continuing basis are not dissimilar to those granted in the regulated power and pipelines sector. In its response to the Commission s IR No. 2, Q. 38 (Ex. B-12), PNG stated that it is reasonably certain that most of these power and pipeline sector income trusts own assets that are regulated on methodologies that are quite dissimilar to those applied for by PNG. For example, PNG believes that none would be subject to an annual revenue requirements review methodology for determining rates and that, while subject to regulation, a very different regulatory construct is used, i.e. a complaint based method of regulation, than that which applies to PNG. Like other major energy utilities operating in British Columbia, PNG has been regulated on a rate base, rate of return methodology using a forecast forward test year Commission Panel Analysis As noted in section 3.1, PNG suggests that it is simply requesting Commission confirmation that the annual revenue requirement for each operating Division will be determined on the same basis as is currently done (RA, Tab Application, p. 16, para. 52). The Commission Panel, however, does not believe that this position gives appropriate regard to the issues that the Commission must consider before providing such confirmation and the fact that there is, in the Commission Panel s view, a substantial difference between what is proposed in this instance and the current situation.