DECISION 2016 NSUARB 42 M07215 NOVA SCOTIA UTILITY AND REVIEW BOARD IN THE MATTER OF THE PUBLIC UTILITIES ACT IN THE MATTER OF AN APPLICATION for approval of NOVA SCOTIA POWER INC. S pre-tax WEIGHTED AVERAGE COST OF CAPITAL and ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION RATES BEFORE: Roberta J. Clarke, Q.C., Panel Chair KulvinderS. Dhillon, P.Eng., Member Murray E. Doehler, CPA, CA, P.Eng., Member APPLICANT: NOVA SCOTIA POWER INC. Brian Curry, LL.B. INTERVENORS: CONSUMER ADVOCATE John Merrick, Q.C. William Mahody, Q.C. SMALL BUSINESS ADVOCATE E.A. Nelson Blackburn, Q.C. INDUSTRIAL GROUP Nancy G. Rubin, Q.C. Maggie A. Stewart, LL.B. FINAL SUBMISSIONS: February 26, 2016 DECISION DATE: April 12, 2016 DECISION: The Board establishes the method for the calculation of annual WACC and AFUDC rates.
-2- I INTRODUCTION [1] This is a decision of the Nova Scotia Utility and Review Board ( Board ) respecting an application ( Application ) by Nova Scotia Power Inc. ( NSPI ) for approval of its pre-tax Weighted Average Cost of Capital ( WACC ) and Allowance for Funds Used During Construction ( AFUDC ) rates. This Application was made on December 18, 2015, under the Public Utilities Act, R.S.N.S. 1989, c. 380 as amended ( Act ). [2] A notice of the proceeding was sent to those parties who expressed an interest in the Annual Capital Expenditure ( ACE ) Plan application for 2016, filed on November 12,2015. Notices of Intervention were filed by the Consumer Advocate ( CA ); the Small Business Advocate ( SBA ); and the Industrial Group. A timeline was established to accommodate Information Requests ( IRs ) and the filing of evidence by the formal intervenors. The Industrial Group, the SBA, and Board staff submitted IRs to which responses were received by January 27, 2016. On February 5, 2016, the CA and the SBA both confirmed that they would not be submitting evidence. A letter from NSPI, dated February 26, 2016, stated it would not be submitting rebuttal evidence. II BACKGROUND [3] The AFUDC represents the cost of financing the construction of plant and equipment. NSPI is allowed to include the financing costs in the value of the related plant and equipment. Once NSPI begins using the asset, AFUDC accumulation stops and its value is transferred into the Regulated Rate Base. Regulated Rate Base is the value of approved capital assets, construction work in progress, and certain other deferred expenses that will be recovered in the power rates.
-3- [4] In the 2013 ACE Plan Decision, the Board noted that NSPI had been charging an AFUDC rate without specific approval and ordered NSPI to use the rate that had been approved in the last general rate application ( GRA ). This rate was also used for the 2014 ACE Plan. In the 2015 ACE Plan proceeding, NSPI argued that adjustments were necessary to the AFUDC rate to match the cost actually being incurred. The Board agreed and reduced the rate to 7.19% only for AFUDC. [5] The third item in the Preliminary Issues List for the 2016 ACE Plan was 2016 AFUDC rate for capital purposes. In response to this issue, NSPI noted: On October 10, 2015 the Board directed NS Power to make a number of revisions in connection with its 2015 ACE Stakeholder Engagement Report (M06963), including the following: With reference to Section 8.0, the Board does not consider that any approval of AFUDC should be taken as approval of WACC for other purposes. Therefore, NSPI is to remove the last sentence from the first paragraph, i.e.: The AFUDC rate in the ACE Plan will be the updated projection of NS Power s WACC for the upcoming year. [NSPI Letter to Board, December 8, 2015, pp. 1-2] [6] On December 8, 2015, NSPI withdrew its request for approval of the AFUDC rate as part of the 2016 ACE Plan proceeding. A separate Application was made on December 18, 2015, for approval of both the AFUDC and WACC rates. The Application also requested approval of an interim rate, effective January 1,2016, pending the Board s decision. The Board responded as follows: The Board notes that no request for interim approval of an AFUDC rate was made in the 2016 ACE Plan application. The Board notes that this request now comes less than one month before the proposed effective date for the interim rate, i.e., January 1, 2016. The Board is not prepared to approve an interim rate, but is agreeable to holding a separate process to consider NSPI s application for approval of the single AFUDC/WACC rate, as requested. [Board Letter to NSPI, December 18, 2015, p. 1]
-4- [7] NSPI also uses the WACC rate for regulatory accounts. The regulatory accounts for 2015 were: Fuel Adjustment Mechanism 2012 Fixed Cost recovery Demand Side Management Streetlight Stranded Asset Renewable to Retail [Exhibit N-3, Response IR-5, p. 2] III APPLICATION [8] The Board generally approves AFUDC and WACC rates as a part of a GRA by NSPI. These rates are calculated on the basis of equity thickness, rate of return and the cost of long term and short term debt projected for the test years. The Board, in reviewing the current Application by NSPI, has used similar principles as it would have used during a GRA review. [9] The Application presented the calculation as follows: Nova Scotia Power Inc. Estimated Average Capital and Cost of Capital Years Ended December 31st Millions of Dollars 2018 Financial Outlook 1 2 2016 (1) 3 Opening 4 5 Estimated Cost of Capital 6 (2) Closing (3) Average Capital <4) Capital Ratio (5) Cost Pre-tax Factor (6) Cost After-tax Factor (7) Weighted Pre-tax Cost (8) Weighted After-tax Cost 7 Short-term debt $77.2 $106,3 $91.7 2 4 o 2 56 o I 77% G 06Go 0 04 o 8 9 Long-term debt 2,210.6 2,209.9 2,210.3 58 l o 6.22*o 4 32*o 3 61 o 2.51 10 Total debt $2,287.7 $2,316.2 $2,302.0 60 5f,o 8 78 o 6 09*o 3 67*o 2.55 o 11 12 Common equity 1,498.3 1,510.0 1,504.1 39 5*o 9 00*0 3 56Cro 3 56 o 13 14 Total $3,786.0 $3,826.2 $3,806.1 100.0% 7.23% 6.11% 15 16 17 Notes: 18 I) Figures presented reflect whole numbers which may cause $0 IM in rounding differences on some line items. 19 2) Pre-tax equity cost excludes the income tax gross-up factor 20 3) Average capital reflects average of year-end balances [Exhibit N-1, Appendix A, p. 1]
-5- [10] NSPI stated that this method is the same as used in past GRAs: In order to avoid the confusion of having separate rates for capital and non-capital deferrals and separate approval processes for each, NS Power requests approval of a single WACC/AFUDC rate of 7.23 percent, for both capital and non-capital matters effective as of the date of approval. The WACC/AFUDC rate would remain in place until such time as a new rate is approved by the Board. [Exhibit N-1,p.3] [11] In addition, for future adjustment, NSPI stated: Depending on the materiality of the changes in the estimated WACC rates, NS Power proposes that it would apply to the Board for any future adjustments to WACC and AFUDC around the same time as it applied for approval of its Annual Capital Expenditure Plan. In the absence of such an application, the previously approved rates would continue to apply. [Exhibit N-3, Response IR-6, p. 1] [12] No evidence was filed to challenge either the method of calculating WACC or the quantum of the various components. IV ANALYSIS AND FINDINGS a) WACC and AFUDC Formula [13] The AFUDC rate has historically been based upon the calculation of the WACC rate. In a GRA the two rates are set to be the same and are used to establish the financing cost portion of revenue requirement for rate making purposes. The Board finds that this relationship should be maintained. [14] The Board notes that NSPI has calculated WACC in accordance with the following formulae: WACC = CRst x Rst + CRlt x Rlt + CRe x Re and CRst + CRlt + CRe = 1.0000 RRB
-6- where: CRst = Capital Ratio for Short Term Debt CRlt= Capital Ratio for Long Term Debt CRe = Capital Ratio for Equity Rst = Short Term borrowing rate rounded to one basis point Rlt = Cost of Long Term Debt, presented as a rate, rounded to one basis point Re = Equity borrowing rate rounded to one basis point RRB = Regulated Rate Base b) Regulated Rate Base [15] In the 2012 GRA (2011 NSUARB 184), the Board accepted a Settlement Agreement which included a provision on the adjustment of Regulated Rate Base. Since that time, the Rate Base has changed to include such items as capital additions, as authorized through the ACE plan and other approval processes, and reduced by depreciation as well as changes in the other elements. [16] In response to Exhibit N-5, IR-8 Revised, NSPI provided the details of the general ledger balances that are built into the Regulated Rate Base. NSPI, in calculating this regulated rate base said: Regulated Capital spend excludes projects that have received special direction from the Board as they do not make up part of Regulated Capitalization. [Exhibit N-5, IR-8 Revised, Attachment 1, p.5] [17] No Intervenors filed evidence to challenge NSPI s calculations of the Regulated Rate Base as being $3,806.1 million for 2016.
-7- [18] The Board accepts NSPI s assurances that it has not included the cost of projects which the Board has not approved. For the purpose of this Application, the Board accepts NSPI s calculation of the average Regulated Rate Base as $3,806.1 million for 2016. c) Capital Ratio i) Equity Ratio [19] In 2015 NSPI had redeemed all of its preferred equity. The equity component now consists of common shares and retained earnings. In the Application, NSPI proposes: For purposes of determining WACC in 2016, NS Power proposes to utilize its projected common equity thickness of 39.5 percent... [Exhibit N-1, p. 8] [20] NSPI explained that increasing this ratio from that used in the GRA was to reflect the present financial position. This, according to NSPI, is within the range approved by the Board in the 2012 GRA: Return on Equity/Capital Structure 7. Treatment as follows: a. Capital Structure - rates will be set on 37.5% equity, NSPI may use a maximum actual equity of 40%, actual average equity will be used to calculate return on equity results. [Exhibit N-2, p. 1] [21] Since the 2012 GRA, the Board s currently approved method to calculate the revenue requirement uses an equity thickness of 37.5%.
-8- [22] The Board has considered NSPI s request and is not prepared to set a ratio that is different from that used in determining the revenue requirement in a GRA. The Board finds, for the purpose of calculating WACC for 2016, the equity percentage should be the same as had been established in the 2012 GRA. NSPI is directed to adjust the Equity Ratio to 0.375. ii) Long Term Debt Ratio [23] The majority of the financing for the Regulated Rate Base comes from Long Term Debt, which by definition has maturities greater than one year. NSPI stated: NS Power can also access the debt capital markets and currently has a long-term debt portfolio of $2,060 million as of October 31, 2015, consisting of medium term notes and debentures. [Exhibit N-1, p. 6] [24] Over the past three years NSPI has accessed debt capital markets, borrowing tranches of $250 million, $300 million and $175 million, all with terms of 30 years. [25] In determining total Long Term Debt, NSPI included a forecasted issue planned for December, 2015. There are no repayments or new debt issues planned for 2016. The average of the Long Term Debt as calculated by NSPI is $2,210.3 million for 2016. [26] The Board considers the amount of Long Term Debt issued by NSPI can be easily predicted and occurs in large amounts. In keeping with the calculation of
-9- Regulated Rate Base, the amount for Long Term Debt will be the average of the opening and projected closing balances for the current year. This is the equivalent of adding one half of the net projected change in Long Term Debt to the balance as at the end of the previous year. This is the method used by NSPI in this Application. [27] The Board finds that the Long Term Debt Capital Ratio should be the amount of the Long Term Debt as calculated above divided by the Regulated Rate Base. [28] As calculated in the Application, the Board accepts the projected Long Term Debt of $2,210.3 million to be divided by the Regulated Rate Base of $3,806.1 million resulting in a Long Term Debt Ratio of 0.581 for 2016. iii) Short Term Debt Ratio [29] NSPI s Short Term Debt is obtained, largely, through a commercial paper program. As explained by the Company: Commercial Paper is short-term debt issued to investors with maturities of anywhere from a day to less than one year. [ibid, p. 6] [30] The Company explained Commercial Paper is the lowest cost form of borrowing and: Participating in this market provides NS Power with flexibility in managing its cash flow, typically rolling over amounts of $20-$25 million daily. [ibid, p. 6] [31] The Board finds that it is prudent for NSPI to have access to short term financing for its various cash flow needs. The Board expects NSPI to manage its cash flow and financing structure in a manner that provides the lowest cost to its rate payers.
-10- [32] The Board finds the Short Term Debt Capital Ratio is the difference between one and the combined ratio financed by Equity and Long Term Debt. [33] As a result of the findings on Equity and Long Term Debt, the Short Term Ratio is 0.044 for 2016 (1.000-0.375-0.581 = 0.044). d) Rates i) Equity [34] In the Application, NSPI proposed using a Return on Equity of 9% which it said is:... in the middle of the UARB approved reasonable return on equity band of 8.75 per cent to 9.25 per cent and on which rates are set. [ibid, p. 8] [35] In the last GRA, the Board used a return on equity of 9% for the purposes of calculating the rate used in determining the revenue requirement. [36] The Board accepts NSPI s request to use a return of 9% on the equity component of the WACC for 2016. ii) Cost of Long Term Debt [37] The projected Cost of Long Term Debt is calculated by using the actual interest costs on the previous year s issued debt that remains outstanding at the end of the current year, plus the cost of any changes. There are no maturities or planned redemptions to occur in the current year. NSPI, when asked if any planned restructuring is to occur in 2016, stated:
-11 - Redeeming or buying back long-term debt issues is done at current market rates. For all existing debt which has a higher coupon relative to current rates, the premium required in order to redeem the issue when added to the principal of the original issue would eliminate any benefit available from a reduced coupon on the new debt security. As a result, no such analysis has been completed. [Exhibit N-3, Response IR-2, pp. 1-2] [38] When asked what rates may be for a new 30 year Long Term Debt issue, NSPI responded that they:...would be in a range of 4.30% to 4.50% should we require it. [Exhibit N-6, Revised Response IR-2(a), p. 1] [39] NSPI stated that the last three borrowings on the capital markets were at 4.15%, 4.50% and 3.61% respectively. [40] In calculating the Cost of Long Term Debt Rate, NSPI used a forecasted new debt rate of 4.80% [Exhibit N-3, IR-2, Attachment 1] for the December, 2015 issue. [41] NSPI calculated the total cost of long term debt, including interest and other debt related charges to be $137,387,784 for 2016. It was presented, in this Application, as a blended rate of 6.22%. [42] The Board directs NSPI to use the actual cost of the December, 2015 issue in determining the total Cost of Long Term Debt in the Compliance Filing. iii) Short Term Debt Interest Rate [43] NSPI has used a projected rate of 2.56% for the Short Term Debt interest rate in this Application. [44] In projecting the Short Term Debt interest rate, NSPI:
-12-... relies on forecasts of major financial institutions to develop its market projections. These independent external financial forecasts provide NS Power with an unbiased estimate of future market rates.... [Exhibit N-4, Response IR-1 (b), p. 1] [45] Historically, the projections have not proved accurate. The following table, prepared by the Board from information extracted from Exhibit N-3, IR-3, illustrates the variation: Projected Actual 2011 5.04% 1.49% 2012 2.32% 0.86% 2013 4.00% 1.38% 2014 5.78% 1.58% [46] There could be other possible short term interest projection models that may prove more accurate than that used by NSPI. However, it is important to be mindful of materiality in attempting to improve accuracy. As stated by NSPI:...a change of.01% in the WACC rate has a minor impact on results of the Company, approximately $10,000 on $100 million of capital over the course of a year.... [Exhibit N-3, Response IR-5, p. 1] [47] For example, if a short term debt interest rate of 1.00% were used, after taking into consideration the requested short term debt capital ratio, this would reduce the weighted pre-tax rate from 0.06% to 0.02%, as calculated by the Board. The difference of 0.04% would translate to a $40,000 adjustment per $100 million of capital to the financial statements of NSPI. [48] The Board notes that a difference of 0.04% in the rate of Short Term Debt is $40,000. The Board does not consider such a difference to be material for this Application. In future, the Board expects NSPI to develop a more accurate prediction model for the short term debt rate.
-13- [49] For the purposes of the calculation of the 2016 WACC, the Board accepts the use of 2.56% for the Short Term Debt interest rate. V CONCLUSION [50] The calculation of WACC/AFUDC is to be done in accordance with the principles outlined in this Decision. A Compliance Filing of the calculation is to be made on or before April 19, 2016, with intervenor comments on or before April 26, 2016. [51] The Board s Decision on this matter is only to determine the amount of capitalization of the financial elements for various accounts. It is not a supplement to, or support for, the determination of these financial elements in the calculation of revenue requirement in any future GRA. [52] NSPI is directed to file, annually, no later than November 30, the calculation of WACC/AFUDC, unless there is a general rate application in the same year, using the principles outlined in this Decision. [53] Upon receipt and acceptance of the Compliance Filing, the Board will issue an order accordingly. DATED at Halifax, Nova Scotia, this 12th day of April, 2016. Roberta? J. Clarki Kulvinder S. Dhillon Murray E. Doehler