Gazifere Fair Return and Capital Structure€¦ · BOOTH Gazifere 2010 Gazifere’s Business Risk...
Transcript of Gazifere Fair Return and Capital Structure€¦ · BOOTH Gazifere 2010 Gazifere’s Business Risk...
BOOTH Gazifere 2010
Gazifere Fair Return and Capital Structure
Professor Laurence Booth
CIT Chair in Structured Finance
Rotman School of Management
BOOTH Gazifere 2010
Key Issues before the Regie
Has Gazifere’s business risk increased since its last hearing in1998?
Is the 75% ROE adjustment to forecast changes in the long Canada bond yield still appropriate?
What is a fair and reasonable ROE for Gazifere and what is a reasonable range for the estimate?
BOOTH Gazifere 2010
Gazifere’s Business Risk
McShane and Booth agreement that risk has a short and long run dimension
Short run: return on capital
– McShane: ability to earn a “compensatory return”
– Booth not earning the allowed ROE
– Whether the allowed ROE is fair and reasonable or “compensatory” is regulatory risk not business risk
– Quantitative assessment
Long run: return of capital
– The ability to recover the investment in rate base
– Viability of the natural gas market in Quebec
– Qualitative assessment
BOOTH Gazifere 2010
Gazifere
ROE Performance
GI-31 Doc 1.1 & GI32 Doc 1.5
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Allowed Actual
BOOTH Gazifere 2010
Short Run Risk
Gazifere has over earned its ROE by an average of 0.96% per year since 1998 (GI-31);
No trend in over-earning
“Gazifere has not gone back.... to establish the drivers for deviations from the allowed return” (GI-31)
– Clearly Gazifere thinks its short run risk is not material?
2005 deviation due to bad debt expense form two large industrial customers (Booth IR#11)
2007-9 uptick due to performance based regulation: PBR is not a risk as company simply earns more than the allowed ROE
BOOTH Gazifere 2010
Gaz Metro Allowed vs Actual ROE
8
9
10
11
12
13
14
15
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Allowed Incentive Actual
Gaz Metro has sometimes failed to earn its full PBR
but still over earned its allowed ROE
BOOTH Gazifere 2010
Gazifere Revenue Composition
1999 2003 2006 2009
Residential 19,748 22,633 28,438 32,077
Commercial 2,539 2,562 2,818 2,968
Industrial 14 14 13 12
Gazifere Revenue Composition
GI-3- Doc 1
0.00
0.10
0.20
0.30
0.40
0.50
0.60
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
RES COMM IND
BOOTH Gazifere 2010
Natural Gas Competitiveness
Development of natural gas from shale has created a disconnect from the price of oil
– 1999 price advantage was 24% for residential and a disadvantage of 8% for commercial
– 2009 residential advantage increased to 50% and commercial 53%
Quebec has abundant electricity
– 1999 price advantage of natural gas was 24% for residential and 57% for commercial
– 2009 this advantage had dropped to 15-27% for residential and 33% for commercial
BOOTH Gazifere 2010
Business Risk Summary
Demonstrated ability to earn allowed ROE
Protective regulatory environment where PBR has increased over-earning
Large increase in customer base as natural gas has a competitive advantage over both oil and electricity for residential and commercial consumers
Drop off in industrial customers, particularly interruptible reduces forecast risk and possibility of bad debt losses similar to 2005
Overall no sign of any increase in business risk, more likely a reduction
BOOTH Gazifere 2010
Regie Gaz Metro Decision
BOOTH Gazifere 2010
Financial
US emerging from a brutal recession, Canada from a mild recession
Cause was the failure of the US financial system that spread contagion around the world
Catalyst: Failure of Lehman Brothers September 14, 2008
– Domino effect around the world as banks focused on survival
Hoarded cash
Reduced lending
Sold off securities to bolster capital
Reduced principal trading in debt markets: reduced liquidity in secondary markets
BOOTH Gazifere 2010
Stock Market Collapse
Index or Exchange Last Trade Date
1Day Change
1 Day %
1 Month %
6 Month %
YTD % 2006 $b Value
United States Composite (US Dollar)
213.40
10/24/2008 -7.52 -3.40% -27.53% -37.17% -40.46% 18,039
Japan Composite (US Dollar)
82.39
10/24/2008 -2.74 -3.21% -22.00% -32.07% -35.54%
4,422
United Kingdom Composite (US Dollar)
149.79
10/24/2008 -11.63 -7.21% -35.44% -48.66% -52.51% 3,441
Canada Composite (US Dollar)
278.25
10/24/2008 -4.74 -1.67% -40.46% -48.15% -49.61% 1,636
Germany Composite (US Dollar)
218.89
10/24/2008 -14.62 -6.26% -39.40% -51.88% -56.28% 1,426
Hong Kong Composite (US Dollar)
186.44
10/24/2008 -10.10 -5.14% -31.80% -51.39% -57.97% 1,361
Spain Composite (US Dollar)
388.93
10/24/2008 -26.01 -6.27% -34.22% -50.24% -51.93% 1,146
Switzerland Composite (US Dollar)
374.65
10/24/2008 -10.44 -2.71% -22.21% -32.06% -34.35% 1,111
Real Economy can not flourish if the financial system is
broken:
1) Credit crunch
2) Real economy stops spending
3) Sharp recession started 2008Q4 in Canada
BOOTH Gazifere 2010
Short Term Credit Spreads
Money market now back to normal in Canada
Money Market Spreads
(CansimV121812,V121778,V121796)
0
50
100
150
200
250
300
1/4
/2006
3/4
/2006
5/4
/2006
7/4
/2006
9/4
/2006
11/4
/2006
1/4
/2007
3/4
/2007
5/4
/2007
7/4
/2007
9/4
/2007
11/4
/2007
1/4
/2008
3/4
/2008
5/4
/2008
7/4
/2008
9/4
/2008
11/4
/2008
1/4
/2009
3/4
/2009
5/4
/2009
7/4
/2009
9/4
/2009
11/4
/2009
1/4
/2010
3/4
/2010
CP BA
BOOTH Gazifere 2010
Overnight Rate
(cansim V39079)
0
1
2
3
4
5
6
7
8
9
10
12/1
/1992
12/1
/1993
12/1
/1994
12/1
/1995
12/1
/1996
12/1
/1997
12/1
/1998
12/1
/1999
12/1
/2000
12/1
/2001
12/1
/2002
12/1
/2003
12/1
/2004
12/1
/2005
12/1
/2006
12/1
/2007
12/1
/2008
12/1
/2009
Bank of Canada has increased the overnight rate twice since
May to remove some of the stimulus as economy has regained
most of the jobs lost during the recession
BOOTH Gazifere 2010
LTC Yields fell, Corporate debt yields increased but now back to pre-
crisis levels
McShane recommends a 50% adjustment to Corporate bond yields,
This means about the same allowed ROE as start of 2008
Recently both Corporates and Canada yields have fallen unlike in the
financial crisis
Yields since January 2008
3
4
5
6
7
8
9
2/1
/20
08
3/1
/20
08
4/1
/20
08
5/1
/20
08
6/1
/20
08
7/1
/20
08
8/1
/20
08
9/1
/20
08
10
/1/2
00
8
11
/1/2
00
8
12
/1/2
00
8
1/1
/20
09
2/1
/20
09
3/1
/20
09
4/1
/20
09
5/1
/20
09
6/1
/20
09
7/1
/20
09
8/1
/20
09
9/1
/20
09
10
/1/2
00
9
11
/1/2
00
9
12
/1/2
00
9
1/1
/20
10
2/1
/20
10
3/1
/20
10
4/1
/20
10
5/1
/20
10
6/1
/20
10
7/1
/20
10
8/1
/20
10
BBB A AA Canada
Gaz Metro hearing August 2009
BOOTH Gazifere 2010
Spreads still high relative to where we are in the recovery,
perhaps 0.50% too high or long Canada’s 0.50% too low
Default Spreads Since Dec 1979
0
50
100
150
200
250
300
350
400
450
500
12/3
1/1
979
12/3
1/1
981
12/3
1/1
983
12/3
1/1
985
12/3
1/1
987
12/3
1/1
989
12/3
1/1
991
12/3
1/1
993
12/3
1/1
995
12/3
1/1
997
12/3
1/1
999
12/3
1/2
001
12/3
1/2
003
12/3
1/2
005
12/3
1/2
007
12/3
1/2
009
AA A BBB
BOOTH Gazifere 2010
Conclusion
LTC Yields remain the only long term opportunity cost or fair rate of return in the capital market
LTC yields expected to increase to 4.5% for 2011,
– 3.93% at time of testimony
– 3.53% currently
– More risk of lower LTC yields than higher for 2011
Corporate yields have followed long Canada yields down the last five months, AA spreads constant, A spreads minor pick up.
Market is still “jittery”
BOOTH Gazifere 2010
Risk Premium Models
Explicit Risk premium model
– CAPM
– Primary reliance by NEB (RH-1-2008)
– Primary reliance by Regie
*MRPRKF
Time Value of
Money
Market Risk
Premium * “beta”
BOOTH Gazifere 2010
BOOTH Gazifere 2010
Arithmetic is simple average; geometric is compound and OLS is the least squares estimate.
Approximately Geometric Mean = Arithmetic Mean - .5*variance
For example, US variance is about 4%, so AM and GM diverge by about 2%
Annual Rate of Return Estimates 1926-2009
U.S.
CANADA
S&P
Equities
Long US
Treasury
Excess
Return
TSE Equities
Long
Canadas
Excess
Return
AM
11.80
5.77
6.03
11.39
6.43
4.96
GM
9.77
5.40
4.37
9.69
6.08
3.61
OLS
11.09
5.11
5.98
10.42
5.80
4.62
Volatility
1
20.48
9.15
18.96
8.87
BOOTH Gazifere 2010
Fernandez Survey May 2009
1) MRP higher in Canada than US
2) Median Canadian MRP is 5.1%
BOOTH Gazifere 2010
If the Regie randomly asked a Canadian finance professor what
the MRP is, the answer would almost certainly be 5.0% or 6.0%
BOOTH Gazifere 2010
BOOTH Gazifere 2010
Relative Risk (BETA)
Average Utility Betas
-0.100
0.000
0.100
0.200
0.300
0.400
0.500
0.600
Jan-8
5
Jan-8
6
Jan-8
7
Jan-8
8
Jan-8
9
Jan-9
0
Jan-9
1
Jan-9
2
Jan-9
3
Jan-9
4
Jan-9
5
Jan-9
6
Jan-9
7
Jan-9
8
Jan-9
9
Jan-0
0
Jan-0
1
Jan-0
2
Jan-0
3
Jan-0
4
Jan-0
5
Jan-0
6
Jan-0
7
Jan-0
8
Jan-0
9
Utility beta Utility (No TAU)
BOOTH Gazifere 2010
Stock Performance over Last Year: Emera
BOOTH Gazifere 2010
Stock Performance over Last Year: Fortis
BOOTH Gazifere 2010
Stock Performance over Last Year: GMLP
BOOTH Gazifere 2010
Fair ROE
LTC Yield: 4.50%
Market Risk Premium: 5.0-6.0%
Beta: 0.45-0.55
Issue costs: 0.50%
Recommended Benchmark ROE: 7.75%
Financial Crisis adjustment: 0.50%
Gazifere addition: 0.25%
Recommended ROE: 8.50%
Since June LTC Yields have dropped but spreads have widened
BOOTH Gazifere 2010
2009 Reviews
AUC November 2009
OEB (August 2009)
BOOTH Gazifere 2010
Analyst Views
Matt Aikman McQuarrie May 2008 to CAMPUT
BOOTH Gazifere 2010
ROE Formula Reviews
OEB 2003 (2004 Decision)
AUC (AEUB) 2003 for 2004
BCUC 2007 changes (100% adjustment to Canada yields changed to 75%)
NEB 2001 confirmation in TCPL Mainline declined to hear ROE evidence in 2004
Regie 2007 Gaz Metro decision
Ms. McShane recommended a 75% ROE adjustment to long Canada yield changes as late as 2007 in an Ontario Power Generation hearing
BOOTH Gazifere 2010
New ROE formula proposals
McShane
– assume NEB correct in 1994
– adjusts for 50% of long term Canada (LTC) and “spread” in A bond yield changes
– collapses to change by 50% of the change in A bond yields
Booth
– assume NEB correct in 2000
– adjusts for 75% of change in LTC yields
– adjusts for 50% of the change in A spreads
%)71.0(*50.0%)25.9(*50.0%25.12 SpreadLTCROE
%)94.0(*50.0%)12.6(*75.90.9 SpreadLTCROE
BOOTH Gazifere 2010
ROE Adjustment Formula
ROE Formula
8
8.5
9
9.5
10
10.5
11
11.5
12
12.5
13
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
NEB McShane Booth1 Booth2
McShane assumes NEB got it right for 199f and wrong
from thereafter
Booth 1 &2 assumes NEB got it right in 2001 or 2004 and
uses spread change to capture the “crisis” premium
BOOTH Gazifere 2010
Gazifere
Assume Regie got it right in 1998
– adjust by 75% of LTC change
– adjust by 50% of spread change
For 2011
– LTC is 4.50%
– Utility spread 1.30%
LTC causes 0.75*1.2% or -0.90%
Spread causes 0.50* 0.30 or +0.15
Overall 9.25%
Update
– LTC forecast yields lower (-0.15%)
– spreads wider (+0.10%)
%)99.0(*50.0%)70.5(*75.0%0.10 spreadLTCROE
BOOTH Gazifere 2010
US Data
Moody’s
– 25% regulation
– 25% ability to earn the allowed ROE
– 10% diversification
– 40% financials: the numbers
“Moody’s views the regulatory risk of US utilities as being higher in most cases than that of utilities located in some other developed
countries, including Japan, Australia and Canada. The difference in risk reflects our view that individual state regulation is less predictable
than national regulation; a highly fragmented market in the US results in stronger competition in wholesale power markets; US fuel and
power markets are more volatile; there is a low likelihood of extraordinary political action to support a failing company in the US; holding
company structures limit regulatory oversight; and overlapping and unclear regulatory jurisdictions characterize the US market. As a result
no US utilities, except for transmission companies subject to federal regulation, score higher than a single A in this factor.”
“as is characteristic of the US, the ability to recover costs and earn returns
is less certain and subject to public and sometimes political scrutiny.”
BOOTH Gazifere 2010
US Utility Bond Ratings
Description is of business risk rating for each rating class
BOOTH Gazifere 2010
Newfoundland Power Decision
BOOTH Gazifere 2010
BCUC Decision
BOOTH Gazifere 2010
Ms McShane’s Use of Analyst Growth Forecasts
BOOTH Gazifere 2010
Optimism Bias
Analyst are over optimistic and gradually zero in on the right numbers as they get guidance from companies
Academic research that analysts are biased
McKinsey (consultants)
– S&P500earnings growth has been 100% too optimistic: 10-12% vs 6%
Ms McShane’s US sample
– Historic & forecast GDP growth 5.0%
– Historic dividend growth: 2.5%
– Historic earnings growth: 4.0%
– Forecast analyst growth: 5.9%
BOOTH Gazifere 2010
Ms McShane’s Risk Assessment for Gazifere
She assumes Gazifere would be a BBB utility and estiamtes the risk premium for US BBB’s relative to her low risk US utilities
US utilities are large risky utilities
Gazifere is a small low risk utility
BOOTH Gazifere 2010
Fair ROE
LTC Yield: 4.50%
Market Risk Premium: 5.0-6.0%
Beta: 0.45-0.55
Issue costs: 0.50%
Recommended Benchmark ROE: 7.75%
Financial Crisis adjustment: 0.50%
Gazifere addition: 0.25%
Recommended ROE: 8.50%
Suggested New ROE Formula: 9.25%
Since June LTC Yields have dropped but spreads have widened