Docket UE20908
Order UE92-17IN THE MATTER of an application of Maritime Electric Company, Limited for confirmation of its rate base, revision in its allowed rate of return, approval of revised rates of depreciation, and approval of revised rates and charges.
BEFORE THE COMMISSION
on Thursday, the 25th day of March, 1993.
Linda Webber, Chairman
John L. Blakney, Vice-Chairman
James Nicholson, Commissioner
Reasons for Order
Contents
Appearances & Witnesses
Reasons for Order
1 Introduction
2 Return on Common Equity
2.1 Introduction
2.2 Risk Premium Approach
2.3 Discounted Cash Flow Approach
2.4 Comparable Earnings Approach
2.5 Conclusion
Appearances & Witnesses
1. For Maritime Electric Company, Limited:
Counsel:
William G. Lea
Witnesses:
John H. Reynolds, President
and Chief Executive OfficerJames A. Lea, Vice-President,
Customer Service & Energy ManagementRobert N. Morrison, Consultant
2. For the Town of Summerside:
Counsel:
Benjamin B. Taylor
3. For the Minister of Energy and Forestry, Government of P.E.I.:
Counsel:
J. Gordon MacKay
4. For the Island Regulatory and Appeals Commission:
Counsel:
Thomas A. Matheson
Staff:
Donald G. Sutherland
Director, Utilities DivisionGeorge W. Mason
Senior Analyst, Utilities DivisionGloria Dalziel, Recording Secretary
Reasons for Order
1 Introduction
These Reasons for Order are issued in respect of Commission Order UE92-17 which was issued by the Commission on December 21, 1992. Order UE92-17 together with these reasons address the issue of an appropriate rate of return on common equity for Maritime Electric Company, Limited ("Maritime Electric", the "Company", or the "Utility"). The Company's application in this docket, which was filed with the Commission on September 14, 1992, seeks an order or orders of the Commission approving a number of amendments to the Company's General Tariff. Public hearings into the application commenced on November 18, 1992, continued on November 19, 26 and 27, 1992 and then adjourned pending further evidence to be filed in early 1993.
The evidence on the matter of return on common equity concluded on November 27. The Company requested that, since no other parties planned to put forward evidence on rate of return, the Commission could proceed to make an interim finding. The Company's request was not supported by the Town of Summerside or the Minister of Energy and Forestry, two of the interveners in this proceeding; however, the Commission believes that the Company's rate of return on common equity has, for some time, been above a just and reasonable level and should be reassessed based on the evidence presented.
Our findings and conclusions on an appropriate return on common equity for the Company follow. The balance of the matters set forth in the application will be addressed following completion of the hearing.
2 Return on Common Equity
2.1 Introduction
The Company seeks a decrease in its allowed rate of return on average common equity from a range of 13.25-13.75% to 13.0%. In a departure from recent practice where rates were based on the mid-point of the range (13.50%) and the Company was allowed to earn up to the maximum, the Company now proposes that the range effectively be eliminated.
Evidence on the Company's proposal was given by Company witness R.N. Morrison. Mr. Morrison's evidence is based primarily on the discounted cash flow model applied to three separate groups of companies with the following results:
Discounted Cash Flow
Investor's Alternative Investment Opportunities Group 13.06%
Non-regulated Canadian Industrials Group 13.26%
Capital Seeking Group 13.39%
Average 13.24%
Mr. Morrison also presented the following evidence on book returns for the same groups of companies:
Comparable Earnings (Five Year Average)
Investor's Alternative Investment Opportunities Group 13.2%
Non-regulated Canadian Industrials Group 13.7%
Capital Seeking Group 11.6%
Average 12.8%
Based on this evidence Mr. Morrison concluded as follows:
The conclusions I have reached in my study are that the dollar return and the rate of return on common equity which the Company estimates it will earn in 1993 if the requested revenue is allowed are close to, but slightly below, the dollar return and rate of return that I have estimated to be fair and reasonable.
(Exhibit M-1, Tab 7, Page 3)
...
In the terms employed by this Commission in its Order No. E91-7, my findings correspond to a "Cost", that is, a required rate of return on common equity of 13.24 per cent in 1993.
(Exhibit M-1, Page 38R)
Discussion at the hearing focused mainly on the risk premium approach, more specifically the fact that it was not used, and certain of the assumptions made by Mr. Morrison.
2.2 Risk Premium Approach
The Commission has concluded in recent years that the various approaches to determining a fair and reasonable rate of return are all useful and should be considered. On this issue, the following comments were made in Order E91-7:
As we have stated previously, we believe we must evaluate all of the approaches in the determination of this important question. In this respect, we agree with the following comments of [Company Witness] Mr. Pavey:
It should be recognized that no single approach by itself will provide the definitive answer to the question of what constitutes a fair rate of return. The implementation of each method requires the use of judgment in evaluating the results of a theoretical model in the context of the real world. All three approaches, however, are useful in providing estimates of a fair return on common equity and also in providing some measure of validation of the results of the other approaches.
(Page 13)
In discussing Mr. Morrison's reasons for not using the risk premium approach, Counsel for the Company, Mr. Lea, argues as follows:
Professor Morrison's reason for not using it was that, although it has an appeal in theory, there is not a degree of demonstrable relationship between debt returns and returns on equity that would support use of the approach, and that under today's conditions he would not use it. He illustrated that by providing material that showed that there was not a relationship between debt and equity returns consistent enough for ratemaking. There was no suggestion in cross examination that he was wrong in that.
(Argument of Maritime Electric, December 8, 1992, Pages 1 & 2)
On the first point, Mr. Morrison presented evidence on the poor correlation between quarterly Long-term Bond Yields and the TSE Total Return Index. While there was no disagreement with respect to this poor correlation, it is clear from past evidence presented before the Commission that the Discounted Cash Flow model itself produces relatively stable expected returns which, if compared with actual returns to shareholders, would show a correspondingly unreliable correlation. In other words, Mr. Morrison's arguments against the risk premium approach might also lead to the rejection of the Discounted Cash Flow approach that he uses, if the latter were subjected to similar scrutiny.
On the latter point, Mr. Morrison agreed that, over time, an average risk premium could be determined; a principle which is used by most witnesses using the Risk Premium approach. His argument against using the method appeared to be with applying a long-term average premium to determine a rate of return in the immediate future, given the points discussed above.
Mr. Morrison also referred to a recent decision of the Canadian Radio-television and Telecommunications Commission ("CRTC"), decision CRTC 92-9, which he felt gave support to his argument against using the Risk Premium approach. After reviewing the decision, the Commission fails to find support for Mr. Morrison's position. In fact, the CRTC makes the following comment preceding the discussion of the various approaches, of which Market Risk Premium is the first:
The Commission considers all of the approaches used by the witnesses in this proceeding to be of assistance, in varying degrees, in assessing a fair and reasonable rate of return.
CRTC 92-9, Page 68
and follows up with a similar statement in its conclusion:
In arriving at an appropriate range for AGT's ROE, the Commission has considered the evidence and has, in general, relied on the three main methods presented for assessing a fair and reasonable return on common equity.
CRTC 92-9, Page 76
After considering all of Mr. Morrison's arguments, the Commission is not convinced that the traditional Risk Premium approach is necessarily unreliable or less reliable than other approaches to rate of return. It is, like all methods, an indicator on which a witness may choose to place more or less reliance. In the absence of specific evidence, the Commission notes that Long-term Government of Canada Bond yields have declined more than 100 basis points since evidence was last presented by the Company and that, all other things being equal, the rate of return resulting from such a methodology would be expected to decrease by a similar amount. Based on this indicator alone, the reduction of 75 basis points (in maximum allowed return) requested by the Company appears to result in a return which is at the upper limit of what would be just and reasonable, but is not excessive.
2.3 Discounted Cash Flow Approach
Mr. Morrison's evidence is based primarily on the discounted cash flow approach and, specifically, on estimating how much investors expect Maritime Electric's earnings to grow from 1991 to 1993. The approach uses three fundamental parameters: the appropriate 1991 earnings per share, expected inflation and expected real growth in earnings above inflation. Discussion at the hearing focused on the first parameter, referenced by Mr. Morrison as follows:
The choice of a base point of earnings per share of Maritime Electric Company, Limited for application of the required growth rate of earnings per share is a critical element in the analysis, since it is the point, taken in the latest year for which appropriate data are available, from which earnings per share should grow in subsequent years in a manner which will sustain the comparability of Maritime Electric Company, Limited with alternative investment opportunities and maintain its attractiveness to investors, thus ensuring the continuing access of Maritime Electric Company, Limited to the capital funds that it requires for expansion to meet the needs of its customers. The base point level of earnings per share must be seen to be acceptable both to investors acting in the financial markets and to the regulatory authority.
(Exhibit M-1, Tab 7, Page 24)
(Emphasis Added)
Mr. Morrison examined both 1991 earnings per share and the value of the trend line projected for the period 1972 to 1991. He selected the lower value of $1.79, the actual earnings per share, because it represented the effect of the Commission's most recent decision and he believes that it leads to a more conservative estimate of required return. Discussion on this issue focused on whether the trend line selected was appropriate given that it included a decade when the company was frequently unable to earn the return that was considered just and reasonable followed by a decade when they consistently earned the maximum allowed return. The growth indicated by Mr. Morrison's evidence could therefore be considered artificial. Mr. Morrison supported his estimate as representing a longer period and a period covering five business cycles.
The Commission cannot fully accept Mr. Morrison's reasons given that real earnings per share have been relatively constant for the entire twenty year period, except for those years in which the Company was unable to earn its allowable return. The trend line through more recent earnings indicates that 1991 earnings, which reflect the maximum allowable return, were at the upper limit of what might be considered just and reasonable. The same conclusion can be drawn from 1992 forecast earnings of $1.84 per share-$1.81 in constant 1991 dollars-which reflect a rate of return that the Commission has considered to be in need of review for some time. The Commission therefore concludes that Mr. Morrison's recommended rate of return is greater than what could be considered just and reasonable. In addition, since Mr. Morrison used the actual earnings per share of Maritime Electric, which reflect the upper limit in allowed earnings, the results are considered by the Commission to reflect the upper limit for rate of return.
2.4 Comparable Earnings Approach
Mr. Morrison also presented Comparable Earnings data on the same groups of companies used in his Discounted Cash Flow analysis. Mr. Morrison's evidence shows a five year average return on book value of 12.8% with a clear downward trend from 14.3% in 1987 to 10.7% in 1991, which he attributed to the state of the economy and other factors. Mr. Morrison concluded that the returns are likely to increase if the rate of inflation continues to remain low and the economy improves. While Mr. Morrison did not appear to place great emphasis on this evidence, nor was it challenged, the Commission notes that significant improvement in earnings per share is needed just to return to the five year average of 12.8%.
2.5 Conclusion
The Commission's responsibility is to allow the common shareholders of Maritime Electric to earn a just and reasonable return while at the same time ensuring that customers receive the lowest rates consistent with the Company's duty to provide safe and adequate service. The Commission does not guarantee that the Company will earn any specific rate of return, but rather approves rates that give the Company an opportunity to earn up to an allowed level.
After reviewing all of the evidence, the Commission finds that the rate of return on common equity of 13% proposed by the Company represents an upper limit on what can be considered just and reasonable given the current conditions in the economy and in financial markets. The Company's financial forecasts indicate that it will continue to have total debt and total debt and preferred dividend coverages towards the upper end of its financial policy range if such a return is realized.
1. For the purpose of determining a just and reasonable rate of return on rate base, a maximum rate of return on average common equity of 13.0% for 1993 is established.
When the hearing recommences, the Commission wishes to hear evidence or argument from the Company and the Interveners on whether a range for rate of return should be continued with rates set to yield the midpoint of the range or whether the range should be eliminated as proposed by the Company.
DATED at Charlottetown, Prince Edward Island, this 25th day of March, 1993.
BY THE COMMISSION:
Linda Webber, Chairman
John L. Blakney, Vice-Chairman
James Nicholson, Commissioner
