RP-1998-0001 THE ONTARIO ENERGY BOARD Ontario Hydro Services Company Inc. (SERVCO) Interim Transmission and Interim Distribution Applications Hearing held at 2300 Yonge Street, 25th Floor, Hearing Room No. 2, Toronto, Ontario on Tuesday, February 2, 1999 commencing at 9:16 a.m. --------------------- TECHNICAL CONFERENCE "Return on Equity" VOLUME 9 --------------------- F A C I L I T A T O R : DAVID HARDY Board Technical Staff 1178 A P P E A R A N C E S DAVID HARDY ) Board Technical Staff KIRSTEN WALLI ) in conjunction with: DR. W. CANNON ) Board Consultants MICHAEL HARRIS ) FRED LONG ) Ontario Hydro DON CARMICHAEL ) Services Company Inc. KATHLEEN McSHANE ) [SERVCO] 1179 ---Upon commencing at 9:16 a.m. MR. HARDY: Good morning. Why don't we begin? Good morning. My name is Dave Hardy. I'm facilitating the Ontario Energy Board conference on return of equity. I am going to go through some of the remarks that some of you have already heard mainly because there's some new people here today. I want to make sure that we're as clear as possible on some of the aspects of the session today. We have booked today and possibly tomorrow to discuss return on equity and cost of capital as it pertains to the SERVCO and transmission distribution rate applications. I want to make sure that everybody has a copy of the first report on appropriate return of equity for the Transco and Disco business operations of Ontario Hydro Services Company. That's the January 22nd report that was produced by Board Staff consultants, okay? I'm sure we can get other copies if somebody doesn't have a copy. And I expect we'll also be dealing with Ms. McShane's report as well on capital structure and fair rate of return on common equity for Ontario Hydro Services Company. I'm sure that that can be obtained as well from SERVCO. There have also been supplemental filings during the sessions and I expect that there will be other supplemental filings today, so flag where they are and make sure you do pick up a copy. There are several goals that we want to achieve Overview 1180 (Facilitator) in this session. First of all, I want to understand an overview of the content of the report produced by Board Staff consultants and also as it pertains to information to be brought forward by Ms. McShane, certainly to ask questions of a clarification and also test the information that's been provided. The session will be somewhat reverse from sessions I think we're used to in the earlier Transco and Disco sessions in that we're going to begin with Board Staff consultants. They'll be leading. We'll have questions of the Board Staff consultants and the report. At an appropriate time, then I'll turn to hear from Ms. McShane as a panel and we'll be then asking questions of Ms. McShane and so on. Again, I'm prepared to go as long as it takes to make sure we thoroughly go through both reports if that's -- if we can finish by today, that's fine, but we do have tomorrow as well. I just want to again remind everybody that there has been an Issues List prepared and should new topics come up during the day, I'm going to be respecting the issues identified earlier. Okay. In terms of my role, again, this is very informal. Nobody is being sworn here. I want to work towards having a conversation about the information in the various reports. I'm simply going to try to keep the agenda on track, be concerned with matters of process and fairness and maximize the listening that's going on. Overview 1181 (Facilitator) One thing I find from going through the Board Staff consultants report is that it doesn't have the advantage of an index or numbered lines, so I'm just going to encourage everybody when referring to a specific page in the report to allow us an opportunity to catch up and make sure we know where you are when you're asking that question. Just to remind everybody that the session is being transcribed. It is important for to you speak into the microphones as you ask questions and also to identify yourself. I will as usual make occasional notes. These are to assist -- particularly flagging any information that needs to be brought forward and I'll be making my own notes just so I can keep up as well, so that's what I would be jotting down throughout the session. At that, I don't have any further additional opening remarks. What I'd like to do is just then ask Dr. Cannon and Mike Harris of Reed Consultants to introduce themselves and then start with your presentation. I understand, Dr. Cannon, there's some additional information you want to bring forward on the report as an outset. Why don't you go ahead? DR. CANNON: Well, my name is Bill Cannon. My day job is a professor at Queens University in the School of Business and the Board has hired me and Reed Consultants to look at the applications of Transco and Disco with respect to the rate of return issues. Board Consultants 1182 (Cannon,Harris) MR. HARRIS: I'm Mike Harris. I'm with Reed Consulting Group. I'm assisting the Board Staff in evaluating the rate applications and I've also assisted Dr. Cannon in developing this report on the appropriate return on equity for the Transco and Disco business operations. MICHAEL HARRIS DR. WILLIAM CANNON; Board Consultants DR. CANNON: There are a number of minor corrections in the document that we've prepared which I would like to run you through. If you could turn to page 5, the very top line, there should be a bracket at the end of 2000, an opening bracket, and a closing bracket at the end of 1998, followed by a comma, and then strike out the word "this". So that sentence should now read in a much more understandable fashion. Page 13. Eight lines down in the second paragraph, the first word of that line is "achieved". I think the next word, instead of "instead", I think it should be "indeed", "indeed" instead of "instead". Page 23. Starting at the end of the fourth line in the second paragraph, it currently says, "this is often the case". Instead, strike "this" and replace it with "it", so "it is often the case'. Insert "that", "it is often the case that", "where these costs are ununcontrollable and exceptional in nature", then strike the word "where", "deviations from forecast levels are absorbed", so strike the word "often". Page 31. The end of the second last paragraph, Board Consultants 1183 (Cannon,Harris) the schedule references are off. The second last line of the second last paragraph, the first should be schedule 12, not schedule 11, schedule 12, and then further along the same line, it should be schedule 11, not schedule 10. Page 38. This one fooled me for awhile. I was looking for the footnote at the end of the first paragraph and, of course, the footnote is, in fact, all of the next paragraph, so you might just put a little '1' in front of the word "readers". Page 46. The middle paragraph on the page, approximately the middle of that paragraph, the line starts with the words "assessment techniques" and then there's a bracket "which are specifically geared to the S&P ratings". There should be a bracket after the word "ratings" and then no bracket at the end of the sentence. Then if we skip ahead to appendix B, the third page of appendix B ... MR. HARDY: Page B3? DR. CANNON: B3, that's right. I'm trying to find it myself here. What happened here is was the translation from Word to WordPerfect or vice versa misaligned some of the things. So if you -- the formula for -- formula 8 there, the MU expression should go underneath the 'A bracket 1 minus RET bracket'. So if you can just put an arrow to kind of move it across it, it goes under that middle term. MR. HARDY: What page number is that? DR. CANNON: This is page No. 78 and at the top Board Consultants 1184 (Cannon,Harris) it's B3. And then, further down that page with the next paragraph you can see just above the equation there's the expression "market effect". Again, I think arrows are the appropriate way to handle this. "Market effect" refers to the last term, the final term of that expression. MR. HARDY: It's missing that? DR. CANNON: Above the equation there's the words, "market effect". MR. HARDY: Okay. DR. CANNON: And they refer to the bracketed term that starts (beta U..., and ends up MIABG)). MR. HARDY: Thank you. DR. CANNON: That whole term is the market effect. And then the number says 0.5, 0.6, 10.4. These are T-statistics that refer to the coefficients of the three terms above. I think Ms. McShane probably understands where they belong but maybe the rest of us don't. The 0.5 should really be underneath the 0.00505. The 0.6 should really be under the next numerical coefficient; in other words, 0.0058, and the 10.4 should go under the coefficient 0.69204. MR. HARDY: Okay. DR. CANNON: Then page B13. B13, which is also page 88, the column headings got butchered there a bit. The first three columns are common share beta Board Consultants 1185 (Cannon,Harris) values. The next three columns are standard deviations of investment return. So you might just kind of circle the standard deviation and then have it circle around the "of investment return". So the three columns on the right-hand side are standard deviations of investment return. Those are also percentage numbers. I don't see per cent signs. The very next page, again, the column headings got skewed a bit. On the right-hand side column that's the time trend variable, although it doesn't play any role in the regressions. Moving to the left, the heading that says, "Averages for a sample of gas and electric utilities", that heading modifies both columns 5 and column 6. In other words, we've got the average beta for that sample and we also have the average standard deviation of investment return. The other column headings are close to lining up. We turn over one more page to B15 and also page B16. On page B15, again, it's the problem that the T-statistics don't line up underneath the appropriate coefficients. In the first -- for the first equation the T-statistic, the 11.2 should refer to 0.812 and similar adjustments should be made on the remaining two equations on that page, as well as the three equations on the next page. The only coefficient that does not have a Board Consultants 1186 (Cannon,Harris) T-statistic is the constant term. There's no reason for the constant term to have a T-statistic here, we're not trying to prove anything with it. Does everybody follow that? Everybody's happy with that? Okay. So that's B15 and B16. And now, to page 108 which is C17. I guess this is the last page. And two, four, five lines down, similar size and geographic diversity are compared. In section -- I believe it is, not 5, it's 3(c), section 3(c). Those are all the corrections that I have that I think might otherwise be misleading to readers. There's other typos and things, but... MR. HARDY: Is everybody clear? Are there any questions on those corrections? Dr. Cannon, then, the floor is yours. DR. CANNON: Well, did somebody want me to make an opening statement? I'm happy just to answer questions. MR. HARDY: Answer questions? MR. HARRIS: Yes, that's fine. We didn't come prepared for a presentation, we've come to answer any questions that you may have on the report. MR. HARDY: Why don't we take any questions that there are on the report. Who would wish to start? Please, could you introduce yourself? MR. LONG: I'm Fred long. I'm going to be asking you questions on behalf of the Ontario Hydro Services Board Consultants 1187 ex (OHSC Panel) Company. And I'm complemented on the panel by Don Carmichael and Kathy McShane. EXAMINATION BY OHSC: MR. LONG: Q. If I could take you first to page 4 of your report and take you to the small paragraph in the middle of that page. And here you state with respect to long-term -- to long-run risk: 'It is not expected that either Transco or Disco will experience a sustained decline in electric throughput.' And further on in that same paragraph you attribute this conclusion to, and again I read: 'Anticipated economic growth and inability of customers to effectively switch to alternative energy sources.' Similarly on page 21, I'll try and read you the reference there. It's the beginning of the second full paragraph just over halfway down, and on the third line of that paragraph you state: 'In short, there is no current or foreseeable practical substitute for electric power in many uses and many markets.' The question I'd like to put to you is, when you drew this conclusion regarding electric throughput, did you consider the implications of self-generation by large industry? MR. HARRIS: A. Yes, we implicitly took that into account. In fact when we had a panel up from OHSC on Board Consultants 1188 ex (OHSC Panel) financial matters, that is one of the questions that I directed at, I believe her name was Ms. Ng on self-generation, and queried her as to whether the company, in fact, had done any studies on whether self-generation was perceived as a real threat. And I believe her response was, no, in fact the company did not. She certainly assumed it was a potential threat but, nonetheless, not a real threat. When we looked at long-term energy throughput we did implicitly take that into consideration but we also did not do any detailed study to determine the actual real threat of self-generation. DR. CANNON: A. We also recognize that transmission rates would likely be set if it followed the proposals of the market design committee in such a way as to make uneconomic bypass not an option that people would choose by having the transmission rates cover the total usage, including any self-generation that generators built subsequent to open access. Q. With respect to the, I guess the consideration of this risk, can you point us to the place in the report where you say -- it's implicit, but is it also explicitly referred to in the report? MR. HARRIS: A. No. As I said it's implicit. Q. I guess similarly, again, in coming to the conclusion that I just referred to, did you consider the prospects and implications of local distributor generation? Board Consultants 1189 ex (OHSC Panel) DR. CANNON: A. Again, in my mind I saw this as not a threat to Transco's, you know, in a stranded asset sense in that the transmission rates would cover -- would be charged on the basis of the total usage by the customer whether it was self-generation or off the Transco system. Q. Finally on I guess this topic, are either of you familiar with the forecasts of fuel cell usage in North America? MR. HARRIS: A. I am not. DR. CANNON: A. No. Q. Let's say you didn't consider those implications to the transmission and distribution sectors of OHSC? A. Well, it passed through my mind but I dismissed it as a very small risk. But I didn't have data to base that on. Q. I'd like to now take you to page 23 of your report. The second full paragraph there, just above the midpoint of the page. The second sentence, maybe I'll read this to you. 'It is expected that Transco and Disco will be subject to the same type of O&M expense variability as any other electric utility situated in a similar climate.' You then conclude: 'As such, the level of business risk arising from O&M expense variability for Transco and Disco should be assumed to be equivalent to other Board Consultants 1190 ex (OHSC Panel) similar situated electric utilities.' I'd just like to explore this statement with you a little bit. First, would you agree with me that both of the service company's wires companies, Transco and Disco, provide service to customers who are located in a wide range of climatic and geographic environments as a consequence of the service territories which these entities have responsibility for? MR. HARRIS: A. Yes, I would agree that the service territories are large and fairly diverse. Q. Would you also agree that typical distribution service territories are relatively compact and serve fairly high density population centres? A. I wouldn't necessarily agree with that. That's not to say that I disagree with it. I just simply don't know what you mean by 'typical'. Q. Well, if we take an Ontario context, if we were to consider the other main component of distribution which is served by the municipal electric utilities? DR. CANNON: A. Yes, most MEUs, I think, are more compact. I'm not sure that that's what we had in mind when we referred to this statement. I think we were sort of thinking across Canada, across North America. Q. Do you have any examples of, you know, the type of distribution company that you were thinking about then when you made that statement in a Canadian context? A. Well, it could be a Canadian -- Alberta Power Board Consultants 1191 ex (OHSC Panel) or TransAlta. Q. For those two utilities, would their primary markets be, I guess, the cities of Edmonton and Calgary? A. Well, I guess Edmonton has its own power company, but TransAlta, I guess one of its major customers would be Calgary. Q. Okay. I guess with respect to again the service company's situation, did you have an opportunity to review the characteristics of particularly the distribution business as set out in the rate order application? I can take you to a page there, page 21, Table 4-1. MR. HARDY: This is the distribution rate order application? MR. LONG: This is the distribution rate order application. MR. HARDY: Can you provide that page number again, please? MR. LONG: It's page 21 and I want to refer to Table 4-1. MR. HARDY: Page 21, table 4-1? MR. LONG: That's correct, and it's titled "key characteristics of the distribution system and customer base". MR. HARRIS: Yes, we have it. MR. LONG: Q. You'll note there that for OHSC's distribution company, it has about 960,000 retail customers - that's line 7 in that table - 200 small Board Consultants 1192 ex (OHSC Panel) municipal electric utilities, which is line 6, and about 40 large industrial customers, which is line 8. And in line 2, it indicates that the distribution company has approximately 120,000 kilometres of lines, I guess specifically 119,100 kilometres. If do you the division, if you trust me on this, this works out at around eight customers per kilometre. Do you agree with that? MR. HARRIS: A. Okay. Q. And do you have any feel for what the similar statistic would be for the municipal electric utilities, say, in Ontario? A. I did not make that calculation, but again, if we can get back to your question at the outset, we're talking about damage caused by ice and wind storms, lightening and overheated wires, and I think what you're trying to say is that the distribution company is large and geographically diverse. And what we're saying is, yes, we agree, and relative to other companies who might not be large and geographically diverse, some of those items could actually affect them much more adversely if you have a very small system in a very harsh area. Q. I guess what I'm trying to put on the record is, in fact, some of the unique characteristics of the distribution company. Just to complete that if you'll accept this for the moment, that in terms of that statistic, I think based on some of the statistics for the MEUs, the average for them is about 100 customers per Board Consultants 1193 ex (OHSC Panel) kilometre. I guess given those statistics, would you agree that the service territory for OHSC is substantially different from an average, say, municipal electric utility in Ontario? DR. CANNON: A. Yes. Q. And would you also agree that OHSC's distribution customers are more geographically dispersed than similar utilities? A. Yes. Q. And so given the nature of the service territory and the sparse population and long distances involved, would you agree that these factors could potentially have a more significant impact on the operation of the system? A. I think we have to distinguish between, you know, the average costs expected to maintain Transco or Disco's system and the uncertainty with respect to predicting the variability of -- or -- yeah, the variability. You're forecasting the size of those costs. So I think we would agree that the configuration of the service territory is one that involves a great deal of costs and expense, but the diversity may very well, in our view, make forecasting the costs of that as a percentage of the total costs much less uncertain than would be true in some smaller isolated MEU. Q. Would you agree that, again, the long distances, the length of the wires creates a greater Board Consultants 1194 ex (OHSC Panel) exposure to things like weather and storms which may create a greater variability in OM&A expense? A. I think in some ways they would. In other ways, the fact that these assets are spread out over such a wide geographic area creates sort of risk reduction through diversification. I live in Kingston and the ice storm hit us pretty badly last year and, you know, relatively speaking, the Kingston utility, public utility system, was hit harder than the average of Disco's system or Transco's system. The entire system in Kingston was hit, whereas, presumably, I don't think the ice storm hit Thunder Bay and other parts of the province the same way. So I think you've got some compensating factors one way and the other. Q. I think you'll find it on the record that the Ontario Hydro distribution system was very badly hit through that ice storm. Okay, we'll move on. I take you now to, I guess, pages 24 and 25 of your report and here -- I'll find the reference. At the bottom of page 24, and I'll read this, and it goes over onto the beginning of page 25, you say: 'The MDC has proposed that the connection charge component of Transco's rates will be payable based on forecast demand even if actual demand is less than forecast. In addition, overrun charges will be applied and collected if the demand proves to be more than forecast. Board Consultants 1195 ex (OHSC Panel) Thus, if this MDC proposal is accepted, this will eliminate an appreciable portion of revenue risk. I'd like to, I guess, explore with you this MDC decision regarding connection charges and, in particular, how it will eliminate the potential for revenue risk. I'd like to refer to the MDC's third quarter report, in particular, I guess recommendation 2-1 -- MR. HARDY: Can you hold until -- give the panel an opportunity to refer to the report? Is this something that's been handed out previously, the report? MR. LONG: I'm not sure. MR. HARDY: Okay. MR. LONG: I have a copy here if you .... MR. HARDY: I wouldn't mind following along. Is it this ...? MR. HARDY: I'll play it by ear then. DR. CANNON: Sorry, what's the reference? MR. LONG: It's page 2-11, recommendation 2-1. I'd just like to read that recommendation: 'A non-fix usage based transmission charge should apply for the immediate future to recover the sunk maintenance and refurbishment costs of the existing common grid asset costs. The charge will be allocated the annual revenue requirements for common grid assets between distributors and direct customers based on a measure or measures if a multiple-part tariff is adopted of actual usage. We will assign to the technical panel the Board Consultants 1196 ex (OHSC Panel) task of examining ways in which actual usage could be defined and the periods over which it could be tracked.' Q. Would you agree with me having read that that the MDC has recommended that transmission charges should be collected from customers based on some measure of their actual usage and not forecast? DR. CANNON: A. My understanding was that the transmission charge would -- there would be two major components to that, one a network service charge which would be based on the most recent peak hourly demands be recovered from all of the Ontario Hydro's -- or all of the Ontario wholesale customers and that might represent about 80 per cent of the total revenue requirement and that the connection charge would be charged in a different way that would give a greater assurance of covering the fixed costs independent of the actual throughput or usage or demand. Now, I understand that the MDC has just recently come out with their final proposals and the best I could do was to get down from -- have e-mailed to me their summary chapter, their very first chapter. And when I looked under the section where they talked about transmission rates, they didn't refer -- they only referred to the network service charge and I wasn't able to access anything in more detail. So if you know that they've refined this proposal or changed it in some ways, then please let us know. That's as current as we could Board Consultants 1197 ex (OHSC Panel) get. Q. If we -- well, if we rely on the third quarter report, because I think that's one that probably everyone has read, and I assume that's where you drew your conclusions from that you state in your report? A. I think we also were given advice by some members of the Board about how the connection charge and the transmission and the network servicing charge would be different. Q. So you -- A. I think this was based on a reading or preliminary reading of what the final report was going to say. Q. So you can't point to me anywhere in this report that led to you that conclusion? A. Not in the third quarter report. Q. But perhaps you can enlighten us; what does the final recommendation -- I personally have not read that, but my understanding is that the connection charges would be collected in the same way as network service charges in terms of them being based on actual usage rather than a forecast usage. A. And totally variant with respect to demand? Q. I think if they're based on actual, then they would vary with demand, yes. Okay. I'd like to take you to page 63 of your report. I guess in the third paragraph there you comment Board Consultants 1198 ex (OHSC Panel) on Ms. McShane's observations regarding regulatory risk. Is that correct? DR. CANNON: A. Yes. Q. Without reading through everything there, is it fair to say that here you're suggesting that because the government is the owner of OHSC, as well as the body that legislates the OEB to regulate the company, that there is less regulatory risk for OHSC? A. First of all, I -- one of the points here was that we didn't see any difference in the regulatory risk between OHSC and the regulatory risk that applies to the major gas distribution companies. There's a question of -- I guess the point I was trying to make here, or we were trying to make here is that in light of the government's stated aim to eventually reduce the cost of electricity in Ontario, it seemed counterproductive to have the government legislate that the Board would regulate OHSC and then to throw up a strawman and say: Ah, but since we're not sure how they're going to do this we think we should get a higher rate of return, a higher dividend to the government, which would presumably be paid by the users in the province for this regulatory risk which we have, in effect, created through our legislation. It just didn't seem appropriate to us. Q. I'd like to follow up on that a little bit. First of all, would you agree that the regulation of the gas industry in Ontario by the OEB is in a much more Board Consultants 1199 ex (OHSC Panel) mature state than it is for electricity? A. Yes. Q. And the process of regulating those utilities has been in place for sort of over 25 years, and that the deregulation of that industry has progressed much further than is the case for electricity? A. Well, I think that the regulation of the gas companies has been evolving over time and, in particular -- of particular interest to us in the rate of return area is the change that the Board adopted in the approach it was going to take to setting and revising the returns on common equity. And I believe that, they started implementing that change, this formulaic approach, with the Consumers Gas hearing a couple of years ago and have only just applied it for the first time to Union Gas this past September or this past fall. So in some of the more important regulatory aspects that affect both the gas distributors and OHSC, the regulatory environment is relatively new for both the gas companies and, of course, OHSC. MR. HARRIS: A. If I could add to that. While the gas utilities have been regulated somewhat longer than OHSC, at the same time the Board has indicated they would like to achieve some symmetry between these two, two industries and that's one of the reasons I assume why we now have a formulaic approach to return on equity. Board Consultants 1200 ex (OHSC Panel) So I would assume that not only would this symmetry exist with respect to cost of equity, it would exist elsewhere as well. Therefore, while the Board has not exerted jurisdiction over OHSC for some time, you can still anticipate that the structure of that regulation will be somewhat similar to what the gas industry has experienced over time. Q. Just coming back to I guess an earlier comment you made with respect to government ownership, in your work, in your recommendation on the return on equity, are you saying that the return that the government as owner should receive should not reflect fully any effect due to regulatory risk? DR. CANNON: A. No, I'm not saying that. I don't believe that on balance regulatory risk represents a very big risk in the grand scheme of things. I mean, my view is that the history has shown that the Board has bent over backwards to accommodate the legitimate needs of the industries that it regulates and, you know, in terms of preventing uneconomic bypass and, as I say, accommodating the needs of the companies that it regulates and I don't see that as an important risk at all. Q. Is it fair to say that at this point in time there is no history of the OEB regulating the electricity sector? A. Not regulating them, that's right. Board Consultants 1201 ex (OHSC Panel) Q. Would you also agree that this lack of history would create uncertainty in the minds of investors? MR. HARRIS: A. Again, I would get back to my comment on the goal of regulatory symmetry between the gas and electric industry, and I think that investors would realize that the Board will treat the electric utilities in a somewhat similar fashion to the way that they've treated gas utilities. And this whole issue of uncertainty in terms of regulatory risk is somewhat troubling for me. I have primarily a U.S. background and have witnessed restructuring in the United States when the gas industry was going through their take or pay debacles and the general restructuring of that industry, and I've seen these arguments being put forth for the last 10 years, but I've never, ever quite seen anyone find any definitive link between this regulatory risk that's supposedly supposed to give rise as a result of the uncertainty of deregulation and the actual impact on investors' expectations. That's not to say that it doesn't exist. I'm simply saying that the nexus between this uncertainty because we're entering a new regulatory environment and expectations of investors is somewhat muddied. DR. CANNON: A. Also I think you have to recognize that the government is already the existing owner of OHSC and if there's any regulatory risk, it's Board Consultants 1202 ex (OHSC Panel) their creation. And what we're really thinking of when we're talking about what's the cost of attracting capital, all right, it's presumably with a view to the future, the cost of attracting outside capital outside of the government to the ownership of OHSC. And by the time that that comes around, these risks will have -- any sort of uncertainty around the regulatory scene will have dissipated. And so I just don't see the point in the government asking for an extra reward for itself so that it will be persuaded to provide capital to OHSC. It's already the owner and I don't see any imminent sale of those -- that equity interest. Q. Do you then not consider that what the government is trying to do through the restructuring is create stand-alone commercially-driven companies which, I would submit, should include a cost of capital and return on equity commensurate with, you know, normal commercial standards? A. Oh, I believe that's the objective and I believe they recognize there's going to be a transition period and it's after that transition period is over that I would imagine the government would contemplate, you know, selling some of, or all of its equity interest in Transco and Disco. Q. So am I to take it that your return on equity recommendation is not fully reflective of the service Board Consultants 1203 ex (OHSC Panel) company being established on a stand-alone basis? A. No, it is reflective of it being on a stand-alone basis in the long run. Q. I thought I just heard you say that you didn't think the government should be getting some return for some risk, however small, in the interim period and I took that to mean that that was the basis for your recommendation. A. It's -- the basis for my saying it doesn't make any logical sense to me to say we're going to restructure this industry and eventually we're going to have a regulation of the electric distribution industry that is very similar to that of the gas industry and the gas industry, to some extent, has shown the way. Until we get there, we would like a higher rate of return for ourselves even though we're the ones that are creating the, you know, the risk for ourselves. I think that we should be considering what's the risk of OHSC in the post-transition phase. Q. I guess, would you agree that it's fair to say that at this point you use the phrase, "when we get there." At this point it is not clear where we'll be getting to, and is it this that creates the uncertainty? A. Well, I think that's the same in the gas distribution industry. We're in the process of separating the retail and supply activities from the monopoly pipes activities and I guess the gas companies have a couple of years head start, but the outcome of that and how that Board Consultants 1204 ex (OHSC Panel) will be interpreted in the regulatory process is not settled. Q. Okay. I'd like to take you on to a couple of other characteristics of the service company. Would you agree that -- we've just talked about them having a new regulatory regime. Would you also agree that the service company has a new board of directors, a new management structure and is going to be operating in a completely new industry environment? MR. HARRIS: A. I would agree that changes have been made. I'd also agree that many of the current employees of the services company are likely to have been former employees of the old Ontario Hydro. I would expect that you wouldn't want to lose the skill set of those people when you started the new company and, therefore, many of the old employees are now the new employees, but I would agree that you now have a new board of directors and new management. At the same time many of those people are skilled in the industry and are skilled at running an electric utility company. DR. CANNON: A. My expectation would be that investors would look favourably upon that and would consider that a factor that very well might reduce their perceptions of the risk of the organization, given the previous press associated with the old Ontario Hydro. MR. HARRIS: A. I guess if I was looking as an investor at the services company versus, say, an IPO for Board Consultants 1205 ex (OHSC Panel) an Internet company that's never turned a profit and has never done really anything in their life, I would certainly say that there's a great deal of uncertainty with that IPO for that Internet company that has never made a dollar. I wouldn't necessarily say that there's uncertainty related to OHSC. DR. CANNON: A. If I can draw a parallel there. While it's not a perfect parallel, when British Gas took over Consumers, can you imagine what the Board's reaction might have been if British Gas had said: Well, gee, now we've taken over Consumers, you don't know what kind of havoc we might wreak at Consumers; because of that risk we'd like to have a higher rate of return. I mean, you know, it just doesn't wash. Q. So is it your position then that credit rating agencies, bond investors, equity investors will overlook these factors? MR. HARRIS: A. I wouldn't necessarily say they would overlook them, I just simply say that they're de minimis. Q. So then, I'd like to take you through some excerpts from some credit rating publications and I take it from your statement that they wouldn't disagree or they wouldn't overlook these factors that you would, in fact, agree with these statements. Maybe I could take you first to -- and I believe you have copies of these. Board Consultants 1206 ex (OHSC Panel) A. We have copies of S&P and two Moody's. Q. Take you first to one of the Moody's documents and that's Approach to Rating Gas Transmission and Distribution Utilities. MR. HARDY: I'm sorry, you're referring to a handout that's been provided by SERVCO and the panel? MR. LONG: That's correct. MR. HARDY: You're providing other copies? MR. HARPER: Yes, it was sent to the Board last night. MR. HARDY: Sorry, Fred, can you refer us again... MR. LONG: It's a Moody's document entitled: Moody's Approach to Rating Gas Transmission and Distribution Companies. MR. HARDY: Could you just hold on and allow us to get there. Is this with the "B" at the top as an Appendix "B" letter? MR. LONG: That's correct. Yes, it's "B". MR. HARDY: Thank you. MR. LONG: Q. Do you have that? DR. CANNON: A. Yes, we do. MR. HARRIS: A. Yes. Q. And I'd like to take you to page 5. The first line under 'management' which I wkould like to, I guess, read into the record: 'The overriding internal factor we explore when issuing a rate is management.' Board Consultants 1207 ex (OHSC Panel) I'd like to take to you the Standard and Poor's document which is, I believe, labelled A. In particular, I'd like to refer to you page 8. And on the right-hand column towards the bottom of the page under 'management', about an inch into that section, and again, I'll read, and it says: 'Management assessment remains significant. Important consideration includes strengths and weaknesses of key members of management, depth and stability of top management and recent and prospective management changes. Returning once again to the subject of -- DR. CANNON: A. You didn't want to quote the first line in that paragraph, eh? MR. HARDY: If I can jump in here, have you had an opportunity to read the documents? DR. CANNON: No. MR. HARDY: Okay. In fairness to the panel here, I believe they should have an opportunity to apprise themselves of the documents you're referring to. You can ask your question, but I think it should be up to the panel to determine whether they need a little bit of time to respond to your question. Certainly you could come forward later on this morning after the break. MR. LONG: I guess we were of the view that because, I guess, particularly S&P as a rating methodology is something that was referred to in your report, that you'd be familiar with some of their publicly available Board Consultants 1208 ex (OHSC Panel) documents. MR. HARRIS: Dave is correct, we have not read this document. MR. HARDY: I wonder if we can allow some time for - not necessarily right now but over the break - for the panel to apprise themselves and be familiar with this document and then to pose the questions later. I don't know if you have another set of questions. MR. LONG: I didn't have any questions at this point. I just wanted to refer to some particular passages. MR. HARDY: Perhaps there's a generic question that doesn't necessarily hinge on some knowledge of this information. Other than that, think it's only fair to the panel to allow them to become familiar with these documents. MR. LONG: Q. Just picking up on what you said, is it fair to say then that the panel hasn't had the opportunity of going through this report? You have not read it, for instance, in preparation of your own work? DR. CANNON: A. No, I haven't read this particular document. Q. Okay. MR. HARDY: Just to clear up that last part then, is it your intention to read these documents over the break? DR. CANNON: We're at your disposal, you know, what you want us to do. Board Consultants 1209 ex (OHSC Panel) MR. LONG: I will be referring to them again, so... MR. HARDY: So we would encourage the panel to try to make themselves familiar with these documents over the break? DR. CANNON: Yes. MR. HARDY: Is that fair? MR. HARRIS: That will be fine. Just one question, do you intend to ask us questions about the document or simply read in passages from the document into the record? MR. LONG: I guess I'll be referring to, I guess, information from those documents, whether it be passages or whether it be some of the rating considerations. MR. HARRIS: As a background for a question to us? MR. LONG: Yes. MR. HARRIS: Okay, thank you. MR. HARDY: I'll make sure that there's enough time over the break so the panel can have a chance to read these documents. MR. LONG: What time were you planning on a break? MR. HARDY: Ten-thirty. MR. LONG: Ten-thirty, okay. Back to that. DR. CANNON: Perhaps you'd have another set of the documents for us, then we .... MR. LONG: Q. Are you familiar with the Board Consultants 1210 ex (OHSC Panel) so-called "White Paper" which, I guess, was issued in, I guess, November 1997, by the government which set the stage for the restructuring of the electricity industry in Ontario? DR. CANNON: A. I read it at one time, probably six months ago, but I haven't reviewed it recently. Q. Would you agree with me that one of the objectives stated by the government there, subject to check, is that the -- was actually referring to the province of Ontario's equity in the successor companies and one of the objectives was to put that on a more businesslike investment footing? A. I don't recall that directly, but it wouldn't surprise me if that was true. Q. Given the, I guess, the newness and untested nature of the service company, would you agree with me that it seems irrational that a conventional corporate investor should bear that risk without any compensation? A. Well, I think we -- we have to put this risk that you're talking about in perspective. I would imagine that every regulatory -- or every rating agency that you would want to refer to would consider the management capability of Ontario Hydro and its successor companies to be superior to that of the typical municipal electric utility, all right? From what I understand, there's a great deal of highly educated, well-paid people who have studied and directed the Ontario electricity system here for years and years and years and they are now going to be Board Consultants 1211 ex (OHSC Panel) thrown into the competitive fray -- or at least not the competitive fray in the monopoly wires part of the business, but they are going to be managing the monopoly wires part of the business in a system that also has some, to start with 200 or more municipal electric utilities, and on a relative basis I would think the management risk associated with Disco and Transco would be considered to be considerably less than that of the other MEUs and perhaps on a par with that of the two big gas distribution companies. Q. Are you aware that many of the senior management of the service company are in new roles in -- I guess the management team as a whole at this point in time is untested? A. All sorts of companies have management shakeups and promote people and other people retire and it doesn't cause their credit ratings to change. This is the normal evolution of business. This is not an extraordinary event. MR. HARDY: I think I've heard this question a couple different ways and a couple times and I'm also hearing a fairly consistent response from the panel. I don't know whether you want to -- MR. LONG: I'll move on. MR. HARDY: Please. MR. LONG: Q. I'd like to now take you to page 9, I guess, of your report. Would you agree that the financial risk of an Board Consultants 1212 ex (OHSC Panel) entity of companies stems from the potential volatility in earnings and the resulting potential for deteriorating future equity returns? MR. HARDY: Sorry, is there a specific passage that you're referring to? MR. LONG: No, I'm not referring to a specific passage. I'll be dealing with that a little later. DR. CANNON: I don't think -- you had better restate your question, I'm sorry. MR. LONG: Q. Would you agree that the financial risk -- and I think you talked about the financial risk on page 9. Maybe the simplest thing would be to direct you to ... it's the last paragraph on page 9. About midway through, you say: 'The market interprets this increased sensitivity as increased volatility and heightened uncertainty about future equity return levels.' DR. CANNON: A. Yes, that's a description of financial risk or part of financial risk. Q. Okay. Are you aware of the average term of the service company's debt portfolio? A. I think it was something like four-and-a-half to five years. Q. I think in Ms. Malen Ng's testimony, she indicated it was 4.2 years, but -- it's certainly of that order of magnitude. And do you know the average term of Consumers Board Consultants 1213 ex (OHSC Panel) Gas' or Union Gas' debt portfolio? A. I'd have to check. It wouldn't surprise me if it was somewhat longer than 4.2. Q. You'll take it subject to check and I can provide credit analysts' reports that deal with this subject from CBRS. According to those reports, the average term are about 9.3 and 13.1 years respectively. Does that sound about right to you? A. It could very well be. Mind you, that point swings both ways. That means that Union, in particular, was stuck with some fairly high cost -- high embedded cost debt for a long period of time. If OHSC's debt on balance comes up for renewal in the nearer term, they're going to have a chance to refund that at a much lower rate than the embedded 7.8 per cent. So from a financial risk point of view, it may very well be that investors would sense that OHSC is in better shape because of its shorter term -- shorter average term of debt. Q. Coming back to the service company again, do you know what the service company's borrowing requirements are over the next few years? MR. HARRIS: A. Yes, I've seen reference in a number of documents as to what those requirements are. I wouldn't be able to tell you precisely though. Q. Again, subject to check, and this is also something that Ms. Ng referred to in her testimony, Board Consultants 1214 ex (OHSC Panel) they're roughly of the order of $7- to $800-million per year. Again coming back to Consumers and Union Gas, are you aware of what their borrowing requirements have generally been? DR. CANNON: A. Yes. Q. Well...? A. One hundred to 150, 200 a year, something like that. Q. So considerably less than the service company's borrowing requirements? A. That's true. Q. I take it you're also, I'm sure, familiar with the, I guess the volatility in the capital markets. And as an example, I guess during 19 -- I guess the last half of 1988, the spreads on A-rated -- A. '98. Q. '98, yes. The spreads on both A-rated and triple B-rated credits doubled, you know, reaching highs for the triple-B credit of over 200 basis points and this effectively closed out the capital markets to a triple-B issue as an even substantially constrained access to A-level credit. Are you familiar with that? A. Yes. Q. But would you agree then that the significant borrowing requirements of the service company, the -- what I'll refer to as refinancing, that this refinancing risk Board Consultants 1215 ex (OHSC Panel) is compounded by a lack of timing flexibility, the borrowing requirements and repayment requirements are essentially on a fixed schedule, that that combined with the capital market volatility creates a great deal of refinancing risk for the service company? A. I don't think it's a great deal of refinancing risk. You have to put those financing requirements in relation to the total size of the organization and the interest in participating in its debt issues that would be shown by institutional investors both in Canada and around the world, but perhaps more primarily in the U.S. With the federal government and the provincial governments to a large extent running budget surpluses now, one of the -- historically, one of the drains on the bond market, one of the sources of demand for funds and supply of bonds has essentially dried up and the investment dealer community in Canada, perhaps even New York, I'm sure is salivating over the opportunity to help OHSC place its debt with institutional investors here and outside of Canada. I don't see the environment that OHSC is going to be refinancing its debt in to be one that is particularly threatening to the company and, indeed, it's bound to be one in which they will be able to issue new debt at a lower rate than their average embedded cost. Q. Would you agree that in comparison to Consumers and Union Gas that this refinancing risk is Board Consultants 1216 ex (OHSC Panel) higher for the service company? A. No, I don't think so. The Consumers and Union are each $2.5-, $3-billion organizations. If you're talking about both Disco and Transco together, what are we up to, 8-billion or something like this? You would expect the financing requirements for a large organization to be larger; it doesn't mean that they're going to have a harder time placing it. There's a great appetite for solid debt in the portfolios of Canadian pension funds and other institutional investors. MR. HARDY: Mr. Long, I'm looking for an appropriate place to break. MR. LONG: Actually, I'm just about to get into the credit rating reports again, so this would be a good time. MR. HARDY: Okay. Why don't we break for 15 minutes to 20 minutes, give you an opportunity to look at those reports as well. When I come back, I'm going to also look for opportunities for other participants to pose questions. So we'll be back at say ten to eleven. ---Recessed at 10:30 a.m. ---On resuming at 10:50 a.m. MR. HARDY: I wonder if we can come back to order, please. Fred, I'm wondering if you have one or two questions as a follow-up from the earlier questions this Board Consultants 1217 ex (OHSC Panel) morning we could start off with that; otherwise, I'll go to other participants and start with their questions. MR. LONG: Okay. At this point I don't have any follow-up, so if you want to -- MR. HARDY: Maybe we'll go to other participants. The floor is open to any participant who wishes to ask questions of this panel. Do any of the participants have questions? Roger, could you identify yourself, please. MR. WHITE: It's Roger White and I'm with Energy Cost Management. EXAMINATION BY MR. WHITE: Q. I would like to start with a general question. Based on your experience in regulatory matters, do regulatory authorities generally reward management for bad management decisions? DR. CANNON: A. No, no. Q. Thank you. Would you say that significant fluctuations in OM&A expenses would be something that would make the market feel comfortable with the performance of a company with respect to investments? In other words, if the OM&A were going up and down from year to year in substantial dollar figures. MR. HARRIS: A. Well, fluctuations in OM&A that are not predicted can certainly increase the business risk of a utility and that will be taken into account by investors. Simply the level of OM&A though is somewhat immaterial. Board Consultants 1218 ex (Participants) DR. CANNON: A. But I would agree with your general statements. I mean, the more they fluctuate from year to year, the harder it would be to predict what they would be. Q. You're aware of Ontario Hydro's substantial increases in some areas of its OM&A for both Transco and Disco for '99? A. Yes. Q. Would you describe those kind of decisions generally within the control of Ontario Hydro Services Company management? A. Yes. MR. HARRIS: A. Yes. Q. It's been introduced in evidence that Ontario Hydro Services Company currently has a no contracting out or any tendering practice in place as a result of its collective agreement. Would you describe negotiating a collective agreement as generally within the control and influence of management? DR. CANNON: A. I suppose so, yes. Q. Thank you. If you were looking at a fully competitive industry, not regulated, would you expect its return on equity to be higher generally or lower than a fully- regulated natural monopoly that we're dealing with here in terms of the transmission company and the distribution company? Board Consultants 1219 ex (Participants) A. Well, since the regulation is just one aspect that affects business risk, I think the general answer to that would depend on the relative business risks of the industry and -- but, generally speaking, regulation reduces the uncertainty of the investor's return and, correspondingly, that deserves a lower rate of return to compensate for that lower risk. Q. The fact that Ontario Hydro Services Company is operating unregulated competitive businesses within its corporate shell, will that tend to increase the business risk for Ontario Hydro Services Company in terms of either equity or debt placement? A. It will, but I think we're not taking account of that in our recommendation, we're simply looking at the wires -- the monopoly wires business as well as the default supply. Q. Thank you. And I take it from that comment the fact that Ontario Hydro Services Company has set up a large area -- I'm sorry, not necessarily large, but a significant area within its corporate shell to be involved in acquisitions, that you would say that you have not considered those activities and what influences they may have on equity for the services company in terms of equity or debt placement? A. Well, we haven't -- I don't believe we have considered that in our recommendation of what the allowed return should be or the riskiness of the monopoly wires business. Board Consultants 1220 ex (Participants) But where I've had to keep that in mind, is often when you look at bond ratings and the evidence that bond raters use in setting those ratings, they look at consolidated ratios, all right, and so I'm always in the position where I'm saying: Well, I have to distinguish between the bond rating and the inputs that go into that for the consolidated organization versus what those would be and how they would be interpreted by the bond rater if it were a stand-alone monopoly operation. So that's the one place where I'm always having to make that mental jump back and forth. Q. Are you aware that under the new regime that Ontario Hydro Services Company will have under its licence terms, for both Transco and separately for Disco, will have a defined service territory and effectively franchise right under the fallout of Bill 35? A. Well, that's my understanding. Q. Are you aware that they did not have a franchise under previous statutes? A. No. Q. With this new franchise area, many municipal electric utilities service areas are fixed or frozen within what will be ultimately their licence areas. As growth and development often occurs at the perimeter of urban areas, let's call them, that would indicate to me probably that growth would happen in the Ontario Hydro serviced area maybe at a higher level than many municipal utilities whose franchise areas are fixed Board Consultants 1221 ex (Participants) and largely more developed. A. I'm not sure that I would be willing to venture a prediction there because I think that it's for the future to reveal whether the municipal electric utilities will, in fact, expand their areas by buying some of the assets and taking over some of the area of Ontario Hydro retail or whether it will go the other way. I think each group would like to expand and who wins in that tussle, I'm not sure. Q. I wasn't suggesting that there wouldn't be buys and sells and puts and takes happening in the industry later on, I was thinking about in terms of the regulatory application that we have before us, the boundaries are fixed. A. Okay. Q. Now, if that scenario happens and the growth occurs in the Ontario Hydro Services area franchise area, would that tend to increase their business risk or reduce their business risk, given that in evidence they've already said that they will pay zero dollars for the connection of new customers, that the customers will pay those dollars? A. Well, I don't think it -- I would interpret that not so much as a business risk factor as a financing flexibility factor and if the growth is not growth that they have to pay for, that they have to finance, then it won't put any extra pressure on them from a financing flexibility point of view. Board Consultants 1222 ex (Participants) Q. Given that we have identified in my first few questions a number of areas where Ontario Hydro management clearly has some control, and given that those items are substantially increasing the revenue requirement of Ontario Hydro Services Company, what should the regulatory's response to that be, based on what's traditionally done in the industry with respect to the rate of return? MR. HARRIS: A. Well, I don't know what the answer to that would be. I mean, the Board will review each of those items that has been requested and determine whether they are a prudent expenditure. The cost of equity determination is going to be based on the business financial risk to the company. To the extent we've seen increase in business financial risk, there should be a corresponding increase on the return on equity; or, if there is a decrease in financial business risk, a decrease on return on equity. I don't know that you can make a direct connection between the cost of equity determination and the items that you just discussed. DR. CANNON: A. And to the extent that what you're referring to is -- it appears that the assets of both, I guess primarily Transco, but also Disco to some extent, need perhaps more than the normal amount of refurbishment and being brought up to date, we consider that to be a budgetary item, that those are capital expenditure items that go through that kind of a review Board Consultants 1223 ex (Participants) process. We don't think that those should be paid for by having an increment added on to the rate of return. Q. Thank you. MR. HARDY: Thank you. Are there other questions from other participants? Thank you. Introduce yourself, please. MR. STEPHENSON: Richard Stephenson for the PWU. DR. CANNON: For whom, sorry? MR. STEPHENSON: The Power Workers Union. EXAMINATION BY MR. STEPHENSON: Q. I just want to come back to the issue of bypassability and the threat of bypass to SERVCO. As I understand it, you discount that threat, be it premised on an assumption regarding the adoption of certain MDC recommendations regarding essentially gross billing of transmission charges. DR. CANNON: A. Correct. Q. Regardless of self-generation; is that what I understand? A. That's correct. MR. HARRIS: A. I would like to add to that. I don't know that we necessarily discounted the threat solely because of that reason. We also looked at the bypass threat of OHSC relative to other utilities and you have to ask the question: Do you believe that this bypass is going to be far greater for the services company Board Consultants 1224 ex (Participants) than other comparably situated utilities? So it's both in relation to other utilities and with respect to this one item you just discussed. Q. We've heard at the last few Ontario Hydro hearings enormous concerns regarding bypass and indeed driven essentially by the claims of high cost of electricity in Ontario and the competitive, relatively competitive cost of alternative sources and particularly natural gas. Are you generally familiar with that environment that has led to electricity restructuring in Ontario? A. Yes. Q. It's my understanding that notwithstanding electricity restructuring, given the combination of charges that customers will face for the commodity, for distribution, transmission, competition transition charge, imputed taxes and so forth, we can expect that in the short to medium term there's not going to be drastic reductions in the global cost of electricity for customers. Is that consistent with your understanding? DR. CANNON: A. Yes. Q. And, similarly, I take it there are not forecast to be substantial increases in the cost of natural gas in the medium term. Is that consistent with your understanding? A. Well, that's a little bit harder to say. As we are able to export more natural gas from Canada to the Board Consultants 1225 ex (Participants) U.S. our prices in Canada will start to reflect the competitive North American situation and that might very well drive up the prices of gas in Ontario. Q. I take it that's not a substantial risk until Alliance Pipeline is on stream? A. That's right, the Alliance Pipeline is the thing that would trigger that. Q. Right. So in the near to medium term, I take it the relative competitiveness of those energy sources is, I take it, that spread is predicted to be more or less the same as it has been for the last few years? MR. HARRIS: A. In general the relative economics of switching from one fuel to the other is more a long-term phenomena rather than a short-term phenomena. That is, even if we were to expect to see wild price spikes, that doesn't necessarily mean that a customer will switch his energy source. I don't know if that answers your question. DR. CANNON: A. Also, I think you have to distinguish between the relative costs of per kilowatthour of building gas-fired cogen with some more traditional form of electric generation whether we're talking about new assets in both cases versus the new cost of cogen versus the almost fully depreciated cost of some existing Hydro facilities or something like this. I think you have to be a little more specific on the scenario you want us to consider if... Q. Well, what I'm talking about is essentially Board Consultants 1226 ex (Participants) people paying more or less constant historical electricity rates versus people paying more or less steady gas rates that they've experienced in the last few years. And the point is simply that, insofar as there was a competitive threat of bypass for electrical customers in the past few years, that has not materially been changed in the near term going forward? A. You're talking about the end users, or you're talking about building self-generation? I mean... Q. Well, they're one and the same. They can be one and the same thing. A. Well, we think that the intention of the recommendations of the Market Design Committee, and we believe that that also reflects the same philosophy or thinking of the Board, to do whatever is necessary to prevent uneconomic bypass, and whether that's through a rate design solution or some other solution, we think that the philosophy that the Board has shown with respect to the gas distribution industry will carry over as is recommended by the, MDC, to the electric distribution industry as well. Q. I take it you'd agree with me that there is certainly some degree of uncertainty as to whether or not whatever MDC recommendations are in fact made in their final report will actually be adopted. There is some answer to that; is that fair? A. Yes, but we make our recommendations on what we believe the future will be, particularly in this area. Board Consultants 1227 ex (Participants) Q. So you've made an assumption that that's your best guess that that's what will happen, I take it? A. We recognize that down the road, once there's a system of congestion pricing in place, that we might very well then -- the policy of the Board might very well be then to open up for more market forces to determine where the investments in generation take place, but we're talking a considerable number of years down the road, and before that happens, many other preconditions have to be in place. And so if that were to happen and if that was thought to be a threat to OHSC or SERVCO or whatever, then there would be ample opportunity for the Board to consider that at some future rate hearing. Q. I take it, nevertheless, the mere existence of the uncertainty as to whether or not these kinds of cost recovery schemes are going to be put in place is a factor which is a business uncertainty for SERVCO? A. Yes, just as it would be a business uncertainty for Consumers or Union Gas. Q. You'd agree with me that the threat of a bypass on the gas side is much lower than on the electricity side? A. I don't necessarily agree with that. What are you thinking of? Q. Do you have examples of people drastically reducing or eliminating their gas usage in favour of electricity? A. No. Board Consultants 1228 ex (Participants) Q. I take it there are counter examples however? MR. HARRIS: A. Well, I think in general, bypass on the gas side can take place when an industrial customer is able to bypass the local distribution system. Q. I understand that. I take it that doesn't apply to transmission? DR. CANNON: A. You've confused us. What are you...? Q. If somebody is bypassing -- if somebody can bypass -- if they're consuming gas, they are getting gas from somewhere and they may be able to avoid local distribution but they cannot avoid transmission, correct? A. Yes. Q. Whereas, if somebody in SERVCO faces a qualitatively different risk, that is, if somebody switches from gas to electricity, they're avoiding not only local distribution but also transmission? A. If they build their own self-generation, is that what you're suggesting? Q. Well, in whole or in part. A. Well, if that were to happen, that would be avoiding the transmission as well, but I think that from everything I've read, there's a strong public policy consensus to avoid that. I mean, why try and design a new system for more efficient electricity and lower cost electricity distribution in Ontario and then permit uneconomic investments to be made that would increase the cost? Board Consultants 1229 ex (Participants) Q. I agree with you. There are, nevertheless, two forms of bypass, of course economic and uneconomic bypass. Some forms of bypass are economic. Fuel switching, cogen may be economic bypass; you'd agree with me? A. Yes. Q. And that's societally beneficial, correct? A. Yes. Q. But nevertheless, it is economically damaging to SERVCO? A. Well, just as in the gas industry, if it's a question of fuel switching, that becomes a forecasting risk, all right, where you have customers that have several ways of being able to, you know, fire their operations or -- I -- as long as SERVCO, you know, surveys their customers and makes reasonable assessments of, you know, which ones are likely to switch under various price scenarios for gas, that's just the normal kind of forecasting risk. Q. But it may well be that there are current customers who will simply decrease their consumption by virtue of fuel switching on an economic basis. A. Okay, and as long as SERVCO predicts that, it won't be an investment risk. Q. But they have already got their asset and debt allocation. It will have the effect of stranding debt, won't it? A. Well, no, I don't think it will because you Board Consultants 1230 ex (Participants) really have to be suggesting that that customer is no longer going to take electricity for any use. Q. No. I'm talking about a net decrease in consumption. To that extent, it will strand debt? A. No. I think that as long as there are enough customers on the entire SERVCO system to absorb that -- remember, you're talking about spreading all of the fixed costs across all of the customers. As long as it doesn't cause the price of electricity to go up so that everybody abandons electricity, which I can't conceive of -- we still need it to turn on our light bulbs, right? We can't use natural gas yet to turn on light bulbs very easily. Q. I'm sorry, I just don't understand this point. Either bypass is a threat or it's not a threat. And to the extent bypass occurs, it always has the same effect, doesn't it? It decreases the customer base and it forces the company to spread its fixed costs over a smaller pool; isn't that right? MR. HARRIS: A. You're assuming there's no growth in the customer base. We're talking about a long-term phenomenon here, remember, not short-term. In your scenario, what you're saying is, bypass will occur and there will be stranded assets, but there will be no corresponding increase in growth, nothing to counterbalance that bypass. Q. Would you agree with me that to the extent that bypass occurs, that any growth in the system will be Board Consultants 1231 ex (Participants) less than it would have been but for the bypass? DR. CANNON: A. That's right, but that's a predictable thing. You just predict what the net growth in the system is going to be. And unless it leads to the death spiral, it's not the long-run risk coming home to roost. Q. Well, it will decrease the profitability, won't it, insofar as it decreases the customer base as compared to what it otherwise would have been but for the bypass? A. No. The rates are set each hearing to recover all the fixed costs plus the allowed rate of return based on the forecasted demand. Q. Thus setting up the death spiral? A. Well, I don't think the death spiral is in the cards, less likely in the cards for the electricity distribution industry than for the gas industry. Q. Let me ask you about distribution. I take it there are no uneconomic bypass restrictions even suggested by the MDC with respect to SERVCO's distribution business. They relate solely to transmission? A. That's where I have seen them referred to. I don't recall it. Q. It doesn't exist on the distribution side and, therefore, they're fully exposed; isn't that fair? MR. HARRIS: A. As Bill has indicated, our comments in the report are focused on the transmission side, and as you pointed out earlier, that bypass on the Board Consultants 1232 ex (Participants) distribution side was, if I understood you correctly, difficult or...? Q. Not at all. A. I haven't tracked that. Q. I would -- no, not at all. DR. CANNON: A. I don't understand what you're talking about by bypass on the distribution side. Somebody is going to build a whole new distribution system, a new set of wires? Q. You can -- you would agree with me bypass can take a number of forms. It can occur through fuel switching, correct? A. Okay, you're back to fuel switching. Well, fuel switching -- Q. It can also occur through cogeneration; is that correct? A. But that's not a distribution system. That's generation. Q. Well, people will be taking less energy off the distribution system than they otherwise would have done, correct? A. Well, then that falls under the same -- no, I don't see that here. Q. I think that's been accepted by this Board consistently in Ontario Hydro hearings as being a form of bypass and I don't know if you're familiar with that. Perhaps not. Let me move on to another issue in respect to Board Consultants 1233 ex (Participants) bypass. I think it's fair to say that certain larger enterprises that might be interested in engaging in self-generation, co-generation or other forms of bypass may well be resistant to paying tariffs or charges, exit fees, if you were, that might recover for these historical costs; is that fair to say? MR. HARRIS: A. Might be resistant to paying these charges? Q. Yes. A. I would think that they would most likely be resistant to them. Q. And it's fair to say that those interests, those industrial and business interests, may well engage in lobbying to avoid the imposition of these kinds of charges? A. Then I would think there would be another group of people lobbying for the exact opposite, yes. Q. And I take it that the outcome of that battle is uncertain. DR. CANNON: A. Yes, but we -- it's our belief that the public policy makers in this area have made their judgments and are going to avoid -- or do what's necessary to avoid uneconomic bypass investments. Q. And you say that notwithstanding the fact that the government has not adopted any policy on this matter? A. Yes. Q. Okay. Now, let me just talk about another Board Consultants 1234 ex (Participants) uncertainty, a business uncertainty, heading as a result of industry restructuring. Part of SERVCO's business on the distribution side at the moment involves such activities as billing and metering and that kind of end-use service. You're aware of that? A. Yes. Q. And that forms part of their rate base? A. Yes. Q. For which they obtain a rate of return? A. Yes. Q. Are you aware that there is going forward going to be some debate about the contestability of some or all of those functions? A. Yes. Q. And insofar as they do become contestable, I take it it's reasonable to assume that SERVCO will lose at least some share of that market? A. Yes. Q. And insofar as SERVCO has received asset allocations and debt allocations in respect of the provision of those services, those kinds of -- those debt allocations will in a sense being stranded as well insofar as they permanently lose some part of that business? MR. HARRIS: A. Can you give me an example of an asset allocation? Q. Well, there are meters, for example, I believe several hundred thousand meters. Board Consultants 1235 ex (Participants) A. Are we talking about the service of a meter reading or the meters themselves? Q. There's the hard assets that are involved in that and the -- A. So what is contestable? Q. Ownership -- A. I'm just not clear on what you're describing as being contestable. Q. Well, one item will be ownership of meters, I take it. That is one issue which may become a contestable service in the future. Similarly, all of the infrastructure and support of those services in terms of minor fixed assets, overheads, et cetera, all of that debt may well become stranded if SERVCO loses that business; isn't that fair? DR. CANNON: A. I don't think so. I think that in the regulatory process that might transpire to create that kind of evolution. The financial integrity of that contestable business will be preserved and it won't be done to the detriment of the monopoly wires business. Q. Well, I mean -- A. You're talking about -- you're painting a picture of things that might happen in the future, all right, and we can't exactly see the canvass you're working on -- Q. And you're painting a picture of what might not happen, I take it; is that fair? MR. HARDY: I think we'll leave it up to them Board Consultants 1236 ex (Participants) to.... MR. STEPHENSON: Q. Well, let's put it this way, you'd agree with me it's an uncertainty; isn't that right? DR. CANNON: A. What that future will be is uncertain, yes. Q. Okay. And that is a matter which, I take it, is relevant in terms of what the market will price in terms of rate of return? A. No, I think it's not relevant for our discussion. We're asked to consider the monopoly wires business on a stand-alone basis and you're projecting a scenario where part of what might currently be in that is separated off and the risks and returns of that portion of the business, once it's separated out of the monopoly regulated wires business, is not of interest to us in setting the rate of return. Q. Okay. In terms of the -- I want to focus on the distribution business for a moment. Is it fair to say that relative to the gas LDCs in Ontario, the Ontario Hydro distribution business serves a relatively less urban environment, generally speaking? A. Yes. Q. And a relatively less industrialized environment? A. Well, all right, yes. Q. And a relatively less dense, generally speaking, environment? A. Yes. Board Consultants 1237 ex (Participants) MR. HARDY: Just as a -- if we can be careful to -- one person talk at a time to allow our court reporter just to catch up, okay? MR. STEPHENSON: Q. In terms of the forecasted growth of -- focusing again on the distribution business, I take it that one item that affects a rate of return will be forecasting risk in terms of the potential accuracy or lack of accuracy regarding growth in the system? MR. HARRIS: A. Yes, that's a long-run risk. Q. I just want to compare the gas LDCs and SERVCO distribution company for the time being. Would you agree with me that in terms of siting of new facilities, if somebody is choosing to connect, that they will -- they have many more choices in Ontario in terms of connecting to an electricity distribution system than they do with respect to a gas distribution system? DR. CANNON: A. Yes. Q. And I take it that because of that choice, there will be a higher degree of uncertainty in terms of any particular siting of new plant? MR. HARRIS: A. I don't know if I follow your conclusion there. I think what you've just painted is a picture that allows for growth. I'm not quite sure how you come to the conclusion that it's now more uncertain, as opposed to a company where the growth opportunities are minimal? Q. No. I'm not talking about there being more Board Consultants 1238 ex (Participants) uncertainty in the past as compared to the future. I'm talking about the relative uncertainty as between the growth prospects of SERVCO distribution versus gas LDCs. DR. CANNON: A. I think that the -- if you say there's more opportunities for customers to connect in more places, from a forecasting point of view, that diversity might very well reduce the riskiness of forecasting the number and the extent of customer additions for the electric industry as opposed to the gas industry. Q. Because you have no idea where they're going? A. Well, no. You've said that it's a bigger system, more opportunities -- Q. No. I said that the customers in terms of new siting opportunities have a greater range of opportunities with respect to their choice of electrical distribution companies and you agreed with me. They have 200-odd options-- A. Yes. Q. --as opposed to two? A. Are you talking about a demand growth forecasting risk here? Q. Yes. A. Okay. Well, that's one of the forecasting risks, I would say relatively minor when compared to, let's say, the forecasting risk with respect to weather conditions or something like that, but that Ontario Hydro has considerable experience at dealing with and we took Board Consultants 1239 ex (Participants) that into account in our applications. Q. I'm asking simply as a matter of comparative analysis as between the gas LDCs and SERVCO distribution and that it is relatively greater for SERVCO distribution. A. No, I don't follow that logic. I don't see the connection between the conditions you've put up and why that makes relative to the gas industry the forecasting of customer additions more risky. Q. And I just wanted to understand again, you have chosen to discount a number of risks faced by SERVCO and I wanted to make sure I understood them. One is the new company risk, and you've discounted that because you say by the time there is any, shall we say, sale to third parties of shares, that issue will have resolved itself one way or the other, I take it? That's the reason you've discounted that risk? A. Yes, I think that's the major reason we've discounted it. Q. And similarly, there's a new industry risk, I take it, in the sense of we've got a restructured industry here and all the parts are going to fall out somewhere or other and nobody is quite sure of that yet. I mean, you'd agree with me, that generally speaking, is -- A. That's true in half the industries in the world. Q. It's not true in the gas business? A. Yes, I think that from an investment risk Board Consultants 1240 ex (Participants) point of view, a lot of the changes that have been happening recently within the gas industry -- Ms. McShane has characterized the change in the formulaic approach as one that she sees as negative. I personally see it as a factor that reduces the risk, but we would both agree that it's a change from the old days, so ... Q. So I take it, do I understand you correctly that you attribute no business risk to SERVCO, at least none different than gas LDCs by virtue of what has been characterized as a revolutionary restructuring of the electrical industry in Ontario? A. No, I think the extent of the changes over, you know, this two-year period, from now until two years out, is greater in the electricity industry than it is in the gas industry. MR. HARRIS: A. And I would add... Q. But you don't attribute any marginal or business risk by virtue of that difference in magnitude of change in restructuring? A. But let's just keep in mind what we're talking about, about change in restructuring and this issue of new company versus existing company and how it fits into business risk. In the prior line of questioning we started talking about the importance of management in determining the overall risk of the company and we were provided a number of documents by Fred that discusses management's role, and in one of these documents, in the Moody's Board Consultants 1241 ex (Participants) Approach to Rating Gas Transmission and Distribution Companies it says, under management: 'Management is less risky when it is a team that is used toward working toward a consistent long-term strategy.' Here we have a company that's long-term strategy hasn't changed, its long-term strategy is simple: Increase the utilization of its system, its distribution system and its transmission system. Nothing has changed about that and will not change. So going forward we might have a new company that is existing employees in new roles, but they have the same long-term strategy. DR. CANNON: A. And furthermore, I think the changes that have taken place, both in the company and in the industry, are ones that have reduced the long-run risk of the industry. I mean, if we hadn't made these changes, I think a lot of observers would say our industry in Ontario would become a dinosaur and become extinct, and we've made these changes to enhance the survivability and vitality and productivity of this industry. So if you compare SERVCO now, its chances of success in the future versus its predecessor company's, I would say the chances are improved by the environment that we've gone into and, therefore, the risk has actually come down. Q. I take it that that would be interesting if Board Consultants 1242 ex (Participants) there was an issue about what Ontario Hydro's past return on equity was, but since there wasn't one, that kind of comparison is not particularly helpful to us. Let me just take you for a second to page 19 of your report. Here you're talking about, I take it, sort of forecast risk and O&M expenses. MR. HARDY: Sorry, Richard, do you have a specific reference? MR. STEPHENSON: Q. Well, actually you're talking about it all through the page, but the first full paragraph there you state: 'Conversely, if utilization is increased above the forecast, the increase in O&M would still increase the utility's cost of service but this would be offset by the increase in revenues collected by the utility. Thus, overall, the two effects counterbalance each other and that might produce a net income equivalent to that commensurate with the utility's ROE.' I take it that's not true under a revenue cap PBR scheme? MR. HARRIS: A. That would be true, but the issue of the PBR brings in a new dimension. If the company is requesting a PBR implicitly they're saying that they are willing to assume a certain amount of risk in return for a certain amount of reward. That is the savings that accrue if they operate efficiently. Q. I take it this comment is directed at the Board Consultants 1243 ex (Participants) period before the time of the introduction of a PBR scheme. Is that generally correct? A. That's true. Q. Let's focus on that. In the period up until the point in time that PBR is introduced, the evidence here is that SERVCO's income will be their revenue requirement, not more and not less. You're familiar with that? DR. CANNON: A. Mm-hmm. Q. I take it this statement doesn't apply in those circumstances either? A. That's right. I think we were talking more generically here in a post-open access environment. Q. So, in other words, this statement doesn't apply to SERVCO for PBR, and it doesn't apply to them after PBR? MR. HARRIS: A. Well, if you look on page 17, which is the beginning of this passage, you'll notice there are italics, the title is Business Risk Characteristics in the electric industry. It has not made any specific reference to Transco or Disco-- Q. I understand. A. --which follows on page 20. Q. I understand that. You don't mention anywhere that this is not relevant to SERVCO? DR. CANNON: A. I think it's background for the... Q. I see, I see. Board Consultants 1244 ex (Participants) MR. STEPHENSON: That's all for me for now. Thank you very much. MR. HARDY: Thank you. Other questions? Could you identify yourself, please, and proceed. MR. MURPHY: Yes. My name is Larry Murphy, I'm with AMPCO, Association of Major Power Consumers. EXAMINATION BY MR. MURPHY: Q. And I just wanted to follow up on this discussion you've been having and one earlier this morning having to do with the issue of uncertainty in the new electricity market and how you've allowed for that in your rate of return. And in your executive summary I notice that when you mention the range of rates of return that you've concluded with -- let me refer specifically to the second paragraph on page 6, you say: 'We've recommended an allowed return at the high end of the range of returns indicated by our analysis to reflect the fact that OHCS is a new entity from the perspective of investors, although this consideration will really only be relevant...', and so and so on. So you have made some allowance for the fact that this is a new entity and they're moving into a new environment. The concept of rate of return that you're using, as I understand it, is that it's a rate of return that will attract private capital at some point in the future. Board Consultants 1245 ex (Participants) So there is some element of taking the future into consideration and those uncertainties and, to some extent, you have allowed for it here; is that correct? DR. CANNON: Yes. MR. HARRIS: A. Yes. Q. And we've talked very generally about what that uncertainty is and how the market reacts to that. I would like to get your reaction to actual experience in responding to this move into a new environment with new regulatory systems and so on, and I'm referring now to the Board's discussion document that was released on October the 16th called Consultation Letter on the Board's Performance-Based Regulation Initiatives, and it refers to the -- MR. HARDY: Sorry, are you familiar with that document? DR. CANNON: I think so. I read a couple of the Board's documents on PBR and I'm assuming this is one of them. MR. HARDY: Fine. Proceed, please. MR. MURPHY: Q. I'll make some general references to the conclusions of that document, okay. And that document, in taking a look at the actual experience in the UK and Australia and elsewhere, concludes that: 'Failure to fully understand the technical intricacies of correctly specified PBR adjustment formulas has often resulted in rapid and Board Consultants 1246 ex (Participants) substantial increases in provided rates of return. These results have been observed across countries, across industries and across firms.' And it gives the experience of the UK, where the rates of return were so high that the regulator had to intervene. And it gives the experience of Australia where the premiums paid on wires assets were far higher than anybody expected. So there is a case, I think, that in fact the market has experienced this uncertainty as an opportunity to realize very substantial rates of return. Could I get your comments on the actual experience in some other jurisdictions where this has actually occurred? MR. HARRIS: A. Are we talking specifically about PBR programs? Q. About the -- yes, I suppose that would be most relevant because that's what we're looking at here in Ontario. A. Yes. I think just giving you the U.S. perspective, clearly a poorly crafted PBR will give rise to some potentially outrageous results and it's all the more important to make sure that your benchmark, your starting point is constructed carefully, all the various components of the PBR plan are crafted and market-sensitive and objective and; otherwise, you will find that some utilities are able to earn a rather higher return that wasn't envisioned by the regulator or the Board Consultants 1247 ex (Participants) customers. And that has certainly happened in the U.S., not only in terms of PBR programs for distribution, but it's also happened with incentive mechanisms in general; for example, for gas cost in the U.S. And so, I guess, my point is simply that you are correct. Unless it's crafted carefully you do run the risk of running into trouble with PBRs. DR. CANNON: A. I think we should also just, you know, for sake of clarity, we did not either increase or decrease our recommended allowed return because of the prospect that OHSC would be regulated, as you know, along with the gas companies under a PBR approach. However, if you asked me personally, if you said this industry or this company is going to be regulated under a PBR approach, I would quickly rush out and try and buy the shares of the company because I would -- my anticipation would be that on the balance of probabilities, it would work out well for the investors and I would want to be on the winning side. Q. So getting back to rate of return on equity we're establishing now, in fact if we're moving into that environment, that could be seen as a reason why you wouldn't have to offer such a high rate of return if in fact the private sector saw that as an opportunity for a extra normal rate of return? A. I don't think that's the intention of the PBR structure. I think within the PBR structure what you want Board Consultants 1248 ex (Participants) as the benchmark, what you want as the starting point is the allowed rate of return that reflects the business and financial risks of the company independent of its PBR structure, and then the PBR structure provides the incentive if the company can do so, you know, meet its productivity, growth factors and that sort of thing, to earn a slightly higher rate of return. And everybody is a winner in that case; costs go down and returns go up. Q. I'm not really trying to make the case that in fact you can discount the rate of return, but rather it's not obvious that you have to offer a premium when you're moving into that environment? A. No, I think you definitely don't offer a premium when you're moving into that environment. MR. MURPHY: Thank you. Those are all my questions. MR. HARDY: Are there other participants' questions? MR. WHITE: Supplemental. EXAMINATION BY MR. WHITE: Q. I was talking about bypass risk. I think I'd like to revisit that a little bit. You talked about the great concerns raised before the Ontario Energy Board about bypass rates, and I think it's fair to say that the restructuring of Ontario Hydro largely dealt with placing the stranded generation debt in Debtco? Board Consultants 1249 ex (Participants) DR. CANNON: A. Yes. Q. Should this leave Genco... MR. WHITE: I'm sorry, it's Roger White, ECMI. Q. Should this leave Genco more competitive; should it result in a higher risk of bypass or a lower risk of bypass? DR. CANNON: A. I don't think we're being asked to make judgments about Genco. Q. Okay. But you were asked to go down the road on bypass, and what I'm suggesting is, if the price of energy is being reduced because a significant amount of the generation system's debt has been placed in a stranded debt pool that's going to be funded through various means, then it would seem to follow that there would be less incentive for bypass to happen if the price of energy remained -- electricity energy remained relatively low as a result of that changing capital structure for the generation system. MR. HARRIS: A. I would just say in general bypass is less likely if you have a competitive generation market. MR. WHITE: Thank you. MR. HARDY: Okay. Why don't we return -- I intend to take us up to twelve and then break. But I wonder if we can start, if there are any additional SERVCO questions now and we'll see how far we get before the break. MR. LONG: Oh, okay. Board Consultants 1250 ex (OHSC) EXAMINATION BY OHSC: MR. LONG: Q. I'd like to, I guess, deal with the subject of bond rating and I'd like you to turn, if you would, to pages 45 and 46 of your report. DR. CANNON: A. I have that. Q. In the third paragraph there you refer to the consultants, who I assume are yourselves, having recently had extensive discussions with two major Canadian bond rating agencies and with the credit rating evaluation department of a major institutional fixed income investor. I was wondering if you could tell us who it was that you actually had contact with at the agencies and the investor? A. Yes. At the Dominion Bond Rating Service it was Ms. Jenny Catalfo and she had discussions with other people at that agency in formulating her response to me. In CBRS Canadian Bond Rating Service, it was Mr. Damian Di Perna. And the institutional investor was the Bank of Montreal and I had discussions with several people there. Mr. Steve Priebe would have been one of them. Stuart Brannan, Betty Liu and Piper Kerr. That's it. Ms. Piper Kerr. Q. Okay, thank you. As, I guess, a result of these discussions and so on, do you actually have a record of the information that they provided you, whether there's a document, notes or some report from both the agencies Board Consultants 1251 ex (OHSC) and the investor. A. My notes on discussions with CBRS and BBRS are, you know, on bits and pieces of paper, et cetera, et cetera. The results of that conversation, however, show up in a paper that I prepared earlier for the Board on the framework for the rate of return for the municipal electric utilities. Q. And does that specifically deal with their assessment of that OHSC? A. That specific -- it deals, as I've indicated on page 45, specifically with a hypothetical distribution -- Ontario electric distribution company without generation assets that has the characteristics that are listed at the bottom of page 45. To continue answering your further question, the people at the Bank of Montreal did send me a -- fax results of their analysis, which I have. Q. Are you able to share that with this proceeding? A. Yes, I would be happy. It is simply computer printouts which require some interpretation, but I would be happy to walk people through that, if they want. MR. HARDY: I'll note then that that information is coming forward. MR. LONG: Okay. Q. I would like to I guess follow up on this a little more; in terms of the information that you provided Board Consultants 1252 ex (OHSC) to, I guess both the rating agencies and the investor, enabling them to do an assessment. Was it just the characterization that's on the -- at the bottom of page 45, those five items there? A. For the two rating agencies it was this characterization and many others. I was asking them to indicate what they felt the bond ratings would be for electric distribution companies in different size and financial strength categories. The top category, the least risk category, the largest category being the one that's described at the bottom of page 45. So I actually queried them about a broader range of issues. With respect to the BMO, I gave them information about the projected rate base, projected equity component, projected earnings under an 8 per cent rate of return scenario, hence projected operating profits under the same scenario, so I -- for the BMO, the example was specified for Disco separately and Transco separately based on what I saw in the applications, their respective applications. Q. Okay. Can you share with us again, you know, exactly the information base that you provided? A. I think so. It may, in fact, show up on the -- the input data may show up on the computer print-outs as well, but the source of it was -- I started with -- this is Disco's application and I looked at the numbers on pages 124 and 126 and those numbers were calculated -- these are projected -- the revenue requirements and the Board Consultants 1253 ex (OHSC) capital structure, projected return on equity, absolute dollar return on equity of profits of 105-million for example. These were based on a 10 per cent rate of return. I simply translated those -- recalculated those on the basis of an 8 per cent rate of return, corrected the tax number, you know, recreated the total operating profits and that became the input data -- and did the same thing for Transco. That became the -- Q. Can I just clarify those page numbers again? That was page 126? A. 124 and 126. Q. 124 is a text page. A. Oh, well, not in my one. Disco rate order application, OHSC distribution filed December 7, '98. Q. Yes, that's what I have, too. I have the revenue requirement on page 126. A. I got mine off the web. Does that matter? Q. Probably. A. Slightly different pages. The title of the page -- it's table 17-1 and table -- I think I also used table 17-2 and table 17-3. Q. Okay. A. And for Transco, I would have used table 6-5, 6-6 and 6-7. MR. HARDY: So what pages? DR. CANNON: Well, again, I got these downloaded from the web, so .... Board Consultants 1254 ex (OHSC) MR. HARDY: Can you just help us generally? DR. CANNON: Well, sorry, 68, 69, 70, yes, 6-5, 6-6 and 6-7. MS. WALLI: Okay. Table 6.5 is starting at page 68 in the official filing for transmission. MR. LONG: Okay. That's fine. Q. Just to go back to the -- so that the information has been provided, there was certainly the characterization at the bottom of page 45 and some financial information taken out of the submissions based on, I guess, I think in each case three tables from the submission? DR. CANNON: A. That's correct. Q. Was that the sum total of the information that was provided to these outside groups? A. Yes. Yes, I think I had conversations with all of them about the nature of the industry and why I was asking my questions and -- but .... MR. HARDY: The question still stands I think. You were asking earlier if there was analysis available; was that correct? MR. LONG: From? MR. HARDY: From the outside -- MR. LONG: From the outside, yes. Right now I'm exploring the information that was provided to them in order for them to do that analysis. MR. HARDY: Okay. So we're not yet at the point where Dr. Cannon has made a commitment to provide that Board Consultants 1255 ex (OHSC) information? MR. LONG: (nods) MR. HARDY: Okay. MR. LONG: Q. Just one further question on these tables, taking the distribution company set. That's table 17-1 through table 17-3. Do you agree that within that information, there is no comprehensive cash flow information? MR. HARDY: Sorry, so back to table 17 what? MR. LONG: 17-1, 17-2 and 17-3 for the distribution rate order application. MR. HARDY: Okay, thank you. DR. CANNON: One can infer -- I mean, when you have an income statement and a balance sheet, you can always create the flow of fund statement between two years, so you can create some aspects of the cash flow statement, but others you can't. I provided -- I was told what information would be needed by the analysts and I generated that information. I think they believed that for the purpose of their model, whatever cash flow information was needed would drop out of the other numbers that I provided. MR. LONG: Q. So when you were saying that you were responding to their definition of the information required, that's what resulted in these three tables plus the type of characterization on page 45? DR. CANNON: A. Yes. I said I would like them if they would to do this task for me, what did they need Board Consultants 1256 ex (OHSC) to know? They told me. I found it -- or as I say, I had to recalculate it on the basis of an 8 per cent rate of return, but other than that, then I provided them with the information that they felt was necessary. Q. I guess the conclusion that we see on page 45 where you say all of these -- and this is, again, in the last paragraph on the page, second sentence: 'All of these sources assured the consultants that an Ontario based regulated monopoly electricity distribution company with no generating assets, et cetera, et cetera, would be accorded an A to A-high bond rating.' So I guess what you're saying, that with the information that you've provided which, I guess, you've summarized for us here in terms of these tables, that based on that information, they were comfortable with actually assuring that these companies would get an A to A high bond rating? A. I think I have to parse this a little bit. The two bond rating agencies assured me that -- if -- instead of saying "all these sources", if you replace the word "all" with "the two bond rating agencies" and then when it came to the institutional investor, in this case the Bank of Montreal, their assurance was as described in the -- or their prediction is as described in the full paragraph on the next page, page 46, and it was -- they were the ones who pointed out to me that, for example, in the case of Transco that predicted A minus credit rating was based on the assumption that Transco would look like Board Consultants 1257 ex (OHSC) the typical U.S. -- they used a model that included -- that was based on data from powered companies all around the world, but that was predominantly U.S., overwhelmingly U.S. data. They said they'll keep in mind that, you know, this is the prediction on the assumption that there are some generation assets in Transco as well and that if there aren't generation assets in Transco, you can expect that that would have a favourable impact on the credit rating. So the strict statement that you referred me to on page 45, it should be the bond rating agencies with reference to that criteria at the bottom of that page. What the BMO analyst told me is described on page 46. Q. Okay. Again coming back to the information that you've provided, was there any company specific information over and above the financial information that came from the tables in the rate order applications that went along with the request? A. No. Q. So you in no way described the overall business environment, business risks and so on, associated with those companies but rather was relying on a generic assessment? A. No. With respect to the two bond rating agencies and the generic description at the bottom of page 45, I did say these are Ontario distribution companies within the new restructured Ontario market. I mean, I was basically suggesting -- Board Consultants 1258 ex (OHSC) Q. I think you were giving the game away. A. Hmm? Q. I said I think that gave the game away given this characterization as to who it was. But I guess what I'm interested in exploring is what I - and I'll come back to this - would like to call -- MR. HARDY: Sorry, do you have a complete response to that question? DR. CANNON: No, it's okay. Thanks. MR. HARDY: Sorry, go ahead. MR. LONG: All right. Q. I guess what I would like to understand is the extent to which you provided the bond rating agencies or the investor with any, what I will call, qualitative, i.e., non-quantitative information that they could use in their assessment. MR. HARRIS: A. Maybe before Dr. Cannon answers that question, if I could repeat something that Bill said earlier, he said, in effect, in his discussions with these people, he asked 'what do you need from me in order to provide this evaluation' and based on those discussions and those requests provided that information to those companies. Was that essentially correct? DR. CANNON: That's -- yes. Q. Sorry, go ahead. A. That's correct, but you are also correct that I didn't supply any -- I didn't say to the bond raters Board Consultants 1259 ex (OHSC) this is Ontario Hydro Service Corporation or this is Toronto Hydro or this is .... I was looking at the entire industry and I was at the time being asked to try to find a system to group Ontario distribution utilities into a limited number of risk classes and so I described it simply as the Ontario distribution industry and I described the characteristics of the five different risk classes as I had set them up and I wanted to assure myself that if the industry were regulated -- for instance, a distributor in the lowest risk class had an allowed equity ratio of 35 per cent and a deemed debt ratio of 65 per cent for example and a certain interest coverage ratio and that sort of thing, I wanted to assure myself that that wasn't going to impair their financial integrity or deprive them of the financial flexibility that they needed. So I described them generically. I didn't attach names or company specific information to my request. MR. LONG: Okay. I think now is probably a good -- now, I was going to take you to those documents, but if you want to break -- MR. HARDY: Yes, why don't we do that because I think we'll probably have additional questions after the break before we get to Ms. McShane. So why don't we break -- it's about say five after. Why don't we come back at five after one then. So we're adjourned. ---Luncheon recess at 12:06 p.m. Board Consultants 1260 ex (OHSC) ---On resuming at 1:10 p.m. MR. HARDY: Let's continue then. Mr. Long, I think we're continuing with your questions and then when we finish your questions, once again, I'll go to participants, and then we'll have Ms. McShane. MR. LONG: Q. Okay, and I'd like to carry on with, I guess, the general subject at least initially of bond ratings and rating agencies. Before I take you to some of those documents again, I guess just one initial question: Are you aware of any fundamental differences between the way Canadian or U.S. bond rating agencies attack the question of placing a bond rating on credits? DR. CANNON: A. I think that whether this is a fundamental difference or a difference of degree, the -- my impression is that the bond raters recognize that the regulatory environment in Canada is much more utility friendly than it is typically in the U.S. and that's taken account of in the ratings, and so the numerical requirements for things like debt to capitalization ratios and interest coverage ratios are more lenient, it seems to me, in Canada with the Canadian bond raters than it might be in the U.S. Q. But in terms of the fundamental approach and the factors considered, are they essentially the same? A. I think they're essentially the same. Q. I'd like to carry on dealing with the Board Consultants 1261 ex (OHSC) question of qualitative factors and take you to some quotes again in the material from Moody's and Standard and Poors and first take you to the - let me find the reference here - the gas document from Moody's and that's the one labelled 'B' and take you to first -- actually, I think I took you to this before, but I'll take you back again, page 5 under 'management'. The first statement there is that the overriding internal factor we explore when issuing a rating is management and then take you back to page 1 and a number of points there. The first bolded subheading which says "a key conclusion is that Moody's does not rate purely by numbers", do you see that? A. I see that, yes, we see it. Q. And then further down the page where we've got another series of bullets, the first bullet there which starts out "credit statistics are not good indicators of Moody's gas company ratings", and then the second bullet in that section which says "qualitative factors often determine regulated gas company ratings". I'd also like to take to you the Standard and Poors' document. That's the one labelled A. And on page 5 there, the right-hand column under 'transmission and distribution qualitative analysis' and the second paragraph there which begins: 'When evaluating electric transmission and distribution companies, Standard and Poors is most concerned about the predictability and sustainability of financial performance. In the Board Consultants 1262 ex (OHSC) near and intermediate term, certain qualitative factors are expected to play a larger role in determining financial performance.' Do you see that? A. Yes. MR. HARRIS: A. Yes. Q. Given these statements and our earlier discussion, would you agree that rating agents by virtue of the statements made in these documents cannot and do not make credit assessments without some fulsome discussion of qualitative factors? A. Yes, I think both Dr. Cannon and I would agree that qualitative factors are considered and used in evaluating the debt rating and you've mentioned a number of them here in terms of management and regulation. I do hope that while you've identified these issues in these reports, you'll also read into the record what some of these reports have to say about management and regulation and some of these other issues. DR. CANNON: A. For example, one of those qualitative factors would be whether a company is regulated or not. That doesn't show up just in the interest coverage ratio or the debt coverage ratio. Just looking at those numbers, it doesn't say whether it's regulated or not. And clearly, as your documents show in many cases, if a firm is a regulated firm, it's going to be subject to a lot less risk and achieve a higher debt rating than an otherwise identical non-regulated firm. Board Consultants 1263 ex (OHSC) Q. I guess within the -- certainly within the two Moody's documents and I guess partially within the Standard and Poors' documents, there's a clear separation between things like the financial ratios that they assess against regulated entities versus non-regulated entities. As I say, the two Moody's documents are entirely about what are regulated businesses, so I think it's quite clear that that's the case there. In the case of Standard and Poors, they make quite a distinction between, for instance, the transmission and distribution businesses and the generation businesses. A. We saw that. Q. To move on from qualitative factors to quantitative factors now and coming back to the -- I guess the information that you received from the Canadian credit rating agencies and the institutional investor, do you recall whether a lot of that -- or part of that analysis centred around the interest coverage question? A. It was one of the input factors. Q. One of the input factors. Do you recall then whether of the coverages that were considered funds or earnings coverage was one of the factors? A. That wasn't explicitly a factor when I talked with DBRS or BBRS, and it wasn't an input factor on my part, with respect, when I sent the material along to the Bank of Montreal, but it may very well have been something that they felt their model calculated internally - I'm not Board Consultants 1264 ex (OHSC) exactly sure how it would do that, but depending on what you include in that cashflow number - but that their model generated internally based on the other information. Q. Okay. Do you recall then whether in the output it was one of the items that was identified? A. I'll check that. It doesn't appear to be. Q. Okay. So as far as the input on interest coverage that you provided, I think in your report you quote, and I don't have the reference-- A. Page 45 is it? Q. It may well be there. Yes, that's it. The item right at the bottom where you say: 'A pro forma ACR of 2.28 times.' That was input that you provided? A. Yes. Q. And is this interest coverage based on pre-tax earnings? A. Yes. Q. So it's fair to say that this coverage ratio is an earnings-based ratio rather than a cashflow-based ratio? A. Yes. Q. Can I then take you back to the second Moody's document, the one dealing with electricity distributors and this is the document labelled "C". A. Yes, I found that. Q. On page 1 there you go almost to the bottom -- the second bullet from the bottom, and I'll read the Board Consultants 1265 ex (OHSC) second sentence there and it says: 'Cashflow coverage ratios will remain the most important measures of financial risk.' And also if I take you to the Standard & Poors document again, document "A" to page 3. A. I have that. MR. HARRIS: A. Yes. Q. And the left-hand column there, about two-thirds of the way down, under financial profile there's a sentence that begins: 'Financial parameters that are increasingly viewed as relevant and reliable, a coverage of fixed financial charges by cashflow and cashflow from operations to total debt, less comparable measures such as shareholder's equity, leverage and reported earnings are also reviewed but de-emphasized.' DR. CANNON: A. I see that. I think maybe I have to revise my earlier statements because I misinterpreted what you meant by cashflow. I thought in your cashflow you were talking about inflows and outflows that included financing requirements. In other words, how much -- you know, it's a cash outflow for investment versus how much is the cash inflow from new financings, that was when you originally brought up the term, it was in the context of your asking me about financing flexibility. So now that I see that you were talking about Board Consultants 1266 ex (OHSC) regular sort of income statement cashflow; in other words, earnings either before or after tax, add back, depreciation and other non-tax charges, you know, you might -- some people would call it a free cashflow number, it might or might not include dividends, that sort of... That kind of cashflow number was considered, all right, by the DBRS and CBRS analysts and by the BMO analysts in particular. They wanted to make sure that I gave them enough information that that would be one of the numbers that came out of the analysis. And so let me -- I beg your pardon for not cluing into which kind of interpretation of cashflow you were -- and let me go back. So the operating income is one of the factors that goes into the BMO analysis, and I think this operating income number is close to the cashflow kind of number that you're talking about there. Operating income would be, for example, before the subtraction of depreciation allowances. So it would be in the same area as -- or, you know, similar to the kinds of cashflow numbers that you've been referring me to. Q. And did they compute the coverage of interest from those operating incomes as you called them? A. No. I think their interest coverage ratio was -- would not have included in the numerator any kind of depreciation number, it would have just been earnings before interest and taxes divided by interest, I guess, Board Consultants 1267 ex (OHSC) interest rate. Q. So, it's the earnings coverage that was reviewed. A. Yes. But your question was: Did they incorporate within their consideration and in their model this cashflow or operating earnings number. I mean, the big difference between earnings before interest and taxes and cashflow, the big, big item in there is the depreciation allowances, the non-cash expenses. Q. I guess that would depend on the detailed accounting policies of the particular entity. But certainly that is one of the factors that's different. I guess I come back to the comments that I read from both Moody's and Standard & Poors where I think it's quite clear that they focus on cashflow coverage and de-emphasize earnings and earnings coverage and I just wanted to make sure that that was clear. Coming back though to -- to come back to the Standard & Poors document for a moment, again, page 3, if I take you to the table at the bottom there. For transmission and distribution companies that are A-rated it specifies a benchmark or a standard of 3.25 times. And I just want to make, I guess the record perfectly clear as to whether or not that appeared in the assessment of either the Canadian rating agencies or the institutional investor in the work that they provided you. A. They didn't make the division but I could do Board Consultants 1268 ex (OHSC) it for you right now. I mean, all the numbers are there to -- you've shown for both Transco and Disco what your projected interest expenses are. I had to calculate as an input for them. I had to recalculate the earnings after tax on the basis of an 8 per cent return on equity. I had to add back the appropriate amount of taxes, add back the interest, add back the depreciation to get the operating earning numbers. So making that kind of calculation would be quite easy for me, and I'm quite confident it would be up in the 3.25 area that you've signalled here on this page. Q. Well, let me -- A. Didn't your Ms. Ng -- is that her name? Q. Let me take you back to the testimony of Ms. Ng because I think this is quite germane and I don't know whether you have a copy of the transcript or not, but it's page... MR. HARDY: Again, I want to make sure that our panelist is comfortable with that testimony. DR. CANNON: I recall a number 2.6 as an interest coverage ratio. And perhaps you can tell me whether that's an interest coverage ratio that is... MR. HARDY: I'm just going to have to stop you because I think we're on terms of introducing some of the information that Ms. Ng had provided. DR. CANNON: Right, okay. MR. HARDY: So if we just cover off that first. Are you familiar with -- are you familiar enough Board Consultants 1269 ex (OHSC) that you're comfortable? DR. CANNON: I read that transcript but I don't think I can put my hands on it right now. And I think I interpreted the transcript correctly, but... MR. HARDY: Okay. So if there's any need to take a look at it, please, let me know and we'll make sure -- MR. LONG: And I think what you just said seems to indicate that you are somewhat familiar with it. Q. There she indicates on actually page 27 in and around lines 24 through 26 that the interest coverage ratios are in the order of 2.6 to 2.8 and what she's speaking about there is the cashflow coverage ratio. DR. CANNON: A. I don't think so. I can't imagine, because I get the same numbers based on what you are determining an earnings coverage ratio. So I think you'd better check that. Q. I'm quite confident that that was -- A. Does it say that in the transcript? Q. Funds flow from operations. A. I don't think it says cashflow coverage ratio in the transcript. Q. Maybe you can confirm for me that your calculation of the equivalent of a cashflow coverage ratio or funds flow from operations ratio is closer to 3.25 based on your calculations? A. Well, you'd have to give me a minute. Why don't you let me do that during the break? MR. HARDY: Yes, I think rather than take the Board Consultants 1270 ex (OHSC) time now, if we can -- can you just make note of that question so you're perfectly clear of the question being asked and then we will take a break some time in the next 45 minutes or so and that will allow you enough time to take a look at that. DR. CANNON: And this is on the basis of an 8 per cent return on equity; is that... MR. LONG: Q. No, this is on the basis of our rate submission. Everything in Ms. Ng's testimony was based on the rate submission. DR. CANNON: A. So you don't want it at 8 per cent, you want it at 10 per cent? Q. Well, why don't you give it to me at 8 and 10 per cent. A. Okay. Q. Is it fair to say, though -- MR. HARDY: Sorry, I'm just going to have to hold. Are you comfortable with the question that... DR. CANNON: Yes, I can see the page that I'm going to use right in front of me here. MR. HARDY: Okay. DR. CANNON: No problem. MR. LONG: Q. Is it fair to say that if the rate submission were based on 10 per cent return on equity as it was and we got a certain funds flow from operations coverage, let's call it "x", that under an 8 per cent return on equity that there would be a substantial reduction in the value of "x"; it would be less? Board Consultants 1271 ex (OHSC) DR. CANNON: A. No. No, actually it wouldn't be a substantial reduction because the earnings part of that numerator of that ratio is actually a relatively small part of it. If you're talking about cashflow, you've got up there, you've got depreciation, you've got taxes, you've got interest and you've got profits. Q. Well, perhaps... A. But profits are just one quarter of the whole... Q. Your calculations can perhaps confirm that view. MR. HARDY: Okay. My suggestion is that I think you're continuing to ask questions on a matter that our panelist has already agreed to provide some calculations on. Perhaps there's another area that we can move into and give our panelist an opportunity to be prepared to respond. MR. LONG: Yes. Although I think, having got the results of that calculation, I'd want to follow on. MR. HARDY: That would be fine, yes. MR. LONG: Q. Okay. Let me turn now to pages 11 and 12 of your report. And I guess at the bottom of page 11 a new section is begun, and starting there and following on to the top of page 12 you list a number of approaches which I believe are commonly employed in regulatory hearings for establishing return on equity. Is Board Consultants 1272 ex (OHSC) that fair? MR. HARRIS: A. Yes. Q. And would you agree that all of those methods are valid and have merit in such an exercise? DR. CANNON: A. Generally speaking, yes. Q. And would you agree that within your work as documented in this report, that you've only used the ERP, the equity risk premium and the cap M approaches? MR. HARRIS: A. That's true. DR. CANNON: A. That's true. But you have to remember that this is not generally speaking. We are conscious of the needs of the Ontario Energy Board and we're conscious of the -- and their stated preference or desire to use this formulaic approach to a rate of return setting as virtually a regulatory requirement given their expanded responsibilities. And we're conscious also that they have used this approach and are planning to use this approach until there's a new generic hearing on the whole subject with the gas companies. And consequently we're also -- have taken account of the -- basically the dictate by the government, the Ontario Government, that the regulatory approach between the gas distributors and the electric distributors should be as similar as possible, and those considerations as we've indicated in our report are the ones that persuaded us to concentrate on equity risk premium and cap M which is a particular variant of the equity risk premium Board Consultants 1273 ex (OHSC) approach. Q. So you didn't consider the DCF or the comparable earnings test methods because they didn't lend themselves to this formulaic approach? A. That's right, and because they were out of favour with the Board. The Board has in the document that we were asked to consider, their draft guidelines to this formulaic approach, the Board went through and considered quite carefully the relative merits of the different approaches and they, you know, these relative merits have been argued before the Board many many times and they came down that the judgment that, for the present time, they wanted their witnesses who contributed to their deliberations to concentrate on the equity risk premium approach. I don't think they precluded using the other approaches, but they made it clear that their interest was to see the results that came out of the equity risk premium approach because it was consistent with the adjustment mechanism that they wanted to use. They wanted to be able to base the year-by-year adjustments in the allowed rates of return on changes in long-term government rates and that neither the DCF approach or the comparable earnings approach lend themselves to that. Q. Okay. Would you agree that at this proceeding that what we're trying to establish is the starting point for the ROE for the services company to Board Consultants 1274 ex (OHSC) later be used in a formulaic approach? A. Yes. We're trying to get the starting point. It's a little different situation, however, I think, in that, as I understand it, it's not the Board that will make the final decision on the rate of return in this particular case. They are simply providing advice to the government, or have I got that wrong? Q. I don't think that's the case. Given that it's the starting point, would you agree that compared to a situation where the rate of return or return on equity is revisited either year in/year out or in all subsequent regulatory hearings, would you agree that it's more important to get the starting point right? MR. HARRIS: A. I think it's important to get the starting point right in any case. Whatever we are talking about it's important to get -- it's important to determine the appropriate cost of the equity period and that does not differ whether you're looking at a firm that's just starting up or firm that's been at regulatory proceedings for the last 20 years. DR. CANNON: A. And we're also conscious that, you know, the returns for the gas companies have been set based on this formulaic approach and have been set primarily on the basis of equity, even the original returns, primarily on the basis of equity risk premium evidence. Board Consultants 1275 ex (OHSC) To set on OHSC's return based on a different set of evidence is bound to lead to inconsistency or perhaps would lead to inconsistency in the return determinations. Q. Have either of you ever used either the DCF or CET methods in providing evidence at regulatory hearings? MR. HARRIS: A. I've used the DCF method, yes. DR. CANNON: A. And I've used both of those other methods. Q. I'd now like to take you to page 44 of your report. And in the bottom paragraph there, do you agree that you conclude that and "all-in ERP" for the services company is in the range of 1.6 to 2.1? This is an analysis around your second ERP test. A. Yes. Q. And that -- so that the 1.6 to 2.1 is a return over and above the return on long-term Canadas? A. That's correct. Q. Do you have any sense of what the spread over long-term Canada is for debt issue by an A-rated entity, particularly an A-rated utility? A. Well, I should say it's been bouncing around, but I would say traditionally it's been 100 basis points, 1 per cent. Q. So would you then agree that given that range of ERP, a 100 basis point spread over Canadas for an A-rated credit, that what this is saying is that the equivalent return to equity holders is between .6 and 1.1 Board Consultants 1276 ex (OHSC) per cent? A. No, I don't think you can interpret that way. First of all, you haven't factored in that the two kinds of returns are taxed differently for different kinds of investors. But more importantly, you've seen in some of the evidence in our report here, evidence that the riskiness of long-term bonds relative to the riskiness of equity investments has been going up over time and you would naturally expect because of that, the equity risk premium, whether it's gauged relative to long-term Canada bonds or as you have just painted the picture, relative to A-rated debt, that equity risk premium is getting compressed over the years. Q. I recall that in your evidence, but are the numbers that I quoted incorrect? A. They're irrelevant. You're comparing apples and oranges. Q. Let me just understand this, that the -- a debt holder -- I guess using the numbers that you have there, a debt holder, say, a third party debt holder in the service company if it's A-rated would receive a return 1 per cent above the return on long-term Canadas? A. So if long-term Canadas - let's pick a number - 6 per cent -- a before-tax return of 7 per cent which might be an after-tax return of 3-1/2? Q. But the return is 7 per cent. A. Before tax. Q. Is tax always a factor for particularly Board Consultants 1277 ex (OHSC) institutional investors that would often invest in such entities? A. Pension investors are not taxed while the funds are in the plan on any kind of investment income and so they are tax indifferent, but individual investors aren't and often the cost of capital is set by the marginal investor which if we're talking about -- if we're postulating equity investors eventually in Ontario Hydro Services Corporation or SERVCO, that marginal investor might very well be an individual investor. Q. Are you saying that an institutional investor wouldn't establish the price at the margin? A. Under some circumstances, yes, but I would imagine that under many circumstances, it might be the individual investor. It depends who the government wants to target as the primary shareholders. Q. Let's go back then to what you said about a pension plan that's non-taxable and let's consider the situation where it's holding potentially both debt and equity. Is the difference in those returns, given the numbers that I've given you, between .6 and 1.1 per cent? Yes? A. Well, again, the -- generally speaking, when an institutional investor buys debt, they are anticipating that most of their return is going to come through the coupon interest level. I mean, occasionally they're betting on capital gains, but they expect the return Board Consultants 1278 ex (OHSC) primarily to be in the form of interest on that debt. Generally speaking, with equity investments however, they're not counting -- they're counting their return -- what they're hoping for is to get a capital gain, all right, and -- so what you have to tell me here or what I have to postulate for you is that if Ontario Hydro were -- SERVCO were to get a rate of return that was 1.6 to 2.1 per cent above long-term Canada rates, I would then, and so would the institutional investor, make a judgment about what kind of capital gains that might lead to in the long run and the investment rate of return would then be different or the increment in the investment rate of return would be different than the .6 to 1.1 that you've put before me. Q. Okay. Could I take you now to - this is just a point of clarification I think - page 51 of your report? We have a table and at the bottom there are four footnotes, the last two dealing with Moody's and Duff & Phelps I can't find a reference for. I was just wondering, was any of the information sourced from them? MR. HARRIS: A. No. Those should have been corrected this morning. Strike footnote 3 and the asterisk. Q. I'd like to now explore a little, I guess, the topic of betas as it's often referred to in your report. Would you agree that in laymen's language, the beta is intended to measure the relative risk of a common Board Consultants 1279 ex (OHSC) stock security in relation to the market as a whole; is that a fair statement? DR. CANNON: A. Generally, yes. There's a little more twist on it, but that will do for a start. Q. Staying on page 51, there you show an average beta for U.S. electric utilities that's quoted as .645? MR. HARRIS: A. In fact, that should be .614. Again, I apologize, that correction should have been made this morning. Q. 614. And is that -- okay. And are they -- MR. HARDY: Sorry, just replacing .645 with .6 -- MR. HARRIS: 14. MR. LONG: Q. If I were to go over to page 52, table 2 then where you have -- you show an electric industry average of .62; is that correction then -- MR. HARRIS: A. Yes. Q. Is that the reason that that was different before from the 645? A. Yes, that's why the error exists. The .62 is .614. Q. So coming back to page 51 then, those betas, are they raw betas or adjusted betas? A. They are adjusted betas as published by a value line. Q. And can you tell me what the equivalent raw beta would be? A. I cannot. Dr. Cannon thinks they could be about .48, .5 Board Consultants 1280 ex (OHSC) Q. Our calculation was .47, so we'll accept that. On page 44 in the middle of the last paragraph, you state that the required risk compensation for Canadian gas and electric utilities is no more than about 50 per cent-- DR. CANNON: A. That's correct. Q. --of the market average. And I understand that this number is derived from your computation of betas on page 83; that's appendix B, schedule 5? A. Well, that's one of the pieces of information. The other, of course, is the comparison of the standard -- the average standard deviation of investment returns for this sample as compared with the market as a whole. So in other words, it's a judgment that's drawn from the numbers on page 44, the one number that says 53 per cent and the other number that's 35 per cent. Q. And is that -- are the betas on page 83, are they raw or adjusted? A. Well, if they're mine, I think they're raw. Q. Okay. So if we've got raw betas -- A. Yes, they are. Q. If we have raw betas for the U.S. electrics and of about .47, close to .5, versus Canadian utilities' raw beta also of about .5, does that suggest that electric utilities in both countries are of approximately similar risk in relation to the overall equity market? Board Consultants 1281 ex (OHSC) A. They are of similar risk with respect to their own equity markets; in other words, Canadian gas and electrics are half as risky as the Canadian market. U.S. gas and electrics are half as risky as the U.S. market. Q. Have you ever done any testing to see whether, in fact, there are fundamental differences in Canadian utilities versus electric utilities as far as their risk's concerned? A. Canadian versus U.S. electrics? Q. Yes, that's correct. A. Well, I haven't done numerical tests, but I read about the kerfuffle with a lot of U.S. electric utilities, the trouble they have with their regulators and the trouble they have with their generating assets, and my impression is that the Canadian electric utilities, particularly the publicly traded ones, are considerably less risky than the average U.S. electric utility. MR. HARDY: Mr. Long, I wonder if it is a good time to take participant questions? MR. LONG: Okay. MR. HARDY: Are there any additional participant questions at this point as a follow-up from any other information provided? MR. STEPHENSON: I just have a couple of questions, Richard Stephenson for the Power Workers' Union. EXAMINATION BY MR. STEPHENSON: Q. Dr. Cannon, are there any other Canadian Board Consultants 1282 ex (Participants) utilities, first off in your report, that have an approved rate of return of 8 per cent or lower? DR. CANNON: A. I don't believe so. Q. None? They're all higher? A. They are all higher. Q. Are there any with an approved rate of return of 8.25 per cent? A. I don't think so. Q. They're all higher? A. I believe so. Q. So you're recommending that we're setting the lowest rate of return of any electrical utility in Canada? Is that -- that flows I take it? A. I'm recommending a rate of return that's lower than what's been approved elsewhere, but, of course, I believe that SERVCO is less risky than these other electric utilities and since those rates of return have been set, interest rates have basically trended down, so I can't make a direct comparison. Q. I wonder if you can perhaps confirm my lawyer's math which is always a dangerous thing. I'm just comparing your recommended rate of return as against the approved rates of return for Union Gas which I think was 9.6? A. Yes. MR. HARDY: Do you have a page reference or anything to ... or is that...? MR. STEPHENSON: I think he's very familiar with Board Consultants 1283 ex (Participants) the number. MR. HARDY: I'll listen carefully then. MR. STEPHENSON: Q. Just at an 8 per cent rate of return for SERVCO, if that was the number, in effect what you're saying is, if I'm an investor and I have a choice between investing in SERVCO or investing in Union Gas for example, I'm going to need a 20 per cent higher rate of return in Union Gas in order to encourage me to invest there; is that right? That's the difference between 8 and 9.6 per cent? DR. CANNON: A. I'm not sure you want to get into that territory. To buy Union Gas, you have to pay -- well, you can't buy it directly, but if you could buy-- Q. I can't buy SERVCO either. A. --it directly, you'd have to pay perhaps 1.8, maybe as much as two times the book value to buy it and so your actual rate of return, your accounting rate of return on what you would pay for those shares would be in the nature of 5 per cent. Q. And that may be true, but that may also be true when and if I can buy SERVCO? A. That's right, one of -- Q. I mean, there's no reason to assume, in particular, that there will be any difference in that. A. Well, from a regulatory point of view, do you want a regulated utility so that when it first goes on sale, it attracts a price that's twice its book value? That's sort of a -- that's a little exorbitant. I mean, Board Consultants 1284 ex (Participants) that tells you -- if that's true, it tells you that the real required rate of return is only half of what you've allowed the utility. Q. And that's true of Union Gas? A. That's right. It's a point I try to argue. Q. And it's gone unheeded, I take it, for the last 20 years? A. I'm not sure. I'm not in the minds of board members. I'm not sure what they -- Q. Well, it has not prevailed, shall we say, for whatever reason? A. Well, over the years, the market-to-book ratios for virtually all the Canadian utilities have trended upward. That's evidence that investors have been very satisfied with the rates of return that they have been achieving -- sorry, achieving but also being allowed. Q. I understand that. I just want to understand the differential. I mean, it's 20 per cent more for Union Gas than SERVCO in terms of their rate of return, in terms of their allowed rate of return. A. There's an explanation for the differential. Q. Want to try again because I didn't hear it? A. You didn't ask, so I asked the question for you. Q. Oh. A. You want -- Q. No, I understand. You've put it in your materials in terms of -- Board Consultants 1285 ex (Participants) A. No, I didn't put it in my materials, but ... Q. Well, you've indicated that there were two factors in your report that explain the differential as far as I understand it. A. In fact, there's three factors. Q. Well, one was that it is the difference in the debt equity ratio, 35/65 versus 40/60 -- 60/40 rather. A. Yes, that's one. Q. And another one is the relative risk differential as between the regulated gas LDCs and SERVCO. Those are the two you listed in your report? A. And the third one -- Q. Which is not in your report? A. Not in my report. Q. Oh, I see. A. But I mean, my report was not trying to justify. I didn't build up my recommendation for SERVCO by saying I'll take Union's rate as a given and then I'll base SERVCO's on Union's. We did after we came to our recommendation try to show that it was consistent with Union's, all right, and the third factor of course is, you have to consider the long-term Canada rate forecast that underpinned the agreed to. It wasn't a regulatory judgment. It was an ADR settlement number. The long-term government forecast that underpinned that agreed-to rate is a lot higher than what we're assuming and we believe will be true next year because in the last four months, again, long-term rates Board Consultants 1286 ex (Participants) and expectations about long-term rates are coming down. Q. Let me just back up for a second. I take it you're sufficiently familiar with the Board's processes, that notwithstanding any ADR agreement, the Board must approve the decision and the Board -- the decision is the Board's decision? A. Yes. Q. Okay. A. But in that ADR process, the participant went to, or at least perhaps Union went to great lengths to say, you know, we want this decision to stand based on the forecast at the time we made our agreement. If rates should happen to come down after that, we want you to turn a blind eye to that and still base our rate award on the -- the formula that we used to forecast long-term rate at the time of the agreement. MR. STEPHENSON: Yes. Those are my questions. Thank you. MR. HARDY: Are there any other participant questions? Okay. SERVCO, back to you. If you have additional questions, and I plan to take a break around -- somewhere between two and two-fifteen, so... MR. LONG: Okay. EXAMINATION BY OHSC: MR. LONG: Q. Just coming back to I guess your results again, and I take you to page 52 again. This is your cap M calculation and here you have applied I guess a Board Consultants 1287 ex (OHSC) beta of .62 to come up with the result of 7.62. If you had instead applied a beta of 50 which you use elsewhere in the report, would then the calculated return have been 7.2 per cent or thereabouts? MR. HARRIS: A. It would have been lower, yes. Q. Would you agree that this -- such an estimate is an unreasonable level of required equity return? A. I wouldn't agree with that. In fact that's not what we are proposing here. We are proposing -- Q. I realize this is not your calculation, but if one had applied the raw beta instead of the adjusted beta which we, I think previously agreed, was of the same order of magnitude whether you're looking at U.S. or Canadian utilities, that you would have got a result which was substantially lower, a result which also presumably would close the gap even more between the return afforded bond holders and equity holders? A. I would agree that you would have received a lower result, yes. Q. In your ERP work you use raw beta I think as we previously discussed and in the cap M work you use adjusted beta, and I believe in your evidence you indicate that - and I think it's in discussing Ms. McShane's work - that the rationale -- or at least I took it as the rationale for that was that in Canada this didn't trend towards one and that was the rationale. So you're saying that there's no evidence for that in Canada. Does evidence for that exist in the U.S.? Board Consultants 1288 ex (OHSC) A. I don't know that evidence does exist for that in the U.S.. The reason that the adjusted beta was employed in the cap M methodology was simply to provide a broader result based on U.S. companies and an alternative approach and Dr. Cannon and I might disagree on whether that's appropriate in terms of using that adjusted beta. Simply a difference in approach. I've used those before and I felt that I should continue to use them in this valuation. Q. Could one then use an adjusted beta in the ERP results, which I presume would give you a higher return on equity result if you did that? DR. CANNON: A. Well, in my ERP work which has been confined to Canadian data over the years, I have always held the position that we should use the raw betas. When we call them raw, we could call them real betas as well, I mean they are the real theoretical calculation because the original rationale for value line to report adjusted betas was the presumption that with most industrial companies, over time, as their corporate histories unfold, they have a tendency for extremely high betas to come down toward one and extremely low betas to go up toward one. And of course one explanation for that is as companies progress they often diversify into more businesses and they come to look more like the average firm. But if we were talking about regulating pure Board Consultants 1289 ex (OHSC) wires or pipes regulated monopolies in Canada, if their relative business risk is not changing over time and they aren't -- the regulated part isn't diversifying and gobbling up other firms, there's no logical reason for the -- their beta risk coefficients to - the expression is - regress toward one, and the empirical evidence argues against it. The empirical evidence - now I'm citing a study that Drs. Booth and Berkowitz did in connection with the multiple pipeline hearing in 1994 - their study, and this is clearly just hearsay, but in their study they said that the betas regressed toward, in Canada, towards a value of about .45 - I've got it in here somewhere if you want me to check the exact number. And my evidence is that betas have stayed relatively stable for Canadian and gas and electric utilities. If anything, the betas have come down relative to the early 1980s, but since about the mid 1980s they've been very stable in the range of about 45 to 50. There was a -- .45 to .50. There was a period there in the five years after the 1987 stock market crash where the measured betas dropped down to the .37, .38 range, but most people agree that that was an artifact of the fact of the crash. I mean, when every other stock was falling out of bed dropping by 15 or 20 per cent during the great crash of 1987, the price of Consumers Gas didn't budge an inch. Well, if I'm an investor, that sounds like low Board Consultants 1290 ex (OHSC) risk to me. So, you know, the fact that the measured betas come down to .38 we'll all agree that for the purposes of our analysis we should put those numbers back up to about .5 or something -- .45. But in fact what they told us is that utilities in the midst of great calamity are a bedrock of stability. And I see no reason -- there's no logical reason, no empirical evidence that suggests that Canadian gas and electric utility betas should be presumed to be anything other than what they actually are, which is about .5. Q. And is the empirical evidence to the opposite in the U.S.? MR. HARRIS: A. As I indicated I'm not aware of any evidence in the U.S. that would suggest that that's the case. Q. Okay. On page 52, again, you show the average yield on 30-year Canadas at 5.57 per cent and this is for 1988; is that correct? A. Yes, it is. Q. And are you aware of what the -- DR. CANNON: A. 1998. Q. Sorry, I keep saying that. Are you aware of what the U.S. treasury yield averaged in 1998? MR. HARRIS: A. I couldn't recite it now. DR. CANNON: A. Probably about 20 bases points lower. Q. So quite similar but... A. Yes. Board Consultants 1291 ex (OHSC) Q. And could you tell us what the sort of level of returns awarded U.S. electrics in 1998 have averaged? MR. HARRIS: A. No, I really couldn't point to any specific sample. Q. As far as your recollection can take you, would you say that they've been higher or lower than Canadian electrics? MR. HARDY: I heard the panelist say he wasn't sure. MR. HARRIS: I suppose it would not be difficult to find a case where an American utility had an allowed return higher than a Canadian utility. I wouldn't disagree with that. MR. LONG: Q. Would you expect there to be a significant difference? MR. HARRIS: A. To the extent capital market conditions in the U.S. are different and business financial risk of those utilities are different, you'd expect there to be a different result. Q. That's even given similar yields on government bonds and similar risks as we saw earlier, raw betas for electric utilities? A. If we're talking about a vertically integrated U.S. utility with generation in a state where the regulatory commission has deemed that there is to be mandatory divestiture and there is a high stranded asset liability and numerous other problems... Q. How about if we restricted to hypothetical Board Consultants 1292 ex (OHSC) utilities of similar risk? A. If you could name me a few, I would be happy to address it. MR. HARDY: We're into an area here where I'm hearing the panelist once say he wasn't aware of any information and we're moving to hypotheticals based on some subsequent responses. I'm not sure how the panel feels about moving -- continuing down this line of questioning without some more specific information to get their teeth into here. MR. LONG: This is probably a good time to break. I may not have too much more. Give the panel the opportunity to do that calculation. MR. HARDY: That's fine. And is it your intention after the break, after the follow-up questions we'll have Ms. McShane start then? Okay. Why don't we break now for, let's say 15 minutes until -- actually Dr. Cannon, I understand you have to do some calculations over the break as well. How much time do you think you need? DR. CANNON: Not much, once I get a calculator. MR. HARDY: We'll give you enough time. Why don't we make it say 2:30, so we'll return at -- MR. CARMICHAEL: Just one point on the calculations. MR. HARDY: Sorry, before we break -- MR. CARMICHAEL: This is just a point on the calculations. You have the Standard & Poors document and Board Consultants 1293 ex (OHSC) you note that they're quite specific in terms of what they're looking at here, funds from operations to interest coverage. DR. CANNON: Is there a page you can point me to? MR. CARMICHAEL: That's on page 3 of the exhibit marked -- MR. LONG: "A". MR. CARMICHAEL: And in your discussion I think you talked about a number of different ways that you might get to a number, but I think this is a specific number and there's a specific definition. DR. CANNON: Go ahead, tell me, does it include or not include depreciation? MR. CARMICHAEL: It -- well, the numerator is funds from operation after tax. DR. CANNON: Okay. Funds from operation, so it includes depreciation but not taxes. MR. CARMICHAEL: That's right, that's right. So it's funds from operation plus interest divided by interest. We just don't want to go through a process here where you come back with a number that is inconsistent with the target of this ratio. DR. CANNON: Yes, I take funds from operation and subtract taxes, that's what you told me. MR. CARMICHAEL: Well, funds from operation. DR. CANNON: Starting at the top of the income statement, take revenue minus -- MR. CARMICHAEL: Let's start with net income. Board Consultants 1294 ex (OHSC) DR. CANNON: Okay. MR. CARMICHAEL: Net income, you would add back deferred taxes. DR. CANNON: Okay. MR. CARMICHAEL: You would add back depreciation and amortization. DR. CANNON: Okay. MR. CARMICHAEL: You would add back other non-cash charges. DR. CANNON: Okay. Sounds like this page 124 isn't going to be broken out. MR. HARDY: I'm wondering here whether it is something that you can write into an equation so that you can clear what you're asking Dr. Cannon. MR. CARMICHAEL: I just want him to be clear, that's all. MR. HARDY: So do I. I think we all do. Perhaps if you can write it down, then make it clear to Dr. Cannon exactly what you're asking then we have some clarity and when we come back we can read the equation into the record to make sure that everybody is aware. But I think that would be helpful over the break so we have a clear understanding of what each side is looking for here. Is that acceptable, Dr. Cannon? DR. CANNON: Yes, although I mean it's a practical matter. I'm dealing with the information that's Board Consultants 1295 ex (OHSC) on page -- for Disco, page, what I think is page 124 but it might be page 123, it's table 17-1. MR. HARDY: Right. DR. CANNON: And if this formula I'm given breaks out the data too finely, I'm not going to be able to find it in this. MR. HARDY: I think then you'll need to assess whether or not you have the information you need to do those calculations. If you don't, you don't. DR. CANNON: Sure. Okay, that's fine. MR. HARDY: Okay. Why don't we adjourn and we'll come back then at 2:30 or so. ---Recessed at 2:15 p.m. ---On resuming at 2:35 p.m. MR. HARDY: As we resume, I want to be careful to flag any items that might speed things along as undertakings, so ... now, the way we left it is, you were going to be attempting a calculation. I wonder what the status of that is. DR. CANNON: I think I can clear up the confusion as we said before. MR. HARDY: Okay. DR. CANNON: We were speaking about two different things. There was the original testimony by Ms. Ng where in the transcript she spoke about interest coverage ratios being in the range of 2.6 to 2.8 and I interpreted that as the sort of straight-up, ordinary garden variety interest -- before-tax interest coverage ratio and that number made Board Consultants 1296 ex (OHSC) sense to me because when I took a look at my own schedule 5 in appendix A, which is on page 75, and when I calculated pro forma interest -- before-tax interest coverage ratios with an assumed 10 per cent rate of return on equity, I got a number in the range of 2.6 to 2.8. So I had no reason to suspect that the number that Ms. Ng was quoting was anything other than an ordinary interest coverage ratio. The company have indicated that they believe that she was referring to a cashflow coverage ratio similar to the one that is referred to in the Standard and Poors' document on page 3 that they have referred me to and, with the available information that I have, I tried to calculate for both Disco and Transco what a corresponding ratio would be corresponding to this 'funds from operations interest coverage ratio' and I recognize that some -- I don't have information on some of the fine details, but based on the numbers that I have on table 17-1 of the Disco application, what I would calculate as the corresponding number for Disco is 3.15 for 1999 and 3.21 for the year 2000. And based on the numbers in schedule 6-5 for Transco, I would calculate this 'funds from operations interest coverage ratio' to be 2.69 for 1999 and 2.68 for 2000. So what I take from is that is that Ms. Ng was referring to these cashflow coverage ratios for Transco and she must not have made any mention of the similar number for Disco. So I mean, that was the -- I thought Board Consultants 1297 ex (OHSC) that we were talking about the same number and it turns out we weren't. MR. HARDY: Thank you. Okay. Good. Can we return to other questions, please? MR. LONG: Okay. I'm just trying to digest those results. Q. You indicated that you didn't have all the bits and pieces, if you will, in order to complete the calculations as per S&P's definition. Is it fair to say that this information was not available to you or the institutional investor? DR. CANNON: A. Well, I'm assuming it was in appendix 9 of the Disco application and I did not have that when I did my evidence and I didn't make any assumptions about the breakout. I didn't make any assumptions about the breakout of the income taxes between cash taxes and deferred taxes. The numbers I gave to the institutional investor simply took the income tax number as reported in table 17-1 of Disco and table 6-5 of Transco. Q. Is it fair to say, though, that the investor didn't request this additional information? A. That's right. Q. And you've stated elsewhere in your evidence that this investor was specifically geared towards the S&P methodology for assessing credit ratings? A. I don't think that's quite -- the model that they use is designed to predict the S&P credit rating. I Board Consultants 1298 ex (OHSC) don't think that the formulas within the model are necessarily the same as the formulas that S&P uses. This apparently is a model that infers information about the likely credit ratings based on the existing credit ratings of a wide variety of companies and whatever other information, it turns out to be a good predictor of that credit rating. Q. The passages I took you to in the -- particularly the S&P material clearly emphasize cashflow and cashflow coverage and one of the financial ratios, particularly the funds flowed from operations interest coverage which is laid out in page 3, table 2 of page 3 of that report is clearly an important component of their quantitative -- of the quantitative part of their assessment methodology. Does it not seem somewhat strange that somebody apparently purporting to use the same approach didn't request all of the requisite information to do that calculation -- MR. HARDY: I just wonder if I can jump in here. I'm hearing more cross than I am probing to -- to understand. I'm hearing again that there was different information where they approached it in a different way. I guess I'm wondering whether there might be more conclusive questions or levels of inquiry that probe some of the larger questions that I sense are revolving around some of the more detailed questions. DR. CANNON: I can't quite accept the premise Board Consultants 1299 ex (OHSC) that you were starting with. I didn't say that they used the same technique as S&P does to predict the bond rating. They use a technique that is designed to predict the S&P ratings. Indeed, they rely much more on market valuation numbers than I imagine S&P and does or .... MR. LONG: Q. So they didn't use S&P's overall approach? I guess the difficulty that I'm having is that - and I need to take your numbers away and check them - is that on the one hand, based on a 10 per cent ROE, our submission, we thought, was based very much on the aggressive side of S&P's target, let's say 2.8 versus 2. -- 3.2.5. Clearly when you put in place an 8 per cent ROE versus a 10 per cent ROE, you move even further away from that target. We're just having some difficulty with what appears to be an unequivocable statement about being able to achieve an A rating with that disparity versus the S&P target. DR. CANNON: A. Well, you've focused on simply one numerical factor. Clearly I think you would disagree with me that a rating, whatever it is, a coverage ratio of 3.0 is going to be much more satisfactory for a $10-billion company than it will be for a $50-million company, right? So I mean, there are many other factors to consider. I mean, how broadly diversified is the utility? How large is it? And these were factors that the institutional investor did take account of and can't Board Consultants 1300 ex (OHSC) possibly be summarized in one funds flow coverage ratio. Q. No, and I think I spent some time on exactly that subject, that there is a lot of considerations, particularly qualitative as well as quantitative, but what I think is clear, is that of the quantitative factors, cashflow coverage of interest is the most important component. Q. Well, even I would dispute that. I think total size is probably most important, but .... MR. HARDY: I'm hearing a disagreement. I'm not sure whether we're going to necessarily get at it through -- MR. LONG: No. I think at the end of the day, it's the rating agency's perspective that's important. I think that concludes. Thank you. MR. HARDY: Before we call on Ms. McShane, are there any other questions from participants? ---(No response) Thank you, panel for your hard work. DR. CANNON: Do we switch seats and things like this? MR. HARDY: No. I think I'll ask Ms. McShane to come up and provide us with some information from this vantage. DR. CANNON: Okay. KATHLEEN McSHANE MR. HARDY: After the presentation, I've had a request if we can do an order. There's two panelists -- OHSC - McShane 1301 ex (Board Consultants) or two participants that are leaving, so I've had a request that Dr. Cannon and Mr. White lead the questions if that's okay. Anyways, go ahead and -- MS. McSHANE: We weren't going to do the presentation because we were going to give them an opportunity to go right ahead. MR. HARDY: And just ask questions? MS. McSHANE: Yes. MR. HARDY: Fine. DR. CANNON: I think we'll let Mike start with a couple of questions if that's all right? MR. HARDY: Well, keep in mind that certainly you're going to make sure that Ms. McShane has an ample opportunity to respond and if that time runs out, it does affect both yourself and Roger White. You can go in whatever order you want. That's the risk you face though. DR. CANNON: That's fine. MR. HARRIS: I just have some fairly general questions to begin with. EXAMINATION BY MR. HARRIS: Q. The first is: Can you tell me generally the date you were asked to provide an evaluation of OHSC's cost of equity? A. I think it was around American Thanksgiving as I recall which would have been the last week in November. Q. Okay. When did you start drafting your OHSC - McShane 1302 ex (Board Consultants) report that was ultimately submitted? A. Probably -- you're testing my memory. Q. Just a general date, plus or minus a day. (Laughter) A. 10th of December. Q. And you presented your first draft of your report? A. The day before Christmas I think because I recall everybody thinking that it was something they could take home and study. MR. HARDY: If there's something that hangs on this, I think you're quite at liberty to go away and refresh your memory and come back. MR. HARRIS: Q. Moving beyond the general, I wanted to discuss the issue of regulatory risk and we've discussed that at some length today, this morning, and particularly with respect to open access. Can you maybe provide us your thoughts on why open access is or is not important for a monopoly electric distributor and transmitter? A. Why it is or isn't important? Q. Yeah, just why it's important, why it's a consideration. I've read through your report and I guess it's not clear to me the nexus between the advent of open access and this supposedly new environment for the company. I just wanted to get your thoughts on what are some of the maybe critical factors that are associated OHSC - McShane 1303 ex (Board Consultants) with open access that impinge on Transco and/or Disco? A. Well, open access is certainly what's required to ensure that end-use customers have an opportunity on a non-discriminatory basis to access their choice of energy. Q. Their choice of power supplier, correct? A. Yes. Q. Not necessarily that they're a distributor or the transmitter? A. No. Q. Then are you saying that open access has little bearing on the business risk of Transco or Disco; and if so, just -- all I'm looking for is just some descriptive language as to what that risk is. A. I mean, you prefaced your question, I guess, by talking about regulatory risk and I guess how the whole concept of open access impacts on regulatory risk and I think that one of the things that investors, debt investors or equity investors, would consider when they're looking at a situation of moving towards open access is the fact that you've taken a system that's been bundled and you're splitting it into parts with different rules. Particularly with respect to transmission where you've got a difference between the owner of the transmission assets and an independent market operator, I mean, there will be concerns about the co-ordination of those two roles and to what extent the owner of the transmission assets will be at risk for decisions that are made by the IMO and that's OHSC - McShane 1304 ex (Board Consultants) true not only here but in the U.S. as well. Q. Okay. In the S&P or Standard and Poors' document that was provided to us this morning, on page 6 there is a statement that says -- on page 6, right under the item 'regulation', probably about four or five lines down, it says: 'The utility with a marginal financial profile can at the same time be considered highly creditworthy as a result of a supportive regulatory environment.' And given that we're talking about regulatory risk, can you speak to whether the environment that Transco and Disco will be operating in will be supportive? MR. HARDY: Sorry, I want to just -- are you to the quote? Have you found the quote? MS. McSHANE: I have to get the right glasses on. MR. HARDY: And are you familiar with this document? MS. McSHANE: Yes. Okay. So point me to -- sorry, again to the ...? MR. HARRIS: Q. Page 6. A. I have page 6. Q. And it's on Standard & Poors'-- A. Under regulation? Q. --infrastructure finance under regulation -- A. Yes? Q. If you look about four lines down, it starts out, the sentence: OHSC - McShane 1305 ex (Board Consultants) 'A utility with a marginal financial profile can at the same time be considered highly credit- worthy as a result of a supportive regulatory environment.' And what I was looking for was just some statement from you as to whether you view the perspective regulatory environment as being supportive. A. Well, I don't have any reason to believe that the regulatory environment is going to be, to use the other term, antagonistic, okay? But having said that -- I mean, I think that you have to consider that just because one tries to be supportive doesn't mean that things work out the way they're expected. I think all you have to do is look at way things -- what's going on in Alberta. I mean the Alberta government had the best intentions in mind when it started down the road to restructuring, but things just haven't quite followed the path that was expected and it's turned out that the whole regulatory framework in Alberta has become quite ponderous, and we've already had one utility that's been downgraded in Alberta, partly as a result of this growing ponderous regulatory environment. That's not exactly the word they use, but that's the idea. So I wouldn't -- just to sort of summarize, I wouldn't expect the environment here not to try to be supportive, but I don't know that, given the experience elsewhere, that you're going to see things progress as smoothly as you might anticipate. OHSC - McShane 1306 ex (Board Consultants) Q. Okay. In reading your background, I take it that you've been involved at least on the gas side in Ontario for some time? A. Yes. Q. And in these types of hearings? A. Yes. Q. And have testified on numerous occasions, maybe dealing with restructuring of the gas industry; would that be correct? A. Yes. I don't know how much I've done on restructuring of the gas industry, but certainly cost of capital questions. EXAMINATION BY DR. CANNON: Q. Okay. And you've commented on it though in your rate of return evidence? A. Oh sure. Absolutely, absolutely. EXAMINATION BY MR. HARRIS: Q. What I'm trying to get you to do is come back to Ontario and speak directly to the potential for this ponderous regulatory regime, or I'm not exactly sure how you termed it, to occur here in Ontario, given that there has been some experience with industry restructuring, albeit on the gas side, and maybe the more specific question is: Did you see any of the things that you're seeing in Alberta or contemplating elsewhere come to pass in Ontario in the gas industry when it underwent... A. It's a whole different ball game. I mean, I don't think you can compare the restructuring of the gas OHSC - McShane 1307 ex (Board Consultants) industry to the restructuring of the electric utility industry. I mean, it's -- the gas industry is much simpler and the time frame is much shorter as well. I mean, we're talking about changes in terms of direct purchase that occurred over a long period of time, effectively starting after deregulation of natural gas back in 1985. Q. So is it just a fact of how much time the industry had to respond to this change? A. I think that's certainly part of it. But I think the other part is that you're trying to take a much more complex situation and, particularly with respect to creating this whole concept of the IMO, a situation that you simply don't have with the gas industry. Q. And again can you tell me the importance of the IMO in your evaluation; is it simply that there's now this loss of control of assets or -- A. That's certainly a great part of it, knowing who's liable for what. It's no longer the company but rather an outside organization who basically is determining how the system is run. And, to the extent that in the context of the regulatory framework that would be anticipated for OHSC, that is a comprehensive PBR framework, you do have to deal with the possibility that you're not going to be able to recover the investments that are required to be made in the transmission system. Q. Are you familiar in general with PBR programs OHSC - McShane 1308 ex (Board Consultants) and incentive rate making? A. I would say yes. Q. This is an issue that I did have a question on in your report. A. Fine, okay. Q. And it comes across in our report as well, and this is the issue of the extent of the IMO control and whether it's going to be evasive or simply sort of short-term operational. My question was simply: If the IMO does possess extensive control over the assets and, therefore, Transco does not have that control over those assets, how is a PBR framework in general appropriate, given they lack that kind of control. In PBR programs in general and incentive rate-making in general, in order for an incentive to be appropriate the company has to have some control over the costs and maybe it's maybe a matter of degree we're talking about. A. I think it is a matter of degree. Because I mean, you could make that comment about lots of different costs that end up being contained in a PBR depending -- Q. Which ones though? A. Well, depending how comprehensive it is. But you know if you're talking about, for example, a price cap PBR, you could make the argument that -- well, the company doesn't have control over its debt cost because it doesn't determine the market cost of debt. OHSC - McShane 1309 ex (Board Consultants) It has control to a certain extent inasmuch as it can use flexibility to, if it has it, to finance under the best conditions. But it is a matter of degree. I mean, if you look at the typical "Z" factors that one sees under these various programs, I mean, these are really costs that the company simply has no type of leverage over. Q. That's why generally they are added in on a dollar for dollar basis. A. Exactly. Q. But for those costs that they do have control over-- A. To a certain degree. Q. --such as to increase our productivity, we generally feel that incentive or PBR programs are appropriate because we think that the company has control over these costs and, therefore, can increase their productivity and lower their cost and benefit the consumer and the shareholder alike, and I'm just trying to get back around to: If the IMO has fairly extensive control over those costs in the operations of the firm, what degree of flexibility does the company have in improving productivity and meeting their own internal goals? A. I think it has less than if it had complete control, but obviously -- I mean, the company believes that given the entire range of costs that would be considered in a revenue cap plan, as they're proposing for Transco, that there is enough control that the tradeoffs OHSC - McShane 1310 ex (Board Consultants) between the risk and the reward and the benefits to the customers are sufficient to seek to be regulated under a PBR framework as opposed to a cost of service framework. Q. Okay. Are you familiar with how that productivity factor in the company's PBR proposal is calculated, just generally? A. In this particular one? Q. Yes. A. I did, but I'd have to -- I'd have to check and see specifically what it entailed. I don't recall off the top of my head exactly what it represented. Q. That's fine, I don't have to pursue those questions if you don't -- if you're not familiar with it. But just one other question on PBR. In your experience, has any utility, gas or electric, been awarded an increase in their equity return given the fact that they also have a PBR program or incentive rate mechanism? A. I don't know. I mean, I'm certain that companies have argued that there is an increase in risk as a result of that. I know for a fact that when Atlantic Gaslight went before its regulator being restructured that it argued specifically that, and the PBR was turned down as it turned out, but they certainly argued that that increased their risk; as did the Stentor Telephone Companies when they asked for their benchmark return in 1998. I guess it was 1998. Q. And these plans were proposed by the company? A. Yes. OHSC - McShane 1311 ex (Board Consultants) Q. I have a few other questions, but I'll let Dr. Cannon interject and ask some of his. EXAMINATION BY DR. CANNON: Q. Okay. Ms. McShane, what assumptions were you making with respect to rate design and the assurance of cost recovery for Disco and Transco when you prepared your evidence? A. What assumptions was I making? Q. On rate design. A. My assumption was, on Transco, it was what was put on page 8. I don't have any line numbers here. EXAMINATION BY MR. HARRIS: Q. It's the discussion of being demand based on forecast peak load? A. Yes, exactly. Q. That is a demand charge, right? It's sort of invariant to usage? A. It's based on -- it's demand based but it's collected on the basis of actual demand. So there's a difference between -- for example, what I was trying to do is make a distinction between if you're a pipeline, whether you actually use your peak demand or not, you pay. And so the pipeline will collect virtually a hundred per cent of its fixed costs in its rates irrespective of how much is flowing through the pipeline. Q. Okay. This was an area where I was confused. And you clarified the passage on page 8, and I'm sorry. OHSC - McShane 1312 ex (Board Consultants) A. I know, but you see -- I mean, when I read the - you can stop me if you don't want me to say this - but I noticed that you made a comment in the testimony on my reference to this and said that you didn't understand how it could contribute to higher risk, and it wasn't supposed to indicate at all that it contributed to higher risk, it was simply a statement of how I envisioned the rates to be set. And, you know, in relation to some kinds of rate design this is relatively advantageous, as you suggested, relative to the pipelines it is not. Q. And I guess that's where you're losing me when you make that connection to the pipelines. But maybe rather than improve my ignorance in that area maybe you can clarify it by commenting on your discussion of rate design for Disco where you start talking about demand and energy-based. Are you clearly making a distinction here now between a rate that's invariant to usage? A. Yes, that was my -- exactly, that there would be a part of it that would be basically a customer charge and there would be part of it that would be based on customer usage. EXAMINATION BY DR. CANNON: Q. And is that also -- did you make that kind of distinction with the Transco as well in the transmission rates, a distinction between the network service charge and the connection charge? Or what-- OHSC - McShane 1313 ex (Board Consultants) A. No. Q. --what if any assumption -- A. I think I was looking at them both being about the same. Q. Are there any aspects of rate design that you think will not be under the control and subject to adjustment by the Board in the post-open access period? I mean, who's pulling the levers on rate design for Transco and Disco? A. Well, ultimately, I mean it's going to be the Board who makes those final decisions. I mean, subject to the company making a proposal that makes good common sense. Q. No. Well, I mean, if one rate design regime turned out to be particularly difficult for Transco or Disco or created a lot of risk, it would be within the control of the Board to adjust that to ameliorate that risk? A. Sure. But I mean, it's not just the risk to the company either. I mean, every time you look at any rate design you have to look at impact, not just on the company but on the customers. Q. In your view, should the riskiness or competitive challenges faced by SERVCO's non-regulated businesses in any way impact on the rate of return that its asked for or gets for its regulated monopoly wires businesses? A. That's a tough question. In principle, no. OHSC - McShane 1314 ex (Board Consultants) But, you know, you had a conversation earlier with... Q. About bond rating? A. No, not about bond rating, it had to do with some of the operations that are now in SERVCO that may be-- Q. Ah. A. --that may be down the road outside because they are subject to regulation at the moment, but subject to -- MR. HARDY: Metering. Mm-hmm. MS. McSHANE: Metering and billing and things that might be outside later on. So in the context of what is competitive versus regulated today, no, the competitive operation should not impact on the required capital structure or return. I don't think you can say that if you expect some -- if some of these things are protected by regulation at the moment that -- then in principle, you have to consider that the company may face some risk down the road that there won't be recovery of assets that are associated with those operations. I have not specifically done anything with that, that's not reflected in this evidence. But, in theory, I think you could say that there should be some consideration given to that possibility. DR. CANNON: Q. Okay. Well, I guess we'll leave it like that. Another aspect that you talk about, and I can OHSC - McShane 1315 ex (Board Consultants) guess at your answer, but I think the Board would appreciate hearing it from you. There are -- there's a sort of pre-open access and post-open access period, and I think you'd agree that some of the risks in the pre-open access period are not going to be as great as they might be post-open access. What's your -- and you speculated about what the post-open access environment will look like for SERVCO. Why is it the Board should be concerned about those risks, sort of three and four and five years down the road now when they make a recommendation on SERVCO's return, when they're going to have ample opportunity to revisit the question of SERVCO's allowed return before these other risks ever have a chance of being applicable? A. Well, two reasons: One, because the rate of return is not a short-term concept. I mean, it is looking at longer-term risk and if you're trying to create a level playing field, as is suggested, you're going to try and look at the required rate of return for SERVCO on the same basis as you would for a gas company which, you know, faces some uncertainties over the next number of years and those uncertainties are reflected in the required return. The second reason is because this is not simply, I mean, an intellectual exercise here. This company actually has to go out and raise money, a fair amount of money in the next six to eight months and, therefore, you know, the bond rating agencies are going to want to know what the basic framework from the Board is. OHSC - McShane 1316 ex (Board Consultants) Q. So I'm stretching this a little, but if the Board were to incorporate a compensation for these risks that might -- might or might not ever be applicable today, if in the future those risks in fact turn out to be real risks, can you promise us that SERVCO won't come back and ask for a higher rate of return to reflect those risks; that they'll agree that the risks have already been taken care of in their previous return? A. No, I can't -- I cannot guarantee you that that will happen. But, I mean, the fact of the matter is that when you set a rate of return, it isn't based on short-term risk, and I recognize that there are a number of uncertainties that remain unsettled, but if you're an investor, an equity investor, those uncertainties are taken into account when you evaluate an investment. And just because in this particular case the Government of Ontario happens to be that investor, the stand-alone principles requires that you evaluate the investment on the same basis you would any other investment owned by multiple shareholders or, you know, a single investment -- sorry, investor owned entity. EXAMINATION BY MR. HARRIS: Q. But you would recognize that there is a distinction between the regulated entity and the unregulated entity from the investor's perspective; that is, the investor who's investing in a regulated entity understands that there's such a thing called a rate hearing that generally comes around every two to three OHSC - McShane 1317 ex (Board Consultants) years-- DR. CANNON: A year here. MR. HARRIS: Q. --where we address these issues -- or maybe every year, where we address these issue and some of these risks can be ameliorated as Bill has indicated; whereas for an unregulated firm that rate hearing never takes place. A. That's correct. And I agree with you that in the context of a regulated firm vis-a-vis an unregulated firm that there is a greater opportunity to have adjustments made to rates. And as we move to an incentive form of regulation, obviously we don't have the same regularity of coming before a regulator and asking for rate relief or having reductions in rates as has been the case in the last number of years, but yes, if you're comparing unregulated versus regulated, that's true. Q. In the case of PBR also, it might even be advantageous for the company to eliminate those rate hearings? A. It provides an opportunity. Obviously it provides an opportunity or there would be not the trend to go in that direction, but at the same time, it does create a higher degree of risk. Q. All right. I guess that's where I'm getting stuck, when you keep coming back to the issue of PBR and a greater deal of risk. I guess I don't understand the source of that risk. And as I've said in the report, I OHSC - McShane 1318 ex (Board Consultants) think it's somewhat self-serving for a company on the one hand to propose a PBR, an incentive program, and then on the other hand to declare that my risk has increased, therefore, I should enjoy a higher return on equity. Purportedly, the reason that you want the PBR program in place is that you understand there's a tradeoff between this risk and this reward and your reward is already coming to you as a result of implementation of the PBR program, not implementation of the PBR program and an adjustment in ROE. I guess I would come back to the issue of whether -- we have seen this happen in commissions in the U.S. or Canada where a commission has awarded a higher ROE because of a PBR program and I think as I understood you earlier, you said, in fact, you were not aware that that has been the case, although some companies have done or proposed just that, but as far as you know that has not been decided or approved? A. That was a long question. So what you want me to do is to explain again why -- what the nexus is between ...? Q. I guess what I would like is your view on whether the company should be allowed a higher return on equity because they're implementing the PBR program. A. Well, I guess my answer to that is 'yes', that there are tradeoffs. There are tradeoffs to the benefit of the customer. I mean, the fact that one has a somewhat higher cost of capital doesn't mean that the OHSC - McShane 1319 ex (Board Consultants) customer doesn't get a net benefit as a result of creating greater efficiencies. Q. You would also agree that the benchmark or the starting point for that PBR program is directly affected by your determination of return on equity? A. Sure, and it's also directly reflected by your base O&M cost and rate base, depreciation, all of those things. Q. Okay. EXAMINATION BY DR. CANNON: Q. Like the 'Certs' commercial, I think in some sense, you can both be right there because I think -- wasn't there a commercial? A. Yes, something like that. Q. In a regular cost of service based approach, presumably the expected rate of return is the allowed rate of return, but in a PBR world, the expected rate of return is somewhat above the allowed rate of return or the company would never go into it. Presumably the company goes for PBR because they expect on average to do a little bit better than they would under the previous regime and so it seemed -- well, I'm arguing here, not asking questions, but it seems to me that's where the higher return comes, in the expectation of beating the allowed return by taking advantage of the incentives. A. Well, I think that you're right in the sense that the company does expect that they can beat the OHSC - McShane 1320 ex (Board Consultants) allowed rate of return, but on the other hand, there is also a greater risk of falling short of the allowed return than there is under a cost of service type of plan where you can come back every year and have your rates adjusted. Q. Let me just finish up the point I was on before. When you're speculating, as you do in your evidence, about what the world might be like in the future and, indeed, on page 9 in a couple of places, you are -- you're talking about the possibility that some of the features of the future environment will be contrary to what the market design committee is proposing. I don't think you have to necessarily look them up. It's a more general question I'm asking. Presumably the regulator -- you would grant that the regulator ought to factor into their assessment of how much allowance they make for these possible risks in the future, the likelihood that the risk will eventually be relevant? A. I'm sorry, could you repeat that, just the last part of it again? Q. If you were to make the case that there's this risk that something bad will happen with the utility five, six, seven years in the future, but there's only one chance in a hundred - that's one situation - and then there's another situation where something bad will happen to the utility of equal damage, but there's one chance in three that it will happen; presumably you'd expect the regulator to pay more attention and possibly incorporate OHSC - McShane 1321 ex (Board Consultants) more of a return allowance for the higher probability -- A. Oh, sure, absolutely. Q. Yes, okay. I'm just ... and so in some sense, you would acknowledge that the Board has to make its own judgments about how relevant or how likely these risks are, particularly risks over which they have virtually full control? I'm thinking of rate design things. A. Well, obviously the Board is going to give what weight it wishes to, you know, the various risk elements that are brought to its attention. Q. A new line of questioning here and this may be a little bit dirty pool, but I've already put my neck out on the line on this, so .... how would you compare the relative business risks of Disco, Disco in particular, with those of Consumers Gas and Union Gas? And you know, you can do an overall -- what I would appreciate and I think the Board would appreciate is what you think are the -- you know, you can tell us what are the broad similarities or you can tell us where you think there might be some significant differences and in which direction they would fall. A. You want me to compare? Q. Disco with -- the regulated, the monopoly regulated wires aspects of Disco with the monopoly regulated pipes aspects of Consumers and Union to be more precise. A. Well, let's see. Because I sort of looked at OHSC - McShane 1322 ex (Board Consultants) this more as an integrated or integrated Transco-Disco operation, so to compare Disco only to Consumers Gas ... Q. Well, I'm thinking they're the more comparable comparison. You could compare Union which has a transmission operation as well-- A. Yes. Q. --you could compare Union to a combination of Disco and Transco. I'm just -- A. I guess my -- when I went through all of the considerations, my view was that basically, in theory - and I say in theory, if you put aside the realities of the new company, new management, those factors, that the theoretical comparison would be between a Union Gas and OHSC, that they basically would have approximately equivalent overall business risk. And the factors that additionally impact on SERVCO due to the fact that it's new to the market, those would be considered incremental and, therefore, it would be somewhat viewed by the market as somewhat higher business risk than a Union Gas. Q. So once SERVCO is no longer new to the market and the smoke is all cleared and this sort of thing, you might equate the overall business riskiness of Union Gas with the combination of Disco and Transco? A. Yeah, I think that that's approximately fair. I mean, there are some differences that you can ignore; I mean, the fact that when you've got an electric utility, they don't -- the electric utility doesn't have access to storage, can't store power, it has to be instantaneously OHSC - McShane 1323 ex (Board Consultants) transmitted, I mean, that's a difference. The electricity competes with natural gas and natural gas has a competitive advantage today. You also have to consider that there is in the electric utility industry what I'll call alternative access, self-generation in the future, the possibility that the transmission system won't be fully utilized because there will be alternative ways to get electricity. You know, you said, well, you can't see that there is this longer term risk to the transmission system because everybody will always need electricity. Well, yes, but will everybody need this huge extensive transmission system to the extent that it's used today, and I think that that's something that distinguishes the gas industry from the electric utility industry. I think another element that you have to keep in mind is that the gas assets are underground and they have a greater degree of protection from the environment than electric utility assets which may have all these towers, lines, sub substations above ground. So one could make a good case that the risks of a Disco/transmission utility are marginally greater than those of a gas company. Q. Do any factors occur to you on the other side. A. That are offsetting? Q. Yes, any areas where you think that an electric distributor, a large diversified electric distributor, you know, the same size and diversity as, OHSC - McShane 1324 ex (Board Consultants) let's say, Consumers would be less risky; any areas where they're less risky? A. Well, they probably have, I would say, somewhat of a greater -- at least in the near to medium term, a greater, I'll call it, market power - I hate that term, but market power - in the sense that there are certain parts of the market that there are no alternatives for whereas in the gas business, virtually -- well, no. Every -- Q. Except for feed stock, everything else is a substitute -- A. Except for feed stock, that there is an alternative. Q. Okay. Well, we don't have to push this. I think the Board would appreciate your views on that. The evidence is that the embedded costs of Disco and Transco's -- the average embedded debt cost is 7.8 per cent. A. Yes. Q. Do you happen to recall offhand what the corresponding numbers are for Union or Consumers? If you don't .... A. Well, I think the number for Consumers as I best remember it was in the 8-1/2 per cent range and for Union it was in the 967 range. Q. Yes, maybe not even quite that high, but they're both higher than SERVCO? A. Yeah, and part of that -- well, I mean, OHSC - McShane 1325 ex (Board Consultants) obviously there are reasons for that: 1, because, you know, SERVCO is getting debt from the government which was raised at effectively a double 'A' rating and Union's average maturity on its debt is significantly longer, I believe, than Consumers which has for a period of time used a medium term notes program. Q. This is getting at a point that you quite rightfully raised in the Union case where the application of the Board's formulaic approach has at least a temporary, if not longer, disadvantage when rates -- interest rates or current interest rates are coming down in the face of high embedded costs. A. Right. Q. And so in that area, while that's a financial risk as opposed to a business risk, at least SERVCO would be slightly better situated than the two big gas companies? A. Well, it depends on what the capital structure and rate of return are. I mean, those things are obviously interrelated. I mean, Union Gas went into its last case and proposed a capital structure which had 35 per cent common equity in it which I viewed as a bare minimum plus a 4-1/2 per cent permanent preferred component and, you know, based on, I think it was a 10-1/2 per cent return on equity, they were still only looking at coverage of 2.1 or 2.2 times. Q. But even at a much lower return, like 9 per cent, the coverage was still 2.1? OHSC - McShane 1326 ex (Board Consultants) A. Well, I'd have to check, but I think you're right, that -- I mean, it was very marginal in terms of their ability to raise long-term debt under their trust indenture. Q. But however you calculate interest coverage ratios - we had interest coverage, but the one that's most familiar in my mind is the straight-up garden variety interest coverage ratio-- A. Sure, and that's the one we've been discussing with respect to Union. Q. --SERVCO is going to -- whether it's the return that we're recommending or the return that you're recommending, SERVCO is going to have a higher interest coverage ratio than Union prospectively was going to have? A. I think that's correct, yes. Q. Have you assumed in your analysis of Transco and Disco that the Board will regulate Transco and Disco in any significantly different manner or with any different attitude than they regulate Consumers and Union? A. No, I mean not as different attitudes, certainly not, but I think what I was trying to suggest earlier is that it's not a question of attitude. It's not a question of the fact that this has been turned over to the OEB. It's a question of this whole system being new and much more complex than it is for the gas companies. I mean, I don't -- I didn't intend in any way to imply that the fact that the Ontario Energy Board was going to be the regulator that that, in and of itself, was a source of OHSC - McShane 1327 ex (Board Consultants) greater risk. To me, it's the whole new system that -- that's what entails the greater risk. EXAMINATINO BY MR. HARRIS: Q. And if the stated objective of the Board was not to maintain some type of regulatory symmetry, would your comments on this issue express an even greater degree of uncertainty or potential risk? A. Sorry, I didn't understand that question. Q. Well, if I understand you correctly and correct me if I'm wrong, I hear what you're saying is that you're not necessarily saying it's an issue of whether the OEB is now exerting jurisdiction over Transco and Disco. A. Right. Q. It's simply that they've never done it before and, therefore, there's potential regulatory risk associated with that? A. No. It's not that they've never done it before per se. It's that you're dealing now with a competitive generation market, an IMO, regulated Disco and Transco, competitive retail operations and somehow that whole thing has to work together. That's what's new. And you can't just take out the pieces, Transco and Disco, and say that because they're being regulated by the Ontario Energy Board that somehow everything is going to go smoothly. It has to fit into the whole plan, if you will. MR. HARDY: I just wondered. That's -- again, I've heard the question on regulatory risk, I think, two OHSC - McShane 1328 ex (Board Consultants) or three times in different ways from this set of questions to this panelist. Certainly she's provided a different response. I'm just wondering, are you pursuing different questions? MR. HARRIS: No, I just wanted my preferred response, but... (Laughter) EXAMINATION BY DR. CANNON: Q. I think the Board would appreciate your comments, Ms. McShane, on -- your view of the risk-related impact of the Board applying their formula-based approach to setting and adjusting allowed returns from year to year. You know that they've introduced that in the gas companies and you've actually -- you've commented in the evidence there, you've pointed out what you think are a couple of the risks or negatives there. Can you tailor your comments to Disco and Transco? How do you think investors are going to view the application of that formula-based approach? A. Actually I didn't have that in mind at all, to be honest with you, particularly for Transco, because I guess my view was that the PBR that was being proposed by the company was along the same lines as the type of PBR that had been proposed for the telephone companies. I mean, there are significant differences - don't get me wrong - but not one which envisioned adjusting the return from year to year. OHSC - McShane 1329 ex (Board Consultants) Q. Oh. Well, I think that's what they had in mind. I think that the benchmark rate of return is going to be established based on this formula, at least that's what the plan is, until they get... A. So, see if I understand you. What you're saying to me is that we establish a benchmark return today, the company proposes its PBR - which you read about, right, okay - so basically you're making the assumption that the Board will turn down that PBR and implement something else which would involve changing the underlying return every year? Q. That's right. I'm assuming that the PBR program will incorporate within it -- I mean, the company has no control over its cost of capital. I mean, essentially that's a factor that has to be given to it. It has control over its efficiency and its O&M expense and that sort of thing, but I believe the plan -- the PBR plan incorporates an adjustable cost of capital from year to year. A. My understanding is that their plan does not. Now, you may be under -- working under the assumption that whatever the Board approves will-- Q. Well, right, so that -- A. --will replace that, but... Q. Clearly what I'm thinking of wasn't entering your mind then? A. No, it wasn't. Q. You weren't imagining this, so we won't OHSC - McShane 1330 ex (Board Consultants) pursue that. We've talked at length - and here I think we more or less agree - about the relationship between allowed common equity ratios and the required return on equity and that there's a tradeoff. A. Sure. Q. If you have a higher allowed common equity ratio you can withstand-- A. Sure. Q. Yes. Have you any reason to - I think I quote you in my evidence about the kinds of numbers you've used with the gas industry, and please feel free to correct me on that if I've misquoted you or misinterpreted your evidence - but is there any reason to think that that kind of relationship which we've talked about applying in the gas industry would be any different in the electric distribution industry? A. No. Q. Okay. So that kind...okay. A. Let me just so you don't misconstrue, that my view is - and, you know, I don't want to bring a lot of this Union Gas evidence in here without people having the ability to review it -- but you probably recall that in the Union Gas evidence I made the comment that I thought that for Union and Consumers to be virtually identical in terms of total investment risk that Union would have to be financed with 40 per cent common equity. So I made an adjustment to the return in that OHSC - McShane 1331 ex (Board Consultants) case to reflect the fact that it didn't have 40 per cent common equity. I just told you a few minutes ago I thought that in theory that without these -- Q. Newness factors. A. Newness risks that Union and SERVCO would be approximately similar risk. Well, SERVCO is proposing to have a 40 per cent common equity ratio and, therefore, the return that I have recommended for it doesn't need any kind of adjustment. Q. Okay. You talk in your evidence quite a bit and cite the CBRS, the Canadian Bond Rating Service and their requirements. Did you talk directly with any of the analysts at CBRS-- A. No. Q. --during your analysis? You don't talk at all, as far as I can see, about DBRS, this playing favorites, I'm not sure that they like this. A. No, I'm not playing -- but for the same reason that I think that there's less reference to Moody's and the fact is that CBRS is the agency that has given us some guidelines on a number of different parameters from which to draw some definitive conclusions. Q. Okay. Do I take it from that, though, that you didn't talk directly with any of the analysts at DBRS? A. No, I did not. I didn't talk to any analysts at either of the rating agencies. DR. CANNON: Now, I would be prepared to -- OHSC - McShane 1332 ex (Board Consultants) Now, I've got more questions, but to stand down my questions and let the other gentlemen have a chance... MR. HARDY: Mr. White, did you have any questions of the panel? MR. WHITE: Thank you. I'm going to stay for a while, so you're more than welcome to carry on. MR. HARDY: Thank you. DR. CANNON: Thank you. Q. Now, we'll switch years and go into the sort of the rate of return evidence, equity risk premium and other tests you use. MR. HARRIS: Before that, can I ask one question about another issue? DR. CANNON: Sure, sure. EXAMINATION BY MR. HARRIS: Q. It's somewhat separate and probably better dealt with prior to the discussion of the analytical methodology. On page 9 of your report you discuss the fiscal condition of the assets and relatively high risk of unexpected repairs. Would you agree that the company has put in place a capital program or plan to address those issues-- A. Yes. Q. --going forward, and that's been covered in their capital expenditures? A. Yes, it is. Q. Okay, thank you. OHSC - McShane 1333 ex (Board Consultants) A. But, again, I mean my point in here was that if you're under a PBR system then and you have these major costs to recover and you're in a more competitive market, there is somewhat less certainty that you will be able to recover those costs. EXAMINATION BY DR. CANNON: Q. On pages 30 and 31 of your evidence you conclude that the investment riskiness of gas and electric utility shares is between 65 per cent and 70 per cent of the market as a whole; is that -- MR. HARDY: Sorry, can you help me where to find -- I'm on page 30. Where are you? DR. CANNON: 30 and 31. Let me turn to that. Well, the bottom line on page 30, for example, and the middle of the page on page 31. MR. HARDY: Thank you. MS. McSHANE: I have that. DR. CANNON: Yes. Q. So is that a correct interpretation that you are saying that the typical, or the average gas and electric utility in Canada is 65 to 70 per cent as risky as the market as a whole? A. No, I don't think that's really a fair characterization. I think that the required risk premium is 65 to 70 per cent of the required market risk premium, which is, I mean, somewhat different than saying that the riskiness is point whatever per cent of the market. OHSC - McShane 1334 ex (Board Consultants) Because once you make that claim, then what you're saying is that there's sort of a one-for-one relationship between risk and risk premium. And I don't believe that any of the empirical analysis that's been done supports the proposition that that relationship is that precise. There are other factors that result in the required return. I mean, this is -- effectively when you take .65 to .7 times a market risk premium, it's a short circuit way of reflecting that more complex relationship. Q. I'm sorry, I misspoke myself and I meant to state my question the way you interpreted it, that the appropriate risk adjustment was .65 to .7. A. So I went all through that for nothing. Okay. Q. I didn't want to be rude and cut you off, but... A. It's okay. Q. All right. So the appropriate risk adjustment for gas and electric utilities in general is .65 to .7? A. Correct. Q. All right. Now, can you confirm for me that if you applied this relative risk adjustment solely to the historical Canadian evidence with respect to experienced market risk premiums - and you identify that at the bottom of page 29 to be the range of -- your judgment is that's the range of 4.8 per cent to 5.9 per cent - if you applied OHSC - McShane 1335 ex (Board Consultants) these .65 to .7 adjustment factor to your range for the Canadian experienced market risk premium, you would find that the equity risk premium for gas and electric utilities was in the range of 3.1 to 4.1 per cent? A. You took 4.8 -- Q. 65 per cent of 4.8 and 70 per cent of 5.9. A. Yes, that's... Q. Okay. And yet when I -- the midpoint of that, between 3.1 and 4.1, the midpoint is 3.6. Maybe I'll just carry on and if you -- but you end up finding that your utility equity risk premium, your recommendation is that it should be 4.5 per cent as opposed to the midpoint of what you would get applying your techniques just to the Canadian evidence. So is it a fair conclusion that your recommended equity risk premium is about 90 bases points higher by virtue of the fact that you have factored in historical market risk premiums for the U.S. economy in your analysis? A. No, I don't think that that's entirely correct. Q. Okay. A. That's certainly part of it. But the other part would be looking at forward risk premiums based on the DCF calculations for the Canadian market as well as for the U.S. market. Q. Okay. So I was just -- I was just aiming at this risk adjusted market risk premium test. But you say OHSC - McShane 1336 ex (Board Consultants) that you get your 4.5 per cent number from several sources. A. Yes, because if you take -- well, if you go to the top of page 30 - hopefully your pages and my pages are the same - that paragraph ends in a 20 per cent weighting of U.S. risk premiums. It's actually the end of the paragraph. MR. HARDY: Of the last sentence? MS. McSHANE: Yes. DR. CANNON: Q. On page 30? A. Yes -- no, it's not the first full paragraph. Q. Yes, I've got it. Yes. A. Okay. So you've got one way of looking at the -- at bringing the U.S. risk premium into the calculation and the 20 per cent U.S. weighting with foreign exchange calculations included gives you 5.8 per cent, all right. So if you actually took .65 of 5.8, you're at 3.77 and .7 times 5.8 you're at 4.06, so that's obviously not 4.5. Q. Okay. You scared me off. I'm going -- A. I scared you off. Q. I'll go somewhere else. A. Then my job here is done. Q. We have this pact afterwards, we split the extra. (Laughter) Now, I'm actually -- that was your adjustment to the market risk premium. Now I'm looking at your test OHSC - McShane 1337 ex (Board Consultants) that is based on direct evidence of the historical utility risk premiums, okay. A. Okay, I have that. Q. Now, presumably your recommended equity risk premium for Transco and Disco in the end is -- should be based on what you see as the relative risk of Transco and Disco. I mean, in the end, however you get there, it's a recommendation that reflects the risk -- the relative riskiness of Transco and Disco? A. Yes. Q. Okay. And is it correct that in this portion of your equity risk premium evidence you've used historical evidence with respect to Canadian gas and electric utilities as a proxy for Transco and Disco? A. Yes. Q. I think you actually say that on page 31 just under the heading at the middle of the page. Okay. Now, on the page 31 evidence you stated that the achieved, and I'm just looking right underneath the heading, the No. 4: Direct estimates of historical utility risk premiums, you say that: 'A direct analysis of the achieved utility risk premiums shows the long-run equity risk premium has been 5.3 per cent for Canadian gas and electric utilities over the 1956-1997 period.' I'm just quoting you there. OHSC - McShane 1338 ex (Board Consultants) A. Yes. Q. Yes, okay. And I'm assuming that having cited that evidence you think that it's appropriate to pick that 1956 to 1997 period for this analysis? A. Well -- Q. Otherwise you wouldn't have picked it. A. The problem is it's the only period -- the longest period that's available. I mean, my preference would have been to use the same period time that I had the market portfolio data over which, would have been the total post-war period but I didn't. Q. All right. A. So, I mean, there's nothing magic about the 1956 to 1997 period, except that when the TSE 300 sub indices were created in 1977, as you know, then they only took the data back to 1956, so... Q. Okay. A. That's what's available. Q. What would be the corresponding achieved equity risk premium for the entire TSE 300 index for that same period from 1956 to 1997? A. Well, I'll tell you what I think it is and then if I'm -- Q. Schedule 19. A. It's on schedule 19? Thank you. Q. Yes, I think it's schedule 19 you'd like to look at. A. Thank you. Yes, okay. That's right. OHSC - McShane 1339 ex (Board Consultants) Q. Now, the number that corresponds to the 5.3 per cent that you cite for the gas and electric utilities. A. It's 3.5. Q. 3.5 per cent. A. Yes, exactly. Q. Okay. So over that fairly extensive period and indeed a period that covers what was big up trends in interest rates for about 20 years, then a big downtrend in interest rates for about 20 years, the achieved rate of return on gas and electric utilities was substantially higher than the achieved rate of return on the TSE itself? A. Oh yes. Q. Okay. Now, does that imply that those gas and electric utilities are riskier than the TSE? A. No, it does not. Q. How come they earn such a great rate of return. A. Because the TSE 300 is a dog. I believe one of the terms that was recently used in The Globe and Mail was a sad sack among markets, and it's an index that has been plagued by problem companies, Bre-X for example. But probably more importantly than that it's a commodity-based index that has, in recent years, been flattened by commodity prices and really is not in the global market sense representative of the market portfolio. Q. Would you agree with me that you can't OHSC - McShane 1340 ex (Board Consultants) compare that 5.3 per cent achieved return for the utilities and the actual achieved return for the TSE index, you can't read any kind of relative risk evidence into that number? A. It's difficult to do that, yes. Q. Now, still on schedule 19, I found it interesting, you know, to compare -- when I made the same kind of comparison with U.S. S&P electric index and the S&P 500 overall index. Would you take it subject to check that the achieved return in the U.S. for electric utilities, depending on which of those two lines used, was somewhere between 66 and 71 per cent of the achieved return for the market as a whole? A. That's about right, yeah. Q. I've divided 5.4 into 8.2 and 4.5 divided by 6.3. Okay. So would you think that you could read any relative risk interpretation into a comparison of those two achieved rates of return? A. I think that they're certainly closer to what we see in terms of the beta numbers that are typically published for U.S. electric and gas companies which are around 60 to 70 per cent. Q. Okay. And can you confirm that within that S&P electric index, the vast majority of the companies have generation, that they operate electric generation as well? OHSC - McShane 1341 ex (Board Consultants) A. Yes, they do. Q. All right. So if investors were to mentally remove the generation assets from that, would it be fair to say that the relative riskiness of that index would -- relative business riskiness of that index would go down? A. Well, I think that certainly the relative riskiness would be different, but let's remember that when you start to look at comparisons of the gas industry and the electric industry over longer periods of time, you see that the gas industry which -- or gas distribution industry I should say that is often compared to transmission distribution companies, there isn't that significant a difference. Q. Okay. But you did put this evidence about the electric utilities-- A. Yes, right. Q. --in evidence -- A. And I could have put in the gas numbers and they would have been in approximately the same range. Q. Yes. Well, we did that for you apparently, so .... A. You put the gas numbers in for me? Q. Did we? You asked us questions about Mike's -- betas for gas companies? A. Sorry, I don't remember. Q. Oh, those were electrics, oh, I'm sorry. A. Yeah, okay. I thought maybe I wasn't here. Q. Yes. OHSC - McShane 1342 ex (Board Consultants) A. No. I was here. Q. All right. Okay. Switching over to your bcf based risk premium test -- A. is that the one for gas distributors or ... Q. Well, my notes say on pages 32 and A18 through A20. A. This is developing the forward-looking risk premiums for the market as a whole? Q. Well, I'm reading from page A18 and the title is 'DCF-based risk premium test for U.S. gas distributors'. A. Oh, sorry. Okay, then we're talking about the one for gas distributors directly? Q. Yes. A. Okay. Okay. And you confirmed that this test is based exclusively on U.S. company data? A. Yes. Q. And exclusively on U.S. gas distribution companies? A. Yes. Q. And it relies on IBES, Institutional Broker Estimation Service, five-year earnings growth projections, expectations? A. Yes. Q. Would you concede that there's a lot of evidence that IBES earnings growth expectations, which are, themselves, consensus numbers based on the consensus of securities analysts' projections, have historically OHSC - McShane 1343 ex (Board Consultants) been too optimistic; and 2, that investors have generally recognized this optimism in these IBES numbers within their investment decision-making? A. Well, I agree with the first part, that there are studies that have been done that indicated that they are -- that they have a tendency to be somewhat optimistic. Q. Indeed you were the author of one of those studies as I recall from 19 -- A. Well, we certainly. MR. HARDY: Just let the panelist fully respond properly. MS. McSHANE: Did some studies but for another reason. When we were looking at these IBES calculations in the period that you're talking about, we were using the IBES calculations for purposes of the comparable earnings test and trying to in a period where there had been, I think, a significant decline in earnings in the '90/91 period, to try to figure out if we looked beyond that severe recession what earnings were likely to be and in that context, it was important to reflect any overestimate that these investment analysts had made. In the context of the DCF test, only if investors recognize this overoptimism is it necessary to make any adjustments to the DCF numbers. I'm not aware of any studies that say that investors have generally recognized and incorporated into their estimates this overoptimism. In fact, what typically happens is when earnings OHSC - McShane 1344 ex (Board Consultants) come in lower than investors' estimates, what you see is a decline in the prices as if investors had not already taken into account the fact that there might have been this overoptimism. But having said that, I mean, I have in the context of this study -- because I noticed that you mentioned that FERC had rejected reliance on five-year forecasts of earnings growth rates as the sole measure of investor expectations. If you take the position that the FERC methodology is correct, which I don't, but nevertheless, I have tried to implement their approach to see what the impact would be -- I should tell you that what they do basically is say, we give two thirds weight to the IBES growth and we give one third weight to the long-term GDP growth on the grounds that over time, investor -- or that the growth of companies will decline to the average rate of growth in the economy. If you do this for gas distributors, you don't get any different risk premium. I mean, effectively over time, the nominal growth in GDP is relatively close to the growth in earnings put forth by the analysts. EXAMINATION BY MR. HARRIS: Q. Do you have any idea of what those earning growth forecasts were that you used to calculate this risk premium here? A. Do I have any idea -- Q. We note you've relied on IBES and the five-year forecast and maybe it's contained in one of your OHSC - McShane 1345 ex (Board Consultants) schedules - what those growth rates are? A. Are you asking me if the actual growth expectations, IBES growth expectations, are in here? Q. Yes. I just want to be clear. Are you suggesting that those IBES growth expectations are comparable to the long-run GDP growth? A. What I'm saying is, if you do the DCF-based analysis using only the five-year IBES growth rates and then calculate the average risk premium over the period that I used in here and compare that to the average risk premium you get if you did the FERC two thirds/one third methodology for the same period, then you would get the same average risk premium. Q. That's too much mental math for me. A. But to answer your specific question, the risk premiums are included on schedule 21, so you have the IBES growth, the dividend yield, the DCF costs, the long treasury yield and the risk premium for each month. Q. Okay. Maybe just a general question related to the IBES growth forecast and we all recognize that they're five-year growth forecasts, but I've heard somewhat repeatedly throughout today's discussion that it's important to take the long-term view particularly because that's what the investor takes. A. Right. Q. That this whole issue of rate hearings coming up every two to three years is not necessarily a critical factor, nor are other short-term factors. It's always OHSC - McShane 1346 ex (Board Consultants) sort of the long term. This seems to be sort of a disconnect from that perspective. Why would investors tend to look at all other long-run issues, but when they start looking at growth expectations, they would be satisfied with using a five-year growth forecast that has been shown to repeatedly overestimate actual growth? A. Because I think they recognize that it's very difficult in terms of earnings forecast to forecast beyond that and there is no good reason to believe that investors explicitly incorporate a change in their view of growth beyond that five years. And these are supposed to be normalized growth rates in the sense that they're not supposed to estimate from a particular period of high earnings or low earnings, that the growth is, indeed, smoothed to eliminate ups and downs. Q. Are you aware whether these growth forecasts have ever been realized? A. If you're asking me if I've done analysis of trying to compare the actuals to the forecasts, no, I haven't. I mean, I'm sure that that can be done, but I have not done that analysis. DR. CANNON: Well -- MR. HARDY: I just wanted to interrupt here. My sense is that we're off into some interesting areas, but (Laughter) I'm wondering if we can get back to the questions that -- I believe you're going through a set of questions here. If it's germane, that's fine, but ... OHSC - McShane 1347 ex (Board Consultants) DR. CANNON: I'll tell you where I'm going. It seems to me that two of Ms. McShane's tests rely heavily on these IBES numbers and I believe they're not all that reliable and the Board, I believe, partly on that basis has tended to discount evidence in the comparable earnings and the DCF area because of this and I wanted to give Ms. McShane a chance to talk about that. MR. HARDY: Okay. And what I'm hearing is several explanations of her view of some of the IBES figures here and I'm not sure if we're getting to the nub of -- DR. CANNON: Okay. EXAMINATION BY DR. CANNON: Q. Well, I'll -- I think -- I asked a two-part question and, Ms. McShane, I think you said that on balance, over time, the IBES estimates have proven to be too optimistic and you've admitted that before. A. I think that generally speaking, that the empirical studies have indicated -- at least for the market as a whole. Now, it may well be different with respect to specific industries. But another interesting thing that's sort of related to this was that we did in the context of a proceeding that was held - it wasn't a proceeding. It was a workshop - that was held before the FERC with respect to this formula because the formula with the two thirds growth/two thirds weight to the IBES and one third to the long-term GDP growth was actually a change from their OHSC - McShane 1348 ex (Board Consultants) earlier approach which gave 50 per cent weight to the IBES and 50 per cent weight to GDP growth which itself was a change from a former approach. But we did some analysis at the time which looked at the forecast, IBES forecast of growth, for pipelines since this was in the context of pipelines to see if, indeed, we could see that there was any trend toward these growth rates coming down towards the long-term growth in the economy and looked at data from 1982 through 1997 and found that there was no reason to believe that somehow over that period that there was this trend toward investors believing that growth would be based on the long-term growth in the economy. And indeed, when you looked at the dividend yields of these companies when they went from 5 per cent to 1 per cent, I mean, it's clearly indicated that investors expected growth to go up and that was embedded in the higher prices they were willing to pay. Q. The second part of my question -- and rather than ask you a question, I'll tell you that what I'd like to you admit, and then if you're not willing to do that, we can go on. I would like you -- you see, I'll never make a lawyer. I'd like you to admit that investors, at least sophisticated investors, understand the game that's being played with these earnings forecasts and that, in fact, they discounted -- that they recognized that the typical pattern is - and I've got all sorts of articles here and quotes to back it up, but if you don't like it, I OHSC - McShane 1349 ex (Board Consultants) won't even - that they recognize that there's some inherent bias towards the analysts at the start of the year to start off with optimistic forecasts and then to revise them downward as the reality of the year progresses, all right, and that the initial forecast, the one that the investors really look at is the one that's made the date just before the earnings are about to be announced and that's the only one that the market really reacts to and that there's an understandable bias or reason for analysts to start off with optimistic projections and then to have to revise them downward. And my key point is, would you admit that sophisticated investors understand this kind of pattern in this game? A. Yes, but these are earnings forecasts that are done for that year, okay? Those are not the long-term earnings forecasts. And if that were true, the point that you just made, I mean, you ought to be able to look at my schedule 17 and say, well, here it is month by month, they went down every month and they don't, so, you know, it's not the same thing. Q. It wouldn't be month by month. It would be year by year presumably. A. Maybe, but we're not seeing that kind of pattern with these numbers. MR. HARDY: Dr. Cannon, I'm kind of enthused and excited by that approach to questioning and it works well, so please continue. OHSC - McShane 1350 ex (Board Consultants) DR. CANNON: Okay. This is actually our last area and it's about the comparable earnings test. Q. You're undoubtedly aware, Ms. McShane, the Board in recent years has commented frequently on the inadequacies of the comparable earnings method and, indeed, the DCF approach, the inadequacies of these approaches to assessing allowed equity returns and as a consequence has chosen to rely almost exclusively on the equity risk premium approach to setting and adjusting allowed returns for the gas distributors. It hurts me just as much as it hurts you. A. I know it hurts. I think that given the timing and severity and impact of the recession in '91 and really carrying over in terms of earnings to '92, that the Board finding that the -- sorry, the comparable earnings test was less useful at that point in time was well-founded. I mean, I agreed with that and I believe you agreed with that. That's not to say that it was not to be found to be useful or more useful in the future. There are other regulators who concluded the same thing and also said that that wasn't to say that it wouldn't be useful in the future and I think that it's appropriate at this point in time when we are trying to set a benchmark return to give weight to those tests that provide a modicum of information to the Board. And my personal view is that just because a particular test doesn't lend itself to making year-to-year changes doesn't mean that it isn't an appropriate test for OHSC - McShane 1351 ex (Board Consultants) determining the benchmark. And indeed -- I mean, I don't want to put words in your mouth, but you were in the 1994 case at the National Energy Board and that was a case in which the Board was setting a benchmark return and going to a formula and we both used comparable earnings there. So, I mean, I don't see that this is any different. I mean, I used comparable earnings in the case for Consumers Gas when its benchmark return was set and I believe that the Board Staff -- Dr. Roberts did as well. Q. Well, there is a slight distinction in that I never ditched the test. I don't think I'm on the record saying that I don't think it's got a useful role to play. And as I recall back in your evidence and that of -- most of the words came from your sidekick, Steve Sherwin, Dr. Sherwin. A. Good. Can he get blamed for something? Q. In the -- this is the EBRO 485 Consumers Gas hearing. A. What year was that? Q. Dated Tuesday, September 7th, 1993. The two of you, but the words were Dr. Sherwin's, were effectively ditched the comparable earnings test and the DCF test, and you can look at this if you want, but the point Dr. Sherwin was making at the time was that you had to ditch these tests because you didn't have the reliable input numbers? A. Right. Q. And you agreed at that time that the IBES OHSC - McShane 1352 ex (Board Consultants) numbers just didn't provide the basis, particularly since -- IBES had adjusted their own numbers between your original filing and subsequent filing and both numbers were -- A. Again, I want to come back to this point about IBES and the different contexts in which they were used in. There is a critical distinction between using IBES forecast for purposes of doing a comparable earnings test because there is no investor expectation element of that test in terms of the dividend yield. So I think that for purposes of comparable earnings -- Q. You need a good number for IBES or you don't have a good comparable earnings test, do you? It has got to be a believable number. A. No, no, I agree. I agree with you. I'm just trying to make the distinction between comparable earnings and the DCF test and the use of IBES in one context versus the other. Q. But if the Board were to come to the same judgment about the reliability of IBES numbers today as you persuaded them about the reliability of those numbers in 1993, it would presumably be reasonable for them to continue to discount evidence based on the comparable earnings test and the DCF test? A. No, because I'm not using any IBES numbers in the comparable earnings test. All I'm doing is using historical returns. OHSC - McShane 1353 ex (Board Consultants) Now, I do have some comparisons of the actual returns to some value line forecast, but there is no deviation between the actual returns earned over the -- I guess it's the '89 to '97 period, and what the result of the comparable earnings test is in contrast to what was being done in 1993. We were actually trying to forecast earnings beyond that period of recession. I'm not trying to do that here. I'm saying: Here were the earnings, here were the basic elements of the economy at that time, inflation, growth, those earnings, without any kind of adjustment, are a reasonable proxy for earnings that are achievable by these low risk industrial companies over the next business cycle. MR. HARDY: I wonder if I could get some idea of how much more time you are going to need? DR. CANNON: I was about to quit here. MR. HARDY: Okay. Sorry. DR. CANNON: Other questions referred to more technical details which we've argued before and probably don't need to fight over again. Q. Would you like an opportunity to tell the Board why they should take comparable earnings and DCF more seriously now than maybe they have in the last two or three years? A. I don't think I am asking them to look at the DCF test. At least not in the same sense that we'd talk about the DCF test as the dividend yield today plus a growth rate. OHSC - McShane 1354 ex (Board Consultants) Q. Right. A. I don't think anybody is doing that. Both you and I are using some form of the DCF test to do a risk premium test. I'm doing it by taking the dividend yield plus the IBES growth rates over time, taking the difference with the corresponding long government yield and saying: This is a measure of investors' expected risk premium, here's the relationship between interest rates and these risk premiums and you're using a different -- Q. Just an adjustment formula. A. Yes. Q. It's not a big component of that test, but... A. You're sort of looking at growth as being allowed return times the-- Q. Yes. A. --retention rate. So, you know, I think that I'm not really asking the Board to go back to looking at the DCF test in the traditional sense. Comparable earnings to me -- I mean comparable earnings has always been the test that is most compatible with original cost rate making because it measures returns in the same way. I think that today the inputs that we have are significantly more reliable as a measure of achievable returns than they were five years ago when we were just coming out of a prolonged period of significantly reduced returns as a result of not only recession but as a result OHSC - McShane 1355 ex (Board Consultants) of restructuring. DR. CANNON: Thank you each very much. MR. HARDY: Are there other participants that wish to ask questions of this panel? Mr. White? MR. WHITE: It's Roger White, ECMI. MS. McSHANE: Good afternoon. Is it still afternoon? MR. WHITE: By my watch, but not for much longer. EXAMINATION BY MR. WHITE: Q. I found your comments about the gas industry and the comparability of the risk for Union Gas versus the electric utility industry to be somewhat interesting. Have you any sense of the cost of repairing underground works versus splicing an overhead cable or some other similar activity in terms of what the financial impact would be on the supplying distributor? A. No, I haven't done analysis of the cost of repair, but, you know, clearly when we look at the industry's industry that has faced the most widespread repair needs it has been the electric utility here, in the States where we, for example, in Washington, D.C. were without power for four days recently. You see these types of situations much, much more often with the electric utilities industry than you do with the gas industry. Q. If I told you that the gas industry was required to walk its distribution system at least once every three weeks with something called a snifter to find OHSC - McShane 1356 ex (Participants) gas leaks and this sort of thing, would you say that is probably a fairly extensive activity? A. I'm sure that it takes a fair amount of money to do that. Q. I would suggest that the cost of a minor interruption on an overhead line are certainly substantially less expensive to repair than any underground facility, whether it be electric or natural gas. Ice storm environments and situations that happen like that tend to be relatively rare events and I think I heard words like 100 years and this sort of thing. Do you think that your assessment of the risk that Ontario Hydro Services Company faces is being influenced by people in eastern Ontario who may be in shock from a one-time ice storm that -- A. No, no I don't. Q. You don't think so? A. No. MR. WHITE: Thank you. MR. HARDY: Are there other questions from participants? Is everybody who has wanted an opportunity to ask a question of this panel had an opportunity to do so? ---(No response) Seeing nobody, I would just like to conclude the session on equity, Return on Equity. Does the Board Staff have any closing remarks at 1357 all? MS. WALLI: One moment, please. ---Off the record discussion MS. WALLI: Well it appears it's a done deal. MR. HARDY: Thank you. Thank you to both panels for your hard work over the day. I appreciate it. Thanks. MS. WALLI: Actually, just a quick reminder that submissions on the Technical Conferences are due Friday, February 5th, but any submissions with respect to return on equity are due next week, Wednesday, February the 10th. ---Whereupon, the Technical Conference proceedings were adjourned sine die at 4:30 p.m. 1358 I N D E X o f P R O C E E D I N G S Page No. Overview (Facilitator) 1179-1182 Introduction of BOARD CONSULTANTS: DR. W. CANNON MICHAEL HARRIS 1182 Examination by OHSC Panel 1187 Examination by Participants 1217 Examination by OHSC Panel 1250 ---[Lucheon 12:06 p.m. - 1:10 p.m.] 1259-1260 Examination by Participants 1281 Examintion by OHSC Panel 1286 Introduction of KATHLEEN McSHANE 1300 for OHSC Examination by the Board Consultants 1301 Examination by the Participants 1355 Participants who questioned: R. White . . . . . . . . . . ECMI R. Stephenson . . . . . . . . PUW L. Murphy . . . . . . . . . . AMPCO JB BX MC [ Copyright 1985].