Rep: OEB Doc: 12QQZ Rev: 0 ONTARIO ENERGY BOARD Volume: 3 28 MAY 2003 BEFORE: P. VLAHOS PRESIDING MEMBER S.F. ZERKER MEMBER A. BIRCHENOUGH MEMBER 1 RP-2002-0147 2 IN THE MATTER OF the Ontario Energy Board Act, 1998, S.O. 1998, c.15 (Schedule B); AND IN THE MATTER OF an Application by Natural Resource Gas Limited for an Order or Orders approving or fixing just and reasonable rates and other charges for the sale, distribution and transmission of gas commencing October 1, 2002 and commencing October 1, 2003. 3 RP-2002-0147 4 28 MAY 2003 5 HEARING HELD AT TORONTO, ONTARIO 6 APPEARANCES 7 MIKE LYLE Board Counsel JAI PRASHAD Board Staff NEIL YEUNG Board Staff RICHARD KING NRG Limited 8 TABLE OF CONTENTS 9 SUBMISSIONS BY MR. KING: [21] 10 EXHIBITS 11 12 UNDERTAKINGS 13 14 --- Upon commencing at 10:00 a.m. 15 MR. VLAHOS: Good morning. 16 Any preliminary matters from Mr. Lyle or Mr. King? 17 MR. KING: I have none. 18 MR. LYLE: I have none, Mr. Chair. 19 MR. VLAHOS: Then we are ready for you, Mr. King, for your reply argument. 20 MR. KING: Thank you. 21 SUBMISSIONS BY MR. KING: 22 MR. KING: I am going to deal with the issues as Mr. Lyle outlined them in his summary, which of course followed the evidence in the proceeding. And I'll start with rate base, and the first issue there being the treatment of the $88,000 gain on NRG's former premises. 23 As you know, the sale of the land and buildings took place in fiscal 2002, and on test year in this proceeding. It is the first time that NRG has disposed of a significant asset, and from an accounting perspective, NRG simply followed the guidelines in the uniform system of accounts, specifically the profit was recorded in the 2002 income statement as an extraordinary item. 24 From a rate-making perspective, the Board was asked to consider whether it would be fairer to share with NRG's ratepayers some of that $88,000 gain. It is the company's view that the Board's considerations ought to be guided by how the Board has treated other gas utilities with respect to significant asset dispositions. 25 And I'll draw the Board's attention to EBRO-465. In that case, the Board dealt with the sale of two properties by Enbridge Gas Distribution. The expected profit from the sale was to be $1.9 million, and the Board in that case found that the most equitable approach was to allocate the profit from the sale on a 50/50 basis, as between the shareholder and the ratepayers, and the reference there is pages 20 to 22 of the 0465 decision. 26 This 50/50 sharing has become standard for Enbridge as the basis upon which the gains or losses realized upon the sale of assets are allocated, and I would draw the panel's attention to the ADR agreement in Enbridge's most recent case, that's the RP-2002-0133 proceeding, and it's at Exhibit N.1, tab 1, schedule 1, page 32. And there, again, the 50/50 sharing methodology was adopted by the parties. 27 So guided by this, it is the submission of the company that if there is any sharing of the $88,000 gain, then it should be limited to 50 percent. 28 I'll move on to capital expenditures and I want to deal with this topic in two parts. First, non-discretionary capital expenditures, and second, major capital projects. 29 I want to address some of the discussion that took place on capital expenditures generally. 30 The initial questioning from Mr. Lyle on the topic dealt with whether NRG had been chronically overestimating capital expenditures. You will recall Mr. Lyle took the witnesses through Exhibit K.1.1, and examined three things. 31 First, NRG's proposed capital expenditures as it would have been found in the pre-filed evidence; second, the Board-approved capital expenditures; and third, NRG's actual capital expenditures. 32 And Mr. Lyle traced these figures back to the year 2000. 33 Now, if you compare those figures with the forecasted capital expenditures of the company for the year 2003 and 2004, the record shows a consistent level of non-discretionary capital expenditures in the range of $550,000 to $600,000, and I'll just give you the figures. For 2001, actual capital expenditures would be $570,000; for 2002, that number was $585,000; and then for the two test years in this proceeding, 2003, the non-discretionary capital expenditures is $587,000, and that's backing out the new building; and for 2004, the number forecasted is $545,000, and that's after backing out the Norfolk East project. 34 So the estimates for non-discretionary capital expenditures in 2003 and 2004 are consistent with NRG's recent past. Mr. Blake testified that this stability in non-discretionary capital expenditures reflects the maturity level of the company. There are fewer unplanned expenditures, there are fewer and smaller expansions and, generally, a lower level of replacements of leaking lines and older facilities. 35 So the capital expenditure estimates for 2003 and 2004 are, based on past years, very accurate, and NRG expects to be very much on target with respect to these non-discretionary capital expenditures. 36 That brings me to major projects. For 2003, the major capital expenditure is NRG's new office. There was some cross-examination on the issue of whether a portion of the building costs should be allocated to affiliates, and we talked about two things here. The first was materials and parts for NRG Corp. That might be received in the service-area part of the new building, and second, the fact that Mr. McCallum works at NRG's new building but spends 25 percent of his time working for companies other than NRG. 37 Now, with respect to the first item, the material and parts -- Mr. Blake testified that these occasions were parts and materials -- are received for NRG Corp. At the new facility are rare, and the transcript reference for that is paragraph 152. 38 Moreover, there are labour and overhead costs associated with this work that NRG charges its affiliate, and this charge shows up as the well-maintenance charge by NRG to NRG Corp., and you can find that at Exhibit A, tab 6, schedule 1. And the fee for the well maintenance service in both test years is $28,800. 39 With respect to Mr. McCallum's time, he spends 75 percent of his time doing work for the utility, and the remaining 25 percent working for other affiliated companies and there are many good reasons not to allocate part of the building costs associated with his time to others. 40 First, the role of financial manager in NRG is at least a three-quarter full-time job, and as a result, an office and associated equipment would have to be dedicated to a financial manager. 41 Second, there are efficiencies with having Mr. McCallum in NRG's offices. NRG receives the benefit from providing him with a permanent place to work, because he can deal with issues as they arise at the company. 42 Finally, any allocation of building costs to affiliates would be very small. If you do the math, it is one quarter, being his time, of one ninth, given that there are nine employees in the office work space, which, as the record shows, is only 2700 square feet. I have roughly done the math on that, and that amounts to less than 1 percent. 43 So for these reasons, the company submits that no portion of the building costs be allocated to affiliates. 44 That brings me to 2004, and there the major discretionary capital expenditure is the Norfolk East project. The issue here is whether the project should be delayed beyond the end of fiscal 2004. And there are four reasons why NRG is requesting that this capital expenditure be approved for the 2004 year. 45 First, it is an economic project. It has a cost-benefit ratio of 1.12, and I would point out that it is economic even on Mr. Blake's conservative estimates with respect to customer uptake. 46 Second, the project is driven by customer demand. Mr. Blake at paragraph 507 of the transcript testified that NRG had contacted a number of farmers along the Norfolk East route who had verbally indicated a sincere interest in getting gas supply. A delay to the project, of course, could cause some of these customers to be permanently lost. 47 Third, the Norfolk East project has already been delayed from fiscal 2003 to fiscal 2004, as part of the updated evidence. 48 And finally, a delay does have implications for other projects, specifically the Norfolk South project. 49 Pushing the Norfolk East project beyond fiscal 2004 would cause the Norfolk South project -- it is an economic project currently scheduled for fiscal 2005 -- to be delayed because it feeds off the Norfolk East expansion; in other words, the Norfolk East project is a necessary precursor to the Norfolk South. 50 So it remains the position of the company today that approval be given to the capital expenditure associated with the Norfolk East project. 51 With respect to cost of service, the only issue here I believe is regulatory costs, and the company agrees with Mr. Lyle's assessment that because this hearing has been shorter than expected, legal, consulting, transcript and Board costs should all be lowered from the forecasted amounts. 52 I come now to cost of capital and the issue of prime rate. The company used the most recent prime rate when it filed its updated evidence in March 2003. Since then, the prime rate has risen from 4 and three-quarters percent to 5 percent. 53 And NRG had forecast that had the prime rate would be approximately 5 percent for the remainder of the year, so for the year 2003, the rate seems to be appropriate. For 2004, you'll recall the company forecasted that the rate would rise over the course of the year and result in an average of 6 percent for fiscal 2004. 54 Events have occurred since March 2003, and that has created uncertainty in the market. As a result, NRG is prepared to accept that the current rate of 5 percent should be used for the 2004 test year as the prime rate. 55 With respect to return on equity, NRG used the Board formula for determining its 2003 ROE based on the August consensus forecasts. The company sees no reason to depart from the Board-approved methodology and timing that has been used by the company since the introduction of the guideline. 56 We would also like to clarify a point on the record regarding the 30-year bond rate. Yesterday, Mr. Lyle stated that the 30-year bond rate was 5.02 percent, I believe, and it was suggested that perhaps that rate could be used for 2003 along with some forecast for the remaining months. 57 And I think there is a problem with that. We went back and calculated the average rate for 30-year bonds from October 1st, 2002, that's the start of the fiscal year, through to the end of last week, and that number comes up as 5.49 percent. So to use the 5.02 for 2003 wouldn't be appropriate. 58 For 2004, the best approach would be to use the current Consensus forecast. We are going to undertake to attempt to obtain the information in the next day or two and will forward it to Board Staff as soon as the company can obtain it, and it is our understanding that the Board was also going to make inquiries about finding that current Consensus forecast. 59 On the issue of long-term debt, Mr. Lyle I think characterized it yesterday, in his final summary, as whether the Board should wish to consider deeming a lower interest rate on long-term debt for the utility than the rate that currently exists in the company's debt instruments. We submit that to do so would be inappropriate for several reasons: 60 First, to deem a lower interest rate on long-term debt, one would expect that the Board would have to decide or come to the conclusion that the company has been imprudent in not refinancing as of today. That simply is not the case. 61 Mr. Blake's testimony is that preliminary discussions with potential lenders have indicated an interest rate above 8 percent. On cross-examination, it became clear that carrying costs on the long-term debt were only lower if a rate of less than 8 and three-quarters percent were achieved, so we are right on the edge here. 62 And there are a bunch of other variables, of course, that aren't known. For example, the terms and conditions of any new financing package and the final transaction costs associated with that. 63 And given these uncertainties and given the fact that we are right on the edge, I would submit to you that to find NRG imprudent in not having refinanced, there would have to be a much greater spread between the rate given to NRG in its preliminary discussions with lenders and what I will call the carrying cost break-even rate of 8 and three-quarter percent. 64 Moreover, this gap narrows further if we make another necessary adjustment to the prepayment penalties. You'll recall that when we ran through the prepayment penalties yesterday with Mr. Lyle and Mr. McCallum, we came up with the number of $460,000. This number largely came out of calculations that Mr. McCallum had carried out about a month and a half ago. At that time, interest rates were 5.315 percent. Today, they are about 4 percent. So if you increase the spread by that amount, that obviously leads to a substantial increase in the prepayment penalties. 65 And before I leave this point, I do want to point out that the prepayment penalties are typical for these types of loans, and that was the evidence of Mr. McCallum based on his experience. 66 The company also believes that it would be inappropriate to deem a longer -- a lower long-term debt rate because of the long-term cost implications of refinancing. The projections that were done by the company indicate that by refinancing the company's debt, any short-term benefit, if there were one, would in a few years result in an increased interest cost to the ratepayers. 67 Again, as I said before, we also don't know what restrictive covenants or terms and conditions new lenders might impose. So there is no good evidence at this time to indicate that the cost of debt would be less if the company had refinanced its debt, and given the record as it stands now, I come to the opposite conclusion. That to refinance at this point, given the facts, would be imprudent and to prohibit the company from recovering its current cost of debt amounts to an unwarranted punitive measure. 68 And just to finish up on this point, Mr. Blake, I think, did say that he would continue to explore refinancing options. Obviously, no refinancing could be completed before the end of the current fiscal year, and even if a favourable deal were to come along in the very near future, we may be some time into fiscal 2004 before that could be finalized. 69 The final point I want to make before I finish just simply deals with a question of a more efficient rate-making process for the company going forward. And really, all that the company has to say here is that they are entirely willing to meet with Board Staff to discuss what can be done to reduce regulatory costs through a more efficient rate-making process, and in the context of these discussions, NRG is willing to consider moving to a PBR approach, filing a three-year cost of service application with periodic updates, moving to a simplified annual filing or returning to a process that involves having ADR sessions. 70 Those are my submissions. 71 MR. VLAHOS: Thank you, Mr. King. 72 Before I turn to my panelists, Mr. Lyle, is there anything there by way of clarification? 73 MR. LYLE: I believe the only point I would clarify is that I was not attempting to state that 5.026 should be used for the entire year of fiscal 2003 for establishing return on equity. 74 MR. VLAHOS: Okay, thank you. 75 A couple of areas of clarification, Mr. King. At the opening, you did talk about the capital gain and that it was registered or incurred in year 2002, which is a non-test year, and I would just like to note that there is a deferral account associated with the expenditures for the new land and building, and I just wonder whether your statement to that effect had reflected that fact that there is a deferral account? There is a deferral account for land and building deferral account, so I am just wondering whether that deferral account would capture or would address your concern about being out of period? 76 MR. KING: It would, wouldn't it? 77 You know what, can I have Mr. Aiken answer? 78 MR. VLAHOS: Certainly. 79 MR. AIKEN: I believe that deferral account was to record expenditures on the new land and new property. I don't believe the deferral account wording dealt with the sale of the old property or any proceeds from the sale. 80 MR. VLAHOS: Because there may not have been any information at that time as to the potential capital gain. In any event, thank you for that. 81 Now, Mr. King, you spoke about the level of non-discretionary capital expenditures that have been pretty even or pretty consistent in the last few years. There was also I believe some discussion about the discretionary expenditures which are over and above the new projects such as the Norfolk East. So my recollection is that there was also some -- a discretionary element into the capital budget, and I believe there was some examples of not, you know, buying a new truck now but rather wait for the next fiscal year and just a few more repairs. Was that your recollection as well? 82 MR. KING: That wasn't actually. I, in reviewing the transcripts, I guess I had come out with the fact that somewhere between 550 to $600,000, there might have been sort of a large non-discretionary component, and then projects of that non-discretionary nature that could be pushed off or moved from year to year, but essentially they sort of had to be done. So I sort of interpreted that as sort of lumping the 550 to $600,000 as pretty much non-discretionary. 83 MR. VLAHOS: But the fact that one can postpone certain expenditures, it just seems to be going opposite the definition of non-discretionary? 84 MR. KING: Maybe the difference is sort of temporarily discretionary versus permanently discretionary. 85 MR. VLAHOS: Temporarily discretionary. 86 MR. KING: Certain projects, large projects can be -- 87 MR. VLAHOS: I would call it deferrable. 88 MR. BLAKE: Can I interject? 89 MR. VLAHOS: Certainly. 90 MR. BLAKE: The concern would be if you were to delay, for example, the purchase of an automobile for another year or two, it would change our forecast for our repairs and maintenance expense possibly on that vehicle, so there would be ripple effects into other accounts. 91 MR. VLAHOS: I appreciate that. 92 Now, Mr. King, I don't have the exhibit before me, but you did speak about the regulatory expense components could be lowered, and I am not sure what the best source for this would be. Maybe one of the witnesses could help us to go through it component by component. 93 MR. KING: I remember the total for legal and consulting together being $6,400. Then the other two items were transcripts and the last one OEB costs. 94 MR. VLAHOS: The OEB costs. Okay. 95 MR. KING: We don't have a figure for OEB costs. That presumably would just get adjusted by whatever you deem appropriate, and the transcript was an undertaking; I think it was J.1.3. 96 MR. VLAHOS: All right. Thanks. Those are all the questions the panel has, Mr. King. Thank you very much, and the witnesses are excused with our thanks and have a safe trip home. 97 And thanks, reporter, for your patience. We are adjourned. 98 --- Whereupon the hearing adjourned at 10:25 a.m.