Rep: OEB Doc: 12RXL Rev: 0 ONTARIO ENERGY BOARD Volume: 1 22 SEPTEMBER 2003 BEFORE: P VLAHOS PRESIDING MEMBER and VICE CHAIR P. SOMMERVILLE MEMBER R. BETTS MEMBER 1 RP-2002-0158 EB-2002-0484 2 IN THE MATTER OF the Ontario Energy Board Act, 1998, S.O. 1998, c.15 (Sched. B); AND IN THE MATTER OF an Application by Union Gas Limited for an Order or Orders approving or fixing just and reasonable rates and other charges for the sale, transmission, distribution, and storage of gas as of January 1, 2003; AND IN THE MATTER OF the customer review process approved by the Ontario Energy Board in the RP-1999-0017 Decision with Reasons; AND IN THE MATTER OF an Application by Enbridge Gas Distribution Inc. for an Order or Orders approving or fixing just and reasonable rates and other charges for the sale, transmission, distribution, and storage of gas as of October 1, 2002; AND IN THE MATTER OF an Application by Enbridge Gas Distribution Inc. and Union Gas Limited for a review of the Board's Guidelines for establishing their respective return on equity. 3 RP-2002-0158 EB-2002-0484 4 22 SEPTEMBER 2003 5 HEARING HELD AT TORONTO, ONTARIO 6 APPEARANCES 7 PAT MORAN Board Counsel HELEN NEWLAND Enbridge Gas Distribution MICHAEL PENNY Union Gas ROBERT WARREN CAC PETER THOMPSON IGUA RANDY AIKEN London Property Management Association MICHAEL JANIGAN VECC JAY SHEPHERD OPSBA MURRAY KLIPPENSTEIN Pollution Probe BRIAN DINGWALL Energy Probe LAURIE SMITH Canadian Gas Association 8 TABLE OF CONTENTS 9 APPEARANCES: [20] PRELIMINARY MATTERS: [34] OPENING SUBMISSIONS BY MS. NEWLAND: [78] UNION GAS LIMITED/ENBRIDGE GAS DISTRIBUTION - PANEL 1; McSHANE [92] EXAMINATION BY MS. NEWLAND: [94] CROSS-EXAMINATION BY MR. THOMPSON: [263] 10 EXHIBITS 11 EXHIBIT NO. F.1.1: SUMMARIES OF INTERROGATORIES PREPARED BY ENBRIDGE GAS DISTRIBUTION AND UNION GAS LIMITED [116] EXHIBIT NO. F.1.2: TABLE PREPARED BY MS. McSHANE ENTITLED "SELECTED CANADIAN UTILITY BOND YIELDS" [197] EXHIBIT NO. F.1.3: BOOK OF CROSS-EXAMINATION MATERIALS FILED BY CAC, IGUA, AND VECC [591] EXHIBIT NO. F.1.4: DOCUMENT PREPARED BY NESBITT BURNS RESEARCH, ENTITLED "FORTIS INC., DETAILS ON AQUILA NETWORK'S ACQUISITION" [980] 12 UNDERTAKINGS 13 UNDERTAKING G.1.1: TO PRODUCE COPIES OF TWO ARTICLES DESCRIBED [506] UNDERTAKING NO. G.1.2: TO PRODUCE A CALCULATION OF THE GROSS REVENUE REQUIREMENT THAT FLOWS FROM THE ROE REQUESTS BY THE TWO COMPANIES [550] UNDERTAKING NO. G.1.3: TO HAVE ENBRIDGE EXPLAIN ITS POSITION WITH RESPECT TO HOW A REDUCTION IN THE BENCHMARK ROE ENBRIDGE HAS SOUGHT IN THIS CASE WILL IMPACT THE 2004 REVENUE REQUIREMENT IN THE CONTEXT OF THE BOARD'S DECISION APPROVING THE PARTIAL SETTLEMENT, SUBJECT TO SOME EARNINGS-SHARING SAFEGUARDS [560] 14 --- Upon commencing at 9:33 a.m. 15 MR. VLAHOS: Please be seated. 16 Good morning, everyone. 17 The Board is sitting today to hear evidence on the applications today by Enbridge Gas Distribution and Union Gas into matters pertaining to rate of return on equity. This combined hearing specifically deals with what changes, if any, are justified to the Board's guidelines on a formula basis return on common equity for regulating utilities. 18 With me today are Board Members Bob Betts, to my left, and Paul Sommerville to my right. My name is Paul Vlahos. 19 For the record, could I have appearances, please. 20 APPEARANCES: 21 MS. NEWLAND: Good morning, Mr. Chairman. Helen Newland appearing for Enbridge Gas Distribution Inc. 22 MR. VLAHOS: Good morning. 23 MR. PENNY: Mr. Chairman, my name is Michael Penny. I'm appearing for Union Gas. 24 MR. WARREN: Robert Warren for the Consumers' Association of Canada. 25 MR. THOMPSON: Peter Thompson for the Industrial Gas Users Association. 26 MR. AIKEN: Randy Aiken for the London Property Management Association. 27 MR. JANIGAN: Michael Janigan for the Vulnerable Energy Consumers Coalition. 28 MR. SHEPHERD: Jay Shepherd for the Ontario Public School Boards Association. 29 MR. KLIPPENSTEIN: Murray Klippenstein for Pollution Probe. 30 MR. DINGWALL: Brian Dingwall for Energy Probe. With me as well are Tom Adams and David McIntosh. 31 MR. SMITH: Laurie Smith for the Canadian Gas Association, and with me is Cynthia Chaplin. 32 MR. VLAHOS: Anyone else? 33 MR. MORAN: Pat Moran, Board Counsel. 34 PRELIMINARY MATTERS: 35 MR. VLAHOS: Anyone else? There being no response, I would appreciate the people who made an appearance, if you would indicate to the Board whether you intend to be active, specifically in cross-examination, perhaps in the same order that they made the appearance, other than the applicant's counsel, of course. 36 MR. WARREN: Sorry, did you want to hear from applicant's counsel -- 37 MR. VLAHOS: No, no. I'm sure they'll be active. 38 MR. WARREN: It depends, sir, I suppose on how the day goes. They may withdraw, but you never know. 39 Among them, Mr. Janigan, Mr. Thompson, and me, Mr. Chairman, as you're aware, the three of us have jointly sponsored evidence. And the plan is, we will not duplicate one another. Mr. Thompson will do the cross-examination of Ms. McShane, and to the extent that there is any examination-in-chief of Dr. Booth, that will be done by Mr. Janigan, leaving everybody in the happy position of not having to hear from me at all. I will be here for the cross-examination of Ms. McShane, and for the examination and cross-examination of Dr. Booth, but other than that, Mr. Chairman, I will not be present and not be participating in the oral phase of it. I will be contributing, obviously, to written argument. 40 MR. VLAHOS: Thank you, Mr. Warren. 41 MR. THOMPSON: I'll also be cross-examining Mr. Case on behalf of the group. 42 MR. VLAHOS: Mr. Aiken? 43 MR. AIKEN: I expect to have a few questions of Ms. McShane, but that will be it. 44 MR. VLAHOS: Mr. Janigan, anything to add? 45 MR. JANIGAN: I don't think so, sir. Mr. Thompson will be doing the cross-examination. I will be here in case there is any follow up. 46 MR. VLAHOS: Mr. Shepherd. 47 MR. SHEPHERD: Yes, we expect to be active, although I'm hoping that Mr. Thompson will cover most of that ground. 48 MR. VLAHOS: Mr. Klippenstein. 49 MR. KLIPPENSTEIN: Yes, Pollution Probe expects to be active and I expect to cross-examine all of the witnesses. 50 MR. VLAHOS: Mr. Dingwall. 51 MR. DINGWALL: Energy Probe expects to be active in a judicious fashion. We will make out best efforts not to duplicate, and we will more than likely leave the majority of our submissions to final argument. 52 MR. VLAHOS: Mr. Smith. 53 MR. SMITH: Mr. Chairman, I'm hiding behind Mr. Aiken here, the short one at the back. We -- 54 MR. VLAHOS: We don't talk about height in this room. 55 MR. SMITH: Thank you, sir. 56 MR. VLAHOS: Thank you. 57 MR. SMITH: We will be active. We have no questions for Ms. McShane. We would have, maximum, a half an hour for each of Drs. Cannon and Booth. That would be a half an hour for each at the most, and we would, obviously, be providing argument at the appropriate time. 58 MR. VLAHOS: Thank you, Mr. Smith. 59 Mr. Moran. 60 MR. MORAN: Yes, I will have questions for Ms. McShane as well and various other witnesses. 61 MR. VLAHOS: Thank you very much. That does help. 62 The Board does have a very busy schedule. This panel does have other commitments starting next week, so all circumstances dictate we must finish, by Friday, the oral part of this proceeding. So in this respect, we expect counsel will restrict their direct examination only for qualifying their witnesses and ask for any necessary corrections or updates to their filed evidence. 63 We will allow the applicants' witness, if she so chooses to take the opportunity at this time, to respond to the critique of her evidence filed by other witnesses. We expect parties to attempt not to duplicate cross-examination, and I'm heartened by what I heard this morning. We expect parties to refrain from seeking undertaking unless they are absolutely necessary and only with the leave the Board. 64 We will be flexible in terms of order of cross-examination. We generally expect that Mr. Moran on behalf of the Board Staff will go last. 65 As for the argument, we will leave that issue until towards the middle or end of the oral proceeding when we have a better idea of scheduling. 66 We will be sitting full days. Starting at 9:30 until about five with the following exceptions: 67 The Board, this Panel, is committed to other Board matters on Wednesday morning; therefore, we cannot begin until 10:30 this Wednesday, and for Thursday, we cannot commence until 1:30 in the afternoon, so be prepared on Thursday to stay a little longer if necessary. 68 MR. PENNY: Mr. Chairman, with respect to the scheduling, it was also my understanding, I think through Mr. Moran, that there were no other witnesses available until Wednesday. Does that remain the case? 69 MR. MORAN: Yes, Mr. Chair, that still remains the case, as far as I know. 70 MR. VLAHOS: Perhaps, Mr. Moran, we don't have a schedule as such. Perhaps you can speak to it now to give the parties a general idea as to who is coming on when. 71 MR. MORAN: As I understand it, Mr. Chair, the only scheduling glitch that we have is in the first two days. We will only have Ms. McShane available for Monday and Tuesday, and then starting on Wednesday, people are generally available, so I think we will be going through the remaining witnesses one by one without any further scheduling problems. Dr. Cannon is available Thursday and Friday, and we wouldn't get to him any earlier than that in any event, I don't think. 72 MR. VLAHOS: So the plan is to have Dr. Booth, then, on Wednesday if we go according to plan? 73 MR. MORAN: I think the CGA witnesses will be prior to that, but starting on Wednesday. 74 MR. VLAHOS: And we will set up a hotline. Ms. Desai will advise us whether it will be her own office line or another dedicated line. 75 Ms. Desai, you can advise the parties, perhaps at the end of the day today, by the end of the day. 76 Any other preliminary matters before we begin. 77 There being none, we will turn to Ms. Newland or Mr. Penny. 78 OPENING SUBMISSIONS BY MS. NEWLAND: 79 MS. NEWLAND: Thank you, Mr. Chairman. 80 I will being leading Ms. McShane through her evidence on behalf of Enbridge and Union Gas. I should say that other than qualifying Ms. McShane, we just have some examination-in-chief that goes, really, to Ms. McShane's response to the evidence of intervenors that has been filed, so we will abide by your comments in your opening remarks. 81 Enbridge Gas and Union Gas Limited have asked the Board to make specific findings regarding the determination of the fair return on equity for each company. Specifically, the utilities are requesting two things: Number one, resetting the benchmark remarks of return on common equity for Enbridge and for Union that were originally set in accordance with the Board's 1997 draft guidelines on a formula-based return on common equity for regulated utilities; and, 82 Number two, to revise the automatic adjustment mechanism that is embedded in the ROE formula and which is used to determine the annual adjustment upwards or downwards to the previous year's allowed ROE. 83 Enbridge and Union are pleased to present Ms. Kathleen McShane as their jointly sponsored witness who will present expert testimony in support to these two ROE requests. 84 Now, Ms. McShane's original written evidence on behalf of Enbridge was prepared in September of 2002. Her original written evidence on behalf of Union was prepared in June 2001, over two years ago, and 16 months before the Enbridge evidence, and prior to September 11, 2001. So it has, accordingly, been superceded by events. 85 Rather than request Ms. McShane to prepare new evidence for Union that would mirror the evidence that she prepared for Enbridge in September 2002, Union and Enbridge decided to jointly present the September 2002 evidence as their prefiled written evidence in this proceeding. 86 The September 2002 evidence, which is Exhibit B to tab 3 was subsequently updated by Ms. McShane in February of 2003, and the updated evidence, sir, is Exhibit B.2, tab 2. 87 Ms. McShane, your written evidence comprises Exhibit B, tabs 2 and 3. 88 MS. McSHANE: That's correct. 89 MS. NEWLAND: Are these exhibits -- 90 MR. THOMPSON: I don't think she's been sworn yet. 91 MR. VLAHOS: If Ms. McShane can come forward to be sworn. 92 UNION GAS LIMITED/ENBRIDGE GAS DISTRIBUTION - PANEL 1; McSHANE 93 K.McSHANE; Sworn. 94 EXAMINATION BY MS. NEWLAND: 95 MS. NEWLAND: Okay. Let's try this again, Ms. McShane. 96 Your written evidence comprises Exhibit B, tabs 2 and 3? 97 MS. McSHANE: Yes. 98 MS. NEWLAND: And these exhibits are accurate, to the best of your knowledge or belief? 99 MS. McSHANE: Yes. Are we going to make the corrections now? 100 MS. NEWLAND: If you have the corrections, please go ahead. 101 MS. McSHANE: I have two corrections, one to tab 3, schedule 1, page -- 102 MS. NEWLAND: That's the September -- 103 MS. McSHANE: That's the September 2002 evidence, yes, and that would -- I would take you to page 42, please. There is a question and answer at the bottom of the page, starting on my version, at least, at line 14, and the answer goes over to lines 1 and 2 of page 43. 104 What I'd like you to do is to take that question and answer and move them to page 41, at line 26. I think if you do that, the flow of the thoughts will make more sense. 105 MS. NEWLAND: Thank you. You have a second correction, I believe. 106 MS. McSHANE: Yes, I have a second correction, which is to the February 2003 update on page 4, line 14. So there is reference to consensus economics, forecast, and it currently reads that the forecast was January 13th, 2002, and it should be January 13th, 2003. And those are my corrections. 107 MS. NEWLAND: Thank you, Ms. McShane. 108 Mr. Chairman, I have provided Board Counsel and the Panel with copies of a document which is entitled "Interrogatory Summaries, ROE" and there have been copies distributed to people in the room. Perhaps we could have an exhibit number for this document. 109 What it is is it's an index to all of the interrogatory responses that were prepared by Enbridge with the name of the person responsible for that response. 110 MR. VLAHOS: I do have my copy, Ms. Newland, and let me see if my fellow Board Members -- 111 MR. SOMMERVILLE: I have it. 112 MS. NEWLAND: Okay. 113 Mr. Moran, could we have an exhibit number? 114 MR. MORAN: Yes, Mr. Chair, that would be Exhibit F.1.1, summaries of interrogatories prepared by Enbridge. 115 MS. NEWLAND: And Union as well. 116 EXHIBIT NO. F.1.1: SUMMARIES OF INTERROGATORIES PREPARED BY ENBRIDGE GAS DISTRIBUTION AND UNION GAS LIMITED 117 MS. NEWLAND: And Union Gas as well. 118 MR. MORAN: And Union Gas. 119 MS. NEWLAND: Ms. McShane, do you have a copy of Exhibit F.1.1? 120 MS. McSHANE: I do. 121 MS. NEWLAND: And this exhibit indicates the responses to Board Staff and to intervenor interrogatories which are included in Exhibit C, tabs 1 through 5, that you prepared; correct? 122 MS. McSHANE: That's correct. 123 MS. NEWLAND: Are the responses to the interrogatories which you prepared and which are indicated in the exhibit accurate, to the best of your knowledge and belief? 124 MS. McSHANE: Yes, they are. 125 MS. NEWLAND: Thank you. 126 Now, Ms. McShane, could you turn up the statement of qualifications that's attached to Exhibit B, tab 3, as appendix A. That would be attached to your September evidence, I believe. 127 MS. McSHANE: I have that. 128 MS. NEWLAND: Mr. Chairman, Ms. McShane has testified to the Board on numerous occasions and I believe she's well-known to most of the intervenors here today. If neither the Board nor intervenors take exception or issue with Ms. McShane's qualifications and expertise, it would save time if I didn't have to lead Ms. McShane all the way through her qualifications, and I would simply ask you to accept Ms. McShane as an expert on these matters. 129 MR. VLAHOS: Any objections to that, parties? 130 Thank you, Ms. Newland. Ms. McShane is accepted as an expert witness. 131 MS. NEWLAND: Thank you. 132 Ms. McShane, your update to your September 2002 written evidence was prepared six months ago in February 2003. Did you -- did Union or Enbridge ask you to prepare a further update? 133 MS. McSHANE: We certainly discussed whether that should be done, and given the fact that evidence had been prepared in June 2001, and then we had prepared evidence in September 2002 and an update in February 2003, we decided since I had recommended a formula that -- that I would go ahead and simply apply the formula to the most recent forecast of long-Canada yields to show what the returns would be for both companies under the most recent consensus forecast. 134 MS. NEWLAND: And what does the most recent consensus forecast indicate? 135 MS. McSHANE: Well, the September 2003 is the most recent forecast and it showed the 3- and 12-month forward, ten-year Canadas will be respectively 4.9 and 5.2 percent. The average would be 5.05 percent. 136 Now, as part of the formula I recommended, I was proposing that we use a constant spread between 10- and 30-year Canadas of 35 basis points, so if I add the 35 basis points to the 5.05 percent forecast, then I would get a long-Canada or 30-year Canada yield of 5.4 percent. 137 So that would -- would result in a change in the benchmark returns, if you will, to -- that I recommended for Union and Enbridge in February 2003 by 30 basis points. Let me just explain why that's the case. 138 In February 2003, I was using a long-Canada forecast of 6 percent. The decline of 60 basis points from the 6 percent to 5.4 is 60 basis points, and my formula recommendation is to adjust the return by 50 percent of the change in the long-Canada forecast, so that's why we would get to a 30 basis point decline, and the result for each of the companies would be based on the -- the most recent forecast, a return for Enbridge of 11.2 percent, and a return for Union of 11.35 percent. 139 However, having said that, it's my assumption that ultimately when the Board makes its decision, that it would rely on the most recent forecast that it has before them at that time. 140 MS. NEWLAND: Thank you, Ms. McShane. 141 Your fair return recommendations are higher than the fair returns recommended by Drs. Booth and Cannon. What would be the principal reasons for this? 142 MS. McSHANE: I guess I would sort of divide it into two principal reasons for the differences between my own recommendations and Dr. Booth's in the first instance. 143 The first I think is because I rely on a somewhat broader range of tests than he does. He uses two versions of an equity risk premium test, and I rely on several versions of an equity risk premium test, the discounted cash flow test and the comparable earnings test. 144 The second difference, or one of the differences would be that in the application of the equity risk premium test, Dr. Booth and I have different inputs to the test, primarily, the market risk premium and the relative risk adjustment. I think essentially on the risk-free rate and the adjustment for financing flexibility or the cushion, we're pretty much in agreement. 145 With respect to Dr. Cannon, both of us do rely on the same range of test, the comparable earnings, discounted cash flow and equity risk premium, but we apply and weight them differently. And also with specific regard to the equity risk premium test, again, we have different conclusions as regards the market risk premium and the relative risk adjustment. 146 MS. NEWLAND: Okay, let's start with the equity risk premium test. What are the principal differences between how you apply the test and how Drs. Booth and Cannon apply it? 147 MS. McSHANE: Well, I sort of look at it in terms of what their main criticisms of my approach are, and I think that I could summarize some of the key criticisms as being the fact that I've disregarded the results of a number of recent studies that seem to indicate that the historic risk premium, particularly in the U.S., is higher than what it will be in the future. 148 Secondly, that by focusing on post World War II data that I've disregarded results from earlier periods, that would lead me to come up with a lower equity risk premium. 149 And third, with respect to my utilization of U.S. data, Dr. Booth, in particular, makes the criticism that one can't simply import U.S. data into Canada because there's a dividend tax credit in Canada that has not been available in the U.S. 150 MS. NEWLAND: Okay. And how would you respond to these criticisms regarding, in particular, a market risk premium? 151 MS. McSHANE: Well, I guess first we should deal with the issue of the recent studies, and I think the suggestion is that I disregarded the studies. 152 I didn't disregard the studies. I simply do not believe that in terms of determining the risk premium for purposes of determining the cost of capital, that the conclusions can be relied on. And I find it quite interesting that -- the equity risk premium puzzle, as it's been called, was a phenomenon that arose back in the '80s, and the idea was that when you looked at the risk premium, it seemed to be too high for the relative risk that was associated with stocks. 153 And particularly as the market soared in the '90s, there became this decreased interest in determining whether that historic risk premium indeed could be perpetuated into the future. 154 The same authors, I would note, who are -- I guess I could call them the proponents of this equity risk premium puzzle, have now reviewed all the studies and said that they haven't resolved the puzzle, and they still expect that we will see a premium in the future that's similar to the one we've seen in the past. 155 And further, one of the key reasons that some of the studies have indicated that we can expect over the longer-term future to see the same premium we saw in the past is because part of the reason for the high premium is that price earnings ratios of the market rose precipitously, and that part of the equity return we cannot expect to see sustained in the future. 156 I went through my evidence and I took out the period which had the major price increase in the price earnings ratios and determined that the returns, once that period was taken out, were clearly sufficient to produce, going forward, based on the level of interest rates we expect, to produce a risk premium in the range of 6 to 7 percent. 157 MS. NEWLAND: Ms. McShane, you've mentioned that one of the original proponents of the so-called equity risk premium puzzle is now concluding that the equity risk premium is likely to be similar going forward to what we've observed in the past. 158 MS. McSHANE: Right. 159 MS. NEWLAND: Could you just identify for the record who that proponent was? 160 MS. McSHANE: There were two authors of the original article called the -- I'm not giving you the exact name, but it's the equity risk premium puzzle. Their last names are Mehra, and Prescott, and one of the authors, Mehra, has published an article called "The Equity Premium - Why is it a Puzzle?" in the January/February Financial Analyst Journal -- 161 MS. NEWLAND: Sorry, January/February of -- 162 MS. McSHANE: 2003. 163 MS. NEWLAND: Thank you. 164 MS. McSHANE: And together, Mehra and Prescott have written a chapter in a book called "The Handbook of the Economics of Finance" published in 2003, called "The Equity Premium in Retrospect", which deals with the same issues. 165 MS. NEWLAND: Thank you. 166 The second criticism regarding the application -- your application of the market risk premium test is that you didn't rely on older data that was available. Could you respond to that criticism. 167 MS. McSHANE: Well, I think part of the criticism of myself and some of the analysis that's been done elsewhere is that, look, if you go back and look at really old data, you'll come up with a lower risk premium. I find it problematic to go back and rely on data that extend back to 1802, when we know that the equity market in 1802 is nothing like the equity market today. 168 In fact, if you go back and look at the actual make-up of the data that's being relied on, we're talking about, perhaps, you know, ten stocks in the banking industry, and somewhat later, some stocks that are in the railroad industry, and so I find it difficult to put much credence in the reliability of data that is that old, and it's simply, to me, not data that are representative of the diverse, complex capital markets that we have today. 169 MS. NEWLAND: And in contrast, do you feel that the period of time that you relied on in terms of historic data is a good indicator of markets as they are today, it reflects the capital market today? 170 MS. McSHANE: I believe that when we look at the post World War II period, that we are capturing a period that is similar enough to the structure of the economy today and at the same time capturing enough different economic and capital market events so as not to overemphasize one or the other as, you know, these types of economic events can. These types of economic events, I would emphasize, could be expected to be experienced in the future. 171 I think that's an important point to make. 172 MS. NEWLAND: Thank you. 173 What about your response to the criticism regarding the comparability of U.S. and Canadian data because of different tax treatments? 174 MS. McSHANE: Well, as I said before, the issue is the dividend tax credit, which we don't have in the U.S. -- well, we do now, but we basically have no dividend tax for the next several years, but historically, which is the data we're relying on, there was a dividend tax credit in Canada for some of that period of time. 175 However, it's -- it's been documented that virtually 75 percent of personal investment income in Canada is not subject to tax, and therefore the dividend tax credit, although it is there, probably has very little impact on what the relative returns will be. 176 MS. NEWLAND: All right. You have also performed a DCFA risk premium test which was also criticized by Dr. Booth and Dr. Cannon. Do you have a comment? 177 MS. McSHANE: The main criticism that they made of the test is that it is based on the idea that growth expectations by investors are derived from analyst forecasts of earnings growth. And both Dr. Cannon and Dr. Booth point out that investors -- sorry, that analyst expectations of growth have been shown to be optimistic. 178 And I wanted to look at this strictly in the case of utilities. And two points, I think, are important to make. One is that if you look at what, specifically, the long-term earnings forecast for the utilities are, they are very consistent with the long-term growth for the economy, and therefore it's not unreasonable that over the long term, that investors in utilities would expect growth of mature industries, like the utilities, to -- to parallel those of the economy as a whole. 179 And second, I would point out that if you look at the -- these DCF-based risk premium test results, and compare them to what the allowed returns of the utilities have been, and these are U.S. pure -- relatively pure-play local gas distribution companies, they're lower. The returns -- sorry, the DCF-based costs are lower than the allowed returns. 180 Where do the allowed returns generally arise from in the U.S.? Well, they come from the application of the discounted cash flow test. And do regulators always use the forecast of growth? No. Regulators in different states for different companies use various forms of growth forecast. 181 Therefore in the aggregate, they should be a good estimate of what investors expect, and if you compare what's implicit in those allowed returns to what's implicit in the growth rates I've used, I don't think that you could reasonably conclude there's any upper bias to those growth rates. 182 MS. NEWLAND: Thank you, Ms. McShane. 183 The second general area of criticism regarding your application of the market risk premium test was regarding your calculation of the relative risk adjustment. Dr. Booth criticizes your data as being too high. What is your response to Dr. Booth? 184 MS. McSHANE: I want to put it in some context. I'm using a relative risk adjustment of 60 to 55, Dr. Booth is using 45 to 55, and Dr. Cannon is using something that's no more than .45. 185 So it's specific to Dr. Booth's criticism, which is my beta is too high. He suggests that the adjustment I've made to the data reflects an unfounded assumption that Canadian utilities betas trend toward the market mean of one. I do not dispute that that is not true. I think I said that very badly. 186 I know that's not true, that they do not tend to trend toward one. But that's not why I have made the adjustment to what I would call a raw beta. 187 My adjustment is intended to -- to produce a relative risk adjustment that is compatible with the observed or empirical relationship between risk and return and to recognize that the beta simply does not measure the relationship between risk and return. 188 A relative risk adjustment, in my view, of 0.6 to 0.65 is much more in line with the observed relationship between risk and return. It recognizes that total investment risk, not just beta risk, and implicitly accounts for the fact that utilities being intrasensitive stocks, that sensitivity to interest rates is not captured in a raw market beta. So all of those factors have led me to a relative risk adjustment that is higher than a simple raw beta. 189 MS. NEWLAND: Thank you. Dr. Cannon's ROE recommendation is 7.7, which is below your recommended ROE and below Dr. Booth's. Do you have any comments on this? 190 MS. McSHANE: Well, just to be fair to Dr. Cannon, his 7.7 percent is at a different interest rate forecast than either mine or Dr. Booth's. But having said that, one of my big concerns is that when he applies his risk premium test at the interest rate level that he does, I believe that he comes up with results that are clearly unreasonable and I really this that this underscores the importance of the Board giving weight to multiple tests. 191 Dr. Cannon's what I call his "bare bones" without any adjustment for financing flexibility, equity risk premium result, which is premised on a long-Canada yield of 4.87 percent is in the range of 585 to 603. I would note that on the same day, used by Dr. Cannon in coming up with his long-Canada yield, the long-term bonds of Enbridge Gas Distribution and Union Gas were trading at 6.1 and 6.3 percent respectively. In fact, I have a table that I put together which shows what the yields were on that day, a selected number of different Canadian utility bonds which we have to distribute. 192 The point simply being that if you come up with an equity risk premium result that is lower than those utilities' own cost of date, I believe that will be prima facie evidence that the result is unreasonable. 193 MS. NEWLAND: Thank you, Ms. McShane. 194 We are, Mr. Chairman, distributing right now a table that is entitled "Selected Canadian Utility Bond Yields," which is the table that Ms. McShane has referred to. 195 MR. VLAHOS: Perhaps we can give this an exhibit number, Ms. Newland. 196 MR. MORAN: Yes, Mr. Chair, this would become Exhibit F.1.2, table prepared by Ms. McShane entitled "Selected Canadian Utility Bond Yields." 197 EXHIBIT NO. F.1.2: TABLE PREPARED BY MS. McSHANE ENTITLED "SELECTED CANADIAN UTILITY BOND YIELDS" 198 MS. NEWLAND: Ms. McShane, could I get you to explain what this table shows and what the sources of the data on this table are. 199 MS. McSHANE: Certainly. This is a table that is provided to foster associates daily by RBC capital markets bond desk, and what it is is a selection of long-term debt issues of a number of Canadian utilities. 200 For example, if you look at the first line, the line BCG 6.95, 21 September '29, and then it gives you a bid yield price of 6.57. So this would be a BC Gas issue, with a coupon of 6.95 percent due the 21st of September 2029, yielding approximately 6.6 percent on that day. 201 MR. VLAHOS: Ms. McShane, what's D plus 28? 202 MS. McSHANE: I knew you were going to ask me that. 203 MR. VLAHOS: If nothing turns on that, that's fine. 204 MS. McSHANE: I don't know. If it's important to know, I will let you know. 205 MS. NEWLAND: Ms. McShane, is there any significance to the dates that are set out in the right-hand column? Why did you pick those dates? 206 MS. McSHANE: This was the date that corresponded to the date that Dr. Cannon used for his long-Canada yield that underpins his equity risk premium test. 207 MS. NEWLAND: Okay. Thank you. 208 Now, Dr. Cannon also suggests that your sustainable growth rate analysis creates -- excuse me, Mr. Chairman, I got ahead of myself. 209 Ms. McShane, could you explain the results on this table that pertain to Enbridge and Union. 210 MS. McSHANE: Oh, certainly. The way the table has been put together, I believe each of the issues that apply to Enbridge and Union are marked with stars, so the first four single stars are issues of Enbridge Gas Distribution, and they were issues that -- what that means, the first one on line 5, CGMT, is Consumers Gas, medium term, which is part of the medium term notes program, and then the double star on line 27 is the Union Gas issue. 211 MS. NEWLAND: Okay. Could you explain what the significance of the bid yield is in the second column. 212 MS. McSHANE: That is the current cost of debt, of that issue -- what it would cost to reissue that, essentially, on that particular date. 213 MS. NEWLAND: And what is the significance of this data on this table to what Dr. Cannon is saying in his evidence? 214 MS. McSHANE: What I'm showing is that for these four issues, for Consumers, they're all trading at 6.12, and the Union issue which is trading at 6.27, the yields on the debt are higher than Dr. Cannon's equity risk premium test result. 215 MS. NEWLAND: On the date that Dr. Cannon chose. 216 MS. McSHANE: On the date -- that's correct. 217 MS. NEWLAND: Thank you. I think we can leave this table now, Ms. McShane. Thank you very much. 218 Still staying with Dr. Cannon's criticism of your positions, he suggests that your sustainable growth rate analysis creates what he calls a self-fulfilling process, in that the sustainable growth rate based on a high ROE will produce a high growth rate. Could you comment on that, please. 219 MS. McSHANE: Well, the sustainable growth rate measure is no more a self-fulfilling proficiency than any other kind of growth rate measure for utilities, because any growth rate measure that's developed for a utility has to be in some way a function of what investors expect utilities to earn, and that in turn, presumably, is to some extent the effect of what regulators allow. 220 There will be differences, obviously, depending on how much a utility can be expected to earn in excess of what the regulator allows or if it's expected to earn less. 221 So whether the growth rate is determined on the basis of historic growth or expected growth in earnings, or whether it's based on sustainable growth, it's related to the returns allowed, so it's no more a self-fulfilling proficiency than the type of growth rates that Dr. Cannon has used in his DCF model. 222 MS. NEWLAND: Thank you, Ms. McShane. 223 Dr. Booth, in his evidence, criticizes your reliance on the comparable earnings test as part of how you've arrived at the recommended ROE. Could you outline for us what his key criticisms are. 224 MS. McSHANE: I had sort of thrown all these criticisms of Dr. Booth and Dr. Cannon together, and I think that the key criticisms, and these are -- the first two are the key criticisms of Dr. Booth, and that is not a measure of the cost of attracting capital - I'm being told I'm not sitting close enough to the microphone - and that it produces results that reflect monopoly power. 225 Dr. Cannon criticizes the results because he says they haven't been, I think the word he used was "cleansed" to remove non-recurring items, and he's also concerned that the results do not reflect a full business cycle. 226 So just dealing with each of those criticisms in turn, I point out with respect to the criticism that the comparable earnings is not intended to be a measure of the cost of attracting capital. It is, however, intended to measure opportunity cost in the sense that it is a measure of the returns achievable on alternative investments of similar risk where the investment is measured in the same vintage dollars as a utility rate base. 227 With respect to the criticism of monopoly power, I think Dr. Booth is suggesting if you have a market-to-book ratio in excess of one as an industrial, than that's some indication that you're able to earn returns in excess of your cost of capital and therefore you're able to exhibit monopoly power. 228 I don't disagree with the proposition that there is a relationship, positive relationship between returns and market-to-book ratios, but there is absolutely no basis in our economy to expect the market-to-book ratios of industrials to equal one. In fact, economic theory tells us that in a competitive environment we should expect that market values will equal not book value, but replacement cost; and if we are, as we are, in an economy that's experienced relatively rapid inflation for a while and on an ongoing basis moderate inflation, we would expect that there would be a divergence between book value and market value. 229 So that if it were true that the companies in my sample reflect monopoly power, then market-to-book ratio, the median is about two times, then when you look over at the S&P 500, which had at the end of 2002 a market-to-book ratio of five times, then essentially what you're saying is the entire aggregate large cap stocks in the U.S. are exhibiting market power. 230 So going on to the third point, which is the cleansing the data, my comparable earnings results reflect what the reported earnings from the Standard & Poors Research Insight Database were. This is a data base used by financial analysts on a regular basis. The reported earnings are based on a standard calculation of return on equity, and I simply don't think it's reasonable to go back and recast the earnings of all of the companies. 231 Having said that, I recognize that there are companies that are going to report from time to time non-recurring items in their returns on equity, and those may be negative or positive in specific years. 232 So my focus would be to look at median values when assessing what the returns are for the sample, and that way, to the extent that there are companies whose returns are extraordinarily high or low because of unusual items, that effect will be mitigated. Whereas, by using an average, you would have more of an effect on that than on your final results. 233 Oh, I've got one more point. 234 MS. NEWLAND: Yes, you do. 235 MS. McSHANE: My business cycle point. 236 Dr. Cannon considers that my period 1992 to 2001 doesn't cover a full business cycle. I disagree. It is a trough to trough business cycle. It covers the end of the extended downturn at the beginning of the 1990s that effectively extended from 1990 to 1993 and included the down turn that we experienced in 2001, plus it included the mini downturn that we experienced in 1996. Consequently, I believe that the 1992 to 2001 period does, indeed, cover a full business cycle. 237 MS. NEWLAND: Thank you, Ms. McShane. 238 Both Dr. Cannon and Dr. Booth believe it is inappropriate to compare the trend in the utility equity risk premium to the trend in the utility bond yield spread about long-Canadas. You have a comment on that. 239 MS. McSHANE: Yes, I do. Since the utility -- the bond yield of utilities reflect their business and financial risk, as does the cost of equity over the longer term, one should expect that the cost of debt and the cost of equity should correlate with each other, and therefore one can look at the trend in the spread between long-term Canadas and utility bond yields to get an indication of what the utility risk premium is doing relative to long-Canada-bond yields. 240 Now, I know that Dr. Cannon has a specific concern that the data of a sample of Canadian utilities may well be contaminated by the fact that a sample would include some utilities whose yields are affected by their non-utility operations, and therefore, the trend that you purport to show is really the function of changes in the business world to the non-regulated side rather than a change in the utility spreads, and that may be true for some companies, but it's certainly not true of Enbridge Gas Distribution. 241 So I simply point out that if we go back to the time when the Board made its -- or came out with the guidelines in 1997, Enbridge -- or at that time I guess it was Consumers Gas -- was able to raise long-term debt at a spread of 35 basis points over long-Canadas. And today, its spread over long-Canadasis 125 basis points. 242 So I think that when the Board comes to making a decision on resetting the benchmark return, that that increase spread is certainly something that is indicative of a change in the spread over -- higher spread over long-Canadas and should be taken into account. 243 MS. NEWLAND: What does this change in the spread between the utility bonds and the long-Canada bonds indicate? 244 MS. McSHANE: It indicates a higher premium between the utility -- the required utility return and the long-Canada yield. 245 MS. NEWLAND: Do you have any other comments you wish to make regarding the evidence of Dr. Cannon -- Drs. Cannon and Booth? 246 MS. McSHANE: I probably have lots, but I will curb my enthusiasm and stop there. 247 MS. NEWLAND: Just -- I have one further question. I'd like to refer you to the evidence of Dr. Booth, and in particular, an appendix that has been prepared, which critiqued your evidence. I believe that's appendix B to the evidence of Dr. Booth, Mr. Chairman, which is -- I'm actually not sure what the exhibit number 1. 248 MR. THOMPSON: I believe it's B.2. 249 MS. NEWLAND: Now, Ms. McShane, in the introduction of appendix B -- 250 Have you located that Mr. Chairman. Did you follow my reference? 251 MR. VLAHOS: Yes, B.2. 252 MS. NEWLAND: Exhibit B.2 -- Exhibit D.2 which is the evidence of Dr. Booth and Berkowitz. 253 MR. VLAHOS: Right. 254 MS. NEWLAND: And in particular, I'm referring to page 1 and also page 23, the introduction and the summary. 255 In those two sections, Ms. McShane, Drs. Booth and Dr. Berkowitz comment that your final return recommendation is higher simply because you've applied a bunch of bells and whistles. Is that a fair characterization? 256 MS. McSHANE: Well, I guess what I would do is I would take you to the last page of their appendix, page 23, and look at the summary, which says: 257 "Once we reject the comparable earnings methodology, which fails to measure investors' opportunity cost and Ms. McShane's DCF estimate, which is based on a non-comparable sample of U.S. utilities, we are left with the risk premium analyses provided by Ms. McShane and ourselves. Setting aside the beta adjustments, the U.S. market risk premium and her financial flexibility adjustments, the estimates of a fair return on equity are remarkably consistent with our estimate." 258 Well, certainly, I'm not going to throw out the comparable earnings result. I don't believe that the DCF estimate is based on a non-comparable sample. Clearly based on the discussion we've had so far, I believe it's totally appropriate to be looking at U.S. data, that the beta adjustments are reasonable. My financing flexibility adjustment is the same as the cushion that Drs. Booth and Berkowitz add, so I think it's really unfair to suggest that this is just bells and whistles but, rather, that all of these elements are important inputs to my conclusions. 259 MS. NEWLAND: Thank you, Ms. McShane. That concludes my examination in chief, Mr. Chairman, and Ms. McShane is available for cross-examination. 260 MR. VLAHOS: Thank you, Ms. Newland. 261 Mr. Thompson, would you like to go first? 262 MR. THOMPSON: Yes, thank you. 263 CROSS-EXAMINATION BY MR. THOMPSON: 264 MR. THOMPSON: Well, I will be referring to the document that Ms. Newland referred to, the evidence of Drs. Booth and Berkowitz, Exhibit D.2. I assume the Board has a copy that is bound something like this, with a three-ring piece on it. We have some additional copies coming up with tabs -- 265 MR. WARREN: We have it. 266 MR. THOMPSON: Oh, they're here. Well, maybe Mr. Warren can provide the updated tabbed version of Exhibit D.2 which, as I understand it, is the same as what Mr. Janigan delivered last week, but the pagination might be slightly different than the electronic version. 267 MR. VLAHOS: Mr. Thompson, just give us a second. Mine is not bound. My colleagues', they are, their copies, so -- 268 MR. WARREN: These just have tabs in them, sir. They're just easier to follow, because the appendices don't have them. I'll get the other copies, two seconds. 269 MR. THOMPSON: There's more on their way, I'm told, but my understanding is what you have, Mr. Chairman, and what the other members have is the same, but for tabs. 270 So perhaps I'll move on, if I may. 271 Ms. McShane, just to -- Mr. Warren is delivering the further copies now. 272 MR. WARREN: I finally found the appropriate function as a delivery boy for Mr. Thompson. 273 MR. THOMPSON: Just to pick up on this comparative analysis that you've been providing in chief, what I'd like to do with you, if I might, at the outset, is just run through each of the tests that you have applied and have you put for us in one place your position, the B&B position and the Cannon position, to help us follow this. 274 The first test that you've applied, and you've described is what's called the equity risk premium test; is that right? 275 MS. McSHANE: Yes. 276 MR. THOMPSON: And there are a number of elements to what you've done, as I understand it. First, you've determined the ERP for the market as a whole? 277 MS. McSHANE: Yes. 278 MR. THOMPSON: And am I correct that your estimate of the ERP for the market as a whole is 6 percent or 6.5 percent, or the way I like to put it, 600 to 650 basis points? 279 MS. McSHANE: Correct. 280 MR. THOMPSON: Am I correct that Drs. B and B have the market as a whole at 400 basis points? This is before the add-on of the cushion. 281 MS. McSHANE: No, I believe it's 450. 282 MR. THOMPSON: You think it's 450? 283 MS. McSHANE: I do. 284 MR. THOMPSON: Okay, well, let's try and get that. I'll put that in my chart. And where is Dr. Cannon on the market as a whole? 285 MS. McSHANE: I would just -- can I go back for the 450 for a second. Appendix E, page 13, says that the market risk premium is 450 in Drs. Booth and Berkowitz's testimony. 286 MR. THOMPSON: Okay. That's fine. 287 MS. McSHANE: Dr. Cannon's estimate, I believe, if we put it on the same basis, is 3.5 percent. 288 MR. THOMPSON: 3.5? 289 MS. McSHANE: I believe so. 290 MR. THOMPSON: 350 basis points? 291 MS. McSHANE: Yes. 292 MR. THOMPSON: Okay. Then the second element of the particular risk premium test that derives the LDC risk premium from the market as a whole, is what I called the low-risk benchmark LDC beta; is that correct? 293 MS. McSHANE: It's a relative risk adjustment, yes. You can call it a beta. 294 MR. THOMPSON: Okay. Well, I call it a beta, cap M and what you've done comes up with the relative risk adjustment, fine, let's call it that. Am I correct that your adjustment is 0.60, to 0.65? 295 MS. McSHANE: Correct. 296 MR. THOMPSON: Am I correct that Drs. B and B are 0.45 to 0.55? 297 MS. McSHANE: Yes. 298 MR. THOMPSON: So if we take their low and your high, however you get there, there's not that big a spread. They're at 0.5 at the upper end and you're at 0.6 at the lower end. Is that a big deal? 299 MS. McSHANE: Not if you view something in between them, no, but I mean, if you're looking at the mid points, then yes, it's a big deal. And it's a bigger deal depending on how big the market risk premium is. 300 MR. THOMPSON: Where is Dr. Cannon on that item? I thought you said he was below 0.45? 301 MS. McSHANE: Well, the way I read his evidence is that he says it's no more than 0.45. 302 MR. THOMPSON: Okay. So less than 0.45. I can put that in my chart, can I? 303 MS. McSHANE: He uses 0.45 in his application of the test, so if he uses 0.45, then presumably he believes 0.45 is a reasonable number. 304 MR. THOMPSON: Let's just stop there on that. So using that measure of market as a whole and the adjustment, risk adjustment that you've described, you multiply the adjustment times the market as a whole, and that produces a number; correct? 305 MS. McSHANE: Yes. 306 MR. THOMPSON: In your case the number is about 400. Is that the one you come up with? 307 MS. McSHANE: It would be about 390. 308 MR. THOMPSON: 390. And Dr. Booth and Dr. Berkowitz's case, am I correct, it ranges around 200. I'm just applying the math to these. 309 MS. McSHANE: It will be 50 times 4.5, so around 200, 225. 310 MR. THOMPSON: 225. Thank you. And where does Dr. Cannon end up on the risk adjustment times, the risk premium for the market as a whole? 311 MS. McSHANE: I'd have to take a calculation. I will. It's not hard. 312 I think if you just take the 0.45 times the 3.5, it would be about 1.6, but that may not be exactly the way he does it. 313 MR. THOMPSON: I'm trying to get your view on this, since you're responding to their criticism of you, and I'm trying to get a going-in, if I could, chart. 314 Now, that's one way of coming at the risk premium test, and I think you indicated you came at it some other ways as well, and if I understood your evidence correctly, you came at it from the utilities directly -- 315 MS. McSHANE: Correct. 316 MR. THOMPSON: -- using historic data, and then using what you call a DCF risk premium calculation? 317 MS. McSHANE: Correct. 318 MR. THOMPSON: And historic data, am I correct, you get a risk premium for the low-risk utility of between 475 and 500 basis points? 319 MS. McSHANE: That's the historical risk premiums, yes, for both the U.S. and Canada. 320 MR. THOMPSON: And then you do what you call a DCF risk premium determination, which Dr. Cannon criticizes as really -- a DCF calculation. He's saying you're using DCF in both the risk premium test and in the DCF test, so you're, in effect, double-counting the DCF test. 321 Do you recall that criticism? 322 MS. McSHANE: I do. 323 MR. THOMPSON: All right. Just before you respond to it, is the DCF number that you've come up with 460 basis points? 324 MS. McSHANE: Yes. The DCF-based risk premium result is 460 basis points. 325 MR. THOMPSON: And then your cushion amount is 50 basis points? 326 MS. McSHANE: Yes. 327 MR. THOMPSON: And Drs. Booth and Berkowitz have a cushion amount of 50 basis points? 328 MS. McSHANE: Correct. 329 MR. THOMPSON: Do Drs. Booth and Berkowitz come up with a risk premium for utilities from deriving it from utilities directly? Have they used this second branch of the risk-premium test that you've used? 330 My understanding is no, but -- 331 MS. McSHANE: I would say no. 332 MR. THOMPSON: What about Dr. Cannon? 333 MS. McSHANE: In this case, no. He used to, but he did not in this case. 334 MR. THOMPSON: So your overall risk premium for the low-risk OEB-regulated utility is 450 to 525 basis points; have I got that straight? 335 MS. McSHANE: You mean including the cushion and the floatation costs -- 336 MR. THOMPSON: Including the cushion. 337 MS. McSHANE: Yes. 338 MR. THOMPSON: This is your overall recommendation? 339 MS. McSHANE: Yes. 340 MR. THOMPSON: What's the overall recommendation of Drs. Booth and Berkowitz? 341 MS. McSHANE: I think it's 250. 342 MR. THOMPSON: 250, thank you. And the overall recommendation of Dr. Cannon is, what? 343 MS. McSHANE: Just based on the risk premium test? 344 MR. THOMPSON: Just based on the risk premium test. 345 MS. McSHANE: 1.6 percent. 346 MR. THOMPSON: 160 basis points? 347 MS. McSHANE: Yes. 348 MR. THOMPSON: Thank you. 349 So that's it for risk premium tests. Let's go, then, to the DCF tests. And my understanding is that you have derived this from a sample of U.S. LDCs; am I correct? 350 MS. McSHANE: Yes. 351 MR. THOMPSON: And for growth you've looked at long-term earnings growth and what you've also called sustainable growth? 352 MS. McSHANE: Correct. 353 MR. THOMPSON: And the long-term earnings growth is derived from what information? 354 MS. McSHANE: From the consensus of analyst forecasts that are provided by IBES, which is a Thompson Financial Corporation company. 355 MR. THOMPSON: And that number, am I correct, in the update is 11.0 percent derived from IBES? 356 MS. McSHANE: Correct. 357 MR. THOMPSON: You've then derived DCF from sustainable growth updated, and am I correct that the range is 10.8 to 11.4 percent? 358 MS. McSHANE: Correct. 359 MR. THOMPSON: You then add a cushion of 50 basis points and come up with an overall DCF amount of 11.5 percent? 360 MS. McSHANE: Correct. 361 MR. THOMPSON: Now, did Drs. Booth and Berkowitz apply, as far as you're concerned, a DCF test? 362 MS. McSHANE: No. 363 MR. THOMPSON: All right. Did Dr. Cannon apply the DCF test? 364 MS. McSHANE: Yes, he did. 365 MR. THOMPSON: And where did he end up? 366 MS. McSHANE: 7.9 to 8.5 percent. 367 MR. THOMPSON: Turning, then, to comparable earnings test, am I correct you looked at a sample of Canadian industrials, and your range was 12.7 -- or is 12.75 to 13.75 percent? 368 MS. McSHANE: Yes. 369 MR. THOMPSON: You looked at a sample of U.S. low-risk industrials? 370 MS. McSHANE: Yes. 371 MR. THOMPSON: And your range there is 14.0 to 14.7 percent? Have I got that straight? 372 MS. McSHANE: Yes, that's correct. 373 MR. THOMPSON: And then that led you, as I understand it, to an overall comparable earnings conclusion of 12.75 to 13.25 percent? 374 MS. McSHANE: Correct. 375 MR. THOMPSON: And am I correct that Drs. Booth and Berkowitz say comparable earnings is an unreliable test. They do not apply it. 376 MS. McSHANE: They do not apply it. 377 MR. THOMPSON: Then Dr. Cannon applied it? 378 MS. McSHANE: He did. 379 MR. THOMPSON: And his conclusion compared to your 12.75 to 13.25 is, am I correct, 10.2 percent. 380 MS. McSHANE: Not anymore. He changed it. He -- in a data request response, he discovered that he had erroneously included one company, and when he took that company out, he altered the result, and it's now 9.9. 381 MR. THOMPSON: Thank you. 382 And your overall -- you take all three tests into account, and am I correct that you say you weight them 37.5 for risk premium conclusion, 37.5 to the DCF conclusion, and 25 to the comparable earnings? Is that the way -- 383 MS. McSHANE: Yes. 384 MR. THOMPSON: -- you weighted them. And that leads you to 11.5 to 11.75? 385 MS. McSHANE: Correct. 386 MR. THOMPSON: And you say EGD is equivalent to the benchmark, and therefore it should be awarded 11.5? 387 MS. McSHANE: No. 388 MR. THOMPSON: No? 389 MS. McSHANE: what I said was that I am determining a return for an average risk utility, that would be Union. So they would be the benchmark, so to speak, and essentially Enbridge would be 15 basis below that. So it's essentially at the lower end of the range. 390 MR. THOMPSON: Well, you lost me there. 391 These numbers were before you updated for this morning, I think, for the -- 392 MS. McSHANE: No, I understood. Are you not looking at the February 2003 -- 393 MR. THOMPSON: No, I was actually -- I thought I got that from the tab 1 in this B binder. Sorry, maybe it's -- B.1, tab 1. Maybe it's the update. 394 Well, you tell me what your recommendation is, because I read it to be 11.5 for EGD -- 395 MS. McSHANE: Correct. 396 MR. THOMPSON: And 11.625 for Union. 397 MS. McSHANE: You're absolutely right, and the only -- only quarrel I'm having with what you're saying is calling Enbridge the benchmark, because -- look at page 10 of 11, lines 1 to 23. What I say here is that the midpoint of this 11.5 to 11.75 range, which is 11.625, applied to Union, which, as an average utility, effectively was considered to be the benchmark, and that Consumers -- and I apologize to you if I call it Consumers, because I called it that for years and years, and it's very difficult to change -- that it would be at the bottom end of the range, which is effectively, or close to 15 basis points below Union, the benchmark. 398 MR. THOMPSON: Okay. So the benchmark, then, you would put Union as the benchmark low-risk utility -- 399 MS. McSHANE: Well, I call it an average-risk utility, but -- 400 MR. THOMPSON: Average. Average. Anyway, that's the benchmark? 401 MS. McSHANE: Yes. 402 MR. THOMPSON: And in your view, Consumers is less riskier than the benchmark? 403 MS. McSHANE: Yes. 404 MR. THOMPSON: But the benchmark is 11.5 percent, whereas for Drs. Booth and Berkowitz, the benchmark, in their view should be 8.5 percent. 405 MS. McSHANE: That's their number of 8.5 percent. 406 MR. THOMPSON: Okay. And so there appears to be a 300 basis points spread between your position and that of Drs. Booth and Berkowitz; am I correct? 407 MS. McSHANE: That's correct. 408 MR. THOMPSON: And Dr. Cannon, there's even a larger spread between his recommendation and yours. His range, as I understand it, is between 7.5 and 7.8. Is that your understanding? 409 MS. McSHANE: It's my understanding, but I don't think that it's fair to say that the spread is effectively that high, because when I prepared my evidence and when Drs. Booth and Berkowitz prepared their evidence, we're both using a benchmark -- we seem to throw that term "benchmark" around a lot -- but a yield on long-Canadas of 6 percent. 410 So effectively my 11.5, and his 8.5 percent are premised on a similar level of interest rates. 411 MR. THOMPSON: Right. 412 MS. McSHANE: Whereas Dr. Cannon's number is premised on a 4.87 long-Canada, so we're really comparing apples and oranges, and if he were to, I guess restate or use his formula to put the return on the same basis, the 6 percent basis, it should give a result very similar to Drs. Booth and Berkowitz's. 413 MR. THOMPSON: What you're saying there, if I understand you, if you took the underlying long-Canada in Dr. Cannon's derived 7.5 to 7.8, moved it up to 6 percent, used his adjustment factor, for the benchmark at 6 percent, we would get about 8.5 percent. Have you done that calculation? 414 MS. McSHANE: I did do that calculation. 415 MR. THOMPSON: So on an apples-to-apples basis, there's about 300 basis points. At a 6 percent long-Canada, there's about a 300 basis points difference between your recommendation and the recommendations of Drs. Booth and Cannon. 416 MS. McSHANE: Correct. 417 MR. THOMPSON: And in terms, then, of the adjustment factor moving from this benchmark, currently the Board's guideline calls for what I call a 0.75, or 75 percent adjustment factor. If long-Canadas go up 1, the equity risk premium goes up 75 basis points; is that correct? 418 MS. McSHANE: If long-Canadas go up by one -- 419 MR. THOMPSON: The equity shrinks by -- 420 MS. McSHANE: The equity risk premium shrinks by 75 basis points and the return goes up by 75 basis points. 421 MR. THOMPSON: Right. And you're proposing a 50 percent adjustment factor, and Dr. Cannon, as I understand it, is recommending a 70 percent adjustment factor? 422 MS. McSHANE: Yes. 423 MR. THOMPSON: And Drs. Booth and Berkowitz are suggesting stay with the existing adjustment factor in the Board's guideline? 424 MS. McSHANE: Yes. 425 MR. THOMPSON: Thanks. 426 Moving from there, then, I'd just like to find out where we are -- well, just before I leave that, your long-Canada is now something less than 6 percent? 427 MS. McSHANE: It would be going forward, yes. 428 MR. THOMPSON: And the number I didn't get. What do you say the long-Canada is as we sit here today? 429 MS. McSHANE: Well, the forecast, as of the September consensus forecast was for a 10-year Canada of 5.05, to which I added -- because my formula that I recommended called for a constant spread, I added to that the constant spread I'd recommended, which was 35 basis points to come up with a 30-year Canada of 5.40. 430 Now, that's a bit different than what would happen under the Board's formula, which would call for using whatever the actual spread was, I believe, in the month before the forecast comes out. 431 MR. THOMPSON: The current long-Canada, as we sit here today, is 5.05? Is that -- sorry, that's the 10-year. 432 MS. McSHANE: That's the forecast for the 10-year Canada. 433 MR. THOMPSON: And you, under your approach that you're recommending here, would derive a 5.40? 434 MS. McSHANE: That's correct. 435 MR. THOMPSON: And you would use your adjustment mechanism to derive the currently recommended ROE, would be below 11.5, and it's down, I think you said, to 11 point -- 436 MS. McSHANE: 2 for Enbridge. So the 11.5 and the 11.2 are comparable numbers. 437 MR. THOMPSON: Right. Thank you. 438 Okay. Now, this application is premised on the notion that the Board's guidelines for determining ROE are no longer producing reasonable results as far as EGD and Union are concerned. Am I correct? 439 MS. McSHANE: Yes. 440 MR. THOMPSON: All right. So what I'd like to find out is where we are ROE with respect to the guidelines, and I served notice of this question on you yesterday as I was grinding away in my office in Ottawa, and hopefully someone will have done some calculations. 441 MS. McSHANE: Unfortunately, I'm not sure that we've gotten the ones you want, but let's try, and if need be, we'll take a second and see if we can't come up with the one you want. 442 MR. THOMPSON: Well, the benchmark for the guideline that the Board established was what? The benchmark ROE was based on a certain long-Canada and produced a certain ROE? 443 MS. McSHANE: Well, if we talk about Enbridge, my understanding is that in EBRO-495, the Board used a benchmark long-Canada of 7.25 percent. And the risk premium that would apply to Enbridge at 7.24 percent was 3.4 percent. So it gave a return of 10.65. 444 MR. THOMPSON: And so from that starting point, and bringing it up to today's forecast, the 7.25 has declined to, what, using the Board's mechanisms for deriving long-Canadas? That's the guideline mechanism. 445 MS. McSHANE: Okay, so what I'm going to do, because I don't know what the exact spread that they would use was, I didn't have a chance to go to the Bank of Canada web site and figure out exactly what it had been over the period they would use, I'm going to use the 35 basis point constant spread as an approximation. 446 Okay, is that fair? 447 MR. THOMPSON: Yeah, that's fine. So you're doing 10-year bonds plus 35 basis points. 448 MS. McSHANE: Right. Right. So we'll then have the 5.4 percent forecast that I spoke of in my examination in chief. 449 MR. THOMPSON: Right. 450 MS. McSHANE: So the decline from 7.25 to 5.40 is 1.85 percent. Take 75 percent of that, which is 1.3875, and we would subtract that from the benchmark return of 10.65, which would give us 9.26. 451 MR. THOMPSON: Okay. 452 MS. McSHANE: And if you did Union, the number is 15 basis points higher on the exact same basis. 453 MR. THOMPSON: Right. So as we sit here today, 9.26 guideline ROE for Enbridge and 9.41, roughly. 454 MS. McSHANE: Roughly, yes. 455 MR. THOMPSON: Does the guideline call for it to be rounded or do you recall? 456 MS. McSHANE: I don't believe that the guideline calls for it to be rounded. Certainly not to anything like the nearest 25 basis points, because I know that the numbers I've looked at are, you know, 9.61, 9.69. They're not rounded the way the BCUC ones used to be. 457 MR. VLAHOS: If I can help, Mr. Thompson, I believe the guidelines do call for rounding to 2 decimal places. 458 MR. PENNY: That's exactly right. 459 MS. McSHANE: Sorry, I was thinking more in terms of the 25 basis point rounding. But you're right. 460 MR. THOMPSON: So with respect to rounding then, it would 9.3 for Enbridge and 9.4 for Union? 461 MS. McSHANE: Two decimal points, so it would be the -- 462 MR. THOMPSON: Oh, I'm sorry, nice try. Right. 463 Well, if that guideline amount is compared to the -- we don't have the B and B recommendation -- let's just, excuse me, do this at 6 percent as well so we'll have consistent comparator to the number we're plugging in our chart. Just help me with that. 464 MS. McSHANE: I get, for Enbridge, 9.71. 465 MR. THOMPSON: And Union would then be -- 466 MS. McSHANE: 9.86. 467 MR. THOMPSON: So the guideline amount at a 6 percent long-Canada compared to your recommendation of 11.625 is 9.71 -- sorry, 9.86. 468 MR. PENNY: Yes. 469 MR. THOMPSON: So it's not quite 200 basis points difference. It's -- 470 MS. McSHANE: Right. 471 MR. THOMPSON: All right. 472 But the guideline amount compared to the recommendations of Drs. Cannon and Booth would be a hundred and -- well, rounded, 35 basis points higher. 473 MS. McSHANE: Right. 474 MR. THOMPSON: Now, again at 6 percent benchmark, the ERP implicit in the 9.71 and 9.86 are 3.71 and 3.86 basis points respectively? 475 MS. McSHANE: Right. 476 MR. THOMPSON: And if we divided each of those by 0.6 to get the implicit market as a whole equity risk premium, what do we get? I'm using the mid-point between your low and Dr. B and B's high. 477 MS. McSHANE: Sorry, if we did what? 478 MR. THOMPSON: What if the market as a whole premium implicit in these ERPs, assuming that the risk adjustment factor is 0.6? 479 MS. McSHANE: That's also including the flotation cost adjustment, whatever that might be. So it's going to overstate the -- 480 MR. THOMPSON: Well, just give me the math, and then we'll -- 481 MS. McSHANE: The math is 6.2. 482 MR. THOMPSON: 6.2 at what number? 483 MS. McSHANE: 3.71. 484 MR. THOMPSON: Pardon? 485 MS. McSHANE: 3.71. 486 MR. THOMPSON: 602 basis points. 487 MR. PENNY: 620. 488 MR. THOMPSON: I can now move into this in a little more detail. 489 I don't know, Mr. Chairman, what your plan was for taking a break. Do you want me to keep going? 490 MR. VLAHOS: If it's okay with you, Mr. Thompson, this may be a good time. According to the clock on the wall, it's ten minutes after 11:00. We will resume at 11:30. 491 --- Recess taken at 11:10 a.m. 492 --- On resuming at 11:27 a.m. 493 MR. VLAHOS: Please be seated. 494 MR. PENNY: Mr. Chairman, the witness is just making a pit stop on her way back to the hearing room. 495 MS. NEWLAND: I was trying to think of a nice way to say that. 496 MR. VLAHOS: Before we turn to Mr. Thompson, I do have the telephone number for the hot line, and it is (416)440-7608. 497 Mr. Thompson. 498 MS. NEWLAND: Mr. Chairman, just before Mr. Thompson resumes, Mr. Warren has asked me to ask Ms. McShane to confirm or to state again the two references that she mentioned in her examination in chief, the two articles, one was a book, one was an article, Ms. McShane, by Mehra and Prescott. The more recent one in 2003. Could you restate those references? 499 MS. McSHANE: The article is entitled, "The Equity Premium: Why Is It a Puzzle?" published in the "Financial Analysts Journal," January/February 2003, and the other was a chapter from the handbook of the Economics of Finance authored by Mehra and Prescott called "The Equity Premium in Retrospect," published 2003. 500 MS. NEWLAND: Thank you, Ms. McShane. 501 MR. WARREN: Thank you. 502 MR. THOMPSON: Are these articles in the record yet, do you know? 503 MS. NEWLAND: Mr. Thompson, they are not. We will endeavour to get copies and make copies available. 504 MR. VLAHOS: Mr. Moran, maybe you can give that undertaking. 505 MR. MORAN: Mr. Chair, that would be undertaking G.1.1, undertaking to produce copies of two articles. 506 UNDERTAKING G.1.1: TO PRODUCE COPIES OF TWO ARTICLES DESCRIBED 507 MR. VLAHOS: If they are not on the record. 508 MR. THOMPSON: At the break, Ms. McShane, we finally nailed down that the -- at a 9.86 guideline amount for the benchmark, 9.86 ROE percent, your recommendation of 11.5 is a hundred and -- what did I say -- approximately 164 basis points above the guideline amount. 509 MS. McSHANE: Yes. 510 MR. THOMPSON: So you're saying the guideline amount is 164 basis points too low; correct? 511 MS. McSHANE: Correct. 512 MR. THOMPSON: And we accept Dr. Booth and Dr. Cannon's evidence, they're saying it's 136 basis points too high. 513 MS. McSHANE: That would be correct, yes. 514 MR. THOMPSON: Okay. Sorry I struggled with that, but it's tough math for me. 515 Now, in the Booth and Berkowitz evidence, Exhibit D.2 at page 14, there is quoted there an excerpt from the Board's EBRO-497 decision about the durability is what I would describe it of the guideline formula, and the quote is: 516 "It's the Board's intention that the rate of return formula be reviewed when conditions arise which may call into question its validity. Any adjustment to the utility risk premium would be done only when there is a clear indication that the relative risks have changed." 517 And my question of you is: Did you consider the question of what constitutes a clear indication that the relative risks have changed, in the terms of basis points up or down of the ROE? Had it been only 25 basis points, would you have supported a request to change the benchmark? Had it been 50? Get my drift? 518 MS. McSHANE: I hadn't really thought about that. I think that if I had thought that the return was within, say, 50 basis points of what I'll consider fair and reasonable, no, I wouldn't have recommended that the company necessarily go through this process. 519 MR. THOMPSON: Okay. Now, can you tell me what 150 -- well, what 100 -- what relief is being sought in this case by EGD and Union? And this is part and parcel, I think, of the information that's contained under Exhibit B.1, tab 1. This is the Enbridge Gas Distribution request, and then it goes on to talk about Union's request. 520 I don't know if you're equipped to testify to this, but my understanding is that Enbridge is looking for an increase in its ROE effective October 1, 2002; is that your understanding? 521 MS. NEWLAND: Mr. Chairman, Mr. Thompson, I should, perhaps clarify that we haven't filed any information in respect of what I'm about to say, but the position of Enbridge is that we would be looking for a prospective change in the ROE. We would not be looking for any retroactive application. I hope that would assist you, Mr. Thompson. 522 MR. THOMPSON: Well, could you tell me, then, what that means? Are you looking for a change in ROE effective October 1, 2003, or some date after that? 523 MS. NEWLAND: I said prospective, Mr. Thompson, so I suppose what we have in mind is we don't know when the Board will issue its decision but from the date of its decision onwards. 524 MR. THOMPSON: Okay, so it's only forward-looking. 525 MR. PENNY: That's true for Union as well, Mr. Chairman and Mr. Thompson. 526 MR. THOMPSON: Is that a change of position? Because -- 527 MR. PENNY: In Union's case, it is not a change in position. 528 MR. THOMPSON: No, I appreciate that. I'm talking about Enbridge. 529 MS. NEWLAND: It's a change from the position we articulated in response to an undertaking earlier on, Mr. Thompson. 530 MR. THOMPSON: All right. Well, my understanding was, Ms. Newland, I don't know if you're aware of this, but Enbridge was quite insistent in the 2003 case, the 2003 test year case, as well as the 2004 case, that decisions elsewhere dealing with ROE would flow through, as I understood it, the claims for relief they were making in those cases. But perhaps now that you're exposed to a refund, the position has changed. 531 MS. NEWLAND: I don't think that's what we're saying, Mr. Chairman and Mr. Thompson. We're just saying that we have revised our position, and it's now that we would only seek prospective relief. 532 MR. THOMPSON: And Mr. Penny, my understanding is Union is seeking relief effective January 1, 2004, in its 2004 rate case. 533 MR. PENNY: That's correct. 534 MR. THOMPSON: And am I correct, Mr. Penny, that the impact for Union's ratepayers of the relief that you're seeking for the 2004 test period is about $34 million? That's gross revenue requirement impact. Would you take that subject to -- will somebody take it subject to check? 535 MS. McSHANE: I'll take it subject to checking. 536 MR. PENNY: We'll confirm and advise the Board and the parties. 537 MR. THOMPSON: Well, that's a great victory right there. I think I'll just pack up. 538 MR. PENNY: Sounds good to me. 539 MR. VLAHOS: Mr. Thompson, maybe we should give the undertaking, after all, for the company to produce the gross revenue requirement that would arise out of their requests. Did I phrase that correctly? 540 MR. THOMPSON: Yes, I guess for Enbridge, it would be for the 2004 test year. 541 MR. VLAHOS: Is there a rate base for 2004 for Enbridge? If there isn't one, maybe we should take one that's already actually approved by the Board. You're looking at both companies, Mr. Thompson. 542 MR. THOMPSON: I'm happy that the information be provided, and perhaps the company could indicate to the Board whether this position that they've just outlined this morning has been communicated to the Board or to stakeholders before this morning? 543 MS. NEWLAND: Mr. Chairman, the position that I articulated this morning has not been communicated either to the Board or to stakeholders before the morning. It is a recent decision of the company in this regard. 544 MR. THOMPSON: All right. Well, just to track it through with a little more detail with respect to Enbridge, Enbridge applied with the Board and obtained relief for 2004 based on a percentage increase in rates of 1.8 percent, and the Board approved that subject to some true-up mechanisms to guard against 2003 overearnings and the possibility of 2004 overearnings. 545 I'm just a little bit confused now as to how, in a scenario where ROE is set at less than the benchmark amount, the Board, in Enbridge's view, is to deal with that in the 2004 rate mechanism that's been established. 546 Can someone perhaps take an undertaking to respond to that? 547 MS. NEWLAND: Mr. Thompson, I think perhaps I'll take that undertaking, and we will endeavour to respond as quickly as possible. 548 MR. VLAHOS: Mr. Moran? 549 MR. MORAN: Mr. Chair, I think we're dealing with two undertakings at the moment. G.1.2 will be to produce a calculation of the gross revenue requirement that flows from the ROE requests by the two companies. 550 UNDERTAKING NO. G.1.2: TO PRODUCE A CALCULATION OF THE GROSS REVENUE REQUIREMENT THAT FLOWS FROM THE ROE REQUESTS BY THE TWO COMPANIES 551 MR. MORAN: With respect to what Mr. Thompson and Ms. Newland have agreed on, I'm not sure if I can capture it accurately. 552 MS. NEWLAND: I can't either, Mr. Moran, I was just going to check the transcript at noon. Maybe, Mr. Thompson, can you articulate in a more precise manner what it is you're seeking? 553 MR. THOMPSON: Has Enbridge explained its position with respect to how a reduction in the benchmark ROE they've sought in this case will impact the 2004 revenue requirement in the context of the Board's decision approving the partial settlement, subject to some earnings-sharing safeguards. 554 Hopefully that's a little clearer, but... 555 MS. NEWLAND: Mr. Thompson, one further point of clarification. You say "reduction in the benchmark". Do you mean up or down? 556 MR. THOMPSON: When I say "reduction", I mean down. You're exposed to reduction in the benchmark of 136 basis points. 557 MS. NEWLAND: Okay. 558 MR. THOMPSON: If that materializes, how is that going to impact 2004 rates. 559 MS. NEWLAND: Okay. I understand, yeah. Thank you. 560 UNDERTAKING NO. G.1.3: TO HAVE ENBRIDGE EXPLAIN ITS POSITION WITH RESPECT TO HOW A REDUCTION IN THE BENCHMARK ROE ENBRIDGE HAS SOUGHT IN THIS CASE WILL IMPACT THE 2004 REVENUE REQUIREMENT IN THE CONTEXT OF THE BOARD'S DECISION APPROVING THE PARTIAL SETTLEMENT, SUBJECT TO SOME EARNINGS-SHARING SAFEGUARDS 561 MR. THOMPSON: Okay, let's move on to get another issue of scope of matters in issue in this case clarified. As I read the case, the issues are the benchmark ROE and the adjustment mechanism. Is that your understanding of the issues, Ms. McShane? 562 MS. McSHANE: Yes, it is. 563 MR. THOMPSON: And the equity component of EGD's capital structure and the equity component of Union's capital structure are not matters at issue in this case? 564 MS. McSHANE: Not in this case, no. 565 MR. THOMPSON: So that whatever business and other risks are covered by the equity component of capital structure are not matters at issue in this case? 566 MS. McSHANE: Not in this case, no. 567 MR. THOMPSON: Now, it's unclear to me whether you're suggesting that there are any material risks in EGD's and Union's circumstances since 1999 or there are not? My impression is they're both low-risk utilities then. They were both low-risk utilities then, and they're still low-risk distribution utilities now. Is that your position? 568 MS. McSHANE: Yes, it is. I am not making this assessment on the basis of changes in the underlying risks of the two utilities. 569 MR. THOMPSON: Okay. And according to the testimony, this is in Exhibit B.1, tab 1, the introduction piece, it talks about this issue of ROE being raised as early as I think the spring of 2001. This is when Enbridge first started whining about it. That's rhetoric. 570 MS. NEWLAND: It's uncalled for. 571 MR. THOMPSON: And I think you prepared some evidence around that time frame, the summer of 2001. Union got into the act, I think, in 2001, and I know that you've prepared some evidence when Union was trying to raise this issue in the context of it's customer review processes. 572 But can you help me as to when the issue surfaced as far as your involvement was concerned with these two companies? As I say, paragraph 3 of B.1, tab 1, page 1, talks about Enbridge raising it in May of 2001. It talks about Enbridge writing the Board on August the 16th of 2001. At 13, it talks about Union's evidence filed on July 30, 2001, proposing changes. 573 So when was it that you were consulted in connection with this matter? 574 MS. McSHANE: I don't recall precisely. My recollection is that it was early in 2001, but I'll have to check that for you to see when we started thinking about this. 575 MR. THOMPSON: Were you consulted first by EGD or by Union? Can you remember? 576 MS. McSHANE: I don't recall which one it was, to be honest with you. 577 MR. THOMPSON: And did they ask you whether the guideline was producing amounts that were reasonable, or did they tell you that, in their view, they were unreasonable? 578 MS. McSHANE: Well, I think it was -- there was some concern on their part that they were unreasonable, and they asked me if I believed that they were unreasonable and whether or not it made sense to go and ask the Board to review the guidelines. 579 MR. THOMPSON: Okay. And then according to the introductory testimony, paragraph 10, they say: "Ms. McShane's evidence confirmed..." and it's not clear what evidence they're talking about there, but I think you started filing evidence back in 19 -- sorry, 2001. But it's your evidence, certainly, that the return derived from the current formula does not much the results from the principal tests traditionally used to determine a fair return, paragraph 10, Exhibit B.1, tab 1, page 3. 580 MS. NEWLAND: I shall just point out for the record, Mr. Thompson, that this particular exhibit was not prepared by Ms. McShane. It's just prepared by the company as a summary or background of events leading to where we are today. 581 MR. THOMPSON: What I'm trying to get at, Ms. McShane, is was it your evidence that prompted the applications, or were the applications brought and then you were solicited to support the claims? 582 MS. McSHANE: Well, I think that the process was that the companies were -- expressed concern that the returns that the formula was indicating were unreasonably low, and they indicated that concern to me and asked me what my view on that was, and whether I believed that it will be appropriate to approach the Board to seek to have the benchmark revised. 583 MR. THOMPSON: All right. Now, this wasn't the first time you had been asked a question like this, was it? You had done virtually the same thing in B.C. in 1999. 584 MS. McSHANE: We had asked the BCUC to review its formula in 1999, yes. 585 MR. THOMPSON: I'd like to just take you to that, if I might. 586 And we have, Mr. Chairman, a book of cross-examination materials that I've provided to the company yesterday, so I believe Ms. McShane has had an opportunity to -- certainly knows that I'm going to be referring to this decision, and it should come as no surprise, but there are other materials in it as well. 587 MS. NEWLAND: This is the decision at tab 8? 588 MR. THOMPSON: Correct. 589 MR. VLAHOS: An exhibit number first, Mr. Moran. 590 MR. MORAN: Yes, Mr. Chair, Exhibit F.1.3, book of cross-examination materials filed by the CAC, IGUA, and VECC. 591 EXHIBIT NO. F.1.3: BOOK OF CROSS-EXAMINATION MATERIALS FILED BY CAC, IGUA, AND VECC 592 MR. THOMPSON: I wanted to take you, Ms. McShane, to -- 593 MR. VLAHOS: Mr. Thompson, just one second. 594 MS. NEWLAND: Mr. Chairman, I just wanted to mention that we did get a list of proposed cross-examination materials from Mr. Thompson yesterday. We didn't get -- we got it in bound form today. We don't -- it's been given an exhibit number, but that does not -- I wouldn't want anyone to take it from that that the companies, either Union or Enbridge, accept the information in this book. 595 I mean, obviously there are, for example, articles that no one is sponsoring, I gather, Mr. Thompson, without calling witnesses. 596 MR. THOMPSON: I'll get to each item under the tab in due course. 597 But right now I'm on tab 8, B.C. Public Utilities Commission, which is referred to in your evidence, I think, Ms. McShane. Do you recall? 598 MS. McSHANE: No. 599 MR. THOMPSON: I'll find it for you. It's referred to somewhere in all of the stuff that's emanated from your side. But you're familiar with this decision? 600 MS. McSHANE: Yes. 601 MR. THOMPSON: And this was a case heard in 1999; is that correct? Page 1 of the decision says "August 26, 1999". I think the text indicates the evidence was heard in the hearing in 1999? 602 MS. McSHANE: I believe that's correct, yes. 603 MR. THOMPSON: And what prompted this case, I suggest to you, was, first of all, the British Columbia Utilities Commission's formula, and the prospect that long-Canadas might fall below 6.6 percent; do you recall that? 604 MS. McSHANE: Not specifically, no, but that would make sense, because they did have a range on their formula. 605 MR. THOMPSON: Right. In other words, conditions similar to what we're experiencing today. Long-Canadas, when we started this case, were around 6 percent, and now with their update, they are forecast to fall below 6 percent; correct? 606 MS. McSHANE: That's true, that when we started they were around 6 percent and now they are below 6 percent. 607 MR. THOMPSON: And if you go to page 2 of the report, you were there representing a number of utilities; am I correct? 608 MS. McSHANE: Yes, I was. 609 MR. THOMPSON: And the utilities, I think, are shown on page 1, BC Gas Utility, Pacific Northern Gas, West Kootenay Power, and Centra Gas Fort St. John; is that your recollection? 610 MS. McSHANE: Those were the companies that the formula covers. 611 MR. THOMPSON: I note with interest that also participating in that case was the Canadian Gas Association supported by evidence from Mr. Olson. Do you recall that? 612 MS. McSHANE: I do recall Mr. Olson being there, yes. 613 MR. THOMPSON: Now, Enbridge and Union are members of the Canadian Gas Association; is that correct? 614 MS. McSHANE: Yes, they are. 615 MR. THOMPSON: Is the Canadian Gas Association really representative of distribution utilities? They're not a consumer? They're not a ratepayer, let's put it that way. 616 MS. McSHANE: They're an organization whose members are LDCs. 617 MR. THOMPSON: So they're really like a co-applicant, aren't they? They're another voice for Enbridge and Union. Is that the way you see it? 618 MS. NEWLAND: I'm not sure, Mr. Thompson, that's a fair question to put to Ms. McShane. 619 MR. THOMPSON: Let's talk about your BC experience. Did you collaborate with the CGA in that case? 620 MS. McSHANE: No. 621 MR. THOMPSON: They were there singing from the same hymn book but with no consultation. 622 MS. McSHANE: I did not consult with them in any way. 623 MR. THOMPSON: Did you in this case? 624 MS. McSHANE: I did not. 625 MR. THOMPSON: Okay. 626 Now, what sort of struck me about this case is some of the similarities between it and the case before this Board. 627 The Board in its decision describes, starting at page 2 and going on thereafter, your evidence in that case, the evidence of Drs. -- I think it was Waters and Winter in response. Would you take that subject to check? 628 MS. McSHANE: That's what the decision describes, yes. 629 MR. THOMPSON: And the issues were similar. You were using your rate of return on equity recommendations derived from -- was it the three tests you were applying there or two tests; can you recall? 630 MS. McSHANE: It was two tests. 631 MR. THOMPSON: What were the tests you applied there? 632 MS. McSHANE: The risk premium test and the comparable earnings test. 633 MR. THOMPSON: I see. And why was DCF excluded there? 634 MS. McSHANE: I hadn't used the discounted cash flow test for a considerable period of time. I used to apply it to industrial companies, and it really wasn't until -- let me back up. 635 I used to apply it to industrial companies and the low-risk industrial companies, and we got to a point that in the mid 1990s, when we went through the period of restructuring and recession, that the past earnings of industrials really were not indicative of future expectations, and so it became very difficult if not impossible to apply the test to low-risk industrials. 636 There is a certain amount of circularity in applying it to utilities, particularly when you only have achieved growth rates to rely on, and it wasn't until early in 2000 that I determined that there was a reasonable enough connection between the LDCs in Canada and the LDCs in the U.S. that one could use U.S. LDCs as a reasonable proxy for a Canadian LDC, as long as it was a low-risk LDC and it was a relatively pure-play LDC. 637 And at that point, we had consensus data for U.S. companies that would allow me to have sort of independent assessment of the growth expectations, rather than my inferring them from historic growth rates. 638 So in the 1999 time frame range, I wasn't quite prepared to do that yet, so that's the reason there was no discounted cash flow test. 639 MR. THOMPSON: So when did you add DCF to your portfolio of tests? 640 MS. McSHANE: I want to say that it was in early 2000, sometime in 2000. 641 MR. THOMPSON: The reports suggests at page 2 you were recommending a range of returns based on the equity risk premium of between 10.5 and 10.75 percent; is that correct? I'm looking at the bottom of page 2. 642 MS. McSHANE: Sorry, what page are you on? 643 MR. THOMPSON: Page 2 of the decision, page 43 of the book, the last two lines. 644 I read this to be your equity risk premium test range, 10.5 to 10.75 percent. 645 MS. McSHANE: That's what it says. 646 MR. THOMPSON: Well, is that what it was? 647 MS. McSHANE: I assume that it's correct. I don't have the testimony sitting in front of me to verify the results, but I have no reason to believe that they misstated the result. 648 MR. THOMPSON: In this case it's 10.5 to 11.25, right, at a 6 percent long-Canada? 649 MS. McSHANE: Correct. 650 MR. THOMPSON: Not much difference. 651 MS. McSHANE: Not a significant difference, no. 652 MR. THOMPSON: Over the next page, we see your comparable earnings, you were suggesting a range of 11.5 to 12 percent, and that's what you started out with -- sorry. Is that lower than what you have in this case or is it about the same? 653 MS. McSHANE: Yes, it is. 654 MR. THOMPSON: Your overall here is 12.5 to 17.25? 655 MS. McSHANE: That's right. 656 MR. THOMPSON: You're saying the comparable earnings went up since '99? 657 MS. McSHANE: Yes. 658 MR. THOMPSON: Is that what you're telling us? 659 Then we have the other side of the coin there, Drs. Waters and Winter, where they were suggesting 8 to 8.25. Do you see that on the next page? 660 MS. McSHANE: We're on page 3 now? 661 MR. THOMPSON: I'm on page 3. Not terribly different from the 8.5 in this case of Drs. Booth and Cannon at a 6 percent long-Canada. 662 The decision then goes on analyzing the requirements or the evidence with respect to the requirements of a fair return equity. Talks about the equity risk premium tests. The debate over the United States weighting and all of this business that follows at pages 5 and 6 and on, there's the usual debate about arithmetic mean and geometric mean. 663 At page 9 it talks about the forward-looking equity risk market premium and the debates that centred on that topic. It talks about relative risk measures at pages 10 and 11, and the debates that centred on that topic. 664 Then it talks about comparable earnings at page 13 and following, and the debates that centred on that topic, and then at pages 14 and following, we get to the commission determinations; correct? 665 MS. McSHANE: Yes. 666 MR. THOMPSON: And with respect to, first of all, the comparable earnings test, if you'd go to page 15 of this decision, page 56 of the book, the commission describes its concerns with the comparable earnings test. You see those? 667 MS. McSHANE: I do. 668 MR. THOMPSON: And that commission found that little reliance should be placed on the comparable earnings test in determining the appropriate rate of return on equity for a low-risk utility; do you see that? 669 MS. McSHANE: I see it. 670 MR. THOMPSON: And can you explain why -- what's your understanding of why they reached that conclusion? What were the frailties that were troubling that commission? 671 MS. NEWLAND: Mr. Thompson, are you asking Ms. McShane to explain her understanding of the Board's intentions when they made this decision? 672 MR. THOMPSON: Well, I was asking her to characterize the frailties that the Board expressed with respect to comparable earnings, yes. I assume she can do that, because these are the same kinds of criticisms that Drs. Cannon and Booth make of the comparable earnings test that you were discussing in your evidence in chief. 673 MR. PENNY: Mr. Chair, the difficulty I have with this portion of Mr. Thompson's cross-examination is that it's really arrangement. He's telling us what's in this decision. Well, we can all read the decision, and frankly, the question he just put to Ms. McShane, is to say, Well, what does it say about X? Why don't we just read it. This is purely argument. If he has a question that he wants to put to her, then let her, but why are we using up all of our time now, which is short, with Mr. Thompson presenting his argument. 674 MR. THOMPSON: That's fine. I'll move on. 675 In any event, Ms. McShane, that commission placed no weight on your comparable earnings test? 676 MS. McSHANE: No, it says it has placed little reliance on the comparable earnings test. 677 MR. THOMPSON: Right. And then that commission went on and talked about the forward-looking DCF risk based premium test utilized by Ms. McShane. This is in your risk -- this is some component of your risk premium analysis; correct? 678 MS. McSHANE: But these were based specifically on the outlook for the market as a whole, not on the utilities that I've used in this DCF-based risk premium analysis. 679 MR. THOMPSON: So the data base was different; is that what you're saying? 680 MS. McSHANE: Yes. 681 MR. THOMPSON: So what was the difference again? You were using their what? 682 MS. McSHANE: Well, in this paragraph on page 15 that talks about concerns, I believe that they're talking about the forward-looking estimates of the market risk premium that used analysts' forecasts of the market return or the market earnings, not specifically the analysts' forecasts for the specific LDCs that I've used in this particular evidence. 683 MR. THOMPSON: Okay. Going on, in the decision, they're dealing with the debate of the relative risk adjustment? 684 MS. McSHANE: Yes, I see that. 685 MR. THOMPSON: Would you agree with me that after considering your positioning, the relative risk adjustment you were proposing there was, I believe, 0.70; is that correct? 686 MS. McSHANE: I don't recall. If you point it out to me in here. 687 MR. THOMPSON: I think it's in the earlier part, but perhaps you would just take that subject to check. 688 MS. McSHANE: I will. 689 MR. THOMPSON: Would you agree that the commission adopt a relative risk for a benchmark utility of 0.6 which is the low end of your range in this case? 690 MS. McSHANE: Yes. 691 MR. THOMPSON: And what did the commission find was the, in effect, the ERP for the market as a whole in this case? 692 MS. McSHANE: 5 percent. 693 MR. THOMPSON: 500 basis points? 694 MS. McSHANE: Yes. 695 MR. THOMPSON: And then with respect to the automatic adjustment mechanism, you're recommending here 0.5, and would you take subject to check that the BC Commission adopted 0.8, within certain -- 696 MS. McSHANE: Within certain bounds, yes, they did. 697 MR. THOMPSON: So is it fair to say the type of proposition that you're advancing here to change the formula-based approach used by a regulator in Canada was rejected in BC in 1999? 698 MS. McSHANE: Yes, it was rejected, but having said that, and I think there are a -- there are more circumstances that have occurred since then that -- that call into question whether one should rely as heavily on the tracking of utility costs of equity and the long-Canada yield. 699 MR. THOMPSON: I'll come to those in a moment, because I don't want to cut you off, but has the decision in BC rejecting the attempt to scrap the formula -- sorry, to recalibrate the benchmark been challenged again in that jurisdiction to your knowledge? 700 MS. McSHANE: Not to my knowledge, no. 701 MR. THOMPSON: And in terms of this -- being this cooperation between -- well, not cooperation, the fact that CGA was there bolstering the utilities in that case and they're here in this case, are you aware of the lobbying effort that the CGA and CEPA, -- do you know what CEPA is? 702 MS. McSHANE: Yes. 703 MR. THOMPSON: What's that? 704 MS. McSHANE: The Canadian Energy Pipeline Association. 705 MR. THOMPSON: Are you aware of the concerted lobbying effort those organizations have been making to get ROEs jacked up. Do you know how far back that goes? 706 MS. McSHANE: I know that the CGA was concerned about it in '99, but whether they were concerned about it prior that, I don't know. 707 MR. THOMPSON: All right. I'll ask them when they get here. 708 What are the differences between the OEB guideline and the BC guideline? 709 MS. McSHANE: If we look at BC Gas as the benchmark utility, at 6 percent, the allowed risk premium is 3.5, and for Enbridge at 6 percent, we figured this out already, but I've forgotten the -- 710 MR. THOMPSON: 9.71. 711 MS. McSHANE: Thank you. 712 MR. THOMPSON: The OEB guideline appears to be more generous at 6 percent. 713 MS. McSHANE: The allowed return is slightly higher, yes, for Enbridge than BC Gas. 714 MR. THOMPSON: Did you take all that into account when you were asked by Enbridge and Union, can we get the OEB guideline amount increased? Did you discuss with them, I just was in BC in '99, and got cleaned? 715 MS. McSHANE: I -- I don't recall my conversations, but I try, when I talk to utilities, to inform them of all the circumstances that are relevant, and I certainly wouldn't have hidden that from them, and you know, if -- if they believed that that was an adequate reason for deciding that it was unreasonable to make that request, I'm sure they would have said so. 716 MR. THOMPSON: Well, rate of return cases in Ontario have -- I bet you a lot of people here that weren't involved in one of them, but you and I go back a long way, and when was the last time we had a full-blown ROE case in Ontario, to your knowledge? 717 MS. McSHANE: For one of the LDCs? 718 MR. THOMPSON: For one of the LDCs? 719 MS. McSHANE: It would have been EBRO-495 which would have been 1997. 720 MR. THOMPSON: About six years ago? 721 MS. McSHANE: That's correct. 722 MR. THOMPSON: For six years we haven't had to listen to this stuff, and hopefully we'll silence it for another six years. 723 But before that, you were a regular -- and you've been a regular presenter of ROE evidence over the year, and we can see that in the response to CAC, IGUA, VECC number 1. Would you turn that up, please. 724 MS. McSHANE: I have that. 725 MR. THOMPSON: And this is an interesting document, because what it has is -- well, let's just back up. 726 You've been with -- is it still called Foster & Associates? 727 MS. McSHANE: Foster Associates. Yes, I still am. 728 MR. THOMPSON: And that goes back to the '80s or even before? 729 MS. McSHANE: I started working at Foster Associates in 1981. 730 MR. THOMPSON: '81. Okay. Well, I started with this Board in 1973, and I didn't see you until '81, but at that time you were carrying the bags for Dr. Sherwin and giving him all the information that he needed; right? 731 MS. McSHANE: Yes, I was carrying his bags. 732 MR. THOMPSON: And eventually, you shunted him aside. 733 How is the old boy, anyway? 734 MS. McSHANE: We'll talk later. 735 MR. THOMPSON: All right. Anyway, this little chart here, this question asked you the date of your evidence and so on, but the bottom line, it compares your recommendations and the alloweds. Somewhere else in the record you indicate you've only acted for applicants; is that right? You've never been on our side of the -- 736 MS. McSHANE: I would be happy to be on your side if you agreed with my position. I'm not opposed to doing rate of return for anybody. I simply have my views of what the fair return is, and if you agree with me, I'll be happy to appear for you. 737 MR. THOMPSON: Okay. Well, looking at this track record, it's unlikely you'll be doing work on our side of the table, because if we look at the allowed returns versus your recommended, I think in every case you're high; is that right? 738 MS. McSHANE: Of course, that's the challenge, isn't it? 739 I'd have to find one where -- but I think, you know, to be fair, the boards have typically looked at the range of opinions that have been provided to them and typically have not said that one is 100 percent correct and the other one is 100 percent wrong and chosen one of the numbers. But, you know, they've realized that a fair return is not a simple mathematical exercise. There is judgment involved. And, to use one of the old boy's favourite expressions, it's not a number that -- I can't remember what the expression was, but something like you can't cut it on the edge of a knife or something along those lines. So, you know, one would expect that the Board's decisions are going to come out somewhere in between the various recommendations. 740 MR. THOMPSON: But again, this ties back to this question of has there been a material change since the Board put its formula into place? 741 What you're, in effect, asking for here is an ROE, benchmark ROE that is a hundred-and-some-odd basis points higher than the guideline amount; but if I look at your track record on recommendations, you have often been more than 100 basis points out. 742 My question is, given that track record, was that discussed with the company when you said, "I'm going to recommend 11.5"? 743 MS. McSHANE: I'm not sure what -- 744 MR. THOMPSON: When the guideline amount is 9.86. 745 MS. McSHANE: Are you asking me did they say, "Do you think you can do it based on your track record?" Is that what you're asking me? 746 MR. THOMPSON: Did you discuss with them the fact that your recommendations have been traditionally high? 747 MS. McSHANE: I don't think that I would have needed to have discussed that specifically with them in any event. I have done cost of capital work for both Union and Enbridge for a number of years, and Dr. Sherwin did before me, and clearly they are well aware of, you know, what the results have been relative to what's been recommended by me and other people. 748 So, you know, that wasn't a conversation that we necessarily had to have. 749 MR. THOMPSON: So did you even consider this question of material change -- that's my spin on the words that I quoted to you from Dr. Booth's evidence from the Board's decision -- or did you just do your thing and let the company make its decision? 750 MS. McSHANE: Do you mean, did I prepare the evidence ahead of time and then see if they thought it was compelling? 751 MR. THOMPSON: No. What I'm asking is this: The Board has said in this decision, it's cited at page 14 of Drs. Booth and Berkowitz's evidence, that "any adjustment to the utility risk premium would be done only when there a clear indication that the relative risks have changed." 752 Did you even consider that? 753 MR. VLAHOS: Mr. Thompson, just to be clear, I think you're referring to the guidelines, are you, the Board's guidelines? 754 MR. THOMPSON: Yes, I don't know, I don't have the guidelines. I've asked them to be produced, but this excerpt -- 755 MR. PENNY: Mr. Chairman, I think the quote is not from the guidelines. 756 MR. THOMPSON: It's from the decision. 757 MR. PENNY: It's from a decision. 758 MR. THOMPSON: Maybe we should get the guidelines, then. 759 Do we have those? I'd ask that those be available for filing. 760 MR. PENNY: We can certainly get a copy. I mean, they're on the OEB web site. We'll get a copy. I think there are several copies in the room. 761 MR. THOMPSON: Well, I don't have one. 762 MR. VLAHOS: Mr. Thompson, you're welcome to use my copy. I have a set, but I -- 763 Mr. Penny, maybe it's not available on the web site. It would be quite nice if it was. But I thought I was looking for them some time ago. 764 MR. PENNY: I thought that my assistant just printed it off for me recently, that's where she got it, but I might be wrong. But that's where I thought it was. She found it electronically somewhere. 765 MR. THOMPSON: Yeah, okay, so this -- I was actually referring to what I understand to be a quote from the Board's EBRO-497 decision, page 69, that's reproduced at page 14 of Exhibit D.2, but it appears to be essentially the same quote -- the same thrust that appears at the bottom of page 2 of the guideline, which has been handed to me under the heading "Term of the Rate of Return Formula." 766 Do you have a copy of that in front of you, Ms. McShane? 767 MS. McSHANE: Sorry, this is at the bottom of page 2? 768 MR. THOMPSON: Page 2 of what I've been handed. A two-page document entitled "Draft Guidelines", and the heading is "Term of the Rate of Return Formula." 769 MR. MORAN: Mr. Chair, perhaps this should be marked as an exhibit for the purpose of the record, since there's going to be evidence on it. 770 MR. VLAHOS: Well, it won't hurt. The full document, just to be clear about it, it is the two pages that Mr. Thompson referred to, but it is a compendium that goes a number of pages. It looks like -- on page 29 there are some appendices. It looks like 30-some pages. 771 MR. THOMPSON: The one I have, Mr. Chair, goes to 36 pages. The compendium is dated March 27. The guideline, as I understand it, is the two-page document that precedes it. 772 Do you have something like this, Ms. McShane? 773 MS. McSHANE: Yes, I do. I have exactly what you're talking about. 774 MR. THOMPSON: All right. The last paragraph, then, under the heading "Term of the Rate of Return Formula" says: 775 "An adjustment to the utility-specific risk premiums should be done only when there is a clear indication that relative risks have changed." 776 MR. PENNY: Well, that's what it says, but with the greatest of respect, perhaps the whole passage should be read because that talks about when an adjustment is made. That doesn't talk about when a party may ask for a review of the formula. That's dealt with in the first paragraph, and that's the question you're asking. 777 MR. THOMPSON: Well, not really. I was asking whether Ms. McShane had addressed the question whether the evidence in the context of the guideline ROE of 9.86 percent for the benchmark, and her defeat in BC, and this tendency to be high, whether she had considered this question of whether the evidence demonstrated a clear indication that the relative risk had changed. 778 Did you even consider that, or did you just produce your material and let the company decide? 779 MS. McSHANE: Okay, can we just sort of divide this up into multiple pieces? 780 First of all, what Mr. Penny just said was that this third paragraph in the guidelines, to my mind, goes to the question of whether or not there is enough information to come in and say, in the case of Union, Okay, we're a lot riskier than we were five years ago. We don't want 15 basis points anymore, we want 50 or something along those lines. 781 What I was considering when -- when I was putting together my evidence was what was in the other paragraphs which -- and which is found at page 5 of my evidence, where I talk about the fact that the Board's guidelines stated that it recognized that the formula might -- that by relying on the risk premium test, sacrifice contributions from other tests. It noted that the parameters and adjustment factors would have a cumulative effect on the results of the mechanism, and the Board concluded that the rate of return formula should be reviewed as questions arise that may call into question its validity. 782 And then I go on to say that in my opinion, there have been changes that would, indeed, suggest that the formula should be revisited. 783 MR. THOMPSON: Okay. Well -- what I take that to mean is this is that you really didn't consider whether there have some threshold level of materiality. You considered: We have a right to ask, and we've asked. 784 MS. McSHANE: I don't think that's fair at all. I mean, you've already asked me a little while ago whether -- if how big, you know, the difference would have to be between what -- being allowed and what I thought a fair return was before I would, you know, recommend to a client that they might go and have their return reviewed. 785 And so, you know, if I said 50 basis points, clearly there a consideration of materiality. 786 MR. THOMPSON: But what you told me in response to that question, you never considered it, before I asked the question. You considered it here today. 787 MS. McSHANE: Sorry then I -- I never considered -- I never sat down and said specifically what the number is, but I can -- I can tell you for a fact that if -- there will have to be what I would consider to be a material difference before I would recommend that a company undertake the effort to -- to have a formula revisited. 788 MR. THOMPSON: Let's move on. 789 In terms of the exercise of determining the ROE, you indicated earlier that it is an exercise of judgment. 790 MS. McSHANE: In part, yes, it is. 791 MR. THOMPSON: Well, as far as the Board is concerned, it's an exercise of judgment. 792 MS. McSHANE: The Board would be correct. 793 MR. THOMPSON: Well, the judgment is based on opinion evidence from people like you and others. 794 MS. McSHANE: Well, it is an opinion. The opinion is based on data and facts and circumstances, but at the end of the day, it's how you interpret and apply the data and the facts. 795 MR. THOMPSON: While you have your opinion based on certain data and certain facts, other experts have their opinion based on certain data and certain facts, and the Board considers those opinions and exercises its judgment, and I suggest in doing that, the Board can also apply its own special expertise; do you accept that? 796 MS. NEWLAND: Mr. Thompson, Mr. Chairman, I don't think that's a proper question to put to the witness who's here to present expert testimony. I don't understand what -- the relevance of Mr. Thompson's question. 797 MR. THOMPSON: Then I'll move on. 798 Would you agree with me, Ms. McShane, that the focus of the analysis that you're doing is the hypothetical, stand-alone, OEB-regulated distribution utility? It's not the parent? 799 MS. McSHANE: Absolutely correct. It's not the parent. 800 MR. THOMPSON: And in dealing with the hypothetical stand-alone OEB-regulated distribution utility, we have, in Enbridge and EGD -- sorry, in EGD and Union utilities protected in part by a plethora of deferral accounts; correct? 801 MS. McSHANE: They have a number of deferral account, that's correct. 802 MR. THOMPSON: Do you know whether the number of deferral accounts since 1997 has increased, decreased, or stayed the same? 803 MS. McSHANE: I haven't counted. 804 MR. THOMPSON: So you don't know. 805 MS. McSHANE: Don't know. 806 MR. THOMPSON: And in the hypothetical, stand-alone, OEB-regulated distribution utility, we have utilities who have their rates set or rebased under the auspices of a forward-looking test year rate-making regime; would you agree? 807 MS. McSHANE: In principle, yes, this is a forward-looking test year jurisdiction. 808 MR. THOMPSON: And would you mind turning up CAC/IGUA/VECC number 46. 809 What this is is a response of both Union and Enbridge with respect to the -- both the historic approved, the actual weather, and the normalized weather for the ROE for the period '90 to 2002 for Union; '90 to '97 for Centra; and '90 to 2002 for Enbridge. Are you familiar with these responses? 810 MS. McSHANE: Yes, I've seen these responses. 811 MR. THOMPSON: Taking Union first, it appears to me that in every year since 1990, except, looks like -- well, every year, I think the normalized ROE exceeds the historical approved. Would you take that subject to check? That's column 3 compared to column 1. 812 MS. McSHANE: And every year since what? 813 MR. THOMPSON: I say since 1990, the column 3 exceeds column 1 -- sorry, no, maybe I'm mistaken. 814 MR. VLAHOS: Mr. Thompson, I'm sorry, I hate to interrupt. We need some assistance here. Perhaps Staff can give us a copy of what they have because I seem to have only one page. How many pages are there? 815 MR. THOMPSON: The original response just had a chart with nothing in it. 816 MR. VLAHOS: Right. 817 MR. THOMPSON: And then the follow-up came as four pages, Mr. Chairman. 818 MR. VLAHOS: Okay. Thank you. 819 MR. THOMPSON: I see I misspoke myself. I think in fiscal '92, Union's normalized was below the approved, but other than that, higher. 820 MS. McSHANE: It's slightly lower in '91 as well. 821 MR. THOMPSON: Sorry, you're right. So 12 of 14 higher? 822 MS. McSHANE: On a normalized basis, yes. 823 MR. THOMPSON: That's the basis on which rates are set, normalized? 824 MS. McSHANE: Yes, that's the basis on which rates are set, but investors see the actual returns. 825 MR. THOMPSON: Well, an actual, whether -- I think in seven years they're higher, and in seven years they're lower, so they won seven times and lost seven times, by my count. Do you take that subject to check? 826 Probably not, since I screwed up the last time. 827 MS. McSHANE: Yeah, that looks like there's seven up and seven down. 828 MR. THOMPSON: And flipping over to Enbridge, I think I'm right here that all 13 years on a normalized basis, they beat the approved. Would you take that subject to check? 829 MS. McSHANE: Yes, on a normalized basis, that's what the chart shows. 830 MR. THOMPSON: On an actual weather basis, it appears to me that they beat the approved seven out of 13 years. Would you take that subject to check? 831 MS. McSHANE: Sorry, that they beat the -- 832 MR. THOMPSON: I make that they're ahead of the approved in seven years, 1990, '92, '93, '94, '96, '97, 2001. And I make that to be seven out of 13 years. 833 MS. McSHANE: You're right. That's seven out of 13 years. 834 MR. THOMPSON: And would you agree with me that's one of the benefits of the prospective forward-looking normalized test year approach to rate-making? 835 MS. McSHANE: Is what one of the benefits? 836 MR. THOMPSON: Is that you can beat the allowed in on a normalized basis in most cases? Therefore, the achieved returns on a normalized basis exceed the allowed? 837 MS. McSHANE: I don't know that that has anything to do with the forward test year. 838 MR. THOMPSON: What do you think it's the result of? 839 MS. McSHANE: Good management. 840 MR. THOMPSON: Could be what? 841 MS. McSHANE: Good management. 842 MR. THOMPSON: Good management, okay. 843 MS. McSHANE: I mean, the forward test year doesn't guarantee that you will be allowed revenues or costs that -- 844 MR. THOMPSON: I'm not suggesting it guarantees anything, but -- 845 MS. McSHANE: I guess I don't see what, in particular, the forward test year has to do with being able to exceed the allowed return on a consistent basis. 846 MR. THOMPSON: Well, it's an opportunity to earn a return greater than the allowed. 847 MS. McSHANE: But everybody has an opportunity to earn a return greater than the allowed. 848 MR. THOMPSON: Not if you're trued up monthly. 849 MS. McSHANE: That's true. I'm sorry. I thought perhaps you were making a distinction with, you know, a historic test year in that context, that you still have an opportunity to exceed the allowed. 850 But if you're talking about the forward test year as contrasted with a company like Foothills, who's on a cost of service basis, yes, you would have an opportunity to earn above, that companies that true-up don't have. 851 MR. THOMPSON: Mr. Chairman, I don't know what the plan is for lunch. Do you want me to keep going to one? 852 MR. VLAHOS: Are you moving to a new area, Mr. Thompson? 853 MR. THOMPSON: Yes, I am. 854 MR. VLAHOS: Perhaps, we will break now. It is a quarter to one. We will resume at 1:30. 855 --- Luncheon recess taken at 12:42 p.m. 856 --- On resuming at 1:35 p.m. 857 MR. VLAHOS: Please be seated. 858 Any preliminary matters? 859 MS. NEWLAND: No, sir. We are in the process of preparing some responses to undertakings, but we haven't got them yet. 860 MR. VLAHOS: Mr. Thompson. 861 MR. THOMPSON: Thank you, Mr. Chairman. 862 Just a clean-up matter that came up during the luncheon break. Mr. Penny relates to what Union was asking for in the material. Union was requesting that Ms. McShane's recommendations, as I understood them to be, be implemented for the purposes of earnings sharing in the, as I understood it, 2002, and 2003 test years of Union. Is that relief still being sought? 863 MR. PENNY: Let me get back to Mr. Thompson on that, if I can, please, so I can consult appropriately with my client. Thank you, Mr. Chairman. 864 MR. VLAHOS: I believe that's part of the first undertaking, Mr. Moran? I shouldn't say the first -- 865 MR. PENNY: We will consider it part of that. 866 MR. MORAN: The second one, I guess, Mr. Chairman. 867 MR. PENNY: The second. 868 MR. VLAHOS: And I'm sorry, Mr. Thompson, this is a schedule here on our -- on the dios. It says: "You total the rate base growth and earnings per share." 869 Now, is that a response to undertakings or a clarification? What is this document? 870 MR. MORAN: This is from Pollution Probe, and it hasn't been introduced yet. 871 MR. VLAHOS: Oh, I'm sorry. It has not, okay. 872 Go ahead, Mr. Thompson. 873 MR. THOMPSON: Thank you, Mr. Chairman. 874 I'd like to move on, if I could, Ms. McShane, to your testimony in Exhibit B.3. This is tab 3 starting at page 31 and following. 875 And I wanted to just get on the record the criteria that, in your view, apply to the setting of the ROE component of just and reasonable rates. You are aware that the Board has under, its statutory mandate, the obligation to set just and reasonable rates? 876 MS. McSHANE: Yes. 877 MR. THOMPSON: And under the OEB Act 1998, the Board will apply whatever methodology it considers to be appropriate in exercising that power. Are you aware of that? 878 MS. McSHANE: Generally aware that they have broad discretion, yes. 879 MR. THOMPSON: Now, page 32 of your testimony, you, at lines 3 to 6 say: 880 "A fair and reasonable return," I assume you're talking about equity return, "falls within a range bounded by the cost for attracting capital and the returns achievable by firms of similar risk to the utilities." 881 MS. McSHANE: Yes. 882 MR. THOMPSON: So it is a number that, for your purposes, falls within a range? 883 MS. McSHANE: Correct. 884 MR. THOMPSON: It's not the highest amount being paid to an entity within the sample that a utility is entitled to under your approach? 885 MS. McSHANE: No. 886 MR. THOMPSON: And would you agree with me that the purpose of establishing the ROE component of just and reasonable rates is to establish an equity return that's sufficient to allow the hypothetical stand-alone utility to attract equity capital on reasonable terms and conditions? 887 MS. McSHANE: That's one of the standard. 888 MR. THOMPSON: And is that's what's commonly referred to as the capital attract standard. 889 MS. McSHANE: Yes, that's often referred to as the capital attraction standard. 890 MR. THOMPSON: And would you agree with me that that concept envisages the hypothetical stand-alone utility attracting the equity capital directly from the capital markets? 891 MS. McSHANE: I don't know that it requires that it be that specific. Clearly, you know, a lot of utilities actually attract capital indirectly, but if you're talking about a stand-alone concept, then I guess in principle it must be true that as a stand-alone company, you will be attracting it directly from the marketplace. 892 MR. THOMPSON: All right. So that the self-serving wishes of the parent in a scenario where the utility is wholly-owned by the parent, the self-serving wishes as to the parent, as to the appropriate return are not relevant for the purposes of determining the fair return for a hypothetical stand-alone OEB-regulated distribution utility? 893 MS. McSHANE: The parent, as an investor, has to be bound by the same concepts as if it were a true stand-alone utility, that no parent should be able to expect that it will be allowed a return that is inconsistent with the basic standards that form the basis for determining that return. 894 MR. THOMPSON: And do we agree that the ROE to be set is a forward-looking ROE? 895 MS. McSHANE: Sorry, that the ROE to the -- 896 MR. THOMPSON: To be set? 897 MS. McSHANE: Oh, to be set. 898 MR. THOMPSON: Is a forward-looking ROE? 899 MS. McSHANE: Yes, it's applied by using tests that look forward, and typically it's applied on a forward-looking basis. 900 MR. THOMPSON: And it's a forward-looking market-based ROE? Would you agree with that? 901 MS. McSHANE: Would I agree with that's the way it's done? 902 MR. THOMPSON: Are you asking me a question? 903 MS. McSHANE: Yes, I am. I'm asking to you clarify, please. 904 MR. THOMPSON: Well, is the exercise that the Board is engaged in to determine a forward-looking market-based ROE? 905 MS. McSHANE: That's part of what they're looking at. They are looking at what the forward-looking cost of attracting capital is. They're looking at what the forward-looking comparable returns are in the marketplace, and they are also looking, to my mind, at the forward-looking achievable returns on a book basis for comparable risk companies, because that's another way of looking at comparable returns. 906 MR. THOMPSON: And the forward-looking market-based ROE is, do we agree, applied in regulated entities in this jurisdiction, to an original cost rate base? 907 MS. McSHANE: The return is certainly applied to an original cost rate base. 908 MR. THOMPSON: And in deriving the return, the point of departure is the risk-free long-Canada rate or some measure of the risk-free rate, not the corporate-specific debt issues? 909 MS. McSHANE: I guess I don't quite understand what you mean by the question. I mean, there are various ways of looking at what an appropriate return is. If you're applying a capital asset pricing model, in particular, then you would be looking at a risk-free rate, but that doesn't mean that looking at the cost of debt for -- for utilities doesn't provide you some additional information about the size of the risk premium. And, in fact, there are -- there are places in which you can find the test -- risk premium test as applied to different forms of securities than just risk-free rates described and used in regulatory proceedings, in particular. 910 MR. THOMPSON: Your presentation in this case, the ERP presentation, is based on applying an ERP for a stand-alone, low-risk OEB utility to the risk-free rate. 911 MS. McSHANE: That risk premium test is applied to the risk-free rate, that's correct. 912 MR. THOMPSON: And so the debt -- sorry, the utility-specific corporate debt issues are not the platform from which the ERP is applied? 913 MS. McSHANE: Not the platform specifically from which my ERP is applied, no. Having said that, that shouldn't lead you to conclude that looking at those yields is not an appropriate additional benchmark. It is. 914 MR. THOMPSON: It's not a benchmark. It may be an additional fact. 915 MS. McSHANE: Okay, factor. 916 MR. THOMPSON: Factor, and what weight the Board chooses to ascribe to it is for the Board to decide, but the benchmark is the risk free rate? 917 MS. McSHANE: In the context of the capital asset pricing model, that's correct. 918 MR. THOMPSON: Well, in the context of the ERP test. 919 MS. McSHANE: Okay. The ERP test, so to speak, is a very broad term. ERP simply means that you determine a risk premium over something. It's -- it's no more precise, really, than that. 920 MR. THOMPSON: You're not advocating an ERP test in this case to operate from the corporate specific debt issues. 921 MS. McSHANE: No, I'm not. All I'm trying to suggest is that -- that I think we're confusing how, you know, how I might have applied this test specifically here or other people in this proceeding might have applied it, or the Board might have applied it in the general concept of equity risk premium and the general concept of equity risk premium is much broader than just the way -- let me put it in terms of the way the Board's applied it, where it's come up with a market risk premium, a relative risk adjustment, a risk-free rate and perhaps a financial flexibility adjustment. That's one way of looking at the financial risk premium test but not the only way. 922 MR. THOMPSON: That's the way you're asking us to look at it. 923 MS. McSHANE: No. The only part I would say I would totally agree with on that is that I am applying a risk premium to a risk-free rate, but I have several different ways of looking at what that risk premium is over the long-Canada yield, not just going at the sort of capital asset pricing model type approach, which is determining the market risk premium and the market risk adjustment. As you discussed with me earlier this morning, the other two tests which look directly at the utility risk premium. 924 MR. THOMPSON: Well, you seem to be making a -- at least the way I understood your evidence in chief this morning, responding to some of the criticisms that have been made of you for referring to the corporate specific debt cost, you seem to be making a big deal out of the widening between -- of spreads between the long-Canada and the corporate yields on EGD and Union's bonds. Is it a big deal? 925 MS. McSHANE: I think it's a fairly big deal, yes. 926 MR. THOMPSON: I see. So how does that big deal factor into your recommendation? Have you sort of jacked up your risk premium because of it? 927 MS. McSHANE: I have certain -- no. I wouldn't say that I have done that, but I have certainly indicated that the increase in spread is one of the reasons that it's more critical to look beyond just a risk premium that tracks the long-Canada yield, because when you track the long-Canada yield to the extent these formulas do, you don't pick up the change in the relationship between the long-Canada yield and the utility bonds. 928 I have shown in my testimony that when you look at DCF-based risk premiums, that not only is there this inverse relationship between the equity risk premium and the long government bond yield, but there has also been a positive relationship between the equity risk premium and the spread on the utility bond yields, so it's reflected in my DCF-based risk premium test, which incorporates both the risk-free rate and the spread in utility bonds. 929 MR. THOMPSON: Well, we know that these spreads can ebb and flow; right? 930 MS. McSHANE: Yes, they can. 931 MR. THOMPSON: And we know that -- at least, I thought we knew -- that from your recommendations in past cases and as I understood your recommendations in this case, the ROE is to be derived from a reasonable indicator of the risk-free rate, which is long-Canadas. 932 MS. McSHANE: Are you talking about the way the formula should be applied after the fact? 933 MR. THOMPSON: The way the formula should be derived is adding a risk premium to the risk free rate represented by long-Canadas? 934 MS. McSHANE: I think that's still the most objective, easily determinable variable, so in the absence of a better benchmark, I would say, yes, that we should continue to apply the equity risk premium to the long-Canada rate, but to recognize that there is not the same kind of tracking that is implicit in the formula right now. 935 MR. THOMPSON: Okay. Now, in terms of access to capital for Union and EGD, are you aware of any hard evidence to show they've had any difficulty raising capital for their utilities since 1997? 936 MS. McSHANE: Well, neither of them have been publicly traded for most of that period. I'm trying to remember if there was still a bit of a Consumers Gas float during that period. I can't recall. But neither of them have really had any opportunity to go out into the equity market and raise common equity on their own. 937 Now, whether they've had any difficulty within the organizational structure because they do compete for capital with other parts of the business, that I don't know. 938 MR. THOMPSON: Well, I'm taking that to be an answer, you do not have any hard evidence to show that Union or EGD had any difficulty in raising capital in the last seven years. 939 MS. McSHANE: No, because as I say, they're not publicly traded equities, so there's no market way to determine that. 940 But having said that, if you look at their debt, their interest coverage ratios have been quite close in the last few years to being at levels which make it difficult for them to raise capital, being in the 2.1, 2.2 times range. 941 MR. THOMPSON: Why do you say it's been difficult for them? What's the evidence of that? Interest coverage is tight? 942 MS. McSHANE: The interest coverage is quite tight, yes. 943 MR. THOMPSON: But if you'd look at the answer to School Board number 3, interrogatories of the Ontario Public School Boards Association, exhibit number -- I don't have it on my book. I'm sorry. D, tab 4, I'm told. C? 944 What we see here is, I think, the equity and debt issuance by Enbridge Inc. This the parent. And isn't it the reality that with EGD and Union Gas in Ontario, that generally they don't access equity capital through the marketplace. 945 MS. McSHANE: No, they would have to access equity capital through the parent, and the parent would have to decide that it wanted to use its equity capacity, so to speak, to fund additional equity infusions into either of the utilities. 946 MR. THOMPSON: What do we do with that in the context of the hypothetical stand-alone utility assessment of cost of equity, where the reality is these companies can't get it, except through the parent, which -- and the circumstances of the parent may have some bearing on the raising of equity. 947 Does that help us in ascertaining the extent to which the ROE allowed to these companies is too high or too low? It sort of masks the reality of the situation, because we don't have any market tests whether it's too high or too low. 948 MS. McSHANE: I think when you are the subsidiary of a publicly-traded company, then, yes, it becomes very difficult to look at the parent company's market value and determine what, if anything, that says about the adequacy of the return for a particular subsidiary. 949 MR. THOMPSON: Would you agree with me that one way of, in view of this difficult, we can't tell how the common stock of the stand-alone is trading, because it doesn't trade, but one way of ascertaining whether the return is too high or too low is to see what happens when they're sold. At that point, we get a market-to-book assessment. 950 MS. McSHANE: Yes, you would get a relative market-to-book valuation of the sale. 951 MR. THOMPSON: And that, then, brings me to tab -- tab 10 of Exhibit F.3, to which there needs to be added a BMO Nesbitt Burns report dated September 17, 2003, just hot off the press. 952 And under this tab, Ms. McShane, at tab 10, there are documents which we have provided to you last night. The first one, page 79 of the book, Fortis takes out Aquila, AB, and BC, and it's dated September 15th, 2003, and it's a discussion of Fortis Inc.'s plan to acquire Alberta and BC-regulated electricity businesses. 953 Are you aware of the transaction in this -- 954 MS. McSHANE: I'm aware that the transaction took place, yes. 955 MR. THOMPSON: And that the initial document was a report provided by -- maybe a news release provided by Jocelyn Parry, the manager of finance, and what I've just handed out is the September 17th, 2003, comment from BMO prepared by Karen Taylor; would you agree? 956 MS. McSHANE: That's what they are, yes. 957 MR. THOMPSON: I'll come back to that in a moment. 958 The next document, starting at page 82 is a credit rating report arising from Altalink LP's purchase of TransAlta's transmission assets. 959 MS. McSHANE: I have that. 960 MR. THOMPSON: There's no third document, but the so-called Witness A refers to the -- page 88 is entitled "Market-to-Book Premiums on Recent Acquisitions of Regulated Assets," refers to the Altalink transaction and the DBRS data that starts at page 82. It also refers to TCPL's land acquisition of Foothills. Are you aware of that transaction? 961 MS. McSHANE: Yes, I am. 962 MR. THOMPSON: Are you aware that the purchase value to equity book value is as shown in this document, $105 million; purchase value to equity book value, $65 million. 963 MS. McSHANE: I was not aware of those data, no. 964 MR. THOMPSON: Would you take them subject to check? 965 MS. McSHANE: I would take them subject to check. 966 MR. THOMPSON: And then the Fortis acquisition of Aquila, the information contained there was derived from the information contained in the document initially included in the books, starting at page 79. Would you take that subject to check? 967 MS. McSHANE: I will take it subject to check, yes. 968 MR. THOMPSON: And the big picture here is that these regulated utilities are being acquired at a fairly significant market-to-book premium; would you agree? 969 MS. McSHANE: I would agree that they are being purchased at significant premiums to book value, yes. 970 MR. THOMPSON: And my client contends that that's a strong indicator that the currently-allowed ROEs for those utilities are more than what investors require. Do you draw the same conclusion? 971 MS. McSHANE: Certainly in the case of Altalink, I think that that would be very difficult to say, since Altalink was set up as a limited partnership with the expectation that there would be tax allowance that would go to its investors who might or might not be taxable. 972 One of its investors was a U.S. company, who potentially could have used the so-called double dip on interest expense deduction and increase its returns, so, you know, I think that from what I've read about Altalink that there certainly are factors that would have suggested that the new owners of the company thought that they could significantly enhance the regulated returns. 973 On the TCPL acquisition, I agree with you that it was bought at a multiple to book, but it seems to me that in the particular case of Foothills, if I were TCPL, I would certainly view that as a very strategic asset, particularly in light of the fact that there's an expectation of the gas coming out of the Mackenzie delta and TCPL then having the ability to control not only the NOVA system, the foothills system, the old Alberta natural gas system, so I think it would be very difficult to conclude that they were looking at this in terms of simply the rate of return, but the fact that that played into part of a very integrated system, which would give them significant control of the gas coming out of Alberta. 974 MR. THOMPSON: All right. 975 MS. McSHANE: And I haven't had a chance to really look at the Fortis situation to determine what the underlying assumptions may have been in that regard. 976 MR. THOMPSON: Let's see what Karen Taylor has to say about it. Page 2 of the additional Fortis Inc. document. 977 And I wonder, Mr. Moran, whether we should make this a separate exhibit? 978 MR. MORAN: Yes. 979 Mr. Chair, this will become Exhibit F.1.4, a document prepared by Nesbitt Burns Research, entitled "Fortis Inc., Details on Aquila Network's Acquisition." 980 EXHIBIT NO. F.1.4: DOCUMENT PREPARED BY NESBITT BURNS RESEARCH, ENTITLED "FORTIS INC., DETAILS ON AQUILA NETWORK'S ACQUISITION" 981 MR. PENNY: Mr. Chairman, Ms. Newland adverted to this a little earlier, Mr. Thompson is obviously entitled to put whatever document he wants to the witness, but he just refers to Ms. Taylor, who's the author of this report. She, of course, is not a witness and is not anticipated to be a witness in this case and I just point that out because that means in a sense this report is not in and of itself evidence. If Ms. McShane agrees with some of it, I suppose that might make it evidence, but by itself it's a piece of paper. 982 MR. THOMPSON: Well, it's an analyst's view I guess, Ms. McShane, and you rely on analyst views in your DCF test, I thought? 983 MS. McSHANE: I rely on the consensus of analysts' views, yes. 984 MR. THOMPSON: Let's take a look at this. You see in the detailed analysis section of this report, the author talks about the equity internal rate of return for the transaction. Is that another word for what the investor requires? 985 MS. McSHANE: Typically, the term "internal rate of return" applies to what the investor is going to get as opposed to what he requires. 986 MR. THOMPSON: Okay. Let's have it your way. The investor is going to get from this transaction 6.8 percent equity internal rate of return. 987 MS. McSHANE: I mean, I have to say I have no way of judging whether that's right or whether that's wrong. I find the phraseology interesting because she says: 988 "We note our assumed internal rate of return for this transaction is ..." 989 Is such and such. But to me, an internal rate of return is something you calculate, you don't assume. So I really don't have a good idea of what she means by this, and if it were me, and I wanted to know, I would call her up and I'd ask her, but you know, I really can't tell you what that's supposed to -- 990 MR. THOMPSON: Well, it's not rocket science. If you buy something that has an allowed return on equity, if you go to the next page, of 9.83 percent and you pay a big premium for it, the return you get from that 9.83 percent on what you paid falls. I think all this is saying is that we estimate that to be 6.8 percent. 991 MS. McSHANE: That may be what she's estimating. And then she goes on somewhere to say that she finds -- I forget what the term she used was: 992 "The transaction appears to be at the upper end of the relevant valuation range." 993 Which sounds to me like they may well have overpaid for it. 994 MR. THOMPSON: Yes, she's saying that it's slightly less than the equity internal rate of return of 7.8 percent that was estimated for the Terasen Gas acquisition of Centra Gas BC, October of 2001. 995 Again indicating a market indicator that these allowed returns are too high. People are prepared to pay a premium over book to get the return of 6.87 percent. 996 MS. McSHANE: I think the assumption is from the point of view of the analyst, is that this all they're going to earn is the allowed rate of return. And if you look at, for example, Fortis and what they talk about in terms of what they can do, they are talking about with the Aquila acquisition that they are going to be able to have diversification which is of value to them across the country. They're going to be able to have synergies which will cut costs for them, which they then say they will share with customers. They expect to see considerable growth, particularly in British Columbia, which would enhance earnings, and they are indeed, talking about PBR, which in conjunction with the high growth they expect in BC would presumably push the returns above the levels, perhaps, that Ms. Taylor is talking about. 997 MR. THOMPSON: Let's go to another current prospective expression of the forward-looking ROE. Go to tab 7 of the book. This is TD Economics topic paper, May 2003. They are prepared, I believe, by Craig Alexander, Senior Economist. 998 You've had an opportunity to review this? 999 MS. McSHANE: I've seen this before, yes. 1000 MR. THOMPSON: On the second page, "equities to delivery 7.75 to 8.75 percent." 1001 That's an analyst's view on a go-forward basis. 1002 MS. McSHANE: That's one analyst's view on what the return for the overall market will be in the next number of years. 1003 MR. THOMPSON: And it breaks down, if you look down the paragraph, first paragraph, to 7.75 percent over the long haul for Canadian equities, and 8.75 percent for U.S. equities. 1004 MS. McSHANE: That's his determination of what the return from the market will be. 1005 MR. THOMPSON: And then just to give another market -- another analyst's view of where we're going here, go to tab 2. This is investor -- this is "Falling down the earnings curve," investor-owned utilities, "Falling down the earnings curve," Richard Stavros, Public Utilities Fortnightly, July 1, 2003. And it's a report, I believe, on views expressed by Lehman Brothers. Is that your understanding of it? 1006 MS. McSHANE: Well, it's a report based on the view of an equities analyst at Lehman Brothers, who suggests that -- I find this sort of interesting. He's sort of determining that interest rates -- I'm sorry, that allowed returns are going to decline because he's looking historically here, and this in the first paragraph -- I'm sorry, the first column, last paragraph, where he talks about the fact that allowed ROEs have been 393 basis points above treasuries. But he's talking about since 1980. 1007 When you look at the returns back in the '80s, I don't think they have much relevance to today, because we did have a squeezing of the utility risk premium in those periods, and if you look at the trend in allowed utility returns in the U.S. -- in the risk premiums within the last decade, we're talking about spreads in excess of 5 percentage points. 1008 So, you know, I really don't think looking at this long-term average is particularly relevant to in terms of determining where these returns might end up. 1009 And as a matter of fact, when we're talking about what FERC is doing for electric utilities, where they're recognizing that it's important to give utilities an incentive to make the investments that will maintain and expand the infrastructure and, you know, looking at returns of in the high 12s with extra incentives if you actually build new plant -- or build new transmission facilities, we may see that the returns in the state jurisdictions are affected by that type of philosophy as well. 1010 MR. THOMPSON: Well, this individual, apparently wrote -- I'm looking at the second column. This is talking about the U.S. now where you tell us things are so great: 1011 "In fact, Ford writes, the current low interest rate environment is likely to lead to more rate cases and lower allowed returns." 1012 In the next paragraph he says: 1013 "However Ford says that he has begun to see staff recommendations in rate cases in the 9 percent range." 1014 Have you started to see that, too? 1015 MS. McSHANE: I've seen it for quite awhile. Sort of tongue in cheek I said to somebody at lunch when they didn't read the next sentence where it says staff people recommended 9.75 in New Jersey. And I said if we had no intervenors recommending 9.75 here we would be thrilled to pieces. But I certainly have seen staff people recommending in the 9s in New York and in Missouri where I've testified in the last few years, yes. 1016 MR. THOMPSON: Is the trend down in the States? 1017 MS. McSHANE: In allowed returns? 1018 MR. THOMPSON: Yes. 1019 MS. McSHANE: I look at these things quarterly, and in the second quarter of 2003, the average allowed rate of return was still over 11 percent. 1020 MR. THOMPSON: Well -- 1021 MR. VLAHOS: I'm sorry, are those new decisions? 1022 MS. McSHANE: Yes, those are new decisions that came out in the second quarter of 2003. 1023 MR. THOMPSON: Where was that, then, please. What decision are you referring to? 1024 MS. McSHANE: I'm not referring to any particular decision, and I probably don't have the piece of paper in front of me at the moment, but there is -- if you look at table -- this is in my initial evidence. Just this is really just illustrative, but if you look at the table 3 on page 29, and you can see in the -- the fifth column there where it says "Average Allowed ROE on U.S. Utilities," and it's dated from 1994 through 2002, and then it references a schedule, which on the schedule -- which is schedule 4, it gives you a bit more detail. 1025 But the -- these data are from -- taken from a publication for the U.S. called "Regulatory Focus, Regulatory Research Associates," which every quarter publishes a list of all of the decisions that have come out for electric and gas utilities during that quarter. And so the most recent publication which tracked decisions for the second quarter of 2003 showed that the allowed returns for electric and gas utilities in the U.S. were still over 11 percent. 1026 MR. THOMPSON: Just carrying on with the additional evidence, I guess, or additional indicators that what you're proposing here is too high, would you go to tab 3, please. This is talking about pension plans. 1027 You're aware of the problems that are surfaced with pension plans recently? 1028 MS. McSHANE: Yes, I'm aware -- 1029 MR. THOMPSON: Since the market crashed. 1030 MS. McSHANE: Yes, I'm aware of them. 1031 MR. THOMPSON: And this Globe and Mail article -- the copy is not the greatest, for which I apologize, but this report, if you look in the second column on the first page talks about the returns being earned by 104 companies, a sample. This is a portfolio return. They're says 7.5 percent down from 7.75 percent a year ago. 1032 MS. NEWLAND: Where is this? 1033 MR. THOMPSON: In the second column just up from the bottom. Begins -- it's actually the last paragraph in the second column: 1034 "Last year --" 1035 MR. PENNY: What numbered page are you on? 1036 MR. THOMPSON: Page 8. 1037 MR. PENNY: Oh, so not the first one. 1038 MS. NEWLAND: Another trick question. 1039 MS. McSHANE: So that's the number of their assumption what the overall portfolio return is for pension accounting purposes. 1040 MR. THOMPSON: Right. And then if you go to the next article -- 1041 MS. McSHANE: Sorry, are we going to tab 4? 1042 MR. THOMPSON: No. This in the same tab. All this stuff is by Elizabeth Church, and the next article is a July 15th article where it's talking about pensions and referencing a new study by UBS. Do you know what UBS is? 1043 MS. McSHANE: United Bank of Switzerland. 1044 MR. THOMPSON: If you go to the next page, top of the paragraph, the study argues 6 percent is a realistic target for portfolios comprising 55 percent stocks, 40 percent bonds, and 5 percent cash. You can go through the mathematics, but that suggests a return on equity of less than 10 percent; would you agree? 1045 MS. McSHANE: It probably would, yes. But don't forget this is pension accounting where these guys have every incentive to be as conservative as possible, because at the end of the day, they do have to be able to pay their retirees, and it's certainly not in their interest at all to even put in what their best estimate would be. 1046 They want to be able to, if anything, come in with a low number so that they can be sure that their pension liabilities will be funded, and particularly if they've had a period like they've had, where there are significant unfunded liabilities that they have to now make up for. 1047 MR. THOMPSON: Well, they are certainly coming down, but they didn't have a great track record in 2000, 2001, or 2002. 1048 MS. McSHANE: No, but -- none of us did. 1049 MR. THOMPSON: That's indicative of investor expectations, I submit. 1050 MS. McSHANE: Oh, I say it's partly investor expectations, and partly a reaction to being in a position where these pension plans are significantly underfunded, and there is a need to make it up, and make it up quickly, because we have -- the baby-boomers who are coming up to retirement, and these companies are going to have to start paying out. So they have every incentive, as I said, to be extremely conservative. 1051 MR. THOMPSON: Let's get a little closer to home. If you go to page 4, Exhibit B.2 - this is from the Booth and Berkowitz testimony - you'll see a reference there to the 2002 annual report of EGDI. 1052 MS. McSHANE: Sorry, what tab are we on? 1053 MR. THOMPSON: Exhibit D.4. 1054 MR. MORAN: D.2. 1055 MR. THOMPSON: D.2, I'm sorry. 1056 MS. NEWLAND: Are you abandoning this for now? 1057 MR. THOMPSON: Where there's a reference to the 2002 report of EGDI. 1058 MS. McSHANE: Sorry, what page were you on? 1059 MR. THOMPSON: Page 4, line 6 in the bound book. 1060 MS. McSHANE: I have that, thank you. 1061 MR. THOMPSON: Where 7.75 is apparently forecast there, and again, that's a portfolio return which, depending on what portfolio is assumed, could well produce an ROE of less than 10 percent. 1062 MS. McSHANE: Again, this is the same question as before where we are talking about a pension fund -- 1063 MR. THOMPSON: We're talking about -- I'm sorry. Finish, I'm sorry. 1064 MS. McSHANE: And the same would hold for the pension fund of EGDI, that there would be a very conservative assumption made on what the investment return would be so as to make sure the pension fund is funded. 1065 MR. THOMPSON: Well, where do they get the basis for the assumption? Do they not get it from the market people like yourself? They don't just pick a number out of the air and say, "This is conservative, I'll go with it," do they? 1066 MS. McSHANE: They may well get a range of numbers, and certainly use something that is conservative, yes. I mean, I have talked to people who decide what numbers that they're going to put in and they have conveyed that they will tend to use the most conservative numbers. 1067 MR. THOMPSON: Do you provide ROE estimates for pension purposes? 1068 MS. McSHANE: No, I do not. 1069 MR. THOMPSON: You would be too high. 1070 MS. McSHANE: I would give them my best estimate and then they would put in something conservative. But the point is, if you have a range of numbers, then they're going to have something that's on the low side to ensure that they can cover the liabilities that they have incurred. 1071 MR. THOMPSON: Do you know what EGD's current assumption is for pension purposes? The long-run return -- 1072 MS. McSHANE: You mean, do I know whether they've changed it? 1073 MR. THOMPSON: Well, do you know what it is; and then my second question is, is it going down or up? 1074 MS. McSHANE: I don't know. I haven't spoken to them about it recently. 1075 MR. THOMPSON: Is that in the public record somewhere? 1076 MS. McSHANE: It wouldn't be in the public record unless it was in a subsequent annual report or a report to shareholders. 1077 MR. THOMPSON: What about Union, do you know what they're assuming for pension investment purposes? 1078 MS. McSHANE: I have not looked at that, no. 1079 MR. THOMPSON: All right. Well, all of that stuff was a strong indicator to my client that your estimates were on the high side, and that the estimates of Drs. Booth and Cannon were more in line with market expectations, and certainly the guideline ROE was, if anything, in the ballpark. Would you like to comment on that? I'm giving you a chance to. 1080 MS. McSHANE: Well, I think you do have to make a distinction between, first of all, what people may be looking at for short-term planning horizons for returns. But the returns that are oftentimes cited, like in this Toronto Dominion study, they aren't really the same as determining an equity risk premium that explicitly has -- explicitly comprises a premium for risk. It's simply an estimate based on, "Well, if the dividend yield is X and the growth in the economy is Y, inflation is Z; I add up those three numbers and that gives me an estimate of what the market return is." 1081 There's nothing built into that whatsoever for the possibility that inflation will be different, growth will be different, that any number of factors may occur that -- that will take that return and make it different from this sort of best-expectation-if-everything-goes-right number. 1082 So I think we have to understand that there is a distinction between those two values, and the one thing that history does do for us is gives us a sense of how things have varied over time. And to me, that is probably a better way of trying to capture all of the different potential events that can impact on the return in the future. 1083 MR. THOMPSON: Well, let's talk about equity risk premium. Again, there's a lot of stuff out there recently on this topic, and my information is it's out there because of what's happened with the results of investing pension funds. That's triggered a lot of study of equity risk premium, premia, I'm informed, and that in the past this used to be a cottage industry for yourself, Dr. Booth, Dr. Berkowitz, and a few other ROE. I may be exaggerating slightly, but what prompted this plethora of studies recently of the ERP, in your view? 1084 MS. McSHANE: Well, I think I might have suggested, I think it started to be of some interest back in the mid '80s, when Mehra and Prescott revealed what they considered to be the equity risk premium puzzle which to their minds said that the returns that had been achieved historically were higher than one would expect using measures of what they referred to as risk aversion. And the returns were too high, essentially, for the amount of risk people were taking on. That was their contention. 1085 And there were a number of studies in the interim that looked at what the forward-looking return might be, but it was really the zooming market in the '90s that started to give rise to some of these studies, particularly when the market was still high, and people were starting to say that, "Well, with the market this high, clearly we can't have a return that high going forward, because in part, this has been produced by these increasing price earnings ratios." Which then, of course, the market crashed, the price earnings ratios declined by a significant amount. 1086 But I think right now we're sort of in a position where there's a significant amount of unease about the market, a lot of uncertainty, people are sort of bearish still and a bit scared of getting back into the market. I think there's a disconnect to some extent between what investors think the market is going to return and what they require to get back into the market. 1087 So there's an equity risk premium that's based on what investors require, and then there are some of these numbers that are well, sort of build-ups from, well, we have a dividend yield that's it's 1.5 percent; long-term economic growth is 3.5 percent; inflation is 2, and when we add those numbers up, what do we get? We get something in the range of 8 percent, but they certainly don't, as I suggested, build in anything for uncertainty or risk. 1088 MR. THOMPSON: Well, these studies that you referred to, they're not mentioned in your evidence by name. The only statement I can find with respect to the recent studies is at page 40 of 98 where you're asked a question: 1089 "How do you respond to recent studies that conclude that market equity risk premiums will be lower in future than have been achieved historically in the United States market?" 1090 And then you go on at length talking about many things, but I can find nowhere in here a reference to the recent studies. Is that a deliberate oversight. 1091 MS. McSHANE: No, it's not an oversight. I mean I simply didn't go in and try to take each study that I was aware of and say this is, well, I don't agree with this one or this one for whatever. I referred to them sort of in the aggregate without citing any particular one specifically. 1092 MR. THOMPSON: Okay. Well, perhaps we can just take a look at them, some of them. 1093 If you go to schedule 17 in Exhibit D.2, Drs. Booth and Berkowitz have summarized a number of them there. And the dates of the publications, I believe, are referenced in the footnotes. 1094 Were you familiar with all of these studies when you wrote your test model? 1095 MS. McSHANE: Yes. 1096 MR. THOMPSON: And do you accept that the market risk premium results of the studies are as shown in the last column? These are for the market as a whole; correct? 1097 MS. McSHANE: That's correct. I did not go back and actually match up each of these numbers with a study but -- 1098 MR. THOMPSON: Would you take them subject to check? 1099 MS. McSHANE: Yeah, I'll take them subject to check that this is an accurate representation. 1100 MR. THOMPSON: So the mean of those studies, a number of them -- are these names well known in financial circles? 1101 MS. McSHANE: Yes, absolutely. 1102 MR. THOMPSON: These aren't fly-by-nighters. These are lucid thinkers, are they? 1103 MS. McSHANE: Well, they're academics, and you can take that however you would. 1104 MR. THOMPSON: Are you an academic? 1105 MS. McSHANE: No. 1106 MR. THOMPSON: Well, I'll take that as I should. 1107 The mean is 4.13 percent, will you take that subject to check? That's 413 basis points as a whole, based on these studies. 1108 MS. McSHANE: If you just average them all together and say that they're all entitled to equal weight, yes. 1109 MR. THOMPSON: I think it's the mean. I'm not so sure -- anyway, that's what the numbers indicate, and your risk premium for the market as a whole is 600 to 650 basis points? 1110 MS. McSHANE: Yes. 1111 MR. THOMPSON: It seems to be quite out of whack with what these studies have shown. 1112 MS. McSHANE: It is higher than what these people are trying to say the forward-looking risk premium should be based on what they think investors should have expected in the past, in particular this -- we're talking about this Arnett and Bernstein article which I see you've provided. They're trying to go back to 1802 and sort of redetermine what investors might have expected at the time. 1113 And I think there is a lot of uncertainty in trying to get back into the minds of investors at that time, particularly when we were only dealing, as I said before, with a very small number of stocks. 1114 So I think that it's very premature for us to conclude that the history of the capital markets in this -- in the last half century in these two economies, Canada and the U.S., is not a relevant benchmark for the future. 1115 MR. THOMPSON: Finished? 1116 MS. McSHANE: Yes, thank you. 1117 MR. THOMPSON: Well, you folks delivered to us -- I don't think I need to file it, because I guess you can use it in your cross-examination of Dr. Booth -- but another article by Dimston, Marsh, and Stonton. It's the run in addition I believe referred to in this document, that is schedule 17. It's dated September 2002 entitled, "Global Evidence of the Equity Risk Premium." 1118 Are you aware that that was sent to us as something that was going to be put to Dr. Booth? 1119 MS. McSHANE: Yes, I was. 1120 MR. THOMPSON: And I'm reading from page 17 of this document, and it says: 1121 "We have illustrated --" this is the last page of what you provided to us in the conclusion -- "We have illustrated one approach that can be used to make such adjustments. The result is a set of forward-looking geometric mean risk premia for the United States, the United Kingdom, and for the world, all falling within a range of around 2.5 to 4 percent and a corresponding set of arithmetic mean risk premia falling in a range around 3.5 to 5.25 percent. These estimates are not only far lower than the historic premia quoted in most textbooks, but they are lower than those cited in surveys of finance academics." 1122 Is that conclusion consistent with what these authors said in their prior paper, or have you checked that? 1123 MS. McSHANE: I haven't checked that to determine exactly what the relationship between the numbers in schedule 17 and the numbers there are, but I think the numbers in the article that you're holding are a later -- they had another year of data that they added to the very long study that's included in schedule 17. 1124 MR. THOMPSON: All right. Let's go to one more piece of evidence of this narrow. If you will go to tab 5 of Exhibit F.3, Canadian Investment Review, summer of 2003. What's the stature of this publication? 1125 MS. McSHANE: The Canadian Investment Review? 1126 MR. THOMPSON: Yes. 1127 MS. McSHANE: The stature of it? 1128 MR. THOMPSON: Well -- 1129 MS. McSHANE: It's not the Journal of Finance, but it's not the Public Utilities Fortnightly. It's a respected -- 1130 MR. THOMPSON: Which one is better? 1131 MS. McSHANE: You know, it's a respected academic journal. 1132 MR. THOMPSON: Okay. Do you know Mr. Silgardo. 1133 MS. McSHANE: No, I don't. 1134 MR. THOMPSON: Another academic, obviously. 1135 MS. McSHANE: Actually, it says he's the chief investment officer for Barclay's. 1136 MR. THOMPSON: He's a smart boy. 1137 In any event, this article says: 1138 "The equity of --" I'm reading from the first sentence, "which is defined as the 10-year expected return difference between equities and government bonds is one of the most important numbers in finance." 1139 Would you agree with that? 1140 MS. McSHANE: It's certainly a very important number in finance, yes. 1141 MR. THOMPSON: "This figure influences strategic asset allocation decisions, pension, and retirement funding ratios, optimal manager mix, and the optimal combination of active versus indexed investments." 1142 Would you agree with that? 1143 MS. McSHANE: Yes. 1144 MR. THOMPSON: So it doesn't sound to me like this is a number that somebody would just low-ball because it's applied to pensions, which is the suggestion you were making previously about the pension number used by the companies that The Globe and Mail reported on. 1145 MS. McSHANE: Sorry, did you ask me a question? 1146 MR. THOMPSON: You were suggesting, as I understood it, that the equity return used by pensions, which would be a product of the expected return difference between equities and government bonds as being some very conservative number, whereas this preamble suggests to me a lot of thought goes into it. It's not just some low-ball number because you're -- 1147 MS. McSHANE: No, I'm not trying to say there was no thought that went into it, but what I was trying to say was that, for the particular group that we're talking about, there is an incentive to be conservative. 1148 MR. THOMPSON: The author writes in the last part of the paragraph: 1149 "Looking ahead, the global ERP as forecast by Barclay's global investors to be 4 percent." 1150 Are you aware of that? 1151 MS. McSHANE: I had not seen this before, no. I had an inkling from something I read that there was going to be this article in the publication, but I haven't seen it before. 1152 MR. THOMPSON: It goes on: 1153 "Importantly, this forecast is lower than the historic realized ERP of 6 percent since 1950." 1154 Which just happens to be the low end of your estimate. Do you agree with those numbers? 1155 MS. McSHANE: Which numbers? 1156 MR. THOMPSON: The 4 percent and the 6 percent? 1157 MS. McSHANE: How can I -- I mean, clearly, this is Barclay's forecast. How can I agree with the number? It's not my number. 1158 MR. THOMPSON: Well, you agree with other analysts' forecasts, factor them into your studies, and you reject criticism that they are too high. So I ask if you can accept those analysts' forecast? 1159 MS. McSHANE: No, my equity risk premium is 6 percent. 1160 MR. THOMPSON: And this author indicates that for Canada, the ERP is estimated to be 375 basis points for the market as a whole; correct? 1161 MS. McSHANE: Based on this formula that he's got in here, that's what his estimate is. 1162 MR. THOMPSON: Was there something wrong with the formula? 1163 MS. McSHANE: Well, it sort of suffers from the problem that I suggested before, that it's just a build-up of where the dividend yield is, where the real earnings growth is, and the capital gain, and there's nothing built in for risk at all or for uncertainty. 1164 MR. THOMPSON: No fat. 1165 MS. McSHANE: No, no risk. 1166 MR. THOMPSON: How can there be no risk in equity risk premium? 1167 MS. McSHANE: Because of the way you derive it. 1168 I mean, if you look at how these numbers are put together, look at Canada, for example, we have a dividend yield which is a very low number relative to history. We add on to that real earnings growth, inflation, which gives us the capital gain, but there's nothing in that number that gives us any consideration to the fact at that there is risk involved in those numbers. 1169 MR. THOMPSON: So you disagree with the number. I guess you disagree with all numbers that are less than six? 1170 MS. McSHANE: No, I simply disagree with the way this is built up and the conclusion that this would constitute a reasonable estimate of what an equity risk premium is. 1171 MR. THOMPSON: All right. Let's move on from those market indicators of equity risk premium to a portion of your evidence that puzzles me a little bit, and I've got to find the page. 1172 It starts at page 35. This a discussion of the equity risk premium test. And then you have at page 36, a statement that I'm a little bit confused about. You say: 1173 "It's critical to recognize that the equity risk premium test is a forward-looking concept." 1174 I understand that. It affects investor expectations. And somewhere in here you talk about, we have to be careful to recognize it's a return on -- oh, I guess it's pages 30 -- starts at page 32 and following. 1175 This goes back to our discussion that the ROE is a forward-looking, market-based return that's applied to the book value of Union and EGD. Do you recall discussing that? 1176 MS. McSHANE: I recall discussing it, yes. 1177 MR. THOMPSON: And here you say, this at line 23: 1178 "The application of a capital market derived cost of attracting capital to the historic rate base, in principle, means that the investment will trend towards the historic cost." 1179 Just explain what you mean there. 1180 MS. McSHANE: What it means is that the determination of the return using the discounted cash flow model or the equity risk premium test is implicitly based on assets that are trading at market value. 1181 So let's say I have assets that are trading at $15, and I determine that the return that investors require on $15 is 10 percent. So then I turn around and take that 10 percent and apply it to a book value, which is $10, not $15. 1182 So instead of getting earnings of $10 on $15, I get earnings of 10 percent on $10, which is a lower stream of earnings, and I would then expect that the value of that investment would go from $15 down to $10. 1183 MR. THOMPSON: Yes? And so what does that have to do with setting ROE? You're supposed to lock in the value somehow? 1184 MS. McSHANE: No, we're not supposed to lock in the value. That's obviously not the Board's job, to lock in the value of market-to-book ratio. But having said that, the role of the Board is to provide a fair and reasonable return. 1185 And part of the determination of what's fair and reasonable is the determination of returns that are comparable with those of alternative investments, and if by the alternatives earning returns, competitive company earning returns are such that they can maintain their book value -- I mean, I'm sorry, their market value above book value, there's certainly no reason that we would expect utility shares to trade at book value. 1186 And in particular, you know, I've discussed this whole concept of undercompetition you wouldn't expect competitive firms to trade at book value. You would expect their market value to equate to what it would cost to replace the assets, and that should, you know, for long-lived asset companies, be -- replacement cost should be above book value. 1187 MR. THOMPSON: Well, let's just track this through with an example. Let's assume you've got a rate base investment of $10, and the return allowed is 10 percent, so the investor gets a dollar. 1188 MS. McSHANE: Okay. 1189 MR. THOMPSON: Okay. And then in year 2, the return is reduced to 5 percent. 1190 MS. McSHANE: So the $10 is the rate base. 1191 MR. THOMPSON: Yeah, the return is 10 percent, let me just get my example. 1192 Would it be convenient for a break Mr. Chairman. I have a real stunner here, but I -- 1193 MR. PENNY: He lost his notes. 1194 MR. VLAHOS: That will be fine Mr. Thompson. It's 3 o'clock. Let's return at 3:20. 1195 --- Recess taken at 2:58 p.m. 1196 --- On resuming at 3:22 p.m. 1197 MR. VLAHOS: Please be seated. 1198 I have found that it's getting a bit hot in this room, so if you want to take off some layers, that would be quite acceptable. 1199 If I can ask counsel for the applicants, I should have known the answer to this question, but forgive me for asking it. I'm not sure whether either Union or Enbridge still issue their own paper debentures, other than commercial paper. If you have the answer to that question now, I'll accept it. If not, if you have some other point. 1200 MR. PENNY: Union still raises its own debt. 1201 MR. VLAHOS: It's own debt. 1202 And what about Enbridge? 1203 MS. NEWLAND: I'm advised Enbridge does as well, sir. 1204 MR. VLAHOS: It still does by itself or through an affiliate? 1205 MS. NEWLAND: Through its parent company, sir, but as Enbridge Gas Distribution Inc. 1206 MR. VLAHOS: Thank you for that. 1207 Mr. Thompson, any idea how long you have to go? 1208 MR. THOMPSON: I understand we're sitting until 5:00. My goal would be to finish, but my guess is I wouldn't be finished much before quarter to 5:00 but I'll get done one way or the other; I'll collapse, probably. 1209 MS. NEWLAND: Mr. Chairman, before Mr. Thompson gives us his stunner, I have two responses to undertakings. Would it be appropriate to file them now? 1210 MR. VLAHOS: Certainly. 1211 MS. NEWLAND: We have a response to Undertaking G.1.1, which have to provide copies of the two articles of reference by Ms. McShane in her evidence in chief, and those articles are by Mehra, and Mehra, both by Professor Mehra. 1212 And the second, Mr. Chairman, was an undertaking that was given by Ms. McShane and to Mr. Thompson, and it was Undertaking G.1.2, it was to: Please provide the 2004 revenue requirement impact using Ms. McShane's recommendation for Union and Enbridge. 1213 There are two pieces to this response. The first is an interrogatory response to CME in RP-2003-0048. That would comprise the response of Enbridge to the undertaking. 1214 The second piece of the response is a typed page, which is Union's response to the question. 1215 MR. VLAHOS: Thank you. 1216 Any other matters? 1217 Mr. Thompson. 1218 MR. THOMPSON: Thank you, Mr. Chairman. 1219 Now, Ms. McShane, I wanted to pick up on this discussion in your testimony about original cost, replacement cost, market value, and then the punchline that concerns me is -- appears at page 34, starting at the bottom of the page where you say: 1220 "Hence, when the allowed return on original cost book value is set, the market-derived cost of attracting capital should be converted to a fair and reasonable return on book equity so that the stream of dollar earnings on book value equates to the investors' dollar return requirements on market value." 1221 That struck me as a fairly unique concept in rate making in this jurisdiction. 1222 What were you getting at there? 1223 MS. McSHANE: I was getting at the idea that it is certainly reasonable to take the position that even if you're operating on an original-cost basis, that if the objective of regulation is to emulate competition, then you should be trying to set returns, returns in dollar terms, at the end of the day, that will equate to the types of returns that competitive firms of similar risk would earn. 1224 And that would, in principle, require making that kind of adjustment that's discussed at page 30 -- 34. On my copy it's 34 going over to page 35. 1225 MR. THOMPSON: All right. Let me just work this through. First of all, with respect to regulated utilities, they're regulated on original cost, and to the extent they have replacement capital costs, that gets added to the rate base? 1226 MS. McSHANE: Sure, it does. 1227 MR. THOMPSON: So if you start out with a rate base of $10, and you add -- or you replace an item of rate base where the replacement cost is more than it's original cost -- let's say it cost $1 and for you it cost $2 -- your rate base goes up to $11. 1228 MS. McSHANE: Right. 1229 MR. THOMPSON: So you get a return on the replacement cost as and when they're incurred? 1230 MS. McSHANE: Correct. 1231 MR. THOMPSON: And really, it's the only business in the free world where you buy a pin and your profit goes up, as long as you put it in rate base. That's rhetoric, in case you missed it. 1232 MR. PENNY: We've learned to tell the difference, I hope by now, all of us. 1233 MS. McSHANE: That's why the poker face. 1234 MR. THOMPSON: Let's just take an assumption here, an example, where we have a rate base of $10 and the ROE expectation -- assume it's all equity for the purposes of this example, in year 1 is 10 perfect, so the return is set at a dollar. 1235 Then in year 2, expectations in the marketplace drop. They go down to 5 percent, but there's no rate change. What happens to the stock price; it doubles, right? You're getting a buck -- 1236 MS. McSHANE: Okay, so I'm getting a dollar on rate base -- 1237 MR. THOMPSON: It's an extreme example, but extreme to make a point. It drops to 5 perfect, so all else being equal, the market price goes up to $20. So the market value of the share is 20 bucks -- 1238 MS. McSHANE: Gotcha. Yes. That's how the theory -- 1239 MR. THOMPSON: Then we go into year 3, and the company then says, Well, now it's back up to 12 percent and I want my market ROE, and I want it on my book -- not on book, but on market value. The market value of my shares is 20 bucks. 1240 You seem to be saying, Well, in year 3, we should get market ROE 12 percent on market value of the share which is then 20 bucks, which would be $2.40; right? 1241 MS. McSHANE: Okay. I've lost where you've gone with that. 1242 MR. THOMPSON: You start with an original investment of 10 bucks. 1243 MS. McSHANE: Yes. 1244 MR. THOMPSON: The return is 10 percent -- 1245 MS. McSHANE: I got that, yes. 1246 MR. THOMPSON: -- so your ROE in rates is a $1. You go into year 2. No change in rates, but the return expectations in the marketplace have declined. So people who have an expectation, want to get 5 percent, will bid up the stock price. 1247 MS. McSHANE: Yes. Yeah, okay. 1248 MR. THOMPSON: So at the end of year 2 -- 1249 MS. McSHANE: You've got a $20 stock price. 1250 MR. THOMPSON: -- you've got a market value of 20 bucks. 1251 MS. McSHANE: Right. 1252 MR. THOMPSON: Then we're going into year 3, and the company says, "Whoops, ROE, market ROE is now more than 10 percent," so they come in for a rate increase. And what you seem to be saying is the Board should be granting a market-based ROE on the market value of the shares. 1253 MS. McSHANE: Can we back up a minute. Year 3, just so I understand this, year 3, the required return went up to 12? 1254 MR. THOMPSON: To 12, right. 1255 MS. McSHANE: Okay, so whereas, in this theoretical example, the price was $20 in year 2, because the market return was lower than what the return the company was getting was; right? Now we're in year 3, and the stock price has gone back down below book value, presumably because the company is only earning 10, and the required return is 12, unless I haven't followed that correctly. 1256 MR. THOMPSON: Is that what your proposing here? 1257 MS. McSHANE: No. In fact, I think if we back up, I was trying to make the point that the theoretical proposition is that market value should be equal to replacement cost. There's no place in here that I am saying that the Board should try to maintain the market value of the stock. 1258 The market value of the stock will be what it is. All I was trying to say is that there is economic reasons why, under competition, market value would have a long-term equilibrium value that's higher than book value. And then, if we're considering regulation as -- or one of the objectives of regulation is to emulate competition, then there's no reason in that context to set returns to keep utility market values at 1, because it's not consistent with what you'd expect under competition. 1259 But I'm not suggesting in any way by what I've done here that the Board has a function to maintain whatever market value utility stocks may reach. 1260 MR. THOMPSON: Okay. Well, my suggestion to you is that with regulation, ROE regulation applied to original cost and, for that matter, replacement cost and growth -- rate base growth capital expenditures, the market-to-book ratio, ideally, should always be near 1. That is a feature of the form of regulation that's applied in this province; do you agree with that? 1261 MS. McSHANE: No. I agree that the original-cost book value is the way the return -- the base to which the return is supposed to be applied. But that doesn't mean to me that once you take that very objective base, that applying the return to it should result in a fair market value of market-to-book of one. 1262 It seems to me that a lot of this idea of original cost versus fair value came out of the whole idea of trying to set a fair value rate base and then a rate of return on a fair value rate base became a very circular exercise. 1263 So partly to avoid that kind of circularity, regulators adopted the original cost rate base concept as being sort of a very, as I said, objective point of departure, and then they can determine what the fair return on that was. 1264 MR. THOMPSON: Just take me through this and let's take that sentence. You say: 1265 "Hence, when the allowed return on original cost book value is set..." 1266 Just stopping there. What's the allowed return on original cost book value for EGD and Union Gas? 1267 MS. McSHANE: What is it? 1268 MR. THOMPSON: What is it, as we speak? Is it the benchmark ROE? 1269 MS. McSHANE: I'm sorry, you'll have to clarify your question for me. 1270 MR. THOMPSON: Well, the allowed return on original cost book value I understand to be the benchmark ROE, at the moment. 1271 MS. McSHANE: Yeah, whatever return the Board's guidelines produce at the moment -- 1272 MR. THOMPSON: Let's just say, for the sake of argument, it's 9.95 percent. 1273 MS. McSHANE: Fine. 1274 MR. THOMPSON: All right. So it's set. 1275 MS. McSHANE: Yes. 1276 MR. THOMPSON: Then you say the market-derived cost of attracting capital, and this is your number of 11.5; right? 1277 MS. McSHANE: The 11.5 is not a market-derived cost in total. It is a cost or a rate of return, a fair rate of return, that is made up of market-derived rates plus a financing flexibility adjustment and a comparable earnings test result. 1278 MR. THOMPSON: All right. Well, let's just go on. I thought it was 11.5. So the market-derived cost of attracting capital under your recommendation is what? 1279 MS. McSHANE: Well, if you look at the strict market-derived cost without any kind of adjustment, then it would be the combination of the ERP result and the DCF result before any adjustment for financing flexibility. 1280 So if you went to the update, it would be the equity risk premium test before any financing flexibility adjustment would be in the range of 10 to 10.75, and the discounted cash flow test is a market-related test and the result would be 11 -- I'm sorry, no, that's wrong. I'm not in the update. I apologize for giving you the wrong numbers. 1281 The DCF test would be 11, and I was correct, those were the results. It will be 10 to 10.75 would be the market-derived equity risk premium test result. 1282 MR. THOMPSON: What do I put in here after this phrase? The market-derived cost of attracting capital in your recommendation is something less than 10.75? 1283 MS. McSHANE: The market-derived part of my recommendation is the bare-bones equity risk premium test result and the bare bones DCF result. 1284 MR. THOMPSON: Is that about 10.75, more or less? I just want to put a number compared to 11.5, so I can understand the next phrase. 1285 MS. McSHANE: Okay, I would say it's about 10.5. 1286 MR. THOMPSON: 10.5. All right. 1287 Then you go on and say: 1288 "The 10.5 should be converted to a fair and reasonable return on book equity so that the stream of dollar earnings on book value equates to investors' dollar return requirements on market value." 1289 Now, what the heck does that mean? 1290 MS. McSHANE: That would mean that if you were looking at the long-term equilibrium market-to-book ratio the return percentage should be such that you would maintain a market-to-book ratio that equated market value to replacement cost. That would be the theory. 1291 That's not what's done here. I was simply suggesting that that's certainly justifiable under the way that utilities are regulated and what the objective of regulation is. 1292 My testimony, actually all it does is takes the bare-bones costs and adds a very minimal amount to the bare-bones costs to adjust for flotation costs, financing flexibility, and to give some small -- some small indication of the fairness principle. 1293 MR. THOMPSON: So you've added 75 points roughly for flotation costs? 1294 MS. McSHANE: 50. 1295 MR. THOMPSON: 50. But that's not what you're talking about here. You're talking about another concept that you're proposing; is that right? 1296 MS. McSHANE: It's sort of an extension of making an adjustment to the bare-bones cost to reflect the fact that under competition, competitive companies can and do maintain their market values in excess of book value. 1297 MR. THOMPSON: So it's not part of your recommendation? 1298 MS. McSHANE: There is no adjustment to equate the market value and the book value, no. 1299 MR. THOMPSON: And that would sort of be a brand-new concept, wouldn't it? 1300 MS. McSHANE: Excuse me? 1301 MR. THOMPSON: It would be a new concept for this Board. The 75 points would become something much larger, I guess. 1302 MS. McSHANE: Yes, it will be considerably larger, if you assume -- we've done some sort of quick and dirty estimates of the equilibrium market-to-replacement costs values for U.S. LDCs and they're about 100 and 1.5. 1303 MR. THOMPSON: 150 basis points? 1304 MS. McSHANE: No, no, sorry, the market-to-book ratio that would equate market to replacement cost would be around 1.5. 1305 MR. THOMPSON: But that's not part of this case? 1306 MS. McSHANE: No, it's not part of this case. 1307 MR. THOMPSON: So why have you used the words care should be taken, sorry: 1308 "Hence when the allowed return on original book value as set, the market-derived cost should be converted." 1309 You're not advocating that -- 1310 MS. McSHANE: Not here no. 1311 MR. THOMPSON: The company is not asking for it? 1312 MS. McSHANE: No. 1313 MR. THOMPSON: This is a McShane specialty. Something yet to come. Strike the McShane specialty. Something yet to come. 1314 MS. McSHANE: No, I'm not suggesting at all that it's something yet to come, and it may explain the concept a bit more thoroughly than I've done before, but I've certainly discussed the concept of the economics of market value being in excess of book value. 1315 MR. THOMPSON: Do you agree with the proposition that allowed returns in excess of what the market requires will produce an increase in the share price and an increase in the market-to-book ratio? 1316 MS. McSHANE: I would put it a different way. I would say that an increase in the expected return will increase the market-to-book ratio, generally speaking. That doesn't mean it's in excess of what the market requires, it just means it's higher than it was. 1317 MR. THOMPSON: Okay. Let's turn, if we might, then, to just some specific criticisms of what you have done, and probably the best way to do this is to go to appendix B of Exhibit D.2. You've given your response to a number of these points already, but I just want to draw your attention to a few pieces with respect to some of these items. 1318 I want to start with, really start at page 11, the market risk premium. And I believe in your evidence, you indicate that you have derived this from historic data, looking at the historic risk premium from some data that you take back to 1947. 1319 MS. McSHANE: It would be the post-World War II period, yes. 1320 MR. THOMPSON: Now, could you take a look at -- it's a schedule in the B and B evidence. It's schedule E.2, so this is under appendix E, and it's E.2. 1321 And this is tracking the results, as I understand it, of data with respect to Oil Canada's T-bills and inflation for the period 136, the results of the data. I think you need five years or more to get a result, so it's tracking from 1936 on. Are you familiar with this schedule or had a look at it? 1322 MS. McSHANE: Sorry, you're in E.2. 1323 MR. THOMPSON: E.2. Net Canada's bond yield, T-bill year old and inflation. And inflation is -- 1324 MR. VLAHOS: Ms. McShane, did you find it? 1325 MS. McSHANE: Yes, sorry. 1326 MR. THOMPSON: I think it's the green line, but I'm color-blind, so I think it's green. 1327 Anyway from 36 to 51 and thereafter, it's up and down. That's the one that goes negative in about 1939. Again negative in '44, and then gets close to zero around '47 and then gets negative in '51. Do you see that line? 1328 MS. McSHANE: Sorry, are you talking about the inflation line. 1329 MR. THOMPSON: Inflation line, yes. Do you have a book with -- 1330 MS. McSHANE: With colours, yes. 1331 MR. THOMPSON: You and I look like Mr. and Mrs. Magoo here. 1332 MR. WARREN: We won't say which one is which. 1333 MR. PENNY: That's it. We've had enough of Mr. Thompson. 1334 MR. SOMMERVILLE: The final straw. 1335 MR. THOMPSON: The point is long-Canadas and T-bills were totally unaffected by inflation until about 1956. Do you know why? 1336 MS. McSHANE: I'm pretty sure because the -- the rates were being kept at a certain rate. 1337 MR. THOMPSON: My information is that there was an accord after the end of the Second World War that basically controlled interest rates in the U.S. and that this ended around 1951. Is that your understanding? 1338 MS. McSHANE: Yes. 1339 MR. THOMPSON: And so it appears that interest rates started to track with inflation or interact with inflation around 1956, '57. Is that the way you would interpret this data? 1340 MS. McSHANE: I would -- I guess I would say it looks like about 1952, but ... 1341 MR. THOMPSON: '62. All right. 1342 MS. McSHANE: '52. 1343 MR. THOMPSON: Oh, '52. But the question we have is, why would you pick '47 as a start point for your data when it appears that the -- there appear to be distinct periods here. Interest rates were trending up the period '56, thereabouts, to '81, and then going in the opposite direction with inflation, '81 and thereafter. 1344 What's the significance of 1947? 1345 MS. McSHANE: The significance in Canada of 1947 was the fact that, combined with the end of the Second World War, there was a true beginning of a change in the economy as the economy became much more dependent on the oil and gas industry as it was the beginning of development in the west. So it was a real, sort of, movement from a more agricultural economy to a resource-based economy. 1346 MR. THOMPSON: Well, is the use of the '47 start point, does that capture the point in time when the equity risk premium was at a high? 1347 MS. McSHANE: Yes, there was a period of relatively high equity risk premiums coming out of the war, yes. 1348 MR. THOMPSON: And do we see that if we go to Exhibit E.5? This is the market risk premium estimates back from 2002. There appears from this data that around 1947 is -- this is on the arithmetic mean, the geometric mean, and the ordinary least squares regression -- I'm sure everybody in the room knew that except me -- but this indicates that the risk premium estimates appear to be at their highest or around the highest in 1948, and they narrow considerably and were even negative for a number of years opposite bond returns. I think it's the period from the early '80s on. That's what this data shows, I'm informed. 1349 Do you agree with that? 1350 MS. McSHANE: That's what this picture suggests, but I have a real problem with presenting the data this way, because essentially what you see is -- and I've shown, I've done some analysis with these numbers back, not to 1928, but at least to 1947, and what you see over this time frame is that the equity returns have been in a relatively narrow range, being between 11 and 13 percent, approximately. 1351 But the big difference is that you've had an increase over time as you add more periods in the bond return. So that if you're looking at rolling averages of bond returns and you, say, start with a 25-year average from '47 to '72, the bond return and the actual bond return is around 3 percent. 1352 But because we went through a period of rising and then falling interest rates, with the falling interest rates, you had large capital gains on bonds which drove up the achieved returns on bonds, so that at your very last rolling average, you still have approximately the same equity returns, but your bond returns are 10 or 11 percent on average through recent periods. But now we're sitting where interest rates are 5 percent, but we're not going to get those capital gains anymore, we're not going to have those high bond returns. 1353 So if you're looking forward and saying, "Well, based on my past experience, I've had, over long periods of time, relatively similar equity returns, but I know that the return on -- or I anticipate -- I shouldn't say "know", you know nothing -- my best estimate of the return on the bond, the long-Canada bond is the yield today and the forecast between 5.5 and 6 percent. So the forward-looking premium on that basis is in the range of, you know, 6 percent." 1354 So it's how you interpret the data. 1355 MR. THOMPSON: Yeah, it is, and that's how you used the time periods. 1356 The point that Dr. Booth will clarify and explain when he gets here is that it appears to us that, had you started in 1956 when things changed in terms of the interest rate policy getting unlocked -- I don't know if that's the way -- or coming to an end, and developed your equity risk premium from that starting point, it would be much lower than the 600 to 650 that you've come up with. 1357 MS. McSHANE: Well, let me just say just to clarify, that even when I start with 1947, I'm -- there's -- I'm not saying that the historic risk premium in Canada was 6 percent. My analysis of the risk premium goes beyond the Canadian experience and looks as well at the U.S. experience for a number of reasons that I explained in my testimony. 1358 And one of the distinctions between the historic numbers in the U.S. and the historic numbers in Canada is the fact that interest rates in Canada historically were systematically higher by a significant amount than in the U.S., but going forward, they're not expected to be. 1359 So I mean, that's one reason why the historic risk premiums from the Canadian experience are somewhat less reliable as estimates of the forward-looking risk premium than the U.S. data, because of the change in the underlying fundamentals of the bond market. 1360 MR. THOMPSON: All right. Well, what I understand you to be saying is the Canadian historic -- what you write on page 39 of your testimony, you indicate you derived at 4.75 to 5.5, compound and arithmetic averages. That's at line 22, page 39. 1361 MS. McSHANE: Sorry, page 39? 1362 MR. THOMPSON: 39 of my material. Then you talk about U.S. equity risk premiums at 6.75 to 7.75. 1363 MS. McSHANE: Yes. 1364 MR. THOMPSON: I think what I heard you saying is you don't give a lot of weight to Canadian historic risk premiums in any event. Is that what I hear you saying? 1365 MS. McSHANE: No, I wouldn't say I don't give a lot of weight to them, but I recognize what the problems are with taking those numbers and saying that they will be applicable in the future. 1366 MR. THOMPSON: Okay. Well, we think they're high, and I guess perhaps we'll leave it at that. 1367 But the reasons you advance for starting at 1947, you say the globalization of the North American economies. My information is there wasn't much globalization in 1947, that Canada had fixed exchange rate up until 1973, as did most of the world. Is there some big globalization turning point in 1947? 1368 MS. McSHANE: Just the fact that the GAT trade barriers were started in 1947. 1369 MR. THOMPSON: Then you talk about demographic changes. They didn't just suddenly change in '47? 1370 MS. McSHANE: No. Nobody's suggesting that all of this stuff started exactly in 1947 but, rather, the post war period is a good demarcation point for the development of these changes. 1371 MR. THOMPSON: Okay. Let's go, then, to the -- we've discussed the forward-looking risk premiums and the apparent differences between your results and those other results of the other studies. 1372 But you have developed your forward-looking risk premium estimates, as I understand it, using these IBIS growth forecast as well as some analysts' forecasts? 1373 MS. McSHANE: Those arrest analysts' forecasts. The IBES forecasts are a compilation or consensus of analysts' forecasts. 1374 MR. THOMPSON: All right. Now, if go to appendix B of our testimony. At page 1, you'll see there that Drs. Booth and Berkowitz, starting at line 2 say: 1375 "The problem with this analysis is that it is generally recognized that analysts' forecasts of earnings are biased upward and this, in turn, biases upward Ms. McShane's equity risk premium estimate in her analysis. For example, on September 28, 2001, Credit Suisse First Boston (CSFB) issued a substantial report on whether equity markets were over or undervalued in response to September 11, 2001. They relied on several valuation measures, one of which was a standard DCF model. They used analyst forecasts (Institutional Brokers Estimation Service, or IBES) out to five years and then trend earnings thereafter. Using trend earnings moderates any bias in the analyst forecasts since they are not projected out to infinity as is often the case. CSFB then equated this current stream to the current market value to determine the implied equity risk premium. Their equity risk premium estimate for the U.S. market was 5.3 percent, but they added: 'we would remind readers that over the last ten years..." 1376 MR. VLAHOS: Mr. Thompson, just one second, please. Okay, we're back in business. I was going to ask you to slow down a bit when you read, Mr. Thompson. 1377 MR. THOMPSON: You didn't turn me off, did you, Mr. Chairman? 1378 MR. PENNY: You don't have to answer that, Mr. Chairman. 1379 MR. VLAHOS: There's a special button. 1380 MR. THOMPSON: "CSFB then equated this earning stream to the current market value to determine the implied equity risk premium. Their equity risk premium estimate for the U.S. market" -- 1381 MR. VLAHOS: Mr. Thompson, slow down, please. 1382 MR. THOMPSON: "Their equity risk premium estimate for the U.S. market was 5.3 percent, but they added: 'we would remind readers that over the last ten years IBES earnings numbers have on average been 6 percent too optimistic 12 months prior to reporting date.'" 1383 Were you aware of that observation by Credit Suisse First Boston about these IBES numbers? 1384 MS. McSHANE: I am aware of that study. I am aware, as I answered in data requests, that the analysts' forecasts have been shown to be optimistic. 1385 I think that it's quite clear that through the behaviour of firms recently, that investors have believed the forecasts, and it explains where the prices of where the stocks have been, and companies have done all they can to make sure that investors were not disappointed. At the end of the day, some of them obviously went way beyond what they should have done, but clearly that was evidence that -- that for -- that, for these companies, investors believed the forecast and that's what's embedded in the stock prices. 1386 MR. THOMPSON: So let me understand that. If investors are having the wool pulled over their eyes by analysts, that's to be reflected in the return allowed by this Board because you factored it into your calculations? 1387 MS. McSHANE: No, I'm not factoring in any judgment. 1388 MR. THOMPSON: You're saying they believe it; therefore, I didn't adjust it. 1389 MS. McSHANE: You can do one of two things when you do a test where you use expectations, and you've got two parts to the equation; one is the dividend and one part is what the expected growth is. 1390 If you're going to say, Well, clearly investors and analysts are too optimistic, and they're too optimistic by 3 percent, I'm going to take 3 percent off the growth rate because they're wrong. 1391 But if they're wrong, they're also wrong about the way they priced the shares, so I can't take the part off of the growth rate and not adjust the dividend yield part to reflect the fact that presumably, under -- under that scenario, investors would adjust their expectations and therefore bid down the price of the stock. 1392 MR. THOMPSON: So did you make an adjustment for this bias, or not? 1393 MS. McSHANE: No, because there's no reason to believe that -- that the optimism that's embedded in those growth rates is not also embedded in the price. 1394 MR. THOMPSON: All right. Let's move on just again on this analyst puffery. If you go to Exhibit F.3, tab 1, we have a Wall Street report on the magnitude of this stuff recently, and it looks pretty significant. This is announcing the settlement by ten of the nation's largest securities firm, a record $1.4 billion to settle government charges involving abuse of investors. 1395 MS. NEWLAND: Mr. Chairman, could I just ask Mr. Thompson to give me that reference again, please. 1396 MR. THOMPSON: Yes, it's tab 1 of Exhibit F.3 -- 1397 MR. MORAN: 1.3. 1398 MR. VLAHOS: F.1.3, the exhibit number is F.1.3. The first number signifies the day. Today is the first day of the hearing. 1399 MR. THOMPSON: Thanks. 1400 So these -- this settlement involves Merrill Lynch, JP Morgan, Goldman Sachs, UPS Warburg, Payne Webber, Piper Jaffray, Niemann Brothers, Bear Sterns, JP Morgan Chase. I mean, pretty good evidence, I would suggest, Ms. McShane, that some of this optimism should be adjusted for, but you didn't do it? 1401 MS. McSHANE: I don't think it's appropriate to adjust when -- when that's clearly what was built into the investors' prices. 1402 If it hadn't been, then we wouldn't have had them -- the resulting declines in the stock prices that we did, and it's because investors were ultimately disappointed that -- that some of these suits have arisen. 1403 But, you know, I think we have to also remember that these concerns are really focused on these high-tech stocks; that it's easy -- it's easy to sort of sell investors on these kind of Internet stocks that nobody really understands the business model for. It's quite a different thing to -- when an analyst is looking at a utility stock. 1404 MR. THOMPSON: Are you suggesting investors will not react to the Wall Street Journal article and discount some of this stuff that comes -- 1405 MS. McSHANE: Well, all I'm saying is let's look where the problem was, and the problem was in these Internet high-tech stocks that -- that these analysts were trying to sell as being, you know, the next best thing since sliced bread. And this was at a time when, effectively, investors were ignoring the -- I don't know what's been sort of referred to as the brick and mortar type stocks like the utilities. 1406 So I think we have to remember that the concerns with the analysts are on the side of these types of companies that nobody really understood, the way they should have, what these companies were doing. 1407 MR. THOMPSON: Well, a lot of them were on the sell side in terms of getting remuneration, weren't they? My understanding is the analysts, some of them were compensated on the sell side. 1408 MS. McSHANE: No, I don't disagree with that, that there has clearly been some incentive, as this was suggesting, for these analysts to over-hype these stocks. 1409 MR. THOMPSON: You didn't take that into account -- 1410 MS. McSHANE: I'm not dealing with these kinds of stocks. 1411 MR. THOMPSON: All right. Well, let's move on now to a debate that glazes my eyes over. CAPM, what is it? Capital pricing model, CAPM, that is discussed, starting in your text, I'm looking at pages 44 and 45. 1412 And what's the point you're trying to make there that the -- is there such a thing as a simple CAPM, or are you trying to suggest that it's fallen out of favour? 1413 MS. McSHANE: Sorry, is that two questions? 1414 MR. THOMPSON: Well, yeah, I guess it is two. What are you talking about here when you refer to CAPM? 1415 MS. McSHANE: Well, the capital asset pricing model, simple capital asset pricing model is take a risk-free rate, add to it a beta custom market risk premium, as opposed to sort of a multiple factor asset pricing model which tries to account for the different factors that determine what the returns of equities are. 1416 MR. THOMPSON: All right. But what is the point you're making at page 45 where you say: 1417 "The body of evidence on CAPM leads to the conclusion that, while betas do measure relative volatility, the proportionate relationship between risk, beta and return posited by the CAPM has not been established." 1418 MS. McSHANE: That means if you start looking at the betas versus returns of stocks, that the model would suggest that you shall see over time the low beta stocks earn low returns and the high beta stocks earn high returns. 1419 In fact, for most periods of time that have been looked at, there is no real discernible relationship. I did a relatively simple analysis using the betas of the various sectors of the TSX in Canada against their returns and the relationship is negative, which means that, in fact, the companies you'd think would earn the highest returns, the riskier stocks, have instead earned the lowest returns of any of the sectors and vice versa. 1420 So it's very difficult to then say, "Well, despite the fact that the model isn't empirically supported, I'm going to go ahead and use these relative volatility measures anyway to measure the risk adjustment to the market risk premium." 1421 MR. THOMPSON: In these studies referred to on page 45, did they use the risk-free rate as the short term? 1422 MS. McSHANE: Yes, I believe that they did. 1423 MR. THOMPSON: Does that make a difference? 1424 MS. McSHANE: It could make a difference, yes. 1425 MR. THOMPSON: And you used the long-term rate; is that right? 1426 MS. McSHANE: Yes, I did. 1427 MR. THOMPSON: So what does that do to the slope of the CAPM line? Does it flatten it if you use the long-term interest rate? 1428 MS. McSHANE: Yes. 1429 MR. THOMPSON: Now, you drew these conclusions from studies -- using the -- well, what's ECAPM stand for? Is that where you use the -- you tell me what it means. 1430 MS. McSHANE: It's not in my testimony, but I'll tell you anyway. 1431 MR. THOMPSON: Okay. Thank you very much. 1432 MS. McSHANE: I'm sorry, I didn't mean to be facetious. 1433 It stands for the empirical capital asset pricing model, and basically I think what it says is that there is a fixed risk premium that a stock would require irrespective of whether it had -- even if it had a zero beta, above the risk free rate. 1434 MR. THOMPSON: Okay, now, just on page 46, you have, I think what we have there would be Canadian utility betas. These would be what we've been terming raw betas? 1435 MS. McSHANE: Yes. 1436 MR. THOMPSON: Is it fair that these numbers are reasonably consistent with the numbers that Drs. Booth and Berkowitz developed? 1437 MS. McSHANE: I think it's fair that they measure in relatively similar ways. They just measure the relative volatility of utility shares over five-year periods. 1438 MR. THOMPSON: Now, at page 47, you -- I'll come back to the relative risk adjustment in a moment. Page 47, you note at line 15: 1439 "Utilities are interest-sensitive stocks and thus tend to move with interest rates which frequently move counter to the equity market." 1440 Correct? 1441 MS. McSHANE: Yes. 1442 MR. THOMPSON: And are you aware that Professors Booth and Berkowitz use a two-factor model, CAPM and an interest -- a CAPM with interest rates and a market return as the two factors? I think that's described in their testimony somewhere. 1443 MS. McSHANE: I'm aware they use a two-factor model. 1444 MR. THOMPSON: Does that make sense in view of the fact that utilities are interest-sensitive stocks and thus tend to move with interest rates, as you suggest? 1445 MS. McSHANE: Does it make sense to use a two-factor model to try to capture that? 1446 MR. THOMPSON: Yes. 1447 MS. McSHANE: Yes. 1448 MR. THOMPSON: Do you have any criticisms of the results of their model application? 1449 MS. McSHANE: It doesn't explain very much. 1450 MR. THOMPSON: I didn't ask that question. 1451 MS. McSHANE: Well, I mean -- 1452 MR. THOMPSON: You don't understand it is what you're saying? 1453 MS. McSHANE: No. What I mean by that is when you look at how much of the way it's put together and how much of the variation in utility returns it explains, it explains very little. 1454 MR. THOMPSON: Well, we'll try and help you out when Dr. Booth testifies. 1455 Now, the next topic is relative risk adjustment. Tell us how you've derived your raw beta numbers with support -- big picture of 0.45 to 0.55 -- 1456 MS. McSHANE: The big picture, raw betas are what they are. I mean, you can't do very much with changing them because that's what the relative volatility has been. 1457 MR. THOMPSON: Okay, but you have adjusted them, and your adjustments are described, I think, starting around the bottom of page 49. You use some value line data. Perhaps you can just describe in 25 words or less what you did. 1458 MS. McSHANE: The whole relative risk adjustment section? 1459 MR. THOMPSON: Well, does is it go on forever? 1460 MS. McSHANE: No, but my adjustment reflects what I suggested in examination-in-chief this morning. It is supposed to reflect the fact that this relative volatility beta by itself doesn't capture the total risk return relationship. I show on page 48 that if you look at total risk, that it suggests a higher relative risk adjustment than just the raw beta, and I discuss how using the adjustment for -- that he used by some of the big beta providers, including Valueline and Bloomberg and Merrill Lynch, would produce a relative risk adjustment that, in my view, is more consistent with the empirical risk return relationship and giving weight -- some weight to total risk. 1461 MR. THOMPSON: Your theory, as I understand it, is there's a regression tendency towards 1.0? 1462 MS. McSHANE: No, I think that I had indicated very clearly this morning that that's not the rationale for the adjustment and I explained what the rationale was. 1463 MR. THOMPSON: I must have missed it. What is the regression tendency, then, in your testimony? 1464 MS. McSHANE: It is not a regression tendency. I'm not adjusting the raw betas for regression tendency. I am adjusting the raw betas for the factors that I previously mentioned: total risk, interest sensitivity, and the fact that the raw betas themselves are not empirically compatible with the observed risk return relationship. 1465 MR. THOMPSON: Drs. Booth and Berkowitz, as I understand it, suggest there's a regression tendency towards the average beta for Canadian utilities, which will be about 0.55. What's your comment on that proposition? 1466 MS. McSHANE: I don't disagree with -- with the statistics that they have produced on the regression tendency. That's, to me, beside the point. And, you know, suggesting that I made this adjustment for a regression tendency when I haven't is sort of not a particularly useful exercise, because that's not what I'm doing. 1467 MR. THOMPSON: All right. Well, that's what they did to support the conclusion that the raw data is appropriate. You have trouble -- 1468 MS. McSHANE: Well, I have trouble accepting the fact that you can -- there are two reasons you adjust beta as far as I'm concerned. One is because you can show that there is a tendency for the beta to drift towards another value, and that values in a particular period may be different than what the long-term predicted value is. 1469 So if you're trying to estimate a future beta, then you would make that adjustment. That's basically what Dr. Booth is doing, and that's fine, if that's what he's trying to accomplish. 1470 I think at the end of the day, what we're really trying to accomplish is what's the return supposed to be, not what the next beta is going to be. 1471 If we know ahead of time that there is this very tenuous relationship between beta and return, then it doesn't do us much good simply to adjust the betas towards their long-run value if we're not getting to the -- measure to the point where it's predicting the return. And that's what we're really trying to do, and that's the rationale for my adjustment. 1472 MR. THOMPSON: Turning to the achieved utility equity risk premiums you've described at page 51 of your testimony, you will agree, I would hope, that there is some circularity to relying on achieved. It may not be 100 percent circularity, but there is some, because they depend on what the regulator allows. I think we discussed that in your evidence this morning. 1473 MS. McSHANE: The projected growth rates certainly do. The actual achieved returns are going to reflect how the market -- how the market translates what the regulators have allowed into true market returns. 1474 So I would say there's -- there may be some -- some little circularity, but not a major amount of circularity. 1475 MR. THOMPSON: Okay. Well, we'll argue that. 1476 You've told us you rely on U.S. LDCs rather than Canadian evidence because you regard U.S. LDCs as reasonable proxies. 1477 MS. McSHANE: Not all of them. Certainly the sample I've selected, yes. 1478 MR. THOMPSON: If the U.S. market risk premium is consistently 2 percent higher than in Canada, even though betas and bond ratings are the same, would the U.S. sample have a higher DCF return? 1479 MS. McSHANE: Pardon me? Say that again. If the U.S. -- 1480 MR. THOMPSON: Do you need the U.S. sample to get your number up where you want it, is really what I'm -- putting it in layman's terms. You can't do it on Canadian data -- 1481 MS. McSHANE: You don't have the data to do it on Canadian data, in the first instance. 1482 MR. THOMPSON: Drs. Booth and Berkowitz, in their testimony, make the case, and I think it starts probably around pages 16 and following that -- that regulators in Canada, through the adoption of these formulaic determinations of ROE and the different equity components of capital structure for the different utilities, tended to stabilize the regulatory, I don't know if "risks" is the right word, but the regulatory atmosphere for utilities in Canada; and from that they conclude they can derive betas from the utility holding companies. They discuss Foothills as being the lowest risk because it's on a monthly true-up, cost of service true-up, and you'll see that at the bottom of page 19. 1483 The bottom line is they derive their beta estimates from the utility holding companies. Is that your understanding? 1484 MS. McSHANE: I thought we were talking about the discounted cash flow test. 1485 MR. THOMPSON: Maybe I've switched gears, but back to betas. 1486 MS. McSHANE: Okay. I use betas for Canadian utilities too, so I don't know what the point of contention is now. 1487 MR. THOMPSON: I just wanted to point out -- I thought you relied on U.S. samples, but maybe I'm mixing apples and oranges here. 1488 MS. McSHANE: I think we're talking about different tests. When I look at Canadian utilities in the context of capital asset pricing model, yes, I'm looking at Canadian utilities, and Canadian utility betas. 1489 When I do the discounted cash flow test, I'm using U.S. LDCs for a variety of reasons, one of which is for Canadian utilities, there are -- we don't have the depth of consensus forecast that we could use to apply the DCF model in the first instance, so that's one reason to use U.S. companies. 1490 Another reason is particularly in the case of LDCs, we don't have any publicly traded LDCs in Canada other than Terasen. We have Canadian utilities to some extent, but that's really a mixed electric/gas company. 1491 And we know that increasingly utilities in the U.S. and utilities in Canada are being used as comparables for each other when analysts look at them. I can pick a sample of LDCs that have the same business risk position that's assigned by Standard & Poors as to the typical utility in Canada, that have the same debt rating as the typical utility in Canada, so it makes sense to have a sample of relatively pure-play U.S. LDCs that serve as a proxy. 1492 MR. THOMPSON: All right. Well, that's your approach. I guess the point is that when it comes to betas, I think the -- Drs. Booth and Berkowitz use somewhat different data than you use and come up with different opinions; is that fair? 1493 MS. NEWLAND: Maybe you can ask a more specific question. 1494 Maybe, Mr. Chairman, you could direct Mr. Thompson to pose his question more specifically. It might be more helpful. 1495 MR. THOMPSON: Can't answer it? 1496 MS. McSHANE: They use -- we have very few, very few Canadian utilities that are publicly traded -- 1497 MR. THOMPSON: They used to be publicly traded. 1498 MS. McSHANE: Pardon me? 1499 MR. THOMPSON: There used to be the odd publicly traded -- 1500 MS. McSHANE: There used to be, but now we have effectively Enbridge, TransCanada, Terasen, Canadian Utilities, Pacific Northern Gas, which is a real small company. I know I'm forgetting -- Fortis and Amira. So we have seven altogether. They're all different, so it's hard to pick a sample of companies that you could say was, you know, similar across all elements of business and financial risk. 1501 So where we might use slightly different data, I mean, we are sort of constrained to a relatively small data set, so it can't be that different. 1502 MR. THOMPSON: Well, I'll move on. The only way we can really see what the market-to-book value of these companies is is when they're sold in the marketplace, as opposed to the trading of shares; right? That's the Canadian -- 1503 MS. McSHANE: So you're saying, if I sell a piece of my company, is that -- 1504 MR. THOMPSON: If you sell the whole thing we can see -- 1505 MS. McSHANE: You can see the market-to-book ratio when it's trading, but if you're talking about if you sell something that's not publicly traded, then you can see the market-to-book ratio of it, yes. 1506 MR. THOMPSON: The DCF tests, now, you've used these -- you've used American companies, you say, because there are no stand-alone utilities in Canada. Is that the reason you've used them, or have you used them because of this globalization concept? 1507 MS. McSHANE: I think I just gave you about six reasons that I use them. 1508 MR. THOMPSON: Was globalization one of them? 1509 MS. McSHANE: Well, globalization in sort of a generic sense, but more specifically that there is an ongoing trend to look at across the U.S. and Canadian borders and to look at U.S. and Canadian utilities as potential proxies and comparables for each other. 1510 MR. THOMPSON: What's the foreign ownership in the -- let me put it to you this way. There's no evidence that these Canadian companies cannot access capital without going to the U.S., is there? 1511 MS. McSHANE: You mean, is the Canadian market large enough for these companies to raise capital in the Canadian market without having a specific issue abroad? Is that what you're asking me? 1512 MR. THOMPSON: I think that's what I'm asking you, sure. Try that one. 1513 MS. McSHANE: Yes, I mean, clearly for most companies, I mean, TransCanada I think has had to access the U.S. market on occasion, but for most of the utilities, the Canadian market is large enough for them to meet their needs. 1514 But I don't really think that's the point. The point is that the shares are traded across borders, and at the end of the day, if I'm, you know, a Canadian firm, I'm going to have to offer a return that's competitive if I'm in the market with U.S. firms. 1515 MR. THOMPSON: Okay. Lastly -- well, not quite lastly but almost lastly. The comparable earnings test. I drew your attention to a passage in the BC decision where that was viewed -- that test was viewed unfavourably, I guess, is the way I would put it. There's another decision I just wanted to draw your attention to. It's in our Exhibit F.1.3 at tab 4. 1516 This is the decision with respect to AltaLink. Were you involved in that case? 1517 MS. McSHANE: This one was not my fault. 1518 MR. THOMPSON: It wasn't. Well, you've seen the passage there in the second paragraph of the excerpt, the Board rejecting the comparable earnings test because of its major limitations? 1519 MS. McSHANE: Yes, I see that they have listed the limitations and I think that, you know, some of these criticisms, clearly, you can apply to any of the tests that you use. 1520 I note that the Board went on to suggest that there was no attempt to try to make the sample truly comparable. That it was just a bunch of large firms in the TSE at the time, and I think I've done better than that. 1521 MR. THOMPSON: Now, your testimony have the comparable earnings for a Canadian sample, I believe, between 12.75 and 13.75; is that right? 1522 MS. McSHANE: Yes. 1523 MR. THOMPSON: And if you look at schedule 1 of the testimony of Drs. Booth and Berkowitz, which gives the average ROE for, I was going to say, corporate Canada as estimated by Statistics Canada. This is in the last column. I'm told that these statistics indicate that only once in the last 20 years has the average ROE been above 20 percent. Would you take that subject to check? 1524 MS. NEWLAND: Mr. Thompson -- Mr. Chairman, could I just get Mr. Thompson to explain a little bit the source of the data in schedule 1, because it's not, I don't think, indicated on my copy. 1525 MR. THOMPSON: Well, I'm told it's from Statistics Canada. 1526 MS. NEWLAND: And these are average ROEs of what -- 1527 MR. THOMPSON: Corporate Canada is what I was told. 1528 MS. NEWLAND: Corporate Canada. Not particularly precise. 1529 MR. THOMPSON: Any idea what they are, Ms. McShane? 1530 MS. McSHANE: I've never looked at these data. I don't know what they are, and I don't know what they represent. 1531 MR. THOMPSON: We'll leave that for Dr. Booth. 1532 In appendix E.1 -- this is at schedule B.1, and what we have here is, I'm told, you take the three largest companies in these various samples that you have selected, consumers' product, industrial products, commercial media and merchandising, you select the companies out of those sectors that give you a mean of 13.99, but if you take the three largest firms in each sector, the mean is quite different. 1533 MS. McSHANE: That's what -- 1534 MR. THOMPSON: Is that correct? 1535 MS. McSHANE: Is that what that is, the three largest firms in consumers products, or that's all the consumer products firms on the TSX? 1536 MR. THOMPSON: Maybe I misstated that. What did you think it was? 1537 MS. McSHANE: I thought it was the total. 1538 MR. THOMPSON: In any event, is the schedule accurate based on your analysis of the data? 1539 MS. McSHANE: I haven't gone and looked at the ROEs of the specific companies in this S&P/TSX group. 1540 MR. THOMPSON: Now, in this case, you've given comparable earnings 25 percent weighting; is that right? 1541 MS. McSHANE: Correct. 1542 MR. THOMPSON: You've weighted the other two tests 37.5, 37.5? 1543 MS. McSHANE: Correct. So in other words, the cost of attracting capital as 75 percent weight and comparable earnings as 25. 1544 MR. THOMPSON: Now, I'm told that in the EBRO-485 proceeding, at transcript 1091, Dr. Sherwin basically relegated comparable earnings -- 1545 MR. VLAHOS: What year was that, Mr. Thompson? 1546 MR. THOMPSON: Yeah, I'm sure I was there. I remember it well. It was a short excerpt from a long speech. 1547 MR. VLAHOS: What year was it, Mr. Thompson? 1548 MR. THOMPSON: What year was it? 485. 1549 MS. NEWLAND: 1802. 1550 MR. THOMPSON: I'll have to get back to you with that. 1551 MS. NEWLAND: Hang on, Mr. Chairman, I'd like to ask Ms. McShane, do you have that decision? 1552 MS. McSHANE: No, but I know exactly what he's going to say. 1553 MR. THOMPSON: You were there. 1554 MS. McSHANE: I was there. 1555 MR. THOMPSON: And he was asked -- somebody asked a question about comparable earnings, and his answer was: 1556 "And I am surprised you would even pursue this line of questioning, because if I had my druthers, I would at this point say to you drop the comparable earnings test right now, drop the discounted cash flow, and rely only on the risk premium test." 1557 What's happened since? 1558 MS. McSHANE: Well, first of all, I am not Dr. Sherwin, okay -- 1559 MR. THOMPSON: Well, you're his clone? 1560 MS. McSHANE: And I take offense that you would say I'm his clone. I do have my own thoughts. I almost died when he said that, to be perfectly frank with you. But I think he was trying -- the context of the statement was this, and I think I've tried to create this context in my testimony, that when he made that statement, we were at the point in a new cycle where we had just basically come out of -- we had come out of the 1980s, which was a period of high inflation. The government had brought in their -- their inflation targets. They cut inflation in 1991 from 5.5 percent to under 2 percent in 1992. We had the free trade agreement coming into play. We went through an extended period of restructuring recession, and so we had historic earnings for companies that we couldn't be very sure how they were going to compare to future earnings at that point, because we were at a real crossroads, and the same was true of the discounted cash flow test. 1561 So at that point in time, truly all -- the tests that gave us the most reliable results was the equity risk premium test. 1562 So it was in that context that he was saying that. He wasn't saying, Drop these tests for all time. He was simply expressing the fact that we were truly at a very unique point in economic history, if you will, that made both of those tests very difficult to apply with any degree of certainty. 1563 MR. THOMPSON: It obviously wasn't producing results that helped. 1564 MS. McSHANE: No, I don't think that's correct, Mr. Thompson. It's not that it wasn't producing results that helped. It was that if you looked at the returns for -- let's say we're sitting -- I don't remember the exact date of 485, but let's say it was 1995, and we were looking at returns that covered a cycle -- 1565 MR. THOMPSON: '93, I'm told. 1566 MS. McSHANE: '93. Okay, so '93. We're looking at returns from a cycle that, let's say, ended '92, but extended back into, like, 19 -- the last cycle ended '83, so let's say '84 on. So you've got a period that covers two very distinct parts of cycles, one with high inflation, one with low inflation. 1567 The answers could have been very good, but it was very difficult to say that -- at that point, since we were entering a whole new inflation environment that those results would be applicable. 1568 But now we're sitting in 2003 and we've come through a full cycle of relatively low inflation, relatively moderate growth and we expect to see another cycle that's similar. So now I think you can say with a fair amount of assurance that the comparable earnings test is a reliable test in that context. 1569 MR. THOMPSON: My final area, it's just a couple questions on adjustment mechanism. You're proposing .5, as we discussed at the outset. The formula and existing guideline calls for .75 and Dr. Cannon is at .7. 1570 Would you agree with the proposition that if the equity risk premium test is continued, it continues to enjoy primary weight and that the adjustment mechanism should be close to one? 1571 MS. McSHANE: Well, it depends how the risk premium test is applied. The way I sort of set out the formula, and I've sort of set it out saying that to some extent, the implication is that when you do the capital asset pricing model, there's sort of an implied one-for-one relationship between interest rates and the risk premium, simply because the way the risk premium in that test is determined is sort of on a long-term average premium, and there's no real attempt to -- there's no real ability with that test to estimate precisely how or even -- not precisely but even approximately how the risk premium in interest rates would vary. You need a different kind of test to do that. 1572 You need a -- a discounted cash flow type test where you can -- where you can make estimates in a serial fashion and then compare those consistently made estimates to interest rate and say, Well how do those two variables relate to each other? So if you look at my DCF-based risk premium test, I would say that if you take into account both the spread and the change in long government bond yields, I mean it's still, we're still looking at about a 50/50 relationship between interest rates and the cost of equity, so, you know, if you look at those two tests, it's only maybe somewhere in the middle of one for one and 50. 1573 MR. THOMPSON: So is that an answer yes or no? It should be -- 1574 MS. McSHANE: I forget what the question was. 1575 MR. THOMPSON: I asked should it be near one if ERP is given primary weight? 1576 MS. McSHANE: And my answer is no, not if you're looking at really trying to establish what the relationship is between interest rates and the risk premium. 1577 MR. THOMPSON: So the Board got it wrong in the first go-around with 75 percent based on the primary weight of the ERP and BC's got it wrong, it should be 50. 1578 MS. McSHANE: No. I think that in any case, there was no real right or wrong as far as they were concerned. The empirical data in support of the risk adjustment suggested that it's something less than one, but it's very difficult to determine precisely what the relationship between the equity risk premium and interest rates is. 1579 So I think that -- I don't pretend to read into the minds of this Board, but if you look at what the National Energy Board did, I think it's perhaps a little more transparent that when they saw the evidence in front them in 1994, they saw some people saying it should be one-to-one, and they saw some people saying it should be 50, and they cut the baby in half and came up with 0.75 with the idea that they weren't convinced that it was a one-for-one relationship, but it was difficult to say precisely what it was. 1580 MR. THOMPSON: We'll argue that. The last question I have is if you gave comparable earnings a weighting of zero, what will your recommendation then be? 1581 MS. McSHANE: If all I had was the other two tests and pretended the comparable earnings simply didn't exist -- 1582 MR. THOMPSON: Well, you weighted it as zero. I wouldn't want to remove it from your portfolio completely. A zero weighting is what I'm interested in, what it does to the -- 1583 MS. McSHANE: Can I just use my update at 6 percent? 1584 MR. THOMPSON: Let's do it on the 6 percent benchmark. Sorry, 6 percent long-Canada, which gives you 11.5 benchmark, I think. 1585 MS. McSHANE: So I've got a -- I'm still in the wrong place. It would be in the range of 10.75 to 11 for the benchmark. 1586 MR. THOMPSON: So it would reduce it by 50 to 75 basis points, roughly; is that right? 1587 MS. McSHANE: And what did I just say to you? 10 -- 1588 MR. THOMPSON: 10.75 to 11, and I was assuming that was the 6 percent long-Canada, 11.5 benchmark. 1589 MR. PENNY: Sorry, Mr. Chairman, I thought the evidence was that a 6 percent long-Canada equated to an 11.625 benchmark. 1590 MS. McSHANE: It does. So yeah, the benchmark, Union Gas would be at 11.625 at 6 percent long-Canada, and that would reduce to about 10.75 to 11, which would be a reduction of -- 1591 MR. THOMPSON: 62 to -- 1592 MS. McSHANE: 45 basis points. No, I'm sorry -- 1593 MR. THOMPSON: The reduction ranging between 62.5 and 87.5? 1594 MS. McSHANE: That sounds right. That's what happens when I don't have my calculator with me. 1595 MR. THOMPSON: Thank you very much, Ms. McShane, and Mr. Chairman for your patience. I'm finished. 1596 MR. VLAHOS: Thank you, Mr. Thompson. 1597 We will have to adjourn for the day unless someone has only about one minute of questions and doesn't wish to come tomorrow. 1598 Any matters we need to deal with, Mr. Moran? 1599 MR. MORAN: Not that I'm aware of, Mr. Chairman. 1600 MR. VLAHOS: Counsel? 1601 MR. PENNY: No, Mr. Chairman, other than we, in our office here, got a notice that there's going to be a fire drill on Wednesday. 1602 MR. VLAHOS: Usually that happens prior to 8:30. Between 7 and 8. 1603 MR. PENNY: Let's keep our fingers crossed then. 1604 MR. VLAHOS: Usually those fire drills are first thing in the morning unless this is something unusual, but in any event, Wednesday we will not meet until 10:30, I believe. 1605 MR. PENNY: 10:30, yes. And can I just, without bothering you, indicate to the intervenors we would like to canvass them tomorrow morning for their time before we leave, but we don't need to use your time doing it. 1606 MR. VLAHOS: We'll stand down until 9:30 in the morning tomorrow. Thank you. 1607 --- Whereupon the hearing adjourned at 4:54 p.m.