Rep: OEB Doc: 12RXM Rev: 0 ONTARIO ENERGY BOARD Volume: 2 23 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 23 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, Q.C. Canadian Gas Association 8 TABLE OF CONTENTS 9 PRELIMINARY MATTERS: [18] UNION GAS LIMITED/ENBRIDGE GAS DISTRIBUTION - PANEL 1; McSHANE; RESUMED [26] CROSS-EXAMINATION BY MR. AIKEN: [28] CROSS-EXAMINATION BY MR. SHEPHERD: [101] CROSS-EXAMINATION BY MR. KLIPPENSTEIN: [642] CROSS-EXAMINATION BY MR. DINGWALL: [774] CROSS-EXAMINATION BY MR. MORAN: [915] QUESTIONS FROM THE BOARD: [1297] RE-EXAMINATION BY MR. PENNY: [1373] PROCEDURAL MATTERS: [1453] 10 EXHIBITS 11 EXHIBIT NO. F.2.1: EXHIBIT J18.231 FROM THE UNION CASE, 2003 [41] EXHIBIT NO. F.2.2: POLLUTION PROBE CROSS-EXAMINATION REFERENCE BOOK, DATED SEPTEMBER 22, 2003 [660] EXHIBIT NO. F.2.3: DOCUMENT ENTITLED "UTILITY RATE BASE GROWTH AND EARNINGS PER SHARE," FILED BY POLLUTION PROBE [663] EXHIBIT NO. F.2.4: RBC INDUSTRY RESEARCH COMMENT, DATED AUGUST 1, 2003, ENTITLED "UTILITIES - IT'S THE GRID, SILLY" [666] EXHIBIT NO. F.2.5: ONTARIO ENERGY BOARD DRAFT GUIDELINES ON A FORMULA-BASED RETURN ON COMMON EQUITY FOR REGULATED UTILITIES, DATED MARCH 1997, WITH DOCUMENT ENTITLED "COMPENDIUM TO DRAFT GUIDELINES" [1241] EXHIBIT NO. F.2.6: DOCUMENT ENTITLED "REGULATORY FOCUS," DATED JULY 7, 2003, WITH THE HEADING "MAJOR RATE CASE DECISIONS JANUARY-JUNE 2003" [1411] 12 UNDERTAKINGS 13 UNDERTAKING NO. G.2.1: TO DETERMINE WHETHER THE INCREASE OF 1.7 PERCENT IS ROUGHLY THE SAME FOR ALL RATE CLASSES IN THE RESPONSE TO LPMA INTERROGATORY NO. 12 [75] UNDERTAKING NO. G.2.2: TO PROVIDE THE IMPLIED FORMULA CHANGE RESULTING FROM GIVING NO WEIGHT TO THE COMPARABLE EARNINGS TEST [88] UNDERTAKING NO. G.2.3: TO PROVIDE FOR THE EIGHT LDCS IN MS. McSHANE'S U.S. LDC SAMPLE WHAT IS THE PROPORTION OF GAS DISTRIBUTION REVENUE TO TOTAL REVENUE [912] UNDERTAKING NO. G.2.4: TO PROVIDE STUDY BY MS. McSHANE WITH RESPECT TO COMPARISON OF ACTUAL TEN-YEAR CANADAS TO CONSENSUS FORECASTS [931] 14 --- Upon commencing at 9:35 a.m. 15 MR. VLAHOS: Please be seated. 16 Good morning, everyone. 17 Ms. Newland, any preliminary matters? 18 PRELIMINARY MATTERS: 19 MR. PENNY: Yes, Mr. Chairman, there was one outstanding issue from Union yesterday which was a clarification of the position on whether Union is seeking any retroactive or retrospective application of the result of this proceeding. I think Union's position has always been clear, that we're seeking no rate impacts retroactively. So we say any rate impacts would be implemented in 2004 forward. 20 Then the second part of the question was, well, what about the potential for earnings sharing under the PBR, which ends at the end of 2003. And there may be some confusion around that issue, because when the original ROE application was made several years ago, or a couple years ago, Union did reserve its rights with respect to that issue. But given the amount of time and water under the bridge, Union has decided the best course is simply to make it clean, so no retroactive application or retrospective application at all, either for direct rate purposes or for earnings sharing purposes. 21 MR. VLAHOS: Thank you for that clarification. 22 Any other matters? 23 There being none, Mr. Shepherd, shall we go to you next? 24 MR. SHEPHERD: I think actually Mr. Aiken is ready to go, if that's all right with you, Mr. Chairman. 25 MR. VLAHOS: Mr. Aiken, go ahead. 26 UNION GAS LIMITED/ENBRIDGE GAS DISTRIBUTION - PANEL 1; McSHANE; RESUMED 27 K.McSHANE; Previously sworn. 28 CROSS-EXAMINATION BY MR. AIKEN: 29 MR. AIKEN: Thank you, Mr. Chairman. 30 Good morning, Ms. McShane. 31 MS. McSHANE: Good morning, Mr. Aiken. 32 MR. AIKEN: My cross-examination has been shortened a little bit based on Mr. Penny's comments, so I don't expect to be too long. 33 I want to start with Dr. Cannon's evidence, which I believe is Exhibit D.1. 34 On page 28 of his evidence, it would seem to indicate that a forward-looking risk premium is significantly lower than what you've estimated, Ms. McShane. And I'm referring here specifically to the estimates provided by the major pension consulting firms. Their estimates appear to be an equity risk premium of 2 to 3 percent, and the total return on Canadian equities of 7 to 8 percent. 35 Now, during your conversations with Mr. Thompson yesterday, you indicated that you believe that those estimates from these pension fund advisors were on the conservative side; is that correct? 36 MS. McSHANE: For purposes of pension fund accounting, yes, so to make sure that the underlying assumptions were such that the pension funds could be funded. 37 MR. AIKEN: Have you performed any analysis or are you aware of any analysis performed by others that would try and quantify the level of conservatism? 38 MS. McSHANE: No. 39 MR. AIKEN: Now, I provided a copy of some evidence from Union's current rate case to you yesterday, and I've provided this hand-out to everybody this morning. On the top right-hand corner it says Exhibit J18.231. 40 MR. MORAN: Mr. Chair, perhaps that should be marked, then, as Exhibit F.2.1, Exhibit J18.231 from the Union case, 2003. 41 EXHIBIT NO. F.2.1: EXHIBIT J18.231 FROM THE UNION CASE, 2003 42 MR. AIKEN: Now, you can see, Ms. McShane, on the first page, that Union is currently using a return on its assets of 7 percent from the 2004 test year. I take it you would consider that estimate to be conservative? 43 MS. McSHANE: It's a conservative estimate and not particularly applicable to determining a risk premium, but rather, this is an estimate, sorry, a conservative estimate of the return without taking into account all of the potential uncertainty around that. 44 MR. AIKEN: And on the letter that's attached from Towers Perrin, page 2 of that letter, the last paragraph on page 2, you see that in 2002, the expected return on assets was 8.5 percent, and then this letter reduced it - and this letter is dated May of 2003 - reduced it to 7.75 percent for 2004, and then their updated evidence in August reduced that to 7 percent. 45 Now, my question is, has there been any change in your outlook for the equity market return between your original evidence, which I believe was September of 2002, and the current time? 46 MS. McSHANE: Well, certainly yesterday I talked about the decline in long-Canada yields and, therefore, reduced my recommended return on that basis. 47 MR. AIKEN: A point of clarification now. On page 67 of your evidence, you have a range of 12.7 percent to 14 percent, and that's on line 10 of page 67. 48 Can you explain how you came up with that range based or in reference to schedule 18 of your evidence? 49 MS. McSHANE: Yes, it's the range of results for the '92 to 2001 period based on the average of all the company returns, the median of the company returns, and the average of the annual medians for the sample, which is the third from the last column. 50 MR. AIKEN: Yes, I see that. 51 Can you then explain how you arrived at the range of 12.75 to 13.5 on the following page, page 68? What adjustment did you make? 52 MS. McSHANE: That's basically the centre of the range. 53 MR. AIKEN: In your response to Board Staff Interrogatory No. 43, you provided the test results for the elimination of Rothmans from the sample of 15 Canadian industrials, and the numbers you come up with, which I believe are comparable to that third-last column on schedule 18 is an average of 12.2 percent, a 13.3 percent median, and a 12.5 percent average of medians. 54 MS. McSHANE: Sorry, I've got to find this. Sorry -- is this Staff 43? 55 MR. AIKEN: Yes, Staff 43. 56 MS. McSHANE: Yes, I see that. 57 MR. AIKEN: My question is how would the use of these numbers affect your ranges on pages 67 and 68 of tab 3? 58 MS. McSHANE: If I simply left Rothmans out of the sample -- 59 MR. AIKEN: Yes. 60 MS. McSHANE: -- and assumed that they didn't belong in it at all? I'd say that the range would be approximately 12.25 to 13.25. 61 MR. AIKEN: Then that will be effectively -- replace your range on 67? Kind of a bottom-line figure? 62 MS. McSHANE: If I agreed that there was no reason to include them, that would be correct. I think that Rothmans is -- it is a profitable company, but there's no particular reason to leave it out of the sample. It's -- I think Dr. Cannon's concern was that Rothmans has, to his mind, monopoly power, but Rothman's only has about 20 percent of the market, and nobody made that claim about leaving AMASCO of the sample when AMASCO in comparable earnings samples a number of years ago, and AMASCO has over 60 percent of the market. Simply that AMASCO's returns were lower, so it didn't become an issue. 63 MR. AIKEN: If you could turn now to the response to the Interrogatory No. 12 of the London Property Management Association. This will be tab 3. 64 MS. McSHANE: Sorry, number 12? 65 MR. AIKEN: Yes. 66 MS. McSHANE: Yes, I have that. 67 MR. AIKEN: There's a statement in there that the -- it's in the first paragraph of the response: 68 "The return on equity component of the revenue requirement would increase by approximately 16.5 million. This would result in an estimated 1.6 percent impact on delivery rates." 69 Do you know or could you undertake too determine whether that 1.7 percent would be fairly consistent across rate classes? 70 MS. McSHANE: Ill have to undertake to find that out, that answer, because I don't know how Union would intend on distributing any increase in revenue requirement. 71 MR. MORAN: Mr. Chair, that would become Undertaking G.2.1. Perhaps Mr. Aiken could state it for the record. 72 MR. AIKEN: Now, finally -- 73 MR. VLAHOS: Mr. Aiken, could you phrase that undertaking for the Board, please. 74 MR. AIKEN: Yes, to determine whether the increase of 1.7 percent is roughly the same for all rate classes in the response to LPMA number 12. 75 UNDERTAKING NO. G.2.1: TO DETERMINE WHETHER THE INCREASE OF 1.7 PERCENT IS ROUGHLY THE SAME FOR ALL RATE CLASSES IN THE RESPONSE TO LPMA INTERROGATORY NO. 12 76 MR. VLAHOS: Ms. McShane, are you comfortable with that. 77 MS. McSHANE: I'm sure there are people at Union who can help me respond to that undertaking. 78 MR. VLAHOS: Perhaps can we leave it on the basis that you will consult with your client and see if that's -- 79 MS. McSHANE: That's fine. 80 MR. VLAHOS: We'll let it go, Mr. Aiken until after the break. 81 MR. AIKEN: Sure. 82 The final question I have is related to the automatic adjustment mechanism, and the table you have on page 77, which shows the weighting of the three tests that you come up with with a 49 percent adjustment factor. 83 My question here is if the comparable earnings test is given no weight for the purposes of determining the appropriate equity rate of return, what would be the impact on your proposal under your proposed adjustment mechanism? 84 MS. McSHANE: Would you be willing to -- rather than my sitting here with calculator be willing to take that as an undertaking, and I can get back to you and let you know what the implied formula change would be or I can sit here and do it. 85 MR. AIKEN: No, an undertaking is fine. 86 MS. McSHANE: Okay. I would be happy to do that. 87 MR. MORAN: Mr. Chair, that will be Undertaking G.2.2, implied formula change resulting from giving no weight to the comparable earnings test. 88 UNDERTAKING NO. G.2.2: TO PROVIDE THE IMPLIED FORMULA CHANGE RESULTING FROM GIVING NO WEIGHT TO THE COMPARABLE EARNINGS TEST 89 MR. VLAHOS: I thought it was covered yesterday, Mr. Moran, or Mr. Aiken. Is there a different -- I believe Mr. Thompson went after the numbers as to what would happen if you give a zero weight to the comparable earnings test. 90 MR. AIKEN: I believe Mr. Thompson's question was on the return. My question is on the adjustment. 91 MR. VLAHOS: I see. 92 MR. AIKEN: The 75 versus the 50 percent. 93 MR. VLAHOS: Okay. 94 MR. AIKEN: Thank you, Mr. Chairman. Those are my questions. 95 MR. VLAHOS: Thank you, Mr. Aiken. 96 Mr. Shepherd, you still want to -- 97 MR. SHEPHERD: I'm next, yes. Thank you. 98 MR. VLAHOS: You want to go next? Okay. 99 MR. SHEPHERD: Mr. Aiken, has, you'll be pleased to know, with his very efficient cross, has reduced the mine by at least that much. 100 MR. VLAHOS: Music to our ears. 101 CROSS-EXAMINATION BY MR. SHEPHERD: 102 MR. SHEPHERD: Before I get to the meat of my cross-examination Ms. McShane, I'd like to follow up with something you discussed with Mr. Thompson yesterday. You explained that returns on equity are based on book value, but, in fact, investors invest at pocket value and so returns are generally overstated; is that right? In terms of the real word, market value is what their investors put their money in; right? 103 MS. McSHANE: Market value is the level at which investors invest, yes. 104 MR. SHEPHERD: And I understood the discussion between you and Mr. Thompson, but you didn't talk about the concept of opportunity cost, which I would have thought was the key to that whole discussion. Can you tell us what opportunity cost is and how that relates to that discussion? 105 MS. McSHANE: Well, I can give you a definition of opportunity cost, but I'm trying to remember the specifics of the discussion. Opportunity cost, to me, is an estimate of the return available on the next best alternative. 106 MR. SHEPHERD: If you invested a dollar, and the value goes up to $2, but your return is still based on the dollar figure, then you can sell at $2 and invest in something else; right? That's your opportunity cost; right? You can sell and change investments? 107 MS. McSHANE: You can sell and change investments, yes. 108 MR. SHEPHERD: So let's take a real example. Let's look at Enbridge Inc., and I'm picking on Enbridge Inc. because Duke has its own financial issues which complicate the situation and Enbridge Inc. is a little simpler. 109 So let's look at them and let's say they have roughly a billion dollars invested in the equity of Enbridge Gas Distribution. Doesn't matter whether that's the right figure; we're in the range. And that equity is churning out 9.6 percent per year, roughly. Call it $100 million. Which is not a suggestion that we increase the rate of return, it's just rounding. Every year. It's a very stable reliable return on that billion dollars. Am I in the ballpark here? 110 MS. McSHANE: Your assumptions are fine. 111 MR. SHEPHERD: Okay. So, now, if that common equity is actually worth $2 billion in the market, they could actually sell it for $2 billion, then why wouldn't they sell that investment, take the money, invest it in risk-free investments at 5 percent or more, and still make at least the same rate of return today with less risk? Why wouldn't they do that? 112 MS. McSHANE: Why wouldn't they invest at a riskless rate? 113 MR. SHEPHERD: They could make as much money without taking any risk at all; right? 114 MS. McSHANE: I'm sorry, I'm not understanding what you mean, "they could make as much money." 115 MR. SHEPHERD: If they sold at market value, they would have twice as much money to invest. 116 MS. McSHANE: Then they would only produce 5 percent returns. 117 MR. SHEPHERD: Which would be fine, because they would still make as much money as leaving it in the current investment. 118 MS. McSHANE: I guess I'm not following that. 119 MR. SHEPHERD: Okay. They've invested the billion dollars. 120 MS. McSHANE: Yes. 121 MR. SHEPHERD: The value goes up to 2 billion. So they can keep the investment and make $100 million a year, which means they're only really making 5 percent of the current value. 122 MS. McSHANE: Oh, I see what you're saying, sorry. 123 MR. SHEPHERD: Or they could sell it and either make more money at the same risk or make the same money at no risk; right? Why wouldn't they do that? 124 MS. McSHANE: Presumably because they feel that they can continue to make a compensatory return for the risk that they're taking. 125 MR. SHEPHERD: But I thought your argument with Mr. Thompson yesterday was that market values are -- real market values are actually higher than book values, so the return they're actually getting on their investment is lower, isn't it? 126 MS. McSHANE: Well, in the theoretical example that you're giving us, it would appear that that is the case, yes. 127 MR. SHEPHERD: All right. But it is true that one of the reasons why they wouldn't sell is because the return they're getting from Enbridge Gas Distribution is tax-free; right? So it's actually worth more than getting that amount of interest; true? 128 MS. McSHANE: I don't understand what you mean by "it's tax-free." 129 MR. SHEPHERD: When Enbridge Gas Distribution receives a return on its common equity -- sorry, when Enbridge Inc. gets a return on its common equity from Enbridge Gas Distribution, it doesn't pay any tax on it, does it? 130 MS. McSHANE: Because the dividends -- the earnings have already been taxed at the Enbridge Gas Distribution level. 131 MR. SHEPHERD: Notwithstanding that, we're setting the return on the basis of the after-tax amount; right? So when they receive that money, it's tax-free in Enbridge Inc.? Surely this is a relevant factor in your analysis. 132 MS. McSHANE: You're saying because if you pay dividends that have already been taxed or the earnings have already been taxed and they flow to another corporation, that they don't incur corporate tax again? 133 MR. SHEPHERD: Right. 134 MS. McSHANE: That's correct. 135 MR. SHEPHERD: Okay. Now, another reason why Enbridge Inc. wouldn't sell, even if the price went up a lot, is that it has a particular business model that it uses, which is that it has a stable foundation, a business, like a bread-and-butter business that pumps out income every year. It uses that to access capital and then invests the capital in growth. Isn't that its business model? 136 MS. McSHANE: I don't know what its business model is. I have not discussed Enbridge Inc.'s business model with them. 137 MR. SHEPHERD: How can you form an opinion on what the appropriate return on equity is for this enterprise if you don't know its business model? 138 MS. McSHANE: I don't think knowing what Enbridge Inc.'s business model is is relevant to knowing what the required stand- alone return on equity is. I mean, that would suggest to me that the return might be different for Enbridge Gas Distribution versus Union Gas versus any other utility, because the parent's business model might be different, or because there is a parent, one parent versus a number of shareholders. I mean, I think that we should cling to the model that has typically been used in this country, which is to determine the return on a stand-alone basis and not make the return dependent on who owns the company. 139 MR. SHEPHERD: Enbridge Gas Distribution is also a major customer for some of Enbridge Inc.'s other ventures, right, like its pipelines and its customer care business and all that sort of stuff; is that correct? 140 MS. McSHANE: That's my understanding, that there are affiliate transactions, yes. 141 MR. SHEPHERD: So there's a synergy that Enbridge Inc. can get by owning the distribution and keeping it as a major customer of its other entities; isn't that also correct? 142 MS. McSHANE: That would probably be true; that they can, through their operations, create synergies. 143 MR. SHEPHERD: Now, as you've just said that your view of ROE - and I understand that this is what the law has said for years, or at least has implied - starts with a hypothetical free market for that equity, and you don't include any of these other benefits to the parent. You don't look at what is the fair amount for the parent, do you; you look at what the fair amount would be in a free market? 144 MS. McSHANE: If your question is, do I consider the identity of the parent specifically in determining what the allowed return should be, no, I do not. 145 MR. SHEPHERD: Do you think it would be appropriate to consider those other benefits in looking at what the appropriate return is for the parent? 146 MS. McSHANE: Not in terms of looking at the appropriate return, no, I don't. To the extent that there are synergies in terms of lower costs across the corporation, those benefits already flow through to customers. To the extent that there are synergies in terms of raising debt capital, even though Enbridge Gas Distribution raises capital on its own, to the extent that there are benefits to having a strong parent from the point of view of the debt market, those benefits already flow through. 147 So, no, I don't think it's appropriate to change the return based on the identity of the parent. It should be based on the risks of the business on a stand-alone basis. 148 MR. SHEPHERD: Your hypothetical, a lawyer would say you're the man on the Clapham omnibus -- 149 MS. McSHANE: My what, sorry? 150 MR. SHEPHERD: It doesn't matter. 151 MR. VLAHOS: It does matter for the reporter. 152 MR. SHEPHERD: I'm sorry. The man on the Clapham omnibus, sort of a generic hypothetical person. 153 Your hypothetical investor is like a pension fund that has really only an investment interest in the equity; is that right? 154 MS. McSHANE: That would be a fair characterization, yes. 155 MR. SHEPHERD: So your approach to ROE says that Enbridge Inc., or Duke, for that matter, which has a number of other interests in the investment, should get the same return as that investor that only has the investment interest; is that right? 156 MS. McSHANE: Correct. 157 MR. SHEPHERD: Okay, good. 158 You testified yesterday that you have no confidence in the information going back to 1802, the older information, because the markets were a lot simpler, they weren't structured the same as today, the information was not as reliable. Is that a fair characterization of what you said? 159 MS. McSHANE: Yes. 160 MR. SHEPHERD: Now, the point of looking at past data in this sort of situation is to see if it reveals any correlations or patterns; right? Because if you find correlations or patterns, then they might have a predictive value for the future is that correct? 161 MS. McSHANE: They might if the correlation is causal. 162 MR. SHEPHERD: I wonder if you could turn up Interrogatory No. 8 from the applicants to Dr. Cannon, and I think this is Exhibit E, tab 1, schedule 1, question 8. I'm a little confused in the numbering, but I think that's it. 163 MS. McSHANE: Sorry, can you give me the tab number again. 164 MR. SHEPHERD: This is Exhibit E, tab 1, schedule 1, question 8. It's an interrogatory from the applicants to Dr. Cannon. 165 MS. McSHANE: Yes, I have that. 166 MR. SHEPHERD: Now, this attaches copies of the Siegel tables. You're familiar with these tables? 167 MS. McSHANE: Yes. 168 MR. SHEPHERD: And I'm looking at the total real return column, and you see under the line 1946 to 2001, the real return on equities over that 50-odd years is 7.1 percent; do you see that? 169 MS. McSHANE: Yes. 170 MR. SHEPHERD: Now, it's clear from the evidence that that's the correct return to look at in this context, it's the compounded return; right? The arithmetic is not really useful in this context, is it? 171 MS. McSHANE: I'm sorry. What context? 172 MR. SHEPHERD: In the context for setting ROE for a long-term equity investment, you look at compounded returns; is that correct? 173 MS. McSHANE: Absolutely not true. We shall be looking at the arithmetic averages. 174 MR. SHEPHERD: Explain. Why is that? 175 MS. McSHANE: Because the arithmetic averages are the averages which implicitly include the risk of the equity markets. The compound returns essentially assume that your return will be the same from year to year, and that over a long period of time, there will be no deviation. It is indeed the arithmetic average, and that's what I have said in my testimony an quoted why that is. 176 MR. SHEPHERD: I would have thought that if you were making a long-term investment what you would want to know is at the end of the day, when I've invested for a long period of time, what is my rate of return going to be over that whole long term. That's compound; right? 177 MS. McSHANE: And if, indeed, that's what happened, that's what you would have. But the fact of the matter is that you have this difference between the long-term compound return and the arithmetic return, which indicates to you that over periods of time, the returns have been up and down, and there is no guarantee that over your investment horizon, you will earn the compound return. 178 That's why on a forward-looking basis we concentrate on the arithmetic average. When we look at the long-term performance, yes, the compound average is what is actually happened. 179 If you look at both Dr. Cannon and Dr. Booth's responses to data requests, they both say that they give major weight to the arithmetic average. 180 MR. SHEPHERD: All right. I'm not an expert in this area, but I'm having trouble with the common sense of that. 181 You accept, I guess -- if I understand what you said, when you're looking at the past information, you look at compound returns. 182 MS. McSHANE: When you're asking yourself the question, What was the past performance? Then, yes, the compound average is relevant. If you're asking yourself the question, What is my expected return in the future? You need to look at all the possible data points, and if you have a whole history of different annual returns, actually what you're saying is that there are equal probabilities of earning each of those returns. 183 So in order to estimate the expected return, you need to take an arithmetic average of those numbers, and that is the number that will incorporate the risk of investing in the equity market. 184 The compound return, essentially, smooths over all of the risks that had been faced in the past. 185 If you look at data, historical data, I mean there are periods of time if you would have invested and held your money, you would have been negative. If that was your -- your -- and we all know that if we had been planning to retire within the next three or four years based on our market portfolio, that today, we might be saying, you know, not 55, 75. 186 So it's all well and good to say yes, over a long period of time this is what would have happened, but clearly there are considerable periods of risk where those compound returns become fairly irrelevant. 187 MR. SHEPHERD: Well, and I guess the Siegel tables show that, because they show that for those 53 years, there's a 7 percent return, but then they decompose those years into sections, and the returns are all over the map. 188 MS. McSHANE: That's absolutely right. 189 MR. SHEPHERD: That's exactly what you're saying; right? 190 MS. McSHANE: Yes. 191 MR. SHEPHERD: Which tells me -- tell me if this is correct, that the longer you invest, the more reliable your return is, the more predictable your return is? 192 MS. McSHANE: So if I were -- I think that's probably, based on history, fair to say that there's more likelihood if I were to invest for 75 years that I would be closer to the long-term compound average than if I were to invest for ten years, but I think we have to consider the reality of how people invest. I mean, they don't, for example, begin to invest, necessarily, when they're in their early 20s, because they can't. So the typical investment period for your average investor is considerably less than the long term, and that very fact makes it considerably more uncertain where their investments are going to end up when the time comes that they need to draw upon the capital in their investments. 193 MR. SHEPHERD: Well, but when we're talking about the common equity of utilities, we're not talking about primarily individual investors, are we, we're talking about institutional investors, generally speaking. Isn't that where the bulk of their money come from? 194 MS. McSHANE: Yes, I think that's fair that the bulk of investment is made by institutions, but they -- the institution -- I mean they're pension funds, so they have to be concerned about when the pensions have to be paid out, so they're still very concerned about where the -- the value of the portfolio is going to be at the time they need to payout their pension liabilities. 195 In this context, we're not talking particularly about a utility investment. We're talking about the market. 196 So when you start and talk about the market, because the first part of the risk premium that you need to -- utility risk premium that you need to establish is the market risk premium. It's the relative risk adjustment that should take into account the relative risk of the utility. 197 MR. SHEPHERD: Okay. You're assuming the methodology. I'm approaching this from a different point of view. Let me just come back to these tables and see whether you can help me out here. I'm looking at the real returns for the last 50 years, for 75 years, for the 50 years before that, for the 70 years before that, for the whole 200 years, and they all appear to be the same. If you take shorter periods, they go all over the place, but if you take long periods, it appears that there's a consistency, that they all appear to be around 7 percent real return for equities. 198 MS. McSHANE: On a compound basis. 199 MR. SHEPHERD: On a compound basis. There's a concept -- I don't know if this is a concept in your area of specialty, but it's certainly in other areas of science, a concept called a revealed constant. Are you familiar with that? 200 MS. McSHANE: I'm not, no. 201 MR. SHEPHERD: What it means is that if you take a time series of number and it keeps coming up with the same average, then that figure generally has significance. Is that something you're familiar with in your work? 202 MS. McSHANE: Certainly that concept is familiar. I've not heard the term, but yes. 203 MR. SHEPHERD: So if you have 200 years of data and every long period of data you take, every way you decompose it for a long period of time, you come up with 7 percent, doesn't that suggest to you that there's something there? 204 MS. McSHANE: I would suggest that yes, that there is something there, but I think that what I've said earlier is very applicable, the fact that people do not invest over these periods of time. Their horizons are considerably less, and that when you look at the arithmetic average, it is, you know, closer to 8.5 percent, not 7. 205 MR. SHEPHERD: Okay. I wonder if you could turn to School Boards' Interrogatory No. 3? 206 MS. McSHANE: This is to me? 207 MR. SHEPHERD: This is, yes, to you. We only gave you interrogatories. 208 MS. McSHANE: I feel so privileged. 209 MR. SHEPHERD: Oh, you should. 210 Do you have that? 211 MS. McSHANE: I do. 212 MR. SHEPHERD: You were talking with Mr. Aiken and Mr. Thompson about pension funds. It says here that Enbridge Inc. raised common equity five times from 1995 to 2002, a total of over three-quarters of a billion dollars; do you see that? 213 MS. McSHANE: You're on the table -- 214 MR. SHEPHERD: I'm on the table under common equity. 215 MS. McSHANE: You're adding up the amounts 254.7, 160.7 -- 216 MR. SHEPHERD: Will you accept it subject to check that it's $785 million? 217 MS. McSHANE: Yes. 218 MR. SHEPHERD: Your answer to the interrogatory says those were bought deals. Can you tell us what a bought deal is? 219 MS. McSHANE: Actually, this isn't my answer. I did not prepare this response. 220 MR. SHEPHERD: Oh, but unfortunately you're the only company witness, so you're the only person to ask. 221 MS. McSHANE: So I have to answer. 222 MR. SHEPHERD: Sorry about that. 223 MS. McSHANE: A bought deal is when there's a prearrangement with underwriters to purchase the shares. 224 MR. SHEPHERD: Is it fair to say that generally the bulk of that three-quarter of a billion dollars of bought deals is likely to be institutional investors, like pension funds and insurance companies? Isn't that how the market normally works in bought deals? 225 MS. McSHANE: Yeah, I think it's possible that the underwriters have prearranged, to some extent, with institutional investors to purchase the shares. 226 MR. SHEPHERD: Now, I'm going back to Dr. Cannon's responses to the applicants. Do you still have that binder out? 227 MS. McSHANE: No. 228 MR. SHEPHERD: Sorry. Number 6. Applicants to Cannon, number 6, which is E, tab 1, schedule 1. 229 MS. McSHANE: Yes. 230 MR. SHEPHERD: And there he's included this warning from Teachers' Pension Fund. It's a major page pension fund; right? 231 MS. McSHANE: Yes, it is. 232 MR. SHEPHERD: That they expect the average annual return in the stock market to be 3.5 percent over the next ten years. That's real return, right, if I understand what they're saying there correctly? 233 MS. McSHANE: I'm not sure whether it's a real return or not. 234 MR. SHEPHERD: Okay. Well, it would be even worse if it was not -- 235 MS. McSHANE: Well, yes. 236 MR. SHEPHERD: And as I understand what you said to Mr. Thompson and Mr. Aiken, the pension plans, and you can understand why, take a very conservative projection of the future, because they have to be careful not to run out of money, not to be underfunded? 237 MS. McSHANE: Yes. Right. Otherwise they have to contribute the cash. 238 MR. SHEPHERD: Yes. By the way, what I understood you to say yesterday was that one of the reasons that they take a conservative return is so they can catch up if they're underfunded. Is that what you said yesterday? Maybe I misunderstood you. 239 MS. McSHANE: Well, yes, they have to actually fund the liabilities, yes. 240 MR. SHEPHERD: Isn't it true that a pension fund doesn't fund the liability by underestimating their returns, they fund it by putting more money in? 241 MS. McSHANE: Well, at the end of the day, if they don't have the investment returns, they have to put up the money. 242 MR. SHEPHERD: But what I'm saying is, they don't deliberately take a conservative view so they can make up for -- 243 MS. McSHANE: No, no. I'm sorry, I didn't mean to -- 244 MR. SHEPHERD: All right. Okay. So if I understand what you're saying, when the pension plans say they expect a certain rate of return, they're really hoping for more, but they're assuming a conservative number? 245 MS. McSHANE: They're assuming a conservative number. 246 MR. SHEPHERD: So that's not actually their expectation? 247 MS. McSHANE: I would say that they are making conservative assumptions so that they don't end up in a -- find themselves having to explain being in a worse position several years down the road. 248 MR. SHEPHERD: Does that imply that they actually expect a higher rate of return? 249 MS. McSHANE: My sense would be that the numbers that they give are at the lower end, but I have not verified that directly with Teachers' to know what they're underlying assumptions are. My discussions with other pension funds in the past have been that their assumptions are always on the conservative side. But I haven't specifically talked to anybody at Teachers' to know what the difference between this 3.5 percent and what their -- I guess what their best estimate might be. 250 MR. SHEPHERD: Here's what I'm driving at. The pension funds and insurance companies and other institutional investors like that, they're the ones that are the primary investors in this sort of investment that we're talking about the ROE of; and what you're trying to determine is what investors expectations are of what they should make, or what their appropriate expectations are. 251 And if the fact out there is they expect X, I would have thought that that's a relevant piece of information for you in determining what the appropriate ROE is. 252 MS. McSHANE: Well, I think it's not irrelevant, but at the end of the day, we're trying to determine what, in this context, a fair return is for a utility, not what it takes to fund the pension fund. Also, we're looking at what the cost of attracting capital is using a long-term model, which incorporates all of the risk around the risk premium. 253 MR. SHEPHERD: The equity risk premium is usually based on ten years; right? 254 MS. McSHANE: No, I -- 255 MR. SHEPHERD: Isn't that what you said yesterday? I thought that's what you said yesterday, it's tested on a ten-year basis. 256 MS. McSHANE: I don't believe I ever said that; if I did, I don't think I meant to do that. Perhaps you could point me to the transcript and we could clear that up, if that's what you understood me to say. 257 MR. SHEPHERD: You said - I don't have the transcript reference; I'll get it at the break - that the equity risk premium is defined as the expected ten-year difference between equities and government bonds -- and risk-free bonds, I'm sorry. That's what I heard, that's what I wrote down. I'll find the transcript reference. 258 MS. McSHANE: Okay, because I can't imagine that I said that. 259 MR. SHEPHERD: All right. Sorry, I wasn't trying to catch you up. I just thought you said that. 260 My point is that if Teachers' legitimately thinks that it's going to get 3.5 percent over the next ten years, then surely that tells us that that's a fair return for a certain portfolio of investments; correct? 261 MS. McSHANE: No, it doesn't. It tells us that they have a very bearish view of the market at the moment, but that doesn't tell us what their return, their true return requirement is. It may tell us that there's a true disconnect between what their return requirement is and what they think that that particular -- that the market, you know, as a whole may return to them over the next ten years. And therefore, what they may do is try to reallocate their assets in such a way that they are able to invest in alternatives that will be more in concert with their return requirements. 262 One of the things we've noticed with some of the pension funds in the past number of years is that they're investing more in real estate, which presumably to me means that they believe that the risk return profile of real estate is, at this point, superior to other alternatives. 263 MR. SHEPHERD: Once more, I'm confused. This will become a motif in this cross-examination. I thought that your assessment of fair return -- it's not a normative decision. It's not what's fair in some moral sense. It's fair in what the market requires to be paid for a comparable investment; isn't that right? It's investor expectations? 264 MS. McSHANE: It's a combination of investor expectation and investor return requirements. Sometimes those concepts do not match exactly over a certain time frame. 265 And in fact, I notice that Drs. Booth and Berkowitz's evidence suggested that there are -- I forget whether they said millions or billions of dollars that are sitting on the sidelines, because investors are not prepared to go back into the equity market at the moment, because their return requirements in the equity market are below what they think the market, the equity market can return to them in the near term. 266 MR. SHEPHERD: I understood you to say before that you can't consider Duke or Enbridge Inc. as special-case investors. We have to look at pure investment situations. A pure investor has no other interest. That's what I understood you to say. So we can't consider the special case, but it sounds like now you're saying, But if the pure investors out there would give Enbridge Gas Distribution a billion dollars of common equity at 8 percent, and they would be happy with that, we can't use that either. 267 MS. McSHANE: I don't know -- I don't understand what you mean. 268 MR. SHEPHERD: If what the pension funds want is 8 percent, and if they would be willing to invest in this equity at 8 percent, let's say, you're saying that that doesn't determine what the fair return is; is that right? 269 MS. McSHANE: Clearly what the market says is the cost of equity, is a consideration in determining what the fair return is, but there are multiple factors, obviously, that one has to consider, and that's only one of them. 270 MR. SHEPHERD: And that's where I'm having the problem. If fairness is not a market concept, if it's got something more to it, then I don't understand what it is. So either what the market reveals is the right number, or it's something else, and I don't get what the something else is. 271 MS. McSHANE: The fairness standard is really not a totally market concept. The fairness standard does go to what other companies are earning on the same type of value as the return for utilities as set, and that is the book value of equity, and that's why we look at the comparable earnings test in the context of the fairness standard. 272 MR. SHEPHERD: All right. 273 Just one other thing on pension plans. The -- the expected rate of return for a pension plan is what determines what the companies have to contribute each year to keep them funded; right? 274 MS. McSHANE: The expected return -- sorry, the difference between the expected return and the discount rate. 275 MR. SHEPHERD: Just a second. 276 MS. McSHANE: Is my understanding. But I'm not saying that I'm an expert on how these -- these how pension fund accounting works. 277 MR. SHEPHERD: If -- I'd like you to turn to the exhibit that Mr. Aiken just filed, to page 2 of the letter from Towers Perrin. You're familiar with Towers Perrin? 278 MS. McSHANE: I know they do pension fund accounting -- consulting, rather. 279 MR. SHEPHERD: Look at the bottom of the second page, last paragraph, the second sentence says: 280 "As the investment return is an offset to the cost of a pension plan, the greater the expected return on the pension fund assets, the lower will be the pension expense." 281 That's true, isn't it? 282 MS. McSHANE: Yes. 283 MR. SHEPHERD: And conversely, if you reduce your expected returns, your pension expense increases to keep it funded; correct? 284 MS. McSHANE: Sorry, say that one more time. I was still reading. 285 MR. SHEPHERD: Conversely, if you reduce your expected returns, that increases how much you have to fund as a pension expense in order to keep it funded. 286 MS. McSHANE: I think that's correct. I'm trying to remember how that works with the discount rate, but you discount the liabilities to figure out -- I mean, yes, you discount the future value of your pension fund liabilities, depending on what the long-term corporate bond rate is. 287 MR. SHEPHERD: So if, for example, Enbridge, Enbridge Gas Distribution, and Union Gas pension funds use low assumptions for their expected returns, 7 percent, let's say, then that will increase their pension expense and if they end up with a high return on equity, that will increase their expense to pay the shareholder for their equity. So don't they get it both ways. That seems inherently unfair to me. 288 MS. McSHANE: I'm sorry, I didn't follow that at all. 289 MR. SHEPHERD: You use one assumed rate of return from the pension plan; right? That's a low one, a conservative one; you said that? 290 MS. McSHANE: Okay. 291 MR. SHEPHERD: And that increases pension expense, the ratepayers pay that. And you use another rate of return, for example, 11.6 percent on the return on equity, and that's also an expense to the ratepayers. It sounds unfair to me. You're estimating similar things, and there's a big difference, and it costs the ratepayers both ways. How do you deal with that? 292 MR. VLAHOS: Mr. Shepherd, sorry, I was going to say: Is there a question here? 293 MR. SHEPHERD: I'm asking whether that's a fair situation. 294 MS. McSHANE: I think you're doing two separate things; right. On the one hand, your dealing with trying to fund your pension plan and making sure that the liabilities that you have incurred are appropriately available when your employees retire, and if there are -- if you do earn returns above the underlying assumptions, those will go to fund the plan and make sure the plan is properly funded. 295 And if it is funded from investment returns, then that will reduce what the -- what the ratepayers have to have. And that, to me, is a different concept than making sure that there is an appropriate and fair return to the shareholders, the stand-alone shareholder, if you will. 296 MR. SHEPHERD: Okay. Let me move on. 297 Could you go back to School Board Interrogatory No. 3, please. 298 MS. McSHANE: I have that. 299 MR. SHEPHERD: And that shows on the second page that: 300 "Enbridge raised common equity five times in the last seven years and at increasing prices." 301 Is that correct? 302 MS. McSHANE: Yes. 303 MR. SHEPHERD: And -- 304 MS. McSHANE: Well, let's see. 305 MR. SHEPHERD: There's a blip in '98; I see that. 306 MS. McSHANE: Okay. 307 MR. SHEPHERD: And I wonder if you could turn to School Boards' Interrogatory No. 7. 308 MS. McSHANE: I'm trying. I'm lost in all of the attachments. Oh, okay. Yes, I have that. 309 MR. SHEPHERD: Can you look at the second page of that. 310 MS. McSHANE: Yes. 311 MR. SHEPHERD: And you'll see a chart there, and that shows, doesn't it, that the market price of Enbridge Inc. stock has been remarkably strong throughout the period of the current ROE formula; is that correct? 312 MS. McSHANE: Yes, it's been remarkably strong since -- I mean, if you want to put it that way, it's been strong over the past -- 313 MR. SHEPHERD: Nine years. 314 MS. McSHANE: -- six years. Well, it was pretty flat from '94 to '96, and there was some decrease with a decline in '99/2000 when the market dropped. But Enbridge Inc.'s price is a function of things other than Enbridge Gas Distribution. 315 In particular, you know, Enbridge Inc. owns one of the major oil pipeline systems which has been subject to a long-term incentive agreement, has significant assets in the U.S., including the Midcoast assets which it inquired, which are expected to provide incremental earnings to Enbridge Inc. So I don't think you could make any direct connection between the allowed ROE for Enbridge Gas Distribution and the price of Enbridge Inc. stock. 316 I mean, if you look at the corporate earnings of Enbridge Inc., the returns have been in the 13 to 17 percent range, very different from the 9.69 that is the number for, I believe, for 2003. 317 MR. SHEPHERD: And Enbridge Inc. has actually bought most of those assets since it bought Enbridge Gas Distribution; isn't that right? 318 MS. McSHANE: Midcoast for sure, yes, but not the oil pipeline system. The oil pipeline system has been Enbridge Inc.'s major investment for decades. 319 MR. SHEPHERD: Can you turn to Interrogatory No. 6 of School Boards'. 320 MS. McSHANE: I have that. 321 MR. SHEPHERD: If you look at the second page, you'll see three common share offerings by Westcoast, which was the former parent of Union. Do you see it there? 322 MS. McSHANE: Yes, I do. 323 MR. SHEPHERD: And will you accept, subject to check, that those were done at $30.30 in 1998, 32.25 in 2000, and 39.20 in 2001? 324 MS. McSHANE: I will accept it, subject to check, yes, I will. 325 MR. SHEPHERD: I guess now I'm coming back to common sense, and I guess you sort of answered this already. Common sense tells me that the market has spoken about the returns on equity for these two companies and has said, "They're just fine, thanks very much." 326 Now, you're saying that because these are the holding companies, there's a disconnect, and the ROE of the underlying LDC is not an important factor in these share prices; is that right? 327 MS. McSHANE: Well, I wouldn't say -- I wouldn't go that far. I'm simply saying that if we look, in particular, at the case of Enbridge which we were discussing before, when you know that the returns of the parent have been in the range of 13 to 17 percent, clearly the market is speaking about those returns; and it's difficult, if not impossible, to come to the conclusion that the market is saying 9.69, or numbers in that range are appropriate, when that's not what they're seeing on the financial statements of Enbridge Inc. 328 MR. SHEPHERD: Have you read the investment reports, the rating reports of the various investment rating companies on Enbridge Inc.? 329 MS. McSHANE: I have read some of them. 330 MR. SHEPHERD: Is it true that consistently they talk about the stable earnings base from Enbridge Gas Distribution? 331 MS. McSHANE: I would say that that would be -- I don't recall that specifically, but I wouldn't be surprised if they say that. 332 MR. SHEPHERD: Okay. Enbridge Gas Distribution, under its former name of Consumers Gas, which you and I both prefer, I'm sure, was acquired by Enbridge Inc. in 1994; is that right? 333 MS. McSHANE: I'll take that subject to check. I don't recall what the specific year was off the top of my head. 334 MR. SHEPHERD: When you acquire a regulated utility and LDC -- when you acquire any company, you have to assess the value that you're going to pay for it; right? 335 MS. McSHANE: Yes. 336 MR. SHEPHERD: And when you acquire a regulated LDC, you look at the return you can expect in the future based on your acquisition price; isn't that right? In fact, that's the primary way you normally value that sort of asset; isn't that true? 337 MS. McSHANE: I would agree that that's certainly a consideration. It may not be the only consideration. 338 Certainly, there are reasons that go beyond the allowed return that would lead the company to want to acquire utility assets, and that would include, you know, the fact that they view, in particular, utility assets as strategic in the sense that they believe that they can combine those assets with other assets that they own and produce returns that are different from the parent for the particular utility. 339 MR. SHEPHERD: Understood. These are the collateral benefits that we talked about before; synergies, access to capital assets, all that stuff, all those other benefits I understand. But I guess I'm focusing on just the inherent value of the assessment. Typically, you would do a discounted cash flow or a pay-back period analysis for your investment based on the return you expect. Isn't that right? Surely that's part of your analysis. 340 MS. McSHANE: Surely -- I agree with that, that would be part of your analysis, yes. 341 MR. SHEPHERD: And unless you had some particular reason to think that your return on equity was going to go up, you would use the Board-approved return or the historical variation around the Board-approved return in that analysis, wouldn't you? 342 MS. McSHANE: I would think that the Board-approved return would be part of what you would consider. But clearly you would consider other factors that you believe would either enhance or detract from that return; those being tax considerations, the synergies we talked about, the fact that you may view those assets as, in the future, being not subject to regulation. 343 For example, if you were acquiring a utility that had, let's say, significant storage assets, that you might believe that in the future, those storage assets would be unregulated, and that you would be able to earn higher returns from deregulating. All of those would come into play in terms of determining what the future cash flows you would expect from a utility acquisition. 344 So to say that you're just looking at the Board-allowed return is -- I mean, certainly it's a point of departure, but clearly, with other significant matters that you would build into your analysis. 345 MR. SHEPHERD: Duke purchased Westcoast in 2002; isn't that right? 346 MS. McSHANE: Yes. 347 MR. SHEPHERD: So another, in my series of common-sense questions, if Duke purchases Westcoast with an ROE of 9.9 or whatever it was, why would it be suitable, and why would you recommend that they get an increase in the ROE that was presumably built into their purchase price? It would be built into their purchase price in some way, wouldn't it? 348 MS. McSHANE: It would be built into their purchase price in some way, presumably, yes. What Duke's strategic considerations were when they acquired all of those assets, I don't know, but it wasn't just Westcoast, and it wasn't just Union. It was presumably a number of factors that led Duke to believe that the acquisition of some or all of those assets fit well into their overall strategic plan to become a North American energy -- use the term -- giant. 349 But, you know, clearly, those strategic elements are major factors and not just the particular allowed returns on some of the parts of the system at a given point in time. 350 MR. SHEPHERD: Is it fair to say that if this Board approves a substantial increase in the ROE for Union Gas, that increases the value of the Duke investment in West Coast Energy? 351 MS. McSHANE: In principle, if you're allowed to earn a higher return than you can, then there would be an increase in the value of the firm. 352 MR. SHEPHERD: Mr. Chairman, I'm moving to a new area now, if this is a convenient time for a break. 353 MR. VLAHOS: Yes, it is, Mr. Shepherd. Can you tell us how long you have left? 354 MR. SHEPHERD: I'm a little more than halfway through. 355 MR. VLAHOS: It is ten to 11:00, according to the clock on the wall. We will return at ten minutes after 11:00. 356 --- Recess taken at 9:50 a.m. 357 --- On resuming at 11:12 a.m. 358 MR. VLAHOS: Please be seated. 359 Mr. Shepherd. 360 MR. SHEPHERD: Thank you, Mr. Chairman. Prior to the break I said I would find the transcript reference. It is yesterday's transcript, line 1138, Ms. McShane, if you have that. 361 I think the quote from Mr. Thompson is actually an error in the transcript. It should read the equity risk premium, which is defined as, et cetera, in that transcript. 362 MS. McSHANE: Okay. 363 MR. SHEPHERD: I took it that you were agreeing with that definition -- 364 MS. McSHANE: No, I think you -- and I may have spoken too quickly to agree with Mr. Thompson, but what -- what I thought the import of his question was, did I agree with the fact that the equity risk premium was one of the most important numbers in finance, which part I would agree with. I would have to go back to the article itself. Let me see if I have it. 365 MR. SHEPHERD: In any case, Ms. McShane, the point is not to catch you out. The point is to ask whether that's correct that it's a ten-year number; if it's not, that's fine. 366 MS. McSHANE: No, I have never heard anybody define it as being -- the equity risk premium as being a ten-year number. I mean in particular -- I guess in the context of what this particular author was doing, that's the way he was defining it, but -- but that's not a standard definition of equity risk premium by any means. 367 MR. SHEPHERD: Thank you. 368 Can you turn to School Boards' Interrogatory NO. 28, please. 369 MR. VLAHOS: Mr. Shepherd, I think it will assist the record, if you try to give the reference as well. We're talking about Exhibit C, tab 4, and then the question itself. It will be better for all of us when we receive the transcript. 370 MR. SHEPHERD: C, tab 24, schedule 28. I actually got a little lost in the number. 371 MR. VLAHOS: The exhibit list should be part of the material. 372 MR. SHEPHERD: Yes. 373 MS. McSHANE: Yes, I have that. 374 MR. SHEPHERD: Thank you. 375 You've argued, I think, not in this interrogatory, but generally in your evidence, that in today's environment U.S. market returns are more relevant to Canadian fair returns on equity than they used to be because of the increasing globalization of equity markets; is that correct? 376 MS. McSHANE: Correct. 377 MR. SHEPHERD: And in this interrogatory, you say that investor expectation in Canada are increasingly reflecting U.S. rates of return; is that right? 378 MS. McSHANE: That's certainly part of it, yes, that they would be looking to what has been achieved in U.S. markets as a basis for setting their expectations for the future. 379 MR. SHEPHERD: But you're also saying that the Canadian domestic market -- I guess you're not saying that risk premiums in the Canadian domestic market are more in line with those other markets, are you? There's no empirical evidence of that. 380 MS. McSHANE: I'd like to just look at the exact reference so that I can respond to this fully. 381 Sorry. Now I've got the reference. Can you ask me the question again, please? 382 MR. SHEPHERD: Okay. You are not saying that achieved risk premiums for the Canadian domestic market would be more in line with other markets. I take that to mean -- the empirical evidence doesn't show that that's happened, but the investor expectations are being increasingly influenced by those markets, different things. 383 MS. McSHANE: I think that's true, and I was responding specifically to the reference at page 8, in which case I certainly was not, in that reference, was saying that the returns in the Canadian markets would be increasing, simply that -- that Canadian investors would be looking at the returns in other markets. 384 Now, having said that, that's not to say that the Canadian equity risk premiums will not increase as -- as time goes by, because the nature of the equity market in Canada is changing, as it's moved from a resource-based equity market to a more technological, financial equity market, and historically the returns of the resource part of the market have actually been lower than the rest of the market. There's also been a change in the Canadian bond market over time, which, as far as past returns go, since Canadian long-term government bond yields were higher, relative to U.S. bond yields historically, and now are not as high, that does suggest that the Canadian market risk premiums may be higher than they were in the past, but my only point was that was not the implication of this particular paragraph, to which you were referring in your question. 385 MR. SHEPHERD: There's still a substantial disconnect between the Canadian risk premiums and the U.S. risk premiums; is that right? 386 MS. McSHANE: Sorry, in what sense? 387 MR. SHEPHERD: They're not at the same levels. 388 MS. McSHANE: You mean historically? 389 MR. SHEPHERD: Yeah, and currently. Recent data doesn't show that they're at the same level, does it. Empirical data. 390 MS. McSHANE: I don't know what you mean by empirical data showing they're not at the same level today. 391 MR. SHEPHERD: Then I guess I'm asking the question: Are Canadian risk premiums at the same level as U.S. risk premiums currently? 392 MS. McSHANE: I guess I don't know how to answer that question. Historical risk premiums have been higher in the U.S. Some people who look at the future return in the Canadian market versus the U.S. suggest that the returns in the U.S. market may still outpace those in the Canadian market. 393 I've seen other studies, international cost of capital studies, for example, those done by Ibbotson, that indicate that the risk premium in the Canadian market is higher than the risk premium in the U.S. market. 394 So I don't know that there's any strong empirical evidence that there is a difference between the market equity risk premiums in the U.S. versus Canada. 395 Now, if we're talking about utility risk premiums, you know, that may be a different story. So I assume if you're not talking about market risk premiums, you'll let me know. 396 MR. SHEPHERD: I had understood that part of the debate that the experts were having in this was whether the higher U.S. risk premiums were appropriate to use in Canada? 397 MS. McSHANE: Well, okay. I think one of the concerns that I discussed with respect to Dr. Booth's evidence was, he was suggesting that you couldn't import U.S. data directly into Canada because of the dividend tax credit, which, to his mind, I guess, suggested that there might be a higher risk premium in the U.S. than in Canada. 398 I wouldn't, first of all, describe that as empirical evidence. And also, as I indicated, since such significant amounts of investment income in Canada, about 70 percent, and very high proportions of investment income in the U.S., are not subject to taxation at the margin, that shouldn't create a differential return requirement. 399 MR. SHEPHERD: Let me return to the flexibility premium you're proposing, and I'm looking at your evidence at pages 55 through 57 where you talk about this. 400 Sorry, Mr. Chairman. This is in Exhibit E, tab 3, pages 55 to 57, I believe. Yes. 401 Do you have that, Ms. McShane? 402 MS. McSHANE: Yes, I do, yes. 403 MR. SHEPHERD: And if I look at the three reasons, the first one is you want to include something for flotation costs. This is the cost of raising money; right? 404 MS. McSHANE: Correct. 405 MS. McSHANE: And the flexibility premium you're proposing is about 8.6 million for Enbridge and about 9 million or so for Union; is that right? 406 MS. McSHANE: I'd have to check that. I know there was an IR that quantified that, but I'd have to get back to you and give you the exact -- 407 MR. SHEPHERD: Can you accept those subject to check? 408 MS. McSHANE: Yes. 409 MR. SHEPHERD: And clearly, and tell me whether this is true, Enbridge Gas Distribution -- sorry, I guess the shareholder, because this is an ROE, doesn't need $8.6 million for flotation costs, do they? They don't spend that much every year. 410 MS. McSHANE: No, they don't spend that much every year. The flotation cost is a component of the cost of capital that permits them to collect costs that they've incurred in the past and to be in a position to raise capital in the future. 411 MR. SHEPHERD: Okay, but it's true, isn't it, that these utilities both seek to include the costs of raising capital in their O&M and charge it to the ratepayers; isn't that true? Were you not aware of that? 412 MS. McSHANE: No, I have no idea what you're talking about. They're asking for recovery of the cost of -- 413 MR. SHEPHERD: Cost of raising capital, yes. Does that surprise you? 414 MS. McSHANE: If it's the cost of raising common equity capital, yes, it would surprise me very much. If they're asking to include the cost of raising debt and preferred shares, in their cost of debt and preferred shares, no, that wouldn't surprise me at all, because that's the way all utilities collect the cost of raising debt and preferred equity. 415 MR. SHEPHERD: That's fine. 416 The second component you have is a cushion for unanticipated capital market conditions. Can you describe what that is? 417 MS. McSHANE: That would include if a utility needed to raise equity capital in turbulent markets, and the price of the shares turned out to be significantly less than what they had anticipated that they would be able to raise the funds at, it would also include a small amount for the possibility that the cost of capital in that time would significantly differ from what had been anticipated. 418 But if it's really a market pressure kind of concept that recognizes that there are, over time, significant declines in the market that may impair a utility's ability to raise capital at or above book value, and it gives them some flexibility to ensure that they can raise new equity capital at no less than book value. 419 MR. SHEPHERD: Let me understand. So they need an extra $18 million a year just in case the markets are bad at the time they need money? 420 MS. McSHANE: That's one of the elements of it. It's obviously not the only element of it, as this suggests in this section to which you're referring. 421 MR. SHEPHERD: Well, can you estimate how much of the 18 million is for that? 422 MS. McSHANE: No, I haven't specifically taken all of those factors and separated them into parts. The financing flexibility adjustment is to cover all of the factors here, including simply that a utility needs the ability to be in a position to raise capital, so it needs to have a return that conceptually keeps its market value slightly in excess of book value. 423 And this is a concept that is accepted by all three of the witnesses in this case. All three of the witnesses have identical -- they may call them different things, but all three have the same 50-basis point addition to the bare bones cost of capital for financing flexibility for a cushion, in my case to reflect, in part, the fairness principle, if you will, that I discussed earlier yesterday. 424 MR. SHEPHERD: I understand that all three expert witnesses say this. I guess just -- you're not suggesting that because all three expert witnesses say, this Board should accept it without understanding it? 425 MS. McSHANE: No, I'm not saying that they should just accept it because all three witnesses say it, but this appears to me one of the least controversial of the items, when we're talking how witnesses differ on different inputs. 426 In this particular instance, all three agree that some additional element is called for to the bare-bones cost to make sure that the utilities can raise new capital without impairing the existing book value. 427 MR. SHEPHERD: Now, this is not a calculated number. It's not a number that has some sort of data underlying it that you build it up to, you know, 49.7 basis points and round it up. 428 MS. McSHANE: No -- 429 MR. SHEPHERD: It's a plug. It's a number out of the air. 430 MS. McSHANE: No, I would -- certainly, it is consistent with maintaining a particular market-to-book ratio. It's not a plug in the sense that, well, 50 basis points, that sounds like a good number. 431 It's applied to saying, well, what is a -- what is an appropriate minimal market-to-book ratio that would permit a utility a fair probability of being able to raise new capital without impairing its book value. And typically, that number is put at about 1.07 to 1.1, and therefore, you can take that market-to-book ratio and translate that into a number of basis points that would need to be added to the bare-bones cost of attracting capital. And that's where the 50 basis points comes from. 432 MR. SHEPHERD: Okay. Let me turn to your adjustment factor. 433 MR. VLAHOS: Mr. Shepherd, just hold off for a minute. 434 Is that market-to-book ratio 1.07 to 1.10, Ms. McShane, is that in anybody's evidence, because I did not get the quantification, the link. 435 MS. McSHANE: It may not be. It may be that everybody sort of assumes that that was the case, and it wasn't mentioned in this particular -- I don't see it in my evidence, so I may have been -- 436 MR. VLAHOS: I'm just trying to work out the arithmetic, because if you assume a 1.10 market-to-book, how do you translate to 50 -- 437 MS. McSHANE: Perhaps maybe what I could do at lunchtime would be to make a calculation for you and give it to you and you can see how it's calculated. But essentially what it does is it takes the bare-bones cost, uses the target market-to-book ratio, and a -- the expected retention rate for earnings, so it's not simply taking the market-to-book ratio times the return, but it adjusts it downward from just taking the cost of equity times the market-to-book ratio to reflect the fact that there is an earnings retention rate of only 35 percent. 438 But I can give you that calculation and you can see how it -- 439 MR. VLAHOS: I appreciate it. Thanks. 440 MS. McSHANE: -- how it mathematically works. 441 MR. SHEPHERD: Let me turn to your adjustment factor, please, and could you look at the School Boards' 17, which is C.4, schedule 17. 442 MS. McSHANE: Yes, I have that. 443 MR. SHEPHERD: As I understand what you're proposing, if I can wrestle my mind around it, here, your -- your proposed ROE would start out substantially higher than the current benchmark, but over time, because you have a different adjustment factor, it would actually move towards a similar number towards the existing formula; is that right? 444 MS. McSHANE: Yes. If you take it out to numbers that high. My recommendation wouldn't -- would not be that it stay in place that long, because it seems to me that interest rates do go, you know, significantly above 8 percent, that we may be talking about a totally different capital market and we shall review whatever formula or whatever returns we have in place. 445 But yes, mathematically, that's what this shows. 446 MR. SHEPHERD: But then the structure of your proposal is that if interest rates are low, then you're proposing a higher return on equity. If interest rates are high, then you're proposing in a we look at it again, reset it? 447 MS. McSHANE: No, I'm also proposing that that -- I would propose that that's the case that interest rates went significantly below to where we are today, because essentially that -- if you assume that the -- that the long-run growth in the economy, let's say, is 3 percent and that will be approximately equal to the real cost of capital, and that long-term expected inflation was 2 percent, and that will give you an estimate of, sort of, the equilibrium long term Canada rate of 5 percent. If you went significantly below that, you're talking potentially about a deflationary economy and you're into levels of low interest rates that certainly we haven't seen in North America since the '50s or the early '60s, so I would say that you would need to look at the formula again if interest rates get to very low. 448 I would not suggest that this formula be in place at interest rates of 2 percent, for example. 449 MR. SHEPHERD: Interest rates of 2 percent would imply, to your mind, that returns -- the equity risk premium should be higher or lower than your formula would created. 450 MS. McSHANE: I guess I don't know the answer to that question. If you're simply talking about what the formula says, it's indicating higher risk premiums but lower interest ray rates. I mean just the way the Boards' formula does only a different adjustment mechanism, but the fact is that interest rates -- long-Canada rates of 2 percent, since that is -- that basically implies no inflation or negative inflation and a very low, if real, cost of capital. 451 What I'm saying to you is I think that's outside the -- the assumptions that are -- are required to have this formula work, and we should be looking at what an appropriate rate of return is if interest rates are at 2 percent again. 452 MR. SHEPHERD: Yes, I understand what you're saying -- I understand that. But as I understood what you're saying, you're suggesting at very low interest rates or very high interest rates, the formula that you proposed probably -- or may not produce the right number? 453 MS. McSHANE: No, I'm not -- well, yes, I guess I am saying it may not produce the right number, because we likely will be in a very different economic environment. 454 MR. SHEPHERD: I understand that. So I'm asking you directionally: How is your number likely to be wrong? Is this not something that should be evident to you or are there too many variables to -- 455 MS. McSHANE: I think that there are too many variables to know, at this point in time, what the implications of are having -- you know, of being back at interest rates of 9 or 10 percent. We may be in a totally different type of capital market that suggests -- it may suggest a lower risk premium. It may suggest a higher risk premium. 456 All I'm asking is that the formula have certain parameters on it that allow it to be reviewed. I -- it may well be there's no need for change. 457 And I certainly would not want somebody to infer from this -- this proposal, which I believe someone did, that I'm suggesting that just because at high levels of interest rates, that the formula that I've projected shows that returns should be lower than they would be under the existing formula means that that's why I want it reviewed. It may well be those are perfectly appropriate at those levels. 458 And the fact of the matter is that when you go back to the early '80s there was, indeed, a very low indicated utility risk premium, and there were people saying at that time that the utility risk premium should be negative, because the cost of equity was not moving as high as the cost of government debt at that time. 459 So it's not out of the realm of possibility that these numbers would be perfectly fine at those levels of interest rates. 460 MR. SHEPHERD: Thank you. 461 Could you turn to the evidence of Mr. Cleland, which is Exhibit D.35.1. 462 MS. McSHANE: Yes, I have that. 463 MR. SHEPHERD: And at the bottom of page 5, Mr. Cleland discusses the fact that Union Gas has to compete within Duke for capital, and his point, it appears, is that U.S. returns are relevant because Union Gas has to compete for capital within a U.S. parent company. 464 So my question is, do you agree with the principle that because Union is owned by a U.S. company, U.S. returns are relevant to its return on equity? 465 MS. McSHANE: Well, I believe that they're relevant in any event, irrespective of who the parent is, because utilities are competing for capital in a global market. I think it brings it closer to home when you're actually owned by a U.S. company who has limited capital-raising capacity and has to decide where that capital is going to be allocated. 466 But at the end of the day, if the returns available on a U.S. utility investment are superior to the returns available on a Canadian utility investment, and you have a choice whether you're Duke or whether you're the Ontario Teachers' Pension Fund, you're going to allocate the capital to the enterprise that will give you the highest risk return reward. 467 MR. SHEPHERD: Just before we leave this, the competition for capital within corporate groups, is that similar to the competition for capital in the public markets, which is sort of a paradigm you're using generally? 468 MS. McSHANE: I think in principle it's very similar, yes. 469 MR. SHEPHERD: I wonder if you could turn now to the evidence of Mr. Case, which is Exhibit D.35.2, please. 470 MS. McSHANE: I have that. 471 MR. SHEPHERD: Are you familiar with Mr. Case? Is he in the circle of ROE people that you deal with on a regular basis? 472 MS. McSHANE: Actually, I met Mr. Case when he worked at the Ontario Energy Board years ago. I've seen him once or twice, and I've read things that he's written, but he's -- and I don't mean anything by this, but he's not a person that I run into at rate cases, so he's not in the inner circle, if you will. 473 MR. SHEPHERD: He's not one of that group of ROE experts? 474 MS. McSHANE: He's not an academic. He certainly, to my mind, has much experience in this area, and certainly based on his experience, both working at the OEB and working on the area of utility analysis for many years, is perfectly qualified to speak on these issues. 475 MR. SHEPHERD: Can you turn to page 5 of his evidence, please. In the middle of that page, you will see that Mr. Case posits the statement that there is increasing competition in the electricity sector in Ontario and this creates an increase in the perceived risk of equity of regulated gas distribution companies. Do you agree with that statement? 476 MS. McSHANE: Sorry, we're on page 5, at what line? 477 MR. SHEPHERD: Page 5 in the middle, that middle paragraph talks about the structural changes in the electricity industry increasing the perceived risk of LDC equity, gas distribution LDC equity. 478 MS. McSHANE: This whole issue goes to, the way I understood it, goes to the fact that the structural changes in the electricity market have been such that there has been an increase in the competitive pressures as between electricity and gas, and I would agree with that, yes. 479 MR. SHEPHERD: Do you believe that increases the perceived risk of gas LDCs? 480 MS. McSHANE: Yes, I would think that if there's an increased perception in the competitive pressures, that that would be viewed as an increased perception of business risk, yes. 481 MR. SHEPHERD: So would you conclude, then, that that should tend to increase the ROE for these two companies? 482 MS. McSHANE: Yes, I would say that if you're dealing with increases in business risk that are not offset through an increase in the common equity ratio, then the appropriate place to reflect them would be in the return. 483 MR. SHEPHERD: When you did this study, you didn't study this particular type of risk, did you? You didn't look at the risk facing the two companies in this sense? 484 MS. McSHANE: I did not, in my testimony, focus my attention on the changes in the risk profiles of the companies. To my mind, since the capital structure was not to be an issue in these proceedings, I was simply dealing with the changes in the overall capital markets for this purpose, and not focusing on the changes in the risk profiles. 485 MR. SHEPHERD: In your evidence, you conclude that Union Gas is an average risk LDC and Enbridge is a lower than average risk LDC; correct? 486 MS. McSHANE: Yes. 487 MR. SHEPHERD: What was the basis of those conclusions? 488 MS. McSHANE: By comparison of those companies to the other LDCs in the country, BC Gas, Pacific Northern Gas, Gaz Metro, ATCO Gas, and, in fact, there is a data request response to VECC on that where they asked me to actually rank each of them by business risk factor. 489 MR. SHEPHERD: Didn't you just say that you didn't look at the specific risks that they face today in Ontario? 490 MS. McSHANE: I did not do a detailed analysis of the changes in business risk for these utilities since that time. I assured myself that the business risks were certainly no less than they were at the time the last determination was made when the guidelines came out. 491 But I did not do, as Mr. Case did, a detailed analysis of the changes -- increases in the business risk that may be faced today relative to 1997. 492 MR. SHEPHERD: The last time you looked at these companies, you assessed their risks as the same as currently; right? Average risk for Union and below average for Enbridge. 493 MS. McSHANE: You mean relative to each other -- 494 MR. SHEPHERD: To the rest of the market. 495 MS. McSHANE: Yes, relative to the rest of the market, that would be correct. 496 MR. SHEPHERD: So you concluded that that hasn't changed? 497 MS. McSHANE: Relative to the universe -- small universe -- of LDCs and other publicly-traded utilities in this country, no, I didn't change my assessment of approximately where they fit on the spectrum. 498 MR. SHEPHERD: Okay. Still on page 5 of Mr. Case's evidence, he says that there's a long-term -- lower down on the page. He says there's a long-term trend of increasing prices for natural gas, which he says increases the uncertainty for regulated natural gas distribution companies. Would you agree that that's an increased risk for LDCs in Ontario? 499 MS. McSHANE: I would say, generally speaking, yes, that when -- this is all part of his competitive risk issue, where you've got increased prices of natural gas, and you've got an electric utility circumstance in which you've got essentially, at this time, fixed prices, that there will be some perception of increased risk that utilities -- gas utilities will not increase or be able to increase their gas deliveries, because electricity is now more competitive. 500 So where gas utilities might have been able to capture a very high proportion of new housing, that with the relatively low prices of electricity, that new developments may -- it may be electricity-powered revenue than gas. 501 MR. SHEPHERD: So that -- that increased risk, presumably, should increase the rate of return on equity for these two companies? 502 MS. McSHANE: If there is increased competitive pressures, those will, indeed, flow through to the required rate of return. 503 MR. SHEPHERD: On the next page of Mr. Case's evidence, around the middle, he talks about the Ontario government changes its energy policy and regulatory policy, and as a result, he says that there is increased regulatory and political risk in the minds of investors relating to these two LDCs. Do you agree with that? 504 MS. McSHANE: I think in principle that when government is -- takes a position or -- in how regulated utilities function that there is a tendency for that perception of increased risk not just to necessarily affect the specific companies that it may change the rules of the game for, but that generally will extend to other regulated utilities, such as the LDCs, and I think that Mr. Case mentions a particular incident which the government expressed concern about Union Gas case. 505 So I mean, there is the, sort of, the indirect evidence that -- that there are concerns about the government interfering, I guess, with regulation, and the more specific case of an LDC. 506 MR. SHEPHERD: So is it fair to conclude, then, that if a government becomes more activist in how it relates to the rates of the LDCs that the shareholders of those LDCs should get higher rates of return. 507 MS. McSHANE: Well, first of all, activity is not the issue. I mean, a government certainly has the ability to impact the utilities positively or negatively, so it's not the activity, per se, it's what the government does specifically. 508 And in this case, we're talking about circumstances in which basically, the government decided to freeze prices on the electricity side, which was viewed by the investment community quite negatively. 509 So that is an increased regulatory risk that if the shares of the stocks that were affected were publicly priced would, indeed, be reflected in -- in the value and in the required rate return. 510 MR. SHEPHERD: Well, I took Mr. Case to be saying two different things, and may be I misunderstood. You can help me here. One being, as you say, that if the government interferes and hurts the competitive position of the LDC, that obviously is going to increase business risk. 511 But I took it -- and tell me whether this is a correct principle -- that just changing the rules, whether it's good or bad, just changing the rules on a -- too often, creates uncertainty and investors don't like uncertainty, so they treat that as a higher risk; is that fair? 512 MS. McSHANE: Can you point me where he says that? 513 MR. SHEPHERD: No, I -- he doesn't say that specifically. That's what I got out of what he was saying. Tell me whether that principle is a correct principle. 514 MS. McSHANE: If a government continually changed the rules, would investors view that as uncertainty? 515 MR. SHEPHERD: Yes. 516 MS. McSHANE: I think yes, they would view that as uncertainty. 517 MR. SHEPHERD: In the bottom of page 7, Mr. Case talks about a specific change in the OEB Act. He says that adding a new objective to the OEB's mandate protecting consumers is a change that's viewed negatively by investors. Would you agree with that? 518 MS. McSHANE: My understanding is that it wasn't -- it wasn't just that the protection of consumers was added, but also that a line was removed that took out the reference to just and reasonable rates. But I would say that if both of those hold, that there might be some concern on the part of investors that the balance had shifted from a fair consideration of the concerns of both investors and ratepayers to more of a focus on the -- on the consumers. 519 MR. SHEPHERD: Well, let's bring it back to this hearing. If -- if the government asks this Board to put more emphasis on protecting consumers, would you agree that in general that should mean that the shareholders of the utilities should get higher ROEs? 520 MS. McSHANE: Sorry, ask me that again. 521 MR. SHEPHERD: If the government asked this Board to increase its emphasis on protecting consumers that that -- that logically means that risks to investors are higher and, therefore, the shareholders should get a higher ROE? 522 MS. McSHANE: I think that if you were look at a market-determined cost of capital for the companies involved, and that concern, obviously, passed through to the shareholders, it would be reflected in the cost of capital, and implicitly, it would be part of the required rate of return. 523 Now, having said that, I mean there's some logical circularity in all of this discussion, because if -- if the legislation indicated that consumers should be given more weight, than -- although the cost equity might be higher, there's going to be the offsetting tendency to set the returns lower, which sort of is -- puts the allowed rate of return and the cost of equity at odds with each other. 524 MR. SHEPHERD: You're suggesting they're sort of self-adjusting? 525 MS. McSHANE: Well, I'm say that -- 526 MR. SHEPHERD: One offsets the other. 527 MS. McSHANE: The idea is obviously that one of the criteria for determining a fair return is the cost of attracting equity capital. The cost of attracting equity capital, in turn, reflects the risk that the investors see in the marketplace. 528 One of the risks that we're talking about that investors would see in the marketplace is the risk that the allowed return won't be high enough, because the legislation is now saying we should give more weight to consumers than shareholders. So all I'm saying is there's some sort of ironic circularity in that whole argument. 529 MR. SHEPHERD: The test that you employ for determining what the appropriate ROE is is a completely market-driven test. It doesn't consider that change in the OEB Act, for example, or any increased emphasis on protecting consumers. The test is a pure market test. 530 MS. McSHANE: Well, that's not correct, because if you look at the market-determined rates of return, the market-determined rates of return should reflect those risks. 531 MR. SHEPHERD: Sorry. My question was obviously incomprehensible, which isn't unusual. 532 It sounds to me like what you're saying is, given this additional risk, it's legitimate for this Board to increase ROE - it might be a small amount, but by some amount - to reflect that risk. That would be correct under the current test that you use and that other people have used for appropriate ROE. 533 But you're also saying, if I understand correctly, that a change in the OEB Act may make it inappropriate for them to do that. 534 MS. McSHANE: Well, what I'm saying is that, in principle, yes, it's proposed for them to increase the rate of return to reflect the additional risk. But the practicality is that the whole idea that there would be more emphasis on consumers suggests that the allowed rate of return and the cost of attracting equity may be at a disconnect. 535 MR. SHEPHERD: Could you please turn to page 11 of Mr. Case's evidence. And under the heading "Supply Risk" there, Mr. Case talks about the uncertainty of the supply of natural gas to Ontario LDCs leading to what he calls a stranded asset risk. Can you briefly describe what a stranded asset risk is. You're familiar with that; right? 536 MS. McSHANE: A stranded asset risk is the risk that assets that have been devoted to public use and for which investors have put up capital will not be fully recovered. 537 MR. SHEPHERD: And one way that happens is because the business can't continue, is not sustainable? 538 MS. McSHANE: Correct. 539 MR. SHEPHERD: The distribution business, for example, is not sustainable so it can't afford to amortize the cost? 540 MS. McSHANE: Yes, that the market will become such that prices cannot be set to recover those costs; be it because the industry becomes obsolete or be it because competitive circumstances are such that prices cannot be set high enough to allow a particular utility industry to compete with alternatives. 541 MR. SHEPHERD: Do you believe there's any reasonable possibility that either Enbridge Gas Distribution or Union Gas will realize a stranded asset risk? 542 MS. McSHANE: It's possible in the long term, yes. I would not say that there was a very high probability of that happening, but I would say that, based on what's happening in the gas supply area in the western sedimentary basin over the past five years, that the probabilities are somewhat higher today than they were five years ago. 543 MR. SHEPHERD: Have any of the investment analyst's reports that you've seen on these two utilities ever mentioned a stranded asset risk? 544 MS. McSHANE: Not to my knowledge, no. 545 MR. SHEPHERD: So I take it that means that in general it's thought to be a very small risk? 546 MS. McSHANE: I would say that in general, it's certainly not a risk that investment analysts are looking at coming to fruition in the near term. 547 MR. SHEPHERD: Are you familiar with the term "legacy business"? Like a cigarette company, for example, is considered a legacy business because it's assumed that its business is going to go down over time and is not sustainable in the long term. Are you familiar with this? 548 MS. McSHANE: I have not heard that term before, no. 549 MR. SHEPHERD: Are you familiar with the concept, that certain types of businesses are not sustainable in the long term? 550 MS. McSHANE: Well, clearly that's true of some businesses, yes. 551 MR. SHEPHERD: And when that's the case, is it true that generally the investors expect higher returns, because in the very long term, the business isn't going to be there; true? 552 MS. McSHANE: I would say that's a fair assumption, yes. 553 MR. SHEPHERD: Now, the risk of uncertainty of supply creates a similar problem for Enbridge and Enbridge Gas Distribution and Union Gas; right? Over the long term they might not be viable because they might not have sufficient supply to grow? 554 MS. McSHANE: That's correct. 555 MR. SHEPHERD: Is that a risk that should be taken into account in setting their ROE? 556 MS. McSHANE: Their long-term viability risk? Yes. 557 MR. SHEPHERD: Have you considered that? 558 MS. McSHANE: Implicitly you consider that in setting their return. If you're asking me if I've said this is a huge risk for which there should be a specific increment of compensation, no; but its long-term sustainability risk is something that you implicitly consider when determining what the required return is. 559 MR. SHEPHERD: Can you turn to page 14 of Mr. Case's evidence. 560 MS. McSHANE: Yes, I have that. 561 MR. SHEPHERD: You'll see where he talks under the heading, "Removal of Assets from Regulation," it talks about the spin-off of what used to be called the ancillary businesses, out of Enbridge and Union, and says that as a result, they now face increased weather risk. Do you agree that that increased risk is there today? 562 MS. McSHANE: Yes. In fact, that has been specifically - and of course I can't find it - noted by DBRS in their downgrade of Consumers Gas in 2001, where they talked about the fact that earnings -- it says: 563 "Earnings volatility from traditional business risks such as weather and economic has increased as a percent of base earnings following the transfer of ancillary businesses to affiliates during fiscal 2000 due to a decline in approved ROEs over the last five years." 564 So they certainly noted that the removal of these assets from regulation increased the exposure to weather risk. And in fact, I mentioned this as well in the response that I made to one of the data requests. 565 MR. SHEPHERD: Now, again, here's another thing I don't understand. 566 So these businesses are spun off, and the parent company -- in the case of Enbridge, the parent company sells this business for a billion dollars, makes a big profit. How is that big profit on the sale factored into the increased risks at the utility level? Because the two things are related; right? 567 MS. McSHANE: I don't understand how they're related. 568 MR. SHEPHERD: Well, you spin out this business and, as a result, you have a higher risk in the utility. 569 MS. McSHANE: Because you were required to. 570 MR. SHEPHERD: But then you make several hundred million dollars profit on the sale of that business, surely those offset each other somehow? Is that not correct? 571 MR. PENNY: Is Mr. Shepherd asking Ms. McShane to assume that that was the case for the purposes of this question? 572 MR. SHEPHERD: Okay. 573 MR. PENNY: And I guess alternatively, is there going to be some evidence that that assumption is, in fact, correct, such that the question has any validity or meaning to it? 574 MR. SHEPHERD: I think everybody in the room knows that Enbridge sold this business for a billion dollars. It's public knowledge. 575 MR. VLAHOS: Would you restate the question, Mr. Shepherd, so we're aware -- 576 MR. SHEPHERD: What I'm trying to understand, Mr. Chairman, and maybe I've phrased it inelegantly, is if there's an increased risk in the utility because some assets are spun off, but those assets are also sold by the parent for a substantial amount of money, how do you, in terms of determining what the fair return on equity is, balance those two considerations? Or do you? I mean, maybe you don't. I don't know. 577 MS. McSHANE: I certainly have not specifically taken into account the fact that the parent may or may not have sold the assets for above or below their book value. 578 And I think that certainly there were, you know, benefits to customers from those ancillary assets prior to having them spun off. 579 And you know, in my particular case, I think that there is some kind of an offset as between, you know, the risks that the company faces today versus before with the ancillary businesses. 580 But, you know, I see Mr. Case's evidence as looking at the compilation of changes in risk over time and not simply saying that one specific risk should be given a specific rate of return, but simply trying to show that in the aggregate, when you look at the changes from 1997 to today, that in the aggregate, there has been an increase in the utility risk over time. 581 MR. SHEPHERD: Perhaps you can turn to page 23 of his evidence. You'll be happy to know, Mr. Chairman, I'm almost finished this. 582 At the top of page 23, Mr. Case refers to the current constraints that Duke is facing in the availability of capital, and the question I want to ask you is a question of principle. 583 In your view, is it appropriate for this Board to consider the capital constraints of the parent in determining what the appropriate ROE is? 584 MS. McSHANE: Not specifically, no, but I think that it has to recognize that the parent does have options, just like any investor would, and that a fair return to the shareholder, be it individual shareholders or a parent like Duke, has to be a competitive return. 585 MR. SHEPHERD: And obviously, I've misstated the question. 586 I'm trying to contrast the parent that has limited resources, Duke, for example, and the parent that has more resources, like Enbridge, and I'm asking you whether the level of resources, the ease with which the parent can fund the utility should be a relevant factor to this Board in determining the appropriate ROE? 587 MS. McSHANE: No, I think what needs to be the relevant consideration of this Board is what the risks are of the business, and what the alternative comparable returns are, but I don't think that the fair return for a particular utility should be a function of what the particular parent circumstances are. 588 MR. SHEPHERD: Finally, if you turn to page 26 near the top of the first full paragraph, Mr. Case talks about the excesses of the U.S. utility holding companies over the last few years, which are well-documented, and as I understand it, it says that while Canadian utilities largely avoided those same excesses, investors have, to a certain extent, tarred them with a same brush, and as a result, have raised their expectations from returns from Canadian utilities, even though they weren't as bad as the U.S. utilities in their behaviour. 589 Would you agree that that's a correct statement of the facts? 590 MS. McSHANE: So we're looking at this paragraph on page 26 above, "This largely U.S. phenomenon." 591 MR. SHEPHERD: Yes. So he says, for example: 592 "After some high-profile negative surprises, investors and credit rating agencies seemed increasingly unable or unwilling to discriminate between classic regulated utilities and riskier diversified utilities." 593 MS. McSHANE: I think for a particular period of time, that was definitely true. 594 MR. SHEPHERD: Is it fair to conclude then that the various messes in the United States are increasing the appropriate ROE for Canadian-regulated LDCs? 595 MS. McSHANE: Well, it certainly wouldn't be a consideration that I would explicitly include in my return recommendation. I mean I would -- if I were looking, for example, to U.S. utilities as a benchmark, I would be looking at utilities that were pure-play regulated utilities and were not involved in circumstances like Pacific Gas Electric or Enron or -- obviously those are extreme examples, but you get the import of my comment. 596 But if -- if it's true that the cost of equity reflects the possibility that the factors that affected U.S. utilities spillover into the capital markets here, I don't think they can be ignored. I mean, if it increases your cost of debt because credit rating agencies and debt investors require a higher cost because the whole industry is viewed differently than it was previously, you can't avoid those costs. 597 MR. SHEPHERD: One final question. I took it from your discussions with Mr. Thompson today -- or yesterday, rather, that while the -- we have a sense here, I think -- a lot of us anyway -- that this is sort of a battle of the experts. 598 MS. McSHANE: I've been told that, yes. 599 MR. SHEPHERD: Each of you have your little black box and out pops a number, and we have to figure it out. I take from what you were saying yesterday that you perceive the role of the Board here as not to figure out what black box is right or which number is right, but to use common sense and come to a number that they feel is a comfortable number. Is that -- do I understand correctly that that's what you think they should be doing? 600 MS. McSHANE: I don't know that I would put it quite that way, but I would clearly say they should use their common sense. 601 I clearly believe that they should look at the range of evidence that's in front of them, and not be necessarily tied to the results of one test when they look at what a fair return is, because to me, you know, simply looking at the specifics of an equity risk premium test is not sufficient to determine what a fair return is. 602 I mean, you need to look at numerous factors including, you know, what true comparable returns are, including what's happened to debt costs over time, what is happening with respect to what other companies are allowed in North America, with which Canadian utilities compete. 603 So in that context, that, to me, is using your common sense to look at all of the factors in coming up with a number that the Board believes is fair and reasonable. 604 MR. SHEPHERD: Mr. Chairman, and Ms. McShane, thank you for your patience, and those are my questions. 605 MR. VLAHOS: Thank you, Mr. Shepherd. 606 Just allow me to clarify one thing, Mr. Shepherd, while you're still here. 607 Let me start with Ms. McShane, first. There was a very quick exchange about the ancillary programs, when they were sold, and I believe you made a statement, Ms. McShane, it may not have been picked up by the reporter, but it's understanding that divestiture of the ancillary programs was a requirement by someone? 608 MS. McSHANE: That was my understanding, and I could be wrong. I was -- my recollection was at some point -- 609 MR. VLAHOS: My understanding is it is not a legal requirement or regulatory requirement, but I'm sure -- 610 MS. McSHANE: I'm sure if I'm wrong, I'll be strained out. 611 MR. VLAHOS: I want to make sure that you understand that that it was not a legal requirement for the ... 612 Mr. Shepherd, when you posed those questions about the potential additional risk investors in the utility would have in those ancillary programs, and you brought the example of selling the business, once you remove it from the utility, then is it still necessary, or would your questions be the same as long as you just left the utility. You see what I'm getting at? 613 MR. SHEPHERD: Yes, Mr. Chairman. I think the questions would be the same in either case, because whether or not you sold it and made a profit, or you kept it and had an asset of higher value, you still have reaped a benefit from that spin off. 614 MR. VLAHOS: By "selling" you mean the utility selling to the parent, or are you talking about the parent selling outside? 615 MR. SHEPHERD: No. The parent selling outside. 616 MR. VLAHOS: What turns on the parent selling outside as long as -- 617 MR. SHEPHERD: If there is a higher risk in the utility and therefore a higher return is required on the utility investment, it makes sense that if there's an external profit of some whatever it is, that offsets that higher risk within the utility. You lose a little money in one place, but you gain money in another place. Your overall position is similar. That was what I was driving at. 618 MR. VLAHOS: I still have difficulty with that, but -- 619 MR. SOMMERVILLE: As I understood it, the core of the point was that the isolation of the stand-alone utility from ancillary services increased its exposure to weather variation, and that really has nothing to do with whatever happens downstream of that divestment, or divestiture. 620 If we're looking at the utility as a stand-alone entity, and we're looking at its risk, and its risk increases with its isolation from the ancillary services, certainly the first part of the analysis is that as soon as you divest yourself of that ancillary cushion, if you like, or that margin around the utility, then you've increased the risk to weather variation. 621 Now, as I took the second layer of your -- or it seemed to me where you were going seemed to be on the idea that there ought to be some monetary or percentage offset related to the proceeds, one way or another, experienced from that divestiture. 622 MR. SHEPHERD: I think, Mr. Sommerville, what I was trying to drive at there was the utility or the parent has already, in effect, been paid for that additional risk by the profit they made selling the ancillary business, so if they're paid for it once, they shouldn't be paid to take it again. That's all I'm saying. 623 MR. SOMMERVILLE: Thank you. 624 MR. VLAHOS: Okay. We can break for lunch now, and we'll come back with -- Mr. Klippenstein, are you going to be next? 625 MR. KLIPPENSTEIN: Yes, I believe so. 626 MR. VLAHOS: Followed by Mr. Dingwall, followed by Mr. Moran. I believe Mr. Smith you don't have any questions you indicated, sir? 627 MR. SMITH: That's correct, sir. 628 MR. VLAHOS: I just want to repeat my message of yesterday, we want to finish as soon as possible, by Friday at the latest. Therefore, it's imperative that we finish with Ms. McShane today. 629 MS. NEWLAND: Mr. Chairman, before you rise, I'd like to ask to be excused from this afternoon's session. I intend to go back to Enbridge's office and sharpen my knife on Mr. Booth, so my colleague, Mr. Penny, will be taking over, with your permission. 630 MR. VLAHOS: Thank you very much. 631 It's 12:30 or so. Let's resume at 1:30. 632 --- Luncheon recess at 12:24 p.m. 633 --- On resuming at 1:34 p.m. 634 MR. VLAHOS: Please be seated. 635 Okay, we're back. Any preliminary matters? Mr. Penny or Mr. Moran? 636 MR. PENNY: No, Mr. Chairman. Ms. McShane got partway through the calculation that you'd asked for but got sidetracked. We'll have it for you this afternoon. 637 MR. VLAHOS: That can wait. You can mail it to us. You haven't given an undertaking. 638 MR. PENNY: We'll have that this afternoon. 639 MR. VLAHOS: Ms. Desai, have we distributed this instruction sheet for the fire alarm? There's a bunch of copies left for tomorrow. You might want to spend a couple minutes reading that at your leisure, after hours. We don't know what time it will be; but just in case it's after 10:30, then we'll be guided by that time. Okay, if there are not any other matters. 640 Mr. Klippenstein. 641 MR. KLIPPENSTEIN: Thank you. When I first received these fire alarm instructions, I thought I was supposed to cross-examine Ms. McShane on them. 642 CROSS-EXAMINATION BY MR. KLIPPENSTEIN: 643 MR. KLIPPENSTEIN: Thank you, Mr. Chairman. 644 Ms. McShane, just by way of introduction, my name, of course, is Murray Klippenstein and I represent Pollution Probe, which has an interest in advocating for cost-effective energy efficiency and energy conservation. 645 In the interests of saving time in cross-examination, I'm going to be rather direct about where I'm headed with my questioning, partly to save time and partly because this might be an area that the Board doesn't usually see in on a return on equity hearing. 646 I'm going to be asking questions about the relationship between the growth of rate base and earnings per share, and I think that's a relationship that the Board doesn't normally need to look at, so let me just tell you where my questions will be headed. 647 I will be asking about whether there is a possibility that energy conservation and energy efficiency measures would slow rate-base growth over what it otherwise would be, and whether that means that earnings per share growth is slower than it otherwise would be; and if that's so, whether Enbridge or Union managers might see energy conservation as harming shareholders. 648 Does that help you at all in terms of seeing where I might be going with my questions? 649 MS. McSHANE: Yes. 650 MR. KLIPPENSTEIN: And following up on that, I will be asking questions related to whether the Board should consider approving some kind of off-setting upward financial allowance in return on equity, such as through a shared-savings program to avoid an anti-conservation pressure in financial incentives. 651 Is that intelligible as to where I might go with my questions? 652 MS. McSHANE: Yes. 653 MR. KLIPPENSTEIN: Okay. Now, having tried to set out a bit of a road map - hopefully to avoid surprises, at least from me to you; I don't know about surprises from you to me - it may be useful, Mr. Chairman, Members of the Board, it may be useful to turn up three documents for ease of reference. I've earlier provided these to my friends and I understand there won't be a problem with them being exhibits. The first is a bound document called "Pollution Probe Cross-examination Reference Book," which was provided. But if Board Members require one, I have extras. 654 MR. VLAHOS: Give us a minute, Mr. Klippenstein. And this was provided yesterday. I seem to be the only one from the Panel who doesn't have that document. I only received a one-pager -- 655 MR. KLIPPENSTEIN: I'll bring an extra. That page you refer to, sir, is the second document I would ask the Board Members to retrieve. That's a chart entitled, "Utility Rate Base Growth and Earnings Per Share." 656 MR. VLAHOS: Sorry, Mr. Klippenstein. Mr. Bob Betts needed two copies to read, just to compare. I've got mine now. Thank you. 657 MR. KLIPPENSTEIN: Thank you. 658 And the third document was just placed before you, and it's an RBC Capital Markets Research Industry Comment. So I wonder, if you do have those, and I believe Ms. McShane should have those, I wonder if I could have exhibit numbers for those three documents, I guess; beginning with the cross-examination reference book which just contains, except from one thing, I think, documents from elsewhere in the materials but collected for, hopefully, your convenience. 659 MR. MORAN: Mr. Chair, the next exhibit is F.2.2 entitled "Pollution Probe Cross-examination Reference Book," dated September 22nd, 2003. 660 EXHIBIT NO. F.2.2: POLLUTION PROBE CROSS-EXAMINATION REFERENCE BOOK, DATED SEPTEMBER 22, 2003 661 MR. KLIPPENSTEIN: And the second document entitled "Utility Rate Base Growth and Earnings Per Share". 662 MR. MORAN: F.2.3 is a chart entitled "Utility Rate Base Growth and Earnings Per Share" filed by Pollution Probe. 663 EXHIBIT NO. F.2.3: DOCUMENT ENTITLED "UTILITY RATE BASE GROWTH AND EARNINGS PER SHARE," FILED BY POLLUTION PROBE 664 MR. KLIPPENSTEIN: And the RBC Research Industry Comment. 665 MR. MORAN: And that would be F.2.4, RBC Industry Research Comment, dated August 1st, 2003, entitled "Utilities - It's the Grid, Silly." 666 EXHIBIT NO. F.2.4: RBC INDUSTRY RESEARCH COMMENT, DATED AUGUST 1, 2003, ENTITLED "UTILITIES - IT'S THE GRID, SILLY" 667 MR. VLAHOS: I want to see how that will show up on the transcript. 668 MR. KLIPPENSTEIN: If I could direct your attention to F.2.3, which is a chart entitled "Utilities Rate Base Growth and Earnings Per Share." I would just like to introduce the chart. It's also entitled "A Share Issue Scenario," and a first column is entitled "Status Before Share Issue," and I'd like to just walk you through this as a scenario on certain relevant factors of a utility before and after it issues shares to finance rate-base expansion. 669 In the column that I've just mentioned, the utility has outstanding shares of -- numbered 100. It has a rate base of $100. These are all just used for simplicity. The book value of the shares is $1, and the market value of the shares is $1.25. The approved return on equity rate is 10 percent, and when you apply that 10 percent to the rate base and account for the number of shares, you have an earnings per share figure of 10 cents. 670 Does that make sense to you as a postulated scenario for a utility? 671 MS. McSHANE: Yes. 672 MR. KLIPPENSTEIN: If I then move on to the next column and suggest a share issue, and this is particularly relevant, because in the scenario I put to you, the market value of the utility's shares is higher than the book value of the share, and I take it you would accept that that's a situation that sometimes happens in the real world? 673 MS. McSHANE: Yes, it is. 674 MR. KLIPPENSTEIN: In this scenario, the utility issued shares to finance expansion, and it issues 80 shares at the market value, thereby raising another $100. Then after that share issue, in the next column entitled "Status After Share Issue" we now have the utility with a rate base of $200, assuming that all of the capital was put into rate base through expansion investment, and the number of shares are now $180; and the book value of the shares, when you average it out before and after shares, is $1.11. The market value of shares is $1.25, because that's the market value of the shares, and the return on equity remains at 10 percent. 675 Is that a plausible scenario so far? 676 MS. McSHANE: Yeah, it's an appropriate illustrative example, I think, to show what happens. Basically you're doubling your rate base here, which is -- 677 MR. KLIPPENSTEIN: Right. 678 MS. McSHANE: -- not likely to happen overnight. But for purposes of illustration, this works. 679 MR. KLIPPENSTEIN: Thank you. It's obviously intended to be only illustrative. In that scenario, then, after the share issue, the earnings per share would calculate out as 11.1 cents, which is based on applying the return on equity to the rate base and then dividing by the number of shares? 680 MS. McSHANE: Correct. 681 MR. KLIPPENSTEIN: Is that fair? 682 MS. McSHANE: Yes. 683 MR. KLIPPENSTEIN: So what this shows you is a scenario in which, because the market value of the utility's shares are higher than the book value, the utility can issue shares at the market value, and increase its rate base, and the earnings per share goes up a little; right? 684 MS. McSHANE: That's correct. 685 MR. KLIPPENSTEIN: And there's no mystery or magic or surreptitiousness about that. That's just because thanks to the higher market value than book value, the amount of rate base goes up more than the number of shares go up; right? 686 MS. McSHANE: Yes, that's right. 687 MR. KLIPPENSTEIN: So the amount of the rate base for each share or the amount of rate base on which each share collects return on equity is increased; correct? 688 Or to put it another way, each share now collects return on equity from a larger amount of rate base? 689 MS. McSHANE: Each share collects return on equity from a larger amount of rate base? 690 MR. KLIPPENSTEIN: Yes. 691 MS. McSHANE: That's right. And because each share is still earning the same rate of return, 10 percent, in your example, then the earnings per share go up. 692 MR. KLIPPENSTEIN: Right. 693 MS. McSHANE: And in effect, this is a bit of an unusual situation that applies to regulated utilities because unlike many other businesses, the new share-financed expansion automatically assumes a rate of return like all the rest of the capital. That's just the way the -- 694 MS. McSHANE: That's the way regulation tends to work. In circumstances for non-regulated companies, the incremental return might be significantly higher. 695 MR. KLIPPENSTEIN: Right. 696 MS. McSHANE: But, yes, the assumption here would be that all of the dollars would earn a 10 percent return. 697 MR. KLIPPENSTEIN: All right. Now, if I could ask you to take the Pollution Probe cross-examination reference book, which is Exhibit F.2.2 and turn to tab 2, that's the interrogatory answers from Dr. Booth and Michael Berkowitz found at Exhibit E, tab 2, schedule 3. And if you could turn to the second page of those answers, page 5 of the Pollution Probe reference book, the paragraph at the top, I'll read to you and suggest to you that that's an answer from Dr. Booth and Michael Berkowitz, which is saying the same thing that I discussed with you. 698 They say: 699 "For regulated utilities where R1 equals R2 as all assets enter the rate base and earn the same rate of return, selling new stock to net in excess of book value increases the EPS, whereas, selling less than book calls dilution and a fall in the EPS." 700 Am I correct in -- or would you agree that that's another way of describing the scenario or the logic that I just discussed with you? 701 MS. McSHANE: Yes, it is. 702 MR. KLIPPENSTEIN: Thank you. And I take it you wouldn't quarrel with their way of stating it either, subject to whatever qualifications you might want to add as well? 703 MS. McSHANE: The way it's stated, I don't have any problem with accepting that that's the theoretical outcome, yes. 704 MR. KLIPPENSTEIN: Let me just take this theoretical situation and ask how it might apply to the parties before us, for example, Enbridge Gas Distribution, which is owned by Enbridge Inc. Would you agree that if Enbridge issues new shares in circumstances where the market value of the shares is higher than book value or Enbridge Gas Distribution, that its earnings per share or the earnings on its shares will increase, assuming that the financing is used for rate-base activities? 705 MS. McSHANE: I thought about that earlier, because theoretically, that's true. If they were to raise equity in the open market and were to raise it above book value, that's correct. The fact is, the equity is basically infused to maintain the common equity ratio at 35 percent, so there's no explicit raising of equity at above book value. But in principle, that's what would apply if they were going out and raising it in the marketplace. 706 MR. KLIPPENSTEIN: So you've mentioned the 35 percent factor, and that would be a variation on the principle or logic we went through, but the logic would apply; is that right? 707 MS. McSHANE: I guess you could say on a stand-alone basis the logic applies. On an actual basis it probably doesn't work quite that way because to the extent that there needs to be an equity infusion from the parent company to maintain the 35 percent common equity, there's not an explicit raising of equity at above book value, at least the way I understand it works. 708 MR. KLIPPENSTEIN: Right, and the other half of that picture, I would gather, is that to the extent that the equity doesn't come from the parent, the logic would apply? 709 MS. McSHANE: That's absolutely right. 710 MR. KLIPPENSTEIN: So whatever capital doesn't come by means of that 35 percent or from the parent, the logic and the results that we've just discussed would apply? 711 MS. McSHANE: Yes, if Enbridge Gas were in a situation where they had to go out into the marketplace and raise the equity, then assuming there were a transparent market price, then that's what the logic would say. 712 MR. VLAHOS: Mr. Klippenstein, I'm not sure if -- I guess the analogy would change, but I notice here that in rate base, you're assuming $100, the number of shares a 100, and book value of shares, so you are assuming 100 percent equity capitalization? 713 MR. KLIPPENSTEIN: Yes. 714 MR. VLAHOS: I don't know whether anything turns on it, but that's not a typical scenario for a utility in Ontario. 715 MR. KLIPPENSTEIN: I understand that's a stipulated assumption. 716 And Ms. McShane, would it be fair to say in response to the chairman's question, that the logic that we've discussed only applies to the extent that it is financed in this way? 717 MS. McSHANE: I think it's fair to say that it really doesn't matter whether it's 100 percent equity financed or 35 percent equity financed, the logicals. 718 I mean, you could take this piece of paper, F.2.3 and put it next to rate base financed by equity, and the logic would still hold, because we're still really -- we could be talking about the amount of rate base that's equity financed. 719 MR. KLIPPENSTEIN: Thank you. 720 Perhaps, before I move on, I'd like to just ask you about applicability of that situation to where we are now. 721 If you could turn to the Pollution Probe cross-examination reference book at tab 5. And that is an information request from Pollution Probe to Enbridge which seems to report that, at least in that -- that point in time, a week or so ago, the share price was approximately $50, and the book value per share was approximately $18.52, so that the book-to -- or rather the market-to-book ratio was about 2.7. Is that a plausible situation now? 722 MS. McSHANE: That's Enbridge Inc.'s market-to-book ratio. 723 MR. KLIPPENSTEIN: Do you happen to know whether Enbridge Gas Distribution's market-to-book ratio now would be likely greater than one to one? 724 MS. McSHANE: They don't have a market-to-book ratio so I couldn't tell you what it would be. I guess you could say on the basis of what the market-to-book ratios of all the utilities which do have publicly-traded data, that it is likely to be at least one. 725 MR. KLIPPENSTEIN: Would you agree that it's likely to be somewhat over one? 726 MS. McSHANE: I don't really have any -- any way to judge that exactly, because -- I guess -- I guess I could say that based on where everybody else is, that it might be no less than 110. 727 MR. KLIPPENSTEIN: And is it possible that it's somewhat over 110. Sorry, what did you say -- 728 MS. McSHANE: 1.1. 729 MR. KLIPPENSTEIN: 1.1. Do you think that it's over 1.1? 730 MS. McSHANE: It's possible. 731 MR. KLIPPENSTEIN: Let's look at the other part of that picture. I guess it's trite to say that Enbridge Gas Distribution and Union would rate base their supply-side investments; in other words, the gas distribution pipes and so forth, they go into rate base. 732 MS. McSHANE: Yes. 733 MR. KLIPPENSTEIN: On the other hand, and I don't know that this is your field particularly, but you may be familiar with this. Compare that to the demand-side management expenditures or the energy conservation expenditures of Union. Would you agree with me that those, generally speaking, do not go into rate base? 734 MS. McSHANE: My understanding is that they're not hard assets, so unless there is something specific in the regulatory model, then no, they wouldn't go into rate base. 735 MR. KLIPPENSTEIN: And would you agree with me that that means that the energy conservation expenses and the effort in promoting energy conservation would reduce Enbridge's or Union's rate-base growth over what it otherwise would be? 736 MS. McSHANE: That would be the tendency, yes. 737 MR. KLIPPENSTEIN: And would it -- would you agree that it's reasonable to conclude that the aggressive promotion of energy efficiency by Enbridge Gas Distribution or by Union would reduce the rate of growth of earnings per share of those companies because of the effect they would likely have on rate-base growth? 738 MS. McSHANE: That will be the tendency, yes. 739 MR. KLIPPENSTEIN: Now, can I turn from that part of the picture to another part of the picture, and this is your recommendations of the -- of the rate of the return on equity that you're recommending to the Board. 740 Would it be fair to say that your mandate did not include -- your mandate did not include an assessment of what return on equity should be allowed for that part of the utilities which is based on promoting energy conservation? 741 MS. McSHANE: That's correct. 742 MR. KLIPPENSTEIN: And in other words, in your assumptions, and your recommendations, you didn't allow for the fact, and I guess weren't asked to allow for the fact, that the utilities are promoting energy conservation in accordance with some of the Board's policies, and if that energy conservation would tend to reduce rate-base growth, and therefore would tend to reduce the total return on equity from what it might otherwise be? 743 MS. McSHANE: That certainly was not what I was asked to do, no. 744 MR. KLIPPENSTEIN: And is it fair to say that, to the extent your recommendations don't take into account the tendency for energy conservation to reduce the rate of rate-base growth, that your recommendations on the rate of return on equity might actually be somewhat less; or, let me put it this way, might not include something to cover what the companies have lost through energy conservation, because you weren't asked to look at that? 745 MS. McSHANE: I think that's fair that -- that there is nothing built into the recommended return explicitly for covering off the potential for earning less due to lower volumes due to conservation. 746 MR. KLIPPENSTEIN: And would you say it would be fair to think that the Board may want to consider adding a little to the return on equity rates that you have recommended to allow for the possibility or the tendency, as we discussed, for energy conservation to slow rate-base growth and, therefore, reduce the total return on equity from what it otherwise would be? 747 MS. McSHANE: I'm trying to understand the logic of that. 748 MR. KLIPPENSTEIN: Would it help if I restated it or perhaps -- 749 MS. McSHANE: Let me see if I can restate what you said, and you stop me when I misstate it. 750 Would it make sense for the Board to allow somewhat more than the recommended return to allow for the fact that with aggressive demand-side management, they will actually end up earning less than is allowed? 751 MR. KLIPPENSTEIN: That's accurate, except for the last few words. 752 MS. McSHANE: Okay. 753 MR. KLIPPENSTEIN: So hold the first part. But my question is whether it would be fair and reasonable for the Board to allow a little bit more for the rate of return on equity than your specific recommendations to allow for the fact, as we discussed, that there is a tendency for aggressive DSM to reduce the rate-base growth, and therefore, the earnings per share in certain circumstances, less than what it otherwise would be, or to less than what it otherwise would be? 754 MS. McSHANE: I think that that makes sense, as long as somehow there is a direct connection between what you're allowing and the actual process of pursuing demand-side management. 755 MR. KLIPPENSTEIN: Is it fair for me to take from what you're saying that you would agree in principle with such an upside allowance as long as it's reasonably related and proportional to the DSM effect that we've discussed? 756 MS. McSHANE: Right. In other words, you can't just allow an extra return. You have to have some way of presumably monitoring how it's actually impacted the pursuit of the conservation efforts. 757 MR. KLIPPENSTEIN: Thank you. 758 Could I then ask you to turn up the third document that I've put to you, and that's Exhibit F.2.4, which is the RBC Capital Markets Research Industry Comment. 759 Now, I don't know if you've seen this before today, but I would just point something out to you and see if this agrees with what your understanding is. At page 1 of this comment, which is dated August 15, 2003, in the middle of the page, and I've highlighted it, the comment states: 760 "To encourage new transmission investment, FERC has proposed additional incentives that would boost allowed ROEs for transmission investments." 761 And then on page 3 of that comment, I've highlighted near the top a couple of sentences that say: 762 "We believe that the renewed focus on the transmission grid could lead to increased incentives designed to promote new capital investment in distribution transmission. Such incentives could include higher allowed ROEs for regulated transmission and distribution businesses." 763 And then in the middle of the page I've highlighted a paragraph that says: 764 "FERC in the United States has proposed an incentive adder on allowed ROE to create an incentive for certain transmission facility investments." 765 Are you generally aware of that sort of idea and steps being taken in the U.S. to actually allow an incentive factor on ROE for certain activities the regulator deems desirable? 766 MS. McSHANE: Yes, I was aware of this particular order by FERC, and there have been several others going back a couple of years, where they have indicated that, you know, they would allow incentive returns above their base -- they've got a base return of 12.4 percent for transmission assets, and then they've got different levels of incentives for joining the RTO, and putting new transmission grid assets in place in a timely fashion. 767 I know that they had one out west where they had different incentives depending on how quickly you can get them online, and the faster you could get them online, the more of an incentive on your return you were allowed. 768 MR. KLIPPENSTEIN: And would it be fair to say that the additional upside allowance on ROE to compensate for an energy efficiency disincentive of the nature we've spent some time discussing now is conceptually similar to these sorts of ROE incentives that are mentioned here? 769 MS. McSHANE: I would say it was conceptually similar in the sense that you want to get somebody to do something that they might not otherwise do, so you need to provide them an additional incentive, the carrot approach as opposed to the stick approach, to get them to either make the additional investment or, in the case we're discussing, not to make the additional investment. 770 MR. KLIPPENSTEIN: Thank you, Ms. McShane. Those are all my questions. 771 Thank you, Mr. Chair. 772 MR. VLAHOS: I've lost my list here. Who is next? Mr. Dingwall? 773 MR. DINGWALL: I'm next. 774 CROSS-EXAMINATION BY MR. DINGWALL: 775 MR. DINGWALL: Good afternoon, Ms. McShane. My name is Brian Dingwall. I'm here in the capacity of counsel for a group called Energy Probe. 776 MS. McSHANE: Good afternoon. 777 MR. DINGWALL: At page 47 of your evidence, you make reference to utilities as "interest sensitive stocks." Would you elaborate on that. 778 MS. McSHANE: Utilities are dividend-paying stocks which are fairly highly levered and therefore raise a fair amount of debt capital, so from two perspectives, their prices tend to move with interest rates from the point of view that, as dividend-paying stocks, they are looked at as more of an income stock than a growth stock. And so to some extent, they have -- to a greater extend than other stocks, they have a correlation with movements in interest rates. And the fact that they're highly levered means they're raising debt capital, so the stock prices have a tendency to move with interest rates as a result of that as well. 779 MR. DINGWALL: Sorry, I'm taking that a step further. How do these stocks tend to correlate with interest rates? 780 MS. McSHANE: In the same direction. So in other words, if interest rates go down and the price of bonds goes up, there will be a tendency for the yield -- the dividend yields on utility stocks to go down and their prices to go up. 781 MR. DINGWALL: So the utility stocks rise in situations of lower interest rates? 782 MS. McSHANE: That's typically correct, yes. 783 MR. DINGWALL: We're kind of in that situation right now; is that correct? 784 MS. McSHANE: We are in a situation where interest rates are at fairly low levels, relatively speaking; that's correct. And we're sort of on the cusp, I guess, of a somewhat increasing interest rate environment. 785 MR. DINGWALL: Would it be fair, then, to presume from that that both of the applicants in this case are likely receiving the benefit of increased share value notionally for their operations as a result of the lower interest rates? 786 MS. McSHANE: I would say, generally speaking, given what I've said, that the market values, all other things being equal, would tend to rise when interest rates go down, and vice versa. 787 MR. DINGWALL: Now, I'd like to apologize. My retainer in this has been somewhat later on in the game, so I have not been able to find whether or not there's an interrogatory or a piece of evidence that lists the U.S. utilities you've used in your ROE comparisons. Is there such a listing of those utilities? 788 MS. McSHANE: I don't know whether there was an interrogatory or not. If you're talking about a sample of local gas distribution utilities as proxies, those are found on -- 789 MR. DINGWALL: Schedule 11, tab C? 790 MS. McSHANE: Excuse me. 791 MR. DINGWALL: Is that the group that's in -- I think it's 11 or 12, tab C? 792 MS. McSHANE: Yes, it's at 12. 793 MR. DINGWALL: Now, is that the grouping that you used for comparison of the return on equity, numbers that you used elsewhere in your evidence? 794 MS. McSHANE: I'm not sure what you mean. If you're asking me is it -- if those utilities are the ones that are included in the tables that compare the allowed returns for the U.S. utilities and the Canadian utilities, the answer is no. 795 MR. DINGWALL: Where would I find a listing of the utilities that are used in the comparison, then? 796 MS. McSHANE: Let's make sure we're clear about what your reference is. Are you talking about -- are you talking about the table 3 on page 29? 797 MR. DINGWALL: Yes. 798 MS. McSHANE: Now, I believe there was a data request on this, but I would be lying to you if I told you I could remember the numbers of all of them. 799 The data come from a publication which is called "Regulatory Research Associates," which has for 15-plus years, every quarter, compiled all of the major rate case decisions in the U.S. 800 So these data cover -- I'm trying to recall, I think over this period some 650 decisions for a wide variety of utilities. And I have never actually gone into each of these publications and compiled a list of all companies that are followed, but it's basically all the major gas and electric utilities in the U.S. that have had rate cases throughout this period. 801 MR. DINGWALL: Now, I believe in CAC Interrogatory 46, there was a calculation that was done that compared return on equity as determined in a rates case with actual return on equity when compared with revenues on a weather-normalized basis. Do you know what base criteria for determination of the return on equity number for the U.S. utilities was? Do you know if that's weather-normalized or based on decision? 802 MS. McSHANE: Sorry. First of all, can I find the response to which you are referring. 803 Okay. So here we are -- this data request that you're talking about, No. 46, if I look at page 3, and we're talking about Union Gas, for example, and I've got approved returns in the first column and then two columns of actuals, one actual-actual and one based on normal. 804 So are you asking me, then, to compare what's on this table to what's on table 3? 805 MR. DINGWALL: No, I'm asking if you know what the base for the number on table 3 in the ROE U.S. utilities column, whether this base is based on actual weather or whether it's based on approved ROE? 806 MR. VLAHOS: It does say, Mr. Dingwall, it does say, "averaged allowed ROE." The question, I guess, is whether it's weather-normalized or not. 807 MR. DINGWALL: That's right. 808 MS. McSHANE: All these companies use some form of weather-normalization. These aren't actual returns, they are what is allowed on a normal basis. 809 MR. DINGWALL: Now, do you know whether or not the figures from the U.S. include or do not include any performance-based adjustments to ROE? 810 MS. McSHANE: They do not. They are allowed returns, not what might have been earned after the fact including an incentive. 811 MR. DINGWALL: For example, I think FERC has a 1 percent ROE increase if you connect to an RTO, which would be fairly automatic but not after the fact. 812 MS. McSHANE: There are no FERC numbers in here, to begin with, but I have read, you know, the footnotes describing the decisions as they've come along. To my understanding, these are pretty base-allowed ROE numbers, and typically state utilities don't have incentives built into the allowed ROEs so much as they have sharing mechanisms. 813 So to the extent that there was a sharing mechanism, these numbers here would be effectively the level of return at which the base rates are set. 814 MR. DINGWALL: In the event that, as a result of this proceeding, a new rate of return is set for the utilities or a new formula is adopted, what changes to market conditions would, in your mind, necessitate revisiting such a formula, the ROE calculation? What kind of shelf life can we get from something like this? 815 MS. McSHANE: Well, I can't guarantee anything, but my recommendation in this -- in this instance, I believe, is here. And this applied to Enbridge, and the assumption would be that if you applied this to a PBR and the PBR plan was, say, a five-year plan, then the mechanism should cover the period of the plan. 816 In the alternative, I was recommending that if interest rates went above 8 percent or long-Canadas went above 8 percent, that the formula be reviewed, or at least, let's say, that it -- that that be a trigger to determine whether the formula should be reviewed; and it may well be that it's determined that it doesn't have to be in full, but just that there is some safety net there to say, well, let's look at it and see if anything needs to be done. 817 In the latter case, forecasts for long-Canadas are -- the longer terms have been in the 6 percent range. The last time long-Canadas were above 8 percent has been seven, eight years. So, I mean, I think you could say the probability is that it will last at least five years, and by that time, I plan to be retired, so you'll never have to hear from me. 818 MR. DINGWALL: Hopefully my cross-examination will be done by then as well. 819 MR. VLAHOS: Dr. Sherwin will come back? 820 MR. THOMPSON: None of us have time for that, enough time. 821 MR. DINGWALL: Now, you stated that you'd expect whatever ROE formula was set as a result of this proceeding, should last the term of whatever performance-based rate making event might come about? 822 MS. McSHANE: That was what I had intended when I wrote this evidence in September 2002, yes. 823 MR. DINGWALL: What influence does the PBR regime have on investor expectations for return on equity? 824 MS. McSHANE: Depends on the PBR plan. I think generally, PBR plans are looked at as a possible means of earning returns above the return that's built into the base rates. But I think they're also viewed as generally having a bit more risk associated with them than regular cost of service regulation. 825 MR. DINGWALL: Do you know which of the Canadian utilities you've referenced in your report are currently subject to PBR plans? 826 MS. McSHANE: All of the Canadian utilities that I've referenced, let's see ... I guess the best list or the most complete list is schedule 5, perhaps. 827 This doesn't have any of the pipelines on it. Some of the pipelines also have PBR plans. Aquila Networks Canada has had a PBR plan. They are resetting base rates this year. BC Gas Utility has one. None of the CU companies do. Enbridge has had a targeted plan. Gaz Metro has a plan. Hydro One. 828 MR. DINGWALL: We don't need to talk about that one. 829 MS. McSHANE: Maritime Electric, no, I'd say not. They do have sort of an automatic adjustment mechanism kind of legislated approach, which moves their rates up and down towards their -- they've got a legislated 11 percent return, but it's not really a PBR plan. It's more they're just trying to maintain their rates in line with, I guess, Newfoundland Power. Newfoundland Power, no. Nova Scotia Power, no. Pacific Northern Gas, no. TransAlta Utilities, which is now split into Aquila Canada and AltaLink, no. Union Gas, yes. 830 MR. DINGWALL: You don't happen to know for which of the utilities that are on PBR plans, how their earnings compare to their return on equity on a weather-normalized basis, do you? 831 MS. McSHANE: On a weather-normalized basis? 832 MR. DINGWALL: Yes? 833 MS. McSHANE: No. Not off the top of my head, no. 834 MR. DINGWALL: Can you identify any other factors that could or should trigger a review or change of the ROE guidelines? We've talked about interest rays, and you've made the suggestion that an 8 percent trigger would be one. 835 MS. McSHANE: Well, I'm not sure that you need to necessarily build into the guidelines a number of specific parameters. I mean, I think that if the formula was such that it produced a return that caused one of the utilities to suffer a significant decrease in -- or a decrease in their debt rating and they were unable to raise capital, that they can certainly come to the Board and ask to have it reviewed. I don't know that you give up your right of review just for the particular circumstances that may be specified, like a change in long-Canada yields to 8 percent. 836 MR. DINGWALL: Moving on to discounted cash flow, you make reference within your evidence to the fact that discounted cash flow is essentially a forward-looking calculation. Could you identify some of the risks associated with making a forward-looking calculation like that? 837 MS. McSHANE: Are you talking about specifically what kinds of forecasting errors might be reflected in the growth rates of part of the DCF model? 838 MR. DINGWALL: Well, what, by the nature of this model being forward-looking, the risks relating to its accuracy could be? 839 MS. McSHANE: Well, I think that the risks that are related to its accuracy are the same kinds of risks that you would face in -- or investors would face in forecasting earnings over the long term. You know, there are the risks that the market won't turn out the way investors or the analysts anticipated. There are the risks that the returns that they expect to be allowed won't transpire, because the capital market has changed. 840 There's the risk that gas supplies will not be available and the market can't be expanded to the extent that was expected. There's the risk that the economy in the particular LDC's service area isn't as vibrant as expected. So there are all those kinds of risks, but those are the risks basically that the LDC itself faces. 841 MR. DINGWALL: And including your sample of eight companies of U.S. LDCs, you used an 85 percent gas distribution asset test as one of your criteria. 842 MS. McSHANE: Right. 843 MR. DINGWALL: Why did you base that on the assets? Wouldn't revenue have given more guidance? 844 MS. McSHANE: No, because typically LDC revenues would include gas costs, and so gas costs generally are pass-through. 845 So I would think that if you use revenues that you would have a tendency to overstate the amount of the business that's truly gas distributing. 846 MR. DINGWALL: In taking a look at the names of the companies that are in the sampling, most if not all of them appear to have substantial unregulated energy trading businesses within their group; would you agree with that? 847 MS. McSHANE: No, I would not. 848 MR. DINGWALL: AGL resources doesn't have an unregulated energy trading business? 849 MS. McSHANE: I didn't say that it didn't, but, no, I would not agree that the majority of these companies have significant energy trading businesses. 850 MR. DINGWALL: Which ones would you suggest don't? 851 MS. McSHANE: Atmos Energy, I know, does not; New Jersey Resources; Piedmont does not; WGL does not. AGL -- I guess what you're calling energy trading is -- is they are a retailer of natural gas, because the distribution company itself is just a wires or pipes company, so it's not energy trading. You throw that term around today, and it sounds like we're talking about the Enron kind of situation. But you know in the case of some of these gas distribution companies that have retail sales, it's really that they simply have a subsidiary selling natural gas to retail customers. 852 MR. DINGWALL: Do you know or do you have the ability to find out what percent of revenues are associated with the distribution businesses of these companies? 853 MS. McSHANE: Yes, I could find that out for you. 854 MR. DINGWALL: Could I have that as an undertaking, please. 855 MS. McSHANE: Yes, you could. 856 MR. VLAHOS: How much work is that, Ms. McShane? 857 MS. McSHANE: Probably would take couple of hours. 858 MR. VLAHOS: To be provided by when? 859 MS. McSHANE: By end of tomorrow. 860 MR. VLAHOS: I don't mean to rush you, but before the hearing -- 861 MS. McSHANE: Before the hearing is over, oh, absolutely. I mean it will be whatever information is publicly available from financial statements. 862 MR. VLAHOS: Mr. Dingwall, can you help us as to what will be the value to the Board? 863 MR. DINGWALL: Well, I'm trying to understand whether or not these companies are true comparables, and in assessing that question, the question comes up: What portion of narrow income is distribution-related and what portion of their income isn't? Because in looking at a discounted cash flow, as we're being suggested to do, understanding what the cash flow expectations are and which business segments they derive from, would be clearly relevant to understanding whether they're comparable to distribution operations. 864 MR. PENNY: Energy Probe is not without resources. Ms. McShane has already said that this is publicly-available information. The list of companies is in her evidence. If Mr. Dingwall had wanted to get that information, he could have gone off and gotten it himself and put it to Ms. McShane in cross-examination. There's no reason why she should be now burdened by doing this work, in my respectful submission. 865 MR. DINGWALL: To respond to Mr. Penny's comments, it's Ms. McShane and the companies that are putting forward this comparison. 866 MR. VLAHOS: Sorry, Mr. Dingwall, I was going to give you a chance to respond, but I was going to confer with my colleagues. Go ahead. 867 MR. DINGWALL: To respond to Mr. Penny's comments, it's the companies that are putting forward Ms. McShane's evidence to be tested; that these companies they've identified on schedule 15 of section C of the evidence are true comparables, and I've raised the concern. I believe I've fleshed out that it's -- if the revenues -- 868 MR. VLAHOS: Mr. Dingwall, I hear you but there is an interrogatory process for that information. That is the very reason for the interrogatory process. To that extent, I agree with Mr. Penny. 869 I also have -- Ms. McShane agrees to do it. But before the Panel makes a final decision, I just want to follow up, Mr. Dingwall, as to if the -- based on the answer, you will argue that this is not a reasonable sample. Then what? I mean that's eight companies out of presumably how many, a thousand, eight companies that came out of a sample of a lot more, a population of a lot more. 870 Is that right, Ms. McShane? 871 MS. McSHANE: That's correct. 872 MR. VLAHOS: I'm not sure where we're going to be left with if that information does not come forward early enough to be cross-examined on. That's where my concern is. 873 MR. DINGWALL: One of the criteria set out on page 59 was that the companies, within your sample, had to have a credit rating of A minus or better. 874 MS. McSHANE: That's correct. 875 MR. DINGWALL: Now, Duke and Enbridge Inc. have different credit ratings, do they not? 876 MS. McSHANE: Than each other? 877 MR. DINGWALL: Yes. 878 MS. McSHANE: Yes, I think so. 879 MR. DINGWALL: And if you expanded the sampling to include the lower of Duke or Enbridge's credit ratings, I'm wondering what effect that will have on the number of companies? 880 MS. McSHANE: First of all, I'm trying to choose companies that are similar risk to Enbridge Gas and Union Gas, not to Duke Energy or the other one, Enbridge. 881 So that's why I chose the credit ratings that I did, not those of the parent companies. And if you're asking me, Would there be other companies included in the sample if you change the decorating criterion, I would imagine that there would be. 882 MR. DINGWALL: Is the sampling that you've got in the form of a spreadsheet whereby it will be of very little difficulty to understand how that would be expanded if you changed one of the variables? 883 MS. McSHANE: You mean do I have a table somewhere that shows the universe and the criteria at the time I chose the sample? 884 MR. DINGWALL: Yes. 885 MS. McSHANE: I would imagine that I do. 886 MR. DINGWALL: I'm just going to take a minute to go through my list, with the Board's indulgence. 887 Thank you very much for your time, Ms. McShane. Those are my questions. 888 MS. McSHANE: Thank you. 889 MR. VLAHOS: Thank you, Mr. Dingwall. 890 One second, please. 891 [the Board confers] 892 MR. VLAHOS: Mr. Dingwall, just to clarify, it's the Panel's sense that your interest in the undertaking has waned since you asked more questions; is that fair? 893 MR. DINGWALL: Give me a moment, sir. 894 It continues to be something that we will like to know. 895 MR. VLAHOS: The panel will reserve that decision until after the break. 896 Mr. Moran, can you wait for your questions until after the break? 897 MR. MORAN: I believe I can, sir. 898 MR. VLAHOS: It is a quarter to three. Can you tell us approximately, Mr. Moran, how long you will take? 899 MR. MORAN: Yes, Mr. Chair, I have two estimates for you -- 900 MR. VLAHOS: All right. The left hand... 901 MR. MORAN: The first estimate is a long-term low risk estimate. I will be finished considerably before I qualify for any pension. My short-term higher risk estimate is less than an hour. 902 MR. VLAHOS: Did you actually write that down? 903 MR. MORAN: No, I didn't. 904 MR. VLAHOS: It's quarter to three, we will resume at 3:15. 905 --- Recess taken at 2:45 p.m. 906 --- On resuming at 3:20 p.m. 907 MR. VLAHOS: Please be seated. 908 Ms. McShane, could you state your understanding as to what you were asked to do from Mr. Dingwall? 909 MS. McSHANE: My understanding is he would like to know for the eight LDCs in my U.S. LDC sample what is the proportion of gas distribution revenue to total revenue. 910 MR. VLAHOS: We will grant that undertaking. Thank you. 911 MR. MORAN: Mr. Chair, that will be Undertaking G.2.3. 912 UNDERTAKING NO. G.2.3: TO PROVIDE FOR THE EIGHT LDCS IN MS. McSHANE'S U.S. LDC SAMPLE WHAT IS THE PROPORTION OF GAS DISTRIBUTION REVENUE TO TOTAL REVENUE 913 MR. VLAHOS: Okay, Mr. Moran. 914 MR. MORAN: Thank you, Mr. Chair. 915 CROSS-EXAMINATION BY MR. MORAN: 916 MR. MORAN: Ms. McShane, the test year ten-year Canada rate in the Boards' current approach relies on the average of the three-month and the 12-month forward predictions from the consensus forecast publication, have you investigated the accuracy of the consensus forecasts against actual ten-year yields at any point? 917 MS. McSHANE: Yes. I don't have the results of my analysis here. 918 MR. MORAN: Do you recall what the results were and what you actually looked at? 919 MS. McSHANE: Basically, I recall that we looked at -- obviously compared the forecasts to the actuals to determine, over a period of time, how different the actuals were than the forecast, and also compared using the forecast to using an actual looking at November, because that's often the forecast that's used by regulators. I was doing it in the context of a Newfoundland Power rate case because that board was using actuals, whereas, other regulators were using forecasts. 920 So my recollection is that the results were somewhat more accurate on average, had the actuals -- and I can't tell you offhand specifically what period they covered. I think we looked at, like, a month average rather than at a spot on a particular day, but that if you looked over a period of time, the variability was somewhat greater using the actuals than the forecasts. There were some bigger differences. 921 And that sort of led me to think that because you can get some anomalies in what's going on in a particular month, that it will be preferable to use the forecast, which would tend to smooth over any particular anomalies rather than using an actual in a particular month or ten-day period, because it might happen to include some extraneous effects from particular events going on in the marketplace. 922 MR. MORAN: And how recently did you do this study? 923 MS. McSHANE: Oh, that would have been probably early in 2003, because that rate case was in May. So that makes it about the right timing. 924 MR. MORAN: As I'm sure you're aware, Dr. Cannon has recommended using the actual ten-year Canada rate that's prevailing at the time that the ROE number is set. What's your response to that recommendation? 925 MS. McSHANE: Well, as I said, yeah, I would be somewhat concerned about using that just because I think you can get into situations where you do have potential anomalies, things that might cause interest rates to go up or down in a particular time frame because of just unusual events in that period. 926 MR. MORAN: All right. Is that study something you can lay your hands on quite easily? 927 MS. McSHANE: I think so, yes. 928 MR. MORAN: Mr. Chair, perhaps I could get an undertaking, then, just to produce that study. 929 MR. VLAHOS: That's fine. 930 MR. MORAN: That will become Undertaking No. G.2.4, study by Ms. McShane with respect to comparison of actual ten-year Canadas to consensus forecasts. 931 UNDERTAKING NO. G.2.4: TO PROVIDE STUDY BY MS. McSHANE WITH RESPECT TO COMPARISON OF ACTUAL TEN-YEAR CANADAS TO CONSENSUS FORECASTS 932 MS. McSHANE: I'm sorry, I'm not sure it's ten-year forecast -- 933 MR. MORAN: Sorry, ten-year yields. 934 MS. McSHANE: No, that wasn't my point. My point was I believe it was on 30s, not on ten years. 935 MR. MORAN: Oh, okay. So you haven't looked at the ten year -- 936 MS. McSHANE: Not specifically, no, because the concern was between the 30-year forecast and the 30-year actual, not the ten year. 937 MR. MORAN: Mr. Chair, I don't need that undertaking, then, on the basis of Ms. McShane's clarification. 938 So in response to Dr. Cannon's recommendation about using actual prevailing ten-year Canada rates, you haven't actually compared the actuals to the consensus forecast for the ten years? 939 MS. McSHANE: I probably have done the comparison of the actuals to the forecast, but I don't recall having gone any further than that in terms of comparing -- using an actual number in the prior year as a substitute for using a forecast. 940 MR. MORAN: In terms of looking at prior forecasts against prior actuals, though, you haven't looked at that; right, if I understand you correctly? 941 MS. McSHANE: That's right. I don't think I've actually specifically looked at a comparison of using the actuals in, say, November as a proxy for the next year's forecast as opposed to using the actual forecast as the forecast. 942 MR. MORAN: Thank you. 943 With respect to the comparative earnings test that you've used, as I understand it, the test period that you've chosen is 1992 to 2001; right? 944 MS. McSHANE: Yes. 945 MR. MORAN: And in your prefiled evidence, you say that that represents an entire business cycle; right? 946 MS. McSHANE: Yes. 947 MR. MORAN: And therefore, would include expansion and declines? 948 MS. McSHANE: Yes. 949 MR. MORAN: And with respect to what constitutes a decline, what's your working definition? 950 MS. McSHANE: It would include the trough of a business cycle, so if you consider that the most recent business cycle ended in 2001, even though I think we only had one quarter of negative growth, it may have extended a little bit into 2002, but at the time we didn't have complete 2002 earnings. So it goes back from the trough of 2001 to the end of the trough from the prior cycle, which would be 1992. 951 And it also, as I indicate in my examination-in-chief, it also includes sort of a mini downturn in 1996, where growth was less than 2 percent. 952 MR. MORAN: All right. And you want to choose a period that represents the full business cycle so that you can ensure that what the analysts are saying in up years as well as in down years is covered; right? 953 MS. McSHANE: Correct. 954 MR. MORAN: Presumably because analysts will predict differently in a down year than they will in an up year; right? 955 MS. McSHANE: I'm not sure that's really the point. What I'm trying to do is to make sure for -- for comparable earnings is to have earnings that are representative over the entire cycle, not just the high ones, not just the low ones, but all the returns that you would experience from expansion to trough. 956 And the idea is that if you measure those from a cycle that's expected to be similar to the next cycle, then those past earnings will be a good proxy for the future earnings. Analysts don't -- analysts' forecasts really have nothing to do at all with the application of that test. 957 MR. MORAN: All right. In the years 1992 to 2001, then, what years do you specifically point to that show a decline in real GDP? 958 MS. McSHANE: None of them overall have negative growth. They are low-growth periods; '92, '96, 2001, are all low-growth periods. 959 MR. MORAN: So there's no periods in what you call your complete business cycle of an actual negative? 960 MS. McSHANE: There's no single year in there that registered negative growth. 961 MR. MORAN: And the closest to your sample that would show negative growth would be in 1991; right? 962 MS. McSHANE: That had the lowest growth rate. I think average growth in 1992 was 0.9 percent. 963 MR. MORAN: 1991 declined by about 2.1 percent compared to -- 964 MS. McSHANE: But also 1991 had a very different inflation rate than the rest of the cycle, which really renders that year fairly atypical of the rest of the cycle, and 5.6 percent inflation, and since then, I mean, the highest rate of inflation we've had is 3, and most of the rates of inflation have been in the 2 range. So 1991 is really not a particularly relevant year for including in the current cycle from that perspective. 965 MR. MORAN: And just for the record, in 1991, real GDP declined by about 2.1 percent compared to 1990; right? It was a recessionary -- 966 MS. McSHANE: I think that's correct, yes. 967 MR. MORAN: Your sample area doesn't really contain any recessionary periods. 968 MS. McSHANE: It doesn't include this total negative earnings. A recession is technically defined as two negative quarters, so you wouldn't necessarily have to see a full year's decline to have a cycle end anyway 969 MR. MORAN: All right. I'd like to look at the choice of some of the companies. There's already been discussion about your use of Rothmans so I won't repeat the questions about the use of Rothmans. 970 But some of the other companies, if we turn up schedule 18 in Exhibit B, tab 3, appendix C. 971 MS. McSHANE: I have that. 972 MR. MORAN: That shows the return for 15 low-risk Canadian industrials as you've chosen them; right? 973 MS. McSHANE: Yes. 974 MR. MORAN: Rothmans on that list but that's been covered with you earlier. 975 MR. BETTS: Excuse me, Mr. Moran, which schedule is that? 976 MR. MORAN: Schedule 18 in Exhibit B, tab 3, appendix C. 977 If we look on the third line down, Empire Company Limited? 978 MS. McSHANE: Yes. 979 MR. MORAN: As I understand it, that's the parent company of the Sobey's Grocery chain. 980 MS. McSHANE: I believe that's correct. 981 MR. MORAN: You have recorded for the year 2000, a return of 69.1 percent. 982 MS. McSHANE: Correct. 983 MR. MORAN: Which is exceptionally high; fair enough? 984 MS. McSHANE: Yes. 985 MR. MORAN: And, as I understand it, or as I'm advised, and I think Dr. Cannon says this in his evidence, most of that came from including the gains from the company's sale of its investment in Hanaford Produce? 986 MS. McSHANE: I believe that's correct. 987 MR. MORAN: And if we look at Weston's returns at the bottom of the table. 988 MS. McSHANE: Yes. 989 MR. MORAN: They record a 37.3 percent return for 1998. 990 MS. McSHANE: I see that. 991 MR. MORAN: Again, that's a pretty high return? 992 MS. McSHANE: Yes. 993 MR. MORAN: And again, Dr. Cannon suggested that this is because Weston included the gains from the sale of it's EB Eddy Forest Products Company; is that your understanding as well? 994 MS. McSHANE: I haven't specifically looked at every single one of the numbers, but I'm sure that he's correct on that. 995 MR. MORAN: And these are examples of non-recurring unusual items? 996 MS. McSHANE: They would be non-recurring items. They are numbers that are included in the standard calculation of return on equity. 997 MR. MORAN: And if we look at Cara Operations Ltd., the second on the list? 998 MS. McSHANE: Yes. 999 MR. MORAN: For the year 2000, you've recorded a return of 34.6 percent? 1000 MS. McSHANE: Yes, that's what was reported. 1001 MR. MORAN: As I understand it, that came from recording the capital gain from the company's sale of Beaver Foods; is that right? 1002 MS. McSHANE: That's my understanding. 1003 MR. MORAN: There's a difference, would you agree, in how the Board would treat capital gain that results from sales by utilities from what happens in the marketplace? 1004 MS. McSHANE: I'm sorry. There's a difference in... 1005 MR. MORAN: How the Board would treat capital gains achieved by a utility compared to how a private company would deal with those gains. Do you have any understanding of how the Board would deal with those capital gains, if it was achieved by a utility? 1006 MS. McSHANE: Yes, I agree with you that the Board would treat them differently. 1007 MR. MORAN: Right. The way they're typically treated is the regulator will look at the gain and determine if it should be shared with the ratepayers; right? 1008 MS. McSHANE: That's correct. 1009 MR. MORAN: On the theory that the ratepayers had something to do with the development of the value -- 1010 MS. McSHANE: That's my understanding. 1011 MR. MORAN: Which, of course, would reduce the return that the company would then have because they would have to share that revenue. 1012 MS. McSHANE: That's right. 1013 MR. MORAN: Whereas a company like Cara Operations or Weston's, they don't have to share that with their customers -- 1014 MS. McSHANE: No, they are allowed to -- 1015 MR. MORAN: Keep it, pass it on to the shareholders 1016 MS. McSHANE: Absolutely correct. 1017 MR. MORAN: All right. So in that context, does it make sense to adjust the data to exclude those kind of items in order to make it more of an apples-to-apples comparison? 1018 MS. McSHANE: I guess you can make an argument that you could go into every single company and judgmentally add or subtract the numbers. These are the earnings as reported to shareholders to the rest of the investment community. Yes, there are non-recurring items in here, and they are positive and negative numbers. And it seems to me that rather than try to judgmentally subtract or add these numbers, in order to better represent the typical return, that one focus on the median values in the sample and that will mitigate any implications of relatively high or relatively low numbers in a given year because of non-recurring items. 1019 MR. MORAN: All right. So you don't see any need to adjust the sample to deal with that issue? 1020 MS. McSHANE: No, because as I say, these are, in the first instance, the numbers that are reported, and in the second instance, there are ways to, through the process of averaging, to look at the median values and therefore, not go through the process of judgmentally subtracting or adding numbers. There are tax implications of these data -- of these adjustments, I should say, that you would have to work through. 1021 At the end of the day, we asked Dr. Cannon, for example, to support the numbers, and we don't have in front of us the support for the numbers that he has. 1022 So it becomes impossible to go back and actually verify whether the judgments that were made were correct or not. 1023 MR. MORAN: All right. Turning now to your ERP test, you've indicated in your evidence that it's not unreasonable to expect an equity market return of 12 to 13 percent in the future; right? 1024 MS. McSHANE: I said, based on the average data that were for the average returns that have been achieved in the past based on the arithmetic type average approach, taking out the implications of the rising price earnings ratios and looking at averages over time, yes, I would say that those data would suggest that that is not an unreasonable expected equity return in the risk premium sense that we were talking about -- that I was talking about earlier, where it takes into account the uncertainty of future returns. 1025 MR. MORAN: I won't ask you any questions about what pension managers are forecasting -- 1026 MS. McSHANE: Thank you. 1027 MR. MORAN: -- because I think that's been well covered. Ibbotson & Associates, as I understand it, are of the view that U.S. stocks are averaging about 8 percent in the long run, assuming inflation rates; is that correct? 1028 MS. McSHANE: That's an interesting question. There are two versions -- at least two version of the Ibbotson & Associates publication. The reference that you're making is to what I'll call the red book, which comes out every year, and it's Ibbotson & Associates stocks, bills, inflation, and there's a paragraph in there that says based on the work of Ibbotson and Chen, using the supply model, they believe that the returns will be 8.8 percent in a risk premium of 3.41 percent. 1029 Interestingly, they published an article quite recently, which I believe is cited by Drs. Booth and Berkowitz in their schedule 17. 1030 MR. MORAN: That's in Exhibit D.2? 1031 MS. McSHANE: Yeah, is that correct? D.2? Yes, I'm told that that's the right exhibit number. 1032 Where they published a paper called "Stock Market Returns in the Long Run," and they are using a couple of different models, one of which is the supply model, and they're estimating using those models, that the premium is basically between 4 and 6 percent. 1033 And the other version of the Ibbotson & Associates book in which they provide all of this historical data, which is called the "Valuation Edition," which is the one where if you're a cost of capital person, you would probably buy that one rather than the so-called red book, doesn't even mention this article at all. 1034 So I was a little interested in the fact that they mentioned it, only that one estimate in the red book, but the studies show a range going up to almost 6 percent based on these sort of new approaches, and their Valuation Edition of their data still goes through and pretty much just discusses the historical data as inputs to the model. 1035 MR. MORAN: I understand that Warren Buffett is looking at a 6 to 7 percent rate of return annually on U.S. stocks for the long run? 1036 MS. McSHANE: I've heard mention that that's the number that he's using. He's historically done considerably better than that. 1037 MR. MORAN: Right. And Bill Gross, the U.S.'s most prominent bond manager, as I understand it, is saying similar numbers? 1038 MS. McSHANE: Well, Bill Gross is a bond manager, so I would take what Bill Gross said with some amount of salt, because he wants people to invest in bonds. So I'm not sure I would give the weight to what Bill Gross had to say about equity markets that I might to other people. 1039 MR. MORAN: Because he's competing with stocks? 1040 MS. McSHANE: Pardon me? 1041 MR. MORAN: Because he's competing with stocks? 1042 MS. McSHANE: Oh, absolutely. He certainly has an incentive to play up how good bonds are going to be relative to the equity market. 1043 MR. MORAN: Are you familiar with Watson Wyatt Investment Consulting's 2003 Canadian survey of economic expectations? 1044 MS. McSHANE: Yes. 1045 MR. MORAN: As I understand it, the consensus forecast you see there, among 49 of Canada's leading business and economists and portfolio managers is that the average return on Canadian stocks over the long term will be about 7.9 percent? 1046 MS. McSHANE: That's about the same as those studies have shown for years. It might be a little bit lower and a lot of those are pension fund managers. 1047 MR. MORAN: And total return on U.S. equities over the long term about 8 percent per year? 1048 MS. McSHANE: Same comment. 1049 MR. MORAN: Are you aware of any credible academic or practitioner studies or consensus surveys that currently expect Canadian or U.S. stocks to provide annual average returns in the future as high as your 12 to 13 percent forecast? 1050 MS. McSHANE: Well, I think all of the studies that have come out are really looking at sort of a geometric kind of return, long-term compound average type approach, except for the ones that are sort of looking at long, long term averages, which as I said, often go back into the 1800s. 1051 I have seen a study which I included into response to a data request, which is a forward-looking study that appeared in the Journal of Corporate Finance, which suggested that the forward-looking U.S. equity premium was around 7 percent. 1052 MR. MORAN: Is that the only study that you would point to? 1053 MS. McSHANE: I think of these studies that have come out recently, they're all sort of trying to focus on where the historical numbers have been off-side in terms of the future. I think there are still an awful lot of people who are doing cost of capital studies who still are very reluctant to disregard the past in favour of these numbers, as far as a risky estimate of the market risk premium, which I don't think a lot -- as I said, I don't think a lot of these studies are really doing a -- a cost of capital type approach to determining the risk premium. 1054 I think that's it. I'm sorry, I thought I might have had something else to say. 1055 MR. MORAN: You've referenced one study. Are there any other studies that you could be point to that would show the same kind of forecast as you're making of 12 to 13 percent? 1056 MS. McSHANE: I'm simply saying, I think, that -- that it's -- that if you're trying to make an estimate of the risk premium, that I don't think that there's any reason to -- to move away from using the historic data which have that riskiness built into it. And I think the people that are doing these studies are looking at it from a somewhat different perspective. 1057 I think in addition to the one study that I did mention, I did mention yesterday the two -- the article in the chapter from the book on finance that the authors of -- or the proponents, I guess, if you will, of the equity premium puzzle which gave rise to all this are now saying that they don't believe that the issues with respect to the premium have been resolved by any of these new studies, and they would look to the past returns as well as being indicative of the equity risk premium in the same context as I'm looking at the equity risk premium. 1058 MR. MORAN: And is the reference that you just made predicting returns in the range of 12 to 13 percent as you are? 1059 MS. McSHANE: I don't believe it is that specific. It's simply saying that historic data are an appropriate benchmark for looking forward. 1060 MR. MORAN: So in the final analysis, you're relying on your own analysis for the 12 to 13 percent forecast; right? 1061 MS. McSHANE: Yeah, I'm relying on my analysis of the trends in the data and, yes, I'd say at the end of the day, I am relying on my analysis. 1062 MR. MORAN: Now, Dr. Cannon suggests that the forward-looking MRP relative to long-Canada bonds is now in the range of 3.25 percent to 3.75 percent, if that's in his evidence. Drs. Booth and Berkowitz now say there is "overwhelming evidence" that their 4.5 percent market risk premium estimate is a reasonable input for the determination of a fair return on equity for the OEB-regulated gas LDCs. 1063 In a contrast, you're suggesting that stocks will return to the 12 to 13 percent return in the long run future. 1064 Would it be fair to say that this is on the basis of a forward-looking MRP in the order of 6 to 6.5 percent? 1065 MS. McSHANE: Yes. 1066 MR. MORAN: And really, that's the main factor that leads to the difference between you and the other -- and the other witnesses? 1067 MS. McSHANE: That's part of it, but I don't think that's necessarily the main factor. I think we do have a difference on what the relative risk adjustment is in the context of that test, and we also have different results for the other tests that we've performed which also lead to, at the end of the day, differences in what we recommend as a fair return. 1068 MR. MORAN: All right. 1069 I'd like to turn now to your discounted cash flow test, or, as you've described it, your DCF-based ERP test. 1070 MS. McSHANE: Yes. 1071 MR. MORAN: And if you can turn up page 78 of Dr. Cannon's evidence. It's Exhibit D.1. 1072 MS. McSHANE: Yes, I have that. 1073 MR. MORAN: If you can just take a moment. I won't read it, because I know you can read. If you can just read the first two full paragraphs on page 78 and just let me know when you've had a chance to do that. 1074 MS. McSHANE: I've read it. 1075 MR. MORAN: What's your response to what Dr. Cannon says in those two paragraphs with respect to your test? In effect, he's suggesting that you're doing some double-counting, what's your response? 1076 MS. McSHANE: If all he's saying is that I'm using a discounted cash flow approach in two different ways, in two different places, I guess I'm not terribly concerned that that's such a terrible thing. I mean, I don't agree that -- that when you do DCF-based estimates over a period of time and subtract bond yields from it and look at the difference and look at the trends, that that doesn't constitute risk premium evidence. It doesn't. It doesn't constitute capital asset pricing model evidence, but it's certainly risk premium evidence. 1077 If you look at some of these studies that are cited by both Dr. Cannon and Dr. Booth in support of the -- their forward-looking mark risk premiums, they're DCF-based studies. They do a DCF for the markets, subtract the bond yield, and say, This is the risk premium. 1078 I've done it over a period of time so that you're -- and looked at the difference in that cost as determined using a DCF model that's consistent with companies and approach to growth rates and tried to figure out what the relationship was with interest rates, long-term government rates, and utility bond rates. I think that constitutes risk premium evidence. 1079 Sure, I used a DCF-based method in two different places, but I don't think that that's something that should be held against me. 1080 MR. MORAN: All right. Moving on with your DCF test. Your DCF results are based on the sample of eight U.S. natural U.S. gas LDCs; right? 1081 MS. McSHANE: Yes. Now, are we talking about the actual U.S. DCF tests now? 1082 MR. MORAN: Yeah. And those are the eight utilities we see in your schedules 15, 16, 17; right? 1083 MS. McSHANE: Yes. 1084 MR. MORAN: I think you've already been asked some questions about the size of that sample. Obviously, if you used different criteria, the sample might be bigger or smaller; that's fair, right? 1085 MS. McSHANE: Yes. 1086 MR. MORAN: If you used a BBB credit rating, you would have got a bigger sample; right? 1087 MS. McSHANE: Three or four more companies, I think. 1088 MR. MORAN: If you would have used Moody's Debt Ratings, you would have gotten a bigger sample as well, instead of the S&P? 1089 MS. McSHANE: That's possible. Let's understand that when we're talking about the relatively pure-play LDCs, it's pretty much the pure-play part that determines what your universe of possible companies is. 1090 I doubt very much that changing from S&P to Moody's Ratings is going to make a huge difference in the size of the sample. 1091 MR. MORAN: And your pure-play criterion was 80 percent -- 1092 MS. McSHANE: 85 percent of assets, yes. 1093 MR. MORAN: 85 percent. So if you used 80 percent, you'd still have a fairly pure play, but maybe a larger sample. 1094 MS. McSHANE: Correct. 1095 MR. MORAN: Did you do any sensitivity analysis with different criterion; 80 percent, 75 percent, to see -- 1096 MS. McSHANE: To see how many more companies you'd get? Not this time. I've done that before. I've done it more with electric utilities than gas companies, because those are the ones that tended to be a bit more diversified, so it's harder to select a sample of electric utilities these days that's relatively pure play. 1097 MR. MORAN: Would you agree that the eight companies that you did choose, all of which are American, are a pretty small sample to base all of your DCF evidence on and half of your ERP evidence on? 1098 MS. McSHANE: Not particularly. I mean, they've been the same eight companies for a long time, and I mean, I've been using these criterion in a sample that's relatively similar to this in U.S. rate cases for years, and I'm very comfortable with the sample. 1099 MR. MORAN: These are your eight favourites, and you're sticking with them? 1100 MS. McSHANE: I mean, there are obviously going to be some changes in the sample, but, you know, these are companies that have been relatively pure play companies for years. 1101 MR. MORAN: Okay. I'd like to move, perhaps reluctantly, to beta risk coefficients. As I understand it, you, along with Dr. Cannon and Drs. Booth and Berkowitz have all used beta risk coefficients; right? 1102 MS. McSHANE: We all use relative risk assessments. I would say that if I had to distinguish among the three of us, Drs. Booth and Berkowitz use betas. They are very strong proponents of, in my view, the argument that all you need to be compensated for is systematic risk, and therefore, beta is the be-all and end-all of relative risk measures. I may be overstating it slightly, but... 1103 And Dr. Cannon is more of the view that you need to look at other risk measures as well, a beta is not the only measure of risk that investors look at. 1104 MR. MORAN: Right. 1105 MS. McSHANE: And I'm more of the second school, and probably even more so than Dr. Cannon, would go further and say that the betas in and of themselves aren't going to estimate the relative return requirement and that we have to make sure that when we do the relative risk adjustment that we appropriately reflected the observed risk return requirement. 1106 MR. MORAN: You and Dr. Cannon, and maybe to a limited extent the other two doctors, also will look at standard deviations of investment return to help you assess relative utility risk -- 1107 MS. McSHANE: Well, Dr. Booth can speak for himself, but I would doubt very much he would agree to that. 1108 MR. MORAN: But you and Dr. Cannon do? 1109 MS. McSHANE: Yes. 1110 MR. MORAN: Yes. And there's other qualitative factors, and I think you've said -- 1111 MS. McSHANE: Correct -- 1112 MR. MORAN: -- you would look at those as well. At the end of this process, you are concluding that the average risk Canadian gas LDC is only 60 to 65 percent as risky as the typical Canadian stock is that right? 1113 MS. McSHANE: Well, I would say if you look at -- what I'm trying to do is look at the standard deviation in a portfolio sense. I'm not talking the individual standard deviations of companies, and I think that's what Dr. Cannon is doing, but rather saying, okay, let's look at a portfolio of utility stocks, because you do get some diversification effect. You're going to get a smaller standard deviation for a portfolio in a particular industry than if you look at the individual companies. 1114 So in my application of the standard deviation, I'm saying let's look at the standard deviation from the point of view that you can get some benefits of diversification by having multiple companies, a portfolio, and so I'm looking at the individual sectors of the TSE, and looking at their standard deviation of returns. 1115 And so when I compare the standard deviation of the portfolio of utilities to the average standard deviation of the other sectors, the relationship is about 65 to 70 percent relative risk. 1116 MR. MORAN: Right. And you're talking about the regulated operations of the utility companies when you say that; right? 1117 MS. McSHANE: Well, obviously, we don't have any real pure-play utilities in Canada either, so they would include the operations of the parent companies. 1118 MR. MORAN: All right. So you're looking at Duke and EI in that regard? 1119 MS. McSHANE: No. No. No, I mean, we're looking at BC Gas and Canadian utilities. 1120 MR. MORAN: And when Drs. Booth and Berkowitz go through their process, they come down at about 45 to 55 percent as risky; right? 1121 MS. McSHANE: Right, and they're only looking at beta. 1122 MR. MORAN: Right. And Dr. Cannon comes down around 45 percent as risky as the typical S&P TSX company? 1123 MS. McSHANE: Yes, and I think in part that has to do with he gives a fair amount of weight to the recent betas that have been affected by the anomalies of the last couple of years with the Nortel situation, which both I and -- I mean, I believe that those results are anomalous and should be excluded from consideration. 1124 I know Dr. Booth believes that they're anomalous and should be excluded. Mr. Case's evidence that I looked at last night expressed some concern about the usefulness of those betas. 1125 Dr. Cannon seems a lot less concerned about them than the rest of us, so I think that in part explains his lower number, and I think he also looked at standard deviation in a different way than I do. He sort of looks at different, individual companies without any weight given to the fact that you can reduce the standard deviation by looking at the stocks within a portfolio context. 1126 MR. MORAN: All right. So in the context of those differences that you would highlight between you and Dr. Cannon and Drs. Booth and Berkowitz, we end up with a range of 45 percent to 65 percent for the relative riskiness; right? 1127 MS. McSHANE: Yes. 1128 MR. MORAN: And that range is due to the exercise of judgment on the part of everybody who has their own view of what that riskiness is in different methodologies? 1129 MS. McSHANE: That's partly due to judgment, yes. 1130 MR. VLAHOS: Mr. Moran, if I may interrupt. 1131 Ms. McShane, each percentage point translates to what basis points difference in the ROE that you have calculated? 1132 MS. McSHANE: Well, that's an interesting question. That depends on what market risk premium you're applying it to. 1133 The smaller the market risk premium, the less the impact of the relative risk adjustment. So if you said -- let's say that we say the market risk premium is six. Just as an example, the difference between a 45 beta and a 65 beta, just to get the whole range, it would be a difference of 1.2 percentage points. 1134 But if you said that the market risk premium was 4.5 percent, then the difference between 65 and 45 is 90 basis points. So it's a function of both what you believe the relative risk adjustment is and what you believe the market risk premium is. 1135 MR. VLAHOS: Thank you. 1136 MR. MORAN: All right. In your evidence, the utility betas that you referred to, are they price betas? 1137 MS. McSHANE: Yes. 1138 MR. MORAN: And we have these other kinds of betas called rate of return betas or total return betas, right, it's another kind of beta. 1139 MS. McSHANE: Yes. I mean, a total return beta means that you explicitly included the dividend in the calculation of the beta? 1140 MR. MORAN: Right. So for the stock of a company that has been paid a dividend, the price beta and the rate of return beta are the same; right? 1141 MS. McSHANE: Yes. 1142 MR. MORAN: But if you have a company that pays out high dividends, the calculated historical price betas and the rate of return betas will be different, obviously? 1143 MS. McSHANE: They could be. But I believe that we provided some calculations where we calculated both the price and the total return beta for the sample -- not the sample, the universe of Canadian utilities, and they are different by 0.001. So when you're talking about a beta of 0.672, if you do a total return beta, you might get 0.671. 1144 They're much more complicated to calculate, and given the closeness of the results and the uncertainty surrounding the meaningfulness of the results, it's simply not worth taking the extra time when you don't get much improved accuracy. 1145 MR. MORAN: If you can just turn up schedule 11 of your evidence. Tab B -- Exhibit B, sorry, tab 3, appendix C. 1146 MS. McSHANE: I have that. 1147 MR. MORAN: This schedule is dealing with betas for regulated Canadian utilities. Is that what you just referred to -- 1148 MS. McSHANE: No. Are you talking about the total return betas that were provided? 1149 MR. MORAN: Yeah. 1150 MS. McSHANE: No, it was ... 1151 MR. MORAN: What we see in schedule 11 is the price betas; right? 1152 MS. McSHANE: They are price betas and then we were asked a data request that went to this whole issue, and -- 1153 MR. MORAN: Ms. McShane -- 1154 MS. McSHANE: Number 26. 1155 MR. MORAN: -- I was just going to say in Board Staff IR 26, there's something in there about rate of return base 1156 MS. McSHANE: Correct. 1157 MR. MORAN: As I understand it, those aren't calculations; you're using indices there, right, as opposed to individual utility betas? 1158 MS. McSHANE: An index is probably a better indication than individual company betas which can be very erratic in any event. 1159 MR. MORAN: So you didn't actually calculate any rate of return betas for individual utilities, then? 1160 MS. McSHANE: I don't think so. 1161 MR. MORAN: Thank you. 1162 If you could turn up in your evidence schedule 4, Exhibit B, tab C. 1163 MS. McSHANE: Yes, I have that. 1164 MR. MORAN: This is the schedule where you prepared allowed equity risk premium for Canadian/U.S. utilities; right? 1165 MS. McSHANE: Yes. 1166 MR. MORAN: If we look at this schedule, there's a couple of things we can observe. First of all, in comparing long-Canadas to long treasuries, they've both declined over the sample period; right? 1167 MS. McSHANE: Yes, they did. 1168 MR. MORAN: And the long-Canadas tend to have higher yields than the long treasury year by year as well? 1169 MS. McSHANE: Slightly. 1170 MR. MORAN: And what will be the explanation for that pattern? 1171 MS. McSHANE: That long --? 1172 MR. MORAN: The long-Canadas tend to have a higher yield than the long treasuries, typically. 1173 MS. McSHANE: Because there's still some requirement that in order for capital to flow into Canadian bonds that they maintain slightly higher interest rates in the U.S. 1174 MR. MORAN: Right. So there's some competition between the two capital markets; right? 1175 MS. McSHANE: Yes. 1176 MR. MORAN: And that continues today; right? 1177 MS. McSHANE: Yes. 1178 MR. MORAN: And when you look at the allowed ROE between the Canadian utilities and the U.S. utilities, again, that has declined over the sample period for both American and Canadian utilities? 1179 MS. McSHANE: The allowed returns have declined? 1180 MR. MORAN: Yes. 1181 MS. McSHANE: Yes. Obviously if you look at -- well, if you look at Canadian returns, there is basically a decline from 13.5 percent in the first three years to then around 12 percent, then to 11, 10, and the last four year, you know, between 9.5, whereas most of the decline in the U.S. took place in the first three years. You've got a little more decline from about 11.4 to 11.5, but in the past seven or eight years, you've been relatively stable in the 11 percent, 11.3 percent range. 1182 MR. MORAN: All right. And when we compare year by year, the allowed ROE on the Canadian side started off higher and ended up lower than it did in the United States; right? 1183 MS. McSHANE: Yes. 1184 MR. MORAN: With respect to the equity risk premium over the sample period, how would you characterize the trends for the Canadian and U.S. utilities? 1185 MS. McSHANE: The U.S. risk premium started off higher, generally speaking, and has gotten -- 1186 MR. MORAN: It's increased? 1187 MS. McSHANE: It's increased. 1188 MR. MORAN: Over the sample period. 1189 MS. McSHANE: The Canadian risk period has been sort of erratic, I guess. It's kind of a bit of a break-point when these -- when the formula started being adopted in the midst mid '90s. There was a bit of a higher risk premium before that, and then the risk premium, when the formulas were adopted, tended to be lower than they'd been in the past; and because most of the formulas incorporate sort of an inverse relationship, there's been a somewhat increase in the risk premiums as interest rates have come down. 1190 MR. MORAN: And year by year, if we compare them, the equity risk premium has tended always to be higher on the American side than on the Canadian side; right? 1191 MS. McSHANE: Yes. 1192 MR. MORAN: Again, a trend over the entire sample period? 1193 MS. McSHANE: The -- yeah -- well, the comparison is that in every year, the U.S. risk premium allowed was higher than in Canada. 1194 MR. MORAN: Right. Throughout the sample period, year by year? 1195 MS. McSHANE: Right. 1196 MR. MORAN: Now, in terms of the ability of Canadian utilities to attract capital on reasonable terms during that same period, is there any evidence to suggest that Canadian utilities with these ROEs and these equity risk premiums have had any difficulty in attracting capital on reasonable terms? 1197 MS. McSHANE: I think we -- 1198 MR. PENNY: Mr. Chairman, it's my recollection that this is exactly the question that Mr. Peter Thompson asked yesterday afternoon. We've heard the answer to this one. 1199 MR. VLAHOS: Mr. Moran, that's my recollection, too, but is there anything specific or anything more? 1200 MR. MORAN: It may simply have been a long afternoon for me, Mr. Chair, and I may have just missed that answer. If it's in the transcript, I'm fine with that. 1201 Is there anything you wanted to add to your answer from yesterday? 1202 MS. McSHANE: I don't think so. 1203 MR. MORAN: All right. Now, you first, I think, became involved in the issue before the Board today around 2001, I think was your evidence yesterday? 1204 MS. McSHANE: There was evidence filed on behalf of Union Gas in June 2001. 1205 MR. MORAN: All right. And I think you indicated in response to another examiner yesterday that the companies had asked you to look at return on equity because they were of the view that their ROE was unreasonable. 1206 Can you recall what reasons they gave you for why they thought it was unreasonable? 1207 MS. McSHANE: No. That was a long time ago. You know, clearly they're looking around at what other companies are being allowed in the U.S. I mean, clearly, I think that's one of their concerns. They're looking at the risk premiums they're being allowed relative to what they were allowed in terms of risk premiums in the past. I think generally they're looking at other return opportunities that are available and, you know, at least asking the question, "Am I being properly compensated?" 1208 MR. MORAN: Kind of a cross-border envy and a nostalgia for the past? 1209 MS. McSHANE: No, I don't think that's fair. Clearly, I think U.S. utilities are being allowed significantly higher returns with no indication that the risks associated with those stand-alone utilities are different enough, nor is the cost of capital environment different enough to justify the differences in the allowed returns. 1210 MR. MORAN: All right. And Mr. Klippenstein may have touched on this for a different purpose, but when we look at schedule 4, and we see Canadian utilities and U.S. utilities, is this restricted solely to gas utilities, or is it a composite of gas and electricity? 1211 MS. McSHANE: I believe this is a composite of gas and electric utilities, but the numbers aren't very different, and if you want them broken down by gas and electric to show that, I'm perfectly willing to give you that. 1212 MR. MORAN: Right. You indicated that you were aware of higher sort of incentive-based ROEs in the United States over the last couple of years, and when we look at the U.S. utility numbers here, would this sample include those utilities that might have an incentive-based ROE to build facilities? 1213 MS. McSHANE: I would say it includes the utility -- it would include any utility that's had a rate of return decision on it. 1214 MR. MORAN: So the answer is yes? 1215 MR. PENNY: Mr. Chairman, may the witness be permitted to finish her answer. 1216 MR. MORAN: Sorry, I apologize. 1217 MS. McSHANE: But if there were an incentive, for example, that you are allowed to earn up to -- let's say your base return is 11 percent, but you're allowed to earn up to 12 percent, if you do X, Y, Z. The number that would be in here is 11, not 12. 1218 MR. MORAN: All right. So this sample does not include the incentive portion of any ROE? 1219 MS. McSHANE: That's correct. 1220 MR. MORAN: Thank you. 1221 MR. VLAHOS: Mr. Moran, if I may just follow up. 1222 Eventually Ms. McShane, when you do the sort of empirical studies, eventually those things will have to show up, won't they, and they will influence the data in terms of actual or achieved return -- 1223 MS. McSHANE: They would certainly show up in terms of achieved returns, yes. I don't think they will -- they won't show up in terms of allowed returns, because they're considered a separate component. 1224 MR. VLAHOS: Just to be -- I'm sorry, go ahead. 1225 MS. McSHANE: I was going say, for example, in Mississippi, there's this plan that has various and sundry increments to the return that you can earn if you meet certain service quality standards. Those numbers would never show up in the allowed returns, but they would show up if you had a table of achieved returns. 1226 MR. VLAHOS: It's like a salary and a bonus; right? 1227 MS. McSHANE: Salary and to bonus, that is correct. 1228 MR. VLAHOS: So it goes beyond the FERC. The evidence today was that it was initiated by FERC and then it has taken legs with province or state regulators or -- 1229 MS. McSHANE: The FERC issue is quite specific to electric utilities, because there obviously is concern that they want to give appropriate incentives to build the system and maintain the system. 1230 With respect to state regulators, I think the Mississippi situation that I was talking to you about is something that's been in place for a number of years. There are various earnings sharing mechanisms that are becoming much more popular in the States where you might have an allowed return of, say, 11, and then you can earn up to 13 without sharing in the next increment, you share 50/50, and the next increment you share 75/25. That's very, very common. 1231 MR. VLAHOS: Thank you. 1232 Sorry Mr. Moran. 1233 MR. MORAN: Not at all, Mr. Chair. 1234 All right. Drs. Booth and Berkowitz don't appear to like comparative earnings very much as a test, and Dr. Cannon doesn't seem to like DCF very much, and Mr. Thompson yesterday put to you a quote from Dr. Sherwin, who agreed collectively perhaps, with them. Maybe it takes three doctors to replace the renowned Dr. Sherwin. 1235 But you indicated that you have a slightly different view and that they're all useful. Would you agree that ultimately the amount of weight to be given to these various tests is an exercise in judgment, primarily? 1236 MS. McSHANE: It is judgment, but I think, you know, it has to be tempered by how much reliability you think each one is worth in terms of the validity of the data. 1237 MR. MORAN: Right. And we've seen from the BCUC decision some comments on some of the disadvantages of some of those at tests as well, that were put to you yesterday? 1238 MS. McSHANE: Yeah, I'm sure that the BCUC gave its view of the advantages and disadvantages of the test. 1239 MR. MORAN: Mr. Chair, the guidelines on the formula have attached to them a compendium. I was wondering if we could just mark all of this as an exhibit. I have a few questions based on what's in the compendium. 1240 That would become Exhibit F.2.5. 1241 EXHIBIT NO. F.2.5: ONTARIO ENERGY BOARD DRAFT GUIDELINES ON A FORMULA-BASED RETURN ON COMMON EQUITY FOR REGULATED UTILITIES, DATED MARCH 1997, WITH DOCUMENT ENTITLED "COMPENDIUM TO DRAFT GUIDELINES" 1242 MR. MORAN: Ms. McShane, do you have a copy? 1243 MS. McSHANE: Mr. Moran, I have it. 1244 MR. MORAN: All right. So Exhibit F.2.5 is the Ontario Energy Board draft guidelines on a formula-based return on common equity for regulated utilities dated March 1997. The guideline itself is the first two pages, and then after those first two pages we have a document entitled "Compendium to Draft Guidelines." 1245 If I could turn you, I guess, to page 3 of the compendium. In the top half, after a description of the comparable earnings test that starts on page 2, there's a paragraph that's headed "Advantages and Disadvantages of the Comparable Earnings Test." 1246 I wonder if you could take a moment to review it and provide whatever comments you want to make on what is set out there? 1247 MS. McSHANE: Well, I have read this before, and my comment is you could replace any test you want in most of those concerns, and the concerns affect all the tests. 1248 So, I mean, none of the tests is totally free from any of these concerns. You can do a discounted cash flow test. The concern would be do you have comparable companies. 1249 MR. MORAN: Let's just stay with the comparable earnings test first and we'll move to the DCF in a minute. 1250 MS. McSHANE: No, but my point is I can see where each of these would be a concern. My only comment is that these concerns that are expressed relative to the comparable earnings test are not just concerns one would have with the comparable earnings test. 1251 MR. MORAN: All right. And with respect to what is set out there on page 3 with respect to the comparable earnings test, do you take issue with anything that's there? 1252 MS. McSHANE: I guess I don't have an issue in the sense that I can see where one needs to address each of those concerns. The concern with assembling a list of acceptable comparable companies means that you have to show that the companies that you've chosen are comparable in risk. If you simply said, Okay, I'm going to use the S&P 500, well, I mean, you haven't borne the burden of showing that those companies are comparable. 1253 It says the process is subjective and open to interpretation and criticism. Well, the process of selecting comparable companies for purposes of any type of analysis can be called subjective and open to criticism. If you're doing a discounted cash flow study, you have to choose criteria that will equate the comparability of the companies to the subject company. 1254 So if you can show that the criteria that you've got are not, well, you know, I just picked everything within a certain industry, yes, I chose companies that have betas, that are less than 0.7. I chose companies within these industries. Sure there is some subjectivity to that, but there's also bright-line criteria that show that you're trying to pick companies that are of similar risk. 1255 The suitable time period, sure, you can make criticisms of that, but if the analysts can show that the characteristics of the cycle that they've picked are similar to what's expected for the future, that's -- that's a reasonable approximation of using something historical, which is likely to be the same in the future. 1256 It says that most of the data in the analysis is historical. Well, it's historical, but it's used as a proxy for the future, because the period is similar. That's also true of the risk premium test. A lot of the data are historical. That's what -- if they weren't historical, they wouldn't be data. That's, you know, the numbers that one picks for various tests have to, to a large extent, come out of history. 1257 No, the historical results do not provide assurance of future performance, but neither do risk premium results or DCF results. They all are subject to some changes occurring in the future that will make the future different from the past. 1258 MR. MORAN: So this is a valid statement of the advantages and disadvantages of the comparable earnings test. 1259 MS. McSHANE: But I think the advantages and disadvantages apply to the other at test as well. 1260 MR. MORAN: And with that, you don't take issue with the validity of the statement as it's set out here? 1261 MS. McSHANE: Well, I don't take issue with the concerns. I think the concerns need to be addressed. 1262 MR. MORAN: Right. So these are valid statements of the advantages and disadvantages of the comparable earnings test. 1263 MR. VLAHOS: We went through that two or three times, Mr. Moran. 1264 MR. MORAN: I just wanted to make sure that I understood her answer, Mr. Chair. 1265 MR. VLAHOS: We hear you. 1266 MR. MORAN: All right. Then if we turn to page 4, at the top of page 4 there's a statement of the advantages and disadvantages of the discounted cash flow test, and would you take issue with that statement? 1267 MS. McSHANE: You want to go through it statement by statement like we did with the other one? 1268 MR. MORAN: It's totally up to you, Ms. McShane. You can say yes, it is a valid statement, or you can go in greater detail if you wish to. 1269 MS. McSHANE: I agree with the advantages. I agree that previous growth experience is not necessarily indicative of actual or expected future growth. The DCF method can use, as I have, forecast growth rates, and therefore we don't have to use past growth rates. 1270 It is a disadvantage to some extent that the OEB-regulated utilities are no longer traded in the open market; however, I think it's very circular to use the subject company as the subject of the test, because when you only use one company, you can have numbers that are very different from what the true cost of equity is. That's why we tend to use samples. 1271 So I think that there obviously would be advantages to having data, market data for the companies just so that the Board has a way of assessing, from a market perspective, the viability of the companies, but I wouldn't propose doing a DCF test on the subject companies on a stand-alone basis anyway. 1272 Okay. That's all I have to say about that. 1273 MR. MORAN: The last sentence in the statement says: 1274 "It is for this and other reasons that the DCF test has not generally been relied on by experts or the Board in determining the ROE for Ontario LDCs." 1275 You do rely on it in your recommendation to the Board in this hearing? 1276 MS. McSHANE: I have. 1277 MR. MORAN: And I think Dr. Cannon also relies on it by giving it a weight of 15 -- 1278 MS. McSHANE: He has, yes. And back in the old day, Drs. Booth and Berkowitz used to use the DCF test almost exclusively. No, I'm sorry, that's not fair. They used to use the DCF test and the cap M test in conjunction with each other. 1279 MR. MORAN: And they've moved away from that in this area? 1280 MS. McSHANE: I think so, because they used to apply it to telephone companies, and there are no real pure-play utility telephone companies anymore. 1281 MR. MORAN: All right. And then on page 5, we have the advantages and disadvantages of the capital asset pricing model. What's your view with respect to the validity of that statement? 1282 MS. McSHANE: Sorry, we're on page 5 -- oh, I'm sorry. We're at the top of page 5. 1283 MR. MORAN: At the top of page 5. 1284 MS. McSHANE: I don't disagree with anything that's in that paragraph. 1285 MR. MORAN: All right. And my last question, then, is at the bottom of the page, a statement of the advantages and disadvantages of the equity risk premium test. Is that a valid statement? 1286 MS. McSHANE: An advantage is that the bond yield data are widely available. That's an advantage. 1287 MR. MORAN: And publicly known? 1288 MS. McSHANE: Yes, and clearly the bond yield is an important input. 1289 Conceptually easy to understand. True. I think really all that means is that because this has been separated from the capital asset pricing model, it's really a more generic approach to CAPM. And really all it means is you take a bond yield and add a premium to it, so that makes it very easy to understand; but the hard part, of course, is determining what the risk premium is, and it's recognized here that that's the difficulty. 1290 So we have one part that's very easy to figure out, and that's also true in the capital asset pricing model; and we have the other part, the equity risk premium, which is what everybody is arguing about, which is the part that's difficult to determine. 1291 MR. MORAN: Generally, then, you would agree with what's written here? 1292 MS. McSHANE: Yes. 1293 MR. MORAN: Thank you very much, Ms. McShane. 1294 Mr. Chair, those are all my questions. 1295 MR. VLAHOS: Thank you, Mr. Moran. 1296 The Board does have some questions. 1297 QUESTIONS FROM THE BOARD: 1298 MR. BETTS: Ms. McShane, I do have one question you can help me with, just to help in a common-sense manner, help me understand the relative benefits of a change in the Board's ROE, and I guess specifically, and I'm looking for your answer in a qualitative sense rather than a quantitative sense, but if the Board was to accept your recommendation for the new ROE and the adjustment mechanism, what impacts, both positive, and negative would you expect for the three primary parties, being the ratepayers, the utility, and the shareholders. 1299 So the benefits and, well, let's call it the positive and negative impacts for both, with a change which would totally agree with your recommendation. 1300 MS. McSHANE: Well, if we deal first with just the change in the level of the return, I think it's probably obvious that from a shareholder perspective, an increase in the level of the return will positively impact their bottom line and make sure that they don't have trouble accessing capital in the future to continue to serve and to add to the infrastructure and to give them the incentive to, perhaps, commit capital to things that they might not otherwise decide are appropriate for the level of return that they're being allowed. 1301 From the ratepayers' perspective, I can't deny that rates are going to increase if the return is raised. I think that from an economic perspective, if you believe that the return that I recommended is fair and indicative of cost, then what it does from a ratepayer perspective is say, "Let me stop and think about whether I shall consume this natural gas." 1302 I mean, the Board, I think, has some role in pursuing the objective of economic allocation of resources. And if a product like natural gas is underpriced, then consumers are going to be incented to overconsume, and if it's overpriced, obviously, they will have to commit funds to consume gas that they might otherwise use elsewhere. 1303 So that's sort of the way I look at from the ratepayers' perspective. 1304 As far as the formula itself, what it does is creates greater stability in the return over time, which presumably, from a ratepayer perspective, is a good thing and is, from the perspective of a retailer, a good thing. A retailer who's purchasing natural gas delivery service wants to bundle that into other services, wants to offer contracts that will last for five years, let's say, for example, would prefer to see a return that's more stable over time, because then they can price their product to the end user with a greater deal of certainty that their costs aren't going to change that much. 1305 And I think stability of return is also a good thing from the company's point of view because they have a better assurance of the level their return is going to be, so they know better what their interest coverage is going to look like, and they're not as concerned about the sensitivity of the return from year to year, which is one of the things, in particular, that the debt rating agencies have been concerned about. 1306 MR. BETTS: With respect to the utility, are the benefits to the utility only those associated with the shareholder having more capital to put back to the utility, or are there any others that you can foresee? 1307 MS. McSHANE: Well, I think that if you're less concerned about your return being sort of -- let's say it's marginal. That means that you often have to make very difficult choices in terms of what expenses you're going to incur. So I think when you've got a company who's return can be described as not minimal but fair, that that goes to a long way to leading to service at low cost and at high quality. 1308 And in fact, the example that comes to mind is Wisconsin, which historically has been a state that's had returns towards the upper end of the range. Returns for example, today, in Wisconsin, are in the 12.5, 12.75 percent range. And some of these companies have equity ratios in the 55 percent range as well. So it's not like their giving them 12.5 on relatively low equity. 1309 At the same time, the Wisconsin utilities have some of the lowest rates in the country, and that's been attributed to the fact that that commission has been ascribed with having the objective of having a financially strong utility industry in the state, and I think that the -- in part that the lack of having to really worry about the financial health has helped lead to being able to, you know, focus on efficiencies and reducing costs in other areas. 1310 MR. BETTS: Where have representatives in groups that are interested or have environmental concerns as well as conservation concerns. Do you see any impact on their goals based on your recommended ROE level and your adjustment mechanism? 1311 MS. McSHANE: I don't know so much about the adjustment mechanism. I guess if I were -- if I were concerned with conservation, then I would want to make sure that the service was priced properly, because I would want to make sure that the consumption was -- was not being pushed up because the price was too low. So that, I think, from that perspective, I would want -- I would want to make sure that, as I said to you earlier, that the -- resources are economically allocated. 1312 I think that's also true if I were concerned about the environment, that I would want to make sure that the service was properly priced with the proper cost of capital in there because, again, it's sort of overconsumption that is going to be directly related to the environment and environmental concerns. 1313 So if I'm particularly a thermoelectric utility with thermal plants, you'd want to make sure that the rate of return was set at a level which reflected the true cost to make sure that you're not erroneously producing environmental problems with green -- gas emissions. 1314 MR. BETTS: One question just to clarify something you said earlier. You referred to the stability of the return with respect your adjustment mechanism, and how that will be perceived to be a benefit, I think in that particular case, to ratepayers. 1315 Can you deal me if there's some difference in the level of stability with your recommendation versus those of the other experts. 1316 MS. McSHANE: Yes, because Dr. Booth is recommending that the return move by 75 percent of the change in long-Canadas, which is the same adjustment mechanism that the Board has right now. Dr. Cannon is recommending that it be reduced a small amount to 70 percent, and mine is that it would move by 50 percent of the change in long-Canada rates. 1317 So if you approved a return of, let's say, 11 percent, just to make it easy for calculation, or maybe it won't that if interest rates changed by 1 percent, and let's say they went up by 1 percent, then Dr. Booth's formula would have the return go from 11 to 11.75; Dr. Cannon from 11 to 11.7; and mine go from 11 to the 11.50. 1318 MR. BETTS: Thank you, those are all my questions. 1319 MR. SOMMERVILLE: I have one question, Ms. McShane. What are the characteristics of a utility that is operating or labouring under an inadequate rate of return? 1320 MS. McSHANE: An inadequate rate of return? 1321 I think, first of all, to me, in the term inadequate -- I'm not sure how -- how you define that. 1322 To me, there's -- there's a concept of a fair return, and there's sort of a minimum return that -- a utility can operate. I mean, obviously, Enbridge and Union aren't going bankrupt. They're still able to go out and raise debt. Does that make it a fair return? No. 1323 It means that it's -- it's set at a level which doesn't -- which hasn't at least, to date, impeded their ability to go to the debt markets, but it doesn't make it a fair return. 1324 If it's truly inadequate, if it's non-compensatory to the point where they can't go out and raise new capital or debt except at very, very high rates, or even if it means that they're put if the position of -- they're -- they're at such a marginal level that it's -- it's difficult to -- to make the investments that they -- they should be making to produce something more than a minimal level of service. 1325 MR. SOMMERVILLE: Thank you. 1326 MR. VLAHOS: Thank you, Mr. Sommerville. 1327 Ms. McShane, just three or four areas in no particular order. I just want to clean up some of the things that I've heard. 1328 I think you said I believe it was yesterday that there didn't appear to be any rhyme or reason for the 75 percent adjustment to the change in long-Canadas. Do you recall that? 1329 MS. McSHANE: I do. 1330 MR. VLAHOS: Yeah. And can you tell me what is the source of your 50 basis points? 1331 MS. McSHANE: The source of my 50 basis points is to basically say that if you look at the capital asset pricing model that, theoretically, because the capital asset pricing model doesn't lend itself to a determination of what the relationship is between interest rates and the risk premium, that I would accept, for purposes of that application, that there is a one-to-one relationship. 1332 When you apply the discounted cash flow test or a DCF-based risk premium test and you can look at the relationship between interest rates and the cost of equity directly, and that relationship is more along the lines of 30 basis points increase in the cost of equity for every 1 percent change in interest rates over the last 13 years. 1333 Comparable earnings is effectively that because you're looking at a cycle average return, then there's no change, zero change in the level of return. 1334 So my 50 basis point difference basically takes the three tests and says, Look they're based on different premises. They assume different relationships. Let's give weight to all three. 1335 MR. VLAHOS: Right so there's not really a mathematical thing here? 1336 MS. McSHANE: No. I mean, it's still recognizing that you can't pinpoint it, and that's sort of what I was saying when I said that the 75 basis points change that came out of National Energy Board decision originally, effectively was on the one hand you had experts that were applying the capital asset pricing model which had this one for one relationship in it, and you had other people who were looking at a DCF-based risk premium test which had a 50/50 change in it, and they said, "Okay, 50/50, one, we will average the two." 1337 They were basically saying, "We know it's not one for one. We also know that any data that you use is subject to some interpretation, depending on the period, depending on the data you choose, so we'll choose something in the middle of the two." 1338 MR. VLAHOS: To the extent there is less weight or no weight to the comparable earnings test, that number of 50 basis points should have been something higher? 1339 MS. McSHANE: Yes. 1340 MR. VLAHOS: You're advocating a fixed spread over the ten year of long-Canadas -- 1341 MS. McSHANE: That's what I was indicating. 1342 MR. VLAHOS: -- and you calculate that to be 35 basis points? 1343 MS. McSHANE: I yes. 1344 MR. VLAHOS: And I assume you're taking X years and I believe Dr. Cannon is quite close to that, 27 basis points? 1345 MS. McSHANE: Yes. 1346 MR. VLAHOS: Is there a difference in the period that's chosen? 1347 MS. McSHANE: Yes. 1348 MR. VLAHOS: Is there? 1349 MS. McSHANE: Sorry. The reason that I was thinking that perhaps a constant number might be used instead of the actuals that have been used in most of these formulas is because, particularly in 2000, there's truly a problem with the potential of scarcity of long-term issues. When the federal government was in a surplus position and they were telling the market that they had no intention of issuing any more 30-year issues, so there was this real scramble for these long-term issues, and there was a decline in the spread between 10- and 30-year Canadas that was solely due to that scarcity problem. 1350 And so I thought rather than run into situations where you had a very anomalous spread that was due to concerns over scarcity, that it made sense to use a fixed number, and I went back to the early '90s to do that. 1351 Now, Dr. Cannon's number is over a shorter period of time, and the reason that it's lower is because it puts more weight on the period in which the scarcity was the concern. So I think that's, in large part, the explanation for his 27 versus my 35. 1352 MR. VLAHOS: But as you know -- do you know where the two doctors are on this? Are they advocating to fixed spread or -- 1353 MS. McSHANE: I don't think so. I think they've either been silent on it, or they've said they're perfectly happy with what the Board has done. 1354 MR. VLAHOS: Ms. McShane, just to follow up on one of the lines of questioning by Mr. Moran, and that's the alternative of using -- instead of using a forecast for long-Canadas, for the ten-year long-Canadas, why can't we just use whatever applies closer to the date of the decision? I think it certainly would make a lot of peoples' lives easier? And you did speak about some of the risk associated with that. 1355 But there's no evidence, if I pick a point today, as to what the interest rates will be next year in terms of short term or long term, that -- I could easily be more wrong than the next time. 1356 MS. McSHANE: All I can say to you on that is I believe that if you look at the average difference -- the biggest differences from the actual, we're using an actual rather than a forecast. 1357 I know that there was -- there's only one regulator to my knowledge that's used the actuals versus the forecast and that was the Public Utilities Board in Newfoundland. And I recall that at least one investment analyst expressed a concern that that that had resulted in Newfoundland Power being allowed the lowest returns of any utility in the country, and they were also very concerned that it was -- that the return for the following year was predicated on a number that happened to be the yield on a particular day. 1358 So I guess over the long-term, chances are that one is not necessarily better than the other, but a utility has to live with an allowed return for a whole year, and if there's a greater probability that you might have an anomalous result or a yield in a particular month, then a forecast would tend to look past those, I mean, my tendency would be to go with the forecast, and no, I don't have any investment in consensus forecast. 1359 MR. VLAHOS: Thank you. 1360 There was some discussion today about when you're going to be outside the parameters where you feel that the formula has to be reviewed and you talk about anything more than 8 percent of long-Canadas, it's territory where you should review it. I haven't heard anything about the other side of the range. 1361 MS. McSHANE: Because we haven't been there, I sort of feel uncomfortable with below 4 percent, but again, I don't necessarily view 4 and 8 as -- I would look at it at those levels and to make sure, if I were the utility, if I were the regulator, to make sure that I was comfortable that the formula that I had chosen was still working, but I would consider sort of 4 and 8 percent as the parameters outside which I would want to at least look at the validity of the results. 1362 MR. VLAHOS: And also there was some discussion about the link of the formula to the PBR regime. Does there have to be a link necessarily? 1363 MS. McSHANE: No, not necessarily, but it seems to me that if you have a five-year PBR, that part of the whole concept of having a PBR is you've got a plan that covers a certain number of years, and that if the formula return is part of the plan, I mean, presumably you could come up with a PBR plan that let's you opt out of the formula return. 1364 There were pipelines at the National Energy Board who aren't covered by the NEB formula, because they were able to come up with a separate plan for themselves which negotiated between them and their customers and they're not affected by that. 1365 But if you're in a PBR plan where you're covered by the formula, I would think that it makes some sense that you would accede to the results of the formula within that period of time, unless there were some major changes in the capital markets. 1366 MR. VLAHOS: One last question, Ms. McShane. I recall your prior testimony over the years having been long on discussion of business risk, financial risk, regulatory, political risk and I didn't see that in your testimony now. 1367 Can you explain to me why? Is it because you're going back to sort of using the other utilities as being a proxy? Why is there no discussion in this context? 1368 MS. McSHANE: I think because as the guidelines suggested, that there were two reasons that you might review the formula. One would be changes in market conditions and one would be changes in the utility risk. 1369 And the companies are basically looking for a change in formula due to the former, and basically the changes in business and financial risk were not viewed as substantive enough to -- to materially affect the results, and that what we wanted to do was focus on the change in the capital markets, which we believed were sufficient to seek a change in the result. 1370 MR. VLAHOS: Thank you. 1371 Mr. Penny, those are the Board's questions. Any redirect. 1372 MR. PENNY: Yes. Thank you, Mr. Chairman. I have I think just about half a dozen specific points that I wanted to touch on. Thank you. It will be brief. 1373 RE-EXAMINATION BY MR. PENNY: 1374 MR. PENNY: Ms. McShane, you were asked earlier on yesterday about the role of the parent in accessing capital and the issue of Union and EGD not having access directly to capital in the marketplace, and then there was a related discussion about the parent. 1375 I wanted to ask you whether it was relevant parent of a regulated utility has other subsidiaries of comparable risk, if that's a relevant consideration when you're thinking about access to capital. 1376 MS. McSHANE: Well, I think certainly if -- 1377 MR. PENNY: Why don't I just ask sort of the entire question I'm going to put to you and you can answer it all at once. 1378 MR. THOMPSON: Just a second. Let her answer the first question. 1379 MR. PENNY: I'm just trying to speed things up, Mr. Chairman. 1380 MR. VLAHOS: As long as it's being helpful, Mr. Penny, yes. 1381 MR. PENNY: Then I would ask if the parent has other regulated-utility subsidiaries, is it relevant to know what returns the other subsidiaries are getting? That's the global question. 1382 MS. McSHANE: I think it's certainly relevant from the parent's perspective, because when a parent company is deciding where to invest, it may be difficult to make a direct comparison with the regulated utility, and a non-regulated operation to determine what the best risk return opportunities are, but when they've got subsidiaries, basically, in the same area of business, and for example, in the case of Duke, I mean, Duke has utility operations in North and South Carolina, and their returns are in the 12 and a quarter to 12.5 percent range. 1383 I think that's certainly a consideration when they look at where they want to put their capital. And presumably those returns that have been determined for those subsidiaries have been determined on the basis of what competitive returns are relative to other utilities. 1384 MR. PENNY: All right. Thank you, Ms. McShane. 1385 Then there was, at one stage -- I think a couple of times this has come up, but yesterday for sure there have a Wall Street report put to you on optimism in analysts' forecasts, and it was put to you that there was -- that this was so-called "good evidence," that investor optimism should be adjusted for in doing an ROE analysis. 1386 And you said thing along the lines of that it would not be appropriate to adjust growth forecasts if investor optimism is also reflected in the prices. I just wanted you to explain that, and if you were to -- if you were to try and adjust growth expectations due to some perceived optimism, whether you would also have to somehow adjust -- try and make some adjustment for prices. 1387 MS. McSHANE: Maybe I can explain this more clearly than I did yesterday. 1388 In the discounted cash flow test, the two parts of the equation are: Dividend yield, which is dividend divided by price, plus expected growth. Implicit in the price is the expectation of the growth. 1389 So if I am going to adjust downward the expected growth rates because I believe that investors are overestimating the growth expectations, I, Kathy McShane believe that, then I would also have to then say, Well, the price is incorrect. The price would have to be lowered to change what I, Kathy McShane, would be willing to pay for the stock because I don't believe the growth rates and, therefore, if I adjust downward the growth rate, and then I adjust downward the price which raises the dividend yield component, I have a higher dividend yield and a lower growth, but I up in the same place, with the same expected return. 1390 MR. PENNY: All right. Thank you. 1391 And just a second follow-up question on that same issue, which is: Did you use any companies that -- you recall the article, first of all? 1392 MS. McSHANE: Yes. 1393 MR. PENNY: And did you use in your -- any of your analysis, but I think this just relates to the DCF analysis, did you use any companies that this article was about in your sample? 1394 MS. McSHANE: No, the companies that the article was talking about, and I think I mentioned this yesterday, were essentially high-tech companies, the so-called high-flyers, that Wall Street was interested in getting the business of. 1395 MR. PENNY: What companies did you use? 1396 MS. McSHANE: The companies that I'm using are relatively boring LDC companies that were not part of this fray over the Internet bubble. 1397 MR. PENNY: And are you aware of any criticism of so-called excessive optimism in that sector? 1398 MS. McSHANE: I've not seen anybody criticized that the utility knows. 1399 MR. PENNY: Thank you. 1400 Then also you, yesterday, mentioned at that relation search report that updated for regulatory decisions in the U.S. showing average returns, and that came up again I think today. What's the name of that? 1401 MS. McSHANE: It's called -- the name of the company that produces it is called Regulatory Research Associates, and the name of the publication is "Regulatory Focus: Major Rate Case Decisions." 1402 MR. PENNY: And you were talking specifically about a report that showed where the second quarter 2003 average returns were coming out, were you able to get a copy of that report? 1403 MS. McSHANE: Yes. 1404 MR. PENNY: Can you identify this document as -- sorry. Is that a copy of the report you were referencing? 1405 MS. McSHANE: Yes, it is. 1406 MR. PENNY: Perhaps, Mr. Chairman, that could be marked as the next exhibit. 1407 MR. VLAHOS: Mr. Moran? 1408 MR. MORAN: Yes, Mr. Chair, Exhibit F.2.5, a document -- an excerpt from -- 1409 MR. VLAHOS: Six? 1410 MR. MORAN: Sorry, 2.6. My mistake. Excerpt from -- sorry, excerpt from the document entitled "Regulatory Focus," dated July 7, 2003, with the heading "Major Rate Case Decisions January-June 2003." 1411 EXHIBIT NO. F.2.6: DOCUMENT ENTITLED "REGULATORY FOCUS," DATED JULY 7, 2003, WITH THE HEADING "MAJOR RATE CASE DECISIONS JANUARY-JUNE 2003" 1412 MR. PENNY: And just so everyone knows what you were referencing, Ms. McShane, can you just point out on this report where the second quarter 2003 average returns show up. 1413 MS. McSHANE: Sure, if you turn to the second page, there are columns for electric utilities, gas utilities, and at the very bottom of the page, there's an average for the first quarter, then the second quarter, then the year to date. 1414 MR. PENNY: And I think this is explained in the note at the top, but what are the numbers in brackets? 1415 MS. McSHANE: The number of decisions. 1416 MR. PENNY: Thank you. 1417 Then, Ms. McShane, today you were asked about some questions by Mr. Moran about the accuracy of the forecast long-Canadas versus actual ten-year yields and I wanted to ask you this: Are you aware or are you aware of any reason for or do you have any reason to think that there is any bias, either up or down, inherent in the consensus forecast methodology of forecasting bond yields, anywhere for that matter, but specifically in Canada? 1418 MS. McSHANE: No, there is absolutely no reason that there should be an upward or downward bias in the forecast. 1419 MR. PENNY: Then you were asked some questions about your schedule 18, which was Exhibit B, tab 3, and that was your list of comparables for the comparable earnings test? 1420 MS. McSHANE: Yes. 1421 MR. PENNY: And you mentioned that you used the median values, and that that therefore -- that did something to the suggestion that there were some unusually high returns in some of the instances, and I just wanted you to explain how your analysis or your model deals with the non-recurring items and why the use of median values eliminates or at least substantially eliminates any concern about particular numbers and particular years. 1422 MS. McSHANE: Well, maybe I can give you a simple example of how focusing on the median would mitigate the impacts of including any non-recurring items, be they positive or negative. 1423 Let's assume that you've got three numbers, and one of them is 50. One of them is 10, and one of them is 20. If you were to average the numbers together, obviously the 50 would have considerable weight in the average result, but if you look at the median, you're looking at the number that's in the middle of all of the companies in the sample so that you would -- the median -- 1424 MR. PENNY: In your example? 1425 MS. McSHANE: Pardon me. 1426 MR. PENNY: The median on your example? 1427 MS. McSHANE: On my example, and also on the median itself. If you had 20 numbers, you'd take the one in the middle in my example. If you've got three numbers, you would take the one in the middle, so you're not giving the same weight to the big numbers or the very small numbers. You're looking at how many numbers are below or above the one in the middle, not how big the biggest numbers are, or how small the smallest numbers are. 1428 MR. PENNY: So if you look on schedule 18, looked at the column for 2000, and -- 1429 MS. McSHANE: Yes. 1430 MR. PENNY: -- all of the returns for that, apply your simple example to the companies and just explain what happens there. 1431 MS. McSHANE: So if I looked at the average for 2000, and one of the concerns was the 69 percent, then if all of the other numbers are sort of in the 12 to 15 range, averaging 69 in with those numbers would boost the average from around 15 to something well above it. 1432 But by looking at the median of those numbers, you're still at around the 15 percent, because you're looking at how many are above the central number and how many are below. 1433 MR. PENNY: All right. Thank you. 1434 A lot of questions in the last few days about the DCF test. I just wanted to ask you what role the DCF, and in particular Mr. Moran was asking you to comment on the Board guidelines and the commentary on the Board guidelines. What role does the DCF test play in the regulation of U.S. LDCs? 1435 MS. McSHANE: The DCF test is the major test that's used by regulators in the United States. 1436 MR. PENNY: Thank you. 1437 And then finally, there again, a number of cross-examiners have asked you about your adjustment formula. I just wanted to ask you, and yours, of course, is to use 50 percent of the change in long-Canadas. 1438 Let ask you this: If the Board, for example, did not accept the methodology of applying all three tests to derive the new benchmark return, do you still recommend your adjustment formula of 50 percent in the change of long-Canadas or would your recommendation change. In other words, is the manner in which you arrive at a new benchmark related to your recommendation on how you change year-over-year under a formula change to a new benchmark? 1439 MS. McSHANE: Yes, it is. 1440 MR. PENNY: Can you explain why? 1441 MS. McSHANE: Well, because there needs to be an internal consistency between the tests that are applied by the Board and the adjustment mechanism. So that if the Board believes that the equity risk premium test is the critical test, then it clearly believes that the return moves with interest rates to a greater extent than if it gave weight to all three tests. 1442 So it would be unfair and unreasonable to hold the companies to 50 percent of the change in interest rates if the very basis for the determination of the return were a test that assumes that the cost of equity moves with interest rates. 1443 MR. PENNY: On a one to one basis. 1444 MS. McSHANE: One to one. Yes. 1445 MR. PENNY: Thank you. 1446 Thank you very much, Mr. Chairman, those are my questions. 1447 MR. VLAHOS: Thank you, Mr. Penny. 1448 Ms. McShane, thank you very much for being here. 1449 MS. McSHANE: Thank you. 1450 MR. VLAHOS: We can't excuse you yet, though. You'll be deemed excuse when the hearing is over, okay? Just in case. 1451 MS. McSHANE: Does that mean I can't go home? 1452 MR. VLAHOS: Yes, you can go home, but I've seen situations where you've had to come back, I believe. We hope that won't be the case. 1453 PROCEDURAL MATTERS: 1454 MR. VLAHOS: Now, for tomorrow we're going to have Messrs. Cleland and Case and Dr. Booth on behalf of both Drs. Booth and Berkowitz. Am I correct, Mr. Moran? 1455 MR. MORAN: That's my understanding, they're available tomorrow. 1456 MR. VLAHOS: My note here says that, Mr. Penny, you're supposed to get the parties together at some point today to discuss what the plan is for the next couple days, two or three days. 1457 MR. PENNY: That comes as a surprise to me, but I'm happy to do it. The only problem is when we're talking about parties, the room is almost empty. 1458 MR. VLAHOS: And I'm just quoting -- "And can I just, without bothering you," that's the Panel, "indicate to the intervenors we would like to canvass them tomorrow morning for their time before we" -- 1459 MR. PENNY: Oh, that. We did that. That was for yesterday and today. 1460 MR. VLAHOS: For today? All right. I thought it was for the balance of the hearing. 1461 MR. PENNY: No, sorry, that was just to deal with Ms. McShane. 1462 MR. VLAHOS: Maybe I can turn to Mr. Moran. We'd like to have a plan. Now, we don't start until 10:30 tomorrow morning so it gives you some time to contact the parties and get us a plan. We want to be sure we're finished by Friday so parties can also be guided by the time that they have allowed or they have given you for cross-examination. 1463 MR. MORAN: I'm certainly happy to give you a longer-term offer than Mr. Penny. 1464 MR. VLAHOS: So maybe we can have that by 10:30, before we start. 1465 MR. PENNY: Just before we go, Mr. Chairman, we've got an answer that Ms. McShane undertook to give Mr. Aiken, G.2.1, and we'll undertake to pass that out now. 1466 MR. VLAHOS: Okay. There being no other matters, thank you, and we're adjourned until tomorrow at 10:30. 1467 --- Whereupon the hearing adjourned at 5:28 p.m.