Rep: OEB Doc: 12WVR Rev: 0 ONTARIO ENERGY BOARD Volume: 4 25 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 25 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 MICHAEL JANIGAN VECC MURRAY KLIPPENSTEIN Pollution Probe BRIAN DINGWALL Energy Probe LAURIE SMITH, Q.C. Canadian Gas Association 8 TABLE OF CONTENTS 9 PRELIMINARY MATTERS: [16] VECC - PANEL 1; BOOTH [59] EXAMINATION BY MR. JANIGAN: [61] CROSS-EXAMINATION BY MR. SMITH: [156] CROSS-EXAMINATION BY MR. KLIPPENSTEIN: [348] CROSS-EXAMINATION BY MR. DINGWALL: [421] CROSS-EXAMINATION BY MS. NEWLAND: [515] PROCEDURAL MATTERS: [1078] 10 EXHIBITS 11 EXHIBIT NO. F.4.1: UPDATES TO DR. CANNON'S EVIDENCE AND COMMENTS ON TRANSCRIPT REFERENCES TO DR. CANNON'S EVIDENCE [24] EXHIBIT NO. F.4.2: ARTICLE ENTITLED "LONG-RUN STOCK RETURNS PARTICIPATING IN THE REAL ECONOMY," AUTHORED BY ROBERT G. IBBOTSON AND PANG CHEN [27] EXHIBIT NO. F.4.3: EXCERPT FROM THE STOCKS, BONDS, BILLS, AND INFLATION 2003 YEARBOOK [32] EXHIBIT NO. F.4.4: GLOBE AND MAIL ARTICLE DATED OCTOBER 30, '01, "BC Gas FINANCING PROVES IT'S THE SILLY SEASON." [307] EXHIBIT F.4.5: UNDERTAKING RESPONSE FROM DRS. BOOTH AND BERKOWITZ, TRANSCRIPT 1304 FILED IN A AEUB CASE, ATCO GAS SOUTH 2001/2002 GENERAL RATES APPLICATION [788] EXHIBIT NO. F.4.6: TABLE ENTITLED "DERIVATION OF ARITHMETIC MARKET RISK PREMIUM, U.S. AND CANADA, 1950 TO 2000" [832] EXHIBIT NO. F.4.7: ARTICLE ENTITLED, "GLOBAL EVIDENCE ON THE EQUITY RISK PREMIUM" BY DIMSON MARSH AND STAUNTON DATED SEPTEMBER 2002 [899] EXHIBIT NO. F.4.8: TRANSCRIPT CORRECTION FILED BY MR. CASE [1095] EXHIBIT NO. F.4.9: RESPONSE OF MR. CASE TO DATA PROVIDED BY MR. THOMPSON SUBJECT TO CHECK [1097] 12 UNDERTAKINGS 13 UNDERTAKING NO. G.4.1: TO PROVIDE CLARIFICATION OF THE ENBRIDGE GAS DISTRIBUTION/UNION POSITION ON ADJUSTMENT FACTOR [49] 14 --- Upon commencing at 1:10 p.m. 15 MR. VLAHOS: Please be seated. 16 PRELIMINARY MATTERS: 17 MR. VLAHOS: Good afternoon. 18 Any preliminary matters, Mr. Moran, or anybody else? 19 MR. MORAN: Yes, Mr. Chair. Just some stuff that we'd like to file. 20 In the interest of efficiency, we thought it would be more useful if some updates that Dr. Cannon wants to speak to could be dealt with in written form so that parties would have it before he appears tomorrow rather having to go through it in direct evidence, so as a result I have some material here to file; an update, and -- some updates to his prefiled evidence, a brief overview and description of that, and a couple of documents which I would ask to be marked as exhibits. 21 MR. VLAHOS: Mr. Moran, I see that's about 3 inches high. That's just many copies; right? 22 MR. MORAN: That's right. Many copies of very thin documents. 23 The first document is entitled "Updates to Dr. Cannon's Evidence and Comments on Transcript References to Dr. Cannon's Evidence," and that would become Exhibit F.4.1. 24 EXHIBIT NO. F.4.1: UPDATES TO DR. CANNON'S EVIDENCE AND COMMENTS ON TRANSCRIPT REFERENCES TO DR. CANNON'S EVIDENCE 25 MR. MORAN: The next set of documents is just replacement pages for his prefiled evidence, so it doesn't need to be marked. 26 The next document is an article entitled "Long-Run Stock Returns Participating in the Real Economy," authored by Robert G. Ibbotson and Pang Chen. That would become Exhibit 4.2. 27 EXHIBIT NO. F.4.2: ARTICLE ENTITLED "LONG-RUN STOCK RETURNS PARTICIPATING IN THE REAL ECONOMY," AUTHORED BY ROBERT G. IBBOTSON AND PANG CHEN 28 MR. JANIGAN: I'm sorry, can you review the numbering system again. 29 MR. VLAHOS: The second document did not get a number, gentlemen. 30 MR. MORAN: That's right. The second document didn't require a number. That's just updates to prefiled by Dr. Cannon. 31 And the last document, Mr. Chair, is an excerpt from the stocks, bonds, bills, and inflation 2003 yearbook. Ms. McShane, I think, referred to this as the red book. That will become Exhibit F.4.3. 32 EXHIBIT NO. F.4.3: EXCERPT FROM THE STOCKS, BONDS, BILLS, AND INFLATION 2003 YEARBOOK 33 MR. MORAN: That's all I have, Mr. Chair. 34 MR. VLAHOS: Thank you, Mr. Moran. 35 No other preliminary matters? 36 MR. THOMPSON: Excuse me, Mr. Chair. 37 MR. VLAHOS: Mr. Thompson. 38 MR. THOMPSON: Yes, I have one. I spoke to both Enbridge and Union about this. It arises out of a couple of transcript references, and it's to get clarification on the Enbridge and Union position with respect to the adjustment factor. 39 At transcript Volume 1, 1575, I asked Ms. McShane if the adjustment factor should be near one if ERP is given primary weight, and her answer at 1576 was: 40 "No, not if you're looking at really trying to establish what the relationship is between interest rates and the risk premium." 41 Then in re-examination by Mr. Penny in Volume 2, at transcript 1437 and following, he asked some questions about the adjustment formula, and it said: 42 "Let me 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?" 43 His question went on a little bit, but the answer to that was from Ms. McShane that -- well, the question was: 44 "In other words, is the manner in which you arrive at a new benchmark related to your recommendation and how you change year over year under a formula change to a new benchmark?" She said: "Yes, it is." And then went on to explain that, in her view, there needed to be internal consistency between the tests that are applied by the Board and the adjustment mechanism, and went on to say: 45 "It would be unfair and unreasonable to hold the companies to a 50 percent change if the basis for the determination of the ROE were a test that assumes that the cost of equity moves with interest rates." 46 So what I asked the company off the record, and they asked me to put this on the record so they can answer it by way of undertaking, is a clarification of the company's position on adjustment factor if the Board finds the ROE to be in accordance with the existing mechanism. That's scenario 1. 47 And the second scenario is if the Board changes the benchmark ROE, but downward, and the company has indicated they would like to answer that by way of undertaking. So if we could give it a number, at some point we would have that put on the record. 48 MR. MORAN: Yes, Mr. Chairman, that would be Undertaking G.4.1. 49 UNDERTAKING NO. G.4.1: TO PROVIDE CLARIFICATION OF THE ENBRIDGE GAS DISTRIBUTION/UNION POSITION ON ADJUSTMENT FACTOR 50 MR. VLAHOS: And I will have to ask you to describe it, Mr. Moran. But we'll leave it to the record. The company has been forewarned about this -- 51 MR. PENNY: Mr. Chairman, I don't think there's any inconsistency, frankly, but we're happy -- essentially Mr. Thompson's wants to know the company's position on this, and we're prepared to do that. I just want to think the issue through. 52 MR. VLAHOS: That's fine. 53 MR. THOMPSON: I'd just call it "Clarification of the EGD/Union Position on Adjustment Factor." 54 MR. VLAHOS: All right. Let's call it that. 55 MR. MORAN: Thank you, Mr. Thompson. 56 MR. THOMPSON: Thank you, very much. 57 MR. VLAHOS: Mr. Janigan, over to you. 58 MR. JANIGAN: Yes, Mr. Chairman, Dr. Booth is prepared to be sworn. 59 VECC - PANEL 1; BOOTH 60 L.BOOTH; Sworn. 61 EXAMINATION BY MR. JANIGAN: 62 MR. JANIGAN: Dr. Booth, you are a professor of finance and CIT chair of structured finance in the School of Management at the University of Toronto? 63 DR. BOOTH: Correct. 64 MR. JANIGAN: And the details of your education, teaching, and research and consulting and interests are set out in appendix A of Exhibit D.2? 65 DR. BOOTH: That's correct. 66 MR. JANIGAN: And either by yourself or with Dr. Berkowitz, you have appeared as an expert witness in ROE proceedings in this Board, the NEB, BCUC, the PUB of Manitoba, AEUB, and the -- 67 MR. VLAHOS: Mr. Janigan, you better slow it down a bit. I want to make sure the reporter gets every word down. Thank you. 68 MR. JANIGAN: You appeared as an expert in ROE proceedings in this Board, the NEB, BCUC, the PUB of Manitoba, the AEUB, and the CRTC 69 DR. BOOTH: That's correct, and the Regie in Quebec. 70 MR. JANIGAN: Dr. Booth, you prepared your -- let me stop there. Is there any dispute regarding Dr. Booth's ability to testify as an expert to ROE matters in this proceeding? 71 MR. VLAHOS: Any objections? 72 MS. NEWLAND: No, sir. 73 MR. JANIGAN: Dr. Booth, you prepared your evidence jointly with Dr. Berkowitz who was unable to attend for health reasons, and you will be testifying today in support of all material that's been filed and the interrogatory answers. 74 DR. BOOTH: That's correct. 75 MR. JANIGAN: What areas of the evidence did you prepare? 76 DR. BOOTH: Dr. Berkowitz and I have been testifying together for about 17 years, but we specialize in different areas. In terms of the table of contents, Dr. Berkowitz had primary responsibility for critiquing Ms. McShane, though she's never realized that, so we're revealing some state secrets here. 77 Ms. McShane -- 78 MR. SOMMERVILLE: As long as no addresses are given. 79 DR. BOOTH: And I have to admit, we've kept this secret because lawyers have always tried to separate us and direct questions at certain parts of our testimony. 80 MR. VLAHOS: Why the revelation this year? 81 DR. BOOTH: But Dr. Berkowitz was also primarily responsible for appendix C, the beta estimation with dividend funds and appendix D, the multifactor model. And in terms of the evidence, he was primarily responsible for schedules 10 and 11 and schedule 17, and the discussion in the testimony that flows from those schedules. And I've been responsible for the rest. 82 MR. JANIGAN: Did you review and discuss the sections that Dr. Berkowitz prepared with Dr. Berkowitz? 83 DR. BOOTH: I've discussed it at length with Professor Berkowitz, and the resulting testimony is joint work between both of us. 84 MR. JANIGAN: And you were able to speak to all the evidence that's been offered in this proceeding on behalf of CAC, IGUA and VECC? 85 DR. BOOTH: Yes. 86 MR. JANIGAN: Now, are there any substantial corrections to the evidence as filed? 87 DR. BOOTH: My understanding is that a revised document correcting some typographical errors has been filed. 88 MR. JANIGAN: And subject to these corrections, is the evidence filed and the answers given and interrogatories, true to the best of your knowledge? 89 DR. BOOTH: Yes, it is. 90 MS. NEWLAND: Excuse me, Mr. Chairman. 91 Mr. Janigan, just a point of clarification. When was that revision filed? 92 MR. JANIGAN: This is the document that you have with all of the tabs that's been filed at the beginning of the proceeding. 93 MS. NEWLAND: Okay. So just for clarification, the looseleaf version of the evidence would not be correct? I should be relying on -- okay, thanks. 94 MR. SMITH: They're all typographical errors. 95 MR. JANIGAN: And the evidence that's been filed and corrected and the version of it that was filed at the beginning of the proceedings, and the answers to the interrogatories, are true to the best of your recollection? 96 DR. BOOTH: They are. 97 MR. JANIGAN: I'm not going to review your evidence and there are a number of topics and matters that were raised in the testimony earlier that we would have wished to review in this direct, but I expect they will be raised in cross-examination and in the interests of time, we're not going to touch upon them now, but we may return to them in reply. 98 There are a number of issues that arose that do require clarification and I just want to touch briefly upon them. 99 The first deals with the change to the long-Canada forecast and it's effect the Board formula and the effect upon, first of all, the estimates derived from the Board formula, and the estimates derived from your calculations? Can you give those, please? 100 DR. BOOTH: At the time that we filed our evidence, the weakness in the second quarter for this year was not quite apparent, and the forecast for long-Canadas for the end of 2003 into 2004 was significantly higher. Over the last three months, we've seen a weakening in long-Canada rates. Currently the consensus forecast for three months and one year hence is 4.9 and 5.2 percent for the over tens, and given the current spread between long-Canadas, 30-year Canadas, and tens, that puts the forecast based upon the consensus estimates at about 5.65 percent for Consumers' test year and a little bit higher, 5.75 for Union. 101 So based upon the 6 percent forecast we had at the time of our testimony, our estimates would be 25 to 35 basis points lower. 102 MR. JANIGAN: And what impact does that have on the Board-derived ROE? 103 DR. BOOTH: Based upon the Board-derived ROE at the time of our testimony with a 6 percent long-Canada yield, the Board formula implied 9.71 percent allowed ROE. Based upon these estimates, it implies 9.45 for Consumers and 9.53 for Union. So there's a slight reduction. 104 MR. JANIGAN: Now, I'd like you to turn up Volume 1 of the transcript, and refer you to paragraph 1442 where your two-factor model used to attempt to measure the relationship between utility risk and return was discussed by Mr. Thompson and Ms. McShane, and Ms. McShane indicated that this model, in her view, didn't explain very much. 105 Can you please explain how your two-factor model is used in relation to the relative risk factor adjustment that you've used of .45 to 5.55? 106 DR. BOOTH: Yes, this is just a reflection of the fact that there has been a criticism of beta as an all-encompassing measure for utilities, and Ms. McShane makes adjustments to her estimates using various techniques. One of the factors that is normally considered for utilities is, in addition to market risk exposure to the board equity market, there's also exposure to changes in interest rate risk, so they embody interest rate risk. 107 So before the NEB, we presented a multifactor model, where we looked at the sources of risk in the economy, including not just interest rates but the market, plus other factors like size. This was found not to explain a significant amount of the risk for utilities. The only significant risk for utilities apart from market risk was found to be interest rate risk. 108 So for this testimony and for the last several hearings after the NEB would reduce that multifactor model, which had five factors, down to two factors, and basically show that changes in interest rates and changes in the overall capital market are the primary drivers that effect utility returns. So this model was just an attempt what's sometimes called an arbitrage pricing model or a multifactor model for utilities, reflecting the two major sources of risk to utilities. 109 MR. JANIGAN: Now, further on in the transcript at paragraph 1523, 1524, Mr. Thompson was discussing with Ms. McShane schedule 1 your testimony and, in particular, he was referring to, in schedule 1, the description of returns from corporate Canada as estimated by Statistics Canada, and Ms. McShane was not familiar with the data, and where it came from or what it represented. 110 Can you enlighten us on that point? 111 DR. BOOTH: Yes, this was subject to an interrogatory, which we answered, which was No. 4. I'm not quite sure of the full reference, but the data comes from quarterly financial statistics for enterprises. This is a regular program that Statistics Canada has for collecting sales, gross profit margins, net profits, total assets, equities for the whole of corporate Canada, and then it takes that data and it develops a number of statistics, one of which is profit margin, and the other one is the return on equity. 112 And this is the return on equity series, and as we explain in that interrogatory response, the formal definition that Stats Canada gives, series title: Canada, return on equity, titled non-financial industries excluding the management of companies and enterprises. 113 So it's a measure of the aggregate profitability of corporate Canada excluding the financial sector, and excluding those management holding companies, diversified conglomerates. So this is a broad measure based upon establishment data, that Statistics Canada has collected for the last 20 year. So we call it corporate Canada's return on equity because it's indicative of the overall profitability of all of the business establishments in Canada, collected by Statistics Canada without any particular motivation for collecting it. 114 MR. JANIGAN: And I wonder if you could -- further on in the transcript, there was another question on this -- the schedules that you prepared in appendix E, schedule B.1. 115 DR. BOOTH: Yes. 116 MR. JANIGAN: And -- I'm sorry, appendix B, sorry, schedule B.1. 117 And the question arose, what this particular schedules represents and what was included in the samples that you listed here. What, and in particular the question arose as to where these firms that you listed under your S&P TSX sample had come from and how were they chosen? 118 DR. BOOTH: This was just part of our critique of comparable earnings test and one of the selection involved with the companies. So we chose an unbiased sample, not a sample that we collected, we looked at the S&P TSX60, which is the biggest 60 companies in Canada. The index was created to represent the type of stocks that the biggest institutions in Canada can invest in, the ones that have got significant liquidity, and we simply went out and looked at their accounting rates of return over the prior ten-year period and then sorted them into the main four major industry groups that Ms. McShane gives for her comparable earnings sample. 119 So for example, on schedule B.1, where we have three firms with an average mean return on equity of 7.72 percent, that's just the average of the three consumer products firms that's in the TSX60 index. And where we have industrial product the, that's just the return on equity of 11.16, that's just the average the 12 firms that the TSX included in the TSX60, and the same for communications and media and merchandising. 120 So this is just basically saying more or less forget about screens, apart from tossing out Rogers Communications Inc. and Bioveil, which have got hugely negative return on equity, this is the data from the TSX60, so it was just meant to indicate a benchmark on what typical profitability is similar to the benchmark for the Statistics Canada data. 121 MR. JANIGAN: And finally, in Volume 2 of the transcript, this follows up an exchange between the Chair and Ms. McShane in relation to Ms. McShane advocating a fixed spread over a ten-year long-Canadas, and the question arose as to what you were advocating with respect to this -- with respect to this matter. Ms. McShane said -- indicated with respect to both you and Dr. Berkowitz at paragraph 1353 in relation to the fixed spread: 122 "I don't think so. They have either been silent on it, or they've said they're perfectly happy with what the Board has done." 123 Can you give your position? 124 DR. BOOTH: We're perfectly happy with what the Board has done. But just to amplify that, the difference between the 30-year bond and the difference between the 10-year bond in terms of the yields, that's part of what we call the yield curve. You can also look at the difference between 20- and 10-year, 10 and 5, 5 and treasury bills. The shape of that yield curve constantly changes according economic conditions. 125 At the moment, we have a steeply normal yield curve, short-term rates are significantly lower than long-term rates. Just a few years ago we had an almost flat yield curve and we have inverted yield curves at times where the short-term rates are significantly in excess of the long-term rates. What that means is simply that the spreads between 10 and 30s isn't constant. It's changing all the time, according to economic conditions. 126 We see no reason to apply an arbitrary spread of 23, 35, 40 or 50 running us up to the capital marks to determine what that spread is. Most people base equity risk premiums on the 30-year Canada, the longest Canada simply because equities have got a bigger duration, a bigger maturity than any long-term bonding. 127 So we are quite happy with the formula that the Board is using, which is using the spread that actually exists. It may mean that somebody has to subscribe to the Financial Post to look at that spread for a 30-day period. And we're quite happy with them using a forecast, which might mean they have to subscribe to the Consensus Economics, but we don't think that's a big deal when it's taking into account that these spreads do change. And we're reluctant to base any sort of long term forecast on sort of daily or even weekly changes in interest rates. 128 The forecasts tend to be a little more stable than rates in existence at any particular point in time. So as far as we're concerned, the formula of the BCUC, the Manitoba PUB, the NEB, the current formula this Board uses, the implicit formulas that are being adopted elsewhere, they seem to work and we see no reason to alter them. 129 MR. JANIGAN: Thank you, Mr. Chairman. Those are all my questions in chief. 130 MR. VLAHOS: Thank you, Mr. Janigan. 131 Mr. Janigan, just follow up for clarification, Dr. Booth, I'm not sure if there's a difference of numbers between yourself and Mr. Case, but you did talk about the long-Canadas -- I'm sorry, let me go back. 132 What have what have we heard it yesterday from Mr. Case that the long-Canadas had bottomed out at the end of June. And I'm not sure if I heard from you, correct me if I'm wrong, in the last few weeks, long-Canadas have what, continued to decline; is that what you said? 133 DR. BOOTH: No, Mr. Case is correct that long-Canadas bottomed out about six weeks ago, so relative to when we presented our testimony, they went down in July. They bottomed out in July. Now they've crept back up a little bit since July. 134 So they're higher than they were at the low, but they're lower than they were when we presented our testimony, when we presented our forecast. 135 So they're still -- the forecast is still lower than at the time we put our testimony -- 136 MR. VLAHOS: Sorry. I want to be clear. They bottomed out at some point the end of June, beginning of July. And what has happened since then? 137 DR. BOOTH: They've crept up a little bit. 138 MR. VLAHOS: okay. So when you talk about the last few weeks coming down, that's why I was thrown off. 139 DR. BOOTH: What's happened is the second quarter of this year has basically just put everything on hold. The effect of SARS and everything else has put the anticipated increase in interest rates basically off three to six months. 140 So when we put our testimony together, people were forecasting that interest rates would increase, and one was forecasting 6 percent long-Canadas. The rates then came down through basically the middle of July, and that was the bottom. Since then, they've crept up a little bit and people are forecasting that they will increase as the economy strengthens, but we're not quite up to where we were 3 months ago. 141 So the last few weeks, interest rates have increased, but we're still 25, 30 basis points below where we were at the time of our testimony. 142 MR. VLAHOS: Okay. Thank you for that. 143 Okay. Now, Mr. Moran, have you talked with your colleagues as to who should go first, or should I turn to them? 144 MR. MORAN: I don't think there's been any discussion -- 145 MR. VLAHOS: Okay, let's see. 146 MR. THOMPSON: I think Mr. Smith wants to go first. 147 MR. VLAHOS: That's right. Mr. Smith indicated that yesterday. And I said subject to the company -- to the applicant, agreeing that they do so. 148 MS. NEWLAND: We're agreed with that. 149 MR. PENNY: Mr. Chairman, I think the common practice is anyone who favours the proponent of the witness goes first, so if there are intervenors who support the opponents of the application or support Mr. Booth's evidence, they should, in fairness, go first before -- 150 MR. VLAHOS: That's one way, Mr. Penny. That's usually, when we deal with motions, it just makes life a little easier to follow the motions, but cross-examination, I guess, we're not as rigid as that. 151 In any event, if Mr. Smith wants to go first, that's no problem with you, Mr. Penny. 152 MR. PENNY: The issue is one of principle. I have no problem with whatever order you adopt. It just seemed to me that it's the fairest thing to do, to let people who have some sort of the sweetheart cross-examination go first so that everyone else knows what they have to say. 153 MR. VLAHOS: Well, Mr. Smith wants to go first. Does anybody else wish to precede Mr. Smith? 154 Mr. Smith, you're on. 155 MR. SMITH: Thank you. Sir, I was encouraged to come forward so as to present a better target for Dr. Booth, and the only element of sweetheart in this discussion, sir, is as follows. 156 CROSS-EXAMINATION BY MR. SMITH: 157 MR. SMITH: Dr. Booth, we were very saddened to hear of Dr. Berkowitz's condition and we just want to convey our very best wishes for his speedy and full recovery. 158 DR. BOOTH: Thank you. 159 MR. SMITH: Dr. Booth, I don't have a great deal, and what I'd like to just do is something that Mr. Thompson and others did at the outset of their cross-examination, is just try and get sort of the playing field arranged so that we're agreed on some things, and my focus is on the methodological footing of your evidence and Dr. Cannon's. I will at some point here refer to Dr. Cannon's testimony, so you may want to have it handy. 160 Now, what I'm really after, just to put it up front, is your definition of each of the tests conventionally used to determine cost of capital together with purpose or role for each of those tests, and I'm going to do something the same with Dr. Cannon and hopefully we can move through this fairly simply. 161 Can we just start with the DCF test? What would be your definition of that test and its role in this exercise? 162 DR. BOOTH: The discounted cash flow model just says, well, this is the stock price. What do investors expect to get from holding the stock, and what's the discount rate that equates the present value of the market price of the stock to those streams of cash flows? So it's frequently called an equity internal rate of return. The way in which it's applied in most regulatory boards was due to Professor Myron Gordon of the University of Toronto in 1956, who applied it in the AT&T case and estimated rates of return based upon dividend yields plus forecast growth rates, so it's dividend yield plus growth, but there are variations of that. 163 It's basically an attempt to put yourself in the position of investors, to work out what are they paying and what do they expect to get from holding the stock. 164 MR. SMITH: Would you agree with the depiction as it is, in essence, a capital attraction test? 165 DR. BOOTH: Yes, it's estimating the investors' opportunity cost. 166 MR. SMITH: And similarly with the equity risk premium, sir, can you just help us with that? 167 DR. BOOTH: The equity risk premium is more a normative model. It's sort of what should investors be doing. Based upon the fact that we know there's a time value to money, so we look at the risk-free rate as the time value of money component, and we know that investors are risk averse in aggregate, so we know there should be some form of risk premium. We also know that people don't like paying taxes, but that's a separate issue. 168 We try and look at those sorts of issues, time value of money to risk value of money, to estimate a model that incorporates those facets to the investors' decision. So it's more a normative model of what should be based upon building up from the basic building blocks of investors. 169 MR. SMITH: And it, as well, is known conventionally as capital attraction test; is that right? 170 DR. BOOTH: That's right. It's an attempt to estimate the investors' opportunity costs. What do they want to buy these stocks? 171 MR. SMITH: Now, let me just explore equity risk premium a little further, sir. Under your definition of the equity risk premium test, should the rate of return on common equity be less than the utility's cost of debt? 172 DR. BOOTH: Could be. Currently, our recommendation for the fair rate of return significantly exceeds the cost of utility debt, but there's no reason conceptually why it couldn't be lower. That just depends upon the amount of risk in the economy, the tax status of different instruments. 173 MR. SMITH: Do you have a copy of Exhibit F.2.5, which is the guidelines for the formula based return? I'll just give you a minute -- 174 DR. BOOTH: I think I have everything. I've read it. If someone could give me a copy. 175 MR. SMITH: I'll give you a minute to get it. 176 MR. THOMPSON: My day to be "boy." I was going to say, we're the three amigos, not the three stooges. 177 MR. SMITH: If we're pressed for time, we may need someone faster. 178 All right. Dr. Booth, the point I'd like to draw your attention to, and to get a reconciliation, if I might put it that way, is at page 5 of the compendium, the Board lays out its understanding of these tests, and it states under 2.4, equity risk premium test, and I'll just really focus on the second sentence. I don't immediate to exclude anything, and if you want to add it for context, please do, but it states as follows: 179 "It relies on the assumption that common equity is riskier than debt, and that investors will demand a higher return on shares relative to the return required on bonds to compensate for that risk." 180 Do you disagree with that? 181 DR. BOOTH: No, there's nothing wrong with that statement. The phrase is usually the yield on long-term government bonds as well, and it's usually the yield on government bonds because only government bonds is to yield an expected rate of return. Corporate bonds the yield is not an expected rate of return. 182 MR. SMITH: But the essence of what the Board said here is that the return on common equity would be expected to be higher than the utility cost of debt? 183 DR. BOOTH: Can you read that to me again. I can't see that. 184 MR. SMITH: Well, and if that's the basis of the disagreement, sir, it said "relative to the return required on bonds to compensate for that risk." The clear implication for me was there was some additional risk associated with equity relative to debt, debt being a secured investment, equity not being. Do I have it wrong, sir? 185 DR. BOOTH: I think you're reading something into that paragraph that I don't read into it. I see -- it's up to the Board to decide what the Board decided six years ago, but I read the sentence usually the yield on long-term government bonds. 186 Because when you look at the yields on corporate debts, there is default risk and as a result the yield is not an expected rate of return, it's a promised yield. So it's the yield that you will get if everything goes according to plan and the corporation doesn't default. 187 I can go out and get promised yields on corporate bonds that are double B, single B, D. I can get yields on even countries, where the yields, the promised yields on those bonds are 16, 17, 18, 20, 30, 40, 50 percent. Those are not expected rates of returns. They are promised yields. When you get yields at those levels, they promise to pay you, but you know very well there's significant risk you're not going to get that money. 188 That's why nobody, as far as I'm aware, has ever written anything in any textbook estimating rates return over corporate bond yields. You're comparing apples with oranges. It's not acceptable. 189 MR. SMITH: Thank you, sir. I wanted to get your position on the record. 190 DR. BOOTH: I think you've heard that before, Mr. Smith. 191 MR. SMITH: I might have. Probably will again. 192 Now, Dr. Booth, I'm going to be referring to Dr. Cannon's evidence in the context of comparable earnings, but before I do, perhaps we can just tidy up with DCF and with the equity risk premium tests. 193 You've acknowledged both of them are principally capital attraction tests; right? 194 DR. BOOTH: That's right. They're both estimates of the fair rate of return to the equity investor. 195 MR. SMITH: And they are not intended to directly measure comparable returns from companies of similar risk? 196 DR. BOOTH: That's correct. Those were accounting rates of return. They're not estimates of fair returns to stockholders, they're not estimates of the investors' opportunity cost. 197 MR. SMITH: That is the role, this latter aspect is the role which is performed by, amongst other things, the comparable earnings test; is that fair? 198 DR. BOOTH: No, I don't think it is fair. Comparable earnings suffers from a large number of deficiencies, so that is not a measure the rate of return that corporations could earn, even on equivalent book value investments. 199 MR. SMITH: Sorry, I'll let you complete the answer, but to be clear, sir, I was just asking what the purpose of the test was. I appreciate that you have a number of disagreements with whether or not it performs that function. I just wanted to understand the purpose. 200 DR. BOOTH: Well, even that I'm -- if it was that purpose, Mr. Smith, I could agree with it, because when corporations make investments; on the one side they take money from investors, which was what we call the opportunity cost, And as long as they can earn a rate of return in excess of that opportunity cost, then they'll make investments. So in equilibrium, those two should be pretty similar. If that was, in fact, the way it was estimated, I would agree with that. 201 But I've heard Dr. Sherwin and Ms. McShane say on numerous occasions that that is not the objective of comparable earnings. That, in fact, is quite the opposite. It's just meant to be a fairness standard, that other firms are earning this, not a question that this is the rate of return they earn on other investments, but other firms are earning this, therefore, in some broad sense, utilities should be allowed to earn this. And so -- 202 MR. SMITH: It's the fairness feature 203 DR. BOOTH: Well, I don't regard that as being fair. Just because other people earn a particular rate of return doesn't make it fair. 204 MR. SMITH: I'm sorry. I thought you had used the word fairness. 205 DR. BOOTH: No. 206 MR. SMITH: Can we go to page 60 of Dr. Cannon's evidence, Exhibit D, tab 1, and that's at page 60. Just let me know when you have it, sir. 207 DR. BOOTH: Page 60. Yes. 208 DR. BOOTH: Yes. 209 MR. SMITH: What I'm going to focus on is just the first half of the response, which was the part which I thought was the methodological discussion, if I can put it that way, and you might just follow along. The answer reads as follows: 210 "The comparable earnings, financial integrity test is designed to shed light on some aspects of the fairness of allowed ROE awards in light of the general regulatory and judiciary principles described earlier in this section." 211 Do you see that part? 212 DR. BOOTH: I see that. 213 MR. SMITH: Stop there. Do you agree with this statement, as far as it goes? 214 DR. BOOTH: No. 215 MR. SMITH: You don't? 216 DR. BOOTH: No. Would you like me to explain that? 217 MR. SMITH: I normally don't have to invite you to do that, sir. 218 DR. BOOTH: I'm under instructions to be very quick and precise. 219 MR. SMITH: Well, then, I'll change my cross. 220 DR. BOOTH: As I mentioned, there's the cost of capital, the cost of raising funds, and the basic message we -- all corporations follow, is you take the cost of the funds that you raise and if that cost is, say, 8 percent for equity, just for argument's sake, as long as they can make more than 8 percent, they're going to make an investment. 221 So that's the critical criteria that we use in finance and economics: What's the rate of return you're going to earn? What's the opportunity cost? 222 In equilibrium, the marginal rate of return on investment will be 8 percent, and the cost of equity for the firm will be 8 percent. The problem with that is that is the conceptual framework that's used to justify looking at actual rates of return. The problem with that is multiple. In the first place, conceptually, if the firm has any positive rate of return investments in excess of the cost of capital, the average rate of return will always be in excess of the marginal rate of return. 223 So conceptually, even if you could say, well, let's look at these rates of return, the rates of the return that we see, even if we forget about accounting problems, selection problems, and all of the other problems, the rate we observe are average rates of return. They are always going to be higher than the marginal rate of return on investment. 224 So there's an implicit bias, even if you forget about all the estimation problems, all of the problems with accounting numbers, all of the problems with cyclical effects, there's always a bias that even if you estimated correctly, the average is going to be greater than the margin. So unless you can actually measure what we call the marginal efficiency of capital, the marginal internal rate of return, the average rate of return earned by other corporations is a biased estimate of the fair rate of return. It's too high. 225 MR. SMITH: And to be clear, then, you don't agree with the passage that I read to you. 226 Let me just then take you to the statement of Dr. Cannon's, which is right at the hole punch in the middle: 227 "The CE test is often helpful in assessing whether a return award satisfies criteria 2 and criteria 4 above." 228 Would you agree with that statement, sir? 229 DR. BOOTH: 4 above, I think, is Mr. Justice Lamont's definition, and Mr. Justice Lamont's definition is a fair return on securities. It's very, very specific. He was looking at a decision involving the Alberta board that looked at changing conditions in the money market. It was not anything to do with rates of return on other corporations. It's rates of return on other financial secures. So I would reject Dr. Cannon's interpretation number 4. It's a misreading of the decision of Mr. Justice Lamont. 230 Number 2: "Enable the utility to meet its detect service obligation and preserve its financial integrities." That's capital attraction. That's the opportunity cost. There's no reason to look at comparable earnings to look at 2 or 4. 231 And when I said I disagreed with Dr. Cannon, I should qualify that a little bit. I mean, he's using a lot of measly words here, I mean they're not outright statements. I mean, to shed some light on some aspects. I'll leave it to him to defend his testimony, but he's not coming out here and saying comparable earnings is a legitimate way and I wholeheartedly endorse it and everything else he's saying, "Shed light on some aspects." Perhaps I was a bit unfair to Dr. Cannon to say I didn't agree with what he was saying. 232 MR. SMITH: Thank you, sir, and I can deal with Dr. Cannon on the balance. 233 I'll just move on to a different subject. Dr. Booth, as an academic, and you are an academic, would you agree that your studies seek to determine how financial markets behave? 234 DR. BOOTH: Well, I am an academic. I'm just thinking about your first statement, Mr. Smith. And I was just wondering why you said it. 235 MR. SMITH: I didn't call you a professional witness. 236 DR. BOOTH: I'm not a professional witness, I have a day job that I can go back to, and I have a certain amount of intellectual capital that determines what I can say and get away with. So from that point of view, I am an academic, and I'm very proud of being an academic. 237 On the other hand, I'm not an academic in some obscure economics department that doesn't deal with day-to-day affairs. I don't know whether you read the "Report on Business" in the Globe and Mail a couple of days ago, but I had an article in the ROB. 238 MR. SMITH: I didn't hear the last part. 239 DR. BOOTH: I had an article in the "Report on Business" a couple of days ago. I'm a frequent commentator on business affairs, and I do too much of this sort of stuff. At least my dean would probably say it's too much. 240 MR. SMITH: We'll leave that with your dean. 241 Dr. Booth, the simple question was whether your area of academic endeavour is the study of how financial markets behave. 242 DR. BOOTH: Actually, it's corporate finance. I hold the chair in structured finance, and my major specialty is corporate finance, how corporations behave. And my major area of teaching is corporate financing, how they interact with the capital markets to raise money, how they determine the overall cost of funds, and how they make investment decisions; and mergers and acquisitions, how they basically buy other companies. So my area was not directly capital markets. We have specialists in capital markets. My area of expertise is how corporates interact with capital markets. 243 MR. SMITH: Well, if you focus on the capital attraction test, for example, is that not a study into how financial markets behave in respect of attracting capital to the business in question? 244 DR. BOOTH: I would agree with that. I think -- I mean we make fine distinctions between corporate finance and capital markets that probably are too fine. 245 MR. SMITH: Fair enough. And that would involve trying to discern what are investor expectations; is that fair? 246 DR. BOOTH: Absolutely correct. The very basis of corporate finance is you want to enhance shareholder value, you want to basically put yourself in the position of shareholders and say, You own the business, what can I do to make you a better off? And to do that, you have to understand what shareholders want. 247 MR. SMITH: And the market for utilities securities is principally large institutional investors; is that fair? 248 DR. BOOTH: No, that's not fair. I'd say quite the opposite. It's primarily retail. 249 MR. SMITH: Do you have a basis for that on the record, sir? 250 DR. BOOTH: Yeah, I think we referred to several things. We referred to comments such as non-academics, such as the people at DS, referring to the fact that since they were high-dividend paying and they were primarily attracted to small Canadian investors who can use the tax features in the Canadian income tax system. 251 MR. VLAHOS: Sorry, is the difference in the initial market and the after market, Mr. Smith, is this where the confusion may be or -- 252 MR. SMITH: That's where I was headed, sir. That is the point, sir. I'd asked: Is the market for utilities securities principally large institutional investors? And in order to be clear, would that be true at the -- in the terms of the initial market? 253 DR. BOOTH: I think the way in which the market for issuing stock has changed over the last ten years, we've moved away from formal underwritten deals that were sold to the retail market and we've moved towards what we call bought deals, where basically an underwriter would buy a whole package of stock and resell it as quickly as possible. And the major vehicle for bought deals is to sell those two institutions. So most new equity is sold through bought deals rather than through traditional underwritten shares, and unfortunately, the retail client doesn't usually get a look in at those sorts of deals. If that's what you're referring to, I'll agree. 254 MR. SMITH: Unless they happen to benefit from a discount because the bought deal wouldn't sell, sir? 255 DR. BOOTH: Are you referring to B.C. Gas's issue by any chance, Mr. Smith? 256 MR. SMITH: I am referring to what Mr. Case referred to yesterday, sir. 257 DR. BOOTH: Well, you do know that that was wrong, I assume? 258 MR. SMITH: And I suspect you're going to tell us -- 259 DR. BOOTH: Well, I was listening to it in my office, and I was surprised at what he had to say, because that deal - and I've got a newspaper article from The Globe and Mail if the Board wants to see it - but it occurred at a point in time when there was a desperate shortage of deals in the Canadian capital markets, and the shortage was so great that all of the dealers competed for that BC Gas issue. The market price of B.C. Gas's stock at the time was $36.10. The underwriters agreed to pay BC Gas $36.15. That's 5 cents more than the market price, because they wanted basically to have the deal to keep their teams together and to underwrite it and sell the issue. They also still got the 4 percent underwriting fee, but BC Gas got the proceeds -- if I can quote from The Globe and Mail: 260 "BC Gas just raised 180 million as neatly as you please." 261 Because all of the dealers were tripping over themselves to underwrite the deal and to buy it from BC Gas. They bought it from BC Gas, they paid more than the market price and then they had to turn around and try and sell the stock that they paid $36.15 for in a market that was selling for $36.10. 262 And Mr. Case said they had trouble selling it. That's hardly surprising. When you pay more than the market price, to turn around and expect to sell it to others for more than the market price is a tough sell. 263 MR. SMITH: The source of your information is The Globe and Mail article that you -- 264 DR. BOOTH: Absolutely. 265 MR. SMITH: Would you mind filing that, sir, so that we all know what you're talking about? 266 MR. JANIGAN: We'll arrange to have copies made. 267 MR. SMITH: Perhaps I could just take a peek at it before I finish. Did you ever consider going to the primary source for your information? 268 DR. BOOTH: I heard this yesterday, Mr. Smith, so I could have gone back, I would guess, if I had the time, to talk to the investment dealers, but the newspaper article summarizes the details and I have no reason to believe that Mr. Andrew Willis of The Globe and Mail is biased in the reporting of those details. 269 MR. SMITH: But you didn't talk to the investors involved? 270 DR. BOOTH: Not since yesterday afternoon or this morning, no. 271 MR. SMITH: And Mr. Case did and does? 272 DR. BOOTH: I don't know whether he talked to the institutions that were buying that deal. I think he just said it was tough to sell. 273 MR. SMITH: The record will speak for itself, sir. But let me ask you, did you talk to institutional investors with respect to the recommendations you're making to this Board for return on common equity? 274 DR. BOOTH: No. Why would I talk to institutional investors who have a vested interest in the answer of the results of this hearing? There's a huge conflict of interest in asking the institutional investors who hold the stock, "What do you think a reasonable rate of return on that stock is?" I don't think for one minute they will say "a low rate of return." If they're believed and the rate of return is allowed and the stock goes down, they've just lost a whole bundle of money. 275 MR. SMITH: Do you recognize the Watson Wyatt report that was referred to by my friend Mr. Warren earlier? 276 DR. BOOTH: No, I don't remember that report. Watson Wyatt, I understand, is a major pension fund and insurance company consulting firm. 277 MR. SMITH: They conducted what I understood to be a survey of economic expectations, which involves a canvass of CEOs, business leaders across the country, as to what they expect will take place and what they might be doing in the way of investment activity? 278 MR. THOMPSON: Is this a document on the record somewhere? 279 MR. SMITH: It was a document referred to by Mr. Warren. 280 MR. THOMPSON: I recall that in the transcript. Is it in an -- 281 MR. MORAN: I don't believe it's on the record anywhere, Mr. Chairman. 282 MR. THOMPSON: Thank you. 283 MR. SMITH: Are you familiar with it, sir? 284 DR. BOOTH: I'm familiar with Watson and Wyatt. I'm not familiar with that survey. My guess is that it's subscription based and they give it out to their clients, but there's a number of companies that do surveys. The Conference Board does this all the time as well. 285 MR. SMITH: That's my point, sir, thank you. The point is that going to the source and asking the people who are actually participating in the economy, is a relevant and useful source of information about how the economy might perform; is that fair? 286 DR. BOOTH: That's completely fair, but if the Conference Board was here testifying as to a rate of return, or Watson Wyatt was here testifying as to rate of return or anything else, then I think it's legitimate that you can ask them, "You went to people and asked them what they want and they knew that you were going to be testifying on this." 287 All I'm saying is there's a conflict of interest in that position. 288 MR. SMITH: Does The Globe and Mail article to which you've referred say that the institutional buyers of that BC Gas deal had no difficulty in reselling it? 289 DR. BOOTH: As far as I remember, it said the institutional investors balked at buying this deal, and the normal procedure in that market is if you can't sell it to institutions, you sell it to the retail. But given the fact these were installment receipts rather than regular shares, they found it difficult to sell it to the retail market. 290 MR. SMITH: So what you inferred by way of information is that Mr. Case was wrong about the fact that the institutional buyer couldn't resell the stock. That's what you inferred from the article, but you didn't call BC Gas to ask -- or the institutional buyers, rather, you didn't call and ask them if what Mr. Case testified under oath was true, whether, in fact, that occurred? 291 DR. BOOTH: No, I think what Mr. Case testified under oath was true, because it says here in The Globe and Mail: 292 "The streets got indigestion and investors balked at the pricing on this deal and less than half the BC Gas subscription receipts sold." 293 So I think what he said was absolutely correct. Trying to resell this deal to institutional investors was difficult. But the reason it was difficult was the fact that they had competed so aggressively to buy this BC Gas deal at a price that exceeded the market price, and it's obviously difficult to resell an issue at 5 cents more than the market price. 294 The fact that shouldn't be ignored is the investment dealers competed aggressively to get this board deal from BC Gas, ask as Mr. Willis said, "BC Gas just raised $180 million as neatly as you please," because of the competition amongst the investment dealers. 295 So I think Mr. Case was focusing on the difficulties of reselling this, and I wouldn't disagree with that, but he ignores the critical point which is that BC Gas raised the money without any trouble whatsoever. 296 MR. SMITH: And that's what you infer to represent a healthy capital market, that when a bought deal takes place, someone can't resell it, that's a good thing? 297 DR. BOOTH: I never said that Mr. Smith. 298 MR. SMITH: I'm asking you? 299 DR. BOOTH: The headline of this says: "BC Gas Financing Proves it's the Silly Season." I mean, nobody in their right -- well, I'll rephrase that. 300 It is the silly season. As he explains, you expect when somebody does an underwriting deal that they get their 4 percent underwriting fees. Normally they price it at a discount so in this case, if the stock was 36.10, normally you'd buy it at, say, 35.80, then you get a 30-basis point spread that you can pick up when reselling it to the institutional market. That's what normally happens. 301 But in this case, you had -- and in fact, for the last two years in Canada, there's been so few new issues, that all of the dealers competed like crazy for this, and as far as I'm concerned is they did something silly. Which is, they overpaid. They paid 5 cents more than the market price, and they did that simply because they still got the 4 percent, but they weren't earning anywhere near their normal profit margins. 302 This is just an indication basically of overcapacity at his point in time amongst investment dealers, and they competed like crazy to get a deal and they basically overpaid. I don't think that's good for the capital markets, and I think I agree with Andrew Willis. It was the silly season. 303 MR. SMITH: We were talking earlier about investor expectations. That's a subjective notion, isn't it, subjective in the mind of the investor? 304 DR. BOOTH: Absolutely. 305 MR. SMITH: Now, Mr. Case had used three examples -- 306 MR. MORAN: Mr. Chair, perhaps we should mark this as an exhibit before Mr. Smith moves on. This will become Exhibit F.4.4, Globe and Mail article dated October 30, '01, "BC Gas financing proves it's the silly season." 307 EXHIBIT NO. F.4.4: GLOBE AND MAIL ARTICLE DATED OCTOBER 30, '01, "BC Gas FINANCING PROVES IT'S THE SILLY SEASON." 308 MR. SMITH: Now, Mr. -- or Dr. Booth, you started off this Globe and Mail article by saying, of course Mr. Case was wrong and you've come back and said no, he was correct. Do you remember what he was -- what the point was in citing the three cases where, in fact, the -- there was not problem-free purchase and resale of utility equities? 309 DR. BOOTH: Just to correct you, Mr. Smith, the -- as I said, Mr. Case was correct, and the underwriters had a problem pushing this deal. There was no problem with BC Gas raising the money and the question that's at issue is: Can utilities access the capital markets and raise money on reasonable terms? 310 And I think Mr. Case was wrong in implying that they couldn't, and perhaps I was wrong in interpreting that he was implying that they couldn't. But clearly, BC Gas had no problem raising the equity through this board deal two years ago. So this is not an indication of any problem in the utility sector in Canada in raising capital at that point in time. 311 MR. SMITH: But his point, sir, that I put to you was that issuing the capital, raising the funds, has not been problem-free. He used two other examples. Have you got any other newspaper articles that infer whether or not institutional investors have problems reselling the other two issues? 312 DR. BOOTH: It's not a question -- first of all, no I haven't had time to look at that. I only heard this yesterday afternoon, the same as everyone else did. It's not a question of whether the institutions can buy the stock. The question is: Can the company raise the money? Can the company access capital markets on a reasonable return and raise money? And the answer with these three issues that he mentioned, the only one I'm aware of, this one, the answer was clearly that they could. 313 MR. SMITH: But it was a hot market; right? 314 DR. BOOTH: it's been a lousy market in equities for the last two, three years, Mr. Smith. 315 MR. SMITH: I'm referring to your article, sir, "The Silly Season." I'm referring to the article. "It was a hot market." Isn't that what you said? 316 DR. BOOTH: I don't think I said it was a hot market. This was October 2001. The equity markets had been falling up until this spring since March 2000. That's why there's so few underwritings. In a hot market, there's lots of underwriting issues, people are snapping up stocks and it's easy to sell them. This capacity market, as the article mentions, underwriters are scrambling to get deals, which is why they were willing to basically buy this deal on -- and overpay. 317 MR. SMITH: And sell it at a discount? 318 DR. BOOTH: And sell it at a -- well, they tried to sell it at a premium to the market price, which is obviously difficult. 319 MR. SMITH: I'll change it, then, sold it at a discount. 320 DR. BOOTH: They sold it at a discount to what they paid for it. Normally you sell deals at a discount to the market price in order to give people an incentive to buy it. If you turn around and you've got $180 million, you'd normally have to shave the market price a little bit to persuade institutions to buy it. Trying to get them to pay a premium is difficult in the best of markets. 321 MR. SMITH: In the minds of the institutional investors that bought this issue, the next time the utility had to go to the capital markets, would they be quite as willing to subscribe for that stock? 322 DR. BOOTH: Sure. I don't think the behaviour of RBC, Dominion, or Wood Gundy in the pricing of the deal is going to affect the way in which the institutions look at the deal. I mean, everyone blamed BC Gas because they got a good deal out of RBC. I mean, they would just say DS messed up and we'll take advantage of it. 323 MR. SMITH: So as long as you can sell it, regardless of the price, in your view, that's capital attraction, and that's all the Board needs to be concerned with, a means test? 324 DR. BOOTH: No, I'm just saying Mr. Smith, that in this example raised by Mr. Case, BC Gas had no problem raising $180 million, and the problems were purely generated on the dealer side because they overbid for an issue. And I don't think any of the major institutions is going to hold that against BC Gas. And I don't think this reflects anything other than the fact that we've had a tight market for underwritten deals in Canada for the last two years. The only thing in town for the last 18 months has been income trust. There's been very few standard new issues. 325 MR. VLAHOS: Mr. Smith, could you please move on from that point? 326 MR. SMITH: Yes. 327 MR. VLAHOS: Thank you. 328 MR. SMITH: I was just about to. 329 Can you turn up page 2 of your evidence of the executive summary. 330 DR. BOOTH: Yes. 331 MR. SMITH: Lines 20 to 26, you note that: 332 Since Enbridge and Union's equity ratios are not under review, lower financial risk for those utilities should result in a --" and I inferred -- "a downwards adjustment to the ROE." 333 Is that a fair depiction of what you're saying here? 334 DR. BOOTH: No, I think all I'm saying here is that there is no business risk testimony that's been filed on behalf of the utilities. And Ms. McShane agreed to that yesterday. It's not a business risk issue here. It's a capital market issue. 335 So nobody said that Union and Enbridge has faced increased business risk. At least that was my understanding of Ms. McShane's testimony. And normally, when we look at regulating utilities, we offset business risk with financial risk. So if you've got significantly more business risk, than you have lower financial risk, you have higher equity ratios. So very low business risk companies, like Foothills, have 30 percent equity ratios. 336 And since there was no business risk evidence filed here, and since there was no suggestion to change the 35 percent deemed equity ratios, we basically had to accept those. What we're then noting is that BC Gas under regulation of the B.C. Utilities Commission has a 33 percent common equity ratio. In our judgment, Consumers and Union are both as low a risk, if not possibly lower in risk than BC Gas. 337 So since they have more financial -- they have, sorry, less financial risk, bigger equity ratios than BC Gas, we shall take the allowed return to the BCUC and shave them down a little bit to be fair. 338 MR. SMITH: Dr. Booth, you said -- you focused in your answer on business risk, and that there was no evidence tendered here on business risk by the utilities, but with respect what you say in that paragraph is both -- says: 339 "Union and Enbridge Gas Distribution Inc., EGDI, have not indicated any risk increase in business or financial risk." 340 You indicate further down in that same paragraph that, in fact, there were lower financial risk, or there is lower financial risk associated with Union and Enbridge, and that it would therefore be appropriate to adjust the ROE, because it isn't the subject of a change in the equity ratio. 341 DR. BOOTH: That's correct. 342 MR. SMITH: Thank you. 343 Thank you, Mr. Chairman. 344 MR. VLAHOS: Thank you, Mr. Smith. 345 Who would like to go next? 346 Mr. Klippenstein, are you volunteering? 347 MR. KLIPPENSTEIN: Certainly. Thank you. 348 CROSS-EXAMINATION BY MR. KLIPPENSTEIN: 349 MR. KLIPPENSTEIN: Dr. Booth, I'm over here. 350 DR. BOOTH: Oh, hi. 351 MR. KLIPPENSTEIN: Over here. 352 DR. BOOTH: Sorry. I thought the person over there was indicating. 353 MR. KLIPPENSTEIN: Good afternoon. I represent Pollution Probe and I have some questions about the relationship between rate-base expansion and earnings per share, and conservation or energy efficiency efforts by Enbridge Gas Distribution, and that's a little bit of an unusual topic in these ROE hearings; however, it's been covered a couple of times in the cross-examination, so I won't start from square one. If I'm getting ahead of myself and being unclear, I'll take a step backward. 354 I was going to refer to, and I think your counsel is just provide to you Pollution Probe's cross-examination reference book, which is Exhibit F.2.2. Do you have that in front of you? 355 DR. BOOTH: Yes, I have it. 356 MR. KLIPPENSTEIN: Also there's one page, Exhibit F.2.3, which is a chart entitled "Utility Rate Base Growth and Earnings Per Share." If you don't have that handy, I can get a sheet to you. 357 DR. BOOTH: I have that. 358 MR. KLIPPENSTEIN: Thank you, Mr. Thompson. I think you touched on what I'm about to ask in your evidence, and that is this: Is it fair to say that in a regulated utility, when the market value of shares exceeds the book value, rate-base growth will lead to an increase in the earnings per share of that utility; is that fair? 359 DR. BOOTH: Yes. 360 MR. KLIPPENSTEIN: And as I understand it, that's a logical or mathematical relationship that follows from the fact that when market value exceeds book value and you expand rate base with share financing, you're increasing the rate base proportionately more than you're increasing the number of shares? 361 DR. BOOTH: Correct. It's a question of arithmetic. It's called the earnings-per-share multiplier game. 362 MR. KLIPPENSTEIN: Earnings-per-share multiplying game? 363 DR. BOOTH: Yes. It's a standard technique that's been used in the capital markets to fool investors, basically unregulated to regulated firms, very high price earnings ratio, very high price to book. They can basically buy up stodgy companies, incorporate those assets in the company and their earnings automatically go up. This has been used by a number of large conglomerates in the '60s, '70s, and again in the '90s to basically manufacture earnings per share growth simply by buying other companies. 364 The most recent example was Tyco, that basically is buying up a whole bunch of small companies, not telling people that it's buying up these companies, at least not disclosing everything, and this process that you're talking about was manufacturing earnings per share growth and everybody looked at that and said, "Wow, what a great growth company." 365 In fact, all it was doing was buying up a lot of stodgy companies. So this is a standard proposition in the capital markets. 366 MR. KLIPPENSTEIN: Well, I'm certainly going to disavow any relationship between Tyco and Enbridge. 367 DR. BOOTH: I think everybody is. 368 MR. THOMPSON: How about Pollution Probe and Tyco. 369 MR. KLIPPENSTEIN: You can ask about that later, Mr. Thompson. 370 Seriously, that's a different context than the regulated activity. 371 DR. BOOTH: True, but it's the same. It's just a question of arithmetic. 372 MR. KLIPPENSTEIN: Yes, it's a question of simple mathematics, in a way. 373 DR. BOOTH: Billions of dollars have been made and lost by people not realizing simple arithmetic. 374 MR. KLIPPENSTEIN: I've lost some, I wouldn't say I've lost billions. 375 If I can just simply see whether that principle has any application to Enbridge in this situation. The materials we've filed, and I won't ask you to turn them up unless it's required, suggest that the shares of Enbridge Inc. are trading at a market to book ratio of about 2.7 to 1 recently in September. Does that sound plausible, do you have any reason to disagree with that? 376 DR. BOOTH: Sure, I think the only utility holding company in Canada that's not trading above book is PNG. 377 MR. KLIPPENSTEIN: All right. In that circumstance, to make a complicated situation simple, at least it's complicated for me, by the same logic, does it not follow that even though Enbridge Gas Distribution is a wholly-owned subsidiary of Enbridge Inc., if Enbridge Inc, trading at market-to-book above significantly above one to one, issues shares to finance rate-base expansion in the subsidy in Enbridge Gas Distribution, the earnings per share of the parent, Enbridge Inc., are increased; is that right? 378 DR. BOOTH: That's correct. 379 MR. KLIPPENSTEIN: And when you strip away the complications, it's the same logical process going on? 380 DR. BOOTH: That's true. 381 MR. KLIPPENSTEIN: Switching to the situation of Duke Energy and Union and Pollution Probe in the materials you have before you has put forward information suggesting that Duke's market-to-book ratio recently is at about 1.06 to 1. 382 DR. BOOTH: That high? 383 MR. KLIPPENSTEIN: Can you comment on that? And I know in your interrogatories you add another factor, which is the cost of underwriting and those transaction costs. Can you comment on whether in the situation I've just mentioned with respect to Duke Energy and the subsidiary Union, rate-base expansion would or would not increase earnings per share for Duke Energy? 384 DR. BOOTH: Well, Duke, if it can just sell stock to net out book value, then if it passes that money on to Union, it would not be able to manufacture a higher earnings simply because of the arithmetic and the way that we calculate earnings per share. 385 But we like to believe the capital markets are smarter, and that they can actually see through this simple arithmetical bump up in earnings per share. As I mentioned, it doesn't always seem to be the case. 386 MR. KLIPPENSTEIN: If, let's say, once transaction costs, underwriting costs are taken into account, Duke's market to book is actually less than 1 to 1. Does the same logic mean that rate-base expansion would cause earnings per share of Duke to fall? 387 DR. BOOTH: That's correct. That's generally what we call dilution. It's why I think Ms. McShane said that you should target a market-to-book of utilities of about 1.05 to 1.15, something in that range, simply so you know that they will be able to net out book value and there will not this be dilution. Otherwise, they will have a reluctance to sell equity and they will be reluctant to reinvest in the facilities that's needed. 388 MR. KLIPPENSTEIN: Is it fair to assume that Duke's ratio of market to book right now is a bit of an aberration, is a bit unusually low due to the shadow of Enron and similar factors? 389 DR. BOOTH: Not just the shadow of Enron, but the shadow of Williams, the shadow of WorldCom, the shadow of Aquila. There's so many U.S. energy companies that got caught within energy trading, that there's a lot of them in very serious financial trouble, which is why their selling at huge discounts. Aquila, for example, as we know, just sold off its assets in Canada to Fortis, because its stock price has dropped from over $35 to 3.50 and it suffered huge losses in the United States because of energy trading, and it's retrenching back to its core. 390 MR. KLIPPENSTEIN: So it does make sense to say that Duke's present market-to-book is perhaps a bit of an aberration on the low side? 391 DR. BOOTH: I think I'd have to go back and see how much Duke has lost in its non-regulated businesses; but clearly, just like TransCanada a couple of years ago, if you get rid of all these energy trading things that have just been a drag on the earnings, all of these sort of peripheral things that look great in a hot market as a great investment opportunity, as you get rid of all of those and focus down on the basic regulated industries, then you would hope that the stock price recovers. The only condition there is that investors believe that utility managers aren't going to go off on another power trip buying up a lot of other companies and doing a whole bunch of weird things the way that they've done in the United States. 392 MR. KLIPPENSTEIN: I mentioned that Pollution Probe's questions connect to some of the -- what's called DSM or energy efficiency or energy conservation efforts that some of the companies are taking part in under the Board's supervision. However, your proposed or recommended return on equity is based on a pure pipes business assessment; is that fair? You haven't tried to specifically address whether those conservation issues should be taken into account, and I suspect that probably was no part of your requested work; is that fair? 393 DR. BOOTH: I have no particular expertise in that other than an informed consumer, the same as the average guy on the street. 394 MR. KLIPPENSTEIN: So you didn't take that into account in your ROE assessment? 395 DR. BOOTH: No. 396 MR. KLIPPENSTEIN: And is it fair that it follows, based on your expertise and the interaction between the corporations and the capital market, that if gas distribution companies take on some conservation or energy efficiency promotion activities, to the extent that that inhibits rate-base growth, it would inhibit earnings per share growth for the company or its parent. Does that follow? Am I right about that? 397 DR. BOOTH: I think the correct causal link is as long as allowed returns are sufficiently high, and the market-to-book is sufficient if I high, there's a tremendous incentive on the part of utilities to expand rate base. And as a result, there's not a tremendous incentive to reduce rate base or focus on reducing consumption for demand-side management policies. 398 So it may be true that the current set of financial parameters encourages rate-base expansion to the detriment of demand-side management. That's about all I can say. 399 MR. KLIPPENSTEIN: You've said it may be true and I don't want to misinterpret you, but it appears to me that that incentive would follow logically from the -- the relationship between rate-base growth and earnings per share. 400 Is it fair to say that as a result, any reasonably smart distribution utility manager would perceive quite likely a bit of a conflicting tug there? 401 DR. BOOTH: I think you're actually correct there. And why I said it may be true, it's simply that we know there's an economic incentive to expand the rate base. Whether that automatically translates into an economic incentive not to pursue demand-side management, where economically it makes sense, I don't know, because I just don't work in that area. 402 MR. KLIPPENSTEIN: Assuming that the Board establishes a fair rate of return for the utilities' invested capital, if this Board also wants to motivate the utilities to aggressively and cost-effectively promote energy efficiency, would it make sense to have some kind of demand-side management incentive mechanism that addresses the shareholders' interest? 403 DR. BOOTH: Well, you're not going to like this answer, but I believe the demand-side management -- 404 MR. KLIPPENSTEIN: Well then let me just stop you. 405 DR. BOOTH: I'm not an environmentalist to the extent that I guess you'd like me to be. I tend to believe that demand-side management should be followed where it's economically feasible, and I see no incentive to subsidize demand-side management. 406 MR. KLIPPENSTEIN: Yeah, that's -- that's an important issue, and you might recall that I'm -- in my question, I used the word cost-effective, and I chose that carefully to make sure that we're only talking about DSM which reduces customers bills on a net basis. 407 DR. BOOTH: No. 408 MR. KLIPPENSTEIN: So given that understanding, is it fair to say that if the Board, in addition to giving a fair return on capital, wants to have a motivational element for the utility to aggressively pursue those cost-effective DSM measures, then some other kind of incentive mechanism that -- that deals with the DSM and shareholder relationship would be needed or would be smart? 409 DR. BOOTH: Could be. The -- as you remove the commodity function from the distribution utility, then presumably, this very much depends on rate design, but they had less incentive just to encourage the consumption of gas apart from putting in the mains and connecting the new consumers. 410 So with the proper rate design, you can uncouple the consumption component for the utilities from -- from their rate of return, and so they'll still get an incentive to expand rate base, but expanding rate base doesn't necessarily mean expanding the consumption of natural gas. 411 In that second area, it's up to the Board whether or not it wants to encourage a reduction in the consumption of natural gas. And as I said, I have no expertise in that particular area and I have no special expertise in the economics of that. 412 MR. KLIPPENSTEIN: Unless you want to continue offering views on areas in which you have no expertise, and I'll give you the opportunity for that, other than that, those are my questions. Thank you, Dr. Booth 413 Thank you, Mr. Chairman. 414 DR. BOOTH: Thank you. 415 MR. VLAHOS: Thank you, Mr. Klippenstein. The Board will take its first afternoon break. It's 25 to 3:00. We'll return at 5 minutes to 3:00. 416 --- Recess taken at 2:35 p.m. 417 --- On resuming at 2:55 p.m. 418 MR. VLAHOS: Please be seated. 419 Mr. Dingwall? 420 MR. DINGWALL: Thank you, sir. 421 CROSS-EXAMINATION BY MR. DINGWALL: 422 MR. DINGWALL: Good afternoon, Dr. Booth. My name is Brian Dingwall. I'm counsel for the intervenor Energy Probe. 423 Would you agree with me that the general purpose of the return on equity is to compensate the shareholders of the utility company? 424 DR. BOOTH: That's correct. The assets are long lived. Once they put the money in, they are beholden to the utility commission to give them a fair return. 425 MR. DINGWALL: In Ms. McShane's evidence, she makes reference to utilities as interest-rate sensitive stocks; would you agree with that statement? 426 DR. BOOTH: Yes, the sensitivity to interest rates changes over time, but generally they're regarded at interest sensitive by the TSX. 427 MR. DINGWALL: And when interest rates are relatively low, as they currently are, how does that sensitivity affect utility stocks? 428 DR. BOOTH: Well, when interest rates go down, the price of fixed income securities go up. That's just a matter of arithmetic. If you think interest rates are going to go down, you buy fixed income securities like long bonds for the same reason you buy utilities shares and you buy other high dividend shares like the banks. So we tend to see that when interest rates go down, utility stocks tend to go up. 429 MR. DINGWALL: And obviously utility stocks going up is a benefit to the shareholders of those stocks? 430 DR. BOOTH: That's correct. When we see that, all it's indicating is that as the interest rates in the capital market are going down, then the investors' opportunity cost, the fair return is going down and as a result the market prices are going up. That's sort of high end law of finance. 431 MR. DINGWALL: Your evidence makes reference to a British Columbia Utilities Commission proceeding involving PNG and how, instead of adjusting the return on equity, a particular utility risk was mitigated through other factors. 432 Are you aware of any other circumstances where commissions have taken a broad view of ROE that takes into account other factors apart from traditional formulas? 433 DR. BOOTH: I think every utility commission does that. You have to remember that utilities are the only type of company where they can actually go to a board to sort of get -- to solve its problems. 434 So if there's a problem in business risk, then the first reaction of most utilities is to talk to the regulators, and say, "How can we moderate this?" 435 We saw this, for example, with TransCanada about 20 years ago. They signed a whole lot of long-term gas contracts and then the price of gas went down and they lost a huge amount of money and they set up a separate utility called Top Gas to regulate and mitigate that risk to the regulated company. 436 We saw that with BC Gas that was very sensitive to weather and the B.C. Utilities Commission put in place a pretty comprehensive deferral account to adjust for weather impact on BC Gas. 437 We've seen that with GMI, where because Quebec, the price of electricity -- have to rephrase this, it's very competitive. There's very little residential use of natural gas relative to other jurisdictions and as a result, GMI tends to have more exposure to industrials and gets a lot of protection from the Regie for doing that. 438 So whenever we see something that tends to cause a problem to a utility, you tend to hear a rate hearing, and sometimes the response is a deferral account or some sort of sharing mechanism. Sometimes the response is, well, the shareholders are just going to have to bear this, and as a result we'll increase the ROE. Sometimes it's increased business risk will lower the financial risk. 439 So, for example, when the telecoms deregulated long distance, the CRTC increased the common equity ratio to offset the increase in business risk. 440 So we've seen this throughout the regulated sector, the regulatory boards or commissions respond to changes in business risk through deferral accounts, through changes in financial risk, the changes in ROE, and this is not what happens for unregulated companies. There's not a regulator that can basically make these sorts of adjustments. 441 MR. DINGWALL: Are you aware of any circumstances where commissions have adjusted ROE because of significant risk reductions? 442 DR. BOOTH: I think when we see significant reductions in business risk, the tendency has been to increase the equity ratio, so TransCanada -- I'm trying to remember the case, but it was when western Canadian sedimentary basin was still expanding like crazy and there was lots of demands for pipelines, and there weren't the supply risks that people are anticipating now. The NEB reduced the common equity ratio for TransCanada to 28 percent. 443 So, generally, if there's a reduction in business risk, it seems that regulators increase the financial risk, so that overall the risk to the shareholders is basically the same. 444 MR. DINGWALL: So in these circumstances, if I'm reading you correctly, there has been no change to the actual formulas used for calculating return on equity; is that correct? 445 DR. BOOTH: That's correct. The first formula was put in place by the BCUC in 1993, and then we've had a succession of follow-ups from then. 446 In my judgment, as in the testimony, the very act of putting utilities on an adjustment formula reduces their risk, but it reduces financial risk, it reduces the investment risk from the point of view of the capital markets, and I don't think that's been taken into account, sufficiently. 447 But I would say that over the last ten years, I have been more aware of increases in equity ratios to offset business risk, more use of deferral accounts to offset business risk rather than increasing allowed rates of return, and I'm not aware of recent reductions based on return on equity purely on the basis of business risk. 448 MR. DINGWALL: Now, I've asked some of the witnesses a similar line of questions with respect to triggers that would lead to reopening the formula for calculating ROE. Do you believe that any such triggers are identifiable or necessary? 449 DR. BOOTH: No. When my colleague and I first testified before the NEB in 1994, all of the witnesses were putting in bands, so we thought we'd join the show and put in a band as well, and I can't remember exactly what it was, but I think it was plus or minus 2 percent. The fact is, for seven years, there was no problem with the NEB formula. 450 The BCUC formula went in place in '93 and was reviewed in '96 -- sorry, '99, so that was six years. The Centra Manitoba formula has been in place for eight years. The formula in this jurisdiction has been in place for six years. I don't see any need for an automatic trigger. 451 Having said that, I've filed evidence in Alberta saying it should be reviewed after five years, but I don't think the Board pays much attention to these sorts of triggers. They will review the evidence when one of the participants says the results aren't fair. So as long as there's the ability of the utility to say, "Oh, my God, interest rates have dropped to 1 percent, the results aren't fair," then there will be a hearing and the Board will decide whether it's fair or not. 452 I don't think an automatic trigger to have a hearing really has any point, because they've been honoured in the breach in the past and I expect them to be honoured in the breach in the future. 453 MR. DINGWALL: So am I understanding you correctly that you don't believe a formulaic trigger is appropriate, but you do anticipate that there might be some circumstances where changes in environment, the business operating environment, or other changes might, just by the way things work, lead utilities to seek variance? 454 DR. BOOTH: Sure. It's a big problem that we always anticipate the economy is going to carry on the way that it is, and then we're surprised when it doesn't. But nobody in the '50s could have anticipated the oil price shocks and the huge inflation that we had through the '70s, early '80s. Nobody in the '80s could anticipate that the government would actually reduce it deficit and get its finances under control and actually not spend money the way that it was in the '60s and '70s. And that really shook investors, that the government would actually have some responsibility in its financial affairs. 455 Right now, people are saying the economy is fine, things are going hunky-dory and the economy is great. Who knows what's going to happen? 456 We've got a president in the United States that's blowing billions of dollars to invade countries around the world. I don't know what's going to happen in the U.S. They might decide they want to also embark on a nation health program and get a deficit and interest rates go up and the U.S. dollar could collapse. I mean it's got a horrendous deficit in the United States on its trade deficit. I mean, who knows? I mean integrated with the U.S. Those things could spillover into Canada. 457 So I don't know what the future holds, but I know it's not going to be what we anticipate and there could be a confluence of events in two, three years where the regulators or the companies or the intervenors say, This isn't fair. And I think I rely upon a complaint basis and the common sense of the people involved to have a hearing at that time. 458 MR. DINGWALL: From where we're sitting today looking at relatively low interest rates, you've stated that you don't believe -- with today's conditions, you believe the ROE should be opened; is that correct? 459 DR. BOOTH: The ROE should be what, sorry? 460 MR. DINGWALL: I'm sorry, that the guidelines should be changed; is that correct? 461 DR. BOOTH: No, I see no problem whatsoever. The -- I tend to think that we're now in a situation similar to the early '50s: stable economy, good growth, a government that's balancing its budget, low inflation, low interest rates. This was the Eisenhower years, these were great years, but they didn't last. 462 MR. DINGWALL: Are there particular interest rate declines or rises that, in your mind, could or should lead to a trigger. 463 DR. BOOTH: When we look at interest rates, the only reason for seeing a substantial increase in interest rates are inflation, because it's primarily inflationary expectations that get embedded in interest rates, so -- and as a result long-term fixed income securities become extremely risky, and frequently we see the yields go up more than the anticipated rate of inflation. I can conceive a scenario, a sort of a doomsday scenario. I mean you go to the book store and read these books: "The Coming," "Doom and Gloom," and "Buy Gold," and "Stock Up and Run for the Mountains." I mean, there is a scenario where there could be a dramatic increase in inflation and there could be serious international political problems, and there could be a run-up in inflation and we could see interest rates back up from 5.4 percent back up to where they were just a few years ago, 10, 12, 13 percent. 464 In that environment, if a significant increase in interest rates, possible deficit problems, exchange rate problems, retreat to sort of trade barriers around the world, I could quite see that the formula would not give reasonable results. 465 In that scenario, as I said, I'd rely upon a complaint mechanism to sort that out. 466 MR. DINGWALL: Given that you appear to favour the variability of procedure and the behaviour of parties who would be expected to take action if circumstances were unreasonable, do you believe a fixed ROE for a five-year PBR plan would be appropriate without openers or without an ability to -- or with no ability whatsoever to open? 467 DR. BOOTH: Let's see if I understand the question. A fixed, allowed ROE, but then there's also some sort of savings that the company gets to keep as a result of an agreement with intervenors; is that correct? 468 MR. DINGWALL: Yes. 469 DR. BOOTH: So they actually earn more than the allowed ROE? 470 MR. DINGWALL: That's right. 471 DR. BOOTH: This is a question I've been asked by many boards. Why should we give them an incentive when they're supposed to be efficient in the first place? And I'd like to believe that there is no fat, that they're doing their job properly in running the utilities as efficiently as possible, and there is no fat. So as a result, the PBR would not expose any fat. 472 The cynic in me or the realist in me that tell me that if there's an incentive to consult costs, then the utilities are more inclined to cut costs than when there's no incentive. I've always supported some form of PBR where the utilities get to keep, say, 50 percent of the savings for three to five years, and then you rebase, based upon what go on. So they have an incentive and they do earn higher rates of return. So I've always been in favour of some form of incentive system where the utility cans get to keep some of the savings from efficiencies. 473 Connected with that, and this was -- and this would throw a ringer in the works, as it were, I've come back to the conclusion that it's about time we scrap forward test years. I think with the rate of inflation that we're getting at the moment, the -- we ought to reconsider going back to historic test years and then adjusting the historic test year revenue requirement for known and measurable effects because the system is so stable at the moment, because the rate of inflation is so low. 474 I think if you throw in the mix PBR, I think my personal recommendation would be you consider the whole idea of a forward test year. 475 MR. DINGWALL: Thank you very much, Dr. Booth. Those are my questions. 476 DR. BOOTH: Thank you. 477 MR. VLAHOS: Thank you, Mr. Dingwall. 478 Dr. Booth, if I can just follow up on a couple of points. 479 The last point first on the historical test year. Based on your knowledge it is something that has been reverted back to in the United States? 480 DR. BOOTH: No, the -- the last time I'm aware of a utility changing was Centra Manitoba, and this must have been about 1992/'93 when it converted from a historic test year to a forward test year, and I'm not aware of any utility reverting back to a historic test year. 481 I think the remark is just taken in the context forward test years were introduced because in the '70s, the significant amount of inflation that exposed to the utility to significant regulatory lag, and they were not getting fair rates of return, because they were not basically passing on legitimate costs. 482 I think with a low inflationary environment, 1 or 2 percent, the advantages of a forward test year are much reduced. 483 MR. VLAHOS: thanks. So what would be the benefits of historical test year versus, as we exercise it today, a future test year. 484 DR. BOOTH: The -- if you look at the actual returns the utilities are able to earn on a forward-test year basis, they always -- I shouldn't say always, but they invariably exceed the allowed rate of return, and I've asked people, the Canadian Association of Petroleum Producers, How is it that TransCanada always overearns it's allowed return? How is it that NGTL overearns? I haven't asked anyone, How it is that Consumers Gas and Union consistently overearns on a weather-normalized basis, but the answer I get from most people is O&M, operations and maintenances. The forecast O&M in the budget tends to be underspent, so the utility tends to overearn it's allowed return. 485 If took out the forward test year and reverted it to a historic test year, and said, Okay, you can get what you did last year, adjust it for no immeasurable impacts, I think the tendency of utilities to overearn on a forward test year would be removed. 486 MR. VLAHOS: How does that -- how would that jibe with any -- with the providing incentives for further efficiencies? 487 DR. BOOTH: Well, I think what you're doing there is you're taking out the tendency to overestimate costs. I think you're starting from the actual money that's being spent, and then you can base the PBR based on what was actually spent last year rather than what you're forecasted to spend, which doesn't get spent. 488 I think it's a question of how you rebase from the starting point and as I've said, I've thrown this out simply because when I look at the actual rate of return the utilities are earning based upon their allowed or based upon weather-normalized, every year it seems that most of the utilities on a forward test year overearn their allowed return, and something seems to be wrong. 489 MR. VLAHOS: Thank you for that. 490 The other matter I want to follow up is this sort of magic trigger mechanism that you discussed with Mr. Dingwall. You can see that working on the basis of instead of an automatic trigger, working on the basis of a complaint, on the basis of a complaint. For an application, we probably would include that as well in an application by the applicants. 491 I guess the issue is, and perhaps not a fair question to you, but once someone makes an application such as an applicant or someone makes a complaint, some of the material attached to that request, how can the Board determine the reasonableness of that evidence, if you so choose to call it, without any testing procedure in the process, such as a hearing? 492 DR. BOOTH: I guess the question, what's the evidentiary basis on which the Board can decide to act on a compliant on the part of an intervenor or the Board. 493 MR. VLAHOS: Yes. 494 DR. BOOTH: And I would suggest there that if an intervenor or the company felt that the adjustment mechanism was given an unfair rate of return, they wouldn't just write to the Board saying, "I think this is unfair, I want it reviewed." 495 I would guess that they would go out and hire a witness, put the information together and sort of send it to the Board and say, "These are the broad outlines. We don't think what's happening is fair, we'd like this to be thoroughly reviewed and it hasn't been seen for two to three years and these are the underlying reasons why some of these things happen." 496 My only concern about this is there's a little bit of an asymmetry and it's easier for the utilities to do that than it is for the intervenors. Usually the intervenors don't have the resources to put together a file indicating that the adjustment mechanism is giving unfair results. 497 MR. VLAHOS: So I guess my question still is that once you get that evidence by the party, then in what form do you test that evidence without having a hearing such as this one? Can the Board do it on its own? I did warn you it may not be a fair question. 498 DR. BOOTH: I think it's an unfair question, Mr. Chair, because the Board imposed the guidelines in the first place without a hearing. 499 If my memory serves me correct, we were in the middle of either a Consumers Gas or Union Gas hearing and all of a sudden the Board's guidelines came out and it threw everyone for a tizzy. So my understanding is the Board has, in the past, acted unilaterally based upon its judgment of what is fair, and I would expect a responsible Board to respond to a carefully responsibly submitted request to review the guidelines, and I would expect the Board to respond whether that's from the intervenors or whether that's from the company. 500 Obviously, if an intervenor writes in and says, "This is totally unfair, review the guidelines," then I think the Board has a right to say, "We're not acting on this request." 501 MR. VLAHOS: Thank you, Doctor. 502 Ms. Newland. 503 MS. NEWLAND: Thank you, sir. Before I begin my cross-examination, I just want to get one housekeeping matter out of the way. Yesterday afternoon, Mr. Chairman, I mentioned that the response by Enbridge to an undertaking to Mr. Thompson, which is Exhibit G.1.3, would be available after the hearing had adjourned for the day and we did put copies at the back of the room. I think most people have it, I just want the record to show that it has been filed. 504 MR. VLAHOS: So what is the exhibit number? 505 MS. NEWLAND: It was Exhibit number G.1.3. 506 I will get copies for you, Mr. Chairman. We had thought we had given copies to the Board Staff yesterday, but perhaps we'll just look at the back of the room and see if there are more copies. 507 MR. VLAHOS: Just to be clear, is this the cross-examination material -- 508 MS. NEWLAND: No, this is a response to undertaking -- 509 MR. VLAHOS: Response to undertaking. 510 MS. NEWLAND: -- which is Exhibit G.1.3. Do you have it, sir? 511 We have additional copies. 512 My helper, Mr. Thompson, will distribute it. 513 MR. THOMPSON: I'm moving a lot faster. 514 MR. VLAHOS: Yes, we have it now. 515 CROSS-EXAMINATION BY MS. NEWLAND: 516 MS. NEWLAND: All right. 517 Good afternoon, Dr. Booth. My name is Helen Newland and I will be cross-examining you this afternoon on behalf of both Enbridge and Union. 518 And with your cooperation, Dr. Booth, Mr. Chairman, I think I could probably come in in under 2.5 hours or close to 2.5 hours. I'll do my best. 519 MR. VLAHOS: Thank you. 520 MS. NEWLAND: Dr. Booth, I have one small housekeeping or preliminary matter before we start and that is to do with the table that Mr. Thompson handed out yesterday and I believe, Mr. Chairman, it was given the Exhibit number F.3.1, and it's the ROE summary at 6 percent long-Canada that Mr. Thompson handed out, more as I understand it as an aid to parties. And Mr. Thompson invited parties to take a look at the table and get back to him, I guess, if we had any questions, and I have one question for you, Dr. Booth. 521 It's regarding the estimate -- well, let's look at this. Under the risk premium, line A is the market as a whole, and your estimate is shown correctly I believe, as 450 basis points, and then it shows your relative risk adjustment as 0.45 to 0.55. 522 And then at line C, it shows your utility risk premium as 200 basis points. And I'm wondering, Dr. Booth, whether that should actually be -- well, 2.025 to 2.475, or whatever that translates into basis points to be absolutely precise? 523 DR. BOOTH: I think you're correct if you just look at what we call our classic CAPM, where you just multiply the average beta 0.5 by the market risk premium and you get 225 basis points. 524 I think Mr. Thompson was taking into account our estimate for the multifactor risk premium model as well, which is slightly lower, so that's why our actual estimate was a 200 basis points risk premium with a 50 basis points cushion. So the benchmark risk premium there, 200 basis points, is a result of the classic capital asset pricing model, risk premium plus a multifactor model. 525 MS. NEWLAND: Thank you. 526 It will hardly surprise you, Dr. Booth, that my questions fall into two main areas, your evidence on a market equity risk premium and your evidence on the relative risk adjustment for regulated utilities and your beta coefficient. 527 And you will need to have, as we go through this exercise, a copy of Exhibit F.3.8, which is our cross-examination materials. Do you have that, Dr. Booth? 528 DR. BOOTH: I have that. 529 MS. NEWLAND: Could you turn to tab 1 in Exhibit 5, F.3.8, book of cross-examination materials? 530 DR. BOOTH: Yes. 531 MS. NEWLAND: And this is your evidence and the evidence of your colleague Dr. Berkowitz, that was filed on behalf of the Ontario Coalition Against Poverty, OCAP, in EBRO-499, and that was Union proceeding, Dr. Booth? 532 DR. BOOTH: That's correct. 533 MS. NEWLAND: And this evidence is dated September 1998; correct? 534 DR. BOOTH: Yeah. 535 MS. NEWLAND: Could I get you to turn to page 38. 536 DR. BOOTH: Nothing of interest in the first 37 pages? Okay, I have page 38. 537 MS. NEWLAND: And just reading at line 26 -- well, let's start at 25, you say: 538 "Our position is that interest rate risk has increased dramatically over the period 1957 to 1997, as compared to the earlier period for 1922 to 1956. As a result, recent equity risk premium, i.e., market less long-Canada yield estimates of 3.5 to 4 percent reflect a correct assessment of the risk premium required over much riskier long-Canada bonds." 539 The point is, I gather, that in September 1998 when this evidence was prepared, you were recommending a market equity risk of between 3.5 and 4 percent? 540 DR. BOOTH: That's correct. 541 MS. NEWLAND: And now your market risk premium estimate is 4.5 or 50 basis points lower -- or rather higher than in 1998; is that correct? 542 DR. BOOTH: That's correct. Everyone else seems to have come down. Professor Berkowitz and I have increased our market risk premium estimates. 543 MS. NEWLAND: And we're happy that you have. I want to confirm my understanding, though, of the reason for the increase. To do this, perhaps you could turn to page 12 of appendix E, Exhibit B, tab 2, which is your written evidence. 544 DR. BOOTH: Okay. 545 MR. SOMMERVILLE: Which page was that, Ms. Newland? 546 MS. NEWLAND: It's appendix E, and it is page 12, sir. 547 MR. SOMMERVILLE: Thank you. 548 MS. NEWLAND: Are you with me, Dr. Booth? 549 DR. BOOTH: I am. 550 MS. NEWLAND: I'm going to just read lines 18 to 23: 551 "The increased interest rate risk and government overborrowing are clearly two sides of the same coin. Their effect was to crowd the bond market with risky long-Canada bonds that could only be sold at premium interest rates frequently to non-residents." 552 MR. VLAHOS: Ms. Newland, the reporter has to slow it down a bit. The reporter has to be able to pick up every word. 553 MS. NEWLAND: Thank you, sir. 554 "This driving up of Canada bond yields reduced the spread between Canada bond yields and equity required rates of return and hence the market-risk premium. It is this deficit and risk phenomenon in the government bond market that created the narrowing market risk premium and the large Canada bond betas in the mid 1990s." 555 So as I understand your evidence, Dr. Booth, the reduction in interest rate risk and the reduction in government deficit since did 1997 or so has reduced or eliminated the interest premium that was previously required in order to make long bonds attractive to investors; is that correct? 556 DR. BOOTH: Pretty much. 557 MS. NEWLAND: okay. And then if I go just over the page to page 13 of the same appendix -- 558 MR. THOMPSON: Have you finished your answer, Doctor? 559 DR. BOOTH: I would just like to add two things to that. In an earlier incarnation, I was a historian, so I actually like to go back and see what happened to generate these number. And I think today, it's very difficult to put ourselves back in the situation of even 6 years ago, certainly 10 years ago. And I was -- we were recommending 3.5 to 4 percent 6 years ago. If you go back to 10 years ago, the debt or recession, '93-'94, I think we actually put in testimony before this Board where our recommendation was only 20 or 30 basis points or the company's long yield. So our risk premium at that point, I think, was down to 1.5 to 2 percent. 560 So over the last ten years our market risk premium has gone up and the reason for that is capital markets have changed dramatically over the last 10 years, and I do take exception to a lot of these historic study the where people just crunch numbers without ever bothering to go back and understand where these numbers came from. 561 And to cut a long answer short, I will just look, ask people to look at our schedule -- our schedule 4. When people talk about long-Canada bonds, they forget that the risk attached to investing in long-Canada bonds is the government inflates the economy, and basically turns the fixed nominal bonds into worthless securities because inflation erodes their purchasing power. 562 And the way inflation is generated is because governments are on deficits, and they can't be bothered to tax people, they can't be bothered to cut spending, they just issue more government debt and we all pay the cost through inflation. This just charts the net government lending, so when it's negative, it's borrowing of the aggregate of our federal/provincial governments in Canada. 563 And we can see that through the '60s, we sort of had some stability up until really about '68, so there's not much difference from zero. And then the number starts going down, particularly in the '70s and the '80s, and in the '90s, in the depth of the recession, governments were borrowing about 9 percent of the GDP in Canada. They were just flooding the bond market with debts, and a lot of that money was sold to foreign investors. 564 And I well remember at the time, Dr. Sherwin and Ms. McShane saying there was a country risk premium, Canada was the place to put money in. And the reason was who knew what was going to happen to the Canadian dollar because the government was borrowing so much money and there was so much inflation in the system. 565 She referred to this at the time as a country risk premium. We just see that it's reflected in interest rates that pushed up the year on government debt, and made government debt extremely risk from the point of view of investors. 566 And we can see that again if you go to back to our Union Gas testimony from 1998 when we -- somewhere we had the betas or risk interest in government debt. This was schedule 5 in that handout you gave. And you see that the government -- the betas on Government of Canada bonds were basically zero most of the time, but in the '90s, they increased dramatically. Government debt was extremely risky. 567 We had betas for government of Canada bonds of 0.5 that were very similar to the betas of utilities, which was why our risk premium estimate were squeezed. And most of that has now been squeezed out of the system. We've now got governments, as we can see, since '97, that actually done what they said they would do and nobody believed they would do is reduced the deficits and basically stop flooding the market with government debt. 568 So the riskiness attached to Government of Canada bonds, in my judgment, has gone down. We're now back to where we were in the '50s: low interest, low inflation, some sanity in overall aggregate government finances, and a relatively low-risk economy. And in that environment, I think it's pretty logical that the market-risk premium over long-Canadas bonds has gone up, and that's what's reflected in our estimates. 569 MS. NEWLAND: We don't disagree with the underlying reasons, sir. 570 Let me move on. I'd like to discuss the multifactor model that you use and describe in your evidence. 571 Dr. Booth, as I understand it, you estimated two different returns: One was the result of the application of the classic CAPM model, and one was the result of this multifactor model; is that right? 572 DR. BOOTH: That's correct. 573 MS. NEWLAND: And the so-called classic CAPM model adjusts the historic average market-risk premium for changes in the risk profile of the long-Canada bond; correct? 574 DR. BOOTH: That's correct. 575 MS. NEWLAND: So its sole focus is on the risk of holding securities in a diversified portfolio; correct? 576 DR. BOOTH: That's correct. 577 MS. NEWLAND: So one of the assumptions that underpins the application of the CAPM model is that investors are perfectly or 100 percent diversified; correct? 578 DR. BOOTH: It assumes that that they hold enough securities so that the risk of individual securities is basically relatively to the market, and that applies, obviously, to any institutional portfolio, because they always hold 60 to 80 securities. 579 MS. NEWLAND: okay. 580 DR. BOOTH: It applies to any individual who basically buys mutual funds, and that's the cornerstone of modern finance, that we diversify, and the risk of individual securities is basically is beta risk. 581 MS. NEWLAND: And it follows from this assumption that the CAPM model has regard only to systematic non-diversifiable risk. 582 DR. BOOTH: That's correct. Correct. 583 MS. NEWLAND: And to the extent that portfolios are not 100 percent diversified, and I know that you have a view on this, but to the extent that they are not 100 percent diversified, what does that mean in terms of a CAPM model estimate of return? 584 DR. BOOTH: First of all, I've yet to see an institutional portfolio that wasn't diversified. 585 MS. NEWLAND: I know you have a view on this, sir, I'm just asking for your answer with respect to the result of the CAPM model. 586 DR. BOOTH: If we had a capital market where people were silly enough to hold one security, and I've yet to see that, then the total risk would be reflected in security prices. They'd look at the total variation in the return on the stock, rather than taking into account that that stock was held in a portfolio. 587 MS. NEWLAND: So the CAPM model in those circumstances would underestimate -- 588 DR. BOOTH: That's correct. The CAPM wouldn't even hold. You would have a model in which investors didn't have capital markets or were restricted to holding one stock for one reason or another. 589 MS. NEWLAND: thank you. Now, you also derived an estimate of the fair return by applying a version of the multifactor model that is based, according to your evidence, on the Fama and French multifactor model? 590 DR. BOOTH: That's correct. 591 MS. NEWLAND: And the multifactor model looks at other variables that are useful in predicting capital market return; correct? 592 DR. BOOTH: They've been found useful in the United States in certain data sets, yes, but they're still very controversial. 593 MS. NEWLAND: I understand that, sir. Thank you. And the multifactor model captures risks that affect equities but which are not captured by the CAPM single factor model. 594 DR. BOOTH: That's correct. The basic problem is despite beta risk, we look at the United States and you look at the full universe of securities, certain firms that are relatively small earn more than they would anticipate, and firms with very low market-to-book ratios, basically earn more than they would anticipate. So the original work by Gene Fama and Ken French at the University of Chicago showed that when we take into account these factors, we can actually explain more of the return on securities. 595 MS. NEWLAND: And those gentlemen, Fama and French, identified five variables, and those are market-risk premium, return spreads, size, book-to-market and default spreads? 596 DR. BOOTH: That's correct. The original one was two, then three, then five, and other people have added on factors. 597 MS. NEWLAND: And in your evidence, sir, you say that five book-to-market and default spreads have each been found to be statistically insignificant for these First Nation firms. By these firms, are you referring to Canadian regulated utilities or regulated utilities in general? 598 DR. BOOTH: They've been found in securities in general, and we found for Canadian regulated utilities, so the results of Fama and French were discovered to be extremely sensitive to the breadth of their database, whether they include just NYSE stocks or all of the universe of stocks, and also very sensitive to the time period over which they estimate their studies. 599 When we replicated their work on Canadian regulated stocks, we found that market-to-book, for example, and size had no impact. And the only reason for that is they're basically quite similar, there's not enough dispersion. 600 MS. NEWLAND: And your version of the multifactor model relies on two of the five factors and those are -- the factors that affect capital market returns, I should add, and those are market risk premiums and term spread; correct? 601 DR. BOOTH: That's correct. I should sort of step back and just provide some motivation for this because -- 602 MS. NEWLAND: Just before you do that, I should say I'm not challenging that aspect of your testimony. If you want to provide the explanation, please feel free to do so, but I'm not challenging this aspect. 603 DR. BOOTH: I was going to explain that before the NEB we used a multifactor model with five factors and three of them were not very significant, so we've dropped that and we've gone back to the two factors that are significant for utilities. 604 MS. NEWLAND: The term factor, as I understand it, is a proxy for the deviation of long-Canada bonds from expected returns due to a shift in interest rates and it's measured as the spread between the return on long-Canada bonds and the 30-day treasury bills; have I got that right? 605 DR. BOOTH: That's correct. 606 MS. NEWLAND: Could you turn to Exhibit D.2, tab 2 in your written evidence, and in particular appendix B. 607 DR. BOOTH: Yes. 608 MS. NEWLAND: And this discusses the merits and applications of the multifactor model, and I want to turn your attention to page 2. Starting at line 21, you state that: 609 "Multifactor models have a long history in the estimation of the capital costs for regulated utilities. The idea is certainly not unique to Fama and French, though they have given the model a recent reverb of sorts. Roll and Ross conclude in their 1983 paper, it, the arbitrage pricing model, provides a superior method from both a theoretical and a pragmatic perspective for computing the cost of equity capital. Furthermore, we have demonstrated its application to a sample of utilities and derived much more sensible estimates of the cost of equity capital than those produced by the CAPM." 610 And I take it, Dr. Booth, that you wouldn't disagree with this statement, since you are quoting it to support your reliance on the model? 611 DR. BOOTH: We're quoting it to justify the fact that others have found the model to be useful. 612 MS. NEWLAND: Do you disagree with this statement? 613 DR. BOOTH: I think it's a useful model for estimating fair rates of return. It's certainly a well-accepted model. The original work was an arbitrage pricing model that's based very generally on the fact that two securities should sell for the same price in the same capital market, zero arbitrage condition in the capital mark, and the problem why the original literature developed by Steven Ross at Ward & Guy^ was nobody knew what the factors were, so it was a model that sort of had theoretical ideas but no content. And then Fama and French came along and they came up with some factors that has the profession buzzing and has had the profession buzzing for the last ten years. 614 MS. NEWLAND: Sounds exciting, Dr. Booth. 615 DR. BOOTH: Well, you know, some of it is exciting, to us people. 616 MS. NEWLAND: What I'm trying to focus on in -- 617 DR. BOOTH: We don't have much of a life. 618 MS. NEWLAND: I've been accused of the same thing. We should talk. 619 The reason I focus your attention, Dr. Booth, on this particular passage in your evidence is really to get you to comment on the opinion of Dr. Roll and Dr. Ross, that the multifactor model provides a superior method and results in more sensible estimates of the cost of equity capital from those produced by the CAPM. 620 Can you agree with that? 621 DR. BOOTH: I think technically it's superior in the sense that whenever you consider more factors, you should get better estimates. Our evidence where we estimate a multifactor model is we get rates of return that are slightly lower than the capital asset, and it very much depends how its implemented. 622 We think Roll and Ross in their '83 paper implemented in a way inconsistent with regulatory practice in Canada or the United States. So their particular implementation was not one that we would adopt or I think any board would adopt, but it's certainly -- the original work by Steve Ross was path-breaking work and we have no problems with it. 623 MS. NEWLAND: Well, you're probably getting ahead of me here. Let me get you to turn to the article that you've just referred to by Messrs. Roll and Ross, and I've included it my book of cross-examination materials at tab 2. Would you turn to that, sir. And in particular, I'd like you to turn to page 26. 624 DR. BOOTH: Yes. 625 MS. NEWLAND: And in the copy that you have Dr. Booth, do you see some underlined portions? 626 DR. BOOTH: I see it. 627 MS. NEWLAND: Okay. The first underlined portion says, and I quote, that: 628 "Consistently positive alphas..." 629 And I'm reading from the left-hand side, left-hand column near the bottom of page 26: "...that consistently positive alphas indicate that the CAPM fairy has consistently underestimated the cost of capital for these firms relative to their historic capital cost." 630 DR. BOOTH: Yes, I would agree with that statement. 631 MS. NEWLAND: You would? 632 DR. BOOTH: Sure. You sound surprised. 633 MS. NEWLAND: Well, I am a little bit surprised in light of your previous comment regarding the results -- 634 DR. BOOTH: Just to put things in perspective -- 635 MS. NEWLAND: -- of your own model. 636 DR. BOOTH: -- positive alphas means to say that the model is underestimated, so there's some extra rate of return that's not being explained. So this would say that the low risk firms, using the CAPM, their actual required return is higher than the CAPMs estimated, and I would have no problem with that. 637 That's something that the literature found, in fact, a long time before Fama and French. The first study that found that was by Fisher Black, who was a Nobel Prize winner, Mike Jensen at Harvard, and Myron Scholes is a Nobel Prize winner. And in fact, Ms. McShane refers to that study and said, "Well, others back in the '60s and '70s had found that." 638 Why I'm not surprised is if you go to the very first page of this paper -- let me see, is there a first page? 639 Sorry, it's page 23. It's the page with the funky picture of Steven Ross on it. 640 MS. NEWLAND: Steven Ross? 641 DR. BOOTH: He doesn't have all that hair now. But anyway, if you look at it, you'll see in the middle of page, the left-hand column, where they go through an example, and -- 642 MS. NEWLAND: Yes, sir. 643 DR. BOOTH: -- you'll see the middle of paragraph that starts "if"; do you see that? 644 MS. NEWLAND: Yes, I do. 645 DR. BOOTH: "If, for the sake of illustration, the S&P 500 has an average return of 5.9 percent, while treasury bills have averaged 5 percent." 646 What they did with this is the standard thing that most studies of capital markets have done, which was treat the risk-free rate as the treasury bill rate. And it's absolutely correct that if you use the risk-free rate as the treasury bill, the capital asset pricing model tends to underestimate the return for low risk securities. 647 And in fact, if you look at the estimates that they provide, even though these are 20-plus years ago, you will discover on page 27, a net column headed "CAPM Alphas." You see right at the bottom there's mean alpha -- 648 MS. NEWLAND: Excuse me, Dr. Booth, I don't mean to be rude, but I'm not terribly interested in this much detail. I think we've established that you don't disagree with the statement that I pointed out. 649 DR. BOOTH: No, I think there's a very substantive point that's about to come. 650 MR. THOMPSON: Let him finish, please. 651 DR. BOOTH: And the very substantive point is this mean alpha is .974 percent, call it 1 percent. What Roll and Ross found was that using the capital asset pricing model, low risk securities like utilities tend to earn about 1 percent more when the capital asset pricing model is using treasury bills. I would not disagree with that. I don't know anybody who would disagree with that. 652 The substantive point is I'm not estimating the capital cost for any of these utilities using treasury bills, I'm using the long-Canada bond rate. And in fact, Ms. McShane's using the long-Canada rate. And in our testimony, and I think also in Dr. Cannon's testimony, we point out that, on average, long-Canada bonding yields about 1 percent more than the treasury bill rate. 653 So I don't think it's an accident that we use a long-Canada rate that's 1 percent on average more than the treasury bill rate, and this mean alpha that they find here is 0.974 percent, indicating that their risk-free rate should have been 0.974 rate percent higher than the T-bill rate. That's entirely consistent with our using the capital asset pricing model with a long-Canada bond yield. We have no problem with this. It's entirely consistent with everything we said in our testimony. In fact, why Ms. McShane uses the long-Canada rate, and why we used the long-Canada rate. 654 MS. NEWLAND: Finished? 655 DR. BOOTH: Yes. 656 MS. NEWLAND: Thanks. 657 You may have already covered this in your explanation, but I was also going to draw your attention to the second underlined portion at the bottom of page 26 on the left-hand corner, column, rather, it says: 658 "These differences are the additional cost of capital implied by APT. As we can see in table 2, column 3, the estimated cost of capital are on average significantly greater for the APT than for the CAPM." 659 You don't disagree with that? 660 DR. BOOTH: No, that's just what I said. On average, that's the spread between the treasury bill rate and the long-Canada rate. 661 MS. NEWLAND: Now, when we turn back to your evidence in Exhibit D.2, and in particular, page 35, we see that you've weighted your CAPM estimate equally with your multifactor model equally, equally with the results of your multifactor model. 662 DR. BOOTH: That's correct. 663 MS. NEWLAND: Why did you choose to weight them equally? 664 DR. BOOTH: Sorry, say that again? 665 MS. NEWLAND: Why did you choose to do this? 666 DR. BOOTH: Because I had a big argument with my colleague, Michael Berkowitz. I indicated that Mike, Professor Berkowitz was primarily responsible for the multifactor model, and it is a legitimate model. It's every bit legitimate as the capital asset pricing model. There is this dissention in the literature whether the CAPM fairly reflects or whether the multifactor model is a better estimate, and we agreed 50/50. 667 MS. NEWLAND: And if you had had your way, you would have done what, sir? 668 DR. BOOTH: I think there's some -- I don't like black boxes, and the multifactor model is a little bit of a black box in the sense there's no economic reason for the factors that go into the multifactor model, and there's a big controversy in the literature whether the results of these Fama and French and the APT models are just the result of data mining. People have looked at the data so many times they know what's there and they can adjustment the factors to fit the data. We call that data mining or data snooping. There is significant scepticism in the profession as to whether the multifactor model results were actually in the mind of investors when they made those investment decisions that generated those results. 669 I'm a little bit more skeptical of the multifactor model than my colleague is, but it is a very well-accepted model in the literature, and I would go so far to say that it's superseding the capital asset pricing model in many textbooks so that's -- it's a legitimate model. 670 MS. NEWLAND: I understand that's your evidence, sir, but could you answer the question, which was: How would you weight it if you had not had to compromise with your colleague? 671 DR. BOOTH: I've just filed testimony in Alberta where I weight it equally 50/50, but I estimate the multifactor model in a slightly different way. I was always inclined 75/25; CAPM, 75 percent; multifactor 25 percent. If my colleague was here, he would be digging me in the ribs saying 50/50. 672 MS. NEWLAND: And we're glad he's not for that reason, sir. And you were to apply a rating of 75/25, how would that affect your recommended overall... 673 DR. BOOTH: On these estimates, the multifactor model gives slightly lower estimates than the capital asset pricing model, so it would increase the estimate slightly. I haven't done the calculations. But -- 674 MS. NEWLAND: Can you give me a -- would you accept that it might -- can you give me -- 675 DR. BOOTH: Have you done the calculation? 676 MS. NEWLAND: Well, Ms. McShane has just written 8.75 on a little note. Would you accept that number subject to check? 677 DR. BOOTH: I think that's assuming 100 percent for the capital asset pricing model; is that correct? 678 MS. NEWLAND: I think Ms. McShane would agree that that is correct. 679 DR. BOOTH: So it's going to be a few basis points, 10 basis points over the 8.5 percent recommendation. 680 MS. NEWLAND: We'll probably have a break, sir, and maybe you could put that number on the record later on. 681 DR. BOOTH: Sure. 682 MR. THOMPSON: I thought he just put the number on the record. You want a precise number? 683 MS. NEWLAND: I put a number on the record, Mr. Thompson, and we're happy to have that number, but I'm not sure Dr. Booth agrees with it. 684 MR. THOMPSON: It's between 8.5 and 8.75, and I thought he said about 10 basis points. So 8.6. Do we have to shave it any finer? 685 MS. NEWLAND: Dr. Booth, are you happy to accept 8.6? 686 DR. BOOTH: I probably would have said a little bit more, probably 8.6 687 MS. NEWLAND: 8.69? 688 DR. BOOTH: I'd be happy with 8.6, based upon a 6 percent forecast long-Canada, and that includes a 50-basis-points cushion. 689 The only qualification is that we went to the cushion at the time that we also went to the multifactor model, so that Mike and I had some discussion about how much cushion or how much extra should we allow, and part of that is related to the fact that I was unhappy with some of the result from the multifactor model. So it could very well be that the cushion would go down. So I don't think, to be honest, it makes a big difference. 690 MS. NEWLAND: No, sir, and I think we can probably move on from this point. 691 I do want to still talk about the multifactor model, but discuss a different aspect, and I think the best way to do this would be to turn to schedule D.3, to appendix D of your evidence. 692 DR. BOOTH: Yes. 693 MS. NEWLAND: And this is -- this is a table that shows the multifactor model of estimates of return for three different utility portfolios, and those are telcos, gas electrics, and pipelines. What category or categories would Enbridge and Union be included in? 694 DR. BOOTH: Union and Enbridge, they're both gas distribution utilities. 695 MS. NEWLAND: They're gas electrics? 696 DR. BOOTH: I mean they're closer to the gas electrics, yes. 697 MS. NEWLAND: This table also indicate an R-squared value for your multifactor return estimate for each utility portfolio, and for those of us who've forgotten all the statistics we ever knew, could you confirm that an R-squared value of zero means that the model has no predictive value, is wrong 100 percent of the time; and conversely, an R-squared value of 1 means it's 100 percent. 698 DR. BOOTH: No. 699 MS. NEWLAND: Could you set me straight on that, sir? 700 DR. BOOTH: The R-squared indicates how much of the variance in the dependent variable is explained by the independent variable. So an R-squared of zero does not mean that the model has no value. What it means is that, in this case, all of the risk is diversifiable. And for example, for utilities, it would mean that everything is diversifiable. It's all unique risk attached to those individual companies. 701 And in fact, the R-squared is directly associated with those regression coefficients. So a low R-squared doesn't mean to say the model has no value. It means that most of the risk attached to that security is diversifiable. 702 MS. NEWLAND: So you wouldn't agree if I were to suggest that the R-squared value for gas electrics of 0.264 -- 2.6 -- rather, sorry, for pipelines of 0.264, and for gas electrics of 0.209 suggest to me this model has little predictive power? 703 DR. BOOTH: No. I would say that that for these gas electrics, the portion of uncertainty in the return coming from the independent variables is less than for the other factors, so the more we will get if the firm -- if you had a stock like a gold and silver stock where they basically move to their own drum, they're almost totally unassociated with what happens in the capital market. We ran a regression on the rate of return on gas and utility stock against the market index or against interest rates, we discover the R-squared is almost zero because they basically, most of their risk is fully diversifiable, which means they're low risk stocks and that's what this is indicating here. 704 MS. NEWLAND: Thank you, sir. I'd like to move on to discuss the choice of arithmetic versus geometric market risk premiums, and I understand, Dr. Booth, you can calculate an arithmetic rate of return or a compounded rate of return. There is a distinction. There's one method and there's the other; correct? 705 DR. BOOTH: Well, there's a whole variety of ways -- 706 MS. NEWLAND: But for the purpose of our discussion, can you accept that we're talking about either geometric or arithmetic? 707 DR. BOOTH: Okay. 708 MS. NEWLAND: I also understand that the average geometric return is always less than the arithmetic returns except when all yearly returns are exactly equal? 709 DR. BOOTH: Absolutely correct. 710 MS. NEWLAND: Whew. 711 Could I get you to turn to tab 3 in my cross-examination book. 712 DR. BOOTH: I have it. 713 MS. NEWLAND: This is an excerpt from a textbook that is sponsored or published by the Association for Investment Management and Research, and it's entitled "Quantitative Methods for Investment Analysis." 714 Are you familiar with the Association for Investment Management and Research? 715 DR. BOOTH: Yeah, they're the people that sponsor the Chartered Financial Analyst designation. 716 MS. NEWLAND: That's my understanding, yes. Thanks. 717 Could I get you to turn to page 145, the underlined portion there, sir. And I will read it, it states: 718 "As we noted previously, the arithmetic mean will always be greater than or equal to the geometric mean. If we want to estimate the average return over a one period horizon, we should use the arithmetic mean because the arithmetic mean is the average of 1 period returns. If we want to estimate the average returns over more than one period, however, we should use the geometric means of return, because the geometric mean captures how the total returns are linked over time." 719 Do you disagree with this statement? 720 DR. BOOTH: No, we say very much the same in our appendix E. It's a standard result. 721 MS. NEWLAND: Okay. I just want to make sure we're on the same page on this issue, Dr. Booth, so could you please turn to tab 4 now in this booklet of cross-examination material. 722 Tab 4 is an excerpt from the best seller entitled "Triumph of the Optimists: 101 Years of Global Investment Returns," authored by Messrs. Dimson, Marsh and Staunton. And it's a book that you yourself referred in one of your footnotes somewhere in your evidence; is that correct, sir? 723 DR. BOOTH: That's correct. 724 MR. THOMPSON: Could I just interrupt for one second here, Ms. Newland. At transcript 1117, I made reference to an article by these folks that you had provided to us and I thought you were going to be putting to Dr. Booth in cross-examination. I didn't file it at that time, and this article in your cross-examination book is not the same one you provided to us, so at some point I'd like to file what I referred to on the assumption that you were going to file it. That was the Dimson, Marsh and Staunton article dated September 2002. 725 MS. NEWLAND: Mr. Thompson, we'll check, but I believe we did file two articles, one of which was the one you just referred to. 726 MR. THOMPSON: You gave it to us, but it is not yet filed on the record. 727 MS. NEWLAND: I thought it was filed in response to an undertaking, there were two articles clipped together. 728 MR. THOMPSON: That was Mehra and Prescott. 729 I'm sorry to interrupt you, but I just want to be able to file this at some point in time. 730 MS. NEWLAND: We'll check it, and certainly, Mr. Thompson, you're free to file it. 731 MR. THOMPSON: Thank you. 732 MS. NEWLAND: Where were we, Dr. Booth? 733 MR. THOMPSON: Tab 4. Triumph of the Optimists. 734 MS. NEWLAND: I don't know if I feel very optimistic right now. 735 Can you turn to page -- 736 MR. VLAHOS: That wasn't a tactic. 737 MS. NEWLAND: I did, as an aside, Mr. Chairman, advise Dr. Booth that I thought this afternoon would be far more painful for me than for him. 738 Dr. Booth, I would like to refer you to page 182. And just one line here, sir, which I have starred. I don't know if your copy is starred. They're talking about when you use the arithmetic mean and when you use the geometric mean and they state that: 739 "But which mean is the right one for discounting risky expected future capital flows? For forward-looking decisions the arithmetic mean is the appropriate measure." 740 And you agree with that? 741 DR. BOOTH: No. 742 MS. NEWLAND: You disagree with Mr. Dimson who authored the Triumph of the Optimists? 743 DR. BOOTH: I was an accountant, but I disagree with it, yes. 744 MS. NEWLAND: Would you agree that you're in the minority in that regard? 745 DR. BOOTH: No, I'm very much in the majority. And just to recap, I mean, this is a hoary old chestnut that comes up all the time, arithmetic versus geometric mean returns. The only difference between them is the investment horizon. If you earn a dollar and you get 100 percent rate of return, you go to $2. If you then lose 50 percent, you go back to a dollar. So if you calculate the arithmetic mean return, you've got plus 100 percent, you've got minus 50 percent, you've got plus 25 percent. So the arithmetic mean in that example would be 25 percent. 746 On the other hand, you started with a dollar and you ended with a dollar, and it's tough convincing people that they've made any money when they've got exactly what they started with. That's the compound rate of return which is zero. That's solely a question of investment horizon. 747 If you instead say, "Well, forget about a two-period problem, going from one to two back to a dollar, say it's a one-period problem, you invested a dollar, you got a dollar." The arithmetic mean in that case is zero, exactly the same as a geometric mean. So the sole difference between the arithmetic mean and the geometric mean is the investor's investment horizon, it's the time period over which you estimate the returns. 748 I would not look at a geometric mean based upon 100 years worth of data as being that useful, because there aren't many investors who invest for 100 years, most of us are long since dead before that happens. So looking forward, I wouldn't use a geometric mean based upon 100 years data if I was doing that. 749 Exactly the same, I wouldn't look upon an arithmetic mean over a one-month horizon because my investment horizons are a lot longer than one month. 750 So for me, the correct investment decision would be based upon some sort of investment horizon based upon, for me, 15 years, because that's what I'm looking for when I make investments, 15, 20, years. And that means, for me, my investment decisions, the correct mean is between the arithmetic and geometric mean. And in fact, I wrote a paper in the 1995 Canadian investment review that basically said, that's exactly what we should be doing. The arithmetic mean is not correct. The geometric mean is not correct. It's a weighted average of the two, and the weights depend upon the individual investor. 751 Exactly the same when we look at these historic time periods. What is a single period? I mean, this just says a single period. I don't know what the correct single period is, is it a month, is it six months, is it a year, is it five years? No one knows. 752 MS. NEWLAND: Dr. Booth, you're basically repeating your answer that you gave to us in Interrogatory No. 11; is that correct? 753 DR. BOOTH: Could be. 754 MR. VLAHOS: Could I ask, so that we can follow that, Dr. Booth, what is at stake here between the geometric and the arithmetic average in terms of the record before us? 755 DR. BOOTH: The difference between the compound -- if the rates of return follow a particular distribution, then the difference between the compound rate of return and the arithmetic return is exactly equal to half the variance in the rate of return. 756 So stock prices vary by about 16 percent on average. That's what we tend to use, because that means a variance of .04, so on average the difference is going to be about 2 percent, so the arithmetic return based upon annual holding periods is always about 2 percent more than the compound rate of return, which is why we constantly get into these discussions of what arithmetic versus compound rates of return, because there is a difference of, on average, about 2 percent between those two different estimates. 757 MR. VLAHOS: And again, to bring it home in terms of everything else being equal based on your analysis and recommendation, if you were to follow the different method, what would be the result? 758 DR. BOOTH: In my case or our case, nothing, because we don't base our estimates on the compound rate of return. Our estimates to the market risk premium is significantly in excess of the compound rate of return. 759 MR. VLAHOS: I'm saying what are we arguing -- so what's the issue, then, Ms. Newland, so we can follow it? 760 MS. NEWLAND: Perhaps I can explain, sir. 761 Doctor, if I can explain by asking you to turn to schedule 17 of Dr. Booth's evidence. And here you see a chart entitled, "Market Risk Premium Studies." 762 MR. VLAHOS: Just one second. 763 Go ahead. 764 MS. NEWLAND: And one of the criticisms -- let me back up. This table is provided, as I understand Dr. Booth's evidence, to show that his estimate of the market risk premium of 4.5 is within a zone of reasonableness when you compare it to the compilation of various risk premium estimates derived by all of these different academics and analysts for various periods of time. 765 So he's going to be -- in his evidence, he compares his 4.5, and he say it is compares favourably with all of these estimates of long-term market risk premiums, which, as you see at the bottom is they average out to a simple average of 4.13 percent. 766 And I intend to show, through this line of questioning, that in Dr. Booth had used the -- and I appreciate we're straying into argument here, but if Dr. Booth had used the arithmetic averages as opposed to the geometric averages in the Dimson data, which is shown at the first four lines of his table, the results would be far different than the 4.13 percent shown at the bottom of the table. 767 I hope that assists you, sir. 768 MR. VLAHOS: I think I understand -- 769 MS. NEWLAND: With your permission -- 770 MR. VLAHOS: -- where you're going with it. Would be different than the 4.13 or the 4.50 would be different? I'm not sure. 771 MS. NEWLAND: I don't know. I don't think it will change Dr. Booth's mind. That's his estimate, but the 4.13 would be far different if we used what, in my submission, would be the correct data, which would be the data that corresponds to an arithmetic mean, and perhaps to assist this discussion, what I can do at this point is to pass out a table that was filed by Dr. Booth in a proceeding before the AEUB in a hearing into the ATCO Gas South 2001/2002 generate application. 772 MR. THOMPSON: Why wasn't this produced before? 773 MS. NEWLAND: I just found it this morning. I had it faxed from Ms. McShane's office, and it's hardly surprising. I don't think Dr. Booth is going to be surprised, because it is his own exhibit in another proceeding. 774 MR. THOMPSON: it's a surprise to us. 775 MS. NEWLAND: it hardly lies in your mouth. 776 MR. THOMPSON: Process. Due process. 777 MR. VLAHOS: I don't see you three gentlemen assisting Ms. Newland here. 778 MR. WARREN: Anything we can do to help, sir. 779 MR. THOMPSON: I'm not delivering any more paper. 780 MS. NEWLAND: You make such a cute Vanna White. 781 Dr. Booth, are you familiar with this table? 782 DR. BOOTH: Yes, the Board staff at the Alberta board said, well, suppose you just looked at the arithmetic means, and what would happen to that table? And we answered some of it could not change because there are no arithmetic means because some of them are forward-looking estimates, but we will do our best to go back and estimate the table based upon arithmetic mean returns. And this the undertaking that was the response to that. 783 And in fact, as I mentioned, we filed testimony in a multihearing out in Alberta and, in fact, we've included that table as the main table in place of this schedule 17, because the Alberta board is interested in looking at these arithmetic mean returns. 784 MS. NEWLAND: Okay. I'm interested in the comment you just made. 785 MR. VLAHOS: Let's get a number, Ms. Newland. 786 MS. NEWLAND: Sorry, Mr. Chairman. 787 MR. MORAN: This will become Exhibit F.4.5, undertaking response from Drs. Booth and Berkowitz, transcript 1304 filed in a AEUB case, ATCO Gas South 2001/2002 general rates application. 788 EXHIBIT F.4.5: UNDERTAKING RESPONSE FROM DRS. BOOTH AND BERKOWITZ, TRANSCRIPT 1304 FILED IN A AEUB CASE, ATCO GAS SOUTH 2001/2002 GENERAL RATES APPLICATION 789 MR. SOMMERVILLE: So I understand, this was filed as a result of the undertaking to change the table that you had originally filed in that case? 790 DR. BOOTH: What happened was the Board Staff went exactly through this discussion on arithmetic and compound rates of return, and I can't remember the exact wording, but they asked us to see whether we could go back and look at all these studies and see if there was an arithmetic mean estimate so that it would all be put on an arithmetic mean return basis, and we agreed to do that. 791 We filed this in response to that, and we changed this table in subsequent testimony that we filed before the Alberta board, because they were interested in this information. 792 MS. NEWLAND: The first thing I'd like to ask you, Dr. Booth, regarding this new Exhibit F.4.5, just a little while ago I thought I heard you say that you estimated the arithmetic market risk premium in the first two lines. Is that what I heard you say? The 6 percent and the 7 percent, which appears from 1900 to 2000 in Canada and 1900 to 2000 in the U.S., did you say those were your estimates? 793 DR. BOOTH: no, no, they're not our estimate. I have to admit Professor Berkowitz created this table, but I think he went back to those sources ask dug out the arithmetic mean estimate the where it was possible to do so. 794 MS. NEWLAND: That's correct. That's my understanding, sir, because if you turn to the "Triumph of the Optimist" article which is included in my book of cross-examination materials, I don't know that you need to do it, but you will find those numbers provided in the pages there. 795 Okay. I just want to quickly go through and make sure I understand the changes you made. With respect to the Dimson estimate you substituted the arithmetic average market risk premiums for the geometric premiums for both Canada and the U.S. for the periods 1900 to 2000; correct? 796 DR. BOOTH: That's correct. 797 MS. NEWLAND: Then you removed the geometric risk premium estimates, both Canadian and U.S. for the periods 1950 to 2000, because, as I understand it, you didn't have -- the data wasn't available -- 798 DR. BOOTH: We removed the geometric mean returns because the Alberta board asked us to do that. Board staff asked us to do that. 799 MS. NEWLAND: My question is really why didn't you provide an arithmetic average -- or arithmetic market risk premium estimate for the periods 1950 to 2000 for both Canada and the U.S.? If you compare it -- and what I'm thinking, Dr. Booth is those lines were included in the table 17 of your evidence in this proceeding? 800 DR. BOOTH: I'd have to go back and look at what the undertaking was, to be honest. I have no idea. I'd have to go back and look and see what the transcript asked us to do. 801 MS. NEWLAND: Okay. 802 And lastly, you substituted the arithmetic average risk premium for the geometric one that you had in included in your original table for the Ibbotson and Chen estimate; correct? 803 DR. BOOTH: That's correct. We dropped out the 3.97, the bottom of the range. 804 MS. NEWLAND: When you made all of these though changes, the simple average creased from 4.13 to 4.34; correct? 805 DR. BOOTH: That's correct. 806 MS. NEWLAND: Dr. Booth, given that the AEUB asked you to file this amended table to show arithmetic averages rather than geometric averages -- 807 MR. WARREN: sorry, his evidence was that the Board didn't ask him to do it, the Board Staff asked for this undertaking. That was his evidence. 808 DR. BOOTH: That's correct. 809 MS. NEWLAND: I'm sorry. I stand corrected, Mr. Warren, Board Staff. 810 Did you give some thought to providing this information to this Board in this proceeding, Dr. Booth? 811 DR. BOOTH: No. 812 MR. THOMPSON: Well, he wasn't asked. Why didn't you ask him, We would have had it for you, if you knew about it. It only increases it from 4.13 to 4.34 and they're recommending 4.50. I mean ... 813 DR. BOOTH: The -- I can't remember the timing involved in this, but the -- I'm sure Ms. McShane will remind us exactly when the undertaking was relative to when we filed our testimony. My recollection is that this was after we filed that testimony, so we would have had to sort of submit this as an addendum or correction, and it isn't an addendum or correction, it's information the Board Staff asked for. 814 MS. NEWLAND: I appreciate that, thank you. 815 MR. THOMPSON: Is there any materiality to this one? 816 Lawrence, is this something you did? 817 DR. BOOTH: No. 818 MR. VLAHOS: Ms. Newland, would you like a break now for about ten minutes or so? 819 MS. NEWLAND: Certainly, this would be an appropriate time to break. 820 MR. THOMPSON: Well, just before we do break, this is nothing Dr. Booth did, this is something somebody else did; right? 821 MS. NEWLAND: That's true, Mr. Thompson -- 822 MR. THOMPSON: Well, why are we getting this at the 11th hour? 823 MR. VLAHOS: Let Ms. Newland explain, Mr. Thompson. 824 MS. NEWLAND: Thank you, sir. 825 I did give this to Dr. Booth. He has had a chance to look at it. I've discussed it with his other counsel, Mr. Janigan. So perhaps you could talk to Mr. Janigan, Mr. Thompson. 826 Dr. Booth will speak as to this, but I -- and I don't want to put words into his mouth, but I understand that he has not got a great deal of difficulty with this. 827 MR. THOMPSON: I withdraw my comments. I wasn't aware you had given it to him. My apologies. 828 MS. NEWLAND: Accepted. 829 MR. MORAN: Exhibit number, Mr. Chair? 830 MR. VLAHOS: Yes. 831 MR. MORAN: This will become Exhibit F.4.6, table entitled "Derivation of Arithmetic Market Risk Premium, U.S. and Canada, 1950 to 2000." 832 EXHIBIT NO. F.4.6: TABLE ENTITLED "DERIVATION OF ARITHMETIC MARKET RISK PREMIUM, U.S. AND CANADA, 1950 TO 2000" 833 MR. VLAHOS: Thank you, Mr. Moran. Let's take a 15-minute break. We will return at 20 to the hour. 834 --- Recess taken at 4:23 p.m. 835 --- On resuming at 4:41 p.m. 836 MR. VLAHOS: Please be seated. 837 I just want to take stock of where we are. Can you advise us how long you expect to be, so we can be guided by whether or not we're going to ask Dr. Booth to stay on or bring him tomorrow morning. 838 MS. NEWLAND: I expect to be another hour -- at least another hour, sir, perhaps a little longer. 839 MR. VLAHOS: In that event, there's not much point in staying beyond 5:30 if you're not going to finish in an hour. If it's an hour, we can probably try to squeeze it in. 840 MS. NEWLAND: Given the length of Dr. Booth's answers to me before the break, I would expect that I can't promise to be an hour. Might be longer. 841 MR. VLAHOS: We'll see where we are at 5:30, and if you are not finished, if you have a substantial number of questions, then we may want to break for the day. 842 MR. VLAHOS: Dr. Booth, is that okay with you? 843 DR. BOOTH: Sure. The driving away from here is better after 6 o'clock than it is at 5:30. 844 MR. VLAHOS: Okay. Let's continue, then. 845 MS. NEWLAND: Dr. Booth, would you agree that determining the fair return for a regulated utility is an exercise in forward-looking decision-making for a one-year period? 846 DR. BOOTH: I think that's the best approximation, so I'm willing to accept that. It could be a different horizon. 847 MS. NEWLAND: Thank you. 848 Before the break, Dr. Booth, I had handed you to table, which got the exhibit number F.4.6, the Derivation of Arithmetic Market Risk Premiums, U.S. and Canada 1950 to 2000. 849 The purpose of handing this table out and putting it on the record, Dr. Booth, is to show the effect on the simple average of 4.34 that we were discussing in Exhibit F.4.5. If you were to include the arithmetic average data for the two periods, 1950 to 2000 both for Canada and the United States, have you had a chance to look at this table? 850 DR. BOOTH: I have. 851 MS. NEWLAND: We see that the arithmetic average for 1950 to 2000 in Canada is -- has been derived by Enbridge as 6.08 percent. Could you accept that number subject to check? 852 DR. BOOTH: That looks in the ballpark, yes. 853 MS. NEWLAND: Okay, and in the U.S. for the same period -- 854 DR. BOOTH: Yes. 855 MS. NEWLAND: -- that estimate is 8.6, and you accept that subject to check? 856 DR. BOOTH: The U.S. estimates look a little bit high, but the -- 857 MS. NEWLAND: If you have a problem with it, maybe -- please continue. I cut you off. 858 DR. BOOTH: Did they estimate them, or did they go and get these from Dimson -- 859 MS. NEWLAND: My understanding, sir, is that these data are not available in the Dimson textbook, so they were derived, and the method of derivation is explained at the bottom of page 1 and on to page 2 of this exhibit. 860 DR. BOOTH: Okay. The only qualification that I have is that these are estimates based upon the formula that's on the second page. 861 MS. NEWLAND: That's exactly right, sir. 862 DR. BOOTH: And the reason why -- if you look at the spreads, for example, between Canada, the compound and the arithmetic return, they're about 150 basis points. 863 MS. NEWLAND: Yes. 864 DR. BOOTH: The U.S., they're 5 to 7 percent, 6.6 to 8.6 percent. 200 basis points. 865 MS. NEWLAND: Yes. 866 DR. BOOTH: So the implication there is that the U.S. capital market asset is riskier than the Canadian capital market because the spread is wider, which means that the volatility is wider. So I think as long as you get on the record that whoever made these calculations is assuming that the U.S. capital market is riskier than Canadian capital market, then that's what these results would flow, and I think that's generally accepted that the Canadian capital market is not as risky as the U.S. capital market, which is why our market risk premiums are lower than in the U.S. 867 MS. NEWLAND: With that qualification you accept the number 8.6 percent as the arithmetic estimate of the risk premium for 1950 to 2000 in the U.S.? 868 DR. BOOTH: Given the fact that they seem to be assuming more risk in the U.S., then those are the results that would follow from that assumption, correct. 869 MS. NEWLAND: Okay. And the simple average of the risk premium -- 870 MR. THOMPSON: Could I just interject here, because I have so some problem with this in the context of transcript 1117 to 1121. 871 MS. NEWLAND: What volume, Mr. Chairman? 872 MR. THOMPSON: Volume 1. This was where I was cross-examining Ms. McShane -- 873 MS. NEWLAND: Mr. Chairman, could you ask Mr. Thompson to slow down. 874 What is the reference, please? 875 MR. THOMPSON: Transcript 1117 to 1121. This was where I was cross-examining Ms. McShane with respect to a Dimson, Marsh and Staunton article that you had provided to me on Friday, September the 19th, indicating that you were going to be using it, and I quoted a passage at 1121 from that article, which is dated September 2002, which seems to update some of these numbers - and I may not have this right - for Canada and the U.S. So I think we should get clarified what the numbers are in your table in the context of these Dimson and Staunton numbers in this document that -- I said I didn't think we needed to file it because you'd indicated you were going to use it in your cross-examination of Dr. Booth. 876 MR. JANIGAN: Just to follow up on Mr. Thompson's point, it would appear they give, in that article, prospective market risk premiums which appear to be missing from your bottom table in any event. 877 MS. NEWLAND: That may be so, Mr. Janigan. 878 Mr. Chairman, what this table does is just to fill in what I would call the missing data from table 17 of Dr. Booth's own evidence, so the context that Mr. Thompson is asking me for is schedule 17 of Dr. Booth's evidence. That's where that data originally appeared. 879 And in that table, Dr. Booth provided geometric averages, and the whole point of this exercise is to show what his results would be if we substituted arithmetic averages. 880 And as we discussed before the break, there were two arithmetic averages available in the Dimson book, "The Triumph of the Optimist," which is the book that is referenced by Dr. Booth in that table in the footnote. 881 So if there is other data that Mr. Thompson should have or would have like to have been brought to the attention of Dr. Booth, that's not what's under discussion here. It's the table that is in Dr. Booth's own evidence. It's as simple as that. 882 MR. VLAHOS: Dr. Booth, could you -- are you prepared to respond to this? 883 DR. BOOTH: I -- I have no problem with the question. I do object to the word "missing," because as was explained, these estimates are not in the Dimson et al. book. They're late interpolated. They're estimates. 884 So it's as if we missed them out, these are things that had to be estimated, and based upon the variance of standard deviation assumptions, somebody estimated them. Dimson and Marsh didn't estimate them. 885 MS. NEWLAND: That's correct, sir. 886 DR. BOOTH: We haven't missed anything. 887 MS. NEWLAND: I'm sorry if that's the implication. You're correct. The data, and I think I stated that earlier, Dr. Booth, was not included in the book, "Triumph of the Optimist," so we derived this estimate, and that's why this exhibit is entitled "Derivation of Arithmetic Market Risk Premium." 888 DR. BOOTH: I'll accept that. 889 MS. NEWLAND: All right. And nevertheless, when we get down to the bottom line here, we see how these arithmetic means change the calculation in your schedule 17 and we see that the adjusted arithmetic average is now instead of 4.13, it's 4.94. Do you accept that calculation? 890 DR. BOOTH: I'd accept that if you knock out the compound rates of return estimates, and you estimate arithmetic terms, then the estimates go up. I have no question with that. 891 MS. NEWLAND: And if you were to exclude the Arnott and Bernstein estimate, which is based on old data from 1802 to 2001, would you accept that the math is -- that the estimate goes up from 4.94 to 5.22 percent? 892 DR. BOOTH: Well, all the data is old data. I mean they're all historic, so it's all old. 893 MS. NEWLAND: Could you answer my question, sir? 894 DR. BOOTH: I will accept that if you knock out certain estimates that are low, then the resulting average is higher, that's correct. That's just a question of arithmetic. 895 MS. NEWLAND: Thank you, sir. 896 MR. THOMPSON: Excuse me, could I just get this article marked now, that was put to Ms. McShane in cross? 897 MR. MORAN: Mr. Chair, that becomes Exhibit F.4.7, article entitled, "Global Evidence on the Equity Risk Premium" by Dimson Marsh and Staunton dated September 2002. 898 MR. THOMPSON: Thank you very much. 899 EXHIBIT NO. F.4.7: ARTICLE ENTITLED, "GLOBAL EVIDENCE ON THE EQUITY RISK PREMIUM" BY DIMSON MARSH AND STAUNTON DATED SEPTEMBER 2002 900 MS. NEWLAND: We're going to move to another issue that arises in respect of your evidence on market risk premium, Dr. Booth, and that is your discussion about the dividend tax credit and the effect of that on the market risk premium estimate. 901 DR. BOOTH: I missed that, my what, sorry? 902 MS. NEWLAND: The effect of the dividend tax credit in Canada on your estimate of the market risk premium or estimates, in general, on market risk premium. That's the topic we're going to move on to. 903 DR. BOOTH: Just my -- something or other. I missed that. That was all. 904 MS. NEWLAND: Dr. Booth, the best way to focus this discussion would be for you to turn up Exhibit B of your evidence, which is -- I was going to say your critique, but I understand it's Dr. Berkowitz's critique of Ms. McShane's evidence; correct? 905 DR. BOOTH: Correct. 906 MS. NEWLAND: If it were you, you would have agreed with everything Ms. McShane said. 907 DR. BOOTH: I very much doubt that. We discussed all of these issues. There's nothing in here which I disagree with. 908 MS. NEWLAND: Okay. 909 MR. SOMMERVILLE: Ms. Newland, can I take us back just a touch to the previous document, just so that I'm clear before we move on to something else. 910 MS. NEWLAND: Yes, sir. 911 MR. SOMMERVILLE: I'm looking at F.4.6, and I just want to understand what this is designed to indicate, and I'm sort of comparing it to schedule 17 of Drs. Booth and Berkowitz's evidence. This is designed, I take it, to show market risk premium studies and the results of those studies as they have tried to assess market risk premiums for different periods in the United States and Canada; is that correct? 912 MS. NEWLAND: That's correct, sir. Just to step back a little bit, this table was originally produced in Dr. Booth's evidence, and it was included, I believe, to support his statement that his market risk premium estimate of 4.5 was reasonable, having regard to these other estimates that -- that you see in this table. 913 What you really need to have in front of you, Mr. Sommerville, is the three tables, the one in schedule 17, the one that was produced by Dr. Booth in response to an undertaking given to Board Staff in Alberta, and then the table that I have handed out, Exhibit F.4.6. 914 And really the only difference among those three tables is that Exhibit F.4.6 includes more arithmetic mean data? 915 MR. SOMMERVILLE: What you're suggesting in all of this is that Dr. Booth's methodology is eccentric. It doesn't jibe with everybody else; is that what you're suggesting? 916 MS. NEWLAND: I don't think that's what I'm suggesting, sir. I think what I'm suggesting is that if Dr. Booth had calculated his, if he had -- if he had presented table 17 using arithmetic data as opposed to geometric means data, the number that we would be discussing wouldn't be 4.13 compared to his 4.5. It will be 4.94 compared to his 4.5. 917 MR. SOMMERVILLE: I understand that. But he's suggested that his methodology is different, that it includes a geometric calculation, and you're suggesting that it should all be arithmetic; is that correct? 918 MS. NEWLAND: That's correct, sir. 919 MR. SOMMERVILLE: Okay. Just so I understand what it is we're pursuing here. Thank you. 920 MS. NEWLAND: Back to dividend tax credits and I had referred you, Dr. Booth, to Exhibit D.2, appendix B. And as I understand, one of your criticisms of Ms. McShane's market risk premium estimate is how much influence the U.S. market should have in the determination of Canadian market risk premiums. 921 DR. BOOTH: That's correct. I mean it's not a question of determination. I mean the realized returns are what the realized returns are. It's a question of do we throw out the Canadian data and rely upon the U.S. data? 922 MS. NEWLAND: And one reason why you are dubious about Ms. McShane's reliance on U.S. data to estimate the market risk premium, as I understand it, is explained on page 17 at line 5. 923 And this explanation has to do with the fact that in Canada, we have a dividend tax credit, and in the States, there is no such credit. 924 DR. BOOTH: That's correct. 925 MS. NEWLAND: And your concern is that the result of this different tax treatment is that the required return on U.S. equity instruments is bid up to compensate for the extra tax burden that American investors have relative to Canadian equities securities? 926 DR. BOOTH: no, my concern is that America is a foreign country. I need a passport to go into there, and there's no reason to believe that the evidence from that foreign country is exactly the same as what we would expect in Canada. I mean we have a different institutional environment. It's not just taxes, it's a whole bunch of things. 927 MS. NEWLAND: Could we look at this package. Perhaps, then, we're just going to have to read it. You say: 928 "In Canada, equity income is given very favourable tax treatment in the hands of ordinary investors to compensate for the corporate income tax; hence, the double taxation of equity income at both the corporate and individual level is mitigated by giving individuals a dividend tax credit. The U.S., by contrast, continues to tax all investment income, whether interest or dividends at the same rate. The result is that the required return on U.S. equity instruments is bid up to compensate for their extra tax burden relative to Canadian equity securities." 929 That's what this passage says, correct, Dr. Booth? 930 DR. BOOTH: That's correct. 931 MS. NEWLAND: Could I get you to turn up tab 6 of my book of examination materials. 932 This is a paper entitled "The Taxation of Personal Investment Income, A Recipe for Reform," and it appears to be comments on a paper prepared by Poddar and English. The comments are by Mr. Ian Russell, and they were made at a tax policy conference of the Canadian Tax Foundation in April 1999; do you see that Dr. Booth? 933 DR. BOOTH: I see that. 934 MS. NEWLAND: Could you turn to page 1. 935 Mr. Russell, the author of this commentary, describes the Poddar and English paper as a "first rate comprehension discussion of the tax system for investment income in Canada." 936 Are you familiar with the paper? 937 DR. BOOTH: I wasn't until you sent it to me. I've read it now and I'm reasonably familiar with it. 938 MS. NEWLAND: All right. Further down the page, Mr. Russell makes the following statement: 939 "The Poddar-English papers concludes that three-quarters of personal investment income in Canada is tax free." 940 Do you disagree with that statement? 941 DR. BOOTH: Yes. 942 MS. NEWLAND: Why? 943 DR. BOOTH: Well, if we go to the paper, and you've got to remember, this is a public finance paper -- 944 MS. NEWLAND: Can I stop you, when you say "paper," are you referring to the article under tab 6 of my materials? 945 DR. BOOTH: That's correct. And different disciplines have a different philosophy about the way in which they approach problems. 946 And this paper is concerned with what we call tax expenditures. We don't call them. That's what the public finance people call them, tax expenditures. 947 And a tax expenditure is any of our money that the government let's us keep, so if the tax rate is 50 percent, they treat the 50 percent of our money that the government let's us keep as a tax expenditure, and the focus of this paper is on tax expenditure, where they have provided subsidies to let us keep our own money. 948 Now, personally, I totally agree with that philosophy, but that is the way public finance people approach these questions. 949 Now, why that's important, if we go Satya Poddar and Morley English's paper, if you look at table 6, this is where they get all their estimates from. And -- 950 MR. MORAN: That's at tab 7, Mr. Chair. 951 DR. BOOTH: That's right. Tab 7, table 6. This is the way -- 952 MS. NEWLAND: I'm sorry, Dr. Booth. I'm not following your references. Could you refer me to where? 953 DR. BOOTH: Sorry, table 6 of this Poddar and English paper. 954 MR. WARREN: Tab 7 of your book. 955 MS. NEWLAND: So we're turning to a different tab in the book now, Dr. Booth? Okay. 956 Tab 6 is the discussion of the Poddar and English -- 957 DR. BOOTH: I'm talking about the actual Poddar and English paper in the next tab that you sent me. 958 MS. NEWLAND: I'm with you now. 959 DR. BOOTH: If you look at table 6, where they came up with a number of 25 percent. 960 MS. NEWLAND: Yes. Thank you. 961 DR. BOOTH: And I think everybody will be amused at the way public financial people look and get these numbers, because it's not the way most of us think. 962 For example, what they define as investment income in that table 6, they come up with $24.98 billion, and the number that jumps out at you is the $7.5 billion in imputed rent on owner-occupied residences. 963 Now, in layman's term, Poddar and English are assuming that if you own your own house, that you are generating investment income by owning your own house, and if you're not paying rent, because you own your own house, they're imputing rent. 964 And in fact, when we had a fair tax commission in Ontario about ten years ago with the provincial government, they thought about taxing imputed rent, which means if you own your own house, they would come along and say, "Well, you're not paying rent, therefore you're actually earning $10-, 15,000 more than somebody who's renting, and we're going to tax you on that imputed rent." 965 So why I have objections to that is, that is not most people's definition of investment income, and I certainly don't want the government coming along and saying, "You own your own house, we're going to impute income to you and then we're going to tax you on that imputed rental income." 966 And believe me, that's the way a lot of these public finance people think. 967 So when you look at this table, there's a lot of things here in the literature we call tax expenditures. I mean, they literally want to impute rent on our own houses and then tax us on that. They're estimating people defrauding the government by keeping money offshore. That's an estimate. They're saying $2.1 billion worth of money is being hidden offshore by Canadians. They're saying, "Well, we've given you a lifetime capital gains exemption for small business. That's a tax exemption, you should have payed tax on that." So they're going along and saying, "We should tax people when they use up those capital gains exceptions." 968 And then the big one is registered retirement savings plans and RPPs, the corporate equivalent of that. They're saying $13 billion of money is not being taxed there, and that's because they're all in our retirement incomes. 969 Now, the big problem with that is it's okay to say there's $13 billion hidden away in our retirement plans that's not being taxed, but they don't include all of the money that is coming out of those plans, and whenever you collapse an RSP or an RPP get's collapsed into a RIF, that's included as income, but it's included as ordinary income. 970 So what they're doing is they're ignoring all of the investment income that comes out of ordinary income from a retirement plan, and yet they're including as a tax expenditure the fact that they're not taxing us on our money in our register retired savings plan. 971 And this is a big philosophical divide in the public finance literature. I would not accept an estimate that one quarter of investment income escapes taxation when a big chunk of that is the fact that they're not taxing me on some imputed rent on my own house, or they're not taxing me on some imputed income on my car, or that they're not taxing me on my RSP income while they're ignoring people who are collapsing their RRSPs into other forms of income. 972 So I dispute this. These are fictitious numbers developed according to a philosophy of tax expenditures that has gotten this country into a mess over the last 30 years in terms of the tax burden. 973 So do I accept these numbers? No, I don't. They're fictitious numbers. 25 percent of investment income in Canada is not escaping taxation. To get those numbers, we all have to accept the fact that the government should be taxing us on the imputed rent on the houses we own. So I object to this. 974 MS. NEWLAND: Thank you, sir. 975 I'd like to move on. Turn up page 36 of your evidence, Exhibit D, tab 2. 976 What I'd like to discuss, Mr. Chairman, is Dr. Booth's evidence regarding what is termed the equity risk premium puzzle. 977 As I understand it, Dr. Booth, this so-called puzzle is based on a proposition described by Seigel and quoted in your evidence that "historic U.S. equity returns were too high, relative to the return on risk-free asset, to be explained by standard economic theory models of risk and return, without involving unreasonably high levels of risk aversion." 978 Is that correct? 979 DR. BOOTH: That's correct. 980 MS. NEWLAND: And the puzzle was first posed by Mehra and Prescott in an article in 1985? 981 DR. BOOTH: That's correct. 982 MS. NEWLAND: And you go on to say that one approach to explain the puzzle is to look at very time specific returns of the market generally and in comparison to real bond returns; correct? 983 DR. BOOTH: That's correct. 984 MS. NEWLAND: And Seigel postulated that the root of the puzzle was not the fact that equity returns were too large, but rather that bond returns were too low; correct? 985 DR. BOOTH: That's correct. That's the same explanation I gave in 1995. 986 MS. NEWLAND: And it was the introduction in the United States in 1997 of inflation index bonds that led to the development of this theory as a proposition; correct? 987 DR. BOOTH: That's correct. They looked at the realized returns on bonds, which were very, very low, and the risk premiums, you look at the realized returns on equities and subtract other realized returns on bonds will be very high if the realized return on the bonds is very low. And Seigel looks at the TIPS and said, "Now we've got an objective measure of what investors want as a real rate of return and it's much higher than the realized return on bonds. 988 MS. NEWLAND: And that is where I'd like to get to and understand this, sir. So to do that, can we look at table at the bottom of page 36 and we see the actual achieved real returns in U.S. bonds for various periods of time this. 989 DR. BOOTH: That's correct. 990 MS. NEWLAND: I'd like to focus on two periods. First of all, the period from 1802 to 1998, we see the real return is 3.5 percent, and then the period within that overall period 1926 to 1998, we see it at 2.2 percent; is that correct? 991 DR. BOOTH: That's correct. 992 MS. NEWLAND: If you take the TIPS yield, and again, TIPS, just so that the record is clear, Dr. Booth, is what? 993 DR. BOOTH: Treasury index security. 994 MS. NEWLAND: These are the indexed inflation bonds that were introduced in the United States in 1997; correct? 995 DR. BOOTH: That's right. We got them in '91. 996 MS. NEWLAND: Okay. If you take the TIPS yield when those bonds were issued in 1997, and you subtract this yield from 1992 to 1998 actual real return of 2 percent, you get 1.8 percent. That's the math; right? 997 DR. BOOTH: Hold on. Say that again. Oh, you're referring to line 18? 998 MS. NEWLAND: I beg your pardon? 999 DR. BOOTH: Are you referring to what I say in page 37, the middle paragraph, talking about realized returns are 1.8 percent less than what was expected? 1000 MS. NEWLAND: That's correct. 1001 DR. BOOTH: Correct. 1002 MS. NEWLAND: Ask Siegel says that: 1003 "But for this 1.8 percent upward bias, the U.S. market risk premium should have been 4.9 percent." 1004 And he gets that by subtracts the 1.8 percent upward bias from the 6.7 percent risk premium for the 1926 to 1998 period; correct? 1005 DR. BOOTH: That's correct. 1006 MS. NEWLAND: Okay. Could you turn up tab 5 of my cross-examination book, sir. What I'd like to do is see how this calculation, this upward bias of 1.8 percent changes things, if you take a more recent estimate off an inflation index bond. So the inflation index bond that was used to derive the 1.8 percent upward bias was the 1997 value. I'd like to look at what happens if you take a 2003 value. 1007 DR. BOOTH: You're using a point estimate? 1008 MS. NEWLAND: I beg your pardon? 1009 DR. BOOTH: Sorry, you're using an actual current estimate? 1010 MS. NEWLAND: I am. I intend to take you to an example using a current estimate. And we see current estimates in this excerpt from Barron's Market Week, which I understand is a weekly financial publication. 1011 DR. BOOTH: Yes. 1012 MS. NEWLAND: And if you have very good eyes, and you look under the heading Inflation Index Treasury Securities, you will see that the current yield for U.S. inflation index securities is about 2.7 percent; would you accept that? 1013 DR. BOOTH: Yeah. 1014 MS. NEWLAND: Okay. And so if we take this number and subtract it from the 1926 to 1998 actual real return of 2.2 percent, you get 0.5 percent. So instead of 1.8 -- will you accept my math, first? 1015 DR. BOOTH: Your arithmetic, yeah. 1016 MS. NEWLAND: Yes, thank you. And if we subtract 0.5 from the 6.7, which is the historic U.S. risk premium for 1926 to 1998, you get 6.2 percent; correct? 1017 DR. BOOTH: I will accept the arithmetic. 1018 MS. NEWLAND: So if you accept Siegel's theory based on -- if you accept Siegel's theory and you use current indexed bond yields, the upward bias inherent in the historic data is not 1.8 percent, but now we see it's only 0.5 percent? 1019 DR. BOOTH: Yes, but we wouldn't do that. 1020 MS. NEWLAND: Why not? 1021 DR. BOOTH: Because look at the interest rates. The T-bill yield in the U.S., if you look at the table on the left-hand side, U.S. treasury bills, the T-bill yield at the moment is 0.9 percent. The federal reserve in the U.S. has been pumping enormous amounts of money into the system, which is lowering interest rates, to try and get the U.S. economy running. So, we've got extremely low levels of yields in the United States, not just the real return bonds down at 2.6, but U.S. T-bills down at 0.9 percent. In fact, there's been an ongoing discussion in the United States about how much power is left in monetary policy. How can they push interest rates down much lower than 0.9 percent? And in fact, the discussion has been whether the U.S. is getting into the same deflationary track as in Japan, where they've had interest rates at basically zero, and negative rates on longer-term bonds. 1022 The United States, at the moment, is in an anomalous position. The real return bonds in Canada have been yielding 4 to 4.5 percent, and that's what normally looks at the real rate of return -- 1023 MS. NEWLAND: Dr. Booth, let me stop you. Could we look at the right-hand corner. And we see the long-term bond rates, and they're about 5.71. That's not that low. 1024 DR. BOOTH: Well, it's all a question of historical perspective. Lots of people would look at that and say they are pretty low. If you were retiring and collapsing a RRIF on that, I'd say that that's pretty poor which is why we've had a huge rush into income trusts and things. 1025 MS. NEWLAND: Relative to Canadian long-term bonds? 1026 DR. BOOTH: Relative to Canadian bonds, that doesn't look very attractive, because they're only marginally -- well, in fact, they're marginally above Canadian bonds, and U.S. treasuries are significantly below Canadian bonds. 1027 But all I'm saying here is what you're trying to do is look at the history from 1802 to the current period, and you're trying to inject an interest rate, a spot interest rate, as of a particular point in time and say, Well if we take that depressed interest rate, and we all know the U.S. economy's been subject to enormous monetary infusion over the last 18 months, then you get a different estimate. So I will accept that estimate, but I don't think it's very meaningful. 1028 MS. NEWLAND: Isn't that what you did when you took the 1997 TIPS yield. To understand Siegel's proposition, you have to pick a point in time. You chose 1997. I chose 2003. I like my result better than your result, and it's more current, Dr. Booth. 1029 DR. BOOTH: If we go to my interrogatory response, I think it was number 15 -- 1030 MS. NEWLAND: You'll have to wait for me to turn it up. Sorry, Dr. Booth. 1031 Just to confirm, this is your response to an Enbridge request? 1032 DR. BOOTH: Yeah, question number 15 it asks: 1033 "What has been the average yield on TIPS since they were first introduced?" 1034 MR. THOMPSON: Have you got it? 1035 MS. NEWLAND: No. Thanks. Yes, sir, I have it, thank you. 1036 DR. BOOTH: And the answer -- I mean, we're asking about what is a real and reasonable interest rate. And you're saying your estimate of 2.2 for the U.S. given the U.S. problems is reasonable. 1037 MS. NEWLAND: well, I didn't say that, Dr. Booth. I said it was current. 1038 DR. BOOTH: Okay. In this answer, we couldn't provide the TIPS, but we did provide, straight off the Bank of Canada's web site, and anybody can go there and click on it and download it, the real yield on Canadian real return bonds since they were introduced, and you can have a quick look at that, but there's no estimate of 2.2 percent. The real return bond in Canada has been about 4.5 percent throughout the '90s, and has been drifting down over the last three to four years, and it's currently around about 3 percent. 1039 So I think if you're thinking in terms of what is a good estimate of the return on bonds, what investors expect over this long period of time, if you're going to look at a real return bond, I think the Canadian data that say it's between 3 and 4.5 percent is a lot more reasonable than looking at one single spot yield for the U.S. given the current monetary conditions in the U.S. 1040 MS. NEWLAND: Dr. Booth, could you turn up tab -- the last tab in the cross-examination book, which is tab 9. This is an excerpt from the National Energy Board reasons for decision on TransCanada's cost of capital hearing, which was RH-4-2001. 1041 DR. BOOTH: Yes. 1042 MS. NEWLAND: And you and your colleague Dr. Berkowitz testified before the NEB in this proceeding? 1043 DR. BOOTH: We did. 1044 MS. NEWLAND: On whose behalf? 1045 DR. BOOTH: The Canadian Association of Petroleum Producers, the umbrella group for all of the big oil and gas producers in Alberta. 1046 MS. NEWLAND: Yes. And if you turn to page 53 of the Reasons for Decision, we see the Board's decision on the equity risk premium issue? 1047 DR. BOOTH: I do. 1048 MS. NEWLAND: Perhaps before we go there, could you just tell me what your recommended estimate of a reasonable market risk equity premium was in that proceeding? 1049 DR. BOOTH: I think it was 4.5 percent. 1050 MS. NEWLAND: So the same as you're recommending to this Board today? 1051 DR. BOOTH: That's correct. 1052 MS. NEWLAND: Now we can turn to page 53. We see what the Board is saying at the bottom of page 53: "At the time of the RH-2-94 decision --" which was the earlier of the generic cost of capital hearings? 1053 DR. BOOTH: That's correct. 1054 MS. NEWLAND: "-- the Board expressed the view that the ERP, equity risk premium, for the market as a whole was 450 to 500 basis points and that a reasonable all-inclusive ERP for the benchmark pipeline was 300 basis points. Several factors such as a decline in interest rates and reduced areas to international investments suggests that the current level of ERP would be higher than it was in 1995. Specifically, the Board is of the view --" carrying over to the next page "-- that the ERP for the market as a whole currently is 550 to 600 basis points and that there has been a commensurate increase in the main lines ERP." 1055 That's what the Board said; correct? 1056 DR. BOOTH: Correct. 1057 MS. NEWLAND: Could I get you to turn to page 55. Here at the bottom under the heading "Drs. Booth, Berkowitz, and Chua." 1058 DR. BOOTH: Chua. 1059 MS. NEWLAND: I gather Dr. Chua appeared with you at that proceeding? 1060 DR. BOOTH: No, I'm trying to remember who he appeared for. 1061 MR. THOMPSON: Mirant. 1062 MS. NEWLAND: Mirant, all right. In any event, the Board is presenting its views of your evidence on behalf of CAPP. And the Board says: 1063 "The Board considering that the MRP for the market as a whole proposed by Drs. Booth and Berkowitz falls outside a range that would be considered reasonable at this time." 1064 And if we continue and they then set out their reasons Dr. Booth, and then over the page, on page 56, just before the heading "Conclusion," they say: 1065 "The Board considers that the multifactual cost of equity model and the instrumental model for estimating data that were advanced by Drs. Booth and Berkowitz have not been tested over a sufficiently long period to be confidently relied upon in a regulatory context at present." 1066 So they rejected your estimate, Dr. Booth, and they expressed serious concerns about your estimation techniques; isn't that the case? 1067 DR. BOOTH: They said it hadn't been tested long enough, that's correct. 1068 MS. NEWLAND: They rejected your estimate? 1069 DR. BOOTH: Rejected the estimate of the market risk premium, correct. 1070 MS. NEWLAND: And they said it did not fall within a range of reasonableness? 1071 DR. BOOTH: Well, that was their judgment, yes. 1072 MS. NEWLAND: Thank you. I would like to completely switch gears and move to discussion of betas, Dr. Booth. This is the second general area of questions. 1073 MR. VLAHOS: Ms. Newland, I'm looking at the clock. It is 5:25, and so -- 1074 MS. NEWLAND: I have considerably more, sir. I can't reasonably expect to finish before 6:00, perhaps not before 6:30. 1075 MR. VLAHOS: Just a minute, please. 1076 Ms. Newland, what we'll do is adjourn for the day and resume at 9 o'clock in the morning. Okay. 1077 Now, I did have a couple of matters. 1078 PROCEDURAL MATTERS: 1079 MR. VLAHOS: Mr. Moran, one of the things that I wanted to talk about is the argument. Are you going to be in a position to talk to the parties by tomorrow, say, lunchtime or so, so they can give us an idea as to what the -- this is on assumption -- well, more than an assumption, it's the plan of finishing tomorrow and whether we -- do we have an oral or written argument, that's the first question, and the timing of the schedule of that argument. 1080 MR. MORAN: Yes, I can certainly canvass the parties and report on that by tomorrow at lunchtime. 1081 MR. VLAHOS: Any other matters? 1082 Mr. Smith. 1083 MR. SMITH: Mr. Chairman, I have two filings, if I might. The first is a transcript correction from Mr. Case. I'd like to be clear that the nature of this, which we have committed to writing, is something that Mr. Case discovered he was wrong about and wanted to clarify it for the record rather than misleading the Board unintentionally. So if I might have a number for that, what I would then do is I'll hand it out to the Board and interested parties, but that's the first document. 1084 The second document is the response of Mr. Case to the data provided by Mr. Thompson through cross-examination on a subject-to-check basis. We have laid out in an explanatory to a schedule that we are tendering what we thought were inconsistent data, apples and bananas, and so this is the subject-to-check that Mr. Case had reserved at the time that we went through that with Mr. Thompson. 1085 MR. VLAHOS: Can we look at those documents now, Mr. Smith? 1086 MR. SMITH: Yes, sir. 1087 MR. VLAHOS: And perhaps Mr. Thompson can look at the second one specifically. 1088 MR. SMITH: Right and the -- 1089 MR. THOMPSON: Yes, Mr. -- sorry. 1090 MR. SMITH: I was just going to say that I have talked to Mr. Thompson and provided him a copy of the second document. 1091 MR. VLAHOS: Right. 1092 MR. THOMPSON: I can say, Mr. Chairman, I'm trying to avoid having to cross-examine Mr. Case on this, and I think what I could do is stipulate on the record my concerns with this document when you see it, and see if I can get some, at least, acknowledgment from Mr. Smith as to what's argument and what isn't and just leave it as a matter of arrangement. But there are a couple of facts I have to get his agreement on, and I haven't had a chance to speak him about this because my witness is being cross-examined. 1093 MR. VLAHOS: So we cannot do it today then. Why don't we do it and get this out of the way. Could we have those two documents up at the dais, please? 1094 MR. MORAN: Mr. Chair, the first document transcript correction by Mr. Case is Exhibit F.4.8. 1095 EXHIBIT NO. F.4.8: TRANSCRIPT CORRECTION FILED BY MR. CASE 1096 MR. MORAN: The second document entitled "Response of Mr. Case to data provided by Mr. Thompson subject to check" is Exhibit F.4.9. 1097 EXHIBIT NO. F.4.9: RESPONSE OF MR. CASE TO DATA PROVIDED BY MR. THOMPSON SUBJECT TO CHECK 1098 MR. VLAHOS: Mr. Smith -- I'm sorry, are you still -- 1099 MR. SMITH: Just handing them out, sir. 1100 MR. VLAHOS: Did you want to speak to them anymore? 1101 MR. SMITH: No, sir. I think Mr. Thompson and I had reviewed the document briefly together, and what he's proposing, I believe we're going to speak again about a way to try and avoid re-empanelling the witness and allow him to establish what facts he's accedes to, and hopefully just argue, so we're moving in the same direction and hopefully we will be able to come back with a proposal tomorrow morning. 1102 MR. THOMPSON: If you want to get away tonight, I could probably put this on the record and see if it works, and if it doesn't, I guess we'll have to discuss it. 1103 If, Mr. Chairman, you take a look at F.4.9, just go to the second page, there's text on the first page, but I'll come back to that in a minute. 1104 And I'll just start with the footnotes, first of all. The first two columns in this table are a correct representation of what took place during the cross-examination. Yesterday, I put the 1997 scenarios, and then the 2003 scenarios to Mr. Case. But I -- in footnotes 1(a) and 1(b), Mr. Case is characterizing my number as the 1(a) debt as not being company-specific, and I disagree with that characterization. Those numbers were developed from the exhibit at 3.4, at least my use of those numbers. I took the 7.80 as a reasonable surrogate of the actual debt cost for Enbridge that were reflected in Exhibit F.3.4, which was the settlement agreement for Enbridge's 1997 test year rates. 1105 So where Mr. Case is saying they're not company-specific, they're not company-specific actuals, but they are, as far as I'm concerned, company-specific estimates and were presented on that basis. 1106 And I did bring in the same documents for the Union number, just to put it on the same basis, and those Union numbers will be an appendix to Union's 1997 test year rate case, so if Mr. Smith has no objection to me referring to that material in argument, then I don't need to bring Mr. Case back to cross-examine him on that aspect of this document, I can just argue it. 1107 So that's one feature of the document that I'm stipulating is a matter of argument, and facts that will be in a Board decision that I have not put to Mr. Case. 1108 The second fact in this document that I suggest is a matter of argument is footnote 4, where he asserts debt spread figures, in my calculations, of 82 basis points and 72 are meaningless. I could cross-examine him on that, but I take that as argument, and we'll argue that. 1109 The other aspect of the matter that I wish to stipulate, and if my friend will agree with these facts, then I guess we can argue this and not have to examine Mr. Case. 1110 What Mr. Case is doing in the third column is using actual numbers as of June 6th, 2003, as I understand the presentation, and I put forward the second column as a surrogate of the current situation going forward, but I don't have any problem with the June 2003 numbers that Mr. Case has provided with this exception that the ROE number, the actual ROE number in June 2003 being recovered in rates for Union is 9.95 percent. 1111 And if Mr. Smith will agree that I don't have to cross-examine Mr. Case on that fact, we'll just admit it, then I don't need to bring him back to cross-examine him. And using the actual ROE of 9.95, the spread ROE versus debt for Union is 3.54. 1112 And similarly, for Enbridge, the actual ROE being recovered in rates as of June 2003 is 9.69, not 8.93 and that produces a spread of 344 basis points. 1113 So it's those facts that I would ask my friend to admit, and I would not need to cross-examine Mr. Case, as long as it's understood that by not cross-examining him, I'm not deemed to accept his characterization of this analysis on the first page, which I would argue is, in a number of respects, an incorrect characterization. 1114 So I'm trying to accommodate my friend and hopefully it will work. 1115 MR. VLAHOS: Thank you, Mr. Thompson. 1116 Mr. Smith. 1117 MR. SMITH: Thank you, Mr. Chairman. We want to be very clear that the -- when we took this -- I guess I'd like to apologize to the Board for this being a little messy, but please understand that these numbers were all put to the witness, and in effect, entered as evidence, and he had no notice of it, and had to stand away to try and understand whether, in fact, the proposition was supportable. 1118 Having looked at the facts, the conclusion of the witness is stated in the document and I won't repeat it. 1119 We understand that my friend, Mr. Thompson, would like to use other facts in order to argue, and that's fine, but we don't, by agreeing to the stipulation, we want to be very clear that we are not agreeing that the numbers he's just related to you are, in fact, correct or acceptable to us, but we understand they're his position. 1120 So I do know, for example -- or at least I'm advised, that the 9.95 percent used for Union as an actual figure was apparently for 2000, and then apparently, there was a PBR entered into. 1121 I think what we're having difficulty with is the difficulty in comparing or rendering consistent all the numbers that are being used. That's why I had said earlier it was an issue of apples and bananas. Again, I won't embark on that. 1122 The only other point I would make is on 1(a). I believe we do discuss that in the text on the first page, starting with the fourth line down on the second paragraph. I won't read that sentence. The real issue there was whether they were forecast or actuals and that's discussed there. 1123 With that explanatory, I'm prepared to accept the stipulation of my friend for his purposes. 1124 MR. THOMPSON: Well, that was pretty fuzzy. Maybe I will try and nail it down. Do you accept that -- we got this number from Union, and I haven't checked it, that 9.95 is what is being recovered Union's rates in June of 2003 as the ROE? That's one fact I need you to accept. 1125 The second is: Do you accept that the 2003 ROE being recovered in EGD's rates in 9.69 percent? 1126 MR. SMITH: Mr. Chairman, I'm happy to confirm that I'm advised that for Enbridge, that is correct, but I would note that the 9.95 percent, which apparently is the actual figure, is subject to some, I think, further qualification as I related, and I really should leave it to Union to explain it further or explore it further with a witness. That's all I can really say. 1127 MR. VLAHOS: It appears to me Mr. Smith, that perhaps what is left over can be dealt with through argument. 1128 MR. SMITH: Yes, sir. 1129 MR. THOMPSON: I think so, yes. 1130 MR. VLAHOS: Anything else? 1131 There being no response, thank you very much again. Until tomorrow at 9:00. 1132 --- Whereupon the hearing adjourned at 5:43 p.m.