Equity Formula - PDF

							   Volume 1, Issue 26, October 21, 2009



Peter Bethlenfalvy
Co-President, Canada       THE NEB’S RETURN ON EQUITY FORMULA DECISION AND ITS POTENTIAL
+1 416 597 7361
pbethlenfalvy@dbrs.com
                           IMPACT ON REGULATED PIPELINES & UTILITIES
                           Earlier this month, the National Energy Board (NEB) released its decision to discontinue the application of
Steven Bavaria
Managing Director,
                           its March 1995 Multi-Pipeline Cost of Capital Decision (RH-2-94). In its Reasons for Decision document,
Leveraged Finance          the NEB indicated that “there have been considerable changes in financial and economic circumstances”
+1 212 806 3285
sbavaria@dbrs.com          since 1994 and that, based on these considerations, the NEB “is of the view that there is a doubt as to the
                           ongoing correctness of the RH-2-94 Decision.” Finally, the NEB concluded that “it is neither necessary nor
Eric Beauchemin, CFA
Managing Director,         appropriate to replace the RH-2-94 Decision with another multi-pipeline cost of capital decision at this time.
Public Finance
+1 416 597 3619
                           Accordingly, the RH-2-94 Decision will not continue to be in effect.”
ebeauchemin@dbrs.com

Michael Caranci            The possibility of this action was foreshadowed by the NEB’s late March 2009 decision to deviate
Managing Director,         significantly from RH-2-94 when it released its decision (RH-1-2008) on the 2007 and 2008 cost of capital
Energy
+1 416 597 7304            application submitted by Trans Québec & Maritimes Pipeline Inc. (TQM, rated A (low) by DBRS). The
mcaranci@dbrs.com          RH-1-2008 decision, which DBRS views positively for TQM from a credit perspective, provides TQM with
Paul Holman, CMA           a 6.4% after-tax weighted-average cost of capital (ATWACC) return (with no explicit deemed capital
Managing Director,
Communications, Media,
                           structure) for each of 2007 and 2008, compared with the 5.5% ATWACC return that would have resulted if
Retailing, Consumer        the NEB had applied the RH-2-94 decision. The RH-1-2008 decision strengthens TQM’s financial profile,
Products and Real Estate
+1 416 597 3617            which was relatively weak under RH-2-94 due to the low deemed equity component (30%) and low allowed
pholman@dbrs.com           return on equity (ROE) (8.46% in 2007 and 8.71% in 2008) under the latter methodology. (Please see
Kam Hon                    DBRS Canada Newsletter dated May 6, 2009 for details.) Subsequently, the NEB solicited submissions
Managing Director,
Natural Resources,
                           from interested parties and initiated a review of the RH-2-94 decision on July 3, 2009.
Industrials and Auto
+1 416 597 7543
khon@dbrs.com              In recent years, as long-term interest rates dropped significantly, the allowed ROE formula under RH-2-94
                           followed, resulting in weakening credit ratios and lower returns on equity capital compared with other
Brenda Lum
Managing Director,         investment alternatives for the pipeline owners. These factors prompted some regulated entities (under both
Canadian Financial         the NEB and its provincial counterparts) to negotiate various forms of incentive agreements with their
Institutions
+1 416 597 7569            customers whereby the parties share in generated cost savings, allowing the regulated entities to partly
blum@dbrs.com
                           mitigate the negative impacts of declining allowed ROEs. In addition, newly-constructed pipelines (e.g.,
Larry J. White             Alliance and Maritimes & Northeast) circumvented RH-2-94 by reaching negotiated long-term contractual
Managing Director,
Business Development       agreements in order to secure construction financing.
and Originations
+1 416 597 7457
lwhite@dbrs.com            DBRS believes that the NEB’s decision to abandon RH-2-94 without replacing it with another generic
                           formula, including, for example, variations on the RH-1-2008 decision, could lead to increased rate case
Toronto
                           activity, at least in the short term. This is especially true with respect to natural gas pipelines, where tolls
DBRS Tower                 impact producer netbacks to a much larger extent than for crude oil pipelines. While the RH-1-2008
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                           decision is likely viewed by pipeline companies as a validation of their position that the cost of capital has
Toronto, ON M5H 3M7        been set at too low a level, their customers have not accepted that position and are likely to continue to make
+1 416 593 5577
                           the same arguments in private negotiations that they do in NEB hearings. Consequently, the NEB will likely
                           have to decide the cost of capital argument on a case-by-case basis in formal hearings until a new playing
Caroline Creighton
Coordinator,               field is established.
Senior Vice President,
Communications and
Media                      Based on the principles articulated in the RH-1-2008 decision and the abandonment of RH-2-94, DBRS
+1 416 597 7317
ccreighton@dbrs.com
                           expects that the NEB will take into account each pipeline’s specific business risk profile when deriving
                           allowed ROEs and equity components, and that the end results will likely be dispersed over a range that
                           exceeds the baseline created by RH-2-94. One scenario would involve the framework of the RH-1-2008
                           decision being widely applied to other NEB-regulated entities. In that event, DBRS would not necessarily
                           view the lack of an explicit deemed capital structure as negative (in that it could allow for higher-leveraged
                           balance sheets) as the move to the RH-1-2008 methodology was presented to the NEB as a means by which
                           to improve financial returns while offsetting potentially rising business risk. Another scenario could involve
                           customized financial criteria, which could lead to substantial dispersion of credit metrics. In any event,
                           DBRS would likely consider any move to reduce equity thickness or allowed ROE from current levels as a
                           negative factor in its ratings.

                           In the event that new principles were to be applied broadly to the pipeline sector, DBRS expects that the
                           impact would be positive from a credit perspective, with the degree of materiality and timing depending on
                           several factors, including: 1) Some pipeline companies would have to wait for expiry of current multi-year
                           negotiated agreements before this issue could be addressed. For example, settlements at TransCanada
                           Corporation’s (TCC) Alberta System and Enbridge Pipelines Inc.’s Mainline expire at the end of 2009;
                           Westcoast Energy Inc.’s B.C. Pipeline System settlement expires at the end of 2010; and TCC’s Canadian
                           Mainline settlement expires at the end of 2011. In each case, the above pipelines have higher equity
                           thickness measures than TQM’s 30% level prior to RH-1-2008 and would therefore likely receive a lower
                           marginal improvement in ROE and credit metrics. In the case of Enbridge Pipelines Inc.’s Mainline, the
                           potential for improvement is relatively limited as the RH-2-94 allowed formula is relevant to only a portion
                           of that pipeline’s operations. 2) Some pipelines have long-term contractual agreements in place and are not
                           likely to be materially impacted by RH-1-2008 (e.g., Alliance and Maritimes & Northeast). 3) Tolls on
                           intra-provincial feeder crude oil pipelines (e.g., Inter Pipeline Fund’s Bow River and Cold Lake systems)
                           are not affected by RH-2-94 and are unlikely to be affected by broad implementation of the principles of the
                           RH-1-2008 decision.

                           Whether the NEB decision to abandon RH-2-94 filters down to the provincial regulatory level, and
                           positively impacts the financial profiles of regulated electric and gas utilities, remains to be seen. The
                           Alberta Utilities Commission, Ontario Energy Board and British Columbia Utilities Commission are all
                           currently reviewing aspects of approved ROEs and/or capital structures. Any positive developments in these
                           provinces would impact a large number of utilities rated by DBRS. While the likelihood of any change is
                           unclear, we would expect that the incorporation of any new regulatory principles at the provincial level
                           would have a neutral-to-positive impact on a utility’s financial profile.

                           Overall, we note that an improvement to a regulated entity’s ROE and/or equity thickness would be viewed
                           positively in the context of its financial risk profile. However, as ROEs have declined in past years, DBRS
                           ratings (to this point) on pure pipeline and utility companies have not been negatively impacted as a direct
                           result of deteriorating ROE levels. Therefore, any future increase in a pipeline or utility’s approved ROE or
                           equity thickness, would not, in itself, be likely to result in positive rating actions unless the improvement
                           was so significant as to be viewed as a material reduction in financial risk. In general, it is more likely that
                           potential improvements in ROEs and equity thickness would be viewed as supportive of current ratings.

                           For further information, please contact Michael Rao at mrao@dbrs.com.

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