Canada: “NEB Drops 1994 Return On Equity Formula”…So Stated The NEB In Its Own Press Release, Marking A Decisive Change In Cost Of Capital Matters In Canada

On October 8, 2009, the National Energy Board ("NEB" or "Board") issued a two-page decision by letter wherein it concluded that the formula-approach to the determination of a generic cost of capital for companies under its jurisdiction, which was implemented in 1995 via Decision RH-2-94 (the "RH-2-94 Formula"), is no longer appropriate in today's financial environment. This recent decision will undoubtedly impact NEB-regulated pipelines in relation to cost of capital matters going forward. It is now up to each individual company to demonstrate to the Board an appropriate return on equity ("ROE"). The decision could also potentially impact other companies under the jurisdiction of provincial regulators, as several jurisdictions currently rely on a formula-approach that was originally modeled after the RH-2-94 Formula.

Background - The RH-2-94 Formula

In Decision RH-2-94, the Board approved a rate of return on common equity for a low risk, high-grade benchmark pipeline at 12.25% (for 1995). The NEB relied upon this benchmark pipeline as the standard for determining the allowed ROE for Group 1 regulated pipelines under its jurisdiction. Pursuant to this methodology, the business risk associated with each specific company was accounted for in the equity component of the deemed capital structure.

Additionally, in Decision RH-2-94, the Board adopted a formula for adjusting the ROE on an annual basis. The RH-2-94 Formula linked the ROE to a forecast of a long-term Government of Canada bond yield and adjusted the ROE for 75% of the change in the forecasted yield.

Over the past 15 years, the RH-2-94 Formula has been relied upon by the NEB to determine the allowed rate of return for Group 1 pipeline companies (that have not entered into negotiated settlements). Several provincial regulators have followed suit by implementing formulas that are virtually identical to the RH-2-94 Formula.

The RH-2-94 Formula has been subject to much debate and criticism from NEB-regulated pipelines, as well as those companies under provincial jurisdiction that have similar formulas. The problem is the inherent structure of the RH-2-94 Formula; namely, that it's tied to long-term Government of Canada bond yields. In essence, as long-term Government of Canada bond yields drifted in a downward direction over the past number of years, the allowed returns for regulated companies under RH-2-94 Formula have headed in the same direction. For this reason, many pipeline and regulated companies have argued that the RH-2-94 Formula is broken.

The Fall Of The RH-2-94 Formula - Decision RH-1-2008

Earlier this year, the NEB released RH-1-2008 – a decision wherein the RH-2-94 Formula was extensively reviewed and ultimately abandoned by the Board for one particular NEB-regulated pipeline company's 2007 and 2008 test years.

Decision RH-1-2008 arose in the context of Trans Québec & Maritimes Pipelines Inc.'s ("TQM") application for approval of the cost of capital to be used in calculating final tolls for a two- year period commencing January 1, 2007 and ending December 31, 2008. In its application to the Board, TQM applied for an Order approving tolls and an overall fair return on capital for the years 2007 and 2008 that would result from the application of a rate of return of 11% to a deemed equity component of 40%1 of the TQM capital structure, together with the actual cost of debt of TQM. 2 TQM was of the view that the requested overall return was equivalent to 6.7% after tax weighted average cost of capital ("ATWACC").

In conjunction with the application, TQM applied for, inter alia, a review and variance of Decision RH-2-94, requesting that the Board set the fair return for TQM for the two-year period using the ATWACC methodology.

The experts for TQM provided their opinion that a more appropriate way to establish a company's required return was to focus directly on the ATWACC, which is the standard used by unregulated businesses throughout the world to evaluate potential investments. The ATWACC was opined to be the most fundamental measure of the rate of return for a given level of business risk, since it focuses on the total return on capital and automatically adjusts for diff erences in capital structure among companies.

On March 19, 2009, the Board granted TQM's review and variance request in relation to Decision RH-2-94. The Board stated that a significant time period has passed, in the context of financial regulation, from the implementation of the RH-2-94 Formula. The Board further stated that there have been significant changes since 1994 in the financial markets as well as in general economic conditions. These changes, in the Board's view, cast doubt on some of the "fundamentals underlying the RH-2-94 Formula as it relates to TQM".

The Board went on to grant TQM an aggregate return on capital and setting a 6.4% total weighted average after tax return (compared to an approximate 5.5% return that would have resulted had the Board used the RH-2-94 Formula), thus leaving TQM to choose its optimal capital structure. It should be noted that the ATWACC approach had been raised in the past, but had not been accepted by the NEB. In this regard, see Decision RH-4-2001 regarding TCPL, wherein the NEB highlighted numerous shortcomings associated with an ATWACC approach. The NEB noted, and TCPL acknowledged, that, at that time, this methodology had not been adopted by any regulatory body in North America. In RH-1-2008 though, the Board decided to rely on the ATWACC approach for TQM's 2007 and 2008 cost of capital because the approach "is more aligned with the way capital budgeting decision-making takes place in the business world". The NEB also stated the ATWACC approach enables better comparisons of return on capital for companies of similar risk.

The RH-1-2008 decision represents the first time that a market-based ATWACC has been accepted as the direct standard for the allowed rate of return for regulated companies, despite the previously stated shortcomings. In short, it represents the beginning of the fall of the NEB's RH-2-94 Formula.

Confirmation The RH-2-94 Formula Is No Longer Valid - The October 8, 2009 Decision

After the review and variance in RH-1-2008 was granted to TQM for the 2007 and 2008 test years, the NEB considered it appropriate to initiate a more wide-spread review of RH-2-94. After hearing from a broad range of interested parties on the applicability of RH-2-94, the NEB issued its October 8, 2009 decision. In the decision, the NEB concluded that there was substantial doubt as to the ongoing correctness of Decision RH-2-94. Stated diff erently, there was substantial doubt as to the correctness of the continued use of the RH-2-94 Formula. In reaching its decision, the Board stated that the length of time that the RH-2-94 Formula has been in eff ect (15 years) is significant in the context of financial regulation. The NEB also noted that there have been "considerable changes in the financial and economic circumstances" over the past 15 years.

The October 8, 2009 decision provides solid confirmation from the NEB that the RH-2-94 Formula is no longer appropriate in today's financial environment. Its decision marks a significant milestone in the evolution of cost of capital matters in Canada.

Implications Of The NEB's Conclusions On The RH-2-94 Formula Going Forward

In terms of the implications of the NEB's decision going forward, NEB-regulated companies will be free to enter into negotiated settlements (which has been the norm for some time at the NEB-level) or file litigated rate cases requesting the Board to set the allowed rate of return. It will be interesting to see whether NEB-regulated pipelines will continue to adopt a ROE formula-approach, the ATWACC methodology or some other method to determine their cost of capital for negotiated settlements and/or rate case applications. In this regard, the impetus to abandon the formula-approach has clearly come from regulated companies and not shippers/ratepayers. As noted above, the regulated entities themselves have long maintained that the formula-method was resulting in returns which did not meet the Fair Return Standard that has been long accepted by Canadian caselaw. In this context, it can reasonably be expected that opposition will arise in respect of attempts to increase the currently awarded level of return.

As for companies that fall under the jurisdiction of provincial regulators, the implications of the NEB's October 8, 2009 decision are less certain. In this regard, we note that many of the provincial regulators, including the Alberta Utilities Commission ("AUC"), currently have formulas in place that were modeled after the NEB's RH-2-94 Formula. The AUC3, Ontario Energy Board4, Quebec Régie de l'énergie5 and the British Columbia Utilities Commission6 are in the midst of undertaking reviews of aspects of approved ROEs and/or capital structures. The NEB's latest move to emphatically abandon the RH-2-94 Formula could cause these provincial regulators to pause prior to reconfirming the validity of a formula modeled after RH-2-94.

In our view, it is open to any NEB-regulated company (that was previously subject to the RH-2-94 Formula) to seek an enhancement to the level of return that would be earned under the now abandoned RH-2-94 Formula. Whether the ATWACC approach, which has been the subject of significant debate in the past, provides the best alternative remains to be seen. At this point, there are no constraints on the options available to regulated entities. The main point is that a clear opportunity now exists for regulated entities to improve their awarded returns.

Likewise, provincial regulators who previously patterned their approach after the NEB's RH-2-94 Formula must now consider whether they agree that a fundamental change in this approach is required. Interestingly, in contrast to the OEB and BCUC's cost of capital proceedings, the AUC and Régie's record to their cost of capital proceeding was closed prior to the issuance of the NEB's October 8, 2009 decision. This may place both the AUC and Régie in a quandary – especially for the AUC since, as noted above, it has typically based its decisions on the now abandoned RH-2-94 Formula originated by the NEB. The same arguments that were presented to the NEB were basically put to the AUC. The thrust of those arguments, from the regulated companies' perspective, was that the RH-2-94 Formula is broken. As per the October 8, 2009 decision, it now appears that the national regulator agrees that the RH-2-94 Formula is broken. Will the AUC agree too? The AUC's decision on the 2009 generic cost of capital proceeding is expected to be released imminently.


1. TQM previously had a 30% deemed component of equity which contributed to a week financial profile for TQM.

2. The Board notes on page 81 of its Decision that when combined with actual debt costs, 9.7% ROE based on 40% equity is equivalent to the market-based ATWACC of 6.4% set by the Board, although some press releases suggest that the Board decision of 6.4% ATWACC equates to a 9.85% return on 40% deemed equity in 2007 for TQM (and a 5.5% ATWACC return had the Board not made changes to the determination of return for TQM); see for example, March 20, 2009: DBRS Comments on NEB Decision on TQM's Cost of Capital Application. The ATWACC results in a higher overall return for TQM.

3. On July 25, 2008, the Commission initiated a generic hearing to consider cost of capital matters for electric, gas and pipeline utilities under its jurisdiction. In May and June 2009, an oral hearing was held by the AUC wherein interested parties provided testimony to support their respective positions. The close of the record occurred on August 13, 2009 with the filing of Reply Argument. The AUC's decision is expected to be released imminently.

4. On March 16, 2009, the OEB initiated a consultative process to determine whether current economic and financial market conditions warrant an adjustment to the cost of capital for companies under its jurisdiction. On June 18, 2009, the Board issued its determination on the cost of capital for 2009 rates and advised stakeholders that it is proceeding with a review of its policy regarding the cost of capital. It is anticipated that any changes to the policy made as a result of this review will apply to the setting of rates for the 2010 rate year. Final written comments from interested parties were filed on November 2, 2009.

5. Gaz Métro filed an application to change its tariff and alter its ATWACC. An oral hearing was held on September 2nd to 29th (which included oral Argument and Reply). The Régie's decision is expected in late November or early December.

6. Terasen Gas Inc., Terasen Gas (Vancouver Island) Inc. and Terasen Gas (Whistler) Inc. filed an application with the BCUC seeking a review of its ROE and capital structure. In October 2009, an oral hearing was held by the BCUC wherein interested parties provided testimony. The close of the record will occur on November 13, 2009 with the filing of final Reply Argument. The BCUC's decision is expected to be released by the end of the year.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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