BOOTH Gazifere 2010

Gazifere Fair Return and Capital Structure

Professor Laurence Booth

CIT Chair in Structured Finance

Rotman School of Management

BOOTH Gazifere 2010

Key Issues before the Regie

Has Gazifere’s business risk increased since its last hearing in1998?

Is the 75% ROE adjustment to forecast changes in the long Canada bond yield still appropriate?

What is a fair and reasonable ROE for Gazifere and what is a reasonable range for the estimate?

BOOTH Gazifere 2010

Gazifere’s Business Risk

McShane and Booth agreement that risk has a short and long run dimension

Short run: return on capital

– McShane: ability to earn a “compensatory return”

– Booth not earning the allowed ROE

– Whether the allowed ROE is fair and reasonable or “compensatory” is regulatory risk not business risk

– Quantitative assessment

Long run: return of capital

– The ability to recover the investment in rate base

– Viability of the natural gas market in Quebec

– Qualitative assessment

BOOTH Gazifere 2010

Gazifere

ROE Performance

GI-31 Doc 1.1 & GI32 Doc 1.5

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Allowed Actual

BOOTH Gazifere 2010

Short Run Risk

Gazifere has over earned its ROE by an average of 0.96% per year since 1998 (GI-31);

No trend in over-earning

“Gazifere has not gone back.... to establish the drivers for deviations from the allowed return” (GI-31)

– Clearly Gazifere thinks its short run risk is not material?

2005 deviation due to bad debt expense form two large industrial customers (Booth IR#11)

2007-9 uptick due to performance based regulation: PBR is not a risk as company simply earns more than the allowed ROE

BOOTH Gazifere 2010

Gaz Metro Allowed vs Actual ROE

8

9

10

11

12

13

14

15

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Allowed Incentive Actual

Gaz Metro has sometimes failed to earn its full PBR

but still over earned its allowed ROE

BOOTH Gazifere 2010

Gazifere Revenue Composition

1999 2003 2006 2009

Residential 19,748 22,633 28,438 32,077

Commercial 2,539 2,562 2,818 2,968

Industrial 14 14 13 12

Gazifere Revenue Composition

GI-3- Doc 1

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

RES COMM IND

BOOTH Gazifere 2010

Natural Gas Competitiveness

Development of natural gas from shale has created a disconnect from the price of oil

– 1999 price advantage was 24% for residential and a disadvantage of 8% for commercial

– 2009 residential advantage increased to 50% and commercial 53%

Quebec has abundant electricity

– 1999 price advantage of natural gas was 24% for residential and 57% for commercial

– 2009 this advantage had dropped to 15-27% for residential and 33% for commercial

BOOTH Gazifere 2010

Business Risk Summary

Demonstrated ability to earn allowed ROE

Protective regulatory environment where PBR has increased over-earning

Large increase in customer base as natural gas has a competitive advantage over both oil and electricity for residential and commercial consumers

Drop off in industrial customers, particularly interruptible reduces forecast risk and possibility of bad debt losses similar to 2005

Overall no sign of any increase in business risk, more likely a reduction

BOOTH Gazifere 2010

Regie Gaz Metro Decision

BOOTH Gazifere 2010

Financial

US emerging from a brutal recession, Canada from a mild recession

Cause was the failure of the US financial system that spread contagion around the world

Catalyst: Failure of Lehman Brothers September 14, 2008

– Domino effect around the world as banks focused on survival

Hoarded cash

Reduced lending

Sold off securities to bolster capital

Reduced principal trading in debt markets: reduced liquidity in secondary markets

BOOTH Gazifere 2010

Stock Market Collapse

Index or Exchange Last Trade Date

1Day Change

1 Day %

1 Month %

6 Month %

YTD % 2006 $b Value

United States Composite (US Dollar)

213.40

10/24/2008 -7.52 -3.40% -27.53% -37.17% -40.46% 18,039

Japan Composite (US Dollar)

82.39

10/24/2008 -2.74 -3.21% -22.00% -32.07% -35.54%

4,422

United Kingdom Composite (US Dollar)

149.79

10/24/2008 -11.63 -7.21% -35.44% -48.66% -52.51% 3,441

Canada Composite (US Dollar)

278.25

10/24/2008 -4.74 -1.67% -40.46% -48.15% -49.61% 1,636

Germany Composite (US Dollar)

218.89

10/24/2008 -14.62 -6.26% -39.40% -51.88% -56.28% 1,426

Hong Kong Composite (US Dollar)

186.44

10/24/2008 -10.10 -5.14% -31.80% -51.39% -57.97% 1,361

Spain Composite (US Dollar)

388.93

10/24/2008 -26.01 -6.27% -34.22% -50.24% -51.93% 1,146

Switzerland Composite (US Dollar)

374.65

10/24/2008 -10.44 -2.71% -22.21% -32.06% -34.35% 1,111

Real Economy can not flourish if the financial system is

broken:

1) Credit crunch

2) Real economy stops spending

3) Sharp recession started 2008Q4 in Canada

BOOTH Gazifere 2010

Short Term Credit Spreads

Money market now back to normal in Canada

Money Market Spreads

(CansimV121812,V121778,V121796)

0

50

100

150

200

250

300

1/4

/2006

3/4

/2006

5/4

/2006

7/4

/2006

9/4

/2006

11/4

/2006

1/4

/2007

3/4

/2007

5/4

/2007

7/4

/2007

9/4

/2007

11/4

/2007

1/4

/2008

3/4

/2008

5/4

/2008

7/4

/2008

9/4

/2008

11/4

/2008

1/4

/2009

3/4

/2009

5/4

/2009

7/4

/2009

9/4

/2009

11/4

/2009

1/4

/2010

3/4

/2010

CP BA

BOOTH Gazifere 2010

Overnight Rate

(cansim V39079)

0

1

2

3

4

5

6

7

8

9

10

12/1

/1992

12/1

/1993

12/1

/1994

12/1

/1995

12/1

/1996

12/1

/1997

12/1

/1998

12/1

/1999

12/1

/2000

12/1

/2001

12/1

/2002

12/1

/2003

12/1

/2004

12/1

/2005

12/1

/2006

12/1

/2007

12/1

/2008

12/1

/2009

Bank of Canada has increased the overnight rate twice since

May to remove some of the stimulus as economy has regained

most of the jobs lost during the recession

BOOTH Gazifere 2010

LTC Yields fell, Corporate debt yields increased but now back to pre-

crisis levels

McShane recommends a 50% adjustment to Corporate bond yields,

This means about the same allowed ROE as start of 2008

Recently both Corporates and Canada yields have fallen unlike in the

financial crisis

Yields since January 2008

3

4

5

6

7

8

9

2/1

/20

08

3/1

/20

08

4/1

/20

08

5/1

/20

08

6/1

/20

08

7/1

/20

08

8/1

/20

08

9/1

/20

08

10

/1/2

00

8

11

/1/2

00

8

12

/1/2

00

8

1/1

/20

09

2/1

/20

09

3/1

/20

09

4/1

/20

09

5/1

/20

09

6/1

/20

09

7/1

/20

09

8/1

/20

09

9/1

/20

09

10

/1/2

00

9

11

/1/2

00

9

12

/1/2

00

9

1/1

/20

10

2/1

/20

10

3/1

/20

10

4/1

/20

10

5/1

/20

10

6/1

/20

10

7/1

/20

10

8/1

/20

10

BBB A AA Canada

Gaz Metro hearing August 2009

BOOTH Gazifere 2010

Spreads still high relative to where we are in the recovery,

perhaps 0.50% too high or long Canada’s 0.50% too low

Default Spreads Since Dec 1979

0

50

100

150

200

250

300

350

400

450

500

12/3

1/1

979

12/3

1/1

981

12/3

1/1

983

12/3

1/1

985

12/3

1/1

987

12/3

1/1

989

12/3

1/1

991

12/3

1/1

993

12/3

1/1

995

12/3

1/1

997

12/3

1/1

999

12/3

1/2

001

12/3

1/2

003

12/3

1/2

005

12/3

1/2

007

12/3

1/2

009

AA A BBB

BOOTH Gazifere 2010

Conclusion

LTC Yields remain the only long term opportunity cost or fair rate of return in the capital market

LTC yields expected to increase to 4.5% for 2011,

– 3.93% at time of testimony

– 3.53% currently

– More risk of lower LTC yields than higher for 2011

Corporate yields have followed long Canada yields down the last five months, AA spreads constant, A spreads minor pick up.

Market is still “jittery”

BOOTH Gazifere 2010

Risk Premium Models

Explicit Risk premium model

– CAPM

– Primary reliance by NEB (RH-1-2008)

– Primary reliance by Regie

*MRPRKF

Time Value of

Money

Market Risk

Premium * “beta”

BOOTH Gazifere 2010

BOOTH Gazifere 2010

Arithmetic is simple average; geometric is compound and OLS is the least squares estimate.

Approximately Geometric Mean = Arithmetic Mean - .5*variance

For example, US variance is about 4%, so AM and GM diverge by about 2%

Annual Rate of Return Estimates 1926-2009

U.S.

CANADA

S&P

Equities

Long US

Treasury

Excess

Return

TSE Equities

Long

Canadas

Excess

Return

AM

11.80

5.77

6.03

11.39

6.43

4.96

GM

9.77

5.40

4.37

9.69

6.08

3.61

OLS

11.09

5.11

5.98

10.42

5.80

4.62

Volatility

1

20.48

9.15

18.96

8.87

BOOTH Gazifere 2010

Fernandez Survey May 2009

1) MRP higher in Canada than US

2) Median Canadian MRP is 5.1%

BOOTH Gazifere 2010

If the Regie randomly asked a Canadian finance professor what

the MRP is, the answer would almost certainly be 5.0% or 6.0%

BOOTH Gazifere 2010

BOOTH Gazifere 2010

Relative Risk (BETA)

Average Utility Betas

-0.100

0.000

0.100

0.200

0.300

0.400

0.500

0.600

Jan-8

5

Jan-8

6

Jan-8

7

Jan-8

8

Jan-8

9

Jan-9

0

Jan-9

1

Jan-9

2

Jan-9

3

Jan-9

4

Jan-9

5

Jan-9

6

Jan-9

7

Jan-9

8

Jan-9

9

Jan-0

0

Jan-0

1

Jan-0

2

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Utility beta Utility (No TAU)

BOOTH Gazifere 2010

Stock Performance over Last Year: Emera

BOOTH Gazifere 2010

Stock Performance over Last Year: Fortis

BOOTH Gazifere 2010

Stock Performance over Last Year: GMLP

BOOTH Gazifere 2010

Fair ROE

LTC Yield: 4.50%

Market Risk Premium: 5.0-6.0%

Beta: 0.45-0.55

Issue costs: 0.50%

Recommended Benchmark ROE: 7.75%

Financial Crisis adjustment: 0.50%

Gazifere addition: 0.25%

Recommended ROE: 8.50%

Since June LTC Yields have dropped but spreads have widened

BOOTH Gazifere 2010

2009 Reviews

AUC November 2009

OEB (August 2009)

BOOTH Gazifere 2010

Analyst Views

Matt Aikman McQuarrie May 2008 to CAMPUT

BOOTH Gazifere 2010

ROE Formula Reviews

OEB 2003 (2004 Decision)

AUC (AEUB) 2003 for 2004

BCUC 2007 changes (100% adjustment to Canada yields changed to 75%)

NEB 2001 confirmation in TCPL Mainline declined to hear ROE evidence in 2004

Regie 2007 Gaz Metro decision

Ms. McShane recommended a 75% ROE adjustment to long Canada yield changes as late as 2007 in an Ontario Power Generation hearing

BOOTH Gazifere 2010

New ROE formula proposals

McShane

– assume NEB correct in 1994

– adjusts for 50% of long term Canada (LTC) and “spread” in A bond yield changes

– collapses to change by 50% of the change in A bond yields

Booth

– assume NEB correct in 2000

– adjusts for 75% of change in LTC yields

– adjusts for 50% of the change in A spreads

%)71.0(*50.0%)25.9(*50.0%25.12 SpreadLTCROE

%)94.0(*50.0%)12.6(*75.90.9 SpreadLTCROE

BOOTH Gazifere 2010

ROE Adjustment Formula

ROE Formula

8

8.5

9

9.5

10

10.5

11

11.5

12

12.5

13

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

NEB McShane Booth1 Booth2

McShane assumes NEB got it right for 199f and wrong

from thereafter

Booth 1 &2 assumes NEB got it right in 2001 or 2004 and

uses spread change to capture the “crisis” premium

BOOTH Gazifere 2010

Gazifere

Assume Regie got it right in 1998

– adjust by 75% of LTC change

– adjust by 50% of spread change

For 2011

– LTC is 4.50%

– Utility spread 1.30%

LTC causes 0.75*1.2% or -0.90%

Spread causes 0.50* 0.30 or +0.15

Overall 9.25%

Update

– LTC forecast yields lower (-0.15%)

– spreads wider (+0.10%)

%)99.0(*50.0%)70.5(*75.0%0.10 spreadLTCROE

BOOTH Gazifere 2010

US Data

Moody’s

– 25% regulation

– 25% ability to earn the allowed ROE

– 10% diversification

– 40% financials: the numbers

“Moody’s views the regulatory risk of US utilities as being higher in most cases than that of utilities located in some other developed

countries, including Japan, Australia and Canada. The difference in risk reflects our view that individual state regulation is less predictable

than national regulation; a highly fragmented market in the US results in stronger competition in wholesale power markets; US fuel and

power markets are more volatile; there is a low likelihood of extraordinary political action to support a failing company in the US; holding

company structures limit regulatory oversight; and overlapping and unclear regulatory jurisdictions characterize the US market. As a result

no US utilities, except for transmission companies subject to federal regulation, score higher than a single A in this factor.”

“as is characteristic of the US, the ability to recover costs and earn returns

is less certain and subject to public and sometimes political scrutiny.”

BOOTH Gazifere 2010

US Utility Bond Ratings

Description is of business risk rating for each rating class

BOOTH Gazifere 2010

Newfoundland Power Decision

BOOTH Gazifere 2010

BCUC Decision

BOOTH Gazifere 2010

Ms McShane’s Use of Analyst Growth Forecasts

BOOTH Gazifere 2010

Optimism Bias

Analyst are over optimistic and gradually zero in on the right numbers as they get guidance from companies

Academic research that analysts are biased

McKinsey (consultants)

– S&P500earnings growth has been 100% too optimistic: 10-12% vs 6%

Ms McShane’s US sample

– Historic & forecast GDP growth 5.0%

– Historic dividend growth: 2.5%

– Historic earnings growth: 4.0%

– Forecast analyst growth: 5.9%

BOOTH Gazifere 2010

Ms McShane’s Risk Assessment for Gazifere

She assumes Gazifere would be a BBB utility and estiamtes the risk premium for US BBB’s relative to her low risk US utilities

US utilities are large risky utilities

Gazifere is a small low risk utility

BOOTH Gazifere 2010

Fair ROE

LTC Yield: 4.50%

Market Risk Premium: 5.0-6.0%

Beta: 0.45-0.55

Issue costs: 0.50%

Recommended Benchmark ROE: 7.75%

Financial Crisis adjustment: 0.50%

Gazifere addition: 0.25%

Recommended ROE: 8.50%

Suggested New ROE Formula: 9.25%

Since June LTC Yields have dropped but spreads have widened