Cost of Capital – Deemed Equity Ratio – Fair Return Standard
On November 30, 2016, ENMAX Power Corporation (“ENMAX”) filed an application with the Alberta Utilities Commission requesting approval of a deemed equity ratio of 37 per cent for its distribution and transmission functions for 2016 and 2017 on a final basis. The deemed equity ratio of 37 per cent was previously approved as a placeholder for ENMAX in Decision 20622-D01-2016 (the 2016 generic cost of capital (“GCOC”) decision).
In the 2016 GCOC Decision, the AUC noted that ENMAX’s 2015 actual year-end capital structure suggested that the deemed equity components determined in Decision 2191-D01-20157 (the 2013 GCOC decision) for ENMAX’s distribution and transmission functions were higher than required to ensure that ENMAX had a reasonable opportunity to earn a fair return.
However, in that decision, the AUC found that ENMAX was not provided an opportunity to address the issue fully in the 2016 GCOC proceeding, and that there was insufficient evidence on the record to decide. Accordingly, the AUC set an interim deemed equity ratio of 37 per cent for the distribution and transmission functions of ENMAX for 2016 and 2017 as a placeholder, and directed ENMAX to submit a compliance filing in order for the AUC to determine the final deemed equity ratio for ENMAX for 2016 and 2017.
The present decision considered that compliance filing by ENMAX.
The Fair Return Standard
With respect to fair return, the AUC cited the Supreme Court of Canada’s (the “SCC”) passage from Northwestern Utilities Ltd. v. Edmonton (City), [1929] SCR 186, where the SCC stated:
By a fair return is meant that the company will be allowed as large a return on the capital invested in its enterprise (which will be net to the company) as it would receive if it were investing the same amount in other securities possessing an attractiveness, stability and certainty equal to that of the company’s enterprise.
The AUC cited its past decision setting out the fair return standard, indicating that it must consider three factors when setting a rate of return namely:
(a) comparable investments;
(b) capital attraction; and
(c) financial integrity.
In its past GCOC decisions, the AUC sought to satisfy the fair return standard by establishing a generic ROE that uniformly applied to all of the affected utilities. The AUC can then make adjustments to individual utilities’ respective deemed equity ratios, to account for the particular business risks faced by individual utilities. The combination of the ROE and deemed equity ratio for each utility is intended to satisfy the fair return standard so as to:
(a) maintain the financial integrity of the company by ensuring it can raise capital to finance its operations and any required investment;
(b) provide a reasonable opportunity for the company to earn a return on the deemed equity investment of its shareholders comparable to investments of similar risk, and
(c) ensure that utility rates are just and reasonable.
The AUC stated that it accepted that the actual equity ratios of a utility would not always be the same as the deemed equity ratio at any given time. The AUC noted that differences can result from such events as regulatory lag in issuing GCOC decisions, variations in net income, the timing and value of capital expenditures, the timing and amount of debt issues and the payment of dividends. The AUC found, however, that if a utility’s actual equity ratio departs sufficiently without reasonable explanation from the deemed equity ratio, then this might signal a shift in the risk profile of the utility, or that the equity ratio established in the relevant GCOC decision was incorrect. It suggests that something other than the existing deemed equity ratio will be sufficient, or may be required, to satisfy the fair return standard.
One indicator that something other than the deemed equity ratio may be sufficient is evidence that a divergence in equity ratios does not impair the utility’s ability to raise capital.
ENMAX’s stated intention was to target the 2015 actual year-end equity ratio to be 39 per cent, equal to the deemed consolidated equity ratio. However, at year-end 2015, ENMAX was actually operating on a consolidated distribution/transmission basis at 34 per cent equity without any apparent impairment to its ongoing operations, its financial integrity or its ability to raise capital in 2015 or in future years. ENMAX submitted that this divergence in 2015 from the deemed equity ratio was inadvertent and unintentional.
2015 Actual Equity Ratio and Dividend Payment
ENMAX explained that two one-time accounting adjustments were made to its 2015 financial statements that resulted in the actual year-end consolidated distribution/transmission equity ratio for 2015 being 34 per cent. Those two adjustments were an IFRS adjustment and a dividend payment of $120 million.
The AUC found that:
(a) the primary reason that the actual year-end consolidated distribution/transmission equity ratio for 2015 was lower than the 39 per cent target was the payment of the $120 million dividend to ENMAX Corporation in November 2015;
(b) if ENMAX had not paid this dividend in 2015, the actual year-end consolidated distribution/transmission equity ratio for 2015 would have been 38.47 per cent;
(c) ENMAX would have preferred to pay more than $120 million in dividends, but the restriction on doing so was the resulting capital structure;
(d) consequently, there is evidence that ENMAX did not wish to exceed a per cent debt ratio (or correspondingly adopt an equity ratio below 37 per cent); and
(e) ENMAX staff and management targeted a 2015 year-end equity ratio of 37 per cent in their analysis conducted in support of paying the $120 million dividend.
The AUC found that regardless of ENMAX’s errors in calculating the resulting equity ratio for 2015, the result was that ENMAX demonstrated that it was capable of paying a substantial dividend and operating at an actual year-end equity ratio of 34 per cent for 2015 (35.3 per cent after correction for the IFRS pension remeasurement adjustment) without any apparent impairment to its ongoing operations, its financial integrity or its ability to raise capital.
The AUC concluded that a deemed consolidated distribution/transmission equity ratio of less than the 37 per cent deemed equity ratio awarded to other distribution and transmission utilities in the 2016 GCOC Decision 20622-D01-2016 for 2016 and 2017 is warranted for ENMAX.
The AUC determined that based on its consideration of the fair return standard, that the deemed equity ratio for ENMAX for 2016 and 2017 should be 36 per cent. The Commission considered that setting the deemed equity ratios for ENMAX’s distribution and transmission functions for 2016 and 2017 at 36 per cent would:
• result in just and reasonable rates for ENMAX and its ratepayers; and
• when multiplied by the ROE percentages established in Decision 20622-D01-2016, would satisfy the fair return standard.
Decision
The AUC approved, on a final basis, a deemed equity ratio of 36 per cent for the transmission and distribution operations of ENMAX for 2016 and 2017.
