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Autopilot Error

Why similar U.S and Canadian risk profiles yield varied rate-making results.

Fortnightly Magazine - May 2010

the accuracy of analysts’ growth estimates and the limited number of publicly-traded utilities in Canada.

In order to estimate the cost of common equity, financial analysts typically develop a proxy group of companies with similar operating characteristics and risk profiles to the company under review, and apply the various financial methods outlined above to that proxy group. The results are used to establish a range of reasonableness, and adjustments are made to reflect differences between the proxy group and the company under review.

Diverging Paths

In 1994, British Columbia was the first Canadian province to adopt a formulaic approach to determining the authorized ROE for public utilities. The NEB likewise adopted a generic ROE formula that was contingent on changes in the government of Canada’s long bond yield. A common objective among Canadian regulators was to enhance regulatory efficiency by reducing the amount of time and resources spent on battling expert witnesses in contentious and adversarial hearings. Regulators adopted an automatic adjustment mechanism to replace the more traditional methods of determining the allowed rate of return on common equity.

When the generic ROE formula first was employed in Canada, the allowed return for Canadian-regulated utilities was slightly higher than it was for comparably-situated U.S.-regulated utilities. However, as government interest rates steadily declined, the authorized ROE for Canadian-regulated utilities followed a similar downward trajectory. Despite the fact that Canadian and U.S. utilities generally were engaged in almost identical businesses with similar operating and financial risks, the allowed return for Canadian utilities gradually diverged from their American counterparts. Naturally, Canadian utilities and regulators began to question whether this disparity was justified by any observable differences in the relative risk profiles of the two groups. The Ontario Energy Board commissioned a study to investigate the reasons for the emerging divergence between authorized returns for natural gas distributors in Canada and the United States in an effort to discern whether there were legitimate explanations that would account for the difference. 1

In 2008, Alberta convened a generic cost-of-capital proceeding to investigate the same question as it related to gas and electric utilities in that Province. During the Alberta hearing, evidence was introduced that demonstrated the divergence of allowed returns in Canada and the United States since the adoption of the generic formula ( see Figure 1 ).2

A comparable analysis was introduced in a report to the Ontario Energy Board pertaining to the growing discrepancy between Ontario utilities and their U.S. counterparts ( see Figure 2 ).3

The evidence suggests that the divergence in returns was predicated on the failure of the generic formula to produce a fair return, rather than on any material differences in the risk profiles of Canadian and U.S. utilities. The problem was exacerbated by the flight to quality that occurred during the financial and credit crisis in the United States and Canada in 2008 and 2009. Risk-averse investors fled more risky asset classes, such as common stock and corporate bonds, for the relative safety of government bonds. This drove the interest rates on Canadian and U.S. government bonds to