Cost of Capital Methodology Review – Consultation Document
File No.: T 6275-17
Cost of capital is defined as the total return on net investment that is required by shareholders and debt holders so that debt costs can be paid and equity investors can be provided with an adequate return on investment consistent with the risks assumed for the period under consideration. The notion of "cost of capital" has many different interpretations, depending on the context in which it might be used.
In regulatory environments, cost of capital is estimated for a broad range of industries and for an equally broad range of economic regulatory purposes, some very wide in scope, others more narrow. There are differing mandates and degrees of significance to determinations of cost of capital among various regulatory jurisdictions. These influence the methodological choices each regulator considers, as does the regulatory history and the prevailing legislative and economic environment unique to each jurisdiction. Therefore, it is important at the outset of this consultation to clarify cost of capital in terms of the mandate and responsibility of the Canadian Transportation Agency (Agency).
Section 5 of the Canada Transportation Act (CTA) sets out the national transportation policy for Canada and states, in part, that regulation and strategic intervention is used to achieve economic outcomes only when they cannot be achieved satisfactorily by competition and market forces. Accordingly, the Agency makes annual cost of capital rate determinations for its regulatory purposes within a context of economic regulation of railways in Canada, which relies primarily on market forces to govern relationships between railway companies and shippers.
In that context, the cost of capital rates for federally-regulated railway companies factor into a number of statutory and regulatory applications provided under the CTA:
- As a component in the volume-related composite price index calculation that establishes the maximum revenue entitlement for the movement of Western grain by rail.
For use in the development of interswitching costs and rates.
For other, less frequently called-upon regulatory purposes requiring cost determinations, such as:
the determination of rates to be paid by a rail passenger service to its host railway for access and other rail services;
the apportionment of the costs of maintaining or constructing railway crossings;
the establishment of a competitive line rate;
the establishment of a joint tariff;
the development of rates for running rights;
railway disputes (level of service and railway noise) where the cost of meeting a given level of service or of mitigating railway noise might be a factor to consider; and,
when requested by the arbitrator, the provision by the Agency of technical costing assistance in Final Offer Arbitration proceedings between a shipper and a carrier.
The Agency established cost of capital rates for the sole purpose of such statutory and regulatory applications.
In addition, the Agency is aware that these rates may be used by railway companies and shippers, or other parties such as arbitrators, for their own purposes, in commercial negotiations or arbitration proceedings.
At present, the Agency determines cost of capital rates in accordance with the principles established in the following Agency decisions:
Decision No. 52-R-2004, in the matter of issues related to the Agency's determination of cost of common equity rates for federally-regulated railway companies, dated February 2, 2004 (2004 Decision);
Decision No. 125-R-1997 in the matter of issues pertaining to the Agency's cost of capital publication/methodology, dated March 6, 1997 (1997 Decision); and,
Decision on the Cost of Capital Methodology, dated July 31, 1985 (1985 Decision).
In 2009, the Agency initiated a two phase consultative review of its current cost of capital publication/methodology. In the first phase of this review, the Agency commissioned an expert independent study of publication/methodologies that might be suitable for determining the cost of capital rates for federally-regulated railway companies in Canada. The study examined principles and existing models that might meet the Agency's criteria for a reasonable, reliable and pragmatic publication/methodology suitable for determining cost of capital in its regulatory environment. The final report of the study, prepared by the Brattle Group and entitled "Review of Regulatory Cost of Capital Methodologies", is now complete and is being provided to participants for their review and comment. To obtain copies of the Brattle Group report, participants can contact Dale McKeague (e-mail: email@example.com, telephone: 819-997-4914). This marks the /conclusion of the study phase and the start of the hearing phase of the Agency's review of its cost of capital publication/methodology.
The terms of reference for this study identified a number of criteria for assessing the merits of various publication/methodologies, namely:
Reasonable – A reasonable publication/methodology should be:
- Consistent with the objective being pursued ─ namely, to provide federally-regulated railway companies with a fair and reasonable return;
- Transparent by relying as much as possible on a formula/structured publication/methodology and by minimizing the use of judgmental factors.
Reliable – A reliable publication/methodology should be:
- Based on auditable information;
- Able to produce consistent results for like conditions;
- Robust, and reasonably sensitive, to a broad range of economic/financial conditions.
Pragmatic – A pragmatic publication/methodology should be:
- Based on readily available information or information that can be obtained with minimal costs;
- Simple to implement for both the regulator and regulated parties;
- Compatible with the regulatory context and legislative requirements in which the Agency is exercising its responsibilities (i.e., timeframe for issuing decisions, nature of regulated parties, context in which the cost of capital is being applied).
The Agency considers these criteria to be appropriate, while recognizing inherent weighting and balancing will be required.
In this second phase, a Panel of Agency Members has been appointed to determine if there is a clearly superior publication/methodology to, or if there are improvements that would clearly improve the Agency's existing cost of capital publication/methodology. For this purpose the Panel will consider the final report of the Brattle Group's study and any comments submitted about it, in addition to considering evidence submitted from railway companies, shippers and other participants pertaining to the Agency's existing publication/methodology or possible alternatives. After this examination, the Panel will determine the appropriate cost of capital publication/methodology that the Agency will use for, at a minimum, the next five year period.
To facilitate the Agency's examination of the matter, this Agency Consultation Document provides participants with an overview of the Agency's existing cost of capital publication/methodology and identifies publication/methodology issues of which the Agency is aware. In the context of these issues, as well as any others that parties consider pertinent to this examination, participants are invited to submit comments on the publication/methodology that should be used by the Agency for determining cost of capital rates for federally-regulated railway companies in Canada.
II. Agency's Cost of Capital Methodology
1. Overview of the Agency's current cost of capital publication/methodology
The Agency's principal determinations of cost of capital rates are based on confidential submissions made by Canada's two Class 1 freight railway companies, the Canadian National Railway Company (CN) and the Canadian Pacific Railway Company (CP). The railway companies' submissions are based on their most recently completed fiscal year, which runs from January 1 to December 31 for both. The Agency analyzes the railway companies' data and issues its determination before the following April 30. The cost of capital rate as so determined for each of CN and CP for the transportation of Western grain for an upcoming crop year establishes the variables, other than the risk-free rate, that the Agency will use also in other cost of capital determinations it makes throughout the year for that railway company.
The process consists of four distinct steps:
a) Determination of net rail investment;
b) Determination of capital structure;
c) Determination of capital structure cost rates, which includes the cost rate of debt, deferred taxes and common equity; and,
d) Calculation of the cost of capital rate.
Net Rail Investment: The net rail investment is defined as the gross book value of all railway assets less accumulated depreciation. This first component defines the portion of the railway company's net assets that are providing regulated railway transportation services and are under Agency jurisdiction. The net rail investment includes an amount for working capital. CN and CP make annual submissions regarding net rail investment, based on book values from their most recent financial statements, with certain approved adjustments. These submissions are audited and approved by the Agency.
Capital Structure: The capital structure refers to the combination of the various sources of capital used to finance the net rail investment. In broad terms, funding can be achieved through borrowing, issuance of debt instruments, deferred taxes and shareholders' equity. Each year, CN and CP submit their actual capital structures, based on book values from their most recent financial statements, with certain approved adjustments. These submissions are audited and approved by the Agency.
Capital Structure Cost Rates: The cost of debt is taken as the actual cost of the debt, that is, the interest paid to financial institutions or bond holders for loans made to the railway companies, as recorded in the most recent financial statements of the railway companies and submitted to the Agency. These submissions are evaluated and approved by the Agency.
Deferred taxes are allocated a zero percent cost rate according to the 1985 Decision. The rationale for this treatment of deferred taxes is that the Agency considers this item to represent a "free" or "no cost" source of funds to the railway companies.
The railway companies also make submissions proposing a cost rate for common equity. The Agency assesses the submissions, makes any changes necessary to adhere to its approved publication/methodology and calculates the cost of common equity using three financial models; the Capital Asset Pricing Model (CAPM), the Discounted Cash Flow (DCF) Model and the Equity Risk Premium (ERP) Model. The Agency then assesses which model or combination of models best reflects the state of capital markets in that year. In each year since the 1997 Decision, the Agency has applied the results of the CAPM alone.
An income tax allowance, based on the railway companies' submitted statutory federal and provincial income tax rate, is added to the cost of equity to establish the before tax value of the shareholders' return. No income tax allowance is applied to interest as it is income tax deductible.
In conjunction with cost of capital rate determinations for the transportation of western grain, the issue of whether a risk adjustment for grain transportation should be included in the cost of equity is also assessed each year. Prior to the 1997 Decision, the Agency applied a grain risk adjustment of -1 percent to the cost of common equity. Subsequent to the 1997 Decision, no grain risk adjustment has been applied. However the applicability of such an adjustment continues to be considered and determined annually.
Weighted Average Cost of Capital Rate: The proportion of each type of funding in the capital structure is used to weight each cost rate and the sum becomes the cost of capital rate expressed in percentage terms. When this rate is applied to the net book value of the assets involved, it results in the cost of capital in dollar terms.
2. Issues regarding the Agency's cost of capital publication/methodology
The following briefly outlines certain issues pertaining to the Agency's cost of capital publication/methodology, which have been raised in previous proceedings or warrant consideration. They relate to the determination of capital structure and capital structure cost rates.
A. Capital Structure
(i) Book-value versus market-value capital structure
The Agency uses an actual rather than deemed capital structure and uses accounting book values to determine the relative weights of long-term debt and common equity. An actual capital structure can also be derived by determining the market value of the long-term debt and common equity components. The market value of common equity is calculated by multiplying the price per share of equity by the total shares of equity outstanding. The market value of long-term debt can be estimated based on several factors: the book value of long-term debt, the duration of the debt, the coupon rate on the debt, the current market interest rate for comparable debt and the weights attached to debt with different maturities. Because calculating the market value of long- term debt requires complex data analysis, calculations and assumptions and the market values of some types of debt instruments are not directly observable, the book value of long-term debt is commonly used as a proxy for the market value of long-term debt.
Should the Agency use book values or market values when determining the relative weights of long-term debt and common equity in the railway companies' capital structure?
(ii) Treatment of deferred taxes
The Agency includes and gives weight in the capital structure to the book value of deferred taxes and assigns it a zero cost rate.
Should the Agency continue to include and give weight to deferred taxes in the capital structure and if so, what rate should be assigned?
B. Capital Structure Cost Rates
(i) Cost rate of long-term debt
The Agency determines the cost rate of long term debt based on the historic cost of debt in the railway companies' financial statements for the most recently completed fiscal year (i.e., January 1 to December 31). It has been suggested that in the current climate of rising financing costs some method of projecting future debt costs should be used.
Should the Agency determine the cost rate of long-term debt by using the historic cost of debt in the railway companies' financial statements for the most recently completed fiscal year? If not, how should the Agency determine the cost of long-term debt?
(ii) Cost rate of common equity
The Agency assesses the cost rate of common equity using three methods of calculation (CAPM, DCF and ERP). For each year since the 1997 Decision, the Agency has determined that the CAPM alone provided the best reflection of the state of capital markets each year. It has been suggested that weight should also be given to the DCF method.
What method or combination of methods should the Agency use to estimate the cost rate of common equity?
(iii) Use of Canadian data to determine cost rate of common equity
To establish the variables for each of the methods used to calculate the cost of common equity the Agency relies exclusively on Canadian data. It has been suggested that US data should be used.
Should the Agency continue to use Canadian data or use some combination of Canadian and US data to establish the variables for each of the methods used to calculate the cost of common equity?
(iv) Short-Run versus Long-Run version of the CAPM model
The Agency uses the yields from a combination of short-term (1-3 year) and long-term (10+ years) Government of Canada marketable bonds as the proxies for risk free rates of return in the CAPM. The bond choice influences the cost of equity result. In terms of stability and responsiveness, both short-term and long-term bonds have certain advantages and disadvantages, as does the use of a combination of both.
Bearing in mind the stability and responsiveness implications and given that the Agency develops cost of equity rates annually, should the Agency develop risk free rates using short-term or long-term bonds, or a combination of both and what time horizon should it use for each?
(v) Market risk premium component of CAPM
Since the 1997 Decision, the Agency has applied a 45 year rolling average to develop the market risk premium in the CAPM. It has been suggested that a longer averaging period should be used.
What averaging period should the Agency use to develop the market risk premium used in the CAPM?
(vi) Assessment of a grain risk adjustment
In accordance with the 1997 Decision, the Agency makes an annual assessment with respect to the appropriateness of applying a grain risk adjustment to the cost of common equity and has determined each year since that time that none should apply.
Should the Agency continue to make an annual assessment of whether the cost of common equity should be adjusted to reflect the risk of carrying grain and if so, on what basis should it be established?
III. Next steps and process
Participants are invited to submit their comments on the publication/methodology that should be used by the Agency for determining the cost of capital rate for federally regulated railways in Canada. Comments should be made in the context of the issues identified in Part II of this document, as well as on any other pertinent issues. In addition, parties may also submit comments on the
Brattle Group study, ‘Review of Regulatory Cost of Capital Methodologies'. Submissions should clearly distinguish the comments on the Brattle Group report from those on publication/methodology to be used by the Agency for determining the cost of capital rate for federally regulated railways in Canada. In addition to comments, submissions should include supporting evidence. If this evidence includes expert reports, each expert report must be accompanied by the curriculum vitae of the author(s).
To obtain full and fair comments from all participants, all submissions will be made available to other participants for response. Responses can reflect the views of the parties and/or those of their experts and should include supporting evidence. Responses must be limited to addressing the comments filed by others. New issues are not to be raised in responses.
Any documents submitted to the Agency become part of the public record. It is the Agency's expectation that the review process will provide for an open, consultative and non-adversarial exchange of viewpoints and information. However, in the event there is any material a party believes to be confidential in nature, they may request that it be kept confidential pursuant to the instructions found in Appendix A. It should be noted that, in the interest of an expeditious review process, there are strictly limited time periods allowed for justifying and objecting to any claims for confidentiality.
Submissions can be made by mail, by fax or electronically and should be addressed to:
Canadian Transportation Agency
Ottawa, Ontario K1A 0N9
All submissions must be made in accordance with the revised timelines specified below. The Agency is of the opinion that a revision to the originally proposed timeline is necessary as there are, in addition to this review process, a number of other important federal rail related initiatives in progress, including the Rail Freight Service Review, the analysis of Limited Distribution Tariffs, a fuel surcharge review and the process to change regulated interswitching rates. The Agency recognizes that many of the participants to the Cost of Capital Methodology Review process may also be involved in these other processes. Given the importance of the subject and in the interest of allowing it a fair, full and meaningful hearing, the Agency has taken these other demands on participant resources into consideration in finalizing these timelines.
Operating within this schedule, the Agency advises it will not be implementing the results of this process in the 2011-2012 volume-related composite price index determination.
Initial submissions from participants
Submissions made available to participants
Responses by participants to initial submissions
January 31, 2011
February 4, 2011
March 4, 2011
Considering the complexity of the issues being reviewed, the Agency anticipates there will be a need for an oral hearing. Parties making submissions should indicate whether an oral hearing would be of value to this consultation. Following analysis of the initial submissions and responses, the Agency will make a determination as to an oral hearing, which, if held, the Agency anticipates would be convened in Ottawa in April, 2011.
For more information, you may contact Dale McKeague at 819-997-4914.
 The Brattle Group will be given the opportunity to respond to any comments filed by participants with respect to the Brattle Group's study. That response will be posted on the Agency's Web site in March 2011, and parties will be notified.
Appendix A: Claims for confidentiality
The Agency has launched a consultative process for reviewing its cost of capital publication/methodology. Given the open, consultative approach adopted and the nature of the proceedings, the Agency expects all submissions to be put on the public record. However, in the unlikely event that a claim of confidentiality is made, the Agency adopts an approach and timelines for addressing such claims. Accordingly:
- The provisions of the Canadian Transportation Agency General Rules dealing with confidentiality will not apply.
- All documents will be considered public documents and will be put on the public record unless they are treated as confidential, as per the following rules.
- There will be four levels of confidentiality, with Level 1 describing the distribution of the most confidential documents and Level 4 describing the distribution of the least confidential documents:
- Level 1: disclosed only to the Agency;
- Level 2: disclosed only to the Agency, counsel and independent experts;
- Level 3 disclosed only to the Agency, counsel, independent experts and all appropriate advisors;
- Level 4: disclosed only to the Agency and to the participants to the consultation (participants)
Note: In any of these four levels, no confidential information will be provided to the public. The reference to "participants" in Level 4 includes such individuals or other corporations that have a direct interest in the participants. The references to "participants", "experts" and "advisors" include witnesses.
- Participants (or their counsel) shall file with the Agency by November 19, 2010 a list of names of those to whom disclosure of confidential documents would be made, including "participants" identified in Level 4. These should be clearly identified as (1) counsel, (2) independent experts, (3) advisors and (4) individuals/corporations that have a direct interest in the interested party. Copies of these lists shall be provided by the Agency to other participants at the same time. This will constitute the confidentiality list. For each person on the confidentiality list, a full mailing address, title, telephone number, fax number and e-mail shall be provided. The Agency will post the confidentiality list on the Agency's Web site and going forward, the participants will be responsible for all further notifications provided for under these procedures. Participants will have 48 hours to raise objections to the inclusion of any person on the confidentiality list. The nominating party will have 24 hours to provide its justification for the inclusion, after which the Agency will rule on whether that person will remain on the confidentiality list.
- No participant can add a person to the confidentiality list after confidential material has been released without providing notification to all participants and the Agency. Other participants will have 48 hours to raise objections to releasing confidential material that is already part of the proceedings to the persons added to the confidentiality list. While an objection to adding a person to the confidentiality list has not been resolved by the Agency, this person shall not have access to the confidential material.
- Each participant who submits materials of a confidential nature with the Agency in the course of this consultation shall, in the cover letter to the submission, assert a claim for confidentiality, indicate which level of confidentiality that they view as appropriate for each document, indicate whether specific individuals on the confidentiality list shall not have access to the material and the rationale, and provide a justification for the level of confidentiality claimed (including a description of the specific direct harm that could result from disclosure of the document or a change to the level of confidentiality claimed). The participant must also file with its claim for confidentiality a redacted "public" version of the document(s) for which confidentiality is being sought. A copy of the cover letter and the redacted version(s) shall be provided to the other participants at the same time as it is submitted to the Agency.
- The other participants will then have 48 hours to file with the Agency any objections they have to the level of confidentiality claimed, persons not having access to the confidential material, and in particular why it would be in the public interest that the information be made available publicly or be subject to a lower level of confidentiality.
- The time frame for objections set out above will apply to all new documents submitted. If, after 48 hours, no objection has been received, the document will be marked as confidential and will be released accordingly.
- When there are objections filed to a claim of confidentiality, the participant making a claim of confidentiality will have 24 hour to prepare a response to the objections.
- Following the receipt of the responses to the objections, the Agency will rule on whether the document should be kept confidential, the level of confidentiality, and the persons having access to the document, and will release the documents accordingly.
- All persons who have occasion to view any document that is confidential will execute a general confidentiality undertaking prior to having access to any confidential document as per a form to be prescribed by the Agency.
- The Agency reserves the right to make a ruling pursuant to section 10 above on a claim of confidentiality on the Agency's own initiative, even if no objection is raised.