Discussion Paper on the Methodology to Determine Net Rail Investment and Capital Structure for the Calculation of Cost of Capital Rates
As part of its mandate to support the efficiency of Canada's national transportation system, the Canadian Transportation Agency (CTA) calculates regulated cost of capital rates, which the CTA uses in various rail related determinations – including regulated interswitching and the Maximum Revenue Entitlement (MRE).
The CTA is now holding public consultations on two components of regulated cost of capital rates:
- Net Rail Investment; and
- Capital Structure.
Based on the input received, the CTA may propose changes to its methodology for calculating cost of capital rates.
Our goal is to ensure that the methodology we use to calculate cost of capital is rigorous, transparent, and fair for rail system users, including shippers, and railway companies. The methodology we use should also treat railway companies consistently. In recent years, the CTA has observed differences in reporting of certain cost of capital elements by the railway companies. As a result, the CTA in Decision No. LET-R-29-2020 and Decision No. LET-R-30-2020 adopted an interim methodology on some of these elements to better align the approaches. As part of our consultation process, we are seeking input on various issues that can help to establish a longer-term solution.
Any changes the CTA makes to the methodology for calculating cost of capital as a result of these consultations could result in a modest difference in rail-related determinations such as regulated interswitching and the MRE.
These consultations build upon a series of initiatives the CTA has taken in recent years to modernize its framework for rail. Recently, the CTA has updated various rail-related regulations (July 2019); extensively reviewed the methodology for determining the cost of common equity rate, leading to Determination R-2019-229 on this issue in December 2019; consulted on regulated interswitching rates, which informed the CTA's 2020 interswitching determination; and, recently began consultations on rail interswitching regulations.
Cost of capital – uses and timing
Cost of capital is an estimate of the total return on net investment that is required by debt holders and shareholders, so that debt costs can be paid and equity investors can be provided with a return on investment consistent with the risks assumed for the period under consideration.
The CTA annually determines unique cost of capital rates for three different purposes:
- To support other calculations required to regulate the transportation of Western grain (e.g., the MRE);
- To support other calculations required for regulated interswitching; and
- For other regulatory purposes requiring costing determinations (such as final offer arbitration).
There are numerous freight railway companies under federal jurisdiction. However, cost of capital rates for the MRE and regulated interswitching are calculated only for Canada's two major class 1 railway companies, the Canadian National Railway Company (CN) and the Canadian Pacific Railway Company (CP), pursuant to the parameters of the MRE and Decision No. R-2019-230 (2020 Interswitching Rates Determination).
The cost of capital for the transportation of western grain is determined on or before April 30 of each year. The interswitching cost of capital rate is determined on or before December 1 of each year. The cost of capital rates for other regulatory purposes are calculated annually for CN and CP, in case they are needed. They are calculated for other railway companies when a costing determination is required for their operations. Each of these cost of capital determinations utilizes data from different time periods, thereby ensuring the most up-to-date cost of capital rate is used for each specific purpose.
Calculation of Cost of Capital – Key Issues
The cost of capital determination process consists of four distinct steps:
- Determination of net rail investment;
- Determination of capital structure;
- Determination of capital structure cost rates (which includes the cost rate of debt, deferred taxes and common equity); and
- Calculation of the cost of capital rate based on A, B and C.
The cost of capital rate (D) is calculated by determining the net value of rail-related investments that a particular railway company has made over time (A), the capital structure of the railway company (i.e., the proportion of each type of funding in the capital structure) (B), and the different cost rates associated with how each particular type of capital was amassed (C).
In 2017, the CTA consulted on the methodology for the working capital allowance and capital structure (B) which resulted in Determination No. R-2017-198 (2017 Determination). In 2019, the CTA held a consultation on its cost of equity model in 2019, and reaffirmed the use of book values over market values in determining the cost rate of debt (C) in the 2017 Determination
This consultation focuses on the determination of net rail investment (A) and capital structure (B). More specifically, the CTA wishes to examine the following questions:
- Should a negative working capital be allowed in the calculation of net rail investment?
- Should commercial paper be included in the calculation of the working capital component within net rail investment?
- Should the current portion of long-term debt be recorded as a current liability or long-term debt?
- What methodology should the CTA use to apportion general purpose debt between regulated and non-regulated activities to determine the capital structure of railway companies?
- Should certain debt receive alternative treatment from the methodology set by the CTA in the 2017 Determination?
Details of current methodology under review
A. First component: Net Rail Investment
Net rail investment is calculated by taking the gross book value of all railway company's assets less accumulated depreciation. This component defines the portion of a railway company’s net assets that are providing railway transportation services, and are under CTA jurisdiction. It does not include assets that are used for providing railway transportation services in the United States (U.S.).
Specifically, the net rail investment is comprised of the following, as defined by the CTA's Uniform Classification of Accounts (UCA)Footnote 1, from the regulatory balance sheet of a railway company:
- the net book value of property assets, defined as Property (UCA Account 29) less Accumulated Amortization – Property (UCA Account 33);
- adjustments to the net book value of property assets to:
- the working capital allowance, which is defined as the average of 12 month estimates, each monthly estimate being an average of the beginning and closing balances of Current Assets (UCA Accounts 1-17) less the average of the beginning and closing balances of Current Liabilities (UCA Accounts 41-59);
- the Net Pension Asset as defined in CTA Decision No. 97-R-2012;
- Deferred Charges (UCA Account 35, excluding the Net Pension Asset); and
- other non-current assets:
- Long-term Intercorporate Investments (UCA Account 27); and
- Construction in Progress (UCA Account 31).
Working Capital Component of Net Rail Investment
As stated above, net rail investment includes an amount for working capital which is comprised of the cash, as well as the materials and supplies required by the railway company to maintain day-to-day operations. Railway companies make annual submissions regarding net rail investment, based on book values from their most recent year's preliminary annual report schedules that are to be filed with Transport Canada, with certain approved adjustments. These submissions are reviewed by the CTA and are adjusted or approved for use in the determination of the cost of capital rates.
The CTA's methodology for working capital is based on a modified classical accounting formula.
Although the CTA recognized in the past that a lead-lag study is a widely-used methodology in financial analysis and is generally considered to be the most accurate for determining the amount of working capital for a company, the CTA rejected it in the 2017 Determination "given the extensive and intensive resource requirements for a lead-lag study, which can be performed only very infrequently". Instead, the CTA opted to use a more cost effective modified version of the classical formula that it deemed to be sufficient for the cost of capital rate determination "given the relative ease of determination and updating of the proposed modification to the classical formula".
B. Second component: Capital Structure
The capital structure refers to the combination of the various sources of capital used to finance the net rail investment. Financing of the net rail investment is achieved through borrowing, issuance of debt instruments, deferred taxes and shareholders' equity. Each year, CN and CP submit their capital structures, based on book values from their most recent year's preliminary annual report schedules that are to be filed with Transport Canada, with certain CTA-approved adjustments. These submissions are reviewed by CTA staff and are adjusted or approved for use in the determination of the cost of capital rates. Other railway companies also submit this information if a cost of capital determination for their operations is required.
The capital structure is comprised of the following, as defined in the UCA, from the regulatory balance sheet of the railway company:
- the following non-current liabilities included in the capital structure at the face value of the cost rate of debt:
- Long-term debt (UCA Account 65); and
- Lease Obligations (UCA Account 67);
- the following non-current liabilities included in the capital structure at a cost rate of zero percent:
- Deferred Liabilities (UCA Account 61);
- Future Income Taxes (Non-Current) (UCA Account 63);
- Other Deferred Credits – Long-term (UCA Account 69);
- Investment Tax Credits (UCA Account 74);
- Stock-Based Employee Compensation Liabilities – Non-Current (UCA Account 75); and
- Deferred downsizing, restructuring or environmental accrual costs not included elsewhere;
- the following included in the capital structure at the cost rate of common equity:
- Share Capital (UCA Account 81);
- Contributed Surplus (UCA Account 83);
- Retained Earnings (UCA Account 85);
- Net Investment in Rail Assets (UCA Account 87); and
- Minority Shareholders' Interest in Subsidiary Companies (UCA Account 71); and
- net cash balances or intercompany transaction balances not deducted from long-term debt.
Capital structure weights are then calculated by equating the book value of the net rail investment to the book value of the sources of capital.
Interim Approach to Capital Structure
In setting a methodology for capital structure, the CTA strives to apply a consistent approach to Canada's two class 1 railway companies. The CTA has taken an interim approach to allocate certain debt, known as the revenue ton miles (RTM) approach, for the immediate term. The RTM approach allocates debt to Canadian operations and U.S. operations based on the proportion of traffic moved in each jurisdiction using reported revenue ton miles.
In Decision No. 125-R-1997, the CTA determined that CN debt is considered part of CN's regulatory balance sheet unless CN can prove that the debt was raised for a specific non-rail purpose, or to finance U.S. operations. Each debt instrument is assigned either 100 percent to Canadian rail operations, partially to Canadian rail operations, or excluded from Canadian rail operations.
However, in a letter sent on August 14, 2017, CN notified the CTA that it performed a detailed examination of its cost of capital calculations and discovered it was reporting all debt for the entire CN corporation and not just its Canadian operations.
Although CN proposed to allocate its debt based on its consolidated company’s balance sheet to address this development, in Decision No. LET-R-41-2019, the CTA did not accept this proposal, noting that it, among other things, did not address differences in accounting rules between the UCA and U.S. Generally Accepted Accounting Principles (US GAAP), and did not provide a detailed reconciliation between the parent company's audited balance sheet and the regulatory balance sheet. Instead, the CTA allocated CN's debt based on the RTM methodology, stating:
The RTM-based approach, in contrast, does not require reconciliation of accounts from different accounting systems, reflects the reasonable expectation that there will be a relationship between investments in assets and revenues earned, and allocates a portion (rather than none) of CN's debt to its [U.S.] operations.
Based on these considerations and the evidence before it, the Agency finds that the RTM-based approach is the most reasonable methodology for allocating debt as part of the cost of capital determination for the 2019-2020 crop year. Debt that can be directly linked to CN's [U.S.] operations is to be excluded from the regulatory balance sheet, similar to the current methodology, and all other general purpose debt will be allocated to the regulatory balance sheet based on the proportion of total network RTM in Canada in the year in which the debt is issued.
CP's Canadian and U.S. rail operations are operating subsidiaries of its corporate parent company, CP Rail Limited, which includes a number of subsidiaries that are not federally regulated. CP Rail Limited raises debt for general purposes for its entire corporation including its regulated and non-regulated rail subsidiaries. In Decision LET-R-29-2020, the CTA also applied the RTM methodology to CP's general purpose debt in the interim to ensure consistent treatment of both railway companies pending the CTA's review of this issue.
Overview of the Issues and Questions for Discussion
In addition to the questions already identified by the CTA, over the past few years, CTA staff have observed a number of issues in calculation of net rail investment and capital structure that merit attention. These issues have generally become apparent with the different reporting practices of the railway companies.
The issues and questions for discussion are outlined below. Overall, the CTA's objective is for the inputs to cost of capital to be methodologically sound; rigorous; fair between system users and railway companies; and consistent between railway companies.
Issue 1: Should a negative working capital be allowed in the calculation of net rail investment?
The purpose of working capital is to ensure a company has sufficient funds to maintain its day to day operations such as paying wages and to satisfy its accounts payable or maturing short-term debt.
A consistent negative working capital will affect a company's long-term investment effectiveness and its financial strength in covering short-term liabilities. For some industries, having a negative working capital for an extended period of time indicates financial weakness, as they are unable to pay their bills, and have to rely on borrowing or issue stocks to finance their working capital.
As working capital could be financed by funds raised from debt/equity issuances or deferred taxes, this allowance is included in the calculation of the cost of capital to provide a sufficient return for the railway companies to pay back their financing obligations.
CTA staff has observed in recent years that the current methodology for calculating the working capital allowance has produced a negative working capital as it is possible for current liabilities to exceed current assets. A reduced working capital in the CTA's cost of capital methodology reduces the railway company’s capital structure, which may have an effect on the final cost of capital rate.
Q.1 Should the cost of capital reflect the economic reality of the railway company at the time it is calculated, regardless of whether it is positive or negative? Please provide a rationale for your response.
Issue 2: Should commercial paper be included in the calculation of working capital?
The 2017 Determination states that all current liabilities should be recorded in various UCA accounts, from Accounts 41-59, in the calculation of the working capital.
Commercial paper is typically an unsecured promissory note with a fixed maturity of 270 days or less. Commercial paper is a security that is issued by large corporations to obtain funds to meet short-term debt obligations such as payroll, accounts payable and inventories. It is only backed by the issuing company's promise to pay the face amount on the maturity date specified on the note.
Due to the shorter maturities of commercial paper relative to bonds, commercial paper will typically carry a lower interest payment than bonds.
Although commercial paper is a short-term obligation, it can be issued as part of a continuous and significantly longer rolling program, matching the time period of some long-term debt. This is achieved by replacing maturing commercial paper with newly issued commercial paper for the remaining amount of the obligation.
If rolled-over commercial paper is removed from current liabilities and treated as long-term debt, it would decrease current liabilities from the working capital calculation which would lead to a higher working capital allowance.
Q.2 Although commercial paper, by definition, is a short-term financial instrument, should commercial paper that is routinely rolled over be treated as a current liability or as long-term debt? Please provide a rationale for your response.
Q.3 If the CTA finds it appropriate to treat rolled over commercial paper differently, how should commercial paper that is rolled over and commercial paper that is not be identified in the railway company's annual submissions to the CTA?
Q.4 How should commercial paper which is raised for general corporate purposes be allocated to regulated activities? Please provide a rationale for your response.
Q.5 Are there other short-term financing instruments (for example, an unsecured revolving credit facility or an accounts receivable securitization program) that should be treated as long-term debt rather than as a current liability? Please provide a rationale for your response.
Issue 3: Should the current portion of long-term debt be identified as a current liability or as long-term debt?
The US GAAP require that the current portion of long term debt be presented in current liabilities.
According to the Business Development Bank of CanadaFootnote 3:
The current portion of long-term debt is the amount of unpaid principal from long-term debt that has accrued in a company's normal operating cycle (typically less than 12 months). It is considered a current liability because it has to be paid within that period.
As stated previously, cost of capital is defined as an estimate of the total return on net investment that is required by debt holders and shareholders, so that debt costs can be paid and equity investors can be provided with a return on investment consistent with the risks assumed for the period under consideration.
The first step in the calculation of the cost of capital is to determine the net rail investment; this is followed by equating the net rail investment to the sources of capital.
Treating the amount of unpaid principal of a long-term debt in the final year as a current liability would cause a reduction in net rail investment, despite the continued existence of the debt obligation, and subsequent removal of the debt interest obligation in the calculation of the sources of capital.
If the current portion of long-term debt was removed from current liabilities, this would, in turn, increase the working capital allowance.
Q.6 Should the current portion of long-term debt be treated as a current liability as per US GAAP or should it be treated as long-term debt? Please provide a rationale for your response.
Issue 4: How to apportion general purpose long-term debt of a railway company between its Canadian rail entities and non-regulated entities?
A railway company may be composed of both Canadian rail entities and U.S. rail entities. While the CTA regulates the Canadian rail entity(ies) of a railway company, it also needs to consider the impact of general corporate activities of the entire railway company on the Canadian rail entity.
When railway companies issue stock, the operating assumption is that the stock issued is a reflection of the future operating incomes that will be generated by the operating entities. In this case, the parent company's issuance is largely backed by the operating incomes of its rail entities.
Likewise, when general purpose debt is issued, the proceeds of the issuances are used for general corporate purposes. These purposes logically include non-regulated entities, U.S. rail entities and Canadian rail entities.
Q.7 To the degree that general corporate activities affect the Canadian rail entity, how should the CTA allocate a portion of those activities to the Canadian rail entity? Please provide a rationale for your response.
Q.8 Alternatively, should the CTA disallow debt whose use cannot be identified? That is, should railway companies be required to identify what general purpose debt is incurred for, in order for such debt to be included or excluded in the calculation of cost of capital? Please provide a rationale for your response
Q.9 Should the CTA enforce stronger data reporting (for example, tracking or projecting what proportion of general purpose debt is used in Canadian rail operations)? Please provide a rationale for your response.
Issue 5: Treatment of debt not issued by a railway company
In Decision No. 425-R-2011 (2011 Decision), the CTA determined that debt should be recorded at its coupon rate where the coupon rate:
…also known as the nominal yield or coupon yield, is the interest rate that the bond issuer is obligated to pay to the bondholder each year until maturity relative to the face value of the bond. It is most commonly used to determine a company's existing debt obligations. In its simplest form, it is expressed as a ratio of the annual coupon payment to the bond's face value.
The CTA concluded in that decision:
To the extent that the method for measuring the yield on long-term debt is attempting to reflect the actual financing cost of existing debt, the Agency finds that the coupon rate method is the most reasonable, reliable and pragmatic of the three models examined.
The Agency finds that projecting future debt and future debt costs and the new issues arising from identified related problems is not a clearly superior approach to the one currently in place.
The Agency determines that it will also calculate the cost of debt rate based on the financing rates recorded in the financial reports of each company, and account for only existing debt and debt costs.
In the 2017 Determination, the CTA determined that the appropriate specification of long-term debt in the capital structure is the face value of the debt, to conform to the long-standing definitions of assets and liabilities, and to conform to the existing 2011 Decision regarding determination of the cost of debt rate.
Q.10 Are there examples of an abnormal situation (such as acquisitions of another railway company and its debt) where the market value of debt should be used, rather than the face value, in the determination of the railway company's capital structure? Please provide a rationale for your response.
Q.11 If market value is determined appropriate, what rate or rate calculation should the CTA use for this debt? Please provide a rationale for your response.
You are invited to submit your input to the questions posed in this discussion paper by November 25, 2020. You are invited to respond to all questions, or simply those questions that are of interest to you or your organization. Your responses to the questions should include a supporting rationale and evidence to allow the CTA to properly assess its validity.
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