The global credit crisis has ignited a duel between Canadian pipelines and natural gas shippers over who should pay potential cost increases created by money market turmoil. The transporters are calling the financial sorrows a reason to scrap a long-standing restraint on their returns and tolls. But their customers are defending the status quo.
The contest centers on a 14-year-old formula devised by the National Energy Board (NEB) for making annual cost-of-capital rulings without holding rate hearings. The standard makes pipeline returns on equity track interest rates paid by long-term government bonds.
For 2009 the formula generated a cut in allowed pipeline rates of return to 8.57 % from 8.71 % last year. The calculation has two steps. The NEB forecasts the government bond interest rate for the year ahead. Then the allowed return rate is adjusted, up or down, by 75% of the anticipated change from the previous year.
The board opened an arena for the ratemaking duel by issuing a general invitation for submissions about whether the old policy is still appropriate. The move followed a decision to make an exception for 2007 and 2008 for one gas pipeline, TransCanada Corp.'s Trans Quebec & Maritimes, which convinced the NEB that the formula did not take into account special circumstances in its case for the period involved.
In the Canadian system, variations from the formula are largely accomplished by adjusting pipeline debt-to-equity ratios. Raising the level of deemed equity in corporate financial structures generates increases in authorized revenue requirements that establish transportation tolls.
But returns allowed by the formula in general no longer satisfy traditional standards of fairness, the Canadian Energy Pipeline Association says. "Most notably the resulting returns are not commensurate with the returns available for investments of similar risk and do not adequately compensate shareholders for existing or new infrastructure investments," says the voice of virtually all significant gas and oil transporters.
The credit crisis poses a risk of being squeezed that the pipelines would plainly prefer to pass on to their customers. Yields on long-term government bonds that drive the NEB formula are dropping because they track interest rate cuts implemented by central banks to counter the economic slump. But interest rates on commercial credit have been rising as lending institutions compensate for heightened risks that borrowers will be unable to repay loans.
In support of the pipelines, the fixed income securities arm of Sun Life Financial, one of Canada's largest savings and investment services firms, says effects of the credit crisis are creeping into the most stable, utility side of the energy industry.
"Unprecedented events in the economy and the financial markets over the past year have had an impact on the companies' ability to raise financing and made the financing cost more expensive," Sun Life says. "Declining equity valuations have made equity financing less attractive for most pipeline companies," the investment firm says. "A liquidity squeeze and higher spread levels have made the cost of issuing new debt more expensive...inability to find affordable capital may cause companies either to delay planned capital expenditure projects or to accept inadequate returns."
Canadian gas shippers, already squeezed badly by fallen energy prices, insist that they do not need to have further financial pain inflicted on them by pipelines. Even subtle changes in return-on-equity rules can spell billions of dollars in cost increases when high financial policy is translated into transportation tolls, warns the Canadian Association of Petroleum Producers (CAPP).
"Of course, regulated companies have been lobbying for higher returns as interest rates have fallen and that is their job for their shareholders," CAPP says in a lengthy submission to the NEB. "But it is the job of the regulator to ignore such lobbying. The role of regulation is to be a surrogate for competition. Competition constrains profitability and disciplines the ability to increase prices."
In effect, Canadian producers urge the NEB to follow a fairness standard saying pipeline creditors and investors should be no more immune to financial risk than counterparts who put money into the other branches of the energy industry. "Maximization of shareholder wealth is not an objective of regulation. Maintenance of shareholder wealth is also not a regulatory objective," CAPP says.
"The adoption of a formula approach to ROE with periodic reviews of capital structure as warranted by material changes in circumstances has provided great certainty and predictability of returns," CAPP says. "It has facilitated many settlements and agreements. It has also reduced the number and cost of capital hearings. These represent enormous gains in regulatory efficiency."
In addition, financial risk levels are lower in Canada than in the U.S. because money markets have remained much more regulated and conservative north of the border, the gas producers say.
"Financial markets are not fully integrated and this is highlighted in the collapse of U.S. banks with massive bailouts while the government of Canada has not needed to follow suit," CAPP points out. "During the last few years TransCanada has raised billions of dollars of both long-term debt and common equity capital in some of the most difficult financial markets experienced in its history."
CAPP's allies in defending the status quo include a recently created arm of the Alberta Utilities Commission, the Office of the Utilities Consumer Advocate. The NEB's formula approach "offers a mechanism that is predictable and has the potential to be even-handed in its treatment of both shareholders and ratepayers while economizing on regulatory costs," the provincial agency says.
But TransCanada, which fought creation of the status quo and has never given up the battle, is urging the NEB to take the simplest, most direct approach possible to the tangled financial issues by just scrapping its return-on-equity formula.
The current process "has become an artificial and unnecessary barrier to the efficient and effective determination of a fair return given the significant changes in financial markets, business circumstances and general economic conditions," TransCanada says in its submission to the board.
Scrapping the formula would help rather than hinder negotiated toll settlements, the pipeline company says, rejecting shipper claims that the NEB policy sets a helpful benchmark. "Current circumstances are such that parties should be left to negotiate cost of capital settlements," TransCanada says.
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