Cost of Capital Methodology Review
Current Costing Reviews
While a full costing review has been refused, the CTA has been directed to conduct two current reviews that have direct cost implications for grain shippers: 1) the Cost of Capital Methodology Review; and 2) the Industry Development Fund Review.
The bottom line is that there is money on the table and these reviews are one-sided: a) all components of the reviews will increase railway revenues if their recommended changes are adopted; and b) the reviews are not looking at changes that would reduce the revenue cap.
Increases to railway revenues from these reviews would be achieved prior to a full costing review being done and become part of the status quo.
Through ongoing reforms in the regulatory framework the railways gained a stronger commercial position and price flexibility in exchange for a revenue cap. Now, they are seeking relief from the constraints of the cap by creating as many opportunities as possible for generating more revenue under the cap.
An initial analysis of the Industry Development Fund Review is available [HERE]
Cost of Capital Methodology Review
Review Process
- The deadline for comments on the initial Terms of Reference was Thursday, Sept. 24.
- APAS sent a comment letter suggesting the CTA conduct a study of a wide range of both railways’ business performance indicators that would provide clarity into their claims that their current regulatory environment related to grain inhibits both their system investments and investors buying their shares.
- Notably, the Coalition of Rail Shippers submission to the CTA about the Terms of Reference opposing the railways’ efforts to increase revenues through changes to CTA cost of capital methodologies, questioning the need for the review at all, and strongly recommending that it be suspended. Their submission can be found at: http://www.ggc-pgc.ca/docs/CRS%20Ltr%20re%20Cost%20of%20Capital%20TOR%20final%20%282%29.pdf
- Apparently, new Terms of Reference have been drafted as of early January, 2010 and will be issued soon.
- The proposed scope of work is to: review current CTA methods; examine approaches used by up to five other regulatory bodies; review recent research; identify different conceptual approaches, screened to an assessment of five, including both the existing CTA approach and a modified version of it.
- A final report will be submitted by the consultant.
- Stakeholders can comment on the report
- Target decision date of July 2010
Issues under Review
The issues below are copied directly from the CTA’s draft Terms of Reference, i.e. draft Request for Proposals to consultants to conduct their Cost of Capital Review. Initial analytical comments from APAS are in bold Italics.
Current and Recurring Issues raised re the current Cost of Capital Methodology
The following briefly outlines certain current and recurring issues raised by the railways pertaining to the Agency’s cost of capital methodology, specifically with regard to the determination of capital structure and capital structure cost rates. The Agency’s responses to these issues can be found in its annual determinations pertaining to the crop year cost of capital rate for the transportation of western grain.
Capital Structure: Agency uses an actual book-based capital structure for the railways, as opposed to a deemed capital structure
Market value vs. Book Value – Railways favour market value capital structure.
The CTA currently uses book value.
Book value is an audited, accurate representation of railway capital value.
Book value is a consistent and dependable way of estimating value that reflects actual business practice and performance.
Book value avoids both conjecture both what current market value might be and the vagaries of changing market conditions.
The railway request for using market value will increase their revenues, not because market value is a better or more logical way of representing capital value.
Deferred taxes given weight in capital structure and assigned a zero cost rate – Railways favour excluding deferred taxes from capital structure.
Deferred taxes are a source of working capital, a permanent one if the taxes are continuously deferred.
Because deferred taxes are zero rated by the CTA, this dilutes the overall costing rate allowed to the railways in proportion to deferred taxes’ share of total capital. Excluding them would increase the cost of capital the railways would be allowed to charge.
Non-rail debt – what is allowable non-rail debt? One railway submits that certain types of debt should be classified as non-rail debt and included in equity.
The ToR does not elaborate on this about so it is difficult to comment.
However, if additional debt IS included in equity, it would provide a larger base from which to calculate the cost of capital, thus increasing railway revenue.
Capital Structure Cost Rates:
Cost of Debt: Based on historic cost of debt reflected in most recent fiscal year, one railway, in the current climate of rising financing costs, favours some method of projecting future debt costs. This was not an issue when financing cost rates were declining year over year.
The cost of debt through financing should be determined by the most recent actual financing costs, not some future projection.
The fact the railways did not raise this issue when costs were declining is evidence of attempts to artificially raise capital costing rates.
Cost of equity – Calculated by three methods (CAPM, DCF & ERP), with Agency giving primary weight to CAPM – One railway favours use of the average of CAPM & DCF.
The advantages of the current practice of giving primary weight to CAPM are amply demonstrated by the CTA’s reference to the issue in the review’s Terms of Reference:
"The reason for the CAPM being chosen is that it is widely known and accepted in regulatory and financial practice and allows for a transparent, quantifiable projection, incorporating reconcilable data from the market as a whole, as well as a company specific factor (beta), to arrive at a cost of common equity forecast that is not subject to the degree of conjecture required to estimate an expected growth rate or risk premium, as is the case with the DCF and EPR methods respectively.”
Market risk premium component of CAPM – Agency uses 45 year time period and Canadian data. Railways object to the time period and data source, favouring a longer time period and the use of American data.
The effect on the Cap of going to a longer time period is not clear.
The use of American data seems inappropriate, since it would not apply to the context of Western Canadian grain shipment and would represent a higher risk market environment in the U. S.
Appropriateness of a grain risk adjustment assessed annually, with Agency consistently determining that none should apply. Railways favour including a grain risk premium.
Prior to 1997 the CTA applied a grain risk adjustment of minus 1%; currently the adjustment is zero.
On the general level of capital investment (i.e. as opposed to investing in some other industry), grain freight presents no risk over time for the railways.
On the contrary, the industry in Western Canada is a captive market.
Grain production is large and has been growing, so the railways are being handed access to a large and stable market.
Even at the operational level, grain presents lower risks than most commodities and is unlikely to pose a liability threat.)
Summary
For all of these issues, revenues to the railways will increase if the CTA adopts their recommendations.
None of the requests from the railways appear to fit the spirit of the CTA’s responsibilities to regulate a monopoly sector and none appear to be justifiable in relation to the CTA’s current procedures or to widely accepted accounting practices.
The interests of producers in all of these issues are not being defended.
The timing of the Cost of Capital review is interesting since requests for a general costing review have been denied.