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Ottawa, 31 January 1989
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Telecom Decision CRTC 89-1
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TELEGLOBE CANADA INC. - RATE STABILIZATION ACCOUNT AND RATE OF RETURN OVER THE TRANSITIONAL PERIOD
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I INTRODUCTION
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On 23 June 1988, the Commission wrote to Teleglobe Canada Inc. (Teleglobe) concerning the company's 1988 financial results to the end of May. The Commission noted that the company expected to earn a rate of return on average common equity (ROE) in 1988 that would be substantially higher than the level prescribed in the Direction to the CRTC on the Regulation of the New Corporation Resulting from the Reorganization of Teleglobe (the Direction). The Commission also noted that the company was preparing an action plan to correct its surplus position. The Commission asked Teleglobe to file a revised outlook for 1988 and 1989, as well as its plan to reduce its expected ROE for 1988.
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Teleglobe replied to the Commission's letter on 4 July 1988. The company proposed to lower international telephone rates by a weighted average of 3.1%, effective 1 September 1988. Teleglobe also proposed to establish a Rate Stabilization Account (RSA), designed to smooth out changes in the company's income attributable to currency fluctuations. On 8 July 1988, the company filed Tariff Notice 28, in which it detailed its proposed rate reductions. The company also filed an application to establish an RSA, effective 1 January 1988.
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In Telecom Letter Decision CRTC 88-5, 20 July 1988 (Letter Decision 88-5), the Commission denied Tariff Notice 28 and directed the company to file proposed tariff revisions providing for a weighted average 5% reduction in international telephone rates, effective 1 September 1988. The rate reduction ordered in Letter Decision 88-5 was the third in 1988. The Commission also stated the view that the RSA, if established, would have a significant impact on the company's financial performance. The Commission therefore concluded that the issues relevant to the establishment of an RSA should be discussed in a public process.
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The Commission also issued CRTC Telecom Public Notice 1988-31, 20 July 1988 (Public Notice 1988-31), in which it initiated a public process to examine the issues related to the establishment of an RSA and to identify and consider methods of administering the averaging provisions contained in section 5(1)(a) of the Direction. Section 5(1)(a) states as follows:
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5(1)In approving tolls of the new corporation the Commission shall
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(a)accept as the allowed rate of return on common equity, on average over the transitional period [1988 to 1991, inclusive], a return that is within the range defined by the weighted average mid-point of the return allowed by the Commission on common equity of Bell Canada and British Columbia Telephone Company, and that mid-point plus 2 per cent.
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The Commission was of the view that Teleglobe considered the RSA a potential element of a mechanism designed to ensure compliance with this section.
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Pursuant to the procedure established in Public Notice 1988-31, Teleglobe filed comments on 28 October 1988. The Government of Ontario (Ontario) and the Government of Québec (Québec) addressed interrogatories to the company and filed comments, directed primarily at Teleglobe's proposal for the establishment of an RSA. Teleglobe filed its reply on 5 December 1988.
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II THE PROPOSED RSA
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A. Teleglobe's Position
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In its 8 July 1988 application, Teleglobe noted that, as an international telecommunications carrier, it is subject to the regulations of the International Telecommunication Union (ITU). Those regulations specify that, in the absence of special arrangements, the balances of international telecommunications accounts must be drawn up and paid in Special Drawing Rights (SDRs). SDRs are based on the value of five of the world's major currencies, namely, the American dollar, the pound sterling, the French franc, the Japanese yen and the deutsche mark. Accounts denominated in SDRs represent about 87% of Teleglobe's outstanding accounts with foreign administrations. Some 12% of Teleglobe's remaining accounts are denominated in U.S. dollars.
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Teleglobe noted that ITU regulations also prescribe the accounting and settlement process for international telecommunications traffic. Under this process, 8 to 10 months may elapse between the time that payables and receivables are first recorded in Teleglobe's accounts for traffic exchanged and the time that accounts with foreign administrations are settled. Accounting rules require that the company revaluate these outstanding accounts each month. Teleglobe indicated that it is exposed to currency gains and losses from three sources: (1) revenue variances arising from the differences between actual exchange rates at the time the company records its revenues and the exchange rates used in the company's financial forecasts and budgets, (2) unrealized gains and losses resulting from the monthly revaluation of its net accounts payable to foreign administrations, and (3) gains and losses realized upon the final settlement of accounts with foreign administrations.
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In its application, Teleglobe noted that Canadians make approximately 50% more outgoing calls than they receive from abroad. Therefore, the company pays larger amounts of money to foreign administrations than it receives in return. Teleglobe stated that its December 1987 view projected that the company's 1988 revenues would be $309 million (Canadian), after the retention by Telecom Canada of landline charges, but before net payments to foreign administrations. Teleglobe stated that approximately 40% of that $309 million, or about $126 million (Canadian), would have to be paid to foreign jurisdictions in foreign currencies, with the remaining $183 million representing its revenues from international telephone service. Accordingly, a 10% difference between the budgeted exchange rates and the actual rates at which revenues are recorded would, in itself, change the company's revenue by some $12.6 million. The company stated that, given its relatively small average equity base, such a difference could change its ROE by about 3%.
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The company noted that its ROE is also affected by the monthly revaluation of its net accounts payable to foreign administrations. A 10% change in exchange rates would alter Teleglobe's 1988 average net accounts payable balance of $85 million (Canadian) by some $8.5 million. This, in itself, could change Teleglobe's ROE by about 2%.
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Teleglobe submitted that swings in exchange rates in the order of 10% are not uncommon. It noted that the value of SDRs, in Canadian dollar terms, dropped 12.45% between December 1987 and 6 July 1988.
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In its submissions and in its responses to interrogatories, Teleglobe identified two instruments capable of providing some protection from fluctuations in currency exchange rates, namely, the forward exchange contract and the SDR-denominated certificate of deposit. The company submitted that, at best, these instruments are complements, and not alternatives, to the RSA.
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Under Teleglobe's proposed RSA, the company would calculate budgeted, or "standard", exchange rates on the basis of four independent forecasts. These budgeted exchange rates would be used in calculating the company's revenue requirement, and would be subject to the Commission's approval prior to the applicable fiscal period.
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Teleglobe's monthly estimated revenues, based on its estimates of traffic carried during the month, would be recorded in Teleglobe's books at the budgeted exchange rates. Revenue variances attributable to the deviation of actual exchange rates from the budgeted exchange rates would be charged and credited to the RSA. Unrealized gains and losses created by the monthly revaluation of accounts outstanding with foreign administrations would also be credited and charged to the RSA. Finally, realized gains and losses would also be credited and charged to the account. Teleglobe proposed no limit on the balance of the RSA.
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Teleglobe's submission of 8 July 1988 contemplated that both gains and losses associated with currency fluctuations would be credited or charged to the RSA. However, in its later comments, Teleglobe submitted that the RSA should always retain a positive balance. Teleglobe stated that, with a positive balance, the account represents a deferred credit, reflecting a real liability to be repaid during the period over which the account is amortized. To permit the account to go into a negative position would result in the establishment of a deferred "debit", reflecting a fictitious asset. Teleglobe submitted that a negative balance would inevitably have a negative impact on the company's viability and on its ability to provide service, ultimately to the detriment of the customer.
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Teleglobe proposed to establish the RSA effective 1 January 1988. The company noted that, during 1988, the strong performance of the Canadian dollar had exceeded expectations. Teleglobe considered it unlikely that the dollar would repeat this performance in the near future. In the company's view, a decrease in the value of the dollar was more likely. The company submitted that, if established in 1988, the RSA would likely peak in that year and would contain a significant positive balance that would shield consumers from future downturns in the Canadian dollar. The company projected that the RSA, if established in 1989, might have a negative balance.
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In its comments, Teleglobe stated that it had already begun to reflect the RSA in its internal financial statements. The company noted that, as of 30 September 1988, the RSA contained a positive balance of $18 million.
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Teleglobe stated that the RSA would not be allowed to earn a return. The company proposed to amortize the account over a period of 10 years beginning in 1989. Teleglobe proposed to calculate the monthly amortization of the RSA by dividing the outstanding unamortized balance in the account by the total number of months in the amortization period. Teleglobe indicated that it believed the 10-year amortization period to be appropriate, given the relatively long cycles in the variation of exchange rates. The amortized amount would be calculated each month and included in the company's income statement.
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Teleglobe submitted that, because it is unique among international telephone carriers in terms of its exposure to the impact of fluctuations in currency exchange rates, there are no direct precedents in the international telecommunications industry for its proposed RSA. However, Teleglobe provided two examples of procedures that have been implemented by Canadian hydro-electric power utilities in order to stabilize rates.
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Teleglobe submitted that the proposed RSA would significantly reduce uncertainties regarding its ROE, and would protect its customers from frequent international telephone rate changes caused by variations in currency exchange rates.
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B. Interveners' Comments
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Ontario is not opposed to the establishment of the RSA, provided that certain principles are adopted. Specifically, Ontario suggested that a limit be placed on the account. Ontario proposed an initial limit of $5 million, but suggested that it might be appropriate to review that limit from time to time. In Ontario's view, any excess should be credited immediately to the normal operations of the company.
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Ontario also proposed that the account be permitted to go into a negative, or debit, position, with a corresponding limit of negative $5 million. Ontario argued that the RSA should offer customers the same protection from having their rates raised as it would offer the company from having to lower rates.
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Québec was of the opinion that Teleglobe's submissions had demonstrated the usefulness of creating the RSA. However, Québec noted Teleglobe's discussion of other methods of protecting the company from fluctuations in exchange rates. Québec suggested that the Commission encourage Teleglobe to consider a combination of all the various means available to protect itself from such fluctuations.
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In light of currency gains during 1988, Québec recommended that the RSA be established as of 1 January 1988. Québec was of the view that the account's amortization period must be long enough to accomplish the company's objectives, but not so long as to unduly delay lower rates arising from foreign exchange gains. Québec therefore recommended an amortization period of 5 years.
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C. Conclusions
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In the Commission's view, the record of this proceeding demonstrates that Teleglobe is unique with respect to the extent of its potential exposure to swings in currency exchange rates. Furthermore, the extent of that exposure is largely due to factors beyond the control of the company.
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The Commission notes Teleglobe's submissions concerning the difficulties involved in the use of forward exchange contracts and SDR-denominated certificates of deposit. In particular, the Commission notes that forward exchange contracts, the more usual means of managing foreign currency exposure, are expensive to purchase. They are more suitable in situations where the number of foreign currency transactions is small, where accounts remain outstanding for a relatively short time, and where transactions are denominated in a currency, e.g., the American dollar, that is generally used in international trade. The Commission also notes that the RSA, since it is an accounting method for dealing with Teleglobe's exposure to foreign currency variations, would entail no significant costs to the company and would require no unusual financial expertise.
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In light of the above, the Commission has concluded that the establishment of an RSA is the most efficient way to minimize frequent tariff changes associated with fluctuations in the company's ROE caused, in turn, by swings in exchange rates. However, as suggested by Québec, the Commission encourages Teleglobe to make prudent use of other available means to manage its foreign currency risks.
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In light of the gains made by the Canadian dollar over the past year, and in order to take full advantage of the benefits of the RSA, the Commission considers it appropriate that the account be established effective 1 January 1988.
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Teleglobe indicated that, in light of the relatively long cycles in the variation of exchange rates, it would prefer a 10-year amortization period for the RSA. In the Commission's view, variations in exchange rates cannot be predicted with any certainty. Therefore, the selection of an amortization period is largely a matter of judgment. The Commission has concluded that a 3-year amortization period would best achieve the objective of smoothing out the company's achieved ROE, without unduly deferring the benefits to customers of lower rates arising from foreign exchange gains. Teleglobe estimated that, without the RSA, its ROE would be 21.2% in 1988 and 11.6% in 1989. The Commission estimates that the establishment of an RSA as specified in this decision will lower the company's ROE by about 3.5% in 1988 and will raise it by about 2% in 1989.
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The Commission notes that the amortization procedure described in Teleglobe's evidence would leave an outstanding balance in the RSA that, while constantly diminishing (assuming no further additions to the account), would never reach zero. The Commission considers it important that the amortization procedure completely recapture all monthly exchange gains and losses within the designated amortization period. Accordingly, the Commission rejects the proposed amortization procedure outlined in Teleglobe's submissions. Teleglobe is directed to identify separately the net foreign currency gain or loss arising from each of (1) revenue variances, (2) the monthly revaluation of accounts, and (3) the final settlement of accounts. The total monthly amount is to be credited or charged to the RSA and amortized on a straight line basis over a 36 month period. Teleglobe is directed to commence amortization in January 1988, from the time the RSA is established.
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The Commission also considers it important that the RSA be used as a true regulatory tool for stabilizing rates, and not as a means for Teleglobe to defer profit. Once the RSA is established, Teleglobe's customers will not receive the full and immediate benefit of rate reductions that the Commission might otherwise have ordered. In return, customers should be afforded protection from rapid rate increases associated with decreases in the value of the Canadian dollar. In the Commission's view, the latter objective can be best attained by permitting the RSA to go into a negative position.
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As noted above, the Commission considers it important that the RSA not be used simply to defer company profits; nor should it be used to delay warranted rate changes. Accordingly, the Commission has concluded that reasonable limits must be placed on the balance allowed to accumulate in the account. The Commission has determined that, in fairness to both the company and its customers, the credit or debit balance of the RSA should be limited to $15 million in any given month.
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The Commission estimates that the RSA, established as directed in this decision, will have a positive balance of about $15 million as of the end of 1988. The company is to determine whether the limit has been reached at the end of each month, after the net foreign currency gain or loss for the month has been credited or charged to the account and before the monthly amortization amount is calculated. Any amount falling outside the limits placed on the account is to be immediately brought into income or recognized as a loss.
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For 1989, the Commission accepts the budgeted exchange rates calculated in accordance with the methods and procedures filed by Teleglobe in this proceeding. Teleglobe has already provided the Commission with those 1989 budgeted exchange rates as part of a filing concerning its 1989 budget view.
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The Commission will hold discussions with Teleglobe in order to set up administrative procedures for the approval of budgeted exchange rates for future years. These procedures will provide for Commission approval of budgeted exchange rates prior to the start of each fiscal year.
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In order to ensure that the RSA is meeting the objectives contemplated in this decision, the Commission intends to review and assess the operation of the account before the end of the transitional period referred to in the Direction.
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III RATE OF RETURN OVER THE TRANSITIONAL PERIOD
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In its comments, Teleglobe submitted that the Direction allows the company to exceed the permissible ROE range in the early years of the transitional period, provided that its average ROE falls within the range over the full transitional period. However, Teleglobe noted that to do so would be to incur the risk that a significant earnings shortfall or excess might be carried into the last year of the period.
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Teleglobe noted that it has adopted the strategy of attempting to maintain an ROE that falls within the prescribed range in each of the 4 years of the transitional period. Teleglobe is of the view that this policy is consistent with sound financial planning and capital investment financing, shareholder expectations, and an orderly collection rate pattern. Teleglobe stated its intention to manage its affairs according to the approach noted above, but "within the ambit of the four-year averaging provided in the Direction."
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Teleglobe noted that ROE is a ratio, expressed as a percentage, of two components, earnings and equity base, that are each measured in dollars. Teleglobe submitted that the ratio is a useful device when applied on a yearly basis. However, the company submitted that the ratio is less desirable for determining permissible earnings levels over a period of years. Teleglobe noted that 1% ROE in a year in which the common equity base is $240 million will have a value of $2.4 million. On the other hand, 1% ROE in a year in which the common equity base is $270 million will have a value of $2.7 million. Teleglobe submitted that, unless the two components change in the same proportion over the 4-year period, an averaging of the ratios will result in inequities to either the consumer or the company.
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Teleglobe submitted that, in order to avoid these inequities, the 4-year average ROE should be based on the dollar amounts of the components. Teleglobe proposed that its permissible ROE over the transitional period be based on the sum of the average common equity in each year of the period multiplied by the permissible range applicable for each year of the period. In its reply, Teleglobe submitted that its proposal provides for a cumulative and ongoing corrective mechanism that is equitable to both shareholder and consumer.
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Québec noted both Teleglobe's interpretation of the Direction and the company's stated intention to remain within the permissible range in each of the 4 years of the transitional period. Québec submitted that, in light of Teleglobe's interpretation, the Commission must ensure that the Direction is applied in such a way that benefits resulting from factors unrelated to currency fluctuations, factors such as more favourable revenue settlement terms and increased demand and productivity, are passed on to consumers without undue delay.
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The Commission considers it appropriate to clarify its approach to the regulation of Teleglobe's ROE over the transitional period. In the Commission's view, the record of the proceeding does not support Teleglobe's contention that the usual method of calculating allowable earnings on a year-by-year basis will result in inequities to either the company's shareholders or its customers. Accordingly, the Commission will apply section 5(1)(a) of the Direction as follows:
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(1) the bottom of the allowed ROE range is the arithmetic average of the weighted average mid-point of Bell Canada's and British Columbia Telephone Company's allowed ROE for each of the 4 years of the transitional period, and the top of the range is that percentage plus 2%; and
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(2) the Commission will consider as excess earnings only those earnings exceeding the top of the defined ROE range for the respective prior year(s); conversely, only the earnings below the bottom of the permissible ROE range will be considered earnings deficiencies.
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The Commission is of the view that the Direction allows the company to exceed its allowed ROE range in any year of the transitional period, provided that its average ROE over the full transitional period falls within the prescribed range. However, the Commission considers that the company's ROE should not deviate so substantially from the range prescribed in the Direction that the company carries a significant earnings shortfall or excess into the last year of the transitional period.
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Fernand Bélisle
Secretary General
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