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TELECOM DECISION
Ottawa, 19 December 1990
Telecom Decision CRTC 90-29
THE ISLAND TELEPHONE COMPANY LIMITED - REVENUE REQUIREMENT FOR 1990 AND 1991
Table of Contents
I INTRODUCTION

II ACCESS TO SERVICE

III QUALITY OF SERVICE

IV CONSTRUCTION PROGRAM

V ACCOUNTING CHANGES

VI INTERCORPORATE TRANSACTIONS

VII OPERATING REVENUES

VIII OPERATING EXPENSES

IX FINANCIAL ISSUES

X REVENUE REQUIREMENT

XI TARIFF REVISIONS

XII PHASE II AND PHASE III COSTING REQUIREMENTS
I INTRODUCTION
A. General
On 4 October 1989, The Island Telephone Company Limited (Island Tel) applied to the Commission for permission to comply, as of 1 January 1990, with the directions in Deferred Tax Liability, Telecom Decision CRTC 89-9, 17 July 1989 (Decision 89-9), and in Bell Canada and British Columbia Telephone Company - Accounting Treatment for Station Connections, Telecom Decision CRTC 86-4, 18 March 1986 (Decision 86-4). Specifically, Island Tel proposed to adjust its Deferred Tax Liability (DTL) by about $1.3 million and to amortize the adjustment in equal amounts over a two-year period. Island Tel also proposed to begin expensing, rather than capitalizing, business inside wiring. The relevant portion of the company's station connection account balance would be amortized over a one-year period.
Island Tel stated that it anticipated a revenue shortfall in 1990 and that, without the adjustments proposed in its application, its 1990 rate of return on average common equity (ROE) would be 11.4%. Island Tel submitted that the proposed adjustments would increase its ROE in 1990 to 13.5%, allowing it to avoid seeking the rate relief that would otherwise be necessary.
In CRTC Telecom Public Notice 1989-51, 24 October 1989 (Public Notice 1989-51), the Commission invited public comment on a proposal for dealing with Island Tel's application. Specifically, the Commission proposed to grant interim approval to the application. The Commission also proposed to direct Island Tel to file, consistent with Part III of the CRTC Telecommunications Rules of Procedure, proposed Directions on Procedure for a revenue requirement and rate proceeding to examine the company's revenues, expenses, rate of return and other aspects of its operations for the test years 1990 and 1991. The Commission proposed that this proceeding include consideration of how best to deal, on a final basis, with Island Tel's excess DTL and with its proposal to expense business inside wiring.
After the receipt of comments in response to Public Notice 1989-51, the Commission issued The Island Telephone Company Limited - Revenue Requirement for 1990 and 1991, Deferred Tax Liability, and Accounting Treatment for Station Connections, Telecom Decision CRTC 89-18, 21 December 1989 (Decision 89-18), granting interim approval to Island Tels application of 4 October 1989. In Decision 89-18, the Commission determined that it would make a final decision with respect to Island Tel's application in a full revenue requirement and rate proceeding, as contemplated in Public Notice 1989-51. Accordingly, the Commission directed Island Tel to file proposed Directions on Procedure for such a proceeding. The Commission specified that the proposed Directions should provide for the filing of Memoranda of Support in May 1990 and the holding of a hearing in September 1990. The Commission noted that it might be necessary after the proceeding to revise Island Tel's 1990 rates. Therefore, effective 1 January 1990, the Commission made interim its approval of all of Island Tel's rates approved prior to that date.
Island Tel filed proposed Directions on Procedure on 18 January 1990 and the Commission approved them by letter dated 1 February 1990. In accordance with the Directions, Island Tel filed an application and Memoranda of Support on 1 May 1990.
In its application, Island Tel requested final approval for the test year 1990 of (1) its current interim general tariff rates, (2) accounting changes related to Station Connections and Income Tax, and (3) the amortization of $748,500 of its excess DTL. Island Tel stated that approval of the above would result in an ROE of 13.5% for 1990.
With respect to the test year 1991, Island Tel requested approval of (1) rate increases and decreases forecast to increase net revenue by $2.4 million, and (2) the amortization of the balance of its excess DTL in the amount of $591,500. Island Tel stated that approval of the above would result in an ROE of 14.25% for the test year 1991.
By letter dated 4 September 1990, Island Tel revised its previous financial exhibits, based on a midyear update of its forecasts and budgets (the Updated View). The company noted that its revised financial exhibits incorporated proposals with respect to the accounting procedures for its Allowance for Funds Used During Construction (AFC) and for the amortization of its excess DTL. With regard to the latter, the company now proposed to amortize $483,600 of its excess DTL in 1990, and the remaining $856,400 in 1991. The company stated that these changes had no effect on its previously proposed rates ROE for 1990 (13.5%), but would result in a small reduction (from 14.25% to 14.1%) in its forecast ROE for 1991.
B. Construction Program Review
On 8 February 1990, the Commission issued The Island Telephone Company Limited - Annual Construction Program Review - 1990 Construction Program, CRTC Telecom Public Notice 1990-13, 8 February 1990 (Public Notice 1990-13), establishing an annual construction program review (CPR) process for Island Tel. Pursuant to Public Notice 1990-13, a CPR meeting was held in Charlottetown, Prince Edward Island, in July 1990. At the review meeting, the Commission directed that comments on the company's construction program be filed with final argument in the revenue requirement proceeding. Accordingly, this Decision contains the Commission's determinations with respect to the 1990 review of Island Tel's construction program.
C. The Hearing
The public hearing was held in Charlottetown from 10 September to 14 September 1990 before Commissioners Louis R. (Bud) Sherman (chairman), Paul E. McRae and Frederic J. Arsenault.
The Commission received a total of five interventions in this proceeding. The following appeared or were represented at the public hearing: Canadian Association of the Deaf (CAD); Rural Dignity of Canada (P.E.I. Chapter), Social Action Commission, P.E.I. Council for the Disabled, Alert on Welfare, and P.E.I. Senior Citizens Federation (collectively, Rural Dignity et al); and Unitel Communications Inc. (Unitel).
II ACCESS TO SERVICE
A. Message Toll Service for Users of Telecommunications Devices for the Deaf
At present, the company offers a 50% discount on long distance calls that originate from and are billed to the residence telephone number of a customer who is registered as a user of a telecommunications device for the deaf (TDD). This discount applies to calls that terminate in any area of Canada, other than the company's operating territory. If the customer's long distance call terminates in the company's operating territory, the terminating number must also be registered to a TDD-user.
Business subscribers who offer TDD service to their customers are required to have separate registered individual lines dedicated to this purpose in order to receive the 50% discount on long distance calls.
In July 1990, Island Tel filed Tariff Notice 31 proposing clarifications to its General Tariff concerning the 50% discount on long distance rates for certain calls placed with a TDD. This filing was considered in the course of this proceeding.
On 6 November 1990, Island Tel filed Tariff Notice 31A, amending its previous filing to include the elimination of the requirement that intra-company long distance calls terminate at a number registered to a TDD-user. By letter dated 26 November 1990, Island Tel requested that the Commission defer consideration of Tariff Notices 31 and 31A. By letter dated 7 December 1990, the company notified the Commission that it wishes to withdraw Tariff Notices 31 and 31A. The company stated that, by 31 January 1991, it would submit a revised filing with respect to the long distance discount available to users of TDDs.
In light of the above-noted letters, the Commission will await the submission of Island Tel's revised filing before considering tariff revisions with respect to the discount applicable to long distance calls placed with a TDD.
B. Message Relay Service
Message Relay Service (MRS) relays messages between hard of hearing or speech impaired persons who use a TDD and persons who do not require TDDs.
On 12 March 1990, CAD filed an application requesting that the Commission require the four Atlantic telephone companies to establish MRS by 1 July 1990. By letter to CAD and Island Tel dated 7 June 1990, the Commission determined that CAD's application as it pertained to Island Tel would be considered in the revenue requirement proceeding.
The Commission issued its decision with respect to the company's implementation of MRS in CRTC Telecom Letter Decision 90-17, 8 November 1990, (Letter Decision 90-17). In that Letter Decision, the Commission approved Island Tel's proposal to implement MRS jointly with Maritime Telegraph and Telephone Company Limited (MT&T), and directed Island Tel to implement MRS within its operating territory, on a 24 hour a day, seven day a week basis, by 8 May 1991, in accordance with its proposals in this proceeding and with Letter Decision 90-17.
In Letter Decision 90-17, the Commission accepted the company's proposal to offer a 50% discount on tariffed inter-provincial and intra-company long distance rates for calls originated in its territory and routed through MRS. The Commission also noted its agreement with the company's approach to working with the hearing-impaired to develop the criteria for accessing MRS, and encouraged the company to designate a senior employee as the primary contact person for consultations between the company and the deaf and hard of hearing community.
The Commission has reviewed the cost information provided by the company regarding its provision of the service jointly with MT&T and has taken these expense estimates, including an allowance for the amounts payable to MT&T under the service agreement between the two companies, into account in its calculation of the company's revenue requirement.
C. Late Payment Charge
The company's billing procedures provide that a late payment charge is to be applied to accounts with an unpaid balance of $7 or more, 30 days from the date of billing. Mr. Vaughn Horton, in a written intervention in this proceeding, submitted that customers receive the company's bills approximately two weeks after the billing date, thereby reducing the time available to the customer to pay without penalty. Mr. Horton noted that Bell Canada (Bell) applies a late payment charge to accounts that have an unpaid balance in excess of $50, 11 days and one month from the date of the bill.
Island Tel recognized that its late payment criteria are inconsistent with those of other federally regulated telephone companies. The company stated that, as a result of representations recently made to it, it has begun a review of its late payment charge criteria.
The Commission considers the company's decision to review its criteria a reasonable response to the complaints it has received regarding late payment charges. The Commission directs Island Tel to file, by 19 March 1991, a copy of the report resulting from the review.
D. Confidentiality of Customer Information
Island Tel's guidelines on the protection of the confidentiality of customer information are not now included in its General Tariff, but are found in an internal company document. In view of the importance of protecting the confidentiality of customer information, the Commission considers it appropriate that provisions relating to the confidentiality of customer records be included in the company's General Tariff.
The Commission therefore directs Island Tel to file with it, by 19 March 1991, a proposed tariff setting out the company's policy with respect to the definition and disclosure of confidential customer records.
E. Disconnection of Service
At the hearing, the Commission questioned Island Tel on an inconsistency between General Tariff Items 90 and 160, which deal with the terms on which the company may suspend or terminate service. The company also provided the Commission with a list of tariff items that refer, directly or indirectly, to disconnection of service.
The Commission considers it desirable that the terms on which service can be disconnected are clear. Accordingly, the Commission directs the company to file, by 19 March 1991, proposed tariff pages amending those items of its General Tariff, including Items 90 and 160, that refer to company-initiated suspension or termination of service in order to set out clearly the company's policy regarding such suspension or termination of service and to eliminate any inconsistencies.
III QUALITY OF SERVICE
In the latter part of the 1970s, the Commission began to require the telephone companies then under its jurisdiction to make regular reports on certain quality of service indicators. An Inquiry Officer was appointed pursuant to what is now section 84 of the National Telecommunications Powers and Procedures Act to make recommendations as to the scope and nature of those reports. After considering the Inquiry Officer's recommendations, the Commission issued Quality of Service Indicators for Use in Telephone Company Regulation, Telecom Decision CRTC 82-13, 9 November 1982 (Decision 82-13), in which it gave interim approval to certain standards and directed the telephone companies to develop others within 15 months.
The framework thus established provides for quarterly reports to the Commission on upwards of 30 indicators assessing performance on seven interfaces, viz., provisioning, repair, local service, toll service, operator service, directory service and billing service. In addition, it provides for a statistical summary of major complaints.
Island Tel, while still regulated by the Public Utilities Commission of Prince Edward Island (PUC), developed a set of indicators for its own purposes. The company collects monthly results and produces a management report comparing performance for the current and previous years.
In this proceeding, Island Tel submitted its indicator results for the period January 1987 to May 1990. The data submitted for 1990 were presented in a format different from that for previous years, and further information was requested to identify the nature of and reasons for the change. Seven service-related indicators existed prior to 1990; there are now nine. Of these nine indicators, three are directly comparable to previous indicators, titles of two have been changed for greater clarity and one is a direct complement of a previous indicator. Another indicator is partitioned, and accounts separately for residence and business service. The company also has two entirely new indicators, one replacing a previously measured value with an associated index, and one related to upgrade requests rather than to service requests.
During the period for which results were submitted, the company rarely met its objectives with respect to keeping installation appointments. The trouble report ratio, although apparently improving, met the target only in 1989, after the target had been relaxed in both 1988 and 1989. However, in 1990, the company returned to a more stringent objective, which it met through May. Island Tel's ability to meet service requests appears to be deteriorating (i.e., the held ratio is increasing) and the company rarely met the target in 1989. Network performance, on the other hand, appears to be improving.
Island Tel explained that, in certain cases, it had adjusted its standards to a level that could be realistically attained. It also stated that one goal in revising the set of indicators was "to better relate reported indicators to existing industry standards".
In its evidence, the company outlined action it proposed to take in order to keep appointments, speed installation service, respond more rapidly to out-of-service conditions and inform customers on work in progress. It also pointed to the development of a management program to improve resource allocation, noting that this should help to improve the quality of its service. The company attributed a certain amount of customer dissatisfaction to increased subscriber expectations, and cited the Single Party Development program as one example of the company's attempts to meet these expectations.
In the course of the proceeding, no subscribers or interveners indicated dissatisfaction with the service received, despite the company's expressed concern and its action plan to improve service.
In light of the above, the Commission finds the company's overall current service quality acceptable and commends the company for its initiatives to improve service. However, the Commission has previously required that standards (objectives) be set at levels that satisfy the great majority of subscribers and, in normal circumstances, expects those standards to be attained and maintained unless a survey indicates that they should be changed. In the longer term, the Commission intends to assess whether or not changes are required to the set of indicators reported by the company and to establish regular reporting requirements. In this regard, the Commission prefers indicators to be expressed directly in terms of measurements, and not converted to indices that require a table for interpretation.
IV CONSTRUCTION PROGRAM
A. The Capital Plan and Planning Process
The capital plan filed with the Commission projected construction expenditures of $23 million and $21 million in 1990 and 1991, respectively, augmenting a capital asset base of $156 million at year-end 1989. The company also documented its construction program management review process, which encompasses the forecasting of service demand, the development of long range plans to meet the demand, the identification of specific project requirements, the management of the capital budget, the approval and implementation of individual projects, the improvement of service quality, the improvement of efficiency, and the use of utilization measurements.
The company subsequently informed the Commission that it had not allowed for the introduction of the Goods and Services Tax (GST), replacing the Federal Sales Tax (FST), in its capital plan. The company estimated that this tax change would reduce its construction program by about 5% ($1 million) for each of the years 1991 to 1994.
The company experienced gains in network access services (NAS) of 4.6% (2,662) and 5.3% (3,214) in 1988 and 1989, respectively. The 1989 gain was the largest ever experienced by the company. In that year, 75% of the company's capital program ($14.7 million of $19.5 million) was expended to meet growth. In 1990, growth-related projects constitute 78% of the capital program ($18 million of $23 million). The company expects NAS gain to decline to approximately 2.9% in 1990 and 2.2% in 1991.
Long distance messages increased by 1.2 million in 1988 and by 1.1 million in 1989. The company forecasts modest message gains for 1990 and 1991 of approximately 1.1 million and 0.9 million, respectively. The total is expected to exceed 13.5 million in 1991, having grown from a 1985 base of 7.6 million.
The company stated that switching equipment modernization (SEM) is primarily associated with switch replacement engendered by projected growth that would exhaust the maximum capacity of the existing equipment. The company expects to have 100% digital switching in place by the year 2000. By the end of 1990, approximately 56% of NAS will be served by digital facilities. Expenditures of $4 million in 1990 and $2.5 million in 1991 are forecast for the installation of digital switches.
The Commission considers the company's capital program management process adequate, accepts the company's rationale for and rate of switching equipment modernization, and finds the projected capital expenditures associated with meeting demand reasonable.
In 1988, the company embarked on the largest capital program in its history. This was the Single Party Development program, aimed at providing universal single party availability by 1997. In 1990, the company will spend $737,000 on this program.
With the exception of Single Party Development, the company has provided an economic justification, showing a positive net present value (NPV), for all major programs. The company has projected a 90% take-up rate for conversion to individual lines as a result of Single Party Development, and this figure has been confirmed where the program has been implemented. The Commission is of the view that this program provides more equitable access to service to subscribers outside the base rate area and, therefore, is in the public interest. Accordingly, the Commission finds reasonable the capital expenditures associated with service improvement and efficiency improvement.
B. Nature and Frequency of Review
Island Tel was asked to express its opinion on the appropriate frequency and nature of public review for its construction program. The company indicated that it is prepared to file its program annually with the Commission, but that a public review is only required every four to five years.
In light of the limited public participation in the 1990 review meeting, the Commission does not consider it necessary to hold such meetings on a frequent and regular basis.
Based on its experience and practices with other companies with comparable budgets, the Commission does not consider it necessary to conduct a public review of Island Tel's construction program every year. However, the Commission will require the company to file its five-year capital plan and related information annually. The Commission will examine the material filed to determine whether a public proceeding is warranted. In any event the Commission will initiate such a proceeding at least every two years. The process will include a review meeting only when necessary, for example, when major program expenditure plans or issues of particular public consequence are involved.
C. Recovery of Modernization Expenditures
Rural Dignity et al filed evidence prepared by Mr. John D. Todd asserting that residential and small business customers should be protected from rate increases resulting from SEM expenditures and the associated accelerated depreciation of replaced equipment. Mr. Todd's evidence was predicated on the assumption that Island Tel, "like other telephone companies across Canada, is currently engaged in a capital investment program to replace existing switches ... with digital switches".
During cross-examination by counsel for Rural Dignity et al, Island Tel denied several times that any such program existed within the company. In the construction program memorandum filed by Island Tel, expenditures on switching (and other) modernization were contained in the growth category, and not in the programs category. The company emphasized this point in interrogatory responses, stating in one such response that "SEM is integrated with the growth requirement of the Company", and indicating in another that SEM costs allocated to conversion were forecast to be in the range 10%-15% for 1990 and 1991.
In argument, Island Tel stated that it is clear from Mr. Todd's evidence that he does not quarrel with the fact that digital switches are the accepted and preferred technology when equipment needs to be replaced. The company submitted that it has demonstrated that its plans to modernize switching equipment relate only to the replacement of facilities as a result of growth or where equipment is worn out. The company argued that Mr. Todd had grossly misinterpreted its capital program with respect to SEM. The company stated that Mr. Todd should have been able to determine that, as specified in the capital program review process and in its Memoranda of Support, its modernization plans do not contain any discretionary component.
Island Tel stated that Mr. Todd's submissions were based wholly on the premise that the company is replacing, on an accelerated basis, equipment that could have a useful life beyond its replacement date Island Tel submitted that any equipment that can be used or reused is placed in its inventory and used for maintenance or for upgrades to existing equipment. The company reiterated that there is no early replacement of existing switches.
The Commission is of the view that Mr. Todd's evidence is based on a faulty extrapolation from programs initiated by other telephone companies in Canada, and that neither Island Tel's written evidence nor its oral testimony provides any basis for this extrapolation. Furthermore, even if this premise were valid, the Commission could not accept the cash-flow analysis carried out by Mr. Todd. For example, Mr. Todd included all SEM costs, but considered only those revenues associated with digital services, while ignoring all revenues arising from growth when more than 85% of SEM costs were attributed to it. The Commission finds no support in the record of this proceeding for the submissions of Rural Dignity et al regarding the recovery of SEM costs.
V ACCOUNTING CHANGES
A. Deferred Income Taxes
In Decision 89-18, the Commission gave interim approval to the adjustment of Island Tel's DTL by about $1.3 million and to the amortization of the excess over a two-year period.
In its revised financial exhibits of 4 September 1990, Island Tel proposed to amortize $483,600 of its excess DTL in 1990 and $856,400 in 1991, instead of $670,000 in each of 1990 and 1991 as proposed in its application of October 1989. This revised proposal, in conjunction with the proposed adoption, effective 1 July 1990, of Directive 22 of Phase I of the Cost Inquiry with respect to the setting of the company's AFC rate, is designed to allow the company to earn an ROE of 13.5% in 1990.
During cross-examination, Rural Dignity et al questioned Island Tel as to whether it could have amortized the excess DTL during the previous six years without seeking a rate increase. Island Tel responded that the amortization could not have taken place prior to Decision 89-9.
In Island Tel's view, its proposal to amortize the excess DTL over two years is reasonable and is beneficial to subscribers because such amortization lowers the revenue requirement of the company. In the company's view, the proposed amortization period permits the Commission to reconcile the three objectives set out in previous proceedings as the appropriate considerations with respect to the amortization period. The company submitted that the period is short enough that subscribers quickly receive the benefit of the excess DTL. Second, the amortization period does not create or lead to wide rate fluctuations. Third, the excess DTL is amortized over an appropriate period of time so as not to adversely affect the company's financial ratios.
In Decision 89-18, the Commission noted that the primary question in the proceeding, in connection with the excess DTL, was whether the specific proposal advanced by Island Tel for the amortization of the excess would ensure that subscribers, rather than shareholders, receive the benefit of the adjustment.
The Commission notes that Island Tel now proposes to amortize $483,600 in 1990 and $856,400 in 1991, which, it is estimated, will enable the company to achieve an ROE of 13.5% in 1990. In the Commission's view, Island Tel's proposal has obviated the need for rate increases in 1990 and will ensure that subscribers receive the benefit of the adjustment. The Commission therefore directs Island Tel to amortize $483,600 of its excess DTL in 1990 and the balance of $856,400 in 1991.
B. Accounting for Station Connections
In its application of 4 October 1989, Island Tel requested permission to account for station connections in accordance with Decision 86-4, i.e., to expense all business station connections and residence reinstallations and reconnections. The Commission granted interim approval to this application on 21 December 1989, and the company now seeks final approval.
The accounting treatment proposed by Island Tel is consistent with the rules applicable to other carriers subject to the Commission's jurisdiction. The Commission therefore approves it on a final basis.
C. Phase I Directives
In Phase I of the Cost Inquiry (see Telecom Decision CRTC 78-1, 13 January 1978, Telecom Decision CRTC 79-9, 8 May 1979, and Telecom Decision CRTC 89-11, 24 August 1989), the Commission set out, in the form of Directives, certain regulatory principles, approaches and procedures in the areas of depreciation and accounting practices. In its revised financial exhibits of 4 September 1990, Island Tel incorporated a proposal to comply with Directive 22, which specifies that, as a rule, the rate applied for AFC purposes shall be the rate of return earned by the carrier during the previous fiscal year. The Commission finds the company's proposal to comply with Directive 22 acceptable.
At this time, some of Island Tel's other accounting practices differ from those set out in Phase I of the Cost Inquiry. For example, Directive 5 requires a company to develop a schedule of life studies in which the maximum interval between studies is five years. Island Tel does not currently have a specific schedule of life studies. However, it reviews every account at least once every three years to determine if a life study is required.
Directives 10 and 11 of Phase I of the Cost Inquiry require that an asset be depreciated over its entire useful life, regardless of any relocation, and that the labour and material costs of relocation be expensed. Island Tel's current practice, upon removal of an asset planned for reuse, is to transfer the asset to an inventory account at original cost. When reused, the asset is reinstalled in service at its original cost and the costs associated with removal and reinstallation are capitalized. Island Tel estimates that implementation of Directives 10 and 11 would result in a net increase in operating expenses (maintenance increases less depreciation decreases) of approximately $110,000 in 1990 and $35,000 in 1991.
Directive 16 states, under the minimum rule, that items with a unit value of $1,500 or more shall be capitalized. Island Tel currently capitalizes amounts of $200 or more. Island Tel noted that compliance with Directive 16 would result in a short term increase in expenses as a result of writing off, over a short period, the embedded cost of items that originally cost between $200 and $1,500. The company currently estimates this embedded cost at $450,000. Excluding this impact, the company estimates that the net effect of increasing the minimum rule to $1,500 would be to decrease its revenue requirement by $60,000 in 1990 and by $35,000 in 1991.
Directive 18 states that, on replacement or removal of units of plant, the associated costs shall be expensed. The company currently capitalizes the costs associated with the replacement or removal of units of plant. Island Tel estimates that it would take three or four months to conduct a study to determine the impact of expensing, rather than capitalizing, the replacement or removal of units of plant. The company stated that it is unable to provide an estimate of the impact of such a change at this time.
While Island Tel stated that it intends to comply with the Phase I Directives, it submitted that compliance should be phased in over an acceptable period so as not to adversely affect Island Tel's investors and subscribers. The company stated that the timing of the imposition of the Directives must be such that rates do not fluctuate in an abnormal pattern. The company also submitted that Directives should only be implemented after careful study of the effects of implementation.
The Commission agrees with Island Tel that implementation of the Directives should only follow a study of the effects of implementation. The Commission notes that Island Tel stated that a study lasting three to four months would be necessary to determine the impact of implementing Directive 18.
Furthermore, in Newfoundland Telephone Company Limited - Revenue Requirement for the Years 1990 and 1991 and Attachment of Customer-Provided Multi-Line Terminal Equipment, Telecom Decision CRTC 90-15, 12 July 1990 (Decision 90-15), the Commission stated that it may be appropriate to change the current $1,500 minimum rule, set in 1979, contained in Directive 16. The Commission also stated that it would issue a public notice initiating a proceeding to review the minimum rule for all carriers under its jurisdiction. Therefore, the Commission does not consider it appropriate that Island Tel change its $200 minimum rule at this time.
In light of the above, Island Tel is directed to file, by 21 May 1991, specific proposals for the implementation, within a five-year period commencing 1 January 1992, of Directives 5, 10 and 11, and 18. The company is to include detailed calculations of the impact of the implementation of each of these Directives on its revenue requirement in each of the five years.
VI INTERCORPORATE TRANSACTIONS
A. Background
Island Tel is a partially-owned (about 52%) subsidiary of Maritime Telecom Holdings Inc., a wholly-owned subsidiary of MT&T. MT&T is itself partially owned (about 34%) by Tele-Direct (Publications) Inc., a wholly-owned subsidiary of BCE Inc. Island Tel itself has no subsidiaries.
Island Tel has not established any formal policies and procedures in connection with intercorporate transactions between it and its affiliates. The company has dealings with MT&T, with Bell, a wholly-owned subsidiary of BCE Inc., and with Northern Telecom Canada Limited (NTCL), whose parent company is a partially-owned (about 53%) subsidiary of BCE Inc. A service agreement with Bell was approved by the Commission in Telecom Orders CRTC 90-162 and 90-316, dated 22 February 1990 and 6 April 1990, respectively. Purchases from NTCL take place in the normal course of trade.
Island Tel also has a service agreement with MT&T, whereby the latter provides it with certain management, administrative, engineering and other operations support services. This service agreement was filed for the Commission's approval by MT&T on 5 June 1990, and by Island Tel on 25 June 1990. The matter was still before the Commission at the time of the hearing.
B. Positions of Parties
Unitel noted that it has the opportunity to comment on the service agreement with MT&T in a separate proceeding, and that the purpose of its submissions in this proceeding is neither to undermine nor support that agreement. Unitel stated that the service agreement may provide for certain economies of scale and certain cost savings. However, Unitel argued that the service agreement should not, at any time, become an impediment to the Commission's exercise of its jurisdiction over Island Tel.
Island Tel argued that it has always managed its service agreement with MT&T by carefully monitoring expenditures and by carefully considering its options. The company observed that the monitoring and negotiation process culminated in a revised agreement, which took effect 1 January 1990. Island Tel noted that the service agreement specifies that the parties intend that the services and materials be transferred at fair and reasonable prices to be negotiated by the parties. In addition, the service agreement states that the intention of the parties is to provide the party receiving services or materials with good value for money spent and to provide the party supplying the services and materials with appropriate contribution for services delivered.
The service agreement states that the annual retainer fee, annual contract fee, prices and pricing formulae for the services and materials to be provided shall be negotiated between the parties prior to 30 September in each year, to take effect 1 January of the following year (unless otherwise agreed), and shall be included in an addendum to be executed by the parties.
Island Tel argued that the determination of price is critical to a consideration of whether its service agreement with MT&T is fair and reasonable and does not result in cross-subsidization. The company took the position that it has provided the Commission with evidence that it carefully monitors the pricing of goods and services obtained from MT&T and is satisfied with the value it is receiving. The company noted that it has commissioned independent studies of the value of certain services received by it, and that these studies conclude that the company is receiving value for the services studied.
The company submitted that the Commission should recognize that there are certain economies of scale to be realized as a result of MT&T's ability to provide sophisticated services to a smaller telephone company. Island Tel stated that it recognizes the importance of obtaining value for service and that it realizes that it must remain accountable to its minority shareholders in obtaining services from MT&T. Island Tel also noted that it is accountable to its subscribers and to the Commission.
C. Conclusions
Based on the record of this proceeding, the Commission concludes that, at this time, it is not necessary to require the company to establish and file formal policies and procedures in connection with its transactions with related companies. In the Commission's view, a thorough review of Island Tel's service agreement with MT&T and periodic auditing by Commission staff will enable the Commission to assess whether Island Tel's intercorporate transactions give rise to any cross-subsidies to the detriment of Island Tel's subscribers or competitors.
The Commission notes Island Tel's statements that it has no details as to how MT&T calculates the amounts payable under the service agreement, and that the company has to make its own determination as to whether it is getting a fair and reasonable price. The company was unable to indicate, during examination, when the price was most recently calculated on the basis of estimated workloads, salaries, loadings, etc., rather than simply increased by a certain percentage over the previous year. Similarly, the Commission was unable to determine when Island Tel most recently performed a "make vs. buy" study in order to assess whether it would be better off financially doing the work itself, rather than paying MT&T for these services.
In light of the above, the Commission does not consider the record of this proceeding sufficient to permit a determination with respect to the service agreement between Island Tel and MT&T. Accordingly, the Commission will seek further information and comment on the service agreement in a separate proceeding. The record of this proceeding as it pertains to the service agreement will form part of the record of that separate proceeding.
VII OPERATING REVENUES
A. Introduction
In its Memoranda of Support, Island Tel estimated its operating revenues at existing rates at $50.6 million for 1990 and $52.9 million for 1991. At the rates proposed to take effect 1 January 1991, the company estimated that its operating revenues in 1991 would be $55.3 million.
The 4 September revisions to the company's financial exhibits included revisions to its revenue forecasts. Island Tel increased its forecast of 1990 revenues by $0.6 million to $51.2 million, attributing the increase primarily to a higher Telecom Canada settled revenue ratio resulting from stronger than expected growth in the company's cost components. Island Tel's revised its forecast of 1991 revenues at proposed rates downwards by $0.8 million to $54.5 million. This decrease was attributed primarily to a forecast decrease in long distance revenues available for settlement, reflecting Telecom Canada's revised forecast for a weaker overseas revenue growth and to the impact of Resale and Sharing of Private Line Services, Telecom Decision CRTC 90-3, 1 March 1990.
Effective 1 January 1991, the Government of Canada intends to introduce the GST and repeal the existing Federal Telecommunications Tax (FTT). The company did not include the impact of this tax change in its forecast of operating revenues.
Island Tel indicated in response to a Commission interrogatory that, in calculating the revenue impact of its proposed MTS rate changes, it has used price elasticities of -0.20 for intra-provincial calling and -0.50 for other long distance calling. Following examination by Commission counsel, the company provided two examples of how it calculated the revenue stimulation that would arise from its proposed long distance rate reductions. The company used price elasticities of -0.08 for intraprovincial calling and -0.34 for other long distance calling. The company referred to these figures, which are averages of quarterly elasticities, as short-run elasticities.
The company stated that its price elasticity estimates are based generally on estimates from Telecom Canada's econometric models, adjusted to reflect the company's past experience and judgment. The company does not have its own mathematical formulae or models to derive price elasticity estimates.
In calculating the revenue impact of its proposed local rate changes, the company assumed there would be no price elasticity effects.
B. Positions of Parties
Unitel submitted that Island Tel's revenue forecast is deficient, as it does not include stimulation to long distance revenues arising from the replacement of the FTT with the GST. Unitel argued that business customers will benefit from the reduction from 11% to 7% in the tax on long distance services, and will further benefit because the GST paid on telephone services used as an input into business operations can be deducted from their total GST bill. Unitel stated that residence customers will also benefit from the tax change, in that the tax applicable to their long distance calls will be lower. Unitel argued that, as a result, the replacement of the FTT with the GST will lead to a significant stimulation of Island Tel's revenues in 1991.
Unitel stated that the two Telecom Canada studies filed by the company in support of its price elasticity estimates treat changes in taxes on the price of telecommunications services as price changes. Unitel cited the company's acknowledgement, during examination by Commission counsel, that four Telecom Canada members (accounting for 82% of the total revenue available for settlement) have treated GST as a price change in their input to the Telecom Canada forecast.
Finally, Unitel filed, in the context of its oral argument, an exhibit showing, on the basis of certain assumptions, estimates of the magnitude of revenue stimulation due to the replacement of the FTT with the GST.
Island Tel responded by reiterating that it had not witnessed any customer response when the FTT was introduced. The company also argued that, when combined with its proposed local rate increases, the effect of the replacement of the FTT with the GST on customers' total bills will be negligible. Finally, Island Tel contended that Unitel's exhibit showing estimates of the revenue stimulation due to the replacement of the FTT with the GST is not evidence and cannot be substantiated, and that it was presented at a point in the proceeding that did not allow sufficient time for a comprehensive analysis of Unitel's estimates.
Unitel also submitted argument with respect to the Telecom Canada Revenue Settlement Plan (RSP), contending that decisions made by the Commission with respect to the rates of other telephone companies have a greater impact on Island Tel's revenue requirement than its decisions as to Island Tel's own rates. Unitel concluded that the RSP limits the Commission's ability to regulate thoroughly and adequately and that it should be given a full review by the Commission.
C. Conclusions
The Commission has certain concerns with respect to Island Tel's long run price elasticity estimates (provided by the company in response to interrogatory IslTel(CRTC)15Jun90-1711) and its use of average elasticities for estimating the impact of its proposed rate revisions on 1991 revenues. For example, the average elasticity for intra-provincial MTS is 34% of the long run elasticity, while the average elasticity for other long distance services is 70% of the long run elasticity. The Commission is of the view that Island Tel's average elasticity for intra-provincial MTS may under-estimate the true elasticity for this revenue category.
In addition, Island Tel uses a single price elasticity to reflect the impact of price changes on a number of rather heterogeneous MTS revenue categories, namely, adjacent company, TransCanada, Canada-U.S. and Canada-overseas.
Notwithstanding the concerns noted above, since the company's price elasticity estimates represent the best information available at this time, the Commission has used them for the purpose of calculating the impact on revenues of the proposed price changes.
With respect to the test year 1990, the Commission concludes that Island Tel's revenue estimation procedures and methods are reasonable and accepts the base revenue forecast provided with the company's revised financial exhibits of 4 September. However, the Commission is concerned that the company has not included in its forecast of 1991 revenues at existing rates any impact from the replacement of the FTT with the GST.
The Commission notes that Island Tel did not carry out any specific studies to isolate any curtailment that might have resulted from the introduction of the FTT and provided only anecdotal evidence in support of its submission that its revenues were not affected by the introduction of the FTT.
Island Tel submitted that the replacement of the FTT with the GST would result in no revenue stimulation. The company was of the opinion that, from the customer's perspective, the combination of the proposed local rate increases and tax decreases on long distance charges would result in no significant difference in the customer's total bill. combined with the effect of its proposed local rate increases. However, using the approach taken by other telephone companies under the Commission's jurisdiction, Island Tel calculated the revenue stimulation resulting from its proposed long distance rate reductions without considering any curtailment that might arise from its proposed local rate increases. In the Commission's view, the company's treatment of the reduction in the tax on long distance service is inconsistent with its approach to estimating the stimulation due to its proposed long distance rate decreases.
In the Commission's view, the appropriate approach is that taken by those members of Telecom Canada that collectively account for 82% of the total revenues of Telecom Canada. These companies considered the change in the applicable tax as a change in price. In this connection, the Commission also notes that Island Tel's price elasticities are based on Telecom Canada studies that assume that customers react to tax changes in the same way that they react to price changes.
The Commission concludes that the company underestimated its 1991 operating revenues at existing rates because it did not include the stimulation of long distance revenues due to the replacement of the FTT with the GST. In calculating the company's revenue requirement, the Commission has therefore adjusted the company's 1991 revenue forecast at existing rates by $151,000 to reflect this stimulation.
Taking all of the above into account, the Commission estimates the company's operating revenues at existing rates at approximately $51.2 million for 1990 and $52.2 million for 1991.
The Commission notes Unitel's submissions concerning the Telecom Canada RSP, but does not consider it necessary to initiate a comprehensive review of the RSP at this time.
VIII OPERATING EXPENSES
A. 1990 and 1991 Forecasts
In its Memoranda of Support of 1 May 1990, Island Tel estimated that its operating expenses would total $35.8 million in 1990 and $37.5 million in 1991, representing year-over-year increases of 8.3% and 4.8%, respectively. On 4 September 1990, the company revised these estimates, increasing its forecast of operating expenses for 1990 to $36.0 million and marginally reducing its forecast for 1991. The revised estimates of operating expenses represent annual increases of 9.1% and 4.0% for 1990 and 1991, respectively.
Excluding the categories of Depreciation and Operating Taxes, and also excluding the impact of accounting changes, the updated operating expenses total $22.3 million in 1990 and $23.2 million in 1991, representing increases of 6.1% and 3.7%, respectively.
In the Memoranda of Support and in response to interrogatories, the company provided details of the 1990 and 1991 forecasts by categories of expense, and further identified the forecast increases in terms of the reason for the increase, i.e., price changes, workload (growth in demand), accounting changes and other.
Island Tel also provided various measures of its operations performance, including employees per 1,000 NAS and various components of expense per NAS. While recognizing that, for various reasons, the value of these broad indicators of performance is limited, the Commission notes that they point, for the most part, to performance gains in 1990 and 1991. This is encouraging in light of the company's performance with respect to total operating expenses per NAS during the period of 1983-1988, when the company showed actual declines in productivity.
B. Goods and Services Tax
On 1 January 1991, the Government of Canada intends that the 7% GST replace the FST of 13.5%, currently levied at the manufacturer's level on goods manufactured or produced in Canada and on goods imported into Canada. Businesses, such as Island Tel, will be entitled to claim input tax credits for the full amount of GST paid on their purchases.
During examination by Commission counsel, Island Tel indicated that the impact of the GST was included in its 1991 operating expense forecast. However, Island Tel was unable to quantify that impact. Island Tel stated that it had not been able to determine a "reasonably solid number" for the impact of the GST, but that it expects the introduction of the GST to result in a reduction in its operating expenses. The company submitted that other items in its budget may have been understated, depending on future negotiations with certain supplies, and that, in these instances, it had been unable to make "a responsible estimate" of the impact on operating expenses. Therefore, the company made a judgment call that these various factors would have a zero impact.
Island Tel acknowledged that the introduction of the GST would lead to certain reductions in its operating expenses. Island Tel's 1991 forecast includes an increase, filed in confidence, in Maintenance expense due solely to "price". In the Commission's view, this increase is large enough to take into account any items that may have been understated in its 1991 forecast. Accordingly, the Commission is not persuaded that the full impact of the savings resulting from the introduction of the GST is reflected in Island Tel's 1991 forecast. Accordingly, the Commission has reduced the company's operating expense forecast by $55,000 in 1991.
C. Depreciation Expense
The Commission approved the life characteristics (average service life and retirement dispersion) for the company's fixed assets in Telecom Order CRTC 90-595, 6 June 1990. The depreciation rates for 1990 have been calculated on the basis of the approved life characteristics.
Depreciation expense increased to $11.0 million in 1989 from $10.1 million in 1988. This represents an increase of 9.1%, due primarily to increased telephone plant in service. Depreciation expense is expected to increase by 7.5% in 1990 to $11.9 million, mainly as a result of an increase in depreciable plant in service and the impact of a reduction in the service life of certain station apparatus. In 1991, notwithstanding increases in depreciable plant, depreciation expense is expected to increase by only 2.2% (to $12.1 million), primarily due to offsetting adjustments.
D. Conclusions
Except for the above-noted adjustment with respect to the GST, the Commission is satisfied that Island Tel's forecasts of its operating expenses for 1990 and 1991 are reasonable. In making this determination, the Commission notes that actual expenses to date closely track the company's Updated View, and that the increases for both 1990 and 1991 are less than the combined increase in projected prices and demand for the company's services.
The Commission nevertheless expects the company to continue its efforts to make operational improvements. By setting rates designed to achieve the mid-point of the allowed ROE range in the 1991 test year, the Commission provides the company with the means to improve its return to shareholders through further improvements in efficiency.
IX FINANCIAL ISSUES
A. General
In its Memoranda of Support of 1 May 1990, Island Tel estimated that its ROE at existing rates would be 11.8% in 1990 and 10.5% in 1991 (excluding the amortization of excess DTL, but including the expensing of station connection costs as proposed). Based on the amortization of $748,500 of its excess DTL in 1990 and $591,500 in 1991, the company estimated that its ROE at existing rates would be 13.5% in 1990 and 11.5% in 1991. On 4 September 1990, the company filed its Updated View, revising the forecasts provided in its 1 May 1990 application. The Updated View included the company's proposal to change its method of accounting for AFC, effective 1 July 1990, to that prescribed in Decisions 78-1 and 79-9. In addition, the company adjusted its excess DTL amortization to $483,600 in 1990 and $856,400 in 1991. The company estimated in its Updated View that, at existing rates, its ROE would be 13.5% in 1990 and 11.4% in 1991. Based on the assumption that its rate proposals for 1991 would be approved, including the 1 January implementation date, the company estimated its 1991 ROE at 14.1%.
Island Tel engaged Dr. Roger A. Morin of Georgia State University to prepare evidence as to a fair and reasonable ROE for the company. Island Tel also engaged Mr. F. Andrew Scott of Wood Gundy Inc. to comment on the impact on Island Tel's credit rating of the company's current capital structure and trends in its financial ratios. Mr. Scott based his comments on his perception of investor expectations as to capital market conditions for 1991. He stated in his evidence that, unlike Dr. Morin, he was not asked to apply generally accepted analytical techniques to establish a fair rate of return.
Rural Dignity et al also engaged expert witnesses, Dr. Michael Berkowitz and Dr. Laurence D. Booth, to provide an opinion on Dr. Morin's evidence on Island Tel's ROE and to present their own independent estimate of Island Tel's cost of common equity.
In its Memoranda of Support, the company noted that it was concerned with its deteriorating financial position over the test period. At the time of its application, the company stated that its capital structure as at 31 December 1989 was about 41% common equity, 7% preferred equity and 52% debt. With rates proposed for 1991, an average capital structure of about 46% common equity, 6% preferred equity and 48% debt would result. According to the company, this would allow for greater protection of its financial integrity.
The company stated in its Memoranda of Support that it had made a strong effort to have Canadian Bond Rating Service (CBRS) improve its bond rating in 1985, and had been told that, due to its size, it would require a debt ratio of 40% to 45% of total capital and an interest coverage ratio of 4.0 times before an upgrade would be considered. Island Tel stated that it believes that it would be most effective to achieve these targets over a reasonable length of time.
The company pointed out that currently its interest coverage and fixed charge coverage ratios (in 1989, 2.8 times and 2.4 times, respectively) were below those of other Canadian telephone companies and that, as a result, the company risks having its bond ratings downgraded. The company believed that, ideally, these ratios should be above 3.6 times and 3.0 times, respectively. Island Tel stated that, in a decision rendered by the PUC in 1987, the company was allowed an ROE of 13.5% and limited to 45% common equity in its capital structure. The company stated that, as a consequence, its interest coverage ratio dropped from 3.6 times in 1987 to 3.3 times in 1988. The company noted that it planned to raise $3.2 million through the sale of common equity in 1990, in order to improve its interest and fixed charge coverage ratios.
Based on its Updated View, Island Tel stated that it requires external financing of debt and common equity of about $6.8 million in 1990 and of about $10.3 million in 1991, in order to fund its construction program and to repay long-term debt as it matures. Island Tel noted that, although its capital requirements are significant to the company, they are considered very small in terms of the capital markets. Consequently, the company depends upon a narrow segment of the capital markets to supply its financing requirements.
The company submitted that its proposed ROE range of 13.75% to 14.75%, together with its financing plans, would be sufficient to protect and to improve its financial position. Island Tel noted that the evidence of its two expert witnesses supported the company's proposed ROE. In final argument, the company confirmed that, in light of all the evidence presented (particularly that pertaining to the negative outlook for the provincial economy), and given the current level of long-term interest rates, it was seeking a minimum ROE range of 13.75% to 14.75% for 1991.
As indicated above, Mr. F. Andrew Scott of Wood Gundy provided evidence on the financial position of the company in Canadian financial markets. During the hearing, Mr. Scott updated the evidence that he had submitted with the company's Memoranda of Support, but did not change his recommendations. Mr. Scott submitted that interest rates would decline over time, but that the timing of the decline was very difficult to predict. He submitted that, although Island Tel is a monopoly supplier of telecommunications services in Prince Edward Island and the industries that it relies on are showing signs of improvement, the company's business risk has increased somewhat since its last rate hearing in 1984, given the perceived weakness of the provincial economy relative to that of many other provinces.
In his analysis of the company's financial ratios, Mr. Scott stated that the steady increase in Island Tel's long-term debt as a percentage of total capital from about 46% in 1985 to about 52% in 1989 has reduced the company's financial flexibility. Mr. Scott emphasized his concern that, given that Island Tel's interest coverage ratio in 1989 was significantly below the Canadian telephone utility industry average, investors would not view favourably the continuing declining trend in the company's interest coverage ratio. In his opinion, without the proposed rates, the company's interest coverage ratio would decline further to 2.6 times in 1991, resulting in a reduction in the company's bond ratings.
Mr. Scott stated in his evidence that, in light of the increasing globalization of capital markets and in order to ensure that Island Tel continues to have access to capital markets as required, the company's allowed return on common equity and its capital structure must be adequate to generate financial ratios sufficient to maintain a credit standing of at least "A".
It was Mr. Scott's opinion that a company with a credit rating of less than "A" would generally have to resort to issues with features that might not be desirable for a telephone utility. In addition, he noted that many institutional investors have investment policy guidelines that preclude their investing in any security rated less than "A". Finally, Mr. Scott stated that, in his opinion, Island Tel's requested rate of return and its projected capital structure would produce financial ratios at the lower end of the range acceptable to maintain its "A(Low)" and "Pfd-2" ratings from Dominion Bond Rating Service (DBRS).
B. Rate of Return
1. Summary of Evidence
In his evidence, Dr. Morin recommended an ROE range of 13.75% to 14.75% for the company. During examination by Commission counsel, he stated that his recommendation applied to the years 1990 and 1991. During the hearing, Dr. Morin updated his evidence and filed supplementary evidence, including a critique of the evidence of Drs. Berkowitz and Booth, but did not change his recommendations.
In his evidence, Dr. Morin stated that Island Tel's overall risk has increased since the last decision of the Puc with respect to its rate of return, due to increases in its business and financial risks. Among other things, Dr. Morin stated that increasing competition and the current economic environment have increased Island Tel's short-term and long-term business risk. In Dr. Morin's opinion, Island Tel's financial risk has increased because the company's capital structure and coverage ratios have not kept pace with those of other federally regulated telephone companies. Dr. Morin submitted that the company's current financial ratios threaten its bond ratings of "B++(High)" from CBRS and "A(Low)" from DBRS.
Dr. Morin's recommendation as to a fair and reasonable rate of return was based on his application of the comparable earnings, quarterly discounted cash flow (DCF) and equity risk premium methods.
In his comparable earnings analysis, Dr. Morin relied on average realized returns for a group of 22 selected industrials over a 10-year period (i.e., 1979 to 1988). He selected these companies using the following risk criteria: (1) standard deviation of ROE, (2) coefficient of variation of ROE, (3) adjusted beta and (4) residual risk.
Dr. Morin calculated risk premium estimates from three studies. However, he relied on the results of only one study in his determination of an appropriate ROE range for Island Tel. In the first study, Dr. Morin applied his quarterly DCF model over the period 1984 to 1988 to Island Tel and five other Canadian telephone companies that he considered to be similar in risk to Island Tel. As a check on this estimate, Dr. Morin examined the risk premiums for the seven Bell regional holding companies in the United States, as well as the functional relationship between interest rates and risk premiums. In the second and third studies, the Capital Asset Pricing Model (CAPM) and an empirical approximation to the CAPM (ECAPM), Dr. Morin used Island Tel's adjusted beta averaged over the period 1979 to 1988 and a market risk premium in the range of 6% to 8%. Dr. Morin used his ECAPM results as a maximum in calculating the mid-point of his recommended range. He adjusted his risk premium estimates to permit the recovery of 7% flotation costs.
Dr. Morin applied the DCF method to data pertaining to Island Tel, to a group of four Canadian telephone companies and to 14 of the 22 industrials selected for his comparable earnings analysis.
Dr. Morin used an average of his DCF results (excluding two estimates derived using earnings-per-share data for Canadian telephone companies and Canadian low-risk industrials to estimate dividend growth) to establish a minimum ROE, and the highest of his three risk premium estimates to establish a maximum. He then used the mid-point of these two results as the mid-point of his recommended range. In his updated evidence, Dr. Morin stated that the net result of the revisions to his DCF and risk premium results was a slightly higher cost of equity, but one that was still within his recommended range.
Dr. Morin stated that he used a quarterly discounting model, instead of an annual discounting model, in order to account for the payment of dividends on a quarterly basis. Dr. Morin stated that the magnitude of error of using the annual model is in the order of 30 to 40 basis points. In his analysis, Dr. Morin estimated dividend growth using dividends per share and earnings per share over a 10-year period (i.e., 1979 to 1988 in his original evidence, 1980 to 1989 in his updated evidence). He then adjusted his DCF cost of capital upward to allow for flotation costs of 7%.
Drs. Berkowitz and Booth calculated a fair and reasonable ROE for Island Tel using the DCF and equity risk premium methods. They obtained a range of 11.34% to 12.26% from their DCF model, with a best point estimate of 11.80%. In their DCF analysis, they relied on data for Island Tel and for a group of telephone companies that they considered equivalent to Island Tel in terms of risk. They calculated the dividend growth rate using two approaches: a historical growth method and an "inflation-plus" growth method. As a check on their growth estimates, they used a components-of-growth approach as well.
In their equity risk premium analysis, Drs. Berkowitz and Booth obtained a range of 11.57% to 12.92% for the cost of common equity, with a best point estimate of 12.09%. Drs. Berkowitz and Booth relied on a CAPM model using a beta estimate of 0.41 for Island Tel and an estimated market risk premium of between 1.8% and 2.3%. As a check on their risk premium estimate, they calculated the market risk premium over yields on preferred equity, accounting for the different tax treatment of returns on preferred equity, as opposed to that afforded returns on bonds. In their view, such a risk premium would be sufficient to satisfy the requirements of investors.
In general, the Commission considers all of the approaches used by all parties in this proceeding to be of assistance in assessing a fair and reasonable rate of return. Issues raised in this proceeding in relation to rate of return on which the Commission wishes to comment are discussed below.
2. Quarterly DCF Model
In their evidence, Drs. Berkowitz and Booth stated that, conceptually, the quarterly DCF model is sound. The problem, they stated, is in Dr. Morin's application of that model.
First, Drs. Berkowitz and Booth stated that shareholders recognize that most Canadian regulatory boards employ annual discounting models. Share prices, therefore, already reflect investors' expectations. Second, they stated that, as pointed out by the Consumers' Association of Canada (CAC) in the proceeding leading to Bell Canada - 1988 Revenue Requirement, Rate Rebalancing and Revenue Settlement Issues, Telecom Decision CRTC 88-4, 17 March 1988 (Decision 88-4), Dr. Morin's quarterly discounting model fails to consider the fact that the rate of return estimated from it is applied to an average annual rate base. Third, Drs. Berkowitz and Booth stated that investors are indifferent as to whether they receive single annual payments to earn an annual rate of return of, for example, 12.55%, or four quarterly payments to earn a quarterly rate of return of 3.0%. More simply put, they stated that, if the annual return on common equity of 12.27% is enough to generate a 12.55% annual rate of return to investors, a 12.55% return on equity to the company will overcompensate investors.
In his supplementary evidence, Dr. Morin did not directly address the concerns of Drs. Berkowitz and Booth regarding his own application of the quarterly DCF model. Instead, he criticized their use of an annual DCF model, since, in his opinion, it assumes that all cash flows received by investors are paid annually. In addition to the concerns expressed in his original evidence, Dr. Morin noted that a company's ability to attract capital is diminished unless its investors are allowed the effective quarterly DCF return, simply because investors are able to earn a higher return from competing comparable risk investments.
In Decision 90-15, as in past proceedings, the Commission noted its concern that the additional 30 to 40 basis points resulting from the application of the ROE from Dr. Morin's quarterly discounting model have already been reflected in the dividend yield component of his DCF calculation. The Commission also stated that the issue raised by CAC in the proceeding leading to Decision 88-4 with respect to Dr. Morin's use of the quarterly discounting model had not been satisfactorily resolved.
The telephone companies under the Commission's jurisdiction, including Island Tel, are allowed a fair rate of return on an annual basis. The Commission finds nothing on the record of this proceeding to alleviate its concern with respect to the use of the quarterly discounting model. Rather, the Commission is persuaded that to increase the company's ROE to reflect the quarterly compounding of dividends, while investors are paid on a quarterly basis, would result in an ROE higher than that needed to permit the company to provide an appropriate return to investors. Therefore, the Commission does not consider it appropriate to use the quarterly DCF model, and has relied on the annual DCF model.
3. Flotation Costs
Drs. Berkowitz and Booth did not adjust their estimates to allow for the recovery of flotation costs. During the hearing, they stated that the company has provided insufficient evidence that these costs are being incurred. They added that, because investors are aware that flotation costs are not awarded in many Canadian jurisdictions, investors would take this into account when pricing the stock.
In response to a Commission interrogatory, the company provided estimates of the flotation costs associated with issuing equity by different methods, including the public issuing of new equity, private placement and rights offering. In response to another Commission interrogatory, Dr. Morin stated that his flotation allowance is intended to reflect the flotation costs associated with the entire equity rate base.
Dr. Morin included a 2% market pressure component in his 7% flotation cost allowance. He relied on two U.S. studies to support his 5% estimate of direct out-of-pocket costs and three U.S. studies for his 2% estimate of the market pressure component. These studies are similar to those that Dr. Morin has relied on in past proceedings before the Commission. Dr. Morin indicated in his evidence that he was unaware of any comparable studies undertaken in Canada. During examination by Commission counsel, Dr. Morin stated that, in response to the Commission's expressed interest in examining estimates of flotation costs in Canada, he conducted the first phase of a study of flotation costs on Canadian equity issues. This survey, which covers commission costs, other expenses and offering spreads for Canadian equity underwritten by Wood Gundy and issued between the years 1980 and 1989, was filed as part of his supplementary evidence. For the issues examined, commission costs averaged about 4.48%, other expenses about 0.61%; and offering spreads about 1.37%. The sum of these costs was about 6.46%.
The Commission notes that Dr. Morin calculated the average offering spread of 1.37% by dividing by the number of companies noted in his study as having a zero or a positive offering spread, ignoring those companies for which no offering spread information was indicated. In the Commission's view, for the purposes of establishing an appropriate flotation cost allowance, Dr. Morin should have handled share issues for which no offering spread information was indicated in the same manner as share issues indicated as having a zero offering spread, since in both cases his data indicated no explicit offering spread. Therefore, the Commission considers it more appropriate to divide the total offering spread by the total number of companies. Using this approach, the offering spread would average about 0.81%.
In an interrogatory response, the company-noted that commission and other expenses are recorded as charges against retained earnings on an after-tax basis. The Commission considers, therefore, that Dr. Morin should have used the after-tax values for commission costs and other expenses in arriving at his flotation cost allowance for Island Tel. Based on Dr. Morin's estimates, commission costs and other expenses on an after-tax basis would be about 3.05 % (5.09 % before-tax). Since a company incurs minimal costs associated with equity sold to its holding company or to a large minority shareholder, and given that MT&T has held a large portion of Island Tel's shares, Dr. Morin's estimate of the direct out-of-pocket expense component of the company's flotation cost allowance can be further reduced.
In addition, Dr. Morin's estimate of flotation costs was derived from new public issues, which is the most expensive method of issuing equity. The inclusion of the flotation costs associated with other, less expensive methods of issuing equity (for example, private placements, rights offerings, dividend reinvestment plans and employee stock option plans would lower his estimate. Since Island Tel has issued equity through both dividend reinvestment and employee stock option plans, estimates of its flotation costs should not be based solely on the costs associated with new public issues.
As stated in previous decisions, the Commission recognizes flotation costs as genuine costs to be recovered. However, in light of the foregoing, it is the Commission's determination that Dr. Morin's recommended flotation cost allowance of 7%, which is included in his recommended ROE, over-estimates the company's flotation costs. The Commission considers it appropriate to grant a substantially lower allowance for Island Tel's flotation costs.
4. Tax Status of Investors
Drs. Berkowitz and Booth stated that estimating a risk premium over preferred stock yields leads to a better estimate of a fair rate of return than estimating a risk premium over debt, since, in terms of tax treatment, preferred equity and common equity have more in common with each other than either form of equity has with debt securities.
During cross-examination by Island Tel, Dr. Booth acknowledged that the risk premium evidence that he had submitted with Dr. Berkowitz would not apply to tax-exempt investors, such as pension funds.
The Commission notes that, in their analyses, Drs. Berkowitz and Booth did not take into account the situation of non-taxable investors. As noted in previous decisions, the Commission is of the opinion that, in estimating the cost of common equity, the return on investment required by both taxable and nontaxable investors should be considered.
5. Interest Coverage
As noted above, the company's updated financial exhibits of 4 September 1990 indicate that the company's interest coverage would be about 2.7 times in 1990 and about 2.5 times in 1991 at existing rates. At the rates proposed for 1991, the company estimated that its interest coverage would be about 3.0 times in that year.
In final argument, Rural Dignity et al stated that evidence submitted by Island Tel's own expert witness, Mr. Scott, showed that several companies have an interest coverage ratio of 2.5 times or less and a bond rating higher than or equal to that of Island Tel's current rating. Rural Dignity et al added that there is no one-to-one relationship between coverage ratios and bond ratings and that Island Tel's suggestions of an immediate drop in bond ratings as a result of a drop in coverage ratios should be dismissed. Finally, Rural Dignity et al stated that, in its opinion, the Commission should be cognizant of improvements for the company in the longer term, rather than over the short term only.
In determining the appropriate ROE for the company, the Commission has remained mindful of the company's current financial ratios and its need to maintain its financial flexibility, particularly in current capital markets. The Commission estimates that, at its allowed ROE for 1990, specified below, the company will achieve an interest coverage ratio of about 2.7 times in that year. The Commission estimates that the company's interest coverage will be approximately 3.0 times in 1991, at the mid-point of the allowed ROE range for that year.
C. Conclusions
In assessing a fair and reasonable return on common equity for 1990 and 1991, the Commission has considered all the evidence presented, including that related to the financial ratios necessary to support Island Tel's credit quality.
The proposals put forward in Island Tel's application are intended to yield the company an ROE of 13.5% in 1990. The Commission concludes that this is an appropriate ROE for the company for that year.
The Commission concludes that the fair and reasonable ROE range for Island Tel for 1991 is 13.25% to 14.25%. In the Commission's view, this range is fair to both subscribers and shareholders.
X REVENUE REQUIREMENT
A. General
Based on information provided by the company, including the financial updates filed on 4 September 1990, the Commission estimates that Island Tel's ROE at existing rates would be 13.5% for 1990 and 11.4% for 1991. The general increase in rates proposed to take effect on 1 January 1991 is expected to produce additional revenue of $2.4 million in 1991. With these proposed increases, the company estimated that its ROE would be 14.1% in 1991.
B. 1990 Revenue Requirement
After incorporating the proposed accounting changes identified in the company's letter of 4 September 1990, the Commission estimates that Island Tel will earn, at existing rates, an ROE of 13.5% in 1990, the return requested by the company and prescribed above. Therefore, no revenue adjustment is necessary for 1990.
C. 1991 Revenue Requirement
The Commission further estimates that, after incorporating the various adjustments for 1991 identified in this Decision, the company would earn, at existing rates, an ROE of 11.6%. The Commission has used the mid-point of the allowed range, i.e., 13.75%, for the purpose of determining the company's revenue requirement for 1991, thus providing the company with the opportunity and the incentive to enhance its return to shareholders through additional gains in efficiency. The Commission estimates that a revenue increase of about $1.9 million in 1991 is necessary to provide the company with an ROE in 1991 of 13.75%.
XI TARIFF REVISIONS
A. Terminal Equipment
Island Tel proposed to increase the rates for the rental of its singleline telephone sets by amounts ranging from approximately 12% to 56%. Basic rotary dial and touch tone sets would increase by 56% and 30%, respectively. The company stated that these increases would bring the monthly rental charges more in line with the costs of providing rental telephone sets.
The company also proposed increases of approximately 10% to 25% to its rates for the rental of multi-line and other terminal equipment. Generally, the increases proposed for its older-technology key system and PBX equipment are greater than the increases proposed for equipment introduced more recently. Island Tel noted that, since the attachment of customer-provided terminals was approved in 1983, customers can acquire terminals either from the company or from other suppliers.
Rural Dignity et al argued that the proposed increases for basic rotary dial sets would have a large impact on rural low income subscribers. It noted that approximately one-fifth of Island Tel's customers have party-line service, most of them being rural customers. Rural Dignity et al submitted that the company is creating a price incentive for customers to convert to touch tone telephones, but contended that touch tone telephones do not benefit party-line subscribers. Rural Dignity et al was of the view that the company's proposed basic telephone set rates are inappropriate in terms of their impact on these subscribers.
It is a long standing policy of the Commission that the rates for competitive offerings be compensatory and maximize contribution. The Commission is of the view that the proposed increases are consistent with increasing the contribution from these services. The Commission therefore approves the proposed terminal equipment rates.
B. Network Exchange Services
1. Single-Line Service
Island Tel proposed various increases to its monthly rates for single-line Network Exchange Service (NES). Generally, the company proposed to increase the rates for rotary dial NES by a greater percentage amount than the rates for touch tone NES. The increases proposed by the company for business touch tone NES are greater than those proposed for comparable residence NES. For residence customers, an average increase of 8.9% was proposed. Single-line business customers would experience an average increase of 10.7%.
In general, the Commission considers appropriate the company's proposed approach in reducing the differential between rotary dial and touch tone NES rates. However, in view of the Commission's determination with respect to the company's 1991 revenue requirement, the Commission does not consider increases of the extent proposed to be necessary. Therefore, the proposed residence and single-line business increases are denied. The following residence NES rates are approved:
Rate Rotary Touch
Group/ Dial/ Tone/
Groupe Téléphone à Touch
tarifaire cadran Tone
One-party/ 2 $ 9.45 $11.25
Ligne à un abonné 3 $11.10 $12.90
4 $11.80 $13.60
Two-party/ 2 $ 8.90 $10.70
Ligne à deux abonnés 3 $10.55 $12.35
4 $11.25 $13.05
Four-party/ 2 $ 8.40 $10.20
Ligne à quatre abonnés 3 $10.05 $11.85
4 $10.70 $12.50
The Commission also approves the following single-line business NES rates:
Rate Rotary Touch
Group/ Dial/ Tone/
Group Téléphone à Touch
tarifaire cadran Tone
One-party/ 2 $21.80 $24.35
Ligne à un abonné 3 $32.45 $35.05
4 $38.75 $41.35
Two-party/ 2 $20.20 $22.70
Ligne à deux abonnés 3 $30.15 $32.70
4 $36.25 $38.85
Four-party/ 2 $18.50 $21.00
Ligne à quatre abonnés 3 $27.80 $30.35
4 $33.85 $36.45
The rates set out above will result in average price increases of approximately 3.2% and 4.6% for single-line residence and business NES, respectively.
2. Multi-Line Service
Island Tel proposed increases ranging from 8.9% to 14.6% to its rates for key system and PBX NES and for Centralized Business Service. (These services are referred to in the company's General Tariff, Item 720, as Series 101 to 107, Series 302, 303, 501, 601 and 602, and Series 401). The Commission is of the view that the relationship between the company's proposed multi-line NES rates and the approved rates for single-line NES is reasonable. Accordingly, the company's proposed multi-line NES rates are approved.
C. Monopoly Toll Rates
1. Intra-provincial Message Toll Service
Island Tel proposed the following changes to its intra-provincial MTS rate schedule:
(1) an increase in the per-call connection charge from $0.08 to $0.10;
(2) increases in operator surcharges to $1.50 for station-to-station calling card calls and to $3.75 for person-to-person calls;
(3) the introduction of automated calling card service (ACCS) at a surcharge of $0.50 per call; and
(4) reductions in the usage rates for certain long haul calls.
The Commission notes that the revisions proposed to the company's intra-provincial MTS rate schedule would generate additional revenues. The proposed increases to the operator handled surcharges would provide consistency between Island Tel's intra-company charges and charges proposed for similar calls to other locations in Canada. The Commission also notes that the proposed rate of $0.50 for ACCS is equal to that proposed for the company's P.E.I.-Canada and P.E.I.-U.S. message toll schedules.
Island Tel proposed to reduce the usage rates for long haul intra-provincial MTS calls in order to provide consistency with its inter-provincial MTS rates. The Commission approves, effective 1 January 1991, the company's proposed intra-provincial MTS rate schedule.
2. P.E.I.-Canada Message Toll Service
Island Tel proposed a number of revisions to its P.E.I.-Canada MTS rate schedule:
(1) reductions in usage rates of approximately 19%;
(2) an increase in the operator surcharge for station-to-station calling card calls from $1.00 to $1.50;
(3) the elimination of the $0.15 per call connection charge;
(4) the introduction of a $0.27 minimum charge per call; and
(5) the introduction of ACCS at a surcharge of $0.50.
The impact on Island Tel of adopting these usage rates is a decrease of $207,000 in settled revenues. Island Tel submitted that, on an originated basis, the reduction would be $2.16 million. On this basis, the company submitted that the proposed revisions result in a benefit to Island Tel's customers in excess of the reduction in settled revenues.
The Commission approves the company's proposed P.E.I.-Canada MTS rate schedule, effective 1 January 1991.
3. P.E.I.-U.S.A./Mexico Message Toll Service
Island Tel proposed the following changes to its P.E.I.-U.S.A./Mexico MTS rate schedule:
(1) an increase in the surcharge on operator handled calling card calls from $1.00 to $1.50;
(2) the elimination of the $0.15 per call connection charge;
(3) the introduction of a $0.27 minimum charge per call;
(4) the introduction of ACCS at a surcharge of $0.50; and
(5) increases in the usage charges for certain short haul calls.
The changes proposed by Island Tel would result in an overall average price reduction of approximately 4%. The proposed increase in the surcharge for operator handled calling card calls, the elimination of the connection charge and the establishment of a per-call minimum charge would provide consistency with the company's P.E.I.-Canada rate schedule.
The Commission approves the company's proposed P.E.I.-U.S. MTS rate schedule.
D. Service Request Charges
Island Tel proposed to increase its service request charges for single-line and multi-line services by an average of 48%. Under the company's proposal, the minimum charge for a premises visit would increase from $22.50 to $33.00 for residence service and from $30.50 to $50.00 for single-line business service. The increases in service charges for multi-line customers would increase by amounts ranging from 29% to 65%.
Island Tel was unable to provide cost information relating to service request charges. However, the company is of the view that the current charges for these services are not compensatory. Rural Dignity et al submitted that the proposed increases would have a heavy impact on low income subscribers.
The Commission notes that most of these charges have not been increased since 1983, and that the company is of the view that the current charges are not compensatory. In light of the company's need for additional revenues in 1991, the proposed service request charges are approved, effective 1 January 1991.
E. Hospital Patient Telephone Service
Island Tel proposed an increase from $1.05 to $1.50 per day for the first 14 days of Hospital Patient Telephone Service. The rate for service beyond 14 days would increase from $0.55 to $1.00 per day. Island Tel was of the view that the increases are warranted, based on value of service considerations and on the costs arising from the degree of non-revenue generating plant required to provide the service.
The Commission approves the proposed increases. However, the company's tariff indicates that a contract between the company and the hospital is required for this service. Therefore, the Commission directs Island Tel to file the relevant agreements by 18 February 1991.
F. Other Proposed Rates
The remainder of the rates proposed by the company in The Island Telephone Company Limited Review of Revenue Requirement 1990-1991, Part A, The Application, Schedule of Proposed Rate Revisions are approved effective 1 January 1991.
G. Disposition of Interim Tariffs
In Decision 89-18, the Commission made interim all Island Tel rates approved prior to 1 January 1990. The company requested that the Commission grant final approval to these rates. The Commission gives final approval, effective 1 January 1991, to the rates made interim as a result of Decision 89-18, as modified by this Decision.
The status of tariffs granted interim approval in other Commission decisions, orders or letters is not affected by the above determination. Such tariffs are to continue in effect on an interim basis until the Commission issues final determinations with respect to them.
H. Filing of Tariffs
The company is directed to issue, by 27 December 1990, final tariff pages giving effect to the tariff revisions approved in this decision.
XII PHASE II AND PHASE III COSTING REQUIREMENTS
In Phase II of the Cost Inquiry (see Telecom Decision CRTC 79-16, 28 August 1979), the Commission established certain requirements for the costing and evaluation of proposed new services. In Phase III of the Cost Inquiry (see Telecom Decision CRTC 85-10, 25 June 1985), the Commission established a conceptual framework for assigning the revenues and costs associated with existing services to certain broad categories of service. Subsequently, the Commission issued Telecom Order CRTC 86-516, 28 August 1986, setting out guidelines for Phase III Manuals.
At the hearing, Unitel questioned Island Tel as to its plans for complying with the requirements set out in Phase II of the Cost Inquiry. Unitel noted that, in Decision 90-15, the Commission directed Newfoundland Telephone Company Limited to comply with Phase II within one year. Unitel submitted that Island Tel should not be granted a longer period to comply. Unitel submitted that Island Tel should be directed to comply, in a prompt and timely manner, with both Phase II and Phase III of the Cost Inquiry.
Island Tel stated that it plans to comply with Phase II and Phase III after records and studies have been completed by MT&T. Island Tel submitted that its present costing methodology complies with most, but not all, of the requirements established in Phase II. It stated that it would be in full compliance with Phase II by 1992-93, approximately one year after the implementation of Phase II by MT&T.
Island Tel indicated that it would cost the company in excess of $400,000 to implement Phase II fully within one year, since it would have to implement the costing methodology itself. Island Tel submitted that it would be most cost-effective to implement Phase II after MT&T.
In light of the magnitude of the additional costs, in relation to its revenue requirement, that Island Tel would incur were it to implement Phase II prior to MT&T, the Commission considers Island Tel's plans for the implementation of Phase II appropriate.
On 13 September 1990, the Commission wrote to the four Atlantic telephone companies, including Island Tel, initiating a multi-stage process with respect to Phase III. This process is intended to lead to the publication of Phase III Guidelines for the Atlantic telephone companies in mid-1991.
Allan J. Darling
Secretary General
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