ARCHIVED -  Telecom Decision CRTC 92-23

Telecom Decision

Ottawa, 18 December 1992

Telecom Decision CRTC 92-23

THE NEW BRUNSWICK TELEPHONE COMPANY LIMITED - RATE OF RETURN ON AVERAGE COMMON EQUITY FOR 1993

Table of Contents

OVERVIEW

I INTRODUCTION

II QUANTITATIVE METHODS

A. Comparable Earnings

B. Discounted Cash Flow

C. Equity Risk Premium

III BUSINESS RISK

A. Introduction

B. Specific Risk Factors

1. The New Brunswick Economy
2. Reliance on Long Distance Revenues
3. Resale of Local Services
4. Proximity to U.S. Border
5. Technological Change
6. National Regulation
7. Other

C. Conclusions

IV CAPITAL STRUCTURE

V OVERALL CONCLUSIONS

OVERVIEW

(Note: This overview is provided for the convenience of the reader and does not constitute part of the Decision. For details and reasons for the conclusions, the reader is referred to the various parts of the Decision.)

On 24 July 1992, the Commission issued The New Brunswick Telephone Company Limited - Rate of Return on Average Common Equity for 1993, Telecom Public Notice CRTC 92-42, initiating a proceeding to establish an appropriate range for the rate of return on average common equity (ROE) of The New Brunswick Telephone Company Limited (NBTel) for 1993. The Commission stated that the proceeding would focus only on issues related to an appropriate ROE for the company, and not on its revenue requirement for 1993.

In addition to providing evidence on an appropriate ROE for 1993, NBTel proposed a modification to the current form of rate base/rate of return regulation. That portion of the application was withdrawn with the Commission's approval on 27 November 1992.

Based on its own evidence, and on expert evidence prepared by Dr. R.A. Morin, NBTel recommended an an ROE range of 12.8% to 13.4%. The New Brunswick Anti-Poverty Association and the Consumers' Association of Canada filed expert evidence prepared by Dr. L.D. Booth and Dr. M.K. Berkowitz, who recommended an ROE of 11.0% with a range of 10.5% to 11.5%.

Having considered the relevant factors, including current capital market conditions and NBTel's business risk following Competition in the Provision of Public Long Distance Voice Telephone Services and Related Resale and Sharing Issues, Telecom Decision CRTC 92-12, 12 June 1992, the Commission approved an ROE range of 11.5% to 12.5%. The Commission also approved a midpoint of 12.0% to be used by NBTel in preparing the budget on which the Commission bases its monitoring process. The Commission stated that it would assess the reasonableness of that budget when it is filed in January 1993. In addition, the Commission approved NBTel's proposal that, over the medium term, it move to a more conservative capital structure containing a common equity component of about 55%.

I INTRODUCTION

On 24 July 1992, the Commission issued The New Brunswick Telephone Company Limited - Rate of Return on Average Common Equity for 1993, Telecom Public Notice CRTC 92-42, initiating a proceeding to establish an appropriate range for the rate of return on average common equity (ROE) of The New Brunswick Telephone Company Limited (NBTel) for 1993. The Commission stated that the proceeding would focus only on issues related to an appropriate ROE for the company, and not on its revenue requirement for 1993. Procedures were established to allow the Commission to issue a decision in an appropriate timeframe for NBTel to incorporate the approved ROE into its 1993 forecast.

NBTel filed its evidence on 8 September 1992. In addition to providing evidence on an appropriate ROE for 1993, NBTel also proposed a modification to the current form of rate base/rate of return regulation. Specifically, NBTel proposed that the Commission establish a wider range for its ROE than has been the traditional practice, with the upper limit set above what would otherwise be the maximum. NBTel also proposed that the Commission adopt a mechanism that would allow for the sharing between customers and shareholders of earnings in excess of this wider range.

The following parties registered as interveners in this proceeding: AGT Limited, Bell Canada, British Columbia Telephone Company, Canadian Business Telecommunications Alliance, Government of New Brunswick, Maritime Telegraph and Telephone Company Limited, Newfoundland Telephone Company Limited (Newfoundland Tel), Northwestel Inc., Ontario Telephone Service Commission, Public Interest Advocacy Centre on behalf of Consumers' Association of Canada (CAC) and New Brunswick Anti-Poverty Association (NBAPA), SaskTel, Telesat Canada and Unitel Communications Inc. NBAPA/CAC provided expert evidence and was the only intervener to file argument (dated 2 November 1992). NBTel filed argument on 23 October 1992 and reply argument on 9 November 1992.

With its Memorandum of Evidence filed on 8 September 1992, NBTel submitted an attachment setting out the recommendations of Dr. R.A. Morin as to the company's ROE for 1993. As in past proceedings, Dr. Morin employed comparable earnings, discounted cash flow (DCF) and equity risk premium approaches. Dr. Morin submitted that the aggregated results of his various tests indicated that a fair and reasonable ROE for NBTel for 1993 would be in the range of 12.3% to 13.0%. However, given his assessment of the additional risk resulting from Competition in the Provision of Public Long Distance Voice Telephone Services and Related Resale and Sharing Issues, Telecom Decision CRTC 92-12, 12 June 1992 (Decision 92-12), Dr. Morin added 50 basis points to both the lower and upper bounds of his ROE range, arriving at a recommended range of 12.8% to 13.5%.

NBTel also provided qualitative evidence, especially with respect to its business risk, in support of Dr. Morin's 50 basis point upward adjustment. NBTel's qualitative evidence included quotations from various credit rating agencies and industry analysts stating that Decision 92-12 has increased the company's business risk, and a list of factors that the company feels have contributed to that increased risk.

Dr. Morin initially submitted that the top of his recommended ROE range (i.e., 13.5%) should be used for rate-making purposes because capital markets are unsettled and uncertain at this time and because the expected recovery of the Canadian economy in 1993 will put upward pressure on long-term interest rates. In addition, Dr. Morin was of the view that NBTel's proposal for incentive regulation would entail sharing the benefits with customers "on the upside", while leaving NBTel "exposed on the downside". He therefore took into account the increased risk that the company would face, should its proposal be approved. Finally, he considered NBTel's capital structure relative to other Canadian telephone companies, concluding that the company's debt ratio is slightly higher than the industry average.

Subsequent to the filing of the company's evidence, the Commission issued The New Brunswick Telephone Company Limited - Incentive Regulation, Telecom Public Notice CRTC 92-64, 19 October 1992 (Public Notice 92-64), initiating a separate proceeding to examine NBTel's proposal for incentive regulation. In response to a Commission interrogatory, Dr. Morin stated that, in order to recognize a reduction in the company's risk due to the fact that its proposals for incentive regulation were to be considered in a separate proceeding, the upper portion of his recommended range should be used for rate-making purposes (i.e., 13.4%) rather than the top end of the range (i.e., 13.5%).

Based on the evidence provided by itself and by Dr. Morin, NBTel requested an allowed ROE range of 12.8% to 13.4% for 1993. NBTel requested that the Commission allow it to operate anywhere within its proposed range, without setting a specific midpoint. The company submitted that, in the absence of a revenue requirement proceeding, the Commission is not required to establish a specific point at which rates must be set. As well, the company was of the view that the setting of a midpoint acts as a disincentive with respect to future innovation.

By letter dated 23 November 1992, NBTel advised the Commission that it was withdrawing its application for incentive regulation. By letter dated 27 November 1992, the Commission approved that withdrawal.

Dr. Morin's test results were determined in a manner similar to those filed in the proceeding leading to Newfoundland Telephone Company Limited - Revenue Requirements for 1992 and 1993, Telecom Decision CRTC 92-15, 28 August 1992 (Decision 92-15), with some exceptions. Specifically, Dr. Morin noted that he had updated the underlying data, excluded the quarterly timing adjustment from his DCF results (although he disagrees with the Commission's position on the use of the quarterly DCF model), and made an adjustment for the tax deductibility of the direct component of flotation costs.

NBAPA/CAC commissioned Dr. L.D. Booth and Dr. M.K. Berkowitz to provide their view as to an appropriate ROE for NBTel for 1993. Their evidence, filed on 4 September 1992, was also similar to that which they filed in the proceeding leading to Decision 92-15, the main difference being the updating of their underlying data. As in that proceeding, Drs. Booth and Berkowitz employed DCF and equity risk premium techniques. Based on their analyses, and with the incorporation of an upward adjustment to reflect, among other things, current economic conditions, Drs. Booth and Berkowitz recommended an ROE of 11.0%. They submitted that, should the Commission wish to set a range, 10.5% to 11.5% would be reasonable.

Dr. Morin's "Summary of Results", which includes the estimates produced by each of his tests, is set out in Table 1 of the Appendix. A summary of the results prepared by Drs. Booth and Berkowitz is set out in Table 2 of the Appendix.

Rate of return and other financial issues raised during the proceeding on which the Commission wishes to comment are discussed in the following Parts.

II QUANTITATIVE METHODS

A. Comparable Earnings

Dr. Morin indicated that his comparable earnings methodology is the same as that employed in his evidence in the proceeding leading to Decision 92-15, except that 1991 data were added and 1981 data were deleted in the computation of the 10-year average ROE for his sample of low-risk industrials. Dr. Morin apparently considered that NBTel's risk is similar to that of his sample of low-risk industrials. Therefore, he made no adjustment to his comparable earnings results.

The Commission has generally held the view that low-risk industrials are somewhat higher in risk than higher-grade, low-risk Canadian utilities. The Commission notes that, in the proceeding leading to Decision 92-15, Dr. Morin relied on the same industrial sample as in this proceeding. In that proceeding, Dr. Morin was also of the view that no adjustment to his comparable earnings results was warranted for the possible existence of a risk differential between his industrial sample and low-risk utilities. However, the Commission found in that proceeding that Dr. Morin's comparable earnings results were, to some extent, overestimated, and concluded that a downward adjustment should be made to his industrial returns in order to reflect the lower risk of higher-grade utilities.

As noted above, Dr. Morins's comparable earnings analysis in this proceeding is virtually identical to that presented in the proceeding leading to Decision 92-15. In light of the absence of any new evidence, the Commission has made a downward adjustment to Dr. Morin's industrial sample results in order to reflect its view as to the lower risk of NBTel relative to Dr. Morin's sample of low-risk industrials.

B. Discounted Cash Flow

Dr. Morin applied the DCF model to a sample of Canadian telephone companies and to the sample of low-risk industrials used in his comparable earnings analysis.

He stated that his DCF results were derived using 10-day average stock prices (18 May to 29 May 1992) and long-term (15-year) historical growth rates ending in 1991. He indicated that the results would be virtually identical using mid-September stock prices.

Dr. Morin also stated that, in recognition of past Commission decisions, he had excluded the impact of the quarterly timing adjustment from his DCF results (as noted by Dr. Morin, this exclusion would not affect his comparable earnings, capital asset pricing model (CAPM), and empirical approximation to the capital asset pricing model (ECAPM) results).

The Commission notes that the DCF results for Canadian telephone companies shown by Dr. Morin in his "Summary of Results", as well as the results shown for his DCF-based equity risk premium method relative to Canadian telephone companies, include both a quarterly timing adjustment and a 7% (pre-tax) allowance for flotation costs. Dr. Morin stated that the incorporation of the quarterly timing adjustment into his "Summary of Results" would reduce his overall average result by about 15 basis points, while adjusting for the tax deductibility of direct flotation costs would further reduce the overall result by about 10 basis points. These downward adjustments would yield an ROE range of some 12.3% to 13.0%, instead of the suggested range of about 12.5% to 13.2% presented in his "Summary of Results".

The Commission also notes that the results shown for the DCF Industrials study appear to have had the effects of the quarterly timing adjustment removed prior to the 15 basis point downward adjustment to his average results. As a result, the quarterly timing adjustment with respect to that study has apparently been taken into account twice in Dr. Morin's calculation of his overall results.

Drs. Booth and Berkowitz employed both a Components of Growth approach and a Real (growth) + Inflation approach in arriving at their DCF results. The latter approach incorporates a growth range of 4.2% to 4.7%, with the top of the range determined by including 50 basis points for their estimate of investors' real growth expectations. Neither of their DCF results incorporates any allowance for flotation costs, given Drs. Booth and Berkowitz's view that Dr. Morin has not shown that NBTel has incurred, or is planning to incur, such costs.

With respect to Dr. Morin's approach to determining an ROE range for NBTel, the Commission agrees both with the removal of the effect of the quarterly timing adjustment and with the adjustment for the tax deductibility of the direct component of flotation costs. However, the Commission considers it more appropriate to make these adjustments in the individual tests themselves, rather than making an adjustment to the average results at the end of the analysis. Such an approach would not only be more precise, but would also provide the Commission with a clearer indication as to the exact steps followed in the analysis. In addition, it would serve to eliminate such problems as Dr. Morin's apparent incorporation in the overall results of a "double-adjustment" with respect to the DCF Industrials study.

As well, the Commission is not persuaded that a flotation cost allowance of the magnitude suggested by Dr. Morin is warranted. The Commission has incorporated a more modest allowance that takes into account such factors as BCE Inc.'s current level of ownership of Bruncor Inc. and the existence of Dividend Reinvestment and Employee Stock Option Plans, which are relatively low-cost means of generating equity capital.

As indicated above, the DCF evidence submitted by Drs. Booth and Berkowitz is similar to that filed in the proceeding leading to Decision 92-15. In Decision 92-15, the Commission expressed its concern that the results produced by this approach may not adequately reflect investors' expectations of real growth in dividends. In the Commission's view, Drs. Booth and Berkowitz have not provided sufficient additional evidence to address that concern. Based on this view, and on its earlier conclusion that a modest allowance for flotation costs should be incorporated into the overall results, the Commission finds that the DCF results of these witnesses are underestimated.

C. Equity Risk Premium

As in his evidence filed in the proceeding leading to Decision 92-15, Dr. Morin presented four separate risk premium analyses: (1) a forward-looking risk premium test based on data for a group of Canadian telephone companies; (2) a forward-looking risk premium test using data for the composite Bell regional holding companies in the United States (U.S.); (3) CAPM; and (4) ECAPM.

In reply argument, NBTel defended the use of U.S. risk premium data by stating that such data is relevant in the Canadian context because "capital markets [around the world] have become highly fluid, interconnected, and interdependent". The company also indicated that the examination of U.S. data is necessary due to the lack of comparable Canadian utility data upon which to draw.

Dr. Morin indicated that his CAPM and ECAPM tests were conducted in the same manner as in his evidence filed in the proceeding leading to Decision 92-15, except that a risk-free rate (i.e., long-term Canada bond yield) of 8.5% was used, instead of 9.0%. In both of these tests, Dr. Morin used an adjusted beta for NBTel of 0.55 and an estimated market risk premium range of 6% to 7%. In addition, he added 30 basis points to the results in order to allow for flotation costs.

Drs. Booth and Berkowitz's risk premium approaches were based on premiums over yields on both long-term Canada bonds and preferred stocks.

As in their evidence filed during the proceeding leading to Decision 92-15, Drs. Booth and Berkowitz used an estimated market risk premium range of 2.25% to 3.25% and beta values ranging from 0.35 to 0.45. Applying these beta values to the market risk premium range resulted in a risk premium for NBTel of 0.79% to 1.46%.

In this proceeding, Dr. Morin incorporated U.S. test results into his overall recommendation as to an appropriate ROE range. In his evidence before this Commission in proceedings prior to that leading to Decision 92-15, Dr. Morin relied on U.S. results only as a check on the reasonableness of his risk premium results for his sample of Canadian telephone companies. In the Commission's view, the differences between Canadian and U.S. capital markets call into question the appropriateness of applying a U.S. risk premium to NBTel's estimated cost of debt. As in the proceeding leading to Decision 92-15, the Commission is of the view that Dr. Morin did not provide sufficient justification to warrant a departure from his previous approach of using U.S. data only as a check on reasonableness.

The Commission notes that, as in previous proceedings, Dr. Morin used adjusted betas, reflecting the view that beta values tend to regress toward one over time. The Commission stated in Decision 92-15 that Dr. Morin had not, at that time, produced any significant new evidence to support the position that Canadian telephone company betas do, in fact, tend to regress towards one over time.

As in past proceedings, including that leading to Decision 92-15, the Commission remains of the view that Dr. Morin's use of adjusted betas is inappropriate. As in that proceeding, Dr. Morin has not provided any significant new information that would justify their use in the Canadian context. In the Commission's opinion, the appropriate beta for NBTel lies closer to the estimated range of 0.35 to 0.45 presented by Drs. Booth and Berkowitz.

The Commission also notes that, as in the proceeding leading to Decision 92-15, Dr. Morin's estimated market risk premium range was 6% to 7%, while that of Drs. Booth and Berkowitz was 2.25% to 3.25%. In Decision 92-15, the Commission concluded that Dr. Morin had overestimated the required market risk premium, while Drs. Booth and Berkowitz had underestimated it. In the Commission's view, no new evidence has been presented that would persuade it to arrive at a different conclusion in this proceeding. Accordingly, the Commission concludes that the market risk premium is somewhat lower than Dr. Morin's estimate, and that the estimates provided by Drs. Booth and Berkowitz are unreasonably low and underestimate the required market risk premium.

III BUSINESS RISK

A. Introduction

In its evidence and in final argument, NBTel stated that it faces increased business risk as a result of Decision 92-12. The company discussed a number of factors that it believes have served to further increase that business risk, in particular: the overall weakness of the New Brunswick economy; technological change; the absolute size of its market; the rural nature of the province and the lack of a major metropolitan centre; its reliance on a few large customers; its dependence on toll revenues, discretionary local revenues and transitting long distance traffic; and the proximity of New Brunswick to the U.S. border. In final argument, NBTel stated that the above factors would, in its opinion, result in Decision 92-12 having a greater impact on its business risk than on the business risk of other telephone companies.

In support of its position, the company presented quotations from a number of credit rating agency and investment analyst reports, and submitted that investors are also fully aware of the impact of Decision 92-12 on the business risk of Canadian telephone companies.

NBTel stated that it believes that its regulatory risk has also increased, since means that have been used to regulate the larger telephone companies are not, in its view, necessarily suitable to companies such as itself.

On the basis of the above, NBTel concurred with Dr. Morin's adjustment of 50 basis points to account for its higher business risk.

Dr. Morin supported his adjustment by noting that telephone company betas in the U.S. have increased by between 10 and 20 basis points since competition was approved in 1984. Dr. Morin estimated that, in a Canadian context, a corresponding increase of 10 basis points in the beta coefficient would increase NBTel's estimated ROE by 50 basis points (using a market risk premium of 5%). Dr. Morin submitted that the impact of Decision 92-12 on a given telephone company's ROE would vary around his 50 basis point estimate, depending on each company's specific circumstances, but concluded that 50 basis points was an appropriate, albeit conservative, adjustment for NBTel, based on several of the risk factors cited by the company.

In light of improvements in certain of the company's operating and financial indicators, Drs. Booth and Berkowitz submitted that NBTel's overall business risk has not changed in the last three years. Further, they were of the view that the impact of Decision 92-12 was already well recognized by the market and reflected in current stock prices of telephone companies. In support of their view, they submitted quotations from a bond rating report, from an article that appeared in the Globe and Mail of 6 November 1991, and from an article that appeared in the Financial Post of 14 September 1992. Since telephone company stock prices are used in the DCF method, Drs. Booth and Berkowitz did not believe that a separate adjustment for the risk from additional competition was required.

As noted above, NBTel identified a number of factors that it believes serve to heighten the level of business risk that it faces as a result of Decision 92-12. The Commission considers it appropriate to assess the risk faced by the company in the context of the current regulatory framework. In the Commission's view, that framework, which entails a determination of a fair and reasonable ROE for the entire company and permits the company to apply for rate increases should it earn below the lower limit of its allowed range, mitigates the impact of Decision 92-12 on the company's business risk. The Commission's assessment of some of the specific risk factors cited by the company are discussed in detail below.

B. Specific Risk Factors

1. The New Brunswick Economy

In reply argument, NBTel stated that, with a relatively weak provincial economy, it would be facing significant future risk from competition. NBTel submitted that its revenues could be affected negatively should its business customers, in an effort to lower their operating costs, either look to the company to lower its toll rates or turn to the company's competitors. NBTel also argued that, as a result of lower levels of personal disposable income in the province, revenues from new enhanced services might be insufficient to offset revenues lost to competition.

Drs. Booth and Berkowitz argued that NBTel's record of consistent profitability over the past six years is not indicative of a company exposed to significant business or financial risk. In reply argument, the company stated that its record of consistent profitability is a measure of its innovation and efficiency and of productivity improvements, and not an indication as to its level of business risk.

In response to interrogatory NBTel(CRTC)22Sept92-108, NBTel stated that, while the weaker economy could affect penetration levels, it has not impeded the introduction of new services. Moreover, NBTel submitted that the high acceptance and penetration of new products and services in its territory are due largely to its marketing approach. The Commission notes that the company's marketing approach, to the extent that it has resulted in higher-than-average penetration rates for new products and services, should work to mitigate the risk of additional competition.

As well, based on current forecasts for 1993 from the Conference Board of Canada's Provincial Outlook (Autumn 1992), the Commission concludes that New Brunswick's real domestic product should grow at a faster rate than those of the other Atlantic provinces, Saskatchewan and Manitoba. This implies that the company should benefit, in 1993 at least, more than several other Canadian telephone companies from the expected economic recovery.

In addition, to the extent that there is stronger economic growth in other Canadian provinces in 1993, translating in turn into increased revenues for Stentor members serving those provinces, NBTel, as a net taker under the Revenue Settlement Plan, should benefit indirectly.

In final argument, NBTel remarked that the Commission had recognized an increase in business risk for Newfoundland Tel, but had not assessed or included the effect of Decision 92-12 on the company's cost of capital. The Commission notes that, during the proceeding leading to Decision 92-15, the Newfoundland economy was deteriorating, and was thus possibly facing a period of greater volatility. Given that the Conference Board of Canada's Provincial Outlook reports for Summer 1992 and for Autumn 1992 indicate that New Brunswick's economy is expected to be better than Newfoundland's in 1993, the Commission does not consider that NBTel's business risk as a result of the provincial economy is higher than Newfoundland Tel's at this time.

2. Reliance on Long Distance Revenues

In its evidence, NBTel stated that the relatively weak provincial economy at this time, in combination with its high reliance on long distance revenues, magnifies its business risk. The company explained that this risk arises because toll revenues depend, in part, on toll message volumes; these, in turn, vary with the level of business activity and the discretionary spending of residence customers. Further, the company stated that it is affected by toll business lost to competitors by other Stentor members, which, it argued, could be significant.

In the Commission's view, NBTel can reduce losses in its share of the toll market by achieving additional gains in productivity and applying them to reductions in long distance rates. The Commission has stated, in Decision 92-12, that it is prepared to grant interim ex parte approval to applications for such reductions, where certain criteria are met. In addition, the company can further reduce losses in market share through the introduction of new contribution-generating services, such as Call Management Service. Finally, should it prove necessary, the current regulatory framework permits NBTel to come back to the Commission for a review of its revenue requirement.

In light of the above, the Commission concludes that NBTel's
business risk in regard to this factor may be lower than estimated by the company.

3. Resale of Local Services

In its evidence, NBTel stated that, since Decision 92-12 allows the resale of local access services, the current price structure of its Business Communications Service (BCS), which provides for a lower per-line price as the number of lines subscribed to increases, results in a significant increase in its business risk. The company stated that local resellers could now buy lines, repackage them and sell them to end users.

In Decision 92-12, the Commission stated that NBTel and other Atlantic telephone companies could file revised tariffs, with supporting evidence, to amend their local service rate structures to address any impact resulting from local resale. On 1 September 1992, prior to the filing of its evidence in this proceeding, NBTel applied to the Commission to request that, in order to prevent uneconomic entry, resellers be prevented from using lower rate groups for BCS. The Commission has not as yet ruled on that application.

4. Proximity to U.S. Border

NBTel noted that, unlike the other Atlantic telephone companies, its territory borders on the U.S. The company stated that this particular characteristic of its territory creates the opportunity for customers to obtain short-haul facilities to the border from a competitor and deliver their traffic via the U.S. (i.e., bypass).

In Teleglobe Canada Inc. - Resale of Transborder Services, Telecom Decision CRTC 91-10, 26 June 1991, the Commission directed the carriers, including NBTel, to amend their tariffs to prohibit the routing by customers of basic service traffic by way of the United States, when that traffic originates or terminates in Canada. However, the Commission expressed the view that the most effective long-term solution for the reduction of bypass is the lowering of Canadian rates.

In Decision 92-12, the Commission again considered the issue of bypass, and concluded that increased competition would, in fact, reduce bypass. Specifically, the Commission stated (at page 12) that:

... competition not only can be expected to increase pressure to reduce rates, but increase choice and supplier responsiveness, particularly in terms of the number of price and service packages tailored to address the specific needs and applications of a greater variety of user groups. This increase in responsiveness and choice would reduce initiatives by business and resellers to bypass the Canadian network ....

In light of the above, the Commission considers that NBTel's business risk attributable to its proximity to the U.S. border is mitigated to the extent that Decision 92-12 is expected to reduce bypass.

5. Technological Change

In its evidence, NBTel stated that technological change will have an impact on its business risk, in that new competitors could gain an advantage in providing competing services at lower cost than the company. The company also stated that, in light of Decision 92-12, the small size of New Brunswick increases the business risk of introducing new products and services and increases its per-unit costs relative to larger Canadian telephone companies.

In their evidence, Drs. Booth and Berkowitz referred to a number of factors that they believe offset any increases in NBTel's level of business risk, including (1) the design and utilization of the company's network, which Drs. Booth and Berkowitz considered "one of the most effectively designed and utilized networks"; (2) the high level of the company's depreciation reserve balance; and (3) NBTel's low growth rates in plant and in net plant per network access service. Drs. Booth and Berkowitz noted that NBTel has relatively more conservative depreciation policies than other telephone companies and, therefore, one of the highest reserve balances. They argued that, since the company has the lowest embedded costs among telephone companies to be recovered from future revenues, its exposure to technological change is not very high.

The evidence filed by NBTel in this proceeding indicates that the company is currently serving 76% of its network access lines with modern digital technology, and that it expects to be 100% digital in 1994. In the Commission's view, this high level of digitalization may well serve to mitigate possible losses in market share, particularly for those products and services requiring digital capability.

NBTel also stated that, through the modernization process, it has been able "to control its ongoing operational costs while, at the same time, providing an array of services to rural communities usually available only in more populated areas." With respect to the company's business risk, the Commission notes that, the size of the company's operating territory does not appear to have hindered its ability to introduce new products and services.

6. National Regulation

In its evidence and in final argument, NBTel stated that its level of regulatory risk has increased, because regulatory mechanisms that are more appropriate for the larger telephone companies are not necessarily suitable for regulating NBTel. Therefore, its flexibility to provide services unique to its marketplace could be reduced.

In interrogatory NBTel(NBAPA/CAC)21Sept92-7, NBAPA/CAC asked NBTel to identify specifically the decisions, rulings, procedures and other matters that increased its regulatory risk. NBTel responded that it did "not intend to engage in a public debate by citing a litany of decisions, the findings of which it does not necessarily support." The company went on to explain its position that federal regulation should not preclude consideration of regional or provincial concerns, because the needs of urban markets tend to be different from those of predominantly rural ones.

In the Commission's view, NBTel has not demonstrated that there has been any increase in its business risk due to the change from provincial to federal regulation. The Commission agrees with NBTel that federal regulation should not preclude consideration of regional or provincial concerns. Indeed, the Commission is of the view that a consideration of such concerns is vital to any determination it may make as to the public interest. The Commission notes that the companies under its jurisdiction have the opportunity to present evidence as to whatever factors they may consider relevant to the Commission's deliberations, including evidence as to any circumstances peculiar to their operating territories.

7. Other

NBTel made numerous references in its evidence to its record of past productivity improvements and cost of service reductions. In response to interrogatory NBTel(NBAPA/CAC)21Sept92-15, NBTel stated that, while productivity improvements and lower costs do not eliminate business risk, they would mitigate the impact of losses in earnings, particularly in an environment of greater competition. However, in final argument, NBTel stated that it believes that it has pushed to the limit on productivity improvements and that there is a risk that it may be unable, through additional cost savings, to offset further long distance rate reductions or toll revenues lost to competition.

In reply argument, NBTel stated that it should not be "penalized", through a lower allowed ROE than it might otherwise be granted, for being an industry leader in initiating productivity improvements. This, NBTel argued, would be tantamount to rewarding companies that have not been as productive and innovative for their poor performance.

The Commission notes that it was prepared to address the company's proposal for incentive regulation, in the proceeding established in Public Notice 92-64. However, NBTel advised the Commission that it wished to withdraw its application. On 27 November 1992, the Commission approved that withdrawal.

The Commission also notes that, in Review of Regulatory Framework, Telecom Public Notice CRTC 92-78, 16 December 1992, it has initiated a proceeding to consider, among other things, alternative forms of regulation. NBTel has been joined as a party to that proceeding.

However, the Commission considers NBTel's submissions in this proceeding as to the appropriate relationship between its productivity and its allowed ROE to be inconsistent with the current form of regulation, which is based on an assessment of the company's cost of equity, i.e., the return on equity required to attract investors at reasonable terms. Specifically, the Commission considers that it would be inconsistent with this form of regulation not to recognize the reduction in risk to investors as a result of whatever past productivity improvements or cost savings the company may have realized.

The Commission would also note that, under the current form of regulation, it generally establishes a range for a company's allowed ROE, while setting rates at the midpoint of that range. The company is permitted to retain any earnings up to the top of the range. In addition, the Commission scrutinizes the costs of the companies and disallows those costs that it finds to be unjustified. Thus, under the current form of regulation, the company is provided with some incentive to strive for further efficiency gains.

C. Conclusions

As indicated above, Dr. Morin recommended a 50 basis point adjustment to NBTel's ROE to account for the increase in the company's business risk as a result of Decision 92-12. NBTel supported this recommendation, citing an increase in its business risk as a result of Decision 92-12, and describing various factors that heightened that increased risk.

In final argument, NBTel called into question the use of betas by Drs. Booth and Berkowitz to support their conclusion that NBTel's risk has not changed in the last three years. The company submitted that:

Recent financial literature is questioning the ability of beta to measure risk.

and that:

An analysis of Schedule 3 [which appears in Drs. Booth and Berkowitz's evidence] clearly shows that market forces other than perceived changes in business risk can affect five year beta calculations.

The Commission agrees that there are problems in estimating betas that, in themselves, would militate against relying too heavily on such estimates. Further, the Commission concurs with NBTel that changes in beta estimates, to the extent that they can be relied upon, may reflect factors other than changes in business risk.

The Commission would note that the concerns expressed by NBTel regarding the particular use of betas by Drs. Booth and Berkowitz would also apply to Dr. Morin's analysis. Moreover, in the case of the latter, any problems inherent in the use of betas are exacerbated by his use of U.S. data. As discussed in Part II, above, the Commission considers that there are differences between the Canadian and U.S. capital markets and telephone industries that call into question the appropriateness of applying in a Canadian context a risk adjustment derived using U.S. data.

In light of the above, the Commission has concerns with respect to the reliability of the estimated betas used by Dr. Morin in calculating his 50 basis point adjustment for additional business risk arising from Decision 92-12.

The Commission considers that some of the impact of Decision 92-12 may already be reflected in the stock data of the Canadian telephone companies. Based on the analysts' reports provided by NBTel, some of which are dated as early as August 1991, it would appear that most industry analysts have, at a minimum, attempted to account for the impact of Decision 92-12 in their recommendations to investors. Therefore, the Commission would consider that investor perceptions of the impact of Decision 92-12 are reflected, to some extent, in the DCF analysis of Canadian telephone companies.

In addition, the Commission would note that the prospect of competition has existed for some years and has been frequently cited both by expert witnesses before the Commission and, as indicated above, in the reports of investment analysts. Accordingly, investors have been aware for some time that competition in the provision of long distance voice services might be permitted. Therefore, any increase in the business risk of Canadian telephone companies as a result of the issuing of Decision 92-12 must be considered in relation to perceived increases in business risk that had already occurred prior to that Decision. Considered in that light, any increase in business risk attributable to Decision 92-12 would be incremental in nature.

Based on its assessment of the specific risk factors cited by the company, and on Dr. Morin's use of U.S. betas, on the fact that increased business risk is reflected to some extent in the DCF results for Canadian telephone companies, the Commission is not persuaded that an adjustment to NBTel's ROE of the magnitude suggested by Dr. Morin is warranted at this time. The Commission would also note that any increase in business risk attributable to Decision 92-12, as discussed above, is incremental in nature. However, the Commission finds that NBTel's business risk may have increased somewhat as a result of the advent of toll competition. As discussed in Part IV, the Commission finds it appropriate, given NBTel's current financial structure, to mitigate this increase in the company's business risk through a more conservative financial structure.

The Commission will continue to monitor the financial performance of the telephone companies and will, as appropriate, assess changes to their respective costs of capital arising from the emergence of toll competition. The Commission notes that while, in the past, many investment analysts and credit rating agencies have attempted to account for the impact of Decision 92-12, it considers the above approach to be consistent with the views of those analysts who have adopted a "wait-and-see" approach.

IV CAPITAL STRUCTURE

Citing an increase in business risk and the current economic uncertainty, NBTel submitted that the common equity component of its capital structure should be allowed to increase to 55%, over the medium term, from the year-end 1991 level of about 51%. In support of this position, NBTel relied, in part, on the views of the Canadian Bond Rating Service and of several investment analysts concerning the impact of Decision 92-12 on the Canadian telephone industry. The company regarded a move to a higher common equity component as an effort to offset some of the recent increase in its business risk, while at the same time reducing its financial risk.

The company's proposal was also motivated by the need to retain its financing flexibility. In particular, NBTel considered its proposed capital structure necessary in order to maintain its current bond rating. It stated that a common equity component of 55% would be consistent with the views of credit rating agencies and analysts, noting their opinions as to the common equity ratios necessary for Canadian telephone companies to maintain their financial integrity and their ability to access capital markets at reasonable terms.

In contrast to the company's proposed capital structure, Drs. Booth and Berkowitz argued for a higher proportion of preferred equity in NBTel's capital structure. They submitted that a capital structure consisting of 45% common equity, 5% to 10% preferred equity, and 45% to 50% debt would seem reasonable and would serve to maintain the company's financing flexibility. They reached this conclusion after examining NBTel's capital structure in relation to those of other Canadian telephone companies and attempting to assess the impact that such a capital structure would have on its interest coverage ratio.

As stated in Part III, the Commission is of the view that NBTel's business risk is, at this time, somewhat higher as a result of the advent of toll competition. As also noted, the Commission considers it appropriate to account for this increase in risk through an adjustment to NBTel's capital structure. The Commission is not convinced that the capital structure proposed by Drs. Booth and Berkowitz would provide any significant benefits over and above those expected under the company's proposal.

Based on the above, the Commission concludes that NBTel's medium-term proposal with respect to its capital structure is reasonable at this time and will provide the company with the financial flexibility it referred to in its evidence.

V OVERALL CONCLUSIONS

Except as noted elsewhere, the Commission considers all of the techniques used by the expert witnesses, as well as NBTel's own evidence, to be of assistance in assessing a fair and reasonable ROE for the company.

In reaching the determinations set out in this Decision, the Commission considered NBTel's views that it would be inappropriate to set a midpoint and that the company should be allowed to earn anywhere within the range. However, the Commission does not concur with the company's position that the setting of a midpoint acts as a disincentive with respect to future innovation. This conclusion is based, in part, on the fact that the setting of a midpoint would provide NBTel with an incentive to continue to operate efficiently in order to achieve the upper end of its allowed ROE range. The setting of a midpoint would also provide some cushion for absorbing any forecasting variances in NBTel's 1993 budget that would otherwise put the company outside of its allowed ROE range. The Commission therefore concludes that it would be appropriate to establish a midpoint within the approved ROE range, which midpoint is to be used by NBTel in the preparation of the budgets to be filed in January 1993.

The Commission concludes that NBTel's ROE for 1993 should be in the range of 11.5% to 12.5% and that the company should estimate to earn near the midpoint when preparing its 1993 budget. As stated above, the Commission will assess the reasonableness of that budget in light of this Decision.

In reaching its conclusions on the appropriate ROE and capital structure, the Commission took into account, among other things, the company's need to support its credit quality and the expected capital market conditions. The Commission is of the view that this allowed ROE range is fair to both the company's customers and its shareholders.

The Commission notes that there has been some upward pressure on interest rates since the expert evidence was filed in this proceeding. The recent movement in short-term interest rates has been somewhat more pronounced than has been the case for long-term interest rates. The Commission is of the view that these recent changes in interest rates should not have a material impact on the long-term interest rate forecasts relied upon by the experts in this proceeding.

Allan J. Darling
Secretary General

APPENDIX

TABLE 1 - DR. MORIN'S "SUMMARY OF RESULTS"

Lower Limit Upper Limit

Comparable Earnings 12.42% 12.86%
Risk Premium (Cdn Utls) 12.62% 12.79%
Risk Premium (US Telcos) 12.70% 13.50%
CAPM 12.10% 12.65%*
ECAPM 12.78% 13.44%
DCF Telcos 11.68%* 13.68%*
DCF Industrials 13.25%* 13.50%
Average 12.51% 13.20%
Truncated Average 12.52% 13.22%

* Dr. Morin removed these estimates in order to calculate the truncated average (see response to interrogatory NBTel(CRTC)22Sept92-114).

Note: Dr. Morin adjusted his average results downward in order to exclude the adjustment for the quarterly payout of dividends and to take into account the tax deductibility of flotation costs. By doing so, he arrived at an average range of 12.3% to 13.0%.

TABLE 2 - SUMMARY OF RESULTS OF DRS. BOOTH AND BERKOWITZ

Range Point Estimate

RISK PREMIUM

Bonds 9.78% - 10.96% 10.37%
Preferred 10.96% - 11.38% 11.17%

DCF

Components of Growth 10.67% - 11.21% 10.94%
Real + Inflation 10.63% - 11.16% 10.90%

OVERALL AVERAGE 10.85%