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Telecom Decision
Ottawa, 30 March 1994
Telecom Decision CRTC 94-8

THE ISLAND TELEPHONE COMPANY LIMITED - REVENUE REQUIREMENT FOR 1994

Table of Contents
OVERVIEW
I INTRODUCTION
II QUALITY OF SERVICE
III CONSTRUCTION PROGRAM
   A. The 1993 CPR View
   B. View-Over-View Comparisons
   C. Programs
   D. Conclusions
IV ACCOUNTING MATTERS
   A. General and Administrative Software
   B. Amortization of Regulatory Proceeding Costs
V OPERATING EXPENSES
   A. Productivity and General Level of Expenses
   B. Customer Services Labour Expense
   C. Wage Increases
   D. Stentor Expenses
   E. Rents & Other - Other
   F. Conclusions
VI OPERATING REVENUES
   A. General
   B. Market Share Loss
   C. Reasonableness of the Revised Forecast
   D. Conclusions
VII FINANCIAL ISSUES
   A. Introduction
   B. Analytical Techniques
   C. Risk and Capital Structure
   D. Conclusions
VIII REVENUE REQUIREMENT
IX TARIFF REVISIONS
   A. Network Exchange Service
   B. Centrex Service
   C. Terminal Equipment
   D. Other Rate Proposals
   E. Disposition of Interim Tariffs
   F. Issuing of Tariff Pages
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.)
A. The Application and the Proceeding
On 5 October 1993, The Island Telephone Company Limited (Island Tel) filed an application for a general rate increase, effective 4 April 1994. Island Tel proposed, among other things, increases in Network Exchange Rates for residence, single-line and multi-line business customers. Island Tel also proposed increases in rates for Small Centrex Business Service, Centrex Business and National Centrex Service and for the rental of certain terminal equipment. Island Tel requested that it be permitted to earn a rate of return on average common equity (ROE) of 12% to 13%.
Island Tel requested that the Commission dispense with the oral public hearing usually held in connection with general rate increase applications. The Commission approved this request and, accordingly, approved Directions on Procedure for a paper proceeding entailing the filing of evidence, the addressing of interrogatories and the filing of written argument and reply.
On 14 January 1994, Island Tel filed a revised forecast based on actual results to November 1993. Island Tel stated that its financial outlook had deteriorated significantly since the preparation of the financial view presented in its application of 5 October 1993. Island Tel projected that, at existing rates, it would earn an ROE of 8.5% in 1994. Island Tel stated that, notwithstanding the fact that its proposed rate increases would not generate sufficient additional revenue to permit it to achieve its original financial objectives, it would not be amending its application.
B. Construction Program
The Commission found Island Tel's construction program for 1993 to 1997 to be reasonable.
C. Accounting Matters
The Commission found Island Tel's policy with respect to the capitalization of general and administrative software to be appropriate. The Commission found that Island Tel's proposal to amortize the costs associated with this proceeding over three years was not in accordance with the Commission's practice for the accounting of costs related to regulatory proceedings. Accordingly, the Commission included in Operating Expenses for 1994 $180,000 that Island Tel had proposed to defer to 1995 and 1996.
D. Operating Expenses and Operating Revenues
In addition to adjusting Island Tel's Operating Expense forecast to account for the expensing, rather than the amortization, of the costs associated with the present application, the Commission reduced the company's forecast by $1.4 million. This reduction consisted of adjustments to specific expense accounts and to the company's Total Implied Productivity index. On this basis, the Commission estimated Island Tel's Total Operating Expenses for 1994, excluding Cellular Service, Depreciation and Operating Taxes, at about $24.1 million, representing an increase of 3.5% over 1993 actuals.
The Commission found Island Tel's estimate of 1994 market share loss of 7.1% to be reasonable. After incorporating an adjustment of $120,000 into the company's estimate of Intra-company toll revenues, the Commission estimated that Island Tel's Total Operating Revenues at existing rates would be $59 million for 1994.
E. Financial Issues
The Commission approved an ROE for Island Tel in the range of 11.50% to 12.50% for 1994. In addition, the Commission found reasonable the company's plan to move towards a common equity ratio of 55%.
F. Revenue Requirement
The Commission found that Island Tel would require additional revenues of $2.8 million in order to earn the midpoint of its approved ROE range, i.e., 12.00%, in 1994.
G. Tariff Revisions
The Commission approved, effective 4 April 1994, increases in rates for Network Exchange Service of $2.60 per month for residence subscribers and $7.75 per month for single-line business subscribers. The Commission also approved increases in, among other things, rates for multi-line business subscribers, for Centrex Service and for the rental of certain terminal equipment. Based on its finding that Island Tel would require less additional revenue than estimated in the company's application, the Network Exchange Service increases approved were lower than those proposed.
The Commission denied an increase in the minimum late payment charge and changes with respect to the interest rate applicable to overdue accounts.
I INTRODUCTION
By letter dated 30 July 1993, The Island Telephone Company Limited (Island Tel) advised the Commission that it planned to apply for a general rate increase, effective 4 April 1994. Island Tel filed for Commission approval proposed Directions on Procedure and a forecast of its financial results for 1993 and 1994. Island Tel requested that the Commission exercise its discretion under the CRTC Telecommunications Rules of Procedure by dispensing with the public hearing contemplated by Part III of the Rules. Island Tel stated that the cost of an oral hearing would increase a residence customer's monthly rate by $0.25 and proportionately increase rates for other services.
By letter dated 12 August 1993, the Commission approved Island Tel's Directions on Procedure for an application for a general increase in rates, effective 1 May 1994. In response to a request from Island Tel, the Commission approved, by letter dated 1 September 1993, Revised Directions on Procedure specifying an effective date of 4 April 1994, as originally suggested by the company.
Island Tel filed its application on 5 October 1993, requesting that its allowed rate of return on average common equity (ROE) be set at 12% to 13% and proposing increases in, among other things, rates for Network Exchange Service, Centrex Service and certain terminal equipment. Island Tel also filed evidence with respect to its 1994 revenue requirement, responses to an initial set of interrogatories from the Commission and an application for an order making all its tariffed rates approved prior to 1 January 1994 interim effective that date.
On 12 November 1993, interrogatories were addressed to Island Tel by the Prince Edward Island Consumers' Coalition, c/o Public Interest Advocacy Centre (PEICC), Rogers Cantel Inc. and Unitel Communications Inc. (Unitel). In addition, the Commission addressed supplementary interrogatories to the company. Island Tel filed its responses on 13 December 1993.
The Commission, having requested comments and having received none, approved, by letter dated 1 December 1993, Island Tel's application to make all tariffed rates approved prior to 1 January 1994 interim effective that date.
On 10 January 1994, the Government of Prince Edward Island (Government of PEI), PEICC and Small Islands Development Committee of the Environmental Coalition of Prince Edward Island (SIDC) filed evidence in the proceeding. The Commission addressed interrogatories to PEICC on 14 January 1994, and responses were filed on 19 January 1994.
On 14 January 1994, Island Tel filed a revised forecast for 1994 based on actual results to November 1993 (the January update). The Commission issued a number of supplementary interrogatories to Island Tel on 10 and 19 January 1994. The company filed responses on 17 and 26 January 1994, respectively.
Final argument was filed by Island Tel on 24 January 1994, and by the Government of PEI, PEICC, SIDC and Unitel on 31 January 1994. Island Tel filed reply argument on 4 February 1994 and on 9 February 1994. In addition, the Commission received a number of letters concerning Island Tel's application.
II QUALITY OF SERVICE
In a letter to the Commission dated 15 November 1993, SIDC stated that Island Tel's request for a rate increase should only be approved after the company demonstrates its willingness to adopt a quality management program equivalent to the International Standards Organization's ISO 9000. By letter dated 10 January 1994, SIDC reiterated that implementation of a total quality management program based on at least ISO 9000 standards would ensure that Island Tel's customers receive the best service that the company can offer. By letter dated 31 January 1994, SIDC again stated that the adoption of a total quality management program equivalent to ISO 9000 or greater would assure members of SIDC, the general public and small businesses that the company is making a concerted effort to deliver services with customers' needs first in mind.
In response to interrogatory IslTel(CRTC)7Jan94-2101, the company stated that it has two distinct quality control systems, (1) an internal quality control indicator system, and (2) an external Quality Service Analysis Plan. Island Tel stated that these systems provide an on-going measurement of the overall quality of service as viewed by the customer, and that the results are analyzed to determine those service areas requiring improvement.
Island Tel also stated that it continuously monitors developments in quality management processes such as Baldridge and ISO 9000. However, the company submitted that the introduction of new systems can be very expensive, with initial start-up costs as high as $100,000, and that a small company must consider the cost-effectiveness of implementing such a program. Island Tel noted that its current research suggests that ISO 9000 standards have been adopted by only 4% of Canadian companies and 2% of American companies. The company stated that it will continue to monitor developments in quality management and will implement changes when significant improvements can be made and when it is cost effective to do so.
Based on the record of the proceeding, the Commission is not persuaded that the application of ISO 9000 to Island Tel is appropriate at this time. After the issuing of its decision in the proceeding initiated by Review of Regulatory Framework, Telecom Public Notice CRTC 92-78, 16 December 1992 (the Regulatory Framework proceeding), the Commission will issue a public notice to start a proceeding on quality of service involving all the telephone companies under its jurisdiction. It may be appropriate to address the subject of quality management programs in that proceeding, in order to assess whether aspects of programs such as Baldridge or ISO 9000 should be considered in developing quality of service indicators to be reported to the Commission.
  III CONSTRUCTION PROGRAM
  A. The 1993 CPR View
  Island Tel filed its proposed construction program (the 1993 CPR View) on 2 September 1993. Island Tel projected expenditures of $90.9 million for the five years 1993 to 1997, inclusive, up from the $89.8 million projected for the five years (1992 to 1996) of the 1992 CPR View. The following table summarizes these expenditures (in millions of dollars) by category.
 
Year 1993 1994 1995 1996 1997
Usage Category ($ million)
Growth (70.1%) 13.5 13.2 12.0 12.8 12.2
Movement (8.3%) 1.4 1.4 1.5 1.6 1.6
Replacement (3.9%) 0.5 1.0 0.6 0.7 0.7
Programs (17.6%) 3.4 3.0 3.7 2.7 3.2
Total (100%) 18.8 18.6 17.8 17.8 17.7
  Note: Percentages are rounded and have been compiled from five-year totals for each category.
  The Growth category encompasses planned expansion of network capacity. The Movement category contains expenditures associated with existing customers moving to new locations. The Replacement category covers plant that is, or shortly will be, out of service and that cannot be economically repaired. The Programs category covers projects designed to attain corporate service and productivity objectives and to provide new services.
  B. View-Over-View Comparisons
  Island Tel expects Network Access Services (NAS) to increase from $6.9 million in 1992 to $8.0 million in 1997 (an average annual growth rate of 3.1%), and Long Distance Messages to increase from 14.7 million to 19.9 million over the same period (an average annual growth rate of 6.4%).
  The aggregate of the 1994 and 1995 NAS net gain demand forecast was 35% higher in the 1993 CPR View than in the 1992 CPR View. Island Tel stated that the 1992 forecast was prepared in 1991 during the closure of Canadian Forces Base Summerside and that the associated weak economic climate was reflected in the 1992 View. The company also noted that actual NAS net gain for 1992 and 1993 was 60% and 40% higher, respectively, than that forecast in the 1992 View.
  Island Tel stated that the 1993 forecast reflects major projects such as the Goods and Services Tax Centre in Summerside and the announcement of the fixed-link crossing. Although the number of toll messages continues to increase over the plan period, the 1994 and 1995 anticipated aggregate toll message growth is 47% lower than in the previous View, due mainly to competition. The aggregate expenditures for the Growth category are 15% lower, while aggregate expenditures for Movement, Replacement and Programs are 12%, 23% and 131% higher, respectively. The company attributed the increase in the Programs category to the introduction of Residential Voice Mail, Stentor requirements, and the capitalization of software.
  For 1994 and 1995, the above changes amount to an increase in total expenditures of 1% over those forecast in the 1992 CPR View. For the four common years 1993 to 1996, inclusive, the total expenditures in the 1993 CPR View were $0.6 million less than in the 1992 CPR View.
  C. Programs
  PEICC submitted that the Commission should require that expenditures associated with efficiency improvements and with projects such as digitalization have a demonstrable effect on the company's bottom line.
  Island Tel submitted that it is committed to productivity improvements and to introducing programs that increase overall performance. Island Tel cited the Automated Telephone Loop Assignment System (ATLAS) as an example of its efforts to improve productivity. The company noted that the ATLAS conversion will have a minor impact in 1994, but will significantly improve productivity in future years. The company stated that efficiency savings from such programs have already been taken into account in the budget.
  The Commission notes that Island Tel's evidence indicates a declining trend for total maintenance expense per NAS, switching maintenance expense per NAS, total maintenance persons per 1,000 NAS, and switching maintenance persons per 1,000 NAS. The Commission is satisfied that this indicates improved maintenance productivity.
  D. Conclusions
  The Commission finds Island Tel's 1993 View of the construction program reasonable.
  IV ACCOUNTING MATTERS
  A. General and Administrative Software
  Effective 1 January 1993, Island Tel adopted a policy of capitalizing the costs of general and administrative software projects with total development costs exceeding $25,000. The company amortizes these costs on a straight-line basis over five years.
  The Commission has reviewed Island Tel's policy with respect to the capitalization of general and administrative software costs and finds it appropriate.
  B. Amortization of Regulatory Proceeding Costs
  In its January update, Island Tel indicated that it had reduced 1994 general and other Operating Expenses by $180,000 as a result of a decision to amortize the costs of major regulatory proceedings over three years, rather than expensing these costs. In reply argument, Island Tel indicated that the costs in question pertain to the present proceeding. The company did not provide a justification for its proposed accounting.
  The Commission's practice for the accounting of costs related to regulatory proceedings requires that those costs be expensed as they are incurred. The Commission remains of the view that this practice is appropriate and that the costs of regulatory proceedings should not be deferred to be recovered from future subscribers. Accordingly, it has included in Operating Expenses for 1994 the $180,000 that Island Tel proposed to defer to 1995 and 1996.
  V OPERATING EXPENSES
  A. Productivity and General Level of Expenses
  Based on its January update, Island Tel's forecast increase in Operating Expenses, excluding Cellular, is 10.2% for 1994. Excluding Depreciation, Operating Taxes and Cellular, the increase is 8.8%. In response to Commission interrogatories, Island Tel forecast an inflation rate of 1.8% for 1994.
  Unitel submitted that Island Tel has overestimated its Total Operating Expenses and that the forecast increase is excessive, given that it is approximately six times the expected rate of inflation in the province. Unitel noted that the forecast increase is the highest of all the telephone companies requesting a local rate increase for 1994. Unitel also noted that the company had "significantly increased 1994 expenses associated with Stentor and competitive response" without substantiation or demonstrated efficiencies. In Unitel's view, if Island Tel had maintained its historical productivity growth in 1994, the current rate application would have been unnecessary.
  Government of PEI also commented on the company's productivity, stating that it is imperative that Island Tel operate in a manner that reflects the new economic reality and at a level of maximum efficiency.
  Island Tel argued that its ability to limit expense growth in 1991 and 1992 reflected increased operating efficiencies. The company added that its size limits its ability, relative to that of other Canadian telephone companies, to achieve economies of scale and scope. As factors contributing to increases in general and other Operating Expenses, the company cited funds expended to control costs and introduce efficiencies in order to minimize price increases and efficiently meet growth in demand. Island Tel cited growing competition for the forecast increases in the costs of sales and customer service activities.
  In response to Unitel, Island Tel explained that approximately 42% of the 1994 increase in Operating Expenses is due to depreciation expense, while the remainder is primarily attributable to increases in pension expense, Stentor costs and wage increases. The company added that increased expenses for sales, marketing and advertising are offset by reductions achieved through productivity improvements, efficiency programs and cost reductions elsewhere in the company.
  The Commission has concerns with Island Tel's 1994 forecast of productivity gains and with the level of forecast increases in Operating Expenses for 1994. Island Tel evaluated its Total Implied Productivity (TIP) index at 4.11% for 1993, and forecasted it at 2.58% and 3.46% for 1994 and 1995, respectively. In its TIP evaluation, Island Tel adjusted the Total Operating Expenses (excluding Cellular, Depreciation and Taxes) for accounting changes and special factors such as Stentor costs, Pensions, Public Relations, Market Planning Sales and the costs of its general rate increase application. The company provided explanations for the various adjustments in response to a Commission interrogatory. Taking into account the 1993 actual year-end results provided by the company following the submission of its TIP index, the Commission estimates that the TIP as calculated by Island Tel would be 5.35% in 1993, 1.30% in 1994 and 3.46% in 1995.
  In Bell Canada - Revenue Requirements for 1993 and 1994, Telecom Decision CRTC 93-12, 30 August 1993, the Commission stated that Bell Canada (Bell) may, for its own purposes, choose to measure its operational efficiency by isolating projected expenditures that may or may not be directly related to the traditional drivers of operations expense. However, in its assessment of an appropriate revenue requirement, the regulator must examine corporate performance, which properly includes all expenditures that are within management's control. Therefore, in calculating Island Tel's TIP, the Commission has taken into account expenses related to such items as Stentor, Pension costs, Public Relations and Market Planning Sales costs, and costs associated with the present application.
  The Commission estimates that, when the TIP index is adjusted for accounting changes and for the impact of interexchange competition start-up and on-going costs (estimated at $255,700 for 1994), and not for the other "special factors" cited by the company, Island Tel's productivity gains will be negative in 1994 (-1.07%) and minimal in 1995 (1.2%). Furthermore, the Commission estimates that, taking into account the 1994 expense disallowances of $759,600 discussed below and the adjustment for the expensing of the costs of the present application, the 1994 TIP will be marginal at 1.41%.
  Further, a forecast provided by the company of productivity indicators, including Employees per 1,000 NAS and Equivalent Employees per 1,000 Average NAS, indicates marginal and no productivity improvements, respectively, for 1994.
  The Commission notes the limited growth in Island Tel's Total Operating Expenses in 1991 and 1992. However, in the Commission's view, Island Tel has not provided sufficient evidence of productivity improvements, operating efficiencies, cost control and cost reductions to justify its forecast increases in Operating Expenses (excluding Cellular, Depreciation and Taxes) for 1994. Furthermore, the Commission shares Unitel's view that, for 1994, the forecast increase in Total Operating Expenses is excessive, in light of an expected inflation rate of only 1.8%.
  The Commission considers that, after incorporating the specific adjustments discussed below, a maximum 3.5% increase over 1993 in Island Tel's 1994 Operating Expenses (excluding Cellular, Depreciation and Taxes) is appropriate, in view of an inflation rate equal to approximately half this year-over-year increase.
  As indicated above, the Commission has reduced total forecast expenditures related to the Customer Services labour expense, Wage increase, Stentor expenses, and Rents & Other accounts by $759,600 in 1994. In addition, in order to limit the increase in Operating Expenses (excluding Cellular, Depreciation and Taxes) to 3.5% in 1994 and to elevate the forecast productivity gain, as measured by the TIP index, to a level between 4.0% and 4.5%, the Commission has reduced Island Tel's forecast expenses by an additional $660,800 in 1994. These adjustments are summarized in the table in Section F. The expense account disallowances are discussed below.
  B. Customer Services Labour Expense
  In response to a Commission interrogatory following the filing of the January update, Island Tel indicated that 1994 Labour expenses for Business Office Operations and for Market Planning Sales had been revised upwards by $136,700 and $189,300, respectively. With the above adjustments, Business Office Operations labour expenses are forecast to increase by 11.5% in 1994. Prior to the adjustments, the corresponding increase was 7.1%. Similarly, Market Planning Sales labour expenses are forecast to increase by 15.5% in 1994. Prior to the adjustments, the corresponding increase was 2.1%.
  Unitel argued that Island Tel is asking the Commission to approve competitive response expenses of $580,000 in Market Planning Sales. Unitel commented further that, while Island Tel decreased its forecast of various expenses associated with the network (depreciation and maintenance) in its January update, the company was unwilling to pass these savings on to its subscribers by reducing its requested local rate increase; instead, Island Tel increased Market Planning Sales costs associated with competitive response.
  In reply argument, Island Tel stated that its Business Office operations are needed to respond to customer demand for new products and services. Island Tel also stated that it has increased its efforts to improve the market penetration of enhanced local services through telemarketing. The company submitted that these costs are financed in part by productivity improvements within the company and are a reasonable and measured response to increased competitive pressures; further, they contribute to the maximization of the toll revenues required to support local rates.
  The Commission would note that Island Tel's filing of revisions to all of its expense accounts at a date as late as 26 January 1994 has precluded the Commission from requesting further clarification regarding the revisions for which the company provided limited or no accompanying explanation.
  Regarding Business Office Operations labour expenses, the Commission is of the opinion that the evidence provided by the company is not sufficient to justify the additional increase of $136,700 in 1994 or the requirement for more staff, given that the company had already included the cost of a new employee in its original submission of 5 October 1993. The Commission estimates that a 75% reduction in the $136,700 additional increase would allow a year-over-year increase of 4.2% in 1994, instead of the forecast 11.5%. A 4.2% increase in 1994 is reasonable considering that the 1993 actual year-end results were 5.3% above the company's July 1993 View.
  The Commission is of the same opinion regarding Island Tel's explanation of the additional 1994 increase in Market Planning Sales labour expenses. The Commission estimates that a 75% reduction in the additional increase, when adjusted for costs of $48,200 associated with transferring one employee to Market Planning Sales from Mobile Communications, will allow a year-over-year increase of 6.7% in 1994, instead of the forecast 15.5%. In the Commission's view, a 6.7% increase in 1994 is reasonable considering that the 1993 actual year-end results were 2.4% above the company's July 1993 View.
  Accordingly, for 1994, the Commission has reduced Island Tel's forecast with respect to Business Office Operations expenses by $102,000 and Market Planning Sales expenses by $105,800, for a total disallowance of $207,800 in the Customer Service account.
  C. Wage Increases
  1. Wage Variances in the January Update
  In response to a Commission interrogatory following the filing of the January update, Island Tel showed a variance of $206,300 between its application of 5 October 1993 and the January update in 1994 Rents & Other - Other labour expenses. The company explained that the variance was due to an error in the original forecast of wage increases, offset by efficiency and productivity savings. However, in response to a Commission interrogatory filed 11 days earlier, the company submitted an upward revision to its Rents & Other - Other expenses, which it attributed to errors in estimating wage increases, that was less than $206,300.
  The Commission is of the opinion that Island Tel has not fully justified the variance in its January update. Accordingly, based on information filed by the company in confidence, the Commission has reduced the forecast 1994 labour expense of Rents & Other - Other by $29,300.
  2. Management Team Award
  In response to a Commission interrogatory, Island Tel submitted that its inflation rate for management wages was 0.0% in 1993 and is forecast at 0.0% in 1994. Island Tel also indicated that a Team Award Plan had been introduced for Management in 1993, with a payout of 3.0% of basic salary for 1993 and a forecast payout of 6.0% for 1994. The company submitted that, in 1993 and 1994, the Team Awards do not increase the base salaries of management.
  Government of PEI noted that, in 1991, the time of the last local rate increase, the number of Island Tel's employees dropped modestly from 343 to 336; yet total payroll expense (reported as "salaries and wages") continued to rise significantly. Government of PEI referred to Island Tel's 1992 Annual Report, stating that, over the period between 1987 and 1992, the average annual increase in average salary and benefits for the company's employees was 6.25%. Government of PEI contrasted Island Tel's average salary and benefits increase of 6.25% with an average increase of 4.07% for all Prince Edward Island employees during the same period.
  In BC TEL - Revenue Requirements for 1993 and 1994, Telecom Decision CRTC 94-1, 25 January 1994 (Decision 94-1), the Commission concluded that BC TEL's Management Variable Compensation Plan (MVCP) should be considered part of the total compensation package included in salary increases for each year. The Commission considered the combined increase of the MVCP and the wage component to be excessive and disallowed a portion of such expenses for 1993 and 1994.
  Consistent with Decision 94-1, the Commission is of the view that a 6.0% Management Team Award in 1994 is excessive for regulatory purposes, in light of an expected inflation rate of only 1.8%. Furthermore, the Commission is of the view that the Management Team Award should be considered part of management salary and wage increases for the year. The Commission estimates that Island Tel, by not including the Management Team Award as part of wage increases, has somewhat understated overall salary increases.
  The Commission considers it appropriate, for the purposes of the company's Operating Expense forecast, that the Management Team Award be reduced to 3.0% for 1994, i.e., the same level as in 1993. Accordingly, the Commission has decreased Island Tel's Operating Expense forecasts by $116,800 in 1994.
  D. Stentor Expenses
  Island Tel's Stentor-related expenses increased by 58.3% in 1993. The January update indicates that such expenses are forecast to increase by a further 18.9% in 1994. In response to a Commission interrogatory following the filing of the January update, Island Tel revised its forecast Stentor-related expenses upward by $27,700 for 1994. Although the Commission requested explanations regarding all revisions to the company's expense accounts, Island Tel did not explain the reason for the revisions to its Stentor-related expenses.
  In another Commission interrogatory, the company was asked to provide the impact on its Stentor-related expenses of Stentor's plan to cut back its 1994 budget and reduce its workforce by 25%. In its response, Island Tel explained that the downsizing of the workforce at Stentor Resource Centre Inc. (SRCI) will significantly reduce its funding to SRCI in 1994. However, it added that the savings would be "more than offset by an unanticipated increase" in costs pertaining to Stentor Canadian Network Management (SCNM) for "several new major projects/thrusts". The amounts of the forecast savings and of the unanticipated SCNM costs were filed in confidence.
  Unitel argued that Island Tel's Operating Expenses associated with Stentor should be adjusted downward to make them comparable to the costs experienced by Island Tel in recent years when comparable functions were performed internally. Unitel noted that Island Tel had not asserted in final argument that the direct costs of the Stentor alliance are offset by the internal cost reductions. Unitel submitted that this could not be the case, since Island Tel considered it necessary to remove from the TIP calculation the effect of Stentor on its operating costs. Unitel also argued that Island Tel had not demonstrated any efficiencies gained from Stentor-related expenses and that, consistent with AGT Limited - Revenue Requirements for 1993 and 1994, Telecom Decision CRTC 93-18, 29 October 1993, the net cost of Island Tel's participation in Stentor should not be borne by subscribers. Unitel submitted that Island Tel's Operating Expenses should be reduced by $800,000 in 1994.
  Island Tel replied that Stentor cost increases forecast for 1994 are outweighed by significant benefits accruing to the company through its participation in the Stentor alliance. Island Tel stated that the 1994 increase is primarily related to the company assuming its proportionate share of 1994 Stentor costs. The company referred to response to interrogatory IslTel(CRTC)12Nov93-1609 as containing more detailed documentation of the benefits that it obtains from the Stentor alliance.
  In the Commission's view, Island Tel has not adequately demonstrated its expected net benefits from Stentor. For example, although Island Tel claimed net benefits and cost savings due to the "very substantial resource leverage it enjoys through its participation in the Stentor alliance", it submitted that costs associated with its participation in Stentor have contributed to the increase in general Operating Expenses for the years 1993 and 1994. Furthermore, while Island Tel provided a list of project titles to be undertaken through Stentor and general statements of expected benefits, it has not provided substantive evidence, such as cost-benefit studies or approximate project costs, to justify the approximately two-fold increase in its Stentor-related expenses from 1992 to 1994.
  Accordingly, the Commission has reduced Island Tel's forecast by the amount of the additional 1994 Stentor-related expenses of $27,700, due to the lack of justification for the revised increases.
  Similarly, the Commission is of the opinion that Island Tel has failed to provide evidence to support its submission that savings resulting from the 1994 downsizing in SRCI would be "more than offset" by "an unanticipated increase in SCNM" costs. Even in its responses to Commission interrogatories following filing of the January update, the company failed to show an increase in Stentor-related expenses equivalent to the difference between the expected SRCI savings and the unanticipated SCNM costs. Accordingly, the Commission has reduced the company's forecast Stentor expenses for 1994 by a further $143,800.
  The two reductions noted above will allow the company a 7.1% increase in Stentor expenses for 1994.
  E. Rents & Other - Other
  Following the filing of its January update, Island Tel revised its forecast increases in the expense account Rents & Other - Other. Based on actual 1993 results, the revised forecast increases in this expense account amount to $1,066,000, or 78.5%, in 1994. The actual 1993 increase over 1992 was $460,000, or 51.3%. After adjusting the expense account Rents & Other - Other for expensing costs associated with the present application, the company's Rents & Other - Other expenses increase by 91.8% in 1994.
  In response to interrogatory IslTel(CRTC)2Sept93-603, Island Tel filed a breakdown of this expense account by year-over-year percentage changes in Price, Growth, Accounting Changes and Other. The Commission has been unable to reconcile this information with the updated expense account information provided in response to interrogatory IslTel(CRTC)19Jan94-3601, after taking into account the information provided in response to interrogatory IslTel(CRTC)10Jan94-2603 and the expensing of the costs of the present application. For 1994, the Commission finds an unexplained difference of approximately $263,500.
  Accordingly, after taking into consideration the disallowance for 1994 of $29,300 for the Wage variance in Section C, above, the Commission has reduced forecast expenses for Rents & Other - Other by a further $234,200 in 1994. This total reduction will allow the company a 72.4% increase in its Rents & Other - Other expenses, taking into account the adjustment for the costs of the present application.
  F. Conclusions
  As detailed above, the Commission finds it appropriate to reduce Island Tel's 1994 Operating Expense forecast in the operating categories and by the amounts summarized below:
 
1994 ($ thousand)
Productivity and Expense Adjustment 660.8
Customer Service Labour Expense 207.8
Wage Increases 146.1
Stentor Expenses 171.5
Rents & Other - Other  234.2
Total 1,420.4
  After adjustments for the effect of expensing the entire cost of the present application and the disallowances set out above, Island Tel's Total Operating Expenses, excluding Cellular, are forecast to be $39.9 million in 1994, an increase of 6.9% over 1993 actuals. After excluding Depreciation and Operating Taxes, Island Tel's Operating Expenses are forecast to be $24.1 million in 1994, an increase of 3.5% over 1993 actuals.
  VI OPERATING REVENUES
  A. General
  In its application of 5 October 1993, Island Tel estimated that 1994 Total Operating Revenues would be $59.2 million at existing rates and $62.4 million at proposed rates. In its January update, based on its 1993 results, the company revised its 1994 revenue forecast downward to $58.9 million at existing rates and $62 million at proposed rates. In the company's opinion, the further refinement of revenue information late in 1993 produced a more accurate forecast.
  B. Market Share Loss
  1. Positions of Parties
  Island Tel submitted that its revenue losses to competitors in the MTS/WATS and 800 Service markets would amount to 2.3% in 1993, 7.1% in 1994 and 12.1% in 1995. In arriving at its estimates of market share loss, Island Tel relied on the Choice Demand Model (CDM), an analysis of competitors' contribution payments to estimate actual market share loss, and external estimates of market share loss.
  The CDM consists of a number of formulae that make use of price and non-price variables. Island Tel last relied on the CDM in the proceeding leading to Contribution Charges Effective 1 April 1993, Telecom Decision CRTC 93-11, 29 July 1993, and has changed a number of these values for these variables since that proceeding. The values for the non-price variables are based, for the most part, on judgment. In this proceeding, Island Tel has reduced the value for the reseller's Originating Coverage variable and, in order to reflect the benefit Unitel is expected to derive from its alliance with AT&T, has increased the Subscribers' Awareness and Supplier Preference variables. The impact of the changes made to reflect the Unitel/AT&T alliance amounts to an increase in Island Tel's estimate of market share loss in 1994 from 6.0% to 7.1%.
  Island Tel also changed some of the price variables in the CDM in order to reflect the smaller discounts being offered by resellers.
  Island Tel stated that, to date, only two firms are known to be operating in its territory, Unitel and a regional reseller. However, the company anticipates that others, particularly national firms, will enter the P.E.I market. It noted that, in 1994, there will be both "1-800" portability and equal access, facilitating and expanding the scope of competition.
  Island Tel noted that Unitel, in the Regulatory Framework proceeding, estimates its 1994 market share in Island Tel's territory at 4%, which compares favourably to Island Tel's estimate of 3.9% for Unitel. Island Tel also noted that, in the proceeding initiated by AGT, BC TEL, Bell, Island Tel, MT&T, NBTel and Newfoundland Tel - 1994 Contribution Charges, Telecom Public Notice CRTC 93-66, 3 November 1993 (the 1994 Contribution Proceeding), Unitel is estimating that, in 1994, it will have 5.6% of MTS/WATS/800 Service originating conversation minutes in PEI.
  Unitel did not dispute Island Tel's estimate of Unitel's market share. However, it did dispute Island Tel's estimate of 1994 market share for resellers, i.e., 3%. Unitel submitted that Island Tel had been unable to verify the loss of any business customers to resellers. Unitel also noted that Island Tel had cited the stock prospectuses of two resellers in support of its view that resellers would be moving into its territory. Unitel submitted that the prospectuses were, in fact, vague on this issue. Finally, Unitel submitted that the variable used for reseller awareness in the CDM is overstated.
  Based on the above factors, Unitel submitted that Island Tel's estimate of resellers' market share for 1994 should be reduced by two-thirds, i.e., to 1%. Unitel translated this into a $200,000 reduction in the company's revenue requirement.
  Island Tel replied that its 1994 estimate represents an incremental loss of only 4.8%. The company noted that there are 15 resellers registered with it and with Unitel for the purpose of providing service in PEI, and submitted that competitive activity will increase with 1-800 number portability and equal access. Island Tel also pointed out that, in response to interrogatories in the 1994 Contribution Proceeding, Unitel estimates resellers' conversation minutes at 2.5% of the market. Finally, Island Tel stated that it receives contribution payments from resellers that indicate significant competitive activity.
  2. Conclusions
  With respect to the CDM, the Commission finds the values of the price variables used by Island Tel to be reasonable. With respect to the adjustments to the non-price variables made for the AT&T/Unitel alliance, the Commission notes that it rejected similar adjustments proposed by Bell and BC TEL in recent general rate increase proceedings. The Commission's view was that Unitel would realize no significant benefits from the alliance in the short term. However, in PEI, competition was introduced much later and is much less developed than in the territories of Bell and BC TEL. Therefore, for Island Tel, the same changes to the non-price input variables have a much less significant impact on market share loss.
  The Commission also notes that Unitel has itself estimated its 1994 market share in PEI at 4%, which is close to Island Tel's estimate of 3.9%.
  In light of the above, the Commission accepts Island Tel's estimate of Unitel's market share for 1994.
  The Commission also considers Island Tel's estimate of market share loss to resellers to be reasonable. The Commission notes that resellers have gained significant market share in the territories of other companies.
  Finally, the Commission notes that Unitel's estimate of Island Tel's market share loss to all competitors, filed in the 1994 Contribution Proceeding and expressed in originating conversation minutes, is of a magnitude similar to Island Tel's own estimate, expressed in terms of revenues.
  In light of the above, the Commission finds Island Tel's estimate of 1994 market share loss of 7.1% to be reasonable.
  C. Reasonableness of the Revised Forecast
  1. Long Distance Revenues
  Long distance revenues represent approximately 45% of Island Tel's total revenues. Two-thirds of Island Tel's toll revenues are its share of Stentor settled revenues, with the remainder generated by Intra-provincial (Intra) messages. Island Tel's toll revenue projections are based on its Long Distance Message forecast, which uses trend analysis adjusted for NAS gain, rate changes and broad economic indicators. Stentor supplements Island Tel's information with national and international message and revenue forecasts and information as to Island Tel's share of Stentor settled revenues.
  Historically, Island Tel's forecasts of toll revenues have been fairly accurate; the variance from the forecast in 1992 and 1993 was within 0.5%. Island Tel's long distance revenues declined in 1991 and 1992, but increased by 1.6% in 1993. The company currently expects long distance revenues to decline to $25.7 million in 1994, a decrease of 1.4% in relation to 1993. However, the company is forecasting an increase in total Long Distance Messages of 5.6%.
  Unitel submitted that the total cumulative revenue impact of long distance price reductions implemented by Island Tel and the settlement impact of reductions by other Stentor members, including international settlements, should be disallowed and removed from Island Tel's revenue requirement.
  PEICC questioned Island Tel's forecast of declining long distance revenues for 1994. Based on Island Tel's toll revenue results for the fourth quarter of 1993, PEICC suggested that 1994 could outperform the company's original estimate of 5 October 1993 by as much as $500,000. In reply, Island Tel attributed the apparent growth in the fourth quarter of 1993 to a one-time settlement adjustment and the deferral of the implementation of the lower-priced Advantage Preferred service.
  In its January update, Island Tel revised its forecast of 1994 Stentor settled revenues upwards by $273,000. In addition, the company lowered its forecast of 1994 Intra toll revenues by $291,000. The company indicated that it had reduced this forecast based on 1993 actuals showing higher than expected customer migration to long distance rate packages and lower than expected growth in Intra Long Distance Messages. In particular, Island Tel revised its 1994 Intra toll message forecast downward by 1.3%. The company is forecasting 4.3% growth in Intra messages over 1993 actuals, the same level of toll message growth as in 1993.
  Taking into account the more optimistic economic outlook for 1994 over 1993, the Commission considers Island Tel's updated forecast of 1994 Intra Long Distance Messages to be somewhat pessimistic. Accordingly, the Commission has increased the company's Intra toll revenue forecast by $120,000 to eliminate the 1.3% downward revision of 14 January 1994.
  Having reviewed the evidence, the Commission is not persuaded that further adjustments to Island Tel's 1994 long distance forecast are required.
  2. Local Service Revenues
  Since 1985, the company's total local revenues have moved steadily upward. In 1993, total local revenues grew by 7.3%, but were 3.3% under forecast. For 1994, local revenues are forecast to increase to $30.2 million at existing rates and $33.3 million at proposed rates, increases of 8% and 19.2%, respectively, over actual results for the previous year. NAS is forecast to grow at a rate of 4.3%. NAS gain, increased subscription to Call Management Services and Voice Messaging features, as well as contribution payments from other long distance suppliers, were cited by Island Tel as contributing to the forecast 1994 growth. However, Island Tel expects that the accelerated trend for customers to purchase their own telephone sets, rather than rent from the company, will continue to have a negative impact on terminal revenues into 1994.
  The company's forecasting performance for local revenues has been very good over the last eight years. With the exception of 1993, local revenues have been within 1.5% of the forecast. Based on the evidence filed by the company, and its local revenue forecasting performance to date, the Commission finds the company's local revenue forecast to be reasonable.
  D. Conclusions
  After incorporating an adjustment of $120,000 into Island Tel's 1994 Long Distance forecast, the Commission estimates the company's Total Operating Revenues at existing rates to be $59 million for 1994.
  VII FINANCIAL ISSUES
  A. Introduction
  Supported by the expert testimony of Dr. R.A. Morin, Island Tel proposed that the range for its ROE be set at 12% to 13%. Island Tel viewed this range as necessary in order for it to maintain its financial integrity and its ability to access capital markets on reasonable terms. In support of its position, Island Tel cited, among other things, a dramatic increase in the risks faced by the company since the issuing of The Island Telephone Company Limited - Revenue Requirement for 1990 and 1991, Telecom Decision CRTC 90-29, 19 December 1990 (Decision 90-29).
  In assessing the strength of Island Tel's capital structure, Dr. Morin examined the recent capital structures of several Canadian and American telephone companies. This analysis led him to conclude that the company's near-term capital structure is relatively weak. While Dr. Morin found the company's proposal of a common equity ratio trending towards 55% over the next few years to be reasonable, he viewed a longer-term target of 60% as being appropriate, as business risk gradually intensifies in the telecommunications industry.
  Based on the evidence of Drs. Booth and Berkowitz, PEICC took the position that the company's ROE should be set in the range of 10.25% to 11.25%. In response to a Commission interrogatory, Drs. Booth and Berkowitz stated that no significant adjustment to this range would be necessary should Island Tel's proposed capital structure be accepted, given the company's proposed common equity ratio relative to that of other Canadian telephone companies.
  B. Analytical Techniques
  1. Introduction
  In general, the Commission considers the techniques used by the expert witnesses to be of assistance in determining a fair and reasonable ROE for Island Tel. The Commission's comments with respect to certain aspects of the application of the various techniques are set out below.
  2. Comparable Earnings
  Dr. Morin's comparable earnings analysis was performed using a sample of 23 low-risk industrials, with returns measured over the 10-year period 1983 to 1992. In his evidence, he indicated that the result for this sample (i.e., 12.08%) was biased downward to the extent that an increase in corporate profits for 1993 and 1994 was not included in the 10-year average ROE. In response to a Commission interrogatory, Dr. Morin stated that the inclusion of ROE estimates for 1993 and 1994 in the calculation of a 10-year average ROE would likely increase the average ROE slightly.
  In the Commission's view, Dr. Morin's perceptions concerning a downward bias in his results are not supported by any substantive evidence. The Commission notes that Dr. Morin did not provide any preliminary ROE figures for 1993 for his sample companies. Further, those companies earned, on average, an ROE of about 13.7% in 1983. The Commission considers it unlikely that these companies would, on average, earn returns in excess of 13.7% in 1993. The Commission recognizes that the results produced from Dr. Morin's sample would likely change somewhat, although probably not materially, if more recent data were taken into account. However, the evidence presented in this case suggests that Dr. Morin's comparable earnings result may, if anything, be biased upward to some extent by not reflecting 1993 data.
  As in past proceedings before the Commission, Dr. Morin made no risk adjustment to his comparable earnings result, given his view that his group of utilities was in the same risk class as his industrials. The Commission remains of the view that some adjustment should be made to Dr. Morin's comparable earnings result for the lower risk of utilities relative to his industrial sample. However, in recognition of the evolving competitive market in telecommunications and the change in risk profiles for Canadian telephone companies, the Commission is of the view that the magnitude of the requisite adjustment has decreased.
  3. Discounted Cash Flow
  The Commission notes the concern raised by Dr. Morin about reliance on discounted cash flow (DCF) results in the current capital market environment. The Commission shares the concern that the DCF approach, under current circumstances, produces results that may underestimate investors' long-run expectations. The Commission has taken this into account in establishing the company's allowed ROE range. Specific concerns about the DCF evidence presented in this proceeding are discussed below.
  The Commission notes that Dr. Morin made use of U.S. data in his DCF analysis. As stated in various recent revenue requirement decisions, the Commission considers that a comparison of U.S. and Canadian data is problematic and that it provides little guidance in determining a fair ROE for Canadian telephone companies. At best, U.S. data should be considered a check of the reasonableness of Canadian data. Further, Dr. Morin, as in other recent proceedings, placed sole reliance on growth in dividends per share for determining the growth component of the DCF formula. The Commission acknowledges that the witness made a number of valid points as to the relevance of such data. However, the Commission is of the opinion that investors would also give earnings per share growth data some weight and has taken this factor into account in determining a fair ROE for the company.
  As in his comparable earnings analysis, Dr. Morin made no adjustment to his DCF result for industrials to account for risk considerations. The Commission therefore considers that result to be somewhat overestimated.Dr. Morin's DCF results incorporate a 5% after-tax adjustment for flotation costs. In contrast, Drs. Booth and Berkowitz view a maximum flotation cost allowance of 3% as reasonable. In coming to this conclusion, Drs. Booth and Berkowitz took into account, among other things, that the company raises a portion of its common equity through its Employee Stock Savings Plan and its Common Shareholder Dividend Reinvestment Plan, which entail little or no flotation costs.
  In addition to the existence of employee and shareholder investment plans, the Commission notes that the costs associated with the company's last public issue (in 1991) were about 2.5% of gross proceeds, exclusive of costs incurred for company staff involved in completing the financing. On balance, the Commission is of the view that a flotation cost allowance closer to the level suggested by PEICC's witnesses would be appropriate in this case.
  The merits of the DCF approaches used by Drs. Booth and Berkowitz were not addressed at length in the company's argument. However, the Commission would reiterate the concerns expressed in other recent revenue requirement decisions as to the reasonableness of the witnesses' estimate of real growth (0.0% to 0.50%), especially the lower end of the range.
  In the context of the "components of growth" DCF approach utilized by Drs. Booth and Berkowitz, the Commission notes the witnesses' position that the historic growth rate in dividends is relevant only to the extent that investors use this information to help determine a reasonable estimate of future growth. While recognizing the concerns raised by the witnesses, the Commission is of the view that investors would take such information into account. Further, the Commission notes the apparent inconsistency of these witnesses in relying on historical payout ratios and ROE levels for Canadian telephone companies for assessing future growth, while expressing concern as to the appropriateness of relying on historical growth data.
  4. Equity Risk Premium
  Dr. Morin relied on several risk premium techniques. One of those techniques entailed an examination of historical data for a sample of six Canadian telephone companies. In this approach, Dr. Morin measured the risk premium, for each of the years 1982 to 1992, as the difference between the average DCF-based cost of equity for the companies and the yield on A+ rated utility bonds. In response to a Commission interrogatory, Dr. Morin provided data indicating what the estimated risk premium would have been if it were determined relative to historical data for A rated utility bonds. Given that the company's historical and present bond ratings are closer to the A level, the Commission considers the latter data more relevant to an assessment of the appropriate risk premium for Island Tel.
  In his evidence dated September 1993, Dr. Morin used the long-term Government of Canada bond (LTC) yield that prevailed at that time, namely 7.75%, and noted that the consensus outlook was that long-term interest rates would essentially remain at current levels in 1994. During the interrogatory process, he indicated that LTC yields had declined to about 7.6% in November 1993, and that such yields were more representative of current capital market conditions. However, his examination of recent forecast data, among other things, led him to suggest that such rates could rise as the economic recovery unfolds in 1994.
  Drs. Booth and Berkowitz relied on an LTC forecast of 7.75% to 8.25% for both 1994 and 1995.
  As stated in Dr. Morin's original evidence, LTC yields were about 7.75% in September 1993. Such yields generally declined in the following few months. However, the Commission notes that LTC yields have increased somewhat recently and that there was a general consensus among the witnesses that interest rates would likely increase throughout 1994 as the economic recovery begins to take hold. Taking into account LTC rates to date in 1994, the various forecast rates put forward by the witnesses, and the consensus that interest rates will probably increase over the next several months, the Commission is of the view that the appropriate LTC rate for the purpose of this proceeding is close to the level presented in Dr. Morin's original evidence.
  In the context of Dr. Morin's risk premium analysis of Canadian telephone companies, little evidence was filed regarding the appropriate spread between LTCs and the cost of new long-term debt for Island Tel. Dr. Morin assumed a spread of 85 basis points between LTC yields and A+ utility bonds in his original evidence. However, in response to a Commission interrogatory, Island Tel noted that the coupon rate associated with its recent issue of Series W bonds (8.76%, issued in late December 1993) exceeded LTC yields by 110 basis points. In argument, PEICC noted that this spread was the lowest for any of the company's debt issues in the past five years. The Commission is of the view that a spread closer to the level recently experienced for the company's Series W bonds should be utilized.
  Dr. Morin also provided an estimated risk premium result based on an analysis of U.S. data, but used the result only to check the reasonableness of his results relative to Canadian telephone companies. Consistent with its remarks in the previous Section of this Decision, the Commission accepts the use of this data in this manner.
  As part of his Capital Asset Pricing Model analysis, Dr. Morin estimated the market risk premium to be in the range of 5.9% to 6.9%. In support of this estimate, Dr. Morin took note of the results from four risk premium studies, including the Hatch and White study and the Canadian Institute of Actuaries' (CIA) study. In response to a Commission interrogatory, Dr. Morin submitted that investors would give the results of the CIA study (5.9%) as much weight as those of the Hatch and White study. Given this statement, together with the impact that the inclusion of data for the period 1988 to 1993 would have on the Hatch and White study, the Commission is of the view that Dr. Morin's range of 5.9% to 6.9%, and in particular the upper end of this range, overstates investors' expectations as to the magnitude of the market risk premium at this time.
  Drs. Booth and Berkowitz noted that the two Canadian studies used by Dr. Morin were out of date. In arriving at their estimated risk premium, they attempted to update the Hatch and White study, concluding that the updated market risk premium would be about 5%. Updating the CIA study to include 1992 data would produce an estimated market risk premium of approximately 5.8%. They also relied on the results of a survey of Canadian firms as to, among other things, the expected cost of various types of capital. Taking the updates and the survey results into account, as well as certain other data, Drs. Booth and Berkowitz estimated the market risk premium over LTCs to be in a range of 3.5% to 4.0%, an increase of 50 basis points over their recommendations in recent revenue requirement proceedings.
  The Commission remains of the view that the market risk premium advanced by Drs. Booth and Berkowitz is considerably underestimated, despite the fact that it represents a 50 basis point increase over the figure used by these witnesses in recent proceedings. The Commission is of the view that investors would give considerable weight to the results of the Hatch and White and CIA studies in their assessment of the estimated level of expected market risk premiums. Further, much of the other data relied on by Drs. Booth and Berkowitz, including that obtained from the survey of Canadian firms, presents an unrealistically low view of prevailing expectations. On a particular level, the survey results display a troubling degree of variability, and the Commission considers that they should not be relied upon. Accordingly, the Commission considers a market risk premium somewhat lower than the bottom of the range suggested by Dr. Morin (5.9%) to be a more reasonable point of departure.
  With respect to the appropriate beta value for Island Tel, Drs. Booth and Berkowitz and Dr. Morin agreed that such values for Canadian telephone companies have recently been trending upwards. Dr. Morin's opinion is that historical beta values are biased downward because the recent increase in risk faced by Canadian telephone companies is not fully reflected in historical risk measures. Therefore, he viewed his beta estimate for Island Tel (.62, based on an average of historical adjusted beta values for a number of Canadian telephone companies) as very conservative. Dr. Morin found further support for this position from an examination of the change in the beta values of U.S. telephone companies after competition was introduced in that country.
  On the other hand, Drs. Booth and Berkowitz attributed the majority of the recent increase in beta values to the removal of October 1987 data from the calculation of five-year average beta values. Based on a review of historical data, but recognizing that a strict reliance on historical data may understate the company's forward-looking risk, the witnesses determined that a reasonable range for an average-risk Canadian telephone company would be 0.40 to 0.50. Given their assessment of the risks faced by Island Tel relative to other Canadian telephone companies, the witnesses viewed a beta range of .45 to .55 as reasonable, given the company's marginally higher investment risk.
  The Commission is cognizant of the concerns expressed by the witnesses that historical beta values for Canadian telephone companies may understate expected future values, given that the historical values do not fully reflect the impact of competition. Once that impact manifests itself in the beta calculation, the beta values of Canadian telephone companies may indeed increase somewhat over current levels. However, the Commission is not convinced that those values are going to increase to the same extent as was the case in the U.S. Further, even if it were assumed that such increases will occur in the future, there is no justification for increasing the beta value by the full amount at this time.
  As in past proceedings, the Commission remains of the view that Dr. Morin's use of adjusted betas is inappropriate. However, overall, the Commission finds that the appropriate beta value in the context of this proceeding is close to the level utilized by Dr. Morin. In reaching this conclusion, the Commission has taken into account the recent increase in Island Tel's risk, the company's risk ranking relative to other Canadian telephone companies, and the view of the expert witnesses that beta values could increase somewhat as the impact of competition is felt.
  C. Risk and Capital Structure
  Island Tel noted that its circumstances have changed since Decision 90-29, citing the introduction of facilities-based competition and the extension of resale and sharing to the Atlantic telephone companies as factors increasing its business risk. Island Tel also cited (1) its small market and small number of business customers, (2) its ratio of long distance revenues to total revenues, and (3) the impact of the Stentor revenue sharing plan, as considerations leading it to conclude that its business risk level is a matter of serious concern. The company also noted the state of the provincial economy, characterizing it as being fragile and undiversified.
  Island Tel stated that the increased risk in the telecommunications industry as a whole has been recognized by both investors and rating agencies. The company pointed to the recent downgrade of the long-term debt and preferred shares of several Canadian telephone companies, including itself, by DBRS. DBRS made specific reference to (1) the increased risk faced by Island Tel as a result of increasing competition, (2) the fact that the company's service territory is mostly rural and lies in a small province with a limited economy, (3) the company's small size, which limits its access to capital markets and increases the potential impact of market share loss, and (4) the fact that, among Canadian telephone companies, Island Tel has one of the weakest balance sheets and one of the highest levels of business risk.
  In light of its increased business risk, Island Tel considers it necessary to increase the common equity component of its capital structure and improve its coverage ratios, thus reducing its financial risk. In this regard, Island Tel noted that it had restrained the growth of its common equity in recent years and had thus been able to contain its revenue requirement and control price increases; however, the company now requires a larger common equity component in order to meet the standards of financial markets and rating agencies.
  Island Tel submitted that its coverage ratios are below acceptable levels and will deteriorate significantly without rate relief. The company sees its coverage ratios at proposed rates as an absolute minimum. In fact, the company is of the opinion that its financial risk will not be reduced with the projected coverage ratios reflected in its application.
  Dr. Morin concluded that the company's demand risk is slightly below average in relation to other Canadian telephone companies. However, he considered that the company's financial risk exceeds that of its peers, given its weak common equity and coverage ratios. In light of Island Tel's relatively low common equity ratio and its increasing business risk, Dr. Morin was of the view that the company should aim for a common equity ratio of 55% in the short run, rising to 60% in the next few years. In this vein, he noted that it is normal and prudent management practice for a company such as Island Tel to lower its financial risk when facing increased business risk.
  Dr. Morin was of the view that Island Tel's overall risk has increased significantly since Decision 90-29. He ranked Island Tel, along with Newfoundland Telephone Company Limited (Newfoundland Tel), at the high end of the overall risk spectrum.
  Drs. Booth and Berkowitz were of the view that Island Tel's business risk had increased only marginally since Decision 90-29. In support of their view that Island Tel's business risk had not increased significantly in recent months, the witnesses stressed the company's readiness for competition and the potential for cost reductions as a result of its on-going system modernization program. They also pointed to the Stentor/MCI alliance, submitting that such alliances indicate that Canadian telephone companies are, in fact, ready to compete. Drs. Booth and Berkowitz concluded that Island Tel is still a low-risk company by almost all standards.
  Among Canadian telephone companies, Drs. Booth and Berkowitz placed Island Tel at the higher end of the business risk scale, with Bell at the low end and Maritime Telegraph and Telephone Company Limited (MT&T) in the middle. They ranked the company near the top end of the financial risk spectrum (only Newfoundland Tel and MT&T were ranked as having higher risk), but viewed the differential in risk between the smaller Canadian telephone companies as fairly insignificant. They considered 50 basis points in ROE a reasonable spread between the low end (Bell) and the high end (Island Tel) of the overall risk scale, citing a narrowing of the risk differential between the two extremes.
  In argument, PEICC noted that all of the witnesses agree that Island Tel's business risk has recently increased, but disagree on the magnitude of the change. PEICC concluded that the company's business risk (and that of other Canadian telephone companies) has not increased significantly. PEICC was of the view that, among Canadian telephone companies, Island Tel's risk had increased the least as a result of Decision 92-12. In support of its view, PEICC pointed to (1) Island Tel's low reliance, relative to other Canadian telephone companies, on long distance revenues, (2) the degree to which its system has been modernized, relative to other Canadian telephone companies and (3) the expectation that, in 1994, the provincial economy will improve at a rate exceeding that of the rest of Canada. In terms of possible negatives, PEICC noted the size of the company and the fact that its stock is illiquid. However, they viewed these factors to be partially offset by the fact that Island Tel, as compared to other telephone companies, will not be viewed as a primary target by competitors.
  Given its view that Island Tel is the least affected by long distance competition, PEICC argued that Island Tel's proposal to increase its common equity ratio is not well supported by recent events. However, PEICC submitted that, should the Commission accept Island Tel's proposals regarding its capital structure, the company's ROE range should be 10% to 11% (25 basis points below the level suggested by PEICC's witnesses).
  The Commission agrees that Island Tel's business risk has increased since Decision 90-29, but disagrees with the company's view as to the extent of the increase. Further, the Commission concludes from the evidence presented by the parties that Island Tel is near the middle of the business risk spectrum for Canadian telephone companies. In reaching this conclusion, the Commission has taken a number of factors into account, including Island Tel's expected near-term market share loss as a result of competition, the state of the provincial economy, the nature of the company's service territory and the impact on the company of the Stentor revenue sharing plan.
  The Commission notes the agreement among the witnesses that Island Tel faces a very high degree of financial risk relative to its peers, given its lower common equity and coverage ratios. Accordingly, the Commission is of the view that the company's proposal to increase its common equity ratio to 55% is reasonable. The Commission notes that this represents a long-term goal for Island Tel and, for the purposes of this proceeding, has given considerable weight to the fact that, in the short term, the company's capital structure will not be as strong as that of other Canadian telephone companies.
  In terms of overall risk, the witnesses essentially agree that Island Tel is at the high end of the risk spectrum for Canadian telephone companies. The Commission considers this a reasonable assessment.
  D. Conclusions
  In assessing an appropriate ROE range for Island Tel, the Commission has considered, in addition to its assessment of the techniques of the expert witnesses, (1) the reduction in long-term interest rates since Decision 90-29, (2) the increased uncertainty that competition has brought to the company, and (3) the company's risk ranking relative to other Canadian telephone companies. In addition, the Commission has taken into account the fact that Island Tel's financial risk, as measured in terms of common equity and coverage ratios, will exceed the level of the majority of its Canadian peer group. In light of these considerations, the Commission finds an ROE range of 11.50% to 12.50% to be appropriate for Island Tel.
  VIII REVENUE REQUIREMENT
  In its application of 5 October 1993, Island Tel forecast that, at existing rates, it would earn a regulated ROE of 9.0% in 1994. In its January update, Island Tel reduced this estimated ROE to 7.9%, stating that its financial outlook had deteriorated significantly. The company forecast that its proposed rates would generate additional revenues of $3.1 million, allowing it to achieve a regulated ROE of 11.0%. Island Tel stated that this ROE is significantly below the low end of its requested range of 12.0% to 13.0%. The company added that the proposed rate increases would not generate sufficient additional revenues to permit it to achieve its original financial objective, as it would be earning below the proposed ROE range. However, the company considered it inappropriate to further increase its local rates in order to generate higher revenues and a higher ROE for 1994.
  Based on the January update, and after including an adjustment for pending and planned tariff filings and the other adjustments identified in this Decision, the Commission estimates that, at existing rates, Island Tel would earn a regulated ROE of 9.3% in 1994. In order to earn a regulated ROE of 12.0%, the mid-point of the allowed range, the Commission estimates that Island Tel will require a revenue increase of $2.8 million.
  IX TARIFF REVISIONS
  A. Network Exchange Service
  1. Residence and Single-line Business Service
  Island Tel proposed to increase Network Exchange Service (NES) rates by $2.95 per month for all residence customers and by $8.85 for single-line business customers. Interveners expressed various concerns regarding the proposed local rate increases.
  In general, the Commission considers appropriate the company's proposed approach in reducing relative rate differentials. However, in view of the Commission's determination with respect to the company's 1994 revenue requirement, the Commission does not consider increases of the extent proposed to be necessary. The Commission approves a residence NES increase of $2.60 per month and a single-line business increase of $7.75 per month, effective 4 April 1994. In approving these rate increases, the Commission notes Island Tel's statement in reply argument that no Intra long distance rate reductions would be proposed in 1994.
  2. Multi-line Service
  Island Tel proposed rate increases for business multi-line service of $18.35 in rate group 2, $17.60 in rate group 3 and $17.85 in rate group 4. As a result of the company's proposals, the rate differential among rate groups would be reduced.
  In light of its determination with respect to the company's 1994 revenue requirement, and having regard to the existing relationship between multi-line and single-line NES rates, the Commission approves the following multi-line NES monthly rate increases, effective 4 April 1994:
 
Rate Group 2 $16.05
  3 $15.40
  4 $15.60
  B. Centrex Service
  Island Tel proposed increases ranging from 8% to 26% in rates for Small Centrex Business Service, Centrex Business Service and National Centrex Service. The Commission approves the proposed rate schedule for Centrex services, effective 4 April 1994.
  C. Terminal Equipment
  Island Tel proposed to increase the rate for the rental of basic telephones from $3.25 per month to $3.75, a 15% increase. The company also proposed increases in rates for other selected telephone sets and terminal equipment.
  It is the policy of the Commission that the rates for competitive terminal equipment offerings be compensatory and maximize contribution. The Commission is of the view that the proposed increases would increase the contribution from these services. The Commission therefore approves the proposed terminal equipment rates, effective 4 April 1994.
  D. Other Rate Proposals
  Island Tel also proposed a reduction in the toll restriction charge, changes with respect to the interest rate applicable to overdue accounts, and increases in the minimum late payment charge, the charge for cheques returned for non sufficient funds, the extension line mileage charge and NES mileage charges.
  Consistent with its treatment of similar proposals by other telephone companies, the Commission denies the increase in the minimum late payment charge and the proposed change with respect to the interest rate applicable to overdue accounts. The Commission approves the remaining proposals, effective 4 April 1994.
  E. Disposition of Interim Tariffs
  The Commission gives final approval, effective 4 April 1994, to the rates made interim in its letter of 1 December 1993, as modified by the revisions approved in 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.
  F. Issuing of Tariff Pages
  Island Tel is directed to issue, final tariff pages forthwith giving effect to the tariffs approved in this Decision.
  Allan J. Darling
Secretary General

Date Modified: 1994-03-30

Date modified: