ARCHIVED -  Telecom Decision CRTC 98-16

2. Telesat’s request for a R&V of Decision 97-17 is based on claims of errors in fact, failure to consider a basic principle raised in the proceeding leading to Decision 97-17 and substantial doubt as to the correctness of that Decision.

3. The Commission notes that Telesat’s application was filed prior to the Commission’s new R&V criteria enunciated in Guidelines for Review and Vary Applications, Telecom Public Notice CRTC 98-6, 20 March 1998. Accordingly, the Commission has considered Telesat’s R&V application under the criteria in effect at that time.

4. Submissions and reply submissions were filed by Telesat on 25 May 1998 and 8 June 1998, respectively, while submissions were filed by Canadian Satellite Communications Inc. (Cancom) on 16 April 1998 and 1 June 1998, and by Canadian Satellite Users Association (CSUA) on 1 June 1998. In the course of the proceeding, Telesat filed responses to interrogatories from the Commission, Cancom, CSUA and the Canadian Cable Television Association. Cancom also filed responses to interrogatories from Telesat concerning its expert evidence in this proceeding.

II DISPOSITION OF TELESAT’S APPLICATION

1. General

5. Telesat outlined the following criteria upon which it has based its application for a R&V of Decision 97-17:

(a) errors in fact: because the current economic evaluation study (EES) model generates a downward systematic bias in terms of allowing Telesat the opportunity to earn its allowed return on average common equity (ROE) on a financial statement basis, application of the model in its current form results in errors in fact;

(b) failure to consider a basic principle raised in the proceeding: because the current EES model effectively precludes Telesat from earning its allowed ROE, a basic principle raised in the original proceeding has not been adequately considered; and

(c) substantial doubt as to the correctness of the Decision: due to the discrepancy in ROE results, and in light of the fact that Telesat’s RF Channel Service rates are among the lowest in the world, even prior to Decision 97-17, there is substantial doubt as to the correctness of Decision 97-17.

6. Telesat stated that it became concerned that it was not achieving its allowed ROE on an average annual financial statement basis when observing its company-wide ROE. This concern led Telesat to investigate the relationship between the EES and Space Segment financial statements.

7. Telesat submitted that it was only in late 1997 that it was able to develop a framework to explain the difference between the results achieved under the EES and the financial statement results. Telesat stated that while it is regrettable that the methodological problems associated with the current EES model have only come to light late in the 10-year study period, it has now proposed a compromise solution under which RF Channel Service rates would be increased by 14.4% (relative to rates prior to Decision 97-17), effective 1 January 1998, instead of from the start of 1993, the date when Telesat’s rates were first made interim.

8. Telesat submitted that this compromise provides rate relief for Telesat for the final three years of the study period only, and effectively means that Telesat’s customers have been shielded for some five years from a rate increase which would have permitted the company to earn its allowed ROE over the entire 10-year study period.

9. Cancom submitted that based on its expert evidence filed in this proceeding, it has demonstrated that Telesat has not met the Commission’s criteria for a R&V of Decision 97-17. CSUA submitted that Telesat’s evidence falls far short of proving the three grounds for R&V, and accordingly the application should be denied.

10. CSUA further submitted that the application seriously undermines the Commission’s ability to provide regulatory certainty due to the attack on the finality of its decisions, and offends the regulatory principle that the applicant should be expected to make its case fully with the available information and should not be able to radically alter its case after the fact. CSUA argued that Telesat could and should have raised its arguments in the proceeding which led to Decision 97-17. CSUA further submitted that the application upsets the regulatory bargain by punishing customers for Telesat’s own mistake and by providing a windfall to Telesat’s investors.

11. As discussed in section II.2 below, the Commission considers that Telesat has failed to substantiate its claim that based on the ROE used in the EES, the Space Segment should be expected to earn a 13.5% ROE on an accounting statement basis.

12. While Telesat has argued in this proceeding that it is not earning an ROE which is consistent with ROEs of terrestrial carriers, the Commission notes that the company has not proposed to abandon its approved EES model nor has it furnished any financial information on the record of this proceeding which is consistent with the financial information that the Commission has relied upon to regulate terrestrial carriers i.e., annual information requirements consistent with rate of return regulation.

13. Furthermore, as discussed in section II.3 below, the Commission finds that Telesat’s pro forma financial statement information filed in this proceeding contains no theoretical support for, and does not prove that the current EES model generates a downward systematic bias in terms of allowing Telesat the opportunity to earn its allowed ROE. In the Commission’s view, any comparison between the ROEs of the EES and of the pro forma financial statements is necessarily flawed due to the differences between the two methodologies which are not intended to be compared. The Commission also considers that certain assumptions used in the preparation of Telesat’s pro forma financial statements, which are discussed in paragraphs 62, 63 and 64, are inconsistent with those inherent in the EES model.

14. The Commission therefore considers that Telesat has not demonstrated that there were errors in fact, or a failure to consider a basic principle in Decision 97-17.

15. Telesat submitted that the independent evidence on international price comparisons provided in its application demonstrates that Telesat’s satellite prices are among the lowest in the world. In Telesat’s view, with the intensively competitive North American satellite services market, profit margins are likely at the lowest acceptable level. As the comparative firms are larger than Telesat, Telesat argued that these firms would likely enjoy the benefits of superior economies of scale and other cost advantages, yet Telesat’s prices are lower.

16. CSUA claimed that Telesat’s new evidence on international price comparisons does not demonstrate that any price differentials are the result of the EES model. CSUA submitted that the price comparison evidence has many shortcomings and weaknesses and is meaningless as other factors could easily explain any differences.

17. CSUA noted that: (1) any price is the combination of the costs and demands faced by individual satellite operators and Telesat does not provide any evidence on the different costs of operation amongst operators; (2) the price comparison is not based on actual market transaction prices and important customer specific terms are not provided; (3) most U.S. prices are individually negotiated on a customer-specific basis; and (4) different jurisdictions will have different regulatory goals.

18. Telesat’s evidence of international price comparisons consists of a market study that contains U.S. satellite rates. The Commission agrees with CSUA’s view that it is difficult to make comparisons between the market study results and Telesat’s publicly tariffed rates.

19. Telesat’s market study provides average U.S. satellite rates by frequency band but does not identify particular satellite operators. The contract terms corresponding to the rates, such as protection from interruption and contract length, are not specified in the study.

20. The Commission considers that the market price study provided by Telesat cannot be used to conclude that its EES model is producing wrong prices or low returns to investors. The Commission therefore disagrees with Telesat’s claim that there is substantial doubt as to the correctness of the Decision.

21. CSUA also submitted that Telesat’s arguments that the current EES model and the results flowing from Decision 97-17 are unfair to Telesat and its investors are simply not borne out by the facts. CSUA noted that two new satellites are on order and submitted that Bell Canada Enterprises Inc.’s acquisition of all shares of Alouette Telecommunications Inc. provides a clear demonstration that Telesat remains a good investment value. CSUA claimed that Telesat’s business outlook has never looked better.

22. In light of the above and as detailed in the following sections of this Decision, the Commission is of the view that Telesat has not demonstrated that the Commission erred in fact or failed to consider a basic principle in Decision 97-17, or that there is substantial doubt as to the correctness of the Decision. The Commission therefore denies Telesat’s R&V application.

2. Detailed Consideration of the EES Methodology and Use of Economic ROE

23. Telesat indicated that while the specifics of the rate setting models differ between Telesat and the terrestrial carriers, the underlying objective of providing a reasonable opportunity to earn the allowed ROE on a financial statement basis is exactly the same for Telesat as for terrestrial carriers. Telesat also submitted that the treatment of Telesat under the current rate-setting model is inconsistent with federal telecommunications policy promoting investment in telecommunications infrastructure and the development of Canadian carriers which are internationally competitive.

24. Cancom and CSUA both submitted that in fact, statements by the Commission and by Telesat in previous proceedings make it clear that both the Commission and Telesat were well aware that the discounted cash flow (DCF) model approach used in the EES and accounting methodologies were not compatible. Cancom also submitted that, in endorsing the EES approach at Telesat’s request in Telesat Canada - Final Rates for 14/12 GHz Satellite Service and General Review of Revenue Requirements, Telecom Decision CRTC 84-9, 20 February 1984 (Decision 84-9), the Commission indicated that the EES approach is different from the accounting models applied to other federally regulated carriers and stated: "The Commission is of the view that, because of the unique nature of Telesat’s operations, the approach to rate-setting utilized for the other federally regulated telecommunications common carriers is not suitable for it. The approach suggested by Telesat is, in the Commission’s view, an appropriate response to the special nature of its operations. Consequently, the Commission accepts that rates for Telesat’s individual services should be established using economic evaluation studies over a multi-year test period in contrast to the use of accounting costs for a single year forward test period."

25. Cancom submitted that a cursory review of textbooks on financial analysis establishes that DCF and accounting models are fundamentally different and do not give rise to compatible measures of rate of return. Cancom submitted that this conclusion necessarily flows from critical differences in the DCF and accounting approaches, and that most significantly, accounting models of return ignore the time value of money and generate a series of returns for each accounting statement period within the study period. Cancom further submitted that it is these differences which explain the continued use of both DCF and accounting models and the consistent preference of a DCF approach to measure the rate of return for multi-year period investments.

26. CSUA submitted that having adopted the DCF model process, the Commission has consistently been clear that the data and results to be used are economic and not accounting. There is also a recognition that the DCF model inputs are not the same as accounting inputs.

27. Moreover, Cancom and CSUA cited instances in past proceedings where Telesat itself has objected to the filing of pro forma financial statements for the Space Segment on the basis that these statements were based on a number of simplifying assumptions and that the returns calculated from these financial statements were not comparable to the EES results.

28. CSUA also submitted that Telesat cannot point to any decision or document which states that the purpose of the discussion on the appropriate cost of equity for Telesat’s EES purposes is in fact to determine an allowed average annual accounting ROE on its Space Segment business.

29. In its reply comments, Telesat noted that the pro forma financial statements in the R&V application are the representation of the EES cash flows and thus do not necessarily conform to generally accepted accounting principles (GAAP). However, Telesat submitted that its proposed financial representation is correct and accurate.

30. The Commission notes that Telesat’s EES rate-setting framework, as proposed by Telesat in the proceeding leading to Decision 84-9 and accepted by the Commission, was established in light of Telesat’s unique nature of its operations. Pursuant to Decision 84-9, rates for Telesat’s individual services are determined using a DCF approach over a multi-year period, in contrast to the use of accounting costs for a single-year forward test period.

31. The EES methodology employed by Telesat to set its Space Segment rates is thoroughly documented in Telesat’s approved Phase III Costing Manual. In the manual, ROE is defined as "the measure of the economic return to shareholders". Accordingly, the EES model provides as output, the economic rate of return on capital and the economic ROE, which equate to the weighted average cost of capital and the allowed ROE at zero net present value.

32. The Commission notes that Telesat itself has on numerous occasions emphasized that the ROE used in the EES is a single weighted measure of the economic return on equity over the study period.

33. The Commission also notes the weaknesses which have previously been cited by Telesat in providing ROE results for the Space Segment on a stand-alone basis.

34. The Commission considers that Telesat’s assertion that the two ROE measures are the same has no foundation given the framework established in Decision 84-9 as reflected in Telesat’s Phase III Manual which specifies that rates are to yield a return established on the basis of an EES over a multi-year study period.

35. In light of the above, the Commission considers that Telesat has failed to substantiate its claim that its Space Segment should be expected to earn a 13.5% ROE on an accounting statement basis.

36. Moreover, the Commission considers that in order to determine whether rates would generate a 13.5% ROE on an accounting basis, methodologies would have to be developed as they were for the terrestrial carriers to calculate accounting ROEs. The rates for these terrestrial carriers have generally been set in revenue requirement proceedings on the basis of financial statements that, generally, are in compliance with GAAP. In the context of a revenue requirement, the Commission also considers whether the accounting records are in compliance with directives in Inquiry into Telecommunications Carriers’ Costing and Accounting Procedures - Phase I: Accounting and Financial Matters, Telecom Decision CRTC 78-1, 13 January 1978.

37. In the case of Telesat, since its Space Segment is regulated on the basis of an EES methodology, the Commission notes that the company has not been required to develop for approval a cost separation based on accounting information, as has been required for terrestrial carriers. Consequently, it is not possible, at this stage, to assess Telesat’s financial earnings on its Space Segment on a stand-alone basis.

3. Detailed Consideration of the Evidence to Demonstrate Flaws in the EES

38. Telesat submitted that the ROE calculated on a pro forma financial statement basis from the cash flows of Telesat’s EES model results in an ROE much lower than the 13.5% cost of equity used as an input in the EES model. According to Telesat, this result establishes that the use of Telesat’s DCF EES model produces a downward systematic bias in the accounting results and thus prevents the company from achieving its allowed ROE of 13.5%.

3.1 Conceptual Link Between the Economic ROE and Pro Forma Financial ROE

39. Telesat’s proposed pro forma financial statements generate a series of returns (i.e., net earnings) for each year within the study period based on the cash flows determined from the DCF EES model. While these financial statements are based on cash flows from the EES, they rely on accounting translations of these cash flows and reflect estimates of depreciation expense and earnings from the re-investment of cash generated.

40. From the pro forma financial statements, Telesat calculated the annual ROE using the earnings for each year and the common equity at the beginning of the year. Telesat proposed to calculate the average return for the study period using the arithmetic average of the annual financial statement returns.

41. Telesat submitted that it has developed a theoretical model consisting of a DCF model and a corresponding set of financial statements that establishes a link between the input of a certain cost of equity in the DCF and the achievement of an average ROE in the financial statements that is equivalent to the cost of equity. Telesat submitted that this link does indeed exist, and that the EES, modified to reflect Telesat’s proposed assumptions, can continue to be used for rate-setting purposes.

42. Telesat submitted that the interveners are incorrect in asserting that there can be no link between the allowed ROE used in the EES and the ROE calculated in the financial statements determined from the EES cash flows. Telesat submitted that the article that is submitted by Ezra Solomon sheds light on why the two approaches are often used for different purposes and may provide different results, but that a link does indeed exist if the framework is properly structured.

43. While Cancom stated that it is merely coincidental if the achieved accounting ROE is equivalent to the cost of equity in the EES model, Telesat claimed that, in fact, without the establishment and maintenance of the strict conditions that link the two models, it is unlikely that the results will align, and this is the essence of Telesat’s application.

44. Telesat also noted that the interveners have attempted to link these financial statements to a series of interrogatories requested over several past proceedings where Telesat was requested to split the company’s aggregate financial statement projections into Space and Non-Space Segments. Telesat submitted that this artificial split required making a number of arbitrary assumptions which could easily skew the results. Telesat further noted that the cash flows in the Space Segment as a result of this split do not in any way tie to the EES cash flows.

45. Cancom submitted that Telesat has not provided any evidence to establish how it has managed to defy financial theory and produce an accounting statement model which generates rates of return that are comparable to EES results or in any way relevant to the evaluation of the EES results.

46. Cancom further noted that Telesat has not filed any expert evidence in this proceeding which would dispute the conclusions in its own expert testimony prepared by D.A. Ford and Associates Ltd. Cancom submitted that in fact, the only theoretical evidence provided by Telesat is the 1970 article by Ezra Solomon.

47. Cancom further submitted that Solomon’s article demonstrates that accounting and DCF rates of return will be equivalent only if the company grows during the life of the asset or project at a rate which is equal to the rate of return. Cancom submitted that in these and only these circumstances, the accounting and DCF measures of return will be equal. Cancom submitted that this condition is clearly not met for Telesat.

48. Cancom submitted that Telesat presumes that a simple, unweighted average of annual accounting rates of return is appropriate based, apparently, on the view that there is no evidence to suggest that a weighted average ROE is more appropriate than a simple average. Cancom argued that this is not a compelling response, particularly when Telesat’s Phase III Manual clearly indicates that the EES ROE is a weighted economic average measure of return - not a simple unweighted average of annual returns over the study period.

49. CSUA submitted that Telesat’s basic premise that the EES results should provide for an average annual accounting ROE over the study period equal to the ROE parameter in the EES model, is flawed, and that the end result is the co-mingling of economic and accounting data to force a result that suits Telesat’s financial objectives.

50. CSUA submitted that Telesat itself has recognized that it cannot reliably produce pro forma financial statements for the Space Segment, as past attempts to produce statements have been described by Telesat as artificial and as based on improper assumptions.

51. CSUA further submitted that regardless of the validity of any pro forma financial statement, the calculation of the average accounting ROE over the study period is in itself an arbitrary process, as demonstrated by the different averaging methods possible, and given that viewing accounting ROEs on the basis of year by year results is most consistent with how the financial community assesses performance and trends in companies.

52. The Commission notes the strong case presented by Cancom’s expert evidence, to dispute Telesat’s proposal to establish links between the economic ROE measure from the DCF model and the average annual ROE taken from the pro forma financial statement.

53. Consistent with Cancom’s expert opinion, the Commission considers that the pro forma financial statement ROE measure ignores the time value of money, and that an average ROE calculated on the basis of arithmetic averages of annual financial returns over the study period, cannot be expected to be equivalent to a weighted economic average DCF ROE measure over the same study period.

54. In light of the above, the Commission considers that from a conceptual standpoint, there is no valid basis to support Telesat’s claim that a link exists between the ROE measures of the EES and the corresponding ROE on a pro forma financial statement basis.

3.2 Assessment of Telesat’s Evidence to Demonstrate Flaws in the EES

55. Telesat submitted that the rate-setting DCF EES model, in its current form, has systematic errors and is flawed. In support of its submission, Telesat filed four DCF models (models A1, A2, A3 and A4) and corresponding financial statements in "Exhibit A - Theoretical Model" of its R&V application. Telesat submitted that its theoretical model A1, under strict conditions, establishes the conceptual link between the input of a certain cost of equity in the DCF model and the achievement of an average ROE in the pro forma financial statement ROE that is equivalent to the cost of equity.

56. Telesat further submitted that when the specific formulae and assumptions from Telesat’s EES model are substituted into its theoretical model A1, this results into a reduced ROE of 10.8% on the pro forma financial statements. Telesat submitted that this result establishes that the assumptions in the EES model bias the ROE downward and will not permit the allowable ROE to be achieved.

57. Telesat also indicated that the above results are further echoed by the financial statement results of Decision 97-17 cash flows as filed in "Exhibit B - Decision 97-17" of its R&V application, i.e., when the theoretical methodology established in Exhibit A is applied to the cash flows of Decision 97-17, this results into a pro forma statement average ROE of only 10.6%.

58. Cancom submitted that Telesat has failed to provide any basis for its presumption that the particular pro forma financial statements provided in its R&V application, rather than the numerous other financial statement representations of Space Segment activities, each of which produce different rates of return, should provide the basis for determining Telesat’s RF Channel Service rates. Cancom submitted that Telesat’s EES-based financial statements have neither theoretical nor practical merit, as they represent ad hoc co-mingling of EES and accounting-based variables and do not reflect the kind of financial statements that are reviewed by investors and financial analysts.

59. Cancom argued that the accounting statements filed in Telesat’s R&V application are based on simple assumptions which are clearly inconsistent with the assumptions in the EES. Cancom claimed that the clearest example of this is the use of inconsistent capital structures in the financial statements and the EES. As noted by Cancom’s expert, Telesat has used a cost of capital for the entire period which is based on a capital structure of 65% debt and 35% equity, but in the accounting statements it has assumed that the debt is paid off over the study period, resulting in a capital structure of 100% equity by the end of the 10-year period. In Cancom’s view, Telesat’s use of inconsistent capital structures undermines the validity of any comparison between the financial statement and EES rates of return.

60. Cancom submitted that in addition to the numerous possible financial statement representations of Telesat’s Space Segment operations, each of which will generate a different set of ROEs, there are also a multiplicity of methods that can be used to aggregate the annual financial statement rates of return over the study period. Cancom further noted that as Telesat’s responses to various interrogatories indicate, the aggregate ROE over the study period varies significantly depending on the averaging method used to calculate it. Cancom further submitted that, in many cases, the weighted average ROE generated from the financial statements filed by Telesat in its R&V application, is higher than Telesat’s target ROE of 13.5%.

61. CSUA submitted that the flaws in Telesat’s arguments described in Cancom’s expert evidence are serious enough to make the statements unreliable for determining the accounting results of the Space Segment rates over the study period.

62. The Commission notes that Telesat’s evidence to demonstrate the alleged linkage between the EES ROE and the corresponding pro forma financial statement ROE relies on Telesat’s proposed DCF model A1 of Exhibit A, which calculates income tax shields based on annual depreciation expense. The Commission considers that this assumption is inconsistent with proper economic costing and evaluation, which instead rely on the allowable capital cost allowance (CCA) claims available to the company to calculate the tax shield impact.

63. The Commission also considers that there are numerous assumptions built into Telesat’s pro forma financial statement methodologies associated with its proposed theoretical models that are inconsistent with the assumptions inherent to the DCF EES model, such as the omission of the effects of compounding within a year, the use of a variable debt/equity ratio over the study period, the repayment of debt over the 10-year study period instead of over the life of the investment, and the use of the opening equity balance in the percentage ROE calculation in each year rather than an average annual equity balance.

64. The Commission notes that in arriving at the pro forma financial statement representation of the Decision 97-17 cash flows in Exhibit B, Telesat has assumed a delay in the use of the CCA tax shields to the year where the company has sufficient earnings to make use of them. The Commission further notes that the pro forma financial statement of Exhibit B includes such additional assumptions as the use of net book values for the opening values of the Anik C and D satellites.

65. The Commission considers that Telesat’s proposed pro forma financial statement representation of Decision 97-17 EES cash flows: (1) relies on several pro forma assumptions that are not consistent with those implicit in the EES model; (2) combines accounting and economic concepts in a manner that produces results that are not supported by economic or financial theory; and (3) are not consistent with generally accepted accounting principles.

66. In light of the above, the Commission does not consider that Telesat’s proposed pro forma financial statement representation of the Decision 97-17 cash flows provides persuasive evidence to demonstrate that Telesat’s EES model produces a downward systematic bias in the Space Segment’s financial ROE results.

3.3 Telesat’s Three Proposed Adjustments

67. Telesat submitted that the consistent downward bias in the financial ROE results presented in its evidence is attributable to the treatment of three principal factors: (1) present value factors, which incorporate monthly compounding, are inconsistent with the performance measurement based on annual financial statements; (2) satellite salvage values derived using an amortization method are significantly higher than those used for accounting purposes because an inappropriate proportion of capital recovery is left to the subsequent study period; and (3) the timing of tax shielding assumes that the benefits are received by Telesat earlier than possible.

68. Despite what is characterized as methodological inconsistencies in the current EES model, Telesat submitted that it has not proposed abandonment of this DCF model for rate setting purposes, but rather, is of the view that the best course of action to address the ROE shortfall is to retain the current DCF EES model, subject to certain narrowly focused revisions which will remove these inconsistencies, and thereby provide Telesat with a reasonable opportunity to earn its allowed ROE on a financial statement basis.

3.3.1 The Present Value Factors

69. Telesat submitted that ROE is a measure of annual performance as determined on financial statements and the annual cash flows that are recorded in annual financial statements are not discounted within the year for the purposes of calculating ROE. Telesat further submitted that the application in the Telesat rating model does not provide for a 13.5% ROE in the same way that it was determined in the process used to arrive at the rate, and that in order for the 13.5% ROE to be achieved, the use of annual compounding is appropriate and necessary.

70. Telesat also submitted that in using monthly discounting factors, the EES model imposes an assumption of monthly reinvestment on Telesat while other carriers use an annual period. Telesat noted that, however, both itself and the telephone companies collect their revenues monthly. Telesat also submitted that the reinvestment assumption which it has presented in its pro forma financial statements is much more conservative than that applied to the telephone companies’ rate-setting process. Telesat further submitted that in its case, all cash has been assumed to be reinvested at a before-tax rate of 23.9%, in contrast to the reporting of actual interest income for the telephone companies.

71. Cancom submitted that Telesat’s application challenges core aspects of the DCF model that has been used to set Telesat’s rates for RF Channel Services since 1979 including, most notably, the discounting of recurring and non-recurring cash flows. Cancom submitted that the use of present value factors in the EES represents a fundamental difference between discounted cash flow and accounting measures of return.

72. Cancom submitted that the formulae for the present value factors which are set out in Telesat’s Phase III Manual have been expressly designed to reflect the timing of exact cash flows to Telesat’s Space Segment operations. Cancom submitted that the EES approach, therefore, provides a more accurate measure of the true monetary impact of cash flows occurring during the study period than annual financial statements, which assume that all income and expenses are incurred at either the beginning or end of the year.

73. CSUA supported Cancom’s arguments noting that the academic references all indicate that the concept of time value of money is the key distinguishing characteristic between accounting analysis and DCF or economic analysis, and that in this one change, Telesat has departed so significantly from the DCF principles to make the revised EES model useless.

74. The Commission agrees with Cancom’s view that, given that Telesat’s rates for RF Channel Services are determined based on a DCF model including, most notably, the discounting of recurring and non-recurring cash flows, the use of present value factors in the EES represents a fundamental difference between discounted cash flow and accounting measures of return.

75. The Commission notes that Telesat’s Phase III Manual has been designed to reflect the precise timing and nature of cash flows to Telesat’s Space Segment operations. For instance, a different time-value conversion factor is applied to the revenues which are assumed to be received at the beginning of the month, in contrast with expenses which are assumed to be paid out at the end of the month. Under this approved approach, the Space Segment’s revenue and expense cash flows are inputted into the EES and exclude the monthly compounding effects of the net cash flows since these are calculated automatically by the EES model. The Commission considers that this practice, which recognizes the time value of money through monthly present value factors, provides an accurate and appropriate measure of the economic impact of cash flows occurring during the study period.

76. The Commission considers that no persuasive evidence has been brought forth to justify any changes to this EES methodology and is of the view that no adjustments to the EES model are necessary to account for this factor.

3.3.2 The Salvage Value Factor

77. Telesat submitted that the EES salvage values for the satellites, which are derived using an amortization method, do not permit Telesat to recover the full value of the assets during the study period. Telesat submitted that the unamortized salvage values are significantly higher than those used for accounting purposes because an inappropriate proportion of capital recovery is allocated to the subsequent study period. Telesat further submitted that the net book value (NBV) approach is justified because it aligns the investment base in the EES more closely to the investment on which investors are permitted to earn an accounting rate of return.

78. Cancom submitted that the uniform amortization approach, which is used in the EES to calculate the salvage or terminal value of the Space Segment satellite assets and is described in Telesat’s Phase III Manual, has been the subject of detailed consideration by the Commission. Unlike an NBV approach, the uniform amortization approach recognizes the time value of money. Cancom noted that the uniform amortization approach was implemented at the express request of Telesat, in order to ensure that investments made by Telesat prior to the commencement of the study period would be recognized in the EES.

79. In Telesat Canada - Final Rates for 6/4 GHz Satellite Service and Valuation of Plant Investment for Economic Evaluation Studies, Telecom Decision CRTC 85-11, 27 June 1985, in accepting Telesat’s proposal for the valuation of its investment in plant, the Commission stated: "Both in this proceeding and the one which led to Decision 85-10, Telesat proposed that an amortization approach be used for the valuation of investment made prior to the commencement of the test period. An amortization approach recognizes the time value of money, unlike a net book value approach which employs original cost less accumulated depreciation in estimating the value of investment. ... The Commission is of the view that, insofar as Telesat is concerned, an amortization approach is more equitable than a net book value approach for developing an estimate of the economic value of investment in plant made prior to the commencement of a multi-year test period, and has concluded that it should be adopted for each of Telesat’s services for both the valuation of prior investment and the valuation of investment remaining at the end of a multi-year test period. ... Accordingly, the Commission has adopted an amortization approach whereby the estimate of economic value is independent of previous actual revenues and expenses. Under this approach, a uniform monthly equivalent cost is determined which will amortize the amount of the investment over the service life of the asset. At any time during the service life of the asset, the unamortized value is the present worth of the remaining monthly equivalent costs..."

80. CSUA submitted that the use of the NBV approach weakens the EES model. CSUA submitted that the Commission has already denied the introduction of accounting depreciation into the EES model when dealing with the treatment of Telesat’s headquarters building, in Telesat Canada - Request to Review and Vary Portions of Telecom Decision CRTC 90-28, Telecom Decision CRTC 91-22, 19 December 1991.

81. CSUA further submitted that in the proceeding initiated by Phase II Costing Issues, Telecom Public Notice CRTC 95-19, 20 April 1995, Stentor Resource Centre Inc. argued against the use of the NBV approach for economic purposes noting that the NBV approach is not prospective in nature, does not use economic principles, and its use can distort expenditure cost information resulting in incorrect economic studies.

82. The Commission notes that it has previously ruled against the introduction of accounting depreciation into the EES model. The Commission considers that no persuasive evidence has been brought forth to justify any changes to the approved plant valuation methodology and is of the view that no adjustments to the EES model are necessary to account for this factor.

3.3.3 The Tax-shielding Factor

83. Telesat indicated that its proposal to adjust the treatment of tax shielding in the EES is required in order to reflect the actual time when the Space Segment can take advantage of the tax shields. Telesat submitted that this proposal is further consistent with the alternative method of calculating tax shielding separately, which is stipulated at page 68 of Telesat’s Phase III Manual. The relevant passage reads: "The company employs a summary method of calculating revenue requirements by flowing through full tax shielding in the year the capital expenditure, revenues or expenses occur. This method eliminates the need to calculate tax effects separately. An alternative approach that would also yield acceptable results, and may indeed be preferable if the tax impacts are seriously out of phase with the assumptions, would be to calculate and incorporate tax effects separately."

84. Cancom submitted that while it does not object, in principle, to the application of the alternative approach to recognizing tax shields in the EES as set forth in Telesat’s Phase III Manual, Cancom does not believe that Telesat’s argument in respect of tax shielding satisfies the test for a R&V. In particular, Cancom noted that Telesat has not provided any indication as to why it failed to pursue the alternative approach to incorporating tax shields in the EES during the proceeding leading to Decision 97-17, and since Decision 97-17 reflects the evidence filed by Telesat in the proceeding with respect to tax shielding, the Commission cannot be said to have erred, on the basis of the facts before it, in utilizing the summary approach to incorporating tax shields in the EES in the Decision.

85. Cancom further noted that the evidence on the record also does not establish the impact of the change in approach to tax shielding on Telesat’s revenue requirement. Cancom submitted that although Telesat has discussed the impact of the change in approach to tax shielding on the average annual ROEs computed from the pro forma financial statements, it would be necessary to recalculate the EES using the revised approach to tax shielding to show that the net present value resulting from the Decision 97-17 revenues is negative and/or that a change in rates would be required to achieve Telesat’s target ROE of 13.5%. Cancom argued that in the circumstances, Telesat has clearly failed to establish that review and variance of the treatment of tax shields in Decision 97-17 is warranted.

86. Cancom and CSUA both submitted that Telesat had ample opportunity to consider the effects of the summary approach to tax shielding and to propose use of an alternative mechanism for dealing with tax shields during the proceeding leading to Decision 97-17 and chose not to. CSUA submitted that Telesat cannot now come forward and change its position on this matter in a way which undermines Decision 97-17.

87. CSUA noted that Telesat’s solution is to incorporate the estimated EES income tax expense as a separate EES cash flow and that the impact of this change is again to increase the revenue requirement for the Space Segment. CSUA submitted that despite Telesat’s argument that the tax shielding treatment in the EES causes a mismatch in timing as to when the benefits are actually received, Telesat has been able to use all the tax shields available to it on a company-wide basis. CSUA submitted that the assumption that tax treatment can be modelled on the Space Segment alone is an artifice. This is one area where the ability to use tax shields is a corporate matter and as long as the benefits are used up by Telesat, no adjustment is required. This position is supported by the reality that the Income Tax Act requires that all transactions per corporate entity be determined together to arrive at the income tax liability.

88. The Commission notes Telesat’s reliance on a quotation from page 68 of the Net Present Value section of the Phase III Costing Manual. This section provides details on the various formulae used to calculate the EES results and indicates that there is a provision to calculate tax effects separately if the tax impacts are seriously out of phase with the assumptions. The Commission considers that this passage is simply intended to recognize that the EES income tax shields can be calculated explicitly for each time period, consistent with the Phase II costing methods and practices used by most terrestrial carriers, and was not intended to imply that an alternative method deviating from Phase II principles could be used.

89. The Commission also notes that the method of calculating the income tax shield is clearly stipulated at page 42 of the Capital Resources section of the Phase III Costing Manual which states: "For EES purposes, the capital cash flow is recognized when the asset is put into service and the tax shielding is recognized at the same time. Both the capital cash flow and the associated tax shielding are present valued to the beginning of the year in which the expenditure occurs to facilitate calculation of the results. This occurs whether or not the company is in a position to use the tax shielding at the time." A footnote at the bottom of page 42 further states that the tax shielding formula assumes that the income tax payable component is assumed to occur in 12 even monthly amounts and is already present-valued to the beginning of the year. From the above passage, the Commission considers that it is quite clear which method is to be used to calculate the income tax shields. The Commission notes that this approved method does not allow for the alternate tax calculation advanced by Telesat in its R&V application, which would not recognize the tax shielding from the time the asset is put into service if the company is not in a position to use the tax shielding at the time.

90. The Commission considers that Telesat has not presented a persuasive rationale for deviating from the EES tax-shielding methodology clearly set out in its own Phase III Costing Manual.

3.4 Telesat’s Proposed Modifications to the EES and Rates

91. Telesat submitted that, having identified the methodologies in the current EES that produce a downward systematic bias in the accounting ROE results, appropriate results can be achieved through narrowly focused modifications to the current EES model to correct for the rate-setting anomalies. In "Exhibit C - Proposed Modifications" of its R&V application, Telesat filed its proposed revised EES model. Telesat submitted that this revised EES will address the three principle methodological inconsistencies identified in its theoretical models. Telesat noted that it is not proposing the abandonment of the DCF EES model, or criticizing DCF methodologies in general.

92. CSUA submitted that Telesat’s adjustments to the EES seek to lump together incompatible accounting and economic concepts done without theoretical basis and in a manner which produces meaningless results. To accede to Telesat’s position would fundamentally undermine the integrity of Telesat’s regulatory regime that has been applied over many years.

93. Cancom submitted that the ad hoc adjustment of three (among numerous) inconsistencies between the assumptions used in the EES and the pro forma financial statements filed by Telesat in the R&V application is completely unprincipled and will yield meaningless results. Cancom indicated that the mere existence of a difference between the EES and these accounting statement assumptions is not a basis for R&V or alteration of the EES. Furthermore, the three revisions proposed by Telesat relate to differences between the EES and accounting statements which are not only widely recognized, but have also been the subject of detailed consideration by the Commission.

94. The Commission notes that in the proposed financial statement representation of the adjusted EES model in Exhibit C, Telesat has introduced additional assumptions to those of its models provided in Exhibits A and B. Such assumptions include the substitution of the NBVs of the Anik E satellites for the end-of-study unamortized balances of the EES and the shifting of the in-service date of the Anik E satellites during the first year of the study period back to the start of the year along with corresponding adjustments for Allowance for Funds used during Construction.

95. As discussed in section II.3.2 above, the Commission does not consider that Telesat’s pro forma financial statement evidence, provided in Exhibits A and B of its R&V application, provides persuasive evidence that Telesat’s EES model produces a downward systematic bias in the accounting ROE results. In sections II.3.3.1, II.3.3.2 and II.3.3.3 of this Decision, the Commission further concludes that no adjustments to the EES are necessary to account for the three factors: present value factors, salvage value, and tax shielding. The Commission also considers that Telesat’s proposed rate adjustments to the EES further seek to combine incompatible accounting and economic concepts without theoretical basis and in a manner that produces inconclusive results. The Commission therefore finds the proposed rate adjustments to be inappropriate.

iii DISPOSITION  IS POSITION OF CANCUM'S REQUEST FOR RATE ADJUSTMENTS FROM 1 JANUARY TO  9 FEBRUARY 1998

96. In its submission, Cancom argued that the 7% rate reduction required in Decision 97-17 should be extended back from its effective date of 9 February 1998 to 1 January 1998, the original date the reduction was to go into place. Cancom submitted that to do otherwise would result in windfall profits for Telesat.

97. The Commission notes that rates were made final effective 9 February 1998 in the Decision which denied Telesat’s stay application. As noted in that Decision, denial of the stay would not preclude the Commission from varying the rates back to 1 January 1998 in the event that it decided to review and vary Decision 97-17. However, given that rates are final, effective 9 February 1998, and that it has determined that Decision 97-17 should not be varied, the Commission considers that a rate reduction back to 1 January 1998 is not possible. Accordingly, Cancom’s request is denied.

IV DISPOSITION OF CANCOM'S   SUMMARY DISMISSAL APPLICATION

98. On 27 February 1998, Cancom filed an application for summary dismissal of Telesat’s application to review and vary Decision 97-17. Cancom characterized Telesat’s R&V application as frivolous and vexatious, noting that Telesat is seeking to revise the regulatory framework set for the company, review and vary the Commission’s decisions regarding the company over a 20-year period, and deviate from a rate-setting model which uses the principles of discounted cash flows.

99. The Commission notes that in rendering a decision on the merits of Telesat’s application, Cancom’s application is moot.

Laura M. Talbot-Allan
Secretary General

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