ARCHIVED - Telecom - Commission Letter - 8652-B2-01/02 - Use of an after-tax weighted average cost of capital (AT-WACC) in Phase II cost studies

Letter

Our file: 2002.8652.B2.01

Ottawa, 22 October 2004 

BY:  E-MAIL/FAX 

To: Distribution List 

Re: Use of an after-tax weighted average cost of capital (AT-WACC) in Phase II cost studies 

A.    Background

A.1  The application 

On 17 July 2002, Bell Canada on behalf of itself, Aliant Telecom Inc., MTS Communications Inc. and Saskatchewan Telecommunications (collectively, "the Companies") filed a  Part VII application (the Application) seeking the Commission's approval for the use of an after‑tax weighted average cost of capital (AT-WACC) approach in Phase II cost studies.  The Companies submitted that the AT-WACC approach was methodologically equivalent to the before-tax hybrid cost of capital approach currently used by the incumbent local exchange carriers (ILECs). 

In support of their request for the approval of this methodological change, the Companies submitted that: (1) the AT-WACC approach was a well-known, well-recognized and sound approach to discounting; (2) since the AT-WACC approach was used by the ILECs for economic studies performed for internal business decisions, using a different approach for regulatory purposes would unnecessarily duplicate the work of study analysts; and (3) the impact of using the AT-WACC approach rather than the hybrid approach to cost of capital was neither significant nor biased in any one direction. The Companies further submitted that its analysis comparing the AT-WACC approach and the before-tax hybrid approach for primary exchange service (PES) and unbundled local loop service cost studies had demonstrated only minor differences in the monthly equivalent costs (MECs[1]), ranging from 0.1% to 0.3%. 

A.2   Cost of capital approaches 

Phase II cost studies are used to assess service proposals that involve cash flows occurring in the future, typically over a multi-year period.  Due to the time value of money, dollars at one point in time cannot be compared directly with dollars at another point in time. In order to permit a valid comparison of the dollars spent or received associated with a particular service over a multi-year study period, it is necessary to convert all cash flows to a common point in time, generally to the beginning of the study period.  

The procedure for converting an amount of money at a given point in time to an economically equivalent amount at a different point in time is termed discounting. The discount rate in a study represents the time value of money. The company's current cost of capital is currently used as the discount rate for Phase II economic cost studies.  

Currently, the discount rate used in Phase II cost studies is based on each company's current "before-tax" cost of capital. This cost of capital reflects an average of the before-tax cost of debt and after-tax cost of equity weighted by their respective proportions under the company's current market value capital structure. Algebraically, this before-tax cost of capital equates to the following: 

               iBT  = iD*RD + iE*(1-RD)
 where:
iBT  = before-tax cost of capital
iD  = cost of debt (based on current cost of debt financing)
RD = debt ratio (based on company's current capital structure)
iE   = cost of common equity (Commission-prescribed at 11% for local services) 

By contrast, the after-tax cost of capital approach assumes that all cash flows in the costing study impact financing and that the associated debt interest represents a deductible expense for income tax purposes. The tax shield related to debt interest is therefore assumed to reduce the cost of debt. The after-tax weighted average cost of capital or AT-WACC is an average of the after-tax cost of debt and cost of equity, weighted by their respective proportions in the company's current market value capital structure. Algebraically, the AT-WACC equates to the following: 

               iAT  = iBT - t *RD*iD
where:
iAT  = after-tax weighted average cost of capital
bT  = before-tax cost of capital
iD  = cost of debt
RD = debt ratio
t= corporate income tax rate 

A.3  Procedure 

The Commission received initial comments and reply comments from interested parties regarding the proposal to use the AT-WACC approach for Phase II cost studies on 7 August and 16 August 2002, respectively. On 24 September 2002, the Commission set out a revised process allowing parties to pose interrogatories and further assess the merits of the proposed methodological change. The timeframes set out in the revised procedure were: interrogatories to be sent out by 18 October 2002; responses by 1 November 2002; comments by interested parties by 15 November 2002; and reply comments by 29 November 2002. 

In response to a deficiency request dated 12 November 2002 by the City of Calgary (Calgary), the Commission issued a letter dated 9 December 2002 ordering that further responses be provided for certain interrogatories. 

AT&T Canada Corp. on behalf of itself, AT&T Canada Telecom Services Company, Call‑Net Enterprises Inc., Rogers Wireless Inc. and Canadian Cable Television Association (collectively, the Competitors), and the Consumers' Association of Canada, the National Anti‑Poverty Organization, and l'Union des Consommateurs (collectively, the Consumer Groups) filed comments on 15 November 2002. Calgary filed comments on 15 November 2002, 27 November 2002 and 17 January 2003. The Companies and TELUS Communications Inc. (TELUS) filed reply comments on 24 January 2003. 

B.    Position of Parties 

B.1  The Competitors 

The Competitors indicated that using either the AT-WACC approach or the before-tax hybrid method should be neutral as both methodological approaches were designed theoretically to achieve the same result.  The Competitors argued,  however, that the practical implementation of the proposed methodological change resulted in differences in the Phase II costing results that could hardly be called minimal and therefore the Companies' application to adopt the AT-WACC approach should be denied. 

The Competitors further noted that the cause of the variation in results was not related to the conceptual use of either the before-tax or after-tax WACC, which was the basis of the Companies' application, but was rather due to differences in the modeling of the financing requirements of a project. 

The Competitors noted that the current implementation of the before-tax hybrid cost of capital approach calculated explicitly the debt interest tax shields associated with the debt component of the capital cash flows based on a declining level of the remaining capital balance. The Competitors noted that under the AT-WACC approach, which adjusted the discount factor by implicitly including the debt tax shield, all cash flows - revenues, expenses and capital - were captured in the calculation of the debt interest tax shield. The Competitors noted that this represented a methodological change regarding which cash flows would be subject to the debt interest tax shield. The Competitors remarked that it was telling that the Companies had not indicated this in their Application. 

The Competitors submitted that the current approach of calculating the debt interest tax shield based on the outstanding capital obligations and using the hybrid cost of capital approach was a sound and reasonable approach. The Competitors further submitted that the Companies' application to change to the AT-WACC approach for Phase II cost studies should be denied. 

B.2  Calgary 

Calgary submitted that one of its overriding concerns during this proceeding was the lack of adequate information provided by the ILECs to allow acceptance of the proposed AT-WACC methodology. 

Calgary submitted that while describing the change as one of AT-WACC versus the before-tax hybrid cost of capital method, the Companies in fact proposed changes to the inputs related to expenses and avoided financing, which were only discovered in the interrogatory process. Calgary noted that in response to the interrogatory The Companies(CRTC)18Oct02-3 AT-WACC, the Companies stated that the current implementation of the hybrid cost of capital approach was deficient in that it did not reflect the financial impacts of expenses and the associated income tax impact. Calgary further submitted that a second change was discovered in the interrogatory process, which was a change related to the avoided impact of certain cash flows that was not recognized in the ILECs' current implementation of the before-tax hybrid cost of capital approach. Calgary argued that owing to the late stage in the process in which this admission was made, there was limited opportunity to review the impacts of these changes. 

Calgary further submitted that the record appeared to lack the breadth of information that would support the contentions of the Companies in support of the proposed AT-WACC approach. Calgary argued that if it accepted TELUS' suggestion that the typical scenario would be a combination of a one-time capital expenditure at the beginning of the study and ongoing operating expenses then the Type 3 scenario[2] proposed by the Commission would be the most appropriate.  Calgary further submitted that in the Type 3 scenarios presented by the Companies and TELUS (refer to Attachment 1), the PWACs were all higher (between +2.7% and +5.3%) under the AT-WACC approach, while the MECs ranged from 0.0% to +0.4%. Calgary further noted that a full review of all the MEC calculations under the AT-WACC approach showed that: (a) the scenarios requested by the Commission were on average positive; (b) the six Type 1 scenarios resulted in four negative and two positive results; (c) all but one of the Type 2 scenarios were positive; and (d) two of the four Type 3 scenarios were neutral with the remainder being positive. Calgary further noted that all the PWAC scenarios calculations were higher under the AT-WACC approach. Calgary argued that the Companies had not demonstrated that the impact of switching from the before-tax hybrid approach to AT-WACC for Phase II costing purposes were negligible, and as such, the proposition of economic neutrality of the proposed AT-WACC method remained unproven. 

Calgary noted the application of different income tax rates and debt rates among the various ILECs and the use of differing methods to select these rates. Calgary argued that the assumptions about the calculation of the average cost of debt may need to be revisited.  Calgary submitted that by answering the interrogatories concerning the cost of debt with a narrow reply, the applicants had denied the Commission an understanding of the ILECs' cost of debt and that such matter should be revisited in a larger proceeding on the costing methodology. 

Calgary submitted that it had outlined and fully addressed the rejection of AT-WACC by other regulators (e.g., National Energy Board (NEB) in respect of the cost of capital for TransCanada Pipelines Limited (TransCanada Pipelines) in 2002, and the Alberta Energy and Utilities Board in respect of the cost of capital for TransAlta Utilities Corporation in 1999) in its previous letters and submissions. In Calgary's view, these references clearly demonstrated that AT-WACC had been thoroughly tested by other regulators in North America and the methodology had been rejected. Calgary further submitted that, consistent with those decisions, the Commission should deny the Application to use AT-WACC for regulatory purposes. 

Calgary also submitted that if the Commission found the issues related to certain expenses and avoided costs, which were not considered in the existing before-tax hybrid models, required an adjustment, then it urged the Commission to order the adjustment without accepting AT-WACC. If the Commission chose not to deny the Application, then Calgary urged the Commission not to accept AT-WACC in Phase II without further in-depth examination. 

B.3   The Consumer Groups 

The Consumer Groups indicated that they did not support the change to AT-WACC and asserted that none of the Companies' three justifications for adopting the AT-WACC approach were valid.  The Consumer Groups concluded that the impact of using an AT-WACC approach in Phase II costs could be significant and biased.  The Consumer Groups referred to Calgary's 12 November 2002 letter as an example of the significant differences in the cost results between the two methods of calculation based on the Companies' data. The Consumer Groups indicated that if the AT-WACC had not generated such significant differences, then the advantage noted by TELUS, that the proposal would eliminate complex and time-consuming calculations for the ILECs, might have been more convincing. 

The Consumer Groups questioned the Companies' claim that the AT-WACC was a well-known and sound approach to discounting, given that other regulators had rejected it, as noted by the City of Calgary. 

The Consumer Groups submitted that the record of the proceeding had not supported the change to AT-WACC in the development of Phase II cost studies. The Consumer Groups concluded that the Commission should dismiss the application and order the Companies to revert to the current approach of calculating the cost of debt component of the cost of capital on a pre-tax basis.  

B.4   TELUS' Reply  

TELUS submitted that it supported the proposed methodological change because, consistent with the Companies' assertion, the results it obtained from the application of the AT-WACC methodology in a limited number of preliminary analyses did not vary significantly from those obtained using the hybrid approach.  Further, TELUS agreed that the approach was well researched in the academic literature and TELUS had in the past used the approach to calculate the cost of capital applied for internal business decision-making purposes. TELUS recommended that if the Commission were to approve the Companies' proposed change in methodology, for reasons of consistency and comparability the AT-WACC approach should be simultaneously adopted for Phase II cost studies by all parties. 

TELUS submitted that while the Competitors opposed the use of the AT-WACC approach, they presented no reasons or evidence in support of this position based on the merits of one approach as compared to the other. TELUS submitted that the Competitors' argument to deny the proposal to change to the AT-WACC approach was without foundation and should be dismissed. 

TELUS noted that Calgary's two arguments against the AT-WACC proposal were that: (i) the evidentiary record was deficient for the purpose of validating the use of AT-WACC in Phase II costing; and (ii) it would be consistent with other regulators that had rejected AT-WACC for regulatory purposes. 

In response to Calgary's first argument that the ILECs had not provided adequate information to allow acceptance of changes in assumptions under the AT-WACC methodology, TELUS indicated that Calgary was relying on an arbitrary threshold test of adequacy that was beyond the scope of what the Commission found to be relevant to the matters at issue. TELUS submitted that Calgary was the only interested party that took issue with the adequacy of the record of the proceeding. In TELUS' view, Calgary's lack of understanding of the relevant issues was largely responsible for Calgary's perception of an inadequate record, and Calgary's claim was simply unfounded.  

TELUS submitted that Calgary erroneously accepted the Type 3 scenarios as representative when, in fact, it would be a combination of Type 1 and Type 3 scenarios that would correctly reflect capital at the beginning of the study and ongoing expenses throughout the study.  TELUS further submitted that because of this erroneous assumption, Calgary found that the range of differences in the results obtained between the AT-WACC approach and the hybrid approach were all positive, some more significantly than others. TELUS submitted that by correctly combining Type 1 and Type 3 scenarios the resulting twenty-four permutations would have a range (as measured by the MEC) from - 0.25% to

+ 0.45%, with an average of -0.01% and a median of -0.05%. TELUS submitted that this outcome fully supported TELUS' view that the results were modestly positive, flat, or negative. Furthermore, TELUS submitted that the results were consistent with TELUS' and the Companies' conclusion that the impact of using the AT-WACC approach rather than the before-tax hybrid approach was neither significant nor biased in any one direction. 

TELUS submitted that the Consumer Groups did not appear to have examined the information provided by the ILECs to any great extent as they relied solely on statements made by Calgary to justify rejecting the proposal to use the AT-WACC methodology. TELUS argued that the Consumer Groups' argument was neither substantive nor compelling and should be afforded no weight in the Commission's determinations. 

TELUS submitted that there was no compelling argument or evidence against the Companies' proposal to use the AT-WACC approach for Phase II cost studies. TELUS further submitted that the Commission should adopt the AT-WACC approach for Phase II costing purposes for all parties. 

B.5   The Companies' Reply 

In their reply comments, the Companies explained that although the request was for a change from their current implementation of the before-tax hybrid cost of capital approach to the AT‑WACC approach, there was no conceptual difference between the two approaches. 

The Companies explained that the change from their current implementation of the hybrid cost of capital approach to the AT‑WACC approach in fact generated a small difference in study results, and such difference was attributable to two issues associated with the Companies' current implementation of the hybrid cost of capital approach.  

The Companies submitted that, first, the AT‑WACC approach assumed that the financing requirements would be based on net cash flows. The Companies noted that this was different from the ILECs' current implementation of the before-tax hybrid cost of capital approach where the financing requirements were assumed to be driven by the declining level of the remaining capital balance (RCB) associated with capital cash flows only. The Companies argued that expenses, however, did impact the ILECs' financing requirements. The Companies noted, for example, that if the revenues were not sufficient to cover both capital expenditures and operating expenses, the ILECs would be required to borrow additional funds to make up the difference. The Companies argued that the use of the AT‑WACC approach would allow the Phase II cost studies to properly reflect the financing requirements caused by both capital and expense cash flows and to properly incorporate the income tax impacts due to these financing requirements. 

The Companies submitted that, secondly, under a hybrid cost of capital approach where all cash flows were assumed to impact financing requirements, the present worth of cash flows should take into consideration the avoided income tax impact on the financing requirements caused by the cash flow's occurrence at a later point in time. This avoided income tax impact was not currently recognized in the ILECs' existing implementation of the hybrid cost of capital approach.  

The Companies further submitted that the Competitors acknowledged the conceptual equivalence of the AT‑WACC approach and the hybrid cost of capital approach. The Companies noted that a formal mathematical proof of the equivalence between the two cost of capital approaches could be found in Haim Levy and Marshall Sarnat, Capital investment and Financial Decisions, 5th ed., Prentice Hall, 1994, page 487. 

The Companies submitted that there appeared to be a fundamental difference between Calgary and themselves over the context and use of the AT-WACC approach. The Companies noted that Calgary understood that the Application would have the same purpose as that of TransCanada Pipelines' application to the NEB, i.e., to establish AT‑WACC as a measurement of the appropriate rate of return awarded by the regulator. The Companies emphasized that the purpose of its Part VII application was instead related to the use of the cost of capital in conducting Phase II cost studies, not as to what level the cost of capital should be.  

With respect to Calgary's claim that, based on the record, it was not possible for the Commission or interveners to independently evaluate the impacts arising out of the changes in the AT-WACC approach and the underlying changes in assumptions, the Companies submitted that, to the contrary, they had provided ample information regarding the impact of using the AT‑WACC approach in Phase II studies. The Companies further submitted that they had provided numerical examples with detailed calculations in their 16 August 2002 reply comments to illustrate the equivalence of AT-WACC approach and the hybrid cost of capital approach under the principle that all cash flows impacted financing. The Companies noted that estimates of the impacts of using the AT-WACC approach in Phase II studies had also been provided based on the hypothetical scenarios specified by the Commission in its 18 October interrogatories. 

The Companies submitted that estimates of the impacts of using the AT-WACC approach versus the current implementation of the hybrid cost of capital approach had also been provided using real study examples such as Bell Canada's residential PES and Type A Loops. The Companies noted that the information provided in the response to The Companies(Calgary)18Oct02‑4 AT‑WACC indicated that there was a non‑material impact on MEC ranging from ‑0.01% to ‑0.14% for residential PES and from ‑0.01% to +0.04% for Type A loops. The Companies submitted that the impact of using the AT‑WACC approach as measured by these real study cases was more indicative of the typical impact on a study than those measured by hypothetical scenarios that used extreme and/or unrealistic assumptions. In the Companies' view, these assessments were sufficient for the Commission and interveners to assess the impacts of their proposal, contrary to Calgary's claim. 

In response to Calgary's claims that the debt rates calculated by the ILECs were not appropriate, the Companies submitted that they were not seeking a change to any of the parameters applicable to economic studies filed by the ILECs, nor were they seeking to affirm the parameters already established in the Commission's decisions. The Companies further submitted that, while the issues related to how the parameters would apply in a Phase II study were relevant to this proceeding, the issues related to how such parameters would be derived were not relevant. The Companies submitted that this was recognized by Commission staff in its 9 December 2002 letter regarding Calgary's deficiency claims, where it had agreed with the Companies that issues related to the determination of the values of the parameters used to calculate AT‑WACC were not pertinent to the application of AT‑WACC.  

The Companies submitted that if the methodology changes that formed the basis of the Application were recognized in this proceeding, the ILECs should be allowed to implement their proposed changes using the simple and practical approach, namely by eliminating the debt interest tax shield in the calculation of income tax cash flows and using the AT‑WACC as the discount rate for present worth and future worth calculations. In the Companies' view, this would avoid having to make the extensive set of changes to the current hybrid cost of capital approach used by ILECs to reflect the necessary adjustments only to arrive at the same answer as would be given by the AT‑WACC approach. 

The Companies submitted that they had established why their proposed AT‑WACC approach was superior to their current methods: it was simple, addressed the deficiencies of ILEC's current implementation of the before-tax hybrid cost of capital approach and was consistent with internal decision-making processes. The Companies submitted that the AT‑WACC approach was well understood in general economic literature and, in this proceeding, was supported by all ILECs that indicated their understanding of the issues involved in the Application. The Companies concluded that the Commission should approve its request to use the AT‑WACC approach in conducting future Phase II cost studies. 

C.         Commission Staff Assessment 

C.1  The context and use of the proposed AT-WACC approach 

In this proceeding, Calgary argued, among other things, that: (i) the AT-WACC approach was tested in depth and rejected for regulatory purposes by regulators in Canada and in the U.S., and (ii) the evidence provided by the ILECs did not provide critical information regarding the inputs (e.g., cost of debt and tax rates) and underlying assumptions. Commission staff considers that the above Calgary arguments stem from a misunderstanding of the purpose of the ILECs' proposed AT-WACC approach.  

First, in Commission staff's view, the fact that the AT-WACC approach was rejected for the purpose of determining the appropriate rate of return in the context of a company's annual revenue requirement proceeding has no bearing on whether this approach would be appropriate or not for Phase II cost purposes.  Commission staff notes that the purpose of this proceeding is related to the use of the cost of capital in order to develop Phase II costs, not to the level of the cost of capital itself. Commission staff notes that both the AT-WACC approach and the current before-tax hybrid cost of capital approach are intended to determine the after-tax present worth estimates of dollars spent or received over a multi-year study period associated with a particular service. Commission staff also notes that in this proceeding, the Competitors have acknowledged the conceptual equivalence of the AT-WACC approach and the before-tax hybrid cost of capital approach for Phase II costing purposes. 

With respect to the issues raised by Calgary regarding the derivation of the Phase II parameter values and underlying assumptions, Commission staff considers that, consistent with the Commission staff's 9 December 2002 deficiency letter, these issues are not relevant to this proceeding. Commission staff notes that for purposes of developing Phase II cost studies, the current before-tax hybrid cost of capital approach and the proposed AT-WACC approach would both rely on the same parameter values such as the cost of debt and equity, debt ratio and tax rates. Commission staff further notes that the information requirements associated with individual Phase II cost inputs such as cost of debt, cost of equity, cost of capital and income tax rates were initially set out in Telecom Decision CRTC 79-16.  As stipulated in Directives 6.6 and 6.7 of that decision, the ILECs are required to provide the tax rates, tax-related information, and discount rate information to be employed in Phase II cost studies, of which the associated values, methods and assumptions are routinely reviewed by the Commission to ensure that the input values used are appropriate and reflect current information. 

C.2  The proposed underlying changes in assumptions that all cash flows will impact financing requirements. 

Commission staff notes that in response to a Commission interrogatory, the Companies provided a detailed rationale for the change in financing assumptions associated with the AT-WACC approach. The Companies argued that the ILECs currently determine their financing requirements based on net cash flows rather than the declining RCB level associated with only capital cash flows. The Companies submitted that, for example, if the ILECs' revenues were not sufficient to cover both capital expenditures and operating expenses, the ILECs would be required to borrow additional funds to make up the difference. The Companies further submitted that the use of the AT‑WACC approach would allow the Phase II cost studies to properly reflect the financing requirements caused by both capital and expense cash flows and to properly reflect the income tax impacts due to these financing requirements.  

Commission staff recognizes that, from an incremental study perspective, all prospective incremental cash flows (i.e., both inward and outward) will impact an ILEC's future financing requirements. On this basis, Commission staff considers it appropriate to recognize such financing impacts for the purpose of estimating an ILEC's prospective incremental Phase II cost study. 

Commission staff notes Calgary's claim that the Companies in fact proposed changes to the inputs related to expenses and avoided financing that were only described at the late stage of the process, and as a result, there was limited opportunity to review the impacts of these changes in the AT-WACC approach, Commission staff considers that, to the contrary, detailed numerical examples were provided in the Companies' 16 August 2002 reply comments to illustrate the equivalence of AT-WACC approach and the hybrid cost of capital approach under the principle that all cash flows impact financing. Contrary to Calgary's claim, Commission staff considers that the parties of the proceeding had an opportunity to assess the merits of the proposed methodology changes and to meaningfully comment on such changes. 

C.3  The economic neutrality of adopting the AT-WACC approach 

The main dispute among the parties in the proceeding related to the significance of the cost differences between the proposed AT-WACC approach and the current before-tax hybrid cost of capital approach.  

The interveners claimed that the practical implementation of the proposed methodological change resulted in significant cost differences. The interveners concluded that the proposition of economic neutrality of the proposed AT-WACC method remained unproven, and that the proposal should therefore be denied.  

By contrast, the ILECs submitted that costs should be compared using the AEC/MEC measure rather than the PWAC measure since the higher PWAC that was derived from the AT-WACC approach was typically divided by the higher present worth of demand, and the resulting MEC tended not to be significantly different from that derived using the current hybrid approach. The ILECs also noted that the AEC/MEC was the measure commonly used to transform Phase II costs into rates. The ILECs further argued that when the AEC/MEC costs were compared for the appropriate hypothetical study scenarios, the impact of using the AT-WACC approach was neither significant nor biased in any one direction.  

AEC/MEC Cost Comparisons 

Commission staff notes that the AEC or MEC is the measure commonly used by ILECs to determine monthly rates (i.e., Phase II costs plus a mark-up). As shown in Attachment 1, the differences in the AEC/MEC measures between the after-tax AT-WACC approach and the before-tax hybrid cost of capital approach vary between -0.5% and +2.4%, depending on the hypothetical scenario. 

In Commission staff's view, a typical cost study performed by an ILEC will reflect a combination of the three study scenarios, reflecting a blend of capital at the beginning of the study period along with ongoing recurring capital and operating expenses over the study period. When these three study scenarios are blended over a five-year study period, as shown in Table 1 below (under staff's view of a typical blend of the three study scenarios), the AEC/MEC differences between the after-tax AT-WACC and the before-tax hybrid methods yield a -0.15% difference for the Companies, and a -0.03% difference for TELUS. This is in the same general range as the cost variability that the Companies identified in their response to The Companies(Calgary)18Oct02-4 AT-WACC. 

                                                                        Table 1

                              The Companies and TELUS AEC/MEC Differences ($)
                       between (Before-tax) Hybrid and (After-tax) AT-WACC approaches
                              based on staff's view of typical blend of Scenarios 1-3
                                                 The Companies                           TELUS          
                    Type *             BeforeTax      AfterTax              BeforeTax    AfterTax
                       1                    67.15             66.85                66.35            66.10
                       2                    38.84             38.85                37.81            38.01
                       3                    83.33             83.33                83.33            83.33
                   TOTAL              189.32            189.03              187.49          187.44
                   TOTAL - % Diff.                        -0.15%                                  -0.03%

 * Study period = 5 years; Inflation=0; CCA=10% or N/A for Type 3; assumes the weighting factors of 5 for Type 1, and 1 for Types 2 and 3. 

Commission staff further notes that AEC/MEC cost differences that were observed for the practical studies associated with the residential PES and Type A unbundled loop cost studies were typically less than 0.3%. 

In light of the above, Commission staff considers that the impact on the AEC/MEC results of using the AT-WACC approach rather than the before-tax hybrid approach is neither significant nor biased in any one direction.

PWAC Cost Comparisons 

As shown in Attachment 1, the differences in the PWAC measures between the AT-WACC approach and the hybrid cost of capital approach are all positive and vary between +2.3% and +7.6%, depending on the hypothetical scenario. Similarly, as shown in Table 2 below, when the three study scenarios are blended over a five-year study period (similar to Table 1 above), the PWAC differences between the AT-WACC approach and the hybrid approach yield significant positive differences (i.e., a +2.59% difference for the Companies, and a +2.71% difference for TELUS).  

Table 2

                                    The Companies and TELUS PWAC Differences ($)
                          between (Before-tax) Hybrid and (After-tax) AT-WACC approaches
                                   based on staff's view of typical blend of Scenarios 1-3
                                                   The Companies                           TELUS          
                         Type *           BeforeTax      AfterTax           BeforeTax     AfterTax
                            1                  3260             3335                 3220            3295
                            2                  1885             1937                 1835            1896
                            3                  4045             4156                 4045            4156
                       TOTAL               9190             9428                 9100            9347
                       TOTAL - % Diff.                     +2.59%                                +2.71%

* Study period = 5 years; Inflation=0; CCA=10% or N/A for Type 3; assumes the weighting factors of 5 for Type 1, and 1 for Types 2 and 3. 

Commission staff notes, however, that the PWAC estimate is rarely if ever used used as the basis to develop tariffed rates.  

Tariffed rates are typically developed and applied on a recurring basis (typically, monthly rates). A tariffed recurring rate will not be established based on the PWAC measure given that this measure provides an estimate of the costs (present worth) at the beginning of the study. As discussed above, the cost measures that are commonly relied on to establish recurring tariffed rates are: (a) the service's cost expressed on an AEC or MEC basis or (b) the service's per-unit cost derived by dividing the PWAC by the present worth of demand. As discussed above, the impact of dividing a higher PWAC value by a higher present worth of demand, both of which are derived using the AT-WACC approach, will produce a result that is not significantly different from that derived using the current hybrid approach. 

Tariffed rates may also be developed and applied on a one-time basis (typically, service charges). However, the cost measure that is commonly relied on to establish one-time service charges is the service charge's per-unit cost derived by dividing the PWAC of the service charge cost component by the present worth of the corresponding service demand.  Examples of past service charge tariff proposals that have relied on this per-unit cost derivation include the loop selection charge proposals by Bell Canada, TELUS and MTS under Stentor Resource Centre Inc.'s  Tariff Notice (TN) 658, and Bell Canada's optical link service charge proposal under TN 6621. 

Commission staff further notes that the second type of study that is routinely used to establish (one-time) service charges is the resource cost study. In such cases, the resource cost study will typically calculate a unit cost based on the AEC value for a single incremental unit of demand. As discussed above, the impact on the resource cost AEC result of using the AT-WACC approach rather than the before-tax hybrid approach is neither significant nor biased in any one direction. 

D.  Conclusion 

Commission staff notes that the AT‑WACC approach for Phase II costing purposes is well understood in general economic literature, and is simpler to understand, model and use.  Commission staff also notes that all ILECs have indicated that the approach would be consistent with their internal decision-making processes. Despite the fact that there are material PWAC cost differences between the AT-WACC approach and the before-tax hybrid approach, Commission staff notes that the impact of using AT-WACC rather than the current approach on the measures that are commonly relied on to transform Phase II costs into rates (i.e., AEC/MEC results or PWAC divided by the present worth of demand) is neither significant nor biased in any particular direction. Commission staff further notes that the AT-WACC approach would allow the Phase II cost studies to properly reflect the financing requirements caused by both capital and expense cash flows and the associated income tax impacts due to these financing requirements. 

In light of the above, Commission staff considers that it would be appropriate to adopt the AT-WACC approach for determining costs in Phase II cost studies.

Commission staff therefore accepts the proposal to use the AT-WACC approach for the purpose of developing Phase II cost studies for each ILEC, from the date of this letter onwards. Each of Aliant, Bell Canada, MTS, SaskTel, and TELUS is requested to indicate, within 15 days of the date of this letter, when it will be able to modify its economic evaluation systems and procedures manuals to incorporate the AT-WACC approach. 

Yours sincerely, 

Original signed by: 

Scott Hutton
Director General
Competition, Costing and Tariffs 

c.c.:    Yvan Davidson, Senior Manager (819) 953-5414

Date modified: 2004-10-22