Appendix 2 Written Evidence of TQM: Business Risk and Total Return Comparison

Transcription

1 Appendix Written Evidence of TQM: Business Risk and Total Return Comparison

2 NATIONAL ENERGY BOARD IN THE MATTER OF the National Energy Board Act and the Regulations made thereunder; AND IN THE MATTER OF an Application by Trans Québec & Maritimes Pipeline Inc. for orders pursuant to Part I and Part IV of the National Energy Board Act. TRANS QUÉBEC & MARITIMES PIPELINE INC. 00 AND 00 COST OF CAPITAL APPLICATION APPENDIX WRITTEN EVIDENCE OF TQM: BUSINESS RISK AND TOTAL RETURN COMPARISON December 00

3 Page of.0 INTRODUCTION AND SUMMARY 0 0 Q. What is the purpose of this evidence? A. This evidence compares the business risk and total returns of Trans Québec & Maritimes Pipeline Inc. ( TQM ) to those of other Canadian pipelines. The comparison is intended to address the requirement of the fair return standard that a fair return on capital should be similar to the return available from investment in other enterprises of similar risk (the comparable investment standard). TQM has chosen Canadian pipelines that it believes to be relevant comparisons to TQM. Dr. Carpenter provides comparisons with U.S. interstate gas pipelines and U.S. gas local distribution companies ( Gas LDCs ) in his evidence (Appendix ). Q. Why is it important for the National Energy Board ( Board or NEB ) to consider the risks and returns of comparable pipelines? A. Determination by the Board of a fair return on capital for TQM requires compliance with the fair return standard. If overall risk is similar, the fair return standard requires that the total return must also be similar. TQM has selected what it believes to be the most relevant Canadian comparables. Since no two entities are identical, the comparables differ from TQM in various ways but the differences can be understood and considered in a comparative analysis. For example, differences in business risk can be compared between pipelines to evaluate whether differences in returns are justified by differences in business risk. Q. What are the results of the comparative analysis? A. The results show that TQM s total return has diverged from those of Canadian comparables and that current differences in total returns are not explained by differences in business risk. In fact, TQM s business risk has increased since the RH-- Decision while its total return has decreased relative to Canadian comparables. The conclusion is that TQM s total return as determined by the NEB return on equity formula ( NEB ROE

4 Page of 0 0 Formula or Formula ) and a 0% deemed equity ratio would not meet the fair return standard. Q. How is this evidence structured? A. Section presents historical total return information for TQM and Canadian comparables. Section evaluates whether it is reasonable to compare the return of TQM to the comparable samples when applying the fair return standard. The evaluation by TQM adopts the business risk analysis of Dr. Carpenter who concludes that TQM s business risk has increased since. Section also demonstrates that the differences between TQM s total return and the total returns of the pipelines in the Canadian comparable samples cannot be explained by differences in business risk. Section provides conclusions..0 RETURN COMPARISONS Q. What comparables were used in this analysis and why were they chosen? A. Two comparable sample groups were used in the analysis. The first sample group (Non- Formula Sample) contains Maritimes & Northeast Pipeline Management Ltd. ( M&NP ), Alliance Pipeline Ltd. ( Alliance ), Enbridge Inc. s Alberta Clipper ( AB Clipper ), Line Extension ( Line Extension ), and Southern Lights ( Southern Lights ) projects, and Trans Mountain Pipe Line ( TMPL ). The total returns of the pipelines and expansions in this sample have been determined through negotiation or settlements approved by the NEB. The second sample group (Formula Sample) is composed of the TransCanada PipeLines Limited Mainline ( TransCanada ) mainline natural gas transmission system ( TransCanada Mainline ) and the Foothills Pipe Lines Ltd. System ( Foothills ). The rates of return on equity ( ROE s) of the TransCanada Mainline, Foothills and TQM have all been determined since the RH-- Cost of Capital proceeding by the NEB ROE Since Board approval of a transfer in February 00, Foothills includes what was previously known as the TransCanada B.C. System after TransCanada purchased it from Alberta Natural Gas Company Ltd.

5 Page of 0 Formula, but the equity ratios of the TransCanada Mainline and Foothills have been increased to reflect increases in business risk. Q. Are there other relevant Canadian comparables whose returns are determined through settlements? A. Yes. The Enbridge Mainline is one. Specific returns were not approved by the NEB, but actual total returns ranging from.0% to 0.0% for the period -00 as reported by the Dominion Bond Rating Service ( DBRS ) suggest that the total returns as determined through Enbridge s settlements are higher than those of TQM. The Enbridge Mainline is included in the comparison analysis although it is not included in either the Non-Formula Sample or the Formula Sample because the Enbridge settlements do not explicitly state an ROE or equity ratio. Q. On what basis is the comparative analysis made? A. The comparative analysis is made on the basis of total return on capital. A company s total return on capital is comprised of the return on equity capital (rate of return applied to deemed equity component of the capital structure) and the return on debt. In its RH-- 00 Phase II Decision relating to the TransCanada Mainline the NEB stated: 0 and The Board also agrees with TransCanada that the case law establishes that it is the overall return on capital to the company which ought to meet the comparable investment, financial integrity and capital attraction requirements of the fair return standard. it is the Mainline s overall return on capital, resulting from the combination of the Mainline s capital structure, ROE and cost of debt (set out in Section.), that must be examined in light of these standards. When examining the cost of capital for the Mainline, the Board is of the view that, since the Mainline s tolls National Energy Board Reasons for Decision, TransCanada PipeLines Limited, RH--00, Phase II, April 00, Cost of Capital ( RH--00 Phase II Decision ), page.

6 Page of 0 0 recover the actual rather than the market cost of debt, establishing a fair total equity return is the paramount concern in this case when ensuring that a fair return on capital has been determined. Given that it is the overall or total return which must meet the fair return standard, this evidence compares total returns. Q. Are returns agreed to in settlements relevant for comparison purposes? A. Yes. It is appropriate and instructive to consider total returns derived through settlements as part of a comparative analysis. However, these comparisons are best made on an aggregate rather than individual basis. Settlements are by definition characterized by trade-offs which may not be readily apparent to those not directly involved in the settlement. Consequently, the returns derived through an individual settlement may not always be reflective of a market required return when considered in isolation from other settlement components and the specific facts and circumstances at the time of the settlement. Furthermore, the returns from these settlements may be reduced from market levels since they are negotiated against the NEB ROE formula which itself does not reflect market levels of return. In contrast, a directional indication of market expectations for acceptable returns on existing and new capital investments can be derived by considering the returns of multiple settlements. In this context, TQM observes that settlements in recent years applicable to NEB regulated pipelines have consistently yielded returns that exceed returns derived solely through application of the NEB ROE Formula. The magnitudes of these differences in returns are not explainable on the basis of differences in business risk. RH--00 Phase II Decision, pages -0.

7 Page of Q. How do the total returns of the pipelines in the Non-Formula Sample differ from TQM s over time? A. Figure. shows that over time the total annual returns of TQM have decreased while the total returns of M&NP, Alliance, and TMPL have increased or remained constant. New projects including AB Clipper, Line Extension and Southern Lights will have higher returns than TQM s current return when they come into service. The total returns plotted in Figure. are calculated assuming an after tax cost of debt of.%. 0 The total returns for 00 and 00 for TQM reflect the NEB ROE Formula and a 0% deemed equity ratio. The 00 total return for M&NP is based on its 00 settlement which includes a % return on.% equity. The total return plotted for M&NP from is based on a % return on % equity, which was re-established several times over this period. 0 The total return for Alliance is based on an adjusted ROE of.% on an equity ratio of 0%. The adjusted ROE was calculated by taking the negotiated % ROE and adjusting it downward by basis points to account for the risk of locking in ROE for a -year period relative to accepting the NEB ROE Formula. This adjustment factor is explained in the evidence of Dr, Kolbe in Appendix. The total return for the Alliance Taylor expansion s is based on an.0% ROE and an equity ratio of 0%. This ROE was calculated using the approved ROE of.% from the NEB GHW--00 Decision and adjusting it downward by basis points to account for the risk of locking in ROE relative to accepting the NEB ROE Formula through 0, as explained in the evidence of Dr. Kolbe in Appendix. This adjustment is conservative given the year lock-in time period. Alliance Pipelines Ltd. GHW--00 Facilities and Toll Methodology Decision, September 00.

8 Page of TMPL s total return is based on an adjusted ROE of 0.0% and an equity ratio of %. The adjusted ROE was calculated by taking the negotiated 0.% ROE and adjusting it downward by basis points to account for the risk of locking in ROE for a year period relative to accepting the NEB ROE Formula. This adjustment is conservative given the short year lock-in time period. The total returns for AB Clipper and Line Extension are based on a negotiated NEB formula ROE plus a basis point premium with an equity ratio of %. 0 The total return for Southern Lights is based on an adjusted ROE of.% on an equity ratio of 0%. The adjusted ROE is calculated by taking the negotiated % ROE and adjusting it downward by basis points to account for the risk of locking in ROE for years relative to accepting the NEB ROE Formula. Figure. TQM vs Non-Formula Sample Allowed Total Returns.00%.%.0%.%.00%.%.0%.%.00% TQM MN&P Alliance AB Clipper/Line Extension Southern Lights TMPL Taylor Expansion

9 Page of 0 Figure. shows that the total returns of the companies in the Non-Formula Sample are higher than those of TQM. Q0. How do the returns of the pipelines in the Formula Sample compare to TQM s returns over time? A0. The total returns of the companies in the Formula Sample are provided in Figure.. The only factor that has caused a change in relative allowed total returns in this sample is a change in equity ratio. TQM was awarded the same equity ratio as the TransCanada Mainline and Foothills (0%) in the RH-- Decision. Since then, the TransCanada Mainline and Foothills have had increases in their equity ratios and now operate pursuant to settlements that result in actual ROEs that exceed the allowed. Figure. TQM vs Formula Sample Allowed Total Returns.0%.%.00%.%.0%.%.00% TQM Mainline Foothills

10 Page of Q. How do the total returns of the Enbridge Mainline compare to TQM s returns over time? A. The actual total returns for the Enbridge Mainline as reported by DBRS are provided in Figure.. The total returns of TQM have decreased while the actual total returns of The Enbridge Mainline have increased over time. Figure. TQM Approved vs Enbridge Actual Total Return 0.0% 0.00%.0%.00%.0%.00%.0%.00%.0%.00%.0%.00% TQM Approved Returns Enbridge Mainline Actual Returns 0 The Enbridge Mainline s actual ROE has ranged from 0.% to %, and its equity ratio has ranged from % to.% over this time period. The total actual returns of the Enbridge Mainline are higher than TQM s returns. Q. What conclusions can be drawn from the comparative analysis? A. The total returns for the companies in the Non-Formula Sample, the negotiated returns of the Enbridge Mainline, and the total returns of the Formula Sample are higher than the total returns for TQM based on a deemed 0% equity ratio and the NEB ROE Formula.

11 Page of 0 0 As shown in the following section, these differences in return cannot be reconciled by differences in business risk alone. The conclusion is that a Formula on 0 total return for TQM would not meet the fair return standard..0 ESTABLISHING COMPARABILITY Q. How is the comparative analysis organized? A. The analysis is organized in two sections. The first section assesses the business risk of TQM and evaluates the change in that business risk since. The second section compares the business risk of the pipelines in the sample groups and the Enbridge Mainline to that of TQM. For comparison to Canadian pipelines, business risks of each of the pipelines and pipeline projects in the samples, and factors which mitigate those risks, were evaluated, using sources of public information. The results of this evaluation were organized into standardized business profiles, included as an Attachment to this evidence. Each profile provides a description of the pipeline, and a review of its long-term and short-term business risk factors. Q. Are long term business risks weighted differently than short term business risks? A. Yes. In conducting the comparative risk analysis, TQM agrees with the conclusion of Dr. Carpenter that long-term business risks should be given greater weight than short-term business risks. Q. Please summarize the results of the comparative analysis. A. The results are summarized in Table -.

12 Page 0 of Table - Comparative Business Risk Summary Pipeline/Project Short-Term Risk Long-Term Risk Overall Risk Relative to TQM 00 Total Return (Assuming.% after-tax debt rate) 00 Total Return TQM O&M fixed for term of settlement. 0% of cost of service covered by deferral accounts. Little revenue risk. Predominantly dependant on WCSB which has decreased supply capability. Partially offset by supply at Dawn and potential LNG. Competition in New England threatens utilization of the PNGTS extension (over half of rate base). Significant competition from alternative fuels in the Québec market. TransCanada contracts on TQM provide limited mitigation. Significant non-renewals in 0 could drive stand-alone treatment of TQM leading to a toll increase and loss of competitiveness and/or toll design changes that lead to non-recovery of invested capital. -.% (NEB Formula ROE.% on 0% equity ratio). Applied-for:.% (% on 0%)..% (NEB Formula ROE.% on 0% equity ratio) Applied for:.% (% on 0%) M&NP (00 Settlement) Lower than TQM. At risk for O&M variance within the year. % of cost of service covered by deferral accounts. Revenue deferral accounts. Alliance Lower than TQM. Flow-through of cost variances. Similar to TQM. Back-stopped for 0 years until 0 by which time over 0% of capital would be recovered. Supply risk greater than TQM as this risk has increased due to the downgrade of off-shore reserves but somewhat mitigated by Deep Panuke, the possibility of LNG plants and New Brunswick production. M&NP is protected from competitive risk as it is the only pipeline connected to its supply areas. Similar to TQM. Fully contracted for initial -year term, with years remaining..% recovery of capital assured through initial contracts. Depreciation incentive to renew on U.S. segment. Default/capacity risk: Creditworthy shippers. Financial assurances. Re-sell the capacity Similar to TQM.% Similar to TQM.% (% on.%). (.% as adjusted for ROE lock-in on 0%)..0% as adjusted for ROE Lock-in on 0% for Taylor expansion Not available, Settlement only covers 00.% (.% as adjusted for ROE lock-in on 0%)..0% as adjusted for ROE Lock-in on 0% for Taylor expansion

13 Page of Pipeline/Project Short-Term Risk Long-Term Risk Overall Risk Relative to TQM 00 Total Return (Assuming.% after-tax debt rate) 00 Total Return Enbridge Mainline Higher than TQM. High cost risk with some costs fixed for years. % of cost of service covered by deferral accounts. Low revenue risk due to Transportation Revenue Variance deferral mechanism. Incentives tied to service levels. AB Clipper/Line Extension Higher than TQM. Non-capital costs will be included in future Enbridge Mainline incentive tolling settlement. Likely to have little revenue risk but will have cost risk. In-service date provision. Initial target capacity provision on AB Clipper. TMPL (00-00 settlement) Higher than TQM. High cost risk with limited deferrals, and inflation of costs over a five-year term. Revenue risk based on capacity incentives. Initial target capacity risk on expansion projects. Southern Lights Lower than TQM. No revenue or cost risk due to deferral type mechanism. All costs recovered from Committed Shippers. Similar to TQM. Minimal supply risk given outlook for oil sands production. Minimal competitive risk in US markets served. Refinery conversions tie refineries to Canadian supplies. Line reversals reduce access to US markets from competing supplies. Lack of contractual protection, and potential for competition to transport growing supplies. Similar to TQM. Minimal supply risk given outlook for oil sands production. Minimal competitive risk in U.S. markets served Refinery conversions tie refineries to Canadian supplies Line reversals reduce access to U.S. markets from competing supplies. Lack of contractual protection, and potential Similar to TQM 00 actual total return:.% Similar to TQM.% (.0% ROE on % equity ratio) (NEB Formula ROE + basis points 0.% on %equity ratio). Not available.% (NEB Formula ROE + basis points 0.% on % equity ratio) for competition to transport growing supplies. Similar to TQM. Similar to TQM.0%.0% Minimal supply risk given outlook for oil sands production. (0.%, as adjusted for (0.%, as adjusted for Low competitive risk due to captive markets ROE Lock-in, on % ROE Lock-in, on % in B.C. and declining US supplies in California equity.) equity.) and Alaska North Slope. California markets forecast to require additional imports of refined products in the future. Lack of contractual protection, and potential for competition to transport growing supplies. Lower than TQM. Low supply risk as supply available from Midwest refineries and from recycling diluent. Low market risk as diluent is required to transport growing oil sands production. Lower than TQM.%.% as adjusted for ROE Lock-in on 0%.%.% as adjusted for ROE Lock-in on 0%

14 Page of Pipeline/Project Short-Term Risk Long-Term Risk Overall Risk Relative to TQM 00 Total Return (Assuming.% after-tax debt rate) 00 Total Return TransCanada Mainline (00-0 settlement) Southern Lights is allocated % of revenue from Uncommitted Shipper revenue. Lower than TQM. O&M risk within a year. 0% of cost of service covered by deferral accounts. Revenue deferral accounts. Foothills Lower than TQM. Incentive agreement for G&A costs, but all other cost variances are flowthrough. 0% of cost of service covered by deferral accounts. Revenue variances are flowthrough. Risk of shipper termination rights if certain benchmarks are not met. Similar to TQM. Predominantly dependant on WCSB which has decreased supply capability. Supply and competitive risk due to contract profile. Competes with Rockies and other basin supplies and potential LNG supplies. Diversified markets. Similar to TQM. Predominantly dependant on WCSB which has decreased supply capability. Diversified markets. Competition due to increasing Rockies production. LNG provides competition in California and potentially in Pacific Northwest markets. Similar to TQM.% Similar to TQM.% (NEB Formula ROE.% on 0%) (NEB Formula ROE.% on %).% (NEB Formula ROE.% on 0%).% (NEB Formula ROE.% on %

15 TQM 00 and 00 Fair Return Application Page of 0 0. TQM Business Risk Q. What is the overall assessment of TQM s business risk? A. TQM s overall business risk has increased since it was last reviewed by the Board in the RH-- proceeding. Long-term business risk has increased in the areas of supply risk and competitive risk. The following review of TQM s business risk is supported by the detailed analysis contained in the evidence of Dr. Carpenter. Q. Has the relative risk assessment between TQM, Foothills and the TransCanada Mainline changed since the RH-- Decision? A. No. In the RH-- Decision, the Board stated: The Board recognizes that the gas pipelines have some individual characteristics, described in its views above, which differentiate one from another. On balance, however, the Board is of the view that the overall business risks of TransCanada, Foothills, ANG, and TQM balance out such that a similar common equity ratio can be given to those four pipelines. It is TQM s view that this balance has not changed over time. Like Foothills and the TransCanada Mainline, TQM has experienced an increase in business risk since. The NEB has assessed increased supply and competitive risk for the Mainline since. Capacity on TQM is part of the TransCanada Mainline integrated system so TQM has experienced similar increases in supply and competitive risk. Q. How has the NEB found that the TransCanada Mainline s supply risk has increased since RH--? A. The Board has twice increased the TransCanada Mainline cost of capital, due in part to an assessment of increase in supply risk. The RH--00 Decision increased the NEB RH-- Decision, page. Foothills now includes what was previously known as the B.C. System after TransCanada purchased it from ANG.

16 Page of 0 0 TransCanada Mainline equity ratio from 0% to %. The RH--00 Phase II Decision increased the equity ratio to %. Q. How has TQM s supply risk increased since the RH--00 Phase II Decision? A. To demonstrate the increase in TQM s supply risk since the RH--00 Phase II Decision, TQM provides the TransCanada TQM Throughput Study filed as Appendix to the Application. Since 00 TransCanada s supply forecast for the Western Canada Sedimentary Basin ( WCSB or Basin ) has declined, and TQM s supply risk has increased. There is no longer an expectation of future supply growth, and the likelihood of a sustained production decline has increased. There is also greater uncertainty with respect to future supplies than was the case in 00 due to increased volatility in gas prices and uncertainty associated with developing unconventional resources. Q0. How has the level of optimism regarding Basin supply changed since 00? A0. Prior to 00, WCSB supply had increased significantly over a 0 year period. The Ladyfern discovery in 00 also provided more optimism that larger gas pools remained to be discovered and that gas supply would continue to increase, albeit at a slower rate. The industry was generally more optimistic. Although TransCanada reflected a similar optimism in its 00 supply forecast, it did state that the Basin was maturing and suggested that there was more downside risk than upside potential if the Basin did not perform as expected considering the high price environment. What TransCanada has observed since is that the risk of there being more downside than upside has been realized. The industry s view in 00 was that there was a lag in production development and that production would eventually increase. While production has increased in some years, it has not been sustained. In 00, there was a view that high gas prices would be the catalyst for significant activity and sustained supply growth. The significant activity levels since 00 have not translated into material supply growth. While gas well connections increased from an estimate of,00 in 00 in the evidence

17 Page of filed in the RH--00 proceeding to a high of,00 in 00, production has remained essentially flat. Q. How does TransCanada s 00 supply forecast compare to other supply forecasts? A. In general, other supply forecasts are lower. For example, Figure. shows scenarios from a November 00 NEB Report. Bcf/d Figure. Supply Forecast Comparison Historical NEB Continuing Trends NEB Fortified Islands NEB Triple E Q. What factors have led TransCanada to be less optimistic about WCSB supply than in 00? A. TransCanada is less optimistic due to the following factors: The trend of higher supply cost; NEB Canada s Energy Future Reference Case Scenarios to 00, November 00.

18 Page of 0 Diminishing shallow drilling prospects, which have been the engine of supply growth; No significant increase in activity in the high resource potential areas, in spite of higher gas prices, primarily due to the high risk nature of developing the resource in an uncertain price environment; Unconventional supply estimates are lower; Mackenzie pipeline has been delayed; Uncertainty and costs introduced by Government decisions on income trusts and royalties; and Higher Canadian currency exchange rate resulting in lower revenues for producers. 0 TransCanada has not only reduced its supply forecast since 00, its level of optimism about future supply has also changed. Q. Does the short-term performance of the Basin influence the longer-term supply view? A. Yes. Short-term performance of the Basin is informative and does influence the longerterm view. When the Basin supply is not performing as expected given a set of inputs, then the longer term view would also have to be adjusted accordingly. For instance, while past forecasts have assumed relatively flat supply costs as a result of technological improvements, the recently experienced increase in supply costs has placed this assumption in question. As illustrated in Figure. there has been a step change in supply costs that does not seem to be short-term or temporary in nature. Figure. presents a history of the -year rolling average of finding and development costs. This actually masks the recent dramatic increase in annual finding and development costs. TransCanada s long-term forecast has not fully considered the impact of higher supply costs and its forecast would be lower if the current trend of higher costs is sustained.

19 Page of $.0 Figure. Gas and NGL Finding and Development Costs (-year rolling average) $/Mcfe :) $.00 $.0 $.00 $.0 $.00 $0.0 $ E 00F 00F Higher costs reduce supplies available at a given price level, and create uncertainty with respect to the economic viability of future supplies. The discovery of smaller and smaller gas pools and falling initial production ( IP ) rates indicate a trend towards higher costs and lower gas supply availability in the future. These factors are evidence of increased supply risk. 0 Q. Are there any factors which offset TQM s increased supply risk? A. Yes. TQM s supply risk is partially offset by the potential for alternative supplies from Dawn, but Dawn supplies may not completely substitute for declines in WCSB supplies to TQM or be available at delivered prices in Québec that are as competitive as was WCSB gas historically. The future potential for LNG supply could also mitigate some of TQM s supply risk. TQM is preparing an application for facilities connecting the receipt point at Gros Cacouna to the existing TQM system. The Rabaska terminal has also been approved and would connect to the TQM system. However, LNG as a supply source is inherently risky on two grounds. First, there is the risk that the regasification projects will not materialize due to environmental, regulatory and market reasons. Second, even if they are

20 Page of 0 0 successfully developed, there is a risk of underutilization of these projects if LNG supplies themselves are tight or not available. The supply of LNG is subject to global competition, and unlike pipeline supply it can be (and is) diverted to other markets at a short notice depending on the nature of the upstream contracts the regasification facility is able to secure. Overall, TQM s supply risk is similar to that of the Mainline, and has increased since and since 00. Q. Has TQM s competitive risk increased since? A. Yes. TQM serves two markets, the Québec market through the Gaz Métro distribution network and the New England market via the Portland Natural Gas Transmission System ( PNGTS ) extension. Competition has increased in both markets. Q. What is the assessment of competition in the Québec market? A. Competition has intensified in the Québec market since. Natural gas has become less competitive relative to both fuel oil and electricity over the last decade. TQM s industrial customers in Québec have declined in number and reduced their aggregate throughput volumes since. Gaz Métro faces a continuing prospect of losses in industrial load due to fuel switching, with of its industrial customers (representing annual load of roughly Bcf) at risk. This risk is not offset by the recent addition of the Bécancour cogeneration plant, since its future utilization is uncertain (it will not operate for all of 00, and possibly beyond). This trend introduces significant uncertainty around the future use of TQM s assets that serve gas customers in Québec. Q. How does competition in the New England market impact TQM? A. Competition to serve the New England market impacts the PNGTS extension to East Hereford which serves this market in conjunction with the PNGTS system. The PNGTS

21 Page of 0 0 extension currently constitutes % of TQM s rate base. The Throughput Study shows reduced throughput on this extension in 00 as a result of LNG imports. The New England market has become more competitive with the construction of the Canaport and Northeast Gateway LNG projects, and approval of the Neptune project that will serve this market. Current PNGTS customers will have options to source their gas from other locations such as these LNG plants so they may not utilize the PNGTS extension to make deliveries in New England. This risk increases as the contracts that PNGTS customers have to East Hereford on the TransCanada Mainline expire throughout 00 to 00. This constitutes a major increase in competitive risk faced by TQM since the RH-- Decision. Q. How does the increase in competition in Québec and New England impact TQM? A. The main TransCanada transportation contract on TQM expires in 0, at which point % of TQM s invested capital will remain to be recovered. If the increase in competitive risk leads to decontracting in one or both markets, the total cost of the TQM system may have to be recovered from much lower volumes. As a result, TransCanada could face pressure to change the Mainline toll design and remove all or part of the contracted capacity on the TQM system from the Mainline integrated system. Full standalone treatment of TQM would result in a to increase in tolls to TQM s markets which would further negatively impact the competitiveness of TQM. The idea of standalone tolling of TQM has been raised in the past, most recently by the Alberta Department of Energy during the Gros Cacouna receipt point proceeding (RH--00). Q. Has TQM s overall business risk changed since? A. Yes. Both supply risk and competitive risk have increased TQM s long-term business risk creating greater uncertainty around the recovery of capital invested in TQM s assets before the end of the economic life of these assets. The evidence of Dr. Carpenter (Appendix ) provides a more detailed analysis of TQM s business risk.

22 Page 0 of 0 0. M&NP.. M&NP Total Return Comparison Q0. What has the Board said in the past about the business risk of M&NP? A0. In the RH--00 Phase II Decision the Board stated: With respect to differences in circumstances, the Board notes that some of these pipelines returns were set at a time when the cost of capital was higher than it is currently. Further, two of the pipelines, Alliance and M&NP, locked in their returns for a number of years. A higher return may be required for bearing the risk associated with locking in returns or rates over an extended period of time. Q. Is it necessary to consider adjusting the return of M&NP to reflect the lock-in of the return for a number of years and for it being set at a time when the cost of capital was different? A. No. M&NP s 00 return is based on a one-year settlement for 00, which set the ROE at % and equity ratio at.%, resulting in a total return of.%. Therefore, M&NP s 00 return is directly comparable to TQM s without considering whether an adjustment is required for locking-in its return. Q. Is any adjustment required to the M&NP return to account for the greenfield nature of the investment? A. No. All else equal, a new pipeline should not and does not require a greater return than an existing pipeline. Each has capital deployed for the same purpose and each has a long-term horizon. Differences in the risk associated with the market being served or the supply source are included in the evaluation under these topics. RH--00 Phase II Decision, page.

23 Page of M&NP Risk Comparison Q. How does the current business risk of M&NP compare to that of TQM? A. M&NP s current business risk is similar to that of TQM. Relative to TQM, M&NP has higher supply risk, which is partially offset by greater contractual support from a 0-year backstopping agreement with ExxonMobil, lower competitive risk and lower short-term risk. Q. How does M&NP s contract protection differ from that of TQM? A. M&NP s actual contract profile is less significant than the risk mitigation offered by the fact that ExxonMobil has agreed to contract any otherwise uncontracted capacity of M&NP over the first 0 years of operation. The ExxonMobil backstop provides great certainty that M&NP will recover its capital and its return on capital over this period. Since M&NP had a % depreciation rate, which was recently increased to.%, there is less than five years of exposure following expiry of the backstop agreement. As discussed above, TQM could experience decontracting on all or part of its system in a much shorter timeframe. Q. What is the supply outlook for M&NP relative to TQM? A. The supply risk of M&NP has increased with the downward revision of Sable Island gas reserves. This risk is partially offset by the possibility of LNG plants that could deliver to the M&NP system. M&NP s supply risk is also partially offset by potential gas reserves in New Brunswick and gas supply from the Deep Panuke project. The supply risk of TQM has increased over time, as the supply capability of the WCSB has decreased. On balance, since both M&NP and TQM have the potential to transport LNG, M&NP s supply risk is greater than TQM s because of its reliance on a smaller reserve base. Maritimes & Northeast Pipeline Management Ltd. (M&NP) Tolls Settlement and Application for Final Tolls January 00 December 00 (00 Tolls Settlement)

24 Page of 0 0 Q. What is the competitive risk for M&NP relative to that of TQM? A. M&NP s competitive risk is lower than that of TQM. M&NP is the only pipeline connecting gas supplies in its supply area. This mitigates the competitive risk as M&NP producers must either accept lower netbacks in the face of competition or shut in their gas. TQM faces greater competitive risk since the producers in the WCSB and other basins have market options for their gas. In addition, TQM serves the Québec market which has competition from alternative fuels. Q. What is the short-term risk for M&NP relative to that of TQM? A. M&NP has lower short-term risk than TQM. M&NP has % if its cost of service covered by deferral accounts while TQM has only 0% deferral account coverage. Both are protected from revenue risk. Q. Please summarize the comparison of M&NP to TQM. A. M&NP is a relevant and meaningful comparable to TQM in application of the fair return standard. M&NP s total return is higher than the current return of TQM, while the business risk of M&NP is similar to TQM s risk.. Alliance Pipeline.. Alliance Total Return Comparison Q. What has the Board said in the past about the business risk of Alliance? A. In its RH--00 Phase II Decision, the Board stated: The Board accepts that the level of risk faced by Alliance is sufficiently similar to the Mainline to make comparison relevant. However, when making comparisons, there is validity in adjusting Alliance s return to account for differences in circumstances. In particular, prior to comparing it with the Mainline, the return of Alliance should be adjusted to reflect the different risk-reward relationship of the two pipelines and the cost of capital environment that existed at the time that Alliance s return was set.

25 Page of 0 0 Unlike the Mainline, Alliance took on construction cost risk, locked in its return over an extended period of time, and took on some capacity risk. On the other hand, Alliance s long-term contracts tend to mitigate, in part, these additional risks. Comparison with Alliance s return ought to account for the different set of circumstances, including construction cost risk, whether such a risk was mitigable or not, and differences in the cost of capital and interest rate environment that prevailed at the time the return was set. Q0. What is TQM s response to these concerns? A0. TQM addresses the Board s concerns in three ways. The first is to point to a 00 NEB Decision that approves an.% ROE on 0% equity ratio for an Alliance expansion in the current capital market, and without construction cost risk. The second is to explain why an adjustment for the Alliance capital incentive mechanism is not required. This discussion is included in the evidence of Dr. Kolbe (Appendix ). The third is to adjust the negotiated ROE downward by basis points to account for the risk of locking in ROE for a multi-year period relative to accepting the NEB ROE Formula. This adjustment factor is explained in the evidence of Dr. Kolbe (Appendix ). Q. Please describe the reaffirmation of Alliance s.% ROE on 0% equity ratio. A. The Board approved Alliance s Taylor expansion in the GHW--00 Decision. Alliance did not purport to accept construction cost risk for the expansion. The cost of the expansion and the toll for the new service reflects an ROE of.% and an equity ratio of 0%. However, the Board specifically found that the founding compact of Alliance was only the tariff 0 and did not extend to the negotiated agreement which established the incentive rate of return. The result is that the Board approved a return of.% for Alliance without any of the differences in circumstances that existed in. 0 TransCanada PipeLines Limited 00 Mainline Tolls and Tariff Application, RH--00 Phase II Decision April 00, pp. -0. Alliance Pipeline GHW--00 Decision, page.

26 Page of 0 0 Q. Alliance was initially a greenfield pipeline. Can greenfield pipelines be directly compared to existing pipelines? A. Yes. The returns of greenfield and existing pipelines should only reflect nondiversifiable risks, since other risks can be eliminated through diversification. As such, greenfield pipelines and existing pipelines can be compared just as existing pipelines can be compared against each other. In other words, comparison of total returns of greenfield and existing pipelines is relevant and meaningful in application of the fair return standard provided that business risk differences are appropriately accounted for... Alliance Business Risk Comparison Q. How does Alliance s business risk compare to TQM s? A. The overall business risk of Alliance is similar to that of TQM. Q. Please describe the long-term risk faced by Alliance relative to TQM. A. Alliance is fully contracted for the primary term of its contracts. Also, Alliance s U.S. contracts include an incentive for contract renewal, which would likely lead to the renewal of matching capacity on the Canadian system. Alliance relies on gas produced from the WCSB, although it is connected to an area of supply growth and is able to attach new supply if necessary. Alliance delivers to a competitive market which has access to many other end markets. Alliance also faces default/capacity risk as it agreed to calculate its demand charges as costs divided by the greater of, MMcf/d or contracted capacity. The effect of this clause is to place the risk of shipper default on Alliance, rather than other shippers, at least initially. This capacity risk is mitigated by the creditworthiness of Alliance s shippers, the financial assurances obtainable under the Alliance tariff and the opportunity for Alliance to re-market the capacity of the defaulting shipper. Calpine s insolvency Alliance Toll Principles, Article.

27 Page of 0 freed about 0 MMcf/d of capacity on Alliance in the spring of 00. Alliance was able to re-contract the capacity on a short-term basis (currently under contract from 00 to 00) and may continue to do so. Nevertheless, Alliance faces greater capacity risk by virtue of its agreement not to allocate the impact of shipper defaults to other shippers. TQM s contract with TransCanada expires in 0, providing contract protection similar to that of Alliance. TQM s supply risk related to the WCSB is somewhat offset by access to alternative supply basins through Dawn and the prospect of LNG supplies. TQM has a high level of competitive risk in its Québec and New England markets, but does not face default/capacity risk. On balance, Alliance has similar long term risk to that of TQM. Q. How does the short-term risk of Alliance compare to the short-term risk of TQM? A. Alliance has lower short-term risk than that of TQM. TQM has greater cost-risk exposure since Alliance flows through all annual variances automatically while TQM has limited deferral accounts. Q. Please summarize the comparison of Alliance to TQM. A. Alliance is a relevant and meaningful comparable to TQM in application of the fair return standard. Alliance s overall business risk is similar to that of TQM s risk while Alliance s total return is higher. Alliance Pipeline, Application for Tariff Amendment Award of Available Firm Service Capacity, August, 00.

28 Page of 0 0. Oil Pipelines Comparison Q. Does TQM believe that it is relevant and meaningful to compare the risks and returns of oil pipelines to those of gas pipelines, including TQM, in application of the fair return standard? A. Yes. Q. How has the Board viewed comparisons to oil pipelines in the past? A. In the RH--00 Phase II Decision, the Board assessed the comparison made by TransCanada of its Mainline and the Enbridge Mainline and gave it no weight. The Board stated: The Board does not agree with TransCanada s proposition that Enbridge is of comparable risk to the Mainline. The Board notes that it has traditionally viewed oil pipelines as riskier than gas pipelines, given oil pipelines common carrier status supported only by monthly nominations, and because of operational complexities arising from the multi-product nature of their operations. None of the evidence presented by TransCanada supports the conclusion that the changed environment in which the Mainline operates has reduced or eliminated these differences in business risks. Further, even if these pipelines were of comparable risk, the Board notes that Enbridge s financial parameters have been determined through negotiation for the past decade and are reflective of the package agreed to for an oil pipeline at the time those settlements were negotiated, not of cost of capital for a gas pipeline in 00. The Board gave no weight to the comparison with Enbridge. NEB Decision RH--00 Phase II, pp. -.

29 Page of 0 0 Q. What is TQM s response to the Board s statements? A. TQM has analysed the differences between oil and gas pipelines in greater detail, and has sought to understand what the Board describes as the origin of the traditional view of relative risk between gas pipelines and oil pipelines. When comparing the historical circumstances to the situation that exists today, it is clear to TQM that the traditional view does not hold and that TQM s business risk is comparable to that of Enbridge and TMPL. Q0. What are the origins of what the Board describes as the traditional view of the relative risks of gas and oil pipelines? A0. TQM understands that the common carrier/contract carrier difference between oil pipelines and gas pipelines stems from the National Energy Board Act, although new oil pipelines and expansions of existing oil pipelines are increasingly underpinned by long term contracts. This is a risk issue that relates to the term of contractual commitments and the creditworthiness of the contracting shippers. It also relates to the certainty of revenue recovery, since contract carriers recover fixed costs from contract holders through demand charges, whereas common carriers collect all costs over forecast volumes. Another related difference is that in the past when oil pipelines such as TMPL and the Enbridge Mainline set tolls according to their cost of service, their earnings were subject to variations between forecast and actual volumes and costs since they had no deferral accounts. An oil pipeline could apply for new tolls based on revised volumes and/or costs if the return on equity were forecasted to vary by over 00 basis points from the approved level. This recourse left oil pipelines exposed to some degree of volume risk and cost risk due to the lag between filing new tolls and having them approved, and the explicit allowance of a 00 basis point variance in the achieved ROE. NEB, Orders TO--, TO--, and TO--, by letter dated June 0, re: Adjustment of Tolls and Tariffs of Certain Oil and Oil Products Pipeline Companies.

30 Page of 0 0 These differences related to contract and common carriage appear to have been the primary reason that oil pipelines were traditionally considered riskier than gas pipelines and awarded higher equity ratios. TQM has been unable to find any NEB decision that expresses a conclusion that the relative business risk of oil pipelines is higher than gas pipelines due to operational complexities arising from the multi-product nature of the operations of oil pipelines. In the RH-- Decision, The Enbridge Mainline (then Interprovincial Pipe Line) was awarded % equity on the basis of business risk. Later in the RH-- proceeding, TMPL was awarded a % equity ratio on the basis of business risk, while TQM, Foothills, and the TransCanada Mainline were awarded a 0% equity ratio. Q. How do the tolling methodologies and circumstances today compare to those that may have led to the traditional view of the relative risk of oil and gas pipelines? A. There have been significant changes since the early 0s. At that time, TQM, the Enbridge Mainline and TMPL applied for cost-of-service based tolls. However, the Enbridge Mainline and TMPL have not calculated rates using their traditional methodology for over a decade. The traditional methodology was replaced by settlements that are based on a different model. They are no longer exposed to the same level of risk and earnings variability. Since, TQM s average contract term has decreased by approximately %. This has diminished although not eliminated the higher relative risk exposure of operating under the common carrier regulatory model with contract terms of one month. As a result of these changes, oil and gas pipelines are more relevant for comparison purposes. The appropriate comparison is to current returns in the current risk environment, as illustrated in the recent commercial agreements for AB Clipper and Line Extension, and TMPL, all of which have explicit ROEs and equity ratios, and to the actual returns of the Enbridge Mainline as generated by its negotiated settlements.

31 Page of 0 0 Q. Are oil pipelines exposed to additional risk due to complexities arising from the multi-product nature of their operations? A. TQM does not believe so. Presumably this is the risk that operating a multi-product, batched pipeline could result in contamination, degradation and the loss of liquids that would affect an oil pipeline s earnings. There is no evidence that an oil pipeline has been exposed to any such risk. The Enbridge Mainline, for instance, has traditionally recovered any such costs as a part of its cost of service. These costs are recovered as part of the Starting Point associated costs under the Enbridge Mainline current settlement, and the Enbridge Mainline generates revenue through the collection of allowance oil as an offset to these costs. The Enbridge Mainline also has tariff protection against claims of loss from shippers, and in the past has recovered the cost of a contamination claim through a Non-Routine Adjustment under its Incentive Tolling Settlement. In the case of TMPL, costs associated with contamination and degradation are treated on a flow-through basis in the settlement. 0 TMPL also has tariff protection against loss claims from its shippers. Q. Are there any other considerations which have changed the relative risks of oil and gas pipelines since the early 0s? A. Yes. In the RH-- Decision, the Board considered supply risk to be low for both oil and gas pipelines. In describing supply risk for oil pipelines the Board stated: The Board s view on crude oil supply risk is that the resource base, in terms of both the remaining established reserves as well as discovered and undiscovered resources, is sufficiently large and diversified to support the existing pipelines beyond their current NEB Decision RH-- pp ; NEB Decision RH--, pp. Enbridge Pipelines, 00 Revenue Requirement, April, 00, note to Statement 0. Enbridge Pipelines, 00 Revenue Require`ment, April, 00, draft tariff NEB No., p. Enbridge Tariff NEB 0, p, Article. Enbridge Pipelines, Calculation of 00 Tolls, Statement 0., SEP II Line / Recoverable Payment, Page. 0 TMPL ITS. Schedule..