Cash Working Capital Allowance Analysis of Semi-Annual Long-Term Bond Interest Payments Newfoundland and Labrador Hydro April 2003
Table of Contents Page # 1. INTRODUCTION... 1 2. REGULATORY CONSIDERATIONS... 2 3. HYDRO S APPROACH TO COST OF DEBT CALCULATION... 5 3. SUMMARY...9 Interest and Working Capital Newfoundland & Labrador Hydro April 2003
1. INTRODUCTION In Newfoundland and Labrador Hydro s ( Hydro ) last 2001 General Rate Application ( GRA ), Mr. Mark Drazen, the witness for the Town of Labrador City, proposed that the Cash Working Capital calculation should take into account the timing differences associated with semi-annual long-term bond interest payments and the receipt of the funds for their payment. At page 100 of Order No. P.U. 7 (2002 2003) the Board concluded, At the present time the Board will not act to adjust the CWCA to reflect the timing difference between the payment of semi-annual long term bond interest and the receipt of the funds for their payment. The Board feels this issue warrants further consideration and will require NLH to submit to the Board, prior to the next rate application, an analysis of this issue. In Order No. P.U. 7 (2002 2003) section 19 (page 179), the Board ordered Hydro to file a study of the implications upon Cash Working Capital Allowance of the timing difference between the payment of semi-annual long term bond interest and the receipt of the funds for their payment. This report is filed in response to that order. In considering this issue, Hydro consulted with its expert financial witness for its 2003 GRA, Ms. K. Mcshane. Ms. Mcshane of Foster Associates Inc. provided the comments for the section below, entitled Regulatory Considerations. In addition, Hydro reexamined the issue, in light of the methodology it uses in the estimation of the cost of debt. Hydro s approach, because it is iterative in nature, as opposed to being forecast on a projected debt schedule, automatically adjusts for the timing issues associated with semi-annual interest. Further detail on this is contained in the section entitled, Hydro s Approach to Cost of Debt Calculation. Page 1
2. REGULATORY CONSIDERATIONS Regulators, in general, define the cash working capital allowance as the average amount of capital provided by investors, over and above the investment in plant and other specifically measured rate base items, to bridge the gap between the time expenditures are made and the time payment is received for service provided. The following summarizes the regulatory posture in North America generally on including interest expense in the calculation of cash working capital: The treatment of funds relating to net operating income is subject to a wide difference of opinion in the evaluation of lead/lag study procedures. From a theoretical standpoint, operating income is earned when service is provided, and the operating income is the property of the investors in the company when earned. This view would recognize a cash working capital requirement for the lag in receipt of operating income. Such a requirement is equal to the revenue lag days multiplied by an amount equal to one day s operating income. The amount for interest or preferred dividends would not be offset, because those amounts are paid from funds belonging to investors (operating income). At the opposite end of the spectrum, on occasion parties have suggested that a source of cash working capital exists in the delay in disbursement of interest, preferred dividends, and dividends on common equity. Robert Hahne and Gregory Aliff, Accounting for Public Utilities, Newark, N.J.: Matthew Bender, 1998, 5-28. Page 2
2. REGULATORY CONSIDERATIONS (cont.) The approach used to estimate the cash working capital allowance for Hydro in P.U. 7, and for Newfoundland Power since at least 1987, focuses solely on the day-to-day operating expenses, not the financing costs. This approach is similar to that which has been adopted for most of the major rate-base regulated utilities in Canada (e.g., BC Gas, the Ontario utilities, the Québec utilities 1, Nova Scotia Power and the NEBregulated pipelines). The approach does not include depreciation or elements of the return on rate base in the calculation of cash working capital allowance. To quote a National Energy Board decision in this regard: The Board believes that an allowance for cash working capital is established to provide Westcoast s shareholders with a return on the funds they have invested, in addition to those invested in plant and inventories, which the Company requires to conduct its utility operations. These funds are typically used to pay employees salaries and wages, purchase outside services and various other supplies and services which the Company requires in its daily operations.... With regard to the payment of interest on long-term debt and preferred share dividends, the Board is of the opinion that these items, which are not a function of operations but of the financing of the Company, are components of the rate of return. Furthermore, they relate to contractual obligations entered into between Westcoast s shareholders and the Company s other investors. As such, they do not involve the day-to-day operations of the Company, and do not properly belong in the calculation of the cash working capital allowance. (National Energy Board, Reasons for Decision, Westcoast Transmission Company Limited, August 1986.) 1 The procedure was recently reviewed for both Gaz Metro (Decision D-99-11, February 10, 1999) and Gazifère (Decision D-2001-55, February 19, 2001). The Régie declined in both cases to include interest expense in the calculation of the cash working capital requirement. Page 3
2. REGULATORY CONSIDERATIONS (cont.) The Alberta Energy and Utilities Board is the only Canadian regulator who includes all financial items in its calculations of the cash working capital allowance. It includes depreciation at a zero payment lag, recognizes a lead in receipt of revenues related to interest, preferred and common equity dividends, and includes the retained earnings component of the equity return at a zero lag (e.g., Decision U97065, October 1997). The Board concluded that the portion of the common equity return that was retained in the business should be treated similarly to depreciation, i.e., at a zero payment lag. The Board stated that depreciation and return were internally generated sources of funds used to finance plant additions. Although there was no certainty regarding the timing of the reinvestment, the assumption was made that the expenditures occur uniformly throughout the year, with a payment date equivalent to the service provision date. The last point is critical. If interest expense is included in the lead/lag study, but there is no consideration of when cash is used for capital expenditures, the estimate of the total cash working capital requirement is understated. Page 4
3. HYDRO S APPROACH TO COST OF DEBT CALCULATION Hydro s approach to estimating its interest expense, further mitigates in favour of excluding a consideration of interest payment timing from the cash working capital calculation. Through an iterative approach to interest estimation, Hydro explicitly takes into account the timing differences between the payment of semi-annual interest, and the receipt of related revenues. By explicitly including the interest earned as a result of such timing differences, in the cost of debt calculation, the amount of interest expense included in the revenue requirement is reduced accordingly. An illustrative example of the methodology follows. Table 1 illustrates the one year debt servicing cash flows associated with a $5 million bond issued at par, and carrying a semi-annual coupon rate of 10%. TABLE 1 Monthly Cash Flows to Service 10% Coupon $ 5 Million Bond issued at Par Month Debt Service Cash Flow 1 2 3 4 5 6 250,000 7 8 9 10 11 12 250,000 Page 5
3. HYDRO S APPROACH TO COST OF DEBT CALCULATION (cont.) Mr. Drazen s argument is that while the annual cost of debt arising from this is 10%, the total $500,000 interest expense would be factored into rates, and would produce a revenue cash flow stream that is received monthly, hence producing a stream of cash flows as in Table 2. TABLE 2 Monthly Cash Flows Accruing Through Rates MONTH REVENUE CASH FLOW $ 1 41,667 2 41,667 3 41,667 4 41,667 5 41,667 6 41,667 7 41,667 8 41,667 9 41,667 10 41,667 11 41,667 12 41,663 Total 500,000 Page 6
3. HYDRO S APPROACH TO COST OF DEBT CALCULATION (cont.) Mr. Drazen argues that based on Tables 1 and 2, cash flows related to revenue are received in advance of debt service. This is not the case for Hydro, because Hydro s interest and cost of debt model is iterative. This means that advance cash flows, such as those referred to in Table 2, are iterated back through the model in the determination of Hydro s final cost of debt. Hydro s model assumes that such advance cash flows are available to reduce short-term debt requirements. For simplicity, the effect of this, assuming that such advance funds were invested at a rate of return 2 is illustrated in Table 3. TABLE 3 Iteration of Timing Differences Month Revenue Cash Flows Investment Account Earnings Debt Service Cash Flow Investment Account Balance 1 41,667 174 41,840 2 41,667 348 83,855 3 41,667 523 126,045, 4 41,667 699 168,410 5 41,667 875 210,952 6 41,667 11 250,000 2,630 7 41,667 185 44,481 8 41,667 359 86,506 9 41,667 534 128,707 10 41,667 710 171,084 11 41,667 886 213,637 12 41,663 22 250,000 5,326 Totals 500,000 5,326 500,000 2 Assumed to be 5% for the purposes of this illustration. Page 7
3. HYDRO APPROACH TO COST OF DEBT CALCULATION (cont.) Hence, because of the nature of Hydro s methodology, the reported cost of debt in this instance, instead of 10%, is 9.9%, calculated as follows: Net debt outstanding = $4,994,674 (Principal outstanding less Investment Account - $5,000,000 - $5,326) Interest cost = $494,674 ((Semi-annual interest less interest earned - $500,000 - $5,326) Cost of debt = 9.9% (Interest cost divided by net debt outstanding) Consequently, Hydro s weighted average cost of capital, and therefore its required return on rate base, is reduced in proportion to the benefit received from the timing of payments related to semi-annual interest. Page 8
3. SUMMARY If interest payments are to be included in the lead/lag study, all items related to financing need to be included. If the cash working capital allowance is interpreted in the broad sense of measuring the full extent to which investors have financed the full cost of service, leads and lags on all elements of the return of and on capital need to be taken into account. Hydro recommends to the Board that it continue to approve the methodology utilized by Hydro for the determination of its cash working capital allowance. That approach focuses on Hydro s operating expenses and measures the additional capital provided by investors to sustain day-to-day operations between the time service is provided and payment received. This analysis concludes that, while there may be a theoretical validity to an approach which considers all financial terms, including depreciation, that approach adds a degree of complexity which is unwarranted for the purpose of estimating a reasonable cash working capital allowance, particularly given that Hydro s method of forecasting interest expense and the cost of debt already reflects the timing of semi-annual interest payments. Page 9