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NATIONAL ENERGY BOARD in the MATTER of the National Energy

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NATIONAL ENERGY BOARD in the MATTER of the National Energy Enbridge – Line 9 Appendix A-7.2 NATIONAL ENERGY BOARD IN THE MATTER OF the National Energy Board Act and the Regulations made under it; and IN THE MATTER OF an Application by Enbridge Pipelines Inc. pursuant to Part IV of the National Energy Board Act for the approval of tolls and tariffs for westbound service on its Line 9. ENBRIDGE PIPELINES INC. APPENDIX A-7.2 TO LINE 9 APPLICATION Expert Evidence – Prepared Testimony of Kathleen C. McShane (Foster Associates, Inc.) ENBRIDGE PIPELINES INC. LINE 9 Prepared Testimony of KATHLEEN C. McSHANE FOSTER ASSOCIATES, INC. Bethesda, MD. 20814 December 2009 TABLE OF CONTENTS Page No. I. INTRODUCTION AND PURPOSE OF TESTIMONY 1 II. BACKGROUND 3 III. FAIR RETURN STANDARD 4 IV. ANALYTICAL FRAMEWORK 5 V. CAPITAL STRUCTURE 9 A. The Stand-Alone Principle 9 B. Compatibility of Capital Structure with Business Risks 10 C. Maintenance of Creditworthiness/Financial Integrity 10 D. Ability to Attract Capital on Reasonable Terms and Conditions 11 E. Comparability of Returns 13 VI. BUSINESS RISKS OF ENBRIDGE 13 A. Conceptual Considerations 13 B. Trend in Business Risks 14 VII. CAPITAL STRUCTURES OF CANADIAN OIL PIPELINES 20 VIII. CAPITAL STRUCTURE GUIDELINES OF DEBT RATING AGENCIES 25 IX. RETURN ON EQUITY FOR ENBRIDGE 27 A. Alternative Approaches 27 B. The Multi-Pipeline ROE Formula 28 C. Adjusted Benchmark Pipeline ROE Formula 34 D. Equity Risk Premium for Enbridge 40 APPENDIX A: Qualifications of Kathleen C. McShane APPENDIX B: Canadian Liquids Pipeline Overview APPENDIX C: Selection of Benchmark Utility Sample and Construction of DCF Cost of Equity Estimates 1 I. INTRODUCTION AND PURPOSE OF TESTIMONY 2 3 My name is Kathleen C. McShane and my business address is 4550 Montgomery 4 Avenue, Suite 350N, Bethesda, Maryland 20814. I am President of Foster Associates, 5 Inc., an economic consulting firm. I hold a Masters in Business Administration with a 6 concentration in Finance from the University of Florida (1980) and the Chartered 7 Financial Analyst designation (1989). 8 9 I have testified on issues related to cost of capital and various ratemaking issues on behalf 10 of oil and gas pipelines, electric utilities, local gas distribution utilities, and telephone 11 companies, in more than 200 proceedings in Canada and the U.S. My professional 12 experience is provided in Appendix A. 13 14 Enbridge Pipelines Inc. (“Enbridge Pipelines”) owns and operates the Enbridge System 15 which is comprised of three segments; one of them is Line 9, which transports liquid 16 petroleum from Montréal, Québec to Sarnia, Ontario.1 The Line 9 assets are described in 17 Appendices A-1 and A-4 to Enbridge’s application for final tolls and tariffs for 2008, 18 2009 and 2010.2 I have been asked by Enbridge Pipelines to assess the reasonableness of 19 its proposed capital structure and recommend a rate of return on equity (“ROE”) for its 20 Line 9 operations on a stand-alone basis; that is, as if Enbridge Pipelines’ only business 21 were owning and operating Line 9. I use the term “Enbridge” for this purpose. My 22 conclusions are summarized below. 23 24 1. The proposed common equity ratio of 50% for Enbridge is reasonable based on: 25 26 (a) its relative business risks; 27 (b) capital structure guidelines issued by the debt rating agencies; 28 (c) the allowed and actual capital structures maintained by other oil 29 pipelines regulated by the National Energy Board (“NEB”). 1 The other two segments for toll-making purposes are the Older System and the Oil Products Transportation System (Line 8). 2 Line 9 was formerly known as the Montréal Extension when it was in west to east service. 3098 Enbridge-Line 9 Foster Associates, Inc. Page | 1 30 31 2. The point of departure for estimating the fair ROE for Enbridge for 2008, 2009, 32 and 2010 is based on a proposed benchmark pipeline ROE formula which 33 incorporates: 34 35 (a) The initial ROE established in RH-2-94 by the NEB; 36 (b) A correlation factor between the forecast long-term Government of 37 Canada bond yield and the ROE of 0.50%; and 38 (c) A correlation factor between the spread between long-term A rated 39 corporate and Government of Canada bond yields and the ROE of 40 0.50%. 41 42 3. The indicated benchmark pipeline ROEs for 2008, 2009 and 2010 are 10.13%, 43 10.73% and 10.30% respectively. 44 45 4. The incremental equity risk premium for Enbridge relative to the benchmark 46 pipeline ROE was estimated at 175-200 basis points, producing (at the mid-point) 47 recommended ROEs for each of the test years as follows: 48 49 Table 1 Year ROE 2008 12.00% 2009 12.60% 2010 12.18% 50 51 52 3098 Enbridge-Line 9 Foster Associates, Inc. Page | 2 53 II. BACKGROUND 54 55 Line 9 was originally built in 1976 with Government of Canada financial support to 56 transport Western Canadian crude oil to Montréal refineries in order to provide additional 57 security of supply, as well as to Lévis (opposite Québec City) and Atlantic Canada 58 refineries via ship from Montréal. In 1997, Enbridge, then Interprovincial Pipe Line Inc., 59 applied to the NEB to reverse Line 9 to permit transportation of off-shore crude to 60 Ontario refineries. The proposed reversal was backed by an eight-year Facilities Support 61 Agreement as amended (“FSA”) between Enbridge and four Ontario refiners (the “FSA 62 Shippers”) that would be the principal shippers on Line 9. The FSA took effect on 63 October 1, 1999 after Line 9 went into reversed service. It included two distinct terms, 64 the Primary Term, which covered the first five years of operation of Line 9 as reversed, 65 and the Extended Term, which covered years six to eight. The FSA expired on 66 September 30, 2007. 67 68 The first five years of the FSA were a transition period during which the tolls on Line 9 69 were charged largely on a stand-alone basis, but with some aspects of integration with the 70 “Older System”.3 The FSA specified the common equity ratio and ROE that were to 71 apply during the Primary Term: the deemed common equity ratio was set at 40% for 72 Year 1, increasing to 45% in Year 5 by 1.25 percentage point increments; and, the ROE 73 for each of the five years would be the multi-pipeline ROE for Group 1 oil and gas 74 pipelines as determined each year in accordance with the automatic adjustment formula 75 that was adopted in RH-2-94. 76 77 For the Extended Term, the FSA specified that (1) the tolls would be calculated on a 78 stand-alone basis; (2) the FSA Shippers would have unapportioned access and rights to 79 transportation based on their historical shipments, and (3) the capital structure would be 80 determined in accordance with the last determination of the NEB. Enbridge entered into 81 letter agreements during the Extended Term with the FSA Shippers that provided for 3 The purpose of the integration was to have the benefits and risks of reversal shared between the Older System shippers and the FSA Shippers, while Enbridge was kept whole in respect to its Line 9 costs. 3098 Enbridge-Line 9 Foster Associates, Inc. Page | 3 82 interim tolls with, when the tolls were made final, full recovery of deviations between 83 forecast and actual costs for the two periods covering October 1, 2004 to March 31, 2005 84 and April 1, 2005 to March 31, 2006. The interim tolls were made final for each period 85 by NEB Orders TO-03-2006 (April 13, 2006) and TO-05-2006 (June 29, 2006), 86 respectively. 87 88 In April 2007, Enbridge, which had been operating on interim tolls since April 2006, 89 applied to the NEB for, and obtained approval of, final tolls for the periods commencing 90 April 1, 2006 and January 1, 2007. In September 2007, Enbridge withdrew its 91 application, having reached agreement with Imperial Oil Limited (“Imperial”) on a 92 “Term Sheet” that outlined the terms and conditions for a new Transportation Service 93 Agreement (“TSA”) for westbound service on Line 9 during a five-year term and having 94 agreed to conduct an open season for other shippers, such as NOVA Chemicals (Canada) 95 Ltd. (“NOVA Chemicals”), that wanted westbound service on Line 9 on the same terms 96 and conditions. In December 2007, following the completion of the open season, 97 Enbridge applied for approval of toll principles as prescribed in the TSA and for interim 98 and then final tolls commencing January 1, 2008.4 The NEB set down this application 99 for hearing in June 2008. Prior to the hearing, Enbridge applied to the NEB for, and 100 obtained approval of, final tolls for the periods commencing April 1, 2006 and January 1, 101 2007. The NEB subsequently rescheduled the TSA-related hearing to January 2009. On 102 April 2, 2009, the NEB denied Enbridge’s application for the approval of the TSA’s toll 103 principles and for the resulting tolls. 104 105 As a result of the NEB’s decision, Enbridge has been operating on interim tolls since 106 January 1, 2008. The current application before the Board is being made to set final tolls 107 for the three periods commencing January 1, 2008, January 1, 2009 and January 1, 2010. 108 109 4 Final tolls for the two interim periods covering April 1, 2006 to December 31, 2007 were approved by NEB Order TO-03-2008 on April 21, 2008.
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