PrefBlog

This is way out of date, but I ran across it and thought I’d pass it along anyway.

The following is from the Alberta Energy & Utilities Board Decision 2006-100, regarding Atco Utilities [AU]:

AU submitted that its preferred shares have ensured that its customers have enjoyed the benefits of the lowest cost financing on the most flexible terms available in the Canadian financial market because AU’s existing preferred shares provide support to its credit rating.
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The Board notes that AU provided an analysis indicating that replacing preferred shares with debt would provide initial savings but the cumulative savings would become negative within four years due to the cumulative higher costs of new debt issued each year.
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The Board notes that the approach used by both AU and CG to determine the cost effectiveness of preferred shares is dependent on AU’s specific debt requirement needs, with a focus on the next four to six years. However, all debt would eventually be refinanced and accordingly would be affected by any lower credit rating. In the Board’s view, the cost effectiveness of using preferred shares should be evaluated on a more generic basis that considers the long-run steady state impacts and that is not dependent on the particular immediate borrowing needs of AU. This can best be accomplished by comparing the total yearly cost of non-common equity financing with and without preferred shares at current market rates for debt and preferred shares. In this context “current” refers to the most current market figures available on the record of this proceeding.

AU’s updated evidence indicated that preferred shares had a current market cost of 4.60% and that AU’s income tax rate was currently 31.37%. This translates to a pre-tax cost of (4.60/ (1-0.3137)) 6.70%. AU’s updated evidence indicated that the current market cost for long-term debt was 5.75%. As a result, preferred shares were estimated to have a current market cost that was 95 basis points higher than the current market cost of debt, at the time of that estimate.

The ATCO Utilities proposed a preferred equity ratio of 6% and a debt ratio that approximates 57% across the four ATCO Utilities, which would then approximate 63% if the preferred shares were replaced with debt. In these proportions, the debt portion of capital is approximately 10 times larger than the preferred equity portion of capital. On this basis, the Board calculates that if the debt costs were to rise by any more than approximately 10 ( i.e. 95/10) basis points, due to the replacement of preferred shares with debt, then the added cost of the (then) approximately 63% debt component would outweigh the approximate 95 basis points savings on the current 6% preferred share component. The Board notes that, in keeping with its steady-state approach, this calculation assumes that the added cost would apply to both existing and new debt.

AU’s expert, Mr. Neysmith indicated that replacing AU’s preferred shares with debt would lead to a debt credit rating downgrade of at least one to two notches. AU estimated that this would increase its debt interest costs by 30 to 60 basis points. AU also provided a letter from a financial market advisor, Mr. Engen, which indicated that AU’s interest costs would rise by 5 to 10 basis points if the market viewed CU’s regulatory environment to be largely unchanged and 20 to 40 basis points if the market viewed CU’s regulatory environment as having worsened because of the Board’s decision to remove the preferred shares. Both of these estimates were based on current market conditions. Mr. Engen indicated that in a less attractive spread environment, the differential could be expected to widen.
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It is not clear how many basis points would be added to AU’s debt costs if preferred shares were replaced with debt. However, the Board accepts that directionally it should expect some increase in debt costs in such a scenario. The Board accepts AU’s submission that the debt cost impact would vary depending on market conditions. In the Board’s view, a 10 basis points or greater increase in debt costs for AU resulting from the discontinuance of the use of preferred shares in AU’s capital structure would be sufficient to demonstrate the continued cost effectiveness of employing preferred shares. The Board considers the evidence provided by AU and its experts persuasive that the discontinuance of the use of preferred shares could be expected in the present market conditions to increase AU’s debt costs by approximately 10 basis points. The Board also notes that AU’s evidence indicated that the impact could be as high as 60 basis points. Therefore the Board finds that the continued use of preferred shares is cost effective at this time.
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Under cross-examination by Board Counsel, AU indicated the optimum amount of preferred shares had been estimated by AU to be within a range of 5% to 10%.

It should be noted that the Alberta Utilities Commission sets Return-on-Equity allowances for the utilities it regulates based on common equity:

In addition, in Decision 2009-216, 2009 Generic Cost of Capital, issued today, the AUC set a new return-on-equity (ROE) level of nine per cent for all the utilities for 2009 and 2010, and established moderately higher individual equity ratios for each of the firms. The changes were in part to address pressures stemming from the global credit crunch.

The changes apply to all regulated utilities in Alberta serving the electricity and natural gas sectors. These include distribution and transmission providers. The uniform, or generic, ROE is applied to the portion of a utility’s rate base financed by common equity to determine the utility’s return on equity capital.