Discussion Paper: Whether General Purpose Debt Should Be Included in the Calculation of Cost of Capital Rates
As part of its mandate to support the efficiency of Canada's national transportation system, the Canadian Transportation Agency (CTA) calculates regulated cost of capital rates, which the CTA uses in various rail-related determinations – including regulated interswitching and the Maximum Revenue Entitlement.
The CTA recently held public consultations on two components of regulated cost of capital rates, namely net rail investment and capital structure (2020 Consultation on Cost of Capital Rates). The CTA is now seeking input on whether the category of debt that it has identified as “general purpose debt” should be included in the calculation of cost of capital rates.
For the purposes of this discussion, the CTA defines general purpose debt as debt that is raised for broad corporate purposes – including share buybacks – as opposed to debt issued to finance specific identifiable assets.
Specifically, the CTA is holding public consultations on the following three questions:
Q1: Should general purpose debt be defined differently and if so, how?
Q2: Should general purpose debt issued by a railway company be included in the calculation of that company's cost of capital rate?
Q3: Should general purpose debt be treated differently between railway companies?
This discussion paper provides information on the:
- CTA's cost of capital calculations; and
- purpose of this consultation.
The CTA's Cost of Capital Calculations
What is cost of capital?
Cost of capital is an estimate of the total return on net investment required by debt holders (cost of debt) and shareholders (cost of common equity) so that debt costs can be paid and shareholders can be provided with a return on investment consistent with the risks assumed for the period under consideration.
A railway's cost of capital shows how much it costs the company to finance its rail assets – through borrowing, issuing debt instruments (such as bonds), deferred taxes and shareholders' equity in the company.
Each year, the CTA determines unique cost of capital rates to support its calculations for each of three different purposes:
- For regulating the transportation of Western grain, determined for the Canadian National Railway Company (CN) and the Canadian Pacific Railway Company (CP) on or before April 30 of each year;
- For regulating interswitching rates, determined on or before December 1 of each year; and
- For other regulatory purposes requiring costing determinations (such as Running Rights and Joint Track Usage), determined annually for CN and CP, and determined for other federal railways when a costing determination is needed.
The cost of capital determination process consists of four distinct steps:
- Determination of net rail investment;
- Determination of capital structure;
- Determination of capital structure cost rates; and
- Calculation of the cost of capital rate based on A, B and C.
The above terms can be described as follows:
- Net rail investment is the portion of a railway company’s net assets that are used to provide railway transportation services, and are under CTA jurisdiction. It does not include assets that are used for providing railway transportation services in the United States (US).
- Capital structure refers to the combination of the various sources of capital used to finance a railway's net rail investment (borrowing, issuance of debt instruments, deferred taxes and shareholders' equity).
- Capital structure cost rates are the cost rates associated with the various sources of capital included in the capital structure. They are comprised of:
- the actual cost of long-term debt, that is, the interest paid for all loans made to the railway companies;
- the cost rate of common equity using the Capital Asset Pricing Model as set out in Determination No. R-2019-229; and
- other sources of capital which are considered to be a zero cost rate, such as deferred taxes.
- Cost of capital rate is a weighted average of each type of funding included in the capital structure (B) and its associated cost rates (C) used to finance net rail investment (A). The sum becomes the cost of capital rate expressed in percentage terms.
The CTA's discussion paper for the 2020 Consultation on Cost of Capital Rates includes a detailed description of how the net rail investment and capital structure are calculated.
The items included in the net rail investment and capital structure to form the balance sheet are based on the accounts and instructions provided in the CTA’s Uniform Classification of Accounts (UCA). For regulatory costing purposes, the UCA balance sheet undergoes certain historical adjustments (relating to the definition of the asset base), and the resulting adjusted balance sheet is known as the regulatory balance sheet.
Each year, CN and CP submit their capital structures to the CTA. These are based on the book values of their liabilities and shareholders' equity from their most recent year's preliminary annual report filed with Transport Canada. The CTA then reviews the submissions and either adjusts them or approves them for use in the determination of the cost of capital rates. Other railway companies also submit this information if a cost of capital determination for their operations is required.
Purpose of this consultation
The CTA's cost of capital calculation is intended to cover capital raised for rail-related investments related to the company's Canadian operations.
For several years, CN and CP have differed in how they report general purpose debt for cost of capital purposes. Even before examining and assessing how this debt should be reported, it is essential to look at the question of whether general purpose debt should be reported on the railway companies' balance sheet.
Accordingly, the purpose of this consultation is to examine whether general purpose debt should be reported by each railway company on their regulatory balance sheet.
The question of the treatment of general purpose debt has been the subject of several CTA decisions, a consultation process, and a decision of the Federal Court of Appeal, as outlined below:
Past CTA decisions
Decision No. 125-R-1997: In this decision dealing with matters pertaining to the CTA's cost of capital methodology, the CTA determined that CN must include its long-term debt on its regulatory balance sheet unless it can prove that the debt was raised for a specific non-rail purpose, or to finance US operations. As a result, each debt instrument was assigned either 100 percent to CN's Canadian rail operations, partially to Canadian rail operations, or excluded from Canadian rail operations.
Decision No. LET-R-49-2009: In this decision, which determined CN's cost of capital rate for the 2009-2010 crop year, the CTA rejected CN's capital structure that identified debt issued for purposes of buying back company shares as non-rail debt, and therefore found that it must be considered as part of CN's regulatory balance sheet:
The Agency does not consider debt incurred for the purpose of buying back shares in a company whose primary, if not exclusive, business line is the railway business to be appropriately classified as identifiable non-rail debt within the meaning of Agency Decision No. 125-R-1997.
In Decision No. LET-R-41-2019, the CTA rejected a proposal by CN to allocate debt based on its consolidated company's balance sheet, as it did not provide sufficient supporting evidence, or address differences in accounting rules between the UCA and US Generally Accepted Accounting Principles. The CTA decided that, given the information provided, the most reasonable approach would be to apply an interim methodology based on revenue ton miles (the RTM methodology) for the apportionment of general purpose debt between CN's Canadian and US rail operations for the cost of capital determination for the 2019-2020 crop year.
In Decision No. LET-R-29-2020, in determining CP's cost of capital rate for the 2020-2021 crop year, the CTA addressed a previously unnoted difference in reporting by CP as compared with CN. The Agency determined that the use of general purpose debt for the purpose of share buy-backs is rail-related and must be included in the determination of CP's capital structure for the calculation of its cost of capital rate. As it had with CN, the CTA addressed the issue of reporting and allocating general purpose debt with CP by applying the same RTM methodology to CP’s general purpose debt for the calculation of its cost of capital.
In 2020, the CTA held a consultation with CN, CP and interested stakeholders to confirm a methodology with respect to the allocation of general purpose debt for rail purposes that is consistent for CN and CP. The CTA indicated that in the interim, general purpose debt would be allocated according to the RTM methodology. CP's cost of capital rate for the 2020-2021 crop year was determined accordingly.
On April 9, 2021, the Federal Court of Appeal quashed Decision No. LET-R-29-2020 insofar as it relates to the determination of CP’s cost of capital rate, and returned the matter to the CTA with the direction that it determine CP’s cost of capital rate for the 2020-2021 crop year on the same basis as the 2019-2020 crop year—that is, by excluding CP’s general purpose debt from the calculations. The Court left it open for the CTA to consult upon the proper characterization of general purpose debt. In light of the Court’s decision, the CTA is conducting a further consultation with CN, CP and other interested stakeholders on the issue of whether to allocate general purpose debt to Canadian rail operations.
Through its 2020 Consultation on Cost of Capital Rates, the CTA has already received input from industry and stakeholders on how best to apportion general purpose debt between Canadian and US operations. Thus, the CTA is now seeking input on the specific issue of whether general purpose debt should be included in the CTA's cost of capital calculations. At the conclusion of this consultation, if it is determined by the CTA that general purpose debt should be included on the regulatory balance sheet, then the CTA will also make a determination on how it should be apportioned based on the submissions filed in the 2020 Consultation on Cost of Capital Rates.
You are invited to submit your input to the questions posed in this discussion paper by August 20, 2021.
Your responses to the questions should include a supporting rationale and evidence to allow the CTA to properly assess its validity.
Your initial public submissions will be posted on the CTA's website on August 20, 2021, in the official language in which they were submitted, along with your name or that of the organization represented.
Stakeholders can provide responses to initial submissions by September 9, 2021.
Public versions of the responses will be posted on the CTA's website by September 10, 2021.
At the conclusion of this consultation, the CTA will consider all input provided in this and the 2020 Consultation on Cost of Capital Rates and render a decision as soon as possible.
Input can be sent to firstname.lastname@example.org.
If you wish to submit your input by video, please send an email to email@example.com with the subject line "Video". We will contact you to coordinate your submission.
If your input includes information you think is confidential, see the Notes below.
If any document you submit contains information you believe should be treated as confidential, you must give us two copies of it, as follows:
- One copy (the public version) from which the confidential information has been blacked out.
- One copy (the confidential version) in which:
- each page is marked “contains confidential information” at the top; and
- you highlight or otherwise identify on each page the confidential information that was blacked out in the first copy.
We will post the public version on our website, and keep the confidential one for our own use only. However, all input we receive is subject to the Access to Information Act and Privacy Act. We will protect the confidentiality of your information in accordance with these Acts, but those Acts can require us to release information if someone requests it and it doesn't fall within the legislated exceptions.