Decision No. 176-R-2009

April 30, 2009

File No.: T6650-2

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Introduction

[1] The Canadian Transportation Agency (Agency) is required to determine the Volume-Related Composite Price Index for crop year 2009-2010. A crop year begins on August 1 of one year and ends on July 31 of the following year.

Background

[2] The current "revenue cap" regime, established August 1, 2000, for the movement of western grain by a prescribed railway company replaced the former rate scale regime for such movements. The Canada Transportation Act (CTA) requires the Agency to determine each railway company's revenue cap annually and to determine whether each cap has been exceeded by the railway company.

[3] Subsection 151(1) of the CTA provides the formula that the Agency is to use in determining the revenue caps. One of the inputs to the formula is the volume-related composite price index. This index is to be determined by the Agency in advance of the crop year on or before April 30. Hence, by April 30, 2009, the Agency must determine the value for the volume-related composite price index for crop year 2009-2010.

[4] Subsection 151(4) of the CTA states that:

The following rules are applicable to the volume-related composite price index:

1. in the crop year 2000-2001, the index is deemed to be 1.0;
2. the index applies in respect of all of the prescribed railway companies; and
3. the Agency shall make adjustments to the index to reflect the costs incurred by the prescribed railway companies for the purpose of obtaining cars as a result of the sale, lease or other disposal or withdrawal from service of government hopper cars and the costs incurred by the prescribed railway companies for the maintenance of cars that have been so obtained.

[5] The development of the volume-related composite price index for 2009-2010 required detailed submissions of historical price information of railway inputs (labour, fuel, material and capital) from the prescribed railway companies, currently the Canadian National Railway Company (CN) and the Canadian Pacific Railway Company (CP). The submitted information was reviewed and verified by Agency staff. In addition, the railway companies and Agency staff developed forecasts for future changes in the price of railway inputs. The historical and forecasted information was summarized in an Agency staff report and shared with grain industry participants for consultation purposes. Consultation included participants from producer organizations, the Canadian Wheat Board, shipper organizations, grain companies, railway companies, and federal, provincial and municipal governments.

Issue of stock-based compensation

Background

[6] Beginning with the 2006-2007 crop year, the development of the labour price index was expanded to include Fringe Benefit items, as well as stock-based compensation. In Decision No. 211-R-2007 dated April 27, 2007, the Agency stated that it intended to review these items prior to the issuance of the crop year 2008-2009 volume-related composite price index. However, participants were later notified that this review would be delayed one year and be completed prior to the issuance of the 2009-2010 volume-related composite price index.

[7] Like many corporations, the railway companies include various forms of performance incentive payments to employees and management in their total compensation packages. These incentive payments are related to the companies' attainment of defined targets related to operational and market performance, and are typically based on the movement of the companies' stock prices. They therefore create contingent liabilities, which raises complex accounting evaluation issues. During the period of operation of these plans, the companies value these future obligations using recognized option pricing models, and allocate the estimated amounts over the plan periods. For each stock-based compensation plan, the actual value of the plan, not the amounts estimated with the option pricing models, is paid out to employees at the end of the plan period, if the pre-set performance and market conditions are met.

[8] The railway companies have several different stock-based compensation plans, each of which is based on the qualified employees realizing the difference in value between the company's stock price when the units are awarded and the stock price at a future date, typically three years forward. The stock-based compensation units are awarded to employees on condition that the company meets some defined performance and share price targets in the future. In some plans, the companies pay out the difference in stock prices as cash to the employee (cash award plans) while, in others, the companies award to the employee company stock priced on the date when the stock option was issued (stock option award plans), which allows the employee to sell the stock in the open market when the plan matures a number of years later, hopefully at a higher price.

[9] The Agency invited comments from participants on the amount of stock-based compensation to be included in the labour price index, and presented two options for consideration:

1. include the cash amounts paid by the company to cover realized obligations under each plan, plus amounts, based on an options valuation model, that are set aside by the company to cover its unrealized obligations under each plan; or,
2. include only the cash amounts paid by the company to cover realized obligations under each plan. The Agency also invited participants to propose other relevant alternatives.

Position of industry participants

[10] Four participants provided comments on the consultation question, and a fifth indicated that it could not offer an informed opinion.

[11] Keystone Agricultural Producers (KAP) does not agree that either management bonuses or stock-based compensation should be included in the labour price index, on the grounds that stock performance, being most directly related to profit levels, does not necessarily reflect operational performance. Therefore, KAP does not agree with either option being used to include stock-based compensation amounts in the index.

[12] CP indicates its operating costs, as reported in its financial statements, include both cash and notional amounts (that is, amounts estimated with option pricing models), and excluding a portion of these amounts does not accurately reflect the impact of stock-based compensation expenses on CP's operating costs. Therefore, it is CP's opinion the Agency should either include all stock-based compensation expenses or exclude all, and to include only a portion distorts the true cost of stock-based compensation and will lead to an incorrect labour index.

[13] CN expresses the view that the Uniform Classification of Accounts (UCA) includes both cash awards and stock options awards without distinction, so there is no reason to include one and not the other in the development of the labour price index. CN indicates it uses Canadian GAAP rules to report the value of the stock option awards in the UCA accounts, these accounts are audited by CN's external auditors and the Agency and these accounts are similar to other non-cash expenses used in the Agency's costing model, such as depreciation and pension expenses. CN states that, based on these considerations, it has a number of problems with option b) as set out in the consultation document. First, as stock option awards do not technically involve direct cash payments by the company, option b) would automatically exclude these expenses and, as there is no reason to include one type of award and not another, this method would be in direct contradiction of the Agency's own UCA accounting rules. CN adds that Option b) would treat stock-based compensation expenses differently from the other types of non-cash labour expenses, such as pension expenses, which would be inconsistent with the Agency's costing model.

[14] The Canadian Wheat Board (CWB) expresses the view that, as amounts for stock-based compensation may accrue in one year and be realized in another year, from a theoretical perspective, this would point to the use of a valuation model to allocate the costs as opposed to only including the actual cash expenditures. CWB adds, however, if the difference between the cash expenditure estimation and the valuation estimates is small, then the use of the cash expense estimation would be sufficient.

Analysis and findings

[15] The Agency has identified three main issues from the participants' comments.

1. whether to include management bonuses and stock-based compensation expenses in the labour price index;
2. whether to use notional amounts from option pricing models or actual cash payment amounts for cash award plans in the development of the index; and
3. whether to include and, if so, how to evaluate, stock option award plans in the index.

Issue 1: Inclusion of management bonuses and stock based compensation expenses in the Index

[16] Bonus programs and stock-based compensation plans are intended to create incentives for employees and to better align employee incentives with those of the employer. They are part of a mix of payment options used by competing companies in the modern financial environment to attract and retain employees. Management and other employees view their total compensation as including the wages and related benefits, bonuses and stock-based compensation. As a result, management and employees may accept lower wages, or remain longer with the company, in the expectation of sharing in the profits generated by the company as represented by the bonus programs and stock-based compensation plans. That is, in the absence of these incentives, the railway companies would likely need to pay higher wage compensation in order to attract and retain the number and quality of workers they require to operate their business. So management bonus programs and stock-based compensation plans are part of the cost of labour. Hence, it is economically consistent to include the management and employee bonus programs, as well as the stock-based compensation plans, in a labour price index intended to track changes in the price of labour over time.

Issue 2: Notional amounts from option pricing models versus actual cash payments

[17] For both cash award plans and stock option award plans, until the future year pre-set conditions for payout of the awards are met, the companies value the stock-based compensation units using Black-Scholes or other standard option pricing models. The companies are required to report these notional amounts for financial reporting purposes, in recognition of the fact that the stock-based compensation plans represent contingent liabilities of the companies, and excluding them would indicate to investors a false sense of the profitability of the company.

[18] The Agency uses information contained in the railway companies' financial statements and in the UCA as a key part of development of regulatory costing. However, the Agency points out that accounting information may be used differently based on the purpose for which it is needed.

[19] For shareholders/investment purposes, the notional amounts of contingent stock-based compensation liabilities (estimated using standard option pricing models) are reported to provide a more accurate picture of the financial state of the companies.

[20] For regulatory costing purposes, the objective is to compensate the railway companies for costs incurred in providing rail service. Therefore, the rationale for including an item in regulatory cost determinations is that it constitutes an incremental cost, which is a cost that would not have been incurred if the railway company did not provide the service in question.

[21] From a regulatory costing standpoint, the notional amounts estimated with option pricing models do not involve the railway company incurring any incremental costs. Indeed, these notional amounts are not economic costs, as the amounts do not represent any use of company resources. On the other hand, cash payments made by the company to meet its obligations when the stock-based compensation plans mature are actual economic costs, in that they use up company resources. These costs are incremental in the sense that they would not have been incurred if the company did not offer rail service.

[22] Further, although in theory the actual cash payments should be equal to the sum of the notional amounts over the cycle of a stock-based compensation plan, the Agency has determined, from a comparison of actual cash payments with notional option pricing model amounts, this is not always the case. This is due to the structure of some plans which allow for the conversion of notional amounts from one type of plan to another. For example, a review of CN data indicated that notional amounts allocated to one plan amounted to 204 percent of the actual cash payments made in 2006.

Issue 3: Inclusion and evaluation of stock option award pans in the Index

[23] The Agency agrees with CN that there is no economic reason to recognize one type of stock-based compensation award (e.g. cash) for regulatory costing purposes and not the other (e.g. stock options). In the past, the Agency has not included stock option award plans in the labour price index because of conceptual and measurement difficulties. However, the Agency agrees that stock option awards should be included in the index, provided the amounts included are the true incremental costs. Notional option valuations are not economic costs, as noted in the case of cash award plans, and should not be included in the index. The major issue with stock option awards is, therefore, the determination of the associated incremental costs.

[24] The Agency does not agree with CN's assertion that, as the value of stock option awards are estimated using Canadian GAAP rules, these amounts are similar to other non-cash expenses which are recognized in the Agency's costing models, such as depreciation and pensions. Depreciation expenses represent the amortization of an already-incurred incremental cost, capital investment. Hence, depreciation is considered an incremental cost for regulatory costing purposes. Similarly, while the railway companies make payments to their pension funds based on actuarial models and market-based parameters, the pension accounts used for regulatory costing purposes include both the payments made to the pension funds and returns received from the pension funds, representing the net incremental cost to the railway companies. However, as noted earlier, unlike depreciation and pension expenses, the notional values of stock option awards are not economic costs.

[25] Once a stock option award matures, the company has the obligation to deliver stock to the employee if the employee chooses to exercise the option. The employee has the right, but not the obligation, to exercise the option, and would choose to do so only if the market price on the exercise date is higher than the exercise price of the option (which is typically, the market price on the grant date). Thus, if a stock option award is exercised, the company delivers stock to the employee and receives the exercise price, while the employee is free to sell the stock in the open market and receive the profit.

[26] CN suggests there is a cost to the company in that it foregoes the proceeds received from selling the shares that go to the employee. That is, if it had sold the stock in the open market instead of issuing it to the employee, the company would have received the market price and, accordingly, the lost profit is an opportunity cost to the company.

[27] The Agency does not accept this argument. As noted earlier, the purpose of regulatory costing is to compensate the railway companies for costs incurred in the provision of rail service. Therefore, the Agency's regulatory costing models are based on incurred costs that are incremental, not replacement costs, market values, or foregone opportunities. For example, in regulatory costing, the Agency includes the net book value of land and other assets, and not their market values, so as to compensate the railway companies for actual costs incurred, as opposed to hypothetical costs from the opportunities that might be foregone.

[28] The Agency notes that the actual cost to the company, when it delivers the stock to the employee and receives the exercise price from the employee in payment, would depend on the cost the railway company incurs to obtain the stock that is delivered to the employee.

[29] The company may issue shares from treasury that it simply created by virtue of a shareholder vote. In that case, there is no usage of company resources, and no incremental cost incurred by the company resulting from exercise of the options. Rather, the company earns revenues from receiving the exercise amounts paid by employees. The potential disadvantage to the company from issuing the shares from treasury is the possibility that the additional shares on the market would depress the stock price, but that effect is not a regulatory cost.

[30] Alternatively, the company may buy the shares on the open market on the date the options are granted, thus paying the exercise price, and hold the shares in the treasury until the exercise date. At this point, it may issue the stock to the employee and receive the exercise price. As the amount paid by the company at purchase is the same as the amount received from the employee on exercise, there is no cost to the company, other than time value of money.

[31] A third possibility, that the company buys the shares on the open market at the time of exercise, is not considered likely by the Agency, on the grounds that a responsible company is not likely to do so. This is because, while a company runs zero risk if it buys the shares on the grant date, as the price it pays is exactly the price it would receive from the employee if the option is exercised, the company is exposed to the risk of unlimited losses if it waits to buy the shares on the exercise date as, theoretically, there is no upper limit to how high a stock can rise. Nevertheless, if this model is actually used by the railway company, the Agency is willing to consider convincing documented and audited actual losses as costs for inclusion in the index.

[32] With respect to bonuses and stock-based compensation, the Agency has determined the following:

1. the inclusion of bonus programs and stock-based compensation plans in the labour price index is economically consistent with the purpose of the index;
2. the actual cash payments for cash award plans, and not notional option pricing model amounts, are the true incremental costs that should be included in the labour price index. To this end, the railway companies are directed to submit to the Agency amounts for cash payment awards for inclusion in the index, as well as, purely for verification purposes, the notional amounts estimated with option pricing models;
3. in response to a March 27, 2009 request by the Agency to submit actual cash payment amounts for stock-based compensation for the years 2002-2008, CN provided the amounts while CP did not. Consequently, only the CN amounts are included in the development of the labour price index for this year's determination of the volume-related composite price index;
4. the Agency approved the inclusion of stock-based compensation amounts beginning with the 2006-07 crop year and CN provided amounts that were understood by the Agency to be amounts paid in cash under CN's cash award plans. This year's review of stock-based compensation plans revealed that the amounts CN had provided also included notional amounts, to CN's benefit. The Agency has therefore revised CN's historical labour price indices downward to reflect only cash payments under its cash award plans; and,
5. the amounts from stock option award plans are to be considered for inclusion in the labour price index in future years. These amounts will be included if they represent actual costs incurred by the railway companies and are verified based on an Agency audit.

Other issues

[33] During this year's determination of the volume-related composite price index the Agency dealt with a number of other issues which are either very technical in nature or involve confidential information or forecasts for specific index components. These issues are contained in a confidential letter decision that was issued to those parties who participated in this year's consultation and who agreed to maintaining confidentiality of such information.

Agency decision

[34] The Agency's determination of the volume-related composite price index for crop year 2009-2010 is: 1.0638, reflecting a decrease of 7.4 percent from crop year 2008-2009.

[35] This determination is in compliance with subsection 151(4) of the CTA in that:

1. the crop year 2009-2010 index is determined on the basis that the crop year 2000-2001 index was deemed to be 1.0;
2. the index applies in respect of all of the prescribed railway companies; and
3. the volume-related composite price index has not been adjusted to reflect the costs incurred by the prescribed railway companies for the purpose of obtaining cars as a result of the sale, lease or other disposal or withdrawal from service of government hopper cars and the costs incurred by the prescribed railway companies for the maintenance of cars that have been so obtained, because no adjustment is warranted in respect of the 2009-2010 crop year.

[36] In making this determination, the Agency considered the views of the grain industry participants with which it consulted during March and April of this year. The Agency also took into account the most recent economic conditions and forecasts from expert third-party sources.

[37] In this Decision, as well as in recent years, the Agency has reviewed and approved methodologies relating to the establishment of historical and forecasted price indices. The Agency finds that it is important to be consistent in using particular methodologies, once selected, and intends that the chosen and approved methodologies only be reviewed every five years, unless there are substantive changes in circumstances. For example, new, more accurate, verifiable data becomes available which permits the use of a superior methodology.

[38] The Volume-Related Composite Price Index of 1.0638 will be applied in the legislative formula under section 151 of the CTA when the Agency is required to make its revenue cap determinations for the crop year 2009-2010, which is legislated to be rendered by December 31, 2010.

Members

• Geoffrey C. Hare
• Raymon J. Kaduck
• John Scott