Letter Decision No. LET-R-29-2020

SUMMARY

[1] This determination addresses the following issues:

• Should general purpose debt, including when used for the purpose of share buy-backs, be considered rail-related, and therefore included in the determination of CP’s capital structure?
• Should commercial paper be included in the calculation of CP’s working capital?
• What is the cost of capital rate for CP in respect of the 2020-2021 crop year for the transportation of western grain?

[2] The Canadian Transportation Agency (Agency) determines 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.

[3] The Agency will continue to consult on how to allocate general purpose debt to Canadian rail operations and, in the interim, general purpose debt will be allocated based on the Revenue Ton Miles (RTM) methodology pending the conclusion of such consultations.

[4] The Agency will also hold a consultation with respect to how commercial paper should be included in the calculation of working capital, and sets working capital to zero in the interim.

[5] For the purpose of computing the volume-related composite price index (VRCPI) in respect of the 2020-2021 crop year, the Agency determines that for CP:

• the cost rate of debt is 5.34 percent;
• the cost rate of deferred income taxes, investment tax credits and deferred downsizing is 0 percent;
• the after-tax cost of common equity rate is 8.93 percent;
• the cost of common equity rate adjusted to include an allowance for income tax is 12.19 percent; and
• the cost of capital rate is 4.79 percent.

[6] The methodology used by the Agency in these determinations is presented in Appendix A. The resulting deemed capital structure is presented in Appendix B.

ANALYSIS AND DETERMINATIONS

Issue 1: Should general purpose debt, including when used for the purpose of share buy-backs, be considered rail-related, and therefore included in the determination of CP’s capital structure?

[7] In August 2017, and on May 24, 2018, in the context of a re-determination of the 2018-2019 VRCPI, following amendments made to the Canada Transportation Act, S.C., 1996, c. 10, as amended(CTA), the Canadian National Railway Company (CN) requested that the Agency re-consider how it determines CN’s cost of capital rate. Specifically, CN asked the Agency to re-examine how CN apportions its reported debt between its Canadian and American operations.

[8] After consultation with CN, the Agency determined, in Decision No. LET-R-41-2019, that the revenue ton miles (RTM) based approach is the most reasonable methodology for allocating CN’s debt as part of its cost of capital determination for the 2019-2020 crop year. Accordingly, debt that can be directly linked to CN’s U.S. operations will be excluded from the regulatory balance sheet, similar to the current methodology, and all other general purpose debt will be allocated to the regulatory balance sheet in proportion to the total network RTM in Canada in the year in which the debt is issued.

[9] In a letter sent to CP on January 14, 2020, Agency staff requested that CP submit, on or before February 14, 2020, information required to assess the RTM methodology with a view to applying this methodology to the calculation of the 2020-2021 cost of capital rate for the transportation of western grain, to both railway companies.

[10] On February 3, 2020, CP responded with a request for further consideration of the issue of the allocation of its general purpose debt to its regulated rail operation’s capital structure.

[11] CP argues that:

• it is not correct to allocate "general purpose" debt to regulated railway operations, and
• the Agency should not make such a change to CP’s structure without proper consultation.

[12] CP’s argument focuses on section 1203 of the Uniform Classification of Accounts (UCA), which defines the scope of the UCA. Subsections 1203.01 through 1203.03 describe Canadian Rail Operations, while 1203.04 through 1203.06 describe the handling of non-rail activities. It contends that it issues debt to finance acquisition and maintenance of rail assets, and for general, non-regulated purposes, including share buy-backs.

[13] CP explains the basis of its share buy-backs, and why it is of the view that these should be excluded from rail operations entirely, but did not explain the nature of its other general and non-regulated transactions, which are financed by its debt issuances, and why they should not be allocated based on the RTM methodology. CP did not provide any information on the proportion of debt issuances that are dedicated to share buy-backs, but indicated that there are other transactions, in addition to share buy-backs, that are included in this category.

[14] Although CP contends that a rail operation is defined by UCA 1203.02, and 1203.06, the Agency finds that UCA 1203.05 is also relevant to this issue. The fact that these transactions are managed through a treasury function does not eliminate their impact on the Canadian rail entity, or relieve the requirement to properly account for those impacts.

[15] With respect to the issue of share buy-backs, CP states that the shares in question relate to the whole corporate structure of Canadian Pacific Railway Ltd. (CPRL), which includes the Canadian rail entity, CP. CP contends that:

Share-buyback programs are carried out by CPRL, the parent company. When CPRL issues or buys back publicly traded equity, it does so on behalf of the entire corporation, including the regulated and non-regulated portions. This is because publicly traded shares encompass the entire corporation rather than only the regulated portion. Stated differently, an investor purchases a share of CPRL, rather than separately purchasing shares of [CP], SOO Line and other subsidiary entities.

[16] The Agency finds that debt issued for the purpose of share buybacks is rail-related. There is a general corporate benefit derived from buying back shares issued. The issuance of debt in lieu of issuing more shares to fund rail-related investments lowers the company’s cost of capital, as the cost rate of debt issuance is lower than the cost of common equity rate that is expected from investors. Lower cost rates paid by the railway company for its investments might allow it to increase investments in other rail-related projects, or to lower freight rates paid by its customers.

[17] The Agency notes that share buy-backs will also reduce the number of outstanding shares on the market, which increases the relative ownership stake of the remaining stakeholders. Many CP employees receive stock as a form of incentive-based compensation. According to CP’s 2019 public annual report on its website, CP awarded $58 million in stock-based compensation that year. According to CP’s VRCPI submission to the Agency, approximately 12 percent of its work force received stock-based compensation in 2019. The possibility of an increase in ownership stake may lead to an increase in employee performance, which is rail-related.

[18] The Agency, in Decision No. LET-R-49-2009, rejected CN’s capital structure that identified debt incurred for the purpose of buying back shares as non-rail debt:

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.

[19] Consistent with Decision No. LET-R-49-2009, the Agency determines that the treatment of general purpose debt, including when issued for the purpose of share buy-backs is rail-related and must be included in the determination of CP’s capital structure.

[20] Over the coming year, the Agency will hold consultations with CN and CP, and other 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, in time for the determination of the 2021-2022 cost of capital rate for the transportation of western grain. In the interim, the Agency will apply the RTM methodology to CP’s general purpose debt.

Issue 2: Should commercial paper be included in the calculation of CP’s working capital?

[21] On February 14, 2020, CN requested that the Agency not include commercial paper in the calculation of its working capital. CN argued that although commercial paper is issued as a short-term financial instrument, CN routinely rolls over these obligations such that it is akin to long-term financing. CN explained that the problem with including commercial paper in the calculation of its working capital is that it leads to negative working capital, which it asserts does not make economic sense in the calculation of the cost of capital.

[22] Given that CN raised this issue, on March 2, 2020, Agency staff sought clarifications from CP on:

• whether CP makes use of commercial paper; and
• if it does, whether CP includes commercial paper in the calculation of its working capital in its cost of capital submission.

[23] On March 6, 2020, CP responded that it did not include any commercial paper in its calculation of working capital, but stated that it is used to support a cash shortage related to its share buy-backs.

[24] In Decision No. R-2017-198 (2017 Determination), the Agency defined working capital as the "cash and materials and supplies required by the company to maintain day-to-day operations", and the Agency approved a modified version of CN’s proposed classical accounting formula methodology to calculate working capital for both CN and CP:

…the annual working capital allowance would be estimated as an average of 12 monthly estimates of the requirements, where each monthly estimate is determined as the average of the opening and closing balances of current assets for the month, less the average of the opening and closing balances of current liabilities for the month.

[25] The Agency has already determined that the treatment of debt for the purpose of share buy-backs is rail-related and must be included in the determination of both CN’s and CP’s capital structure, in Decision No. LET-R-49-2009 and in issue 1 of this Determination, respectively. However, in light of the submissions made by both railway companies on this issue, the Agency intends to launch a consultation in 2020, with a view to re-examining the issue of how commercial paper is treated in the calculation of the railway companies’ working capital, including but not limited to stakeholders who participated in the consultation leading up to the 2017 Determination.

[26] As CP has excluded all commercial paper from the calculation of its working capital and CN has proposed to exclude all commercial paper from the calculation of its working capital, but has not provided the information necessary to do so, treatment of the railway companies in this regard would be inconsistent. To avoid this, and notwithstanding the methodology set out in the 2017 Determination, the Agency will set working capital for both railway companies to zero to ensure a consistent approach in the interim.

Issue 3: What is the cost of capital rate for CP in respect of the 2020-2021 crop year for the transportation of western grain?

[27] Pursuant to subsection 151(1) of the CTA, the Agency determines the maximum revenue entitlement for the movement of grain in a crop year. One component of this formula is the calculation of the VRCPI, which requires the determination of an appropriate cost of capital rate.

[28] The cost of capital rate is set in accordance with the methodological approach set out in Determination No. R-2019-229, dated November 29, 2019 (2019 Determination), and previous determinations of the Agency and its predecessors related to cost of capital rates.

[29] For the purpose of computing the VRCPI in respect of the 2020-2021 crop year, the Agency has decided that for CP:

• the cost rate of debt is 5.34 percent;
• the cost rate of deferred income taxes, investment tax credits and deferred downsizing is 0 percent;
• the after-tax cost of common equity rate is 8.93 percent;
• the cost of common equity rate adjusted to include an allowance for income tax is 12.19 percent; and
• the cost of capital rate is 4.79 percent.

[30] The methodology used by the Agency in these determinations is presented in Appendix A. The resulting deemed capital structure is presented in Appendix B.

---

APPENDIX A : 2020-2021 CROP YEAR COST OF CAPITAL RATE FOR THE TRANSPORTATION OF WESTERN GRAIN

1.0 Net rail investment

The working capital allowance in the calculation of net rail investment was adjusted to $0 in the interim until the Agency makes a determination on the use of commercial paper.

2.0 Capital structure

CP’s capital structure was adjusted based on the allocation of general purpose debt using the revenue ton mile (RTM) methodology.

3.0 Capital structure cost rates

Deferred taxes and Investment cost rate are accepted as submitted on February 14, 2020. Total debt cost rate was adjusted by staff in accordance with the RTM interim approach and the associated adjustments made to long-term debt as stated in section 2.0. The cost of common equity rate was also adjusted by staff in accordance with the 2019 Determination.

In accordance with Decision No. 97-R-2012, the Net Rail Investment and Capital Structure reflect the unamortized portion of the payments made towards statutory pension deficits and the financing of such payments, respectively.

In accordance with the 2019 Determination, the cost of common equity rate for the movement of grain is based on results obtained from the Capital Asset Pricing Model, using both Canadian and American data, in the manner set out in the Appendix of the 2019 Determination. The variables for these calculations are discussed in turn.

i. Appropriate risk-free rates

With respect to the Canada cost of common equity rate, the Agency accepts CP’s submitted risk-free rate of 1.51 percent. It is the rate obtained by averaging the published daily bond yields for 5 to 10-year Government of Canada marketable bonds, as found on the Bank of Canada’s website, for the month of January 2020.

The Agency accepts the U.S. risk-free rates of return submitted by CP. The 2019 Determination stipulates the use of 5-year and 10-year U.S. Treasury bonds as proxies for the risk-free rates of return used to determine two distinct cost of common equity rates, which are then averaged to estimate the U.S. cost of common equity rate. CP submitted U.S. risk-free rates of 1.56 percent for U.S. 5-year bonds and 1.76  percent for U.S. 10-year bonds. These rates were estimated by averaging the published daily bond yields individually for each of U.S. Treasury 5-year and 10-year Constant Maturities, as found on the U.S. Federal Reserve’s website, for the month of January 2020.

ii. Appropriate market risk premium

CP’s submitted market risk premium of 4.88 percent for the Canada cost of common equity rate was accepted by the Agency. In the 2019 Determination, the market risk premium is the arithmetic average of annual excess returns of the stock market over the risk-free rate, as measured from the year 1951 to the present for the Canadian cost of common equity rate. It is the premium obtained by examining the average difference between the historical total returns on the TSX, as published by the TSX, and the income return in the month of January for 5 to 10-year Government of Canada marketable bonds, as published by the Bank of Canada, for the period 1951 to 2019.

The U.S. market risk premiums were accepted as submitted by CP. The 2019 Determination stipulates that the U.S. cost of common equity rate is determined by averaging an estimate of two distinct U.S. cost of common equity rates, one based on 5-year U.S. Treasury bonds, and the other based on 10-year U.S. Treasury bonds, with the market risk premium for each being the arithmetic average of annual excess returns of the stock market over the income return for the respective bond instrument, as measured from 1954 to present. CP submitted U.S. market risk premiums of 7.03 percent for U.S. 5-year bonds and 6.70 percent for U.S. 10-year bonds. These premiums were estimated by individually examining the average difference between the historical total returns on the S&P 500, as published by Standard and Poors, and the income return for January on each of U.S. 5-year and 10-year Treasury bonds, as published by the U.S. Federal Reserve, over the period 1954 to 2019.

iii. Beta

CP’s submitted betas of 1.27 for Canada and 1.17 for the U.S. The Agency revised the Canadian beta to 1.28 and the U.S. beta to 1.18. These were calculated using country-specific data to the end of January 2020, based on five years of weekly observations of the percentage change in weekly returns of the company share and the stock market as a whole, with both rates of return adjusted by the weekly income return on 3-month treasury bills.

iv. Appropriate weighting factors used to determine the weighted Canada/U.S. cost of common equity rate

The Canada/U.S. cost of common equity rate is the weighted average of the Canada and the U.S. cost of common equity rates, with the weights for CP being based on the volume of shares traded on the Toronto and New York stock exchanges, respectively. Weights are determined as the relative proportions of the daily trading volumes of CP on the Toronto and New York stock exchanges during 2019. To calculate the weighted Canada/U.S. cost of common equity rate, CP submitted weights of 41.21 percent for Canada and 58.79 percent for the U.S. based on 2019 trading volumes for CP of 75,844,000 for Canada and 108,209,400 for the U.S. The Agency accepts the weights for Canada and the U.S., based on 2019 trading.

Conclusion

The cost of common equity rate of 12.19 percent (including an adjustment for an income tax allowance) and the resulting cost of capital rate of 4.79 percent estimated for the 2020-2021 crop year for CP, are considered by the Agency to be fair and reasonable.

---

APPENDIX B

CP Cost of Capital And Associated Cost Rates As At December 31, 2019 As Approved By The Canadian Transportation Agency

	Weighted Rate
Long Term Debt	3.21%
Future Income Taxes And Investment Tax Credits	0.00%
Common Equity	1.58%
Approved Cost Of Capital Rate For The 2020/2021 Crop Year	4.79%