Letter Decision No. LET-R-35-2021
2021–2022 Crop Year Cost of Capital Rate for the Canadian National Railway Company (CN) for the Transportation of Western Grain.
SUMMARY
The Canadian Transportation Agency (Agency) determines CN’s maximum revenue entitlement for the movement of grain in each crop year in accordance with the formula set out in subsection 151(1) of the Canadian Transportation Act, SC 1996, c 10 (CTA). One component of this formula is the calculation of the volume-related composite price index (VRCPI), which requires the determination of an appropriate cost of capital.
This determination addresses the following issues:
- Should CN’s BC Rail debt receive special treatment?
- What is the cost of capital rate for CN in respect of the 2021–2022 crop year for the transportation of western grain?
For the purpose of computing the VRCPI in respect of the 2021–2022 crop year, the Agency determines for CN that:
- the cost of debt rate is 4.02 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 4.90 percent;
- the cost of common equity rate adjusted to include an allowance for income tax is 6.65 percent; and
- the cost of capital rate is 4.33 percent.
ANALYSIS AND DETERMINATIONS
Issue 1: Should CN’s BC Rail debt receive special treatment?
During the development of CN’s 2020–2021 cost of capital rate for the transportation of western grain, the Agency discovered that CN’s BC Rail debt, acquired in its acquisition of BC Rail in 2004, was not reported in accordance with Determination No. R-2017-198 which states that all debt should be reported at its face value.
The Agency also discovered that, historically, CN has always submitted the BC Rail debt at its discounted value and at a 0% cost rate.
Prior to the determination of CN’s 2020–2021 cost of capital for the transportation of western grain, Agency staff sent two emails to CN asking for clarification as to why CN reported this debt at its market value; however, CN did not respond to these emails until after the 2020–2021 cost of capital for the transportation of western grain was determined, in Determination No. LET-R-30-2020.
As a result, the Agency reverted the BC Rail debt to its face value in Determination No. LET-R-30-2020.
CN subsequently sent a letter on May 28, 2020, to Agency staff that responded to the two emails.
In its letter, CN explains that the BC Rail debt has virtually no value to CN. CN was required to take on this debt as part of the purchase agreement, and must honour the debt payments; however, it did not receive the same value of assets as the face value of the debt.
This matter was included in the consultation on the Methodology to Determine Net Rail Investment and Capital Structure for the Calculation of Cost of Capital Rates. The Agency continues to assess the submissions made by stakeholders, including whether the BC Rail debt should have an implied interest rate of 5.75 percent instead of 0 percent.
In light of the information provided by CN in its response letter dated May 28, 2020, which clarified its treatment of this debt, the Agency will allow the historical treatment of the BC Rail debt at its discounted value with an interest rate of 0 percent pending completion of the consultation.
Issue 2: What is the cost of capital rate for CN in respect of the 2021–2022 crop year for the transportation of western grain?
The calculation of the VRCPI, used to determine the maximum revenue entitlement for the movement of grain in a crop year, requires the determination of an appropriate cost of capital rate.
The cost of capital rate is set in accordance with the Agency’s methodological approaches set out in previous determinations related to cost of capital rates, including:
- Determination No. R-229-2019 dated November 29, 2019: sets out the Agency’s methodology to determine the cost rate of common equity for federally-regulated railway companies (2019 Determination);
- Determination No. R-2017-198 dated December 5, 2017: sets out the methodology to be used by federally-regulated railway companies to determine the working capital amounts and capital structure for regulatory purposes;
- Decision No. 425-R-2011 dated December 9, 2011: sets out the Agency’s methodology to determine the cost of capital for federally-regulated railway companies;
- Decision No. 125-R-1997 dated March 6, 1997: addresses issues pertaining to the Agency’s cost of capital methodology for regulated railways; and
- The 1985 Cost of Capital Methodology Decision.
For the purpose of computing the VRCPI in respect of the 2021–2022 crop year, the Agency determines for CN that:
- the cost of debt rate is 4.02 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 4.90 percent;
- the cost of common equity rate adjusted to include an allowance for income tax is 6.65 percent; and
- the cost of capital rate is 4.33 percent.
The methodology used by the Agency in these determinations is contained in Appendix A. The resulting deemed capital structure is contained in Appendix B.
As you are aware, the Agency has already consulted with CN on the issue of share buy-backs and the treatment of general purpose debt (GPD). Some level of GPD has always been included in the capital structure of CN, including in its submissions. Since 2019, the application of the revenue ton miles approach has reduced the impacts of this debt on CN’s cost of capital rate. The Agency recently became aware that similar issues arise with CP’s issuance of debt for general corporate purposes, and conducted a consultation process in late 2020 and early 2021 with a view to addressing differences between the reporting of CN and CP through a single standard for both railway companies. In light of the Federal Court of Appeal’s recent decision with respect to CP, the Agency will conduct further consultations with CN, CP and other interested stakeholders on the issue of whether to allocate GPD to Canadian rail operations.
The Agency acknowledges the concerns raised by CN in its letter of April 21, 2021, but is not convinced that removing all GPD from CN’s regulatory balance sheet, even on an interim basis, would represent an accurate characterization of CN’s capital structure, which forms the basis of its entitlement for cost of capital items. The CTA requires not just fairness between the railway companies, but also fairness to all persons affected by this determination, including the shippers who pay the rates established by the railway companies under this regime. The Agency simply does not have sufficient evidence to justify making a significant methodological change to CN’s capital structure at this late stage.
The Agency expects to complete its consultations by late summer. If these consultations result in a new reporting standard that would lead to materially different results in the determination of the cost of capital rate for CN, in the early fall the Agency will conduct a section 32 review of this letter determination for the 2021–2022 crop year. In this way, negative impacts identified by CN from continuing to apply the methodology to it pending the completion of these consultations could be mitigated and any uncertainty reduced to the first few months of the 2021–2022 crop year.
Agency staff will follow up directly with you shortly to launch these consultations.
APPENDIX A
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
Long-term debt acquired by CN in its BC Rail acquisition is determined to be of special nature and is permitted to be recorded at discounted value pending completion of consultations on the issue.
3.0 Capital structure cost rates
Deferred taxes and investment cost rate are accepted as submitted on February 12, 2021. The cost of common equity rate was also adjusted 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 below.
i) Appropriate Risk-Free Rates
With respect to the Canadian cost of common equity rate, the Agency accepts CN’s submitted risk‑free rate of 0.68 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 2021.
For the U.S. cost of common equity rate, CN submitted risk-free rates of return of 0.45 percent for U.S. 5-year bonds and 1.08 percent for U.S. 10-year bonds, which is accepted by the Agency. 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 2021.
ii) Appropriate Market Risk Premium
The Agency accepts CN’s submitted market risk premiums of 4.87 percent for the Canadian cost of common equity rate based on 5- to 10-year Government of Canada bonds, and 7.18 percent for the U.S. cost of common equity rate based on 5-year Treasury bonds, and 6.85 percent for the U.S. cost of common equity rate based on 10-year Treasury bonds. They are the market risk premiums obtained by examining the average differences between the historical total returns on stocks and the income return in the month of January for bonds, as published by the TSX and the Bank of Canada for the 1951 to 2020 period for the Canadian calculation, and by Standard and Poor’s and the U.S. Federal Reserve for the period 1954 to 2020 for the American calculations.
iii) Beta
CN submitted a Canadian beta of 0.81 and a U.S. beta of 0.85. The Canadian beta was revised to 0.71, the American beta was revised to 0.76. Betas were calculated using country-specific data to the end of January 2021, based on 5 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 Canadian/U.S. Cost of Common Equity Rate
The Canadian/U.S. cost of common equity rate is the weighted average of the Canadian and the American cost of common equity rates, with the weights for CN 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 CN on the Toronto and New York stock exchanges during 2020. CN submitted weights of 61.10 percent for Canada and 38.90 percent for the U.S., based on trading volumes of 360,723,450 shares for Canada and 229,626,500 shares for the U.S. CN’s submitted data was missing trade volumes from September 18, 2020. Consequently, the Agency substituted for weights of 61.32 percent for Canada and 38.68 percent for the U.S. based on 2020 trading volumes for CN of 364,841,300 shares for Canada and 230,163,300 shares for the U.S.
Conclusion
The cost of common equity rate of 6.65 percent (including an adjustment for an income tax allowance) and the resulting cost of capital rate of 4.33 percent estimated for the 2021‑2022 crop year for CN are considered by the Agency to be fair and reasonable.
APPENDIX B
Weighted Rate | |
---|---|
Longterm debt | 1.47% |
Future income taxes and investment tax credits | 0.00% |
Common equity | 2.87% |
Approved cost of capital rate for the 2021/2022 crop year | 4.33% |
Member(s)
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