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Enbridge Gas Distribution
Gas Distribution and Services
ENBRIDGE GAS DISTRIBUTION
EGD is a rate-regulated natural gas distribution utility serving customers in its franchise areas of central and eastern Ontario, including the City of Toronto and surrounding areas as well as the Niagara Peninsula, Ottawa and many other Ontario communities. EGD is Canada's largest natural gas distribution company and has been in operation for more than 150 years. It serves over 1.8 million customers in central and eastern Ontario, Southwestern Quebec and parts of Northern New York State. EGD's operations in Ontario are regulated by the Ontario Energy Board (OEB). Results of Operations Earnings for the year ended December 31, 2007 were $128.8 million compared with $61.8 million and $111.9 million for the years ended December 31, 2006 and 2005, respectively. Weather changes over the past three years were the major factor in the earnings fluctuations.
In 2007, weather was colder than normal resulting in increased earnings, whereas in 2006 weather was warmer than normal which resulted in lower earnings compared with 2005 when the weather was considered relatively normal.
Earnings in 2007 also increased compared with 2006 because of customer growth, higher operating margins and benefits earned for exceeding targets in the promotion of energy efficient use of natural gas. The decrease in earnings between 2006 and 2005 was also a result of a lower allowed rate of return on common equity, partially offset by a higher rate base.
Normal weather is the weather forecast by EGD in the Toronto area using the forecasting methodology approved by the OEB. Determination of normal weather may also be based on a negotiated settlement with the interveners as part of the regulatory process. This financial measure is unique to EGD and, due to differing franchise areas, is unlikely to be directly comparable to the impact of weather normalized factors that may be identified by other companies. Moreover, normal weather may not be comparable year-to-year given that the forecasting models are updated annually.
As part of its 2007 rate application, EGD requested a change in the methodology used to calculate normal weather to a 20-year trend method, which is a better predictor of weather. In its decision released on July 5, 2007, the OEB approved the proposed 20-year trend method for calculating normal weather in EGD's main franchise area, the Greater Toronto Area. As a result, the effect of 2007 weather was calculated retroactively to January 1, 2007, based on the approved method, which corresponds to normal weather of 3,617 annual degree days.
Incentive Regulation
Improving the regulatory environment is one of the key strategic thrusts to provide greater operational and organizational flexibility. EGD remained in a cost of service methodology environment in 2007, but will change to Incentive Regulation (IR) methodology in 2008, with 2007 as the base year for a potential five year plan. Under IR, rates are set based on a formulaic approach, using the base year rates as the starting point for the IR plan term.
The objectives of the IR plan are as follows:
- reduce regulatory costs with less frequent hearings — under normal circumstances, every five years — rather than every year under cost of service;
- provide incentives for improved efficiency;
- provide more flexibility for utility management; and
- provide more stable rates.
Rate Application for the IR Term Starting 2008
On February 11, 2008, the OEB approved the Settlement Agreement (the Settlement) filed by EGD which reflected negotiations with ratepayer representatives regarding the type of IR methodology as well as the applicable terms and conditions. The Settlement encompasses all major financial aspects of the IR methodology that will operate for 2008 to 2012 (inclusive).
EGD's rate application requested a revenue cap incentive rate mechanism calculated on a revenue per customer basis for the 2008 to 2012 period. The application also requested that revenue per customer be calculated by increasing the prior year's revenue by inflation and reducing it by a productivity challenge factor which would motivate EGD to increase productivity. Revenue could also include specific categories of expenses to enable EGD to recover cost increases beyond management's control.
This IR methodology adjusts revenues every year, not rates, and relies on an annual process to forecast volume and customer additions. Unlike the cost of service methodology used in prior years, the concepts of rate base and return on rate base are not relevant for the purpose of setting rates. Under IR, EGD will have the opportunity to benefit from productivity enhancements and incremental revenues.
The key terms of the Settlement are summarized as follows:
Revenue per Customer Cap – The Settlement allows for the annual reset of volumes, with revenues increasing proportionately with the growth in the number of customers. The revenue per customer cap will continue to minimize EGD's exposure to declining average use of natural gas while providing incentive for EGD to continue growing its customer base.
Earnings Sharing – To align the interests of customers with EGD, an earnings sharing mechanism forms part of the Settlement. To the extent the actual utility return on equity represented by normalized earnings (i.e. excluding the effects of weather) (ROE) exceeds a notional allowed utility rate of return on equity (NROE) by certain prescribed thresholds, the excess will be shared with customers.
Adjustments – The Settlement provides for the recovery of capital invested in new power generation laterals. EGD is also allowed to recover expenses above a defined threshold, to the extent any such expenses result from new regulatory orders and/or changes in statutory obligations.
Off Ramps – An OEB review will be triggered if EGD's ROE varies more than 300 basis points (either negatively or positively) relative to the NROE.
EGD applied for and, on December 18, 2007, was granted approval for interim rates effective January 1, 2008 and expects the OEB's final 2008 rate order will be applied retroactively to January 1, 2008.
2007 and 2006 Rates
The key elements of the 2007 and 2006 decisions are summarized below:
Regulatory year |
Approved |
Approved |
|---|---|---|
Rate base (millions of Canadian dollars) |
$3,745.7 |
$3,633.6 |
Deemed common equity for regulatory purposes |
36% |
35% |
Rate of return on common equity |
8.39% |
8.74% |
The OEB released its final decision relating to EGD's 2007 cost of service rate application on July 5, 2007. The new rates approved by the OEB's decision resulted in an overall increase in rates of approximately 3.5% for the average residential customer. EGD was granted a 1% increase in the equity component of its deemed capital structure to 36% from 35% reflecting changes in EGD's business risk environment and financial risk position. In addition, the new 20-year trend method to calculate normal weather was approved. Finally, EGD was directed to cease its risk management program, which utilized price swaps, calls and collars to manage the volatility in the price of natural gas. Consistent with prior years, changes in the price of natural gas flow through to the customer.
EGD's 2007 and 2006 rates were established pursuant to a cost of service methodology that allowed revenues to be set to recover EGD's forecast costs. Forecast costs included gas commodity and transportation, operation and maintenance, depreciation, municipal taxes, income taxes, and the debt and equity costs of financing the rate base. The rate base is EGD's investment in all assets used in gas distribution, storage and transmission as well as an allowance for working capital. Under the cost of service model, it is EGD's responsibility to demonstrate to the OEB the prudence of the forecast costs.
The rate base is financed through a combination of debt and equity. For the debt portion, interest expense incurred by EGD is recovered in rates. For the equity portion, the OEB sets the rate of return that EGD may recover in rates. The allowed rate of return on equity for EGD is based on the forecast yield on Canadian government long-term bonds.
Effects of Rate Regulation
As EGD is subject to rate-regulation, either in a cost of service or incentive model, there are circumstances where revenues recognized do not match the amounts billed. Certain amounts are deferred for recovery or refund with the approval of the regulator and are not included in revenues or expenses that would otherwise be recognized in the income statement, in the absence of rate regulation.
The regulator allows certain variances between approved and actual expenses to be recovered from, or refunded to, customers in future periods. The deferred amounts are not included in the calculation of rates billed to customers. While there are numerous deferral accounts approved by the regulator, the difference between the price of gas approved by the regulator and the actual cost of gas purchased is the most significant. On refund or recovery of this difference, no earnings impact is recorded. Effectively, the income statement captures only the approved cost of gas and the related revenue rather than the actual cost of gas and related revenue. EGD has no exposure to changes in the cost of gas as it is a flow through cost that is passed to the ratepayer.