The following principles should be respected when establishing the appropriate capital structure for OPG’s regulated operations:
1. The stand-alone principle.
2. Compatibility of capital structure with business risks. 3. Maintenance of creditworthiness/financial integrity. 4. Compatibility with the benchmark return on equity.
Each of these principles is defined below.
A.1. The Stand-Alone Principle
As discussed in Chapter II.B, the stand-alone principle encompasses the notion that the cost of capital incurred by the ratepayers should be equivalent to that which would be faced by each division raising capital in the public markets on the strength of its own business and financial parameters. The cost of capital should reflect neither subsidies given to, nor taken from, other activities of the firm. Application of the stand-alone principle to OPG’s regulated operations means that they should be treated as if they were operating separately from the other operations of the firm.
The consolidated operations of OPG are rated by both DBRS and Standard & Poor’s. DBRS rates OPG A(low) with a Stable trend and S&P rates OPG BBB+ with a Positive trend. The ratings of OPG on a purely stand-alone basis would be lower if it were not for the perceived support of the Province as shareholder. S&P, for example, has stated that OPG’s rating benefits from two notches of government support.54 In other words, in the absence of the perceived level of government support, OPG’s S&P debt rating would be BBB-. Nevertheless, S&P has also stated that
(I)t is with the potential for changing circumstances in mind that the ratings on Hydro One and OPG are more closely aligned to the underlying creditworthiness of the individual companies than their owner. Governments change, government policies change, views on ownership change, economic circumstances change, and the financial ability and willingness of the province to support its enterprises can change also.
Fundamentally, it is not possible to predict the future political willingness to support a separately incorporated entity. Politics by definition is populist, expedient, and capricious, and creditors should not dismiss the likelihood of change. 55
While DBRS concludes that the current rating is more “reflective of OPG’s improved financial profile on a stand-alone basis, which has been driven by a more favourable regulatory environment,” they note “that the rating on OPG over the past several years has been supported by the Province of Ontario (the Province, rated AA), OPG’s sole shareholder and provider of financial support. The provincial ownership and financial support limited downward movement in OPG’s rating to below the A (low) level during prior periods of weak financial performance by the Company....”56 Although OPG does not currently borrow long-term debt in the public markets, but rather from the Ontario Electricity Financial Corporation (OEFC), the credit spreads for its funding are based on the market debt costs of regulated firms in Canada with similar or better investment grade debt ratings. As a result, ratepayers receive the benefit of a lower cost of debt than would be achievable by OPG in the absence of the perceived government support.
54 Standard & Poor’s, Summary: Ontario Power Generation, April 24, 2007.
55 Standard & Poor’s, Credit FAQ: Implied Government Support as a Rating Factor for Hydro One Inc. and Ontario Power Generation Inc., October 20, 2005.
This benefit is provided at no cost (i.e., there is no debt fee paid to the Province for the potential financial support). The proper application of the stand-alone principle to the determination of the deemed capital structure (and return on equity) for OPG’s regulated operations ignores the happenstance of ownership; the capital structure should reflect the business risks of OPG’s regulated operations irrespective of the identity of the shareholder. This approach ensures that the shareholder is properly compensated for the total risk borne.
A.2. Business Risks
The capital structure should be consistent with the business risks of the specific entity for which the capital structure is being set. The business risks to which investors in a utility are exposed are those that reflect the basic characteristics of the operating environment and regulatory framework of the utility that can lead to the failure to recover a compensatory return on, and/or the return of the capital investment itself.
A.3. Maintenance of Creditworthiness and Financial Integrity
The capital structure, in conjunction with the returns allowed on the various sources of capital, should provide the basis for stand-alone investment grade debt ratings for the regulated operations. An investment grade debt rating provides the basis for access to the capital markets on reasonable terms and conditions. As a corporate entity operating with a commercial mandate to operate on a financially sustainable basis, OPG should be positioned to access the public debt markets. The regulated operations of OPG should contribute their fair share to the creditworthiness and financial integrity of Ontario Power Generation Inc., the corporate entity responsible for raising debt capital on behalf of the entire organization. The importance of investment grade debt ratings is discussed in detail in Chapter IV.C.
A.4. Compatibility with Benchmark Return
The approach I have taken applies a benchmark return on equity to a deemed equity ratio. Thus, the deemed equity ratio needs to be set at a level that, given OPG’s business risks, equates the level of OPG’s total risks to that of the proxy utilities used to estimate the benchmark return.