The rationale behind a composite I factor

157. In Decision 2009-035, dealing with ENMAX‘s 2007-2016 FBR (formula-based ratemaking) application, the Commission approved a composite I factor that includes the distribution construction price index as measured by the Canadian Electric Utility Construction Price Index (EUCPI) and the Alberta Average Hourly Earnings (AHE) index with a 50:50 fixed weighting throughout the PBR term.¹⁶⁴

158. The companies argued that, in general, no single measure of inflation can explain all the cost trends facing a utility, and they maintained that greater accuracy can be achieved by

constructing a composite index composed of published indexes, weighted according to the average relationship among the company‘s various inputs.

159. Specifically, AltaGas‘ experts explained that a utility primarily purchases two types of inputs, employee time and goods and services from other firms. The prices that a company in Alberta must pay for these inputs will be affected primarily by economic conditions within the province of Alberta.¹⁶⁵ This position was supported by the other companies with each proposing that their respective I factors consist of two inflation indexes, one reflecting labour cost and the other reflecting the cost of non-labour items. Such a blended I factor would generally be

calculated each year using the following weighted-average formula:

I factor = wl * Labour Price Index + wn * Other Costs Price Index

160. For labour costs, the companies preferred to use either Average Hourly Earnings (AHE) or Average Weekly Earnings (AWE) for Alberta. For non-labour costs, the companies preferred to use either the EUCPI adjusted for Alberta inflation or the Alberta Consumer Price Index (CPI). These sub-indexes would be weighted based on the companies‘ historical proportions of labour (w_l) and non-labour (w_n) costs. The following table summarizes the proposed I factors as outlined in the electric distribution companies‘ respective PBR applications:

164 Decision 2009-035, paragraphs 144 and 149.

165 Exhibit 110.01, Christensen Associates evidence, paragraph 30.

Table 5-1 Summary of electric distribution companies’ I factor proposals ENMAX¹⁶⁶

(distribution)

ATCO Electric

(distribution) Fortis

EPCOR (distribution)

Labour costs Alberta AHE Alberta AWE Alberta AHE Alberta AHE

Non-labour costs EUCPI (no adjustment)

EUCPI (adjusted for Alberta)

EUCPI (adjusted for Alberta)

Alberta CPI Weights

(labour/non-labour) 50:50 65:35 61:39 80:20

161. Table 5-2 below presents the I factors proposed by the gas distribution companies in their respective PBR plans:

Table 5-2 Summary of gas distribution companies’ I factor proposals

ATCO Gas AltaGas

Labour Costs Alberta AWE Alberta AWE Other Costs Alberta CPI Alberta CPI Weights

(labour/non-labour) 57:43 57:43

162. The UCA supported the use of a composite I factor and indicated that the Commission should use the input price index approved for ENMAX in Decision 2009-035 for all the companies in this proceeding.¹⁶⁷

163. The CCA also acknowledged the need for an inflation measure that reflects the ―special inflationary conditions that sometimes occur in Alberta.‖ The CCA pointed out that inflation can be much more rapid in Alberta than in Canada as a whole in some periods (for example, 2006 to 2008) and appreciably lower in other periods (2009 to 2010), since the province‘s economy can experience ―booms and busts‖ because it is largely influenced by the production of price-volatile commodities.¹⁶⁸

164. The CCA recommended that the I factor consist of either a single macroeconomic measure of Alberta price inflation or an appropriately designed custom index of Alberta utility input price inflation. With respect to macroeconomic inflation measures, the CCA recommended using either the Alberta gross domestic product implicit price index for final domestic demand (GDP-IPI-FDD) or the Alberta CPI.

165. PEG on behalf of the CCA, developed an index that tracks the prices of three categories of input costs: labour, materials and services, and capital. Specifically, PEG recommended using either CPI or GDP-IPI-FDD for Alberta as the proxy for the materials and supplies input price index and the Alberta AHE or AWE for the labour price index. For the capital cost category, PEG constructed this element as the product of a rate of return on capital (set initially at the weighted average cost of capital established for the subject utility in its most recent rate case)

166 As approved in Decision 2009-035. ENMAX was included in this table for comparison purposes.

167 Exhibit 634.02, UCA argument, paragraph 73.

168 Exhibit 636, CCA argument, paragraph 44.

and a triangularized weighted average of past values of the EUCPI, with an adjustment to reflect Alberta construction market conditions.¹⁶⁹

166. Calgary also recommended using the Alberta GDP-IPI-FDD index and indicated that it did not support the adoption of a composite I factor consisting of several weighted indexes because such an inflation measure would not be consistent with the simplicity principle.¹⁷⁰ Commission findings

167. A number of parties pointed out that, because the Alberta economy is influenced by the production of price-volatile commodities such as oil and natural gas, it can experience wider swings in economic activity than the rest of the Canadian economy. As a result, inflation in the province can be quite different from inflation in the Canadian economy as a whole.

168. The companies also highlighted the fact that the presence of large scale capital-intensive oil and gas activity in Alberta leads to strong competition for labour resources, especially those involved in technical and engineering services, as well as capital-intensive projects. Accordingly, the companies were particularly concerned that the I factor be able to capture the effect of the tight labour market in Alberta.¹⁷¹ As Dr. Cicchetti on behalf of EPCOR explained:

But high oil prices and high gas prices, although those are now falling, but high oil prices at least have the effect of making the demand in the job market tighter, and the demand for people who are engineers of whatever kind who can be employed by electric distribution companies is tighter.¹⁷²

169. The Commission agrees with these observations. Because of the relatively tight labour market in Alberta, salaries and wages have been rising faster than the national average during petroleum industry booms and have declined more rapidly or risen less quickly during economic slowdowns, as compared to the rest of Canada. Therefore, the Commission will include an Alberta-specific labour inflation component in the I factor of the companies‘ PBR plans to reflect labour inflation in the province.

170. The Commission agrees with the companies that all-encompassing macroeconomic inflation measures, such as Alberta GDP-IPI-FDD or Alberta CPI proposed by the CCA and Calgary, when used as the only measure of inflation, do not reflect the input price inflation faced by the companies. As ATCO Gas pointed out, using a single macroeconomic index for the I factor may result in a significant revenue shortfall due to the under-recovery of its labour-related costs.¹⁷³ Furthermore, the CCA agreed that both CPI and GDP-IPI-FDD in this context are output price indexes, thus requiring adjustments to the productivity measure (in this case a TFP (total factor productivity) study) in determining an X factor as explained in Section 6.4.1 below.¹⁷⁴ In the Commission‘s view, the need for such an adjustment more than offsets any simplicity and transparency benefits of using a single macroeconomic inflation measure.

169 Exhibit 307.01, PEG evidence, pages 52-54 and Exhibit 376.18, ATCO-CCA-63 attachment.

170 Exhibit 629.01, Calgary argument, page 22.

171 Transcript, Volume 7, page 1291, lines 13-16, Volume 11, page 2137, line 24 to page 2138, line 1.

172 Transcript, Volume 11, page 2061, lines 19-24.

173 Exhibit 632, ATCO Gas argument, paragraph 49.

174 Exhibit 636, CCA argument, paragraph 51.

171. Accordingly, for the reasons above the Commission finds that the use of a composite I factor in the PBR plans of Alberta utilities is warranted.

172. The Commission considers that the composite I factors proposed by the companies generally conform to the input price index selection criteria outlined in Section 5.1. The proposed sub-indexes for labour and non-labour costs are published by Statistics Canada on a regular basis and, as explained in further sections of this decision, do not require any subjective modifications. The Commission considers that these indexes are sufficiently broad-based to avoid potential concerns about the activities of the companies significantly influencing these measures.

173. In addition, as explained in Section 6.4.1 below, since all the components of the I factors proposed by the companies can be considered input price indexes for the Alberta electric and gas distribution companies, using such a composite I factor does not require an adjustment to TFP in determining an X factor in order to account for an input price differential and a productivity differential.

174. With respect to the customized index for labour, capital and materials proposed by the CCA, the Commission notes that a similar index was proposed by the UCA in the ENMAX FBR proceeding, as outlined in Decision 2009-035. In that decision, it was noted that this type of I factor was more data intensive and more complex than the Commission considered desirable for the purposes of a PBR plan.¹⁷⁵ Indeed, in this proceeding, the CCA pointed out that the selection of an inflation measure for a PBR plan is difficult because greater accuracy comes at the cost of greater complexity.¹⁷⁶ ATCO Gas pointed out that the CCA‘s index needed a 15 page spreadsheet with a number of significant, complex calculations.¹⁷⁷ During the hearing, Dr. Lowry concurred that the calculation of the proposed customized index would likely require a

Ph.D.‘s expertise.¹⁷⁸ As such, the Commission considers that the customized index proposed by the CCA suffers from the same data intensity and complexity drawbacks as did the UCA‘s proposal for ENMAX. Furthermore, similar to the proposed I factors of ATCO Gas and Fortis, the CCA‘s customized inflation factor involves a modification to EUCPI to attempt to better reflect Alberta inflation. The Commission discusses the shortcomings of such adjustments in Section 5.2.3 below.

175. Finally, the CCA contended that the added complexity of a customized inflation index was warranted because it better tracked input price inflation. However, when the CCA compared its proposed customized I factor to a GDP-IPI-FDD index, the results were within

0.01 percentage points of each other over the 2001 to 2010 period.¹⁷⁹

176. In light of the above considerations, the Commission is not persuaded that the customized index proposed by the CCA is superior to the types of I factors proposed by the companies.

177. Similar to the findings in Decision 2009-035, the Commission recognizes that the blended I factors proposed by the companies do not specifically account for changes in the cost

175 Decision 2009-035, paragraph 139.

176 Exhibit 636, CCA argument, paragraph 49.

177 Exhibit 472.02, ATCO Gas rebuttal evidence, paragraph 164.

178 Transcript, Volume 13, page 2587, lines 1-6.

179 Exhibit 372.01, AUC-CCA-20(c).

of capital.¹⁸⁰Although there was some debate at the proceeding as to whether financing rates in the economy as a whole may be reflected sufficiently in the rate of inflation, it is the

Commission‘s view that financing rates are afunction of interest rates in the economy as a whole, which themselves are ultimately reflected in the rate of inflation. As Dr. Lowry stated:

But the one that raises an eyebrow to me in this category is the financing of – financing rate changes. I have never seen a plan involving an index that also involves an adjustment for financing rate changes. You would think that the – there is a danger of

double-counting of that since [if] there is a change in interest rates eventually it will have an effect on general inflation rates. And this is particularly so inasmuch as the other – the second inflation measure proposed by ATCO Gas is the CPI for Alberta…¹⁸¹

178. On the issue of whether changes in the cost of capital are reflected in the selected I factor, AltaGas stated in its rebuttal evidence:

The inflation factor, like the X-factor, is designed to mirror the way prices change in a competitive economy. In a competitive economy, the price of capital inputs is determined by the real rate of return on assets, their rate of economic depreciation and the price of acquiring and installing capital. In much of productivity research, including previous productivity research conducted by us [Christensen Associates Energy Consulting] and PEG, the real rate of return has been computed using the current year‘s nominal rate of return and the rate of inflation in recent years. This produced significant year-over-year volatility in the real rate of return, which, in turn, led to significant year-over-year volatility in the price of capital services. With this volatility, researchers were unable to determine the trend rates of price inflation with any degree of accuracy. In recent years, researchers have noted the real rate of return fluctuates around a constant value and have taken the approach of using a fixed, real rate of return when computing capital price inflation. Fixing the real rate of return at a constant value implies the price of capital services moves in proportion to the price of acquiring and installing that capital. Thus, the relatively straight forward way of computing the inflation factor proposed by AUI is also theoretically sound.¹⁸²

179. The theory supported by the AltaGas experts implies that changes in the cost of capital (both debt and equity) are sufficiently reflected in the company‘s selected inflation measure.

AltaGas‘ proposed I factor is similar to what the Commission has adopted.

180. Accordingly, the Commission considers that a composite I factor consisting of two broad-based indexes for labour and non-labour costs captures changes in the cost of capital (both debt and equity). In addition, including a separate adjustment for the company‘s actual cost of capital in the I factor would require accounting for other cost items such as rate base and depreciation to determine the weighting of the capital cost component of such an I factor. In Decision 2009-035, the Commission expressed its concerns with an I factor that appeared to be an effort to move closer to an inflation index that tracked the experience of a specific company to which the PBR plan would apply rather than a broader industry inflation measure.¹⁸³ The more the selected inflation measure tracks the actual performance of an individual company, the more it resembles cost of service regulation and the more the incentive properties of PBR are

180 Decision 2009-035, paragraphs 139-140.

181 Transcript, Volume 14, pages 2660, line 18 to page 2661, line 2.

182 Exhibit 477, Christensen Associates rebuttal evidence filed on behalf of AltaGas, paragraph 56.

183 Decision 2009-035, paragraph 141.

diminished. For all these reasons, the Commission finds that no adjustments for company-specific capital costs should be incorporated in the I factor.

181. Overall, the Commission is satisfied that a composite I factor consisting of two indexes (one for labour and the other for non-labour costs), represents a reasonable balance between the need for transparency and the need for accuracy in establishing an input price inflation measure for the Alberta electric and gas distribution companies.

182. The individual components of a composite I factor are discussed below.