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INCREMENTAL CAPITAL MODULE. Board Staff Presentation Stakeholder Conference – August 5-8, 2008. July 28, 2008. The Question. “What is an appropriate capital expenditure to depreciation threshold value to determine materiality?”. Purpose of Staff Presentation.

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  1. INCREMENTAL CAPITAL MODULE Board Staff Presentation Stakeholder Conference – August 5-8, 2008 July 28, 2008

  2. The Question “What is an appropriate capital expenditure to depreciation threshold value to determine materiality?”

  3. Purpose of Staff Presentation • Provide background information and analysis to assist in determination of threshold • Explain components in Board staff analysis • Provide illustrative application of components • Show implications of threshold at various levels

  4. 1. Background: Report of the Board on 3rd Generation Incentive Regulation for Ontario Electricity Distributors • “The Board has determined that there will be an incremental capital module in 3rd Generation IR • For incremental CAPEX to be considered for recovery prior to rebasing, amounts must satisfy the eligibility criteria set out in “Table 5” • Eligibility of a distributor to apply for rate relief through the module will be subject to a materiality threshold. However, the Board would be assisted by further consultation on the appropriate materiality threshold ... • The Board has also determined that there will be annual reporting on actual capital spending and a prudence review at the time of rebasing” * Pages 32 and 33 of the Board’s Report

  5. Eligibility Criteria

  6. 2. Components in Board Staff Analysis • Materiality Threshold • Average of 3 most recent fiscal years actual net capital spending, i.e., additions to in-service PP&E net of third party capital contributions • Most recent year’s depreciation expense • A expressed as a percent of B, i.e., A÷B=C% • If C exceeds X%, then eligible to apply to Board • Demonstrate in application that • criteria met • Incremental revenue requested will not be recovered through other means

  7. Components in Materiality Threshold • Components that add up to a threshold of X%* • 100% Base depreciation value • XX% IRM3 escalator automatically provides new money for incremental CAPEX – avoid double counting • YY% Inflation adder – to adjust depreciation from historical to replacement dollars • ZZ% Other * Customer growth considered separately

  8. Determining the Component Values Automatic Increase Already Provided – Avoid double counting • IRM3 escalator already provides dollars to fund new CAPEX – depreciation and return on rate-base are in base year costs $ 676M depreciation in ’06, all Ontario distributors* $ 667M return at 7% WACC on $9,526M * Rate Base (net PP&E) $ 144M tax effect of equity component of return (35% tax rate; 40% equity thickness) $1,487M is total of above (57% of Ontario distribution revenue) • If IRM3 escalator is 1%, there will be $15M more to fund new capital related costs (1,487x0.01) • Average depreciation rate is 4%*. This plus WACC of 7% means $15M new money in rates will support $136M new CAPEX (15M÷[0.04+0.07]=136M). • This level of spending can be observed to be 20% of annual depreciation (136÷676 = 20%). • Summary: 1% IRM3 escalator provides enough new money in rates to fund new CAPEX equivalent to about 20% of depreciation expense (2% would fund CAPEX of 40% of depreciation). * Source: 2006 Yearbook of Electricity Distributors, OEB

  9. Determining the Component Values Inflation Adder – Bring historical costs to current dollars • Average age of PP&E in Ontario is 25.3 years • Total gross distribution PP&E $17,136M * • Total depreciation expense $676M * • 17,136÷676=25.3 years, or 4.0% depreciation per year • Depreciation reflects dollars of the years the assets were placed in service – not current replacement dollars • If assume relatively stable utility asset base, then any given asset is 50% consumed at any point in time. The average asset is therefore ~12.6 years old (25.3÷2). • If replaced today, inflation at CPI would have eroded purchasing power by 49.1% over 12.5 years of a 25 year time span (Canada/Ontario CPI change over 25 years is 233.1%, compound average over 12.5 years is 49.1%). See page 13 • Escalation of deprecation today by approximately 50% would bring it to approximate current dollars * Source: 2006 Yearbook of Electricity Distributors, OEB

  10. Determining the Component Values Other Factors • Various other factors/uncertainties affect calculation of threshold based on historical cost, including: • Assumption that escalation factor will be about 1% • Accuracy of other estimates • Historical uplift in input prices for capital works in addition to inflation • More efficient manufacturing/constructing of capital works

  11. 3. Illustrative Application of Components

  12. Implications

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