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

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

3 Purpose of Staff Presentation 1.Provide background information and analysis to assist in determination of threshold 2.Explain components in Board staff analysis 3.Provide illustrative application of components 4.Show implications of threshold at various levels

4 1. Background: Report of the Board on 3 rd Generation Incentive Regulation for Ontario Electricity Distributors “The Board has determined that there will be an incremental capital module in 3 rd 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 A.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 B.Most recent year’s depreciation expense C.A expressed as a percent of B, i.e., A÷B=C% D.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% * 1.100% Base depreciation value 2.XX% IRM3 escalator automatically provides new money for incremental CAPEX – avoid double counting 3.YY% Inflation adder – to adjust depreciation from historical to replacement dollars 4.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÷[ ]=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

12Implications

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