ACIG / IGUA Rates case 2010, R-3690-2009

REGIE DE L'ENERGIE

(ECONOMIC REGULATION AGENCY)

EVIDENCE OF THE GAZ MÉTRO RISK

JEAN-BENOIT TRAHAN

FOR

THE ACIG

July 2009

HBdocs - 6734527v1

Original: 2009.07.14 ACIG — 5, Document 1 (48 pages)

Société en commandite Gaz MétroCause tarifaire 2010, R-3690-2009

Original : 2009.07.27 Gaz Métro - 7, Document 19(50 pages)

Evidence of the Gaz Métro Risk

by Jean-Benoit Trahan

Q1. Please indicate your name and business address.

A1. My name is Jean-Benoit Trahan and my business address is 120 rue Guy, St-Jean-sur-

Richelieu.

Q2. Please indicate the assignment you have been given by the ACIG in the scope of this case.

A2. The ACIG sought my services in order to determine the risk of Gaz Métro, which is a partial response

to the evidence submitted by Dr. Carpenter on behalf of Gaz Métro.

Q3. Please describe your experience and training relevant to your understanding of the

Gaz Métro business risk.

A3. From an academic point of view, I have a baccalauréat in economics and an MBA from the Université de

Sherbrooke.

With regard to economic regulation, I have worked in this area since 1994, both on the regulator side and as an

analyst and expert for different actors representing consumers before the Régie de l'énergie and the National

Energy Board. I have also done work giving training, assistance, and expertise on an international level in

various countries in West Africa.

More specifically, I have represented the ACIG as an analyst in the Gaz Métro cases since 2000. I have

therefore participated in all work from the different cases, particularly the rates cases and the incentive

mechanism renewal cases. In addition, over the years I have developed in-depth knowledge of the energy sector,

and more specifically in Quebec.

Please find my résumé in annex 1.

Q4. Please describe how you are presenting your evidence.

A4. My evidence will relate to the business risk of Gaz Métro in two stages:

1- Short-term business risk;

2- Long-term business risk.

Q5. Please indicate that you understand the evidence regarding the business risk presented by Dr.

Carpenter on behalf of Gaz Métro.

A5. The evidence submitted by Dr. Carpenter indicates that the business risk of Gaz Métro is considerable and

particularly greater than that of the group of companies proposed by Dr. Vilbert. He bases this assertion mainly on

two elements, that is to say, that the industrial portion of Gaz Métro's customer base is larger, and that there is a

reduction of volumes per consumer.

In addition, Dr. Carpenter indicates that the Gaz Métro franchise has been at greater risk from increased volatility

of natural gas prices since 2000 when comparing the company to itself.

Finally, according to Dr. Carpenter, the effect of using an incentive mechanism, which does not include a variance

account to take into account the difference between the forecast case and the closure case, is to increase the risk of

Gaz Métro as a result of such variances. Furthermore, the fact that the incentive mechanism does not completely

offset the downward trend of volumes per customer makes the mechanism riskier than traditional regulation based

on service cost.

Q6. Do you share Dr. Carpenter's opinion?

A6. No. The analysis put forward by Dr. Carpenter is not in line with our understanding of Gaz Métro's business

risk in several aspects both in relation to the long-term and short-term outlook. We have set out the main elements

of disagreement below.

1- We believe that the analysis put forward is not sufficiently detailed in several aspects.

2- The analysis put forward by Dr. Carpenter, which is largely based on the impact of the volumes,

draws on a false premise. The aspect that should be studied in a regulated company's risk analysis is the

generation of revenues and not the volatility of the sales volumes.

3- A portion of his analysis is theoretically correct, but does not stand up to the test of reality, that is, the

comparison between Gaz Métro and a regulated company with a full end-of-year compensation system.

4- With regard to the incentive mechanism, this offers a lesser risk to Gaz Métro compared to the

traditional service-cost method that was in force until 1999, which runs contrary to Dr. Carpenter's opinion.

5- He has not taken into account past and prospective growth of Gaz Métro's customer base, the effect of

which would be to reduce Gaz Métro's business risk over time and influences the downward trend of volumes.

6- He has not taken into account Gaz Métro's rates structure, both past and prospective, the effect of

which is to reduce Gaz Métro's risk over time and very much puts into perspective the risk associated with

corporate customers.

7- He has not taken into account the risk of training in the development of the residential sector, the effect of

which is to reduce Gaz Métro's business risk in the present compared to 2004 and 1999.

8- He has not taken into account the new business opportunities that would arise from the start of

shale gas production in Quebec, both from the point of view of the new customers for Gaz Métro that these

producers would represent, and the beneficial effect of this resource on the population, including greater

independence from the TCPL network.

9- We have a different perception of the competition between the forms of energy, particularly through the

positioning of natural gas, which can no longer be considered only as a source of low-cost energy.

10- We believe that the reduction of gas volumes per customer is a very interesting indicator whi ch

helps to reduce Gaz Métro's business risk over time.

Q7. Do you also dispute the comparison of risk between the regulated companies of the United States with

those of Canada?

A7. I will deal with this aspect partially in the last part of the brief, only from the perspective of Gaz Métro

compared to the companies chosen for purposes of comparison by the Brattle Group.

Short-term business risk analysis

Q8. How would you describe the short-term business risk of a regulated company?

A8. The short-term business risk of a regulated company represents the capacity of a company to generate the

revenue necessary to meet its service cost during the year, including the authorized basic rate of return.

Q9. Over the last few years, has Gaz Métro succeeded in meeting its authorized basic rate of return?

A9. Yes, every year since 2001 1 and therefore during the period of application of the incentive mechanism.

In addition, in the preceding period from 1990 to 2000, Gaz Métro succeeded in reaching its basic rate of return

every year, except in 1995, when it suffered a rate of return deficit of 22 basis points.

Q10. Has the incentive mechanism had any positive effect on the overall rate of return of Gaz Métro?

A10. Yes. Gaz Métro has had the capacity to make a surplus rate of return on top of its basic rate of return since

the implementation of the incentive mechanism. Thus, during the preceding period, when tax overpayments were

distributed only at the end of the year, Gaz Métro made an average of 22 basis points (1994 to 2000) on top of the

authorized basic rate of return. Since the incentive mechanism was implemented, this surplus rate of return has

been quantified at 104 basis points on average (2001 to 2006).

There is no doubt that the capability of achieving at least the basic rate of return every year since implementation

of the incentive mechanism has been historically demonstrated.

Q11. Has the introduction of the incentive mechanism modified the risk of Gaz Métro achieving its basic rate

of return in the short term?

1 See Gaz Métro-7, document 8.3, page 2 of 5.

A11. Yes, for four reasons.

First of all, the incentive mechanism enables rates to be improved, as these include a 50% share of the

productivity gains established in the rates case (in forecast format). The effect of this is to increase the

distribution rates to the same extent. Thus, to simplify, if the service cost is 100, the productivity gain is 5, and

volume is 100, the rate under a service cost regime would be 1, whereas under the incentive mechanism, the rate

would be closer to 1.025. As such, the effect of the incentive mechanism is to offer a potential for loss of

revenues coming from the variable portion of the rate without affecting the authorized basic rate of return, which

is not the case under a service cost regime.

In addition, this situation came about in 2005, when the basic rate of return was 9.69 %, plus an established rebate

of 1.95% leading to an expected rate of return of 11.64%. However, the real rate of return was actually 10.51%,

that is, 113 basis points less than the expected rate of return, but also 82 basis points more than the basic rate of

return. Thus, we can conclude that in a traditional service-cost situation, Gaz Métro's basic rate of return would

have fallen by 113 basis points, therefore going from 9.69% to 8.56%, which is similar to the situation that arose

in 1995.

Secondly, the incentive mechanism means that a maximum rebate can be made at around $ 4M in order to achieve

the energy efficiency objectives. This addition to the basic rate of return with the rebate is also supposed to be a

supplementary protection enabling Gaz Métro to achieve its basic rate of return. Indeed, if it turned out that the

Distributor was not achieving its basic rate of return up to $ 4M during a year but was achieving its energy

efficiency objective, the Distributor would still achieve its basic rate of return. Also note that this rebate on rate of

return did not exist in 1999 or 2004.

Thirdly, and in the same way as for the energy efficiency rebate, Gaz Métro receives a rebate for operations that

optimize transmission and balancing costs. We will deal with these surpluses in the passages set out below.

Finally, if the Distributor does not manage to achieve revenue at the end of the year equivalent to its required

revenue, including only its basic rate of return (excluding rebates), Gaz Métro would then suffer a loss on the rate

of return. However, in the scope of a service cost process, in the manner in which it was applied

before 2000, Gaz Métro should then assume the entire loss of profit. This is no longer the case. If such a situation

occurred, only 50% of the variance would be sustained by the shareholders, while the other portion would be

sustained by customers through an account for costs carried over.

All of these elements show that in the short term, the incentive mechanism has had the effect of reducing Gaz

Métro's risk of not achieving at least its authorized basic rate of return when analyzing the real results in relation

to the forecasts.

Q12. What happens in the event that Gaz Métro cannot make productivity gains at the start of the year?

A12. In this case, for the year in progress, it is the required revenue established as in a regulated regime based on

service cost which would be applied. This will, in any case, be the case for 2010. Such a situation would not make any

difference to risk in the short term compared to the use of a regulation under traditional service costs.

Q13. In any case, would this situation have any impact on the next few years to come?

A13. Indeed, it would have the consequence of creating a debt for Gaz Métro toward its customers. As

such, any end-of-year surplus or productivity gain made in future years would first be used to absorb

this debt.

It is worth noting that the entire gain or surplus is used to repay the debt, which means that the portion of customers

would also be allocated to this payment before they can obtain any other rate benefit derived from the incentive

mechanism (in addition to processing of transmission surpluses). Thus, assuming Gaz Métro succeeded in

absorbing this debt, the customers would then sustain 50% to 75% of this cost, according to the proportion of

surpluses between start-of-year gain or end-of-year surplus.

In addition, if it turned out that the debt could not be fully repaid before the end of the incentive mechanism, Gaz Métro

would then have to absorb 50% of this debt in three years up to a maximum of 0.75 % of the rate structure

basis.

Q14. Have you evaluated the maximum extent of such a debt that Gaz Métro could suffer on the basic rate of return?

A14. Absolutely. In this respect, we agree with Dr. Carpenter's calculations, which establish an effect of a

maximum reduction of 65 basis points (before tax) on the basic rate of return over a period of three years.

Q15. Is this Gaz Métro's only risk of not achieving its basic rate of return?

A15. No. There is another aspect that may be a risk, that is, the procedures surrounding the resale revenues of

the transmission surpluses.

In this respect, if it turns out that Gaz Métro is reselling below the forecast revenues, this could have the

effect of reducing the authorized rate of return and/or with rebate through a loss of profit.

However, both historically and for the next few years, we do not believe that there is a realistic chance of such a

situation (loss of profit) occurring. In fact, the methodology used to determine these revenues is still conservative

and makes it possible to establish relatively large surpluses for each year.

Thus, although theoretically possible, we do not believe that Gaz Métro is subject to any such risk. Quite the

contrary, this enables the forecast basic rate of return to be protected further still. This can be seen particularly in the

presentation of results of July 5, 2009, as explained by Gaz Métro:

"The tax overpayment anticipated for 2009 comes to $ 2.9M. This tax overpayment is derived from

optimization operations on the transmission and balancing tools, for an amount of $ 4.8M, partially

offset by a rate of return deficit and a loss of profit, totaling $ 2.0M 2"

Q16. What is your conclusion with regard to the risks associated with the incentive mechanism?

2 Gaz Métro-8, document 8, page 2.

A16. Gaz Métro benefits from an incentive mechanism, the effect of which is to reduce its business risk in

the short and medium term compared to traditional regulation based on service cost. In particular, we believe

that Gaz Métro is less at risk today with this incentive mechanism than when it was regulated on the basis of a

traditional service cost before 1999.

Furthermore, in order to illustrate this situation, we can simply look back at the case of 2005, which enabled

Gaz Métro to achieve more than its basic rate of return, while it would have suffered a rate of return deficit under

the traditional regulation method based on service cost.

Q17. Are there any other aspects that have an effect on Gaz Métro achieving the basic rate of return in the

short term?

A17. Indeed, one important aspect is the capacity to generate the forecast revenues at the end of the year in the

scope of the rates case. In order to do this, there are two aspects that substantially affect this capacity, that is, the

realization of sales volumes by customer type and the nature of the rates structure.

When we analyze the capacity of a regulated company to achieve its basic rate of return, it is necessary to take a

look at its rates structure. Theoretically, a company with a rates structure having a completely fixed rate would not

be subject to any risk associated with volume fluctuations. This is especially the case at TransÉnergie, whose local

charge rate (paid by Hydro-Quebec Distribution) is equivalent to the required revenue minus the revenues

established for the point-to-point service. Thus, regardless of whether HQD uses its reserve transmission capacity

at 100% or 2%, the Operator's revenue will not be affected in any way.

In the case of Gaz Métro, the fixed portion of the rates is very large, particularly for customers considered to be the

riskiest, that is, industrial customers. Indeed, the fixed portion is about 80% for customers on the D4 rate.

For customers on the interruptible D5 rate, the POMA percentage is also relatively large. Although not specified in

Gaz Métro's response to our information request, we can conclude, from reading the Rate, that the fixed portion

remains relatively large (more than 50%), all in relation to the terms accepted by the customer (particularly

contract term, whether or not it has already modified its OMA, and whether it accepts the maximum discount for

the OMA).

Finally, these percentages are different for the other rates.

Table 1 below shows the fixed and variable portion of Gaz Métro's rates:

Table 1

Fixed portion of Gaz Métro rates

Fixed revenues Variable revenues Revenues total

excluding funds

Fixed portion of

rates Rate D1 22,309 318,919 341,228 6.5%

Rate DM 247 59,164 59,411 0.4%

Rate D3 1,624 237 1,861 87.3%

Rate D4 36,975 8,982 45,957 80.5%

Continuous Service

Total

61,155 387,302 448,457 13.6%

Rate D5 - 15,882 15,882 0

Assuming a percentage of 50% fixed for D5:

Rate D 7,941 7,941 15,882 50.0%

Total under services 69,096 395,243 464,339 14.9%

Source: Gaz Métro--7, document 13.27, page 2 of 2.

We can see that the fixed portion of the Gaz Métro rates is relatively weak from the company's general point of

view, with a total of 13.2% (or 14.9%). However, it is especially necessary to recall that the customers

considered as being the riskiest have an excessively large fixed portion compared to the less risky customers.

We have included rate D5 for this purpose. Indeed, once the customer has signed its contract, a large portion of its

annual cost becomes fixed, which is not the case, for example, for D1 customers or even DM customers.

This rates structure runs counter to the principle largely supported in recent years that Gaz Métro's business risk,

and more specifically its short-term risk, is strongly influenced by the large composition of corporate customers

in matters of volume.

An analysis of volumes demonstrates that the risk of volume fluctuations is about 20% for continuous service

customers. Proportionally, the risk that Gaz Métro is subject to from variable revenues from continuous industrial

customers is limited to just 2% of the company's total revenue.

In the same way, if we add the totally variable (although this is not the case) rate D5, the revenue variation

percentage increases to 5.35 %, whereas with an annual fixed-portion percentage of 50% (which is closer to

reality), the percentage would then be 3.6%. For the purpose of comparison, with regard to volumes, these

customers represent nearly 42% of the franchise volumes.

In short, although industrial customers may represent a large volume, this exercise demonstrates that the risk of

loss of revenues generated by these customers is very limited.

Only one other aspect could modify these figures. In fact, when the customer is at the end of the contract, it is

possible that said customer might not sign new contracts with Gaz Métro. In this case, 100% of the revenue from

this customer would be at risk. However, the customers' contractual term is generally more than one year. In any

case, here is a response from Gaz Métro indicating the remaining term of its industrial customers' contracts:

"c) The average duration of industrial customers' contracts is 52 months. This information comes

from the "VGE" customer database; customers from the institutional, public, and para-public sectors

have been removed from this database. However, in the case of customers on stable output and

interruptible rates, the vast majority have taken advantage of the contract extension clause and

therefore have remaining terms of at least 3 years. 3"

As such, exposure to risk of loss of revenue from industrial customers (we should also note, in passing, that rates

D4 and D5 include some institutional, public, and para-public customers considered less risky than the industrial

customers) is assumed to be less than 5 % over one year. This appears to be quite remote from exposure to the

volume fluctuations that represent 41.9% for 2010 (including the GAC).

Q18. Can cost aspects also have effects on the basic rate of return during the year?

3Gaz Métro-7, document 13.27, page 2 of 2.

A18. With regard to costs, we should refer to two aspects.

Firstly, Gaz Métro controls a part of its costs. As such, in order to achieve its rate of return, it may, during the

year, and if it notices that its revenues are not sufficient, decide to reduce its expenditure. This method is not

very often used in a substantial way but it did arise in the period before 1999, with a considerable reduction of

operating costs over one year.

It is worth noting that this cost reduction potential is relatively limited when taking into account that a large

proportion of the costs comes from write-downs of the rates structure basis. For example, during 2010, the

required distribution revenue of $564,142,000 was composed of $154,500,000 in operating costs, which represents

27.4%. Thus, cutting 10% of the operating expenses made it possible to save up to $15 M. However, some

expense items are difficult to compress, particularly retirement contributions, minimum service to customers,

safety department, etc.

Furthermore, with regard to costs other than operating costs, Gaz Métro is almost completely free of risk,

particularly in dealing with the account for costs carried over, including:

1 . Variance due to the PGEE;

2 . Cost variance from Green Fund;

3 . Costs of participants;

4 . Fees to the Régie.

Q19. Does that complete your analysis of the short-term risk?

A19. In general, yes. In addition, some aspects in the section relating to the more long term risks also have effects

on short-term risk.

Analysis of long-term business risk

Q20. Consumption volume per customer is a major aspect of Dr. Carpenter's evidence on Gaz Métro's

business risk. What do you think about this?

A20. Consumption volume per customer can indeed be perceived as a risk factor during the first years of the

phenomenon. At that time, it was not necessarily clear why this phenomenon arose and what would be the

consequences of it.

However, as we mentioned last year, the reduction of consumption volumes per customer is a positive

phenomenon for Gaz Métro, as this reduction is particularly derived from the efforts made with regard to

energy efficiency which, according to many, improved Gaz Métro's position with respect to the competition,

and in the face of other energy sources.

For example, since the start of the 2000s, the preferred electric heating system in Quebec (the baseboard)

has simply maintained its efficiency. For its part, natural gas has, in many cases, seen its boilers gain more

than 10% in efficiency. All things otherwise being equal, natural gas has improved its competitive situation

accordingly. Without this considerable contribution to equipment efficiency, natural gas would be in a much

more difficult competitive position than it is today.

In the same way, and as mentioned last year, energy efficiency for large manufacturers is a source of

assurance, over time, of competitiveness for large Quebec manufacturers and, consequently, of their

sustainability.

In this respect, we can submit that these conclusions are broadly similar to the IndEco report submitted by

Gaz Métro:

"Achieving declines in the average use of gas per customer is not, per se, a problem. From a

customer perspective, declining average use means that customers are using natural gas more wisely

and saving on their gas bills. From a utility perspective, declining average use contributes to

customer retention. For utilities with DSM, their DSM programs further help

their customers to achieve wiser use. 4"

In short, reduction of volumes per customer is not bad news. On the contrary, it is a very interesting

opportunity for Gaz Métro, reducing the cost to consumers in order to obtain the same satisfaction of their

need. In addition, through a well-executed marketing approach, Gaz Métro has succeeded in using its PGEE

as a way of attracting new customers, particularly as the PGEE schemes are part of Gaz Métro's commercial

offer in its initiative to win back the residential market.

The only aspect that must be taken into account is in fact the possibility that Gaz Métro may not recover the

costs of its investments through its rates, as again submitted by the IndEco report:

"Declining average use only becomes a problem for a gas distribution utility if the declines are not

adequately captured in rates.5"

However, as we will demonstrate in the passages below, there is nothing to indicate that Gaz Métro is in a

situation where it might lose its customer base. On the contrary, this base is growing and the future seems

promising.

Q21. In addition to energy efficiency, are there any other factors that influence volume per customer?

A21. Yes. There are two additional factors that must be taken into account.

The first is the composition of the Gaz Métro customer base. Gaz Métro's growth in the 2000s was especially

concentrated in the residential and commercial SME sector. This is derived from the fact that the strategy of

returning to the residential market, since the start of the 2000s, has often been achieved through the gas

district concept. Thus, a new residential project will have its business and natural gas residences nearby, thus

adding many customers, but at lower volumes than in previous years. Furthermore, Gaz Métro has gained

many new customers with perimeter equipment, without heating. For example, in the 2005-2006 period

4 Gaz Métro-7, document 11.5, IndEco report, page 26.

5 Gaz Métro-7, document 11.5, IndEco report, page 26.

this type of customer represented 49% of new sales6. The effect of these customers is to establish a lower average

sales level than for traditional customers with air heating.

During the 1990s, Gaz Métro "concentrated (its efforts) exclusively on the commercial, institutional, and small

and large manufacturing sectors7". It is therefore not surprising that the largest customers in these categories

engaged in skimming8 as a certain volume was necessary particularly to make termination (or extension)

profitable. Nowadays, Gaz Métro is able to make profitable several small extensions or terminations, for all types

of customers, even if the volumes are smaller than during the 1990s, as the network passes near these new

customers.

We have not been able to accurately quantify this phenomenon, but it directly affects the nature of the

analysis to be carried out on the phenomenon of volume reductions per customer since 2000, proportionally

reducing the alarm signal that would result from a volume reduction per customer.

Still in relation to the composition of the customer base, it should be noted that Gaz Métro has also lost several

former customers, particularly as a result of their switching to other energy sources (usually electricity). Again, we

do not have precise figures in relation to this phenomenon, but it should be noted that these customers are mainly

of two types, namely, the small plexes (small apartment blocks), which forgo hot-water central heating (which

negatively affects volume per customer as this category includes customers with good volumes) and the smallest

customers who only have an old perimeter unit (usually those known as "ronds de pale"). The latter customers

use very small volumes and offset, either fully or partially, the effect of the losses from the small plexes with

regard to average volume.

The analysis put forward by Dr. Carpenter does not take these aspects into account. Furthermore, although he

maintains that "The fundamental changes in the commodity price environment described above have begun to

induce changes in customer use of Gaz Métro's network. This can be seen in decreases in Gaz Métro's historical

and forecast usage per customer. 9", it would appear, on analysis of the charts shown below, that the reality is not

as simple as Dr. Carpenter claims.

6 D-2007-116, page 54. 7 R-3397-98, SCGM-3, document 3, page 3 of 13. 8

In this respect, see R-3630-2007, Gaz Métro-2, document 7, page 21. On the subject of customers

representing more than 75,000 m3, Gaz Métro indicated "However, these markets tend to stabilize or even decline.

The penetration rate is currently very high and the numerous threats to these markets, both with respect to

competing energies and in particular optimized off-peak electricity, and to the actual environment and structure

of the economy." (our emphasis) 9 Gaz Métro-7, document 13, page 26.

Graph 1 relates to customers on rate D1. It clearly shows that the downward trend since the start of the 2000s

runs contrary to the growth in customer numbers. This phenomenon – the growth in number of residential

customers - therefore negatively affects the average volume of D1 customers.

Graph 1

Graph 2 shows the growth of the customer base and the average volume for the rates D3 and DM. It is

remarkable to see a similar situation (reduction of average volume during a period of customer growth) but

at a different time.

Customer growth and use of gas per customer, rate D1

Customer growth

Decline in volumes Number of

customers (000)

Average use (103

m3)

Average use

Number of

customers

Graph 2

As such, we can see that from the 1994-1995 period to the 2002-2003 period, there is a decline in volumes per

customer, all linked to continuous growth of customer numbers. Subsequently, from the 2005-2006 period to the

2008-2009 period, we can actually see quasi-stability, both with respect to number of customers and level of

volumes per customer.

Therefore, although we are not claiming that the price volatility of natural gas, combined with the arrival of

more efficient equipment and other energy-saving measures, has no effect, it is necessary to note that the

premise that these aspects are at the root of the volume reductions per customer is mistaken. On the contrary,

the effect of the marked growth in the residential sector on rate D1 considerably affects the data for use of

gas per customer. As regards DM, we should note

Number of

customers

Average use (103

m3)

Customer growth Average use

Number of

customers

Customer growth and use of gas per customer, rate D3 and DM

Decline in volume Customer stability

Volume stability

the quasi-stability prevailing in the sense of average use of gas per customer since the 2003-2004 period10

.

The IndEco report refers to a fall in volume per customer of about 1.1% for the residential sector and 1.9% for all

sectors. According to Gaz Métro's data, this would mean an alarming decline of about 3.2% a year between 2000-

2001 and 2008-2009. However, this data for the D3 and DM customers is actually closer to 1.4%, which is more in

line with the results of the report.

In short, it is clear that the data on volume per customer in the D1 sector, if not placed in the context of a franchise

in growth in the residential sector, leads to false or exaggerated conclusions.

The second factor is derived from the effects of competition. In fact, the volatility of natural gas prices has led to

some customers seeking solutions that reduce their dependency on this product.

From our point of view, the considerable efforts made by customers are drawing to a close. In fact, price volatility

in itself is not particularly important, but rather the extent of this volatility compared to competing energy sources

and especially the extent of the price difference between natural gas and other energy sources 11

. In addition, we

can see in graph 3 below, relating to the number of customers and the volume of the interruptible sector, which is

the most likely to switch its energy consumption to another source, that since the shock of 2001-2002, the total

volume of this sector has stabilized.

As such, the companies that had the means to do so switched to another energy source following the price shock at

the start of the 2000s. Thereafter, the volume in place appeared increasingly to be a basic volume, which was more

difficult to switch to another energy source.

In this context, with a natural gas price again under $4/GJ and an oil price remaining at a relatively high minimum

level, there are no longer any advantages in acquiring equipment capable of using another energy source.

10

In fact, we could say since 1999-2000, with the exception of 2002-2003, which was supposed to have been a

reaction to the high gas prices. It is also interesting to note that this volume is relatively uninfluenced by this

sudden rise in the cost of gas, as customers were able to reduce their average use of gas by about 10%. In addition,

the return to normal use of gas returned in the following year and has been maintained since then. 11

Although volatility among the energy sources was identical, the competition situation remained the same and

therefore did not affect any interest or lack of interest in a specific energy source.

Graph 3

Therefore, although the preceding passage referred to the competition from heating oil, it is also necessary to

discuss the competition from electricity.

An important aspect in this respect changed as of 1999: the electricity rate was no longer frozen. In fact, it is now

growing every year, with an energy proportion that is more substantial than the power. However, it is precisely

this aspect, the low energy cost, that most affects Gaz Métro particularly in the small industry sector. In time, this

difference tends to be reduced and the initial advantage, from a few years ago, tends to disappear. We can see, in

passing, that the low cost of natural gas since the end of 2008 has also had the effect of substantially reducing the

advantage of obtaining additional equipment to switch the charge over to a rate optimization method. Finally, in

this SME sector, it is worth noting the abolition by HQD of the BT rate (in place in 1999), which offered an

advantage in addition to electricity for those who benefitted from it.

Thus, all these elements demonstrate that the reduction of volume per customer is not as risky as Dr. Carpenter

wishes to claim in his analysis.

Q22. What is Gaz Métro's situation then in the face of its growth and business model?

Customer numbers and volume growth, interruptible rate

Volume 106 m3

Volume 106 m3

Number of

customers

Number of

customers

Volume stability

Price shock

Decline #

customers

A22. Gaz Métro is a company in growth and in the process of diversification. Since 2000, Gaz Métro began to

grow again through customer numbers by means of a marked return in residential and commercial development.

Thus, after a period of decline in its customer base, which fell by 4.6% in 10 years (1989-1999), growth increased

to 16.2% over 11 years.

Graph 4

This phenomenon mostly explains the growth of the rates structure basis during this period, particularly with

service being rendered to a major customer, TCE, which required considerable investment. However, an analysis

of the rate basis per customer, particularly in constant dollars, demonstrates great stability, as shown in graph 5 12

.

Therefore, the growing needs of the rates basis in current dollars is accompanied by growth in the customer base

and not only by a situation of maintaining the infrastructures of a stagnating franchise.

12

The data on the rate basis in constant dollars and current dollars comes from exhibit R-3680-2008, Gaz Métro-

16, document 1, page 8. We have not added any data to that presented in this table in order to limit the risk of error

or interpretation (which level of inflation to take, etc.).

Number of Gaz Métro customers

Situation change

Slow decline

Graph 5

In fact, we can compare Gaz Métro to a single-sector type economy (before 2000) switching to a multi-sector

economy (as of 2010). As such, we can now see a growth in residential and commercial customers, particular in

relation to revenues, which gains a little ground every year, thus relegating other customer classes to secondary

roles, and reducing Gaz Métro's risk 13

, as shown in graph 6.

13 The graph draws its data from exhibit R-3680-2008, Gaz Métro-16, document 1, page 1. It should be noted that the

reduction in percentage of part D1, D3, and DM in 2008-2009 is largely attributed to the cost of the Green Fund, which does

not put Gaz Métro at risk in any way. This is why the arrow showing the trend stops in the preceding year.

Growth of rate basis per customer

Rate basis

per customer

$

BT stability in constant $ Number of customers

BT/Customer

BT$C/Customer

Number of customers

Graph 6

Growth of VGE revenue vs others

Q23. Do you have any other points to add regarding the effect of growth in the residential sector?

A23. Yes. Over the last few years, despite all the obstacles (especially with respect to the competitive nature

of natural gas in the face of other energy sources), Gaz Métro has regained its place at the center of

residential growth in Quebec. The data regarding the number of customers presented above speak for

themselves. Nevertheless, there is another very relevant piece of information, namely, Gaz Métro's

penetration rate in a market where it has a relatively strong presence, the RMR of Montréal. Graph 7 confirms

the preceding explanations regarding the fact that Gaz Métro has now assumed an important position as an energy

source in the residential sector. Of course, when we analyze the total average data for Quebec, the upward trend of

the position of natural gas in the Quebec residential sector is not evident, but when we analyze the results of

previous years a little more closely, we notice the substantial gains that Gaz Métro has accomplished. In the case

of the RMR, going from 3% of the market share to 26% in ten years is remarkable. It is a case of going from

a status of bit-part player to major player.

Even more importantly, this situation took place in a difficult period of competition with the most competitive

energy source in this market, that is, electricity. As shown in

Continuous upward trend

D4 and D5

D1, D3, and

DM

graph 7, the competition situation is no longer the basic element of consumer choice in opting for natural

gas over electricity.

Graph 7

This is the result of a change of attitude by the customers in Quebec toward this energy source. Before Gaz Métro

implemented its marketing strategy at the start of the 2000s, Quebec customers were rather lukewarm to natural

gas, and particularly had strong fears about the level of safety associated with the use of this energy source. In

addition, this energy was perceived as a budget product: cheap and uninspiring. So natural gas went to large

companies with large heating systems. In the residential sector, gas was particularly used for heating needs in plex

buildings with hot-water central heating, or in old kitchen ranges dating back to the time of town gas.

Nowadays, natural gas is perceived as an attractive and trendy strategy, offering specific characteristics,

well adapted to the lifestyles of customers. We can therefore find natural gas in residential

developments, where natural gas is used as:

An energy source for comfort heating,

An energy source in the kitchen for speed, quality, and excellence

(qualities of any self-respecting chef);

Growth of market share vs competition situation

Percentage Percentage

Above the black line: competitive

advantage of gas over electricity

Competition situation

over electricity

RMR market share

An energy source for perimeter units (including fireplaces, pool heaters, patio

heaters, and barbecues). The attitude of Quebec consumers has quickly evolved and

Gaz Métro is now able to maintain its market share in new construction in the future,

and maybe even improve it.

Gaz Métro's business model has therefore changed considerably, and is resolutely

centered on the future, with very interesting and less risky growth perspectives in these

markets.

Q24. Could other business opportunities arise in the near future and thus allow Gaz Metro to

continue diversifying its customer base?

R24. Yes. For nearly a decade now if not longer, Gaz Metro has been doing everything possible

to modify its situation with regards to its dependence on western gas, and particularly towards

the service of TCPL. Gaz Metro now finds itself as the last distributor at the end of the pipe and

the diversity of its supply is quite limited.

Over the last few years, Gaz Metro has been working hard to develop supplies free of carriage

charges from the east, either via the defunct project for transporting the gas from Ile de Sable to

Quebec, or via the implantation of a methane terminal, notably the Rabaska project.

These two projects have still not provided Gaz Metro with relief from its dependence towards

TCPL. Of course, a certain level of competition originating at the Dawn storage and exchange

site improved Gaz Metro's situation with regards to both the TCPL (long haul) monopoly and the

resulting captivity of Gaz Metro, although there was nothing comparable with any true opening

up .

Yet, it clearly appears that natural gas will be commercially produced in Quebec over the coming

years. That is due to the fact that Quebec is relatively rich in shale gas, the production of which

was,

until just recently, not commercially viable14

. Technological advances

14 Shale gas have been known for more than a hundred years; but most of them were not developed because the

techniques up to now did not allow a profitability of the projects. On the other hand, nowadays there is an enthusiasm for

this type of deposit due to many factors: stocks of natural gas are diminishing, prices are higher, and mainly, progressing

technology ensures economical exploitation of this resource

.

now allow for commercial production, as evidenced by the far-reaching Barnett project in Texas. In Quebec,

several players are active in this meme sector, notably the Junex, Petrolia and Gastem. Elsewhere, a certain

credibility was reinforced recently with the arrival of a major player (Talisman, Inc)15, as well as through the

discoveries of 2008 that assessed Quebec's potential at 4.1 trillion sq. ft. of gas16. Since then, exploration and

business pre-development work continues, with some expecting the launching of production by pilot projects for

201017.

Gaz Metro does not participate in these exploration projects and the launching into natural gas production in

Quebec shall not notably affect the price of gas merchandise in Quebec. However, gas production in Quebec risks

having two effects.

On the one hand, the projects are in many cases located on the territory served by Gaz Metro via its current

distribution network which can thus respond to a new type of customer, that is, the producers of natural gas in

Quebec. These new customers risk finding themselves fairly close to the Gaz Metro network (in the regions of the

low lands of the St-Lawrence, in Monteregie, etc.) and will certainly be able to connect to the Gaz Metro network

at a relatively low cost (when compared to an extension of the transport network coming from Ile de Sable, for

example).

Thus, Gaz Metro is in an enviable position whereby it may use its facilities for a totally

new type of customer. And even if natural gas production in Quebec only reaches the half or the fourth of the

expected quantities, this type of customer just may become quite

Explosion of Production in the United States

Explosion of gas production from the Shale in the United States started at the beginning of years 2000; it can be

mainly explained because of the improvement of wells fracturation techniques and with the use of horizontal.

drillings. For example, in 2006, we counted more than 6,200 natural gas production wells in the Barnett Shale,

located in Texas. In 1999, there were only 523 wells in operation while in 1989, 10 years earlier, there were only

47 wells producing gas from the Shales.

http://www.junex.ca/en/oilgas/shale-gas.php

15 Talisman's Quebec acreage is along the St. Lawrence River where the Company has currently earned or

acquired a total of 310,000 net acres. The Company also has rights to earn up to an additional 460,000 net acres.

In 2008, one well was drilled and another was drilling over year end. Initial tests from the Gentilly recompletion

were also conducted. Talisman expects to complete the drilling component of its earning phase (two additional

wells) by the end of the first quarter of 2009. The Company anticipates that testing will continue into the second

and third quarters of 2009 depending on equipment availability. Talisman will continue evaluating the potential

for commercial gas in Quebec throughout 2009.

http://www.talisman-energy.com/operations/north _america/carlyle.html?disclaimer= l

16 http://lapresseaffaires.cyberpresse.ca/economie/200901/06/01-688474-gaz-naturel-la-

frenesiegagnelequebec.php

17 http://www.ledevoir.com/2009/06/03/253203.html

important in the composition of Gaz Metro's clientele, thus ensuring for so much the utilization of

existing facilities and revenue diversification.

Q25. Could the launching of natural gas production in Quebec have other effects on Gaz Metro's

current clientele?

R25. Yes, for three reasons.

The first is gas access. The addition of network extensions for reaching these new customers

could allow for serving other customers that do not currently have access to natural gas,

since they do not have the required quantities for putting a network extension in place. Thus, the

more the Gaz Metro distribution network spreads, the greater the opportunities for adding new

customers.

Secondly, should natural gas production in Quebec reach a certain level, it will unblock the

bottleneck at the entry of Quebec. This bottleneck hinders access to all the duty-free gas desired at

all times. That is why interruptible customers have potential periods of interruption that are

particularly long in comparison with most other franchises. Thus, a supply of gas directly onto the

Quebec territory should reduce the number of days of interruption and thus improve the revenue

originating from interruptible customers, and more particularly, for customers using back-up gas

from the competition. Actually, these customers are the last ones served (after interruptible rate

customers). Through the bottleneck phenomenon at the franchise entrance, winter supplies are

usually limited for these customers. Opening this up in Quebec through the addition of domestic

production should allow for enhanced service for this type of customer during the winter months.

The third reason is a matter of marketing. In fact, Quebec is a land of electricity, primarily

hydro-electric, and since only recently, wind energy as well. This energy is the only one produced in

Quebec in significant amounts with the exception of biomass. Yet natural gas would certainly be

boosted from greater enthusiasm if the product originated in Quebec. The media buzz surrounding

the launching into production of major natural gas wells exerting a strong effect upon revenue that

the government would derive from this energy laying in the Quebec sub-soil is likely to become a

driving force for Quebec consumers. Although the result of this phenomenon may be

intangible, it is clear that it would be a powerful sales argument for natural gas should production be

put into place. Gaz Metro will never have had so much thrust towards its goal of providing, "the right

energy at the right place."

Q26. Have you considered other elements of risk concerning business development for Gaz Metro

over the coming years in comparison with the period 1999-2009?

R26. Yes. Any company that undertakes a new market development project incurs additional risk

when working in a well known environment. This was particularly the case for Gaz Metro over the

past few years in developing biogas (the Ste-Sophie/St-Jerome project) and in residential

development.

These two new types of projects brought Gaz Metro to launch projects with data and information,

considered accurate at the time, that ultimately proved inexact (both in terms of cost as well as in

terms of maturation volumes18

). Incidentally, these additional customers did not have the anticipated

effect on rates as their profitability was largely reduced.

In the case of the residential sector, it was the arrival of new information processes (SAP) that

revealed the error in costs. A case was then submitted to the Authority in order to make the proper

adjustments.19

Today, residential development includes a subscription charge of $300 for all new

18

In response to a request for information from the ACIG (Gaz Metro-7, document 11.5, page 3),

Gaz Metro indicated:

"As explained in exhibit Gaz Metro-7, document 2 of this rate case, Gaz Metro observed a drop in

profitability in the residential market caused essentially by better knowledge of connection costs

following implantation of the SAP system and not by a problem of forecasting signed volumes.

The situation prevailed up until that time, yet was unknown. The consumption volume forecast for

residential projects are in fact adjusted at the source according to the consumption history in order to

compensate any overestimation of the real situation. There is thus no problem of profitability in the

residential development program resulting from volumes forecast."

Yet, in this same case, Gaz Metro indicated that the volumes of maturation had been overestimated:

The results show that the new measure of the maturation of new residential market sales is less than

previous estimates, as much for the new construction market as for that of conversion." (R-3630-2007,

Gaz Metro-2, document 7, page 30)

According to this information contained in this file, it would appear that problems related to

estimation of profitability originated as much from cost as volume forecasts.

19

"The development plan 2006-2007 displays a drop in profitability of the residential market relative

to last year. SCGM mentions that this drop is notably attributable to better knowledge of real costs of

connection for customers following implementation of the SAP system. Meanwhile, these costs

turned out to be higher than those used in calculating the profitability of plans of prior residential

development." (D-2006-140, page 12)

connections20

, as well as a raising of the daily obligation in order to best cover the fixed costs and

allow for economies of costs.

The most important knowledge that Gaz Metro has acquired today from its residential development

implies that the risk of error concerning profitability of such projects is reduced. Actually, what Gaz

Metro has learned over the past few years (2000-2009) should allow it to offer more profitable

residential development which will in turn, over time, improve the competition of natural gas, all other

things being equal.

Thus, the risks linked to residential development (learning risk) that existed in 1999 will no longer

exist for the period after 2009.

Q27. What do you foresee in the way of electric competition in the future?

R27. Electricity competition in Quebec will be quite different from what it was prior to the year 2000.

It is important look back somewhat to remember the huge projects that were put in place (Baie-James,

Cote-Nord) for creating waves of available energy. In order to not simply let the water pass over the

dams, Hydro-Quebec decided, especially in relation with the goal of energy independence so

fashionable at the time, to sell electricity at a low cost and to aggressively market electric heating.

Business and rate programs were then launched, notably the blue boiler programs in the industrial

sector or encore the BT rate for the SMEs. These rates were set in such way as to make alternative

energy more expensive and incite Quebec consumers to prefer electricity.

All of these rates have now disappeared. Today, Hydro-Quebec has been divided into three

companies and the mandate of each one of them is no longer the same as it was during the period of

huge surpluses of the 1980's. Thus, Hydro-Quebec Distribution must provide for its customers' needs

by procuring, in addition to proprietary energy, the necessary energy on the market, either through

long term contracts (such as 20 The contribution is for all new small-volume customers, whether residential or not.

TCE) or by short term contracts (such as on adjoining markets).

The transporter's role is assumed by Trans-Energie, i.e., allowing the electricity produced to arrive at the

distribution networks or to interconnections with neighboring markets.

The Producer, for its part, has the responsibility of maximizing the revenue and profits of their entity. In

order to do so, it uses a three-point strategy:

1- Respond to the Distributor's needs by making the energy and the proprietary power available to

them;

2- Respond to certain needs of the Distributor through calls for tenders or des special contracts;

3- Create wealth in Quebec by marketing electricity on neighboring networks, either by selling the

energy and the power of its dams directly or by optimizing the utilization of its equipment

according to the needs of neighboring networks (e.g., purchasing at night, selling by day).

This expanded role for the Producer is set forth by the government, notably within Quebec's energy strategy, which

incites it to increase its level of exportation:

―We are mobilizing the means that will allow us to significantly contribute to the collective

efforts for fighting climate change. With regards to energy efficiency, our government will

go further than any of its predecessors. And by exporting more energy, we will be

contributing directly to improving the continental greenhouse gas emissions footprint.21

"

After all, the results forecast by the Producer do not imply any great surplus over the coming years, as

submitted by Hydro-Quebec to the NPCC in its triennial review of 200822

. 21 22

The energy for building tomorrow's Quebec, a message by the Prime Minister, page IV. http://www.regie-energie.qc.ca/audiences/Suivis/Suivi-D-2008-133 Criteres/HQD R-3648- 2007 Annexes Suivi D2008-133 16marsO9.pdf. See Table page 16.

Insert 1

Table 7 Planned and Required Reserves (Base Case)

Planned

Resources MW

Annual

Peak Load MW

Planned Reserves

LOLE

Day/Year

Required

Reserves

MW % MW %

2008/2009 41,827 37,099 4,728 12.7% 0.033 3,608 9.7% 2009/2010 42,726 37,620 5,106 13.6% 0.038 3,902 10.4% 2010/2011 43,336 38,130 5,206 13.7% 0.051 4,106 10.8% 2011/2012 43,158 38,527 4,631 12.0% 0.088 4,381 11.4% 2012/2013 44,238 39,375 4,863 12.4% 0.080 4,588 11.7%

Insert 1 shows that the added capacities via the new electricity production projects (all forms taken together)

will not result in creating a significant annual surplus that could lead to discounted rate proposals for quickly

selling the surplus.

This same conclusion is found in the assessment of Hydro-Quebec Production energy stocks for the years

1992 to 2007 and for the years to come23

:

23 http://www.regie-energie.qc.ca/audiences/CriteresFiabilite/HQ_CriteresFiab_AnnexA-B_10sept07.pdf

Insert 2

Energy Stocks

History 1992 - 2007

Insert 3

CHANGES IN ENERGY STOCK

From January 2008 to May 2012

That said, one must now analyze the electric competition via Hydro-Quebec Distribution. On this

point, an important transformation since 2004 in comparison with 1999 should be underlined, that being the

presence of annual rate increases (except for the first year that had two rate increases in

a single year). These rate increases, linked to Hydro-Quebec Distribution's rate strategy, result in greater

weight being carried by the energy part of the electric rate, a share that has the greatest effect upon the

competition of natural gas of which the rates have been unbundled. Table 2 presents the average rate

increases from 2003 to 2009, revealing a total increase in the cost of electricity of 18.2%. Meanwhile,

during this same period, the energy portion increased to higher levels, varying between 23 % and 34 %

according to the rate, as shown in Table 3.

Table 2

HQD rate increases since 2003

Effective date Percentage Base 100 01/2004 3,00% 103,0 04/2004 1,41% 104,5 04/2005 1,20% 105,7 04/2006 5,33% 111,3 04/2007 1,90% 113,5 04/2008 2,90% 116,7 04/2009 1,22% 118,2

Table 3

Increase in the second tranche of HQD rates 2003-2009

Rate 2003 2009 Increase D 5.57 7.46 34%

G 3.74 4.64 24% M 2.42 3.12 29% L 2.42 2.97 23%

This rate strategy should continuer to be applied (it did not apply to the first rate modifications, which

reduces the spread between the two types of increases), which will result in a continued accelerated

increase of the energy portion of HQD rates. This situation is to the advantage of natural gas over time

since it reduces, all other things being equal, the advantage of electricity on the energy portion more

quickly than the average increase in HQD rates.

Elsewhere, what remains to be seen is the nature of rate increases to come. This question is far from simple,

yet it must be emphasized that several elements argue for significant rate increases over the coming years.

Following are a certain number of reasons that may explain average rate increases likely to surpass the

anticipated rates of inflation:

❖ The drop in interest rates greatly contributed to reduction in the cost of Hydro-Quebec debt.

Yet, the base rates for the Transporter and the Distributor are important. In the case of the

Transporter, it must be remembered that its equipment carry over very long distances, resulting

in a very high cost per transport kWh relative to other transporters in general. The increase in

interest rates to come will certainly exert upward pressure on the transport rate. The same

scenario will apply for the Distributor that has no non-compliant infrastructures as does the

Transporter.

❖ Ageing infrastructures. Gaz Metro states that it must invest several million yearly in addition

to its usual expenditures in order to deal with the ageing of its infrastructure. In the case of the

Transporter, for the item asset maintenance, investments in 2004 totaled $230M per year with

some $630M forecast from 2011. Ageing infrastructures is every bit as much an issue for Gaz

Metro as for the electricity sector.

❖ Electricity consumption is in a special "lose-lose situation" situation. Should consumption rise,

the revenue obtained will not be sufficient for countering rising costs and that will have a

marginal effect on the increase in rates. Should demand not be present, HQD will have to incur

costs, either lower sales prices than the costs paid, or a compensation for non-consumption to

the Producer. Regardless of the future, the average electricity rate will have an upward bias.

❖ The introduction of IFRS: for Hydro-Quebec, the shock could be quite serious, since the

company currently uses a sliding scale of depreciation at 3%. The transition to straight-line

depreciation may cause rates to rise significantly for the Distributor and Transporter alike.

Although electricity remains a formidable competitor for natural gas in Quebec, it must be said that

the future for this energy is far from the stability experienced prior to 1999 and 2004, in a period of rate

freeze.

Of course, the daily or monthly volatility is less for this energy than for natural gas, but that has been the case

since the end of the 1990's.

One mustn't think that Gaz Metro faces less competitive risk than gas distributors in Ontario or in other states

of in the eastern United States. However, the situation that was deteriorating during the rate freeze and that

lasted up until 2004 is long gone. Year over year, we can now expect improvement in Gaz Metro's

competitive position, at least over the long term.

Q28. With the many energy efficiency programs that have been developed in Quebec these last years, is Gaz

Metro really at a disadvantage relative to Hydro-Quebec?

R28. The impact of the different cost components associated with energy efficiency is not identical for all

distributors. An important difference is the duration of the depreciation of CEEP costs that are spread over 10

years at Hydro-Quebec while they their expenditure is imputed in the year of their implantation for Gaz

Metro (except for variance accounts). Thus, the share of energy efficiency costs at Hydro-Quebec is

constantly growing since there has not been, to date, a duration long enough for integrating 10 years of

depreciation into the rates.

For the year 2009, $79.9M will pass in the electricity rates for the Hydro-Quebec Comprehensive Energy

Efficiency Plan CEEP (Plan global d'efficacité énergétique PGEE). Agency costs must be added to this

amount that will also be spread over a 10-year period. For 2009, a depreciation allowance of $3.8M must be

added that will grow every year through the introduction of a tenth supplementary allowance for depreciation

and the increase in costs of the Agency24

.

On required revenue of 10,661 M$, the cost of energy efficiency in 2009 is approximately 0.8 % of the total

rate for Hydro-Quebec.

For Gaz Metro, the energy efficiency share in the rates, including the Green Fund and the Agency is

24 See R-3677-2008, HQD-8, document 2, page 6 of 10.

evaluated at $24M for 2008-200925.

This cost corresponds to approximately 1.3 % of the total rates for Gaz

Metro (taking all components into account), on a budget of $1,842.2 M26

.

This spread, which may seem significant, will thus continue to abate each year, the more Hydro-Quebec's

rates include years of depreciation, from both CEEP as much as the Agency.

Elsewhere, it should be noted that in Gaz Metro's case, should the CEEP end or be largely reduced in terms of

costs, rates will be immediately impacted. Hydro-Quebec will thus be facing depreciation over a minimum

duration of 10 years.

In our opinion, when everything is compared, it seems clear that energy efficiency will have little impact on

the Gaz Metro's long term competitive position.

Elsewhere, Green Fund costs have a negative impact with regards to electricity. Since this element is already

included in Gaz Metro's 2010 rates, as for the year 2009, there is little additional risk in integrating this

element.

Q29. Could other forms of energy become interesting to the point of supplanting natural gas in its different

functions?

R29. Generally speaking, the new energy that could most affect the development of Gaz Metro is geothermal

energy. It carries the disadvantage of requiring heavy capitalization, although its utilization costs are quite

limited.

It is difficult to forecast the potential extent of utilisation of this energy source, yet it is difficult to imagine

that geothermal energy could supplant natural gas in the short term. On the one hand, it appears that this

energy source does not present a plausible interest for heavy industry. On the other hand, if this energy is to

be used massively by the population, the government must invest massively, in particular via substantial

subsidy programs, if this product is to grow to such an extent as to significantly reduce the market for natural

gas. We currently do not feel that this is the case.

25 26

Gaz Metro-9, document 3, page 5. R-3662-2008, Gaz Metro-9, document 9, page 1.

Q30. Does Gaz Metro, in particular through its incentive mechanism, thus present particular risks in light of

its regulatory environment in a long term perspective?

R30. No. The long term risk of an incentive mechanism lay in its inability to adapt to an ever-changing

business environment. Ongoing developments in the business world may be due to a variety of factors,

whether due to the nature of the company's internal growth, the effects of service costs that are beyond the

control of a regulated company, etc.

Gaz Metro is a company that enjoys a very favorable regulatory environment consisting of the utilisation of a

great number of deferred expense accounts or variance accounts that provide it with a high level of security.

In particular, we find accounts of this kind for:

❖ the Green Fund;

❖ the Agency share;

❖ the CEEP;

❖ temperature;

❖ interest rates;

❖ marketing programs;

❖ contributor's expenses;

❖ taxes levied by the Energy Authority.

Elsewhere, Gaz Metro enjoys a rather privileged regulatory environment. The work Group and its

contributors have proven their worth and they are often cited as a model, as much from the standpoint of

Canadian gas companies as for Hydro-Quebec. This environment of ongoing discussion has allowed all

participants to gain better understanding of Gaz Metro's business and thus allow adjustments over time in

order to ensure that the regulatory environment remains healthy.

The incentive mechanism was established in 2000 in a long term perspective. Thus, although the initial term

was for five years, it was planned that, after filing the third rate case, work would be carried out in order to

allow for renewal for an additional period. Since the mechanism was put into place, two renewals have been

made and introduced prior to the five-year term, notably in order to allow the mechanism to adapter to

observed or anticipated developments in the business environment.

Gaz Metro further indicates its appreciation with regards to the adaptations of the incentive mechanism in

response to one of our questions:

The modifications described above show that the process surrounding the incentive mechanism has

effectively facilitated a certain adaptation over the years. On the other hand, the modifications

provided were not perfect. For example, the modifications brought forth during the 2006

renegotiation in order to partially neutralize Gaz Metro for reductions in volumes linked, notably, to

efficiency energy do not perfectly compensate the variations observed at this level. The purpose of

Gaz Metro's incentive mechanism is to foster productivity gains that will also be beneficial for

customers. It is thus normal to periodically revise an incentive mechanism, its adaptation over time

for the purpose of prompting Gaz Metro emphasize the right elements."

In fact, with regards to Gaz Metro's position, it should be understood that that the incentive mechanism is less

than perfect. Unfortunately, perfection, regardless of the model, does not exist. In order to do so, the future

would have to be known precisely in order to gauge, with perfect exactitude, a formula for an incentive

mechanism. Yet, while perfection may be out of reach, there remains the ongoing developmental capacity of

the mechanism that largely compensates for it.

The first renewal came after relatively difficult period during which significant gains in productivity were

realized.

Table 4

Evolution of the base yield with price increases

Year basic yield Gains forecast Expected yield True yield Total Gains

2001 9,60% 0,78% 10,38% 10,38% 0,78% 2002 9,67% 0,02% 9,69% 10,67% 1,00% 2003 9,89% 0,45% 10,34% 10,82% 0,93% 2004 9,45% 1,51% 10,96% 11,47% 2,02%

It is observed that, despite a very harsh competitive environment in 2001 caused by the dramatic increase in

natural gas prices, the incentive mechanism withstood the test. Better yet, it even allowed Gaz Metro to

increase yield by 0.78 %. This would not have been accessible with a traditional regulation method based on

service cost.

It is also observed that in 2002, despite a negative sales forecast for Gaz Metro due to the impact of 2001, the

gain at the end of the year was 1.00 %, or 0.98 % more than forecast. Since the price increase was then 66 %

for customers at the end of the year, it would have been 1.56 % if it had been anticipated at the beginning of

the year. Finally, the gain in 2003 was forecast at 0.45 % to finally stabilize at close to 1.00 %.

In short, all these elements show that Gaz Metro had the capacity to make significant gains, as demonstrated

by the results of the year 2004, with gains ultimately reaching 2.02 %. In these conditions, it is normal to

expect the incentive mechanism to tighten in such way as to allow the company to continue be motivated to

make gains without these latter generating excessive price increases. That is exactly what the mechanism did,

notably by having the X factor rate of 0.3 % pass to 0.5 % and by modifying the rate of sharing to the

consumers' advantage.

The second version of the incentive mechanism provided equally positive results, although they were less

pronounced than those of the first period. A loss in yield expected is further observed in 2005, equally

impacted by a sharp increase in the cost of natural gas. It should also be emphasized that, when drafting the

third version, the rates known were those of 2005 and 2006, for price increases of less than 1.00 %.

Table 5

Changes in base yield with price increases

Year Base Yield Expected Gains Expected Yield Actual Yield Total Gains

2005 9.69% 1.95% 11.64% 10.51% 0.82%

2006 8.95% 0.38% 9.33% 9.66% 0.71% 2007 8.73% 0.84% 9.57% 9.90% 1.17%

Despite these good results, the mechanism was modified to take into account Gaz Metro's ongoing business

context, notably by making a qualifying statement regarding average volume per customer for the PMD1

sector as well as by a return of the X factor to a level of 0.3 % to take into account, notably, the drop in

revenue in the VGE sector27

.

These modifications bore fruit in 2008 and in 2009 since, for both of these years (and despite the

backdrop of a major financial crisis afflicting a part of the rate year 2009), Gaz Metro realized

27 In this concern, see the proof provided by the ACIG in the 2008 rate case: http://www.regie-

energie.qc.ca/audiences/3630-07/Preuve3630/C-8-11_ACIG Preuve-Risque_3630_6juillO7.pdf

or will realize productivity gains at the beginning and at the end of the year when taking into account

all gains taken together (energy efficiency, processing of transport and distribution transactions). The only

downside is that the required revenue based on service cost must be established for the year 2010.

This result (utilisation of required revenue) is due to an exceptional year with a forecast affected by one of the

worst financial crises of modern times. Not only were Gaz Metro's sales volumes affected, but worse, its

revenue, from both the VGE as well as from PMD sectors, was greatly affected. The case proposed

demonstrates required revenue greater than 12 M$ above the revenue ceiling.

This situation is quite special and comforting. Actually, Gaz Metro, like all companies, must face up to an

exceptional economic context that carries with it its share of bad news, including the drop in revenue resulting

from a reduction in consumption by all of its clienteles as well as cost increases (such as the cost of pension

contributions). Despite these important phenomena, these excesses remain largely within the amount of the

maximum debt forecast within the incentive mechanism. Essentially, this means that the calibration of the

incentive mechanism has proven sufficiently effective for adapting itself well, as much to a crucial growth

period (2001-2008) as to a period characterized by a major financial crisis (2009-2010).

If, amid a backdrop of financial crisis, the incentive mechanism that involves a volume effect had

nevertheless produced productivity gains at the beginning of the year, it would then have been clear that it

was too favorable to the regulated company. However, such is not the case and it is much better that way.

Elsewhere, this debt should be compensated in the coming years, and perhaps even from the end of 2010, if

sales volumes return quicker than forecast. Elsewhere, in any event, the mechanism provides for total

maximum impacts for Gaz Metro that, all told, are relatively minor, as explained above in the section

concerning short term risk.

For the current year, it is thus the required revenue that will be applied. This will leave Gaz Metro in a

situation identical to that of a company in a cost of service environment, with the privilege nevertheless of

enacting price increases on yield at the end of the year, notably via the transactions concerning transport,

equalization and the CEEP price increase .

Ultimately, a new round of re-evaluation has been inaugurated for which work will begin starting in August

2009. Once again, this re-evaluation shall take into account Gaz Metro's business environment, the effect of

volumes per customer together with other elements (access to new clientele [producers], continuing growth in

the development of the small volume clientele, ageing infrastructures, IFRS, etc.) in order to ensure that the

mechanism may continuer to deliver equitable results for all stakeholders. In any event, should the

mechanism be done away with, Gaz Metro would simply return to a traditional regulatory method based on

cost of service staring from the rate year 2013.

This history of the evolution of Gaz Metro's regulatory environment under the incentive mechanism shows

that over the long term, Gaz Metro is not a company subject to greater risk than a company using a cost of

service. The regulatory environment reveals a strong capacity to evolve and adapt in the time that allows for

envisaging the incentive mechanism with a high degree of sustainability.

Q31. What do you think of Dr. Carpenter's comparison concerning the fact that Gaz Metro's incentive

mechanism is riskier than a company subject to a cost of service scheme with a mechanism containing a

variance account at the end of the year?

R3 1. Theoretically, the affirmation is exact. However, such a scheme rarely exists. Moreover,

Dr. Carpenter was able to identify very few regulated companies using such a system28

.

Although quite interesting from a theoretical point of view, this analysis cannot be accepted when comparing

real companies. 28 Gaz Metro-7, document 13.12.

Comparison of Gaz Metro/LDCs proposed by the Brattle Group

Q32. What is your opinion concerning the comparison made by the Brattle Group between Gaz Metro and

selected American companies?

R32. Dr. Carpenter's analysis reveals itself as both limited and insufficient. It does not take into

consideration all of the elements of analysis that should be required, such as the stability of revenue rather

than volumes.

In response to the information requested, Dr. Carpenter indicates not having performed any analysis

regarding the nature of the rating for companies compared while the rating for Gaz Metro, with over 80 %

fixed costs for major industrial customers, is potentially unique within this group of companies. At least, a

partial review of companies compared allow us to see that none of those reviewed has a fixed share of this

scope in their rates.

Likewise, many other elements such as marketing programs, future business opportunities, the duration of

contracts and the nature of obligations towards industrial customers or the time between the rate cases were

not compared29

.

Likewise, Dr. Carpenter points out, in his comparison of companies with a cost of service scheme with

variance accounts at the end of the year:

"Atlanta Gas Light in Georgia, which is owned by AGL Resources, does not have a deferral

mechanism. However, most of its costs are recovered through fixed charges.30

"

Thus, if this element, the fixed share of rates, is important in this comparison, why did he not take this into

account for Gaz Metro's industrial clientele?

The analysis performed is fragmented and is not comprehensive enough for acceptance by the Authority.

29 30

Gaz Metro-7, document 13.27. Gaz Metro-7, document 13.12

Conclusions and Recommendations

There is no doubt, since 1999, Gaz Metro's business environment has undergone significant transformation.

The increase in the price of natural gas that took place at the beginning of the years 2000

and the extreme volatility in these prices has modified the nature of natural gas as a product. Moreover, the

Authority confirmed its concern regarding this phenomena through upward adjustment of the risk premium

associated with Gaz Metro's business within the framework of its decision regarding the rate of return (ROR)

in 200731

(D-2007-116).

Elsewhere, the proof presented hereafter clearly shows that the Gaz Metro franchise was able to adapt to this

new reality. Natural gas is no longer a source of energy that scares Quebecers. Quite the contrary, it is

perceived as an energy that procures a certain standing. The use of a gas stove or BBQ next to a gas-heated

pool replaces more and more the almost exclusive utilisation prior of air heating. The fact that Gaz Metro

succeeded, during the period from 1999 to 2009, in increasing its market share in new construction from 3%

to over 25 % for the Montreal Metropolitan area shows a radical change in the positioning of natural gas as a

preferred energy source for the Quebec consumer.

The risk analysis presented by Dr. Carpenter, as we have demonstrated, is based on erroneous premises. The

first is constituted of the reasons that have led to a downward trend in natural gas volumes in Quebec since

1999. Dr. Carpenter claims that it is above all a question of increased price volatility of the natural gas

commodity. However, we have demonstrated that at the customer level, rates D3 and DM, the demand by

customer stopped deteriorating during 2003-2004, at a time when the addition of new customers faded.

Elsewhere, with regards to customers at the Dl rate, it is clear that the effect of the increase in clientele

significantly affects the average volume per consumer. Failure to take these elements into account necessarily

results in a salient prejudice in Dr. Carpenter's risk analysis.

The second element is the fact that Dr. Carpenter bases his analyze on the volatility of volumes rather than on

the volatility of revenue which is the only representative measure of the real risk of a regulated company. On

this point, the largely fixed share of short- and mid-term rates for industrial clientele is a crucial element that

must be taken into account. Furthermore, the substantial growth

31 D-2007-116, pages 29 and 30.

in the number of new residential customers modifies, for 2010 and more for the future, the nature of the risk

for Gaz Metro. Once again, not taking this element into account inevitably prompts a biased perception in the

risk analysis carried out. Moreover, this reduction in risk tied to growth in the residential clientele was

already factored in during Gaz Metro's launch of its residential development:

"The impact of residential customers on the revenue stability for the company must not be

neglected. Today, the residential market is under-represented globally in the SCGM clientele while

the industrial market is over-represented relative to other gas distributors. Greater representation in

residential would make overall sales by the Company less vulnerable to economic uncertainties.32

"

Elsewhere, nothing leads us to believe that the incentive mechanism involves additional risk

for Gaz Metro. The results demonstrate quite the contrary, for the mechanism has allowed for reduced

regulatory risk for Gaz Metro, notably in the example of the results for the year 2005 in comparison with

1994. The developmental capacity, the short spans of time between each revision, the reduction of learning

risk in devising incentive mechanism are so many factors that demonstrate that the long term business risk

has not increased, quite the contrary. As far as we are concerned, the mechanism presents an opportunity

rather than a risk.

Thus, when one takes into account the transition in the business model that Gaz Metro has undergone since

1999, the enviable success of its residential development, the potential in new markets resulting from the

arrival of commercial production of shale gas in Quebec, the unfreezing of electricity rates and more

substantial growth of the energy share of this rating, it would appear to us that the business risk for Gaz Metro

is less than what it was only a few short years ago.

That explains why we consider that the decision regarding the business risk for Gaz Metro delivered by the

Authority in 2007 today represents a maximum level that should not be surpassed. Actually, our

recommendation today would be rather to reduce the adjustment for Gaz Metro's business risk.

32 R-3397-98, SCGM-3, page 13 de 13.

Annexe 1

Curriculum Vitae

of

Jean-Benoit Trahan

Jean-Benoit Trahan

120 rue Guy St-Jean-sur-Richelieu, Quebec J2X 4W4

Home Tel.: (450) 347-5590 Cellphone.: (514) 887-0395

Email: jb.trahan@videotron.ca

EDUCATION

2009-

DBA, Doctor in business administration University of Sherbrooke and University of Quebec in Trois-Rivieres Sherbrooke, Quebec

2005-2008

MBA, for practicing manager University of Sherbrooke Longueuil, Quebec

1998-1999

Regional Planning and

Development Laval University Quebec, Quebec

1992-1995

Specialized Bachelor's Degree

in Economics University of Sherbrooke Sherbrooke, Quebec

Beginning of August 2009

Acquired

Master's training

Acquired

PROFESSIONAL EXPERIENCE

2000 to date

President

Eneconsult Inc. St-Jean-sur-Richelieu, Quebec

Mr. Trahan is acting president and leading analyst for

the firm Eneconsult Inc. That he founded in 2000. This firm's

activities are focused on financial regulation. The company thus

develops its activities both in Quebec and abroad in the fields of

training, practice and consultation.

TRAINING AND TEACHING

- Lecturer, University of Sherbrooke (summer 2006)

- The external corporate environment

One week training course on financial regulation and

privatization of electrical operators in Benin (2003)

- Consisted of presenting financial regulation in the

electricity field to different groups representing civil society

4- Conference on the role of financial regulation, Niger (2003)

- Consisted of presenting multi-sector financial regulation

to different groups representing civil society

Co-organizer and/or trainer for training sessions in cooperation with the

Center for financial and economic regulation [Centre d'etude en regulation economique

and financiale (CEREF)] at the University of Sherbrooke and for the Institute for

environment and energy in French-speaking countries [Institut en environment and

energy des pays francophone (IEPF)].

- These training programs are offered to practicing managers from

over 20 different French-speaking countries

- Sessions held annually in Quebec since 2000

- A more specialized session on tariffication was held in Togo (2003).

Publication of a chapter in a collective of symposiums of the IEPF: the

economic and financial regulation for network industries; Collection Actes, the

publications of the IEPF, 2005.

International Consultation

Petroleum, electricity, telecommunications and transport

Representative of the Mali Ministry of Mines, Energy and Water

in the implementation of an economic and financial regulatory model (2003-2004)

- Created, in relation with the regulator's consultant and the

water and electricity distributor, a computerized economic and financial

model

Participation in a workshop on the review of rate formulas for the

electricity and water distributor of Mali (2002)

- Participation in public workshops bringing together the national authorities

of the country, civil society as well as the water and electricity distributor,

with presentation of a short speech

Assistance in setting up multi-sector regulators: Mauritania (2001-2002)

and Niger (2003-2004)

- Consultation concerning laws and regulatory procedures

- Production of organizational charts and job descriptions for personnel

- Participation in the selection of employees

- On-site training of personnel

- Support for personnel in regulatory efforts

Regulation of the energy sectors of Quebec and Canada

NATURAL GAS, ELECTRICITY and PETROLEUM

INTEREST GROUPS REPRESENTED SINCE 2000

1. Association of industrial consumers of natural gas [Association des consommateurs

industriels de gaz naturel] (ACIG)

2. Association of Industrial Consumers of Electricity [Association des consommateurs

industriels d'électricité] (AQCIE)/ The Forest Industry Council of Quebec [Conseil

de the industrie forestiere du Quebec] (CIFQ)

3. Quebec Association of Glass Products and Fenestration Industries [Association des

Industries de produits verriers and de fenestration du Quebec](AIPVFQ)

4. Quebec Association Lumber Manufacturers [Association des manufacturiers de boil

de sciage du Quebec](AMBSQ)

5. Quebec Association of Ski Resorts [Association des stations de ski du Quebec]

(ASSQ)

6. Canadian Federation of independent companies [Federation canadienne de the

entreprise independante] (FCEI)

7. Quebec Union of Municipalities [Union des municipalities du Quebec] (UMQ) REGULATED DISTRIBUTORS

Hydro-Quebec Distribution Gaz Metro

TransEnergie Gazifere inc.

TQM

NATURE OF CASES

Rate cases

Plans for energy supplies

Incentive and financial mechanisms

Marketing and energy efficiency programs

Supply conditions

Rate strategy

Rate of Return (ROR)/risk for the regulated company

Other work, from 2007 to date

Quebec Association for Energy Management AQME (Association Quebecoise de

maitrise de l'énergie) 2007

- Research and analysis, regulated energy sector and biomass-wood.

1994 a 2000, as analyst

\

The Energy Authority

The Natural Gas Authority

Montreal, Quebec

Economic Regulation

Petroleum, natural gas and electricity

1998-2000

1996-97 et

1994-1995 (stages)

- Acted as analyst and consultant with regulatory

authorities.