10.	Regulatory Matters

Regulatory Liability

The Company’s regulatory liability is established through depreciation rates related to cost of removal and represents amounts that the Company expects to incur in the future. As of December 31, 2016 and 2015, the Company recorded on the Consolidated Balance Sheets as a long-term liability $21.0 million and $10.6 million, respectively, net of actual removal costs incurred.

Rate Case Filing

On April 29, 2016, Sharyland filed a system-wide rate proceeding with the PUCT to update its rates (April Rate Case Filing). Pursuant to a restructuring order issued by the PUCT in 2008 allowing the Company to utilize a REIT structure (2008 Restructuring Order), the April Rate Case Filing was prepared using the audited books and records of both Sharyland and SDTS and proposed rates to be set on a combined basis. However, as a result of a preliminary order issued by the PUCT in October 2016 (Preliminary Order), Sharyland and SDTS filed an amended rate case on December 30, 2016 with the PUCT (December Rate Case Filing) which supersedes the April Rate Case Filing and requests:

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PUCT approval of a tariff establishing terms and conditions for the leases between Sharyland and SDTS, including rent rates that SDTS will charge Sharyland under the leases;

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the PUCT to issue SDTS its own certificate of convenience and necessity; and

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new system-wide rates for Sharyland’s system.

Sharyland and SDTS have requested the following rate case metrics, among others:

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allowed return on equity of 10%;

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maintain the capital structure of 55% debt to 45% equity; and

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reduce the cost of debt to 4.97%, down from 6.73%.

Consistent with the Preliminary Order, SDTS and Sharyland proposed to replace their five existing lease agreements with two new leases, one for transmission assets and one for distribution assets. Each of the leases, if approved by the PUCT, will be executed upon the effectiveness of the rate case and will have a four year term. Sharyland will continue to have operational control over the Company’s T&D assets and will remain primarily responsible for regulatory compliance and reporting requirements related to the Company’s T&D assets on behalf of and with cooperation with SDTS. Further, the Company will continue to be responsible for funding footprint project capital expenditures that are included in the capital expenditure budgets that Sharyland provides on a rolling three year basis, which will be subject to the Company’s approval. Sharyland will remain responsible for funding repair expenditures.

The proposed lease payments will include both base and percentage rent as established by the PUCT. Base rent under the leases is a fixed amount. Percentage rent will be an annual amount equal to the percentage (percentage rent rate) of gross revenues collected by Sharyland during the year, subject to certain adjustments as described in the leases, in excess of applicable annual percentage rent breakpoints.

The transmission lease, as proposed, will have one annual percentage rent breakpoint and one percentage rent rate. The distribution lease, as proposed, will have two annual percentage rent breakpoints and two percentage rent rates. Sharyland will owe percentage rent based on the percentage rent rate on the portion of its adjusted gross revenues in excess of the applicable annual percentage rent breakpoint.

As proposed in the December Rate Case Filing, lease payments under the transmission lease will be updated upon effectiveness of the rate case to give effect to TCOS filings that have been approved by the PUCT after the 2015 test year. The base rent payments will also be updated through TCOS and DCRF filings with the PUCT. These updates will replace the current rent supplements and validation process in the Company’s existing lease structure.

The rent rates that have been proposed in the December Rate Case Filing are based on the premise that the Company, as the owner of regulated T&D assets, should receive most of the regulated return on its invested capital, while leaving Sharyland with a portion of the return that gives it the opportunity to operate prudently and remain financially stable.

The PUCT’s existing tariff construct does not contemplate the use of a lessor/lessee structure and therefore does not provide a mechanism for updating an asset company’s rates to account for load growth in its tenant’s distribution service territories. Accordingly, we and Sharyland have developed a proposed solution (Transition Payment Agreement) that is intended to allocate the growth in Sharyland’s distribution revenues as additional assets are placed in service after the 2015 test year between TDC, as the unregulated parent company of SDTS, and an unregulated parent company of Sharyland. The Transition Payment Agreement will provide the Company the opportunity to realize an additional portion of Sharyland’s revenue growth to mitigate the regulatory lag on the Company’s assets placed in service between rate cases, similar to the opportunity that integrated utilities enjoy. The Company expects the payments under the Transition Payment Agreement, which will be executed upon the conclusion of the rate case, to be based on a variety of factors, including Sharyland’s distribution revenue growth and the amount of distribution assets placed in service. Without the Transition Payment Agreement in place, the Company would be subject to considerable regulatory lag related to its distribution assets and, accordingly, the potential for reduced revenue related to the Company’s incremental distribution capital expenditures.

The initial hearings for the rate case are currently scheduled for March 29 to April 7, 2017 with an anticipated conclusion of the rate case during the third quarter of 2017. Although there is a current timeline for the rate case and proposal for regulating the leases between SDTS and Sharyland, the ultimate timing and outcome of the rate case are uncertain.