HomeMy WebLinkAboutHanley rebuttal testimony.doc PURPOSE
Q. Please state your name, occupation and business address.
A. My name is Frank J. Hanley and I am President of AUS Consultants - Utility Services. My business address is 155 Gaither Drive, P.O. Box 1050, Moorestown, New Jersey 08057.
Q. Are you the same Frank J. Hanley who previously submitted prepared direct testimony in this proceeding?
A. Yes.
Q. What is the purpose of this testimony?
A. The purpose of this testimony is to rebut the prepared direct testimony of Terri Carlock, Staff Witness of the Idaho Public Utilities Commission concerning her recommended common equity cost rate. My rebuttal testimony is limited to common equity cost rate because Ms. Carlock has adopted United Water Idaho, Inc.s (UWID or the Company) recommended capital structure, long-term debt, and minority interest cost rates. Consequently, the only point in dispute is common equity cost rate.
SUMMARY
Q. Please briefly summarize your rebuttal testimony.
A. I will show that Ms. Carlocks recommended point estimate of common equity cost rate of 10.6% is understated because it is based, in part, on a range of DCF common equity cost rates that are grossly substandard and would not maintain the financial integrity of presently-invested capital; and also because her approach to the determination of common equity cost rate based upon the comparable earnings method is seriously flawed and grossly understates the appropriate indicated common equity cost rate by use of that method.
I will also provide reasoning why I believe that Ms. Carlock has underestimated UWIDs relative business risk and will show why her recommended common equity cost rate results in an unreasonably low implicit equity risk premium. Moreover, I will show why UWIDs requested 11.30% common equity cost rate does result in a reasonable, albeit conservative, implicit equity risk premium over the prospective yield on A rated public utility bonds.
Q. Have you prepared an exhibit in support of your rebuttal testimony?
A. Yes, I have. It has been denoted as Exhibit No. 19 and it consists of five schedules.
COMMON EQUITY COST RATE
Q. In formulating her recommendation of common equity cost rate, Ms. Carlock considered a range of DCF common equity cost rates of from 8.6% to 9.6% as specified at page 19, lines 3-4 of her testimony. Please comment.
A. At page 18, line 21 through page 19, line 2 of her testimony, Ms. Carlock suggests that the current dividend yield of United Water Resources produces unreasonable results. It is as though, implicitly, she suggests that the DCF results using a dividend yield of 5% are reasonable DCF return rates. They are not. I will show that DCF common equity cost rates of 8.6% to 9.6% are not reasonable and would not maintain the financial integrity of capital presently invested in UWID. Consequently, such cost rates do not comply with the landmark cases of the U.S. Supreme Court cited by Ms. Carlock at pages 3-5 of her testimony.
Q. Please describe Schedule 1 of Exhibit No. 19.
A. On Schedule 1, I have shown UWIDs capital structure, long-term debt, and minority interest cost rates which are not in dispute. I have also shown the implicit range of overall cost of capital if Ms. Carlocks DCF common equity cost rate range of from 8.6% to 9.6% were used. Also shown is the implicit range of before-income tax weighted cost of capital. It is shown, at the top half of the page, that the implicit before-income tax interest coverage of all interest charges would range from 2.44 times to 2.61 times. Such an opportunity range of pretax interest coverage would surely result in the downgrading from the A rating which UWID enjoys (through long-term debt capital raised by its parent, United Waterworks) and the concomitant assigned business position of 3" by Standard & Poors (S&P). It is shown that the S&P required range of before-income tax coverage for all interest charges for a utility with an A bond rating and a business position of 3" is from 2.8 - 3.4 times. In contrast, it is also shown that the range required for a utility with a business position of 3" and a bond rating of BBB is from 1.8 - 2.8 times. Clearly, an opportunity for before-income tax interest coverage of from approximately 2.4 - 2.6 times falls within the range related to a BBB bond rating and a business position of 3". Moreover, the S&P financial ratios are those expected to be actually achieved over time and not just an opportunity to earn. Invariably, opportunities to earn result in lower levels of actual earnings due to the inevitable impact of attrition.
In view of the foregoing, it should be obvious that the current S&P bond rating of A which is enjoyed by UWID would not be maintained with an opportunity for before-income tax interest coverage that clearly falls within the BBB credit rating parameters. Moreover, it should be pointed out, as also shown on Schedule 1, that in 1999 the average before-income tax coverage for all interest charges of the C.A. Turner Water Companies, upon which Ms. Carlock relies in part, was 3.15 times. Before-income tax interest coverage of 3.15 times clearly falls comfortably within the range required by S&P for a utility with an A bond rating and a business position of 3". As shown on page 2 of Schedule 1, the average business position for those companies in the C.A. Turner Water Companies group which have bonds rated by S&P is 2.8 (or 3") while the average bond rating is A+. As mentioned supra and as shown in Note 5 on Schedule 1, page 1, United Waterworks, the source of UWIDs external long-term debt capital, has been assigned by S&P a bond rating of A and a business position of 3".
In view of the foregoing, it should be perfectly obvious that any reliance on Ms. Carlocks range of DCF common equity cost rates in formulating her ultimate recommendation places serious downward bias on her ultimate recommendation.
Q. At page 16 of her testimony, Ms. Carlock, at lines 4-9 explains how she arrived at her risk adjusted range of common equity cost rate of from 9.3% - 9.9% based upon her comparable earnings approach. Please comment.
A. I have no serious disagreement with Ms. Carlocks suggested appropriate range of total returns on industrials of 15.5% to 16.5%. However, I seriously disagree with the manner of her determination of risk adjusted rates of return because the manner in which she utilizes beta is theoretically flawed and results in a gross understatement of risk adjusted return rates.
Q. Please explain why Ms. Carlocks approach to the comparable earnings methodology, on a risk-adjusted basis, is theoretically flawed.
A. When an analyst employs beta to adjust for risk, he or she is implicitly relying upon the principles of the Capital Asset Pricing Model (CAPM) described in the financial literature. In Ms. Carlocks application of the comparable earnings model, she begins with a range of expected total return rates for industrials, i.e., 15.5% - 16.5%. The problem is that when she risk adjusts through the use of beta, she seriously violates the fundamental precepts of beta and the CAPM. Ms. Carlock should have removed from the expected total return the expected risk-free rate. The difference is the markets equity risk premium upon which the risk adjustment should be made through the use of beta. An adjusted equity risk premium so properly calculated should then be added to the expected risk-free rate, the sum of which would equal the proper expected risk adjusted total return rate.
Q. Have you an excerpt from the financial literature which clearly exemplifies the essence of a proper beta-adjusted equity risk premium?
A. Yes. Exhibit No. 19, Schedule 2, which consists of four pages, has been excerpted from Eugene F. Brighams textbook entitled Fundamentals of Financial Management - Fifth Edition. Page 1 shows the inside cover of said textbook to properly give credit. Pages 2 through 4 contain that portion of the text relating to the topic The Relationship Between Risk and Rates of Return. Page 2 of Schedule 2 shows that the risk premium on a stock is equal to the total return rate on the market minus the risk-free rate, i.e., market risk premium, which is then multiplied by beta which yields the risk premium of the stock in question. This concept is expressed in an example by Dr. Brigham and is contained on page 3 of Schedule 2. In his example, Dr. Brigham uses a total expected return on the market of 12% (in this instance, it would be equivalent to the range of Ms. Carlocks total return rates on industrials of 15.5% - 16.5%), and a risk-free rate of return of 8%. His example clearly shows that the risk-free rate is subtracted from the market total return rate of 12% indicating a market equity risk premium of 4%. It is shown in Equation 4-6 on Schedule 2, page 3 that the market equity risk premium of 4% is then risk adjusted to be applicable to the stock in question by multiplication of the beta (i.e., 4% x 0.5 = 2%). In Equation 4-7 (on the same page), it is shown that the required rate of return on the stock in question is then equal to the risk-free rate plus the markets equity risk premium adjusted by beta for the stock in question.
Page 4 of Schedule 2 contains Dr. Brighams Figure 4-9 illustrating the Security Market Line. This shows that the entire concept of the relationship between risk as measured by beta and the required rate of return for individual securities relates to that portion of the total required rate of return over and above the risk-free rate. In other words, Dr. Brighams graphical portrayal shows that the slope of the line from which beta is calculated is between the Securities Market Line and the risk-free rate. Thus, it is clear that the financial literature confirms that Ms. Carlocks risk-adjusted common equity cost rate is grossly misstated because she neglected to deduct the risk-free rate before risk adjusting through the application of beta.
Q. At this point in time, what is the most reasonable expectation of a risk-free rate for use in calculating a risk-adjusted cost rate for a specific stock based upon an expected range of total market returns?
A. As shown in Note 2 on Schedule 3, page 1 of Exhibit No. 19 the details of which are contained in page 2 of Schedule 3, that rate is 6.2%, the expected average yield on 30-year U.S. Treasury Bonds. It is based upon the June 1, 2000 consensus forecast of nearly 50 economists as published by Blue Chip Financial Forecasts.
Q. Does the financial literature confirm that the best expectation of a risk-free rate for purposes of calculating the cost of common equity capital with a long-term horizon (implicit in utilities common stocks) is the yield on the long-term U.S. Treasury Bond?
A. Yes. One current example has been derived from Stocks, Bonds, Bills and Inflation: 2000 Yearbook - Valuation Edition published by Ibbotson Associates, Chicago, Illinois. At page 37, Ibbotson Associates states:
A common choice for the nominal riskless rate is the yield on a U.S. Treasury Security. The ability of the U.S. government to create money to fulfill its debt obligations under virtually any scenario makes U.S. Treasury securities practically default-free. While interest rate changes cause government obligations to fluctuate in price, investors face essentially no default risk as to either coupon payment or return of principal. The horizon of the chosen Treasury security should match the horizon of whatever is being valued. When valuing a business that is being treated as a going concern, the appropriate Treasury yield should be that of a long-term Treasury bond. Note that the horizon is a function of the investment, not the investor. If an investor plans to hold stock in a company for only five years, the yield on a five-year Treasury note would not be appropriate since the company will continue to exist beyond those five years. (underlining added for emphasis)
Q. Have you properly recalculated the indicated range of common equity cost rate applicable to UWID using Ms. Carlocks range of total returns and the beta of United Water Resources, Inc.?
A. Yes. I have shown such information at the top of Schedule 3, page 1 of Exhibit No. 19. On Line 1, I have shown the total range of industrial returns utilized by Ms. Carlock of 15.50% - 16.50%. On Line 2, I have shown the average prospective yield on 30-year U.S. Treasury Bonds of 6.20%. Line 3 represents the equity risk premium on the market with a range of from 9.30% - 10.30% (which is Line 1 minus the risk-free rate on Line 2). Line 4 shows the beta of United Water Resources of 0.60. Line 5 represents the beta-adjusted equity risk premium range properly calculated in a manner consistent with the financial literature. As shown, that range is from 5.58% - 6.18%. Shown on Line 6 is the properly calculated comparable earnings result, i.e., a range of from 11.78% to 12.38%. This range, calculated in a manner consistent with the financial literature confirms the gross understatement of Ms. Carlocks theoretically flawed range of 9.3% - 9.9%.
Q. As part of Ms. Carlocks comparable earnings analysis, she also reviewed achieved returns on book equity for electric, gas distribution, and water utilities. Please comment.
A. The financial literature casts serious doubt about the significance of relying on achieved returns of other utilities. This is essentially because the achieved returns of utilities result from what has been allowed by regulatory commissions and are not necessarily indicative of what could have been earned in the competitive market. For example, Phillips states:
...returns of regulated firms must always be used with extreme caution. At best, they reflect what the informed judgments of regulatory commissions have permitted such utilities to earn and may not be indicative of what could have been earned in the competitive market.
Moreover, Professor Roger Morin states:
In defining a population of comparable-risk companies, care must be taken not to include other utilities in the sample since the rate of return on other utilities depends on the allowed rate of return. The book return on equity for regulated firms is not determined by competitive forces, but instead reflects past actions of regulatory commissions. It would be hopelessly circular to set a fair return based on the past actions of other regulators, much like observing a series of duplicate images in multiple mirrors. (Italics added for emphasis)
It should be clear from the foregoing that the achieved earnings on book equity of other utilities is of little relevance. However, as to the three types of utilities, i.e., electric, gas distribution and water utilities that Ms. Carlock reviewed, the most relevant would, of course, be that related to the C.A. Turner Reports Water Utilities which are shown on Schedule 11 of Exhibit No. 108. As shown therein, the recent averages excluding United Water Resources has been between 10.8% and 11.2%, thus indicating an average achieved rate on water companies of 11%. If an achieved rate of 11% is to be actually earned, an opportunity rate needs to be higher, thereby indicating UWIDs requested 11.30% as conservatively appropriate. UWIDs requested 11.30% is conservatively appropriate, especially in view of the properly adjusted range of comparable earnings cost rate derived from industrial returns, as discussed above, of between 11.78% and 12.38%.
Q. At page 15, lines 6-7 of her testimony, Ms. Carlock states that utility groups are less risky than industrials and water utilities continue to be the least risky. She also states, water companies, including United Water Resources and United Water Idaho, are less risky than an average utility company ... Please comment.
A. I have had an opportunity to review Ms. Carlocks testimony in the Avista Utilities case in 1999 (Docket No. WWP-E-98-11 at Tr. Page 1120) where she stated:
...the cost of equity capital would be less for Avista than that of both an average utility and that of an average industrial company. When considering the risk differentials between Avista and other companies, the lower risk for Avista due to implementing the PCA compared to its risks before the PCA must be considered along with the current competitive position related to low cost resources and low rates.
I am aware of the fact that Avista has in place a Power Cost Adjustment (PCA), a tracker mechanism which minimizes risk associated with rising variable costs. UWID does not enjoy any type of mechanism such as Avistas PCA. Despite a cost of service study submitted by UWID in Docket No. UWI-W-98-3, which the Staff found to be a reasonable allocation of cost between fixed and variable, the Commission declined to make any adjustment to the fixed bi-monthly charge of $13.00 despite the fact that UWIDs cost of service study indicated the need for a bi-monthly fixed charge of $18.00. Regardless of the Commissions motivation to leave the fixed charge unchanged, UWID is in a position where it must recover a portion of its fixed costs through variable rates making UWID extremely dependent on conditions beyond its control such as weather and consumption patterns of customers, thereby increasing uncertainty of recovery -- and greater uncertainty equals greater risk. In view of these factors, it should be clear that the risk differential between UWID and Avista is not as great as suggested in Ms. Carlocks testimony in this proceeding.
Q. What cost rate of common equity capital did the Commission authorize Avista Utilities in its Order No. 28097 dated July 29, 1999?
A. In its Order, the Commission authorized Avista Utilities an opportunity to earn a return rate of 10.75% on common equity capital.
Q. Have you reviewed any information which provides insight into the relative change in capital costs from the time of the Commissions issuance of Order No. 28097 re: Avista Utilities and the present?
A. Yes, I have. That information is contained in Schedule 4 of Exhibit No. 19. As shown on Schedule 4, there has been an average increase of 0.61% (or 61 basis points) in the average yield on Moodys A rated public utility bond yields. Both Avista Utilities (Washington Water Power) and UWIDs parent, United Waterworks, have bonds rated A by S&P. As shown, an increase of 0.61% in A rated long-term debt would result in, all else equal, a minimum 11.36% cost rate of common equity capital (10.75% authorized in Docket No. 28097 plus the increase in the cost rate of long-term debt capital of 0.61%). It is reasonable to assume that the cost of equity would increase by at least the same percentage as the increase in the cost rate of long-term debt capital. I believe that this indicates, especially in view of not so significant a risk differential as presumed by Ms. Carlock with other types of utilities that UWIDs requested 11.30% common equity cost rate is conservatively reasonable in the current and prospective market environment.
Q. Have you performed an analysis to test the reasonableness of the implicit equity risk premium included in UWIDs requested return rate on common equity of 11.30%?
A. Yes. I have prepared Schedule 5 of Exhibit No. 19, which consists of two pages. On page 1 of Schedule 5, I have shown that there was an implicit equity risk premium of 3.04% (304 basis points) in the common equity return rate authorized for Avista Utilities on July 29, 1999 by this Commission in Order No. 28097. This is shown on Lines 1 through 3 of Schedule 5, page 1. The average yield on Moodys A rated public utility bonds in July 1999 was 7.71%. Lines 4 through 6 on Schedule 5, page 1, show that the current prospective yield on A rated public utility bonds is 8.55%. On Line 7, I have shown that if the implicit 304 basis points equity risk premium which was contained in the Avista Utilities decision were equally applicable at this time, an 11.59% common equity cost rate would be indicated for UWID at this time.
Lines 8 through 10 of Schedule 5, page 1, show that there is an implicit equity risk premium of only 2.75% (275 basis points) implicit in UWIDs requested rate of return on common equity of 11.30% in view of a prospective average yield on A rated public utility bonds of 8.55%.
Notes relevant to Schedule 5, page 1 are shown on Schedule 5, page 2.
Q. Why have you utilized this risk premium-type analysis?
A. In Order No. 28097 re: Avista Utilities, at page 22, the Commission stated:
A third methodology to determine a required rate of return on common equity is the risk premium analysis. The risk premium method starts with the rate of return for a low risk investment such as government or utility bonds, and adds a premium based on the relative risk associated with a utilitys stock.
In view of the foregoing, UWIDs requested 11.30% rate of return on common equity capital is extremely reasonable and should be authorized by this Commission when it issues its final determination in this matter.
Q. Does this conclude your rebuttal testimony?
A. Yes.
Charles F. Phillips, Jr., The Regulation of Public Utilities, Public Utilities Reports, Inc., 1993, p. 398.
Roger A. Morin, Regulatory Finance - Utilities Cost of Capital, Public Utilities Reports, Inc., 1994, p. 395.
Hanley, Reb 1
United Water Idaho, Inc.