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HomeMy WebLinkAbout20050406Carlock direct.pdff) ' t"! \.l. ", ' V L.- i . BEFORE THE ft. (:1 "'. nnrA""'D C . ~. ~ L ':(!uJ Rr~rl i.j: q IDAHO PUBLIC UTILITIES COMMISSION :,,/ fL.BL. UTilIT IES COr"ir-1fSSION IN THE MATTER OF THE APPLICATION OF UNITED WATER IDAHO INC. FOR AUTHORITY TO INCREASE ITS RATES AND CHARGES FOR WATER SERVICE IN THE STATE OF IDAHO CASE NO. UWI-04- DIRECT TESTIMONY OF TERRI CARLOCK IDAHO PUBLIC UTILITIES COMMISSION APRIL 6, 2005 Please state your name and address for the record. My name is Terri Carlock.My business address is 472 West Washington Street, Boise, Idaho. By whom are you employed and in what capaci ty? I am employed by the Idaho Public Utilities Commission as the Accounting Section Supervisor. Please outline your educational background and experience. graduated from Boise State University in May 1980, with a B.A. Degree in Accounting and in Finance.I have attended various regulatory, accounting, rate of return, economics, finance and ratings programs. I chaired the National Association of Regulatory Utilities Commissioners (NARUC) Staff Subcommittee Economics and Finance for over 3 years.Under thi s subcommittee, I also chaired the Ad Hoc Committee on Di versif ication.I am currently a member of the NARUC Staff Subcommittee on Accounting and Finance.I ha ve made presentations before the Institute of Public Utili ties at Michigan State Uni versi ty, NARUC Accounting and Audit Seminars and for many other conferences. Since joining the Commission Staff in May 1980, I have participated in audits, performed financial analysis on CASE NO. UWI -W- 04- 04/06/05 CARLOCK , T (Di) 1 STAFF various companies and have presented testimony before this Commission on numerous occasions. Please describe the scope of your responsibilities in the preparation of this case. My responsibilities were numerous but generally fall in three basic categories.The first category includes an analysis of all theories, policies and ratemaking analysis.This responsibility ranges from coordinating Staff witness testimonies to assure the theories and policies used to establish rate base and the revenue requirement are implemented appropriately and are consistent with general ratemaking and accounting theories.I support the position presented by Staff wi tness Lobb to assure that no accounting requirements are violated with this policy. The second category of responsibility encompasses the supervision of all accountants working on thi s ease.I discussed numerous adj ustments wi th the Staff and assisted in coordinating the positions and testimonies. The third category of responsibility relates to the cost of capi tal.My testimony supports the Staff recommendations for the 10% return on equity and the development of the recommended 8.1% overall rate of return. CASE NO. UWI -W- 04-04/06/05 CARLOCK, T (Di) 2 STAFF Please elaborate on the Staff's policy to establish rate base levels based on the average of the monthly averages. Staff witness Lobb discusses this policy in his testimony.I support this policy position and the rationale he has presented and have assisted in coordinating the numerous adjustments to assure consistent treatment.As discussed by other wi tnesses, the Columbia Water Treatment Plant is included in rate base as if in place for the full year and the associated cost s and revenues are annual i zed.Other construction proj ects are reflected in rate base using the average of monthly averages rate base calculation.This is consistent with other cases recently evaluated by Staff and was determined by the Commission where only maj or proj ects are included in rate base at a level greater than the average of the monthly averages figure. Inclusion by Staff witness Harms of the December 31, 2004 plant balances for proforma plant adjustments reasonable for many reasons.These reasons include the availability of financial statements, consistency between the report ing period used by Uni ted Water Idaho and ratemaking adjustments, the ability to reconcile the various adjustments, and the desire to reduce regulatory lag where possible. CASE NO. UWI -W- 04-04/06/05 CARLOCK, T (Di) 3 STAFF Please move to the cost of capi tal analysis and recommendations made by Staff in this case.Please summarize the cost of capital recommendations. I am recommending a return on common equity in the range of 9.25% - 10.25% with a point estimate of 10.0%.The recommended overall weighted cost of capital is in the range of 7.75% - 8.21% with a point estimate of 1% to be applied to the rate base for the test year. Are you sponsoring any exhibits to accompany your testimony? Yes, I am sponsoring Staff Exhibi t No. 120. Have you reviewed the testimony and exhibits of United Water Idaho (UWI , Company) witnesses, particularly witness Ahern? Much of the theoretical approach usedYes. by UWI witness Ahern in her testimony and exhibits generally the same as I have used.My judgment in some areas of application results in different outcomes and recommendations. Please explain how Staff witness Hall' testimony links with your testimony. Staff witness Hall prepared, under my direction , Exhibit Nos. 117 , 118 and 119 along with support ing test imony .I asked her to cover the legal standards and basic explanation on how returns are CASE NO. UWI -W- 04-04/06/05 CARLOCK, T (Di) 4 STAFF derived.She also makes the Staff's recommendations on cost of debt , cost of minority interest (preferred stock) and the capital structure used to calculate the revenue requirement for UWI in this case. What approach have you used to determine the cost of equity for United Water Idaho specifically? I have primarily evaluated two methods:the Discounted Cash Flow (DCF) method and the Comparable Earnings method. Please explain the Comparable Earnings method and how the cost of equi ty is determined using this approach. The Comparable Earnings method for determining the cost of equi ty is based upon the premlse that a given investment should earn its opportunity costs.In competi ti ve markets, if the return earned by a firm is not equal to the return being earned on other investments of similar risk , the flow of funds will be toward those investments earnlng the higher returns. Therefore, for a utility to be competitive in the financial markets , it should be allowed to earn a return on equity equal to the average return earned by other firms of similar risk.The Comparable Earnings approach is supported by the Bluefield Water Works and Hope Natural Gas decisions as a basis for determining those CASE NO. UWI -W- 04- 04/06/05 CARLOCK, T (Di) 5 STAFF average returns. Industrial returns tend to fluctuate with business cycles , increasing as the economy improves and decreasing as the economy declines.Utility returns are not as sensitive to fluctuations in the business cycle because the demand for utility services generally tends to be more stable and predictable. Please evaluate interest rate trends. The prime interest rate ranges by year are shown on Staff Exhibi t No. 120, Schedule Interest rates are increasing but continue to be below the level seen during the last two Uni ted Water Idaho rate cases, UWI-OO-l and UWI-W~97- Please evaluate the recent prlce index trends. The trends for prlce indexes are shown on Staff Exhibi t No. 120, Schedule Both the consumer prlce index (CPI) and the producer price index (PPI) were higher in 2004.The percent change in the cpr averaged 5% for 2002 -2004.The average remains less than many historical periods. Please provide the current index levels for the Dow Jones Industrial Average and the Dow Jones Utili ty Average. The Dow Jones Industrial Average (DJIA) CASE NO. UWI-04-04/06/05 CARLOCK, T (Di) 6 STAFF closed at 10,458 on April 5, 2005.The DJIA high of 10,940 in February 2005 is the highest close since 2001. The Dow Jones Utility Average closed at 363 on April 2005. Please explain the risk differentials between industrials and utilities. Risk is a degree of uncertainty relative to a company.The lower risk level associated with utilities is attributable to many factors even though the difference is not as great as it used to be.Utili ties continue to have limited competition for distribution of utility serVlces within the certificated area.With limited competition for regulated services, there is less chance of losses related to pricing practices, marketing strategy and advertising policies.The competitive risks for water utilities , including United Water Idaho are less than for other utilities operating in Idaho. The demand for utility services is relatively stable and certain with customer growth increasing at about 3% for the last two years. The investment risk following this case for UWI will be less since Staff proposes to include the Columbia Water Treatment Plant as if it were in service for the full year.This allows UWI the opportunity to fully recover the used and useful costs invested in this CASE NO. UWI -W- 04-04/06/05 CARLOCK , T (Di) 7 STAFF plant.The investment risk for UWI will still be lower than for other utilities even though the Staff recommends the average of monthly averages rate base instead of the forecasted year-end rate base proposed by the Company. Under regulation, utilities are generally allowed to recover through rates, reasonable, prudent and justifiable cost expenditures related to regulated servlces.Unregulated firms have no such assurance. Utilities in general are sheltered by regulation for reasonable cost recovery risks, making the average utility less risky than the average unregulated industrial firm. Considering all of these comparisons, I believe a reasonable return on equity attributed to United Water Idaho is 9.5% - 10.5% under the Comparable Earnings method.Uni ted Waterworks, Inc. and Uni ted Water Idaho continue to be able to obtain financing at a reasonable cost. You indicated that the Discounted Cash Flow method is utilized in your analysis.Please explain this method. The Discounted Cash Flow (DCF) method is based upon the theory that (1) stocks are bought for the income they provide (i. e ., both dividends and/ or galns from the sale of the stock), and (2) the market price of CASE NO. UWI-04- 04/06/05 CARLOCK, T (Di) 8 STAFF stocks equals the discounted value of all future incomes. The discount rate, or cost of equi ty, equates the present value of the stream of income to the current market price of the stock.The formula to accomplish this goal is: -------------------------- (l+ks ) 1 ( 1 + ks) 2 (1 +ks ) N (l+ks ) N Po =Current Price D =Di vidend ks =Capitalization Rate, Discount Rate, or Required Rate of Return N =Latest Year Considered The pattern of the future income stream the key factor that must be estimated in this approach. Some simplifying assumptions for ratemaking purposes can be made without sacrificing the validity of the results. Two such assumptions are:(1) dividends per share grow at a constant rate in perpetuity and (2) prices track earnlngs These assumptions lead to the simplified DCF formula , where the required return is the dividend yield plus the growth rate (g) ks = -:- - - + g CASE NO. UWI -W- 04- 04/06/05 CARLOCK, T (Di) 9 STAFF Staff witness Hall shows a basic DCF analysis using the Value Line water utilities industry. I have evaluated additional DCF analyses for other groups, including those presented by UWI witness Ahern, and expanded on the basic analysis to develop the Staff recommended return on equity range. Have you factored flotation costs in with your cost of capital analysis? Yes, I have considered direct flotation costs in my analysis by increasing the dividend yield component of the DCF analysis.Since only direct costs should be considered, I have used a flotation cost factor of 2% that is consistent with that previously used for Uni ted Water.Flotation costs should be company specific so Staff witness Hall's Exhibit No. 119 does not reflect the increase for flotation costs.I have adjusted the DCF formula to include the direct flotation costs as "df" ks = (- - - (1 + df) J + What is your estimate of the current cost of capital for UWI using the Discounted Cash Flow method? The current cost of equity capital for UWI CASE NO. UWI-04- 04/06/05 CARLOCK, T (Di) 10 STAFF uslng the Discounted Cash Flow method is between 8% - 10.5% during various time intervals.Due to ongolng capi tal requirements, including ref inancing requirements, I believe a dividend yield of 3.4% to 3.5% with a growth rate of 5% to 6% is the most representative for UWI. How is the growth rate (g) determined? The growth rate is the factor that requires the most extensive analysis in the DCF method.It is important that the growth rate used in the model be consistent with the dividend yield so that investor expectations are accurately reflected and the growth rate is not too large or too small. I have used an expected growth rate of 5% to 6%.This expected growth rate was derived from an analysis of various historical and proj ected growth indicators, including growth in earnings per share, growth in cash dividends per share, growth in book value per share, growth in cash flow and the sustainable growth for water utili ty industry groups. You indicated the cost of common equity range for UWI is 9.5% - 10.5% under the Comparable Earnings method and 8% - 10.5% under the Discounted Cash Flow method.What is the cost of common equi ty capi tal you are recommending? The fair and reasonable cost of common CASE NO. UWI -W- 04- 04/06/05 CARLOCK , T (Di) 11 STAFF equity capital I am recommending for United Water Idaho is in the range of 9.25% - 10.25%.Al though any point wi thin this range is reasonable, the return on equi granted would not normally be at either extreme of the fair and reasonable range.I utilized a point estimate of 10% in calculating the overall rate of return for the revenue requirement. What is the basis for your ,point estimate being 10% when your range is 9.25% - 10. 25%? The 10% return on equity point estimate utilized is based on a review of the market data and comparables, water utilities industry and UWI capital structures and ratios , and average risk characteristics. What are the costs, the capital structure and overall cost of capi tal recommended? Staff witness Hall's Exhibit No. 117 shows the capital structure and cost rates recommended in this case.I support each of these components, as they are consistent with my independent analysis. The overall weighted cost of capi tal recommended in this case is in the range of 7.75% - 21%.For use in calculating the revenue requirement, a point estimate consisting of a return on equity of 10% and a resul ting overall rate of return of 8.1% was utilized as shown on Staff Exhibit No. 117. CASE NO. UWI-04- 04/06/05 CARLOCK , T (Di) 12 STAFF Does this conclude your direct testimony in this proceeding? Yes, it does. CASE NO. UWI -W- 04- 04/06/05 CARLOCK, T (Di) 13 STAFF