20050406Hall direct.pdf

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BEFORE THE ""'..,r,
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IN THE MATTER OF THE APPLICATION OF
UNITED WATER IDAHO INC. FOR
AUTHORITY TO INCREASE ITS RA T~S
AND CHARGES FOR WATER SERVICE IN THE STATE OF IDAHO
CASE NO. UWI-04-
DIRECT TESTIMONY OF CAROlEE HAll
IDAHO PUBLIC UTiliTIES COMMISSION
APRil 6, 2005
Please state your name and business address.
My name is Carolee Hall and my business address
472 West Washington , Boise, Idaho 83702.
By whom are you employed and in what capacity?
I am employed by the Idaho Public Utilities
Commission as a Telecommunications Analyst.
Please describe your work experience and
educational background.
I have been with the Commission Slnce April 1997.
I have completed a Regulatory Studies program offered
through NARUC at Michigan State Uni versi ty.I have al
attended National Exchange Carrier Association (NECA)
training seSSlons where federal issues associated wi th the
changing telecommunications industries were topics of
discussion.
In October 2004 I completed an advanced Utilities
Finance and Accounting seminar for Financial Professionals
in New York.Seminar instruction was provided by the
Financial Accounting Institute and covered various fields of
study including Corporate accounting and auditing, taxation,
management and cost of capital.
Prior to coming to work for the Commission , I
worked for two years as a Financial Manager for a
competitive long distance provider.I graduated from Boise
State University in 1993 with a B.A. in Finance.
CASE NO. UWI -W- 04-04/06/05 HALL , C (Di)
STAFF
What is the purpose of your testimony in this
proceeding?
The purpose of my testimony is to present the
Staff's recommendations for the overall cost of capital for
United Water Idaho to be used in calculating the revenue
requirement for this case.I will specifically address the
overall capi tal structure wi th the cost of capi tal for debt,
minori ty interest (preferred stock), and return on common
equity as it pertains to the overall rate of return.
Describe your testimony regarding the return on
equi ty?
My testimony will focus primarily on the return on
equity portion in general as it pertains to the capital
structure of the Company.Staff witness Terri Carlock will
be the primary cost of capi tal wi tness and address this
issue in her testimony.
Please summarlze the parent/subsidiary
relationship for United Water Idaho.
Uni ted Water Idaho s common stock is not traded.
It is a wholly owned subsidiary of Uni ted Waterworks, Inc.
which is owned by United Water Resources Inc., which all are
ultimately owned by Suez Lyonnaise des Eaux , a French
Corporation that holds many water companies, and other
business endeavors, throughout the world.
CASE NO. UWI-04-04/06/05 HALL , C (Di)
STAFF
OVERVIEW OF CAPITAL STRUCTURE AND RECOMMENDATIONS
Will you please briefly summarlze your
recommendations?
Staff is recommending a cost of debt of 6.45% and
a cost of Minority Interest (Preferred Stock) of 5%.Staff
has used, and recommends, a point estimate of 10% for return
on common equity.The recommended overall weighted cost of
capital of 8.10% is used to calculate the revenue
requi remen t .Please see Staff Exhibi t No. 117.
How many Exhibits will you be sponsoring with your
testimony?
I have three Exhibits identified as Exhibit Nos.
11 7 through 119.
Have you reviewed the testimony and exhibits of
United Water s witness Ms. Pauline Ahern with AUS
Consul tants?
Yes I have.
Please identify the relative time period used in
your analysis.
The historical test year used in this case
August 1 , 2003 - July 31 , 2004. My testimony uses December
, 2004 for the capital structure with proformed debt
changes so current, cost rates reflect financing costs that
are relevant when rates are established in this case.
Do you have any adjustments to the December 31
CASE NO. UWI -W- 04-04/06/05 HALL, C (Di)
STAFF
2004 data?
Yes.On March 22 , 2005, the Company notified
Staff of two recent financial activities it was making to
avoid interest rate creep. First, the Company repaid a $10
million medium term note that was to mature in February
2025.This note had a stated interest rate of 8.84%.The
second event was to refinance an Idaho Water Resource tax-
exempt revenue bond instrument that had an outstanding
balance of $19,975,000 and a maturity date of October 2024.
By refinancing this debt instrument, the Company reduced the
interest rate from 6.4% to 4.7% resulting in a pre-tax
savings to the total Company of approximately $280,000.
using the December 31 , 2004 capital structure with the two
stated adjustments , Staff is able to capture these known and
measurable changes for ratemaking purposes.These
activities also improved the Company s debt-to-equity ratio
from 55.10% debt and 44.9% equity to 53.41% debt and 46.59%
equity.In doing this, the Company was able to bring its
overall debt-to-equity ratio closer in line to the composite
statistics for water utilities listed in Value Line.
Overall , this is beneficial to the Company and for Idaho
customers as it will help maintain credit ratings.
Would you please recap the capi tal structure of
the Company reflecting the December 31, 2004 numbers?
Again Staff is proposing an overall rate Yes.
CASE NO. UWI -W- 04-
04/06/05
HALL , C (Di)
STAFF
return on rate base of 8.10% and a Return on Common Equity
of 10% as reflected in Exhibit No. 117.
Is the proposed capital structure consistent with
the Company s current credit rating?
This capital structure allows the Company toYes.
fund its required capital expenditures while increasing the
equity ratio contributing to maintaining credit ratios that
support the continuance of its current 'A' credit rating.
How does maintenance of a strong credit rating
benefit customers?
The credi t rating given to a company has a direct
impact on the cost that a company will lncur to obtain
capital necessary to support its current and future
opera t ing needs.A strong credit rating directly benefits
customers by reducing immediate and future borrowing costs
related to the financing needed to support regulatory
opera t ions.
Are there other benefits?
During periods of capital marketYes.
disruptions, a company wi th a higher credi t rating has an
easier time accessing capi tal for various proj ects.This is
not necessarily the case wi th lower rated companles, which
often find themselves unable to obtain capi tal or , incurring
increased costs associated with financing and/or collateral
requirements.Such access to capi tal provides companies
CASE NO. UWI -W- 04-04/06/05 HALL , C (Di)
STAFF
with more alternatives when attempting to meet current and
future capi tal proj ects to meet consumer demand.
DEBT
Financing Calculations
How did the Company calculate the embedded debt
cost?
As shown in Exhibi t No. 118 , the Company took the
face value of the debt issuance (Column 4 ~outstanding
amount") and subtracted the unamortized net discount,
premi um and expense in Column This calculation resulted
in the current net proceeds value in column
The second step in its calculations was to take
the face value again in Column 4 and multiply it by ~he
stated interest rate of the issuance in Column 7 resul ting
in the annual interest expense in Column The annual
interest expense was then added to Column (Amortization of
net discount premium and expenses) resul ting in an annual
cost number in Column 10.
The third and final step in the Company s embedded
debt calculation was to take the annual interest and
amortization costs (Column 10) divided by the Net Proceeds
(Col umn 6) .By doing this, the Company has reflected the
issue costs in the unamortized cost figures and in the
annual amortization.Staff believes that the Company has
not reflected the discounting properly, thereby inflating
CASE NO. UWI -W- 04-04/06/05 HALL, C (Di)
STAFF
the embedded cost rate and the overall long-term debt cost.
How did you calculate the Company s cost of long-
term debt?
Also shown Exhibit No. 118 I used the data
provided by the Company to calculate the cost of debt for
Uni ted Water.In order to calculate the long-term debt cost
(the Company refers to this number as the embedded cost rate
In Column 11) the annual cost of debt (column 10) comprised
of the annual interest expense (column 8) plus the
Amortization of Net Discount Premium and Expense (Column
were used.I took the Company s annual cost of debt (Column
10) and divided that by the amount of debt outstanding
(Column 4) .This accurately reflects the discounting of
issuance costs to properly allow the Company to recover in
rates the annual interest cost and the annual amortization
of issuance costs.
Please summarize the differences between your
calculations and those of the Company
As mentioned earlier , in my calculations I used
the annual interest and amortization costs (Column 10)
divided by the face value or outstanding amount (Column 4) .
Please refer to Staff Exhibi t No. 118.Given these
calculations, a proper embedded cost rate of 6.45% was
derived.The Company calculated its embedded cost rate to
be 6.90% after it made its adjustments to debt previously
CASE NO. UWI -W- 04-04/06/05 HALL , C (Di)
STAFF
discussed.The Company s calculation differs from Staff'
because the annual cost is divided by the unamortized net
proceeds (column 6) .
In other cases before the Commission , the Staff'
proposed debt cost calculation has been utilized.Another
method also accepted by the Commission reflects embedded
cost of debt rate using the net proceeds at the time
issue but the interest cost only, not the interest plus
amortization costs, as the numerator used to reflect the
annual cost when calculating the embedded cost of debt rate.
For calculating the cost of debt, did you use
Idaho specific numbers or the consolidated numbers provided
by the Company?
I ran various scenarlO analyses for calculating
the cost of debt and capi tal structure.It is cri tical to
assure that Idaho customers receive the benefit of the
Department of Water Resource Revenue bonds in Idaho.Staf f
determined that by using the consolidated numbers provided
by the Company, Idaho customers continue to receive this
benefit with the Company-wide sponsored debt and capital
structure.
MINORITY INTEREST (PREFERRED STOCK)
Did you have any adjustments to the Company
costs for its minority interest (preferred) stock?
No, the minori ty interest has not changed from the
CASE NO. UWI -W- 04-04/06/05 HALL , C (Di)
STAFF
previously approved rate and is reasonable.
COMMON EQUITY
What legal standards have been established for
determining a fair and reasonable rate of return for the
Company?
The legal test of a fair rate of return for
utility company was established in the Bluefield Water Works
decision of the United States Supreme Court and is repeated
specifically in the Hope Natural Gas case.
In Bluefield Water Works and Improvement Co. V
West Virginia Public Service Commission , 262 U. S. 679, 692
43S.Ct.675,67 L.Ed. 1176(1923), the Supreme Court stated:
A public utility is entitled to such rates
as will permit it to earn a return on the
value of the property which it employs for
the convenience of the public equal to that
generally being made at the same time and in
the same general part of the country on
investments in other business undertakings
which are attended by corresponding risks
and uncertainties but it has no consti tutional
right to profits such as are realized or
anticipated in highly profitable enterprisesor speculative ventures. The return should
be reasonably sufficient to assure confidence
in the financial soundness of the utility and
should be adequate, under efficient and
economical management, to maintain and support
its credit and enable it to raise the money
necessary for the proper discharge of its
public duties. A rate of return may be
reasonable at one time and become too high or
too low by changes affecting opportunities for
investment, the money market and business
condi tions generally.
The Court stated in FPC v Hope Natural Gas Company
CASE NO. UWI -W- 04-
04/06/05 HALL , C (Di)
STAFF
320 U.S. 591, 603, 64 S.CT. 281, 88 L.Ed.333 (1944)
From the investor or Company point of view
it is important that there be enough revenue
not only for operating expenses but also for
the capi tal costs of the business. These
include service on the debt and dividends
on the stock. By that standard the return
to the equity owner should be commensurate
with returns on investments in other enterprises
having corresponding risks. That return,
moreover , should be sufficient to assure
confidence in the financial integrity of the
enterprise, so as to maintain its credi t and
to attract capital. (Citations omitted.
The Supreme Court decisions in Bluefield Water
Works and Hope Natural Gas have been affirmed in In
Permian Basin Area Rate Case, 390, U.S. 747 , 88 S. Ct 1344,
20 L.Ed 2d 312 (1968) and Duquesne Light Co. V. Barasch , 488
U . S. 299, 109 S. Ct. 609, 102 L. Ed. 2 d . 646 1989) Hayden
Pines Water Company v. IPUC, 122 ID 356, 834 P. 2d 873
(1992) .As a resul t of these Uni ted States and Idaho
Supreme Court decisions, three standards have evolved for
determining a fair and reasonable rate of return:(1) the
Financial Integrity or Credit Maintenance Standardi (2) the
Capital Attraction Standardi and,(3) the Comparable
Earnings Standard.If the Comparable Earnings Standard
met, the Financial Integri ty or Credi t Maintenance Standard
and the Capital Attraction Standard will also be met, as
they are an integral part of the Comparable Earnings
Standard.
CASE NO. UWI-04-04/06/05 HALL , C (Di)
STAFF
Did Staff consider these standards in its analysis
and recommendations?
These standards were considered in all ofYes.
Staff's return analysis upon which its recommendations are
based. It is also noteworthy to recognize that the fair rate
of return that allows the utility Company to maintain its
financial integrity and to attract capital is established
assuming efficient and economic management, as specified by
the Supreme Court in Bluefield Water Works.
Please define the term ~cost of common equity
capi tal" and provide an overVlew of the process to determine
this cost.
The cost of common equi ty, or equi ty capi tal, is
the prof i t that investors expect to receive.Equi ty
investors expect a return on their capital commensurate with
the risks they take and consistent with returns that might
be available from other similar investments.This profi t
return is paid to shareholders as dividends or retained by
the Company to grow the equity investment and future
returns.Unlike returns from debt and preferred stocks,
however , the equity return is not directly observable in
advance and therefore, it must be calculated or inferred
from capital market data and trading activity.
Would you please provide a narrative example to
illustrate the cost of equity?
CASE NO. UWI -W- 04-04/06/05 HALL, C (Di)
STAFF
A very simplified example would be that I purchase
a stock for $30 per share.I f the stock's expected dividend
during the year is $1.00, the expected dividend yield is
percent ($1.00 / $30 = 3 percent) Now, let's assume that
the stock (being extremely stable) increases in value to
$31.50 one year after purchase.I have then gained another
5 percent in the expected total rate of return ($1.5 /
$30.00 = 5 percent)As a resul t of buying my stock at $30
per share, I should expect a total return of 8 percent:
percent dividend yield and 5 percent appreciation.
Therefore, my total expected rate of return at 8 percent is
the appropriate measure of the cost of equi ty capi tal,
because it is this rate of return that caused me to commit
the $30 of equi ty capi tal in the first place.Should the
stock be riskier, I would have required a much higher return
to be compensated for taking on that risk.
Has Staff analy?ed the cost of equi ty and
established a range for United Water Idaho?
Yes, using the three Companies in Value Line, I
calculated a water utilities industry cost of equity of 10%
and recommend that this rate be authorized for United Water
Idaho.Staff witness Terri Carlock will be providing
testimony with respect to the cost of equity and she will
support the equity ranges around the 10% point.
In your opinion , do you believe that the 10%
CASE NO. UWI-04-04/06/05 HALL, C (Di)
STAFF
Return on Equity is in line with the composite Value Line
returns for the industry?
According to Value Line s composi teYes.
statistics for water utilities industry (October , 2004 and
January 2005) the return on shareholder s equity and common
equity for 2004 and 2005 was 9.5%.For the years of 2007 -
2009 it is projected to be at 10%.
Did you review any recent Idaho rate cases where
the Commission established the return on equity rate?
The Idaho Commission recently authorizedYes.
Avista Utilities and Idaho Power Company rates of 10.4% and
10.25% respectively.
Will a 10% return on equity provide the Company
the opportunity to maintain its current bond ratings and
borrowing ability in the capital markets?
Yes, Staff believes it will.According to Value
Line, the Composite Water Utility Industry return on equity
has been 8.8% in 2003 and 9.5% in 2004 and 2005.
Through its own actions, the Company s debt-to-
equi ty ratios were improved wi th its debt retirement and
refinancing.With these financial adjustments, the equity
ratio was increased and the debt ratio decreased , thus
maintaining the Company s abili ty to access the capi tal
markets wi th a good bond rating.Staff believes that the
projected 2007 - 2009 return rates of 10% will continue to
CASE NO. UWI -W- 04-
04/06/05
HALL, C (Di)
STAFF
afford the Company this opportunity.
The Company maintains that it needs a common
equity cost rate of 11.2% glven varlOUS risk factors
presented by the Company.Would you please comment on these
assertions?
Risk is the uncertainty or unpredictabilityYes.
of the future resul ts of a company.The greater the range
within which future results are likely to fall, the greater
the risk associated wi th an investment in , or extension of
credi t to the company.Certain factors may include high
rates of technological changes , such as is occurring in the
telecommunications industry.Technological changes are not
substantial for water utilities so this is not a significant
risk issue for Uni ted Waterworks.Other risk factors may
include uncertainty about demand.In the monopoly
environment in which United Water Idaho currently operates
this risk is minimal compared to competi ti ve industries like
Micron, Simplot or most local businesses in Idaho.The
Company s request for a ll. 2% return on equity is higher
than needed given the environment in which it operates.
The Company s consultant, witness Ahern
discussed the risks associated wi th Uni ted Water and a beta
study.Do you agree wi th the Company s pos it ion?
Of the three Value Line companies used in theNo.
sample, two of the companies have betas of .7, and the third
CASE NO. UWI -W- 04-04/06/05 HALL, C (Di)
STAFF
Company has a beta of . 75 .These betas are all well under
the market indicator of 1.0, therefore the sample presented
by the Company reflects a lower than market risk for these
water utilities.
Did you perform any other equi ty analysis for the
Company?
Yes, under the direction of Staff witness Terri
Carlock , I prepared a discounted cash flow analysis (DCF)
See Staff Exhibit No. 119.
Were you able to calculate a DCF for United Water
Idaho?
Uni ted Water Idaho s cost of equi ty cannot be
directly calculated from its own market data because United
Water Idaho is a subsidiary of Uni ted Waterworks Inc.
United Waterworks Inc. is a wholly owned subsidiary of Suez,
a French conglomerate, and, only Suez has publicly traded
common stock.Independent market data required to determine
cost of equity directly for the regulated water utility
operations of Uni ted Water Idaho simply is not available.
The DCF analysis shown on Exhibit No. 119 uses the three
sample companies as listed in Value Line Investment Survey.
Staff witness Carlock will expand upon this analysis in her
test imony .
Given the Staff analysis discussed in your
testimony, would you please summarize your recommendations?
CASE NO. UWI -W- 04-04/06/05 HALL , C (Di)
STAFF
Yes , Staff recommends a set point of 10% as an
appropriate return for Common Equi ty.For the cost of debt,
the recalculated composite rate using the appropriate
calculation derived a 6.45% cost. The Minority Interest rate
of 5 % did not change.Staff reflects the Company s recent
debt changes as they improved the Company s debt-to-equity
ratios, thereby benefiting the Company as well as Idaho
customers.Finally, Staff recommends an overall rate of
return of S.10% as the point authorized for use in the
revenue requirement calculation.
Does this conclude your direct testimony in this
proceeding?
Yes it does.
CASE NO. UWI -W- 04-04/06/05 HALL, C (Di)
STAFF
CERTIFICATE OF SERVICE
HEREBY CERTIFY THAT I HAVE THIS 6Th DAY OF APRIL 2005
SERVED THE FOREGOING DIRECT TESTIMONY OF CAROLEE HALL, IN
CASE NO. UWI-04-, BY MAILING A COpy THEREOF POSTAGE PREPAID
TO THE FOLLOWING:
MARK GENNARI
UNITED WATER
200 OLD HOOK RD
HARRINGTON PARK NJ 07640
DEAN J MILLER ESQ
McDEVITT & MILLER LLP
PO BOX 2564
BOISE ill 83701
DOUGLAS K STRICKLING
BOISE CITY ATTORNEY'S OFFICE
150 N CAPITOL BLVD.
PO BOX 500
BOISE ill 83701
CHUCK MICKELSON
CITY OF BOISE
150 N CAPITOL BLVD.
PO BOX 500
BOISE ill 83701
WILLIAM M. EDDIE
ADVOCATES FOR THE WEST
PO BOX 1612
BOISE ill 83701
BILL SEDIVY
ill AH 0 RIVERS UNITED
PO BOX 633
BOISE ill 83701
BRAD M. PURDY
ATTORNEY AT LAW
2019 N 17TH STREET
BOISE ill 83702
SHARON ULLMAN
9627 W. DESERT AVE
BOISE ill 83709
SCOTT L. CAMPBELL
101 S CAPITOL BLVD., 10TH FLOOR
PO BOX 829
BOISE ill 83701
CERTIFICATE OF SERVICE