20040206Avera Direct.pdf

DAVID J. MEYER
SENIOR VICE PRESIDENT AND GENERAL COUNSEL
A VISTA CORPORATION
O. BOX 3727
1411 EAST MISSION AVENUE
SPOKANE, W ASIllNGTON 99220-3727
TELEPHONE: [phone]
FACSIMILE: [phone]
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATIER OF THE APPLICATION
OF A VISTA CORPORATION FOR THE
AUTHORITY TO INCREASE ITS RATES
AND CHARGES FOR ELECTRIC AND
NATURAL GAS SERVICE TO ELECTRIC AND
NATURAL GAS CUSTOMERS IN THE STATE OF IDAHO
CASE NO. A VU-04-
CASE NO. A VU-04-
DIRECT TESTIMONY
WILLIAM E. AVERA
FOR A VISTA CORPORATION
(ELECTRIC AND NATURAL GAS)
INTRODUCTION
Please state your name and business address.
William E. Avera, 3907 Red River, Austin, Texas, 78751.
In what capacity are you employed?
I am the President of FINCAP, Inc., a firm providing financial, economic, and
policy consulting services to business and government.
Qualifications
What are your professional qualifications?
I received a RA. degree with a major in economics from Emory University.
After serving in the United States Navy, I entered the doctoral program in economics at the
University of North Carolina at Chapel Hill. Upon receiving my Ph.D., I joined the faculty at
the University of North Carolina and taught finance in the Graduate School of Business. I
subsequently accepted a position at the University of Texas at Austin where I taught courses
in financial management and investment analysis. I then went to work for International Paper
Company in New York City as Manager of Financial Education, a position in which I had
responsibility for all corporate education programs in finance, accounting, and economics.
In 1977, I joined the staff of the Public Utility Commission of Texas ("PUCT") as
Director of the Economic Research Division. During my tenure at the PUCT, I managed a
division responsible for financial analysis, cost allocation and rate design, economic and
financial research, and data processing systems, and I testified in cases on a variety of
financial and economic issues. Since leaving the PUCT in 1979, I have been engaged as a
consultant. I have participated in a wide range of assignments involving utility-related
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matters on behalf of utilities industrial customers, municipalities, and regulatory
commissions. I have previously testified before the Federal Energy Regulatory Commission
FERC"), as well as the Federal Communications Commission ("FCC"), the Surface
Transportation Board (and its predecessor, the Interstate Commerce Commission), the
Canadian Radio-Television and Telecommunications Commission, and regulatory agencies,
courts, and legislative committees in 30 states, including the Idaho Public Utilities
Commission (the "Commission" or "IPUC"
I was appointed by the PUCT to the Synchronous Interconnection Committee to
advise the Texas legislature on the costs and benefits of connecting Texas to the national
electric transmission grid. Currently, I serve as an outside director of Georgia System
Operations Corporation, the system operator for electric cooperatives in Georgia.
I have served as Lecturer in the Finance Department at the University of Texas at
Austin and taught in the evening graduate program at St. Edward's University for twenty
years. In addition, I have lectured on economic and regulatory topics in programs sponsored
by universities and industry groups. I have taught in hundreds of educational programs for
financial analysts in programs sponsored by the Association for Investment Management and
Research, the Financial Analysts Review, and local financial analysts societies. These
programs have been presented in Asia, Europe, and North America, including the Financial
Analysts Seminar at Northwestern University. I hold the Chartered Financial Analyst (CFA (8)
designation and have served as Vice President for Membership of the Financial Management
Association. I also have served on the Board of Directors of the North Carolina Society of
Financial Analysts. I was elected Vice Chairman of the National Association of Regulatory
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Commissioners ("NARUC") Subcommittee on Economics and appointed to NARUC'
Technical Subcommittee on the National Energy Act. I also have served as an officer of
various other professional organizations and societies. A resume containing the details of my
experience and qualifications is attached as Appendix A.
Overview
What is the purpose of your testimony in this case?
The purpose of my testimony is to present to the Commission my independent
evaluation of Avista Corp.s ("Avista" or "the Company ) current cost of common equity for
its jurisdictional electric utility operations. I conclude that Avista s current cost of equity
significantly exceeds 11.5 percent and endorse strongly the Company s request that this value
be used as the rate of return on common equity ("ROE") for purposes of determining the
weighted average cost of capital.
Please summarize the basis of your knowledge and conclusions
concerning the issues to which you are testifying in this case.
As is common and generally accepted in my field of expertise, I have accessed
and used information from a variety of sources. I am familiar with the organization
operations, finances, and operation of Avista from my participation in prior proceedings
before the IPUC, the Washington Utilities and Transportation Commission ("WUTC"), and
the Oregon Public Utility Commission ("OPUC"). In connection with the present filing, I
considered and relied upon corporate disclosures and management discussions, publicly
available financial reports and filings, and other published information relating to Avista. I
also reviewed information relating generally to current capital market conditions and
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specifically to current investor perceptions, requirements, and expectations for vertically
integrated electric utilities. These sources, coupled with my experience in the fields of
finance and utility regulation, have given me a working knowledge of investors' ROE
requirements for Avista as it competes to attract capital, and form the basis of my analyses
and conclusions.
What is the role of ROE in setting a utility s rates?
The rate of return on common equity serves to compensate investors for the
use of their capital to finance the plant and equipment necessary to provide utility service.
Investors only commit money in anticipation of earning a return on their investment
commensurate with that available from other investment alternatives having comparable
risks. Consistent with both sound regulatory economics and the standards specified in the
Bluefieldl and Hope cases, the return on investment allowed a utility should be sufficient to:
1) fairly compensate capital invested in the utility, 2) enable the utility to offer a return
adequate to attract new capital on reasonable terms, and 3) maintain the utility s financial
integrity.
How did you go about developing your conclusions regarding a fair rate
of return for Avista?
first reviewed the operations and finances of Avista and the general
conditions in the electric utility industry and the economy. With this as a background, I
developed the principles underlying the cost of equity concept and then conducted various
Bluefield Water Works Improvement Co. v. Pub. Servo Comm n, 262 U.S. 679 (1923).
Fed. Power Comm n v. Hope Natural Gas Co., 320 U.S. 591 (1944).
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generally accepted quantitative analyses to estimate the Company s current cost of equity.
These included discounted cash flow ("DCF") analyses and risk premium methods applied to
a reference group of electric utilities, as well as reference to earned rates of return expected
for utilities and industrial firms. Based on the cost of equity estimates indicated by my
analyses, the Company s ROE was evaluated taking into account the specific risks and
economic requirements for Avista consistent with restoration and preservation of its financial
integrity.
Summary of Conclusions
What is your conclusion regarding the reasonableness of the 11.5 percent
ROE requested by Avista?
Based on my capital market analyses and the economic requirements for
electric utility operations, I conclude that a 11.5 percent ROE falls below the current required
rate of return for Avista, in light of investors' economic requirements and the Company
specific risks. Results of my quantitative analyses indicated that the cost of common equity
for a benchmark group of electric utilities in the western U.S. is presently in the range of 10.4
to 11.9 percent.The investment risks associated uniquely with Avista, however, are
significantly greater than those of the utilities in the benchmark group and investors require a
higher rate of return to compensate for that risk. Coupled with expectations for higher utility
bond yields going forward, at a minimum these greater risks would suggest a rate of return on
equity at the uppermost end of the range for the proxy group.
The reasonableness of Avista s requested ROE is further reinforced by investors
continued focus on the uncertainties associated with the electric power industry in which
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Avista must operate to meet its energy requirements. Unsettled conditions in western power
markets, Avista reliance on hydrogeneration and purchased power, and regulatory
uncertainties all compound the investment risks associated with the Company s jurisdictional
utility operations. The cost of fully funding the Company s common equity capital is small
relative to the potential benefits that a financially sound utility can have in providing reliable
service at reasonable rates; especially when compared against the burden imposed by a
financially troubled service provider.Considering the importance of ensuring investor
confidence, strengthening Avista s financial standing, and enhancing the Company s ability to
attract the capital necessary to expand utility infrastructure, an 11.5 percent rate of return on
equity is both necessary and reasonable at this juncture.
II.FUNDAMENTAL ANALYSES
What is the purpose of this section?
As a predicate to my economic and capital market analyses, this section briefly
describes Avista and reviews its operations and finances. This section also examines the risks
and prospects for the electric utility industry as a whole and conditions in the capital markets
and the general economy. An understanding of these fundamental factors, which drive the
risks and prospects of electric utilities, is essential to developing an informed opinion about
current investor expectations and requirements and forms the basis of a fair rate of return on
equity.
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A vista Corp.
Briefly describe Avista.
Headquartered in Spokane, Washington, Avista is engaged primarily in the
procurement, transmission, and distribution of electric energy and natural gas, as well as
other energy-related businesses. The Avista Utilities operating division is comprised of state-
regulated utility activities, including retail electric and natural gas distribution and
transmission services and energy generation. In addition to providing electric and natural gas
utility service within a 26,000 square mile area of eastern Washington and northern Idaho,
Avista s utility segment also provides gas distribution service in 4 000 square miles of
northeast and southwest Oregon and in the South Lake Tahoe region of California.
Avista Capital, a wholly owned subsidiary, is the parent company of all non-utility
subsidiaries.Through these companies, Avista is engaged in electric and natural gas
marketing, trading, and resource management, primarily within the eleven Western states
comprising the Western Electricity Coordinating Council, and internet-based specialty billing
and information services. As of September 30, 2003, Avista had total assets of approximately
$3.4 billion, with consolidated revenues totaling over $980 million for the 2002 fiscal year.
Please describe Avista's electric utility operations.
Avista provides retail electric service to approximately 321,000 customers
with principal industries in the area including agriculture, mining, and forestry, as well as
health care, electronic and other manufacturing, and tourism. During the 2002 fiscal year,
Avista s electric deliveries total 9.8 million megawatt hours ("mWh"). Approximately 42
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percent of 2002 retail electric revenues were from residential customers, with 42 percent
from commercial and 16 percent from industrial users and street lighting.
Avista s generating facilities include 8 hydroelectric generating stations located in
Idaho, Montana, and Washington with a combined capacity of approximately 960 megawatts
MW"). In addition, Avista holds a 15 percent interest in the coal-fired Colstrip plant
(approximately 220 MW) and a 50 percent interest in the 280 MW combined cycle natural-
gas fired Coyote Springs 2 facility, which was placed into operation in July 2003. Avista also
owns a wood-fired plant with a generating capacity of approximately 50 MW and has four
natural gas-fired generating facilities used primarily to meet peak demand. Avista anticipates
total capital expenditures for electric utility operations of approximately $230 million for
2004 and 2005.
During 2002, company-owned generation accounted for 55 percent of the electric
energy provided by Avista, with the balance being obtained through purchased power and
exchanges. The electrical output of Avista s hydroelectric plants, which has a significant
impact on total energy costs, is dependent on stream flows, which have fallen significantly
below normal levels in recent years. Although Avista estimates that hydroelectric generation
is capable of supplying 50 percent of total system requirements under normal conditions
streamflow conditions for 2003 were approximately 85 percent of normal levels. Avista
expects that below-normal water conditions will continue into 2004.
Avista s transmission system interconnects the Company with other western electric
utilities permitting the interchange, purchase, and sale of power among all major electric
systems in the west. Avista offers firm and non-firm transmission services in the eastern
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Washington, northern Idaho, and western Montana areas of the Pacific Northwest. Avista is
also participating with nine other western utilities in the possible formation of a Regional
Transmission Organization ("RTO"), RTO West. RTO West received limited approval of its
Stage 2 proposal from the FERC in September 2002. Fluctuations in the output of the
Company s hydroelectric generating facilities due to variable water conditions force Avista to
rely more heavily on wholesale power markets to meet its customers' energy needs.
In response to the business and regulatory risks inherent in substantial reliance on
wholesale power markets for electricity supply, and recognizing the continuing uncertainty
concerning the reliability and volatility of such purchases, Avista has proposed a plan to
expand access to additional generating resources and upgrade its electric transmission system.
Avista s Integrated Resource Plan has identified the potential need for the Company to
finance total expenditures for electric facilities of approximately $725 million over the next
ten years? The preferred strategy outlined in Avista s 2003 Integrated Resource Plan, which
seeks to reduce exposure to wholesale market volatility, contemplates total expenditures of
$2.4 billion over the plan s 20-year horizon. Considering the Company s weakened credit
standing, enhancing Avista s financial integrity and flexibility will be instrumental in
attracting the capital necessary to fund these projects in an effective manner.
Avista is subject to state retail regulation by the IPUC, the WUTC, the OPUC, and the
Public Utilities Commission of the State of California, and at the federal level by FERC.
Additionally, all but one of Avista s hydroelectric facilities are subject to licensing under the
Federal Power Act, which is administered by FERC. After agreeing to institute various
3 Avista Corp., 2003 Integrated Resource Plan at 48.
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protections, mitigation, and enhancement measures in order to address environmental
concerns, Avista received new operating licenses covering its two largest hydroelectric
facilities - Cabinet Gorge and Noxon Rapids - in 2000.The license covering five
hydroelectric plants on the Spokane River expires in August 2007 and the planning and
consultation process with stakeholders is underway. Relicensing is not automatic under
federal law, and Avista must demonstrate that it has operated its facilities in the public
interest, which includes adequately addressing environmental concerns.
How are fluctuations in A vista's operating expenses caused by varying
hydro and power market conditions accommodated in its rates?
Beginning in 1989, Avista implemented a power cost adjustment mechanism
PCA"), under which Idaho jurisdictional rates are adjusted periodically to reflect changes in
variable power production and supply costs. When hydroelectric generation is reduced and
power supply costs rise above those included in base rates, the PCA allows Avista to increase
rates to recover a portion of its additional costs. Conversely, if increased hydroelectric
generation were to lead to lower power supply costs, rates would be reduced. Although the
PCA provides for rates to be adjusted periodically, it applies to 90 percent of the deviation
between actual power supply costs and normalized rates.
What credit ratings have been assigned to Avista?
Like many other utilities in the region, Avista was adversely affected by
volatile and unprecedented energy prices in the western U.S. in 2000 and 2001.
Unprecedented increases in wholesale prices, rate structures that did not capture full costs of
acquiring fuel and purchased power led to severe liquidity problems, depressed earnings, and
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debt ratings downgrades. Avista is currently assigned a corporate credit rating of "BB+" by
Standard & Poor s Corporation (S&P), with Avista s senior secured debt being rated "BBB-
Similarly, Moody s Investors Service ("Moody s) has assigned an issuer credit rating of
Bal" Avista, while rating the Company s first mortgage bonds "Baa3". These corporate
credit ratings place Avista in the same category as speculative, or "junk " bond companies
with its senior debt ratings occupying the bottom rung on the ladder of the investment grade
scale.
Electric Power Industry
What are the general conditions in the electric power industry?
The industry is characterized by structural change resulting from market
forces, decontrol initiatives and judicial decisions.
Please describe these structural changes.
At the federal level, the FERC has been an aggressive proponent of regulatory
driven reforms designed to foster greater competition in markets for wholesale power supply.
The National Energy Policy Act of 1992, which reformed the Public Utility Holding
Company Act of 1935, and to a limited extent, the Federal Power Act, greatly increased
prospective competition for the production and sale of power at the wholesale level. In April
1996, FERC adopted Order No. 888, mandating "open access" to the transmission facilities
of jurisdictional electric utilities.FERC also has pushed for the regionalization of
transmission system control, by establishing frameworks for creation of Regional
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Transmission Organizations ("RTOs ) in its Order No. 2000.4 "Open access" has, in the view
of most market observers, resulted in more competition and competitors in wholesale power
markets, but not without the introduction of substantial risks - particularly for utilities (like
Avista) that depend on wholesale power markets for a significant portion of their resource
requirements. On July 31 , 2002 FERC issued a notice of proposed rulemaking proposing a
framework to address alleged discrimination in providing interstate transmission services and
in other industry practices.s More recently, on April 28, 2003, FERC issued a White Paper
refining its vision for a wholesale power market platform, taking into account recent
developments in market design and comments filed in response to the earlier SMD NOPR.
Wholesale wheeling provides transmission-dependent electric utilities with additional
energy supply options; but it has also introduced new risks to participants in the wholesale
power markets. Policies affecting competition in the electric power industry vary widely at
the state level, but over 25 jurisdictions have enacted some form of industry restructuring.
This process of industry transition led to the disaggregation of many formerly integrated
electric utilities into three primary components - generation, transmission, and distribution.
Presently, however, Avista is, and is expected to remain, a fully integrated public utility.
Regional Transmission Organizations, Order No. 2000 (Dec. 20, 1999),89 FERC'JI 61,285.
5s Remedying Undue Discrimination through Open Access Transmission Service and Standard Electricity
Market Design 67 Fed. Reg. 55,451, FERC Stats. & Regs. 'JI 32,563 (2002) ("SMD NOPRn6 FERC White Paper Wholesale Power Market Platform April 28, 2003, available at
http://www.fere.govlEleetrieIRTOlMrkt-Stret-eomments/Whi te _paper. pdt.
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What impact has the western power crisis had on investors' risk
perceptions for firms involved in the electric power industry?
During the course of the last several years, investors have dramatically altered
their assessment of the relative risks associated with the electric power industry. A well-
publicized energy crisis throughout the west has wreaked havoc on the State s customers,
utilities, and policymakers. It also has had dramatic repercussions for western wholesale
power markets and investors and utilities nationwide. Beyond causing state regulators and
legislators to re-evaluate their restructuring initiatives for the retail sector of the electric
industry, the financial implications of the western power crisis experience demonstrated the
risks facing all segments of the electric power industry.
The massive debts owed by California s retail utilities to banks, power producers and
other creditors shattered their financial integrity and the subsequent bankruptcy filing of
Pacific Gas and Electric Company ("PG&E") brought the uncertainties associated with
today s power markets into sharp focus for the investment community. Enron s, and later
Mirant Corporation , bankruptcies only served to magnify the risks associated with the
power sector and increased investors' reluctance to commit capital in the energy industry, as
former FERC Commissioner Massey succinctly recognized:
Sadly, the tsunami of the western energy crisis, coupled with the collapse of
Enron, have left a devastating wake within the industry. Investor confidence
has been shaken by these events, by a declining national economy, indictments
of energy traders, accounting irregularities, downgrades by rating agencies,
and continuing investigations by the FERC, CFTC, the SEC, and the Justice
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Department. .
. .
The flight of capital from the industry has been severe since
the collapse of Enron.
While the case of California and PG&E represents an extreme example, there is every
indication that investors' risk perceptions for electric utilities shifted sharply upward as
events in the western U.S. continued to unfold. The resolution is far from over, as even
today, the FERC, federal and state courts, and other agencies debate and examine the
underlying causes of the volatility, high prices and erratic supply patterns characteristic of
western wholesale power markets in 2000 and 2001.
Have these events affected electric utilities ' credit standing?
Yes. The last several years have witnessed steady erosion in credit quality
throughout the electric utility industry, both as a result of revised perceptions of the risks in
the industry and the weakened finances of the utilities themselves. For example, during
2002, S&P recorded 182 downgrades in the electric power industry, versus only 15 upgrades,
while Moody s downgraded 109 utility issuers and upgraded one; an acceleration of the trend
in bond rating changes during the previous two years. Moreover, credit quality has continued
to decline. S&P reported an unprecedented 88 ratings downgrades during the first half of
2003 alone,s and noted that the utility industry "continued its downward credit slope that was
firmly established in early 2000 in this year s third quarter.9 Similarly, Moody s downgraded
51 utilities between January and June 2003, while upgrading only one firm.
Remarks by William L Massey, Center for Public Utilities Advisory Council, "The Santa Fe Conference
(March 17,2003).8 Standard & Poor s Corporation, "Credit Quality For U.S. Utilities Continues Negative Trend,RatingsDirect
(Ju!. 24, 2003).9 Standard & Poor s Corporation, "Downgrades Continue to Dominate U.S. Rating Actions in Third Quarter,
RatingsDirect (Oct. 16, 2003).10 Moody s Investors Service, Moody s Credit Perspectives (Ju!. 14,2003) at 33-34.
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What was the impact of these capital and credit market conditions on the
ability of electric utilities to raise funds?
Combined with a stagnant economy and global uncertainties, the dramatic
upward shift in investors' risk perceptions and the weakened financial picture of most
industry participants combined to produce a severe liquidity crunch in the electric power
industry. S&P cited the debilitating impact of these developments on investors' willingness
to provide capital:
The last 24 months have witnessed extraordinary turmoil for power and energy
debt, unprecedented since Samuel Insull's utility empire collapsed during the
1930s. Events ranging from the credit collapse of the California utilities
through the Enron bankruptcy and subsequent market disruptions for U.
energy merchant companies have destroyed billions of dollars of value for
investors. Wall Street has virtually shut down new investment in this sector. 1 1
Increasingly constrained capital market access as a result of investor
skepticism over accounting practices and disclosure, more and more federal
and state investigations and subpoenas, audits, and failing confidence in future
financial performance has created a liquidity crisis.
The challenges faced by electric utilities resulted in reduced financing activity, with
many utilities being forced to rely on bank debt. Access to the commercial paper markets
long the low-cost staple of high-grade utility credits for meeting working capital needs
virtually disappeared for certain companies. S&P noted that this falloff in financing activity
was partly attributable to "capital market jitters, especially for those firms that are most in
need of capital market access.13 As a result, at the same time that industry uncertainty and
market volatility increased the importance of financial flexibility, S&P observed that
11 Standard & Poor s Corporation, 2002 Power Energy Credit Conference: Beyond the Crisis (Jun. 12,2002).12 Standard & Poor s Corporation, "S. Power Industry Experiences Precipitous Credit Decline in 2002;
Negative Slope Likely to Continue RatingsDirect (Jan. 15,2003).
Id.
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constrained access to capital markets and investor skepticism was contributing to the bleak
cre It pIcture.
How has Avista been impacted by the turmoil in the electric power
industry?
The Company s financial integrity has been severely damaged by the turmoil
in the electric power industry. Like others, Avista was swept up in the maelstrom of the
western energy crisis. While a full description of the western power crisis and its effects is
beyond the scope of this testimony, the chaotic market conditions were felt directly and with
full force. Because of Avista s dependence on hydroelectric generation, it has always been
exposed to the uncertainties associated with year-to-year fluctuations in water conditions.
Nevertheless, the degree of price volatility that participants in the western power markets
were forced to assume was unprecedented and variability in short-term market prices bore no
resemblance to fluctuations experienced in the past.
Increased wholesale prices and rate structures that did not capture full costs of
acquiring fuel and purchased power led to depressed earnings. As of December 31, 2001, for
example, Avista had recorded a regulatory asset of $193 million related primarily to power
cost deferrals resulting from record low hydroelectric generation and higher purchased power
prices.IS Avista was forced to use cash flows from operations, various bank borrowings, and
short- and long-term debt to fund unrecovered energy supply costs. This led to a sharp
deterioration in Avista s financial condition, a severe liquidity crunch, and a dramatic increase
in credit risk. As a result, commercial banks were reticent to extend financing for ongoing
14 Standard & Poor s Corporation, "Credit Quality For U.S. Utilities Continues Negative Trend,RatingsDirect
(Ju!. 24, 2003).
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operations or new construction , and the Company s power and natural gas suppliers were
unwilling to transact business absent special credit terms. To varying degrees, utilities
throughout the western U.S. were confronted with the difficult task of maintaining reliable
service and financial integrity in a power market characterized by short supply and
unprecedented price volatility. Municipal utilities in the Northwest were also forced to
approve or propose significant rate increases to recover rising fuel and purchased power
costS.
Even for electric utilities that have permanent fuel and purchased power adjustment
mechanisms in place, there can be a significant lag between the time the utility actually incurs
the expenditure and when it is recovered from ratepayers. One example of this regulatory lag
was noted by The Value Line Investment Survey (Value Line):
A lag in the recovery of sharply higher power costs is hurting Sierra
Pacific Resources. Power prices in the West have soared since the second
quarter of 2000, and until recently, SPR's two utilities lacked a mechanism for
recovering these increases. The Nevada Commission has granted one, but it
won t solve the utilities' problem right away. That's because the mechanism
tracks power costs over a trailing 12-month period and because the amount by
which the utilities can raise rates each month is capped.
Because of record low stream flows available to Avista s hydroelectric facilities in 2001 and
the resulting dependence on wholesale power markets in the west, the chaotic market
conditions were felt directly.
The continuing prospect of further turmoil in western power markets cannot be
discounted.Investors recognize that volatile markets, unpredictable stream flows, and
15 Avista Corp., Form lO-K Report (2001).
16
Standard Poor s Corporation, Public Power Companies in Northwest Increase Rates Due to Low Water,
Skyrocketing Prices , Infrastructure Finance, p. 1 (January 18,2001).
17 The Value Line Investment Survey, p. 1758 (November 17, 2000).
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Avista s reliance on wholesale purchases to meet a portion of its resource needs can create a
perfect storm " exposing the Company to the risk of reduced cash flows and unrecovered
power supply costs.In response, Avista s Integrated Resource Plan contemplates an
expansion of the electric utility system, including the construction of additional generating
resources, to insulate customers and the Company from the risks inherent in substantial
reliance on wholesale power markets. Accordingly, strengthening Avista s financial integrity
and flexibility will be instrumental in the Company s ability to attract the capital necessary to
implement this plan in an effective manner. From the standpoint of the capital markets, the
west is risky - and Avista s weakened financial profile and continued exposure to wholesale
electric and natural gas markets in meeting shortfalls in hydroelectric generation and other
variations in resources and loads compound these uncertainties.
What are the implications of the power outages experienced in the upper
Midwest and Northeast during August 2003?
These events underscore the continuing risks inherent in the industry and the
uncertain state of affairs with respect to the industry s structure. The massive blackout
which stretched from New York to Detroit and from Ohio into Canada, was the largest power
outage in u.S. history. This single event has sharpened the focus of industry stakeholders -
utilities, consumers, regulators, and investors - on the need to improve the nation s electricity
infrastructure, especially in light of the additional stress that deregulated wholesale markets
have placed on the network. The importance of rapidly stimulating investment in electric
power infrastructure has been almost universally cited as the key to ensuring that further
outages are avoided. As FERC Chairman Wood noted:
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If we draw any conclusions from this blackout, it is the urgent need for more
investment in the nation s transmission grid to serve broad regional needs.
Indeed, Avista has committed to expand the scope and reliability of its utility system in order
to provide customers with the benefits of wholesale competition, while attempting to insulate
them from the potential impact of power market anomalies.
Are investors likely to consider the impact of industry uncertainty in
assessing their required rate of return for Avista?
Absolutely. While electric utility restructuring has not been actively pursued
in Idaho, Avista continues to face the prospect of FERC driven changes in the transmission
function of their business, as well as more fundamental reforms in how utilities operate to
optimize their assets for the benefit of retail ratepayers.I9 As noted earlier, Avista is an active
participant in the formation of the proposed RTO West, an independent entity that would
operate the transmission grid in seven western states.
Policy evolution in the transmission area has been wide-reaching. Investors' focus on
regulatory change in their assessment of risks and prospects was exemplified by S&P:
The FERC is in the process of changing every aspect of the electric utility
landscape, with industry sages anticipating further transmission and wholesale
market development guidance, which could affect the segment'credit
prospects and quality. ...Significant uncertainty still exists for transmission
companies that may operate under an RTO or ISO structure, which will
significantly impact the full scope of capital expenditures necessary to ensure
18 Statement of Pat Wood, Ill, Chairman, Federal Energy Regulatory Commission, On the Power Failure in the
S. and Canada, Press Release (Aug. 15, 2003).
19 See, , Remedying Undue Discrimination through Open Access Transmission Service and Standard
Electricity Market Design, 67 Fed. Reg. 55,451, FERC Stats. & Regs. 'JI 32,563 (2002) ("SMD NOPR") and
FERC White Paper, Wholesale Power Market Platform April 28, 2003, available at
http://www.fere.govlEleetrieIRTO/Mrkt-Stret-eomments/White paper. pdt.
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reliability and increase capacity in the future. Uncertainty will exist until
operating rules are in place and have stabilized.
Virtually all industry stakeholders have recognized that regulatory uncertainties increase the
risks associated with the electric industry. Former FERC Commissioner Massey has noted
that regulatory uncertainty is "part of the problem" explaining under-investment in electric
utility infrastructure.21 The Department of Energy ("DOE") identified "reducing regulatory
uncertainty" as critical in stimulating increased investment in the power industry and has
noted that lack of clarity in the regulatory structure was inhibiting planning and investment.
The DOE also recognized the impact that this regulatory uncertainty has on investors
required rates of return for electric utilities:
Because transmission assets are long lived, regulatory uncertainty increases
the risks to investors and, therefore, increases the returns they need to justify
transmission system investments.
In remarks before NARUC, a representative of MBIA Insurance Corporation, the world'
largest financial guaranty insurance company, noted the increased risks posed by inconsistent
regulatory decision-making "have made access to the capital markets very difficult and very
expensive.24 Similarly, while the Consumer Energy Council of America recognized that
improvements in electric utility infrastructure are necessary to ensure reliability and support
20 Standard & Poor s Corporation, "Electric Transmission at the Starting Gate RatingsDirect (May 10,2002).21 Massey, William L., "Restoring Confidence in Energy Markets , Remarks at the 9th Annual Spring
Conference for the New England Energy Industry (May 21, 2002).
22 U.
S. Department of Energy, National Transmission Grid Study (May 2002), at 24 and 31.
23 Id. at 31.
24 Draft Remarks of Kara M. Silva, Vice President, MBIA Insurance Corporation, NARUC Joint Committee on
Electricity, Gas, and Finance and Technology (Feb. 26, 2003).
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the economy, they concluded that regulatory uncertainty "has contributed to a fear of
instability for the entire system"?S
The recent blackout has only served to reinforce the importance of regulatory risks for
investors. The Wall Street Journal cited the debilitating impact of an "unsteady regulatory
environment" and the "chaotic combination of regulated and deregulated markets" in
explaining inhibitions to increased investment in the electric utility system.26 Similarly,
FERC Chairman Wood concluded in his initial comments on the power outages that:
Clearly, we need regulatory certainty and other incentives for investment??
Nevertheless, S&P recently warned investors that the partial reforms presently characterizing
wholesale power markets invites dysfunction and that elevated risks will discourage new
capital
, "
or at least make it more expensive.,,28 S&P observed:
Investors should not expect that such risk will dissipate any time soon.
Instead, credit risk could actually intensify if the politically charged debate
over reform continues for years, as it might very well do. And even if policy
makers succeed in crafting a comprehensive solution to the problems of the
nation s energy grid, the regulatory treatment of the costs needed to upgrade
the infrastructure remains uncertain.
Because of potential exposure to wholesale markets, the risks of transmission uncertainties
and potential market volatility are intensified for utilities that depend heavily on purchased
power. Thus, Avista s dependence on purchased power to meet shortfalls in hydroelectric
generation magnifies the importance of maintaining the financial flexibility necessary to fund
25 Consumer Energy Council of America, "Positioning the Consumer for the Future: A Roadmap to an Optimal
Electric Power System" (Apr. 2003) at XVII.
26 Smith,
Rebecca, Overloaded Circuits Blackout Signals Major Weakness in U.S. Power Grid," The Wall
Street Journal (Aug. 18,2003).
27 Statement of Pat Wood, III, Chairman, Federal Energy Regulatory Commission, On the Power Failure in the
S. and Canada, Press Release (Aug. 15, 2003).28 Standard & Poor s Corporation
, "
Electric Utility Blackouts Put Spotlight on Political and Regulatory Credit
Risk"RatingsDirect (Aug. 21, 2003).
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an adequate and reliable utility system. At the same time, it also exposes the Company and
its investors to the ongoing regulatory uncertainties and other risks imposed by federal
restructuring of wholesale power markets.
Are these uncertainties the only risks being faced by electric utilities?
No. Apart from these factors, the industry continues to face the normal risks
inherent in operating electric utility systems, including the potential adverse effects of
inflation, interest rate changes, growth, the general economy, and regulatory uncertainty and
lag. Electric utilities are confronting increased environmental pressures that leave them
exposed to uncertainties regarding emissions and potential contamination. S&P recognized
the potential financial challenges posed by such uncertainties:
Pension obligations, environmental liabilities, and serious legal problems
restrict flexibility, apart from the obligations' direct financial implications.
Capital Markets and Economy
What has been the pattern of interest rates over the last decade?
Average long-term public utility bond rates, the monthly average prime rate,
and inflation as measured by the consumer price index since 1990 are plotted in the graph
below. After rising to approximately 10 percent in mid-1990, the average yield on long-term
public utility bonds generally fell as economic conditions weakened in the aftermath of the
1991 Gulf war, with rates dipping below 7 percent in late 1993. Yields subsequently rose
again in 1994, before beginning a general decline, with investors requiring approximately 6.4
percent from average public utility bonds in November 2003:
Id.
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~ 6
'" \,
Inflatio
~'"
- 0"
...-....-,.. ~ . --. -
-.J -- ....--
......-',... .
01..
Are investors likely to anticipate any substantial decline in interest rates
going forward?
No. Since early 2001 , a great deal of attention has been focused on the actions
of the Federal Reserve as they have moved successively to lower short-term interest rates in
response to weakness in the United States economy. But while interest rates are currently at
relatively low levels, investors are unlikely to expect any further significant declines going
forward. The general expectation is that, as economic growth strengthens, interest rates will
begin to rise. For example, the Energy Information Administration ("EIA"), a statistical
agency of the DOE, routinely publishes a 25-year forecast for energy markets and the nation
economy. The most recent forecast, released December 16,2003, anticipates that the double-
A public utility bond yield will increase from approximately 6.7 percent in 2004 to 7.49
percent over the next five years, with the average being 7.3 percent over the next 10 years.
Similarly, Gioballnsight (formerly DRI/WEFA), a widely referenced forecasting service, calls
30 Standard & Poor
s Corporation, Corporate Ratings Criteria at 29, available at
www .standardandpoors.comlratings.
31 Energy Infonnation Administration, Annual Energy Outlook 2004, Table 20 (Dec. 16,2003).
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for double-A public utility bond yields to average 7.35 percent over the next ten years, with
yields ranging between 6.70 and 8.02 percent.
How has the market for common equity capital performed?
Between 1990 and early 2000 stock prices pushed steadily higher as the
longest bull market in United States history continued unabated. While the S&P 500 had
increased over four times in value by August 2000, mounting concerns regarding prospects
for future growth, particularly for firms in the high technology and telecommunications
sectors, pushed equity prices lower, in some cases precipitously. While common stock prices
have recovered strongly from recent lows, the market remains volatile, with share values
repeatedly changing in full percentage points during a single day s trading. The graph below
plots the performances of the Dow-Jones Industrial Average, the S&P 500, and the New York
Stock Exchange Utility Index since 1990 (the latter two indices were scaled for
comparability):
16,Soo
SOO
12,SOO
IO,Soo
Soo
Soo
Soo
SOO
500
32 Gioballnsight
, "
The U.S. Economy, The 25- Year Focus , Table 33 (Summer 2003).
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What is the outlook for the United States economy?
During the decade through the first quarter of 2001, the United States
economy enjoyed the longest peacetime expansion in history. Monetary and fiscal policies
resulted in modest inflation during this period, with unemployment rates falling to their
lowest levels since the 1960s. A revolution in information technology, rising productivity,
and vibrant international trade all contributed to strong economic growth. However, even
before the events of September 11, 2001, there were increasing signs that the economic
expansion would not be sustainable. Concerns regarding the slowing pace of economic
activity were exemplified by the Federal Reserve s sequential lowering of interest rates. The
economic picture has brightened more recently, with gross domestic product surging 8.
percent in the third quarter of 2003. Manufacturing activity has rebounded and construction
spending has increased. Nevertheless, businesses have been reluctant to expand hiring and
uncertainties over the durability of the economy recovery continue to be magnified by the
aftermath of war in Iraq, which undermines consumer confidence and contributes to global
economic uncertainty. These factors cause the outlook to remain tenuous, with persistent
stock and bond price volatility providing tangible evidence of the uncertainties faced by the
United States economy.
How do these economic uncertainties affect electric utilities?
Uncertainties over the extent and durability of the economic recovery have
combined to heighten the risks faced by electric utilities. Stagnant economic growth would
undoubtedly mean flat electric sales, while the potential for higher inflation and interest rates
that would likely accompany an economic rebound would place additional pressure on the
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adequacy of existing service rates. While the economy may ultimately return to a path of
steady growth and the volatility in the capital and energy markets may abate, the underlying
weaknesses now present cause considerable uncertainties to persist, which increase the risks
faced by the electric utility industry.
III.CAPITAL MARKET ESTIMA TES
What is the purpose of this section?
In this section , capital market estimates of the cost of equity are developed for
a benchmark group of electric utilities. First, I examine the concept of the cost of equity,
along with the risk-return tradeoff principle fundamental to capital markets. Next, DCF and
risk premium analyses are conducted to estimate the cost of equity for a reference group of
electric utilities.
Economic Standards
What role does the rate of return on common equity play in a utility
rates?
The return on common equity is the cost of inducing and retaining investment
in the utility s physical plant and assets. This investment is necessary to finance the asset
base needed to provide utility service.Competition for investor funds is intense and
investors are free to invest their funds wherever they choose. They will commit money to a
particular investment only if they expect it to produce a return commensurate with those from
other investments with comparable risks. Moreover, the return on common equity is integral
in achieving the sound regulatory objectives of rates that are sufficient to: 1) fairly
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compensate capital investment in the utility, 2) enable the utility to offer a return adequate to
attract new capital on reasonable terms, and 3) maintain the utility s financial integrity.
What fundamental economic principle underlies this cost of equity
concept?
Unlike debt capital, there is no contractually guaranteed return on common
equity capital since shareholders are the residual owners of the utility. Nonetheless, common
equity investors still require a return on their investment, with the cost of equity being the
minimum "rent" that must be paid for the use of their money. This cost of equity typically
serves as the starting point for determining a fair rate of return on common equity.
The cost of equity concept is predicated on the notion that investors are risk averse
and willingly bear additional risk only if compensated for doing so. In capital markets where
relatively risk-free assets are available (e.
g.,
u.S. Treasury securities) investors can be
induced to hold more risky assets only if they are offered a premium, or additional return
above the rate of return on a risk-free asset. Since all assets - including debt and equity -
compete with each other for scarce investors' funds, more risky assets must yield a higher
expected rate of return than less risky assets in order for investors to be willing to hold them.
Given this risk-return tradeoff, the required rate of return (k) from an asset (i) can be
generally expressed as:
Kj = Rf+RPj
where:Rf = Risk-free rate of return; and
RPj = Risk premium required to hold risky asset i.
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Thus , the required rate of return for a particular asset at any point in time is a function of: 1)
the yield on risk-free assets, and 2) its relative risk, with investors demanding
correspondingly larger risk premiums for assets bearing greater risk.
Does the risk-return tradeoff principle actually operate in the capital
markets?
Yes. The risk-return tradeoff is readily observable in certain segments of the
capital markets where required rates of return can be directly inferred from market data and
generally accepted measures of risk exist. Bond yields, for example, reflect investors
expected rates of return, and bond ratings measure the risk of individual bond issues. The
observed yields on government securities, which are considered free of default risk, and
bonds of various rating categories demonstrate that the risk-return tradeoff does, in fact, exist
in the capital markets.
Does the risk-return tradeoff observed with fixed income securities
extend to common stocks and other assets?
It is generally accepted that the risk-return tradeoff evidenced with long-term
debt extends to all assets. Documenting the risk-return tradeoff for assets other than fixed
income securities is complicated by two factors, however. First, there is no standard measure
of risk applicable to all assets. Second, for most assets - including common stock - required
rates of return cannot be directly observed. Nevertheless, it is a fundamental tenet that
investors exhibit risk aversion in deciding whether or not to hold common stocks and other
assets, just as when choosing among fixed income securities. This has been supported and
demonstrated by considerable empirical research in the field of finance and is confirmed by
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reference to historical earned rates of return, with realized rates of return on common stocks
exceeding those on government and corporate bonds over the long-term.
Is this risk-return tradeoff limited to differences between firms?
No. The risk-return tradeoff principle applies not only to investments in
different firms, but also to different securities issued by the same firm. Debt, preferred stock
and common equity vary considerably in risk because they have different characteristics and
priorities.
When investors loan money to a utility in the form of long-term debt, they enter into a
contract under which the utility agrees to pay a specified amount of interest and to repay the
principal of the loan in full at the maturity date. The bondholders have a senior claim on a
utility s available cash flow for these payments, and if the utility fails to make them
bondholders may force it into bankruptcy and liquidation for settlement of unpaid claims.
Following first mortgage bonds are other debt instruments also holding contractual claims on
the utility s cash flow, such as debentures and notes. Similarly, when a utility sells investors
preferred stock, the utility promises to pay specified dividends and, typically, to retire the
preferred stock on a predetermined schedule.The rights of preferred stockholders to
available cash flow for these payments are junior to creditors, and preferred stockholders
cannot compel bankruptcy, their claims are senior to those of common shareholders.
The last investors in line are common shareholders. They receive only the cash flow
if any, that remains after all other claimants - employees, suppliers, governments, lenders,
have been paid. As a result, the rate of return that investors require from a utility s common
33 See e.g.IbbotsonAssociates, 2003 Yearbook.
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stock, the most junior and riskiest of its securities, is considerably higher than the yield on the
utility s long-term debt.
What does the above discussion imply with respect to estimating the cost
of equity?
Although the cost of equity cannot be observed directly, it is a function of the
prospective returns available from other investment alternatives and the risks to which the
equity capital is exposed. Because it is unobservable, the cost of equity for a particular utility
must be estimated by analyzing information about capital market conditions generally,
assessing the relative risks of the company specifically, and employing various quantitative
methods that focus on investors' current required rates of return. These various quantitative
methods typically attempt to infer investors' required rates of return from stock prices
interest rates, or other capital market data.
Have you relied on a single method to estimate the cost of equity for
A vista?
No. In my opinion, no single method or model should be relied upon to
determine a utility s cost of equity because no single approach can be regarded as wholly
reliable. As the Federal Communications Commission recognized:
Equity prices are established in highly volatile and uncertain capital markets...
Different forecasting methodologies compete with each other for eminence,
only to be superceded by other methodologies as conditions change... In these
circumstances, we should not restrict ourselves to one methodology, or even a
series of methodologies, that would be applied mechanically. Instead, we
conclude that we should adopt a more accommodating and flexible position.
34 Federal Communications Commission, Report and Order 42-43, CC Docket No. 92-133 (1995).
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Therefore, in addition to the DCF model, I applied the risk premium method based on data
for electric utilities and using forward-looking estimates of required rates of return. In
addition, I also evaluated my results using a comparable earnings approach based on
investors' current expectations in the capital markets. In my opinion, comparing estimates
produced by one method with those produced by other approaches ensures that the estimates
of the cost of equity pass fundamental tests of reasonableness and economic logic.
Discounted Cash Flow Analyses
How are DCF models used to estimate the cost of equity?
The use of DCF models is essentially an attempt to replicate the market
valuation process that sets the price investors are willing to pay for a share of a company
stock. The model rests on the assumption that investors evaluate the risks and expected rates
of return from all securities in the capital markets. Given these expected rates of return, the
price of each stock is adjusted by the market until investors are adequately compensated for
the risks they bear. Therefore, we can look to the market to determine what investors believe
a share of common stock is worth. By estimating the cash flows investors expect to receive
from the stock in the way of future dividends and capital gains, we can calculate their
required rate of return. In other words, the cash flows that investors expect from a stock are
estimated, and given its current market price, we can "back-into" the discount rate, or cost of
equity, that investors presumptively used in bidding the stock to that price.
What market valuation process underlies DCF models?
DCF models are derived from a theory of valuation which assumes that the
price of a share of common stock is equal to the present value of the expected cash flows
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(i., future dividends and stock price) that will be received while holding the stock,
discounted at investors' required rate of return, or the cost of equity. Notationally, the general
form of the DCF model is as follows:
1 O 2 0, P
+... +
0 (1+k )1 (1+k )2 (1+k )' (1+k
where:= Current price per share;
= Expected future price per share in period t;
= Expected dividend per share in period t;
= Cost of equity.
That is, the cost of equity is the discount rate that will equate the current price of a share of
stock with the present value of all expected cash flows from the stock.
Has this general form of the DCF model customarily been used to
estimate the cost of equity in rate cases?
No. In an effort to reduce the number of required estimates and computational
difficulties, the general form of the DCF model has been simplified to a "constant growth"
form. But converting the general form of the DCF model to the constant growth DCF model
requires a number of strict assumptions. These include:
. A constant growth rate for both dividends and earnings;
. A stable dividend payout ratio;
The discount rate exceeds the growth rate;
. A constant growth rate for book value and price;
. A constant earned rate of return on book value;
. No sales of stock at a price above or below book value;
. A constant price-earnings ratio;
. A constant discount rate (Le., no changes in risk or interest rate levels and a
flat yield curve); and
All of the above extend to infinity.
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Given these assumptions, the general form of the DCF model can be reduced to the more
manageable formula of:
p -
0 - ke - 9
where:g = Investors' long-term growth expectations.
The cost of equity (ke) can be isolated by rearranging terms:
k =-1..+e p
This constant growth form of the DCF model recognIzes that the rate of return to
stockholders consists of two parts: 1) dividend yield (DdPo), and 2) growth (g). In other
words, investors expect to receive a portion of their total return in the form of current
dividends and the remainder through price appreciation.
Are the assumptions underlying the constant growth form of the DCF
model always fully met?
In practice, none of the assumptions required to convert the general form of
the DCF model to the constant growth form are ever strictly met. Nevertheless, where
earnings are derived from stable activities, and earnings, dividends, and book value track
fairly closely, the constant growth form of the DCF model offers a reasonable working
approximation of stock valuation that provides useful insight as to investors' required rate of
return.
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How did you implement the DCF model to estimate the cost of equity for
Avista?
Avista s recent financial challenges and weakened credit standing hinder the
application of the DCF model directly to the Company. As an alternative, the cost of equity is
often estimated by applying the DCF model to publicly traded firms engaged in the same
business activity.In order to reflect the risks and prospects associated with Avista
jurisdictional utility operations, my DCF analyses focused on a reference group of other
electric utilities composed of those companies included by Value Line in their Electric
Utilities (West) Industry group. Excluded from my analyses were five firms that do not pay
common dividends or recently cut their payout and two that were rated below investment
grade by S&P (including Avista). Given that these eight utilities are all engaged in electric
utility operations in the western region of the U., investors are likely to regard this group as
facing similar market conditions and having comparable risks and prospects. There are
important factors distinguishing western utilities from those located in other regions,
including customer density and the complexities associated with greater reliance on
hydroelectric generation. Indeed, as noted earlier, the ongoing uncertainties associated with
hydroelectric generation and western power markets are important considerations in
evaluating investors ' required rate ofreturn for Avista.
What other considerations support the use of a proxy group in estimating
the cost of equity for Avista?
Apart from recognizing the inherent risks and prospects for an electric utility
operating in the west, reference to a proxy group of electric utilities is essential to insulate
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against vagaries that can result when the stochastic process involved in estimating the cost of
equity is applied to a single company. The cost of equity is inherently unobservable and can
only be inferred indirectly by reference to available capital market data. To the extent that the
data used to apply the DCF model does not capture the expectations that investors have
incorporated into current stock prices, the resulting cost of equity estimates will be biased.
For example, the potential for mergers or acquisitions or the announced sale of a major
business segment would undoubtedly influence the price investors would be willing to pay
for a utility s common stock. But because such factors are not typically reflected in the
growth rates used to apply the DCF model, cost of equity estimates for any single company
may fail to reflect investors' required rate of return. Indeed , using even a limited group of
companies increases the potential for error, as the FERC noted in its July 3, 2003 Order on
Initial Decision in Docket No. RPOO-1O7-000:
Both Staff and Williston agreed that a proxy group of only three companies
presented problems because "single company will have a magnified
influence on the group results." It was with those changing market dynamics
in mind that witnesses of both Staff and Williston proposed to expand the
group of proxy companies to determine a zone of reasonableness.
A proxy group composed of western electric utilities is consistent not only with the shared
circumstances of electric power markets in the west, but also with the need to ensure against
the potential that a single cost of equity estimate may not reflect investors' required rate of
return.
Regulatory and economic standards require that the allowed rate of return should
reflect what investors expect for a utility of comparable risk.As will be described
35 Williston Basin Interstate Pipeline Co.104 FERC 'JI 61,036, at 14-15 (Jul. 3,2003).
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subsequently, Avista s investment risks exceed those of the utilities in the benchmark group.
Accordingly, because investors require a higher rate of return to bear increased risk, this
implies that the Company s cost of equity exceeds that of the proxy group of western electric
utilities.
Why did you excluded from your benchmark group firms that do not pay
common dividends, cut their dividend payout, or have below investment grade bond
ratings?
As discussed earlier, under the DCF approach, observable stock prices are a
function of the cash flows that investors' expected to receive, discounted at their required rate
of return. Because dividend payments are a key parameter required to apply the DCF
method, this hinders application of the DCF model to firms that do not pay common
dividends or have recently cut their payout. Meanwhile, the financial stress and lack of
stability that accompanies below investment grade bond ratings greatly complicates any
determination of investors' long-term expectations that form the basis for DCF applications
to estimate the cost of equity. It is not practicable to apply the DCF model directly to Avista.
What form of the DCF model did you use?
I applied the constant growth DCF model to estimate the cost of equity for
Avista, which is the form of the model most commonly relied on to establish the cost of
equity for traditional regulated utilities and the method most often referenced by regulators.
Other forms of the general, or non-constant DCF model, such as "two-stage" or
multi-stage" analyses can be used to estimate the cost of equity; however, such approaches
increase the number of inputs that must be estimated and add to the computational
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difficulties. While such methods might be warranted when investors expect a discontinuity
in the operations of a particular firm or industry, they generally require several very specific
assumptions regarding investors' expected cash flows that must occur at given points in the
future. This makes the results of non-constant growth DCF applications sensitive to changes
in assumptions and, therefore, subject to greater controversy in a rate case setting.
Moreover, to the extent that each of these time-specific suppositions about future cash
flows do not reflect what real-world investors actually anticipate, the resulting cost of equity
estimate will be biased. Indeed, the benchmark for growth in a DCF model is what investors
expect when they purchase stock. Unless we replicate investors' thinking, we cannot uncover
their required returns and thus the market cost of equity. In practice, applying a non-constant
DCF model would lead to error if it ignores the requirements of real-world investors.
Are there circumstances where a multi-stage DCF model might be
preferable to the constant growth form?
Yes.The greater complexity of the non-constant growth DCF model is
sometimes warranted when it is evident that investors anticipate a well-defined shift in
growth rates over the horizon of their expectations. For example, in response to structural
reforms introduced in the early 1990s, it was widely anticipated that certain segments of the
electric power industry would transition from fully regulated to competitive businesses.
Because of the difficulty associated with capturing these expectations in the single growth
measure of the constant growth DCF model, many witnesses, including myself, chose to
apply a multi-stage approach. A number of regulatory commissions also departed from the
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simplicity of the constant growth DCF model that they had traditionally favored in order to
recognize the transition to competition that was anticipated by investors.
But acceptance of the multi-stage DCF model was predicated on very specific
assumptions tailored to investors' actual expectations at the time. As discussed earlier
however, investors are no longer anticipating that such a transition will take place going
forward. Broad-reaching structural changes once anticipated by investors at the state and
federal levels have been largely effectuated to the extent investors expect them to occur. In
the minds of investors, any new initiatives focused on deregulation of the electric utility
industry at the retail level have been indefinitely postponed or abandoned altogether. This is
certainly true in Idaho, where retail deregulation is not being actively pursued.
While the complexity of non-constant DCF models may impart an aura of accuracy,
there is no evidence that investors ' current view of electric utilities anticipates a series of
discrete, clearly defined stages. As a result, despite the considerable uncertainties now
confronting the electric utility industry, there is no discernable transition that would support
use of the multi-stage DCF approach.
How is the constant growth form of the DCF model typically used to
estimate the cost of equity?
The first step in implementing the constant growth DCF model is to determine
the expected dividend yield (Di/PO) for the firm in question. This is usually calculated based
on an estimate of dividends to be paid in the coming year divided by the current price of the
stock. The second, and more controversial, step is to estimate investors' long-term growth
expectations (g) for the firm. Since book value, dividends, earnings, and price are all
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assumed to move in lock-step in the constant growth DCF model, estimates of expected
growth are sometimes derived from historical rates of growth in these variables under the
presumption that investors expect these rates of growth to continue into the future.
Alternatively, a firm s internal growth can be estimated based on the product of its earnings
retention ratio and earned rate of return on equity. This growth estimate may rely on either
historical or projected data, or both. A third approach is to rely on security analysts
projections of growth as proxies for investors' expectations. The final step is to sum the
firm s dividend yield and estimated growth rate to arrive at an estimate of its cost of equity.
How was the dividend yield for the reference group of electric utilities
determined?
Estimates of dividends to be paid by each of these electric utilities over the
next twelve months, obtained from Value Line, served as Dl. This annual dividend was then
divided by the corresponding stock price for each utility to arrive at the expected dividend
yield. The expected dividends, stock price, and resulting dividend yields for the firms in the
reference group of electric utilities are presented on Schedule WEA-1. As shown there,
dividend yields for the eight firms in the electric utility proxy group ranged from 2.9 percent
to 5.4 percent, with the average being 4.2 percent.
What are investors most likely to consider in developing their long-term
growth expectations?
In constant growth DCF theory, earnings, dividends, book value, and market
price are all assumed to grow in lockstep and the growth horizon of the DCF model is
infinite. But implementation of the DCF model is more than just a theoretical exercise; it is
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an attempt to replicate the mechanism investors used to arrive at observable stock prices.
Thus, the only "" that matters in applying the DCF model is that which investors expect and
have embodied in current market prices. While the uncertainties inherent with common stock
make estimating investors' growth expectations a difficult task for any company, in the case
of electric utilities, the problem is exacerbated due to the ongoing turmoil in the power
industry. Thus, apart from the fact that investors do not currently expect a clearly-defined
shift in growth rates for electric utilities, these unsettled conditions make the specific
forecasts required to implement the non-constant growth DCF model even more tenuous.
Are dividend growth rates likely to provide a meaningful guide
investors' growth expectations for electric utilities?
Dividend policies for electric utilities have become increasinglyNo.
conservative as business risks in the industry have become more accentuated. Thus, while
dividends have remained largely stagnant as utilities conserve financial resources to provide a
hedge against heightened uncertainties, earnings may be expected to grow at a much swifter
pace. Investors' focus has increasingly shifted from dividends to earnings as a measure of
long-term growth, as payout ratios for firms in the electric utility industry have been trending
downward from approximately 80 percent historically to on the order of 60 percent.36 As a
result, growth in earnings, which ultimately support future dividends and share prices, is
likely to provide a more meaningful guide to investors' long-term growth expectations.
36 See, The Value Line Investment Survey (Sep. 15, 1995 at 161, Sep. 5,2003 at 154).
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What other evidence suggests that investors are more apt to consider
trends in earnings in developing growth expectations?
The importance of earnings in evaluating investors' expectations and
requirements is well accepted in the investment community. As noted in Finding Reality in
Reported Earnings published by the Association for Investment Management and Research:
(E)arnings, presumably, are the basis for the investment benefits that we all
seek. "Healthy earnings equal healthy investment benefits" seems a logical
equation, but earnings are also a scorecard by which we compare companies, a
filter through which we assess management, and a crystal ball in which we try
to foretell the future.
Value Line s near-term projections and its Timeliness Rank, which is the principal investment
rating assigned to each individual stock, are also based primarily on various quantitative
analyses of earnings. As Value Line explained:
The future earnings rank accounts for 65% in the determination of relative
price change in the future; the other two variables (current earnings rank and
current price rank) explain 35%.
The fact that investment advisory services, such as Value Line and IIB/E/S International, Inc.
IBES"), focus on growth in earnings indicates that the investment community regards this
as a superior indicator of future long-term growth.Indeed Financial Analvsts Journal
reported the results of a survey conducted to determine what analytical techniques investment
analysts actually use.39 Respondents were asked to rank the relative importance of earnings,
dividends, cash flow, and book value in analyzing securities. Of the 297 analysts that
responded, only 3 ranked dividends first while 276 ranked it last. The article concluded:
37 Association for Investment Management and Research, "Finding Reality in Reported Earnings: An
Overview , p. 1 (Dec. 4,1996).38 The
Value Line Investment Survey, Subscriber s Guide, p. 53.
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Earnings and cash flow are considered far more important than book value and
dividends.
What are security analysts currently projecting in the way of earnings
growth for the firms in the electric utility proxy group?
The consensus earnings growth projections for each of the firms in the
reference group of electric utilities reported by IDES and published in S&P'Earnings Guide
are shown on Schedule WEA-2. Also presented are the earnings growth projections reported
by Value Line, First Call Corporation ("First Call"), and Multex Investor ("Multex ), which
is a service of Reuters. As shown there, with the exception of Value Line s estimates, these
security analysts' projections suggested growth the order of 5.1 to 5.4 percent for the
reference group of electric utilities:
Electric Utility Proxy GroupService Growth Rate
IRES
Value Line 2.4%
First Call
Multex 5.4%
What other earnings growth rates might be relevant in assessing
investors' current expectations for electric utilities?
Short-term projected growth rates may be colored by current uncertainties
regarding the near-term direction of the economy in general and the spate of challenges faced
in the electric power industry specifically. Consider the example of Value Line, which
recently noted that the electric utility industry "is still in a state of flUX,,41 and that:
39 Block, Stanley B., "A Study of Financial Analysts: Practice and Theory Financial Analysts Journal
(July/August 1999).
40 Id. at 88.41 The Value Line Investment Survey (July 4,2003) at 695.
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. . .
this industry still faces problems. The after-effects of the turbulence in the
power markets still exist, some companies are stressed financially, and even
for traditional utilities, regulatory risk is often a potential problem.
Value Line has also reduced its Timeliness ranking, a relative measure of year-ahead stock
price performance for the 98 industries it covers, for the electric utility industry from 70 to
87.43 While this cautious outlook may explain the fact that Value Line s near-term growth
estimates are out of line with other analysts' projections, it is not necessarily indicative of
investors' long-term expectations for the industry.
Given the unsettled conditions in the economy and electric utility industry over the
near-term, historical growth in earnings might also provide a meaningful guide to investors
future expectations. Accordingly, earnings growth rates for the past 10- and 5-year periods
reported by Value Line for the firms in the electric utility group are also presented on
Schedule WEA-2. As shown there, lO-year historical earnings growth rates for the group of
eight electric utilities averaged 7.3 percent, or 8.1 percent over the most recent 5 year period.
How else are investors' expectations of future long-term growth prospects
often estimated for use in the constant growth DCF model?
In constant growth theory, growth in book equity will be equal to the product
of the earnings retention ratio (one minus the dividend payout ratio) and the earned rate of
return on book equity. Furthermore, if the earned rate of return and payout ratio are constant
over time, growth in earnings and dividends will be equal to growth in book value. Although
these conditions are seldom, if ever, met in practice, this approach may provide investors
with a rough guide for evaluating a firm s growth prospects. Accordingly, conventional
42 The Value Line Investment Survey (Aug. 15,2003) at 1776.
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applications of the constant growth DCF model often examine the relationships between
retained earnings and earned rates of return as an indication of the growth investors might
expect from the reinvestment of earnings within a firm.
What growth rate does the earnings retention method suggest for the
reference group of electric utilities?
The sustainable, "b x r" growth rates for each firm in the reference group is
shown on Schedule WEA-3. For each firm, the expected retention ratio (b) was calculated
based on Value Line s projected dividends and earnings per share. Likewise, each firm
expected earned rate of return (r) was computed by dividing projected earnings per share by
projected net book value. As shown there, this method resulted in an average expected
growth rate for the group of electric utilities of 4.6 percent.
What did you conclude with respect to investors' growth expectations for
the reference group of electric utilities?
I concluded that investors currently expect growth on the order of 5.0 to 7.
percent for the average firm in the electric utility proxy group. This determination was based
on the growth projections discussed above, but giving little weight to Value Line
projections, which deviated significantly from the more broadly-based consensus growth rate
projections reported by ffiES and Multex, as well as past experience.
43 The Value Line Investment Survey (Jan. 2,2004) at 695.
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What cost of equity was implied for the reference group of electric
utilities using the DCF model?
Combining the 4.2 percent average dividend yield with the 6.percent
midpoint of my representative growth rate range implied a DCF cost of equity for this group
of electric utilities of 10.2 percent.
Risk Premium Analyses
What other analyses did you conduct to estimate the cost of equity?
As I have mentioned previously, because the cost of equity is inherently
unobservable, no single method should be considered a solely reliable guide to investors
required rate of return. Accordingly, I also evaluated the cost of equity for Avista using risk
premium methods.My applications of the risk premium method provide alternative
approaches to measure equity risk premiums that focused specifically on data for electric
utilities and forward-looking estimates of investors' required rates of return.
Briefly describe the risk premium method.
The risk premium method of estimating investors' required rate of return
extends to common stocks the risk-return tradeoff observed with bonds. The cost of equity is
estimated by first determining the additional return investors require to forgo the relative
safety of bonds and to bear the greater risks associated with common stock, and then adding
this equity risk premium to the current yield on bonds. Like the DCF model, the risk
premium method is capital market oriented. However, unlike DCF models, which indirectly
impute the cost of equity, risk premium methods directly estimate investors' required rate of
return by adding an equity risk premium to observable bond yields.
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How did you implement the risk premium method?
The actual measurement of equity risk premiums is complicated by the
inherently unobservable nature of the cost of equity. In other words, like the cost of equity
itself and the growth component of the DCF model, equity risk premiums cannot be
calculated precisely. Therefore, equity risk premiums must be estimated, with adjustments
being required to reflect present capital market conditions and the relative risks of the groups
being evaluated.
I based my estimates of equity risk premiums for electric utilities on (1) surveys of
previously authorized rates of return on common equity for electric utilities, (2) realized rates
of return on electric utility common stocks; and (3) forward-looking applications of the
Capital Asset Pricing Model ("CAPM"). Authorized returns presumably reflect regulatory
commissions' best estimates of the cost of equity, however determined, at the time they
issued their final order, and the returns provide a logical basis for estimating equity risk
premiums. Under the realized-rate-of-return approach, equity risk premiums are calculated
by measuring the rate of return (including dividends, interest, and capital gains and losses)
actually realized on an investment in common stocks and bonds over historical periods. The
realized rate of return on bonds is then subtracted from the return earned on common stocks
to measure equity risk premiums. The CAPM approach measures the market-expected return
for a security as the sum of a risk-free rate and a risk premium based on the portion of a
security s risk that cannot be eliminated by holding a well-diversified portfolio. Under the
CAPM, risk is represented by the beta coefficient (3), which measures the volatility of a
security s price relative to the market at a whole. Even before the widely cited study by
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Eugene F. Fama and Kenneth R. French 44 considerable controversy surrounded the validity
of beta as a relevant measure of a utility s investment risk. Nevertheless, the CAPM is
routinely referenced in the financial literature and in regulatory proceedings.
While these methods are premised on different assumptions, each having their own
strengths and weaknesses, they are widely accepted approaches that have been routinely
referenced in estimating the cost of equity for regulated utilities.
How did you implement the risk premium approach using surveys of
allowed rates of return?
While the purest form of the survey approach would involve queryIng
investors directly, surveys of previously authorized rates of return on common equity are
frequently referenced as the basis for estimating equity risk premiums. The rates of return on
common equity authorized electric utilities by regulatory commissions across the U.S. are
compiled by Regulatory Research Associates ("RRA") and published in its Regulatory Focus
report. In Schedule WEA-4, the average yield on public utility bonds is subtracted from the
average allowed rate of return on common equity for electric utilities to calculate equity risk
premiums for each year between 1974 and 2002. Over this 29-year period, these equity risk
premiums for electric utilities averaged 3.08 percent, and the yield on public utility bonds
averaged 9.81 percent.
44 Fama, Eugene F. and French, Kenneth R., "The Cross-Section of Expected Stock Returns The Journal of
Finance (June 1992).
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Is there any risk premium behavior that needs to be considered when
implementing the risk premium method?
There is considerable evidence that the magnitude of equity riskYes.
premiums is not constant and that equity risk premiums tend to move inversely with interest
rates. In other words, when interest rate levels are relatively high, equity risk premiums
narrow, and when interest rates are relatively low, equity risk premiums widen. To illustrate,
the graph below plots the yields on public utility bonds (solid line) and equity risk premiums
(shaded line) shown on Schedule WEA-4:
15%
10%
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
~ ~ 8
1- Bond Yield """
"""""""""
Equity Risk Premium I
The graph clearly illustrates that the higher the level of interest rates, the lower the equity risk
premium, and vice versa. The implication of this inverse relationship is that the cost of
equity does not move as much as, or in lockstep with, interest rates. Accordingly, for a
percent increase or decrease in interest rates, the cost of equity may only rise or fall, say, 50
basis points. Therefore, when implementing the risk premium method, adjustments may be
required to incorporate this inverse relationship if current interest rate levels have changed
since the equity risk premiums were estimated.
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What cost of equity is implied by surveys of allowed rates of return on
equity?
As illustrated above, the inverse relationship between interest rates and equity
risk premiums is evident. Based on the regression output between the interest rates and
equity risk premiums displayed at the bottom of Schedule WEA-4, the equity risk premium
for electric utilities increased approximately 43 basis points for each percentage point drop in
the yield on average public utility bonds. As illustrated there, with the yield on public utility
bonds in December 2003 being 345 basis points lower than the average for the study period,
this implied a current equity risk premium of 4.58 percent for electric utilities. Adding this
equity risk premium to the December 2003 yield on triple-B public utility bonds of 6.
percent produces a current cost of equity for the utilities in the benchmark group of
approximately 11.2 percent.
How did you apply the realized-rate-of-return approach?
Widely used in academia, the realized-rate-of-return approach is based on the
assumption that, given a sufficiently large number of observations over long historical
periods, average realized market rates of return will converge to investors' required rates of
return. From a more practical perspective, investors may base their expectations for the
future on, or may have come to expect that they will earn, rates of return corresponding to
those realized in the past.4S By focusing on data for electric utilities specifically, my realized
rate of return approach avoided the need to make assumptions regarding relative risk (e.
beta) that are often embodied in applications of this method.
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Stock price and dividend data for the electric utilities included in the S&P 500
Composite Index ("S&P 500") are available since 1946. Schedule WEA-5 presents annual
realized rates of return for these electric utilities in each year between 1946 and 2002. As
shown there, over this 57-year period realized rates of return for these utilities have exceeded
those on single-A public utility bonds by an average of 4.01 percent. The realized-rate-of-
return method ignores the inverse relationship between equity risk premiums and interest
rates and assumes that equity risk premiums are stationary over time; therefore, no
adjustment for differences between historical and current interest rate levels was made.
Adding this 4.01-percent equity risk premium to the November 2003 yield of 6.61 percent on
triple-B public utility bonds produces a current cost of equity for the electric utility proxy
group of approximately 10.6 percent.
Please describe your application of the CAPM.
The CAPM is a theory of market equilibrium that measures risk using the beta
coefficient. Under the CAPM, investors are assumed to be fully diversified, so the relevant
risk of an individual asset (e.
g.,
common stock) is its volatility relative to the market as a
whole. Beta reflects the tendency of a stocks price to follow changes in the market. A stock
that tends to respond less to market movements has a beta less than 1.00, while stocks that
tend to move more than the market have betas greater than 1.00.The CAPM is
mathematically expressed as:
45 Indeed, average realized rates of return for historical periods are widely reported to investors in the financial
press and by investment advisory services as a guide to future performance.
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Where:
Rj = Rf +3iRm - Rf)
Rj = required rate of return for stockj;
Rf = risk-free rate;
Rm = expected return on the market portfolio; and,
3j = beta, or systematic risk, for stockj.
Schedule WEA-6 presents an application of the CAPM to the eight companies in the
electric utility proxy group based on a forward-looking estimate for investors' required rates
of return from common stocks. Rather than using historical data, the expected market rate of
return was estimated by conducting a DCF analysis on the firms in the S&P 500. The
dividend yield was obtained from S&P, with the growth rate equal to the average of the
composite earnings growth projections published by IDES for each firm. As shown there
subtracting a 5.2 percent risk-free rate based on the December 2003 average yield on long-
term government bonds from the 13.7 percent forward-looking rate of return produced a
market equity risk premium of 8.5 percent. Multiplying this risk premium by the average
Value Line beta of 0.77 for the firms in the electric utility group, and then adding the
resulting risk premium to the long-term Treasury bond yield, resulted in a current cost of
equity of approximately 11.7 percent.
Proxy Group Cost of Equity
What did you conclude with respect to the cost of equity for the
benchmark group of electric utilities?
The cost of equity estimates implied by my quantitative analyses are
summarized in the table below:
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Method
DCF
Risk Premium
Authorized Returns
Realized Rates of Return
CAPM
Cost of Equity Estimate
10.
11.2%
10.
11.7%
Consistent with the results of my quantitative analyses, I concluded that the cost of equity for
the proxy group is presently in the 10.2 to 11.7 percent range.
What other considerations are relevant in setting the return on equity for
a utility?
The common equity used to finance the investment in utility assets is provided
from either the sale of stock in the capital markets or from retained earnings not paid out as
dividends.When equity is raised through the sale of common stock, there are costs
associated with "floating" the new equity securities. These flotation costs include services
such as legal, accounting, and printing, as well as the fees and discounts paid to compensate
brokers for selling the stock to the public. Also, some argue that the "market pressure" from
the additional supply of common stock and other market factors may further reduce the
amount of funds a utility nets when it issues common equity.
Is there an established mechanism for a utility to recognize equity
issuance costs?
No. While debt flotation costs are recorded on the books of the utility,
amortized over the life of the issue, and thus increase the effective cost of debt capital, there
is no similar accounting treatment to ensure that equity flotation costs are recorded and
ultimately recognized.Alternatively, no rate of return is authorized on flotation costs
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necessarily incurred to obtain a portion of the equity capital used to finance plant. In other
words, equity flotation costs are not included in a utility s rate base because neither that portion
of the gross proceeds from the sale of common stock used to pay flotation costs is available to
invest in plant and equipment, nor are flotation costs capitalized as an intangible asset. Unless
some provision is made to recognize these issuance costs, a utility s revenue requirements will
not fully reflect all of the costs incurred for the use of investors' funds. Because there is no
accounting convention to accumulate the flotation costs associated with equity issues, they must
be accounted for indirectly, with an upward adjustment to the cost of equity being the most
logical mechanism.
What is the magnitude of the adjustment to the "bare bones" cost of
equity to account for issuance costs?
There are any number of ways in which a flotation cost adjustment can be
calculated, and the adjustment can range from just a few basis points to more than a full
percent. One of the most common methods used to account for flotation costs in regulatory
proceedings is to apply an average flotation-cost percentage to a utility s dividend yield.
Based on a review of the finance literature, Roger A. Morin concluded:
The flotation cost allowance requires an estimated adjustment to the return on
equity of approximately 5% to 10%, depending on the size and risk of the
Issue.
Applying these expense percentages to a representative dividend yield for an electric utility of
2 percent implies a flotation cost adjustment on the order of 20 to 40 basis points.
46 Roger A. Morin, Regulatory Finance: Utilities ' Cost of Capital, 1994, at 166.
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What then is your conclusion regarding a fair rate of return on equity for
the companies in your benchmark group?
After incorporating a minimum adjustment for flotation costs of 20 basis
points to my "bare bones" cost of equity range, I concluded that a fair rate of return on equity
for the proxy group of electric utilities is currently in the 10.4 to 11.9 percent range.
IV.RETURN ON E UITY FOR VISTA CORP.
What is the purpose of this section?
This section addresses the economic requirements for Avista s return on
equity. It examines other factors properly considered in determining a fair rate of return, such
as market perceptions of Avista s relative investment risks and comparable earnings for
utilities and industrial firms. This section also discusses the relationship between ROE and
preservation of a utility s financial integrity and the ability to attract capital.
Capital structure
Is an evaluation of the capital structure maintained by a utility relevant
in assessing its return on equity?
Yes. Other things equal , a higher debt ratio, or lower common equity ratio,
translates into increased financial risk for all investors. A greater amount of debt means more
investors have a senior claim on available cash flow, thereby reducing the certainty that each
will receive his contractual payments. This increases the risks to which lenders are exposed
and they require correspondingly higher rates of interest. From common shareholders
standpoint, a higher debt ratio means that there are proportionately more investors ahead of
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them, thereby increasing the uncertainty as to the amount of cash flow, if any, that will
remaIn.
What common equity ratio is implicit in Avista's requested capital
structure?
Avista s capital structure is presented in the testimony of Mr. Malquist. As
summarized in his testimony, the common equity ratio used to compute Avista s overall rate
of return was 44.3 percent in this filing.
How does Avista's common equity ratio compare with those maintained
by the reference group of utilities?
As shown on Schedule WEA- 7, for the eight firms in the Electric Utility
(West) group, common equity ratios at September 30, 2003 ranged from 34.6 percent to 58.
percent and averaged 44.7 percent.
What implication does the increasing risk of the electric power industry
have for the capital structures maintained by utilities?
The challenges imposed by the evolving structural changes in the industry
imply that utilities will be required to incorporate relatively greater amounts of equity in their
capital structures. Moody s noted early on that utilities must adopt a more conservative
financial posture if credit ratings are to be maintained:
The key issue " says the analysts in a recent special comment
, "
is that the
competitive industries have much lower operating and financial leverage and
47 Puget Energy subsequently announced a sale of common stock, with the net proceeds expected to total
approximately $100 million. Other things equal, considering this stock sale would result in an average equity
ratio for the benchmark group of 45 percent, with only one company (Pinnacle West Capital) having a common
equity ratio below 40 percent.
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that utilities must streamline both in order to be effective competitors.
Analysts say the utilities must do this in order to post stronger financial
indicators and maintain their current ratings leve1.
As shown on Schedule WEA- 7, Value Line expects that the average common equity ratio for
the proxy group of eight western electric utilities will increase to 52.7 percent over the next
three to five years.
The continued decline in credit quality in the electric industry is indicative of the need
for utilities to strengthen financial profiles to deal with an increasingly uncertain and
competitive market. S&P cited the inadequacy of current balance sheets in the electric
industry as one of the key factors explaining this deterioration:
The downward slope in the power industry s credit picture can be traced to
higher debt leverage and overall deterioration in financial profiles, constrained
access to capital markets as a result of investor skepticism over accounting
practices and disclosure liquidity problems, financial insolvency, and
investments outside the traditional regulated utility business, principally
merchant generation facilities and related energy marketing and trading
activities.
more conservative financial profile is consistent with the increasing uncertainties
associated with restructuring and the imperative of maintaining continuous access to capital
even during times of adverse capital market conditions.
How does Avista's capital structure compare with other widely cited
financial benchmarks for electric utilities?
The financial ratio guidelines published by S&P specify a range for a utility
total debt ratio that corresponds to each specific bond rating. Widely cited in the investment
48 Moody
s Investors Service, Credit Risk Commentary, p. 3 (July 29, 1996).49 Standard & Poor s Corporation, Credit Quality For U.S. Utilities Continues Negative Trend, RatingsDirect,
Jul. 24,2003.
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community, these ratios are viewed in conjunction with a utility business profile ranking,
which ranges from 1 (strong) to 10 (weak) depending on a utility s relative business risks.
Thus, S&P's guideline financial ratios for a given rating category (e.g., triple-B) vary with the
business or operating risk of the utility. In other words, a firm with a business profile of "
(i.relatively lower business risk) could presumably employ more financial leverage than a
utility with a business profile assessment of "9" while maintaining the same credit rating.
S&P has assigned A vista a business profile ranking of ". so
S&P's current capital structure guideline ratios are attached as Schedule WEA-
These capitalization benchmarks are presented in the form of total debt ratios, with the
remainder of capital structure being composed of equity. Consistent with S&P's current
ratings criteria and Avista s S&P business profile ranking of ", as shown on Schedule
WEA-8, a utility would be required to maintain a ratio of total debt to total capital on the
order of 51.0 percent to qualify for a triple-B bond rating. This benchmark equates to a total
equity ratio of 49.0 percent to qualify for a rating at the very bottom of the investment grade
scale.
How do the rating agencies view preferred trust securities and preferred
stock in their assessment of a company s capital structure?
The rating agencies recognize the specific structure of preferred trust securities
and preferred stock in evaluating financial leverage. Depending on the degree of permanence
and other attributes, preferred securities may be considered more "debt-like" and only a
50 Standard & Poor s Corporation Utilities Perspectives (Dec. 22,2003)51 Standard & Poor s, Corporate Ratings Criteria 2004 (Nov. 13,2003) at 54, available at
www .standaredandpoors.com/ratings.
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portion of the outstanding balance will receive equity treatment in assessing the company
capitalization. As a result, a portion of the preferred trust securities and preferred stock that
Avista has in its capital structure may be treated more as debt than equity in evaluating the
Company s financial risk.
What conclusions can you draw from Avista's proposed capital structure
as to how the rating agencies would view it?
While the rating agencies consider a plethora of factors besides a company
capital structure when determining a credit rating, financial leverage is an important
component of the rating analysis. Considering that only a portion of Avista s preferred trust
securities and preferred stock is likely to receive equity treatment, the total equity ratio
implied by Avista s proposed capital structure would barely meet the targets that S&P expects
for a "BBB" -rated utility.
What other indications confirm the reasonableness of Avista's requested
capital structure?
In the wake of recent turmoil in the electric power industry, bond rating
agencies and investors are continuing to scrutinize debt levels. For those firms with higher
leverage, this intense focus can lead not only to ratings downgrades, but to reduced access to
capital and increased borrowing costs. The Wall Street Journal reported that even firms with
stock prices at recent lows may be forced to issue new common equity in adverse markets
and quoted a credit analyst with Fitch, Inc.
(B)anks are fearful to put more money into the sector" and it is making credit
analysts nervous as well. The smart companies, he says, are the ones that
voluntarily "get their balance sheets in line" and the "let the market know
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they re in charge of their destiny...since the market clearly has the heebie-
jeebies."s2
The article went on to note the crucial role that financial flexibility plays in ensuring that the
utility has the wherewithal to meet the needs of customers, especially during times of stress:
All the belt tightening spells bad news for the continued development of the
nation s energy infrastructure. Companies that can borrow more money and
stretch their dollars, quite simply, can build more plants and equipment.
Companies that are increasingly dependent on equity financing - particularly
in a bear market - can do less.
What did you conclude with respect to Avista's requested capitalization?
Avista s proposed capital structure is in-line with industry standards, although
its requested equity ratio of 44.3 percent falls slightly below the 44.percent average for the
electric utility benchmark group.Similarly, the total equity ratio implied by Avista
requested capital structure equity ratio would barely meet S&P's published benchmarks for
the lowest investment grade credit rating. The reasonableness of Avista s requested capital
structure is reinforced by the ongoing uncertainties associated with the electric power
industry, the need to support Avista s efforts to strengthen its credit standing, and the
imperative of maintaining continuous access to capital, even during times of adverse industry
and market conditions.
52 Smith, Rebecca, "Rating Agencies Crack Down on Utilities , The Wall Street Journal, p. Cl (December 19,
2001).
53 Id.
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Relative Risks
How does Avista's credit rating compare to those of the reference groups?
The average corporate credit rating for the Electric Utility (West) group used
to estimate the cost of equity is "BBB". As noted earlier, Avista s corporate rating is currently
BB+
" .
What does A vista's credit rating imply with respect to the rate of return
required by investors?
The cost of equity estimates developed earlier for the benchmark group of
electric utilities are predicated on the investment risks associated with the utilities in the
proxy group, which have corporate credit ratings of triple-B or higher. Meanwhile, Avista
below investment grade rating is indicative of an entirely different risk class. Because
investors require a higher rate of return to compensate them for bearing more risk, the greater
investment risk implied by Avista s credit ratings suggests that the cost of equity
correspondingly higher than for the proxy groups.
What is the significance of "investment grade" versus "below investment
grade
The term "investment grade" refers to a security having sufficient quality, or
relatively low risk, to be suitable for certain investment purposes.In discussing this
distinction, S&P noted that:
The term "investment grade" was originally used by various regulatory bodies
to connote obligations eligible for investment by institutions such as banks,
insurance companies, and savings and loan associations. Over time, this term
gained widespread usage throughout the investment community. Issues rated
in the four highest categories, 'AAA', 'AA'
, ', '
BBB', are recognized as
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being investment grade. Debt rated 'BB' or below generally is referred to as
speculative grade. The term '~unk bond" is merely a more irreverent
expression for this category of more risky debt.
There is a precipitous increase in risk associated with moving from investment grade
to below investment grade securities. S&P documented this in its description of the risks
associated with triple-B rated bonds and below investment grade instruments:
An obligation rated 'BBB' exhibits adequate protection parameters. However
adverse economic conditions or changing circumstances are more likely to
lead to a weakened capacity of the obligor to meet its financial commitment
on the obligation. Obligations rated 'BB'
, ', '
CCC', and 'c' are regarded as
having significant speculative characteristics. 'BB' indicates the least degree
of speculation and 'c' the highest. While such obligations will likely have
some quality and protective characteristics , these may be outweighed by large
uncertainties or major exposures to adverse conditions.
A study conducted by Moody s indicated that default rates on double-B rated bonds exceeded
those for triple-B rated debt by a factor of 5.82 times over the period 1970 through 2002.
Thus, bond ratings differences within the investment grade range tend to reflect relatively
modest gradations among fairly secure investments.Meanwhile, moving to below
investment grade implies an altogether different risk plateau - one where the firm is regarded
as a speculative investment.
Is there any direct capital market evidence regarding the amount of the
premium investors require from a firm that is rated double-B, such as Avista?
Although rates of return on equity for below investment grade firms cannot be
directly observed, the observed yields on long-term bonds provide direct evidence of the
additional return that investors require to bear the risks associated with speculative grade
54 Standard & Poor s, Corporate Ratings Criteria at 9, available at www.standaredandpoors.comlratings.
ss ld.
at 8.
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credit ratings. While average yields on double-public utility bonds are not routinely
published, Moody s recently reported that the average yield on speculative-grade debt
securities exceeded prevailing yields on long-term government bonds by 387 basis points
during the period 1993 through 1997.Since that time, however, the number of
downgrading actions affecting below investment grade debt accelerated as the economy
weakened and uncertainties increased.As a result, the speculative-grade yield spread
widened sharply to an average of 666 basis points from year-end 1997 through the first
quarter of 2003,S8 before narrowing to 403 basis points in December 2003. The table below
calculates the implied risk premium for speculative grade debt based on current long-term
government and industrial bond yields:
1993-1997-
1997 1 s1 0 2003 Dec. 2003
Speculative Grade Yield Spread 87%66%03%
Dec. 2003 Long-term Govt. Bond Yield 15%15%15%
02%11.81 %18%
Less:
Dec. 2003 Average Industrial Bond Yield 04%04%04%
Implied Risk Premium 98 %77%14%
Based on this evidence, the capital markets would require approximately 3.0 to 5.8 percent in
additional return in order to compensate for the greater risks associated with speculative
grade debt instruments. Investors would undoubtedly require a significantly greater premium
for bearing the higher risk associated with the more junior common stock of a utility with
Avista s below investment grade rating.
56 Moody s Investors Service, "Tracing the Origins ofInvestment Grade,Special Comment (Jan. 2004) at 6.57 Moody s Investors Service, Credit Perspectives (Jul. 14,2003) at 35.
58 Id.
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What does this evidence suggest with respect to Avista's cost of equity
relative to the proxy group of electric utilities?
Because of the additional investment risks associated with Avista s speculative
grade corporate ratings and the Company s weakened credit standing and financial flexibility,
investors' required rate of return on equity for Avista exceeds that of the benchmark group of
electric utilities. Considering the evidence presented earlier, a rate of return on equity from
the uppermost end of my 10.4 to 11.9 percent range is justified to support Avista s continued
progress in improving its financial health and flexibility and, ultimately, an investment grade
credit rating. Denying investors the opportunity to earn a return that is commensurate with
Avista s investment risks would perpetuate the Company s anemic credit standing and
hamper its ability to attract capital on reasonable terms.
Implications for Financial Integrity
Why is it important to allow Avista an adequate rate of return on equity?
Given the social and economic importance of the electric utility industry, it is
essential to maintain reliable and economical service to all consumers. While Avista remains
committed to deliver reliable electric service, a utility s ability to fulfill its mandate can be
compromised if it lacks the necessary financial wherewithal.
What lessons can be learned from recent events in the energy industry?
Events in the western u.s. provide a dramatic illustration of the high costs that
all stakeholders must bear when a utility s financial integrity is compromised. California
failed regulatory structure and its impact throughout the west led to unprecedented volatility
in wholesale power costs. For many utilities, recovery of purchased energy costs that they
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were forced to buy to serve their customers was either prevented and/or postponed. As a
result, they were denied the opportunity to earn risk equivalent rates of return and access to
capital was cut off. Regional economies have been jolted and consumers have suffered the
results of higher cost power and reduced reliability. Moreover, while the impact of the
utilities' deteriorating financial condition was felt swiftly, stakeholders have discovered first
hand how difficult and complex it can be to remedy the situation after the fact.
Do you have any personal experience regarding the damage to customers
that can result when a utility s financial integrity deteriorates?
Yes. I was a staff member of the Public Utility Commission of Texas when
the financial condition of EI Paso Electric Company ("EPE") began to suffer in the late
1970s. I later observed first-hand the difficulties in reversing this slide as a consultant to
Asarco Mining, EPE's largest single customer. EPE's ultimate bankruptcy imposed enormous
costs on customers and absorbed an undue amount of the PUCT's resources, as well as those
of the Attorneys General and other state agencies. Now I am serving as a consultant to the
utility as it completes a long struggle to fully recover its financial health. There is no
question that customers and other stakeholders would have been far better off had EPE
avoided bankruptcy by maintaining the utility s financial resilience.
What danger does an inadequate rate of return pose to Avista?
Once lost, investor confidence is difficult to recover and the damage is not
easily reversible. Consider the example of bond ratings. To restore a company s rating to a
previous, higher level, rating agencies generally require the company to maintain its financial
indicators above the minimum levels required for the higher rating over a period of time.
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Given that Avista s corporate credit rating is already below investment grade, the perception
of a lack of regulatory support could lead to further downgrades or, at a minimum, prolong
Avista s efforts to achieve investment grade ratings. Moreover, the negative impact of
declining credit quality on a utility s capital costs and financial flexibility becomes more
pronounced as debt ratings move down the scale from investment to non-investment grade.
At the same time, Avista s long-term plans include significant plant investment to
ensure that the energy needs of its service territory are met and that customers and the
Company are insulated from exposure to the vagaries of competitive wholesale markets.
While providing the infrastructure necessary to meet the energy needs of customers is
certainly desirable, it imposes additional financial responsibilities on Avista. To meet these
challenges successfully and economically, it is crucial that Avista receive adequate support to
improve its credit standing.
Other Factors
What else should be considered in evaluating the relative risks of Avista?
Because close to one-half of Avista s total energy requirements are provided
by hydroelectric facilities, the Company is exposed to a level of uncertainty not faced by most
utilities, which are less dependent on hydro generation.While hydropower confers
advantages in terms of fuel cost savings and diversity, investors also associated hydro
facilities with risks that are not encountered with other sources of generation. Reduced
hydroelectric generation due to below-average water conditions forces Avista to rely more
heavily on purchased power or efficient thermal generating capacity to meet its resource
needs. As noted earlier, in the minds of investors, this dependence on wholesale markets
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entails significant risk, especially for a utility located in the west. The ongoing risks
associated with uncertainty in western power markets has been recognized by the
Commission, which voiced its concern "about the unknown water and market conditions that
lie ahead" and noted that "as we have learned over the past two years, there are no guarantees
about future stream flows or market prices.S9 Similarly, S&P recently observed that:
Utilities in the Pacific Northwest continue to face a host of challenges. If the
western power crisis left a large number of them, investor-owned as well as
publicly-owned, in dire financial straits, weak economic conditions and the
uncertain hydro situation have hampered recovery prospects.
S&P went on to note the significant potential costs and risks imposed by uncertainty over
fish-conservation measures that might be required to meet federal law and continued
volatility in wholesale power markets, concluding that "managing hydro risk has assumed a
critical importance to credit quality.
What other factors would investors likely consider in evaluating their
required rate of return for Avista?
Investors have clearly recognized that structural change and market evolution
in the electric power industry have led to a significant increase in the risks faced by industry
participants. For a firm caught between expanding wholesale competition in the industry and
the constraints of regulation, as are electric utilities, these risks are further magnified. As
S&P recognized:
Although the move to competition from regulation is obviously negative for
credit quality in general, the transition period can often be worse for
59
Idaho Power granted $256 million deferral, but bond plan denied, Idaho Public Utilities Commission (May
13, 2002).60 Standard & Poor s Corporation, "Legal Developments Add to Utilities' Disquiet in U.S. Northwest,Utilities
Perspectives (July 21, 2003) at 2-
Id.
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bondholders than would be a fully competitive industry. In the interim,
companies can be saddled with many of the disadvantages of being regulated
(e.limits on return on capital and higher costs to comply with regulatory
mandates) while simultaneously being gradually exposed to marketplace
risks.
Similarly, the Wall Street Journal highlighted the risks that investors associate with the
interface between competition and regulation in the power industry:
Now, with the power industry hovering uneasily between regulation and
deregulation, it faces the prospect of a market that combines the worst features
of both: a return to government restrictions, mixed with volatility and price
spikes as companies struggle to meet the nation s energy needs.
Moreover, investors recognize that regulation has its own risks.In some
circumstances regulatory uncertainty can eclipse all of the other risk factors facing particular
utilities. Considering the magnitude of the events that have transpired since the third quarter
of 2000, investors' sensitivity to market and regulatory uncertainties has increased
dramatically. The sharpened focus on the risks associated with unrecoverable wholesale
power costs, for example, was noted by RRA:
The potential for volatility in wholesale power electricity markets, as
highlighted by the temporary price spikes experienced in the Midwest in June
1999 and, more recently, by the ongoing severe capacity shortage/pricing crisis
in California, has raised investors' level of awareness and concern with regard
to the ability of electric utilities to recover increased wholesale power costs
and fuel expenses from customers.
Investors' required rates of return for utilities are premised on the regulatory compact that
allows the utility an opportunity to recover reasonable and prudently incurred costs. By
sheltering utilities from exposure to extraordinary power cost volatility, ratepayers benefit
62 Standard & Poor s, CreditWeek, Nov. 1,2000, at 31.63 Rebecca Smith, Shock Waves, The Wall Street Journal, Nov. 30,2001, at AI.64 Regulatory Research Associates, "Recovery of Wholesale Power Costs: Who is at Risk and Who is Not?"
Regulatory Focus, p. 1 (February 28, 2001).
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from lower capital costs than they would otherwise bear. Of course, the corollary implies
that, if investors believe that the utility might face continued exposure to potentially extreme
fluctuations in power supply costs while remaining obligated to provide service at regulated
rates, their required return would be considerably increased. As S&P noted, the August 14th
blackout is unlikely to ease investors ' concerns:
Clearly, the blackout has highlighted the complexity of the system, the
diversity of its many stakeholders and the susceptibility of the industry to
political and regulatory risk.
Conclusions
What is your conclusion regarding the 11.5 percent ROE requested by
Avista in this case?
Based on the capital market research presented earlier, I concluded that a fair
rate of return on equity for the proxy group of electric utilities was in the 10.4 to 11.9 percent
range. In evaluating the rate of return for Avista, it is important to consider investors
continued focus on the unsettled conditions in restructured wholesale power markets, the
Company s ongoing reliance on these markets to purchase a portion of its energy supply, as
well as other risks associated with the power industry, such as heightened exposure to
regulatory uncertainties. In addition, Avista s below-investment grade credit rating implies a
level of investment risk that exceeds that of the proxy group used to estimate the cost of
equity. This suggests that, at a minimum, Avista s required rate of return on equity falls at the
uppermost end of my 10.4 to 11.9 percent range for the firms in the benchmark group of
western electric utilities. Considering the economic requirements and risks discussed above,
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it is my conclusion that the 11.5 percent ROE represents a conservative estimate of investors
required rate of return for Avista in today s capital markets.
How does Avista's requested 11.5 percent return on equity compare with
other benchmarks that investors would consider?
Reference to rates of return available from alternative investments can also
provide a useful guideline in assessing the return necessary to assure confidence in the
financial integrity of a firm and its ability to attract capital. This comparable earnings
approach avoids the complexities and limitations of capital market methods and instead
focuses on the returns earned on book equity, which are readily available to investors.
Value Line s most recent projections indicate that its analysts expect average rates of
return on common equity for the electric utility industry over the next three to five years of
11.0 percent 66 with rates of return for gas distribution utilities expected to average 11.5
percent.67 Meanwhile, the firms included in Value Line s Composite Index are expected to
earn 16.0 percent on book equity during the 2006-2008 time frame.68 Considering Avista
higher risk profile, these expected earned rates of return confirm the reasonableness of the
Company s request.
Avista s requested rate of return is further supported by the fact that investors are
likely to anticipate increases in utility bond yields going forward. Moreover, an 11.5 percent
rate of return on equity is reasonable at this critical juncture, given the importance of
65 Standard & Poor s Corporation, "Electric Utility Blackout Puts Spotlight on Political and Regulatory Credit
Risk,RatingsDirect (Aug. 21, 2003).66 The Value Line Investment Survey (Jan. 2, 2003) at 695.67 The Value Line Investment Survey (Dec. 19,2003) at 458.68 The Value Line Investment Survey, Selection Opinion (July 18,2003) at 2857.
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supporting the financial capability of Avista as it prepares to develop and enhance utility
infrastructure. As the summer power failures amply demonstrated, the cost of providing
Avista an adequate return is small relative to the potential benefits that a strong utility can
have in providing reliable service. Considering investors' heightened awareness of the risks
associated with the electric power industry and the damage that results when a utility
financial flexibility is compromised, supportive regulation is perhaps more crucial now than
at any time in the past.
Does this conclude your pre-filed direct testimony?
Yes.
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APPENDIX A
QUALIFICATIONS OF WILLIAM E. AVERA
FINCAP, INC.
Financial Concepts and Applications
Economic and Financial Counsel
WilLIAM E. AVERA
3907 Red Ri ver
Austin, Texas 78751
[phone]
FAX [phone]
fincap~texas.net
Summary of Qualifications
Ph.D. in economics and finance; Chartered Financial Analyst (CFA (B)) designation; extensive expert
witness testimony before courts, alternative dispute resolution panels, regulatory agencies and
legislative committees; lectured in executive education programs around the world on ethics
investment analysis, and regulation; undergraduate and graduate teaching in business and economics;
appointed to leadership positions in government, industry, academia, and the military.
Emplovment
Principal,
FINCAP, Inc.
(Sep. 1979 to present)
Director, Economic Research
Division,
Public Utility Commission of Texas
(Dec. 1977 to Aug. 1979)
Manager, Financial Education,
International Paper Company
New York City
(Feb. 1977 to Nov. 1977)
Financial, economic and policy consulting to business
and government. Perform business and public policy
research, cost/benefit analyses and financial modeling,
valuation of businesses (over 100 entities valued),
estimation of damages, statistical and industry studies.
Provide strategy advice and educational services in public
and private sectors, and serve as expert witness before
regulatory agencies, legislative committees, arbitration
panels, and courts.
Responsible for research and testimony preparation on
rate of return, rate structure, and econometric analysis
dealing with energy, telecommunications, water and
sewer utilities. Testified in major rate cases and appeared
before legislative committees and served as Chief
Economist for agency. Administered state and federal
grant funds. Communicated frequently with political
leaders and representatives from consumer groups
media, and investment community.
Directed corporate education programs in accounting,
finance, and economics. Developed course materials
recruited and trained instructors, liaison within the
company and with academic institutions. Prepared
operating budget and designed financial controls for
corporate professional development program.
WilLIAM E. AVERA
Lecturer in Finance,
The University of Texas at Austin
(Sep. 1979 to May 1981)
Assistant Professor of Finance
(Sep. 1975 to May 1977)
Assistant Professor of Business,
University of North Carolina at
Chapel Hill
(Sep. 1972 to Jul. 1975)
Education
Ph.D., Economics and Finance,
University of North Carolina at
Chapel Hill
(Jan. 1969 to Aug. 1972)
B.A., Economics,
Emory University, Atlanta, Georgia
(Sep. 1961 to Jun. 1965)
Page 2 of 6
Taught graduate and undergraduate courses in financial
management and investment theory. Conducted research
in business and public policy. Named Outstanding
Graduate Business Professor and received various
administrative appointments.
Taught in BBA, MBA, and Ph.D. programs. Created
project course in finance, Financial Management for
Women, and participated in developing Small Business
Management sequence. Organized the North Carolina
Institute for Investment Research, a group of financial
institutions that supported academic research. Faculty
advisor to the Media Board, which funds student
publications and broadcast stations.
Elective courses included financial management, public
finance, monetary theory, and econometrics. Awarded
the Stonier Fellowship by the American Bankers
Association and University Teaching Fellowship. Taught
statistics, macroeconomics, and microeconomics.
Dissertation: The Geometric Mean Strategy as a
Theory of Multiperiod Portfolio Choice
Active in extracurricular activities, president of the
Barkley Forum (debate team), Emory Religious
Association, and Delta Tau Delta chapter. Individual
awards and team championships at national collegiate
debate tournaments.
Professional Associations
Received Chartered Financial Analyst (CFA) designation in 1977; Vice President for Membership,
Financial Management Association; President, Austin Chapter of Planning Executives Institute;
Board of Directors, North Carolina Society of Financial Analysts; Candidate Curriculum Committee
Association for Investment Management and Research; Executive Committee of Southern Finance
Association; Vice Chair, Staff Subcommittee on Economics and National Association of Regulatory
Utility Commissioners (NARUC); Appointed to NARUC Technical Subcommittee on the National
Energy Act.
WilLIAM E. AVERA Page 3 of 6
TeachinQ in Executive Education ProQrams
Universitv-Sponsored Prof!rams:Central Michigan University, Duke University, Louisiana State
University, National Defense University, National University of Singapore, Texas A&M University,
University of Kansas, University of North Carolina, University of Texas.
Business and Government-Sponsored Prof!rams:Advanced Seminar on Earnings Regulation,
American Public Welfare Association, Association for Investment Management and Research
Congressional Fellows Program, Cost of Capital Workshop, Electricity Consumers Resource
Council, Financial Analysts Association of Indonesia, Financial Analysts Review, Financial Analysts
Seminar at Northwestern University, Governor s Executive Development Program of Texas,
Louisiana Association of Business and Industry, National Association of Purchasing Management
National Association of Tire Dealers, Planning Executives Institute, School of Banking ofthe South
State of Wisconsin Investment Board, Stock Exchange of Thailand, Texas Association of State
Sponsored Computer Centers, Texas Bankers' Association, Texas Bar Association, Texas Savings
and Loan League, Texas Society of CP As, Tokyo Association of Foreign Banks, Union Bank of
Switzerland, U.S. Department of State, U.S. Navy, U.S. Veterans Administration, in addition to
Texas state agencies and major corporations.
Presented papers for Mills B. Lane Lecture Series at the University of Georgia and Heubner Lectures
at the University of Pennsylvania. Taught graduate courses in finance and economics in evening
program at St. Edward's University in Austin from January 1979 through 1998.
Expert Witness Testimony
Testified in nearly 200 cases before regulatory agencies addressing cost of capital, rate design, and
other economic and financial issues.
Federal Af!encies:Federal Communications Commission, Federal Energy Regulatory Commission
Surface Transportation Board Interstate Commerce Commission, and the Canadian
Radio-Television and Telecommunications Commission.
State Ref!ulatorv Af!encies:Alaska, Arizona, Arkansas, California, Colorado, Connecticut,
Delaware, Florida, Hawaii, Idaho, lllinois, Indiana, Kansas, Maryland, Michigan, Missouri,
Nevada, New Mexico, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina,
Texas, Virginia, Washington, West Virginia, and Wisconsin.
Testified in over 30 cases before federal and state courts, arbitration panels, and alternative dispute
tribunals (over 60 depositions given) regarding damages, valuation, antitrust liability, fiduciary
duties, and other economic and financial issues.
Board Positions and Other Professional Activities
Audit Committee and Outside Director, Georgia System Operations Corporation (electric system
operator for member-owned electric cooperatives in Georgia); Chairman, Board of Print Depot, Inc.
and FINCAP, Inc.; Co-chair, Synchronous Interconnection Committee, appointed by Governor
George Bush and Public Utility Commission of Texas; Operator of AAA Ranch, a certified organic
producer of agricultural products; Appointed to Organic Livestock Advisory Committee by Texas
Agricultural Commissioner Susan Combs; Appointed by Texas Railroad Commissioners to study
group for The UP/SP Merger: An Assessment of the Impacts on the State of Texas; Appointed by
WilLIAM E. AVERA Page 4 of 6
Hawaii Public Utilities Commission to team reviewing affiliate relationships of Hawaiian Electric
Industries; Chairman, Energy Task Force, Greater Austin-San Antonio Corridor Council; Consultant
to Public Utility Commission of Texas on cogeneration policy and other matters; Consultant to
Public Service Commission of New Mexico on cogeneration policy; Evaluator of Energy Research
Grant Proposals for Texas Higher Education Coordinating Board.
Community Activities
Board Member, Sustainable Food Center; Chair, Board of Deacons, Finance Committee, and Elder,
Central Presbyterian Church of Austin; Founding Member, Orange-Chatham County (N.) Legal
Aid Screening Committee.
Militarv
Captain, U.S. Naval Reserve (retired after 28 years service); Commanding Officer, Naval Special
Warfare (SEAL) Engineering Support Unit; Officer-in-charge of SWIFT patrol boat in Vietnam;
Enlisted service as weather analyst (advanced to second class petty officer).
Bibliographv
Monographs
Ethics and the Investment Professional (video, workbook, and instructor s guide) and Ethics
Challenge Today (video), Association for Investment Management and Research (1995)
Definition of Industry Ethics and Development of a Code" and "Applying Ethics in the Real
World " in Good Ethics: The Essential Element of a Firm s Success, Association for Investment
Management and Research (1994)
On the Use of Security Analysts' Growth Projections in the DCF Model," with Bruce H. Fairchild
in Earnings Regulation Under Inflation, J. R. Foster and S. R. Holmberg, eds. Institute for Study
of Regulation (1982)
An Examination of the Concept of Using Relative Customer Class Risk to Set Target Rates of Return
in Electric Cost-of-Service Studies with Bruce H. Fairchild, Electricity Consumers Resource
Council (ELCON) (1981); portions reprinted in Public Utilities Fortnightly (Nov. 1982)
Usefulness of Current Values to Investors and Creditors Research Study on Current-Value
Accounting Measurements and Utility, George M. Scott, ed., Touche Ross Foundation (1978)
The Geometric Mean Strategy and Common Stock Investment Management," with Henry A.
Latane in Life Insurance Investment Policies, David Cummins, ed. (1977)
Investment Companies: Analysis of Current Operations and Future Prospects, with J. Finley Lee
and Glenn L. Wood, American College of Life Underwriters (1975)
Articles
Should Analysts Own the Stocks they Cover?" The Financial Journalist (March 2002)
Liquidity, Exchange Listing, and Common Stock Performance," with John C. Groth and Kerry
Cooper, Journal of Economics and Business (Spring 1985); reprinted by National Association of
Security Dealers
WilLIAM E. AVERA Page 5 of 6
The Energy Crisis and the Homeowner: The Grief Process Texas Business Review (Jan.Feb.
1980); reprinted in The Energy Picture: Problems and Prospects, J. E. Pluta, ed., Bureau of
Business Research (1980)
Use of IFPS at the Public Utility Commission of Texas,Proceedings of the IFPS Users Group
Annual Meeting (1979)
Production Capacity Allocation: Conversion, CWIP, and One-Armed Economics,Proceedings of
the NARUC Biennial Regulatory Information Conference (1978)
Some Thoughts on the Rate of Return to Public Utility Companies," with Bruce H. Fairchild in
Proceedings of the NARUC Biennial Regulatory Information Conference (1978)
A New Capital Budgeting Measure: The Integration of Time, Liquidity, and Uncertainty," with
David Cordell in Proceedings of the Southwestern Finance Association (1977)
Usefulness of Current Values to Investors and Creditors," in Inflation Accountingflndexing and
Stock Behavior (1977)
Consumer Expectations and the Economy,Texas Business Review (Nov. 1976)
Portfolio Performance Evaluation and Long-run Capital Growth " with Henry A. Latane
Proceedings of the Eastern Finance Association (1973)
Book reviews in Journal of Finance and Financial Review. Abstracts for CFA Digest. Articles in
Carolina Financial Times.
Selected Papers and Presentations
The Who, What, When, How, and Why of Ethics , San Antonio Financial Analysts Society (Jan.
16,2002). Similar presentation given to the Austin Society of Financial Analysts (Jan. 17 2002)
Ethics for Financial Analysts," Sponsored by Canadian Council of Financial Analysts: delivered in
Calgary, Edmonton, Regina, and Winnipeg, June 1997. Similar presentations given to Austin
Society of Financial Analysts (Mar. 1994), San Antonio Society of Financial Analysts (Nov.
1985), and St. Louis Society of Financial Analysts (Feb. 1986)
Cost of Capital for Multi-Divisional Corporations," Financial Management Association, New
Orleans, Louisiana (Oct. 1996)
Ethics and the Treasury Function," Government Treasurers Organization of Texas, Corpus Christi,
Texas (Jun. 1996)
A Cooperative Future," Iowa Association of Electric Cooperatives, Des Moines (December 1995).
Similar presentations given to National G & T Conference, Irving, Texas (June 1995), Kentucky
Association of Electric Cooperatives Annual Meeting, Louisville (Nov. 1994), Virginia,
Maryland, and Delaware Association of Electric Cooperatives Annual Meeting, Richmond (July
1994), and Carolina Electric Cooperatives Annual Meeting, Raleigh (Mar. 1994)
Information Superhighway Warnings: Speed Bumps on Wall Street and Detours from the
Economy," Texas Society of Certified Public Accountants Natural Gas, Telecommunications and
Electric Industries Conference, Austin (Apr. 1995)
EconomiclW all Street Outlook," Carolinas Council of the Institute of Management Accountants
Myrtle Beach, South Carolina (May 1994). Similar presentation given to Bell Operating Company
Accounting Witness Conference, Santa Fe, New Mexico (Apr. 1993)
WILLIAM E. AVERA Page 6 of 6
Regulatory Developments in Telecommunications," Regional Holding Company Financial and
Accounting Conference, San Antonio (Sep. 1993)
Estimating the Cost of Capital During the 1990s: Issues and Directions," The National Society of
Rate of Return Analysts, Washington, D.C. (May 1992)
Making Utility Regulation Work at the Public Utility Commission of Texas," Center for Legal and
Regulatory Studies, University of Texas, Austin (June 1991)
Can Regulation Compete for the Hearts and Minds of Industrial Customers," Emerging Issues of
Competition in the Electric Utility Industry Conference, Austin (May 1988)
The Role of Utilities in Fostering New Energy Technologies," Emerging Energy Technologies in
Texas Conference, Austin (Mar. 1988)
The Regulators ' Perspective," Bellcore Economic Analysis Conference, San Antonio (Nov. 1987)
Public Utility Commissions and the Nuclear Plant Contractor Construction Litigation
Superconference, Laguna Beach, California (Dec. 1986)
Development of Cogeneration Policies in Texas," University of Georgia Fifth Annual Public
Utilities Conference, Atlanta (Sep. 1985)
Wheeling for Power Sales," Energy Bureau Cogeneration Conference, Houston (Nov. 1985).
Asymmetric Discounting of Information and Relative Liquidity: Some Empirical Evidence for
Common Stocks" (with John Groth and Kerry Cooper), Southern Finance Association, New
Orleans (Nov. 1982)
Used and Useful Planning Models," Planning Executive Institute, 27th Corporate Planning
Conference, Los Angeles (Nov. 1979)
Staff Input to Commission Rate of Return Decisions," The National Society of Rate of Return
Analysts, New York (Oct. 1979)
Electric Rate Design in Texas," Southwestern Economics Association, Fort Worth (Mar. 1979)
Discounted Cash Life: A New Measure of the Time Dimension in Capital Budgeting," with David
Cordell, Southern Finance Association, New Orleans (Nov. 1978)
The Relative Value of Statistics of Ex Post Common Stock Distributions to Explain Variance,
with Charles G. Martin, Southern Finance Association, Atlanta (Nov. 1977)
An ANOV A Representation of Common Stock Returns as a Framework for the Allocation of
Portfolio Management Effort " with Charles G. Martin, Financial Management Association,
Montreal (Oct. 1976)
A Growth-Optimal Portfolio Selection Model with Finite Horizon," with Henry A. Latane,
American Finance Association, San Francisco (Dec. 1974)
An Optimal Approach to the Finance Decision," with Henry A. Latane, Southern Finance
Association, Atlanta (Nov. 1974)
A Pragmatic Approach to the Capital Structure Decision Based on Long-Run Growth," with Henry
A. Latane, Financial Management Association, San Diego (Oct. 1974)
Multi-period Wealth Distributions and Portfolio Theory," Southern Finance Association, Houston
(Nov. 1973)
Growth Rates, Expected Returns, and Variance in Portfolio Selection and Performance
Evaluation," with Henry A. Latane, Econometric Society, Oslo, Norway (Aug. 1973)