20110706Avera Di.pdf

DAVID J. MEYER
VICE PRESIDENT AND CHIEF COUNSEL OF
REGULATORY & GOVERNMENTAL AFFAIRS
AVISTA CORPORATION
P.O. BOX 3727
1411 EAST MISSION AVENUE
SPOKANE, WASHINGTON 99220-3727TELEPHONE: [phone]FACSIMILE: [phone]
RECEI
2011 JUL -S A
BEFORE THE IDAHO PUBLIC UTILITIES COMISSION
IN THE MATTER OF THE APPLICATION
OF AVISTA 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. AVU-E-11-01
CASE NO. AVU-G-11-01
DIRECT TESTIMONY
OF
WILLIAM E. AVERA
FOR AVISTA CORPORATION
(ELECTRIC AND NATURAL GAS)
DIRECT TESTIMONY OF WILLIAM Eo AVERA
TABLE OF CONTENTS
Io INTRODUCTION 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 00 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1
A 0 Overview 0 0 0 0 0 0 0 0 0 0 0 0 0 0 . 0 0 . . . . . . . . 0 . . . . 0 0 . . . 0 . 0 0 . . 0 0 . 0 .. 1
Bo Summary of Conclusions 0 . 0 0 .. . . . . .. . . . . .. .. .. . . .. . .. . ... 4
II. RISKS OF AVISTA ... 0 . . . . 0 . . 0 . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 7
A. Operating Risks..... . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 . . . . . .. 8B. Implications of Attrition.. 0 0 o. 0.000..000......00.. 0" . 15
Co Impact of Capital Market Conditions 0 0 . . . . . . . . . . . . 0 . . . . 018
D. Support For Avista's Credit Standing..... 0...........0.23
E. Capital Structure............... 0 . . . . . 0 . 0 . . . . . . . . . . . . . .29
III. CAPITAL MARKET ESTIMATES..................... 0 . . . . . . . . .35
A. Overview...... 0 0 . . . . . . . . . . . . . . 0 . 0 . . . . . . . . . . . . . . . . . . . . . .35
B. Results of Quanti tati ve Analyses 0 0 . . 0 0 . . . . . . . . . . . . . . . . .38
Co Flotation Costs....... 0 0 00............................ .47
IV. RETURN ON EQUITY RECOMMENDATION . . . . . . . . . 0 0 . . 0 . . 0 . . . . . . . .50
EXHIBIT No.3
Schedule -1 - Qualifications of William E. Avera
Schedule -2 - Description of Quantitative Analyses
Schedule -3 - Capital Structure
Schedule -4 - Constant Growth DCF Model - Utility proxy
Group
Schedule -5 - Sustainable Growth Rate - Utility Proxy Group
Schedule -6 - Constant Growth DCF Model - Non-Utility Proxy
Group
Schedule -7 - Sustainable Growth Rate - Non-Utility Proxy
Group
Schedule -8 - Forward-looking CAPM - Utility Proxy Group
Schedule -9 - Forward-looking CAPM - Non-Utility Proxy
Group
Schedule -10- Comparable Earnings Approach
1 I.INTRODUCTION
2 Q.Please state your name and business address.
3 A.William E. Avera, 3907 Red River, Austin, Texas,
4 78751.
5 Q.In what capacity are you employed?
6 A.I am the President of FINCAP, Inc., a firm
7 providing financial,economic,and policy consul ting
8 services to business and government.
9 Q.Please describe your educational background and
10 professional experience.
11 A.A description of my background and
12 qualifications, including a resume containing the details
13 of my experience, is attached as Schedule 1.
14 A. Overview
15 Q.What is the purpose of your testimony in this
16 case?
17 A.The purpose of my testimony is to present to the
18 Idaho Public Utilities Commission (the ~Commission" or
19 ~IPUC") my independent evaluation of the fair rate of
20 return on equity (~ROE") for the jurisdictional electric
21 and gas utility operations of Avista Corp. ("Avista" or
22 ~the Company").In addition,I also examined the
Avera, Di 1
Avista Corporation
1 reasonableness of Avista's capital structure, considering
2 both the specific risks faced by the Company and other
3 industry guidelines.
4 Q.Please sumrize the informtion and materials
5 you relied on to support the opinions and conclusions
6 contained in your testimony.
7 A.To prepare my testimony, I used information from
8 a variety of sources that would normally be relied upon by
9 a person in my capacity.I am familiar with the
10 organization, finances, and operations of Avista from my
11 participation in prior proceedings before the IPUC, the
12 Washington Utili ties and Transportation Commission, and the
13 Oregon Public Utility Commission.In connection with the
14 present filing, I considered and relied upon corporate
15 disclosures, publicly available financial reports and
16 filings, and other published information relating to
17 Avista.I also reviewed information relating generally to
18 current capital market conditions and specifically to
19 current investor perceptions,requirements,and
20 expectations for Avista's utility operations.These
21 sources, coupled with my experience in the fields of
22 finance and utility regulation, have given me a working
23 knowledge of the issues relevant to investors' required
Avera, Di 2
Avista Corporation
1 return for Avista, and they form the basis of my analyses
2 and conclusions.
3 Q.What is the practical test of the
4 reasonableness of the ROE used in setting a utility's
5 rates?
6 A.The ROE serves to compensate common equity
7 investors for the use of their capital to finance the plant
8 and equipment necessary to provide utility service.
9 Investors commit capital only if they expect to earn a
10 return on their investment commensurate with returns
11 available from al ternati ve investments with comparable
12 risks.To be consistent with sound regulatory economics
13 and the standards set forth by the U. S. Supreme Court in
14 the Bluefieid and Hope2 cases, a utility's allowed ROE
15 should be sufficient to: 1) fairly compensate the utility's
16 investors, 2) enable the utility to offer a return adequate
17 to attract new capital on reasonable terms, and 3) maintain
18 the utility's financial integrity.
19 Q. How is your testimony organized?
20 A. I first reviewed the operations and finances of
21 Avista and industry-specific risks and capital market
1 Bluefield Water Works & Improvement Co. v. Pub. Servo Comm'n, 262
U.S. 679 (1923).2 Fed. Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591 (1944).
Avera, Di 3
Avista Corporation
1 uncertainties perceived by investors.Wi th this as a
2 background, I conducted various well-accepted quantitative
3 analyses to estimate the current cost of equity, including
4 alternative applications of the discounted cash flow
5 (~DCF") model, the Capital Asset Pricing Model ("CAPM"), an
6 equity risk premium approach based on allowed rates of
7 return, as well as reference to comparable earned rates of
8 return expected for utili ties. Based on the cost of equity
9 estimates indicated by my analyses, the Company's ROE was
10 evaluated taking into account the specific risks and
11 potential challenges for Avista' s utility operations in
12 Idaho as well as other factors (e. g., flotation costs) that
13 are properly considered in setting a fair ROE for the
14 Company.
15 B. Sumary of Conclusions
16 Q.What are your findings regarding the 10.9 percent
17 ROE requestèd by Avista?
18 A.Based on the results of my analyses and the
19 economic requirements necessary to support continuous
20 access to capital under reasonable terms, I determined that
21 10.9 percent is a fair and reasonable estimate of
22 investors' required ROE for Avista.The bases for my
23 conclusion are summarized below:
Avera, Di 4
Avista Corporation
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. In order to reflect the risks and prospectsassociated with Avista's jurisdictional utility
operations, my analyses focused on a proxy group of
twenty-eight other utili ties wi th comparable
investment risks. Consistent with the fact thatutili ties must compete for capital with firms
outside their own industry, I also referenced a
proxy group of comparable risk companies in the
non-utili ty sector of the economy;
.Because investors' required return on
unobservable and no single method should
in isolation, I applied both the DCF
methods, as well as the expected earnings
to estimate a fair ROE for Avista;
equity is
be viewed
and CAPM
approach,
. Based on the results of these analyses, and giving
less weight to extremes at the high and low ends of
the range, I concluded that the cost of equity forthe proxy groups of utili ties and non-utility
companies is in the 10.3 percent to 11.3 percent
range, or 10.45 percent to 11.45 percent after
incorporating an adjustment to account for the
impact of common equity flotation costs; and,
. As reflected in the testimony of Mark T. Thies,
Avista is requesting a fair ROE of 10.9 percent,
which is essentially equal to the midpoint of my
recommended range. Considering capital market
expectations, the exposures faced by Avista, and
the economic requirements necessary to maintain
financial integrity and support additional capital
investment even under adverse circumstances , it is
my opinion that 10.9 percent represents a fair and
reasonable ROE for Avista.
Q. What other evidence did you consider in
evaluating your ROE recommndation in this case?
A. My recommendation is reinforced by the following
findings:
. The reasonableness of a 10.9 percent ROE for Avista
is supported by the need to consider the challenges
to the Company's credit standing:
Avera, Di 5
Avista Corporation
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o The pressure of funding significant capital
expenditures of $482 million in the next two
years , given that the Company's rate base is
$2.1 billion, coupled with increased operating
risks, heighten the uncertainties associated
with Avista;
o Because of Avista' s reliance on hydroelectric
generation and increasing dependence on natural
gas fueled capacity, the Company is exposed to
relatively greater risks of power cost
volatili ty, even with the power cost adj ustment
(~PCA"); and,
o My conclusion that a 10.9 percent ROE for
Avista is a reasonable estimate of investors'
required return is also reinforced by the
greater uncertainties associated with Avista's
relatively small size and the fact that current
cost of capital estimates are likely to
understate investors' requirements at the time
the outcome of this proceeding becomes
effective and beyond.
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. Sensi ti vi ty to financial market and regulatory
uncertainties has increased dramatically and
investors recognize that constructive regulation isa key ingredient in supporting utility credit
standing and financial integrity; and,
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. Providing Avista with the opportunity to earn a
return that reflects these realities is an
essential ingredient to support the Company's
financial position, which ultimately benefits
customers by ensuring reliable service at lowerlong-run costs.
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. Continued support for Avista's financial integrity,
including a reasonable ROE, is imperative to ensure
that the Company has the capability to maintain an
investment grade rating while confronting potentialchallenges associated with funding infrastructure
development necessary to meet the needs of itscustomers.
Avera, Di 6
Avista Corporation
1 Q.What is your conclusion as to the reasonableness
2 of the Company's capital structure?
3 A.Based on my evaluation, I concluded that a common
4 equi ty ratio of 50.15 percent represents a reasonable basis
5 from which to calculate Avista' s overall rate of return.
6 This conclusion was based on the following findings:
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. Avista's requested capitalization is consistent
wi th the Company's need to maintain its credit
standing and financial flexibility as it seeks to
raise additional capital to fund significant system
investments and meet the requirements of itsservice terri tory;
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. Avista' s proposed common equity ratio is entirelyconsistent with the range of capitalizations
maintained by the proxy group of utilities, and
falls wi thin the 49.3 percent and 51.5 percent
average common equity ratios for the proxy
utilities, based on year-end 2010 data and near-
term expectations, respectively; and,
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. The requested capi talization reflects the
importance of an adequate equity layer to
accommodate Avista's operating risks and thepressures of funding significant capital
investments. This is reinforced by the need to
consider the impact of uncertain capital market
condi tions, as well as off-balance sheet
commi tments such as purchased power agreements,
which carry with them some level of imputed debt.
29 II. RISKS OF AVISTA
30 Q.What is the purpose of this section?
31 A.As a predicate to my capital market analyses,
32 this section examines the investment risks that investors
Avera, Di 7
Avista Corporation
1 consider in evaluating their required rate of return for
2 Avista.
3 A. Operating Risks
4 Q.How does Avista's generating resource mix affect
5 investors' risk perceptions?
6 A.Because over 40 percent of Avista's total energy
7 requirements are provided by hydroelectric facilities, the
8 Company is exposed to a level of uncertainty not faced by
9 most utilities.While hydropower confers advantages in
10 terms of fuel cost savings and diversity,reduced
11 hydroelectric generation due to below-average water
12 condi tions forces Avista to rely more heavily on wholesale
13 power markets or more costly thermal generating capacity to
14 meet its resource needs. As Standard & Poor's Corporation
15 ("S&P") has observed:
16 A reduction in hydro generation typically1 7 increases an electric utili ty' s costs by18 requiring it to buy replacement power or run more19 expensive generation to serve customer loads.20 Low hydro generation can also reduce utili ties'21 opportuni ty to make off-system sales. At the22 same time, low hydro years increase regional23 wholesale power prices, creating potentially a
24 double impact - companies have to buy more power25 than under normal conditions, paying higher26 prices. 3
3 Standard & Poor's Corporation, "Pacific Northwest Hydrology And Its
Impact On Investor-Owned Utilities' Credit Quality," RatingsDirect
(Jan. 28, 2008).
Avera, Di 8
Avista Corporation
1 Investors recognize that volatile energy markets,
2 unpredictable stream flows,and Avista's reliance on
3 wholesale purchases to meet a portion of its resource needs
4 can expose the Company to the risk of reduced cash flows
5 and unrecovered power supply costs. S&P noted that Avista,
6 along with Idaho Power Company, ~face the most substantial
7 risks despite their PCAs and cost-update mechanisms,"4 and
8 concluded that Avista' s ~chief risks include the electric
9 utili ty' s exposure to replacement power costs (particularly
10 in low water years) .,,5
11 Addi tionally, Avista has become increasingly reliant
12 on natural gas fired generating capacity to meet base-load
13 needs.Given the significant price fluctuations
14 experienced in energy markets discussed subsequently,
15 increasing reliance on natural gas heightens Avista's
16 exposure to fuel cost volatility.
17 Q.Does Avista anticipate the need to access the
18 capi tal markets going forward?
19 A.Yes.Avista will require capital investment to
20 meet customer growth, provide for necessary maintenance and
21 replacements of its natural gas utility systems, as well as
4 Id.
S Standard & Poor's Corporation, "Research Update: Avista Corp.
Corporate Credit Rating Raised To 'BBB' ; Outlook Stable, "
RatingsDirect (Mar. 2, 2011).
Avera, Di 9
Avista Corporation
1 fund new investment in electric generation, transmission
2 and distribution facilities.As discussed by Company
3 witness Mr. Thies, planned capital additions for 2011-2012
4 alone total approximately $482 million, with $1.2 billion
5 in expenditures being expected through 2015.This
6 represents a substantial investment given Avista's rate
7 base was $2.1 billion as of year-end 2010.
8 Continued support for Avista's financial integrity and
9 flexibility will be instrumental in attracting the capital
10 necessary to fund these projects in an effective manner.
11 Avista's reliance on purchased power to meet shortfalls in
12 hydroelectric generation magnifies the importance of
13 strengthening financial flexibility, which is essential to
14 guarantee access to the cash resources and interim
15 financing required to cover inadequate operating cash
16 flows, as well as fund required investments in the utility
17 system.
18 Q.Is the potential for energy market volatility an
19 ongoing concern for investors?
20 A.Yes.In recent years utili ties and their
21 customers have had to contend with dramatic fluctuations in
22 fuel costs due to ongoing price volatility in the spot
23 markets, and investors recognize the potential for further
Avera, Di 10
Avista Corporation
1 turmoil in energy markets. In times of extreme volatility,
2 utili ties can quickly find themselves in a significant
3 under-recovery position with respect to power costs, which
4 can severely stress liquidity. The power industry and its
5 customers have had to contend with dramatic fluctuations in
6 gas costs due to ongoing price volatility in the spot
7 markets.
8 While current expectations for significantly lower
9 wholesale power prices reflect weaker fundamentals
10 affecting current load and fuel prices, investors recognize
11 the potential that such trends could quickly reverse. For
12 example, heightened uncertainties in the Middle East have
13 led to sharp increases in petroleum prices, and the
14 potential ramifications of the Japanese nuclear crisis on
15 the future cost and availability of nuclear generation in
16 the U. S. have not been lost on investors.S&P observed
17 that ~short-term price volatility from numerous
18 possibili ties is always possible, "6 while Moody's
19 recognized that "the inherent volatility of commodity costs
20 comprises one of the most significant risk factors to the
21 industry,
"7 and concluded, ~This view, that commodity
, Standard & Poor's Corporation, "Top 10 Investor Questions: U. S.
Regulated Electric Utilities," RatingsDirect (Jan. 22, 2010).7 Moody's Investors Service, "Credit Opinion: Avista Corp.," Global
Credi t Research (Mar. 17, 2011).
Avera, Di 11
Avista Corporation
1 prices remain low, could easily be proved incorrect, due to
2 the evidence of historical volatility."8
3 Q.What other financial pressures impact investors'
4 risk assessment of Avista?
5 A.Investors are aware of the financial and
6 regulatory pressures faced by utilities associated with
7 rising costs and the need to undertake significant capital
8 investments.S&P noted that cost increases and capital
9 proj ects,along with uncertain load growth,were a
10 significant challenge to the utility industry. 9 As Moody's
11 observed:
12 (W) e also see the sector's overall business risk13 and operating risks increasing, owing primarily
14 to rising costs associated with upgrading and15 expanding the nation's trillion dollar electric16 infrastructure. 10
17 Providing the infrastructure necessary to meet the
18 energy needs of customers imposes additional financial
19 responsibili ties on Avista.As noted earlier,the
20 Company's plans include electric utility capital
21 expenditures of approximately $482 million just over the
22 2011-2012 period, and Moody's has noted that Avista's
· Moody's Investors Service, "u. S. Electric Utili ties: Uncertain Times
Ahead; Strengthening Balance Sheets Now Would Protect Credit," Special
Comment (Oct. 28, 2010).
· Standard & Poor's Corporation, "Industry Economic And Ratings
Outlook," RatingsDirect (Feb. 2, 2010).10 Moody's Investors Service, "Regulation Provides Stability As Risks
Mount," Industry Outlook (Jan. 19, 2011).
Avera, Di 12
Avista Corporation
1 primary challenge is related to cost recovery of increasing
2 capital investment. "11 Investors are aware of the
3 challenges posed by rising costs and burdensome capital
4 expendi ture requirements, especially in light of ongoing
5 capi tal market and economic uncertainties.
6 Q.What other considera tions affect investors'
7 evaluation of Avista?
8 A.Utili ties are confronting increased environmental
9 pressures that could impose significant uncertainties and
10 costs.Moody's noted that ~the prospect for new
11 environmental emission legislation particularly
12 concerning carbon dioxide - represents the biggest emerging
13 issue for electric utili ties. "12 While the momentum for
14 carbon emissions legislation has slowed, expectations for
15 eventual regulations continue to pose uncertainty.Fitch
16 recently concluded, ~Prospects of costly environmental
17 regulations will create uncertainty for investors in the
18 electricity business in 2011. ,,13
11 Moody's Investors Service, "Credit Opinion: Avista Corp.," Global
Credi t Research (Mar. 17, 2011).
" Moody's Investors Service, "u. S. Investor-Owned Electric Utili ties,"
Industry Outlook (Jan. 2009).11 Fitch Ratings Ltd., "2011 Outlook: U.S. Utilities, Power, and Gas,"
Global Power North America Special Report (Dec. 20, 2010)
Avera, Di 13
Avista Corporation
1 Q.Would investors consider Avista's relative size
2 in their assessment of the Company's risks and prospects?
3 A.Yes.A firm's relative size has important
4 implications for investors in their evaluation of
5 alternative investments, and it is well established that
6 smaller firms are more risky than larger firms.With a
7 market capitalization of approximately $1.3 billion, Avista
8 is one of the smallest publicly traded electric utili ties
9 followed by The Value Line Investment Survey (~Value
10 Line") ,which have an average capitalization of
11 approximately $7.3 billion. 14
12 The magnitude of the size disparity between Avista and
13 other firms in the utility industry has important practical
14 implications with respect to the risks faced by investors.
15 All else being equal, it is well accepted that smaller
16 firms are more risky than their larger counterparts, due in
17 part to their relative lack of diversification and lower
18 financial resiliency. 15 These greater risks imply a higher
19 required rate of return, and there is ample empirical
20 evidence that investors in smaller firms realize higher
u www.valueline.com (Retrieved Mar. 25, 2011).
15 It is well established in the financial literature that smaller
firms are more risky than larger firms. See, e.g., Eugene F. Fama and
Kenneth R. French, "The Cross-Section of Expected Stock Returns", The
Journal of Finance (June 1992); George E. Pinches, J. Clay Singleton,and Ali Jahankhani, "Fixed Coverage as a Determinant of Electric
Utility Bond Ratings", Financial Management (Summer 1978).
Avera, Di 14
Avista Corporation
1 rates of return than in larger firms. 16 Common sense and
2 accepted financial doctrine hold that investors require
3 higher returns from smaller companies, and unless that
4 compensation is provided in the rate of return allowed for
5 a utility, the legal tests embodied in the Hope and
6 Bl uefield cases cannot be met.
7 B. Implications of Attrition
8
9
Q.
A.
What causes attrition?
Attrition is the deterioration of actual return
10 below the allowed return that occurs when the relationships
11 between revenues, costs, and rate base used to establish
12 rates (e. g., using a historical test year without adequate
13 adjustments) do not reflect the actual costs incurred to
14 serve customers during the period that rates are in effect.
15 For example, if external factors are driving costs to
16 increase more than revenues, then the rate of return will
17 fall short of the allowed return even if the utility is
18 operating efficiently.Similarly, when growth in the
19 utility's investment outstrips the rate base used for
20 ratemaking, the earned rate of return will fall below the
21 allowed return through no fault of the utili ty' s
22 management.
,. See for example Rolf W. Banz, "The Relationship Between Return and
Market Value of Common Stocks", Journal of Financial Economics
(September 1981) at 16.
Avera, Di 15
Avista Corporation
1 Q. Why is it necessary to address the impact of
2 attri tion?
3 A. Investors are concerned with what they can expect
4 in the future, not what they might expect in theory if a
5 historical test year were to repeat.It is the end result
6 in the future that determines whether or not the Hope and
7 Bl uefield standards are met.S&P observed that its risk
8 analysis focuses on the utility's ability to consistently
9 earn a reasonable return:
10 Notably, the analysis does not revolve around11 ~authorized" returns, but rather on actual earned
12 returns. We note the many examples of utili ties13 with healthy authorized returns that, we believe,14 have no meaningful expectation of actually15 earning that return because of rate case lag,16 expense disallowances, etc.17
17 Similarly, Moody's concluded, "we evaluate the framework
18 and mechanisms that allow a utility to recover its costs
19 and investments and earn allowed returns. We are less
20 concerned with the official allowed return on equity,
21 instead focusing on the earned returns and cash flows. ,,18
22
17 Standard & Poor's Corporation, "Assessing U. S. Utility Regulatory
Environments," RatingsDirect (Nov. 7, 2008).15 Moody's Investors Service, "Electric Utilities Face Challenges
Beyond Near-Term," Industry Outlook (Jan. 2010).
Avera, Di 16
Avista Corporation
1 Q.Is it reasonable to consider the impact of
2 Avista's exposure to attrition?
3 A.Yes.Central to the determination of reasonable
4 rates for utility service is the notion that owners of
5 public utility properties are protected from confiscation.
6 The Supreme Court has reaffirmed that the end result test
7 must be applied to the actual returns that investors expect
8 if they put their money at risk to finance utili ties. 19
9 This end result can only be achieved for Avista if the
10 allowed return is sufficient to offset the impact of
11 attrition.That end result would maintain the utility's
12 financial integrity, ability to attract capital and offer
13 investors fair compensation for the risk they bear.
14 In real world capital markets, investors have many
15 competing places to put their money.If the money that is
16 dedicated to utility public service does not have an
17 opportuni ty to earn a return commensurate with that
18 available from alternatives of equivalent risk in the
19 capi tal markets,investors are not being adequately
20 compensated for the use of their money and bearing risk.
19 Verizon Communications, et al v. Federal Communications Commission,
et al, 535 U.S. 467 (2002). While I cannot comment on the legal
significance of this case, I found the economic wisdom of looking to
the reasonable expectations of actual investors compelling. Economic
logic and common sense confirm that a utility cannot attract capital
on reasonable terms if investors expect future returns to fall short
of those offered by comparable investments.
Avera, Di 17
Avista Corporation
1 Since the capital dedicated to utility service cannot be
2 wi thdrawn from public service, its economic value to
3 investors is reduced by the amount necessary to make the
4 utili ty investment competi ti ve with al ternati ve investments
5 on the open market.This reduction in economic value
6 necessary to bring the rate of earnings on utility
7 investment into line wi th market opportuni ties of
S commensurate risk constitutes a taking of investors'
9 capi tal by the governmental authority setting rates.
10 C. Impact of Capi tal Market Conditions
11 Q.What are the implications of recent capitai
12 market conditions?
13 A.The deep financial and real estate crisis that
14 the country experienced in late 200S, and continuing into
15 2009 led to unprecedented price fluctuations in the capital
16 markets as investors dramatically revised their risk
17 perceptions and required returns. As a result of investors'
1S trepidation to commit capital, stock prices declined
19 sharply while the yields on corporate bonds experienced a
20 dramatic increase.
21 Wi th respect to utili ties specifically, as of March
22 2011, the Dow Jones Utility Average stock index remained
23 approximately 20 percent below the previous high reached in
24 May 200S.This prolonged sell-off in common stocks and
Avera, Di 1S
Avista Corporation
1 sharp fluctuations in utility bond yields reflect the fact
2 that the utility industry is not immune to the impact of
3 financial market turmoil and the ongoing economic downturn.
4 As the Edison Electric Institute ("EEI") noted in a letter
5 to congressional representatives in September 2008 as the
6 financial crisis intensified, capital market uncertainties
7 have serious implications for utilities and their
8 customers:
9 In the wake of the continuing upheaval on Wall10 Street, capital markets are all but immobilized,11 and short-term borrowing costs to utili ties have12 already increased substantially. If the13 financial crisis is not resolved quickly,14 financial pressures on utilities will intensify15 sharply, resulting in higher costs to our16 customers and, ul timately, could compromise17 service reliability. 20
18 While conditions have improved significantly since the
19 depths of the crisis, investors have nonetheless had to
20 confront ongoing fluctuations in share prices and stress in
21 the credit markets.As the Wall Street Journal noted in
22 February 2010:
23 Stocks pulled out of a 167-point hole with a late
24 rally Friday, capping a wild week reminiscent of25 the most volatile days of the credit crisis. ... It26 was a return to the unusual relationships, or27 correlations, seen at major flash points over the28 past two years when investors fled risky assets
29 and jumped into safe havens. This market
20 Letter to House of Representatives, Thomas R. Kuhn, President,
Edison Electric Institute (Sep. 24, 2008).
Avera, Di 19
Avista Corporation
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behavior, which has reasserted itself repeatedly
since the financial crisis began, suggests that
investment decisions are still being driven more
by government support and liquidity concerns than
market fundamentals. 21
6 In response to renewed capital market uncertainties
7 initiated by unrest in the Middle East, the natural
8 disaster in Japan, ongoing concerns over the European
9 sovereign debt crisis,and questions over the
10 sustainabili ty of economic growth,investors have
11 repeatedly fled to the safety of U. S. Treasury bonds, and
12 stock prices have experienced renewed volatility. 22 The
13 dramatic rise in the price of gold and other commodities
14 also attests to investors'heightened concerns over
15 prospective challenges and risks, including the overhanging
16 threat of inflation and renewed economic turmoil.With
17 respect to electric utili ties, Fitch observed that, ~the
18 outlook for the sector would be adversely affected by
19 significantly higher inflation and interest rates. "23
20 Moody's recently concluded:
21 Gongloff, Mark, "Stock Rebound Is a Crisis Flashback - Late Surge
Recalls Market's Volatility at Peak of Credit Difficulties; Unusual
Correlations," Wall Street Journal at B1 (Feb. 6, 2010).22 The Wall Street Journal recently reported that the Dow Jones
Industrial Average experienced its largest drop since August 2010,
which marked the fourth triple-digit move in less than two weeks. Tom
Lauricella and Jonathan Cheng, "Dow Below 12000 on Mideast Worries -
Troubles in Europe and China Add to Jitters," Wall Street Journal C1
(March. 11, 2011).23 Fitch Ratings Ltd., "2011 Outlook: U.S. Utilities, Power, and Gas,"
Global Power North America Special Report (Dec. 20, 2010).
Avera, Di 20
Avista Corporation
1
2
3
4
5
6
7
Over the past few months, we have been reminded
that global financial markets, which are still
receiving extraordinary intervention benefits bysovereign governments, are exposed to turmoil.
Access to the capital markets could therefore
become intermittent, even for safer, more
defensive sectors like the power industry. 24
8 Uncertainties surrounding economic and capital market
9 conditions heighten the risks faced by electric utilities,
10 which, as described earlier, face a variety of operating
11 and financial challenges.
12 Q.How do interest rates on long-term bonds compare
13 with those projected for the next few years?
14 A.Table WEA-1 below compares current interest rates
15 on 30-year Treasury bonds, triple-A rated corporate bonds,
16 and double-A rated utility bonds with near-term projections
17 from the Value Line,IHS Global Insight, Blue Chip
18 Financial Forecasts (~Blue Chip") ,and the Energy
19 Information Administration (~EIA"), which is a statistical
20 agency of the U.S. Department of Energy (~DOE"):
" Moody's Investors Service, "Regulation Provides Stability As RisksMount," Industry Outlook (Jan. 19, 2011).
Avera, Di 21
Avista Corporation
1 TABLE WE-l
2 INTEREST RATE TRENDS
Current (a)2012 2013 2014 2015
30- Yr. Treasur
Value Line (b)4.2%4.9%5.2%5.5%6.0%
IRS Global Insight (c)4.2%4.7%5.0%5.1%6.0%
Blue Chip (d)4.2%4.8%5.2%5.4%5.5%
AA Corporate
Value Line (b)4.9%5.6%6.0%6.3%6.5%
IRS Global Insight (c)4.9%5.2%6.0%6.2%6.8%
Blue Chip (d)4.9%5.4%5.8%6.1%6.3%
S&P (e)4.9%6.5%7.1%7.2%
AA Utilty
IRS Global Insight (c)5.1%5.4%6.3%6.4%7.2%
EIA (t)5.1%5.5%6.4%7.0%7.4%
(a) Based on monthly average bond yields for the six-month period Sep. 2010 - Feb. 2011
reported at ww.credittends.moodys.com and htt://ww.federalreserve.gov/releases
/h 15/data.htm.
(b) The Value Line Investment Survey, Forecast for the U.S. Economy (Feb. 25,2011).
(c) IRS Global Insight, u.s. Economic Outlook at 19 (Febrary2011).
(d) Blue Chip Financial Forecasts, VoL. 29, No. 12 (Dec. 1,2010).
(e) Standard & Poor's Corporation, "US. Economic Forecast: Warming Up Or Frozen Over?,"
RatingsDirect (Feb. 14,2011).
(t) Energy Information Administration, Annual Energy Outlook 2011 Early Release (Dec. 16,
2010).
3 As evidenced above, there is a clear consensus that the
4 cost of permanent capital will be higher in the 2012-2015
5 time frame than it is currently. As a result, current cost
6 of capital estimates are likely to understate investors'
7 requirements at the time the outcome of this proceeding
8 becomes effective and beyond.
9
10
11
Q. What do these events imply with respect to the
ROE for Avista?
A. No one knows the future of our complex global
12 economy.We know that the financial crisis had been
Avera, Di 22
Avista Corporation
1 building for a long time, and few predicted that the
2 economy would fall as rapidly as it has, or that corporate
3 bond yields would fluctuate as dramatically as they did.
4 While conditions in the economy and capital markets appear
5 to have stabilized significantly since 2009, investors
6 continue to react swiftly and negatively to any future
7 signs of trouble in the financial system or economy.The
8 fact remains that the electric utility industry requires
9 significant new capital investment.Given the importance
10 of reliable electric utility service, it would be unwise to
11 ignore investors' increased sensitivity to risk and future
12 capital market trends in evaluating a fair ROE in this
13 case. Similarly, the Company's capital structure must also
14 preserve the financial flexibility necessary to maintain
15 access to capital even during times of unfavorable market
16 condi tions .
17 D. Support For Avista' s C~edit Standing
18 Q.What credit ratings have been assigned to Avista?
19 A.Reflecting improved financial metrics,S&P
20 recently raised its corporate credit rating for Avista one
Avera, Di 23
Avista Corporation
1 notch from ~BBB-" to ~BBB", 25 and Moody's upgraded Avista's
2 Corporate Credit Rating to ~Baa2" from "Baa3". ~
3 Q.How have investors' risk perceptions for firms
4 involved in the utility industry evolved?
5 A. The past decade witnessed steady erosion in
6 credi t quality throughout the utility industry, both as a
7 resul t of revised perceptions of the risks in the industry
8 and the weakened finances of the utili ties themselves.In
9 December 2009, S&P observed with respect to the industry's
10 future that:
11 Looming costs associated with environmental
12 compliance, slack demand caused by economic
13 weakness, the potential for permanent demand
14 destruction caused by changes in consumer15 behavior and closing of manufacturing facilities,16 and numerous regulatory filings seeking recovery17 of costs are some of the significant challenges18 the industry has to deal with.27
19 Similarly, Moody's noted:
20 (AJ sustained period of sluggish economic growth,21 characterized by high unemployment, could stress22 the sector's recovery prospects, financial23 performance, and credit ratings. The quality of24 the sector's cash flows are already showing signs
25 Standard & Poor's Corporation, "Research Update: Avista Corp.
Corporate Credit Rating Raised To 'BBB' ; Outlook Stable,"
RatingsDirect (Mar. 2, 2011).26 Moody's Investor Services, "Rating Action: Moody's Upgrades Avista i s
Ratings to Baa2," Global Credit Research (Mar. 2011).27 Standard & Poor's Corporation, "u. S. Regulated Electric Utilities
Head Into 2D10 With Familiar Concerns," RatingsDirect (Dec. 28, 2009).
Avera, Di 24
Avista Corporation
1 of decline, partly because of higher operating
2 costs and investments. 28
3 More recently, Moody's concluded, ~we also see the sector's
4 overall business and operating risks increasing. "29
5 Q.What are the implications for Avista, given the
6 potential for further dislocations in the capital markets?
7 A.As documented in the testimony of Mr. Mark Thies,
8 the Company's prolonged efforts to regain investment grade
9 ratings and improve its financial stature have been
10 successful.Nevertheless, continued support for Avista's
11 financial integrity and credit standing is imperative to
12 ensure the Company's capability to confront potential
13 challenges.
14 Fitch observed that when credit market conditions are
15 unsettled, ~ 'flight to quality' is selective within the
16 (utili tyJ sector, favoring companies at higher rating
17 levels. "30 As Avista has experienced, the negative impact
18 of declining credit quality on a utility's capital costs
19 and financial flexibility becomes more pronounced as debt
20 ratings move down the scale from investment to non-
2. Moody's Investors Service, "U.S. Electric Utilities: Uncertain Times
Ahead; Strengthening Balance Sheets Now Would Protect Credit," Special
Comment (Oct. 28, 2010).2. Moody's Investors Service, "Regulation Provides Stability As Risks
Mount," Industry Outlook (Jan. 19, 2011).30 Fitch Ratings Ltd., "U.S. Utilities, Power, and Gas 2010 Outlook,"
Global Power North America Special Report (Dec. 4, 2009).
Avera, Di 25
Avista Corporation
1 investment grade.As the Chairman of the New York state
2 Public Service Commission noted in his role as spokesman
3 for the National Association of Regulatory Utility
4 Commissioners:
5 While there is a large difference between A and
6 BBB, there is an even brighter line between
7 Investment Grade (BBB-/Baa3 bond ratings by
8 S&P/Moody's, and higher) and non-Investment Grade
9 (Junk) (BB+/Ba1 and lower). The cost of issuing10 non-investment grade debt, assuming the market is11 recepti ve to it, has in some cases been hundreds12 of basis points over the yield on investment13 grade securities. To me this suggests that you14 do not want to be rated at the lower end of the
15 BBB range because an unexpected shock could move16 you outside the investment grade range. 31
17 The pressures of significant capital expenditure
18 requirements reinforce the importance of supporting
19 Avista's credit standing.Investors understand from past
20 experience in the utility industry that large capital needs
21 can lead to significant deterioration in financial
22 integri ty that can constrain access to capital, especially
23 during times of unfavorable capital market conditions.
24 Considering the uncertain state of financial markets,
25 competi tion with other investment al ternatives,and
26 investors'sensi ti vi ty to the potential for market
31 Brown, George, "Credit and Capital Issues Affecting the Electric
Power Industry," Federal Energy Regulatory Commission TechnicalConference (Jan. 13, 2009).
Avera, Di 26
Avista Corporation
1 volatility, greater credit strength is a key ingredient in
2 maintaining access to capital at reasonable cost.
3 As Mr. Thies confirms in his testimony, continued
4 regulatory support will be a key driver in solidifying
5 Avista' s financial health, which serves as a critical
6 backstop in the event of a recurring capital market crisis
7 or other operating challenges,such as poor hydro
8 condi tions or increased capital outlays.
9 Q.What role does regulation play in ensuring that
10 Avista has access to capital under reasonable terms and on
11 a sustainable basis?
12 A.The maj or rating agencies have warned of exposure
13 to uncertainties associated with political and regulatory
14 developments.Investors recognize that constructi ve
15 regulation is a key ingredient in supporting utility credit
16 ratings and financial integrity, particularly during times
17 of adverse condi tions.With respect to Avista
18 specifically,the maj or bond rating agencies have
19 explici tly cited the potential that adverse regulatory
20 rulings could compromise the Company's credit standing,
21 with Moody's concluding that, ~Avista' s ratings could be
22 negatively impacted if the level of regulatory support
Avera, Di 27
Avista Corporation
1 wanes. "32 S&P observed that management of Avista's
2 regulatory relationships ~is a critical underpinning of its
3 investment-grade credit quality. "33
4 As Mr. Thies confirms in his testimony, regulatory
5 support will be a key driver in securing additional
6 improvement in the Company's financial health.Further
7 strengthening Avista's financial integrity is imperative to
8 ensure that the Company has the capability to maintain an
9 investment grade rating while confronting large capital
10 expenditures and other potential challenges.
11 Q.Do customers benefit by enhancing the utility's
12 financial flexibility?
13 A.Yes.While providing an ROE that is sufficient
14 to maintain Avista's ability to attract capital, even in
15 times of financial and market stress, is consistent with
16 the economic requirements embodied in the U. S. Supreme
17 Court's Hope and Bl uefield decisions , it is also in
18 customers' best interests.Customers and the service area
19 economy enjoy the benefits that come from ensuring that the
20 utili ty has the financial wherewithal to take whatever
21 actions are required to ensure reliable service.
32 Moody's Investors Service, "Credit Opinion: Avista Corp.," Global
Credit Research (Mar. 17, 2011).33 Standard & Poor's Corporation, "Avista Corp. Corporate Credit Rating
Rai~edTo 'BBB'; Outlook Stable," RatingsDirect (Mar. 2, 2011).
Avera, Di 28
Avista Corporation
1 E. Capital Structure
2 Q.Is an evaluation of the capital structure
3 maintained by a utility relevant in assessing its return on
4 equity?
5 A.Yes. Other things equal, a higher debt ratio, or
6 lower common equity ratio,translates into increased
7 financial risk for all investors. A greater amount of debt
8 means more investors have a senior claim on available cash
9 flow, thereby reducing the certainty that each will receive
10 his contractual payments.This increases the risks to
11 which lenders are exposed, and they require correspondingly
12 higher rates of interest.From common shareholders'
13 standpoint, a higher debt ratio means that there are
14 proportionately more investors ahead of them, thereby
15 increasing the uncertainty as to the amount of cash flow,
16 if any, that will remain.
17 Q.What common equity ratio is implicit in Avista's
18 requested capital structure?
19 A.Avista's capital structure is presented in the
20 testimony of Mr. Thies.As summarized in his testimony,
21 the pro-forma common equity ratio used to compute Avista's
22 overall rate of return was 50.15 percent in this filing.
Avera, Di 29
Avista Corporation
1 Q.What was the average capitalization maintained by
2 the utility proxy group?
3 A.As shown on Schedule 3, for the 28 firms in the
4 utility proxy group, common equity ratios at December 31,
5 2010 ranged between 39.2 percent and 63.8 percent and
6 averaged 49.3 percent.
7 Q.What capitalization is representative for the
8 proxy group of utilities going forward?
9 A.As shown on Schedule 3, Value Line expects an
10 average common equity ratio for the proxy group of
11 utilities of 51.5 percent for its three-to-five year
12 forecast horizon, with the individual common equity ratios
13 ranging from 41.5 percent to 67.5 percent.
14 Q.How does Avista's common equity ratio compare
15 with those maintained by the reference group of utilities?
16 A.The 50.15 percent common equity ratio requested
17 by Avista is entirely consistent with the range of equity
18 ratios maintained by the firms in the Utility Proxy Group
19 and falls wi thin the 49.3 percent and 51.5 percent average
20 equity ratios at year-end 2010 and based on Value Line's
21 near-term expectations , respectively.
Avera, Di 30
Avista Corporation
1 Q.What implication does the increasing risk of the
2 utility industry have for the capital structures maintained
3 by utili ties?
4 A.As discussed earlier, utili ties are facing energy
5 market volatility, rising cost structures, the need to
6 finance significant capital investment plans, uncertainties
7 over accommodating economic and financial market
8 uncertainties,and ongoing regulatory risks.Taken
9 together, these considerations warrant a stronger balance
10 sheet to deal with an increasingly uncertain environment.
11 A conservative financial profile, in the form of a solid
12 common equity ratio,is consistent with increasing
13 uncertainties and the need to maintain the continuous
14 access to capital under reasonable terms that is required
15 to fund operations and necessary system investment,
16 including times of adverse capital market conditions.
17 Moody's has repeatedly warned investors of the risks
18 associated with debt leverage and fixed obligations and
19 advised utili ties not to squander the opportunity to
20 strengthen the balance sheet as a buffer against future
21 uncertainties. 34 More recently, Moody's concluded:
34 Moody's Investors Service, "Storm Clouds Gathering on the Horizon
for the North American Electric Utility Sector," Special Comment (Aug.
2007); "U.S. Electric Utility Sector," Industry Outlook (Jan. 2008).
Avera, Di 31
Avista Corporation
1 From a credit perspective, we believe a strong
2 balance sheet coupled with abundant sources of
3 liquidi ty represents one of the best defenses
4 against business and operating risk and potential
5 negative ratings actions. 35
6 Similarly, S&P noted that, ~we generally consider a debt to
7 capital level of 50% or greater to be aggressive or highly
8 leveraged for utilities. "36 Fitch affirmed that it expects
9 regulated utilities "to extend their conservative balance
10 sheet stance," and employ "a judicious mix of debt and
11 equity to finance high levels of planned investments. "37
12 Q.What other factors do investors consider in their
13 assessment of a company's capital structure?
14 A.Depending on their specific attributes,
15 contractual agreements or other obligations that require
16 the utility to make specified payments may be treated as
17 debt in evaluating Avista's financial risk. Power purchase
18 agreements ("PPAs") and leases typically obligate the
19 utili ty to make specified minimum contractual payments akin
20 to those associated with traditional debt financing and
21 investors consider a portion of these commitments as debt
22 in evaluating total financial risks.Because investors
35 Moody's Investors Service, "U. S. Electric Utili ties Face Challenges
Beyond Near-Term," Industry Outlook (Jan. 2010).36 Standard & Poor's Corporation, "Ratings Roundup: U. S. Electric
Utility Sector Maintained Strong Credit Quality In A Gloomy 2009,"
RatingsDirect (Jan. 26, 2010).37 Fitch Ratings Ltd., "U.S. Utilities, Power, and Gas 2010 Outlook,"
Global Power North America Special Report (Dec. 4, 2009).
Avera, Di 32
Avista Corporation
1 consider the debt impact of such fixed obligations in
2 assessing a utility's financial position,they imply
3 greater risk and reduced financial flexibility.In order
4 to offset the debt equivalent associated with off-balance
5 sheet obligations, the utility must rebalance its capital
6 structure by increasing its common equity in order to
7 restore its effective capitalization ratios to previous
8 levels.The capital structure ratios presented earlier do
9 not include imputed debt associated with power purchase
10 agreements or the impact of other off-balance sheet
11 obligations.
12 These commitments have been repeatedly cited by maj or
13 bond rating agencies in connection with assessments of
14 utili ty financial risks. 38 For example, S&P reported that
15 it adjusts Avista's capitalization to include approximately
16 $81 million in imputed debt from PPAs,leases,and
17 postretirement benefit obligations. 39 Unless Avista takes
18 action to offset this additional financial risk by
38 See, e. g., Standard & Poor's Corporation, "Standard
Methodology For Imputing Debt For U. S. Utilities' Power
Agreements," RatingsDirect (May 7, 2007); Standard &
Corporation, "Implications Of Operating Leases On Analysis
Electric Utilities," RatingsDirect (Jan. 15, 2008); Standard
Corporation, "Top 10 Investor Questions: U. S. Regulated
Utilities," RatingsDirect (Jan. 22, 2010).
" Thies Testimony, P. 18, lL. 16-19. Similarly, Moody's noted thatimputed debt may cause a deterioration in Avista's financialperformance. Moody's Investors Service, "Credit Opinion: AvistaCorp.," Global Credit Research (Mar. 17, 2011).
& Poor'sPurchasePoor's
Of U.S.& Poor'sElectric
Avera, Di 33
Avista Corporation
1 maintaining a higher equity ratio, the resulting leverage
2 will weaken the Company's creditworthiness, implying a
3 higher required rate of return to compensate investors for
4 the greater risks. 40
5 Q.What did you conclude with respect to the
6 Company's capital structure?
7 A.Based on my evaluation, I concluded that Avista's
8 requested capital structure represents a reasonable mix of
9 capi tal sources from which to calculate the Company's
10 overall rate of return.While industry averages provide
11 one benchmark for comparison, each firm must select its
12 capi talization based on the risks and prospects it faces,
13 as well its specific needs to access the capital markets.
14 A public utility with an obligation to serve must maintain
15 ready access to capital under reasonable terms so that it
16 can meet the service requirements of its customers.
17 Avista' scapi tal structure is consistent with industry
18 benchmarks and reflects the challenges posed by its
19 resource mix, the burden of significant capital spending
20 requirements,and the Company's ongoing efforts to
40 Apart from the immediate impact that the fixed obligation of
purchased power costs has on the utility's financial risk, higherfixed charges also reduce ongoing financial flexibility, and the
utili ty may face other uncertainties, such as potential replacement
power costs in the event of supply disruption.
Avera, Di 34
Avista Corporation
1 strengthen its credit standing and support access to
2 capi talon reasonable terms.Moody's observed that its
3 ratings for Avista anticipate "a balanced mix of debt and
4 equi ty. ,,41 The need for access becomes even more important
5 when the company has capital requirements over a period of
6 years, and financing must be continuously available, even
7 during unfavorable capital market conditions.
8 I I I. CAPITAL MAT ESTIMATES
9 Q.What is the purpose of this section?
10 A.This section presents capital market estimates of
11 the cost of equity.The details of my quantitative
12 analyses are contained in Schedule 2, with the results
13 being summarized below.
14 A. Overview
15 Q.Wha t role does the ra te of return on common
16 equity play in a utility's rates?
17 A.The return on common equity is the cost of
1S inducing and retaining investment in the utility's physical
19 plant and assets. This investment is necessary to finance
20 the asset base needed to provide utility service.
21 Investors will commit money to a particular investment only
41 Moody's Investors Service, "Credit Opinion: Avista Corp.," Global
Credi t Research (Mar. 17, 2011).
Avera, Di 35
Avista Corporation
1 if they expect it to produce a return commensurate with
2 those from other investments with comparable risks.
3 Moreover, the return on common equity is integral in
4 achieving the sound regulatory obj ectives of rates that are
5 sufficient to: 1) fairly compensate capital investment in
6 the utility, 2) enable the utility to offer a return
7 adequate to attract new capital on reasonable terms, and 3)
8 maintain the utility's financial integrity. Meeting these
9 objectives allows the utility to fulfill its obligation to
10 provide reliable service while meeting the needs of
11 customers through necessary system replacement and
12 expansion.
13 Q.Did you rely on a singlè method to estimate the
14 cost of equity for Avista?
15 A.No.In my opinion, no single method or model
16 should be relied upon to determine a utility's cost of
17 equi ty because no single approach can be regarded as wholly
18 reliable. Therefore, I used both the DCF and CAPM methods
19 to estimate the cost of common equity. In addition, I also
20 evaluated a fair ROE using an earnings approach based on
21 investors' current expectations in the capital markets. In
22 my opinion, comparing estimates produced by one method with
23 those produced by other approaches ensures that the
Avera, Di 36
Avista Corporation
1 estimates of the cost of equity pass fundamental tests of
2 reasonableness and economic logic.
3 Q.Are you aware that the IPUC has traditionally
4 relied primarily on the DCF and comparable earnings
5 methods?
6 A.Yes, although the Commission has also evidenced a
7 willingness to weigh alternatives in evaluating an allowed
8 ROE. For example, while noting that it had not focused on
9 the CAPM for determining the cost of equity, the IPUC
10 recognized in Order No. 29505 that ~methods to evaluate a
11 common equity rate of return are imperfect predictors" and
12 emphasized "that by evaluating all the methods presented in
13 this case and using each as a check on the other," the
14 Commission had avoided the pitfalls associated with
15 reliance on a single method. 42
16 Q.What was your conclusion regarding a fair ROE for
1 7 the proxy companies?
18 A.Based on the results of my quantitative analyses,
19 and my assessment of the relative strengths and weaknesses
20 inherent in each method, I concluded that the cost of
21 equity for the proxy companies is in the 10.3 percent to
22 11.3 percent range, or 10.45 percent to 11.45 percent after
23 including a minimum adj ustment for flotation costs.
42 Order No. 29505 at 38 (emphasis added).
Avera, Di 37
Avista Corporation
1 B. Results of Quantitative Analyses
2 Q.What specific proxy group of utilities did you
3 rely on for your analysis?
4 A. In estimating the cost of equity, the DCF model
5 is typically applied to publicly traded firms engaged in
6 similar business acti vi ties or with comparable investment
7 risks. As described in detail in Schedule 2, I applied the
8 DCF model to a utility proxy group composed of those
9 dividend-paying companies included by Value Line in its
10 Electric Utili ties Industry groups with: (1) S&P corporate
11 credi t ratings of ~BBB-" to ~BBB+," (2) a Value Line Safety
12 Rank of ~2" or ~3", and (3) a Value Line Financial Strength
13 Rating of ~B+" to ~B++". 43 I refer to this group of 28
14 comparable-risk firms as the ~Utili ty Proxy Group."
15 Q.What other proxy group did you consider in
16 evaluating a fair ROE for Avista?
17 A. Under the regulatory standards established by
18 Hope and Bluefield, the salient criterion in establishing a
19 meaningful benchmark to evaluate a fair ROE is relative
20 risk, not the particular business activity or degree of
21 regulation.With regulation taking the place of
43 In addition, I excluded four utili ties (Allegheny Energy, Inc. ,
FirstEnergy Corp., Northeast Utilities, and Progress Energy, Inc.)
that otherwise would have been in the proxy group, but are not
appropriate for inclusion because they are currently involved in a
maj or merger or acquisition.
Avera, Di 38
Avista Corporation
1 competi ti ve market forces, required returns for utili ties
2 should be in line with those of non-utility firms of
3 comparable risk operating under the constraints of free
4 competi tion.Consistent with this accepted regulatory
5 standard, I also applied the DCF model to a reference group
6 of comparable risk companies in the non-utility sectors of
7 the economy.I refer to this group as the ~Non-Utili ty
8 Proxy Group".
9 Q.Do utilities have to compete with non-regulated
10 firms for capital?
11 A. Yes. The cost of capital is an opportunity cost
12 based on the returns that investors could realize by
13 putting their money in other alternatives.Clearly, the
14 total capital invested in utility stocks is only the tip of
15 the iceberg of total common stock investment, and there are
16 a plethora of other enterprises available to investors
17 beyond those in the utility industry.Utili ties must
18 compete for capital, not just against firms in their own
19 industry, but with other investment opportunities of
20 comparable risk.
Avera, Di 39
Avista Corporation
1
2
Q.Is it consistent with the Bluefield and Hope
cases to consider required returns for non-utili ty
3 companies?
4 A.Yes.Returns in the competitive sector of the
5 economy form the very underpinning for utility ROEs because
6 regulation purports to serve as a substitute for the
7 actions of competi ti ve markets.The Supreme Court has
8 recognized that it is the degree of risk, not the nature of
9 the business, which is relevant in evaluating an allowed
10 ROE for a utility. The Bluefield case refers to ~business
11 undertakings attended with comparable risks and
12 uncertainties." 44 It does not restrict consideration to
13 other utili ties. Similarly, the Hope case states:
14 By that standard the return to the equity owner
15 should be commensurate wi th returns on16 investments in other enterprises having17 corresponding risks. 45
18 As in the Bluefield decision, there is nothing to restrict
1 9 ~other enterprises" solely to the utility industry.
20 Indeed,in teaching regulatory policy I usually
21 observe that in the early applications of the comparable
22 earnings approach, utili ties were explicitly eliminated due
23 to a concern about circularity. In other words, soon after
44 Bluefield Water Works & Improvement Co. v. Pub. Servo Comm'n, 262
U.S. 679 (1923).4S Federal Power Comm'n v. Hope Natural Gas Co. (320 U.S. 391,1944).
Avera, Di 40
Avista Corporation
1 the Hope decision regulatory commissions did not want to
2 get involved in circular logic by looking to the returns of
3 utili ties that were established by the same or similar
4 regulatory commissions in the same geographic region.To
5 avoid circularity, regulators looked only to the returns of
6 non-utili ty companies.
7 Q.Does consideration of the results for the Non-
8 Utility Proxy Group make the estimation of the cost of
9 equi ty using the DCF model more reliable?
10 A. Yes. The estimates of growth from the DCF model
11 depend on analysts' forecasts.It is possible for utility
12 growth rates to be distorted by short-term trends in the
13 industry or the industry falling into favor or disfavor by
14 analysts. The result of such distortions would be to bias
15 the DCF estimates for utili ties.For example, Value Line
16 recently observed that near-term growth rates understate
17 the longer-term expectations for gas utili ties:
18 Natural Gas Utility stocks have fallen near the19 bottom of our Industry spectrum for Timeliness.20 Accordingly, short-term investors would probably21 do best to find a group with better prospects22 over the coming six to 12 months. Longer-term,23 we expect these businesses to rebound. An
24 improved economic environment, coupled with25 stronger pricing, should boost results across26 this sector over the coming years. 46
" The Value Line Investment Survey at 445 (Mar. 12, 2010).
Avera, Di 41
Avista Corporation
1 Because the Non-Utility Proxy Group includes low risk
2 companies from many industries, it diversifies away any
3 distortion that may be caused by the ebb and flow of
4 enthusiasm for a particular sector.
5
6
7
Q. What criteria did you apply to develop the Non-
Utility Proxy Group?
A. My comparable risk proxy group of non-utility
8 firms was composed of those U. S. companies followed by
9 Value Line that:(1) pay common dividends; (2) have a
10 Safety Rank of ~1tt; (3) have a Financial Strength Rating of
11 ~B++tt or greater; (4) have a beta of 0.85 or less; and, (5)
12 have investment grade credit ratings from S&P.
13 Q.How do the overall risks of your proxy groups
14 compare with Avista?
15 A.Table WEA-2 compares the Utility Proxy Group with
16 the Non-Utility Proxy Group and Avista across four key
17 indicators of investment risk:
18 TABLE WE-219 COMPARISON OF RISK INDICATORS
S&P Value Line
Credit Safety Financial
Rating Rank Strength Beta--
Utili ty Group BBB 3 B++0.74
Non-Utili ty Proxy A 1 A+0.70
Group
Avista BBB 2 B++0.70
Avera, Di 42
Avista Corporation
1 Q.Do these comparisons indicate that investors
2 would view the firm in your proxy groups as risk-
3 comparable to the Company?
4 A.Yes. Considered together, a comparison of these
5 objective measures, which consider a broad spectrum of
6 risks, including financial and business position, and
7 exposure to firm-specific factors, indicates that investors
8 would likely conclude that the overall investment risks for
9 Avista are generally comparable to those of the firms in
10 the Utility Proxy Group.
11 With respect to the Non-Utility Proxy Group, its
12 average credit ratings, Safety Rank, and Financial Strength
13 Rating suggest less risk than for Avista, with its 0.70
14 average beta indicating identical risk.While the impact
15 of differences in regulation is reflected in objective risk
16 measures, my analyses conservatively focus on a lower-risk
17 group of non-utility firms.
18 Q.What cost of equity is implied by your DCF
19 results for the utility proxy group?
20 A.My application of the DCF model, which is
21 discussed in greater detail in Schedule 2, considered three
22 al ternative measures of expected earnings growth, as well
23 as the sustainable growth rate based on the relationship
24 between expected retained earnings and earned rates of
Avera, Di 43
Avista Corporation
1 return ("br+sv").As shown on Schedule 4 and summarized
2 below in Table WEA-3, after eliminating illogical low- and
3 high-end values, application of the constant growth DCF
4 model resulted in the following cost of equity estimates:
5 TABLE WE-3
6 DCF RESULTS - UTILITY PROXY GROUP
Growth Rate
Value Line
IBES
Zacks
br+sv
Average Cost of Equity
10.9%
10.6%
10.6%
9.2%
7 Q.What were the results of your DCF analysis for
8 the Non-Utility Proxy Group?
9 A.As shown on Schedule 6, I applied the DCF model
10 to the non-utility companies in exactly the same manner
11 described earlier for the Utility Proxy Group.As
12 summarized below in Table WEA-4,after eliminating
13 illogical low- and high-end values, application of the
14 constant growth DCF model resulted in the following cost of
15 equity estimates:
16 TABLE WE-4
1 7 DCF RESULTS - NON-UTILITY GROUP
Growth Rate
Value Line
IBES
Zacks
br+sv
Average Cost of Equity
11. 9%
12.4%
12.5%
12.1%
Avera, Di 44
Avista Corporation
1 Q.How did you apply the CA to estimate the cost
2 of equity?
3 A.Like the DCF model, the CAPM is an ex-ante, or
4 forward-looking model based on expectations of the future.
5 As a result, in order to produce a meaningful estimate of
6 investors' required rate of return, the CAPM is best
7 applied using estimates that reflect the expectations of
8 actual investors in the market, not with backward-looking,
9 historical data.Accordingly, I applied the CAPM to the
10 utility proxy group based on a forward-looking estimate for
11 investors' required rate of return from common stocks.
12 Because this forward-looking application of the CA~M looks
13 directly at investors' expectations in the capital markets,
14 it provides a more meaningful guide to the expected rate of
15 return required to implement the CAPM.
16 Q.What cost of equity was indicated by the CAPM
1 7 approach?
18 A.As shown on Schedule 8, my forward-looking application
19 of the CAPM model indicated an ROE of 11.5 percent for the
20 utili ty proxy group.Applying the CAPM approach to the
21 firms in the non-utility proxy group (Schedule 9) implied a
22 cost of equity of 10.1 percent.
Avera, Di 45
Avista Corporation
1 Q.What other analyses did you conduct to estimate
2 the cost of equity?
3 A.As I noted earlier, I also evaluated the cost of
4 equi ty using the comparable earnings approach.Reference
5 to rates of return available from alternative investments
6 of comparable risk can provide an important benchmark in
7 assessing the return necessary to assure confidence in the
8 financial integrity of a firm and its ability to attract
9 capital.This comparable earnings approach is consistent
10 wi th the economic underpinnings for a fair rate of return
11 established by the U. S. Supreme Court. Moreover, it avoids
12 the complexities and limitations of capital market methods
13 and instead focuses on the returns earned on book equity,
14 which are readily available to investors.
15 Q.What rates of return on equity are indicatèd for
16 utili ties based on the comparable earnings approach?
17 A.Value Line reports that its analysts anticipate
18 an average rate of return on common equity for the electric
19 utility industry of 10.5 percent in 2011 and over its 2013-
20 2015 forecast horizon.47 The capital structure
21 corresponding with this expected return reflects an equity
22 ratio of 49.5 percent.Meanwhile, for the gas utility
47 The Value Line Investment Survey at 139 (Feb. 25, 2011).
Avera, Di 46
Avista Corporation
1 industry Value Line expects returns on common equity of
2 10.0 percent throughout its forecast horizon. 48 As shown
3 on Schedule 10, Value Line's projections for the utility
4 proxy group suggested an average ROE of 10.4 percent after
5 eliminating outliers. 49
6 C. Flotation Costs
7 Q.What other considerations are relevant in setting
8 the return on equity for a utility?
9 A.The common equity used to finance the investment
10 in utility assets is provided from either the sale of stock
11 in the capital markets or from retained earnings not paid
12 out as dividends.When equity is raised through the sale
13 of common stock, there are costs associated wi th ~floating"
14 the new equity securities.These flotation costs include
15 services such as legal, accounting, and printing, as well
16 as the fees and discounts paid to compensate brokers for
17 selling the stock to the public. Also, some argue that the
18 "market pressure" from the additional supply of common
19 stock and other market factors may further reduce the
20 amount of funds a utility nets when it issues common
21 equi ty.
4. The Value Line Investment Survey at 546 (Mar. 11, 2011).
4' As highlighted on Schedule 10, I eliminated two extreme low-end
outliers.
Avera, Di 47
Avista Corporation
1 Q.Is there an established mechanism for a utility
2 to recognize equity issuance costs?
3 A.No.While debt flotation costs are recorded on
4 the books of the utility, amortized over the life of the
5 issue, and thus increase the effective cost of debt
6 capital, there is no similar accounting treatment to ensure
7 that equity flotation costs are recorded and ultimately
8 recognized.No rate of return is authorized on flotation
9 costs necessarily incurred to obtain a portion of the equity
10 capi tal used to finance plant.In other words, equity
11 flotation costs are not included in a utility's rate base
12 because neither that portion of the gross proceeds from the
13 sale of common stock used to pay flotation costs is
14 available to invest in plant and equipment, nor are
15 flotation costs capitalized as an intangible asset. Unless
16 some provision is made to recognize these issuance costs, a
17 utili ty' s revenue requirements will not fully reflect all of
18 the costs incurred for the use of investors' funds. Because
19 there is no accounting convention to accumulate the
20 flotation costs associated with equity issues, they must be
21 accounted for indirectly, with an upward adjustment to the
22 cost of equity being the most logical mechanism.
Avera, Di 48
Avista Corporation
1 Q.What is the magnitude of the adjustment to the
2 ~bare bones" cost of equity to account for issuance costs?
3 A.While there are a number of ways in which a
4 flotation cost adjustment can be calculated, one of the
5 most common methods used to account for flotation costs in
6 regulatory proceedings is to apply an average flotation-
7 cost percentage to a utility' s dividend yield. Based on a
8 review of the finance literature, New Regulatory Finance
9 concluded:
10 The flotation cost allowance requires an11 estimated adjustment to the return on equity of
12 approximately 5% to 10%, depending on the size13 and risk of the issue. 50
14 Al terna ti vely,a study of data from Morgan Stanley
15 regarding issuance costs associated with utility common
16 stock issuances suggests an average flotation cost
17 percentage of 3.6 percent. 51
18 Issuance costs are a legitimate consideration in
19 setting the ROE for a utility, and applying these expense
20 percentages to a representative dividend yield for a
so Roger A. Morin, "New Regulatory Finance," Public Utilities Reports,
Inc. at 323 (2006).51 Application of Yankee Gas Services Company for a Rate Increase, DPUC
Docket No. 04-06-01, Direct Testimony of George J. Eckenroth (Jul. 2,
2004) at Exhibit GJE-11. 1. Updating the results presented by Mr.
Eckenroth through April 2005 also resulted in an average flotation
cost percentage of 3.6%.
Avera, Di 49
Avista Corporation
1 utili ty of 4.5 percent implies a flotation cost adjustment
2 on the order of 15 to 45 basis points.
3 Q.Has the I PUC Staff previously considerèd
4 flotation costs in estimting a fair ROE?
5 A.Yes. For example, in Case No. IPC-E-OS-10, IPUC
6 Staff witness Terri Carlock noted that she had adj usted her
7 DCF analysis to incorporate an allowance for flotation
S costs. 52
9 iv. RETUR ON EQUITY RECOMMNDATION
10 Q.What did you conclude with respect to the cost of
11 equity implied by your analyses for the proxy groups?
12 A.The cost of equity estimates implied by my
13 quantitative analyses are summarized in Table WEA-5, below:
52 Case No. IPC-E-08-10, Direct Testimony of Terri Carlock at 12-13
(Oct. 24, 2008).
Avera, Di 50
Avista Corporation
1
2
TABLE WE-5
SUMY OF QUANITATIVE RESULTS
3
DCF Utilty Non-Utilty
Earnings Growth
Value Line 10.9%11.9%
IBES 10.6%12.4%
Zacks 10.6%12.5%
br+sv 9.2%12.1%
CAPM 11.5%10.1%
Expected Earnings Electric ~
Value Line 2014-16 10.5%10.0%
Utility Proxy Group 10.4%
4 Considering the relative strengths and weaknesses inherent
5 in each method, and conservatively giving less emphasis to
6 the upper- and lower-most boundaries of the range of
7 resul ts, I concluded that the cost of common equity is in
8 the 10.3 percent to 11.3 percent range.
9 Q.Wha t then is your conclusion regarding a fair ROE
10 based on your analyses for the companies in your proxy
11 groups?
12 A.After incorporating a minimum adjustment for
13 flotation costs of 15 basis points to my ~bare bones" cost
14 of equity range, I concluded that my analyses indicate a
15 fair ROE in the 10.45 percent to 11.45 percent range, with
16 a midpoint of 10.95 percent.
Avera, Di 51
Avista Corporation
1 Q.Based on the results of your evaluation, what is
2 your opinion regarding the reasonableness of the ROE
3 requested by Avista in this case?
4 A.Because the Company's requested 10.9 percent ROE
5 falls essentially at the midpoint of my recommended range
6 it represents a reasonable estimate of investors' required
7 return that is adequate to compensate investors, while
8 maintaining Avista's financial integrity and ability to
9 attract capital on reasonable terms.
10 Apart from the results of the quantitative methods
11 summarized above, it is crucial to recognize the importance
12 of supporting the Company's financial position so that
13 Avista remains prepared to respond to unforeseen events
14 that may materialize in the future.Recent challenges in
15 the economic and financial market environment highlight the
1 6 imperative of maintaining the Company's financial strength
17 in attracting the capital needed to secure reliable service
18 at a lower cost for customers.The reasonableness of the
19 Company's requested ROE is reinforced by the operating
20 risks associated with Avista's reliance on hydroelectric
21 generation,the higher uncertainties associated with
22 Avista's relatively small size, and the fact that current
23 cost of capital estimates are likely to understate
Avera, Di 52
Avista Corporation
1 investors'requirements at the time the outcome of this
2 proceeding becOmes effective and beyond.
3 Q.Does this conclude your pre-filèd direct
4 testimony?
5 A.Yes.
Avera, Di 53
Avista Corporation
DAVID J. MEYER
VICE PRESIDENT AND CHIEF COUNSEL FOR
REGULATORY & GOVERNMENTAL AFFAIRS
AVISTA CORPORATION
P.O. BOX 3727
1411 EAST MISSION AVENUE
SPOKANE, WASHINGTON 99220-3727
TELEPHONE: [phone]
FACSIMILE: [phone]
DAVID .MEYER&AVISTACORP. COM
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF AVISTA 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. AVU-E-11-01
CASE NO. AVU-G-11-01
EXHIBIT NO. 3
WILLIAM E. AVERA
FOR AVISTA CORPORATION
(ELECTRIC AND NATURAL GAS)
EXHIBIT 3, SCHEDULE 1
QUALIFICATIONS OF WILLIAM E. AVERA
Q. What is the purpose of this exhibit?
A. This exhibit describes my background and experience and
contains the details of my qualifications.
Q. Please describe your qualifications and experience.
A. I received a B.A. degree with a major in economics from
Emory University.After serving in the U. S. Navy, I
entered the doctoral program in economics at the
Uni versi ty 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,
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 1, p. 1 of 10
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, I have been engaged as a
consul tant.I have participated in a wide range of
assignments involving utility-related 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, 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 over 40 states, including the Public Utilities
Commission of Ohio (~PUCO" or the "Commission").
In 1995, 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. In addition,
I served 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
Exhibit No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 1, p. 2 of 10
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
uni versi ties 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~) designation and have served as Vice President for
Membership of the Financial Management Association. I
have also 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
Commissioners (~NARUCtt) Subcommittee on Economics and
appointed to NARUC's Technical Subcommittee on the
National Energy Act. I have also served as an officer of
various other professional organizations and societies.
A resume containing the details of my experience and
qualifications is attached.
Exhibit No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 1, p. 3 of 10
FINCAP, INC.
Financial Concepts and Applications
Economic and Financial Counsel
WILLIAM E. AVERA
3907 Red River
Austin, Texas 78751
[phone]
FAX [phone]
fincap(ftexas.net
Summary of Qualifications
Ph.D. in economics and finance; Chartered Financial Analyst (CF A il) designation; extensive exper
witness testimony before cours, alternative dispute resolution panels, regulatory agencies and
legislative committees; lectued in executive education programs around the world on ethics,
investment analysis, and regulation; undergraduate and grduate teaching in business and economics;
appointed to leadership positions in government, industr, academia, and the miltar.
Employment
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, costlenefit analyses and financial modeling,
valuation of businesses (almost 200 entities valued),
estimation of damages, statistical and industr 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 cour.
Responsible for research and testimony preparation on
rate of retu, rate structue, and econometrc 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 fuds. 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 instrctors, liaison within the
company and with academic institutions. Prepared
operating budget and designed financial controls for
corporate professional development program.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 1, p. 4 of 10
Lecturer in Finance,
The University of Texas at Austin
(Sep. 1979 to May 1981)
Assistant Professor of Finance,
(Sep. 1975 to May 1977)
AssistantProfessor of Business,
University of Nort Carolina at
Chapel Hil
(Sep. 1972 to Ju1. 1975)
Education
Ph.D., Economics and Finance,
University of North Carolina at
Chapel Hil
(Jan. 1969 to Aug. 1972)
B.A., Economics,
Emory University, Atlanta, Georgia
(Sep. 1961 to Jun. 1965)
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 fuds student
publications and broadcast stations.
Elective courses included financial management, public
finance, monetary theory, and econometrcs. 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 extracurrcular 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 touraments.
Professional Associations
Received Charered Financial Analyst (CF A) 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 Curculum Committee,
Association for Investment Management and Research; Executive Committee of South em Finance
Association; Vice Chair, Staff Subcommittee on Economics and National Association of Regula tory
Utility Commissioners (NARUC); Appointed to NARUC Technical Subcommittee on the National
Energy Act.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 1, p. 5 of 10
Teaching in Executive Education Programs
University-Sponsored Programs: Central Michigan University, Duke University, Louisiana State
University, National Defense University, National University of Singapore, Texas A&M University,
University of Kansas, University of Nort Carolina, University of Texas.
Business and Government-Sponsored Programs: Advanced Seminar on Earings 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 Industr, National Association of Purchasing Management,
National Association of Tire Dealers, Planning Executives Institute, School of Banng 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 CPAs, Tokyo Association of Foreign Banks, Union Ban of
Switzerland, U.S. Departent of State, U.S. Navy, U.S. Veterans Administration, in addition to
Texas state agencies and major corporations.
Presented papers for Mils B. Lane Lectue Series at the University of Georgia and Heubner Lectues
at the University of Pennsylvania. Taught graduate courses in finance and economics for evening
program at St. Edward's University in Austin from Januar 1979 through 1998.
Expert Witness Testimony
Testified in over 300 cases before regulatory agencies addressing cost of capital, regulatory policy,
rate design, and other economic and financial issues.
Federal Agencies: Federal Communications Commission, Federal Energy Regulatory Commission,
Surface Transporttion Board, Interstate Commerce Commission, and the Canadian
Radio- Television and Telecommunications Commission.
State Regulatory Agencies: Alaska, Arzona, Arkansas, California, Colorado, Connecticut,
Delaware, Florida, Georgia, Hawaii, Idaho, llinois, Indiana, Iowa, Kansas, Kentucky, Maryland,
Michigan, Missouri, Nevada, New Mexico, Montana, Nebraska, North Carolina, Ohio,
Oklahoma, Oregon, Pennsylvania, South Carolina, South Dakota, Texas, Utah, Virginia,
Washington, West Virginia, Wisconsin, and Wyoming.
Testified in 42 cases before federal and state cours, arbitration panels, and alternative dispute
trbunals (89 depositions given) regarding daages, valuation, antitrst liabilty, 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 electrc cooperatives in Georgia); Chairman, Board of Print Depot, Inc.
and FINCAP, Inc.; Co-chair, Synchronous Interconnection Committee, appointed by Public Utilty
Commission of Texas and approved by governor; Appointed by Hays County Commission to
Citizens Advisory Committee of Habitat Conservation Plan, Operator of AAA Ranch, a certified
Exhibit No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 1, p. 6 of 10
organic producer of agrcultual products; Appointed to Organic Livestock Advisory Committee by
Texas Agricultual 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 Hawaii Public Utilties Commission to team reviewing affliate relationships of Hawaiian Electrc
Industries; Chairman, Energy Task Force, Greater Austin-San Antonio Corrdor Council; Consultat
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 of Directors, Sustainable Food Center; Chair, Board of Deacons, Finance Committee, and
Elder, Central Presbyterian Church of Austin; Founding Member, Orange-Chatham County (N.C.)
Legal Aid Screening Committee.
Miltary
Captain, U.S. Naval Reserve (retired after 28 years service); Commanding Officer, Naval Special
Warfare Engineering (SEAL) Support Unit; Officer-in-Charge of SWIFT patrol boat in Vietnam;
Enlisted service as weather analyst (advanced to second class pett offcer).
Bibliography
Monographs
Ethics and the Investment Professional (video, workbook, and instrctor's guide) and Ethics
Challenge Today (video), Association for Investment Management and Research (1995)
"Definition of Industr 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, 1. 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 Utilties Fortnightly (Nov. 11, 1982)
"Usefulness of Curent Values to Investors and Creditors," Research Study on Current-Value
Accounting Measurements and Utilty, George M. Scott, ed., Touche Ross Foundation (1978)
"The Geometrc Mean Strategy and Common Stock Investment Management," with Henr A.
Latané in Life Insurance Investment Policies, David Cummins, ed. (1977)
Investment Companies: Analysis of Current Operations and Future Prospects, with 1. Finley Lee
and Glenn L. Wood, American College of Life Underwiters (1975)
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 1, p. 7 of 10
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 Kerr
Cooper, Journal of Economics and Business (Spring 1985); reprinted by National Association of
Security Dealers
"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 ofIFPS at the Public Utilty 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 Retu to Public Utilty 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 Uncertinty," with
David Cordell in Proceedings of the Southwestern Finance Association (1977)
"Usefulness of Curent Values to Investors and Creditors," in Inflation Accounting/Indexing and
Stock Behavior (1977)
"Consumer Expectations and the Economy," Texas Business Review (Nov. 1976)
"Portfolio Performance Evaluation and Long-ru Capital Growth," with Henr A. Latané in
Proceedings of the Eastern Finance Association (1973)
Book reviews in Journal of Finance and Financial Review. Abstracts for CF A Digest. Articles in
Carolina Financial Times.
Selected Papers and Presentations
"Economic Perspective on Water Marketing in Texas," 2009 Water Law Institute, The University of
Texas School of Law, Austin, TX (Dec. 2009).
"Estimating Utilty Cost of Equity in Financial Turoil," SNL EXNET 15th Anual FERC Briefmg,
Washington, D.C. (Mar. 2009)
"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 Treasur Function," Governent Treasurers Organization of Texas, Corpus Chrsti,
Texas (Jun. 1996)
"A Cooperative Futue," Iowa Association of Electric Cooperatives, Des Moines (December 1995).
Similar presentations given to National G & T Conference, Iring, Texas (June 1995), Kentucky
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-1l-01
W. Avera, Avista
Schedule 1, p. 8 of 10
Association of Electric Cooperatives Anual Meeting, Louisvile (Nov. 1994), Virginia,
Maryland, and Delaware Association of Electrc Cooperatives Anual Meeting, Richmond (July
1994), and Carolina Electrc Cooperatives Annual Meeting, Raleigh (Mar. 1994)
"Information Superhighway Warings: Speed Bumps on Wall Street and Detours from the
Economy," Texas Society of Certified Public Accountats Natul Gas, Telecommunications and
Electric Industries Conference, Austin (Apr. 1995)
"Economic!Wall Street Outlook," Carolinas Council of the Institute of Management Accountants,
Myrle Beach, South Carolina (May 1994). Similar presentation given to Bell Operating Company
Accounting Witness Conference, Santa Fe, New Mexico (Apr. 1993)
"Regulatory Developments in Telecommunications," Regional Holding Company Financial and
Accounting Conference, San Antonio (Sep. 1993)
"Estimating the Cost of Capital Durng the 1990s: Issues and Directions," The National Society of
Rate of Retu Analysts, Washington, D.C. (May 1992)
"Making Utilty Regulation Work at the Public Utilty Commission of Texas," Center for Legal and
Regulatory Studies, University of Texas, Austin (June 1991)
"Can Regulation Compete for the Hears and Minds of Industrial Customers," Emerging Issues of
Competition in the Electric Utilty Industr Conference, Austin (May 1988)
"The Role of Utilties 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 Utilty Commissions and the Nuclear Plant Contractor," Constrction Litigation
Superconference, Lagua Beach, California (Dec. 1986)
"Development of Cogeneration Policies in Texas," University of Georgia Fift Anual Public
Utilties Conference, Atlanta (Sep. 1985)
"Wheeling for Power Sales," Energy Bureau Cogeneration Conference, Houston (Nov. 1985).
"Asymetrc Discounting of Information and Relative Liquidity: Some Empirical Evidence for
Common Stocks" (with John Groth and Kerr 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 Retu Decisions," The National Society of Rate of Retu
Analysts, New York (Oct. 1979)
""Discounted Cash Life: A New Measure ofthe 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 Henr A. Latané,
American Finance Association, San Francisco (Dec. 1974)
Exhibit No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 1, p. 9 of 10
"An Optimal Approach to the Finance Decision," with Henr A. Latané, Southern Finance
Association, Atlanta (Nov. 1974)
"A Pragmatic Approach to the Capital Strctue Decision Based on Long-Run Growt," with Henr
A. Latané, Financial Management Association, San Diego (Oct. 1974)
"Growth Rates, Expected Retus, and Varance in Portfolio Selection and Performance Evaluation,"
with Henr A. Latané, Econometric Society, Oslo, Norway (Aug. 1973)
Exhibi t No. 3
Case Nos. AVU-E-I1-01 & AVU-G-11-01
W. Avera, Avista
Schedule 1, p. 10 of lO
EXHIBIT 3, SCHEDULE 2
DESCRIPTIONS OF QUANTITATIVE ANALYSES
1
2
Q.
A.
What is the purpose of this schedule?
Schedule 2 presents capital market estimates of
3 the cost of equity. First, I examine the concept of the
4 cost of equity, along with the risk-return tradeoff
5 principle fundamental to capital markets. Next, I
6 describe DCF, CAPM, and comparable earnings analyses
7 conducted to estimate the cost of equity for reference
8 groups of comparable risk firms.
9 Q.
A. Overview
Wha t role does the rate of return on common
10 equity play in a utility's rates?
11 A.The return on common equity is the cost of
12 inducing and retaining investment in the utility's
13 physical plant and assets. This investment is necessary
14 to finance the asset base needed to provide utility
15 service. Investors will commit money to a particular
16 investment only if they expect it to produce a return
17 commensurate with those from other investments with
18 comparable risks. Moreover, the return on common equity
19 is integral in achieving the sound regulatory objectives
20 of rates that are sufficient to: 1) fairly compensate
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 1 of 40
1 capi tal investment in the utility, 2) enable the utility
2 to offer a return adequate to attract new capital on
3 reasonable terms, and 3) maintain the utility's financial
4 integri ty. Meeting these obj ecti ves allows the utility to
5 fulfill its obligation to provide reliable service while
6 meeting the needs of customers through necessary system
7 expansion.
8 Q.What fundamental economic principle underlies
9 any evaluation of investors' required return on equity?
10 A.The fundamental economic principle underlying
11 the cost of equity concept is the notion that investors
12 are risk averse. The required rate of return for a
13 particular asset at any point in time is a function of: 1)
14 the yield on risk-free assets, and 2) its relative risk,
15 with investors demanding correspondingly larger risk
16 premiums for assets bearing greater risk. Given this
17 risk-return tradeoff, the required rate of return (k) from
18 an asset (i) can be generally expressed as:
19 ki = Rf +RPi
20
21
22
where:Rf Risk-free rate of return, and
RPi = Risk premium required to holdriskier asset i.
23 Thus, the required rate of return for a particular asset
24 at any point in time is a function of: 1) the yield on
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 2 of 40
1 risk-free assets, and 2) its relative risk, with investors
2 demanding correspondingly larger risk premiums for assets
3 bearing greater risk.
4 Q.Is the cost of equity observable in the capital
5 markets?
6 A.No. Unlike debt capital, there is no
7 contractually guaranteed return on common equity capital
8 since shareholders are the residual owners of the utility.
9 Because it is unobservable, the cost of equity for a
10 particular utility must be estimated by analyzing
11 information about capital market conditions generally,
12 assessing the relative risks of the company specifically,
13 and employing various quantitative methods that focus on
14 investors' current required rates of return. These
15 various quantitative methods typically attempt to infer
16 investors' required rates of return from stock prices,
17 interest rates, or other capital market data.
B. COmparable Risk Proxy Groups
18 Q. How did you implement these quantitative methods
19 to estimate the cost of common equity for Avista?
20 A.Application of the DCF model and other
21 quantitative methods to estimate the cost of equity
22 requires observable capital market data, such as stock
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 3 of 40
1 prices. Moreover, even for a firm with publicly traded
2 stock, the cost of equity can only be estimated. As a
3 result, applying quantitative models using observable
4 market data only produces an estimate that inherently
5 includes some degree of observation error. Thus, the
6 accepted approach to increase confidence in the results is
7 to apply the DCF model and other quanti tati ve methods to a
8 proxy group of publicly traded companies that investors
9 regard as risk comparable.
10 Q.What specific proxy group did you rely on for
11 your analysis?
12 A.In order to reflect the risks and prospects
13 associated with Avista' s jurisdictional utility
14 operations, my DCF analyses focused on a reference group
15 of other utili ties composed of those companies included by
16 The Value Line Investment Survey (~Value Line") in its
17 Electric Utilities Industry groups with: (1) S&P corporate
18 credit ratings of ~BBB-" to ~BBB+," (2) a Value Line
19 Safety Rank of ~2" or ~3", and (3) a Value Line Financial
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 4 of 40
1 Strength Rating of ~B+" to ~B++". 1 I refer to this group
2 as the ~Utili ty Proxy Group."
3 Q.Wha t other proxy group did you consider in
4 evaluating a fair ROE for Avista?
5 A.Under the regulatory standards established by
6 Hope and Bluefield, the salient criterion in establishing
7 a meaningful benchmark to evaluate a fair ROE is relative
8 risk, not the particular business acti vi ty or degree of
9 regulation.With regulation taking the place of
10 competitive market forces,required returns for utilities
should be in line with those of non-utility firms of
comparable risk operating under the constraints of free
competi tion.Consistent with this accepted regulatory
11
12
13
14 standard, I also applied the DCF model to a reference
15 group of comparable risk companies in the non-utility
16 sectors of the economy.I refer to this group as the
17 ~Non-Utility Proxy Group".
1 In addition, I excluded four utili ties (Allegheny Energy, Inc.,
FirstEnergy Corp., Northeast Utilities, and Progress Energy, Inc.)
that otherwise would have been in the proxy group, but are not
appropriate for inclusion because they are currently involved in a
maj or merger or acquisition.
Exhibit No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 5 of 40
1 Q.What criteria did you apply to develop the Non-
2 Utility Proxy Group?
3 A.My comparable risk proxy group of non-utility
4 firms was composed of those U. S. companies followed by
5 Value Line that:(1) pay common dividends; (2) have a
6 Safety Rank of ~1"; (3) have a Financial Strength Rating
7 of ~B++" or greater; (4) have a beta of 0.85 or less; and,
8 (5) have investment grade credit ratings from S&P.
9 Q.Do these criteria provide objective evidence to
10 evaluate investors' risk perceptions?
11 A.Yes. Credit ratings are assigned by independent
12 rating agencies for the purpose of providing investors
13 wi th a broad assessment of the creditworthiness of a firm.
14 Ratings generally extend from triple-A (the highest) to D
15 (in default). Other symbols (e.g., "A+") are used to show
1 6 relative standing wi thin a category. Because the rating
1 7 agencies' evaluation includes virtually all of the factors
18 normally considered important in assessing a firm's
19 relative credit standing, corporate credit ratings provide
20 a broad, objective measure of overall investment risk that
21 is readily available to investors. Although the credit
22 rating agencies are not immune to criticism, their
23 rankings and analyses are widely cited in the investment
Exhibit No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 6 of 40
1 communi ty and referenced by investors. 2 Investment
2 restrictions tied to credit ratings continue to influence
3 capi tal flows, and credit ratings are also frequently used
4 as a primary risk indicator in establishing proxy groups
5 to estimate the cost of common equity.
6 While credit ratings provide the most widely
7 referenced benchmark for investment risks, other quality
8 rankings published by investment advisory services also
9 provide relative assessments of risks that are considered
10 by investors in forming their expectations for common
11 stocks. Value Line's primary risk indicator is its Safety
12 Rank, which ranges from ~1" (Safest) to ~5" (Riskiest).
13 This overall risk measure is intended to capture the total
14 risk of a stock, and incorporates elements of stock price
15 stability and financial strength. Given that Value Line
16 is perhaps the most widely available source of investment
17 advisory information, its Safety Rank provides useful
18 guidance regarding the risk perceptions of investors.
19 The Financial Strength Rating is designed as a guide
20 to overall financial strength and creditworthiness, with
2 While the ratings agencies were faulted during the financial crisis
for failing to adequately assess the risk associated with structured
finance products, investors continue to regard corporate credit
ratings as a reliable guide to investment risks.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 7 of 40
1 the key inputs including financial leverage, business
2 volatility measures, and company size. Value Line's
3 Financial Strength Ratings range from ~A++" (strongest)
4 down to ~ctt (weakest) in nine steps. Finally, Value
5 Line's beta measures the volatility of a security's price
6 relative to the market as a whole. A stock that tends to
7 respond less to market movements has a beta less than
8 1.00, while stocks that tend to move more than the market
9 have betas greater than 1.00.
10 Q.How do the overall risks of your proxy groups
11 compare with Avista?
12 A.Table WEA-2 compares the Utility Proxy Group
13 wi th the Non-Utility Proxy Group and Avista across four
14 key indicators of investment risk:
15 TABLE 116 COMPARISON OF RISK INDICATORS
S&P Value Line
Credit Safety Financial
Rating Rank Strength Beta--
Utili ty Group BBB 3 B++0.74
Non-Utili ty Proxy A 1 A+0.70
Group
Avista BBB 2 B++0.70
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 8 of 40
1 Q.Do these comparisons indicate that investors
2 would view the firms in your proxy groups as risk-
3 comparable to the Company?
4 A.Yes. Considered together, a comparison of these
5 obj ecti ve measures, which consider of a broad spectrum of
6 risks, including financial and business position, and
7 exposure to firm-specific factors, indicates that
8 investors would likely conclude that the overall
9 investment risks for Avista are generally comparable to
10 those of the firms in the Utility Proxy Group.
11 With respect to the Non-Utility Proxy Group, its
12 average credit ratings, Safety Rank, and Financial
13 Strength Rating suggest less risk than for Avista, with
14 its 0.70 average beta indicating identical risk. While
15 the impact of differences in regulation is reflected in
16 objective risk measures, my analyses conservatively focus
17 on a lower-risk group of non-utility firms.
18 Q.
C. Discounted Cash Flow Analyses
How are DCF models used to estimate the cost of
19 equity?
20 A.DCF models attempt to replicate the market
21 valuation process that sets the price investors are
22 willing to pay for a share of a company's stock. The
23 model rests on the assumption that investors evaluate the
Exhibi t No. 3
Case Nos. AVU-E-ll-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 9 of 40
1 risks and expected rates of return from all securities in
2 the capital markets. Given these expectations, the price
3 of each stock is adjusted by the market until investors
4 are adequately compensated for the risks they bear.
5 Therefore, we can look to the market to determine what
6 investors believe a share of common stock is worth. By
7 estimating the cash flows investors expect to receive from
8 the stock in the way of future dividends and capital
9 gains, we can calculate their required rate of return. In
10 other words, the cash flows that investors expect from a
11 stock are estimated, and given its current market price,
12 we can ~back-into" the discount rate, or cost of equity,
13 that investors implicitly used in bidding the stock to
14 that price.
15 Q.What market valuation process underlies DCF
16 models?
17 A.DCF models assume that the price of a share of
18 common stock is equal to the present value of the expected
19 cash flows (i.e., future dividends and stock price) that
20 will be received while holding the stock, discounted at
21 investors' required rate of return. That is, the cost of
22 equity is the discount rate that equates the current price
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 10 of 40
9
10
11
12
13
14
15
16
17
18
19
20
1 of a share of stock with the present value of all expected
2 cash flows from the stock.
3 Q.What form of the DCF model is customarily used
4 to estimate the cost of equity in rate cases?
5 A.Rather than developing annual estimates of cash
6 flows into perpetuity, the DCF model can be simplified to
7 a ~constant growth" form: 3
8 p=~o ke-9
where:Po = Current price per share;
Di = Expected dividend per share in the
coming year;
ke = Cost of equity;
g = Investors' long-term growth
expectations.
The cost of equity (Ke) can be isolated by rearranging
terms:
Dk =-1+9e p
o
This constant growth form of the DCF model recognizes that
the rate of return to stockholders consists of two parts:
1) dividend yield (D1/Po), and 2) growth (g).In other
3 The constant growth DCF model is dependent on a number of
assumptions, which in practice are never strictly met. 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(i. e., no changes in risk or interest rate levels and a flat yield
curve); and all of the above extend to infinity.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-I1-01
W. Avera, Avista
Schedule 2, p. 11 of 40
1 words, investors expect to receive a portion of their
2 total return in the form of current dividends and the
3 remainder through price appreciation.
4
5
Q.What steps are required to apply the DCF model?
The first step in implementing the constantA.
6 growth DCF model is to determine the .expected dividend
7 yield (Di/Po) for the firm in question. This is usually
8 calculated based on an estimate of dividends to be paid in
9 the coming year divided by the current price of the stock.
10 The second, and more controversial, step is to estimate
11 investors' long-term growth expectations (g) for the firm.
12 The final step is to sum the firm' s dividend yield and
13 estimated growth rate to arrive at an estimate of its cost
14 of equity.
15 Q.How was the dividend yield for the Utility Proxy
16 Group determned?
17 A.Estimates of dividends to be paid by each of
18 these utili ties over the next twelve months, obtained from
19 Value Line, served as Di. This annual dividend was then
20 di vided by the corresponding stock price for each utility
21 to arrive at the expected dividend yield. The expected
22 dividends, stock prices, and resulting dividend yields for
Exh~bi t No. 3
Case Nos. AVU-E-l1-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 12 of 40
1 the firms in the Utility Proxy Group are presented on
2 Schedule 4.
3 Q.What is the next step in applying the constant
4 growth DCF model?
5 A.The next step is to evaluate long-term growth
6 expectations, or "g", for the firm in question. In
7 constant growth DCF theory, earnings, dividends, book
8 value, and market price are all assumed to grow in
9 lockstep, and the growth horizon of the DCF model is
10 infinite. But implementation of the DCF model is more
11 than just a theoretical exercise; it is an attempt to
12 replicate the mechanism investors used to arrive at
13 observable stQck prices. A wide variety of techniques can
14 be used to derive growth rates, but the only ~g" that
15 matters in applying the DCF model is the value that
16 investors expect.
17 Q.Are historical growth rates likely to be
18 representative of investors' expectations for utilities?
19 A.No. I f past trends in earnings , dividends, and
20 book value are to be representative of investors'
21 expectations for the future, then the historical
22 condi tions giving rise to these growth rates should be
23 expected to continue. That is clearly not the case for
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 13 of 40
1 utili ties, where structural and industry changes have led
2 to declining growth in dividends, earnings pressure, and,
3 in many cases, significant write-offs. While these
4 conditions serve to depress historical growth measures,
5 they are not representative of long-term expectations for
6 the utility industry or the expectations that investors
7 have incorporated into current market prices. As a
S resul t, historical growth measures for utili ties do not
9 currently meet the requirements of the DCF model.
10 Q.What are investors most likely to consider in
11 developing their long-term growth expectations?
12 A.While the DCF model is technically concerned
13 wi th growth in dividend cash flows, implementation of this
14 DCF model is solely concerned with replicating the
15 forward-looking evaluation of real-world investors. In
16 the case of electric utilities, dividend growth rates are
17 not likely to provide a meaningful guide to investors'
1S current growth expectations. This is because utili ties
19 have significantly altered their dividend policies in
20 response to more accentuated business risks in the
21 industry, with the payout ratio for electric utilities
22 falling from approximately SO percent historically to on
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 14 of 40
1 the order of 60 to 70 percent. 4 As a result of this trend
2 towards a more conservative payout ratio, dividend growth
3 in the utility industry has remained largely stagnant as
4 utilities conserve financial resources to provide a hedge
5 against heightened uncertainties.
6 As payout ratios for firms in the utility industry
7 trended downward, investors' focus has increasingly
8 shifted from dividends to earnings as a measure of long-
9 term growth. Future trends in earnings, which provide the
10 source for future dividends and ultimately support share
11 prices, playa pivotal role in determining investors'
12 long-term growth expectations. The importance of earnings
13 in evaluating investors' expectations and requirements is
14 well accepted in the investment community. As noted in
15 Finding Reali ty in Reported Earnings published by the
16 Association for Investment Management and Research:
17 (E) arnings, presumably, are the basis for the18 investment benefits that we all seek. ~Healthy19 earnings equal healthy investment benefits"20 seems a logical equation, but earnings are also
21 a scorecard by which we compare companies, a
22 filter through which we assess management, and a
4 The Value Line Investment Survey (Sep. 15, 1995 at 161, Feb. 4, 2011
at 2237).
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 15 of 40
1 crystal ball in which we try to foretell future
2 performance. 5
3 Value Line's near-term projections and its Timeliness
4 Rank, which is the principal investment rating assigned to
5 each individual stock, are also based primarily on various
6 quantitative analyses of earnings. As Value Line
7 explained:
8 The future earnings rank accounts for 65% in the
9 determination of relative price change in the10 future; the other two variables (current11 earnings rank and current price rank) explain12 35%.6
13 The fact that investment advisory services, such as Value
14 Line, Thompson, and Reuters, focus on growth in earnings
15 indicates that the investment community regards this as a
16 superior indicator of future long-term growth. Indeed, "A
17 Study of Financial Analysts: Practice and Theory, If
18 published in the Financial Analysts Journal, reported the
19 results of a survey conducted to determine what analytical
20 techniques investment analysts actually use. 7 Respondents
21 were asked to rank the relative importance of earnings,
22 di vidends, cash flow, and book value in analyzing
23 securities. Of the 297 analysts that responded, only 3
5 Association for Investment Management and Research, "Finding Reality
in Reported Earnings: An Overview", p. 1 (Dec. 4, 1996).6 The Value Line Investment Survey, Subscriber's Guide, p. 53.
7 Block, Stanley B., "A Study of Financial Analysts: Practice and
Theory", Financial Analysts Journal (July/August 1999).
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 16 of 40
1 ranked dividends first while 276 ranked it last. The
2 article concluded:
3 Earnings and cash flow are considered far more
4 important than book value and dividends. 8
5 More recently, the Financial Analysts Journal
6 reported the results of a study of the relationship
7 between valuations based on alternative multiples and
8 actual market prices, which concluded, ~In all cases
9 studied, earnings dominated operating cash flows and
10 dividends. "9
11 Q. Do the growth rate projections of security
12 analysts consider historical trends?
13 A.Yes. Professional security analysts study
14 historical trends extensively in developing their
15 projections of future earnings. Hence, to the extent
16 there is any useful information in historical patterns,
17 that information is incorporated into analysts' growth
18 forecasts.
8 Id. at 88.
9 Liu, Jing, Nissim, Doron, & Thomas, Jacob, "Is Cash Flow King in
Valuations?," Financial Analysts Journal, VoL. 63, No. 2 (March/April
2007) at 56.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 17 of 40
1
2
3
4
Q. What are security analysts currently projecting
in the way of growth for the firms in the Utility Proxy
Group?
A. The Value Line earnings growth projections for
5 each of the firms in the Utility Proxy Group are displayed
6 on Schedule 4. Also presented are the earnings per share
7 (~EPS") growth projections reported by Thomson Reuters
8 (~IBES") and Zacks Investment Research (~Zacks"). 10
9 Q. Some argue that analysts' assessments of growth
10 rates are biased. Do you believe these projections arè
11 inappropriate for estimating investors' required return
12 using the DCF model?
13 A. No. In applying the DCF model to estimate the
14 cost of common equity, the only relevant growth rate is
15 the forward-looking expectations of investors that are
16 captured in current stock prices. Investors, just like
17 securi ties analysts and others in the investment
18 community, do not know how the future will actually turn
19 out. They can only make investment decisions based on
20 their best estimate of what the future holds in the way of
21 long-term growth for a particular stock, and securities
22 prices are constantly adjusting to reflect their
23 assessment of available information.
10 Formerly I/B/E/S International, Inc., IBES growth rates are now
compiled and published by Thomson Reuters.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 18 of 40
1 Any claims that analysts' estimates are not relied
2 upon by investors are illogical given the reality of a
3 competi ti ve market for investment advice. If financial
4 analysts' forecasts do not add value to investors'
5 decision making, then it is irrational for investors to
6 pay for these estimates. Similarly, those financial
7 analysts who fail to provide reliable forecasts will lose
8 out in competi ti ve markets relative to those analysts
9 whose forecasts investors find more credible. The reality
10 that analyst estimates are routinely referenced in the
11 financial media and in investment advisory publications
12 (e. g., Value Line) implies that investors use them as a
13 basis for their expectations.
14 The continued success of investment services such as
15 Thomson Reuters and Value Line, and the fact that
16 projected growth rates from such sources are widely
17 referenced, provides strong evidence that investors give
18 considerable weight to analysts' earnings projections in
19 forming their expectations for future growth. While the
20 projections of securities analysts may be proven
21 optimistic or pessimistic in hindsight, this is irrelevant
22 in assessing the expected growth that investors have
23 incorporated into current stock prices, and any bias in
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 19 of 40
1 analysts' forecasts - whether pessimistic or optimistic -
2 is irrelevant if investors share analysts' views.
3 Earnings growth projections of security analysts provide
4 the most frequently referenced guide to investors' views
5 and are widely accepted in applying the DCF model. As
6 explained in New Regula tory Finance:
7 Because of the dominance of institutional
8 investors and their influence on individual
9 investors, analysts' forecasts of long-run10 growth rates provide a sound basis for11 estimating required returns. Financial analysts12 exert a strong influence on the expectations of13 many investors who do not possess the resources14 to make their own forecasts, that is, they are a15 cause of g (growth). The accuracy of these16 forecasts in the sense of whether they turn out17 to be correct is not an issue here, as long as18 they reflect widely held expectations. 11
19 Q.How elsè are investors' expectations of future
20 long-term growth prospects often estimated for use in the
21 cons tan t growth DCF model?
22 A.In constant growth theory, growth in book equity
23 will be equal to the product of the earnings retention
24 ratio (one minus the dividend payout ratio) and the earned
25 rate of return on book equity. Furthermore, if the earned
26 rate of return and the payout ratio are constant over
27 time, growth in earnings and dividends will be equal to
28 growth in book value. Despite the fact that these
11 Morin, Roger A., "New Regulatory Finance," Public Utilities Reports,
Inc. at 298 (2006).
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 20 of 40
1 conditions are seldom, if ever, met in practice, this
2 ~sustainable growth" approach may provide a rough guide
3 for evaluating a firm's growth prospects and is frequently
4 proposed in regulatory proceedings.
5 Accordingly, while I believe that analysts' forecasts
6 provide a superior and more direct guide to investors'
7 growth expectations, I have included the ~sustainable
8 growth" approach for completeness. The sustainable growth
9 rate is calculated by the formula, g = br+sv, where "b" is
10 the expected retention ratio, ~r" is the expected earned
11 return on equity, ~s" is the percent of common equity
12 expected to be issued annually as new common stock, and
13 "v" is the equity accretion rate.
14
15
Q.What is the purpose of the ~sv" term?
Under DCF theory, the ~sv" factor is a componentA.
16 of the growth rate designed to capture the impact of
17 issuing new common stock at a price above, or below, book
18 value. When a company's stock price is greater than its
19 book value per share, the per-share contribution in excess
20 of book value associated with new stock issues will accrue
21 to the current shareholders. This increase to the book
22 value of existing shareholders leads to higher expected
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 21 of 40
1 earnings and dividends, with the ~sv" factor incorporating
2 this additional growth component.
3 Q. What growth rate does the earnings retention
4 method suggest for the Utility Proxy Group?
5 A.The sustainable, "br+sv" growth rates for each
6 firm in the Utility Proxy Group are summarized on Schedule
7 4, with the underlying details being presented on
8 Schedule 5. For each firm, the expected retention ratio
9 (b) was calculated based on Value Line's projected
10 dividends and earnings per share. Likewise, each firm's
11 expected earned rate of return (r) was computed by
12 dividing proj ected earnings per share by proj ected net
13 book value. Because Value Line reports end-of-year book
14 values, an adjustment was incorporated to compute an
15 average rate of return over the year, consistent with the
16 theory underlying this approach to estimating investors'
17 growth expectations. Meanwhile, the percent of common
18 equity expected to be issued annually as new common stock
19 (s) was equal to the product of the projected market-to-
20 book ratio and growth in common shares outstanding, while
21 the equity accretion rate (v) was computed as 1 minus the
22 inverse of the proj ected market-to-book ratio.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 22 of 40
1 Q. What cost of equity estimates were imlied for
2 the Utility Proxy Group using the DCF model?
3 A. After combining the dividend yields and
4 respective growth proj ections for each utility, the
5 resul ting cost of equity estimates are shown on
6 Schedule 4.
7 Q. In evaluating the results of the constant growth
8 DCF model, is it appropriate to eliminate estimates that
9 are extreme low or high outliers?
10 A. Yes. In applying quantitative methods to
11 estimate the cost of equity, it is essential that the
12 resul ting values pass fundamental tests of reasonableness
13 and economic logic. Accordingly, DCF estimates that are
14 implausibly low or high should be eliminated when
15 evaluating the results of this method.
16 Q. How did you evaluate DCF estimates at the low
17 end of the range?
18 A.It is a basic economic principle that investors
19 can be induced to hold more risky assets only if they
20 expect to earn a return to compensate them for their risk
21 bearing. As a result, the rate of return that investors
22 require from a utility's common stock, the most junior and
23 riskiest of its securities, must be considerably higher
24 than the yield offered by senior, long-term debt.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 23 of 40
1 Consistent with this principle, the DCF results must be
2 adjusted to eliminate estimates that are determined to be
3 extreme low outliers when compared against the yields
4 available to investors from less risky utility bonds.
5 Q. What does this test of logic imply with respect
6 to the DCF results for the Utility Proxy Group?
7 A.As noted earlier, the average S&P corporate
8 credi t rating for the Utility proxy Group is ~BBB", the
9 same as for Avista. Companies rated "BBB-", ~BBB", and
10 "BBB+" are all considered part of the triple-B rating
11 category, with Moody's monthly yields on triple-B bonds
12 averaging approximately 6.1 percent in February 2011.12 It
13 is inconceivable that investors are not requiring a
14 substantially higher rate of return for holding common
15 stock. Consistent with this principle, the DCF results
16 for the Utility Proxy Group must be adjusted to eliminate
17 estimates that are determined to be extreme low outliers
18 when compared against the yields available to investors
19 from less risky utility bonds.
20
21
Q.Have similar tests been applied by regulators?
Yes. FERC has noted that adjustments areA.
22 justified where applications of the DCF approach produce
12 Moody's Investors Service, www.credittrends.com.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 24 of 40
1 illogical results. FERC evaluates DCF results against
2 observable yields on long-term public utility debt and has
3 recognized that it is appropriate to eliminate estimates
4 that do not sufficiently exceed this threshold. In a 2002
5 opinion establishing its current precedent for determining
6 ROEs for electric utilities, for example, FERC noted:
7 An adjustment to this data is appropriate in the
8 case of PG&E's low-end return of 8.42 percent,
9 which is comparable to the average Moody' s ~A"10 grade public utility bond yield of 8.06 percent,11 for October 1999. Because investors cannot be12 expected to purchase stock if debt, which has13 less risk than stock, yields essentially the14 same return, this low-end return cannot be15 considered reliable in this case. 13
16 Similarly, in its August 2006 decision in Kern River Gas
17 Transmission Company, FERC noted that:
18 (T)he 7.31 and 7.32 percent costs of equity for
19 El Paso and Williams found by the ALJ are only20 110 and 122 basis points above that average21 yield for public utility debt. 14
22 The Commission upheld the opinion of Staff and the
23 Administrative Law Judge that cost of equity estimates for
24 these two proxy group companies ~were too low to be
25 credible." 15
13 Southern California Edison Company, 92 FERC ~ 61,070 at p. 22
(2000) .14 Kern River Gas Transmission Company, Opinion No. 486, 117 FERC ~
61,077 at P 140 & n. 227 (2006).
15 Id.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 25 of 40
1 The practice of eliminating low-end outliers has been
2 affirmed in numerous FERC proceedings,16 and in its April
3 15, 2010 decision in SoCal Edison, FERC affirmed that, ~it
4 is reasonable to exclude any company whose low-end ROE
5 fails to exceed the average bond yield by about 100 basis
6 points or more.,,17
7 Q.What elsè should be considered in evaluating DCF
8 èstimates at the low end of the range?
9 A.As indicated earlier, while corporate bond
10 yields have declined substantially as the worst of the
11 financial crisis has abated, it is generally expected that
12 long-term interest rates will rise as the recession ends
13 and the economy returns to a more normal pattern of
14 growth. As shown in Table 2 below, forecasts of IHS
15 Global Insight and the EIA imply an average triple-B bond
16 yield of 7.19 percent over the period 2012-2015:
16 See, e.g., Virginia Electric Power Co., 123 FERC ~ 61,098 at P 64
(2008) .17 Southern California Edison Co., 131 FERC ~ 61,020 at P 55 (2010)
("SoCal Edison").
Exhibì t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 26 of 40
1 TABLE 2
2 IMPLIED BBB BOND YIELD
2012-15
Projected AA Utilty Yield
IRS Global Inight (a)6.33%
EIA (b)6.58%
Average 6.45%
Curent BBB - AA Yield Spread (c)0.74%
Implied Triple-B Utilty Yield 7.19%
(a) IRS Global Insight, U.S. Economic Outlook at 19 (February 2011).
(b) Energy Information Administration, Annual Energy Outlook 2011
Early Release (Dec. 16,2010).
(c) Based on monthly average bond yields for the six-month period
September 2010 - Februry 2011.
3 The increase in debt yields anticipated by IHS Global
4 Insight and EIA is also supported by the widely-referenced
5 Blue Chip Financial Forecasts, which projects that yields
6 on corporate bonds will climb more than 100 basis points
7 through the period 2012-2016.18
8 Q. What does this test of logic imply with respect
9 to the DCF results for the Utility Proxy Group?
10 A.As shown on Schedule 4, fourteen low-end DCF
11 estimates ranged from 2.6 percent to 6.9 percent. Eight
12 of these values were below current utility bond yields,
13 wi th cost of equity estimates below 7.0 percent being less
18 Blue Chip Financial Forecasts, Vol. 29, No. 12 (Dec. 1, 2010) & Vol.
30, No.3 (Mar. 1, 2011).
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 27 of 40
1 than the yield on triple-B utility bonds expected during
2 the period 2012-2015. In light of the risk-return
3 tradeoff principle and the test applied in SoCal Edison,
4 it is inconceivable that investors are not requiring a
5 substantially higher rate of return for holding common
6 stock, which is the riskiest of a utility's securities.
7 As a result, consistent with the test of economic logic
8 applied by FERC and the upward trend expected for utility
9 bond yields, these values provide little guidance as to
10 the returns investors require from utility common stocks
11 and should be excluded.
12 Q. Do you also recommend excluding estimates at the
13 high end of the range of DCF resul ts?
14 A.Yes. The upper end of the cost of common equity
15 range produced by the DCF analysis presented in Schedule 4
16 was set by three cost of equity estimates for Otter Tail
17 Corp. that exceeded 20 percent. When compared with the
18 balance of the remaining estimates, these values are
19 clearly implausible and should be excluded in evaluating
20 the results of the DCF model for the Utility Proxy Group.
21 This is also consistent with the precedent adopted by
22 FERC, which has established that estimates found to be
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avi$ta
Schedule 2, p. 28 of 40
1 ~extreme outliers" should be disregarded in interpreting
2 the results of the DCF model. 19
3 Q. What cost of equity is implied by your DCF
4 results for the Utility Proxy Group?
5 A.As shown on Schedule 4 and summarized in Table
6 3, below, after eliminating illogical low- and high-end
7 values, application of the constant growth DCF model
8 resul ted in the following cost of equity estimates:9 TABLE 3
10 DCF RESULTS - UTILITY PROXY GROUP
Growth Rate
Value Line
IBES
Zacks
br+sv
Average Cost of Equity
10.9%
10.6%
10.6%
9.2%
11 Q.What were the results of your DCF analysis for
12 the Non-Utility Proxy Group?
13 A.I applied the DCF model to the Non-Utility Proxy
14 Group in exactly the same manner described earlier for the
15 Utili ty Proxy Group. The results of my DCF analysis for
16 the Non-Utility Proxy Group are presented in Schedule 6,
17 with the sustainable, "br+sv" growth rates being developed
18 on Schedule 7. As shown on Schedule 6 and summarized in
19 Table 4, below, after eliminating illogical low- and high-
19 See, e.g., iso New England, Inc., 109 FERC ~ 61,147 at P 205 (2004).
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 29 of 40
1 end values, application of the constant growth DCF model
2 resul ted in the following cost of common equity estimates:
3 TABLE 4
4 DCF RESULTS - NON-UTILITY PROXY GROUP
Growth Rate
Value Line
IBES
Zacks
br+sv
Average Cost of Equity
11.9%
12.4%
12.5%
12.1%
5 As discussed earlier, reference to the Non-Utility Proxy
6 Group is consistent with established regulatory principles
7 and required returns for utili ties should be in line with
8 those of non-utility firms of comparable risk operating
9 under the constraints of free competition.
10
11
Q.
D. Capi tal Asset Pricing Model
Please describe the CAPM.
The CAPM is a theory of market equilibrium thatA.
12 measures risk using the beta coefficient. Assuming
13 investors are fully diversified, the relevant risk of an
14 individual asset (e. g., common stock) is its volatility
15 relative to the market as a whole, with beta reflecting
16 the tendency of a stock's price to follow changes in the
17 market. The CAPM is mathematically expressed as:
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU~G-I1-01
W. Avera, Avista
Schedule 2, p. 30 of 40
1 Rj = Rf +ßj (Rm - Rf)
2
3
4
5
6
where:Rj =required rate of return for stock j ;
Rf =risk-free rate;
Rm =expected return on the marketportfolio;and,
ßj =beta,or systematic risk,for stock j .
7 Like theDCF model, the CAPM is an ex-ante, or forward-
8 looking model based on expectations of the future. As a
9 resul t, in order to produce a meaningful estimate of
10 investors' required rate of return, the CAPM must be
11 applied using estimates that reflect the expectations of
12 actual investors in the market, not with backward-looking,
13 historical data.
14 Q.How did you apply the CAPM to estimate the cost
15 of common equi ty?
16 A.Application of the CAPM to the Utility Proxy
17 Group based on a forward-looking estimate for investors'
18 required rate of return from common stocks is presented on
19 Schedule 8. In order to capture the expectations of
20 today's investors in current capital markets, the expected
21 market rate of return was estimated by conducting a DCF
22 analysis on the dividend paying firms in the S&P 500.
23 The dividend yield for each firm was calculated based
24 on the annual indicated dividend payment obtained from
25 Value Line, increased by one-half of the growth rate
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 31 of 40
1 discussed subsequently (1 + O. 5g) to convert them to year-
2 ahead dividend yields presumed by the constant growth DCF
3 model. The growth rate was equal to the earnings growth
4 projections for each firm published by IBES, with each
5 firm's dividend yield and growth rate being weighted by
6 its proportionate share of total market value. Based on
7 the weighted average of the projections for the 354
8 individual firms, current estimates imply an average
9 growth rate over the next five years of 10.5 percent.
10 Combining this average growth rate with an adjusted
11 dividend yield of 2.3 percent results in a current cost of
12 common equity estimate for the market as a whole (Rm) of
13 approximately 12.8 percent. Subtracting a 4.7 percent
14 risk-free rate based on the average yield on 30-year
15 Treasury bonds produced a market eaui ty risk premium of
16 8.1 percent.
17 Q.What was the source of thè beta values you used
18 to apply the CAPM?
19 A.I relied on the beta values reported by Value
20 Line, which in my experience is the most widely referenced
21 source for beta in regulatory proceedings. As noted in
22 New Regula tory Finance:
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 32 of 40
1
2
3
4
5
6
7
8
9
Value Line is the largest and most widely
circulated independent investment advisory
service, and influences the expectations of a
large number of institutional and individual
investors. ... Value Line betas are computed on a
theoretically sound basis using a broadly based
market index, and they are adj usted for the
regression tendency of betas to converge to
1.00.20
10 Q.What else should be considered in applying the
11 CAPM?
12 A.As explained by Morningstar:
13 One of the most remarkable discoveries of modern14 finance is that of a relationship between firm15 size and return. The relationship cuts across16 the entire size spectrum but is most evident
17 among smaller companies, which have higher18 returns on average than larger ones. 21
19 Because empirical research indicates that the CAPM does
20 not fully account for observed differences in rates of
21 return attributable to firm size, a modification is
22 required to account for this size effect.
23 According to the CAPM, the expected return on a
24 security should consist of the riskless rate, plus a
25 premium to compensate for the systematic risk of the
26 particular security. The degree of systematic risk is
27 represented by the beta coefficient. The need for the
28 size adjustment arises because differences in investors'
20 Morin, Roger A., "New Regulatory Finance," Public Utilities Reports
at 71 (2006).21 Morningstar, "Ibbotson SBBI 2010 Valuation Yearbook," at p. 85
(footnote omitted) .
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 33 of 40
1 required rates of return that are related to firm size are
2 not fully captured by beta. To account for this,
3 Morningstar has developed size premiums that need to be
4 added to the theoretical CAPM cost of equity estimates to
5 account for the level of a firm's market capitalization in
6 determining the CAPM cost of equity. 22 Accordingly, my
7 CAPM analyses incorporated an adjustment to recognize the
8 impact of size distinctions, as measured by the average
9 market capitalization for the respective proxy groups.
10 Q. What cost of equity estimate was indicated for
11 the Utility Proxy Group based on this forward-looking
12 applica tion of the CAPM?
13 A.The average market capitalization of the Utility
14 Proxy Group is $6.8 billion. Based on data from
15 Morningstar, this means that the theoretical CAPM cost of
16 equi ty estimate must be increased by 74 basis points to
17 account for the industry group's relative size. As shown
18 on Schedule 8, adjusting the theoretical CAPM result to
19 incorporate this size adj ustment results in an average
20 indicated cost of common equity of 11.5 percent.
22 Id. at Table C-1.
Exhibit No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 34 of 40
..
1 Q. What cost of commn equity was indicated for the
2 Non-Utility Proxy Group based on this forward-looking
3 applica tion of the CAPM?
4 A.As shown on Schedule 9, applying the forward-
5 looking CAPM approach to the firms in the Non-Utility
6 Proxy Group results in an average implied cost of common
7 equity of 10.1 percent.
8 Q. Should the CAPM approach be applied using
9 historical rates of return?
10 A.No. The CAPM cost of common equity estimate is
11 calibrated from investors' required risk premium between
12 Treasury bonds and common stocks. In response to
13 heightened uncertainties, investors have repeatedly sought
14 a safe haven in U. S. government bonds and this ~flight to
15 safety" has pushed Treasury yields significantly lower
16 while yield spreads for corporate debt have widened. This
17 distortion not only impacts the absolute level of the CAPM
18 cost of equity estimate, but it affects estimated risk
19 premiums. Economic logic would suggest that investors'
20 required risk premium for common stocks over Tréasury
21 bonds has also increased.
22 Meanwhile, backward-looking approaches incorrectly
23 assume that investors' assessment of the required risk
24 premium between Treasury bonds and common stocks is
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 35 of 40
1 constant, and equal to some historical average. At no
2 time in recent history has the fallacy of this assumption
3 been demonstrated more concretely than it is today. This
4 incongruity between investors' current expectations and
5 historical risk premiums is particularly relevant during
6 periods of heightened uncertainty and rapidly changing
7 capi tal market conditions, such as those experienced
8 recently. 23
9 Q.
E. Comparable Earnin9s Approach
What other analyses did you conduct to estimate
10 the cost of equity?
11 A.As I noted earlier, I also evaluated the ROE
12 using the comparable earnings method. Reference to rates
13 of return available from al ternati ve investments of
14 comparable risk can provide an important benchmark in
15 assessing the return necessary to assure confidence in the
16 financial integrity of a firm and its ability to attract
17 capi tal. This comparable earnings approach is consistent
18 wi th the economic underpinnings for a fair rate of return
19 established by the Supreme Court in Hope and Bluefield.
20 Moreover, it avoids the complexities and limitations of
23 FERC has previously rejected CAPM methodologies based on historical
data because whatever historical relationships existed between debt
and equity securities may no longer hold. See Orange & Rockland
Utils., Inc., 40 F.E.R.C. P63,053, at pp. 65,208 -09 (1987), aff'd,
Opinion No. 314, 44 F.E.R.C. P61,253 at 65,208.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 36 of 40
1 capi tal market methods and instead focuses on expected
2 earned returns on book equity, which are more readily
3 available to investors.
4 Q.What economic premise underlies the comparable
5 earnings approach?
6 A.The simple, but powerful concept underlying the
7 comparable earnings approach is that investors compare
8 each investment alternative with the next best
9 opportunity. If the utility is unable to offer a return
10 similar to that available from other opportunities of
11 comparable risk, investors will become unwilling to supply
12 the capital on reasonable terms. For existing investors,
13 denying the utility an opportunity to earn what is
14 available from other similar risk alternatives prevents
15 them from earning their opportunity cost of capital. In
16 this situation the government is effectively taking the
17 value of investors' capital without adequate compensation.
18 The comparable earnings approach is consistent with the
19 economic rationale underpinning established regulatory
20 standards, which specifies a methodology to determine an
21 ROE benchmark based on earned rates of return for a peer
22 group of other regional utilities.
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 37 of 40
1 Q.How is the comparison of opportunity costs
2 typically implemented?
3 A.The traditional comparable earnings test
4 identifies a group of companies that are believed to be
5 comparable in risk to the utility. The actual earnings of
6 those companies on the book value of their investment are
7 then compared to the allowed return of the utility. While
8 the traditional comparable earnings test is implemented
9 using historical data taken from the accounting records,
10 it is also common to use proj ections of returns on book
11 investment, such as those published by recognized
12 investment advisory publications (e.g., Value Line).
13 Because these returns on book value equity are analogous
14 to the allowed return on a utility's rate base, this
15 measure of opportunity costs results in a direct, ~apples
16 to apples" comparison.
17 Moreover, regulators do not set the returns that
18 investors earn in the capital markets - they can only
19 establish the allowed return on the value of a utility's
20 investment, as reflected on its accounting records. As a
21 result, the expected earnings approach provides a direct
22 guide to ensure that the allowed ROE is similar to what
23 other utili ties of comparable risk will earn on invested
Exhibit No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 38 of 40
1 capi tal. This opportunity cost test does not require
2 theoretical models to indirectly infer investors'
3 perceptions from stock prices or other market data. As
4 long as the proxy companies are similar in risk, their
5 expected earned returns on invested capital provide a
6 direct benchmark for investors' opportunity costs that is
7 independent of fluctuating stock prices, market-to-book
8 ratios, debates over DCF growth rates, or the limitations
9 inherent in any theoretical model of investor behavior.
10 Q.What rates of return on equity are indicated for
11 electric utili ties based on the comparable earnings
12 approach?
13 A.Value Line reports that its analysts anticipate
14 an average rate of return on common equity for the
15 electric utility industry of 10.5 percent over its
16 forecast horizon. 24 Meanwhile, for the gas utility
17 industry Value Line expects returns on common equity of
18 10.0 percent over the period 2011-2016.25
19 For the firms in the Utility Proxy Group
20 specifically, the returns on common equity proj ected by
21 Value Line over its forecast horizon are shown on
22 Schedule 10. Consistent with the rationale underlying the
24 The Value Line Investment Survey at 139 (Feb. 25, 2011).
25 The Value Line Investment Survey at 546 (Mar. 11, 2011).
Exhibi t No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 39 of 40
1 development of the br+sv growth rates, these year-end
2 values were converted to average returns using the same
3 adjustment factor discussed earlier and developed on
4 Schedule 5. As shown on Schedule 10, after eliminating
5 two low-end outliers, Value Line's projections for the
6 utility proxy group suggested an average ROE of 10.4
7 percent.
8 Q.
F. Sumry of Quantitative Results
Please sumrize the results of your
9 quantitative analyses.
10 A.The cost of equity estimates implied by my
11 quantitative analyses are summarized in Table 5 below:
12 TABLE 5
13 SUMY OF QUANTITATIVE RESULTS
~
Earnings Growth
Value Line
IBES
Zacks
br + sv
ytility Non-ytillty
~
10.9%11.9%
10.6%12.4%
10.6%12.5%
9.2%12.1%
11. 5%10.1%
Electric G.
10.5%10.0%
10.4%
Expected Earnlngs
Value Line 2014-16
Utili ty Proxy Group
Exhibit No. 3
Case Nos. AVU-E-11-01 & AVU-G-11-01
W. Avera, Avista
Schedule 2, p. 40 of 40
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DCFMODEL
NON.UTILIT PROxY GROup
(a)(a)(h)(c)(d)(e)(e)(e)(e)
Dividend Growt Rates Cost of Equity Estimates
Company Yield Y.IBES Zacks br+v V Line !!Zacks l!
1 3M Company 2.39%7.0%11.9%11.3%12.9%9.4%14.3%13.7%15.3%
2 Abbott Labs.3.67%10.0%8.9%9.0%15.0%13.7%12.6%12.7%
3 Alberto-Culver 1.02%15.0%9.4%12.5%8.4%16.0%10.4%13.5%
4 AT&T Inc. 6.09%5.5%5.7"10 7.0%5.4%11.6%11.8%13.1%11.5%
5 Automatic Data Proc.2.93%8.0%10.6%10.8%9.5%10.9%13.5%13.7%12.4%
6 Bard (C.R.)0.77%9.5%10.9%11.8%18.1%10.3%11.7%12.6%
7 Baxter Intl Inc.2.45%10.0%9.6%9.3%15.5%12.5%12.1%11.8%
8 Becton, Dickinson 1.97%9.5%9.9%10.8%9.0%11.5%11.9%12.8%lUJ%
9 Bristol-Myers Squibb 5.11%8.5%1.8%2.0%5.7%13.6% I)~;~rlil 10.8%
10 Brown-Fonnan 'B'1.90%7.5%10.9%13.0%10.6%9.4%12.8%12.5%
11 Chubb Corp. 2.55%2.5%8.7%9.8%8.0% t~.t~l 11.3%12.4%10.5%
12 Church & Dwight 0.97"/0 12.0%11.8%12.0%10.3%13.0%12.8%13.0%11.3%
13 Coca-Cola 2.80%9.5%8.7%9.0%9.9%12.3%11.5%11.8%12.7%
14 Colgate-Palmolive 2.76%11.0%9.3%9.2%18.1%13.8%12.1%12.0% r~¡8%:1
15 Commerce Bancshs.2.22%7.0%7.0%7.0%7.9%9.2%9.2%9.2%10.1%
16 ConAgra Foods 3.92%10.5%7.7%8.0%8.1%14.4%11.6%11.9%12.0%
17 Costco Wholesale 1.24%7.5%13.3%12.9%8.2%8.7%14.5%14.1%9.5%
18 Cullen/rost Bankers 2.96%4.5%8.5%8.0%5.7% li\i(~il 11.5%11.0%8.6%
19 CVS Caremark Corp.1.2%9.5%10.1%12.0%7.8%10.9%11.5%13.4%9.2%
20 Ecolab Inc.1.41%12.0%13.2%13.2%19.6%13.4%14.6%14.6% 1;.if.1:.~1
21 Exxon Mobil Corp.2.26%6.0%12.1%8.4%13.5%8.3%14.4%10.7%15.7%
22 Gen'lMills 3.02%9.5%7.7"/0 8.0%9.3%12.5%10.7%11.0%12.3%
23 Heinz (H.J.)3.85%6.5%7.0%8.0%13.9%10.4%10.9%11.9% liiil~¡~1
24 Honnel Foods 2.01%10.5%10.0%9.3%10.700 12.5%12.0%11.3%12.7"/0
25 Intl Business Mach.1.77%13.0%11.5%9.3%20.4%14.8%13.3%11.%
26 Johnson & Johnon 3.4%4.5%6.0%5.8%10.8%7.9%9.4%
27 Kellogg 3.14%9.5%8.6%9.0%9.7%12.6%11.7%12.1%12.9%
28 Kimberly-Oark 4.09%6.5%7.5%8.7%18.%10.6%11.6%
29 Kraft Foods 3.71%8.0%8.4%8.0%10.7%11.7%
30 Lily (Eli) 5.64%-2.5%-6.4%-5.3%8.4%
31 Lockheed Martin 3.78%10.0%8.1%6.8%20.3%
32 McConnick & Co.2.24%8.5%9.6%9.5%13.3%10.7%11.8%11.7%
33 McDonald's Corp.3.25%9.5%9.8%9.3%10.7"/0 12.8%13.1%12.6%13.9%
34 McKesson Corp.0.98%10.0%14.2%11.0%11.7%11.0%15.2%12.0%12.7%
35 Medtronic, Inc.2.47%7.5%8.8%8.4%11.7"10 10.0%11.3%10.9%
36 Microsoft Corp.2.26%12.5%11.3%11.7%15.3%14.8%13.6%14.0%
37 NIKE, Inc. 'B'1.49%9.5%10.9%12.5%12.2%11.0%12.4%14.0%
38 Northrop Grumman 2.82%12.5%110%11.1%7.9%15.3%138%13.9%10.7"10
39 PepsiCo, Inc.2.91%11.0%8.9%9.5%14.5%13.9%11.8%12.4%
40 Pfizer, Inc.4.50%5.0%2.8%3.5%7.0%9.5%8.0%
41 Procter & Gamble 3.01%8.0%8.9%9.2%7.2%11.0%12.2%10.3%
42 Raytheon Co.3.02%10.0%8.0%10.0%8.6%13.0%11.0%13.0%11.6%
43 Strker Corp.1.26%12.5%10.9%11.4%13.6%13.8%12.2%12.7%14.9%
44 SyscoCorp.3.47%8.0%10.0%9.7%14.2%11.5%13.5%132% IJ7'c.(¡~1
45 1JX Companies 1.28%13.5%14.5%14.4%11.1%14.8%15.8%15.7%12.4%
46 United Parcel Serv.2.59%9.0%11.7"/0 11.5%17.9%11.6%14.3% 14.1% 120.5%1
47 Verizon Communic.5.63%4.0%6.2%14.9%5.7%9.6%11.8% 120.5'y.1 11.%
48 Walgreen Co.1.68%11.5%13.4%13.0%8.4%13.2%15.1%14.7%10.1%
49 Wal-Mart Stores 2.16%10.0%10.7%11.3%9.9%12.2%12.9%13.5%12.1%
50 Waste Management 3.52%5.5%9.6%11.0%5.2%9.0% 13.1% 14.5% 8.7%----
Average (f)11.9%12.4%12.5%12.1%
(a)www.valueline.com (retrieved Jan. 28, 2011).
(h)T1mson Reute Company in Context Reor Gan. 28, 2011).
(c)www.zacks.com (retreved Jan. 31, 2011).
(d)See Schedule 7.
(e)Sum of dividend yield and respective growth rate.
(f)Excludes highlighted figures.
Case Nos. AVU-E-11-01 AVU-G-11-01
W. Avera, Avista
Schedule 6, p. 1 of 1
DR + SV GROWTH RATE
NON-UTILIT PROxy GROUP
(a)(a)(a)(b)(c)(d)(e)
------- 2014 ---Adjust.--- "sv" Factor ---_.
Company EPS ~~-l -L B!Mi -R -L -X ..~
1 3M Company $7.60 $3.10 $40.05 59.2% 19.0%1.0818 20.5%12.2%0.0106 0.6731 0.71%12.9%
2 Abbott Labs.$5.70 $2.8 $22.05 61.8% 25.9%1.0384 26.8%16.6%(0.0197)0.7900 -1.56%15.0%
3 Alberto-Culver $2.35 $0.55 $17.85 76.6% 13.2%1.0315 13.6%10.4%(0.0330)0.6033 -1.99%8.4%
4 AT&TInc.$3.25 $2.00 $24.05 38.5% 13.5%1.0327 14.0%5.4%(0.0001)0.4656 -0.01%5.4%
5 Automatic Data Proc.$3.45 $1.60 $22.95 53.6% 15.0%1.0786 16.2%8.7%0.011 0.7039 0.78%9.5%
6 Bard (C.R.)$7.75 $0.85 $31,5 89.0% 24.6%1.0255 25.3%22.5%(0.0564)0.7754 -4.37%18.1%
7 Baxter Intl Inc.$5.85 $1.50 $22.90 74.4% 25.5%1.0560 27.0%20.1%(0.0633)0.7224 -4.57%15.5%
8 Becon, Dickion $7.65 $2.20 $34.10 71.2% 22.4%1.0306 23.1%16.5%(0.1030)0.7216 -7.43%9.0%
9 Bristol-Myers Squibb $2.35 $1.54 $11.65 34.5% 20.2%1.0263 20.7%7.1%(0.0212)0.6671 -1.42%5.7%
10 Brown-Forman 'B'$4.50 $1.48 $20.40 67.1% 22.1%1.0372 22.9%15.4%(0.064)0.7368 -4.71%10.6%
11 Chubb Corp. $7.00 $1.60 $64.85 77.1% 10.8%1.0184 11.0%8.5%(0.0319)0.1632 -0.52%8.0%
12 Church & Dwight $5.80 $1.00 $39.25 82.8% 14.8%1.045 15.5%12.8%(0.0414)0.6075 -2.52%10.3%
13 Coca-Cola $4.95 $2.48 $18.20 49.9% 27.2%1.0479 28.5%14.2%(0.0526)0.8267 -4.34%9.9%
14 Colgate-Palmolive $7.20 $3.20 $13.25 55.6% 54.3%1.0671 58.0%32.2%(0.1557)0.9086 -14.15%18.1%
15 Commerce Bancshs.$3.35 $1.5 $32.10 65.7% 10.4%1.0480 10.9%7.2%0.0240 0.2867 0.69%7.9%
16 ConAgra Foods $2.35 $1.00 $15.00 57.4% 15.7%1.0288 16.1%9.3%(0.0217)0.5385 -1.7%8.1%
17 Costco Wholesale $4.20 $0.95 $33.50 77.4% 12.5%1.0315 12.9%10.0%(0.0301)0.5939 -1.79%8.2%
18 Cullen/rost Baners $4.35 $2.10 $4.00 51.7%9.9%1.0382 10.3%5.3%0.0132 0.2667 0.35%5.7%
19 CVS Caremark Corp.$4.00 $0.56 $38.15 86.0% 10.5%1.0268 10.8%9.3%(0.0395)0.3642 -1.44%7.8%
20 EcolabInc.$3.60 $0.85 $14.45 76.4% 24.9%1.0530 26.2%20.0%(0.0056)0.7592 .0.43%19.6%
21 Exxon Mobil Corp.$9.35 $2.05 $45.50 78.1% 20.5%1.0546 21.7%16.9%(0.0578)0.5956 -3.4%13.5%
22 Gen'lMils $3.15 $1.6 $11.95 56.8% 26.4%1.0318 27.2%15.5%(0.0809)0.7610 .6.16%9.3%
23 Hein (H.J.)$4.10 $2.32 $14.65 43.4% 28.0%1.0908 30.5%13.3%0.0085 0.7830 0.66%13,9%
24 Hormel Foods $2.10 $0.70 $13.55 66.7% 15.5%1.0527 16.3%10.9%(0.0025)0.6387 -0.16%10.7%
25 Intl Business Mach.$18.00 $3.60 $48.75 80.0% 36.9%1.0856 40.1%32.1%(0.1501)0.7759 .11.65%20.4%
26 Johnson & Johnson $5.85 $2.65 $27.60 54.7% 21.2%1.0378 22.0%12.0%(0.0185)0.6846 -1.26%10.8%
27 Kellogg $5.10 $1.88 $9.95 63.1% 51.%1.0352 53.1%33.5%(0.2690)0.8829 -23.75%9.7%
28 Kimberly-Clark $6.25 $2.75 $15.55 56.0% 40.2%1.0140 40.8%22.8%(0.0506)0.8363 -4.24%18.6%
29 Kraft Foods $3.00 $1.40 $24.00 53.3% 12.5%1.0480 13.1%7.0%0.0716 0.5200 3.72%10.7%
30 Lily (Eli) $3.40 $2.20 $15.60 35.3% 21.8%1.0636 23.2%8.2%0.0032 0.6716 0.21%8.4%
31 Loceed Mart $13.25 $3.50 $31.25 73.6% 42.4%1.0882 46.1%34.0%(0.1663)0.8188 -13.62%20.3%
32 McCormick & Co.$3.50 $1.36 $18.95 61.1% 18.5%1.069 19.7%12.0%0.0178 0.7293 1.0%13.3%
33 McDonad's Corp.$6.05 $3.00 $19.00 50.4% 31.8%1.0303 32.8%16.5%(0.0734)0.8000 -5.87%10.7%
34 McKesson Corp.$6.80 $0.72 $46.65 89.4% 14.6%1.0421 15.2%13.6%(0.0380)0.4957 -1.88%11.7%
35 Medtronic, Inc.$4.50 $1.8 $25.95 73.8% 17.3%1.0597 18.4%13.6%(0.0326)0.5848 -1.91%11.7%
36 Microsoft Corp.$3.35 $0.96 $10.75 71.% 31.2%1.0763 33.5%23.9%(0.1104)0.7850 -8.66%15.3%
37 NIKE, Inc. '8'$5.65 $1.50 $34.60 73.5% 16.3%1.0643 17.4%12.8%(0.0085)0.6358 -0.54%12.2%
38 Northrop Grumman $10.25 $2.50 $68.00 75.6% 15.1%1.0293 15.5%11.7%(0.0783)0.4868 -3.81%7.9%
39 PepsiCo, Inc.$6.40 $2.34 $24.00 63.4% 26.7%1.0724 28.6%18.1%(0.0449)0.8118 -3.64%14.5%
40 Pfizer, Inc.$2.05 $1.6 $13.00 43.4% 15.8%1.0154 16.0%7.0%-0.5273 0.00%7.0%
41 Procter & Gamble $5.25 $2.18 $29.45 58.5% 17.8%1.0230 18.2%10.7%(0.0495)0.6900 -3.41%7.2%
42 Raytheon Co.$7.20 $2.00 $38.65 722% 18.6%1.0231 19.1%13.8%(0.0870)0.5932 -5.16%8.6%
43 Stryker Corp.$5.35 $0.84 $32.75 84.3% 16.3%1.0660 17.4%14.7%(0.0144)0.7213 -1.04%13.6%
44 Sysco Corp.$2.75 $1.0 $10.10 60.0% 27.2%1.0502 28.6%17.2%(0.0385)0.7756 -2.98%14.2%
45 1JX Companies $4.80 $0.80 $12.75 83.3% 37.6%1.0374 39.1%32.5%(0.2565)0.8355 -21.43%11.1%
46 United Parcel Servo $5.50 $2.20 $19.30 60.0% 28.5%1.0912 31.%18.7%(0.0090)0.8245 -0.75%17.9%
47 Verizon Communic.$3.05 $1.96 $18.95 35.7% 16.1%1.0250 16.5%5.9%(0.0032)0.6555 -0.21%5.7%
48 Walgreen Co.$3.65 $1.00 $21.5 726% 17.3%1.0252 17.7%12,8%(0.0684)0.6475 -4.43%8.4%
49 Wal-Mart Stores $6.05 $1.75 $23.40 71.% 25.9%1.0072 26.0%18.5%(0.1157)0.7400 -8.56%9.9%
50 Waste Mangement $2.90 $1.60 $15.30 44.8% 19.0%1.0079 19.1%8.6%(0.0515)0.6600 -3.40%5.2%
Case Nos. AVU.E-11.01 AVU.G-11.01
W. Avera, Avista
Schedule 7, p. 1 of 2
BR + SV GROWT RATE
NON-UTILITY PROXY GROUP
(a)(a)(f)(a)(a)(g)(a)(a)(f)
-- Common Equity -_.----- 2014 Price ------ Common Shares -...
Company ~Wi Qi !l I...Ml ~Wi ~
1 3M Company $12,764 $28,975 17.8% $135.00 $110.00 $122.50 3.059 710.60 723.00 0.35%
2 Abbott Labs.$22,856 $33,550 8.0%$115.00 $95.00 $105.00 4.762 1,551.90 1,520.00 .0.41%
3 Alberto-Culver $1,197 $1,640 6.5%$50.00 $4.00 $45.00 2.521 98.26 92.00 -1.31%
4 AT&T Inc.$102,339 $141,895 6.8%$50.00 $40.00 $45.00 1.871 5,901.90 5,900.00 -0.01%
5 Automatic Data Proc.$5,323 $11,700 17.1%$85.00 $70.00 $77.50 3.377 501.70 510.00 0.33%
6 Bard (C.R.)$2,194 $2,830 5.2%$155.00 $125.00 $140.00 4.452 95.92 90.00 -1.27%
7 Baxter Intl Inc.$7,191 $12,600 11.9%$90.00 $75.00 $82.50 3.603 600.97 550.00 -1.76%
8 Becton, Dickion $5,143 $6,985 6.3%$135.00 $110.00 $122.50 3.592 237.08 205.00 -2.87%
9 Britol.Myers Squibb $14,785 $19,230 5.4%$40.00 $30.00 $35.00 3.004 1,709.50 1,650.00 -0.71%
10 Brown-Forman 'B'$1,895 $2,750 7.7%$85.00 $70.00 $77.50 3.799 146.96 135.00 -1.68%
11 Chubb Corp. $15,634 $18,800 3.8%$85.00 $70.00 $77.50 1.95 332.01 290.00 -2.67%
12 Church & Dwight $1,602 $2,550 9.7%$110.00 $90.00 $100.00 2.548 70.55 65.00 -1.63%
13 Coca-Cola $24,799 $40,035 10.1% $115.00 $95.00 $105.00 5.769 2,303.00 2,200.00 -0.91%
14 Colgate-Palmolive $3,116 $6,100 14.4% $160.00 $130.00 $145.00 10.943 494.17 460.00 -1.42%
15 Commerce Bancshs.$1,886 $3,050 10.1%$50.00 $40.00 $45.00 1.02 87.26 95.00 1.71%
16 ConAgra Foods $4,721 $6,300 5.9%$35.00 $30.00 $32.50 2.167 441.66 420.00 -1.00%
17 Costco Wholesale $10,018 $13,725 6.5%$90.00 $75.00 $82.50 2.463 435.97 410.00 -1.22%
18 Cullen/rost Bankers $1,894 $2,775 7.9%$65.00 $55.00 $60.00 1.364 60.04 63.00 0.97%
19 CVS Caremark Corp.$35,768 $46,750 5.5%$65.00 $55.00 $60.00 1.573 1,391.00 1,225.00 -2.51%
20 Ecolab Inc.$2,001 $3,00 11.2%$65.00 $55.00 $60.00 4.152 236.60 235.00 -0.14%
21 Exxon Mobil Corp.$110,569 $191,000 11.6% $125.00 $100.00 $112.50 2.473 4,727.00 4,200.00 -2.34%
22 Gen'l Mils $5,175 $7,115 6.6%$55.00 $45.00 $5.00 4.184 656.00 595.00 -1.93%
23 Hein (H.J.)$1,891 $4,700 20.0%$75.00 $60.00 $67.50 4.608 318.06 321.00 0.18%
24 Hormel Foos $2,124 $3,60 11.%$40.00 $35.00 $37.50 2.768 267.19 266.00 -0.09%
25 Intl Business Mach.$22,755 $53,650 18.7% $240.00 $195.00 $217.50 4.462 1,305.30 1,100.00 -3.36%
26 Johnson & Johnn $50,588 $73,850 7.9%$95.00 $80.00 $87.50 3.170 2,754.30 2,675.00 -0.58%
27 Kellogg $2,272 $3,230 7.3%$95.00 $75.00 $85.00 8.543 381.38 325.00 -3.15%
28 Kimberly-Clark $5,406 $6,220 2.8%$105.00 $85.00 $95.00 6.109 417.00 400.00 -0.83%
29 Kraft Foods $25,972 $42,000 10.1%$55.00 $45.00 $5.00 2.083 1,477.90 1,750.00 3.44%
30 Lily (Eli)$9,524 $18,000 13.6%$50.00 $45.00 $47.50 3.045 1,149.00 1,155.00 0.10%
31 Lockheed Martn $4,129 $10,000 19.4% $190.00 $155.00 $172.50 5.520 372.90 320.00 -3.01%
32 McCormick & Co.$1,335 $2,555 13.9%$75.00 $65.00 $70.00 3.694 131.80 135.00 0.48%
33 McDonald's Corp.$14,034 $19,000 6.2%$105.00 $85.00 $95.00 5.000 1,076.70 1,000.00 -1.47%
34 McKesson Corp.$7,532 $11,480 8.8%$100.00 $85.00 $92.50 1.983 271.00 246.00 -1.92%
35 Medtronic, Inc.$14,629 $26,600 12.7%$70.00 $55.00 $62.50 2.08 1,097.30 1,025.00 -1.35%
36 Microsoft Corp.$39,558 $85,000 16.5%$55.00 $45.00 $50.00 4.651 8,908.00 7,900.00 -2.37%
37 NIKE, Inc. 'B'$8,693 $16,550 13.7% $105.00 $85.00 $95.00 2.746 485.50 478.00 -0.31%
38 Northrop Grumman $12,687 $17,000 6.0%$145.00 $120.00 $132.50 1.949 306.87 250.00 -4.02%
39 PepsiCo, Inc.$17,442 $36,015 15.6% $140.00 $115.00 $127.50 5.313 1,565.00 1,500.00 -0.84%
40 Pfizer, Inc.$90,014 $105,000 3.1%$30.00 $25.00 $27.50 2.115 8,070.00 8,070.00 0.00%
41 Procter & Gamble $63,099 $79,455 4.7%$105.00 $85.00 $95.00 3.226 2,917.00 2,700.00 -1.53%
42 Raytheon Co.$9,827 $12,375 4.7%$105.00 $85.00 $95.00 2.458 383.20 320.00 -3.54%
43 Strker Corp.$6,595 $12,775 14.1% $130.00 $105.00 $117.50 3.588 397.90 390.00 -0.40%
44 Sysco Corp.$3,450 $5,700 10.6%$50.00 $40.00 $45.00 4.455 590.03 565.00 -0.86%
45 1JX Companies $2,889 $4,200 7.8%$85.00 $70.00 $77.50 6.078 409.39 330.00 -4.22%
46 United Parcel Serv.$7,630 $19,035 20.1 % $120.00 $100.00 $110.00 5.699 992.85 985.00 -0.16%
47 Verizon Communc.$41,600 $53,439 5.1%$60.00 $50.00 $55.00 2.902 2,835.70 2,820.00 -0.11%
48 Walgreen Co.$14,376 $18,500 5.2%$65.00 $55.00 $60.00 2.837 988.56 875.00 -2.41%
49 Wal-Mart Stores $70,749 $76,025 1.4%$100.00 $80.00 $90.00 3.846 3,786.00 3,250.00 -3.01%
50 Waste Management $6,285 $6,800 1.6%$50.00 $40.00 $45.00 2.941 486.12 445.00 -1.75%
(a) www.valueline.com(retrievedJan.28,2011).
(b) Computed using the formula 2"(1+5-Yr. Change in Equity)/(2+5 Yr. Change in Equity).
(c) Product of year-end "r" for 2014 and Adjustment Factor.
(d) Product of change in common shares outstanding and M/B Ratio.
(e) Computed as 1 - BIM Ratio.
(f) Five-year rate of change.
(g) Average of High and Low expected market prices divided by 2013-15 BVPS.Case Nos. AVU-E-11-01 AVU-G-11-01
W. Avera, Avista
Schedule 7, p. 2 of 2
CAPITAL ASSET PRICING MODEL
UTILITY PROXY GROUP
Market Rate of Return
Dividend Yield (a)
Growth Rate (b)
Market Return (c)
2.3%
10.5%
12.8%
Less: Risk-Free Rate (d)
Long-term Treasury Bond Yield
Market Risk Premium (e)
4.7%
8.1%
Utility Proxy Group Beta (f
Utility Proxy Group Risk Premium (g)
Plus: Risk-free Rate (d)
Long-term Treasury Bond Yield
Unadjusted CAPM (h)
0.74
6.0%
4.7%
10.7%
Size Adjustment (i)0.74%
Implied Cost of Equity (j)11.5%
(a) Weighted average dividend yield for the dividend paying firms in the S&P 500 from
www.valueline.com (retrieved Jan. 281 2011).
(b) Weighted average of IBES earnings growth rates for the dividend paying firms in the S&P 500
(retrieved Feb. 23, 2011).
(c) (a) + (b)
(d) Average yield on 30-year Treasury bonds for February 2011 from the Federal Reserve Board at
http://www.federalreserve.gov /releases/h15/data/Monthly/H15_ TCMNOM_ Y20. txt.
(e) (c) - (d).
(f) The Value Line Investment Survey (Feb. 4, Feb. 251 & Mar. 251 2011).
(g) (e) x (f).
(h) (d) + (g).
(i) Morningstar 1 "Ibbotson SBBI 2010 Valuation Yearbook/' at Table C-1 (2010).
0) (h) + (i).Case Nos. AVU-E-11-01 AVU-G-11-01
W. Avera, Avista
Schedule 8, p. 1 of 1
CAPITAL ASSET PRICING MODEL
NON-UTILITY PROXY GROUP
Market Rate of Return
Dividend Yield (a)
Growth Rate (b)
Market Return (c)
2.3%
10.5%
12.8%
Less: Risk-Free Rate (d)
Long-term Treasury Bond Yield
Market Risk Premium (e)
4.7%
8.1%
Non-Utilty Proxy Group Beta (f
Utilty Proxy Group Risk Premium (~)
0.71
5.7%
Plus: Risk-free Rate (d)
Long-term Treasury Bond Yield
Unadjusted CAPM (h)
4.7%
10.4%
Size Adjustment (i)-0.37%
Implied Cost of Equity (j)10.1%
(a) Weighted average dividend yield for the dividend paying firms in the S&P 500 from
www.valueline.com (retrieved Jan. 28, 2011).
(b) Weighted average of IBES earnings growth rates for the dividend paying firms in the S&P 500
(retrieved Feb. 23, 2011).
(c) (a) + (b)
(d) Average yield on 30-year Treasury bonds for February 2011 from the Federal Reserve Board at
http://ww.federalreserve.gov/releases/h15/data/Monthly/H15_ TCMNOM_Y20. txt.
(e) (c) - (d).
(f) www.valuelihe.com (retrieved Jan. 28, 2011).
(g) (e) x (f).
(h) (d) + (g).
(i) Morningstar, "Ibbotson SBBI 2010 Valuation Yearbook," at Table C-1 (2010).
(j) (h) + (i).Case Nos. AVU-E-11-01 AVU-G-11-01
W. Avera, Avista
Schedule 9, p. 1 of 1
EXPECTED EARNINGS APPROACH
UTILITY PROXY GRQUP
(a)(b)(e)
Expected Return Adjustment Adjusted Return
Company on Common Equity Factor on Common Equity
1 ALLETE 9.5%1.021077 9.7%
2 Allant Energy 12.0%1.020547 12.2%
3 Ameren Corp.7.0%1.0188
4 American Elec Pwr 10.5%1.028674 10.8%
5 Avista Corp.9.0%1.02525 9.2%
6 Black Hils Corp.8.0%1.023679 8.2%
7 Cleco Corp.10.0%1.026528 10.3%
8 Constellation Energy 7.0%1.025032
9 DTE Energy Co.9.0%1.020027 9.2%
10 Edison International 8.5%1.028458 8.7%
11 Empire District Elec 10.5%1.011911 10.6%
12 Entergy Corp.11.0%1.02555 11.3%
13 Exelon Corp.14.5%1.020388 14.8%
14 Great Plains Energy 8.0%1.023109 8.2%
15 Hawaiian Elec.10.5%1.021957 10.7%
16 IDACORP, Inc.8.5%1.030347 8.8%
17 Integrys Energy Group 9.5%1.014113 9.6%
18 OGE Energy Corp.12.0%1.038907 12.5%
19 Otter Tail Corp.8.5%1.035333 8.8%
20 PG&ECorp.12.0%1.038435 12.5%
21 Pinnacle West Capital 8.5%1.033878 8.8%
22 Portland General Elec.8.5%1.032728 8.8%
23 Pub Sv Enterprise Grp 11.5%1.03748 11.9%
24 SCANA Corp.9.5%1.041985 9.9%
25 Sempra Energy 10.5%1.022958 10.7%
26 UIL Holdings 9.0%1.081864 9.7%
27 Westar Energy 10.0%1.020723 10.2%
28 Wisconsin Energy 13.0%1.021472 13.3%
Average (d)10.4%
(a) The Value Line Investment Survey (Feb. 4, Feb. 25, & Mar. 25, 2011).
Case Nos.AVU-E-11-01 AVU-G-11-01(b) Adjustment to convert year-end "r" to an average rate of return from ExhibifNo. (WcA-6). W A A . t- . vera, vis a(e) (a) x (b). Schedule 10, p. 1 of 1
(d) Excludes highlighted figures.