20160526McKenzie Direct.pdf

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]
[e-mail]

BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION

IN THE MATTER OF THE APPLICATION ) CASE NO. AVU-E-16-03
OF AVISTA CORPORATION FOR THE )
AUTHORITY TO INCREASE ITS RATES )
AND CHARGES FOR ELECTRIC SERVICE ) DIRECT TESTIMONY
TO ELECTRIC CUSTOMERS IN THE ) OF
STATE OF IDAHO ) ADRIEN M. MCKENZIE
)

FOR AVISTA CORPORATION

(ELECTRIC)

DIRECT TESTIMONY OF ADRIEN M. MCKENZIE

TABLE OF CONTENTS

I. INTRODUCTION ........................................... 1
A. Overview ........................................... 1
B.Summary of Conclusions ............................... 5
II. RISKS OF AVISTA ....................................... 12
A.Operating Risks ..................................... 12
B.Outlook for Capital Costs ........................... 16
C.Support for Avista’s Credit Standing ................ 25
D.Capital Structure ................................... 29
III. CAPITAL MARKET ESTIMATES .............................. 34
A.Quantitative Analyses ............................... 34
B.Flotation Costs ..................................... 42
IV. OTHER FACTORS ......................................... 47
A.Non-Utility DCF Model ............................... 48
B.Regulatory Mechanisms ............................... 52

Exhibit No. 3
Schedule 1 – Qualifications of Adrien M. McKenzie
Schedule 2 – Description of Quantitative Analyses
Schedule 3 – ROE Analyses – Summary of Results
Schedule 4 – Capital Structure
Schedule 5 – Constant Growth DCF Model – Utility Group
Schedule 6 – Sustainable Growth Rate – Utility Group
Schedule 7 – Capital Asset Pricing Model
Schedule 8 – Empirical Capital Asset Pricing Model
Schedule 9 – Electric Utility Risk Premium
Schedule 10 – Expected Earnings Approach
Schedule 11 – Constant Growth DCF Model – Non-Utility Group

McKenzie, Di 1
Avista Corporation

I. INTRODUCTION 1
Q. Please state your name and business address. 2
A. Adrien M. McKenzie, 3907 Red River, Austin, Texas,
78751.
Q. In what capacity are you employed? 5
A. I am a Vice President of FINCAP, Inc., a firm
providing financial, economic, and policy consulting services
to business and government.
Q. Please describe your educational background and 9
professional experience. 10
A. A description of my background and qualifications,
including a resume containing the details of my experience,
is attached as Exhibit No. 3, Schedule 1.
A. Overview 14
Q. What is the purpose of your testimony in this case? 15
A. The purpose of my testimony is to present to the
Idaho Public Utilities Commission (the “Commission” or 17
“IPUC”) my independent evaluation of the fair rate of return
on equity (“ROE”) for the jurisdictional electric utility 19
operations of Avista Corp. (“Avista” or “the Company”). In 20
addition, I also examined the reasonableness of Avista’s 21

McKenzie, Di 2
Avista Corporation

capital structure, considering both the specific risks faced
by the Company and other industry guidelines.
Q. Please summarize the information and materials you 3
relied on to support the opinions and conclusions contained 4
in your testimony. 5
A. To prepare my testimony, I used information from a
variety of sources that would normally be relied upon by a
person in my capacity. I am familiar with the organization,
finances, and operations of Avista from my participation in
prior proceedings before the IPUC, the Washington Utilities
and Transportation Commission (“WUTC”) and the Oregon Public
Utility Commission. In connection with the present filing, I
considered and relied upon corporate disclosures, publicly
available financial reports and filings, and other published
information relating to Avista. I have also visited the
Company’s main offices and had discussions with management in
order to better familiarize myself with Avista’s utility 17
operations. My evaluation also relied upon information
relating to current capital market conditions and
specifically to current investor perceptions, requirements,
and expectations for electric utilities. These sources,
coupled with my experience in the fields of finance and
utility regulation, have given me a working knowledge of the

McKenzie, Di 3
Avista Corporation

issues relevant to investors’ required return for Avista, and 1
they form the basis of my analyses and conclusions.
Q. How is your testimony organized? 3
A. After first summarizing my conclusions and
recommendations, my testimony reviews the operations and
finances of Avista and industry-specific risks and capital
market uncertainties perceived by investors. With this as a
background, I present the application of well-accepted
quantitative analyses to estimate the current cost of equity
for a reference group of comparable-risk utilities. These
included the discounted cash flow (“DCF”) model, the
traditional Capital Asset Pricing Model (“CAPM”), the
empirical form of Capital Asset Pricing Model (“ECAPM”), an 13
equity risk premium approach based on allowed ROEs for
electric utilities, and reference to expected rates of return
for electric utilities, which are all methods that are
commonly relied on in evaluating investors’ required rate of 17
return. Based on the cost of equity estimates indicated by
my analyses, the Company’s ROE was evaluated taking into 19
account the specific risks and potential challenges for
Avista’s electric utility operations in Idaho, as well as
other factors (e.g., flotation costs) that are properly
considered in setting a fair ROE for the Company.

McKenzie, Di 4
Avista Corporation

In addition, I corroborated my utility quantitative
analyses by applying the DCF model to a group of low risk
non-utility firms. Finally, my testimony addresses the
impact of regulatory mechanisms on an evaluation of a fair
ROE for Avista.
Q. What is the role of the ROE in setting a utility's 6
rates? 7
A. The ROE is the cost of attracting and retaining
common equity investment in the utility’s physical plant and 9
assets. This investment is necessary to finance the asset
base needed to provide utility service. Investors commit
capital only if they expect to earn a return on their
investment commensurate with returns available from
alternative investments with comparable risks. Moreover, a
fair and reasonable ROE is integral in meeting sound
regulatory economics and the standards set forth by the U.S.
Supreme Court in the Bluefield1 and Hope2 cases, which state
that a utility’s allowed ROE should be sufficient to: 1) 18
fairly compensate the utility’s investors, 2) enable the 19
utility to offer a return adequate to attract new capital on
reasonable terms, and 3) maintain the utility’s financial 21

1 Bluefield Water Works & Improvement Co. v. Pub. Serv. Comm'n, 262 U.S.
679 (1923).
2 Fed. Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591 (1944).

McKenzie, Di 5
Avista Corporation

integrity. These standards should allow the utility to
fulfill its obligation to provide reliable service while
meeting the needs of customers through necessary system
replacement and expansion, but they can only be met if the
utility has a reasonable opportunity to actually earn its
allowed ROE.
B. Summary of Conclusions 7
Q. Please summarize the results of your analyses. 8
A. The results of my analyses are presented on page 1
of Exhibit No. 3, Schedule 3, and in Table 1, below:

McKenzie, Di 6
Avista Corporation

TABLE 1 1
SUMMARY OF RESULTS 2

Utility DCF Average Midpoint
Value Line 9.06%2 10.37%19
IBES 9.45%6 9.47%7
Zacks 9.15%4 9.26%5
Internal br + sv 8.35%1 9.14%3
Non-Utility DCF
Value Line 9.59%8 10.12%14
IBES 10.31%17 10.71%23
Zacks 10.49%21 11.18%26
CAPM
Historical Bond Yield 9.66%10 9.60%9
Projected Bond Yield 9.96%12 9.90%11
Empirical CAPM
Historical Bond Yield 10.14%15 10.10%13
Projected Bond Yield 10.38%20 10.35%18
Utility Risk Premium
Historical Bond Yields 10.70%22
Projected Bond Yields 11.74%27
Expected Earnings
Industry 10.85%25
Proxy Group 10.14%16 10.76%24
Cost of Equity Recommendation
Cost of Equity Range 9.5%--10.7%
Flotation Cost Adjustment
Dividend Yield
Flotation Cost Percentage
Adjustment
ROE Recommendation 9.62%--10.82%
Note: Footnotes correspond to rank order in the figure below.
3.3%
3.6%
0.12%

McKenzie, Di 7
Avista Corporation

Figure 1, below, presents the 21 cost of equity 1
estimates presented in Table 1 in rank order, and compares 2
them with Avista’s 9.9% ROE request: 3
FIGURE 1 4
RESULTS OF ANALYSES VS. AVISTA REQUEST 5

Q. What are your findings regarding the 9.9 percent 7
ROE requested by Avista? 8
A. Based on the results of my analyses and the
economic requirements necessary to support continuous access
to capital under reasonable terms, I determined that 9.9
percent is a conservative estimate of investors’ required ROE 12
for Avista. The bases for my conclusion are summarized
below:

McKenzie, Di 8
Avista Corporation

 In order to reflect the risks and prospects associated
with Avista’s jurisdictional utility operations, my 2
analyses focused on a proxy group of 16 other
utilities with comparable investment risks;
 Because investors’ required return on equity is
unobservable and no single method should be viewed in
isolation, I applied the DCF, CAPM, ECAPM, and risk
premium methods to estimate a fair ROE for Avista; as
well as referencing the expected earnings 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 for the
proxy group of utilities is in the 9.5 percent to 10.7 13
percent range, or 9.62 percent to 10.82 percent after
incorporating an adjustment to account for the impact
of common equity flotation costs; and,
 As reflected in the testimony of Mr. Thies, Avista is
requesting an ROE of 9.9 percent, which falls below
the 10.22 percent 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 9.9 percent
represents a conservative ROE for Avista.
Q. What other evidence did you consider in evaluating 26
your ROE recommendation in this case? 27
A. My recommendation is reinforced by the following
findings:
 The reasonableness of a 9.9 percent ROE for Avista is
supported by the need to consider the challenges to
the Company’s credit standing:
o The pressure of funding significant capital
expenditures of approximately $1.2 billion over
the next three years heighten the uncertainties
associated with Avista, especially given that the
Company’s existing rate base is approximately $2.8
billion;
o Because of Avista’s reliance on hydroelectric 39
generation and increasing dependence on natural

McKenzie, Di 9
Avista Corporation

gas fueled capacity, the Company is exposed to
relatively greater risks of power cost volatility,
even with the Power Cost Adjustment Mechanism
(“PCA”);
o Widespread expectations for higher interest rates
emphasize the implication of considering the
impact of projected bond yields in evaluating the
results of the ECAPM and risk premium methods;
and,
o My conclusion that a 9.9 percent ROE for Avista is
a conservative estimate of investors’ required 11
return is also reinforced by the greater
uncertainties associated with Avista’s relatively 13
small size.
 Sensitivity to financial market and regulatory
uncertainties has increased dramatically and investors
recognize that constructive regulation is a key
ingredient in supporting utility credit standing and
financial integrity;
 Providing Avista with the opportunity to earn a return
that reflects these realities is an essential
ingredient to support the Company’s financial 22
position, which ultimately benefits customers by
ensuring reliable service at lower long-run costs;
 Continued support for Avista’s financial integrity, 25
including a reasonable ROE, is imperative to ensure
that the Company has the capability to maintain and
build its credit standing while confronting potential
challenges associated with funding infrastructure
development necessary to meet the needs of its
customers; and,
 Regulatory mechanisms approved for Avista are viewed
as supportive by investors, and the implications of
the Fixed Cost Adjustment Mechanism (“FCA”) and other
mechanisms are fully reflected in Avista's credit
ratings, which are comparable to those of the proxy
group used to estimate the cost of equity. Because
the utilities in my proxy group operate under a wide
variety of regulatory mechanisms, including provisions
akin to the FCA, the effects of the Company’s 40
regulatory mechanisms are already reflected in the
results of my analyses.

McKenzie, Di 10
Avista Corporation

These findings indicate that the 9.9 percent ROE
requested by Avista is reasonable and should be approved.
Q. What other factors should be considered in 3
evaluating the ROE requested by Avista in this case? 4
A. Apart from the results of the quantitative methods
summarized above, it is crucial to recognize the importance
of supporting the Company’s financial position so that Avista 7
remains prepared to respond to unforeseen events that may
materialize in the future. Potential challenges in the
economic and financial market environment, including rising
interest rates and capital market volatility, highlight the
imperative of continuing to build the Company’s financial 12
strength in order to attract the capital needed to secure
reliable service at a reasonable cost for customers. The
reasonableness of the Company’s requested ROE is reinforced 15
by the fact that, due to broad-based expectations for higher
bond yields, current cost of capital estimates are likely to
understate investors’ requirements at the conclusion of this
proceeding and beyond.
Q. Does an ROE of 9.9 percent represent a reasonable 20
cost for Avista’s customers to pay? 21
A. Yes. Investors have many options vying for their
money. They make investment capital available to Avista only
if the expected returns justify the risk. Customers will

McKenzie, Di 11
Avista Corporation

enjoy reliable and efficient service so long as investors are
willing to make the capital investments necessary to maintain
and improve Avista’s utility system. Providing an adequate
return to investors is a necessary cost to ensure that
capital is available to Avista on reasonable terms now and in
the future. If regulatory decisions increase risk or limit
returns to levels that are insufficient to justify the risk,
investors will look elsewhere to invest capital.
Q. What is your conclusion as to the reasonableness of 9
the Company’s capital structure? 10
A. Based on my evaluation, I concluded that a common
equity ratio of 50.0 percent represents a reasonable basis
from which to calculate Avista’s overall rate of return. 13
This conclusion was based on the following findings:
 Avista’s requested capitalization is consistent with
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 its service territory;
 Avista’s proposed common equity ratio is entirely
consistent with the range of capitalizations for the
proxy utilities, both for year-end 2015 and based on
the near-term expectations of the Value Line
Investment Survey (“Value Line”); and,
 The requested capitalization reflects the importance
of an adequate equity layer to accommodate Avista’s 26
operating risks and the pressures of funding
significant capital investments. This is reinforced
by the need to consider the impact of uncertain
capital market conditions, as well as off-balance

McKenzie, Di 12
Avista Corporation

sheet commitments such as purchased power agreements,
which carry with them some level of imputed debt.
II. RISKS OF AVISTA 3
Q. What is the purpose of this section? 4
A. As a predicate to my capital market analyses, this
section examines the investment risks that investors consider
in evaluating their required rate of return for Avista.
A. Operating Risks 8
Q. How does Avista’s generating resource mix affect 9
investors’ risk perceptions? 10
A. Because over 40 percent of Avista’s total energy 11
requirements are provided by hydroelectric facilities, the
Company is exposed to a level of uncertainty not faced by
most utilities. While hydropower confers advantages in terms
of fuel cost savings and diversity, reduced hydroelectric
generation due to below-average water conditions forces
Avista to rely more heavily on wholesale power markets or
more costly thermal generating capacity to meet its resource
needs. As S&P has observed:
A reduction in hydro generation typically increases
an electric utility’s costs by requiring it to buy 21
replacement power or run more expensive generation
to serve customer loads. Low hydro generation can
also reduce utilities’ opportunity to make off-
system sales. At the same time, low hydro years
increase regional wholesale power prices, creating
potentially a double impact – companies have to buy

McKenzie, Di 13
Avista Corporation

more power than under normal conditions, paying
higher prices.3
Investors recognize that volatile energy markets,
unpredictable stream flows, and Avista’s reliance on 4
wholesale purchases to meet a significant portion of its
resource needs can expose the Company to the risk of reduced
cash flows and unrecovered power supply costs.
S&P has noted that Avista, along with Idaho Power
Company, “face the most substantial risks despite their PCAs 9
and cost-update mechanisms,”4 and concluded that Avista’s 10
“Northwest hydropower has been subject to significant
volatility in recent years, so [Avista] is exposed to
purchased power costs.”5
Similarly, Moody’s Investors Service (“Moody’s”) has
recognized that, “Avista’s high dependency on hydro resources 15
(approximately 50% of its production comes from hydro fueled
electric generation resources) is viewed as a supply
concentration risk which also lends to the potential for
metric volatility, especially since hydro levels, due to

3 Standard & Poor’s Corporation, “Pacific Northwest Hydrology And Its
Impact On Investor-Owned Utilities’ Credit Quality,” RatingsDirect (Jan.
28, 2008).
4 Id.
5 Standard & Poor’s Corporation, “Industry Report Card,” RatingsDirect
(Apr. 19, 2013).

McKenzie, Di 14
Avista Corporation

weather, is a factor outside of management's control.”6 More
recently, S&P affirmed the importance of constructive
regulation in light of the potential need “to purchase power 3
for customers when hydro power is unavailable.”7 Avista’s 4
reliance on purchased power to meet shortfalls in
hydroelectric generation magnifies the importance of
strengthening financial flexibility.
Q. Do financial pressures associated with Avista’s 8
planned capital expenditures also impact investors’ risk 9
assessment? 10
A. Yes. Avista will require capital investment to
meet customer growth, provide for necessary maintenance, as
well as fund new investment in electric generation,
transmission and distribution facilities. Utility capital
additions are expected to total approximately $375 million
for 2016, and $405 million for each of the years 2017 through
2019. This represents a substantial investment given
Avista’s current rate base of approximately $2.8 billion.
Continued support for Avista’s financial integrity and
flexibility will be instrumental in attracting the capital

6 Moody’s Investors Service, “Credit Opinion: Avista Corp.,” Global Credit
Research (Mar. 17, 2011).
7 Standard & Poor’s Corporation, “Avista Corp.,” RatingsDirect (May 19,
2015).

McKenzie, Di 15
Avista Corporation

necessary to fund these projects in an effective manner.
Investors are aware of the challenges posed by burdensome
capital expenditure requirements, especially in light of
ongoing capital market and economic uncertainties, and
Moody’s has noted that increasing capital expenditures are a 5
primary credit concern for Avista.8
Q. Would investors consider Avista’s relative size in 7
their assessment of the Company’s risks and prospects? 8
A. Yes. A firm’s relative size has important
implications for investors in their evaluation of alternative
investments, and it is well established that smaller firms
are more risky than larger firms. With a market
capitalization of approximately $2.4 billion, Avista is one
of the smallest publicly traded utility holding companies
followed by Value Line, which have an average capitalization
of approximately $11.8 billion.9
The magnitude of the size disparity between Avista and
other firms in the utility industry has important practical
implications with respect to the risks faced by investors.
All else being equal, it is well accepted that smaller firms
are more risky than their larger counterparts, due in part to

8 Moody’s Investors Service, “Credit Opinion: Avista Corp.,” Global Credit
Research (Mar. 11, 2015).
9 www.valueline.com (retrieved Apr. 25, 2016).

McKenzie, Di 16
Avista Corporation

their relative lack of diversification and lower financial
resiliency.10 These greater risks imply a higher required
rate of return, and there is ample empirical evidence that
investors in smaller firms realize higher rates of return
than in larger firms.11 Accepted financial doctrine holds
that investors require higher returns from smaller companies,
and unless that compensation is provided in the rate of
return allowed for a utility, the legal tests embodied in the
Hope and Bluefield cases cannot be met.
B. Outlook for Capital Costs 10
Q. What are the implications of current capital market 11
conditions in evaluating a fair ROE? 12
A. Current capital market conditions continue to be
deeply affected by the Federal Reserve's unprecedented
monetary policy actions, which were designed to push interest
rates to historically low levels in an effort to stimulate
the economy and bolster employment. Since the Great
Recession, investors have also had to contend with a level of

10 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).
11 See for example Rolf W. Banz, “The Relationship Between Return and
Market Value of Common Stocks”, Journal of Financial Economics (September
1981) at 16.

McKenzie, Di 17
Avista Corporation

economic uncertainty that has been unprecedented in recent
history. The ongoing potential for renewed turmoil in the
capital markets has been seen repeatedly, and in response to
heightened uncertainties in recent years, investors have
repeatedly sought a safe haven in U.S. government bonds. As
a result of this “flight to safety,” Treasury bond yields 6
have been pushed significantly lower in the face of
political, economic, and capital market risks. While serving
as President of the Federal Reserve Bank of Philadelphia,
Charles Plosser observed that U.S. interest rates were
unprecedentedly low, and “outside historical norms.”12
Q. Are these very low interest rates expected to 12
continue? 13
A. No. Investors continue to anticipate that interest
rates will increase significantly from present levels. For
example, the March 4, 2016 quarterly economic review from the
Value Line Investment Survey (“Value Line”) anticipates that
corporate bond yields will increase 180 basis points over the
next five years. Figure 2 below compares current interest
rates on 10-year and 30-year Treasury bonds, triple-A rated

12 Barnato, Katy, “Fed’s Plosser: Low rates ‘should make us nervous’,” CNBC
(Nov. 11, 2014). The average yield on 10-year Treasury bonds for the six-
months ended March 2016 was 2.1%, which is even lower than the 2.3% yields
prevailing at the time of Mr. Plosser’s observations.

McKenzie, Di 18
Avista Corporation

corporate bonds, and double-A rated utility bonds with near-
term projections from Value Line, IHS Global Insight, Blue
Chip Financial Forecasts (“Blue Chip”), and the Energy
Information Administration (“EIA”), which are sources that
are highly regarded and widely referenced:
FIGURE 2 6
INTEREST RATE TRENDS 7

As evidenced above, projections by investment advisors,
forecasting services, and government agencies support the
general consensus in the investment community that the
present low level of long-term interest rates will not be
sustained.
Source:
Value Line Investment Survey, Forecast for the U.S. Economy (Mar. 4, 2016)
IHS Global Insight, The U.S. Economy: The 30-Year Focus (Third-Quarter 2015)
Energy Information Administration, Annual Energy Outlook 2015 (April 2015)
Blue Chip Financial Forecasts, Vol. 34, No. 6 (Dec. 1, 2015)
1.5%
2.5%
3.5%
4.5%
5.5%
6.5%
Mar. 2016 2016 2017 2018 2019 2020
Aa Utility Aaa Corp.30-Yr Govt.10-Yr Govt.

McKenzie, Di 19
Avista Corporation

Q. Does the Federal Reserve’s December 16, 2015 1
decision to raise the target range for the federal funds rate 2
by one-quarter percentage point mark a return to “normal” in 3
the capital markets? 4
A. No. The Federal Reserve’s long-anticipated move to
increase the federal funds rate represents a first, and very
modest, step towards implementing the process of monetary
policy normalization outlined in its September 17, 2014 press
release.13 While the Federal Reserve’s action marks the onset 9
of the normalization process, this first move does not result
in a fundamental alteration of its highly accommodative
monetary policy. Nor does it remove uncertainty over the
trajectory of further interest rate increases or the
overhanging implications of the Federal Reserve’s enormous 14
holdings of long-term securities.
The Federal Reserve continues to exert considerable
influence over capital market conditions through its massive
holdings of Treasuries and mortgage-backed securities. Prior
to the initiation of the stimulus program in 2009, the
Federal Reserve’s holdings of U.S. Treasury bonds and notes 20
amounted to approximately $400 - $500 billion. With the

13 Press Release, Fed. Reserve Sys., Policy Normalization Principles and
Plans, (Sept. 17, 2014),
http://www.federalreserve.gov/newsevents/press/monetary/20140917c.htm.

McKenzie, Di 20
Avista Corporation

implementation of its asset purchase program, balances of
Treasury securities and mortgage backed instruments climbed
steadily, and their effect on capital market conditions
became more pronounced. Table 2 below charts the course of
the Federal Reserve’s asset purchase program:
TABLE 2 6
FEDERAL RESERVE BALANCES OF 7
TREASURY BONDS AND MORTGAGE-BACKED SECURITIES 8
(BILLION $) 9

Far from representing a return to normal, the Federal
Reserve’s holdings of Treasury bonds and mortgage-backed
securities now amount to more than $4 trillion,14 which is an
all-time high. The Federal Reserve has announced its
intention to maintain these balances by reinvesting principal
payments from these securities “until normalization of the
level of the federal funds rate is well under way.”15

14 Federal Reserve Statistical Release, “Factors Affecting Reserve Balances
of Depository Institutions and Condition Statement of Federal Reserve
Banks,” H.4.1.
15 Federal Reserve Press Release (Mar. 16, 2016),
http://www.federalreserve.gov/monetarypolicy/files/monetary20160316a1.pdf.

McKenzie, Di 21
Avista Corporation

Of course, the corollary to these observations is that
changes to this policy of reinvestment would further reduce
stimulus measures and could place significant upward pressure
on bond yields, especially considering the unprecedented
magnitude of the Federal Reserve’s holdings of Treasury bonds 5
and mortgage-backed securities. As a Financial Analysts 6
Journal article noted:
Because no precedent exists for the massive
monetary easing that has been practiced over the
past five years in the United States and Europe,
the uncertainty surrounding the outcome of central
bank policy is so vast. . . . Total assets on the
balance sheets of most developed nations’ central 13
banks have grown massively since 2008, and the
timing of when the banks will unwind those
positions is uncertain.16
With expectations for higher interest rates, concerns
about China’s economy and fears of a global economic 18
slowdown, dramatic decreases in oil prices, ongoing concerns
over political stalemate in Washington, and political and
economic unrest in the Middle East and Europe, the potential
for significant volatility and higher capital costs is
clearly evident to investors.

16 Poole, William, “Prospects for and Ramifications of the Great Central
Banking Unwind,” Financial Analysts Journal (November/December 2013).

McKenzie, Di 22
Avista Corporation

Q. Can you provide an example of how this uncertainty 1
has negatively impacted the credit markets for utilities like 2
Avista? 3
A. Yes, this uncertainty has led the “cost” of risk to 4
increase. This relationship is illustrated in Table 3,
below:
TABLE 3 7
INTEREST RATE SPREADS 8

As seen above, average Baa utility bond yields have
increased by 102 basis points from January 2015 to March
2016. Only a small portion of this increase (38 basis
points) can be tied to the increase in “risk-free” Treasury 13
bond rates. This is one measure of the increase in interest
Baa 30-Year Yield
Month Utility Treasury Spread
Jan-15 4.39%2.46%1.93%
Feb-15 4.44%2.57%1.87%
Mar-15 4.51%2.63%1.88%
Apr-15 4.51%2.59%1.92%
May-15 4.89%2.96%1.93%
Jun-15 5.13%3.11%2.02%
Jul-15 5.22%3.07%2.15%
Aug-15 5.23%2.86%2.37%
Sep-15 5.42%2.95%2.47%
Oct-15 5.47%2.89%2.58%
Nov-15 5.57%3.02%2.55%
Dec-15 5.55%2.97%2.58%
Jan-16 5.49%2.86%2.63%
Feb-16 5.28%2.62%2.66%
Mar-16 5.41%2.84%2.57%
Change 1.02%0.38%0.64%
Sources: Moody's Investors Service;
http://www.federalreserve.gov/releases/h15/data.htm.

McKenzie, Di 23
Avista Corporation

rates across the markets in general. However, another
phenomenon is occurring. As uncertainties facing capital
markets increase, investors are requiring more compensation
to assume greater risk. In January 2015, triple-B rated
utilities were required to pay investors 193 basis points
over the cost of Treasury bonds to entice them to purchase
their debt issues. In March 2016, that additional cost was
257 basis points. The difference (64 basis points), is the
additional “cost” investors are now requiring to assume
additional risk. For utilities like Avista, uncertainties
across the globe and across capital markets are directly
leading to higher capital costs.
Q. What do these events imply with respect to the ROE 13
for Avista more generally? 14
A. Current capital market conditions continue to
reflect the impact of unprecedented policy measures taken in
response to recent dislocations in the economy and financial
markets. As a result, current capital costs are not
representative of what is likely to prevail over the near-
term future. As FERC recently concluded:
[W]e also understand that any DCF analysis may be
affected by potentially unrepresentative financial
inputs to the DCF formula, including those produced
by historically anomalous capital market
conditions. Therefore, while the DCF model remains
the Commission’s preferred approach to determining 26
allowed rate of return, the Commission may consider

McKenzie, Di 24
Avista Corporation

the extent to which economic anomalies may have
affected the reliability of DCF analyses.17
This conclusion is supported by comparisons of current
conditions to the historical record and independent
forecasts. As demonstrated above, recognized economic
forecasting services project that long-term capital costs
will increase from present levels. FERC ultimately
determined that due to unrepresentative capital market
conditions, an upward adjustment to the 9.39 percent midpoint
of its DCF range was required in order to meet the regulatory
standards established by Hope and Bluefield. Based on its
examination of alternatives to the DCF approach, FERC
authorized an ROE from the upper end of its DCF range, or
10.57 percent.18
Given investors’ expectations for rising interest rates 15
and capital costs, the Commission should consider near-term
forecasts for higher public utility bond yields in assessing
the reasonableness of individual cost of equity estimates and
in evaluating a fair ROE for Avista from within the range of
reasonableness. As discussed in Exhibit No. 3, Schedule 2,
this result is supported by economic studies that show that

17 Opinion No. 531, 147 FERC ¶ 61,234 at P 41 (2014).
18 Id. at P 9.

McKenzie, Di 25
Avista Corporation

equity risk premiums are higher when interest rates are at
very low levels.
Q Do ongoing economic and capital market 3
uncertainties also influence the appropriate capital 4
structure for Avista? 5
A Yes. Financial flexibility plays a crucial role in
ensuring the wherewithal to meet funding needs, and utilities
with higher financial leverage may be foreclosed from
additional borrowing, especially during times of stress. As
a result, the Company’s capital structure must maintain
adequate equity to preserve the flexibility necessary to
maintain continuous access to capital even during times of
unfavorable market conditions.
C. Support for Avista’s Credit Standing 14
Q. What credit ratings have been assigned to Avista? 15
A. S&P has assigned Avista a corporate credit rating
of “BBB”, while Moody’s has set Avista’s Issuer Rating at 17
“Baa1”.
Q. What considerations impact investors’ assessment of 19
the firms in the utility industry? 20
A. Numerous factors have the potential to impact
investors’ perceptions of the relative risks inherent in the 22
utility industry and have implications for the financial

McKenzie, Di 26
Avista Corporation

standing of the utilities themselves. These include the
possibility of volatile fuel or purchased power costs,
uncertain environmental mandates and associated costs, the
implications of declining demand associated with economic
weakness or structural changes in usage patterns, and
increased reliance on distributed generation or other
alternatives to the incumbent utility. Apart from these
considerations, utilities may face increasing costs of
operating their systems, as well as the financial pressures
associated with large capital expenditure programs, which are
magnified during periods of turmoil in capital markets.
Q. What are the implications for Avista, given the 12
potential for further dislocations in the capital markets? 13
A. The pressures of significant capital expenditure
requirements, along with the need to refinance maturing debt,
reinforce the importance of supporting continued improvement
in Avista’s credit standing. Investors understand from past 17
experience in the utility industry that large capital needs
can lead to significant deterioration in financial integrity
that can constrain access to capital, especially during times
of unfavorable capital market conditions. Considering the
uncertain state of financial markets, competition with other
investment alternatives, and investors’ sensitivity to the 23
potential for market volatility, greater credit strength is a

McKenzie, Di 27
Avista Corporation

key ingredient in maintaining access to capital at reasonable
cost. As Mr. Thies confirms in his testimony, ongoing
regulatory support will be a key driver in continuing to
build Avista’s financial health.
Q. What role does regulation play in ensuring that 5
Avista has access to capital under reasonable terms and on a 6
sustainable basis? 7
A. Investors recognize that constructive regulation is
a key ingredient in supporting utility credit ratings and
financial integrity, particularly during times of adverse
conditions. As Moody’s noted, “the regulatory environment is 11
the most important driver of our outlook because it sets the
pace for cost recovery.”19 With respect to Avista
specifically, the major bond rating agencies have explicitly
cited the potential that adverse regulatory rulings could
compromise the Company’s credit standing. S&P observed that 16
the stable outlook on Avista Corp. is due in part to their
expectation that the company “will continue to effectively 18
manage regulatory risks,” and concluded that “greater 19
borrowing or increased rate lag, a large deferral, or adverse

19 Moody’s Investors Service, “Regulation Will Keep Cash Flow Stable As
Major Tax Break Ends,” Industry Outlook (Feb. 19, 2014).

McKenzie, Di 28
Avista Corporation

regulatory decisions” could lead to a downgrade.20 Similarly,
Moody’s concluded that “Avista’s ratings could be negatively 2
impacted if the level of regulatory support wanes.”21
Continuing support for Avista’s financial integrity is 4
imperative to ensure that the Company has the capability to
maintain a strong investment grade rating while confronting
large capital expenditures and other potential challenges.22
Q. Do customers benefit by enhancing the utility’s 8
financial flexibility? 9
A. Yes. Providing an ROE that is sufficient to
maintain Avista’s ability to attract capital under reasonable
terms, even in times of financial and market stress, is not
only consistent with the economic requirements embodied in
the U.S. Supreme Court’s Hope and Bluefield decisions, it is
also in customers’ best interests. Customers enjoy the 15
benefits that come from ensuring that the utility has the
financial wherewithal to take whatever actions are required
to ensure reliable service.

20 Standard & Poor’s Corporation, “Avista Corp.,” RatingsDirect (May 19,
2015).
21 Moody’s Investors Service, “Credit Opinion: Avista Corp.,” Global Credit
Research (Mar. 11, 2015).
22 As noted in the testimony of Mr. Thies, continued regulatory support
will be instrumental in achieving Avista’s objective of a BBB+ rating,
which is consistent with the average credit standing in the electric
utility industry.

McKenzie, Di 29
Avista Corporation

D. Capital Structure 1
Q. Is an evaluation of the capital structure 2
maintained by a utility relevant in assessing its return on 3
equity? 4
A. Yes. Other things equal, a higher debt ratio, or
lower common equity ratio, translates into increased
financial risk for all investors. A greater amount of debt
means more investors have a senior claim on available cash
flow, thereby reducing the certainty that each will receive
his contractual payments. This increases the risks to which
lenders are exposed, and they require correspondingly higher
rates of interest. From common shareholders’ standpoint, a 12
higher debt ratio means that there are proportionately more
investors ahead of them, thereby increasing the uncertainty
as to the amount of cash flow that will remain.
Q. What common equity ratio is implicit in Avista’s 16
requested capital structure? 17
A. Avista’s capital structure is presented in the 18
testimony of Mr. Thies. As summarized in his testimony, the
proposed common equity ratio used to compute Avista’s overall
rate of return is 50.0 percent in this filing.

McKenzie, Di 30
Avista Corporation

Q. What was the average capitalization maintained by 1
the Utility Group? 2
A. As shown on Exhibit No. 3, Schedule 4, for the 16
firms in the Utility Group, common equity ratios at December
31, 2015 ranged between 30.3 percent and 54.8 percent. After
excluding one low-end outlier, the average common equity
ratio was 49.9 percent.
Q. What capitalization is representative for the proxy 8
group of utilities going forward? 9
A. As shown on Exhibit No. 3, Schedule 4, Value Line
expects the individual common equity ratios for the proxy
group of utilities to range from 34.5 percent to 57.5
percent. After again eliminating a single low-end outlier,
the average equity ratio corresponding to Value Line’s three-
to-five year forecast horizon is 50.8%.
Q. How does Avista’s common equity ratio compare with 16
those maintained by the reference group of utilities? 17
A. The 50.0 percent common equity ratio requested by
Avista is consistent with the range of equity ratios
maintained by the firms in the Utility Group and is in-line
with the 48.7 percent and 49.8 percent average equity ratios
at year-end 2015 and Value Line’s near-term expectations,
respectively.

McKenzie, Di 31
Avista Corporation

Q. What implication do the uncertainties inherent in 1
the utility industry have for the capital structures 2
maintained by utilities? 3
A. As discussed earlier, utilities are facing rising
costs, the need to finance significant capital investment
plans, uncertainties over accommodating economic and
financial market uncertainties, and ongoing regulatory risks.
Coupled with the potential for turmoil in capital markets,
these considerations warrant a stronger balance sheet to deal
with an increasingly uncertain environment. The common
equity ratio proposed by Avista is consistent with the need
to maintain the continuous access to capital under reasonable
terms that is required to fund operations and necessary
system investment, including times of adverse capital market
conditions. S&P noted that, “we generally consider a debt to 15
capital level of 50% or greater to be aggressive or highly
leveraged for utilities.”23
Q. What other factors do investors consider in their 18
assessment of a company’s capital structure? 19
A. Depending on their specific attributes, contractual
agreements or other obligations that require the utility to

23 Standard & Poor’s Corporation, “Ratings Roundup: U.S. Electric Utility
Sector Maintained Strong Credit Quality In A Gloomy 2009,” RatingsDirect
(Jan. 26, 2010).

McKenzie, Di 32
Avista Corporation

make specified payments may be treated as debt in evaluating
Avista’s financial risk. Power purchase agreements (“PPAs”),
leases, and pension obligations typically require the utility
to make specified minimum contractual payments akin to those
associated with traditional debt financing and investors
consider a portion of these commitments as debt in evaluating
total financial risks. Because investors consider the debt
impact of such fixed obligations in assessing a utility’s 8
financial position, they imply greater risk and reduced
financial flexibility. In order to offset the debt
equivalent associated with off-balance sheet obligations, the
utility must rebalance its capital structure by increasing
its common equity in order to restore its effective
capitalization ratios to previous levels.
These commitments have been repeatedly cited by major
bond rating agencies in connection with assessments of
utility financial risks.24 The capital structure ratios
presented earlier do not include imputed debt associated with
power purchase agreements or the impact of other off-balance
sheet obligations.

24 Standard & Poor’s Corporation, “Utilities: Key Credit Factors For The
Regulated Utilities Industry,” RatingsDirect (Nov. 19, 2013).

McKenzie, Di 33
Avista Corporation

Q. What does this evidence indicate with respect to 1
the Company’s capital structure? 2
A. Based on my evaluation, I concluded that Avista’s 3
requested capital structure represents a reasonable mix of
capital sources from which to calculate the Company’s overall 5
rate of return. While industry averages provide one
benchmark for comparison, each firm must select its
capitalization based on the risks and prospects it faces, as
well its specific needs to access the capital markets. A
public utility with an obligation to serve must maintain
ready access to capital under reasonable terms so that it can
meet the service requirements of its customers. Financial
flexibility plays a crucial role in ensuring the wherewithal
to meet the needs of customers, and utilities with higher
leverage may be foreclosed from additional borrowing under
reasonable terms, especially during times of stress.
Avista’s capital structure is consistent with industry 17
benchmarks and reflects the challenges posed by its resource
mix, the burden of significant capital spending requirements,
and the Company’s ongoing efforts to strengthen its credit 20
standing and support access to capital on reasonable terms,
and on a sustainable basis.

McKenzie, Di 34
Avista Corporation

III. CAPITAL MARKET ESTIMATES 1
Q. What is the purpose of this section? 2
A. This section presents capital market estimates of
the cost of equity. The details of my quantitative analyses
are contained in Exhibit No. 3, Schedule 2, with the results
being summarized below.
A. Quantitative Analyses 7
Q. Did you rely on a single method to estimate the 8
cost of equity for Avista? 9
A. No. In my opinion, no single method or model
should be relied upon to determine a utility’s cost of equity 11
because no single approach can be regarded as wholly
reliable. Therefore, I used the DCF, CAPM, ECAPM, and risk
premium methods to estimate the cost of common equity. In
addition, I also evaluated a fair ROE using an earnings
approach based on investors’ current expectations in the 16
capital markets. In my opinion, comparing estimates produced
by one method with those produced by other approaches ensures
that the estimates of the cost of equity pass fundamental
tests of reasonableness and economic logic.

McKenzie, Di 35
Avista Corporation

Q. Are you aware that the IPUC has traditionally 1
relied primarily on the DCF and comparable earnings methods? 2
A. Yes, although the Commission has also evidenced a
willingness to weigh alternatives in evaluating an allowed
ROE. For example, while noting that it had not focused on
the CAPM for determining the cost of equity, the IPUC
recognized in Case No. IPC-E-03-13, Order No. 29505 that
“methods to evaluate a common equity rate of return are 8
imperfect predictors” and emphasized “that by evaluating all 9
the methods presented in this case and using each as a check
on the other,” the Commission had avoided the pitfalls
associated with reliance on a single method.25
Q. What specific proxy group of utilities did you rely 13
on for your analysis? 14
A. In estimating the cost of equity, the DCF model is
typically applied to publicly traded firms engaged in similar
business activities or with comparable investment risks. As
described in detail in Exhibit No. 3, Schedule 2, I applied
the DCF model to a utility proxy group composed of those
dividend-paying companies included by Value Line in its
Electric Utilities Industry groups with:
1. S&P corporate credit ratings of BBB-, BBB, or BBB+;

25 Case No. IPC-E-03-13, Order No. 29505 at 38 (2004) (emphasis added).

McKenzie, Di 36
Avista Corporation

2. Moody’s issuer ratings of Baa2, Baa1, or A3;
3. Value Line Safety Rank of 2 or 3;
4. No involvement in a major merger or acquisition;
and,
5. Currently paying common dividends with no recent
dividend cuts.
I refer to this group of 16 comparable-risk firms as the
“Utility Group.”
Q. How do the overall risks of your proxy group 9
compare with Avista? 10
A. Table 4 compares the Utility Group with Avista
across four key indicators of investment risk:
TABLE 4 13
COMPARISON OF RISK INDICATORS 14
15
Q. Do these comparisons indicate that investors would 16
view the firms in your proxy groups as risk-comparable to the 17
Company? 18
A. Yes. Considered together, a comparison of these
objective measures, which consider a broad spectrum of risks,
including financial and business position, and exposure to
Safety Financial
S&P Moody's Rank Strength Beta
Utility Group BBB Baa1 2 B++0.76
Avista BBB Baa1 2 A 0.75
Value Line
Credit Rating

McKenzie, Di 37
Avista Corporation

firm-specific factors, indicates that investors would likely
conclude that the overall investment risks for Avista are
generally comparable to those of the firms in the Utility
Group.
Q. What cost of equity is implied by your DCF results 5
for the Utility Group? 6
A. My application of the DCF model, which is discussed
in greater detail in Exhibit No. 3, Schedule 2, considered
three alternative measures of expected earnings growth, as
well as the sustainable growth rate based on the relationship
between expected retained earnings and earned rates of return
(“br+sv”). As shown on page 3 of Exhibit No. 3, Schedule 5
and summarized below in Table 5, after eliminating illogical
values,26 application of the constant growth DCF model
resulted in the following cost of equity estimates:

26 I provide a detailed explanation of my DCF analysis, including the
evaluation of individual estimates, in Exhibit No. 3, Schedule 2.

McKenzie, Di 38
Avista Corporation

TABLE 5 1
DCF RESULTS – UTILITY GROUP 2
3
Q. How did you apply the CAPM to estimate the cost of 4
equity? 5
A. Like the DCF model, the CAPM is an ex-ante, or
forward-looking model based on expectations of the future.
As a result, in order to produce a meaningful estimate of
investors’ required rate of return, the CAPM is best applied
using estimates that reflect the expectations of actual
investors in the market, not with backward-looking,
historical data. Accordingly, I applied the CAPM to the
Utility Group based on a forward-looking estimate for
investors' required rate of return from common stocks.
Because this forward-looking application of the CAPM looks
directly at investors’ expectations in the capital markets, 16
it provides a more meaningful guide to the expected rate of
return required to implement the CAPM.
Empirical research indicates that the CAPM does not
fully account for observed differences in rates of return
attributable to firm size. The need for an adjustment to
Growth Rate Average Midpoint
Value Line 9.1%10.4%
IBES 9.4%9.5%
Zacks 9.1%9.3%
br + sv 8.3%9.1%
Cost of Equity

McKenzie, Di 39
Avista Corporation

account for relative market capitalization arises because
differences in investors’ required rates of return that are
related to firm size are not fully captured by beta.
Accordingly, my CAPM analyses incorporated an adjustment to
recognize the impact of size distinctions, as developed by
Morningstar.
Q. What cost of equity was indicated by the CAPM 7
approach? 8
A. As shown on page 1 of Exhibit No. 3, Schedule 7,
after incorporating the size adjustment, my forward-looking
application of the CAPM model indicated an ROE of 9.7 percent
for the Utility Group.
Q. Did you also apply the CAPM using forecasted bond 13
yields? 14
A. Yes. As discussed earlier, there is widespread
consensus that interest rates will increase materially as the
economy continues to strengthen. Accordingly, in addition to
the use of current bond yields, I also applied the CAPM based
on the forecasted long-term Treasury bond yields developed
based on projections published by Value Line, IHS Global
Insight and Blue Chip. As shown on page 2 of Exhibit No. 3,
Schedule 7, incorporating a forecasted Treasury bond yield
for 2016-2020 implied a cost of equity of approximately 10.0

McKenzie, Di 40
Avista Corporation

percent for the Utility Group after adjusting for the impact
of relative size.
Q. What cost of equity was indicated by the ECAPM 3
approach? 4
A. My applications of the ECAPM were based on the same
forward-looking market rate of return, risk-free rates, and
beta values discussed above in connection with the CAPM. As
shown on page 1 of Exhibit No. 3, Schedule 8, applying the
forward-looking ECAPM approach to the firms in the Utility
Group results in an average cost of equity estimate of 10.1
percent after incorporating the size adjustment corresponding
to the market capitalization of the individual utilities.
As shown on page 2 of Exhibit No. 3, Schedule 8,
incorporating a forecasted Treasury bond yield for 2016-2020
implied an average cost of equity of approximately 10.4
percent after adjusting for the impact of relative size.
Q. How did you implement the risk premium method? 17
A. I based my estimates of equity risk premiums for
electric utilities on surveys of previously authorized rates
of return on common equity, which are frequently referenced
as the basis for estimating equity risk premiums. My
application of the risk premium method also considered the
inverse relationship between equity risk premiums and

McKenzie, Di 41
Avista Corporation

interest rates, which suggests that when interest rate levels
are relatively high, equity risk premiums narrow, and when
interest rates are relatively low, equity risk premiums
widen.
Q. What cost of equity was indicated by the risk 5
premium approach? 6
A. As shown on page 1 of Exhibit No. 3, Schedule 9,
adding an adjusted risk premium of 5.29 percent to the
average yield on triple-B utility bonds for March 2016 of
5.41 percent resulted in an implied cost of equity of
approximately 10.7 percent. As shown on page 2 of Exhibit
No. 3, Schedule 9, incorporating a forecasted yield for 2016-
2020 and adjusting for changes in interest rates since the
study period implied a cost of equity of approximately 11.7
percent.
Q. Please summarize the results of the expected 16
earnings approach. 17
A. Reference to rates of return available from
alternative investments of comparable risk can provide an
important benchmark in assessing the return necessary to
assure confidence in the financial integrity of a firm and
its ability to attract capital. This expected earnings
approach is consistent with the economic underpinnings for a

McKenzie, Di 42
Avista Corporation

fair rate of return established by the U.S. Supreme Court.
Moreover, it avoids the complexities and limitations of
capital market methods and instead focuses on the returns
earned on book equity, which are readily available to
investors.
Q. What rates of return on equity are indicated for 6
utilities based on the expected earnings approach?
A. Value Line’s projections imply an average rate of 8
return on common equity for the electric utility industry of
10.8 percent over its 2019-2021 forecast horizon.27 As shown
on Exhibit No. 3, Schedule 10, Value Line’s projections for 11
the Utility Group suggest an average ROE of approximately
10.1 percent, with a midpoint value of 10.8 percent.
B. Flotation Costs 14
Q. What other considerations are relevant in setting 15
the return on equity for a utility? 16
A. The common equity used to finance the investment in
utility assets is provided from either the sale of stock in
the capital markets or from retained earnings not paid out as
dividends. When equity is raised through the sale of common
stock, there are costs associated with “floating” the new 21

27 The Value Line Investment Survey (Feb. 19, Mar. 18, & Apr. 29, 2016).
Value Line reports return on year-end equity so the equivalent return on
average equity would be higher.

McKenzie, Di 43
Avista Corporation

equity securities. These flotation costs include services
such as legal, accounting, and printing, as well as the fees
and discounts paid to compensate brokers for selling the
stock to the public. Also, some argue that the “market 4
pressure” from the additional supply of common stock and 5
other market factors may further reduce the amount of funds a
utility nets when it issues common equity.
Q. Is there an established mechanism for a utility to 8
recognize equity issuance costs? 9
A. No. While debt flotation costs are recorded on the
books of the utility, amortized over the life of the issue,
and thus increase the effective cost of debt capital, there
is no similar accounting treatment to ensure that equity
flotation costs are recorded and ultimately recognized. No
rate of return is authorized on flotation costs necessarily
incurred to obtain a portion of the equity capital used to
finance plant. In other words, equity flotation costs are not
included in a utility’s rate base because neither that portion 18
of the gross proceeds from the sale of common stock used to
pay flotation costs is available to invest in plant and
equipment, nor are flotation costs capitalized as an
intangible asset. Unless some provision is made to recognize
these issuance costs, a utility’s revenue requirements will
not fully reflect all of the costs incurred for the use of

McKenzie, Di 44
Avista Corporation

investors’ funds. Because there is no accounting convention 1
to accumulate the flotation costs associated with equity
issues, they must be accounted for indirectly, with an upward
adjustment to the cost of equity being the most appropriate
mechanism.
Q. Is there a theoretical and practical basis to 6
include a flotation cost adjustment in this case? 7
A. Yes. First, an adjustment for flotation costs
associated with past equity issues is appropriate, even when
the utility is not contemplating any new sales of common
stock. The need for a flotation cost adjustment to
compensate for past equity issues has been recognized in the
financial literature. In a Public Utilities Fortnightly 13
article, for example, Brigham, Aberwald, and Gapenski
demonstrated that even if no further stock issues are
contemplated, a flotation cost adjustment in all future years
is required to keep shareholders whole, and that the
flotation cost adjustment must consider total equity,
including retained earnings.28 Similarly, New Regulatory 19
Finance contains the following discussion:

28 Brigham, E.F., Aberwald, D.A., and Gapenski, L.C., “Common Equity
Flotation Costs and Rate Making,” Public Utilities Fortnightly, May, 2,
1985.

McKenzie, Di 45
Avista Corporation

Another controversy is whether the flotation cost
allowance should still be applied when the utility
is not contemplating an imminent common stock
issue. Some argue that flotation costs are real
and should be recognized in calculating the fair
rate of return on equity, but only at the time when
the expenses are incurred. In other words, the
flotation cost allowance should not continue
indefinitely, but should be made in the year in
which the sale of securities occurs, with no need
for continuing compensation in future years. This
argument implies that the company has already been
compensated for these costs and/or the initial
contributed capital was obtained freely, devoid of
any flotation costs, which is an unlikely
assumption, and certainly not applicable to most
utilities. . . . The flotation cost adjustment
cannot be strictly forward-looking unless all past
flotation costs associated with past issues have
been recovered.29
Q. What is the magnitude of the adjustment to the 21
“bare bones” cost of equity to account for issuance costs? 22
A. While there are a number of ways in which a
flotation cost adjustment can be calculated, one of the most
common methods used to account for flotation costs in
regulatory proceedings is to apply an average flotation-cost
percentage to a utility’s dividend yield. Based on a review 27
of the finance literature, New Regulatory Finance concluded:
The flotation cost allowance requires an estimated
adjustment to the return on equity of approximately

29 Morin, Roger A., “New Regulatory Finance,” Public Utilities Reports,
Inc. (2006) at 335.

McKenzie, Di 46
Avista Corporation

5% to 10%, depending on the size and risk of the
issue.30
Alternatively, a study of data from Morgan Stanley
regarding issuance costs associated with utility common stock
issuances suggests an average flotation cost percentage of
3.6 percent.31
Issuance costs are a legitimate consideration in setting
the ROE for a utility, and applying these expense percentages
to the average dividend yield for the Utility Group of 3.3
percent implies a flotation cost adjustment on the order of
12 basis points.32
Q. Has the IPUC Staff previously considered flotation 12
costs in estimating a fair ROE? 13
A. Yes. For example, in Case No. IPC-E-08-10, IPUC
Staff witness Terri Carlock noted that she had adjusted her
DCF analysis to incorporate an allowance for flotation
costs.33

30 Roger A. Morin, “New Regulatory Finance,” Public Utilities Reports, Inc.
at 323 (2006).
31 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 percent.
32 Calculated as the product of the 3.3 percent average dividend yield and
a flotation cost percentage of 3.6 percent. 3.3% x 3.6% = 0.12%
33 Case No. IPC-E-08-10, Direct Testimony of Terri Carlock at 12-13 (Oct.
24, 2008).

McKenzie, Di 47
Avista Corporation

Q. Have other regulators previously recognized that 1
flotation costs are properly considered in setting the 2
allowed ROE? 3
A. Yes. For example, in Docket No. UE-991606 the WUTC
concluded that a flotation cost adjustment of 25 basis points
should be included in the allowed return on equity:
The Commission also agrees with both Dr. Avera and
Dr. Lurito that a 25 basis point markup for
flotation costs should be made. This amount
compensates the Company for costs incurred from
past issues of common stock. Flotation costs
incurred in connection with a sale of common stock
are not included in a utility's rate base because
the portion of gross proceeds that is used to pay
these costs is not available to invest in plant and
equipment.34
IV. OTHER FACTORS 17
Q. What is the purpose of this section? 18
A. This section presents the results of my DCF
analysis applied to a group of low-risk firms in the
competitive sector and discusses the implication of
regulatory mechanisms approved for Avista. It is my opinion
that these findings are a relevant consideration that support
my conclusion that the 9.9% ROE requested by Avista is
conservative.

34 Third Supplemental Order, WUTC Docket No. UE-991606, et al., p. 95
(September 2000).

McKenzie, Di 48
Avista Corporation

A. Non-Utility DCF Model 1
Q. What other proxy group did you consider in 2
evaluating a fair ROE for Avista? 3
A. I also present a DCF analysis for a low risk group
of non-utility firms, with which Avista must compete for
investors’ money. Under the regulatory standards established
by Hope and Bluefield, the salient criterion in establishing
a meaningful benchmark to evaluate a fair ROE is relative
risk, not the particular business activity or degree of
regulation. With regulation taking the place of 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 competition.
Consistent with this accepted regulatory standard, I also
applied the DCF model to a reference group of low-risk
companies in the non-utility sectors of the economy. I refer
to this group as the “Non-Utility Group”.
Q. Do utilities compete with non-regulated firms for 18
capital? 19
A. Yes. The cost of capital is an opportunity cost
based on the returns that investors could realize by putting
their money in other alternatives. Clearly, the total
capital invested in utility stocks is only the tip of the
iceberg of total common stock investment, and there are a

McKenzie, Di 49
Avista Corporation

plethora of other enterprises available to investors beyond
those in the utility industry. Utilities must compete for
capital, not just against firms in their own industry, but
with other investment opportunities of comparable risk.
Indeed, modern portfolio theory is built on the assumption
that rational investors will hold a diverse portfolio of
stocks, not just companies in a single industry.
Q. Is it consistent with the Bluefield and Hope cases 8
to consider required returns for non-utility companies? 9
A. Yes. Returns in the competitive sector of the
economy form the very underpinning for utility ROEs because
regulation purports to serve as a substitute for the actions
of competitive markets. The Supreme Court has recognized
that it is the degree of risk, not the nature of the
business, which is relevant in evaluating an allowed ROE for
a utility. The Bluefield case refers to “business 16
undertakings attended with comparable risks and
uncertainties.”35 It does not restrict consideration to other
utilities. Similarly, the Hope case states:

35 Bluefield Water Works & Improvement Co. v. Pub. Serv. Comm’n, 262 U.S.
679 (1923).

McKenzie, Di 50
Avista Corporation

By that standard the return to the equity owner
should be commensurate with returns on investments
in other enterprises having corresponding risks.36
As in the Bluefield decision, there is nothing to
restrict “other enterprises” solely to the utility industry.
Q. Does consideration of the results for the Non-6
Utility Group make the estimation of the cost of equity using 7
the DCF model more reliable? 8
A. Yes. The estimates of growth from the DCF model
depend on analysts’ forecasts. It is possible for utility 10
growth rates to be distorted by short-term trends in the
industry or the industry falling into favor or disfavor by
analysts. The result of such distortions would be to bias
the DCF estimates for utilities. Because the Non-Utility
Group includes low risk companies from many industries, it
diversifies away any distortion that may be caused by the ebb
and flow of enthusiasm for a particular sector.
Q. How do the overall risks of this Non-Utility Group 18
compare with the Utility Group and Avista? 19
A. Table 6 compares the Non-Utility Group with the
Utility Group and Avista across the four key risk measures
discussed earlier: 22

36 Federal Power Comm’n v. Hope Natural Gas Co. (320 U.S. 391, 1944).

McKenzie, Di 51
Avista Corporation

TABLE 6 1
COMPARISON OF RISK INDICATORS 2

As shown above, the average credit ratings, Safety Rank,
Financial Strength Rating, and beta for the Non-Utility Group
suggest less risk than for Avista and the proxy group of
utilities. These objective indicators suggest that investors
would likely conclude that the overall investment risks for
the Utility Group and Avista are greater than those of the
firms in the Non-Utility Group.
Q. What were the results of your DCF analysis for the 11
Non-Utility Group? 12
A. As shown on Exhibit No. 3, Schedule 11, I applied
the DCF model to the non-utility companies using the same
analysts’ EPS growth projections described earlier for the
Utility Group. As summarized below in Table 7, after
eliminating illogical values, application of the constant
growth DCF model resulted in the following cost of equity
estimates:
Safety Financial
S&P Moody's Rank Strength Beta
Non-Utility Group A-A2 1 A+0.68
Utility Group BBB Baa1 2 B++0.76
Avista BBB Baa1 2 A 0.75
Value Line
Credit Rating

McKenzie, Di 52
Avista Corporation

TABLE 7 1
DCF RESULTS – NON-UTILITY GROUP 2
3
Considering that the investment risks of the Non-Utility
Group are lower than those of the Utility Group and Avista,
these results understate investors’ required rate of return 6
for the Company.
B. Regulatory Mechanisms 8
Q. Did you consider the implications of regulatory 9
mechanisms approved for Avista’s electric utility operations? 10
A. Yes. Adjustment mechanisms and cost trackers have
been increasingly prevalent in the utility industry in recent
years. Reflective of this trend, the companies in my Utility
Group operate under a wide variety of cost adjustment
mechanisms, which range from riders to recover bad debt
expense and post-retirement employee benefit costs to revenue
decoupling and adjustment clauses designed to address rising
capital investment outside of a traditional rate case and
increasing costs of environmental compliance measures.
Growth Rate Average Midpoint
Value Line 9.6%10.1%
IBES 10.3%10.7%
Zacks 10.5%11.2%
Cost of Equity

McKenzie, Di 53
Avista Corporation

Similarly, Moody’s upgraded most regulated utilities in 1
January 2014.37 Recognizing this industry trend, Moody’s 2
premised its assessment of Avista’s risks on the expectation 3
that “similar treatment will be afforded to Avista and that 4
the company will have improved cost recovery mechanisms
(e.g., decoupling).”38 In evaluating Avista’s relative risks,
I referenced the Company’s current credit ratings, which
reflect the investment community’s evaluation of the impact 8
attributable to the FCA. In other words, the implications of
the FCA and other regulatory mechanisms are already fully
reflected in Avista’s credit ratings, which are comparable to 11
those of the proxy group used to estimate the cost of equity.
Thus, while investors would consider the FCA to be supportive
of the Company’s financial integrity and credit ratings, 14
regulatory mechanisms do not provide a basis to distinguish
the risks of Avista from the utilities in my Utility Group.
Q. Does this conclude your pre-filed direct testimony? 17
A. Yes.

37 Moody’s Investors Service, “US utility sector upgrades driven by stable
and transparent regulatory frameworks,” Sector Comment (Feb. 3, 2014).
38 Moody’s Investors Service, “Avista Corp.,” Global Credit Research (Mar.
28, 2014).