20190610McKenzie Direct.pdf

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DAVID J. MEYER
VICE PRESIDENT AND CHIEF COUNSEL OF
REGULATORY & GOVERNMENTAL AFFAIRS
AVISTA CORPORATION
P.O.BOX3727
1411 EAST MISSION AVENUE
SPOKANE, WASHINGTON 99220 -37 21
TELEPHONE: (509)49s-43r6
FACSIMILE: (s09)49s-88s1
REC E IVE D
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':ilELlC;iLil'ilri CCtlt{lSSl
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 SERVICE
TO ELECTRIC CUSTOMERS IN THE
STATE OF IDAHO
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CASE NO. AVU-E-19-04
DIRECT TESTIMONY
OF
ADRIEN M. MCKENZIE
FOR AVISTA CORPORATION
(ELECTRIC)
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o DIRECT TESTIMONY OF ADRIEN M. MCKENZIE
TABLE OF CONTENTS
I. INTRODUCTION.....I
I
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9
9
II.
A. Overview.............
B. Summary of Conclusions......
RISKS OF AVISTA
A. Operating Risks...
B.
C.
D.
Other Factors......
Support for Avista's Credit Standing.....
Outlook for Capital Costs
I4
.... 18
2l
E. Capital Structure ...25
M. CAPITAL MARKET ESTIMATES 29
A. Quantitative Analyses.....
B. Non-Utility DCF Model..
C. Flotation Costs
...29
...36
...39
...45IV. IMPACT OF REGULATORY MECHANISMS
o Exhibit No. 3
Schedule 1 - Qualifications of Adrien M. McKenzie
Schedule 2 - Description of Quantitative Analyses
Schedule 3 - ROE Analysis - Summary of Results
Schedule 4 - Capital Structure
Schedule 5 - Constant Growth DCF Model - Utility Group
Schedule 6 - Sustainable Growth Rate - Utility Group
Schedule 7 - Caprtal Asset Pricing Model
Schedule 8 - Empirical Capital Asset Pricing Model
Schedule 9 - Electric Utility Risk Premium
Schedule 10 - Expected Earnings Approach
Schedule 1 I - Constant Growth DCF Model - Non-Utility Group
Schedule 12 - Flotation Cost Study
Schedule 13 - Regulatory Mechanisms - Utility Group
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I. INTRODUCTION
a. Please state your name and business address.
A. Adrien M. McKenzie,3907 Red River, Austin, Texas, 78751.
a. In what capacity are you employed?
A. I am President of FINCAP, Inc., a firm engaged in financial, economic, and
policy consulting services to business and government.
a. Please describe your educational background and professional
experience.
A. A description of my background and qualifications, including a resume
containing the details of my experience, is attached as Exhibit No. 3, Schedule l.
a. what is the purpose "ri"***.,r,r*y in this case?
A. The purpose of my testimony is to present to the Idaho Public Utilities
Commission (the "Commission" or "IPUC") my independent evaluation of the fair rate of
return on equity ("ROE") for the jurisdictional electric utility operations of Avista Corp.
("Avista" or "the Company"). In addition, I also examined the reasonableness of Avista's
capital structure, considering both the specific risks faced by the Company and other
industry guidelines.
a. Please summarize the information and materials you relied on to support
the opinions and conclusions contained in your testimony.
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
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o organization, finances, and operations of Avista from my participation in prior proceedings
before the IPUC, the Washington Utilities and Transportation Commission ("WIJTC") and
the Oregon Public Utility Commission. [n 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 beffer familiarize myself with
Avista's utility 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 issues relevant to
investors' required return for Avista, and they form the basis of my analyses and
conclusions.
a. How is your testimony organized?
A. After first summarizing my conclusions and recommendations, my testimony
reviews the operations and finances ofAvista 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 Capital Asset Pricing Model ("CAPM"), the empirical form of Capital Asset Pricing
Model ("ECAPM"), an equity risk premium approach based on allowed ROEs for electric
utilities, and reference to expected rates of retum for electric utilities, which are all methods
that are commonly relied on in regulatory proceedings. Based on the cost of equity
estimates indicated by *y analyses, the Company's ROE was evaluated taking into account
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the specific risks and potential challenges for Avista's electric utility operations in Idaho, as
well as flotation costs, which are properly considered in setting a fair ROE for the Company.
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 forAvista.
a. What is the role of the ROE in setting a utility's rates?
A. The ROE is the cost of attracting and retaining common equity investment in
the utility's physical plant and 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 Bluefield
and Hopez cases, which state that a utility's allowed ROE should be sufficient to: 1) fairly
compensate the utility's investors,2) enable the utility to offer a return adequate to attract
new capital on reasonable terms, and 3) maintain the utility's financial integdty.3 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.
I Blue/ield Ll/ater Works & Improvement Co. v. Pub. Serv. Comm'n,262U.5.679 (1923) ("Bluefield').
2 Fed. Power Comm'n v. Hope Natural Gas Co.,320 U.S. 591 (1944) ("Hope").
3 The Idaho Supreme Court has adopted these standards (see Application of Citizens Utilities Co., I 12 Idaho
1 06 l, 1 067, 739 P.2d 360, 366 (1987)).
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a.
A.
B. Summary of Conclusions
Please summarize the results of your analyses.
The results of my analyses are presented on Exhibit No. 3, Schedule 3, and in
TABLE 1
SUMMARY OF RESULTS
Table 1, below:
DCF
Value Line
IBES
Tacks
lnternal br * sv
cAPy
Empilcal CAPM
Utilitv Risk Premium
Current Bond Yields
Projected Bond Yields
Exnected Earninss
Cost of Equitv Recommendation
Cost of Equity Range
rc.20A7
10.60 10
lo.70h 11 ll.40A ts
9.8o/o l0.go
10.9o/o
Average
rc.\Yo3
10.006 4
9.20 2
g.goA I
rc.4rhe
n3\o 13
Midpoint
ll.4Yo t4
ll.50A t6
rc.006 5
rc.20 8
rc.P 6
ll.lyo 12
Flotation Cost Adiustment 0.t%
Reco@ 9.9o/o
Note: Footnotes correspondto rankorder inthe subsequent figure.
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Figure 1, below, presents the 16 cost of equity estimates presented in Table 1 in rank
order, and compares them with Avista's 9.9 percent ROE request:
FIGURE 1
RESULTS OF ANALYSES VS. AVISTA REQUEST
12.0o/o
11.5o/o
11.0o/o
lO.5o/o
10.0%
9.5o/o
9.OVo
E.50/o
E.OVo
7.syo
7 .09/o I 2 3 4 5 6 7 8 9 l0 lt 12 t3 t4 15 16
N RoEMethods
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AvistaRequest
a. What are your findings regarding the 9.9 percent ROE requested by
Avista?
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 for Avista. The bases for my
conclusion are summarized below:
In order to reflect the risks and prospects associated with Avista's jurisdictional
utility operations, my analyses focused on a proxy group of 22 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.
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a 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 9.8 percent to 10.8 percent range, or 9.9 percent to
10.9 percent after incorporating an adjustment to account for the impact of
common equity flotation costs.
As reflected in the testimony of Mark T. Thies, Avista is requesting an ROE of
9.9 percent, which falls below the 10.4 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.
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
$400 million per year through 2030 heighten the uncertainties associated
with Avista, especially given that the Company's existing rate base is
approximately $3.3 billion.
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 volatility, even with the Power Cost
Adjustment Mechanism ("PCA").
o Avista's opportunity to actually eam a fair ROE and mitigate exposure to
eamings attrition is an important objective.
o My conclusion that a 9.9 percent ROE for Avista is a conservative estimate
of investors' required return is also reinforced by the greater uncertainties
associated with Avista's relatively small size.
Investors recognize that constructive regulation is a key ingredient in supporting
utility credit standing and financial integrity and providing Avista with the
opportunity to earn a return that adequately reflects its risks is an essential
ingredient to support the Company's financial position, which ultimately benefits
customers by ensuring reliable service at lower long-run costs.
Continued support for Avista's financial integrity, including the opportunity to
actually earn 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.
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a. What other evidence did you consider in evaluating your ROE
13 recommendation in this case?
t4 A. My recommendation is reinforced by the following findings:
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a 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 regulatory mechanisms are already reflected in the results of my
analyses.
These flrndings indicate that the 9.9 percent ROE requested by Avista is reasonable and
should be approved.
a. What else is relevant in weighing your quantitative results?
A. No single methodology used to estimate the cost of equity is inherently
superior, and the results of alternative quantitative approaches should serve as an integral
part of the decision-making underlying the determination of a just and reasonable ROE. In
this light, it is important to consider alternatives to the DCF model.a As shown in Table l,
alternative risk premium models (i.e., the CAPM, ECAPM, and utility risk premium
approaches) produce ROE estimates that generally exceed the DCF results. My expected
earnings approach corroborated these outcomes.
O. What did the DCF results for your select group of non-utility firms
indicate with respect to your evaluation?
A. Average DCF estimates for a low-risk group of firms in the competitive
sector of the economy ranged from 9.6 percent to 10.2 percent, and averaged 10.0 percent.
These results confirm that a 9.9 percent ROE falls in the lower end of the reasonable range
a As discussed in Exhibit No. 3, Schedule 2, this is consistent with the ROE methodology recently proposed by
Federal Energy Regulatory Commission (*FERC"), which considers the results of four different
methodologies, including the same CAPM, risk premium, and expected eamings approaches applied in my
testimony. See, e.g., Coakley v. Bangor Hydro-Elec. Co., Order Directing Briefs, 165 FERC fl 61,030 (2018).
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to maintain Avista's financial integrity, provide a return commensurate with investments of
comparable risk, and support the Company's ability to attract capital.
a. What other factors should be considered in evaluating the ROE
requested by Avista in this case?
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 remains prepared to respond to unforeseen events that may materialize in the future.
Recent erosion in Avista's credit standing highlights the imperative of buttressing the
Company's financial 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 by the operating risks associated with Avista's reliance on hydroelectric
generation and the higher uncertainties associated with Avista's relatively small size.
a. Does an ROE of 9.9 percent represent a reasonable cost for Avista's
customers to pay?
A. Yes. Investors make capital available to Avista only if the expected returns
justify the risk. Customers will 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.
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a. What is your conclusion as to the reasonableness of the Company's
capital structure?
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.
This conclusion was based on the following findings:
a Avista's requested capitalization is consistent with the Company's need to
support its credit standing and financial flexibility as it seeks to raise additional
capital to fund significant system investments, refinance maturing debt securities,
and meet the requirements of its service territory.
Avista's proposed common equity ratio is consistent with the range of
capitalizations for the proxy utilities, both for year-end 2018 and based on the
near-term expectations of the Value Line Investment Survey ("Value Line").
The requested capitalization reflects the importance of an adequate equity layer
to accommodate Avista's operating risks and recognize the impact of off-balance
sheet commitments such as purchased power agreements, which carry with them
some level of imputed debt.
II. RISKS OF AVISTA
a. What is the purpose of this section?
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.
perceptions?
A. Operatins Risks
How does Avista's generating resource mix affect investors' risk
A. Because approximately 49 percent of Avista's total energy requirements are
provided by hydroelectric facilities, the Company is exposed to a level of uncertainty not
faced by most utilities. While hydropower confers advantages in terms of fuel cost savings
and diversity, reduced hydroelectric generation due to below-average water conditions
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forces Avista to rely more heavily on wholesale power markets or more costly thermal
generating capacity to meet its resource needs. As Standard & Poor's Corporation, now
S&P Global Ratings ("S&P"), has observed:
A reduction in hydro generation typically increases an electric utility's costs
by requiring it to buy 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 more power than under normal conditions,
paying higher prices.s
lnvestors recognize that the potential for volatile energy markets, unpredictable stream
flows, and Avista's reliance on 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 and cost-update mechanisms."6 Similarly, Moody's
lnvestors Service ("Moody's") has recognized that, "Avista's high dependency on hydro
resources (approximately 50o/o 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 weather, is a factor outside of
management's control."T More recently, S&P aff,rrmed the importance of constructive
regulation in light of the potential need to "maintain operating cash flow after purchasing
power for customers when the hydroelectric generation is unavailable,"8 and confirmed that
s Standard & Poor's Corporation, Pacific Northwest Hydrology And lts Impact On Investor-Owned Utilities'
Credit Quality, RatingsDirect (Jan. 28, 2008).
6Id.
7 Moody's Investors Service, Credit Opinion: Avista Corp., Global Credit Research (Mar. 17,20ll).
8 Standard & Poor's Corporation, Avista Corp., RatingsDirect (May 26,2016).
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o "dependence on hydro-electric generation introduces fuel replacement risk during periods of
unfavorable hydro conditions."e Avista's reliance on purchased power to meet shortfalls in
hydroelectric generation magnifies the importance of strengthening financial flexibility,
which is essential to guarantee access to the cash resources and interim financing required to
cover inadequate operating cash flows.
a. Do financial pressures associated with Avista's planned capital
expenditures also impact investors' risk assessment?
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 $400 million annually for the five year period ending December 31,2023.
This represents a substantial investment given Avista's current rate base of approximately
$3.3 billion. tn addition, as discussed in the testimony of Mr. Theis, beginning in 2019
through 2023 the Company is obligated to repay maturing long-term debt totaling $405.5
million.
Continued support for Avista's financial integrity and flexibility will be instrumental
in attracting the capital necessary to fund these projects and debt repayments 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
e S&P Global Ratings, Avista Corp. Ratings Affirmed; Off Watch Positive; Outlook Stable, Research Update
(Dec. 10.2018).
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Moody's has noted that increasing capital expenditures are a primary credit concern for
Avista.lo
a. Do utility such as Avista continue to face environmental risks?
A. Yes. Environmental concerns are leading to a profound transformation in the
electric utility industry The generation segment is undergoing material changes in fuel mix,
as natural gas and renewable sources increasingly supplant coal. Over the next decade,
renewable sources are widely expected to account for a rising share of the electricity
generated in the U.S., including a significant expansion in distributed generation, which will
accompany declining costs and increased efficiency of energy storage technologies.
Accommodating this effort to decarbonize generation will also require significant
investment to modernizethe transmission grid. And while this disruption offers the potential
for growth through increased capital investment, it also conveys higher risks, such as the
potential for stranded costs. With respect to Avista, S&P noted that the "environmental
footprint is a significant risk factor." As S&P explained, "[t]his reflects the potential for
ongoing cost of operating fossil units in the face of disruptive technology advances and the
potential for changing environmental regulations that may require significant capital
investments."l l
r0 Moody's Investors Service, Credit Opinion: Avista Corp.,Global Credit Research (Mar. I l, 2015).rr S&P Global Ratings, Avista Corp. Ratings Affirmed; Off Watch Positive; Outlook Stable, Research Update
(Dec. 10, 2018).
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a. Would investors consider Avista's relative size in their assessment of the
Company's risks and prospects?
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 $2.7 billion, Avista is
one of the smallest publicly traded electric utility holding companies followed by Value
Line, which have an average capitalization of approximately $20.8 billion.12
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 their relative lack of diversification and lower financial
resiliency.l3 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.la 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.
12 The Value Line Investment Survey (Feb. 15, Mar. 15, & Apr. 26,2019).
13 It is well established in the financial literature that smaller firms are more risky than larger frms. See, e.g.,
Eugene F. Fama and Kenneth R. French, The Cross-Section of Expected Stock Returns, Joumal 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).
ra See for example Rolf W. Banz, The Relationship Between Return and Market Value of Common Stocks,
Joumal of Financial Economics (September 1981) at 16.
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B. Other Factors
a. Would investors consider the potential impact of Avista's exposure to
earnings attrition?
A. Yes. The deterioration of actual return below the allowed return that occurs
when the relationships between revenues, costs, and rate base used to establish rates (e.g.,
using a historical test year without adequate adjustments) do not reflect the actual costs
incurred to serve customers can lead to earnings shortfalls. Investors are concemed with
what they can expect in the future, not what they might expect in theory if a historical test
year were to repeat. To be fair to investors and to benefit customers, a regulated utility must
have a reasonable opportunitv to actually earn a retum that will maintain financial integrity,
facilitate capital attraction, and compensate for risk. In other words, it is the end result in
the future that determines whether or not the Hope and Bluefield standards are met.
Ratemaking practices that allow the utility an opportunity to actually earn its
authorized ROE are consistent with fundamental regulatory principles. The Supreme Court
has reaffirmed that the end result test must be applied to the actual returns that investors
expect if they put their money at risk to finance utilities.ls That end result would maintain
the utility's financial integrity, ability to attract capital and offer investors fair compensation
for the risk they bear.
ts 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 acfual 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.
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a. What other considerations have impact investors' risk evaluation for
utilities?
A. Income taxes, like other expenses necessary to provide utility service, are one
component of the cost of service. Amendments to the tax code stemming from the Tax Cuts
and Jobs Act ("TCJA") have served to reduce rates for customers, but they also have had
detrimental implications for the credit standing of regulated utilities. By lowering the
income tax allowance reflected in rates and requiring the eventual refund of excess
accumulated deferred income taxes, the TCJA results in reduced cash flow and weaker credit
metrics for utilities.
For example, Moody's initially revised its ratings outlook for 24 utilities from
"stable" to "negative," and one utility from "positive" to "stable," due to the potential
impact of the TCJA on cash flows and financial integrity.l6 As Moody's observed:
Investors-owned utilities' rates, revenue and profits are heavily regulated.
The rate regulators allow utilities to charge customers based on a cost-plus
model, with tax expense being one of the pass-through items. In practice,
regulated utilities collect revenues from customers based on book tax expense
but typically pay much less tax in cash. Under the new tax regime, utilities
will collect less revenue associated with tax expenses and pay out more cash
tax, squeezing its cash flows.17
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20 Moody's noted that supportive regulatory actions, in the form of timely cost recovery and
2l constructive determinations regarding capital structure and ROE, would be important to
22 stave offdeterioration in credit metrics and potential ratings downgrades.l8
r6 Moody's Investors Service, Moody's changes outlool<s on 25 US regulated utilities primarily impacted by
tax reform, Ratings Action (Jan. 19, 2018).
17 Moody's Investor Service, Tax reform is credit negativefor sector, but impact varies by company, Sector
Comment (J an. 24, 20 18).
18 Moody's Investors Service, Moody's changes outlooks on 25 US regulated utilities primarily impacted by
tax reform, Ratings Action (Jan. 19, 2018).
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Avista Corporation
o I Similarly, S&P highlighted the potential negative financial consequences of the
2 TCJA for rate-regulated utilities:
The impact of tax reform on utilities is likely to be negative to varying
degrees depending on a company's tax position going into 2018, how its
regulators react, and how the company reacts in return. It is negative for
credit quality because the combination of a lower tax rate and the loss of
stimulus provisions related to bonus depreciation or full expensing of capital
spending will create headwinds in operating cash-flow generation capabilities
as customer rates are lowered in response to the new tax code. . . . Regulators
must also recognize that tax reform is a strain on utility credit quality. and we
expect companies to request stronger capital structures atd othelrneaus lq
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offset some of the negative impact.le
Fitch also highlighted its expectation that the TCJA "has negative credit implications for
regulated utilities and utility holding companies over the short to medium term,"2O and
concluded that:
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The impact could be sharpened or softened by regulators depending on how
much they want to lower utility rates immediately instead of using some of
the lower revenue requirement from tax reform to allow the utility to retain
the cash for infrastructure investment or other expenses. Regulators must
also recognize that tax reform is a strain on utility credit quality, and we
expect companies to request stronger capital structures and other means to
offset some of the negative impact.2l
As Fitch concluded, "[a]bsent mitigating strategies on the regulatory front, this is expected
to lead to weaker credit metrics and negative ratings actions,"22 and an "IilngrcAgg-in
authorized equitv ratio and/or retum on equity"would be one tool to suooort utilities' credit
standing.23 Coupled with the need to undertake significant new capital investment, the
le S&P Global Ratings, U.S. Tax Reform: For Utilities'Credit Quality, Challenges Abound, RatingsDirect
(J an. 24, 20 1 8) (emphasis added).
20 Fitch Ratings Inc., Tax Reform Impact on the U.S. Utilities, Power & Gas Sector, Special Report (Jan.24,
20 l 8).
2t Id.
22 Id.
23 Id. (emphasis added).
McKenzie, Di 16
Avista Corporation
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implications of the TCJA heighten the importance of supportive regulatory actions in order
to maintain utilities'financial integrity and access to capital.
a. What is Moody's current outlook for utilities?
A. On June 18, 2018, Moody's announced that it was changing the utility sector
outlook from stable to negative.2a Moody's stated that:
The change in outlook primarily reflects a degradation in key financial credit
ratios...The change in outlook also reflects uncertainty with respect to the
timing and extent of potential changes in regulatory recovery provisions,
authorized retums and equity layers or self-help options by individual
companies in response to lower cash flow."25
The change in fundamental sector outlook reflects a declining financial trend,
which is a function of higher holding company debt levels incurred in the
past few years and a lower deferred tax contribution to cash flow going
forward due to tax reform.26
a. Has the TCJA impacted Avista's risk profile?
A. Yes. With respect to Avista specifically, Moody's recently downeraded the
Company's credit rating from Baal to Baa2, in part due to the impact of the TCJA.
Moody's noted that "[p]re-tax reform, deferred income taxes constituted a significant
portion ofAvista's operating cash flow," and concluded declining cash flow due to the TCJA
has eroded Avista's financial metrics.2T
2a Moody's Investors Service, Announcement: Moody's changes the US regulated utility sector outlook to
negative from stable,(June 18, 2018).
2s Id.
26 Id.
27 Moody's Investors Service, Moody's downgrades Avista Corp. to Baa2, outlook stable, Rating Action (Dec.
2,20t8).
McKenzie, Di 17
Avista Corporation
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C. Support for Avista's Credit Standing
a. What credit ratings have been assigned to Avista?
A. S&P has assigned Avista a corporate credit rating of "BBB", while Moody's
has setAvista's Issuer Rating at"Baa2".
a. What considerations impact investors' assessment of the firms in the
utility industry?
A. Numerous factors have the potential to impact investors' perceptions of the
relative risks inherent in the utility industry and have implications for the financial 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.
a. What are the implications for Avista?
A. The pressures of significant capital expenditure requirements, along with the
need to refinance maturing debt obligations, reinforce the importance of supporting
improvement in Avista's credit standing. lnvestors understand from past 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 potential for financial market instability, competition
with other investment alternatives, and investors' sensitivity to the potential for market
McKenzie, Di 18
Avista Corporation
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volatility, greater credit strength is a 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 maintaining and enhancing Avista's financial health.
a. Throughout your testimony you refer repeatedly to the concepts of
"financial strengthr" "financial integrityr" and "financial flexibility." Would you
briefly describe what you mean by these terms?
A. These terms are generally synonymous and refer to the utility's ability to
attract and retain the capital that is necessary to provide service at reasonable cost, consistent
with the Supreme Court standards. Avista's plans call for a continuation of capital
investments to preserve and enhance service reliability for its customers. The Company
must generate adequate cash flow from operations to fund these requirements and for
repayment of maturing debt, together with access to capital from external sources under
reasonable terms, on a sustainable basis.
Rating agencies and potential debt investors tend to place significant emphasis on
maintaining strong financial metrics and credit ratings that support access to debt capital
markets under reasonable terms. This emphasis on financial metrics and credit ratings is
shared by equity investors who also focus on cash flows, capital structure and liquidity,
much like debt investors. Investors understand the important role that a supportive
regulatory environment plays in establishing a sound financial profile that will permit the
utility access to debt and equity capital markets on reasonable terms in both favorable
f,rnancial markets and during times of potential disruption and crisis.
McKenzie, Di 19
Avista Corporation
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a. What role does regulation play in ensuring that Avista has access to
capital under reasonable terms and on a sustainable basis?
A. Regulatory signals are a major driver of investors' risk assessment for
utilities. lnvestors 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 the most important driver of our outlook
because it sets the pace for cost recovery."28 Similarly, S&P observed that, "Regulatory
advantage is the most heavily weighted factor when S&P Global Ratings analyzes a
regulated utility's business risk profile."2e Value Line summaizes these sentiments:
As we often point out, the most important factor in any utility's success,
whether it provides electricity, gas, or water, is the regulatory climate in
which it operates. Harsh regulatory conditions can make it nearly impossible
for the best run utilities to earn a reasonable return on their investment.3o
More recently, in response to concerns regarding the potential negative impact of the TCJA
on utilities' financial strength, the investment community has emphasized the need for
supportive regulatory actions to bolster cash flows.
a. Do customers benefit by enhancing the utility's financial flexibility?
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 benefits that
28 Moody's Investors Service, Regulation Will Keep Cash Flow Stable As Major Tax Break Ends,Industry
Outlook (Feb. 19, 2014).
2e S&P Global Ratings, Assessing U.S. Investors-Owned Utility Regulatory Environments, RatingsExpress
(Aug. 10,2016).
30 Value Line Investment Survey, Water Utility Industry (Jan. 13, 2017) atp. 1780.
McKenzie, Di 20
Avista Corporation
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come from ensuring that the utility has the financial wherewithal to take whatever actions
are required to ensure safe and reliable service.
D. Outlook for Capital Costs
a. Please summarize current economic and capital market conditions.
A. Investors have faced renewed volatility as capital markets have responded to
uncertainties regarding the implications of an expanding economy at or near full
employment, indications of price pressures and wage gains, coupled with the massive f,rscal
stimulus under the TCJA. These underlying risks have been exacerbated by concerns over
continued geopolitical instability and the implications of the Trump Administration's tariff
policies. Fears of an escalating international trade war with China have mounted in the face
of uncertainties over the ability to successfully negotiate a trade deal, while investors
continue to confront signs of global economic weakness. Economic activity has remained
weak in many emerging market economies, including Brazil and Mexico, along with
continued signs of softening in China and the Eurozone, which faces uncertain
developments surrounding Brexit.
In the U.S., growth in real gross domestic product remains on a solid pace in 2019,
supported by inventory investment exports, and state and local government spending. After
disappointing job gains in February 2019, employment resumed a more favorable trend and
the unemployment rate fell to 3.6 percent in April 2019, the lowest rate since 1969 and
indicative of a strong labor market. Consumer spending remains upbeat and inflation
appears to have moderated, with changes in the core price index falling somewhat below the
Federal Reserve's 2.0 percent guideline. On balance, these indicators point to continued
resilience in the U.S. economy.
McKenzie, Di 2l
Avista Corporation
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a. What is the recent direction of Federal Reserve monetary policies?
A. On December 20,2018, the Federal Reserve raised the target range for its
benchmark funds rate by 25 basis points, the ninth such move since the Fed began
normalizing rates in December 2015. ln response to muted upward pressure on prices and a
number of potential risks to the economic outlook-including international developments-
the Federal Reserve has indicated that intends to adopt a more patient and accommodative
stance to future policy adjustments. While observing that the appropriate target range for
the federal funds rate will depend on future data, a majority of the Federal Open Market
Committee continues to expect that the range will move higher through 202L.
The Federal Reserve continues to exert considerable influence over capital market
conditions through its massive holdings of Treasuries and mortgage-backed securities, which
continue to exceed $3.8 trillion.3r While beginning a gradual balance sheet normalization
program in October 2017, the Fed has indicated that it now intends to slow the reduction in
its holdings of Treasury securities by reducing the cap on monthly redemptions from $30
billion to $15 billion beginning in May 2019. Reductions to the holdings of Treasury bonds
are expected to conclude in September 2019, while the Federal Reserve intends to continue
shrinking its investment in agency debt and mortgage-backed securities at a gradual pace.
a. Have the ongoing uncertainties regarding Federal Reserve policies been
recognized by the investment community?
A. Yes. As The Economist noted:
3t Factors Affecting Reserve Balances,H.4.l (May 2,2019).
https://wwrv.f'ederalreserve.gov/releases/h41/current/. Prior to the initiation of the stimulus program in2009,
the Federal Reserve's holdings of U.S. Treasury bonds and notes amounted to approximately $400-$500
billion.
McKenzie, Di 22
Avista Corporation
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Concerns are growing that the Fed might trip up. It has no guiding example
of reversing [quantitative easing] and quitting a zero-interest-rate policy. Tax
cuts in America complicate the Fed's task. Higher barriers to trade will add
to inflation and hurt GDP, but to an extent that is hard to fathom.32
Despite an apparent hiatus in the policy of normalizing short-term interest rates and the size
of its balance sheet, investors continue to confront uncertainties over the future trajectory of
monetary policies, which have significant, but unknown implications for financial markets.
The unprecedented nature of these normalization efforts and their impacts on investors'
expectations further support the consideration of alternatives to DCF analyses and other
ROE benchmarks when evaluating a just and reasonable ROE forAvista.
a. Is there evidence that investors continue to anticipate higher interest
rates?
A. Yes. Investors continue to anticipate a continuation of the present economic
expansion, which, coupled with the impact of fiscal policies and expanding federal deficits,
contributes to ongoing expectations for higher capital costs. The table below compares
current interest rates on l0-year and 3O-year Treasury bonds, triple-A rated corporate bonds,
and double-A rated utility bonds with the average of near-term projections from Value Line,
IHS Global Insight, Blue Chip Financial Forecasts, and the Energy Information
Administration ("ElA") :
32 The Economist, Even stockmarket bulls are more cautious than at the start of the year, Buttonwood (Jul. 12,
2018).
McKenzie, Di 23
Avista Corporation
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TABLE 2
INTEREST RATE TRENDS
10-Yr. Treasury
30-Yr. Treasury
Aaa Corporate
Aa Utility
Apr. 2019
2.5%
2.9%
3.7%
3.9%
2019
3.2%
3.4%
4.3%
4.7%
2020
3.4%
3.6%
45%
4.9%
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Sources:
Moody's Investors Service.
https : //fredstloui s fed.org/.
Value Line Investment Survey, Forecast for the U.S. Economy (Mar. 1,2019).
IHS Global hsight, Long-Term Macro Forecast - Baseline (Apr. 30, 2019).
Enerry Information Administration, Annual Energy Outlook 20l9 (Jan 24,2019).
Wolters Kluwer, Blue Chip Financial Forecasts, (Dec. l, 2018).
As the table shows, investors continue to anticipate higher interest rates over the
near-term. These projections are from forecasting services that are highly regarded and
widely referenced. The interest rate increases shown in the table above are on the order of
70-100 basis points through 2020, which implies higher long-term capital costs over the
period when rates established in this proceeding will be in effect.
a. Is it necessary that interest rate forecasts, like those shown above, be
perfectly accurate in order to be relied on?
A. No. When estimating investors' required rate of retum, what investors
expect, not what actually happens, is what matters most. While the projections of various
services may be proven optimistic or pessimistic in hindsight, this is irrelevant in assessing
expected interest rates and how they might influence the Company's allowed ROE. Any
difference in actual rates as compared to analysts'forecasts is beside the point. What is most
important is that investors share analysts' views when the forecasts were made and
incorporate those views into their decision making process, not the actual rates that
ultimately transpire.
McKenzie, Di 24
Avista Corporation
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a. Do ongoing economic and capital market uncertainties also influence the
appropriate capital structure for Avista?
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 or have
limited access to 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.
E. Capital Structure
a. Is an evaluation of the capital structure maintained by a utitity relevant
in assessing its return on equity?
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 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.
McKenzie, Di 25
Avista Corporation
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a. What common equity ratio is implicit in Avista's requested capital
structure?
A. Avista's capital structure is presented in the testimony of Mr. Thies. As
summarized in his testimony, the proposed capital structure used to compute Avista's overall
rate of return consists of 50 percent equity / 50 percent long-term debt in this filing.
a. What was the average capitalization maintained by the Utility Group?
A. As shown on page I of Exhibit No. 3, Schedule 4, for the 22 firms in the
Utility Group, common equity ratios at December 31,2018 ranged between 26.9 percent and
71.4 percent and averaged 45.7 percent.
a. What capitalization is representative for the proxy group of utilities
going forward?
A. As shown on page I of Exhibit No. 3, Schedule 4, Value Line expects an
average common equity ratio for the proxy group of utilities of 48.0 percent for its three-to-
five year forecast horizon, with the individual common equity ratios ranging from 33.5
percent to 61.5 percent.
a. How does Avista's proposed equity ratio compare with those of the
operating companies held by the proxy group parent companies?
A. The individual operating company capital structures are presented on page 2
of Exhibit No. 3, Schedule 4. As shown there, the operating company equity ratios ranged
from 44.8 percent to 16.4 percent. The simple average of these results points to an equity
ratio of 54.1 percent; the average weighted by total caprtalization for each operating entity
was 51.9 percent.
McKenzie, Di 26
Avista Corporation
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have for the capital structures maintained by utilities?
A. As discussed earlier, utilities are facing rising cost structures, 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. A more conservative financial profile, in the
form of a higher common equity ratio, is consistent with increasing uncertainties and 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. This is consistent with the views of the investment community, as reflected in
the comments of the ratings agencies discussed earlier in my testimony, with both Moody's
and Fitch highlighting the need for constructive determinations regarding capital structure,
with Fitch expressly noting the importance of "stronger capital structures . . . to offset some
of the negative impact" associated with the TCJA.33
a. What other factors do investors consider in their assessment of a
company's capital structure?
A. Depending on their specific attributes, contractual agreements or other
obligations that require the utility to make specified payments may be treated as debt in
evaluating Avista's financial risk. Power purchase agreements, leases, and pension
obligations typically require the utility to make specified minimum contractual payments
33 Fitch Ratings Inc., Tax Reform Impact on the U.S. Utilities, Power & Gas Sector, Special Report (Jan.24,
20 l 8).
McKenzie, Di 27
Avista Corporation
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these commitments as debt in evaluating total financial risks. Because investors consider
the debt impact of such fixed obligations in assessing a utility's financial position, they
imply greater risk and reduced financial flexibility. These commitments have been
repeatedly cited by major bond rating agencies in connection with assessments of utility
financial risks.3a [n 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. Unless the utility
takes action to offset this additional financial risk by maintaining a higher equity ratio, the
resulting leverage will weaken its creditworthiness and imply greater risk.
a. What does this evidence indicate with respect to the Company's capital
structure?
A. Based on my evaluation, I concluded that Avista's requested capital structure
represents a reasonable mix of capital sources from which to calculate the Company's
overall 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
3a See, e.g., Standard & Poor's Corporation, Utilities: Key Credit Factors For The Regulated Uilities Industry,
RatingsDirect (Nov. 19, 2013).
McKenzie, Di 28
Avista Corporation
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foreclosed from additional borrowing under reasonable terms, especially during times of
stress.
Avista's capital structure is consistent with range of equity ratios maintained by the
parent firms in the Utility Group and their operating subsidiaries, and reflects the challenges
posed by its resource mix, the burden of significant capital spending requirements, the
implications of the TCJA, and the Company's ongoing efforts to strengthen its credit
standing and support access to capital on reasonable terms. The reasonableness of a 50
percent common equity / 50 percent long-term debt capital structure for Avista is reinforced
by the importance of supporting continued investment in system improvements and the
Company's debt repayment obligations, even during times of adverse capital market
conditions.
III. CAPITAL MARKET ESTIMATES
a. What is the purpose of this section?
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. Ouantitative Analyses
a. Did you rely on a single method to estimate the cost of equity for Avista?
A. No. In my opinion, no single method or model should be relied upon to
determine a utility's cost of equity because no single approach can be regarded as wholly
reliable. 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 a
comparable earnings approach based on investors' current expectations in the capital
McKenzie, Di 29
Avista Corporation
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markets. As the Commission has noted with respect to the DCF, comparable earnings, risk
premium, and CAPM approaches:
While each of these methods can be useful in estimating a utility's ROE, as
with other analytical tools used in ratemaking, these methods only
imperfectly predict the Company's future requirements and performance.35
Consistent with this view, I compare estimates produced by one method with those produced
by other approaches in order to ensure that the estimates of the cost of equity pass
fundamental tests of reasonableness and economic logic.
a. What specific proxy group of utilities did you rely on for your analysis?
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 following criteria to
identiff a proxy group of other utilities:
l. Included in the Electric Utility Industry groups compiled by Value
Line.
2. Corporate credit ratings from S&P and Moody's corresponding to one
notch above and below the Company's current ratings. For S&P, this
resulted in a ratings range of BBB-, BBB, and BBB+; for Moody's
the range was Baa3, Baa2, or Baa1.
3. Value Line Safety Rank of "2" or "3".
4. No ongoing involvement in a major merger or acquisition that would
distort quantitative results.
5. No cuts in dividend payments during the past six months and no
announcement of a dividend cut since that time.
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25 As discussed in Exhibit No. 3, Schedule 2, Algonquin Power & Utilities, fnc. and Emera,
26 Inc. should also be considered in evaluating investors' required rate of retum for Avista.
35 Case No. INT-G-l 6-02, Order No. 33757 (Apr. 28, 2017) at8
McKenzie, Di 30
Avista Corporation
o I These criteria result in a proxy group of 22 comparable-risk firms, which I refer to as the
2 "Utility Group."
How do the overall risks of your proxy group compare with Avista?
Table 3 compares the Utility Group with Avista across four key indicators of
TABLE 3
COMPARISON OF RISK INDICATORS
Value Line
Credit Rating
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a.
A.
investment risk:
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Utility Group
Avista
S&P
BBB+
BBB
Moodvts
Baa2
BaaZ
Safety
Rank
2
2
Flnancial
Streneth
B++
A
Beta
0.64
0.65
8
9
a. Do these comparisons indicate that investors would view the firms in
your proxy groups as risk-comparable to the Company?
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 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.
a. What cost of equity is implied by your DCF results for the Utility Group?
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.
McKenzie, Di 31
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application of the constant growth DCF model resulted in the following cost of equity
estimates
TABLE 4
DCF RESULTS - UTILITY GROUP
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IBES
Zacl<s
br*sv
Average
t0.0%
t0.0%
9.2%
89%
Midpoint
tt.4%
II.5%
10.0%
r0.2%
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a. How did you apply the CAPM to estimate the cost of equity?
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, it
provides a more meaningful guide to the expected rate of return required to implement the
CAPM.
36 I provide a detailed explanation of my DCF analysis, including the evaluation of individual estimates, in
Exhibit No. 3, Schedule 2.
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Avista Corporation
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a. What cost of equity was indicated by the CAPM approach?
A. As shown on page I of Exhibit No. 3, Schedule 7, my forward-looking
application of the CAPM model indicated an ROE of 10.4 percent for the Utility Group after
adjusting for the impact of firm size.
a. Did you also apply the CAPM using forecasted bond yields?
A. Yes. Recognizing that widely-referenced forecasting services continue to
document expectations for higher interest rates over the near-term, I also applied the CAPM
using a forecasted long-term Treasury bond yield 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 2019-2023 implied an
average cost of equity of 10.5 percent after adjusting for the impact of relative size.
a. What cost of equity was indicated by the ECAPM approach?
A. Empirical tests of the CAPM have shown that low-beta securities earn returns
somewhat higher than the CAPM would predict, and high-beta securities earn less than
predicted. The ECAPM incorporates a refinement to address this observed relationship
documented in the financial research. My applications of the ECAPM were based on the
same forward-looking market rate of retum, 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 1 1.3 percent. As shown on page 2 of Exhibit No. 3, Schedule 8,
incorporating a forecasted Treasury bond yield for 2019-2023 implied an average cost of
equity of 11.4 percent using the ECAPM.
McKenzie, Di 33
Avista Corporation
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a. How did you implement the risk premium method?
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 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. This
relationship is illustrated in the f,rgure below, which is based on three-year rolling averages
for the utility bond yields and risk premiums shown on page 3 of Exhibit No. 3, Schedule 9.
FIGURE 3
INVERSE RELATIONSHIP
McKenzie, Di 34
Avista Corporation
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14. 0t
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l-0. 0%
8 .0t
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,"^"rsordro*"f "go"""*orr"o"o*,
-Utility
Bond Yield
-f,41ity
Risk Premium
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a. What cost of equity was indicated by the risk premium approach?
A. As shown on page 1 of Exhibit No. 3, Schedule 9, adding an adjusted risk
premium of 5.38 percent to the average yield on triple-B utility bonds for April 2019 of 4.81
percent resulted in an implied cost of equity of 10.19 percent.3T As shown on page 2 of
Exhibit No. 3, Schedule 9, incorporating a forecasted yield for 2019-2023 and adjusting for
changes in interest rates over the 1974-2018 study period implied a cost of equity of
approximately 1 0.65 percent.
a. Please summarize the results of the expected earnings approach.
A. Reference to rates of return available from alternative investments of
comparable risk provide an important benchmark in assessing the return necessary to assure
confidence in the hnancial integrity of a firm and its ability to attract capital. The simple,
but powerful concept underlying the expected earnings approach is that investors compare
each investment alternative with the next best opportunity. If the utility is unable to offer a
return similar to that available from other opportunities of comparable risk, investors will
become unwilling to supply the capital on reasonable terms. For existing investors, denying
the utility an opportunity to earn what is available from other similar risk alternatives
prevents them from earning their opportunity cost of capital. This expected earnings
approach is consistent with the economic underpinnings for a 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.
37 Moody's yield averages are based on seasoned bonds with a remaining maturity of at least 20 years.
McKenzie, Di 35
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As shown on Exhibit No. 3, Schedule 10, Value Line's projections for the Utility
Group suggest an average ROE of approximately 10.7 percent, with a midpoint value of
11.4 percent.
B. Non-Utilitv DCF Model
a. What other proxy group did you consider in evaluating a fair ROE for
Avista?
A. As indicated earlier, I also present a DCF analysis for a low risk group of
non-utility firms, with which Avista must compete for investors' capital. 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 retums 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".
a. Do utilities have to compete with non-regulated firms for capital?
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 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. lndeed, modern portfolio theory is
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built on the assumption that rational investors will hold a diverse portfolio of stocks, not just
companies in a single industry.
a. Is it consistent with the BlueJield and. Hope cases to consider required
returns for non-utility companies?
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 undertakings attended with comparable risks
and uncertainties."38 It does not restrict consideration to other utilities. Similarly, the Hope
case states:
By that standard the return to the equity owner should be commensurate with
returns on investments in other enterprises having corresponding risks.3e
As in the Bluefield decision, there is nothing to restrict "other enterprises" solely to the
utility industry.
a. Does consideration of the results for the Non-Utility Group make the
estimation of the cost of equity using the DCF model more reliable?
A. Yes. The estimates of growth from the DCF model depend on analysts'
forecasts. It is possible for utility growth rates to be distorted by short-term trends in the
industry or the industry falling into favor or disfavor by analysts. Such distortions could
result in biased DCF estimates for utilities. Because the Non-Utility Group includes low risk
38 Bluefield Water Worl<s & Improvement Co. v. Pub. Serv. Comm'n,262U.5.679 (1923).
3e Federal Power Comm'n v. Hope Natural Gas Co. (320 U.S. 391,1944).
McKenzie, Di 37
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companies from more than one industry, it helps to insulate against any possible distortion
that may be present in the results for a particular sector.
a. How do the overall risks of this Non-Utility Group compare with the
Utility Group and Avista?
A. Table 5 compares the Non-Utility Group with the Utility Group and Avista
across the four key risk measures discussed earlier:
TABLE 5
COMPARISON OF RISK INDICATORS
Value Line
Credit Rating
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utility Group
Avista
S&P
A-
BBB+
BBB
Moody's
A3
Baa2
Baa2
Safety
Rank
I
2
2
trInancial
Streneth
A+
B++
A
Beta
0.13
0.64
0.65o9
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As shown above, the average credit ratings, Safety Rank, and Financial Strength Rating 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.
a. What were the results of your DCF analysis for the Non-Utility Group?
A. As shown on ExhibitNo.3, Schedule 11, I applied the DCF model to the
non-utility companies using the same three alternative measures of expected earnings
growth described earlier for the Utility Group. As summarized below in Table 8, after
eliminating illogical values, application of the constant growth DCF model resulted in the
following cost of equity estimates:
McKenzie, Di 38
Avista Corporation
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TABLE 8
DCF RESULTS - NON-UTILITY GROUP
Growth Rate
Value Line
IBES
Zacks
Average
t0.2%
I0.t%
9.6%
Midpoint
Lt.t%
10.5%
9.7%
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As discussed earlier, reference to the Non-Utility Group is consistent with
established regulatory principles. Required returns for utilities should be in line with those
of non-utility firms of comparable risk operating under the constraints of free competition.
Because the actual cost of equity is unobservable, and DCF results inherently incorporate a
degree of error, cost of equity estimates for the Non-Utility Group provide an important
benchmark in evaluating a fair and reasonable ROE for Avista. The DCF results for the
Non-Utility Group support a finding that the 9.9 percent requested ROE for Avista's utility
operations is reasonable.
C. Flotation Costs
a. What other considerations are relevant in setting the return on equity for
a utility?
A. The common equity used to f,rnance the investment in utility assets is
provided from either the sale of stock in the capital markets or from retained earnings not
paid out as dividends. When equity is raised through the sale of common stock, there are
costs associated with "floating" the new equity securities. These flotation costs include
services such as legal, accounting, and printing, as well as the fees and discounts paid to
compensate brokers for selling the stock to the public. Also, some argue that the "market
pressure" from the additional supply of common stock and other market factors may further
reduce the net amount of funds a utility receives when it issues common equity.
McKenzie, Di 39
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issuance costs?
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. ln other words, equity flotation
costs are not included in a utility's rate base because neither that portion of the gross proceeds
from the sale of common stock used to pay flotation costs is available to invest in plant and
equipment, nor are flotation costs capitalized as an intangible asset. Unless some provision is
made to recognize these issuance costs, a utility's revenue requirements will not fully reflect
all of the costs incurred for the use of investors' funds. Because there is no accounting
convention to accumulate the flotation costs associated with equity issues, they must be
accounted for indirectly, with an upward adjustment to the cost of equity being the most
appropriate mechanism.
a. Is there a sound basis to include a flotation cost adjustment in this case?
A. Yes, the financial literature and evidence in this case supports an adjustment
to include consideration of flotation costs. 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. ln a Public Utililies Fortnightly 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
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shareholders whole, and that the flotation cost adjustment must consider total equity,
including retained earnings.ao Similarly, New Regulatory Finance contains the following
discussion:
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 andlor 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.al
a. Can you illustrate why investors will not have the opportunity to earn
their required ROE unless a flotation cost adjustment is included?
A. Yes. Assume a utility sells $10 worth of common stock at the beginning of
year 1. If the utility incurs flotation costs of $0.48 (5 percent of the net proceeds), then only
$9.52 is available to invest in rate base. Assume that common shareholders'required rate of
return is 10.5 percent, the expected dividend in year 1 is $0.50 (i.e., a dividend yield of 5
percent), and that growth is expected to be 5.5 percent annually. As developed in Table 6
below, if the allowed rate of return on common equity is only equal to the utility's 10.5
percent "bare bones" cost of equity, common stockholders will not eam their required rate of
return on their $10 investment, since growth will really only be 5.25 percent, instead of 5.5
percent:
40 E.F. Brigham, D.A. Aberwald, and L.C. Gapenski, Common Equity Flotation Costs and Rate Making,Pub.
Util. Fortnightly (May, 2,1985).
ar Roger A. Morin, New Regulatory Finance, Pub. Util. Reports, Inc. (2006) at 335.
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TABLE 6
NO FLOTATION COST ADJUSTMENT
Common Retained Total Market lWB Allowed Payout
Year Stock Earnings Equity Price Ratio ROE EPS DPS Ratio
1 $ 9.s2 $ $ 9.s2 $10.00 1.0s0 10.s0% $1.00 $0.s0 s0.0%
2 s 9.52 $ 0.50 $ 10.02 $ 10.s3 1.050 r0.s0% s 1.05 $0.s3 s0.0%
3 $ 9.s2 $ 0.s3 $ 10.ss $ r 1.08 r.0s0 t0.s0% $ 1.11 $0.ss s0.0%
Growth 5.25o/o 5.25o/o 5.25o/o 5.25oh
The reason that investors never really earn 10.5 percent on their investment in the
above example is that the $0.48 in flotation costs initially incurred to raise the common
stock is not treated like debt issuance costs (i.e., amortized into interest expense and
therefore increasing the embedded cost of debt), nor is it included as an asset in rate base.
Including a flotation cost adjustment allows investors to be fully compensated for the
impact of these costs. One commonly referenced method for calculating the flotation cost
adjustment is to multiply the dividend yield by a flotation cost percentage. Thus, with a 5
percent dividend yield and a 5 percent flotation cost percentage, the flotation cost
adjustment in the above example would be approximately 25 basis points. As shown in
Table 7 below, by allowing a rate of return on common equity of 10.75 percent (an 10.5
percent cost of equity plus a 25 basis point flotation cost adjustment), investors earn their
10.5 percent required rate of return, since actual growth is now equal to 5.5 percent:
TABLE 7
INCLUDING FLOTATION COST ADJUSTMENT
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Common Retained Total
Year Stock Earnings Equity
Market n/VB Allowed
Price Ratio ROE EPS DPS
Payout
Ratio1 $9.s2 $2 s9.s2 $3 s9.s2 $
rowth
0.52
0.55
$ 9.s2
$ 10.0s
$ 10.60
s 10.00
$ lO.ss
$ I 1.13
1.0s0 r0.7s% $ 1.02
1.0s0 r0.7s% $ 1.08
1.0s0 t0.7s% $ 1.14
48.8%
48.8%
48.8%
5.50oh 5.50o/o
McKenzie, Di 42
Avista Corporation
$0.s0
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The only way for investors to be fully compensated for issuance costs is to include an
ongoing adjustment to account for past flotation costs when setting the return on common
equity. This is the case regardless of whether or not the utility is expected to issue additional
shares of common stock in the future.
a. What is the magnitude of the adjustment to the "bare bones" cost of
equity to account for issuance costs?
A. The most common method used to account for flotation costs in regulatory
proceedings is to apply an average flotation-cost percentage to a utility's dividend yield.
Exhibit No. 3, Schedule 12 presents an analysis of flotation costs associated with the most
recent open-market common stock issues for each company in Value Line's electric and gas
utility industries. This data includes Avista's 2006 public offering where it incurred issuance
costs equal to approximately 2.3 percent of the gross proceeds. For all companies in the
electric and gas industries, flotation costs averaged approximately 3.0 percent. Applying
this 3.0 percent expense percentage to the 3.4 percent average dividend yield for the Utility
Group produces a flotation cost adjustment on the order of 10 basis points. I thus
recommend the Commission increase the cost of equity by 10 basis points in arriving at a
fair ROE forAvista.
a. Has the IPUC Staff previously considered flotation costs in estimating a
fair ROE?
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
McKenzie, Di 43
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o 1 flotation costs.a2 Similarly, in Case No. NT-G-16-02 the IPUC Staff supported the use of
the same flotation cost methodology that I recommend above, concluding:
[I]s the standard equation for flotation cost adjustments and is referred to as
the "conventional" approach. Its use in regulatory proceedings is
widespread, and the formula is outlined in several corporate finance
textbooks.a3
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a. Have other regulators previously recognized that flotation costs are
properly considered in setting the allowed ROE?
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.aa
11
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18 The South Dakota Public Utilities Commission has recognized the impact of
19 issuance costs, concluding that, "recovery of reasonable flotation costs is appropriate."as
20 Another example of a regulator that approves common stock issuance costs is the
2I Mississippi Public Service Commission, which routinely includes a flotation cost adjustment
22 in its Rate Stabilization Adjustment Rider formula.a6 The Public Utilities Regulatory
23 Authority of ConnecticutaT and the Minnesota Public Utilities Commissiona8 have also
a2 Case No. IPC-E-08-10, Direct Testimony of Terui Carlock at 12-13 (Oct. 24, 2008).
a3 Case No. INT-G-16-02, Direct Testimony of Mark Rogers at l8 (Dec. 16, 2016).
aa Third Supplemental Order, WUTC Docket No. UE-991606, et al., p. 95 (September 2000).
as Northern States Power Co,ELll-019, Final Decision and Order atP 22 (2012).
46 See, e.g., Entergy Mississippi, Inc., Formula Rate Plan, Rider Schedule FRP-6, https://wrvrv.enterqy-
rnississiooi.con/userflles/content/price/tarif tsieml fip.pdf (last visited Apr. 19, 2019).
a7 See, e.g., Docket No. l4-05-06, Decision (Dec. 17, 2014) at 133-134.
McKenzie, Di 44
Avista Corporation
o recognized that flotation costs are a legitimate expense worthy of consideration in setting a
fair ROE.
IV. IMPACT OF REGULATORY MECHANISMS
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a. Would any adjustment to the ROE be warranted due to Avista's FCA?
A. No. The FCA is supportive of Avista's financial integrity, but there is no
evidence to suggest that implementation of this mechanism has altered the relative risk of
Avista enough to warrant any adjustment to its ROE. As noted earlier, the investment
community and the major credit rating agencies in particular, pay close attention to the
regulatory framework, including various adjustment mechanisms. Based largely on the
expanded use of ratemaking mechanisms such as revenue decoupling and cost-recovery
riders, Moody's upgraded most regulated utilities in January 2014.4e Similarly, Moody's
and S&P have noted Avista's ability to benefit from these regulatory mechanisms in their
assessment of the Company's risk prof,rle.50 tn other words, the implications of revenue
decoupling and other regulatory mechanisms are already fully reflected in Avista's credit
ratings, which are comparable to those of the proxy group used to estimate the cost of
equity.
Moreover approval of the FCA does not remove overhanging regulatory risks.
Avista remains exposed to future determinations as to the prudency of its expenditures and
aB See, e.g., DocketNo. E00l/GR-10-276, Findings of Fact, Conclusions, and Order at 9.
ae Moody's Investors Service, US utility sector upgrades driven by stable and transparent regulatory
frameworks, Sector Comment (Feb. 3,2014).
50 Moody's Investors Service, Moody's downgrades Avista Corp. to Baa2, outlook stable, Rating Action (Dec.
20,2018). See also, S&P Global Ratings, Avista Corp. Ratings Affirmed; Off Watch Positive; Outlook Stable,
RatingsDirect (Dec. 10, 2018).
McKenzie, Di 45
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investments, and investors continue to evaluate expectations for balance in the regulatory
framework and in establishing allowed ROEs.
a. Do the regulatory mechanisms approved for Avista set the Company
apart from other firms operating in the utility industry?
A. No. Adjustment mechanisms and cost trackers have been increasingly
prevalent in the utility industry in recent years. In response to the increasing risk sensitivity
of investors to uncertainty over fluctuations in costs and the importance of advancing other
public interest goals such as reliability, energy conservation, and safety, utilities and their
regulators have sought to mitigate some of the cost recovery uncertainty and align the
interest of utilities and their customers through a variety of adjustment mechanisms.
Reflective of this trend, the companies in the electric and gas utility industries
operate under a wide variety of cost adjustment mechanisms, which range from revenue
decoupling and adjustment clauses designed to address rising capital investment outside of a
traditional rate case and increasing costs of environmental compliance measures to riders to
recover bad debt expense and post-retirement employee benefit costs. RRA Regulatory
Focus concluded in its recent review of adjustment clauses that:
More recently and with greater frequencv. c.ontmissions have approved
mechanisms that permit the costs associated with the construction of new
generation capacity or delivery infrastructure to be reflected in rates.
effectivellu including these items in rate base without a full rate case. [n some
instances. these mechanisms may even provide the utilities a cash return on
construction work in progress.
As shown in the bottom image on the next page, certain types of adjustment
clauses are more prevalent than others. For example, those that address
electric and fuel and gas commodity charges are in place in all jurisdictions.
Also, nearly two-thirds of all utilities have riders in place to recover costs
McKenzie, Di 46
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related to energy effrciency programs, and roughly half of the utilities utilize
some type of decoupling mechanism.sl
RRA Regulatory Focus observed that "[capital expenditures] for the companies in the
RRA universe [are] estimated to exceed $130 billion for the full year 2018," and noted that a
"key component" in addressing the financial and regulatory implications of elevated capital
spending "has been the implementation of adjustment clauses to address recovery of these
expenditures."52 As the report summarized, "[m]ore recently and with greater frequency,
commissions have approved mechanisms that permit the costs associated with the
construction of new generation capacity or delivery infrastructure to be reflected in rates,
effectively including these items in rate base without a full rate case."53 In contrast to this
industry trend, Avista does not operate under an adjustment clause for new capital
investment. The Company's need to file successive rate proceedings is primarily driven by
increased capital expenditures and the lack of a comparable infrastructure mechanism puts
Avista, and its common equity investors, at a disadvantage relative to a majority of its
peers.54
The firms in the Non-Utility Group also have the ability to alter prices in response to
rising production costs, with the added flexibility to withdraw from the market altogether.
As a result, the mitigation in risks associated with utilities' ability to adjust revenues and
attenuate the risk of cost recovery is already reflected in the cost of equity range determined
earlier, and no separate adjustment to Avista's ROE is necessary or warranted.
sr S&P Global Market Intelligence, Adjustment Clauses, A State-by-State Overview, RRA Regulatory Focus
(Sep. 28, 2018) (emphasis added).
s2 Id.
s3 Id.
s4 RRA Regulatory Focas reported that 52 percent of the utilities it follows benefit from infrastructure tracking
mechanisms and revenue decoupling. 1d
McKenzie, Di 47
Avista Corporation
o
o 1 a. Have you summarized the various tracking mechanisms available to the
other firms in the Utility Group?
A. Yes. As summarized on Exhibit No. 3, Schedule 13, reflective of industry
trends, the companies in the Utility Group operate under a variety of regulatory adjustment
mechanisms.ss For example, twelve of the firms benefit from some form of revenue
decoupling and seventeen operate in jurisdictions that allow the use of future test years. In
contrast to Avista, fourteen of the firms in the proxy group have operating utilities that
benefit from mechanisms that allow for cost recovery of infrastructure investment outside a
formal rate proceeding. Many of these utilities also have the ability to implement periodic
rate adjustments to reflect changes in a diverse range of operating and capital costs,
including expenditures related to environmental mandates, conservation programs,
transmission costs, and storm recovery efforts.
a. Have other regulators recognized that approval of adjustment
mechanisms do not warrant an adjustment to the ROE?
A. Yes. For example, the WUTC recognized in a 2015 order that the impact of
adjustment mechanisms is already reflected in cost of equity estimates for the proxy group:
We believe it is correct that cost of capital analysis cannot be expected to
produce results that support measurement of decrements to ROE ostensibly
due to approval of one risk mitigation mechanism or another. Nor would cost
of capital analysis be adequate to the task of identiffing increments to ROE
that might be considered due to some measure of additional risk a company
takes on at some point in time. The Commission has never tried to account
separately in its ROE determinations for specific risks or risk mitigating
factors, nor should it. Circumstances in the industry today and modern
regulatory practice that have led to a proliferation of risk reducing
5s Because this information is widely referenced by the investment community, it is also directly relevant to an
evaluation of the risks and prospects that determine the cost of equity.
McKenzie, Di 48
Avista Corporation
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mechanisms being in place for utilities throughout the United States make it
particularly inappropriate and unnecessary to consider such an undertaking.
The effects of these risk mitigating factors was by 2013, and is today,
built into the data experts draw from the samples of companies they
select as proxies.56
Similarly, the Staff of the Kansas State Corporation Commission concluded that no
ROE adjustment was justified in the case of certain tariff riders because the impact of
similar mechanisms is already accounted for:
Those mechanisms differ from company to company and jurisdiction to
jurisdiction. Regardless of their nuances, the intent is the same; reduce cash-
flow volatility year to year and place recent capital expenditures in rates as
quickly as possible. lnvestors are aware of these mechanisms and their
benefits are a factor when investors value those stocks. Thus, any risk
reduction associated with these mechanisms is captured in the market data
(stock prices) used in Staffs analysis.sT
Consistent with this view, the mitigation in risks associated with Avista's ability to recover
its costs in a more timely manner through various adjustment mechanisms is already
reflected in the results of the quantitative methods presented in my testimony.
a. What does this imply with respect to the evaluation of a fair ROE for
Avista?
A. While investors would consider Avista's regulatory mechanisms to be
supportive of the Company's financial integrity and credit ratings, this does not support a
downward adjustment to the ROE. The only relevant question in evaluating a fair ROE is
how Avista's risks compare with those of other utilities-and in particular those that are
used as the basis to estimate the cost of equity. As demonstrated by -y review of regulatory
s6 Wash. tltils. & Transp. Comm'n v. Puget Sound Energt,1nc., Dockets UE-130130 and UG-130138
(consolidated) et al., Order 15.14 at69,1155 (June 29,2015) (internal citations omitted, emphasis added).
s7 Direct Testimony Prepared by Adam H. Gatewood, State Corporation Commission of the State of Kansas,
Docket No. 12-ATMG-564-RTS, pp. 8-9 (June 8, 2012). This proceeding was ultimately resolved through a
stipulated settlement.
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Avista Corporation
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mechanisms for the Utility Group, any risk-reducing impact of recovery mechanisms like
decoupling is already reflected in the cost of equity estimates underlying my recommended
ROE range, and no separate adjustment to Avista's ROE is necessary or warranted.
Moreover, Avista's lack of an infrastructure mechanism places the Company at a
disadvantage relative to the majority of the firms in the Utility Group.
a. Does this conclude your pre-filed direct testimony?
A. Yes.
McKenzie, Di 50
Avista Corporation
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