20031021Avera Direct.pdf

BEFORE THE IDAHO PUBLIC UTILITIES COMMISSIONIN THE MATTER OF THE APPLICATIONOF IDAHO POWER COMPANY FOR AUTHORITY TO INCREASE ITS RATESAND CHARGES FOR ELECTRIC SERVICETO ELECTRIC CUSTOMERS IN THE STATE)OF IDAHO. CASE NO . IPC-O3-
IDAHO POWER COMPANY
DIRECT TESTIMONY
WILLIAM E AVERA
I .II III
IV.
TABLE OF CONTENTS(For Convenience of Reader)INTRODUCT ION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 1A. Qualifications . 1B . 0 ve rv i e . 4C . Summary 0 f Conc us ions . .. 6FUNDAMENTAL ANALYSES.A. Idaho Powe r Company . .. 8B. Electric Power Industry.. 13C . Capi tal Markets and Economy . 26CAPITAL MARKET ESTIMATES.A. Economic Standards . 31B . D i s c 0 u n t e d Cas h low An a 1 y s e s . . 3 7C. Risk Premium Analyses . 55D . Proxy Group Cos t of Equi t y. . .. 63
RETURN ON EQUITY FOR IDAHO POWER COMPANY
A. Cap ita 1 S t ruc t ure .. 6
B . 0 the r act 0 r s . 7
C. Implications for Financial Integrity . 76
D . Con c 1 u s ion s . 8
Exhibi t
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- DCF Model - Dividend Yield
- DCF Model - proj ected Earnings Growth
- DCF Model lib x r" Growth
- Risk Premium Method Authorized Returns
- Risk Premium Method - Realized Returns
- Risk Premium Method - CAPM
- Qualifications of William E Avera
I .I NTRODUCT IONPlease state your name and business addresswilliam E . Avera, 3907 Red River , AustinTexas,78751 What is your present occupation?a financial , economic, and policyconsul tant to business and governmentA. QualificationsQ .What are your qualifications?I received a B . A. degree wi th a maj or economics from Emory Uni vers i ty.After serving in theUnited States Navy,I entered the doctoral program economics at the University of North Carolina at Chapel
Hi 11 Upon receiving my Ph.I joined the faculty at the
University of North Carolina and taught finance in the
Graduate School of Business I subsequently accepted
position at the University of Texas at Austin where
taught courses in financial management and investment
analysis I then went to work for International Paper
Company in New York Ci ty as Manager of Financial Education
a position in which I had responsibility for all corporate
education programs in finance, accounting, and economics
In 1977 I joined the staff of the Public Utility
Commission of Texas (" PUCT") as Director of the Economic
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Research Division.During my tenure at the PUCT I manageda division responsible for financial analysis , costallocation and rate design , economic and financialresearch, and data processing systems, and I testified cases on a variety of financial and economic issues Sinceleaving the PUCT in 1979 I have been engaged as aconsul tant I have participated in a wide range assignments involving utility-related matters on behalf utilities industrial customers municipalities, andregulatory commissions I have previously testified beforethe Federal Energy Regulatory Commission ("FERC") , as wellas the Federal Communications Commission ("FCC", theSurface Transportation Board (and its predecessor , theInterstate Commerce Commission), the Canadian Radio-
Television and Telecommunications Commission , and
regulatory agencies, courts, and legislative commi ttees in
30 states including the Idaho Public Utilities Commission
the Commission " or "IPUC"
wi th the approval of then-Governor George W. Bush
was appointed by the PUCT to the Synchronous
Interconnection Committee to advise the Texas legislature
on the costs and benefits of connecting Texas to the
national electric transmission grid.Currently, I serve
an outside director of Georgia System Operations
Corporation , the system operator for electric cooperatives
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in Georgia.I have served as Lecturer in the Finance Departmentat the University of Texas at Austin and taught in theevening graduate program at St . Edward's University fortwenty years In addition I have lectured on economic andregulatory topics in programs sponsored by universities andindus try groups I have taught in hundreds of educationalprograms for financial analysts in programs sponsored bythe Association for Investment Management and Research , theFinancial Analysts Review , and local financial analystssocietiesThese programs have been presented in Asia,Europe, and North America, including the Financial AnalystsSeminar at Northwestern Uni vers i ty.I hold the CharteredFinancial Analyst (CFA ) designation and have served as Vice
President for Membership of the Financial Management
Association. I have also served on the Board of Directors
of the North Carolina Society of Financial Analysts I was
elected Vice Chairman of the National Association
Regulatory Commissioners NARUC") Subcommittee on
Economics and appointed to NARUC' s Technical Subcommi t tee
on the National Energy Act I have also served as an
officer of various other professional organizations and
societies A resume containing the details of my
experience and qualifications is attached as Exhibit No
11
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Idaho Power Company
B. Overvi ewWhat is the purpose of your testimony in thiscase?The purpose of my testimony is to present tothe Commission my independent evaluation of a fair rate ofreturn on equity ("ROE"range for Idaho Power CompanyIdaho jurisdictional electric utility operationsPlease summarize the basis of your knowledgeand conclusions concerning the issues to which you aretestifying in this caseTo prepare my testimony,I used informationfrom a variety of sources that would customarily be reliedon by a person in my area of expertise I am familiar wi the organization and operations of Idaho Power from my
prior participation before the Commission on behalf of the
Company in Case No.I PC - E - 94 - 5 .In connection with the
present filing,I considered information relevant to Idaho
Power obtained through discussions wi th corporate
management and from my review of numerous documents
relating to the Company and its parent I DACORP ,Inc
( "
IDACORP"These included financial reports and filings,
prior regulatory proceedings and orders, as well as bond
rating agency reports I also reviewed information
relating generally to current capi tal market condi tions and
specifically to investor perceptions , requirements , and
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Idaho Power Company
expectations for vertically integrated electric utilitieslike Idaho Power.These sources, coupled wi th myexperience in the fields of finance and utility regulationhave given me a working knowledge of investors ' ROErequirements confronting Idaho Power as it competes attract capital , and form the basis of my analyses andconc 1 us ions What is the role of ROE in setting a utilityra tes?The rate of return on common equity serves tocompensate investors for the use of their capi tal tofinance the plant and equipment necessary to provideut i 1 i ty service Investors only commi t money inanticipation of earning a return on their investment
commensurate with that available from other investment
alternatives having comparable risks Consistent wi th both
sound regulatory economics and the standards specified
the Bluefield (Bluefield Water Works Improvement Co. v.
Pub. Serv. Comm 262 U. S (1923 ) J and Hope (Fed.679
Power Comm v. Hope Natural Gas Co.320 U.. 591 (1944)
cases, the return on investment allowed a utili ty should be
suf f icient to: fairly compensate capital invested in the
utility,2 )enable the utility to offer a return adequate
to attract new capi tal on reasonable terms, and 3) maintain
the utility s financial integrity.
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Idaho Power Company
How did you go abou t deve lop i ng yourconclusions regarding a fair rate of return on equity rangefor Idaho Power?I first reviewed the operations and financesof Idaho Power and the general condi tions in the electricutility industry and the economy.with this as abackground,I developed the principles underlying the costof equi ty concept and then conducted various generallyaccepted quantitative analyses to estimate the Companycurrent cost of equi ty.These included discounted cashflow ("DCF") analyses and risk premium methods applied to reference group of electric utilities, as well as referenceto earned rates of return expected for utilities andindustrial firms Based on the cost of equity estimates
indicated by my analyses , the Company s ROE was evaluated
taking into account the relative strengths and weaknesses
of the alternative methods, as well as other factors (e.
flotation costs)that are properly considered in setting
the ROE for Idaho Power s electric utility operations
Idaho.
C. Summary of Conclusions
Please findings regarding thesummarlzeyour
fair rate return equi ty for Idaho Powe r.
My quantitative analyses the cost equity
included applications of the DCF model and risk premium
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methods to a benchmark group of eight electric utilitiesoperating in the western U. s Based on the resul ts these approaches I concluded that the fair rate of returnon common equi ty for Idaho Power is presently in the rangeof 10 6 to 11 9 percentIn evaluating the ROE for Idaho Power it important to consider investors continued focus on theunsettled conditions in western power markets and theunique risks imposed by the Company s much greater relianceon hydroelectric generation to meet its energy needsRegulatory uncertainties , along with unfavorable capitalmarket condi tions, compound the investment risks associatedwith the jurisdictional utility operations of Idaho Power.Coupled with investors ' expectations for higher utility
bond yields going forward, these greater risks support the
reasonableness of my 10 6 to 11 9 percent ROE range
The cost of fully funding the Company s return on
common equity is small relative to the potential benefits
that a financially sound utility can have in providing
reliable service at reasonable rates and supporting
economic growth.Considering the importance of ensuring
investor confidence and maintaining Idaho Power s financial
flexibility and the ability to attract needed capital , an
ROE in the 10 6 to 11 9 percent range is both necessary and
reasonable at this critical juncture
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Idaho Power Company
FUNDAMENTAL ANALYSESWhat is the purpose of this section?This section examines the risks and prospectsfor the electric utili ty industry as a whole and condi tionsin the capi tal markets and the general economy.understanding of these fundamental factors that drive therisks and prospects of electric utilities is essential todeveloping an informed opinion about current investorexpectations and requirements that form the basis of a fairrate of return on equity.In addition , as a predicate tomy economic and capi tal market analyses, this sect ionbriefly describes Idaho Power and reviews its operationsand finances A. Idaho Power Comp
Briefly describe Idaho Power.
Headquartered in Boise,Idaho Power is a
wholly-owned subsidiary of IDACORP and is principally
engaged in providing integrated retail electric utility
service in a 20 000 square mile area in southern Idaho and
eastern Oregon.During the most recent fiscal year Idaho
Power s energy deliveries totaled 15 0 million megawatt
hours ("mWh"Sales to residential customers comprised
percent of retail sales, with 27 percent to commercial , 25
percent to industrial end-users, and 14 percent
at tributable to irrigation pumping.Idaho Power also
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supplies firm wholesale power service to various utilitiesand municipali ties, as well as three large customers undersales contracts Idaho Power s service area hasexperienced strong population growth , expanding over percent in the last decade compared wi th the nationalaverage of 3 8 percentAt year-end 2002 Idaho Power had total assets $2 .7 billion and during the most recent fiscal year totalelectric revenues amounted to approximately $867 million.Principal industries in the area include food processing,lumber , electronics and general manufacturing,fertilizerproduction, and year-round recreational facilities, such those in the Sun Valley resort area.Idaho Poweranticipates total capital expendi tures of approximately
$675 million over the next three years The Company
recently approved a development contract,subj ect
Commission approval for construction of a 160 megawatt
MW") gas - f ired generating plant near Mountain Home,
Idaho.Total cost of the proj ect which includes plant
construction and necessary transmission system upgrades, is
$61 million with Idaho Power taking ownership once the
facility has been fully tested and operational In order
to provide additional support for its capital expenditure
program Idaho Power s Board of Directors Board") voted
to cut its common stock di vidends for the next quarter by
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more than $6 million prompting IDACORP to announced thatit was reducing annual common dividends some 35 percentfrom $1 86 to $1 20 per share . 1wi th a combined capaci ty of approximately 3 11 7 MWIdaho Power s existing generating units include hydroelectric generating plants located in southern Idahoand interests in three coal- fired plants located in OregonNevada, and Wyoming.During 2002 , company-owned generationaccounted for 82 1 percent of the electric energy providedby Idaho Power , wi th the balance being obtained throughpower purchases The electrical output of itshydroelectric plants is dependent on streamflows , whichhave fallen below normal levels for the last three yearsAs a result approximately 45 percent of Idaho Power
total system generation in 2002 was provided by
hydroelectric generation , as compared with 57 percent under
normal condi tions Snowpack and upstream reservoir storage
for 2003 have fallen below measurements for the previous
year and Idaho Power is experiencing its fourth consecutive
year of below-normal water conditions
Idaho Power's transmission system interconnects the
Company with other western electric utilities Coupled
wi th Idaho Power s membership in the Western Electricity
Coordinating Council , the Western Systems Power Pool , the
Northwest Power Pool and the Northwest Regional
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Transmission Association , these transmissioninterconnections permi t the interchange, purchase, and saleof power among all maj or electric systems in the westIdaho Power is subj ect to state retail regulation Idaho and Oregon and at the federal level by FERCAdditionally,Idaho Power s hydroelectric facilities aresubj ect to licensing under the Federal Power Act, which administered by FERC, as well as the Oregon HydroelectricActCurrent ly, the permanent icenses for five of IdahoPowers hydroelectric facilities have expired.Idaho Powe is actively seeking relicensing under a process that couldcontinue for up to 15 years Relicensing is not automaticunder federal law , and Idaho Power must demonstrate that has operated its facilities in the public interest, which
includes adequately addressing environmental concerns The
most significant of Idaho Power s relicensing efforts
concerns it s Hells Canyon Complex which represent
percent of the Company s hydro capaci ty and 40 percent of
its total generating capability.After a prolonged period
of planning and consul tation wi th interested parties,Idaho
Power has developed a draft license application that
includes various protection , mi tigation , and enhancement
measures in order to address environmental concerns while
preserving the peak and load following operations of the
facilities The estimated cost of these measures is $78
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million in the first five years of the licenseQ .How are fluctuations in Idaho Poweroperating expenses caused by varying hydro and power marketconditions accommodated in its rates?Beginning in May 1993 , Idaho Power implementeda power cost adj ustment mechanism ("PCA") , under whichrates are adjusted annually to reflect changes in variablepower production and supply costs When hydroelectricgeneration is reduced and power supply costs rise abovethose included in base rates, the PCA allows Idaho Power increase rates to recover a portion of its additionalcostsConversely,if increased hydroelectric generationwere to lead to lower power supply costs, rates would bereduced.Al though the PCA provides for rates to be
adjusted annually,it applies to 90 percent of the
deviation between actual power supply costs and normalized
ra tes As a resul t , the net amount of power supply costs
not recovered through the PCA mechanism totaled
approximately $55 2 million over the past three years
What credit ratings have been assigned
Idaho Power and its parent,IDACORP?
Idaho Power and its parent I DACORP are bot
currently assigned a corporate credit rating of "" by
Standard & Poor s Corporation ("S&P"Meanwhi le, Moody
Investors Service (Moody s) has assigned issuer credit
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Idaho Power Company
ratings of "A3" and "Baal" to Idaho Power and IDACORPrespect i vely.S&P recently revised its outlook on bothcompanies downward from "positive " to "stable primarilydue to expected weakness attributable to Idaho Powerongoing recovery of deferred power costs, poor watercondi tions, and lower than expected sales . 2B. Electric Power Industr~What are the general condi tions in theelectric power industry?For almost twenty years, electric utilitiesand their consumers have enj oyed a respi te from thevolatility characteristic of the late 1970s and early1980sMore recent ly, however , these general economicfactors have been overshadowed by structural changes in the
electric utility industry resulting from market forces,
decontrol initiatives , and judicial decisions
Please describe these structural changes
At the federal level FERC has been
aggressive proponent of regulatory driven reforms designed
to foster greater competition in markets for wholesale
power supply.The National Energy Policy Act of 1992
which reformed the Public Utility Holding Company Act of
1935 , and to a limi ted extent, the Federal Power Act,
greatly increased prospective competition for the
production and sale of power at the wholesale level
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April 1996 FERC adopted Order No . 888 mandating "openaccess" to the transmission facilities of jurisdictionalelectric utilities FERC also has pushed for theregionalization of transmission system control byestablishing frameworks for creation of RegionalTransmission Organizations in its Order No. 2000( "RTOsand through subsequent policy statements . 4 Open accesshas, in the view of most market observers, resul ted in morecompeti tion and competi tors in wholesale power markets, butnot wi thout the introduction of substantial risksPolicies affecting competition in the electric powerindustry vary widely at the state level , but over jurisdictions have enacted some form of industryrestructuring.This process of industry transition has led
to the disaggregation of many formerly integrated electric
utilities into three primary components - generation
transmiss ion , and distribut ion.Present ly, however Idaho
Power is, and is expected to remain , a fully integrated
public utility.
What impact has the western power crisis had
on investors ' risk perceptions for firms involved in the
electric power industry?
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Idaho Power Company
During the course of the last several yearsinvestors have dramatically altered their assessment of therelative risks associated wi th the electric power industry.A well-publicized energy crisis throughout the west, whichoriginated in California, has wreaked havoc on the regioncustomers, uti li ties, and policymakers It also has haddramatic repercussions for western wholesale power marketsand investors and utilities nationwide Beyond causingstate regulators and legislators to re-evaluate theirrestructuring initiatives for the retail sector of theelectric industry, the financial implications of theCalifornia experience demonstrated the risks facing allsegments of the electric power industry.The massive debts owed by California s retail
utilities to banks, power producers and other creditors
shattered their financial integrity and the subsequent
bankruptcy filing of Pacific Gas and Electric Company
(" PG&E") brought the uncertainties associated wi th today
power markets into sharp focus for the investment
communi ty.Enron ' s , and now Mirant Corporation
bankruptcies only served to magnify the risks associated
with the power sector and increased investors reluctance
to commi t capi tal in the energy industry, as FERC
Commissioner Massey succinctly recognized:
Sadly, the tsunami of the western energy cris is,
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coupled wi th the collapse of Enron , have left devastating wake wi thin the industry. Investorconf idence has been shaken by these events, by declining national economy, indictments of energytraders, account ing irregulari ties, downgrades byrating agencies, and continuing investigations bythe FERC, CFTC, the SEC, and the JusticeDepartment. ...The f light of capi tal from theindustry has been severe since the collapse ofEnron While the case of California and PG&E represents anextreme example, there is every indication that investorsrisk perceptions for electric utilities have shiftedsharply upward as events in the western U. S continued tounfold.The resolution is far from over , as even today,FERC, federal and state courts, and other agencies continuetheir investigations to determine the underlying causes the volatility, high prices and erratic supply patterns
characteristic of western wholesale power markets in 2000
and 2001
Have these events affected electric utilities
credit standing?
The last several years have wi tnessed Yes
steady erosion in credit quality throughout the electric
utility industry, both as a result of revised perceptions
of the risks in the industry and the weakened finances of
the utilities themselves For example, during 2002 , S&P
recorded 182 downgrades in the electric power industry,
versus only 15 upgrades, while Moody s downgraded 109
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utility issuers and upgraded one; an acceleration of thetrend in bond rating changes during the previous two yearsThe fourth quarter of 2002 alone witnessed 48 downgrades the negative pressure on utility creditworthiness continuedunabated.What is the impact of these capi tal and credi market conditions on the ability of electric utilities raise funds?Combined wi th a stagnant economy and globaluncertainties, the dramatic upward shift in investors ' riskperceptions and the weakened financial picture of mostindustry participants , have combined to produce a severeliquidity crunch in the electric power industry.S&P ci tedthe debilitating impact of these developments on investors
willingness to provide capital
The last 24 months have wi tnessed extraordinary
turmoil for power and energy debt, unprecedented
since Samuel Insull's utility empire collapsed
during the 193 Os Events ranging from the credi
collapse of the California utilities, through the
Enron bankruptcy and subsequent market
disruptions for U. S . energy merchant companies
have destroyed billions of dollars of value for
investors Wall Street has virtually shut down
new investment in this sector.
Increasingly constrained capi tal market access
a result of investor skepticism over accounting
practices and disclosure, more and more federal
and state investigations and subpoenas , audi ts,
and failing confidence in future financial
performance has created a liquidi ty crisis . 7
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Idaho Power Company
In light of the challenges faced by electricutilitiesfinancing activity actually declined some percent in 2002 , with many utilities being forced to relyincreasingly on bank debt Access to the commercial papermarketslong the low-cost staple of high-grade utilitycredits for meeting working capital needs virtuallydisappeared for certain companies S&P noted that thefalloff in financing activity was partly attributable capital market it ters, especially for those firms thatare most in need of capital market access " 8 As a resul at the same time that industry uncertainty and marketvolatility has increased the importance of financialflexibi li ty, electric ut il it ies are facing limited accessand higher costs for the capital required to maintain
suff icient liquidity.Moreover , credi t quality has
continued to decline S&P reported an unprecedented
ratings downgrades during the first half of 2003 alone, an
acceleration of the downward trend witnessed during the
prevlous year.Similarly, Moody s downgraded 51 utilities
between January and June 2003 , while upgrading only one
firm. 1 0 S&P also noted that constrained access to capi tal
markets and investor skepticism was contributing to the
bleak credi t picture . 11
How has Idaho Power been impacted by the
turmoil in the electric power industry?
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Idaho Power Company
Like others Idaho Power was swept up in themaelstrom of the western energy crisis in 2000 and 2001Because of Idaho Power s dependence on hydroelectricgenerat ion it has always faced the uncertaintiesassociated with year-to-year fluctuations in waterconditionsNevertheless, the degree of price volatili tythat participants in the western power markets were forcedto assume was unprecedented and variabili ty in short -termmarket prices bore no resemblance to fluctuationsencountered in the pastIncreased wholesale prices and rate structures thatdid not capture full costs of acquiring fuel and purchasedpower led to depressed earnings As of December 31 2001for example, Idaho Power had recorded a regulatory asset of
$290 million related primarily to power cost deferrals
resulting from low hydroelectric generation and higher
purchased power prlces To varying degrees, ut il it ies
throughout the western U. s . were confronted wi th the
difficult task of maintaining reliable service and
financial integrity in a power market characterized by
short supply and unprecedented price volatili ty.Municipal
utilities in the Northwest were also forced to approve or
propose significant rate increases to recover rising fuel
and purchased power costs . 13
Even for electric utili ties such as Idaho Power that
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have permanent fuel and purchased power adj ustmentmechanisms in place, there can be a significant lag betweenthe time the utility actually incurs the expenditure andwhen it is recovered from ratepayers One example of thisregulatory lag was noted by The Value Line InvestmentSurvey (Val ue Line) A lag in the recovery of sharply higher powercosts is hurting Sierra Pacific Resources. Powerprices in the West have soared since the secondquarter of 2000 , and until recently, SPR's twoutilities lacked a mechanism for recovering theseincreasesThe Nevada Commission has grantedone, but it won t solve the utilities ' problemright away. That's because the mechanism trackspower costs over a trailing 12 -month period andbecause the amount by which the utilities canralse rates eac mont lS cappe Because Idaho Power was dependent on wholesale power
markets in the west to meet the gap in its resource needs
crea ted by reduced hydro genera t ion , the chaot ic market
conditions were fel t directly.The continuing prospect
further turmoil in western power markets cannot be
discounted.From the standpoint of the capital markets
the west is risky - and Idaho Power s exposure to wholesale
markets in meeting shortfalls in hydroelectric generation
compounds these uncertainties
Investors recognize that volatile markets
unpredictable stream flows, and Idaho Power s dependence on
wholesale purchases to meet the needs of its customers can
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create a "perfect storm , exposing the Company to the riskof reduced cash flows and unrecovered power supply costsIn response to the risks inherent in substantial relianceon wholesale power markets for electrici ty supply, andrecognizing the continuing uncertainty concerning theavailability of hydroelectric generation Idaho Power hasproposed a plan to expand its electric utility systemincluding the construction of additional generatingresources at Mountain Home Accordingly, maintaining IdahoPowers financial integrity and flexibility will beinstrumental in attracting the capital necessary to fundthese proj ects in an effective manner.What are the implications of the recent poweroutages recently experienced in the upper Midwest and
Northeast?
These events underscore the continuing risks
inherent in the industry and the uncertain state of affairs
wi th respect to the industry s structure The mas s i
blackout, which stretched from New York to Detroit and from
Ohio into Canada, was the largest power outage in u. s
history.This single event has galvanized the attention
all industry stakeholders - utilities, consumers
regulators, and investors - on the urgent need to improve
the nat ion s electrici ty infrastructure, especially
light of the additional stress that deregulated wholesale
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markets have placed on the network.The importance ofrapidly stimulating investment in electric powerinfrastructure has been almost universally ci ted as the keyto ensuring that further outages are avoided.As FERCChairman Wood noted:If we draw any conclusions from this blackout,is the urgent need for more investment in thenations transmission grid to serve broadreglona nee sIndeed, as noted earlier Idaho Power is committed expanding the scope and reliability of its utility systemin order to provide customers with reliable service whileattempting to insulate them from the potential impact ofpower market anomaliesAre investors likely to consider the impact
industry uncertainty in assessing their required rate
return for Idaho Power?
Absolutely.While electric utility
restructuring has not been actively pursued in Idaho, the
Company continues to face the prospect of FERC-dri ven
changes in the transmission sector of their business,
well as fundamental reforms in the operation of wholesale
markets Idaho Power is an active participant in the
formation of a proposed RTO ("RTO West", an independent
entity that will operate the transmission grid in seven
western states While RTO West received Stage II approval
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from FERC, substantial additional filings will be necessarybefore federal and state approval are received.Indeed, the pace of policy evolution in thetransmission area has been brisk.Investors focus onregulatory change in their assessment of risks andprospects was exemplified by S&P:The FERC is in the process of changing everyaspect of the electric utility landscape, withindustry sages anticipating further transmissionand wholesale market development guidance, whichcould affect the segment s credi t prospects andquality. ...Significant uncertainty still existsfor transmission companies that may operate underan RTO or ISO structure, which will significantlyimpact the full scope of capital expendituresnecessary to ensure reliabili ty and increasecapaci ty in the future Uncertainty will existuntil operating rules are in place and havestab i 1 i zed. 1 7
Virtually all industry stakeholders have recognized that
regulatory uncertainty increases the risks associated wi
the electric industry.FERC Commissioner Massey says that
regulatory uncertainty is "part of the problem " explaining
under-investment in electric utility infrastructure .The
Department of Energy ("DOE"identif ied "reducing
regulatory uncertainty " as critical in stimulating
increased investment in the power industry and has noted
that lack of clari ty in the regulatory structure was
inhibiting planning and investment .The DOE also
recognized the impact that this regulatory uncertainty has
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on investors required rates of return for electricutilitiesBecause transmission assets are long lived,regulatory uncertainty increases the risks investors and, therefore, increases the returnsthey need to justify transmission systemlnvestmentsIn remarks before NARUC, a representative of MBIA InsuranceCorporation, the world's largest financial guarantyinsurance company, noted the increased risks posed byinconsistent regulatory decision-making "have made accessto the capital markets very difficult and very expensive. "Similarly, while the Consumer Energy Council of Americarecognized that improvements in electric utilityinfrastructure are necessary to ensure reliabili ty and
support the economy, they concluded that regulatory
uncertainty "has contributed to a fear of instability for
the ent ire system . 22
The recent blackout has only served to reinforce the
importance of regulatory risks for investors The Wall
Street Journal cited the debilitating impact of an
unsteady regulatory environment" and the "chaotic
combination of regulated and deregulated markets " in
explaining inhibitions to increased investment in the
electric utility system.Similarly, FERC Chairman Wood
concluded in his initial comments on the power outages
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that Clearly, we need regulatory certainty and otherincentives for investment . 24Nevertheless, S&P recently warned investors that thepartial reforms presently characterizing wholesale powermarkets invites dysfunction and that elevated risks willdiscourage new capital or at least make it moreexpens lve . "S&P observed:Investors should not expect that such risk willdissipate any time soon. Instead, credit riskcould actually intensify if the politicallycharged debate over reform continues for years,as it might very well do And even if policymakers succeed in crafting a comprehensivesolution to the problems of the nation s energygrid, the regulatory treatment of the costsneeded to upgrade the infrastructure remainsuncertain.
Because of potential dependence on wholesale markets, the
risks of transmission uncertainties and potential market
volatility are intensified for utilities that must meet
shortfalls in resource needs through power purchases
Thus Idaho Power s greater dependence on hydroelectric
generation , which fluctuates with changes in streamflows
exposes the Company and its investors to the ongoing
regulatory uncertainties and other risks imposed by federal
restructuring of wholesale power markets and magnifies the
importance of maintaining financial flexibili ty.
Are these uncertainties the only risks being
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faced electric utilities?Apart from these factors,the industrycont inues face the normal risks inherent opera t ingelectric utility systems including the potential adverseeffects of inflation interest rate changes , growth , andregulatory uncertainty and lag.Electric utilities areconfronting increased environmental pressures that leavethem exposed to uncertainties regarding emissions andpotential contamination.S&P recognized the potentialfinancial challenges posed by such uncertaintiesPens ion obl iga tions , environmental iabil it ies,and serious legal problems restrict flexibility,apart from the obligations ' direct financiallmp lcatlons Capi tal Markets and Econom~
What has been the pattern of interest rates
over the last decade?
Average long-term public utility bond rates,
the monthly average prime rate, and inflation as measured
by the consumer price index since 1990 are plotted in the
graph below.After rising to approximately 10 percent
mid-1990 , the average yield on long-term public utility
bonds generally fell as economic condi tions weakened in the
aftermath of the 1991 Gulf war , with rates dipping below
percent in late 1993 Yields subsequently rose again in
1994 , before beginning a general decline, with investors
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requiring approximately 6 8 percent from average publicut il i ty bonds in August 2003--+-'(\)(\)p.,,...,,. ......~ ~ Inflation ~'" -"..",...J -......\ ,-""-"""'\ -. -..-.. - -,...--... ..... "- ,.,.- ~, --/'" .. .... ,""""'iIF ---, ..... J....,Are investors likely to anticipate anysubstantial decline in interest rates going forward?Since early 2001 , a great deal at tention has been focused on the actions of the FederalReserve as they have moved successively to lower short-term
interest rates in response to weakness in the Uni ted States
economy.But while interest rates are currently at
relatively low levels,investors are unlikely to expect any
further significant declines going forward.The general
expectation is that as economic growth strengthens,
interest rates will begin to rise.For example, the Energy
Information Administration ("EIA", a statistical agency
the DOE routinely publishes 25 -year forecast for energy
markets and the nation's economy.The most recent
forecast, released November 20 2002 , anticipates that the
double-A public utility bond yield will increase from 6
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percent in 2002 to 8 10 percent by 2005 , wi th the averagebelng 7 49 percent over the next 10 years Similarly, themost recent long-term proj ections from GlobalInsight(formerly DRI/WEFA) anticipate that public utility bondyields will increase to 8 19 percent by 2007 and averageapproximately 7 8 percent over the intervening years . 29How has the market for common equi ty capi talperformed?Between 1990 and early 2000 stock pricespushed steadily higher as the longest bull market in UnitedStates history continued unabated.While the S&P 500 hadincreased over four times in value by August 2000 mountingconcerns regarding prospects for future growthparticularly for firms in the high technology and
telecommunications sectors, pushed equi ty prices lower , in
some cases precipitously.While equity prices have
recovered from recent lows , the market has become
increasingly volatile, with share values repeatedly
changing in full percentage points during a single day
trading.The graph below plots the performances of the
Dow-Jones Industrial Average, the S&P 500 , and the New York
Stock Exchange Utility Index since 1990 (the latter two
indices were scaled for comparability)
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500500500500(\)'"d 500,.....,500500500500 S&P 500 (xl0)'-""-,"NYSE UtilitWhat is the outlook for the United Stateseconomy?During the decade through the first quarter 2001 , the United States economy enjoyed the longestpeacetime expansion in history.Monetary and fiscalpolicies resulted in modest inflation during this period,wi th unemployment rates falling to their lowest levels
since the 1960s A revolution in information technology,
rising productivity,and vibrant international trade all
contributed to strong economic growth.However even
before the events of September 11 2001 there were
increasing signs that the economic expansion would not be
sustainable Concerns regarding the slowing pace
economic acti vi ty have been exemplif ied by the Federal
Reserve s sequential lowering of interest rates The
economy continues to chart an uneven course,corporate
prof its remain under pressure,capital spending continues
to be weak and businesses have been reluctant to expand
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hiring. More recently, uncertainties over the fragility the economy have been magnif ied by the aftermath of war Iraq and ongoing instabili ty in the Middle East, whichundermines consumer conf idence and contributes to globaleconomic uncertainty.These factors cause the outlook remain tenuous , wi th persistent stock and bond pricevolatility providing tangible evidence of the uncertaintiesfaced by the Uni ted States economy.How do these economic uncertainties affectelectric utilities?The weakened state of the economy and theuncertainty of recovery have combined to heighten the risksfaced by electric utili ties Stagnant economic growthwould undoubtedly mean flat electric sales, while the
potential for higher inflation and interest rates that
would likely accompany an economic recovery would place
addi tional pressure on the adequacy of existing service
rates While the economy may ul timately return to a path
of steady growth and the volatility in the capital and
energy markets may abate, the underlying weaknesses now
present cause considerable uncertainties to persist, which
i n c rea se t he r i s k s f ace d b y the e 1 e c t r i c ut i 1 i t y i n d us t ry
III. CAPITAL MARKET ESTIMATES
What is the purpose of this section?
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In this section , capital market estimates the cost of equi ty are developed for a benchmark group electric utilities First I examine the concept of thecost of equity, along with the risk-return tradeoffprinciple fundamental to capi tal markets . Next, DCF andrisk premium analyses are conducted to estimate the cost ofequity for a reference group of electric utilitiesA. Economic StandardsWhat role does the rate of return on commonequity play in a utility s rates?The return on common equi ty is the cost inducing and retaining investment in common shares Thisinvestment is necessary to finance the asset base needed provide utility service Competition for investor funds is
intense and investors are free to invest their funds
wherever they choose They wi 11 commi t money to a
particular investment only if they expect it to produce
return commensurate wi th those from other investments wi
comparable risks Moreover , the return on common equity
integral in achieving the sound regulatory objectives of
rates that are sufficient to fairly compensate capital
investment in the utili ty, 2) enable the utili ty to offer
return adequate to attract new capital on reasonable terms,
and 3) maintain the utility s financial integrity.
What fundamental economic principle underlies
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this cost of equi ty concept?Unlike debt capital , there is no contractuallyguaranteed return on common equity capital sinceshareholders are the residual owners of the utility.Nonetheless, common equi ty investors still require a returnon their investment , wi th the cost of equi ty being theminimum II rent II that must be paid for the use of theirmoney.This cost of equi ty typically serves as thestarting point for determining a fair rate of return oncommon equi ty.The cost of equi ty concept is predicated on thenotion that investors are risk averse and willingly bearaddi tional risk only if paid for doing so In capi talmarkets where relatively risk-free assets are available
, u.Treasury securities)investors can be induced
to hold more risky assets only if they are offered
premium , or additional return , above the rate of return on
a risk-free asset Since all assets - including debt and
equi ty - compete wi th each other for scarce investors
funds, more risky assets must yield a higher expected rate
of return than less risky assets in order for investors
be willing to hold them.
Given this risk-return tradeoff , the required rate
of return (k)(i)can be generally expressedfrom an asset
as
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ki Rf RPiwhereRf = Risk-free rate of return; andRPi = Risk premium required to hold riskyasset iThus, the required rate of return for a particular asset atany point in time is a function of the yield on risk-free assets , and its relative risk , with investorsdemanding correspondingly larger risk premiums for assetsbearing greater risk.Does the risk-return tradeoff principleactually operate in the capital markets?The risk-return tradeoff is observableYesin certain segments of the capi tal markets where requiredrates of return can be directly inferred from market dataand generally accepted measures of risk exist Bond
yields,for example, reflect investors ' expected rates
return , and bond ratings measure the risk of individual
bond issues The observed yields on government securities,
which are considered free of default risk , and bonds
various rating categories demonstrate that the risk-return
tradeoff does,in fact, exist in the capi tal markets
Does the risk-return tradeoff observed with
fixed income securi ties extend to common stocks and other
assets?
It is generally accepted that the risk-return
tradeoff evidenced with long-term debt extends to all
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assets Documenting the risk-return tradeoff for assetsother than fixed income securities, however , is complicatedby two factors First, there is no standard measure risk applicable to all assets Second,for most assets including common stock - required rates of return cannot bedirectly observed.Nevertheless, it is a fundamental tenetthat investors exhibi t risk aversion in deciding whether ornot to hold common stocks and other assets,just as whenchoosing among fixed income securi ties This has beensupported and demonstrated by considerable empiricalresearch in the field of finance and is confirmed byreference to historical earned rates of return , withrealized rates of return on common stocks exceeding thoseon government and corporate bonds over the long-term.
Is this risk-return tradeoff limited
differences between firms?
The risk-return tradeoff principle
applies not only to investments in different firms , but
also to different securities issued by the same firm.
Debt, preferred stock , and common equi ty vary considerably
in risk because they have different characteristics and
priori ties
When investors loan money to a utility in the form
of long-term debt (or bonds), they enter into a contract
under which the utility agrees to pay a specified amount of
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interest and to repay the principal of the loan in full the maturity date The bondholders have a senior claim ona utility s available cash flow for these payments , and the utili ty fails to make them , they may force it intobankruptcy. Following first mortgage bonds are other debtinstruments also holding contractual claims on theut il i ties cash flow such as debentures and notesSimilarly, when a utility sells investors preferred stockthe utility promises to pay specified dividends and,typically, to retire the preferred stock on a predeterminedscheduleThe rights of preferred stockholders toavailable cash flow for these payments are junior credi tors , and preferred stockholders cannot compelbankruptcy, their claims are senior to those of common
shareholders
The last investors in line are common shareholders
They receive only the cash flow , if any, that remains after
all other claimants - employees,suppliers , governments,
lenders , have been paid.Because cash flows to common
shareholders are not contractually defined, dividend
payments may be eliminated al together or substantially
reduced, as illustrated by the recent actions of Idaho
Power s Board and IDACORP.As a resul t, the rate of return
that investors require from a utility s common stock , the
most junior and riskiest of its securi ties,is considerably
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higher than the yield on the utility s long-term debtWhat does the above discussion imply wi respect to estimating the cost of equity?Al though the cost of equi ty cannot be observeddirect ly,it is a function of the prospective returnsavailable from other investment alternatives and the risksto which the equity capi tal is exposed.Because it unobservable, the cost of equity for a particular utilitymust be estimated by analyzing information about capi talmarket conditions generally, assessing the relative risksof the company specif ically, and employing variousquanti tati ve methods that focus on investors ' currentrequired rates of return.These various quantitativemethods typically attempt to infer investors ' required
rates of return from stock prices,interest rates, or other
capi tal market data
Have you relied on a single method to estimate
the cost of equi ty for Idaho Power?
In my opinion , no single method or model
should be relied upon to determine a utility s cost of
equi ty because no single approach can be regarded as wholly
reliable As the Federal Communications Commission
recogni zed:
Equi ty prices are established in highly volatile
and uncertain capital markets Different
forecasting methodologies compete wi th each other
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for eminence, only to be superceded by othermethodologies as condi tions change . In thesecircumstances, we should not restrict ourselvesto one methodology, or even a series methodologies, that would be appliedmechanically. Instead, we conclude that weshould adopt a more accommodating and flexiblepOSl tlon.Therefore,in addi t ion to the DCF mode 1 I appliedthe risk premium method based on data for electricutilities and using forward-looking estimates of requiredrates of return.In addition I also evaluated my resul tsusing a comparable earnings approach based on investorscurrent expectations in the capital markets In myopinion, comparing estimates produced by one method wi those produced by other approaches ensures that theestimates of the cost of equity pass fundamental tests reasonableness and economic logic
B. Discounted Cash Flow Analyses
How are DCF models used to estimate the cost
of equi ty?
The use of DCF models is essentially an
attempt to replicate the market valuation process that sets
the price investors are willing to pay for a share of a
company s stock.The model rests on the assumption that
investors evaluate the risks and expected rates of return
from all securities in the capital markets Given these
expected rates of return , the price of each stock
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adjusted by the market until investors are adequatelycompensated for the risks they bear.Therefore, we canlook to the market to determine what investors believe share of common stock is worth.By estimating the cashflows investors expect to receive from the stock in the wayof future dividends and capi tal gains, we can calculatetheir required rate of return.In other words, the cashflows that investors expect from a stock are estimated, andgiven its current market price, we can "back- into " thediscount rate, or cost of equi ty, that investorspresumptively used in bidding the stock to that priceWhat market valuation process underlies DCFmodels?DCF models are derived from a theory of
valuation which assumes that the price of a share of common
stock is equal to the present value of the expected cash
flows (i . e ., future dividends and stock price) that wi 11 be
received while holding the stock discounted at investors
required rate of return , or the cost of equi ty.
Notationally, the general form of the DCF model is as
follows
P -
+ ..
0 - (1+k )1 (1+k )2 (1+k )t (1+k
where Po = Current price per share;Pt = Expected future price per share inperiod t;
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Dt = Expected dividend per share in periodKe = Cost of equi ty.That is, the cost of equity is the discount rate that willequate the current price of a share of stock with thepresent value of all expected cash flows from the stock.Has this general form of the DCF modelcustomarily been used to estimate the cost of equity rate cases?In an effort to reduce the number required estimates and computational difficulties , thegeneral form of the DCF model has been simplified to constant growth" form.But converting the general form ofthe DCF model to the constant growth DCF model requires number of strict assumptions These include
A constant growth rate for both dividends and
earnlngs;
A stable dividend payout ratio;
The discount rate exceeds the growth rate;
A constant growth rate for book value and price;
A constant earned rate of return on book value;
No sales of stock at a price above or below book
value;
A constant price-earnings ratio;
A constant discount rate (i . e., no changes in risk orinterest rate levels and a flat yield curve); and
All of the above extend to infini ty.
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Given these assumptions, the general form of the DCF modelcan be reduced to the more manageable formula ofp - - k - 9Where: g = Investorsexpectations long-term growthThe cost of equity (Ke) can be isolated by rearrangingtermsk ==This constant growth form of the DCF model recognizes thatthe rate of return to stockholders consists of two parts1) dividend yield (D1 /PO) , and 2) growth (g)In otherwords,investors expect to receive a portion of their totalreturn in the form of current dividends and the remainder
through price appreciation.
Are the assumptions underlying the constant
growth form of the DCF model always fully met?
In practice, none of the assumptions required
to convert the general form of the DCF model to the
constant growth form are ever strictly met Nevertheless,
where earnings are derived from stable acti vi ties, and
earnings, dividends , and book value track fairly closely,
the constant growth form of the DCF model may be
reasonable working approximation of stock valuation that
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can provide useful insight as to investors ' required rateof return.How did you implement the DCF model estimate the cost of equity for Idaho Power?Application of the DCF model directly to IdahoPower is hindered because, as a wholly-owned subsidiary,the Company does not have publicly traded common stock.Meanwhile, as discussed earlier Idaho Power and,in turnIDACORP recently elected to cut common dividend paymentssignificantly in order to improve cash flow and helpmaintain the strong credi t ratings necessary to support theCompanys capital expansion plan.Under the DCF approachobservable stock prices are a function of the cash flowsthat investors ' expected to receive, discounted at their
required rate of return.Because dividend payments are
key parameter required to apply DCF methods, this approach
is not well-suited for firms that do not pay common
dividends or have recently cut their payout
As an alternative, the cost of equity is often
estimated by applying the DCF model to publicly traded
companies engaged in the same business acti vi ty.In order
to reflect the risks and prospects associated wi th Idaho
Power s jurisdictional util i ty operations, my DCF analyses
focused on a reference group of other electric utilities
composed of those companies included by Value Line in their
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Electric Utilities (West)Industry group.Exc 1 uded f rom myanalyses were four firms that do not pay common dividendsand two that were rated below investment grade by S&P . 31Given that these eight utilities are all engaged electric utility operations in the western region of theinvestors are likely to regard this group as facingsimilar market conditions and having comparable risks andprospectsThere are important factors distinguishingwestern utilities from those located in other regions, the Electric Consumers Resource Council recently reported:The West is different than the East in terms electrici ty grid operations, according to MarshaSmith, a Commissioner with the Idaho PublicUtilities Commission and Chair of (NARUC)The vast geographic areas served by westernutilities mean electricity is being transmitted
over much longer distances that in other regions,particularly the East , and there are fewer
customers per mi le of transmiss ion ine,resulting in greater line loss, Ms . Smith said.
She also said the West's rel iance on
hydroelectric energy makes planning more
difficul t than in the East Hydropower cannot be
forecast, and the amount of winter snow
determines how much may be shipped each spring
and summer to power-dependent areas such California. Reliance on hydropower makes long-
term planning difficult and plays havoc with the
day-ahead market, envisioned in FERC's proposed
standard market design (SMD) rule . 32
Indeed, as noted earlier , the uncertainties associated with
relying on hydroelectric generation is an important
consideration in evaluating investors ' required rate
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return for Idaho Power.What other considerations support the use of aproxy group in estimating the cost of equity for IdahoPower?Apart from recognizing the inherent risks andprospects for an electric utili ty operating in the westreference to a proxy group of electric utilities essential to insulate against vagaries that can resul t whenthe stochastic process involved in estimating the cost ofequi ty is applied to a single company.The cost of equi is inherently unobservable and can only be inferredindirectly by reference to available capi tal market data.To the extent that the data used to apply the DCF modeldoes not capture the expectations that investors have
incorporated into current stock prices, the resul ting cost
of equi ty estimates will be biased.For example, the
potential for mergers or acquisi tions or the announced sale
of a major business segment would undoubtedly influence the
price investors would be willing to pay for a utility
common stock.But because such f actors are not typically
reflected in the growth rates used to apply the DCF model
cost of equi ty estimates for any single company may fail to
reflect investors ' required rate of return.Indeed, using
even a limi ted group of companies increases the potential
for error , as the FERC noted in its July 3 2003 Order on
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Initial Decision in Docket No. RPOO-107-000Both Staff and williston agreed that a proxygroup of only three companies presented problemsbecause "a single company will have a magnifiedinfluence on the group results It was withthose changing market dynamics in mind thatwi tnesses of both Staff and williston proposed expand the group of proxy companies to determinea zone of reasonableness . 33A proxy group composed of western electric utilities consistent not only with the shared circumstances electric power markets in the west , but also wi th the needto ensure against the potential that a single cost ofequi ty estimate may not reflect investors ' required rate return.What form of the DCF model did you use?I applied the constant growth DCF model
estimate the cost of equity for Idaho Power , which is the
form of the model most commonly relied on to establish the
cost of equity for traditional regulated utilities and the
method most often referenced by regulators
Other forms of the general , or non-constant DCF
model such as "two- stage " or "multi - stage " analyses can be
used to estimate the cost of equi ty; however such
approaches increase the number of inputs that must be
estimated and add to the computational difficulties While
such methods might be warranted when investors expect
discontinuity in the operations of a particular firm or
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industry, they generally require several very specificassumptions regarding investors ' expected cash flows thatmust occur at given points in the future This makes theresults of non-constant growth DCF applications sensitiveto change s in as sumpt ions and, there fore,subj ect greater controversy in a rate case set ting.Moreover , to the that extent each of these time-specific suppositions about future cash flows do notreflect what real-world investors actually anticipate, theresulting cost of equity estimate will be biased.Indeed,the benchmark for growth in a DCF model is what investorsexpectwhen they purchase stock.Unless we replicateinvestors' thinking, we cannot uncover their requiredreturns and thus the market cost of equi ty.In practice,
applying a non-constant DCF model would lead to error if it
ignores the requirements of real-world investors
Are there circumstances where mul t i-stage
DCF mode 1 might preferable the constant growt h form?
Yes The greater complexity of the non-
constant growth DCF model is sometimes warranted when it
evident that investors anticipate a well-defined shift
growth rates over the horizon of their expectations For
example,in response to structural reforms introduced in
the early 1990s,it was widely anticipated that certain
segments of the electric power industry would transition
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from fully regulated to competitive businesses Because ofthe difficul ty associated wi th capturing these expectationsin the single growth measure of the constant growth DCFmodel, many witnesses including myself , chose to apply mul t i-stage approach.A number of regulatory commissionsalso departed from the simplicity of the constant growthDCF model that they had tradi tionally favored in order recognize the transition to competition that wasanticipated by investorsBut acceptance of the multi-stage DCF model waspredicated on very specific assumptions tailored investors ' actual expectations at the time As discussedearlier, however , investors are no longer anticipating thatsuch a transition will take place going forward.Broad-
reaching structural changes once anticipated by investors
at the state and federal levels have been largely
effectuated to the extent investors expect them to occur.
In the minds of investors, any new initiatives focused on
deregulation of the electric utility industry at the retail
level have been indef ini tely postponed or abandoned
altogether.This is certainly true in Idaho, where retail
deregulation is not being actively pursued.
While the complexity of non-constant DCF models may
impart an aura of accuracy, there is no evidence that
investors ' current view of electric utilities anticipates
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series of discrete, clearly def ined stages As a resul tdespite the considerable uncertainties now confronting theelectric utility industry, there is no discernabletransition that would support use of the multi-stage DCFapproach.How is the constant growth form of the DCFmodel typically used to estimate the cost of equi ty?The first step in implementing the constantgrowth DCF model is to determine the expected dividendyield (D1 /PO)for the firm in question.This is usuallycalculated based on an estimate of dividends to be paid the coming year divided by the current price of the stock.The second, and more controversial , step is to estimateinvestorslong-term growth expectations (g)for the firm.
Since book value, dividends, earnings, and price are all
assumed to move in lock-step in the constant growth DCF
model , estimates of expected growth are sometimes derived
from historical rates of growth in these variables under
the presumption that investors expect these rates of growth
to continue into the future Al ternat i vely, a firm'
internal growth can be estimated based on the product
its earnings retention ratio and earned rate of return on
equi ty.This growth estimate may rely on ei ther historical
or projected data, or both.A third approach is to rely on
security analysts projections of growth as proxies for
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investors ' expectations The final step is to sum thefirm's dividend yield and estimated growth rate to arriveat an est imate of its cost of equi ty.How was the dividend yield for the referencegroup of electric utilities determined?Estimates of dividends to be paid by each these electric utilities over the next twelve months,obtained from Value Line,served This annualdividendthendividedthecorrespondingstockwas prlcefor each utility to arrive at the expected dividend yield.The expected dividends, stock price, and resul ting dividendyields for the firms in the reference group of electricutilities are presented on Exhibit No.As shown there,dividend yields for the eight firms in the electric utility
proxy group ranged from 3 2 percent to 6 0 percent , wi
the average being 4 4 percent
What are investors most likely to consider
developing their long-term growth expectations?
In constant growth DCF theory, earnings,
dividends , book value, and market price are all assumed
grow in lockstep and the growth horizon of the DCF model
infinite But implementation of the DCF model is more than
just a theoretical exercise; it is an attempt to replicate
the mechanism investors used to arrive at observable stock
prlces Thus, the only "" that matters in applying the
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DCF model is that which investors expect and have embodiedin current market prices While the uncertainties inherentwi th common stock make estimating investors ' growthexpectations a difficult task for any company,in the caseof electric utilities , the problem is exacerbated due tothe ongoing turmoil in the power industry.Are dividend growth rates likely to provide meaningful guide to investors growth expectations forelectric utilities?No.While the dividend yield import antcomponentDCFapplicationsandinvestorslookdividendsoneindicatorfirmfinancialheal thtrends in dividends are unlikely to reflect the long-termpresumed by the DCF model As illustrated by the
recent decision of the Board and IDACORP to significantly
reduce their payout , dividend pol icies for electric
utili ties have become increasingly conservative as business
risks in the industry have become more accentuated.Thus,
while earnings may be expected to grow significantly,
dividends have remained largely stagnant as utilities
conserve financial resources to provide a hedge against
heightened uncertainties Investors focus has
increas ingly shi fted from di vidends to earnings as a
measure of long-term growth as payout ratios for firms in
the electric utility industry have been trending downward
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from approximately 80 percent historically to on the orderof 65 percent As a resul t, growth in earnings whichultimately support future dividends and share prices,likely to provide a more meaningful guide to investorslong-term growth expectationsWhat other evidence suggests that investorsare more apt to consider trends in earnings in developinggrowth expectations?The importance of earnings in evaluatinginvestorsexpectations and requirements is well acceptedin the investment communi ty.As noted in Finding Reali in Reported Earnings published by the Association forInvestment Management and Research:(EJ arnings, presumably, are the basis for the
investment benefits that we all seek. "Healthy
earnings equal heal thy investment benef its II seems
a logical equation , but earnings are also
scorecard by which we compare companies, a f il ter
through which we assess management, and a crystalball in which we try to foretell the future . 35
Value Line s near-term proj ections and its Timeliness Rank
which is the principal investment rating assigned to each
individual stock , are also based primarily on various
quantitative analyses of earnings As Value Line
explained:
The future earnings rank accounts for 65% in the
determination of relative price change in the
future; the other two variables (current earnings
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rank and current price rank)exp aln 35~The fact that investment advisory services such as ValueLine and I/B/E/S International IBES") ,focus onIncgrowth in earnings indicates that the investment communi regards this as a superior indicator of future long-termgrowth.Financial Analysts Journal reported theIndeed,resul ts of a survey conducted to determine what analyticaltechniques investment analysts actually use . 37 Re sponden t swere asked to rank the relative importance of earnings,dividends , cash flow , and book value in analyzingsecuritiesOf the 297 analysts that responded, only ranked di vidends first whi le 276 ranked it last Thearticle concluded:Earnings and cash flow are considered far more
important than book value and dividends . 38
What are securi ty analysts currently
proj ect ing in the way of earnings growth for the firms in
the electric utility proxy group?
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The consensus earnings growth proj ections foreach of the firms in the reference group of electricutilities reported by IBES and published in S&P'Earning~Guide are shown on Exhibi t No Also presented are theearnings growth proj ections reported by Value Line, FirstCall Corporation (" First Call", and Mul tex InvestorMultex) , which is a service of Reuters As shown there,wi th the exception of Value Line s estimates , thesesecurity analysts projections suggested growth the orderof 5 0 to 5 5 percent for the reference group of electricutilitiesElectric Utili ty Proxy GroueService Growth RateIBESValue LineFirst Call
Mul tex
5 . 3 2 .
5 . 5
5 .0 %
What other earnings growth rates might be
relevant in assessing investors ' current expectations for
electric utilities?
Short -term proj ected growth rates may be
colored by current uncertainties regarding the near-term
direction of the economy in general and the spate
challenges faced in the electric power industry
specifically.Consider the example of Value Line, which
recently noted that the electric utility industry is still
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in a state of flux 39 and that...this industry still faces problems The after-effects of the turbulence in the power marketsstill exist , some companies are stressedfinancially, and even for tradi tional utili ties,regulatory risk is often a potential problem. Value Line also reduced its Timeliness ranking, a relativemeasure of year-ahead stock price performance for the industries it covers,for the electric utility industryfrom 7 0 to 8 9 .While this cautious outlook may explain thefact that Value Line s near-term growth estimates are outof ine wi th other analysts ' proj ect ions,it is notnecessarily indicative of investors long-term expectationsfor the industry.Given the unsettled conditions in the economy and
electric utility industry over the near-term historical
growth in earnings might also provide a meaningful guide to
investors future expectations Accordingly, earnings
growth rates for the past 10 - and 5 -year periods reported
by Value Line for the firms in the electric utility group
are also presented on Exhibi t No.As shown there,6 .10 -
year historical earnings growth rates for the group
eight electric utilities averaged 7 3 percent , or 8
percent over the most recent 5 year period.
How else are investors expectations of future
long-term growth prospects often estimated for use in the
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constant growth DCF model?In constant growth theory, growth in bookequi ty will be equal to the product of the earningsretention ratio (one minus the dividend payout ratio)andthe earned rate of return on book equi ty.Furt he rmo re the earned rate of return and payout ratio are constantover time, growth in earnings and dividends will be equalto growth in book value Al though these condi tions areseldom, if ever , met in practice, this approach may provideinvestors with a rough guide for evaluating a firm s growthprospectsAccordingly, conventional applications of theconstant growth DCF model often examine the relationshipsbetween retained earnings and earned rates of return as anindication of the growth investors might expect from the
reinvestment of earnings within a firm.
What growth rate does the earnings retention
method suggest for the reference group of electric
utilities?
The sustainable,b x r " growth rates for each
firm i n th e re fer e n c e r 0 up i s h 0 wn 0 n x h i bit No.For
each firm , the expected retention ratio (b) was calculated
based on Value Line s proj ected dividends and earnings per
share Likewise, each firm s expected earned rate
return (r) was computed by dividing proj ected earnings per
share by proj ected net book val ue As shown there, this
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method resul ted in an average expected growth rate for thegroup of electric utilities of 4 7 percentWhat did you conclude wi th respect toinvestorsgrowth expectations for the reference group electric utilities?I concluded that investors currently expectgrowth on the order of 5 0 to 7 0 percent for the averagefirm in the electric utili ty proxy group.Thisdetermination was based on the growth proj ections discussedabove, but giving it t le weight to Value Lineproj ections which deviated significantly from the morebroadly-based consensus growth rate proj ections reported byIBES, First Call , and Mul tex , as well as past experienceWhat cost of equity was implied for the
reference group of electric utili ties using the DCF model?
Combining the 4 4 percent average dividend
yield with the 6 0 percent midpoint of my representative
growth rate range implied a DCF cost of equity for this
group of electric utilities of 10 4 percent
c. Risk Premium Analyses
What other analyses did you conduct
estimate the cost equi ty?
have mentioned previous ly,because the
cost of equi ty is inherently unobservable, no single method
should be considered a solely reliable guide to investors
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required rate of return.Accordingly,I also evaluated thecost of equi ty for Idaho Power using risk premium methodsMy applications of the risk premium method providealternative approaches to measure equity risk premiums thatfocused specifically on data for electric utilities andforward-looking estimates of investors ' required rates return.Briefly describe the risk premium method.The risk premium method of estimatinginvestors' required rate of return extends to common stocksthe risk-return tradeoff observed with bonds The cost equity is estimated by first determining the additionalreturn investors require to forgo the relative safety bonds and to bear the greater risks associated wi th common
stock , and then adding this equi ty risk premium to the
current yield on bonds Like the DCF model , the risk
premium method is capi tal market oriented.However , unlike
DCF models, which indirectly impute the cost of equity,
risk premium methods directly estimate investors ' required
rate of return by adding an equity risk premium
observable bond yields
How did you implement the risk premium method?
The actual measurement of equi ty risk premiums
is complicated by the inherently unobservable nature of the
cost of equity.In other words like the cost of equity
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itself and the growth component of the DCF model , equi tyrisk premiums cannot be calculated precisely.Therefore,equi ty risk premiums must be estimated, with adj ustmentsbeing required to reflect present capital market conditionsand the relative risks of the groups being evaluated.I based my estimates of equity risk premiums forelectric utilities on (1)surveys of previously authorizedrates of return on common equity for electric utilities(2 realized rates of return on electric utility commonstocks; and (3 forward-looking applications of the CapitalAsset pricing Model ( "CAPM"Authorized returnspresumably reflect regulatory commissions ' best estimatesof the cost of equi ty, however determined, at the time theyissued their final order , and the returns provide a logical
basis for estimating equity risk premiums Unde r the
realized-rate-of -return approach , equity risk premiums are
calculated by measuring the rate of return (including
dividends, interest, and capi tal gains and losses) actually
realized on an investment in common stocks and bonds over
historical periods The realized rate of return on bonds
is then subtracted from the return earned on electric
utility common stocks to measure equity risk premiums The
CAPM approach measures the market-expected return for a
securi ty as the sum of a risk- free rate and a risk premium
based on the portion of a security s risk that cannot be
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eliminated by holding a well-diversified portfolio.Unde rthe CAPM , risk is represented by the beta coefficient (:)) ,which measures the volatility of a security s pricerelative to the market at a whole Even before the widelyci ted study by Eugene F. Fama and Kenneth R. French , 41considerable controversy surrounded the validi ty of beta a relevant measure of a utility s investment risk.Nevertheless, the CAPM is routinely referenced in thefinancial literature and in regulatory proceedingsWhile these methods are premised on differentassumptions, each having their own strengths andweaknesses, they are widely accepted approaches that havebeen routinely referenced in estimating the cost of equityfor regulated utilities
How did you implement the risk premium
approach using surveys of allowed rates of return?
While the purest form of the survey approach
would involve querying investors directly,surveys of
previously authorized rates of return on common equity are
frequently referenced as the basis for estimating equity
risk premiums The rates of return on common equi ty
authorized electric utili ties by regulatory commissions
across the U. s . are compiled by Regulatory Research
Associates
( "
RRA" and published in its Regulatory Focus
report In Exhibi t No., the average yield on public
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utility bonds is subtracted from the average allowed rateof return on common equity for electric utilities calculate equity risk premiums for each year between 1974and 2002 Over this 29 -year period, these equity riskpremiums for electric utilities averaged 3 08 percent, andthe yield on public utility bonds averaged 9 81 percentIs there any risk premium behavior that needsto be considered when implementing the risk premium method?There is considerable evidence that theYesmagni tude of equi ty risk premiums is not constant and thatequi ty risk premiums tend to move inversely wi th interestra tes In other words, when interest rate levels arerelatively high equi ty risk premiums narrow and wheninterest rates are relatively low equi ty risk premiums
widen.To illustrate, the graph below plots the yields on
public utility bonds (shaded bars) and equity risk premiums
(sol id bars)shown on Exhibi t No.8 :
15%
"'i'"('..I "'i'"('..I "'i'"('..I
0\.
10%
I D Bond Yield 18 Equity Risk Premium
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The graph clearly illustrates that the higher the level interest rates, the lower the equi ty risk premium , and viceversa.The implication of this inverse relationship that the cost of equi ty does not move as much as , or inlockstep wi th interest rates Accordingly,for a percent increase or decrease in interest rates, the cost ofequi ty may only rise or fall , say, 50 bas is pointsTherefore, when implementing the risk premium method,adjustments may be required to incorporate this inverserelationship if current interest rate levels have changedsince the equi ty risk premiums were estimated.What cost of equity is implied by surveys ofallowed rates of return on equi ty?As illustrated above, the inverse relationship
between interest rates and equi ty risk premiums is evident
Based on the regression output between the interest rates
and equi ty risk premiums displayed at the bottom of Exhibit
, the equi ty risk premium for electric util it ies
increased approximately 43 basis points for each percentage
point drop in the yield on average public utility bonds
As shown there, with the yield on public utility bonds
August 2003 being 302 basis points lower than the average
for the study period, this implied a current equity risk
premium of 4 39 percent for electric utilities Adding
this equi ty risk premium to the August 2003 yield on
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single-A public utility bonds of 6 79 percent implies current cost of equi ty for Idaho Power of approximately2 percent How did you apply the realized-rate -of -returnapproach?Widely used in academia, the realized-rate-of-return approach is based on the assumption that, given sufficiently large number of observations over longhistorical periods, average realized market rates of returnwill converge to investors ' required rates of return.Froma more practical perspective,investors may base theirexpectations for the future on , or may have come to expectthat they wi 11 earn , rates of return corresponding to thoserealized in the past . 42 By focusing on data for electric
utilities specifically, my realized rate of return approach
avoided the need to make assumptions regarding relative
risk (e.beta)that are often embodied in applications
of this method.
Stock price and dividend data for the electric
utilities included in the S&P 500 Composite Index ("S&P
500") are available since 1946 Exhibi t No 9 presents
annual realized rates of return for these electric
utilities in each year between 1946 and 2002 As shown
there, over this 57-year period realized rates of return
for these utilities have exceeded those on single-A public
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utili ty bonds by an average of 4 01 percent The realized-rate-of -return method ignores the inverse relationshipbetween equity risk premiums and interest rates and assumesthat equity risk premiums are stationary over time;therefore, no adjustment for differences between historicaland current interest rate levels was made Adding thi s. 01-percent equity risk premium to the August 2003 yieldof 6 79 percent on single -A public utility bonds suggests acurrent cost of equi ty for Idaho Power of approximately8 percent Please describe your application of the CAPM.The CAPM is a theory of market equilibriumthat measures risk using the beta coefficient Under theCAPM, investors are assumed to be fully diversified, so the
relevant risk of an individual asset (e
. g.
, common stock)
is its volatility relative to the market as a whole Beta
reflects the tendency of a stocks price to follow changes
in the market A stock that tends to respond less to
market movements has beta less than while stocks
that tend to move more than the market have betas greater
than The CAPM mathematically expressed
Rj Rf +3j (Rm - Rf)
Where required rate of return for stock jrisk-free rate;
expected return on the market
port fol io; and,
Rj
Rf
Rm =
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3j = beta, or systematic risk for stockExhibi t No. 10 presents an application of the CAPMto the eleven companies in the electric utili ty proxy groupbased on a forward-looking estimate for investors requiredrates of return from common stocks Rather than usinghistorical data, the expected market rate of return wasestimated by conducting a DCF analysis on the firms in theS&P 500 The dividend yield was obtained from S&P withthe growth rate equal to the average of the compositeearnings growth proj ections published by IBES for eachfirm.As shown there, subtracting a 5 39 percent risk-freerate based on the August 2003 average yield on 20-yeargovernment bonds from the 14 24 percent forward-lookingrate of return produced a market equity risk premium
85 percent Multiplying this risk premium by the average
Value Line beta of 0 71 for the firms in the electric
utility group, and then adding the resulting risk premium
to the long-term Treasury bond yield, resul ted in a current
cost of equity of approximately 11 7 percent
D. Proxy Group Return on Equi
What did you conclude with respect the cost
equi ty for the benchmark group electric utilities?
Consistent with the resul ts quanti t at i
analyses, I concluded that the cost of equity for the proxy
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group is present ly in the 10 4 to 11 7 percent rangeWhat other considerations are relevant insetting the return on equity for a utility?The common equity used to finance theinvestment in utility assets is provided from either thesale of stock in the capi tal markets or from retainedearnings not paid out as dividends When equi ty is raisedthrough the sale of common stock , there are costsassociated with II floa ting" the new equity securi tiesThese flotation costs include services such as legalaccounting, and printing, as well as the fees and discountspaid to compensate brokers for selling the stock to thepubl ic Al so,some argue that the "market pressure II fromthe additional supply of common stock and other market
factors may further reduce the amount of funds a utility
nets when it issues common equi ty.
Is there an established mechanism for a
utility to recognize equity issuance costs?
While debt flotation costs are recorded
on the books of the utili ty, amortized over the life of the
issue, and thus increase the ef fecti ve cost of debt
capital , there is no similar accounting treatment to ensure
that equity flotation costs are recorded and ultimately
recogni zed.Alternatively, no rate of return is authorized
on flotation costs necessarily incurred to obtain a portion
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of the equi ty capi tal used to finance plant In otherwords, equity flotation costs are not included in utility s rate base because neither that portion of thegross proceeds from the sale of common stock used to payflotation costs is available to invest in plant andequipment, nor are flotation costs capitalized as anintangible asset Unless some provision is made torecognize these issuance costs, a utility s revenuerequirements will not fully reflect all of the costsincurred for the use of investors funds Because there no accounting convention to accumulate the flotation costsassociated with equity issues, they must be accounted forindirectly, wi th an upward adjustment to the cost of equi being the most logical mechanism.
What is the magnitude of the adjustment to the
"bare bones II cost of equi ty to account for issuance costs?
There are any number of ways in which
flotation cost adjustment can be calculated, and the
adjustment can range from just a few basis points to more
than full percent One of the most common methods used
to account for flotation costs in regulatory proceedings
to apply an average flotation-cost percentage to a
utility s dividend yield.Based on a review of the finance
literature, Roger A. Morin concluded:
The flotation requlresallowancecost
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estimated adjustment to the return on equity ofapproximately 5% to 10%, depending on the sizeand risk of the issue . 43Applying these expense percentages to a representativedividend yield for an electric utility of 4 4 percentimplies a flotation cost adjustment on the order of 20 to40 basis pointsWhat then is your conclusion regarding a fairrate of return on equity for the companies in yourbenchmark group?After incorporating a minimum adjustment forflotation costs of 20 basis points to my "bare bones " costof equity range,I concluded that a fair rate of return onequity for the proxy group of electric utilities current ly in the 10 6 to 11 9 percent range
IV. RETURN ON EQUITY FOR IDAHO POWER COMPANY
What is the purpose of this section?
This section addresses the economic
requirements for Idaho Power s return on equi ty.
examines other factors properly considered in determining
fair rate of return such as market perceptions of Idaho
Power s relative investment risks and comparable earnings
for uti li ties and industrial firms This section also
discusses the relationship between ROE and preservation
a utility s financial integrity and the ability to attract
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capital A. ~ital StructureIs an evaluation of the capi tal structuremaintained by a utili ty relevant in assessing its return onequi ty?Other things equal , a higher debt rat io,Yesor lower common equity ratio, translates into increasedfinancial risk for all investors A greater amount of debtmeans more investors have a senior claim on available cashflow, thereby reducing the certainty that each will receivehis contractual payments This increases the risks towhich lenders are exposed, and they require correspondinglyhigher rates of interest From common shareholdersstandpoint, 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
if any, that will remain.
What common equity ratio is implicit in Idaho
Power s requested capital structure?
Idaho Power s capital structure is presented
in the test imony of Dennis C . Gribble As summarized in
his testimony, the common equity ratio used to compute
Idaho Power s overall rate of return was approximately 44
percent
How does Idaho Power s common equity ratio
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Idaho Power Company
compare wi th those maintained by the reference group utilities?For the eight firms in the Electric Utility(West) group, common equity ratios at year-end 2002 rangedfrom 37 4 percent to 60 6 percent and averaged 45percentHow does Idaho Power s capital structurecompare wi th other widely ci ted financial benchmarks forelectric utilities?The financial ratio guidelines published byS&P specify a range for a utili ty ' s total debt ratio thatcorresponds to each specific bond rating.Widely cited the investment communi ty, these ratios are viewed conjunction with a utility business profile ranking,
which ranges from (strong) to (weak) depending on a
utility s relative business risks Thus, S&P' s guideline
fin a cia 1 rat i 0 s for a g i ve n rat i n g cat ego ry ( e . g., t rip 1 e -
B ) vary wit h the bus i n e s s r 0 per a tin g r i s k 0 f the uti 1 i t Y
In other words , a firm with business profile of "
. e , relatively lower business risk)could presumably
employ more financial leverage than a utility with
business profile assessment of "9" while maintaining the
same credit rating.
Consistent with S&P's current guidelines and Idaho
Power s S&P business profile ranking of ", a utility
AVERA , DI
Idaho Power Company
would be required to maintain a ratio of total debt total capital of 46 0 percent to quali fy for a single-on ratlng.This benchmark equates to total equity ratioof 54 0 percentWhat implication does the increasing risk the electric power industry have for the capital structuresmaintained by utilities like Idaho Power?The challenges imposed by evolving structuralchanges in the industry imply that utilities will berequired to incorporate relatively greater amounts ofequi ty in their capi tal structures Moody s not ed ear y onthat utilities must adopt a more conservative financialposture if credit ratings are to be maintained:The key issue," says the analysts in a recent
spec ial comment, "i s that the compet it i
industries have much lower operating andfinancial leverage and that utilities must
streamline both in order to be effective
competitors
. "
Analysts say the utilities must dothis in order to post stronger financial
indicators and maintain their current ratings
leve 1
More recently, Value Line reported that the average common
equity ratio for all firms in the electric utility industry
is expected to increase from 43 percent in 2003 to
percent over the next three to five years . 46 Indeed,
continued pressure on credit quality in the electric
industry is indicative of the need for utilities to
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Idaho Power Company
strengthen financial profiles to deal wi th an increasinglyuncertain market S&P ci ted the inadequacy of currentbalance sheets in the electric industry as one of the keyfactors explaining this deterioration:The downward slope in the power industry s credi picture can be traced to higher debt leverage andoverall deterioration in financial prof ilesconstrained access to capital markets as a resultof investor skepticism over accounting practicesand disclosure, liquidi ty problems, financialinsolvency, and investments outside thetraditional regulated ut il i ty businessprincipally merchant generation facili ties andrelated energy marketing and trading activities. A more conservative financial profile is consistent withthe increasing uncertainties associated wi th restructuringin wholesale power markets and the imperative maintaining continuous access to capital , even during times
of adverse capital market and industry conditions
What other indications confirm the
reasonableness of Idaho Power s capital structure policies?
In the wake of Enron' s collapse, bond rating
agencies and investors are closely scrutinizing debt
levels For those firms with higher leverage, this intense
focus has led not only to ratings downgrades, but
reduced access to capi tal and increased borrowing costs
The Wall Street Journal reported that even firms wi th stock
prices at recent lows have been forced to issue new common
equi ty and quoted a credi t analyst wi th Fi tch Inc
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Idaho Power Company
" (BJ anks are fearful to put more money into thesector" and it is making credit analysts nervousas well The smart companies, he says , are theones that voluntarily "get their balance sheetsin line " and the "let the market know they re charge of their destiny...since the market clearlyhas the heebie - j eebies . "The article went on to note the crucial role that financialflexibility plays in ensuring that the utility has thewherewi thal to meet the needs of customersAll the belt tightening spells bad news for thecontinued development of the nation's energyinfrastructureCompanies that can borrow moremoney and stretch their dollars , quite simply,can build more plants and equipment Companiesthat are increasingly dependent on equityfinancing - particularly in a bear market - cando less What did you conclude wi th respect to IdahoPowers requested capitalization?
Idaho Power s proposed capital structure is
in-line wi th the ranges maintained by the comparable group
of electric utilities , although its equity ratio falls
somewhat below the guideline specified by S&P for a single-
A rated utility.The reasonableness of Idaho Power
requested capi tal structure is reinforced by the ongoing
uncertainties associated wi th the electric power industry,
the need to support system expansion , and the imperative
maintaining continuous access to capital , even during times
of adverse industry and market condi tions
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B. Other FactorsHow does Idaho Power s credit rating compareto those of the reference groups?Corporate credit ratings for the eight firmsin the Electric Utility (West) group used to estimate thecost of equity range from "BBB-" to "As notedearl ier Idaho Power s senior debt is also currently rated, comparable to the firms in the benchmark group.What else should be considered in evaluatingthe relative risks of Idaho Power?Because approximately one-half of IdahoPowers total energy requirements are provided byhydroelectric facili ties, the Company is exposed to a levelof uncertainty not faced by other utilities, which are lessdependent on hydro genera t ion.While hydropower confers
advantages in terms of fuel cost savings and diversity,
investors also associated hydro facilities with risks that
are not encountered with other sources of generation.
Reduced hydroelectric generation due to below-average water
conditions forces Idaho Power to rely on less efficient
thermal generating capacity and purchased power to meet its
resource needs As noted earlier in the minds
investors , this dependence on wholesale markets entails
significant risk especially for a utility located in the
west Indeed, the ongoing risks associated with
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uncertainty in western power markets has been recognized bythe Commission.In declining to spread recovery of powercost deferrals over multiple years, the Commissionrecognized that...the Commission is very concerned about theunknown water and market conditions that lieahead. ...A one -year recovery wi 11 take care ofnearly all the deferred costs remaining from sustained period of extraordinarily highwholesale prices at the same time that hydro-dependent Idaho Power customers were experiencingthe second worst drought in 75 years . ...Howeveras we have learned over the past two years, thereare no guarantees about future stream flows ormarket prices . 50Apart from exposure to market uncertainties IdahoPower also confronts the complexities associated withobtaining the necessary licenses to operate itshydroelectric stations The process of relicensing
prolonged and involved and often includes the
implementation of various measures to address environmental
and stakeholder concerns These measures can impose
significant additional costs and/or lead to reduced
generating capacity and flexibility.Moody s recently
noted that " (Idaho Power rating outlook is negative
the utility continues to cope with difficult power supply
markets in its region 51 and concluded the Company s bond
ratings could be reduced based on the following factors
Continued delay in return to more normal hydro
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and weather condi tions in combination wi unexpected harsh treatment from Idaho regulatorsin the upcoming general rate proceedingsSignificant increases in relicensing costs and/orstringent operational constraints impose as partof the license renewal process . 52Similarly, S&P recently observed thatUtilities in the Pacific Northwest continue face a host of challenges If the western powercris is left a large number of them , investor-owned as well as publicly-owned, in direfinancial straits, weak economic conditions andthe uncertain hydro situation have hamperedrecovery prospects . 53S&P went on to note the significant potential costs andrisks imposed by uncertainty over fish-conservationmeasures that might be required to meet federal law andcontinued volatility in wholesale power markets, concludingthat "managing hydro risk has assumed a cri tical importance
to credlt qua lty.
What other factors would investors likely
consider in evaluating their required rate of return for
Idaho Power?
Investors have clearly recognized that
structural change and market evolution in the electric
power industry have led to a significant increase in the
risks faced by industry participants . For a firm caught
between expanding wholesale competition in the industry and
the constraints of regulat ion , as are electric uti lit ies,
these risks are further magnified.As S&P recogni zed:
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Although the move to competition from regulationis obviously negative for credit quality general , the transition period can often be worsefor bondholders than would be a fully competitiveindustry. In the interim companies can saddled wi th many of the disadvantages of beingregulated (e. limi ts on return on capi tal andhigher costs to comply with regulatory mandates)while simultaneously being gradually exposed tomarketplace risks . 55Similarly, the Wall Street Journal recently highlighted therisks that investors associate wi th the interface betweencompeti tion and regulation in the power industry:Now , with the power industry hovering uneasilybetween regulation and deregulation , it faces theprospect of market that combines the worstfeatures of both: return to governmentrestrictions, mixed with volatility and pricespikes as companies struggle to meet the nation'energy needs . 56
Moreover investors recognize that regulation has
its own risks In some circumstances regulatory
uncertainty can eclipse all of the other risk factors
facing particular utilities Considering the magni tude of
the events that have transpired since the third quarter
2000 investors sensi ti vi ty to market and regulatory
uncertainties has increased dramatically.The sharpened
focus on the risks associated with unrecoverable wholesale
power costs for example, was noted by RRA:
The potential for volatility in wholesale power
electrici ty markets, as highlighted by the
temporary price spikes experienced in the Midwest
in June 1999 and, more recently, by the ongoing
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severe capacity shortage/pricing crisis California, has raised investors ' level ofawareness and concern with regard to the abilityof electric utilities to recover increasedwholesale power costs and fuel expenses fromcustomers. 57Investors' required rates of return for utili tiesare premised on the regulatory compact that allows theutility an opportunity to recover reasonable and necessarycosts. By sheltering utilities from exposure toextraordinary power cost volatility, ratepayers benefitfrom lower capital costs than they would otherwise bear.Of course, the corollary implies that, if investors believethat the utility might face continued exposure potentially extreme fluctuations in power supply costswhile remaining obligated to provide service at regulated
rates, their required return would be considerably
increased.As S&P noted, the August 14 th blackout is
unlikely to ease investors ' concerns
Clearly, the blackout has
complexity of the system
many stakeholders and theindustry to poli tical and
highlighted thethe diversity of itssusceptibility of the
regu atory rlS
c. ~lications for Financial Integrit~
Why is it important to allow Idaho Power an
adequate rate of return on equi ty?
Given the social and economic importance of
the electric utility industry,it is essential to maintain
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reliable and economical service to all consumers WhileIdaho Power remains committed to deliver reliable electricservice at the lowest possible price, a utility s abilityto fulfill its mandate can be compromised if it lacks thenecessary financial wherewithalWhat lessons can be learned from recent eventsin the energy industry?Events in the western U. s provide a dramaticillustration of the high costs that all stakeholders mustbear when a utility s financial integrity is compromised.California s failed market structure led to unprecedentedvolatility in the region s wholesale power costs For manyut il i ties , recovery of purchased energy costs that theywere forced to buy to serve their customers was ei ther
prevented and/ or postponed.As a resul t , they were denied
the opportuni ty to earn risk-equivalent rates of return and
access to capital was cut off Regional economies have
been j 01 ted and consumers have suf f ered the resul ts of
higher cost power and reduced reliability.Moreover , while
the impact of the utilities ' deteriorating financial
condition was felt swiftly,stakeholders have discovered
first hand how difficult and complex it can be to remedy
the situation after the fact
Do you have any personal experience regarding
the damage to customers that can result when a utility
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Idaho Power Company
financial integri ty deteriorates?I was a staff member of the PUCT whenYesthe financial condit ion of El Paso Electric Company ("EPE"began to suffer in the late 1970s I later observed first-hand the difficulties in reversing this slide as aconsul tant to Asarco Mining, EPE ' s largest single customer.EPE s ultimate bankruptcy imposed enormous costs oncustomers and absorbed an undue amount of the PUCT ' sresources, as well as those of the Attorneys General andother state agencies Now I am serving as a consul tant tothe utility as it continues its struggle to fully recoverit s financial health.There is no question that customersand other stakeholders would have been far better off hadEPE avoided bankruptcy by maintaining its financial
resilience
What danger does an inadequate rate of return
pose to Idaho Power?
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Idaho Power Company
While Idaho Power has been successful inmaintaining its financial flexibility,it is important remember that, once lost investor confidence is difficultto recover and the damage is not easily reversibleConsider the example of bond ratings To restore company s rating to a previous , higher level , ratingagencies generally require the company to maintain itsfinancial indicators above the minimum levels required forthe higher rating over a period of time Consideringinvestorssharp focus on the risks associated wi th thewest and the uncertainties imposed by the Companyrelative reliance on hydroelectric generation , theperception of a lack of regulatory support would almostcertainly lead to a decline in Idaho Power s credit quality
and financial flexibility.
At the same time,Idaho Power plans to add
significant plant investment,such as the Mountain Home
generating facility, to ensure that the energy needs of its
service territory are met While providing the
infrastructure necessary to support economic growth
certainly des irable,it imposes significant
responsibilities on Idaho Power.To meet these challenges
successfully and economically,it is crucial that the
Company receive adequate support for its credi t standing.
Finally, maintaining Idaho Power s access to capital on
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reasonable terms has the added benef it of preserving theCompanys independence and ability to maintain qualityservice based on the interests of Idaho ratepayersD. ConclusionsWhat is your conclusion regarding a fair rateof return on equi ty range for Idaho Power?Based on the capital market research presentedearlier and the economic requirements discussed above,is my conclusion that a return on equi ty in the range 10 .6 to 11 9 percent represents a conservative estimate ofinvestors' required rate of return for Idaho Power today s capital marketsIn evaluating the rate of return for Idaho Power , itis important to consider investors continued focus on the
unsettled conditions in western power markets These
uncertainties are compounded by the Company s continued
reliance on hydroelectric power for a relatively greater
portion of its energy supply, as well as other risks
associated with the power industry,such as heightened
exposure to regulatory uncertainties
How does your recommended fair rate of return
equi ty range for Idaho Power compare with other
benchmarks that investors would cons ider?
Reference rates return avai lable from
al ternative investments can also provide a useful guideline
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in assessing the return necessary to assure confidence the financial integri ty of a firm and its ability at tract capital This comparable earnings approach avoidsthe complexities and limitations of capital market methodsand instead focuses on the returns earned on book equi ty,which are readily available to investorsIndeed, the most recent edition of Value Linereports that its analysts expect average rates of return oncommon equity for the electric utility industry of 11percent and 11 8 percent for 2003 and 2004 , respectively,with their three to five year projections anticipating return on equl ty of 12 0 percent Similarly, expectedrates of return for gas distribution utilities are expectedto average 11 5 percent over Value Line s forecast
horizon 6O while the 696 industrial , retail , and
transportation companies included in Value Line s Composite
Index are expected to earn 16 0 percent on book equity
urlng t e 2006-2008 tlme rame Accordingly, these
expected earned rates of return confirm the reasonableness
of my recommended rate of return on equi ty range for Idaho
Powe r
My recommended ROE range is further supported by the
fact that investors are likely to anticipate increases in
utili ty bond yields going forward.Moreover , an ROE in the
10 .6 percent to 11 9 percent range is reasonable at this
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critical juncture, given the importance of supporting thefinancial capability of Idaho Power as it invests thecapital that is needed to develop and enhance utilityinfrastructureAs the recent power failures amplydemonstrated, the cost of providing Idaho Power an adequatereturn is small relative to the potential benefits that strong utility can have in providing reliable service andfostering growth.Considering investors ' heightenedawareness of the risks associated wi th the electric powerindustry and the damage that results when a utilityfin a cia 1 f 1 e x i b i 1 i t y i s com pro m i sed, sup po r t i ve r e gu 1 a t ionis perhaps more crucial now than at any time in the pastDoes this conclude your direct testimony this case?
i t doe s Yes,
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Idaho Power Company
ENDNOTE S1 IDACORP , Inc , "IDACORP Reduces Dividend To StrengthenBalance Sheet,News Scans (Sep. 18 , 2003)2 Standard & Poor s Corporation , "IDACORP and Unit RatingsAffirmed; Outlook Revised to Stable,RatingsDirect (Oct, 2003Regional Transmission Organizations, Order No. 2000 (Dec., 1999), 89 FERC ~ 61 , 285 Remedying Undue Discrimination through Open AccessTransmission Service and Standard Electrici ty MarketDesign, Notice of Proposed Rulemaking, IV FERC Stats . &Regs . ~ 32 563 (2002) ("SMD NOPR"; FERC White PaperWholesale Power Market Platform April 28 , 2003 , availableat ht tp : / /www. ferc gov /Electric/RTO/Mrkt -Strct -comments/White paper. pdf Remarks by William L. Massey, Center for Public UtilitiesAdvisory Council , "The Santa Fe Conference (March 1720036 Standard & Poor s Corporation , 2002 Power Energy CreditConference: Beyond the Cri si (Jun. 12 , 2002)7 Standard & Poor s Corporation , "U. S . Power IndustryExperiences Precipitous Credit Decline in 2002 Negative
Slope Likely to Continue RatingsDirect (Jan. 15 , 2003)
Id.9 Standard & Poor s Corporation
, "
Credit Quali ty For U. SUtilities Continues Negative Trend,RatingsDirect (Jul
, 2003)
10
. .
Moo y s Investors Servlce, Moody Cred~ Perspect~ ves
(Ju 1 . 14 2 003 ) at 3 3 - 34
11 Standard & Poor s Corporation
, "
Credi t Quali ty For U. SUtilities Continues Negative Trend,RatingsDirect (Jul
, 2003)12 Idaho Power Company, Form 10-K Report (2001)
13
Standard Poor s Corporation Public Power Companies in
Northwest Increase Rates Due to Low Water , Skyrocketing
Prices , Infrastructure Finance, p . 1 (January 18 , 2001)
14
The Val ue Line Investment Survey,
p.
1758 (November 17
2000)
AVERA , DI
Idaho Power Company
15 Statement of Pat Wood, III , Chairman , Federal EnergyRegulatory Commission On the Power Failure in the u.S. andCanada, Press Release (Aug. 15 , 2003)16 See, e. , Remedying Undue Discrimina tion through OpenAccess Transmission Service and Standard Electrici ty MarketDesign67 Fed. Reg. 55 451 , FERC Stats . & Regs ~ 32 563(2002) ("SMD NOPR") and FERC White Paper Wholesale PowerMarket Platform April 28 , 2003 available ht tp : / /www. ferc gov /Electric/RTO/Mrkt -Strct-comments/White paper. pdf 17 Standard & Poor's Corporation , "Electric Transmission the Starting Gate RatingsDirect (May 10 , 200218 Massey, wi lliam L., "Restoring Conf idence in EnergyMarkets, Remarks at the 9 th Annual Spring Conference forthe New England Energy Industry (May 21 , 200219 U. S Department of Energy, Na tional Transmission GridStudy (May 2002), at 24 and 3120 Id. at 3121 Draft Remarks of Kara M. Silva, Vice President, MBIAInsurance Corporation NARUC Joint Commi ttee onElectrici ty, Gas , and Finance and Technology (Feb. 26200322 Consumer Energy Council of America, "Positioning the
Consumer for the Future : A Roadmap to an Optimal Electric
Power System (Apr. 2003) at XVI
23 Smith , Rebecca, Overloaded Circuits Blackout Signals
Maj or Weakness in U. S . Power Grid," The Wall Street Journal
(Aug. 18 2 003
24
Statement of Pat Wood, III , Chairman , Federal Energy
Regulatory Commission On the Power Failure in the U. S. and
Canada, Press Release (Aug. 15 , 2003)
25 Standard & Poor s Corporation
, "
Electric Uti li ty
Blackouts Put Spotlight on Political and Regulatory Credit
Risk"RatingsDirect (Aug. 21 , 2003)
26 Id.
27 Standard & Poor s Corporation Corporate Ratings Criteriaat 29, avai lable at www. standardandpoors com/rat ings 28 Energy Information Administration Annual Energy Outlook
2003, at Tab 1 e 2 0 , N ov. 2 0 2 0 02 , a va i lab le
ht tp : / /www. eia . doe gov / oiaf / aeo/pdf / aeo base pdf
AVERA , DI
Idaho Power Company
29 Global Insight The U.S. Economy, The 25-Year Focus(Winter 2003) at Table 3330 Federal Communications Commission , Report and Order 42-, CC Docket No . 92-133 (1995)31 The financial stress and lack of stability thataccompanies below investment grade bond ratings greatlycomplicates any determination of investors ' long-termexpectations that form the basis for DCF applications estimate the cost of equity.32 Idaho Commissioner Meets wi th ELCON ELCON Report (No.2003 ) at 733 williston Basin Interstate Pipeline Co.104 FERC 6 1 , 0 3 6 , at 14 - 15 Ju 1 . 3 2 0 0 334 See, e. The Value Line Investment Survey (Sep. 151995 at 161 , Sep . 5 , 2003 at 154)35 Association for Investment Management and ResearchII Finding Reali ty in Reported Earnings : An Overview , p. (Dec . 4 , 1996)36 The Value Line Investment Survey, Subscriber's Guide, 53 Block , Stanley B.Practice and Theory
(July/August 1999)
38
Id. at 88
"A Study of Financial AnalystsFinancial Analysts Journal
39 The Value Line Investment Survey (July 4
40 The Value Line Investment Survey (Aug. 15,
ama, Eugene F. and French , Kenneth R.II The Cros
Section of Expected Stock Returns "The Journal of Finance
Jun e 1 9 9 2)
42 Indeed, average realized rates of return for historical
periods are widely reported to investors in the financial
press and by investment advisory services as a guide to
future performance43 Roger A. Morin Regulatory Finance: Utilities ' Cost
Capi tal 1994 , at 166
44 Standard & Poor s, Corpora te Ra tings Cri teria at 58
available at www. standaredandpoors . com/ratings
45 Moody s Investors Service, Credi Risk Commentary,
p.
July 2 9, 1996)
2003) at 695
2003) at 1776
AVERA , DI
Idaho Power Company
46 The Value Line Investment Survey, p . 1776 (Aug. 15200347 Standard & Poor s Corporation Credi Qual i ty For U. S.Utilities Continues Negative Trend, RatingsDirect, Jul . 242003 48 Smith , Rebecca, "Rating Agencies Crack Down onUti 1 tie s , The Wall S t r e e t J urn a 1 , p . C ( D e c e mb e 1 9 ,2001) 49 Id.50 Idaho Power granted $256 million deferral , but bond plandenied, Idaho Public Utilities Commission (May 13 , 2002)51 Moody s Investors Service, Opinion Update : Idaho PowerCompany (Jun. 20 , 2003)52 Id.53 Standard & Poor s Corporation , "Legal Developments Add Ut il i ties ' Disquiet in U. S . Northwest,Util i ti es &Perspectives (July 21 , 2003) at 254 Id.55 Standard & Poor's, CreditWeek , Nov. 1 , 2000 , at 3156 Rebecca Smi th Shock Waves, The Wall Street Journal , Nov., 2001 , at AI57 Regulatory Research Associates , "Recovery of Wholesale
Power Costs : Who is at Risk and Who is Not? "Regula tory
Focus,
p.
(February 28 , 2001)
58 Standard & Poor s Corporation
, "
Electric Utility Blackout
Puts Spotlight on Political and Regulatory Credit Risk
RatingsDirect (Aug. 21 , 2003)
59 The Value Line Investment Survey (Aug. 15 , 2003) at 1 77660 The Value Line Investment Survey (June 20 , 2003) at 45861 The Value Line Investment Survey, Selection Opinion
July 18 2 003 ) at 857
AVERA , DI
Idaho Power Company