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BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF IDAHO POWER COMPANY FOR
AUTHORITY TO INCREASE ITS INTERIM
AND BASE RATES AND CHARGES FOR
ELECTRIC SERVICE.
CASE NO. IPC-O3-
IDAHO POWER COMPANY
DIRECT REBUTTAL TESTIMONY
WILLIAM E. AVERA
INTRODUCTION
Please state your name and business address.
William E. Avera, 3907 Red River, Austin,
Texas, 78751.
Are you the same William E. Avera that
previously submitted direct testimony in this case?
Yes, I am.
What is the purpose of your rebuttal
testimony?
The purpose of my testimony is to respond to
the direct testimony of Ms. Terri Carlock, submitted on
behalf of the staff of the Idaho Public Utili ties Commission
( "
IPUC"
) .
In addition, I will also rebut the
recommendations contained in the direct testimony of Mr.
Dennis E. Peseau testimony, on behalf of Micron Technology,
Inc., concerning the cost of equity for Idaho Power Company
( "
Idaho Power " or "the Company
) .
Please summarize the conclusions of your
rebu t tal tes timony
With respect to the testimony of Ms. Carlock,
I concluded that her discounted cash flow ("DCF") results
were biased because of her exclusive reliance on IDACORP,
Inc.IDACORP"
) ,
whose recent dividend cut violates the
assumptions of this method.Additionally, Ms. Carlock'
approach ignored other accepted methods of estimating the
AVERA, Di-Reb
Idaho Power Company
cost of equity, as well as the flotation costs necessary to
raise equity capital.Finally, Ms. Carlock's assessment of
Idaho Power s relative risks focused exclusively on the
Company s low rates, while ignoring the substantial
uncertainties that investors must bear in order to provide
the benefits of lower electricity costs to Idaho Power
After excluding Ms. Carlock's flawed DCF resultscus tomers .
and considering investors ' risk perceptions and an
adjustment for flotation costs, the results of Ms. Carlock'
comparable earnings approach support Idaho Power s reques ted
fair rate of return on equity in this case.
Meanwhile, Mr. Peseau did not conduct any
independent analyses of the cost of equity to Idaho Power.
Instead, his recommendations were based entirely on
Much like theupdates" and "revisions " to my analyses.
Holy Roman Empire, however, nei ther of these two terms
accura tely describes Mr. Peseau ' s selective - and baseless -
alteration of my original analyses, which must be rejected
in their entirety.
II.TERRI CARLOCK
How did Ms. Carlock arrive at her 10.
percent cost of equity recommendation for Idaho Power?
Ms. Carlock estimated the cost of equity by
applying the constant growth DCF model directly to Idaho
She concluded that the results ofPowers parent, IDACORP
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Idaho Power Company
this single DCF application indicated a cost of equity in
the 7.4 to 8.8 percent range.Ms. Carlock also applied the
comparable earnings approach, which resulted in an indicated
cost of equity in the 10.0 percent to 11.0 percent range.
Based on these two analyses, Ms. Carlock concluded that the
cost of equity was in the 9.5 to 10.5 percent range,
selecting the 10.0 percent midpoint as her recommendations
for Idaho Power.
Do the results of Ms. Carlock's DCF analysis
represent a reliable basis on which to establish Idaho
Power s rate of return on equi ty?
No.Because she restricted her DCF analysis
to a single company - IDACORP - Ms. Carlock's results are
extremely susceptible to measurement error and bias.As I
discussed at length in my direct testimony, estimating the
cost of equity is a stochastic process.In other words,
because the cost of equity is unobservable, it can only be
inferred by indirect reference to other available data in
the capi tal markets.But for any single cost of equity
estimate, there is always the potential that the data used
to apply the DCF model will not reflect the expectations and
required returns that investors considered in arriving at
the stock prices we can observe in the capital markets.
a result, it is essential to insulate against this bias by
referencing a proxy group or electric utilities with
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Idaho Power Company
comparable risks.
Why is this particularly critical in the case
of IDACORP?
As discussed in my direct testimony, Idaho
Power and, in turn, IDACORP recently elected to cut common
dividend payments significantly in order to improve cash
flow and help maintain the strong credit ratings necessary
to support the Company s capi tal expansion plan.Under the
DCF approach, observable stock prices are a function of the
cash flows that investors ' expected to receive, discounted
at their required rate of return.Because dividend payments
are a key parameter required to apply DCF methods, this
approach is not well-suited for firms that do not pay common
dividends or have recently cut their payout.Indeed, Ms.
Carlock recognized in her testimony that "changes in the
markets and the dividend cut for IDACORP" complicated any
assessment of representative data for the DCF model.
Indeed, IDACORP' s decision to reduce annual common
dividends by some 35 percent severely violates the
assumptions underlying the constant growth DCF model that
Ms. Carlock used to estimate the cost of equity.
explained in my direct testimony, this approach is based on
the presumption of stable conditions, with earnings
dividends, and book value all growing at a constant rate.
Such is hardly the case for IDACORP in light of its decision
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Idaho Power Company
to substantially alter its dividend payout.
Ms. Carlock recognized the importance of matching
the growth rate with a consistent dividend yield "so that
investor expectations are accurately reflects. ,,~t ~
choosing to focus only on IDACORP in implementing the DCF
model, Ms. Carlock needlessly introduced significant
addi tional complexity into an already challenging process.
Indeed, the fact that the 8.1 percent midpoint of Ms.
Carlock's DCF range falls almost 200 basis points below the
lower bound of her comparable earnings analysis illustrates
the problems of bias associated with her limited DCF
analysis.The proxy group of western electric utilities
referenced in my analyses is consistent not only with the
shared circumstances of electric power markets in the west,
but also with the need to ensure against the potential that
a single cost of equity estimate may not reflect investors
required rate of return.
Did Ms. Carlock apply the risk premium
approach to estimate the cost of equity for Idaho Power?
No.While Ms. Carlock stated that "much of
the theoretical approach" that she used was consistent with
my testimony, Ms. Carlock did not use the risk premium
approach to estimate the cost of equity.The risk premium
method is widely recognized as a meaningful approach to
estimate the cost of equity.No single method or model
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Idaho Power Company
should be relied upon to determine a utility s cost of
equi ty because no single approach can be regarded as wholly
reliable.This is especially the case in light of the fact
that Ms. Carlock's DCF range was based on the results of a
single company.Indeed, as documented in my direct
testimony, applications of the risk premium approach provide
further evidence of the downward bias inherent in Ms.
Carlock's DCF resul ts .
Did Ms. Carlock recognize that the investment
risks associated with electric utilities have increased?
Yes.Ms. Carlock noted that a plethora of
changes have impacted investors ' risk perceptions, observing
that:
The competitive risks for electric utilities have
changed with increasing non-utility generation, deregulation
in some states, open transmission access, and changes in
electrici ty markets.
Ms. Carlock concluded that, because of these greater
uncertainties, the difference in risk between industrial
firms operating in a competitive market and electric
utili ties " is not as great as it used to be. ,,
Did Ms. Carlock consider this increase in
risk in her analysis of the cost of equity for Idaho Power?
No.Ms. Carlock ignored this trend in
investment risks for electric utili ties, asserting instead
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Idaho Power Company
that Idaho Power s "competitive risks " are lower because of
its " low-cost source of power and the low retail rates. ,,
Ms. Carlock also asserted that the Power Cost Adjustment
mechanism ("PCA") reduces Idaho Power s risks relative to
other electric utili ties.
Does this represent an accurate assessment of
the investment risks investors ' associate with Idaho Power?
No.While I agree with Ms. Carlock that
Idaho Power s relatively low rates provide benefits to
customers and may improve the Company s competi ti
posi tion, this one-sided view ignores the substantial
uncertainties that Idaho Power assumes to realize these
benefi ts.As explained in detail in my direct testimony,
because approximately one-half of Idaho Power s total energy
requirements are provided by hydroelectric facilities, the
Company is exposed to a level of uncertainty not faced by
other utili ties, which are less dependent on hydro
generation.While hydropower confers advantages in terms of
fuel cost savings and diversity, investors also associated
hydro facilities with risks that are not encountered with
other sources of generation.
Reduced hydroelectric generation due to below-
average water conditions forces Idaho Power to rely on less
efficient thermal generating capacity and purchased power to
meet its resource needs.As the Commission has noted,
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Idaho Power Company
there are no guarantees about future stream flows or market
prices, ,,7 and in light of the recent past, this dependence
on wholesale markets entails significant risk in the minds
of investors, especially for a utility located in the west.
Investors recognize that volatile markets, unpredictable
stream flows, and Idaho Power s dependence on wholesale
purchases to meet the needs of its customers exposes the
Company to the risk of reduced cash flows and unrecovered
power supply costs.
Apart from exposure to market uncertainties, Idaho
Power also confronts the complexities associated with
obtaining the necessary licenses to operate its
hydroelectric stations.The process of relicensing is
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
flexibili ty.
Does the fact that Idaho Power has a PCA
absolve investors from risks of volatility in wholesale
power markets, as Ms. Carlock seems to imply?
No.The fact that Idaho Power has been
granted a PCA does not translate into lower risk vis-vis
other electric utilities.First, adjustment mechanisms to
account for changes in power supply costs are the rule,
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Idaho Power Company
rather than the exception, so that Idaho Power s PCA merely
moves its risks closer to those of other utili ties.Second,
the PCA does not prevent the lag between the time Idaho
Power actually incurs power supply expenses and when it is
actually recovered from ratepayers.Investors are well
aware that the significant reduction in cash flows
associated with mounting deferrals can have a debilitating
impact on a utility s financial position.
Moreover, the PCA does not apply to 100 percent of
the difference between the actual cost of purchased power
and the amount collected through rates, with Idaho Power
shareholders remaining at risk for 10 percent of any
discrepancy.Indeed, Idaho Power and its investors has
already experienced the impact that chaotic market
condi tions can have when the Company is forced to rely on
wholesale purchases to meet the gap in its resource needs
created by reduced hydro generation.Investors cannot
afford to discount the continuing prospect of further
turmoil in western power markets.Ms. Carlock's focus on
low retail rates" entirely ignores market realities and the
substantial risks that investors must assume to provide
customers with the resulting benefits.
Did Ms. Carlock adjust the results of her
quantitative methods to reflect flotation costs?
No.Ms. Carlock entirely failed to address
AVERA, Di-Reb
Idaho Power Company
the issue of flotation costs, which, as discussed in my
direct testimony are a necessary cost incurred in connection
wi th raising common equity capital.When equity is raised
through the sale of common stock, there are costs associated
with "floating " the new equity securities.Unl ike debt
flotation costs, which are recorded on the books of the
utility, amortized over the life of the issue, there is no
established mechanism for a utility to recognize equity
issuance costs. Unless some provision is made to recognize
these issuance costs, a utility s revenue requirements will
not fully reflect all of the costs incurred for the use of
investors' funds and investors will not have the opportunity
to earn their required rate of return.Because there is no
accounting convention to accumulate the flotation costs
associated with equity issues, I recommended a minimum
upward adjustment to the cost of equity of 20 basis points.
In light of the shortfalls in Ms. Carlock'
DCF approach and her failure to meaningfully address Idaho
Power s relative investment risks or the issue of flotation
costs, what is your conclusion regarding her recommendations
in this case?
In my opinion, Ms. Carlock's recommended 10.
percent cost of equity significantly understates the rate
return that investors require from Idaho Power.Idaho Power
plans to add significant plant investment, such as the
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Idaho Power Company
Mountain Home generating facility, to ensure that the energy
needs of its service territory are met.To meet these
challenges successfully and economically, it is crucial that
the Company receive adequate support for its credit
standing.Because of the shortfalls in her analyses, Ms.
Carlock's recommended cost of equity is inadequate to meet
this goal.
At the very least, the Commission should reject the
result of Ms. Carlock's DCF analyses, which is unreliable
and downward biased because of its focus on a single company
- IDACORP - that has significantly cut its common dividends.
Meanwhile, Ms. Carlock's comparable earnings approach
resul ted in a cost of equity range of 10.0 to 11.0 percent,
wi th Ms. Carlock noting that, in selecting a point estimate
from within a range, "any point within (the) range is
reasonable. "Considering the ongoing risks associated with
Idaho Power s continued exposure to wholesale power markets,
a rate of return at the upper end of this range is
warranted.Combining the 11.0 percent upper end of Ms.
Carlock's comparable earnings range wi th a 20 basis point
minimum allowance for flotation costs results in a rate of
return on equity of 11.2 percent, which is equal to what
Idaho Power has requested in this case.
III. DENNIS E. PESEAU
How did Dr. Peseau evaluate the cost of
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Idaho Power Company
equi ty for Idaho Power?
It is important to note that Dr. Peseau ' s
opinions were not based on any independent analyses of the
cost of equity to Idaho Power.Rather, he arrived at his
recommendations based on a purported "update " of my analyses
by making "revisions " to my methods.
What "updates " and "modifications" did Dr.
Peseau make to your cost of equity analyses?
Apart from conducting no analyses of his own,
Dr. Peseau did not actually update my analyses.Ra ther, he
simply plugs in an updated figure for dividend yield"lo to
my DCF mode 1 .Thus, Dr. Peseau ' s "update " completely
ignored the other half of the constant growth DCF equation;
namely, the growth rate.To the extent that inves tors
expectations for growth increase, this would serve to offset
any decline in dividend yields.Apart from this incomplete
update , Dr. Peseau ' s remaining modifications consisted of
ignoring historical trends in earnings growth in applying
the DCF model, using alternative bond yields to apply my
risk premium approaches, and substituting a lower market
return in the CAPM.Finally, Dr. Peseau completely ignored
the flotation cost adjustment supported in my direct
testimony.
What was the basis for Dr. Peseau ' s
revision " to exclude historical growth rates from his
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Idaho Power Company
update " of your DCF analyses?
While Dr. Peseau granted that my "methodology
is not unreasonable, ,,11 he asserted that historical growth
rates should be discarded because I excluded firms rated
below investment grade from my comparable group.
Does your decision to exclude utili ties with
junk bond ratings from your proxy group represent an
implementation flaw," as Dr. Peseau asserts (p. 15)?
Absolutely not.The purpose of employing
proxy group to estimate the cost of equity is to avoid
potential bias by focusing on firms facing comparable risks
and prospects.As I noted in my direct testimony, the
financial stress and lack of stability that accompanies
below investment grade bond ratings greatly complicates any
determination of investors ' long-term expectations required
to implement the DCF model.Moreover, the move from
investment grade to junk bond ratings implies a quantum
increase in investment risks.It is hypocritical for Dr.
Peseau to assert that my proxy group is "not representative"
of electric utili ties in the west, while simultaneously
arguing that firms with junk bond ratings should be
considered comparable to Idaho Power.
What about Dr. Peseau ' s contention that the
companies in your group "are not really a sample of electric
utili ties (p. 16)?
AVERA, Di-Reb
Idaho Power Company
The fact that these firms may be engaged in
other lines of business is hardly remarkable, as the same
can be said about virtually every electric utility operating
in the U. S .Nevertheless, the fact that investors regard
these firms as electric utili ties is evidenced by the fact
that The Value Line Investment Survey ("Value Line
classifies them in its Electric Utility (West) industry
group.Moreover, the statistics cited by Dr. Peseau do not
convey an accurate portrayal of the importance of utility
operations to the firms in my proxy group.Consider Black
Hills, for example.While Dr. Peseau reports that
electrici ty sales accounted for 38 percent of total
revenues, he failed to report that Black Hills ' electric
power generation and utility operations accounted for
approximately 84 percent and 65 percent of operating
earnings and total assets, respectively, for 2003.Con trary
to Dr. Peseau ' s assertions, the firms included in my proxy
group provide a reasonable basis on which to estimate the
cost of equity for an electric utility in the western
region.
Does Dr. Peseau ' s reference to earnings
growth trends for PNM Resources ("PNM") provide any basis to
exclude historical growth rates from your DCF analysis?
No.Dr. Peseau simply notes that PNM'
earnings per share in 1987 of $2.00 are equal to what Value
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Idaho Power Company
Line is proj ecting for 2004.But this observation says
nothing about what investors might reasonably expect for
future growth based on more recent historical trends.
fact, Dr. Peseau ' s observation implies that investors would
anticipate zero growth, which would produce a cost of equity
for PNM equal to its dividend yield, or 3.2 percent.
course, this is clearly a nonsensical result that is
unrelated to a determination of investors ' future
expectations.In fact, variability in historical earnings
serves to illustrate the increasing risks associated with an
investment in electric utility common stocks.But given the
unsettled conditions over the near-term direction of the
economy and the spate of challenges faced in the electric
power industry, the historical growth trends reported by
Value Line provide a meaningful benchmark in implementing
the DCF model.As a result, when assessing investors
expectations of future growth it is entirely appropriate to
consider historical trends in earnings, along with
securities analysts' projections, as I have done.
Is there any basis for Dr. Peseau ' s statement
that Idaho Power s requested 11.2 percent cost of equity is
unreasonable on its face (p. 18)?
No.Based on changes in bond yields, Dr.
Peseau implies that the cost of equity for Idaho Power has
dropped "by 200 basis points or more. ,,But Dr. Peseau ' s
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Idaho Power Company
First, he ignores the dramaticobservation is meaningless.
increase in the level of risks that investors now associate
with electric utilities.As discussed in my direct
testimony, these uncertainties are heightened for a utility
operating in the western U. S., especially given Idaho
Power s ongoing exposure to potential volatility in
Moreover, as I also explained inwholesale power markets.
my direct testimony, there is considerable evidence that
when interest rates are relatively low, equity risk premiums
widen. Accordingly, the cost of equity does not move in
lockstep with interest rates.In fact, the only way to
assess the relative impact of changes in risks and capital
market conditions since the Commission s last decision in
1995 is to conduct an independent analysis of the cost
equity - something Dr. Peseau did not even attempt.
Is there any merit to Dr. Peseau ' s suggestion
that there are inconsistencies in your risk premium
approaches that lead to an upward bias in your results
(pp.
13-14)?
No.The bond yields used in my applications
of the risk premium method were consistent with the
underlying data sources used to compute the equity risk
premiums, as well as with the investment risks corresponding
to Idaho Power s single-A grade credit rating.
developing risk premiums based on authorized rates of return
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Idaho Power Company
on equity on Exhibit WEA-8, I matched the average allowed
rates of return in each year with the average yield on
public utility bonds reported by Moody s Investors Service
( "
Moody
) .
This composite interest rate reflects the
average risk profile of the electric utility industry, and
there is simply no basis for Dr. Peseau ' s insinuation that
this somehow results in upward bias.Similarly, my analysis
of realized rates of return reported on Exhibit WEA-9 was
based on a consistent set of data, as reported by Standard &
Poor s Corporation ("S&P"Because S&P does not publish an
average public utility bond yield, my analyses relied on the
yield on single-A rated issues as a proxy for the average
risk of the industry.Moreover, the interest rates that Dr.
Peseau cites in his "update " to not correspond to other
published sources.For example, Moody s reported that the
average yield on single-A public utility bonds for February
2004 was 6.15 percent,13 considerably higher than the 5.
percent rate cited by Dr. Peseau.
How did Dr. Peseau "update " your application
of the Capital Asset pricing Model ("CAPM"
Dr. Peseau did not update or otherwise
address my CAPM approach.Rather, he ignored it entirely
and instead substituted a market risk premium into my
analysis that was based on an entirely different method.
explained in my direct testimony, I applied the CAPM based
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Idaho Power Company
on a forward-looking estimate of the market risk premium
that relied on investors ' current expectations in the
capi tal markets.Meanwhile, Dr. Peseau simply asserted that
" (t) he correct market risk premium to use at this time " is
00 percent. In fact, however, this 7.00 percent risk
premium is based on historical realized returns, not on the
forward-looking expectations that drive investors ' required
rate of return in today s capital markets.The end resul t
of Dr. Peseau s thinly veiled shell game is not an update or
revision to my analysis, but instead a CAPM cost of equity
that fails to reflect investors ' current required rate of
return.
Did Dr. Peseau consider the need to account
for past flotation costs?
No.Dr. Peseau does not take issue with my
testimony that an adjustment for flotation costs is
reasonable in establishing a fair rate of return for Idaho
Power.Like Ms. Carlock, however, Dr. Peseau entirely
ignored the issue of flotation costs in conducting his
revisions " and "updates " to my analyses.As discussed
earlier and in my direct testimony, flotation costs are
legi timate and necessary, and unless an adjustment is made
to the cost of equity, investors will not have the
opportuni ty to earn their fair rate of return.
Is there any merit to Dr. Peseau s contention
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Idaho Power Company
that your characterization of conditions within the electric
utili ty industry is "too bleak" (p. 11)?
No.It is curious that Dr. Peseau takes
issue with my description of the challenges that investors
have confronted in the electric power industry, while
simultaneously granting that "all of these observations are
accurate enough.Moreover, the simple fact that the
maj ori ty of utili ties have "weathered the recent disasters ,,
says nothing about the risks that investors now associate
wi th the indus try.As I documented in my direct testimony,
observable measures such as bond ratings clearly illustrate
the revised perceptions of the risks in the industry and the
weakened finances of the utilities themselves.Moreover,
while Dr. Peseau suggests that this assessment just reflects
a pessimistic bias on my part, my personal opinions are
irrelevant and were not the basis of my analyses.What
matters are the opinions of investors, who, demonstrated in
my direct testimony, recognize that the risks inherent in
the electric utility industry have increased significantly.
Indeed, as noted earlier, Ms. Carlock also granted that
electric utilities now face greater uncertainties than in
the past.
Does Dr. Peseau ' s reference to a single
earned rate of return (p. 11) provide any meaningful basis
to evaluate investors risk perceptions or their required
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Idaho Power Company
rate of return?
No.The fact that Idaho Power's shareholders
may have earned positive returns in a single, historical
period says nothing about their forward-looking assessment
of investment risks or their return requirements.In fact,
as Dr. Peseau grants, "the previous few years produced some
negatlve returns.Dr. Peseau ' s observations regarding the
seemingly high variability of returns to Idaho Power'
shareholders are more supportive of my contention that the
investment risks associated with electric utilities,
including Idaho Power, have increased.Indeed, Dr. Peseau
grants that the recent "boom and bust" has "produced wildly
erratic year to year results ... for most of the utili ties in
the wes tern Uni ted ta tes . ,,wildlyFor investors,
erratic " is synonymous with a level of investment risk far
in excess of what Dr. Peseau presumes.
Does this conclude your direct rebuttal
testimony in this case?
Yes, it does.
AVERA, Di-Reb
Idaho Power Company
ENDNOTES
1 Carlock Direct at 11.
Id.
3 Carlock Direct at
Id.
Id.
6 Carlock Direct at 8-
Idaho Power granted $256 million deferral, but bond plan
denied, Idaho Public Utili ties Commission (May 13, 2002).
8 Carlock Direct at 13.
9 Peseau Direct at 13.
10 Id.
11 Peseau Direct at 15.
12 Peseau Direct at 18.
13 Moody s Investors Service,
2004) .
14 Peseau Direct at 14.
15 Id.
16 Peseau Direct at 11.
17 Id.
18 Peseau Direct at 11.
19 Peseau Direct at 16.
Credit Perspectives (Mar.
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Idaho Power Company