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HomeMy WebLinkAbout20040322Avera Rebuttal.pdf" "~"";--~ ! Ell r'-'c, ':;::,1 i'QDlj r;! 9 Pi'i 4: ; ie .ii iLl; it:.) CJi'ii-:iSSION 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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, AVERA, Di-Reb 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, AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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 AVERA, Di-Reb 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. AVERA, Di-Reb Idaho Power Company