20051028Avera 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 STATEOF IDAHO. CASE NO. IPC-E- 05 -IDAHO POWER COMPANY
DIRECT TESTIMONY
WILLIAM E. AVERA
TABLE OF CONTENTS(For Convenience of Reader)INTRODUC T I ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1Summa r y 0 f Con c 1 u s ion s . . . . . . . . . . . . . . . . . . . . . . . . . . . 4II.FUN DAME N TAL ANAL Y S E S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9Operations & Finances Utility Industry .. 14Risks of Idaho Power .. 19I I I .. CAP I TAL MARKE T EST I MAT E S . . .. . . . . . . . . .. . . . . . . . . .. . . . . . . . . .. 3 7B..Overview .. . .. .. . .. . . .. . . . . .. . . .. .. . . . . .. . . .. .. . . . . .. . . .. . . . . Results of Quantitative Analyses .. . .. .. . .. .. . .. .. . .. .. . .. .. 42Proxy Group Cost of Equi ty .. . . .. .. . . .. . .. . . .. .. . . .. . .. .. . .. .. 49IV.RETURN ON EQUITY FOR IDAHO POWER . 52
Exhibi t
Exhibi t
Exhibi t
Exhibi t
Exhibi t
Exhibi t
Exhibi t
Exhibi t
Exhibi t
Implications for Financial Integrity . 53Changes Since Case No. IPC-E-O3-13 ... ... .. ... .. . Conclusions . . . . . . .. . .. . . .. .. . .. .. . .. . . .. .. . .. .. . .. . . .. .. . .. .. . .. .
WEA-l - Qualifications of William E. Avera
WEA-2 - Capital Structure
WEA-3 - Risk Premium - Authorized Rates of Return
WEA-4 - Risk Premium - Realized Rates of Return
WEA-5 - CAPM - Forward-looking Risk Premium
WEA-6 - CAPM - Historical Risk Premium
WEA-7 - DCF - Expected Dividend Yield
WEA-8 - DCF - Earnings Growth Rates
WEA-9 - DCF - Sustainable Growth Rate
I..INTRODUCTIONPlease sta te your name and busines s addresswilliam E" Avera, 3907 Red River , Austin Texas, 78751"In what capacity are you employed?I am the President of FINCAP, Ine", a firmproviding financial , economic, and policy consultingservices to business and government.Please describe your educational backgroundand professional experlence"A description of my background andqualifications, including a resume containing the details ofmy experience, is attached as Exhibit WEA-l.
A" Overview
What is the purpose of your testimony in this
case?
The purpose of my testimony is to present
the Idaho Public Utilities Commission (the "Commission " or
IPUC") my independent evaluation of the fair rate of return
on equity ("ROE"for the jurisdictional utility operations
of Idaho Power Company ("Idaho Power " or "the Company
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Idaho Power Company
Please summarize the basis of your knowledgeand conclusions concerning the issues to which you aretestifying in this case"As is common and generally accepted in myfield of expertise, I have accessed and used informationfrom a variety of sources.I am familiar wi th theorganization, operations, finances, and operation of IdahoPower from my participation in prior proceedings before theIPUC and the Oregon Public Utility Commission..connection wi th the present filing, I considered and reliedupon corporate disclosures and management discussions,publicly available financial reports and filings, and otherpublished information relating to the Company and itsparent, IDACORP , Inc"(\' I DACORP"I also reviewed
information relating generally to cur rent capi tal market
conditions and specifically to current investor perceptions,
requirements, and expectations for the Company s utility
operations.These sources,coupled wi th my experience
the fields of finance and utility regulation, have given me
a working knowledge of investors ' ROE requirements for Idaho
Power as it competes to attract capital , and form the basis
of my analyses and conclusions"
What is the role of ROE in setting
utility s rates?
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Idaho Power Company
The rate of return on common equi ty serves compensa te investors for the use of their capital to financethe plant and equipment necessary to provide utilityserVlce"Investors will only commit money if they expect earn a return on their investment that is commensurate withwhat is available from other investment alternatives comparable risks..Consistent wi th both sound regulatoryeconomics and the standards specified in the Bluefield1 andHopecases, the return on investment allowed a utilityshould be suf ficient to: fairly compensate capitalinvested in the utility, 2) enable the utili ty to offer return adequate to attract new capital on reasonable terms,and 3) maintain the utility s financial integrity"How did you go about developing your
conclusions regarding a fair rate of return for Idaho Power?
I first reviewed the operations and finances
of Idaho Power and the general conditions in the utility
industry and the economy"Wi th this as a background, I
conducted various well-accepted quantitative analyses to
estimate the current cost of equity for a benchmark group
western utilities, including alternative risk premium
Bluefield Water Works Improvement Co. v. Pub. Serv. Comm n, 262 u.
679 (1923)
Fed. Power Comm v. Hope Natural Gas Co.320 u.S. 591 (1944)
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Idaho Power Company
analyses, an application of the discounted cash flow ("DCF"model and reference to comparable earned rates of returnexpected for utilities and industrial firms.Based on thecost of equity estimates indicated by my analyses, theCompanys ROE was eval uated taking in to account the rela ti strengths and weaknesses of the al ternati ve methods and thespecific risks and economic requirements for Idaho Power,consistent with preservation of its financial integrity"B" Summary of ConclusionsWhat are your findings regarding investorsrequired rate of return on equity for Idaho Power?I conclude that a fair rate of return equity for Idaho Power falls in the range of 11 " 0% to 12 " 0%..Dr" Avera, what are the salient factors that
should be considered in evaluating a fair rate of return
equi ty for Idaho Power?
Idaho Power must compete for investors
capital with other utilities and businesses of comparable
risk"If the Company is not provided an opportunity to earn
a return that is sufficient to compensate for the underlying
risks , investors will be unwilling to supply capital..There
are two broad categories of risks tha t form the backdrop for
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Idaho Power Company
an evaluation of investors ' required return and should beconsidered in establishing an ROE for Idaho Power:Market RisksInvestors recognize that utilities continue to facethe potential for vola tile commodi ty prices especially in the west;For utilities that rely on hydro generation , theseuncertainties are compounded by exposure to thenegative impact of ongoing drought conditions;In the wake of the western power market crisis, therisk that investors associate with utilities hasshifted sharply higher , which ha s only heightenedthe importance of supportive regulatory actions;andA widely anticipated increase in interest ratesimplies higher capital cost s when rates establishedin this proceeding will go into effect... Ris ks of Idaho Power:Idaho Power s credit standing is under pressure
a time when the Company must support relicensing
key hydroelectric facilities and significant
capital expendi tures required to meet the growth
and reliability needs of its service area;
Since over one-half of Idaho Power s energy
requirements are provided by hydroelectric
generation , the Company is exposed to additional
rig ks that other utili ties do not face;
During times of
Power is forced
purchased power
genera tioD;
In the aftermath of the crisis in western
wholesale power markets, investors equate this
exposure to potential volatility in wholesale
energy markets with higher investment risk;
Investors view Idaho Power s Power Cost Adjustment
Mechani sm (" PCA") as upporti ve of the Companyfinancial integri ty, but they understand that the
reduced stream flows, Idaho
to rely more heavily
or more costly thermal
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Idaho Power Company
PCA does not apply to 100 of power costs; nor doesit insulate Idaho Power from the need to financeaccrued power production and supply costs or shieldthe Company from potential regulatorydisallowancesWhy is it so critical to consider these ris in establishing a fair rate of return for Idaho Power inthis case?Providing Idaho Power wi th the opportunity earn a return that reflects these realities is an essentialingredient to bolster the Company s financial position,which ultimately benefits customers by ensuring reliableservice at lower long-run costs There are compellingreasons why the IPUC should support Idaho Power s efforts tomaintain its financial integrity by authorizing an adequateROE:
The financial impact of an inadequate ROE would
almost certainly lead to further downgrades, which
implies higher capital cost s and reduced financialflexibility;
Idaho Power must access the capi tal markets to fundsignificant capital expendi tures to maintain and
enhance its utility system, with improved financial
strength translating into lower borrowing rates and
lower long-run financing costs;
The challenges that have recently characterized the
utility industry illustrate the need to ensure that
Idaho Power has the ability to respond effectively
to unforeseen events"
Ultimately it is customers and the service area economy
that enj oy the rewards that come from ensuring that the
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Idaho Power Company
utility has the financial wherewithal to take whateveractions are necessary to provide a reliable energy supply"In summary, why is it so important for theIPUC to establish a sufficient return on equity, along withan appropriate capital structure?In order for the Company to maintain itsfinancial strength, a sufficient return on equity must beapproved, together wi th an appropriate capi tal structureAs discussed later in my testimony, and in the testimony Mr.. Gribble, in addition to its longer-term financing needs,Idaho Power has signif icant capi tal requirements associa tedwith meeting the needs of its growing service area andensuring continued reliability"Accordingly, it important to bolster Idaho Power s financial standing
order to attract capital to fund the Company s eommi tments
at the lowest cost"
Do developments since Idaho Power s last rate
proceeding (IPC-E-03-13) support an increase in the
Company s rate of return on equi ty?
Yes"First, the fact that Idaho Power
credit ratings have been lowered indicates that a higher ROE
will be required to maintain the Company s financial
standing and compensate investors for bearing greater risks
Second, expected capital market condi tions indicate a higher
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Idaho Power Company
i n t ere s t rat e e vir 0 nm e n t an d an i n c rea s e i n cap ita 1 c 0 s t s Third, the investment community s concern indicates theirperception that the current authorized ROE falls well shortof returns available from alternatives of comparable risk"Fourth , the uncertainties inherent with Idaho Poweroperations and the pressures associated wi th significantcapital requirements have become increasingly apparent toinvestors"After considering these factors, what wereyour conclusions regarding a fair ROE and capital structurefor Idaho Power?In light of these considerations,I concludedthat a fair rate of return on equi ty for Idaho Power is the 11 0% to 12 0% range"I based this conclusion on the
results of quantitative analyses of the cost of equity for
proxy group of other western utilities, and in light
Idaho Power s relative risks:
My analyses weighed the results of al ternative
methods, as well as expecta tions for higherinterest rates;
After incorporating a 20 basis point allowance forflotation costs, the results of my analyses for the
reference group of western utilities implied a cost
of equi ty range of 11 " 0 to 12 " 0 , wi th a midpoint
of 11
Similarly, I strongly endorse Idaho Power
requested capital structure, which is entirely consistent
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Idaho Power Company
wi th the average capi taliza tion for the proxy group used estimate the cost of equi ty and contains less equity than proj ected for these reference utilities over the near-term.II..FUNDAMENTAL ANAL Y SE SWhat is the purpose of this section?As a predicate to my economic and capitalmarket analyses, this section examines conditions in theutili ty industry generally, and for Idaho Powerspecifically, that investors consider in evaluating theirrequired rate of return"An understanding of thesefundamental factors, which drive the ris ks and prospects forIdaho Power, is essential to develop an informed opinionabout investor expectations and requirements that form the
basis of a fair rate of return on equity..
A" Operations & Finances
Q..Briefly describe Idaho Power..
Idaho Power is a wholly-owned subs idiary
IDACORP and is principally engaged in providing integrated
retail electric utility service in a 24 000 square mile area
in southern Idaho and eastern Oregon"During the most
recent fiscal year , Idaho Power s energy deliveries totaled
16 "I million megawatt hours
( "
mWh Sales to residential
customers comprised 35 % of retail sales, with 27% to
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Idaho Power Company
commercial , 25 to industrial end-users, and 13%attributable to irrigation pumping"Idaho Power alsosupplies firm wholesale power service to various utilitiesand municipalities, as well as three large customers undersales contracts At year-end 2004 , Idaho Power had totalassets of $3" 0 billion and during the most recent fiscalyear total revenues amounted to approximately $820 million..Idaho Power s existing generating units include hydroelectric generating plants located in southern Idaho"The electrical output of its hydroelectric plants dependent on stream flows, which have fallen significantlybelow normal levels in recent years.Al though Idaho Powerestimates that hydroelectric generation is capable supplying 55% of total system requirements under normal
conditions, the Company has experienced persistent below-
normal water conditions"Fluctuations in the output of the
Company s hydroelectric generating facilities due to
variable water conditions force Idaho Power to rely more
heavily on more costly fossil fuels and wholesale power
markets to meet its customers ' energy needs
Additionally, Idaho Power s hydroelectric facilities
are subj ect to licensing under the Federal Power Act, which
is administered by FERC, as well as the Oregon Hydroelectric
Act Relicensing is not automatic under federal law , and
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Idaho Power Company
Idaho Power must demonstrate that it has operated itsfacilities in the public interest, which includes adequatelyaddressing environmental concerns The most significant Idaho Power s relicensing efforts concerns its Hells CanyonComplex, which represents of the Company s hydrocapacity and 40% of its total generating capability"After a prolonged period of planning andconsultation with interested parties, Idaho Power hassubmitted a license application for the Hells Canyon complexthat includes various protection , mitigation , andenhancement measures in order to address environmentalconcerns while preserving the peak and load followingoperations of the facilities"The estimated cost of thesemeasures is $106 million in the first five years of the
lieense and $218 million over the following twenty-five
years, or a total estimated cost of $324 million"The
relicensing process is complex, protracted, and expensive"
As of June 30 , 2005 , Idaho Power had accumulated $71 million
of construction work in progress associated with its Hells
Canyon relicensing efforts..
How are fluctuations in Idaho Power
operating expenses caused by varying hydro and power market
conditions accommodated in its rates?
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Idaho Power Company
Beginning in May 1993 , Idaho Powerimplemented a PCA , under which rates are adj usted annuallyto reflect changes in variable power production and supplycosts..When hydroelectric generation is reduced and powersupply costs rise above those included in base rates, thePCA allows Idaho Power to increase rates to recover portion of its additional costs Conversely, if increasedhydroelectric generation were to lead to lower power supplycosts, rates would be reduced.Al though the PCA providesfor rates to be adj usted annually, it applies to 90% of thedeviation between actual power supply costs and normalizedrates At year-end 2004, the net amount of Idahojurisdictional power supply costs deferred under the PCAmechanism totaled approximately $ 4 7 ,,5 million"
What credi t ratings have been assigned
Idaho Power?
Citing concerns over the impacts of
sustained drought, the outcome of Idaho Power s last rate
proceeding, and the pressures of ongoing capital
requirements, Standard & Poor s Corporation ("S&P"lowered
Idaho Power s corporate credit rating from "" to "BBB+U in
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Idaho Power Company
November 2004 Moody s Investors Service Moody alsodowngraded the Company s issuer rating from "A3rt to "Baal"based on similar concerns. While Fitch Ratings Ltd"Fitchrt does not publish a corporate credit rating forIdaho Power it followed suit and downgraded the Companysenlor debt ratings one notch in February 2005Q..Does Idaho Power anticipate the need access the capital mar kets going forward?Most definitely..Idaho Power will requirecapital investment to meet customer growth , provide fornecessary maintenance and replacement s of its utilityinfrastructure,as well as fund new investment in electricgeneration, transmission and distribution facilities IdahoPowers service area has experienced strong population
growth,and the Company s most recent resource plan
anticipates the addition of 10 , 000 new customers annually"
In order to keep pace with customer growth,enhance
transmission infrastructure, and balance generation resource
uncertainty Idaho Power anticipates construction
3 Standard & Poor s Corporation, n IDACORP and Unit Ratings Lowered,
Removed From CreditWatch Negative Ra tingsDi reet (Nov. 29 , 2004)4 Moody s Investors Service , n Ratings Action: IDACORP , Inc.Global
Credit Research (Dec. 3 , 2004):J Fi tch Ratings Ltd.., n Idaho Power Company,Global Power/North AIneriea
Credi Analysis (Feb. 18, 2005)
Idaho Power Company, 2004 Integrated Resource Plan (July 2004) at
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Idaho Power Company
expenditures of approximately $672 million over the 2005-2007 period alone,,Over the longer-term, Idaho Power s IntegratedResource Plan has identified the potential need for theCompany to finance construction of approximately 500 MW additional baseload generation , in addition to other systemupgrades.. R Moreover, as indicated earlier, protection,mitigation , and enhancement measures associated with HellsCanyon relicensing are estimated to total $324 million..Consider ing the recent deteriora tion in the Company s creditstanding, support for Idaho Power s financial integrity andflexibility will be instrumental in attracting the capitalnecessary to fund these proj ects in an effective manner"B" Utility Industry
What general conditions have recently
characterized the utili ty industry?
Over the past decade, the industry has
experienced significant structural change resulting from
market forces and decontrol initiatives"At least
initially, this proces s was largely driven by regulatory
reforms at the federal level..The Na tional Energy Policy
'JUIDACORP, Inc.2- Quarter 2004 Form lO-Q Report (June 30, 2005)
Id. at 84"
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Idaho Power Company
Act of 1992 greatly increased prospective competition forthe production and sale of power at the wholesale levelwi th FERC being an aggressi ve proponent for actions designedto foster greater competition in markets for wholesale powersupply"Most market observers agree that, while "openaccess" to FERC-urisdictional transmission facilities hasresulted in more competition in wholesale energy markets, has also introduced substantial risks - particularly forutili ties (like Idaho Power) tha t depend on wholesalemarkets for a portion of their resource requirementsWhat impact did the western power crisis haveon investors ' risk perceptions for firms involved in theelectric power industry?
Events of the last several years caused
investors to rethink their assessment of the relative risks
associated wi th the electric power industry"A well-
publicized energy crisis throughout the west wreaked havoc
on the customers, utilities, and policymakers"It also had
dramatic repercussions for western wholesale power markets
and investors and utilities nationwide..State regulators
and legislators in many jurisdictions have re-evaluated
restructuring initiatives for the retail sector of the
electric industry and the financial implications of the
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Idaho Power Company
western power crisis brought the uncertainties associatedwith today s power markets into sharp focus for theinvestment community"While the case of Californiarepresents an extreme example, there is every indicationthat investors risk perceptions for utili ties shiftedsharply upward In response to these eventsQ..Was there a corresponding impact on theindustrys credit standing?Yes"The last several years witnessed steadyerosion in credit quality throughout the utility industry,both as a result of revised perceptions of the risks in theindustry and the weakened finances of the utili tiesthemselves"For example, during 2002 , S&P recorded 182downgrades in the utility industry, versus only
upgrades, while Moody s downgraded 109 utility issuers and
upgraded 3" 10 Credit quality continued to decline during
2003, with S&P reporting that downgrades outpaced upgrades
by more than 15 to one in the fourth quarter of 2003.
While the pace and scale of nega ti ve ratings actions has
since diminished,S&P reported that the maj ori ty of the
Standard & Poor s Corporation
, ~
u. S. Power Industry Experiences
Precipitous Credit Decline In 2002; Negative Slope Likely to Continue,
RatingsDirect (Jan. 15 , 2003)
H: ~T1oody ' s Investors Service Credit Perspectives (Jul. 14 , 2003) at 33.11 Standard & Poor s Corporation, ~u. s. Utilities ' Ratings Decline
Continued in 2003 , But Pace Slows RatingsDirect (Feb. 2 , 2004)
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companies in the utility sector now fall in the triple-Brating category and noted a continued negative bias in thecredi t outloo k" 12What other developments have contr ibuted investors reassessment of the risks associated with theelectric utility industry?A..Policy evolution in the electric transmissionarea has been wide-reaching and inves tors have increasinglyfocused on uncertainty over operating rules and marketdevelopment Virtually all industry stakeholders haverecognized that regulatory uncertainties increase the risksassociated with the utility industry"For example 1 theDepartment of Energy ("DOE"identified "reducing regula toryuncertainty" as critical in stimulating increased investment
in the power industry and has noted that lack of clarity
the regulatory structure was inhibiting planning and
1 ....I ~lnvestment.. The DOE also recognized the impact that this
regulatory uncertainty has on investors ' required rates of
return for electric utilities
Because transmiss ion assets are long lived,regulatory uncertainty increases the risks investors and, therefore, increases the returns
1 ~::I ,- Standard & Poor s Corporatlon Rat~ngsD~rect (Jul. 6 , 2005 , Jul. 29
2004)
13 u. S. Department of Energy, Na tional Transmission Grid study (May
2002), at 24 and 31.
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Idaho Power Company
they need to justify transmission systeminvestrnents.The 2003 blackout only served to reinforce the importance regulatory risks for investors"The Wall Street Journalcited the debilitating impact of an "unsteady regulatoryenvironment" and the "chaotic combination of regulated andderegulated markets " in explaining inhibitions to increasedinvestment in the electric utility system" Are these uncertainties the only risks beingfaced by utilities?No"Apart from these factors, electricutilities continue to face the normal risks inherent operating utility systems, including the potential adverseeffects of inflation interest rate changes, growth , the
general economy, and regula tory uncertainty and lag..
Fi tch Ra tings, Ltd..Fitch") noted in a survey of the
utility industry:
Taking a longer view , over the coming five years
through 2009, the sector will increasingly face
some potentially negative factors These include
rising interest rates, higher capital expenditures
and volatile cornmodi ty prices.
1 "
rd. at 31.15 Smith , Rebecca , n Overloaded Circuits Blackout Signals Major Weaknessin u. s. Power Grid " The Wall Street Journal (Aug. 18 , 2003)16 Fitch Ratings, Ltd., n Outlook 2005: u. S. Power & Gas,Global Power
North American Special Report (Jan" 6 , 2005) at
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Idaho Power Company
Electric utilities are confronting increased environmentalpressures that leave them exposed to uncertainties regardingemissions and potential contamination.S & P recogni zed thepotential financial challenges posed by such uncertaintiesPension obligations, environmental liabili ties,and serious legal problems restrict flexibility,apart from the obligations ' direct financial, 1'lmpllcatlons.. C" Risks of Idaho PowerHow was Idaho Power impacted by the turmoilin the electr ic power industry?A..Like others,Idaho Power was swept up in themaelstrom of the western energy crisi s Because of IdahoPowers dependence on hydroelectric generation , it hasalways been exposed to the uncertainties associated with
year-to-year fluctuations in water conditions"
Nevertheless, the degree of price volatili ty that Idaho
Power was forced to assume was unprecedented and variability
in short-term market prices bore no resemblance
fluctuations experienced in the past"
Increased wholesale prices and rate structures that
did not capture full costs of acquiring fuel and purchased
power led to depressed earnings To varying degrees,
1')' Standard & Poor s Corporation, Corporate Ratings Criteria at 29/
available at www standardandpoors. com/ratings"
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utili ties throughout the western U" S.. were confronted wi the difficult task of maintaining reliable service andfinancial integrity in a power market characterized by shortsupply and unprecedented price volatility"Because of lowstream flows available to Idaho Power s hydroelectricfacilities and the resulting dependence on wholesale powermarkets in the west! the chaotic market conditions were feltdirectly"Are investors likely to consider the impactof industry uncertainty in assessing their required rate ofret urn for Idaho Power?Absolutely.~'\7h i Ie utili ty restructuring hasnotbeenactivelypursued Idaho,Idaho Power continuesfacetheprospectFERCdrivenchanges the electric
transmission function of their business, as well as other
fundamental industry reforms"Moreover , because roughly
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 most utilities"
While hydropower confers advantages in terms of fuel cost
savings and diversity, reduced hydroelectric generation due
to below-average water conditions forces Idaho Power to rely
more heavily on purchased power or more costly thermal
generating capacity to meet its resource needs
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Idaho Power Company
Additionally, in recent years utilities and their customershave also had to contend wi th dramatic fluctuations in gascosts due to ongoing price volatility in the spot markets" The IPUC acknowledged these trends in connection wi th itsapproval of increase in the weighted average cost ofgas for Intermountain Gas Company ("Intermountain GasWholesale natural gas prices have continued fluctuate dramatically" The volatile natural gasmarket has seen forecasts of fut ure costs atrecord levels, and resulted in increaseduncertaint~, about when and where prices will1 "stablllze.. In the minds of investors, dependence on wholesalemarkets entails signif icant ris k, especially for a utili located in the west..Investors recognize that volatileenergy markets, unpredictable stream flows, and Idaho
Power s reliance on wholesale purchases to meet a portion
its resource needs can create a "perfect storm " exposing
the Company to the ris k of reduced ca sh flows and
unrecovered power supply costs"Idaho Power s reliance
purchased power to meet shortfalls in hydroelectric
generation magnifies the importance of strengthening
1;: - For example , the Energy Informatlon Admlnlstratlon (n EIA") reported
(Mar. 27 / 2003) that the average spot gas price at the Henry Hub spikedto $18. 85 per Mt1Btu in February 2003 , before declining to approximately
$5.00. More recently, EIA noted that "prices at the Henry Hub on
Wednesday, October 12 exceeded last year s level by $ 8" 3 6 per i~tu
about 156 percent.
ff
(lVa ural Gas vveekly Upda te.l Oct. 13 , 2005)
19 Idaho Public utilities corn..mission, Order No. 29875 (Sep. 29, 2005) at
7 .
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Idaho Power Company
financial flexibility, which is essential to guaranteeaccess to the cash resources and interim financing requiredto cover inadequate operating cash flows, as well as fundrequired investments in the utility system..Have the risks of market volatilitydissipated since the crisis in 2000-2001?A..No..Investors recognize that the continuingprospect of further turmoil in western energy markets cannotbe discounted, wi th S&P reporting continued spikes inwholesale market prices in the aftermath of the crisis:For 2003, record-high wholesale power prices werethe defining feature of the U. S" merchant powermarkets" " .. Power prices across the U. Scontinent generally rose on the order of 50% ormore in 2003" " "" Prices in the western regionswere also the highest on record outside of the2000-2001 California energy crisis"
More recently, S&P noted that, while the severe
distortions that characterized the energy crisis of 2000-
2001 have faded, "(nJ atural gas volatility, poor hydro
conditions in the Northwest, the Southwest's sustained
drought, and uncertainty over future generation development"
are "daily reminders " of the challenges to the financial
LU Standard & Poor s Corporation, "Energy Commodity Report: U. S. Power
Prices Record High in 2003 n Ra
tingsDi rect (Jan. 15 , 20 a 4) .
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Idaho Power Company
" .) 1health of western utlll tles " ~S &P noted the danger posedby "high and volatile natural gas prices," which increase, ...'the uncertainties associated with power supply costs. the Economist Intelligence Unit,Ltd..indicated,thissensitivity has only been magnified by fallout of thenatural disaster in the Gulf Coast region:Hurricane Katrina has sent gas prices to newrecord levels, exacerbating an already supply-tight market that has seen high prices for thelast two years. There is Ii ttle indication thatthe si tua tion will improve in 2006"Meanwhile, the FERC Staff has warned of the ongoingpotential for market disruption in the west, due in part toconstrained hydro generation.As a recent report concl uded:Our review of supply and demand condi tions in thewest this summer indicates that there may beperiods of market tightness most likely expressed" .2.ias prlce splkes and posslble lnterruptlons
S&P observed that utilities in the Pacific Northwest
(::
continue to face a host of challenges, If,.and went on to
note the significant potential costs and risks imposed by
~ Standard & Poor s Corporation, utili ties Perspecti ves (Oct. 18,
2004) 22 Standard & Poor s Corporation
, ~
Prolonged High Natural Gas Prices May
Increase Credit Risk for S. Gas Distributors RatingsDirect (Jan. 19
2005)22 Economi,st Intelligence Unit , Ltd.
, ~.
World Commodities - Natural ga,
market outlook (Sep. 1 , 2005) at 2q Federal Energy Regulatory Commission, Office of Market Oversight and
Investigations
, ~
Summer Energy ~,1arket As,sessment 2005 (May 4 , 2005) at
11.25 Standard & Poor s Corporat ion
, ~
Legal Developments Add to Ut il itie 0'3
Disquiet in s. Northwest,utilities Perspectives (July 21, 2003) at
2 -
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uncertainty over fish-conservation measures that might berequired to meet federal law and continued vola tili ty wholesale power markets" S &P concluded that "managinghydro risk has assumed a critical importance to creditquality" ,,27 Do recent weather conditions ameliorateinvestorsconcerns?No"Lack of snow and warmer than normaltemperatures last winter have only deepened concerns overpower pr lces..The Wall Street Journal observed earlier thisyear that:Regional weather watchers say conditions arestarting to resemble those of 2001 , when dryweather and a low snowpack brought droughtconditions to the Pacific Northwest"
On April 29 2005 Idaho s Governor issued a drought
emergency for Power County,one of 20 county drought
declarations for the year,citing sharply reduced flows in
) c,the Snake Rl ver..
Similarly,Fi tch noted that the Pacific Northwest
was "in the midst of its sixth consecutive year of well-
L() Id"
2) Id"2:::' ~ Stepankowsky, Paula L.
, ~
Lack of Snow ln Paclflc Northwest Helghtens
Wor ry About Power," The ~'lall Street Journal (Feb" 16, 2005)
2"'~ The Governor of the State of Idaho
, "
Kempthorne Declares Drought
Emergency in POvJer County,News Release (April 29 , 2005)
; ~
Kempthorne
Declares Drought Emergency in Lincoln County,News Release (June 1 7 ,
2005)
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Idaho Power Company
below-normal water conditions, ff with runoff in the SnakeRiver Basin estimated at to ::z ()0 f 3 0 - yea r norm s " -, ---Fitch recognized that lower stream flows would force greaterreliance on more expensive thermal generating facilities andconcluded that:The adverse financial effect of continued dryweather conditions on load-serving entities (LSEs)in the region is exacerbated by high natural gasprices, which will make replacement power services(i" e"purchased power and operation of naturalgas-fired combined cycle) and peaking capacitymore expensive.. Investor s recognize the significant financial burdenassociated with prolonged dry weather in the west"As Fitchsummarized:(T he duration and severity of the currentdrought, which stretches back through the energycrisis of 2000-2001 , has resulted in meaningful
cash flow volatility, balance-sheet erosion and
diminished financial flexibility." 32
From the standpoint of the capital markets, the west is
risky - and Idaho Power s continued exposure to wholesale
electric and natural gas markets in meeting shortfalls
hydroelectric generation and other variations in resources
and loads compound these uncertainties
jU Fitch Ratings Ltd"
, "
Hydro Update fl Global Power/North America
Special Report (June 2 , 2005)
31 rd..
32 rd.,
AVERA , DI
Idaho Power Company
Does the PCA remove the risk associated withfluctuations in power supply costs?No.While the PCA is supportive of IdahoPowers financial integrity, it does not apply to 100power costs Moreover , even for utilities with permanentenergy cost adj ustment mechanisms in place, there can be significant lag between the time the utili ty actually incursthe expenditure and when it is recovered from ratepayersThi s lag can impinge on the utility s financial strengththrough reduced liquidi ty and higher borrowings As S&Pnoted, the PCA does not insulate Idaho Power from the needto finance accrued power production and supply eosts:The drought that has affected stream flows in theSnake River is in its fifth year and has raisedcosts substantially for customers by depressing
low-cost hydro output. This has meant tha t
deferred revenues ($ 71 million a s of Dee" 31,
2003) never decreased to zero since the time of
the western U"power crisis
What other factors would investors consider
in evaluating the impact of the PCA?
Idaho Power s PCA applies to 90% of the
deviation between actual power supply costs and normalized
rates As originally contemplated, this provision would
res u 1 t in a m 0 re o r 1 e s s s ymm e t r i c a 1 s h a r i n g 0 r i s k s , wit h
33 Standard & Poor s Corporation, "IDACORP and Unit Ratings Lowered,
Removed From CreditWatch Ra tin gsDi Ie ct (Nov" 2 9 004) .
AVERA , DI
Idaho Power Company
customers reaping the benefits when power costs exceedednormal levels and Idaho Power benefiting when power supplieswere obtained at below-normal cost.However , the confluence of prolonged drought andsharply higher natural gas prices - both of which are beyondthe control of Idaho Power s management - has resul ted sustained shortfalls between actual power costs andnormalized rates"Combined with the provisions of the PCAthe end result has been that Idaho Power s shareholders haveeffectively provided customers with discount towardscost increases for the largest single component in the priceof electricity..In 2003 and 2004 for example, the Companyunrecovered power costs totaled $23" 4 million and $13"
million,respecti vely" Moreover 1 with no apparent end to
drought conditions, and with the IPUC warning consumers
prepare for "an indefinite period of higher than normal
prices for natural gas, n2fj there is no indication that this
established pattern will soon reverse"As a resul
3q While these figures include amounts attributable to Idaho Power
Oregon-jurisdictional operations , the majority are associated with the
provisions of the PCA in Idaho.35 Idaho Public Utili ties Commission
, "
Higher than normal gas prices may
be with us for awhile," htt ://,~w. uc.state.id.us/ (Retrieved Oct. 19,
2005)
AVERA , DI
Idaho Power Company
investors undoubtedly consider this exposure in evaluatingIdaho Power s risks and their required rate of return"Does the PCA protect Idaho Power from thepotential for regulatory disallowances?No"Even wi th an energy cost adj ustmentmechanism, investors recognize the ongoing potential forregulatory disallowances As S & P observed:(Fuel and purchased power adj ustment mechanisms(FPPA) J vary substantially in their ability protect utilities daily and under catastrophicmarket movements" Moreover, it is critical note that FPPAs are not a substitute forsupportive regulation; the regulator s ability disallow costs through ex-post prudency review,regardless of the existence of a FPPA , is a factof life for utilities. Similarly, Fi tch noted that "because of the lagbetween when the exces s costs are incurred and when they are
reeovered and the potential disallowanees of such costs 1 "
substantial uncertainties remain even for utili ties with
fuel and purchased power cost adj ustment mechanisms " ~ I
Significantly, Fitch specifically highlighted Idaho Power
one of 29 utilities having "relatively greater fuel or
purchased power exposure wi thin the sector jU and cited the
36 Standard & Poor s Corporation, utili ties Perspectives (Oct. 18,
2004) 37 Fitch Ratings Ltd., n Out look 2 a 05: U.. S.. Power & Gas " Global
Power/North America Special Report (Jan. 6, 2005) at 26.
::
Id.. at 27..
AVERA , DI
Idaho Power Company
earnings volatili ty inherent in the utili ty ' s hydrogeneration system " as a primary factor in its decision to. (,downgrade Idaho Power s senior debt ratings. Is an evaluation of the capital structuremaintained by a utility relevant in assessing its return equi ty?A..Yes Other things equal, a higher debtratio, or lower common equity ratio, translates intoincreased financial risk for all investors A greateramount of debt means more investors have a senior claim available cash flow, thereby reducing the certainty thateaeh will receive his contractual payments This increasesthe risks to which lenders are exposed, and they requirecorresponding ly higher rates of interest.From common
shareholders standpoint, a higher debt ratio means that
there are proportionately more investors ahead of them
thereby increasing the uncertainty as to the amount of cash
flow , 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 testimony of Mr. Gribble and Ms " Smi th"
;' Fitch Ratings Ltd. Idaho Power Company,Global Power/North America
Credi Analysis (Feb. 18 2005) at
AVERA , DI
Idaho Power Company
summarized in their testimony, the common equity ratio usedto compute Idaho Power s overall rate of return was 49" 4 62in this filing"What was the average capitalizationmaintained by the reference group of utili ties?As shown on Exhibit WEA-2 , for the ten firmsin the proxy group, common equity ratios at December 31,2 0 0 4 ran 9 e d from 3 7 " 2 % to 6 5 " 8 % and ve rag e 4 9 " 7 % What implication does the increasing risk ofthe utility industry have for the capital structuresmaintained by utilities?The decline in credi t quality in the electricindustry is indicative of the need for utilities strengthen their balance sheets to deal wi th an increasingly
uneertain and competitive market.S&P cited higher debt
leverage and the inadequacy of financial profiles in the
electric industry as one of the key factors explaining this
deterioration.A more conservative financial profile
consistent wi th increasing uncertainties and the need
maintain the continuous access to capital that is required
to fund operations and necessary system investment, even
during times of adverse capital market conditions
As shown on Exhibit WEA-2, the Value Line Investment
Survey ("Value Line expects that the average common equi
AVERA , DI
Idaho Power Company
ratio for the proxy group of western utili ties will increaseto 55,,over the next three to fi ve yearsHow does Idaho Power s common equity ratiocompare with those maintained by the reference group utilities?Idaho Power 49" 4 common equity ratio entirely cons istent with the 49.. 7 average for the proxygroup at year-end 2004 and falls well short of the 55" 6%equity ratio based on Value Line s expectations for thesewestern utilities over the near-term"How does Idaho Power s capital structurecompare with other widely cited financial benchmarks forutilities?The financial ratio guidelines published by
S&P specify a range for a utility s total debt ratio that
corresponds to each specific bond rating"Widely cited
the investment community, these ratios are viewed
conj unction with a utility business profile ranking, which
ranges from (strong) to (weak) depending on a utili ty ' s
relative business risks..Thus , S &P' s guideline financial
ratios for a given rating category (e" g", triple-B) vary
with the business or operating risk of the utility"
other words, a firm with business profile of "(i"
relatively lower business risk) could presumably employ more
AVERA , DI
Idaho Power Company
financial leverage than a utility with a business profileassessment of "9" while maintaining the same credit rating"S&P has assigned Idaho Power business profile ranking ofk ff 4 U:J Consistent wi th an S&P business profile ranking of, a ratio of total debt to total capi tal in the range to is specified for a triple-B bond rating 1 whichtranslates to an equity ratio between 40% and 50%" 41What other factors do the rating agenciesconsider in their assessment of a company s capitalstructure?Beca use pOi."ler purcha se agreements (" PPAstypically obligate the utility to make specified minimumcontractual payments akin to those associated with
tradi tional debt financing,investors consider a portion
these commitments as debt in evaluating total financial
risks..Further changes in financial accounting standards
also result in adjustments that have the effect of further
increasing financial leverage"Because bond ratings
agencies and investors adjust for these various commitments
4n Standard & Poor s Corporatlon
, ~
U. S. Utility and Power Ranking List
RatingsDirect (May 13 , 2005)41 Standard & Poor s Corporation
, ~
New Business Profile Scores Assignedfor u. s. Utility and Power Companies; Financial Guidelines Revi,sed,
(June 2 , 2004) at Tab 1 e
AVERA , DI
Idaho Power Company
in assessing a utility s financial position , they implygreater risk and reduced financial flexibility..Do mandated PPA's with PURPA QualifyingFacili ties QF') have a similar impact?Yes"When a utility enters into a PPA with , the fixed charges associated with the contract increasethe utility s financial risk in the same way that long-termdebt and other financial obligations increase financialleverage"Under current accounting rules, the accountingfor a PPA is not discretionary if the transaction meetsspecified tests for accounting for capital leases, whichrequire that the obligation be explicitly recorded as a debtobligation on the utili ty ' s balance sheet"As a result, the utility must rebalance its capital
structure by increasing its common equity in order to
restore its capitalization ratios to previous levels Since
the cost of equi ty exceeds the cost of debt, this
rebalancing imposes additional costs, which are properly
considered by regulators
Do QF PPAs that do not meet the accounting
definition for capital lease treatment still impact
investors ' assessment of Idaho Power s financial risks?
Yes"The accounting standards simply reflect
the longstanding perception of investors that the fixed
AVERA , DI
Idaho Power Company
obligations associated with PPAs diminish a utilitycreditworthiness and financial flexibility"Theimplications of purchased power commi tments have beenrepeatedly cited by maj or bond rating agencies in connectionwith assessments of utili ty financial risks"For example, in reviewing its evaluation of thecredit implications of PPAs, S&P affirmed its position thatsuch agreements are "debt-like in nature " and that theincreased financial risk must be considered in evaluating utility s credit risks .. 42 As the rating agency explained:(PJ urchased power agreements typically result inthe assumption of fixed costs representing theportion of the purchase price that is linked the capacity component of the total payment"These fixed capacity payments are similar to debtservice payments incurred by a utility thatconstructs debt-financed power generationfacilitiesTherefore, whether a utility builds
its own generating plants, or enters into a long-
term power purchase agreement wi th a fixed-cost
component, that utility is taking on financial
risk" iI,
When evaluating Idaho Power s financial risks, investors
likewise recognize that the Company s contractual payment
obligations to QFs are fixed commitments with debt-like
characteristics
4;' - Standard & Poor s Corporatlon '" Buy Versus BUlld': Debt Aspects of
Purchas ed Power Agreement s,utili ties Perspecti ves (May 12, 2003)43 Standard & Poor s Corpora t ion Ra tingsDirect (Nov. 2003)
AVERA , DI
Idaho Power Company
Indeed, payment obliga tions under Idaho Powerexisting PPAs with QFs currently total approximately $46 " 4million.Unless Idaho Power takes action to offset thisadditional financial risk the resulting leverage lowers theCompanys creditworthiness and places downward pressure its ratings QF PPAs thus potentially increase investorsrequired rate of return for Idaho Power s debt and equitysecurities" What does this evidence suggest with respectto Idaho Power s proposed capital structure?While industry averages provide one benchmarkfor comparison,each firm must select its capitalizationbased on the risks and prospects it faces,as well itsspecific needs to access the capital markets"A public
utility with an obligation to serve must maintain ready
access to capital so that it can meet the service
requirements of its customers The need for access becomes
even more important when the company has large capital
requirements over a period of years, and financing must be
4 j '- Apart from the lmmedlate lmpact that the flxed obllgatlon of
purchased power costs has on the utility s financial risk , higher fixed
charges also reduce ongoing financial flexibility, and the utility may
face other uncertainties, such as potential replacement power costs in
the event of supply disruption.
AVERA , DI
Idaho Power Company
continuously available, even during unfavorable capitalmarket conditionsThe recent decision of S&P and Fitch to downgradeCentral Vermont Public Service ("Central Vermont"fromtriple-B to below investment grade highlights the importanceof maintaining sufficient common equi ty to preserve theutilitys creditworthiness, even during times of stressDespite a common equity ratio that exceeded 60%, S&P andFitch determined that Central Vermont's financial positionwas inadequate to support an investment grade rating in theface of an unfavorable regulatory order" As indicated earlier,the decline in the Companycredit standing and the heightened uncertainty associatedwith Idaho Power s reliance on hydroelectric generation
magnifies the importance of preserving financial
flexibility"Under these circumstances, it is es sential
that Idaho Power s capital structure include adequate
borrowing capacity to maintain an ongoing ability to raise
capital sufficient to fund planned capital investments and
meet its service obligations..While financial flexibili
plays a crucial role in ensuring the wherewi thaI to meet the
45 "S&P Do\vngrades cVPS Corporate Credit Rating,
If Business viire (June
14, 2005)
; "
Fitch Ratings Downgrades CVPS,Business Wire (June 201
2005)
AVERA , DI
Idaho Power Company
needs of customers, utilities wi th higher leverage may beforeclosed from additional borrowing, especially duringtimes of stress In this regard, Idaho Power s equity ratioreflects the challenges posed by its resource mix , as wellas the burden of significant capital spending requirementsIdaho Power s proposed capi tal structure is just onereflection of the Company s ongoing efforts to enhance itscredit standing and maintain access to capital on reasonableterms in order to ensure its ability to meet its obligationsto customers..The reasonableness of Idaho Power s requestedcapital structure is reinforced by the ongoing uncertaintiesassociated with the electric power industry, the Companyrelative risks and circumstances, the need to supportcontinued system investment, and the imperative
maintaining continuous access to capital, even during times
of adverse industry and market conditions As the
experience of Central Vermont illustrates, even a healthy
equity cushion may not be sufficient to support a utility
credit rating s when investors perceive a lack of regulatory
support
III" CAPITAL MARKET ESTIMATES
What is the purpose of this section?
AVERA , DI
Idaho Power Company
This section presents capital marketestimates of the cost of equity for a benchmark group utilities"The details of my quantitative analyses arecontained in my Addi tional Direct testimony, wi th theresults being summarized below"A.. OverviewWhat role does the rate of return on commonequity play in a utility s rates?The return on common equity is the cost inducing and retaining investment in the utility s physicalplant and assets"This investment is necessary to financethe asset base needed to provide utility service"Investorswill commit money to a particular investment only if theyexpect it to produce a return commensurate with those from
other investments with comparable rig ks"Moreover, the
return on common equity is integral in achieving the sound
regulatory objectives of rates that are sufficient to:
fairly compensate capital investment in the utility,
enable the utility to offer a return adequate to attract new
capital on reasonable terms, and 3) maintain the utility
financial integri ty..Meeting these obj ecti ves allows the
utility to fulfill its obligation to provide reliable
AVERA , DI
Idaho Power Company
service while meeting the needs of customers throughnecessary system expansion"What fundamental economic principle underliesany evaluation of investors ' required return on equity?Underlying the concept of the cost of equitylS the fundamental notion that investors are risk averse,and will willingly bear additional risk only if they expectcompensation for doing so"As explained in greater detailin my Additional Direct testimony, the required rate ofreturn for a particular asset at any point in time is afunction of: 1) the yield on ris k-free assets, and itsrelative risk, wi th investors demanding correspondinglylarger risk premiums for assets bearing greater risk"Because common shareholders have the lowest priority claim
on a firm s cash flows, they receive only the residual that
remains after all other claimants - employees, suppliers,
governments,lenders, have been paid..As a result, the rate
of return that investors require from a utility s common
stock, the most junior and riskiest of its securities,
considerably higher than the yield on the utili ty ' s long-
term debt"
Is the cost of equity observable in the
capital markets?
AVERA , DI
Idaho Power Company
No"Unlike debt capital , there is nocontractually guaranteed return on common equity capitalsince shareholders are the residual owners of the utility"Because it is unobservable, the cost of equity for particular utili ty must be estimated by analyzinginformation about capital market conditions generally,assessing the relative ris ks of the company specifically,and employing var ious quanti tati ve methods that focus oninvestors' current required rates of return These variousquanti ta ti ve methods typically ttempt to infer investor srequired rates of return from stock prices, interest rates,or other capital market data.Did you rely on a single method to estimatethe cost of equi ty for Idaho Power?
No" In my opinion, no single method or model
should be used to estimate a utility s cost of equi ty
because no single approach can be regarded as wholly
reliable"As the Federal Communications Commission
recognized:
Equity prices are established in highly volatile
and uncertain capital markets
* ..
.. Different
forecasting methodologies compete with each other
for eminence, only to be superceded by other
methodologies as conditions change"" In these
circumstances, we should not restrict ourselves
one methodology, or even a series of
methodologies, that would be applied mechanically..
2 6
AVERA , DI
Idaho Power Company
Instead, we conclude that we should adopt a moreaccommodating and flexible position" Therefore, I considered the results of both the DCF modeland risk premium methods to estimate the cost of equi ty"addi tion,I also evaluated a fair rate of return using comparable earnings approach based on inve stars ' currentexpectations in the capital markets..In my opinion,comparing estimates produced by one method with thoseproduced by other approaches ensures that the estimates the cost of equity pass fundamental tests of reasonablenessand economic logic"Which companies did you reference in applyingthe risk premium and DCF approaches to estimate the cost ofequi ty?
As explained in my Addi tional Direct
testimony, my quantitative analyses of investors ' required
rate of return focused on a group of ten publicly traded
utilities included by Value Line in their Electric Utili ties
(West)Industry group, all of which pay common dividends and
have investment grade credi t ratings"
4.) Federal Communications Commission, Report and Order 42-43, CC Docket
No. 92-133 (1995)
AVERA , DI
Idaho Power Company
Based on the results of your analyses, whatwas your conclusion regarding a fair rate of return equity for the companies in the proxy group?After incorporating an adj ustment forflotation costs, I concluded that a fair rate of return equity for the proxy group of utilities is in the 11.0% to12 . 0 range, with a midpoint of 11 .. 5 B" Resul ts of Quanti ta ti ve AnalysesBriefly describe your risk premium methods.The details of my risk premium analyses arepresented in my Additional Direct testimony"As explainedthere, the risk premium method involves determining theaddi tional return above the yield on bonds that investors
require for bear ing the higher risks of common stock"This
equity risk premium is then added to the current yield on
bonds to estimate the cost of equi ty..My applications of
the risk premium method provide alternative approaches to
measure equity risk premiums that focused specifically on
data for electric utilities and employed alternative
estimates of investors ' required rates of return.
My risk premi um analyses were based on three widely
accepted and commonly applied approaches -- (1)surveys of
previously authorized rates of return on common equi ty,(2
AVERA , DI
Idaho Power Company
realized rates of return , and (3) alternative applicationsof the Capital Asset Pricing Model ( "CAPM"Is it appropriate to consider anticipatedcapital market changes in applying ri sk premium methods?Yes"As detailed in my Addi tional Directtestimony, there is widespread consensus that interest rateswill increase materially as the economy continues tostrengthen, with the Federal Reserve s recent actionsindicati ve of tighter credi t condi tions and higher interestrates in the years ahead"As a result, current bond yieldsare likely to understate capital market requirements at thetime the outcome of this proceeding beeome s eff ecti ve.Accordingly, in addi tien to the use of current bondyields, I also applied the alternative risk premium methods
using forecasted bond yields for 2006 developed based on an
average of the projections published by GlobalInsight, the
Energy Information Administration, and Blue Chip Financial
Forecasts"
What were the results of your risk premium
analyses for the proxy group of utili ties?
4 '
j'
An analogous approach was adopted by the staff of the Florlda PubllC
Service Commission in a May 20 , 2004 Memorandum in Docket No. 040006-WS
and in the testimony of staff witness Andrew L. Maurey in Docket No.
0O0824-EI (Jan" 2002)
AVERA , DI
Idaho Power Company
As detailed in my Addi tional Directtestimony, my risk premium analyses implied the followingcost of equity estimatesRisk Premi urn ApproachAuthorized ReturnsCurrent Yieldproj ected YieldRealized Rates of ReturnCurrent Yieldproj ected YieldCAPM - Forward-lookingCurrent YieldProj ected YieldCAPM - HistoricalCurrent YieldProj ected Yield Cos t of Equi Estimatec'~" ~11" 9.. 8 c,~" ~.. 6?~q:k. ~ 0.. ....What cost of equity was indicated by your DCFanalyses for the proxy group of western utilities?
Dividend yields for the nine firms in the
utility proxy group ranged from 2 " 2 to 4 " 6%, and averaged
.::-r
" ...
Comb i n i n 9 t his d i ide n d y i e 1 d wit h the 5 " 5 % 9 row t h
rate indicated for the proxy group implied a DCF cost
equity of 9..0/6
Q..Do you believe this DCF result represents
reasonable estimate of the cost of equity for the proxy
group or Idaho Power?
No"As I noted earlier , because the cost of
equity is unobservable, no single method should be viewed in
AVERA , DI
Idaho Power Company
isolation"While the DCF model has been routinely relied in regulatory proceedings as one guide to investorsrequired return, it is a blunt tool that should never beused exclusively, and regulators have customarily consideredthe results of al ternative approaches in determining allowedret urns"The need to consider al ternati ve methods isespecially important where the result s of one approachdeviate significantly from cost of equi ty estimates producedby other applications"Indeed, as di scussed earlier , theresults of alternative risk premium methods suggest a costof equity far in exces s of this single DCF value.Moreover, as discussed in my Additional Direettestimony, the short-term projected growth rates typicallyused to apply the DCF model may be colored by lingering
uneertainties regarding the near-term direction of the
economy in general and the spate of challenges recently
faced in the electric power industry specifically..This
short-term "hangover is exemplified by Value Line, which
has assigned its Utilities sector the lowest ranking of all
10 sectors it covers for year-ahead stock price
per formance, 4:3 while noting that " (t J he electric utility
industry carries a below-average industry Timeliness
4~: The Value Line Investment Survey, Selection Opinion (July 29, 2005)at 1606.
AVERA , DI
Idaho Power Company
rank"As a result of this cautious near-term outlookDCF growth rates do not necessarily capture investors ' long-term expectations for the industry, and the resulting costof equity estimates will be downward biased"Accordingly, it would be unreasonable to establishan ROE based on this single DCF resul t, especiallyconsidering my earlier discussion of Idaho Powerinvestment risks and the importance of maintaining theCompanys ability to attract capital..Q..What other analyses did you conduct toestimate the cost of equity?As I noted ear ier,I also evaluated the eostof equity using the comparable earnings method.Referenceto rates of return available from alternative investments of
comparable risk can provide an important benchmark
assessing the return necessary to assure confidence in the
financial integrity of a firm and its ability to attract
capi tal.This comparable earnings approach is consistent
with the economic underpinnings for a fair rate of return
established by the Supreme Court..Moreover, it avoids the
complexities and limitations of capital market methods and
4 Cf- The Value Llne Investment Survey \July 1 , 2005) at 695.
AVERA , DI
Idaho Power Company
instead focuses on the returns earned on book equi ty, whichare readily available to investors"What rates of return on equi ty are indicatedforutilitiesbasedthisapproach?With respect expectations for electricutilitiesspecifically,the most recent edition ValueLine reports that its analysts anticipate an average rate return on common equi ty for the electric utili ty industry 5% in 2005 and 2006 , increasing to 11 0% over its three-to-five yearexpectsthataveragerate forecast horizon.. 50 Meanwhile, Value Linenatural gas distribution utilities will earn of return on common equi ty of 12 in 2005 and2006, and 12 (::: -"1for 2008-2010 . .Can the comparable earnings method be applied
to other firms of similar risk?
Yes.Under the regulatory standards
established by Hope and Bl uefield, the salient criteria
establishing a meaningful benchmark to evaluate a fair rate
of return is relative risk , not the particular business
activity or degree of regula tion..Utilities must compete
for capital , not just against firms in their own industry,
but with other investment opportunities of comparable risk.
U The Value Line Investment Survey (Sep. 2, 2005) at 156.
r" ..~~ The Value Line Investment Survey (Sep~ 16 , 2005) at 459~
AVERA , DI
Idaho Power Company
Consistent with this accepted regulatory standard,I alsoapplied the comparable earnings approach based on reference group of companies in the unregulated sector ofthe economy.The average Value Line Safety Ranking for the firmsin the proxy group is "2" with beta values for the tenelectric utilities ranging from 0 .. 70 to 1 .. 05..According ly,my reference group was composed of those U. S" companiesfollowed by Value Line that 1) pay common dividends, 2) havea Safety R_ank of 2fT f and 3) have beta values between 0 .. and 1"Value Line s projections indicate that itsanalysts expect that rates of return on shareholders ' equityfor the resulting group of 151 firms will average 15wi th the median being 14
What return on equi ty is indicated by the
results of the comparable earnings approach?
Based on the results discussed above, I
concluded that the comparable earnings approach implies
fair rate of return on equity in the range of 11.
12 " 0'
%..
l' ,
~~ www~valueline~com (Retrieved Oct~ 11 , 2005)
AVERA , DI
Idaho Power Company
C. Proxy Group Cos t of Equi What did you conclude wi th respect to thecost of equity for the proxy group of utilities?A..In light of anticipated capital market trendsand the recent challenges experienced in the utilityindustry, caution should be exercised in interpreting theresults of DCF and risk premium applications..As notedearlier, the single DCF result is out of line with thepreponderance of estimates produced by the risk premium andcomparable earnings approaches and should not be viewed isolation, especially considering the potential for downwardbias when DCF growth rates do not capture investors ' long-term expectations Moreover , in light of acceleratingeconomic growth and expecta tions for higher interest rates,
risk premium estimates based on projected capital market
condi tions should receive more weight
Accordingly, based on the resul ts of my quanti tati ve
analyses, and my assessment of the relative strengths and
weaknesses inherent in each method, I concluded that the
cost of equity for the utility proxy group is in the 10 " 8%
to 11,,range"
What other considerations are relevant in
setting the return on equity for a utility?
AVERA , DI
Idaho Power Company
The common equi ty used to finance theinvestment in utility assets is provided from either thesale of stock in the capital markets or from retainedearnings not paid out as dividends When equity is raisedthrough the sale of common stock , there are costs associatedwith "floating " the new equity securi ties..These flotationcosts include services such as legal, accounting, andprinting, as well as the fees and discounts paid compensate brokers for selling the stock to the public..Also, some argue that the "market pressure " from theadditional supply of COITlrTlon stock and other market factorsmay further reduce the amount of funds a utility nets whenit issues common equity"Is there an established mechanism for a
utility to recognize equity issuance costs?
No"While debt flotation costs are recorded
on the books of the utility, amortized over the life of the
issue, and thus increase the effective cost of debt capi tal
there is no similar accounting treatment to ensure that
equity flotation costs are recorded and ul timately
recognized"Alternatively, no rate of return is authorized
on flotation costs necessarily incurred to obtain a portion
of the equi ty capi tal used to finance plant..I n other 'Vlords,
equity flotation costs are not included in a utility s rate
AVERA , DI
Idaho Power Company
base because neither that portion of the gross proceeds fromthe sale of common stock used to pay flotation costs isavailable to invest in plant and equipment, nor are flotationcosts capitalized as an intangible asset.Unless someprovision is made to recognize these issuance costs, utility s revenue requirements will not fully reflect all ofthe costs incurred for the use of investors funds..Becausethere is no accounting convention to accumulate the flotationcosts associated with equity issues, they must be accountedfor indirectly, with an upward adj ustment to the cost equity being the most logical mechani sm.What is the magnitude of the adj ustment the "bare bones " cost of equity to account for issuancecosts?
There are a number of ways in which
flotation cost adjustment can be calculated, and the
adj ustment can range from just a few basis points to more
than a full percent.One of the most common methods used
account for flotation costs in regulatory proceedings is to
apply an average flotation-cost percentage to a utility
dividend yield"Based on a review of the finance
literature, Regula tory Firlance: Utili ti es
I' Cost of Capi tal
concluded:
AVERA , DI
Idaho Power Company
The flotation cost allowance requiresadj ustment to the return approximately to 10 , depending on,- ~r i s k 0 f the i s sue " ~-an estimatedequity the size andAlternatively, a study of recent data from Morgan Stanleyregarding issuance costs associated with utility commonstock issuances suggests an average flotation cost.--- percentage of 3 .. 6%" Applying these expense percentages a representative dividend yield for a utility of 3" 5%implies a flotation cost adj ustment on the order of 13 to basis points"What then is your conclusion regarding a fairrate of return on equi ty for the companies in your proxygroup of western utilities?After incorporating an adj ustment forflotation costs of 20 basis points to my "bare bones " cost
of equi t y range,I concluded that a fair rate of return
equity for the proxy group of utilities is in the 11" 0%
12 . 0% range, with a midpoint of 11 " 5
IV.RETURN ON EQUITY FOR IDAHO POWER
What is the purpose of this section?
53 Roger A.. :r-.1orin Regula tory Finance: utili ties F Cost of Capi tal 1994 at 166..52 ,Appl~cat~on of Yankee Gas Serv~ces Company for a Rate Increase DPUC
Docket No. 04-06-, Direct Testimony of George J. Eckenroth (Jul. 2
2004) at Exhibit GJE-11~1~ Updating the results presented by Mr.
Eckenroth through April 2005 also resulted in an average flotation cost
percentage of 3. 6%.
AVERA , DI
Idaho Power Company
In addi tion to presenting the conclusions my evaluation of a fair rate of return on equity for IdahoPower, this section also discusses the relationship betweenROE and preservation of a utility s financial integrity andthe sustained ability to attract capi tal under reasonableterms"A. Implications for Financial IntegrityWhy is it important to allow Idaho Power adequate rate of return on equity?Given the social and economlC importance the utility industry,it is essential to maintain reliableand economical service to all consumers.While Idaho Powerremains committed to deliver reliable service, a utilityability to fulfill its mandate can be compromised if it
lacks the necessary financial wherewithal"As S & P noted,
Idaho Power faces "significant exposure to hydrological
variations in the Snake River and significant capital
expendi ture requirements for new generation and hydro
(;;
re Ii Gens ing " ,,:1-Coupled wi th the ongoing potential for
energy market volatility, this poses a number of potential
challenges that might require the relatively swift
-' Standard & Poor s Corporation, "IDACORP and Unit Ratings Lowered,
Removed From CreditWatch Ne gat ive Ra tingsDi Ie c t (Nov. 29 , 2004)
AVERA , DI
Idaho Power Company
commitment of significant capital resources in order maintain the high level of service that customers have cometo expect.Events in the western U" S.. provide a dramaticillustration of just how swiftly unforeseen circumstancescan lead to deterioration in a utility s financialcondition, and stakeholders have discovered first hand howdifficult and complex it can be to remedy the situationafter the fact..For a utility with an obligation to providereliable service, investors ' increased reticence to supplyadditional capital during times of crisis highlights theneeessi ty of preserving the flexibili ty necessary toovercome periods of adverse capi tal market conditions"What role does regulation play in ensuring
Idaho Power s access to capital?
Considering investors ' heightened awareness
of the risks associated with the utility industry and the
damage that resul ts when a utili ty ' s financial flexibili
is compromised, supportive regulation remains crucial
Idaho Power s access to capital..Investors recognize that
constructive regulation is a key ingredient in supporting
utility credit ratings and financial integrity, particularly
during times of adverse conditions S&P noted that
AVERA , DI
Idaho Power Company
When examining the quality of regulation , Standard& Poor s factors in what level of support theutility might get in times of di streB s, when its:::: rneeds are most acute" S&P went on to note the importance of financial flexibility,especially considering the capital markets ' ability toconstrict access to capital when investors ' confidence compromised"As S&P concluded, "(dJ ecisions by publicservice cormnissions can profoundly affect utilities ' creditM .quality" fl.Investors recognize that regulation has its ownrisks"Considering the magnitude of the events that havetranspired since the third quarter of 2000 , investorssensitivity to market and regulatory uncertainties hasincreased dramatically"The recent decision of S &P and
Fitch to downgrade Central Vermont from triple-B to below
investment grade highlights the importance of constructive
regulation"In explaining its rationale, S&P and Fitch
cited an unfavorable rate order by the Vermont Public
Service Board"S&P concluded that:
The rate order represents an adverse shift in the
company s regulatory environment, which heightens
its business risk for the foreseeable future..
..
It also limits the company s ability to generate
adequate and stable cash flows over the
r.. .
...
~0 Standard & Poor s Corporation
, ~
Regulation and Credit Quality in the
U., s. Util ity Sector,Ra tingsDi Teet (Jan. 30, 20 a 3) .
r.. ....
~!
Id.,
AVERA , DI
Idaho Power Company
foreseeable future.. To be considered highlycreditworthy, a utility with a marginal financialprofile must operate in a regulatory environmentc: "that provides for financial stability. Business l/1.7ire reported to investors that Central Vermontwill now have to provide cash collateral for some powersupply arrangements " and pay "increased financing costs fordebt" with the end result being "higher customer costs .. ,,Has the investment community also recognizedthat regulatory support is a crucial determinant of IdahoPowers credit standing?Yes.All of the maj or bond rating agencieshave specifically noted tha t constructive regulation will a deciding factor in establishing the future course of IdahoPowers financial strength"For example, Moody s noted the
need for "additional support'! from the I PUC as Idaho Power
adds new generation and transmission infrastructure to meet
. .. (..
growth and ensure rellablllty.Similarly,Fi tch noted the
need for over $600 million in capital expenditures for
additional generating capacity and infrastructure upgrades,
necessitated in part by continued growth and incremental
5';:'
~, "
S&P Downgrades CVPS Corporate Credit Rating,
fI Business
Wire (Jun.
, 2005)
r" r.Y:;: Id..aU Ivloody s Investors Service, "Ratings Action: IDACORP, Inc.Glohal
Credit Research (Dec. 3 , 2004)
AVERA , DI
Idaho Power Company
t res s on the rma 1 res 0 U r c e s a s a re suI t 0 f poor wa t e rconditions," concluding that:A lack of regulatory support, combined withcontinuing poor hydro condi tions could lead tofurther deterioration in (Idaho Power s Jcreditworthiness. What danger does an inadequate rate of returnpose to Idaho Power?Given the recent decline in Idaho Powercorporate credi ra ting, the perception of a lack ofregulatory support would almost certainly lead to furtherdowngrades"At the same time, Idaho Power s plans includesignificant plant investment to ensure that the energy needsof its service territory are met in a reliable and cost-eff ecti ve manner"While providing the infrastructure
necessary to meet the energy needs of customers is certainly
desirable, it imposes additional financial responsibilities
on Idaho Power"To continue to meet these challenges
successfully and economically, it is crucial that Idaho
Power receive adequate support to maintain its credit
standing
Do customers also benefi t by enhancing the
utili ty ' s financial flexibili ty?
01 Fitch Ratings, Ltd.
, "
Idaho Power Company,Global Power/North
America Credit Analysis (Feb.. 18 , 2005) at
AVERA , DI
Idaho Power Company
Yes"While providing an ROE that sufficient to maintain Idaho Power s ability to attractcapital, even under duress, is consistent with the economicrequirements embodied in the Supreme Court'Hope andBluefield decisions, it is also in ratepayers ' bestinterests.Ultimately, it is customers and the service areaeconomy that enj oy the benefits that come from ensuring thatthe utili ty has the financial wherewi thaI to take whateveractions are required to ensure a reliable energy supply"the same token ratepayers also bear a significant burdenwhen the ability of the utility to attract necessary capitalis impaired and service quality is compromised"B.. Changes Since Case No" IPC-E-O3-13
circums tances Case I\J IPC-E-O3-13Slnce
support Idaho Power ROE?lncrease
Yes"its order Idaho Power last rate
proceeding, the IPUC clearly expressed its goal of
supporting Idaho Power s efforts to maintain its financial
strength:
(TJ his Commission acknowledges its desire
maintain Idaho Power as a financially viable
utility with c~edit ratings at or above the
current level .. 'JL
u ~
I P U C Or de r No.2 9 5 0 5 , Cas e No. I PC - E - 0 3 - 13 Ma y 2 5 , 2 0 0 4) a t 4 3 .
AVERA , DI
Idaho Power Company
Considering the perceptions of the investment community,which are instrumental in any evaluation of Idaho Powercreditworthiness, a higher ROE will be required if theCompany is to regain its former credit ratings, consistentwith the stated objectives in the IPUC's last rate order.In fact, regulatory support, in the form of a higher allowedreturn on equity, may be necessary just to stabilize ratingsat current levels S&P noted that "supportive future ratecase rulings by the IPUC" \tJould be required "to support therating at the current level.. "')3Apart from the need to meet the IPUC's obj ective ofstabilizing Idaho Power s credit standing, a higher ROE also warranted to compensate for greater investment risks.The fact that Idaho Power s credit ra tings have been lowered
by all of the maj or ratings agencies supports a finding that
its risks and required rate of return have moved higher
since the Company s last ra te proceeding..At the same time,
the importance of enhancing Idaho Power s credi tworthiness
has increased as planned system expansions and debt
refinancing will require greater access to capital markets
than at any time in the recent past"
63 Standard & Poor s Corporation, "IDACORP, Inc.,RatingsDirect (Sep.
, 2005) at
AVERA , DI
Idaho Power Company
Meanwhile, anticipated capital market trends alsosupport a higher ROE for Idaho Power in this proceeding..Since the time of the IPUC's decision in Case No. IPC-E-O3-, utility bond yields have been relatively stable,, ,( /although spot Ylelds have recently lncreased" discussed earlier , however , long-term interest rates areexpected to increase during 2006 and into the foreseeablefuture, with the projections of widely recognized sourcesproviding independent evidence of increasing capital costsThus, capital market conditions over the period when ratesestablished in this proceeding will be in effect alsosuggest that the ROE has increased sinee Case No. IPC-E-03-13 .Uncertainties as sociated wi th Idaho Power
operations - including the impact of prolonged drought on
hydroelectric generation , uncertainties and cash
requirements associated with relicensing,renewed focus
regulatory uncertainties, exposure to potential energy
market volatility, and the need for significant capital
investment - have become increasingly apparent to investors
Here again , the trends since the IPUC's decision in Case No"
M Moody s Investors Service reported an average yields on triple-B
public utility bonds of 5.88% and 5.80% for May and August 2005,respectively, with the yield on October 10 , 2005 being 5. 96
AVERA , DI
Idaho Power Company
IPC-E-03-13 would argue for an increase to Idaho Powerallowed return"C" ConclusionsWhat is your conclusion regarding a fair rateof return on equi ty range for Idaho Power?Based on the capital market researchpresented earlier and the economic requirements discussedabove, it is my conclusion that a return on equity in therange of 11 . a % to 12 . a % represents a reasonable estimate investors ' required rate of return for Idaho Power intodays capital markets..In evaluating the rate of return for Idaho Power , itis important to consider investors ' continued focus on the
unsettled conditions in restructured wholesale energy
markets, the Company s ongoing reliance on these markets to
purchase a portion of its energy supply, as well as other
risks associated with the utility industry, such
heightened exposure to regulatory uncertainties
My recommended ROE range is further supported by the
fact that investors are likely to anticipate increases
utility bond yields going forward.Moreover, an ROE in the
11 ,,0% to 12 " 0 % range is reasonable at this critical
juncture, given the importance of supporting the financial
AVERA , DI
Idaho Power Company
capability of Idaho Power as it seeks to maintain its creditstanding while raising the capital necessary to develop andenhance utility infrastructure.The cost of providing IdahoPower an adequate return is small relative to the potentialbenefits that a strong utility can have in providingreliable serVlce"Considering investors ' heightenedawareness of the risks associated with the utility industryand the damage that results when a utility s financialflexibility is compromised,supportive regulation is perhapsmore crucial now than at any time in the past.Does this conclude your pre-filed directtestimony?Yes.Are you sponsoring additional testimony that
contains the details underlying your quantitative analyses
of the cost of equity?
Yes, I am
AVERA , DI
Idaho Power Company
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 STATEOF IDAHO. CASE NO. IPC-E-O5-28IDAHO POWER COMPANY
ADDITIONAL DIRECT TESTIMONY
WILLIAM E "AVERA
I..INTRODUCT IONWhat your Addi tionalthepurposeDirect testimony?The purpose of this testimony is to presentthe details under lying my quanti tati ve analyses of the costof equi ty for the proxy group of electric utili ties First, I review general conditions in the capital marketsand general economy..I examine the concept of theNext,cost of equi ty, along wi th the risk-return tradeoffprinciple fundamental to capital markets .. Finally, describe risk premium and discounted cash flow ("DCF"analyses conducted to estimate the cost of equity for the
reference group of electric utilities
A. Capi tal Markets and Economy
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 in mid-
1 9 9 0 the ve rag e y i e 1 d on Ion 9 - term pub 1 i c ut i 1 i t Y bon d
AVERA , ADD Dr
Idaho Power Company
generally fell as economic condi tions weakened in theaft e rma th o f the 1 9 91 G u 1 f war , wit h rat e s dip pin g be 1 ow 7 %in late 1993"Yields subsequently rose again in 1994,before beginning a general decline, with investorsrequiring approximately 5 " 5% from average public utilitybonds in August 005 :10 8 J.......1; Q..; ;""""......,..., ..."'" ""-- .., " i""1, ~ "'I.:/ -.. ~ ,,- -, ....."""he.- -' '" .., ~ ~ --' :'4,-"",,,\ 1. - ahon, ""',f "" i\ I .I "'",..- -, JI '" \. :,J / "".r'~ "'~ -j\ J r ..l ., ~""--"""~~~.".--.----,----,,--,,,,,,-----------w""-----------"""--"----------'--Y"-----------""--""----------j""'-_._---------"--"""------;----".--.,..----------"""----;--------.--m---------"""T---------'-""'-'---------r""---------m--.--------;----"""------------,,,--.,,---,-------"""--"----------'--"1'---------""--""-----------1""'----------"--"""----------;w",,-----------,,,,,,--,,----:----m---------"""--~-----------m-----~90 ~92 ~94 ~96 ~98 ~OO ~O2 ~O4
investors anylikelyanticipateAre
substantial decline in interest rates going forward?
Since early 2001 , a great deal ofNo"
attention has been focused on the actions of the Federal
Reserve Board ("Fed"as it has moved successively to lower
short-term interest rates in response to weakness in the
United States economy.But while interest rates are
currently at relatively low levels, investors are unlikely
to expect any further significant declines going forward..
I n d e ed, 0 S e p t e mb e 2 0 , 2 0 0 5 the Fed r a i sed i n t ere s t rat e s
AVERA , ADD Dr
Idaho Power Company
for the eleventh time since June 2004 and signaled investors that higher rates were likely in the future"Thelatest quarter-point increase raised the discount rate to3" 7 5%, or over three times the 4 6-year low of 1effect when the Fed began its credit-tightening campaign in2004 As Value Line noted,l the general expectation is thatinterest rates will eontinue to rise with strengtheningeconomic growth.The Wall Street Journal reported that,with growing inflationary concerns 1 investors are concernedthat the Fed will adopt a more aggressive stance:(S igns have emerged that inflation may beworking itself into the economy" That would bebad news for stocks, notably because it likelywould prompt the Federal Reserve to try to coolthe economy by pushing interest rates higher,raising borrowing costs for businesses and
consumers ali ke. "" Particularly worrisome
investors was the sight this week of the
presidents of three regional Federal Reserve
banks publicly warning the Fed is concerned
about inflation. The Fed can t "let theinflation virus infect the blood supply and
poison the system,
If said Dallas Fed President
Richard Fisher yesterday. Investors took that
to mean the Fed, which has already boosted
short-term interest ra tes 11 times in the past
15 months, could continue to do so for some
time..
1 The Value Line Investment Survey, Selection Opinion (Jun. 24 , 2005)at 1659.2 Browning!
E. S. Inflation Worries Send Shivers Through Markets Investors See Warning Signs Despite Falling Oil Prices; Watching
Earnings Season " The Wall Street Journal (Oct. 7 , 2005) at AI.
AVERA ADD Dr
Idaho Power Company
Consistent wi th the general expectations that theseactions will also translate into higher long-term bondyields, the most recent forecast of GlobalInsight, a widelyreferenced forecasting service, calls for double-A publicutility bond yields to reach 6" 41% in 2 0 0 6, averaging 6" 99%over the next five years . 3 Meanwhile, the EnergyInformation Administration ("EIA") 1 a statistical agency the DOE , anticipates that the double-A public utili ty bondyield will average 7 over the 2006-2010 period.TheSeptember I , 2005 edition of Blue Chip Financial Forecas ts( "Blue Chip ) also anticipa tes that bond yields will risesignificantly over the coming year.How has the market for common equi ty capital
performed?
Between 1990 and early 2000 stock prices
pushed steadily higher as the longest bull market in Uni ted
States history continued unabated.While the S&P 500 had
inereased over four times in value by August 2000, mounting
concerns regarding prospects for future growth
particularly for firms in the high technology sector
3 Global lnsight
, "
The U.S. Economy, The 25-Year Focus , Table 33 (First
Quarter 2005) 4 Energy Information Administration, "Annual Energy Outlook 2005", Table
19 .5 Blue Chip Financial Forecasts (Sep~ 1 , 2005) at
AVERA , ADD Dr
Idaho Power Company
pushed equity prices lower, in some cases precipitously"While common stock prices have recovered strongly fromtheir lows, the market remains volatile, with share valuesroutinely changing in full percentage points during single day s trading"The graph below plots theperformances of the Dow-Jones Industrial Average, the S &P500, and the Dow Jones Utility Average since 1990 (thelatter two indices were scaled for comparability) 500500 """"" """"" """"'" """"" """"" """"" """"" ......... """"'" """"" """"" """"" """"" ......... """"'" """"" """"" """"" """"" ......... """"'" """"" """"" """"" """""""'"..".'""..'..'.. """'""".""' ,""'""'" ,....'..'.. ".".. "....'..'" """""""""",..'..'.., ,."..'.."""""""""'125001 0 500'"0:::,....:, 5 (X)500500 xlOi -l'-"""""" /",J,.--.,,
f'--.J
- ""
_t"""" ./' ,
500 ,,
' ""'~~~~~""""""""""""""""""""""""""""""""""""""""""""""""""""""~""""""""""""""""""""'
500 ...l""""
""""'~""""'""""':--"
1"""
:--"""'" """"'
-r-""""'
:--""'"""':--""""'~""""'"""",--
J-OO J-O2
What the outlook for the Uni ted States
economy?
While the economlC picture has brightened
significantly since the downturn that began in 001 , growth
in gross domestic product slowed to 3 2% in the second
quarter of 005 Uncertainties over the durability and
paee of economlC growth continue to be impacted by
AVERA , ADD Dr
Idaho Power Company
overhanging government and trade deficits and higher energyprices, which have been exacerba ted by the fallout from thenatural disasters experienced in the Gulf Coast region..Continued conflict and instabili ty in Iraq and the ongoingthreat of terrorism also undermine consumer confidence andcontribute to global economic uncertainty.These factor cause the outlook to remain tenuous, with persistent stoekand bond price vola tili ty providing tangible evidence the uncertainties faeed by the Uni ted Sta tes economy.economlC affectuncertaintiestheseHowutilities?Uncertainties over the extent and durabilityof the economic recovery have combined to heighten the
risks faced by utilities Stagnant economic growth would
undoubtedly mean flat sales, while the potential for higher
inflation and interest rates would plaee additional
pressure on the adequacy of existing service rates
Meanwhile, the aftermath of hurricanes Katrina and Rita,
coupled with continued conflict and instability in the
Middle East, intensifies concerns over prolonged volatility
in oil and gas pr ices.While the economy may ultima tely
return to a path of steady growth and the volatility in the
AVERA ADD Dr
Idaho Power Company
capital and energy markets may abate, the underlyingweaknesses now present cause considerable uncertainties persist, which increase the risks faced by the utilityindustry"B. Risk-Return Tradeoff PrincipWhat fundamental economic principle under-lies a determination of the cost of equity?Unlike debt capital, there is contractually guaranteed return on common equity capitalsince shareholders are the residual owners of the utility"Nonetheless, common equity investors still requlre a returnon their investment, with the cost of equi ty being theminimum "rent" that must be paid for the use of their
money..This cost of equity typically serves as the
starting point for determining a fair rate of return
common equity"
The cost of equity concept is predicated on the
notion that investors are risk averse, and will willingly
bear additional risk only if they expect compensation for
doing so.In capital markets where relatively risk-free
assets are available (e.. g"U" S" Treasury securities)
investors can be induced to hold more risky assets only
AVERA , ADD Dr
Idaho Power Company
they are offered a premium, or additional return, above therate of return on a risk-free asset"Since all assetscompete with each other for investors ' funds, more riskyassets must yield a higher expected rate of return thanless risky assets in order for investors to be willing tohold them.Given this ri sk-return tradeoff 1 the required rateof return (k)from an asset (i)can be generally expressedas :Rf + RP~where:Rf'- Ri s k - f r e e ra t e 0 f r e t urn; andRP: = Risk premium required to holdrisky asset iThus, the required rate of return for a particular asset at
any point in time is a function of: 1) the yield on risk-
free assets, and its relative risk , with investors
demanding correspondingly larger risk premiums for assets
bearing greater ris k.
the risk-return tradeoff principleDoes
actually operate in the capital markets?
The risk-return tradeoff is readilyYes"
observable in certain segments of the capi tal markets where
required rates of return can be directly inferred from
AVERA ADD Dr
Idaho Power Company
market data and generally accepted measures of risk exist"Bond yields, for example, reflect investors ' expected ratesof return, and bond ratings measure the risk of individualbond issues The observed yields on government securities,which are considered free of default ris k, and bonds ofvarious rating categories demonstrate that the risk-returntradeoff does 1 in faet 1 exi st in the capital market s .the risk-return tradeoff observed withDoesfixed income secur i tie s extend to common stocks and otherassets?It is generally accepted that the risk-return tradeoff evidenced with long-term debt extends toall assets"Documenting the risk-return tradeoff for
assets other than fixed income securi ties, however, is
complicated by two factors"First, there is no standard
measure of risk applicable to all assets Second, for most
assets - including common stock - required rates of return
cannot be directly observed.Nevertheless, it is
fundamental tenet that investors exhibit risk aversion
deeiding whether or not to hold common stocks and other
assets, just as when choosing among fixed income
seeurities.This has been supported and demonstrated by
AVERA , ADD Dr
Idaho Power Company
considerable empirical research in the field of finance andis confirmed by reference to historical earned rates ofreturn, with realized rates of return on common stocksexceeding those on government and corpora te bonds over thelong-term"this risk-return limi tedtradeoffdifferences between firms?The risk-return tradeoff principleNo"applies not only to investments in different firms, butalso to different securities issued by the same firm"Debt, preferred stock , and common equity vary considerablyin risk because they have different characteristics andpriorities"
When investors loan money in the form of debt (e. g.
long-term bonds), they enter into a contract whereby the
utili ty agrees to pay the bondholders a specified amount
interest and to repay the principal of the loan in full
The bondholders have a senior claim on available cash flow
for these payments, and if the utility fails to make them
they may force it into bankruptcy and liquidation for
settlement of unpaid claims Similarly, when a utility
sells investors preferred stock, the utili ty promises
AVERA ADD Dr
Idaho Power Company
pay preferred stockholders specified dividends and,typically, to retire the preferred stock on a predeterminedscheduleWhile the rights of preferred stockholders toavailable cash flow for these payment s are junior tocreditors, and preferred stockholders cannot compelbankruptcy, their claims are senior to those of commonshareholders.The last inve stars in line are common shareholders"They only receive the cash flow, if any, that remains afterall other claimants - employees, suppliers, governments,lenders, and preferred stockholders - have been paid.As result, the rate of return that investors require from utility s common stock, the most junior and riskiest of its
securities, is considerably higher than the yield on the
utili ty ' s long-term debt or preferred stock, which have
more certain , senior claims
What discussion withimplydoestheabove
respect to estimating the cost of equity?
Al though the cost of equi ty cannot be
observed directly, it is a function of the returns
available from other investment alternatives and the risks
to which the equi ty eapi tal is exposed.Because it
AVERA , ADD Dr
Idaho Power Company
unobservable, the cost of equi ty for a particular utili tymust be estimated by analyzing information about capitalmarket conditions generally, as sessing the rela ti ve risksof the company specifically, and employing variousquantitative methods that focus on investors ' requiredrates of return.These various quantitative methodstypically attempt to infer investors ' required rates ofret urn from stock prices, interest ra tes, or other capitalmarket data.did you implement these quanti ta ti Howmethods to estimate the cost of equity for Idaho Power?In estimating the cost of equity,quanti ta ti ve methods are typically applied to publicly
traded firms engaged in similar business acti vi ties
order to reflect the risks and prospects associated with
Idaho Power s jurisdictional utili ty operations, my
analyses focused on a reference group of other electric
utilities composed of those companies included by Value
Line in their Electric Utilities (West)Industry group.
Exeluded from my analyses were five firms that either
not pay common di vidends or were rated below investment
grade by S&P.
AVERA , ADD Dr
Idaho Power Company
Given that these ten utilities are all engaged utility operations in the western region of the U" sinvestors are likely to regard this group as facing similarmarket conditions and having comparable risks andprospects"The Supreme Court recogni zed the relevance ofgeographical location in Bluefield, noting that utilitiesare entitled to earn a return equal to those being made byfirms of comparable risk "in the same general part of thecountry.b Indeed, there are important factorsdistinguishing western utilities from those located inother regions, including customer density and thecomplexities associated with greater reliance onhydroelectric generation..As noted in my Direct testimony,
the ongoing uncertainties associated wi th hydroelectric
generation and western power markets are important
considerations in evaluating investors ' required rate of
return for Idaho Power"
Bluefield Water Works Improvement Co. v. Pub. Serv. Comm nr 262 u.
679 (1923)
AVERA , ADD Dr
Idaho Power Company
What other considerations support the use ofproxy group in estimating the cost of equity for IdahoPower?Apart from recognizing the inherent ris ksand prospects for a utility operating in the west,reference to a proxy group of utilities is essential insulate against vagaries that can result when thestochastic process involved in estimating the cost ofequity is applied to a single company.The cos t of equi t yis inherently unobservable and can only be inferredindirectly by reference to available capital market dataTo the extent that the data does not capture investorsactual expectations, the resulting cost of equi ty estimates
will be biased and fail to reflect the required rate of
return..As the FERC noted in its July 3, 2003 Order on
Ini tial Decision in Docket No" RPOO-I07-000 , even using
limited group of companies increases the potential for
error:
Both Staff and Williston agreed that a proxy
group of only three companies presented
problems because "a single company will have
magnified influence on the group results.
1/
was with those changing market dynamics in mind
that witnesses of both Staff and Williston
AVERA , ADD Dr
Idaho Power Company
......proposed to expand the group of proxy companiesto determine a zone of reasonablenessA proxy group composed of western utilities is consistentnot only with the shared circumstances of energy markets the west, but also with the need to ensure against thepotential that a single cost of equity estimate may notref lect investors ' required rate of return.Why did you firmsexclude that not paycommondi vidends investmenthavebelow grade bondratings?As discussed subsequently, under the DCFapproach, observable stock prices are a function of thecash flows that investors ' expected to receive, discounted
at their required rate of return"Because dividend
payments are a key parameter required to apply the DCF
method, this hinders application of the DCF model to firms
tha t do not pay common di vidends Meanwhile, the financial
stress and lack of stability tha t accompanies below
investment grade bond ratings greatly complicates any
determination of investors ' long-term expectations that
form the basis for DCF applications..
Williston Basin Interstate Pipeline Co. r 104 FERC ~ 61 036 , at 14-
(Jul.. 3 , 2003)
AVERA ADD Dr
Idaho Power Company
C. Risk Premium AnalysesBriefly describe the risk premium method"The risk premium method of estimatinginvestors' required rate of return extends the risk-returntradeoff observed wi th bonds to common stocks The cost equity is estimated by first determining the additionalreturn investors require to forgo the relative safety bonds and bear the greater risks associated with commonstock, and then adding this equi ty risk premium to thecurrent yield on bonds Like the DCF model , the riskpremlum method is capital market oriented.Howeve r , unl i keDCF models, which indirectly impute the cost of equity,risk premium methods directly estimate investors ' required
rate of return by adding an equi ty risk premium
observable bond yields
did you implement risk premlumtheHow
method?
I based my estimates of equity risk premiums
on (1) surveys of previously authorized rates of return
common equity (2) realized rates of return , and (3)
alternative applications of the Capital Asset Pricing Model
( "
CAPM"
) .
AVERA , ADD Dr
Idaho Power Company
Authorized returns pre sumably reflect regulatorycommissions' best estimates of the cost of equity, howeverdetermined, at the time they issued their final order..Such returns should represent a balanced and impartialoutcome that considers the need to maintain a utili ty ' sfinancial integrity and ability to attract capital.Moreover, allowed returns are an important considerationfor investors and have the potential to influence otherobservable investment parameters, including credit ratingsand borrowing costs"Thus, this data provides a logicaland frequently referenced basis for estimating equi ty riskpremlumsUnder the realized-rate-of-return approach, equity
risk premiums are calculated by measuring the rate
ret urn (incl uding dividends, interest, and capi tal gains
and losses) actually realized on an investment in common
stocks and bonds over long historical periods The
realized rate of return on bonds is then subtracted from
the return earned on common stocks to measure equity risk
premlums
The CAPM approach measures the market-expected
r e t urn for s e cur i t Y a s the s um 0 f r i s k - f r e e ra te a n d
risk premium based on the portion of a security s risk that
AVERA , ADD Dr
Idaho Power Company
cannot be eliminated by holding a well-diversifiedportfolio.Under the CAPM , ris k is represented by the betacoefficient (~), which measures the volatility of security s price relative to the market as a whole"Whilebeta is not wi thout controversy, the CAPM is routinelyreferenced in the financial literature and in regulatoryproceedingsdidyouimplementriskpremlumtheHowapproach using surveys of allowed rates of return?While the purest form of the survey approachwould involve querying investors directly, surveys ofpreviously authorized rates of return on common equity arefrequently referenced as the basis for estimating equity
risk premiums The ra tes of ret urn on common equi
authorized electr ic utilities by regulatory commissions
across the U. s. are eompiled by Regulatory Research
Associates RRA") and published in its Regulatory Focus
report.In Exhibit WEA-3, the average yield on public
utility bonds is subtracted from the average allowed rate
of return on common equity for electrie utilities to
calculate equity risk premiums for each year between 1974
and 2004 Over this 31-year period, these equity risk
AVERA ADD Dr
Idaho Power Company
premiums for electric utilities averaged 3 1 7%, and theyield on public utility bonds averaged 9" 5 9%"there any risk premlum behavior thatneedsconsidered when the risk premiumimplement ingto method?There is considerable evidence thatYes"the magnitude of equity risk premiums is not constant andthat equity risk premiums tend to move inversely withinterest rates"In other words, when interest rate levelsare relatively high , equity rig k premiums narrow , and wheninterest rates are relatively low , equity risk premiumswiden To illustrate, the graph below plots the yields public utility bonds (solid line) and equity risk premiums
(shaded line)shown on Exhibi t WEA-3:
"""""
.M.M"""
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..MM"""MW""..MM""'..M"""MMM""
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MMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMM.MM
Bond yTicld d""";,,,e,,';;;;:&i""" Equity Risk Prelniulll
AVERA , ADD Dr
Idaho Power Company
The graph clearly illustrates that the higher the level interest rates, the lower the equity risk premium , and viceversa..The implication of this inverse relationship that the cost of equity does not move as much as, or inlockstep with, interest rates Accordingly, for increase or decrease in interest rates, the cost of equi may only rise or fall, say, 50 basis points Therefore,when implementing the risk premium method, adj ustments maybe required to incorporate this inverse relationship current interest rate levels have changed since the equi risk premiums were estimated.What cost of equity is implied by surveys ofallowed rates of return on equity?
As illustrated above, the inverse
relationship between interest rates and equity risk
premiums is evident.Based on the regression output
between the interest rates and equity risk premiums
displayed at the bottom of page 1 of Exhibit WEA-3, the
equity risk premium for electric utilities increased
approximately 43 basis points for each percentage point
drop in the yield on average public utility bonds
illustrated there, with the yield on average public utility
AVERA , ADD Dr
Idaho Power Company
bonds in August 2005 being 5.. 51%, thi s implied a currentequity ris k premium of 4 93% for electric utilitiesAdding this equity risk premium to the August 2005 yield triple-B public utility bonds of 5" 80% produces a currentcost of equity for the utilities in the benchmark group approximately 1 0" 7 % What considered applyingelseshould risk premium methods?As noted earlier , because there widespread consensus that interest rates will increasematerially as the economy continues to strengthen I alsoapplied the alternative risk premium methods based on forecasted bond yield for 2006.
What equi ty was produced thecost
authori zed rate of return approach after incorporating the
2006 bond yield forecast?
As shown on page 2 of Exhibit WEA-3
incorporating a forecasted yield for 2006 and adj usting for
changes in interest rates since the study period implied
equity risk premium of 4 37% for electric utilities
Adding this equity risk premium to the implied yield
AVERA , ADD Dr
Idaho Power Company
triple-B public utility bonds for 2006 of 7 " 0% resulted inan implied cost of equity of approximately 11.did you apply the realized-ra te-of-Howreturn approach?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 of future earned returns on those realized the past, wi th average realized rates of return forhistorical periods being widely reported in the financial
press and by investment advisory serviees as a guide to
future performance.By focusing on data for utilities
specifically, my realized rate of return approach avoided
the need to make assumptions regarding relative risk (e" g.
beta) that are often embodied in applieations 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 for the period 1946 through 2004
AVERA , ADD Dr
Idaho Power Company
shown in Exhibit WEA-4, over this 59-year period realizedrates of return for these utilities have exceeded those onpublic utility bonds by an average of 3" 99% In contrastto other risk premium approaches, the realized-rate-of-return method assumes that equity ris k premiums arestationary over time; therefore, no adjustment for theinverse relationship between equity risk premiums andinterest rates was made"Adding this 3.99% equity riskpremium to the August 2005 yield of 5 80% on triple-Bpublic utility bonds produces a current cost of equity forthe electric utility proxy group of approximately 9Once again , however , this does not consider theanticipated increase in bond yields through 2006"Adding
this 3 99% equity risk premium to the 7 forecasted yield
on triple-B public utility bonds for 2006 implies cost of
equity of approximately II" 0%
Please describe your application the
CAPM.
The CAPM is a theory of market equilibrium
that measures risk using the beta coefficient.Under the
CAPM , investors are assumed to be fully diversified, so the
relevant risk of an individual as set (e. g.common stock)
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is its volatility relative to the market as a whole Betareflects the tendency of a stocks ' price to follow changesin the market"A stock that tends to respond les s mar ket movements has a beta les s than 1., while stocksthat tend to move more than the market have betas greaterthan 1 00.The CAPM is mathematically expressed asRj = Rf + ~ j (Rrn Rt)Where:required return for stock jrisk-free rate;expected return on the marketportfolio; and,beta, or systematic risk , for stockR-F =Rci =~j -I applied the CAPM to the ten companies in the utili proxy group using market risk premiums (Rrn - Rt) based
( 1 )forward-looking estimates of investors ' required rates
of return and (2) historical realized rates of return..
Q..Please describe your forward-looking
application of the CAPM"
A..Application of the CAPM to the utilities
the proxy group based on a forward-looking estimate for
investors ' required rate of return from common stocks is
pre s e n t e d on Ex h i bit WEA - 5 Rather than using historical
data , the expected market rate of return was estimated by
conducting a DCF analysis on the 356 dividend paying firms
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Idaho Power Company
in the S &P 500, with each firm s dividend yield and growthrate being weighted by its proportionate share of totalmarket value" The dividend yield for each firm was obtained fromVal ue Line, with the growth rate being equal to the averageof the earnings growth proj ections for each firm publishedby I/B/E/S International, Inc.IBES") and Value Line.Based on the weighted average of the proj ections for the356 individual firms, current estimates imply an averagegrowth rate over the next five years of 11 Combiningthis average growth rate wi th a dividend yield of 2res u 1 t s in a cur r e n C 0 s t 0 f e qui t y es t ima t e for the ma r k e as a whole of approximately 13" 5 Subtracting a 4 .. 5
risk-free rate based on the September 2005 average yield
2 a-year Treasury bonds from the 13 " 5% forward-looking ra
of return produced a market equity ri sk premium of 9
Mul tiplying this risk premium by the average Value Line
beta of 0.89 for the utilities in the proxy group, and then
adding the resulting 8 " 0% risk premium to the September
2 005 average long-term Treasury bond yield, resulted in
current cost of equity of approximately 12 .. 5
8 This is analogous to the approach relied on by the Illinois Commerce
Commission Staff in Docket No. 96-0486 (Testimony of Joy Nicdao-
Cuyygan)
AVERA , ADD Dr
Idaho Power Company
What equi ty thisimpliedcostforward-looking application of the CAPM after incorporating2006 proj ected government bond yields?As shown on page 2 of Exhibi t WEA-interest rate projections published by GlobalInsight, EIA,and Blue Chip imply a proj ected yield on 2 O-year Treasurybon d S 0 5. 5 % for 2 0 0 6, w hie h res u t s in a ma r k e r i s kpremium of 8 Once again multiplying the market riskpremium by the average Value Line beta of 0 89 for theelectric utilities in the proxy group, and then adding theresulting 7 .1% risk premium to the 5.5% long-term Treasurybond yield for 2006 , implied a cost of equity ofapproximately 12 .. 6%
What other CAPM analyses did you conduct to
estimate the cost of equi ty?
I also applied the CAPM using risk premiums
based on historical realized rates of return"This
approach to estimating investors ' equity risk premiums
premised on the assumption that, given a sufficiently large
number of observations over long, historical periods,
average realized market rates of return will converge to
investors ' required rates of return"
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Idaho Power Company
What equi basedproducedCAPMcoston historical realized rates of return for stocks and long-term government bonds?I applied the CAPM using data published byIbbotson Associates, which is perhaps the most exhaustiveand widely referenced annual study of realized rates ofret urn.Application of the CAPM based on historicalrealized rates of return is presented in Exhibit WEA-6.their 2005 Yearbook, Valuation Edi tion,Ibbotson Associatesreported that, over the period 1926 through 2004 , theari thmetic mean realized rate of return on the S&P 500exceeded that on long-term government bonds by 7Mul tiplying this historical market ri sk premium by the
average Value Line beta of 0" 8 9 produced an equity risk
premium of 6" 4 for the electric utility proxy group"
shown on page 1 of Exhibit WEA-6 , adding this equity risk
premium to the September 2005 average yield on 20-year
9 Ibbotson Ass ocia tes computes the equity ris k premium by subtracting
the income return (not the total return) on long-term Treasury bonds
from the return on common stocks. As Ibbotson As sociates noted (2005
Yearbook, Valuation Edition at 75J
Price changes in bonds due to unanticipated changes in
yields introduce price risk into the total return.
Therefore , the total return on the bond series does not
represent the riskless rate of return. The income return
better represents the unbiased estimate of the purelyriskless rate of return, since an investor can hold a bond
to ma turi ty and be enti tIed to the income return wi th nocapital loss~
AVERA , ADD Dr
Idaho Power Company
Treasury bonds of 4 .. 5% resulted in an implied cost ofequity of 10.As shown on page 2 of Exhibit WEA-after incorporating a the 5 " 5 proj ected government bondyield for 2006 , application of the CAPM based on historicalrealized rates of return implied a cost of equity of 11 " 9%What else should be considered in evaluatingCAPM cost of equity estimates based on historical realizedrates of return?The CAPM model , like the DCF approach , is anex-ante, or forward-looking model based on expectations ofthe fut ure"As a result, in order to accurately estimaterequired returns the CAPM must be applied using data thatreflects the expectations of actual investors.While
reference to historieal data represents one way to apply
the CAPM , these realized rates of return reflect, at best,
an indirect estimate of investors ' current requirements
Because my forward-looking applications of the CAPM look
directly at current expecta tions in the capital markets
these results are apt to provide a more meaningful guide to
investors ' required rate of return.
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Please summarlze your risktheresul tspremium analyses"The cost of equi ty estimates implied by myris k premium analyses are summarized in the followingtable:Risk Premium AeproachAuthorized ReturnsCurrent YieldProj ected YieldRealized Rates of ReturnCurrent YieldProj ected YieldCAPM - Forward-lookingCurrent Yieldproj ected YieldCAPM - HistoricalCurrent Yieldproj ected Yield Cos t of Equi Estimate10.. 79:i'7,... .9.. 8f:" ... 5" 6qq..... ~11" 9
D. Discounted Cash Flow Analyses
How are DCF models used to estimate the cost
of equi ty?
The use of DCF models is essentially
attempt to replicate the market valuation process that sets
the price investors are willing to pay for a share of
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 Gi ven these
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expected rates of return, the price of each stock isadj listed 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 capital gains, we can calculatetheir required rate of return.In other words, the cashflows that investors expect from a stoek are estimated, andgiven its current market pr ice, we can "back-in thediscount rate, or cost of equity, that investorspresumptively used in bidding the stock to that price"What mar ket valuation process DCFunderlies
models?
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", future dividends and stock price) that will be
received while holding the stock , discounted at investors
required rate of return, or the cost of equity.
Notationally, the general form of the DCF model is as
follows:
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== + ... + (1 + k e ) (1 + k e )2 (1 + k e ) t (1 + k e ) twhere:Po = Current price per share;Pt = Expected future price per share inperiod t;Dt = Expected dividend per share inperiod t;k0 = Cost of equity..That is, the cost of equity is the discount rate that willequate the current price of a share of stock wi th thepresent value of all expected cash flows from the stock..this DCF mode 1generalformtheHascustomarily been estimate equi tyusedthecostrate cases?In an effort to reduce the number No.
required estimates and computational difficulties, the
general form of the DCF model has been simplified to
constant growth" form"But converting the general form
the 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;
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No sales of stock at a price above or below bookvalue;A constant price-earnings ratio;A constant discount ra te (i" e., no changes inrisk or interest rate levels and a flat yieldcurve); and,All of the above extend to infinity"Given these assumptions, the general form of the DCF modelcan be reduced to the more manageable formula of:a ~e ~where:g = Investors ' long-term growthexpectationsThe cost of equity (Ke ) can be isolated by rearrangingterms:
k ==
This constant growth form of the DCF model recognizes that
the rate of return to stockholders consists of two parts
1) dividend yield (Dl /PO)' and 2) growth (g)In other
words, investors expect to receive a portion of their total
return in the form of current di vidends and the remainder
through price appreciation"
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the assumptions constantunder lying theAregrowth form of the DCF model met in the real world?In practice, none of the assumptionsrequired to convert the general form of the DCF model the constant growth form are ever strictly metNevertheless, where earnings are derived from stableacti vi ties, and earnings, dividends, and book value trackfairly closely, the constant growth form of the DCF modeloffers a reasonable working approximation of stockvaluation that provides useful insight as to investorsrequired rate of return.How DCFtheconstant growth form of themodel typically used to estimate the cost of equity?
The first step in implementing the constant
growth DCF model is to determine the expected dividend
yie ld (01 / Pl This is usually calculated based on an
estimate of dividends to be paid in the coming year divided
by the current price of the stock.The second, and more
controversial , step is to estimate investors ' long-term
growth expectations
(g)
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
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are sometimes derived from historical rates of growth these variables under the presumption that investors expectthese rates of growth to continue into the future..Al terna ti vely, a firm s internal growth can beestimated based on the product of its earnings retentionra tio and earned ra te of return on equi ty.This growthestimate may rely on either historical or projected data,or both"A third approach is to rely on securi ty analystsproj ections of growth as proxies for investorsexpectations.The final step is to sum the di vidend yieldand estimated growth rate to arrive at an estimate of thecos t of equi ty"How did you determine the dividend yield for
the proxy group of utilities?
Estimates of di vidends to be paid by each
these utilities over the next twelve months, obtained from
Val ue Line, served as 01.This annual dividend was then
divided by the corresponding stock priee for each utility
to arrive at the expected dividend yield"The expected
dividends, stock priee, and resulting dividend yields for
the firms in the reference group of western utilities are
pre sented on Exhibi t WEA- 7 As shown there, di vidend
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yields for the ten firms in the electric utility proxygroup ranged from 2 " 2% to 4 , with the average being3.. 5%"What investors most likely considerarein 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 inf ini te But implementation of the DCF model is more thanjust a theoretical exercise; it is an attempt to replica tethe mechanism investors used to arrive at observable stockprlces Thus, the only "" that matters in applying theDCF model is that which investors expect and have embodied
in current market prices While the uncertainties inherent
with common stock make estimating investors ' growth
expectations a diffieult task for any eompany, in the case
of utilities, the problem is exacerbated due to the
unsettled conditions in the industry, which contrast with
the steady-state environment as sumed by the constant growth
DCF model.This lack of stabili ty is exemplified by
IDACORP , Inc.' s decision to preserve cash by cutting common
dividend payments significantly during 2003, in part due to
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the pressures associated wi th shortfalls in hydrogeneration"historical rates likelydividend growthAreprovidemeaningfulguideinvestors growthexpectations for electric utilities?In response to more accentuatedNo"business risks in the industry, utili ties adopted dividendpolicies that were much more conservative than in the past..As a result, dividend growth in the utility industry hasremained largely stagnant in recent years as utilitiesconserved financial resources to provide a hedge againstheightened uncertainties Responding to this trend,investors ' focus increasingly shifted from dividends
earnings as a measure of long-term growth, as payout ratios
for firms in the electric utility industry trended downward
from approximately 80% historically to on the order of
60 .
What about projected dividend growth rates?
As the industry recovers from the financial
challenges of the last several years, some electric
utilities have begun to reevaluate their dividend policies
10 See The Value Line Investment Survey (Sep. 15 , 1995 at 161
Aug. 12 , 2005 at 1776)
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and reinstate increases to their quarterly payout..~'\7h i 1 einvestors have recently expressed renewed interest dividend payments, Value Line s most recent forecastindicates negati ve proj ected dividend growth for one of theproxy firms, while one is listed as "Nil" and another NM F" " 11 Negative or zero growth rates imply a cost ofequity equal to, or below, the utility s dividend yield.Such nonsensical results provide little guidance as toinvestors' expectations for the electric utility proxygroup"What investors considerothertrendsdeveloping growth expectations?Trends in earnings, which ul timately support
future dividends and share prices, are likely to play
pivotal role in determining investors ' long-term growth
expectations.Indeed, the importance of earnings
evaluating investors expectations and requirements is well
aceepted in the investment communi ty.As noted in Finding
Reali ty in Reported Earnings published by the Association
for Investment Management and Research:
(EJ arnings, presumably, are the basis for the
investment benefi ts that we all seek. "Healthy
11 The Value Line Investment Survey (Aug~ 12 , 2005)
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......earnings equal healthy investment benefitsseems a logical equation , but earnings are alsoa scorecard by which we compare companies, filter through which we assess management, anda crystal ball in which we try to foretell thefu t ure . 1.2Value Line s near-term proj ections and its Timeliness Rankwhich is the principal investment rating assigned to eachindividual stock, are also based primarily on variousquantitative analyses of earnings As Value Lineexplained:The future earnings rank accounts for 65% inthe determina tion of rela ti ve pr ice change the future; the other two variables (currentearnings rank and current price rank) explain35 .. 13The fact that investment advisory services,such as ValueLine and IBES, focus on growth in earnings indieates that
the investment community regards this as a superior
indicator of future long-term growth.Indeed,Financial
Analysts Journal reported the results of a survey conducted
to determine what analytical techniques investment analysts
actually use. Respondents were asked to rank the relative
importance of earnings, dividends, ca sh flow, and book
val ue in analyzing securities Of the 297 analysts that
12 Association for Investment Management and Research , n Finding Reality
in Reported Earnings: An Overview
, p.
(Dec. 4 , 1996)13 The Value Line Investment Survey, Subscriber s Guide,
p.
53.1q Block , Stanley B., n A Study of Financial Analysts: Practice and
The 0 r y , Fin a n cia An a 1 y s t J 0 urn ( J u 1 y / Au g U :3 1 9 9 9)
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responded, only 3 ranked dividends first while 276 rankedit last"The article concluded:Earnings and cash flow are considered far moreimportant than book value and dividends .. 15Whatsecuri ty currentlyanalystsareproj ecting in the way of earnings growth for the firms inthe electric utility proxy group?A..The consensus earnings growth proj ectionsfor each of the firms in the reference group of electricutilities reported by IBES and published in S&P'EarningsGuide are shown on Exhibit WEA-g Also presented are theearnings growth proj ections reported by Value Line, FirstCall Corporation (" First Call", Zack's Investment ResearchZacks, and Reuters As shown there, these security
analysts ' proj ections suggested growth the order of 5" 3% to
5.. 7 % for the reference group of electric utilities
Electric Utili ty Proxy GroupService Growth Rate
IBES 5 . 3
Value Line 5~'First Call 5 .
Zacks .. 7
Reu ters 5 .
J Id ~ at 88..
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What considerations are relevantevaluatingratesforelectricthesegrowthnear-termutilities?Short-term proj ected growth rates may becolored by lingering uncertainties regarding the near-termdirection of the economy in general and the spate ofchallenges recently faced in the electric power industryspecifically.This short-term "hangover is exemplified byValue Line, which has assigned its Utilities sector thelowest ranking of all 10 sectors it covers for year-aheadstock price performance,lb while noting that " (t J he electricutility industry carries a below-average industryTimeliness rank..
ff While this cautious outlook may be
indicative of relatively low near-term growth proj ections,
it does not necessarily reflect investors long-term
expectations for the industry.
else inve stars expectationsHoware
future estimated uselong-term growth prospects often for
in the constant growth DCF model?
Based on the assumptions underlying constant
growth theory, conventional applications of the constant
1;~: The Value Line Investment Survey, Selection Opinion (July 29, 2005)at 1606~17 The Value Line Investment Survey (July I , 2005) at 695~
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growth DCF model often examine the relationships betweenretained earnings and earned rates of return as anindication of the sustainable growth investors might expectfrom the reinvestment of earnings within a firm.Thesustainable growth rate is calculated by the formula, g =br + sv , where "b" is the expected retention ratio,the expected earned return on equity, "is percent common equity expected to be issued annually as new commonstock, and "" is the equity accretion rate1fJhat is the purpose of the " sv " term?Under DCF theory, the "" factor is component of the growth rate designed to capture the impactof issuing new cornman stock at a price above, or below
book value.When a eompany s stock price is greater than
its book value per share, the per-share contribution in
exeess of book value associated with new stock issues will
accrue to the current shareholders The higher book value
per share leads to higher expected earnings and dividends,
with the "II factor incorporating this additional growth
component.
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Idaho Power Company
What growth rate does the earnings retentionmethod suggest for the proxy group?The sustainable, "br + sv " growth rates foreach firm in the proxy group are shown on Exhibit WEA-9..For each firm, the expected retention ratio (b) wascalculated based on Value Line s proj ected dividends andearnings per share.Likewise, each firm s expected earnedrate of return (r) was computed by dividing projectedearnings per share by proj ected net book value.BecauseValue Line reports end-of-year book values, an adjustmentwas incorporated to eompute an average rate of return overthe year , consistent with the theory underlying thisapproach to estimating investors 1 growth expectations..
Meanwhile 1 the percent of common equi ty expected to be
issued annually as new common stock (s) was equal to the
product of the proj ected market-to-book ratio and growth
common shares outstanding, while the equity accretion ra
(v) was computed as 1 minus the inverse of the projected
market-to-book ratio"As shown there, this method resul ted
in an average expected growth rate for the group of ten
utilities of 4 .. 6% .
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Idaho Power Company
What did you withconcl ude therespectgrowthexpectationsgroupimpliedforreferencethewestern utilities?I concluded that the measures discussedabove indicated growth on the order of 5 .. 5% for the averagefirm in the utility proxy group"What equi ty was implied for thecostproxy group of utilities using the DCF model?Combining the 3 .. 5 average dividend yieldwith the 5" 5:6 growth rate implied a DCF cost of equity forthis group of electric utilities of 9.. 0%As discussed inmy testimony, however , it would be unreasonable establish an ROE based on this single DCF resul t"
Does this conclude your Additional Direct
testimony?
Yes, it does.
AVERA , ADD Dr
Idaho Power Company