20070611Avera Direct.pdf

Idaho Public Utilities
Office of the
Commission
R E eEl ~~tary
JUN
--:
" 8 2007
Boise, Idaho
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF IDAHO POWER COMPANY FOR
AUTHORITY TO INCREASE ITS RATES
AND CHARGES FOR ELECTRIC SERVICE
TO ELECTRIC CUSTOMERS IN THE STATEOF IDAHO.
CASE NO. IPC-O7-
IDAHO POWER COMPANY
DIRECT TESTIMONY
WILLIAM E. AVERA
DIRECT TESTIMONY OF WILLIAM E. AVERA
TABLE OF CONTENTS
INTRODUCTION ...........................................
II.
Overview
..........................................
Summary of Conclusions ............................
FUNDAMENTAL ANALYSES ...................................A. Idaho Power Company ............................... 7B. Utility Industry ................................. 12
III. CAPITAL MARKET ESTIMATES ..............................
Overview
.........................................
Discounted Cash Flow Analyses
. . . . . . . . . . . . . . . . . . ..
Capital Asset pricing Model ...................... 51
Comparable Earnings Method .......................
Flotation Costs ..................................
Proxy Group Cost of Equity ....................... 59
RETURN ON EQUITY FOR IDAHO POWER COMPANY
... . . . . . . . . . ..
A. Implications for Financial Integrity ............. 60B. Capital Structure ................................C. Return on Equity Recommendation ..................
IV.
Exhibi t 1:
Exhibi t 2:
Exhibi t 3:
Exhibi t 4:
Exhibi t 5:
Exhibi t 6:
Exhibi t 7:Exhibit
Exhibi t 9:
Qualifications of William E. Avera
DCF Model - Utility Group
Sustainable Growth Rate - Utility Group
DCF Model - Non-Utility Group
Sustainable Growth Rate - Non-Utility Group
CAPM - Forward-looking Risk Premium
CAPM - Historical Risk Premium
Comparable Earnings Approach
Capi tal Structure
78751.
INTRODUCTION
Please state your name and business address.
William E. Avera, 3907 Red River , Austin, Texas,
In what capacity are you employed?
I am the President of FINCAP , Inc., a firm providing
financial , economic, and policy consulting services to
business and government.
Please describe your educational background and
professional experience.
A description of my background and qualifications,
including a resume containing the details of my experience, is
attached as Exhibit
A. Overview
What is the purpose of your testimony in this case?
The purpose of my testimony is to present to the
Idaho Public Utilities Commission (the "Commission" or "IPUC"
my independent evaluation of the fair rate of return on equity
ROE"for the jurisdictional utility operations of Idaho
Power Company (" Idaho Power" or "the Company
) .
The overall
rate of return applied to Idaho Power s 2007 test year rate
base is developed in the testimony of Mr. Steve Keen.
Please summarize the basis of your knowledge and
conclusions concerning the issues to which you are testifying
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Idaho Power Company
in this case.
As is common and generally accepted in my field of
expertise, I have accessed and used information from a variety
of sources.I am familiar with the organization , operations,
finances, and operation of Idaho Power from my participation
in prior proceedings before the IPUC, the Oregon Public
Utility Commission, and the Federal Energy Regulatory
Commission ("FERC"In connection with the present filing, I
considered and relied upon corporate disclosures and
management discussions, publicly available financial reports
and filings, and other published information relating to the
Company and its parent, IOACORP, Inc.IOACORP"
) .
I also
reviewed information relating generally to current capital
market conditions and specifically to current investor
perceptions, requirements, and expectations for Idaho Power
electric utility operations.These sources, coupled with my
experience in 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
capi tal , and form the basis of my analyses and conclusions
What is the role of ROE in setting a utility
rates?
The rate of return on common equity serves to
compensate investors for the use of their capital to finance
the plant and equipment necessary to provide utility service.
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Idaho Power Company
Investors only commit money in anticipation of earning a
return on their investment commensurate with that available
from other investment al ternati ves having comparable risks.
Consistent with both sound regulatory economics and the
standards specified in the Bluefielcf and Hope cases, the
return on investment allowed a utility should be sufficient
to: 1) fairly compensate capital invested in the utility,
enable the utility to offer a return adequate to attract new
capi tal on reasonable terms, and 3) maintain the utility
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.with this as a background, I conducted
various well-accepted quantitative analyses to estimate the
current cost of equity, including al ternati ve applications of
the discounted cash flow ("DCF") model and the Capital Asset
pricing Model ("CAPM"), as well as reference to comparable
earned rates of return expected for utilities.Based on the
cost of equity estimates indicated by my analyses, the
Company s ROE was evaluated taking into account the specific
1 Bluefield Water Works & Improvement Co. v. Pub. Servo Comm , 262 U.
679 (1923).
Fed. Power Comm V. Hope Natural Gas Co., 320 U.S. 591 (1944).
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Idaho Power Company
risks and economic requirements for Idaho Power consistent
with preservation of its financial integrity.
B. Summary of Conclusions
What are your findings regarding the fair rate of
return on equity for Idaho Power?
Based on the results of my analyses and the economic
requirements necessary to support continuous access to
capital, I recommend that Idaho Power be authorized a fair
rate of return on equity in the 11.2 percent to 12.2 percent
range.The bases for my conclusion are summarized below:
Considering investors' expectations for capital
markets and the need to support financial integrityand fund crucial capital investment even underadverse circumstances, it is my opinion that an ROEin the 11.percent to 12.percent range is
reasonable for Idaho Power. Specifically, Iconcluded that:
0 DCF estimates for alternative groups of proxy
companies implied a cost of equity range of 10.
percent to 12.4 percent;
0 A forward-looking application of the CAPM that bestreflects the underlying assumptions of this
approach resulted in a cost of equity for a proxygroup of utili ties of 12.8 percent , while applying
the CAPM using historical data implied a required
return of 11.5 percent;
Application of the comparable earnings approachbased on expected returns on book equity for
utilities implied a cost of equity of 11.0 percent;
Considering these results and my assessment of the
relative strengths and weaknesses inherent in each
method , I concluded that my quantitative analyses
implied a cost of equity in the 11.0 percent to
12.0 percent range, or 11.2 percent to 12.2 percentafter incorporating an allowance for equity
flotation costs;
0 Based on my evaluation, I concluded that this 11.
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Idaho Power Company
percent to 12.2 percent range bounds a reasonable
rate of return on common equity for Idaho Power.
What is your conclusion as to the reasonableness of
the Company s capital structure?
I strongly endorse Idaho Power s requested capital
structure, which is consistent with the range of
capitalization maintained by the firms in my utility proxy
group, especially when considering the impact of off-balance
sheet commitments and trends towards lower debt leverage going
forward.In addition , Idaho Power s requested capitalization
is consistent with the Company s efforts to maintain its
credit standing and financial flexibility as it seeks to raise
additional capital to fund system investments.
What other evidence did you consider in evaluating
your recommendation in this case?
My recommendation was reinforced by the following
findings:
Sensitivity to regulatory uncertainties has increaseddramatically and investors recognize thatconstructive regulation is key ingredient insupporting utility credit standing and financialintegri ty;
Because of Idaho Power reliance on hydroelectricgenerationthe Company is exposed to relatively
greater risks of power cost volatility;
Investors recognize that Idaho Power Power CostAdjustment Mechanism ("PCA") provides some level of
support for the Company financial integrity, but
they understand that the PCA does not apply to 100%
of power costs; nor does it insulate Idaho Power fromthe need to finance accrued power production and
supply costs or shield the Company from potential
regulatory disallowances.
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Idaho Power Company
Idaho Power must compete for investors ' capital with
other utilities and businesses of comparable risk.
If Idaho Power is not provided an opportunity to earnreturn that is sufficient to compensate for the
underlying risks, investors will be unwilling to
supply capital;
Providing Idaho Power wi th the opportunity to earn a
return that reflects these realities is an essentialingredient to support the Company financialpositionwhich ultimately benefits customers by
ensuring reliable service at lower long-run costs;
Past challenges confronting the utility industryillustrate the need to ensure that Idaho Power hasthe ability to respond effectively to unforeseenevents.
Ultimately, it is customers and the service area economy that
enjoy the rewards that come from ensuring that the utility has
the financial wherewithal to take whatever actions are
necessary to provide a reliable energy supply.
II.FUNDAMENTAL ANALYSES
what is the purpose of this section?
As a predicate to my economic and capital market
analyses, this section examines conditions in the utility
industry generally, and for Idaho Power specifically, that
investors consider in evaluating their required rate of
return.An understanding of these fundamental factors, which
drive the risks and prospects for Idaho Power , is essential to
develop an informed opinion about investor expectations and
requirements that form the basis of a fair rate of return on
equi ty.
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Idaho Power Company
A. Idaho Power Company
Briefly describe Idaho Power.
Idaho Power is a wholly-owned subsidiary of IDACORP
IDACORP") and is principally engaged in providingInc.
integrated retail electric utility service in a 24,000 square
mile area in southern Idaho and eastern Oregon.During 2006
Idaho Power s energy deliveries totaled 19.8 million megawatt
hours ("MWh"Sales to residential customers comprised 36%
of retail sales, with 27% to commercial, 25% to industrial
end-users, and 12% attributable to irrigation pumping.Idaho
Power also supplies firm wholesale power service to various
utili ties, municipalities, and large customers under sales
contracts.At year-end 2006 , Idaho Power had total assets of
$3.4 billion, with total revenues amounting to approximately
$926 million.
Idaho Power s existing generating units include 17
hydroelectric generating plants located in southern Idaho and
eastern Oregon.The electrical output of its hydroelectric
plants is dependent on stream flows, which have fallen
significantly below normal levels in recent years.Al though
Idaho Power estimates that hydroelectric generation is capable
of supplying 55% of total system requirements under normal
condi tions, the Company has experienced persistent below-
normal water conditions in the past.Fluctuations in the
output of the Company s hydroelectric generating facilities
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Idaho Power Company
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.In addition to
weather-related fluctuations in water flows, Idaho Power is
also exposed to uncertainties regarding water rights, as
evidenced by its April 2006 stipulation with the State of
Idaho to divert water for aquifer recharge.While water flows
exceeded normal levels during 2006, investors nevertheless
recognize these uncertainties are an ongoing operational risk
associated with Idaho Power.
Idaho Power s retail electric operations are subject
to the jurisdiction of the IPUC and the Oregon Public Utility
Commission , with the interstate jurisdiction regulated by
FERC.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 Idaho
Power must demonstrate that it has operated its facilities in
the public interest , which includes adequately addressing
environmental concerns.The most significant of Idaho Power
relicensing efforts concerns its Hells Canyon Complex ("Hells
Canyon ), which represents 68% of the Company s hydro capacity
and 40% of its total generating capability.
In June 2003, after a prolonged period of planning
and consultation with interested parties, Idaho Power
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Idaho Power Company
submitted a license application for Hells Canyon that included
various protection , mitigation , and enhancement measures in
order to address environmental concerns while preserving the
peak and load following operations of the facilities.The
current license for Hells Canyon expired at the end of July
2005 and until the new multi-year license is issued, Idaho
Power will operate the proj ect under an annual license issued
Apart from significant ongoing expendituresby FERC.
associated with proposed environmental measures , the
relicensing process is complex, protracted, and expensive.
of December 31, 2006, Idaho Power had accumulated $86 million
of construction work in progress associated with its Hells
Canyon relicensing efforts.
How are fluctuations in Idaho Power s operating
expenses caused by varying hydro and power market conditions
accommodated in its rates?
Beginning in May 1993 , Idaho Power implemented a
PCA , under which rates are adjusted annually to reflect
changes in variable power production and supply costs.When
hydroelectric generation is reduced and power supply costs
rise above those included in base rates, the PCA allows Idaho
Power to increase rates to recover a portion of its additional
costs.Conversely, when increased hydroelectric generation
leads to lower power supply costs, rates are reduced.
Although the PCA provides for rates to be adjusted annually,
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Idaho Power Company
it applies to 90% of the deviation between actual power supply
costs and normalized rates.
What credit ratings have been assigned to Idaho
Power?
Ci ting concerns over the impacts of a sustained
drought , the outcome of Idaho Power s last rate proceeding
before the IPUC, and the pressures of ongoing capital
requirements, Standard & Poor s Corporation ("S&P"lowered
Idaho Power s corporate credit rating from "" to "BBB+" in
November 2004.Moody s Investors Service ("Moody s) also
downgraded the Company s issuer rating from "A3" to "Baal"
based on similar concerns. While Fitch Ratings Ltd.
Fitch") does not publish a corporate credit rating for Idaho
Power,it followed suit and downgraded the Company s senior
debt ratings one notch in February 2005.S&P has assigned a
negative " outlook to Idaho Power, warning investors of the
potential for further deterioration in the Company s credit
standing going forward.
3 Standard & Poor s Corporation, "IDACORP and Unit Ratings Lowered, Removed
From CreditWatch Negative, U RatingsDirect (Nov. 29, 2004).
4 Moody s Investors Service, "Ratings Action: IDACORP, Inc., U Global Credit
Research (Dec. 3, 2004).
5 Fitch Ratings Ltd., "Idaho Power Company, U Global Power/North America
Credit Analysis (Feb. 18, 2005).
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Idaho Power Company
Does Idaho Power anticipate the need to access the
capital markets going forward?
Most definitely.Idaho Power will require capital
investment to meet customer growth , provide for necessary
maintenance and replacements of its utility infrastructure, as
well as fund new investment in electric generation,
transmission and distribution facilities.Idaho Power
service area has experienced strong population growth, and the
Company s most recent resource plan anticipates the addition
of 11 000 to 12,000 new customers annually. In order to keep
pace with customer growth , enhance transmission
infrastructure, and balance generation resource uncertainty
Idaho Power anticipates construction expenditures of
approximately $299 million in 2007 and an additional $543
million over the period 2008-2009.
Over the ten-year planning period, Idaho Power
Integrated Resource plan has identified the potential need for
the Company to obtain 1 063 MW of supply- side capacity, which
will entail additional purchased power commitments and
financing construction of additional baseload generation, in
addition to other system upgrades. Moreover , as indicated
earlier, Idaho Power must also bear the costs of protection,
6 Idaho Power Company, 2006 Integrated Resource Plan (Oct. 12, 2006) at
7 IDACORP, Inc., 2006 Form-l0K Report at 36.
8 Idaho Power Company, 2006 Integrated Resource Plan (Oct. 12, 2006) at 95.
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Idaho Power Company
mitigation , and enhancement measures associated with Hells
Canyon relicensing.Considering the unfavorable outlook for
the Company s credit standing, support for Idaho Power
financial integrity and flexibility will be instrumental in
attracting the capital necessary to fund these projects in an
effective manner.
B. Utility Industry
What general conditions have recently characterized
the utility industry?
Over the past decade, the industry has experienced
significant structural change resulting from market forces and
decontrol ini tiati ves At least initially, this process was
largely driven by regulatory reforms at the federal level.
The National Energy Policy Act of 1992 greatly increased
prospective competition for the production and sale of power
at the wholesale level, with FERC being an aggressive
proponent for actions designed to foster greater competition
in markets for wholesale power supply.
Most market observers agree that, while "open
access " to FERC-jurisdictional transmission facilities has
resulted in more competition in wholesale energy markets, it
has also introduced substantial risks - particularly for
utilities (like Idaho Power) that depend on wholesale markets
for a portion of their resource requirements.
What impact did the Western power crisis have on
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Idaho Power Company
investors ' risk perceptions for firms involved in the electric
power industry?
These events caused investors to rethink their
assessment of the relative risks associated with 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
wholesale power markets and investors and utilities
nationwide.In many states, restructuring ini tiati ves for the
retail sector of the electric industry were cancelled or
placed on hold as the financial implications of the Western
energy crisis brought the uncertainties associated with
today s power markets into sharp focus for the investment
community and other stakeholders.While the case of
California represents an extreme example, there is ample
evidence that investors ' risk perceptions for all electric
utili ties shifted sharply upward in response to these events.
Was there a corresponding impact on the industry
credit standing?
The years following the Western power crisisYes.
witnessed steady erosion in credit quality throughout the
utility industry, both as a result of revised perceptions of
the risks in the industry and the weakened finances of the
utilities themselves.For example , during 2002 , S&P recorded
182 downgrades in the utility industry, versus only fifteen
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Idaho Power Company
upgrades,9 while Moody s downgraded 109 utility issuers and
upgraded three. Credit quality continued to decline during
2003, with S&P reporting that downgrades outpaced upgrades by
more than fifteen to one in the fourth quarter of 2003.S&P
reported that the majority of the companies in the utility
sector now fall in the triple-B rating category and noted a
continued negative bias in the credit outlook.
Is the potential for energy market volatility an
ongoing concern for investors?
Most definitely.Investors recognize that the
prospect of further turmoil in energy markets cannot be
discounted, with S&P reporting continued spikes in wholesale
market prices since the Western power crisis. Similarly,
Fi tch recently noted that "elevated energy commodity prices
contribute to a "challenging environment" for electric
utilities.Meanwhile, the FERC Staff has continued to
recognize the ongoing potential for market disruption in the
West, as a 2005 market assessment report concluded:
Id.
10 Moody 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).12 Standard & Poor s Corporation, "Few Rating Actions For U. S. Electric,
Gas, And Water Utilities In Third Quarter,RatingsDirect (Oct. 25,2006).13 Standard & Poor s Corporation
, "
Fuel and Purchased Power Cost Recovery
In The Wake Of Volatile Gas And Power Markets - U. S. Electric Utili ties
Watch,(Mar. 22 , 2006).
14 Fitch Ratings, Ltd., "S. Power and Gas 2007 Outlook,Global Power
North American Special Report (Dec. 15, 2006) at 1.
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Idaho Power Company
Our review of supply and demand conditions in the
west this summer indicates that there may be periods
of market tightness most likely expressed as pricespikes and possible interruptions.
FERC continues to warn of load pockets vulnerable to periods
of high peak demand and unplanned outages of generation or
transmission capacity, 16 and ongoing reliability concerns led
FERC to establish mandatory standards for the bulk power
system.
Additionally, in recent years utilities and their
customers have also had to contend with dramatic fluctuations
in natural gas costs due to ongoing price volatility in the
spot markets. S&P concluded that "natural gas prices have
proven to be very volatile" and warned of a "turbulent
journey" due to the uncertainty associated with future
fluctuations in energy costs. Fi tch also highlighted the
challenges that fluctuations in commodity prices can have for
utili ties and their investors, observing that:
15 Federal Energy Regulatory Commission, Office of Market Oversight andInvestigations, "Summer Energy Market Assessment 2005," (May 4 , 2005) at
16 See Open Commission Meeting Sta tement of Chairman Joseph T. Kelliher,
Items E-13: Mandatory Reliability Standards for the Bulk-Power System
(Docket No. RM06-16-000) (March 15, 2007).
17 Federal Energy Regulatory Commission , Office of Market Oversight andInvestigations, "Summer Energy Market Assessment 2006," (May 18, 2006) at
18 For example, the Energy Information Administration reported that the
average price of gas used by electricity generators (regulated utilities
and non-regulated power producers) spiked from an average price of $7.
per Mcf for the first eight months of 2005 to over $11.00 per Mcf in
September and October (http: / /tonto. eia. doe. gov/dnav/ng/ng pri _sum dcu
nus htm) .19 Standard & Poor s Corporation, "Top Ten Credit Issues Facing U. S.Utilities,RatingsDirect (Jan. 29, 2007).
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Idaho Power Company
(H) igher gas prices tend to generate increased bad
debt expense, which may not be fully recoverable in
rates, and depress consumer demand, particularly
industrial and low-margin electric usage. Al though
residential demand tends to be relatively price-inelastic , high customer bills are politically
unpopular and can encourage prudency reviews byregulators. Moreover, lags in gas recovery can
drive up working capital borrowings, particularlyduring peak winter usage.
More recently, Fitch concluded,Historically high and
volatile commodity prices will continue to affect nearly the
entire power and gas sector. "
In addition, while coal has historically been a
relatively stable source of fuel, the potential for price
volatili ty has raised investors ' concerns.In an article
entitled "Rising Coal Prices May Threaten U. S. Utility Credit
Profiles," S&P noted that:
More recently, several current and structural
developments for the coal mining industry haveresul ted in a dramatic increase in spot coalprices.
At the same time, heightened environmental awareness,
particularly over carbon and other emissions, has increased
exposure to mandated remediation and other compliance costs
and further complicates resource planning for utilities that
20 Fitch Ratings, Ltd., "Outlook 2005: u.s. Power & Gas,Global Power
North American Special Report (Jan. 6, 2005) at 16.
21 Fitch Ratings, Ltd., "U. S. Power and Gas 2007 Outlook,Global Power
North American Special Report (Dec. 15, 2006) at 22 Standard & Poor s Corporation, "Rising Coal Prices May Threaten U. S.
Utility Credit Profiles,RatingsDirect (Aug. 12, 2004).
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Idaho Power Company
must add generating capacity, such as Idaho Power.
Does the PCA remove the risk associated with
fluctuations in power supply costs?
While the PCA provides some level of supportNo.
for the Company s financial integrity, it does not apply to
Moreover, even for utili ties with100% of power costs.
permanent energy cost adj ustment mechanisms in place, there
can be a significant lag between the time the utility actually
incurs the expenditure and when it is recovered from
ratepayers.This lag can impinge on the utility s financial
strength through reduced liquidity and higher borrowings.
Even with an energy cost adjustment mechanism
investors continue to recognize the ongoing potential for
regulatory disallowances.As S&P observed:
(Fuel and purchased power adjustment mechanisms
(FPPA)) vary substantially in their ability to
protect utilities daily and under catastrophicmarket movements. Moreover, it is critical to note
that FPPAs are not a substitute for supportive
regulation; the regulator s ability to disallow
costs through ex-post prudency review , regardless of
the existence of a FPPA, is a fact of life for
utili ties.
Similarly, Fitch noted that "because of the lag between when
the excess costs are incurred and when they are recovered and
the potential disallowances of such costs," substantial
23 Standard & Poor s Corporation, Utili ties Perspectives (Oct. 18, 2004).
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Idaho Power Company
uncertainties remain even for utilities with fuel and
purchased power cost adjustment mechanisms. Significantly,
Fitch specifically highlighted Idaho Power as one of 29
utilities having "relatively greater fuel or purchased power
exposure within the sector 25 and cited the "earnings
volatility inherent in the utility s hydro generation system
as a primary factor in its decision to downgrade Idaho Power
senior debt ratings.
Are there other mechanisms that affect Idaho Power
rates for utility service?
Included in the provisions of Idaho PowerYes.
PCA is a Load Growth Adjustment Rate ("LGAR"The LGAR
subtracts the cost of serving new Idaho retail customers from
the power supply costs that the Company is allowed to include
in its PCA.In April 2006, Idaho Power petitioned the IPUC to
revise the basis of the LGAR to reflect the embedded cost of
serving new load, rather than the marginal cost methodology
that had been previously approved.On January 9, 2007 , the
IPUC issued a final order revising the LGAR, while retaining
the marginal cost methodology.
In support of its decision to retain the existing
24 Fitch Ratings
America Special
25 Id. at 27.
26 Fitch Ratings
Credi Analysis
Ltd., "Outlook 2005: u.s. Power & Gas,Global Power/North
Report (Jan. 6, 2005) at 26.
Ltd., "Idaho Power Company,Global Power/North America
(Feb. 18, 2005) at
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Idaho Power Company
load growth component of the PCA , the IPUC recognized that
Idaho Power would continue to be exposed to the risks of
shortfalls associated with load growth.The IPUC specifically
noted that these uncertainties are properly considered in
establishing a fair ROE for Idaho Power:
Because this process puts the Company at some
business and financial risk , it is awarded a
commensurate equity return. Idaho Power s current
equi ty return was set in a process that recognized
it would not recover the power supply costs of load
growth in the PCA mechanism.
What other developments have contributed to
investors ' reassessment of the risks associated with the
electric power industry?
Policy evolution in the transmission area has been
wide reaching and investors' focus on regulatory change in
their assessment of risks and prospects was exemplified by
S&P's conclusion that:
The FERC is in the process of changing every aspect
of the electric utility landscape, with industry
sages anticipating further transmission and
wholesale market development guidance, which could
affect the segment's credit prospects and quality.
Uncertainty will exist until operating rules are inplace and have stabilized.
Transmission operations have become increasingly complex and
27 Order No. 30215 at 10.28 Standard & Poor s Corporation, "Electric Transmission at the Starting
Gate,RatingsDirect (May 10, 2002).
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Idaho Power Company
investors have recognized that difficulties in obtaining
permi ts and uncertainty over the adequacy of allowed rates of
return have contributed to heightened risk and fueled concerns
regarding the need for additional investment in the
transmission sector of the electric power industry.
At the same time, the development of competitive
wholesale power markets has resulted in increased demand for
transmission resources.Concerns regarding the need to
encourage further investment in the transmission sector were
exemplified by FERC's rulings in Docket No. RM06-29 which
established incentive-based rate treatments to promote
investment in electric utility infrastructure.While there is
little debate that increased investment in the transmission
system will be required to fully realize the benefits of
effective wholesale power markets, the challenges posed by an
increasingly complex marketplace heighten the uncertainties
associated with transmission operations while requiring the
commitment of significant new capital investment to maintain
and enhance service capabilities.
29 Promoting Transmission Investment through pricing Reform, Order No. 679,
116 FERC ~ 61,057 (July 20, 2006); Order No. 679-A, 117 FERC ~ 61,327 (Dec.
22, 2006).
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Idaho Power Company
Are investors likely to consider the impact of
market restructuring in assessing their required rate of
return for Idaho Power?
While retail restructuring has not beenAbsolutely.
actively pursued in Idaho, the Company continues to face the
prospect of FERC driven changes in the electric transmission
function of their business , as well as other fundamental
industry reforms.Virtually all industry stakeholders have
recognized that regulatory uncertainties increase the risks
associated with the utility industry.For example, the DOE
identified "reducing regulatory uncertainty" as critical in
stimulating increased investment in the power industry and has
noted that lack of clarity in the regulatory structure was
inhibiting planning and investment.
Lack of restructuring legislation in Idaho does not
leave industry stakeholders immune from adversity, with market
trends and federal policies continuing to impact Idaho Power
and its investors.Already, Idaho Power has confronted the
uncertainties associated with the establishment of regional
transmission management through the numerous regulatory and
legal proceedings associated with the formation of Grid West.
Moreover , because of potential exposure to wholesale markets,
reliance on purchased power to fill potential shortfalls in
30 U.S. Department of Energy, National Transmission Grid Study (May 2002),
at 24 and 31.
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Idaho Power Company
generation or meet resource needs magnifies the importance of
maintaining the financial flexibility necessary to fund an
adequate and reliable utility system.Thus, while
restructuring has not been implemented for Idaho Power
service territory, investors undoubtedly consider these
factors in assessing the required rate of return on long-term
capi tal , such as common equity.
What other factors would investors likely consider
in evaluating the relative investment risks of Idaho Power?
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 di versi ty, 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.
The prolonged drought conditions experienced in the
recent past have only deepened concerns over power prices and
fluctuations in gas costs.Investors recognize the
significant financial burden associated with constrained hydro
generation, as Fitch summarized:
(T) he duration and severity of the current drought,
which stretches back through the energy crisis of
2000-2001 , has resulted in meaningful cash flow
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Idaho Power Company
volatility, balance-sheet erosion and diminishedfinancial flexibility...
Investors recognize that volatile energy markets,
unpredictable stream flows, and Idaho Power s reliance on
wholesale purchases to meet a portion of its resource needs
expose the Company to the risk of reduced cash flows and
The IPUC has recognized "theunrecovered power supply costs.
unique circumstances of Idaho Power s highly variable power
supply costs, "32 and the Company s reliance on purchased power
to meet shortfalls in hydroelectric generation magnifies the
importance of strengthening financial flexibility.A strong
credit profile is essential to guarantee access to the cash
resources and interim financing required to meet any shortfall
in operating cash flows, as well as fund required investments
in the utility system.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 in hydroelectric generation and other
variations in resources and loads compound these
uncertainties.
Are these uncertainties the only risks being faced
by utilities?
As noted earlier , utilities are confrontingNo.
31 Id.32 Order No. 30215 at
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increased environmental pressures that could impose
significant uncertainties and costs.S&P cited environmental
including emissions, conservation, and renewablemandates
resources, as one of the top ten credit issues facing U. S.
utili ties. Similarly, Moody s noted that "considerable
uncertainty" accompanied any assessment of the future
requirements associated with environmental compliance. Apart
from these factors, the industry continues to face the normal
risks inherent in operating electric utility systems,
including the potential adverse effects of inflation , interest
rate changes, growth , the general economy, and regulatory
uncertainty and lag.As a senior analyst for Fitch noted:
Capital expenditures are on the rise for network
reliabili ty, mandated environmental compliance, andresource adequacy. Utilities face rising non-fuel
operating and maintenance expenses, particularly for
pensions, employee medical expenses, and post-
retirement benefits. trend of declining interest
expenses that benefited the sector over the past
four years is likely to reverse in the next severalyears. -. In Fi tch' view , the sector s credit
recovery is now fading, and investors should
exercise greater caution regarding the power and gassector.
33 Standard & Poor s Corporation, "Top Ten Credit Issues Facing u. S.Utilities,RatingsDirect (Jan. 29, 2007).
34 Moody s Investors Service, "Regulatory Pressures Increase For U. S.Utilities,Special Comment (March 2007).35 Lapson, Ellen
, "
Rising Unit Costs & Credit Quality: Warning Signals,
Public Utilities Fortnightly (Feb. 1, 2006).
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III. CAPITAL MARKET ESTIMATES
What is the purpose of this section?
This section presents capital market estimates of
the cost of equity.First , I examine the concept of the cost
of equity, along with the risk-return tradeoff principle
fundamental to capital markets.Next , I describe DCF , CAPM,
and comparable earnings analyses conducted to estimate the
cost of equity for reference groups of comparable risk firms.
A. Overview
What role does the rate of return on common equity
play in a utility s rates?
The return on common equity is the cost of inducing
and retaining investment in the utility s physical plant and
assets.This investment is necessary to finance the asset
base needed to provide utility service.Investors will commit
money to a particular investment only if they expect it to
produce a return commensurate with those from other
investments with comparable risks.Moreover , the return on
common equity is integral in achieving the sound regulatory
obj ectives of rates that are sufficient to: 1) fairly
compensate capital investment in the utility, 2) enable the
utility to offer a return adequate to attract new capital on
reasonable terms, and 3) maintain the utility s financial
integri ty.Meeting these obj ecti ves allows the utility to
fulfill its obligation to provide reliable service while
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meeting the needs of customers through necessary system
expansion.
What fundamental economic principle underlies any
evaluation of investors ' required return on equity?
Underlying the concept of the cost of equity is the
fundamental notion that investors are risk averse, and will
willingly bear additional risk only if they expect
compensation for doing so.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 2) its relative risk, with
investors demanding correspondingly larger risk premiums for
assets bearing greater risk.Given this risk-return tradeoff,
the required rate of return (k) from an asset (i) can be
generally expressed as:
i = Rf + RP
where:f = Risk-free rate of return; and
i = Risk premium required to holdrisky asset i.
Thus, 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 2) its relative risk , with investors demanding
correspondingly larger 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
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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, is
considerably higher than the yield on the utility s long-term
debt.
Is the cost of equity observable in the capital
markets?
Unlike debt capital, there is no contractuallyNo.
guaranteed return on common equity capital because
shareholders are the residual owners of the utility.since it
is unobservable , the cost of equity for a particular utility
must be estimated by analyzing information about capital
market conditions generally, assessing the relative risks of
the company specifically, and employing various quantitative
methods that focus on investors ' current required rates of
return.These various quantitative methods typically attempt
to infer investors' required rates of return from stock
prices, interest rates, or other capital market data.
Did you rely on a single method to estimate the cost
of equity for Idaho Power?
No. In my opinion, no single method or model should
be relied upon to determine a utility s cost of equity because
no single approach can be regarded as wholly reliable.As the
Federal Communications Commission recognized:
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Equi ty prices are established in highly volatile and
uncertain capital markets. .. Different forecastingmethodologies compete wi th each other for eminence,
only to be superceded by other methodologies as
condi tions change... In these circumstances, we
should not restrict ourselves to one methodology, or
even a series of methodologies, that would beapplied mechanically. Instead, we conclude that we
should adopt a more accommodating and flexibleposition.
Therefore, I used both the DCF and CAPM methods to estimate
the cost of equity.In addition, I also evaluated a fair ROE
return using the comparable earnings approach.In my opinion
comparing estimates produced by one method with those produced
by other approaches ensures that the estimates of the cost of
equity pass fundamental tests of reasonableness and economic
logic.
Do you believe the constant growth DCF model should
be relied on exclusively to evaluate a reasonable ROE for
Idaho Power?
Because the cost of equity is unobservable, noNo.
single method should be viewed in isolation.While the DCF
model has been routinely relied on in regulatory proceedings
as one guide to investors' required return, it is a blunt tool
that should never be used exclusively.Regulators have
customarily considered the results of alternative approaches
36 Federal Communications Commission , Report and Order 42-43, CC Docket No.
92-133 (1995).
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in determining allowed returns. It is widely recognized that
no single method can be regarded as a panacea; all approaches
having their own advantages and shortcomings.For example, a
publication of the Society of Utility and Financial Analysts
(formerly the National Society of Rate of Return Analysts)
concluded that:
Each model requires the exercise of judgment as to
the reasonableness of the underlying assumptions of
the methodology and on the reasonableness of the
proxies used to validate the theory. Each model has
its own way of examining investor behavior , its own
premises, and its own set of simplifications ofreality. Each method proceeds from different
fundamental premises , most of which cannot be
validated empirically. Investors clearly do not
subscribe to any singular method , nor does the stock
price reflect the application of any one single
method by investors.
Moreover, evidence suggests that reliance on the DCF
model as a tool for estimating investors ' required rate of
return has declined outside the regulatory sphere, with the
CAPM being "the dominant model for estimating the cost of
equity. "Regulatory Finance: Utili ties Cost of Capi tal noted
the inherent difficulties of the DCF approach:
37 For example, a NARUC survey reported that 26 regulatory jurisdictions
ascribe to no specific method for setting allowed ROEs, with the results of
all approaches being considered. "Utility Regulatory Policy in the U. S.
and Canada, 1995-1996," National Association of Regulatory UtilityCommissioners (December 1996) .
38 Parcell , David C., "The Cost of Capital - A Practitioner s Guide,
Society of Utility and Regulatory Financial Analysts (1997) at Part 2, p.
39 See, Bruner, R.F., Eades, K.M., Harris, R.S., and Higgins, R.C.,
Best Practices in Estimating Cost of Capital: Survey and Synthesis,
Financial Practice and Education (1998).
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(C) aution and judgment are required in interpreting
the results of DCF models because of (1) the
questionable applicability of the DCF model toutili ty stocks in certain market environments, (2)
the effect of declining earnings and dividends on
financial inputs to the DCF model and biases caused
by the effect of changes in risk and growth, and (3)
the conceptual and practical difficulties associated
with the growth component of the DCF model.
The publication concluded If the cost of equity estimation
process is limited to one methodology, such as DCF, it may
severely bias the results. "
Are you aware that the IPUC has traditionally relied
primarily on the DCF and comparable earnings methods?
Yes, although the Commission has also evidenced a
willingness to weigh alternatives in evaluating an allowed
ROE.For example, while noting that it had not focused on the
CAPM for determining the cost of equity, the IPUC recognized
in Order No. 29505 that "methods to evaluate a common equity
rate of return are imperfect predictors " and emphasized "that
by evaluating all the methods presented in this case and using
each as a check on the other " the Commission had avoided the
pitfalls associated with reliance on a single method.
B. Discounted Cash Flow Analyses
How are DCF models used to estimate the cost of
40 Morin, Roger A., "Regulatory Finance: Utilities ' Cost of Capital,
Public Utilities Reports, Inc. (1994) at 238.
41 Id.42 Order No. 29505 at 38 (emphasis added).
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equity?
DCF models attempt to replicate the market valuation
process that sets the price investors are willing to pay for a
The model rests on the assumptionshare of a company s stock.
that investors evaluate the risks and expected rates of return
from all securities in the capital markets.Given these
expectations, the price of each stock is adjusted by the
market until investors are adequately compensated for the
risks they bear.Therefore, we can look to the market to
determine what investors believe a share of common stock is
worth.By estimating the cash flows investors expect to
receive from the stock in the way of future dividends and
capital gains, we can calculate their required rate of return.
In other words, the cash flows that investors expect from a
stock are estimated, and given its current market price, we
can "back- into" the discount rate , or cost of equity, that
investors implicitly used in bidding the stock to that price.
What market valuation process underlies DCF models?
DCF models assume 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.In other words, the cost of equity
is the discount rate that equates the current price of a share
of stock with the present value of all expected cash flows
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from the stock.
What form of the DCF model is customarily used to
estimate the cost of equity in rate cases?
Rather than developing annual estimates of cash
flows into perpetuity, the DCF model can be simplified to a
constant growth" form:
p -
0 - ke - 9
o = Current price per share;where:
1 = Expected dividend per share in the
coming year;
e = Cost of equity;
g = Investors ' long- term growthexpectations.
The cost of equity (K ) can be isolated by rearranging terms:
k = ----1.. + e p
This constant growth form of the DCF model
recognizes that the rate of return to stockholders consists of
two parts: 1) dividend yield (D ), and 2) growth (g).
other words, investors expect to receive a portion of their
total return in the form of current dividends and the
remainder through price appreciation.
Are the assumptions underlying the constant growth
form of the DCF model met in the real world?
The constant growth DCF model is dependent on a
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number of strict assumptions, 43 which in practice are never
strictly met.Nevertheless , where earnings are derived from
stable activities, and earnings, dividends , and book value
track fairly closely, the constant growth form of the DCF
model offers a reasonable working approximation of stock
valuation that provides useful insight as to investors
required rate of return.
How did you define the utility proxy group you used
to implement the DCF model?
In estimating the cost of equity, the DCF model is
typically applied to publicly traded firms engaged in similar
business acti vi ties.In order to reflect the risks and
prospects associated with Idaho Power s electric utility
operations, my utility proxy group was composed of those
di vidend-paying companies included by The Value Line
Investment Survey ("Value Line in its Electric utili ties
Industry groups with:S&P corporate credit ratings between(1 )
BBB" and "(2) a Value Line Safety Rank of 3" or better
(3) a Value Line Financial Strength Rating of "B" to "B++
and (4) published growth estimates from Value Line, I/B/E/S
43 These include a constant growth rate for both dividends and earnings; a
stable dividend payout ratio; the discount rate exceeds the growth rate; a
constant growth rate for book value and price; a constant earned rate of
return on book value; no sales of stock at a price above or below book
value; a constant price-earnings ratio; a constant discount rate (i.e., no
changes in risk or interest rate levels and a flat yield curve); and all of
the above extend to infinity.
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International , Inc.IBES"), and Reuters, Inc.Reuters
) .
Do these criteria provide obj ecti ve evidence that
investors would view the firms in your utility proxy group as
risk-comparable?
Credit ratings are assigned by independentYes.
rating agencies for the purpose of providing investors with a
broad assessment of the creditworthiness of a firm.Because
the rating agencies ' evaluation includes virtually all of the
factors normally considered important in assessing a firm
relative credit standing, corporate credit ratings provide a
broad measure of overall investment risk that is readily
available to investors.Widely cited in the investment
communi ty and referenced by investors as an obj ecti ve measure
of risk , credit ratings are also frequently used as a primary
risk indicator in establishing proxy groups to estimate the
cost of equity.
While credit ratings provide the most widely
referenced benchmark for investment risks, other quality
rankings published by investment advisory services also
provide relative assessments of risk that are considered by
investors in forming their expectations.Value Line s primary
risk indicator is its Safety Rank, which ranges from "
(Safest) to "This overall risk measure is(Riskiest)
intended to capture the total risk of a stock, and
incorporates elements of stock price stability and financial
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Given that Value Line is perhaps the most widelystrength.
available source of investment advisory information , its
Safety Rank provides a useful guide to the likely risk
perceptions of investors.
The Financial Strength Rating is designed as a guide
to overall financial strength and creditworthiness, with the
key inputs including financial leverage, business volatility
measures, and company size.Value Line s Financial Strength
Ratings range from "A++(weakest) in(strongest) down to "
nine steps.Based on these criteria, which reflect objective,
published indicators that incorporate consideration of a broad
spectrum of risks, including financial and business position
relative size , and exposure to company specific factors,
investors are likely to regard this group as having comparable
risks and prospects.
Why did you exclude firms that do not pay common
dividends from your utility proxy group?
As discussed earlier, under the DCF approach,
observable stock prices are a function of the cash flows that
investors expect 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 that do not pay common dividends.
What steps are required to apply the DCF model?
The first step in implementing the constant growth
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DCF model is to determine the expected dividend yield (D
for the firm in question.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 I long-term growth
expectations
(g)
for the firm.The final step is to sum the
firm I s dividend yield and estimated growth rate to arrive at
an estimate of its cost of equity.
How was the dividend yield for the utility proxy
group determined?
Estimates of dividends to be paid by each of these
utili ties over the next twelve months, obtained from Value
Line, served as D This annual dividend was then divided by
the corresponding stock price for each utility to arrive at
the expected dividend yield.The expected dividends, stock
prices, and resulting dividend yields for the firms in the
utility proxy group are presented on Exhibit As shown
there , dividend yields for the nineteen firms in the utility
proxy group ranged from 2.1 percent to 4.9 percent.
what are investors most likely to consider in
developing their long-term growth expectations?
The only "" that matters in applying the DCF model
is the value that investors expect and have embodied in
current market prices.In constant growth DCF theory,
earnings , dividends, book value, and market price are all
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assumed to grow in lockstep, and the growth horizon of the DCF
model is infinite.But implementation of the DCF model is
more than just a theoretical exercise; it is an attempt to
replicate the mechanism investors used to arrive at observable
stock prices.
How is the growth component of the constant DCF
model measured?
A wide variety of techniques can be used to derive
growth rates, but the only "" that matters in applying the
DCF model is the value that investors expect and have embodied
in current stock prices.While the DCF model is technically
concerned with growth in dividend cash flows, implementation
of this DCF model is solely concerned with replicating the
forward-looking evaluation of real-world investors.In the
case of utilities, dividend growth rates are not likely to
provide a meaningful guide to investors ' current growth
expectations.This is because utilities have significantly
al tered their dividend policies in response to more
accentuated business risks in the industry. As a result of
this trend towards a more conservative payout ratio, dividend
growth in the utility industry has remained largely stagnant
as utilities conserve financial resources to provide a hedge
44 For example, the payout ratio for electric utilities fell from
approximately 80% historically to on the order of 60%. (The Value Line
Investment Survey (Sep. 15, 1995 at 161 , Feb. 9, 2007 at 1774)J
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against heightened uncertainties.
What are investors most likely to consider in
developing their long-term growth expectations?
As payout ratios for firms in the utility industry
trended downward, investors focus has increasingly shifted
from dividends to earnings as a measure of long- term growth.
Future trends in earnings, which provide the source for future
dividends and ultimately support share prices, play a pivotal
role in determining investors long-term growth expectations.
The importance of earnings in evaluating investors
expectations and requirements is well accepted in the
investment community.As noted in Finding Reali ty in Reported
Earnings published by the Association for Investment
Management and Research:
(E) arnings, presumably, are the basis for the
investment benefits that we all seek. "Healthy
earnings equal healthy investment benefits " seems a
logical equation, but earnings are also a scorecard
by which we compare companies, a filter through
which we assess management, and a crystal ball in
which we try to foretell future performance.
Value Line s near-term projections and its Timeliness Rank,
which is the principal investment rating assigned to each
individual stock , are also based primarily on various
45 Association for Investment Management and Research, "Finding Reality in
Reported Earnings: An Overview , p. 1 (Dec. 4, 1996).46 The Timeliness Rank presents Value Line s assessment of relative price
performance during the next six to twelve months based on a five pointscale.
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quantitative analyses of earnings.As Value Line explained:
The future earnings rank accounts for 65% in the
determination of relative price change in the
future; the other two variables (current earnings
rank and current price rank) explain 35%.
The fact that investment advisory services , such as
Value Line, IBES, and Reuters, focus on growth in earnings
indicates that the investment community regards this as a
superior indicator of future long-term growth.Indeed, "
Study of Financial Analysts: Practice and Theory," published
in the 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, cash
flow, and book value in analyzing securities.Of the 297
analysts that responded, only 3 ranked dividends first while
276 ranked it last.The article concluded:
Earnings and cash flow are considered far moreimportant than book value and dividends.
What are security analysts currently proj ecting
the way of growth for the firms in the utility proxy group?
The earnings growth proj ections for each of the
47 The Value Line Investment Survey, Subscriber s Guide, p. 53.
48 Block, Stanley B., "A Study of Financial Analysts: Practice and Theory
Financial Analysts Journal (July/August 1999).
49 Id. at 88.
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firms in the utility proxy group reported by IBES and
published in S&P' s Earnings Guide are displayed on Exhibit
Also presented are the earnings per share ("EPS") growth
proj ections reported by Value Line and Reuters.
How else are investors ' expectations of future long-
term growth prospects often estimated for use in the constant
growth DCF mode 1 ?
Based on the assumptions underlying constant growth
theory, conventional applications of the constant growth DCF
model often examine the relationship between retained earnings
and earned rates of return as an indication of the sustainable
growth investors might expect from the reinvestment of
earnings wi thin a firm.The sustainable growth rate is
calculated by the following formula:
g = br + sv
where:g = investors ' expected long-termgrowth rate;
b = expected retention ratio;
r = expected earned return on equity;
s = percent of common equity expected
to be issued annually as new
common stock; and,
v = expected equity accretion rate.
What is the purpose of the "" term?
Under DCF theory, the "" factor is a component of
the growth rate designed to capture the impact of issuing new
common stock at a price above , or below , book value.When a
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company s stock price is greater than its book value per
share, the per- share contribution in excess of book value
associated with new stock issues will accrue to the current
This increase to the book value of existingshareholders.
shareholders leads to higher expected earnings and dividends,
with the "" factor incorporating this additional growth
component.
How did you apply the earnings retention method for
the proxy group of utilities?
The sustainable,br+sv" growth rates for each firm
in the proxy group are summarized on Exhibit 2, with the
underlying details being presented on Exhibit For each
firm , the expected retention ratio (b) was calculated based on
Value Line s projected dividends and earnings per share.
Likewise , each firm s expected earned rate of return (r) was
computed by dividing proj ected earnings per share by proj ected
net book value.Because Value Line reports end-of -year book
values, an adjustment was incorporated to compute an average
rate of return over the year, consistent with the theory
underlying this approach to estimating investors ' growth
expectations.Meanwhile, the percent of common equity
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 in common shares outstanding, while the equity
accretion rate (v) was computed as 1 minus the inverse of the
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projected market-to-book ratio.
What cost of equity estimates were implied for the
utility proxy group using the DCF model?
As shown on Exhibit 2 , combining the dividend yields
and respective growth proj ections for each utility resulted in
current cost of equity estimates ranging from 4.8 percent to
18.3 percent.
In evaluating the results of the constant growth DCF
model , is it appropriate to eliminate cost of equity estimates
that fail to meet threshold tests of economic logic?
It is a basic economic principle thatYes.
investors can be induced to hold more risky assets only if
they expect to earn a return to compensate them for their risk
bearing.As a result , the rate of return that investors
require from a utility s common stock , the most junior and
highest risk of its securities , must be considerably higher
than the yield offered by senior, long-term debt.consistent
wi th this principle, the DCF range for the proxy group of
electric utilities must be adjusted to eliminate cost of
equity estimates that fail fundamental tests of economic
logic.
The average bond rating associated with the firms in
the proxy group is triple-, with Moody s monthly yields on
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triple-B bonds averaging approximately 6.1 percent over the
s ix-month period ending March 2007.In the present instance
eight of the individual cost of equity estimates exceeded this
threshold by 100 basis points or less. In light of the risk-
return tradeoff principle , it is inconceivable that investors
are not requiring a substantially higher rate of return for
holding common stock , which is the riskiest of a utility
securities.As a result, these values provide little guidance
as to the returns investors require from the common stock of
an electric utility.
Have similar tests been applied by regulators?
For example , FERC has noted that adj ustmentsYes.
are justified where applications of the DCF approach produce
illogical results:
An adjustment to this data is appropriate in the
case of PG&E I s low- end return of 8.42 percent , which
is comparable to the average Moody I s II A" grade
public utility bond yield of 8.06 percent , forOctober 1999. Because investors cannot be expected
to purchase stock if debt , which has less risk thanstock, yields essentially the same return, this low-
end return cannot be considered reliable in thiscase.
More recently, in its October 2006 decision in Kern River Gas
50 Based on data from Moody Credit Perspectives (Dec. 4, 2006, Feb 5 &April 16, 2007).51 As highlighted on Exhibit 2, eight DCF estimates ranged from 4.8 percent
to 7.1 percent.
52 Southern California Edison Company, 92 FERC ~ 61,070 (2000) at 22.
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Transmission Company, FERC noted that:
(T) he 7.31 and 7.32 percent costs of equity for El
Paso and Williams found by the ALJ are only 110 and
122 basis points above that average yield for public
utility debt.
FERC upheld the opinion of Staff and the Administrative Law
Judge that cost of equity estimates for these two proxy group
companies "were too low to be credible." 54
What other objective evidence demonstrates that cost
of equity estimates of 7.1 percent or less are not logical?
Expectations for a continued upward trend in long-
term capital costs further supports a finding that these
estimates are illogical and should be disregarded.Widely
referenced proj ections continue to anticipate that long- term
interest rates will increase.The most recent forecast of
Global lnsight , a widely referenced forecasting service, calls
for double-A public utility bond yields to reach 6.98 percent
in 2008 and average 7.22 percent over the five years ended
2012.Meanwhile, the Energy Information Administration
EIA"), a statistical agency of the U. S. Department of
Energy, anticipates that the double-A public utility bond
yield will reach 6.85 percent in 2008, or an average of 7.
53 Kern River Gas Transmission Company, Opinion No. 486, 117 FERC ~ 61,077
(2006) at P. 140 & fn. 227.
54 Id.55 Global Insiqht
, "
The U.S. Economy: The 30-Year Focus " (Third-Quarter
2006) at Table 34. This is the only series of projections for public
utility bond yields reported by Global Insight
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percent for the period 2008-2012.As shown in Table 1 below
with the average yield spread between double-A and triple-
utility bonds over the six months ended March 2007 being 43
basis points, these forecasts imply an average triple-B bond
yield of 7.34 percent for 2008, or 7.68 percent over the
year period 2008-2012:
TABLE 1
IMPLIED BBB BOND YIELD
Line
No.2008 2008-
Projected AA UtilityYieldGlobalInsight (a)EIA (b)98%22%
85%30%
92%26%
42%42%
34%68%
Average
BBB - AA Yield Spread
(c)
Implied BBB UtilityYield
(a) Global Insight
, "
The U.S. Economy: The 30-
Year Focus" (Third-Quarter 2006) at Table
34.
(b) Energy Information Administration, "Annual
Energy Outlook 2007,(Feb. 2007) at Table
19.
(c) Based on monthly average bond yields for the
six months Oct. 2006 - Mar. 2007 reported in
Moody Credi Perspecti ves
Expectations for an increase in long- term debt yields is also
supported by the widely-referenced Blue Chip forecast, which
proj ects that yields on corporate bonds will climb on the
56 Energy Information Administration, "Annual Energy Outlook 2007,(Feb.
2007) at Table 19. This is the only series of projections for public
utility bond yields reported by EIA.
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order of 50 basis points through the second quarter of 2008.
Given that low-end cost of equity estimates of 7.1 percent or
less are below investors ' expectations for comparable utility
bond yields, these cannot be considered credible estimates of
investors ' required return on common stocks.
Is there any basis to exclude cost of equity
estimates at the high end of the range of DCF results?
Yes.The upper end of the cost of equity range
produced by the DCF analysis presented in Exhibit 2 was set by
a cost of equity estimate of 18.3 percent for Dominion
Resources.Compared with the balance of the remaining
estimates, this 18.3 percent estimate is an extreme outlier
and should also be excluded in evaluating the results of the
DCF model for the utility proxy group.
What cost of equity is implied by your DCF results
for the utility proxy group?
As shown on Exhibit 2 and summarized in Table
below , after eliminating illogical low- and high-end values,
application of the constant growth DCF model resulted in the
following cost of equity estimates:
57 Blue Chip Financial Forecasts (Jan. 1 , 2007) at
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TABLE 2
DCF RESULTS - UTILITY PROXY GROUP
Growth Rate
IBES
Val ue LineReutersbr+sv
Average Cost of Equity
11.
10.
10.
10.
What considerations are relevant in evaluating these
DCF results for utilities?
The short-term proj ected growth rates used to apply
the DCF model may be colored by lingering economic
uncertainties and the numerous challenges faced in the utility
indus try.The impact of this short-term focus 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 performance, 58 while noting that "we don ' t totally
discount the possibility that the industry will be accorded
higher sustainable valuations going forward. "While a
cautious short-term outlook may be indicative of relatively
low near-term growth proj ections, it does not necessarily
reflect investors ' long-term expectations for the industry.
As a result, DCF growth rates do not necessarily capture
investors ' long-term expectations for the industry, and the
resulting cost of equity estimates will be downward-biased.
58 The Value Line Investment Survey, Selection Opinion (Apr. 6, 2007) at
4790.59 The Value Line Investment Survey (Mar. 2, 2007) at 153.
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How else can the DCF model be applied to estimate
the ROE for Idaho Power?
Under the regulatory standards established by Hope
and Bluefield the salient criteria in establishing a
meaningful benchmark to evaluate a fair rate of return is
relative risk, not the particular business activity or degree
of regulation.Utilities must compete for capital, not just
against firms in their own industry, but with other investment
opportuni ties of comparable risk.With regulation taking the
place of competitive market forces , required returns for
utilities should be in line with those of non-utility firms of
comparable risk operating under the constraints of free
competition.Consistent with this accepted regulatory
standard, I also applied the DCF model to a reference group of
comparable risk companies in the non-utility sectors of the
economy.
What criteria did you apply to evaluate investors
risk perceptions?
My assessment of comparable risk relied on three
obj ecti ve benchmarks for the risks associated with common
stocks - - Value Line s Safety Rank , Financial Strength rating,
and beta.My comparable risk proxy group was composed of
those U. S. companies followed by Value Line that 1) pay common
dividends , 2) have a Safety Rank of ", 2) have a Financial
Strength Rating of "A" or above, and 3) have beta values of
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95 or less. Consistent with the development of my utility
proxy group, I also eliminated firms with below-investment
grade credit ratings.
How do the overall risks of this non-utility
comparable group compare with those of the utility proxy
group?
As shown below , Table 3 compares the comparable risk
reference group with the utility proxy group and Idaho power
across four key indicators of investment risk:
TABLE 3
COMPARISON OF RISK INDICATORS
S&P Value Line
Credi t Safety FinancialRatingRankStrength Beta
Non-utility Group
Utility Proxy Group BBBIdahoPower(a)BBB+1. 05
Considered along with S&P's corporate credit ratings, a
comparison of these Value Line indicators, which encompass a
broad spectrum of risk measures , demonstrates that the average
investment risks associated with the non-utility group fall
below those of the utility proxy group and Idaho Power.
Considering the fundamental tradeoff between risk and return
discussed earlier , this comparison suggests that cost of
equi ty estimates for the non-utility group should provide a
60 This threshold is equal to the average beta value for my utility proxy
group discussed earlier.61 Value Line risk indicators are those published for Idaho Power s parent,
IDACORP, Inc.
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conservative estimate of investors ' required rate of return
for Idaho Power s utility operations.
What were the results of your DCF analysis for the
non-utility reference group?
As shown on Exhibit 4, I applied the DCF model to
the non-utility companies in exactly the same manner described
earlier for the utility proxy group. As summarized in Table
, below , after eliminating illogical low- and high-end
values, application of the constant growth DCF model resulted
in the following cost of equity estimates:
TABLE 4
DCF RESULTS - NON-UTILITY GROUP
Growth Rate
IBES
Val ue LineReuters
br+sv
Average Cost of Equity
12.
11.
12.
12.
What did you conclude with respect to the cost of
equity implied for Idaho Power using the constant growth DCF
mode 1 ?
Taken together, I concluded that these DCF results
for the two alternative proxy groups implied a cost of equity
range of 10.4 percent to 12.4 percent.
62 Exhibit 5 contains the details underlying the calculation of the br+sv
growth rates for the non-utility group.
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c. Capital Asset Pricing Model
Please describe the CAPM.
The CAPM is generally considered to be the most
widely referenced method for estimating the cost of equity
among academicians and professional practitioners , with the
pioneering researchers of this method receiving the Nobel
Prize in 1990.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 asset (e.
g.,
common stock) is
its volatility relative to the market as a whole.Beta
reflects the tendency of a stock's price to follow changes in
the market.A stock that tends to respond relatively less to
market movements has a beta less than 1.00, while stocks that
tend to move more than the market have betas greater than
00.The CAPM is mathematically expressed as:
j = R +(3j (R,. - R
where:= required rate of return for stock
= risk- free rate;
R,. = expected return on the market portfolio; and
(3j = beta, or systematic risk, for stock
Like the DCF model , the CAPM is an ex-ante,
forward-looking model based on expectations of the future.
a result, in order to produce a meaningful estimate of
investors ' required rate of return, the CAPM must be applied
using estimates that reflect the expectations of actual
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investors in the market , not with backward-looking, historical
data.
How did you apply the CAPM to estimate the cost of
equity?
Application of the CAPM to the utility proxy group
based on a forward-looking estimate for investors' required
rate of return from common stocks is presented on Exhibit
In order to capture the expectations of today s investors in
current capital markets , the expected market rate of return
was estimated by conducting a DCF analysis on the dividend
paying firms in the S&P 500.
The dividend yield for each firm was obtained from
Value Line, with the growth rate being equal to the average of
the earnings growth proj ections for each firm published by
IBES and Value Line , with each firm s dividend yield and
growth rate being weighted by its proportionate share of total
market value.Based on the weighted average of the
proj ections for the 361 individual firms, current estimates
imply an average growth rate over the next five years of 11.
percent.Combining this average growth rate with a dividend
yield of 2.1 percent results in a current cost of equity
estimate for the market as a whole of approximately 13.
percent.Subtracting a 4.8 percent risk- free rate based on
the average yield on 20-year Treasury bonds for March 2007
produced a market equity risk premium of 8.5 percent.
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Multiplying this risk premium by the average Value Line beta
of 0.95 for the utilities in the proxy group, and then adding
the resulting 8.0 percent risk premium to the average long-
term Treasury bond yield, indicated an ROE of approximately
12.8 percent.
What other CAPM analyses did you conduct to estimate
the cost of equity?
I also applied the CAPM using risk premiums based on
historical realized rates of return.This approach to
estimating investors ' equity risk premiums is premised on the
assumption that , given a sufficiently large number of
observations over long, historical periods, the average
realized market rate of return will converge to investors
required rate of return.Put another way, because future
expectations are unobservable, historical returns are often
extrapolated into the future on the presumption that past
experience heavily conditions future expectations.
While reference to historical data represents one
way to apply the CAPM , these realized rates of return reflect,
at best, an indirect estimate of investors ' current
requirements.The cost of capital is a forward-looking, or
expectational concept that is focused on the perceptions of
today s capital market investors.While past investment
returns are frequently referenced and may provide a useful
benchmark, the only factors that actually determine the
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Idaho Power Company
current required rate of return are investors ' expectations
for the future.As a result, forward-looking applications of
the CAPM that look directly at investors ' expectations in the
capi tal markets are apt to provide a more meaningful guide to
investors ' required rate of return.
What CAPM cost of equity is produced based on
historical realized rates of return for stocks and long-term
government bonds?
I applied the CAPM using data published by Ibbotson
Associates, which is perhaps the most exhaustive and widely
referenced annual study of realized rates of return.
Application of the CAPM based on historical realized rates of
return is presented in Exhibit In their 2006 Yearbook/
Valuation Edition, Ibbotson Associates reported that, over the
period from 1926 through 2005, the arithmetic mean realized
rate of return on the S&P 500 exceeded that on long-term
government bonds by 7.1 percent. Mul tiplying this historical
market risk premium by the average Value Line beta of 0.
63 Ibbotson Associates computes the equity risk premium by subtracting the
income return (not the total return) on long-term Treasury bonds from the
return on common stocks. As Ibbotson Associates noted (2006 Yearbook,
Valuation Edition at 77J:
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 purely riskless rate of return, since
an investor can hold a bond to maturity and be entitled to the
income return with no capital loss.
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produced an equity risk premium of 6.7 percent for the utility
As shown on Exhibit 7, adding this equity riskproxy group.
premium to the average yield on 20-year Treasury bonds for
March 2007 of 4.8 percent resulted in an implied cost of
equity of 11.5 percent.
D. Comparable Earnings Method
What other analyses did you conduct to estimate the
cost of equity?
As I noted earlier , I also evaluated the cost of
equity using the comparable earnings method.Reference to
rates of return available from alternative investments of
comparable risk can provide an important benchmark in
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 United States Supreme Court and has been
traditionally relied on by the IPUC.Moreover , it avoids the
complexities and limitations of capital market methods and
instead focuses on the returns earned on book equity, which
are readily available to investors.
What rates of return on equity are indicated for
utilities based on this approach?
With respect to expectations for electric utilities
generally, Value Line reports that its analysts anticipate an
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Idaho Power Company
average rate of return on common equity for the electric
utility industry of 11.0 percent in 2007 and 11.5 percent over
its three-to-five year forecast horizon.Meanwhi Ie, Value
Line expects that natural gas distribution utilities will earn
an average rate of return on common equity of 11.5 percent in
2007, and 12.0 percent over the years 2010 through 2012.
For the firms in the utility proxy group
specifically, the returns on common equity proj ected by Value
Line over its three-to-five year forecast horizon are shown on
Exhibi t 8.Consistent with the rational underlying the
development of the br+sv growth rates discussed earlier , these
year-end values were converted to average returns using the
same adj ustment factor developed in Exhibit As shown on
Exhibi t 8, after eliminating high-end outliers, Value Line
proj ections suggested an average ROE of 10.6 percent.
What return on equity is indicated by the results of
the comparable earnings approach?
Based on the results discussed above, I concluded
that the comparable earnings approach implies a fair rate of
return on equity of 11.0 percent.
E. Flotation Costs
What other considerations are relevant in setting
64 The Value Line Investment Survey (Mar. 2, 2007) at 153.65 The Value Line Investment Survey (Mar. 16, 2007) at 460.
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the return on equity for a utility?
The common equity used to finance the investment in
utility assets is provided from either the sale of stock in
the capital markets or from retained earnings not paid out as
dividends.When equity is raised through the sale of common
stock, there are costs associated with "floating" the new
equity securities.These flotation costs include services
such as legal , accounting, and printing, as well as the fees
and discounts paid to compensate brokers for selling the stock
to the public.Also, some argue that the "market pressure
from the additional supply of common stock and other market
factors may further reduce the amount of funds a utility nets
when it issues common equity.
Is there an established mechanism for a utility to
recognize equity issuance costs?
While debt flotation costs are recorded on theNo.
books of the utility, amortized over the life of the issue,
and thus increase the effective cost of debt capital, there is
no similar accounting treatment to ensure that equity
flotation costs are recorded and ultimately recognized.
Al ternati vely, no rate of return is authorized on flotation
costs necessarily incurred to obtain a portion of the equity
capital used to finance plant.In other words, equity
flotation costs are not included in a utility s rate base
because neither that portion of the gross proceeds from the
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sale of common stock used to pay flotation costs is available
to invest in plant and equipment , nor are flotation costs
capi talized as an intangible asset.Unless some provision is
made to recognize these issuance costs, a utility s revenue
requirements will not fully reflect all of the costs incurred
for the use of investors ' funds.Because there is no
accounting convention to accumulate the flotation costs
associated with equity issues, they must be accounted for
indirectly, with an upward adjustment to the cost of equity
being the most logical mechanism.
What is the magnitude of the adjustment to the "bare
bones " cost of equity to account for issuance costs?
There are any number of ways in which a flotation
cost adjustment can be calculated, and the adjustment can
range from just a few basis points to more than a full
percent.One of the most common methods used to account for
flotation costs in regulatory proceedings is to apply an
average flotation-cost percentage to a utility s dividend
yield.Based on a review of the finance literature,
Regulatory Finance: Utilities ' Cost of Capital concluded:
The flotation cost allowance requires an estimated
adjustment to the return on equity of approximately
5% to 10%, depending on the size and risk of theissue.
66 Roger A. Morin, Regulatory Finance: Utilities ' Cost of Capital, 1994, at
166.
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Al ternati vely, a study of data from Morgan Stanley regarding
issuance costs associated with utility common stock issuances
suggests an average flotation cost percentage of 3.6%.
Applying these expense percentages to a representative
dividend yield for a utility of 3.6 percent implies a
flotation cost adjustment on the order of 13 to 36 basis
points.
F. Proxy Group Cost of Equity
What did you conclude with respect to the cost of
equity for the proxy group of utilities?
The cost of equity estimates implied by my
quantitative analyses are summarized in Table 5, below:
TABLE 5
SUMMARY OF QUANTITATIVE RESULTS
Method
DCF
CAPM
Forward -lookingHistoricalComparable Earnings
Cost of EquityEstimate
10.4% - 12.
12.
11.
11.
Based on the results of my quantitative analyses, and my
assessment of the relative strengths and weaknesses inherent
in each method, I concluded that the cost of equity for the
67 Application of Yankee Gas Services Company for a Rate Increase, DPUC
Docket No. 04-06-01, 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
6% .
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utility proxy group is in the 11.0 percent to 12.0 percent
range, with a midpoint of 11.5 percent.
In order to account for the impact of past issuance
costs, I recommend a flotation cost adjustment of 20 basis
points, which roughly corresponds with the midpoint of the
range discussed earlier.Incorporating an adj ustment for
flotation costs of 20 basis points to my "bare bones " cost of
equity range results in a fair rate of return on equity range
for the proxy group of utilities of 11.2 percent to 12.
percent.
IV.RETURN ON EQUITY FOR IDAHO POWER COMPANY
What is the purpose of this section?
In addition to presenting the conclusions of my
evaluation of a fair rate of return on equity for Idaho Power
this section also discusses the relationship between ROE and
preservation of a utility s financial integrity and the
ability to attract capital under reasonable terms on a
sustainable basis.
A. Implications for Financial Integrity
Why is it important to allow Idaho Power an adequate
ROE?
Given the social and economic importance of the
utility industry, it is essential to maintain reliable and
economical service to all consumers.Whi Ie Idaho Power
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Idaho Power Company
remains committed to deliver reliable service , a utility
ability to fulfill its mandate can be compromised if it lacks
Coupled with the ongoingthe necessary financial wherewithal.
potential for energy market volatility, Idaho Power s exposure
to variations in hydroelectric generation and plans for
significant infrastructure investment pose a number of
potential challenges that might require the relatively swift
commitment of significant capital resources in order to
maintain the high level of service that customers have come to
expect.
Events in the Western U. S. provide a dramatic
illustration of just how swiftly unforeseen circumstances can
lead to deterioration in a utility s financial condition, and
stakeholders have discovered first hand how difficult and
complex it can be to remedy the situation after the fact.For
a utility with an obligation to provide reliable service,
investors ' increased reticence to supply additional capital
during times of crisis highlights the necessity of preserving
the flexibility necessary to overcome 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
results when a utility s financial flexibility is compromised,
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Idaho Power Company
supportive regulation remains crucial to 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 " (r) egulatory rulings have
returned to center stage as a dominant factor in assessing
companies ' credit quality. ,,Investors recognize that
regulation has its own risks, with Moody s specifically noting
the need for ongoing support from regulators as Idaho Power
adds new generation and transmission infrastructure to meet
growth and ensure reliability.
What danger does an inadequate rate of return pose
to Idaho Power?
Given the pressure on Idaho Power s corporate credit
rating, which is exemplified by S&P's negative outlook , the
perception of a lack of regulatory support would almost
certainly lead to further downgrades.At the same time, Idaho
Power s plans include significant plant investment to ensure
that the energy needs of its service territory are met in a
reliable and cost-effective manner.While providing the
infrastructure necessary to meet the energy needs of customers
is certainly desirable, it imposes additional financial
68 Standard & Poor s Corporation, "Industry Report Card: U. S.
Electric/Gas/Water,RatingsDirect (May 3, 2005) at
69 Moody s Investors Service, "Summary Opinion: Idaho Power Company,
Global Credit Research (Oct. 6, 2006).
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Idaho Power Company
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 benefit by enhancing the utility
financial flexibility?
While providing an ROE that is sufficient toYes.
maintain Idaho Power s ability to attract capital , even in
times of financial and market stress, is consistent with the
economic requirements embodied in the Supreme Court'Hope and
Bl uefield decisions, it is also in customers ' best interests.
Ultimately, it is customers and the service area economy that
enjoy the benefits that come from ensuring that the utility
has the financial wherewithal to take whatever actions are
required to ensure reliable service.By the same token,
customers also bear a significant burden when the ability of
the utility to attract necessary capital is impaired and
service quality is compromised.To continue to meet potential
challenges successfully and economically, it is crucial that
Idaho Power receive adequate support for its credit standing.
Are these concerns germane to Idaho Power and its
investors?
Investors have many alternatives andYes.
competi tion for capital is intense.Lingering uncertainties
from a prior era, as well as new challenges in the utility
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Idaho Power Company
industry, breed reluctance to make the long-term commitment of
capital that is required to ensure the reliable and economic
supply of electricity and gas that customers both demand and
deserve.Thus, while customers might realize short-term
savings" through a downward-biased ROE, these will prove
illusory when the utility is precluded from making investments
that are consistent with providing sustained , high quality
service at the lowest possible price in the long run.
B. Capital Structure
Is an evaluation of the capital structure maintained
by a utility relevant in assessing its return on equity?
Other things equal, a higher debt ratio, orYes.
lower common equity ratio, translates into increased financial
risk for all investors.A greater amount of debt means more
investors have a senior claim on available cash flow , thereby
reducing the certainty that each will receive his contractual
payments.This increases the risks to which lenders are
exposed , and they require correspondingly higher rates of
interest.From common shareholders ' standpoint , a higher debt
ratio means that there are proportionately more investors
ahead of them , thereby increasing the uncertainty as to the
amount of cash flow, 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
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Idaho Power Company
testimony of Mr. Steve Keen.As summarized in his testimony,
the common equity ratio used to compute Idaho Power s overall
rate of return was approximately 50.3 percent in this filing.
What was the average capitalization maintained by
the utility proxy group?
As shown on Exhibit 9, for the firms in the utility
proxy group, common equity ratios at December 31 , 2006 ranged
from 39.2 percent to 64.2 percent and averaged 48.7 percent.
What implication does the increasing risk of the
utility industry have for the capital structures maintained by
utilities?
The decline in credit quality experienced in the
electric industry is indicative of the need for utilities to
strengthen their balance sheets to deal with an increasingly
uncertain market.A more conservative financial profile is
appropriate given greater uncertainties in the utility
industry and the need to 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 Fitch recently noted:
Companies that form growth plans and financial
structures without considering the potential for a
shift in the capital market environment or downturn
in valuations can run into financial problems down
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Idaho Power Company
the road.
This is especially the case for electric utilities that are
exposed to potential significant fluctuations in power supply
costs, such as Idaho Power.
What capitalization is representative for the proxy
group of utilities going forward?
As shown on Exhibit 9, Value Line expects that the
average common equity ratio for the proxy group of Western
utility holding companies will increase to 50.8 percent over
the next three to five years, wi th the individual common
equity ratios ranging from 43.0 percent to 60.5 percent.
How does Idaho Power s common equity ratio compare
with those maintained by the reference group of utilities?
Although Idaho Power s requested common equity ratio
of approximately 50.3 percent for its 2007 test year is
slightly over the average maintained by the utility proxy
group based on year-end 2006 book values, it falls below the
50.8 equity ratio based on Value Line s expectations for the
indus try.
What other factors do investors consider in their
assessment of a company s capital structure?
Because power purchase agreements ("PPAs ) typically
70 Fitch Ratings, Ltd., "S. Power and Gas 2007 Outlook,Global
Power/North America Special Report (Dec. 15 , 2006).
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obligate the utility to make specified minimum contractual
payments akin to those associated with traditional debt
financing, investors consider a portion of these commitments
as debt in evaluating total financial risks.Similarly, when
a utility enters into a mandated PPA with a Qualifying
Facility under PURPA, the fixed charges associated with the
contract increase the utility s financial risk in the same way
that long-term debt and other financial obligations increase
financial leverage.The implications of purchased power
commitments have been repeatedly cited by major bond rating
agencies in connection with assessments of utility financial
risks.For example, in reviewing its evaluation of the credit
implications of PPAs, S&P affirmed its position that such
agreements are "debt-like in nature " and that the increased
financial risk must be considered in evaluating a utility
credit risks.
What does this evidence suggest with respect to
Idaho Power s proposed capital structure?
While industry averages provide one benchmark for
comparison , each firm must select its capitalization based on
the risks and prospects it faces, as well its specific needs
to access the capital markets.A public utility with an
obligation to serve must maintain ready access to capital so
71 Standard & Poor s Corporation, ", Buy Versus Build': Debt Aspects of
Purchased Power Agreements,Utilities Perspectives (May 12, 2003).
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Idaho Power Company
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 continuously available, even during
unfavorable capital market conditions.
The decline in Idaho Power s credit standing and the
heightened uncertainty associated with energy market
volatility magnifies the importance of preserving financial
flexibility.Under these circumstances, it is essential 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 flexibility plays a
crucial role in ensuring the wherewithal to meet the needs of
customers, utili ties with higher leverage may be foreclosed
from additional borrowing, especially during times of stress.
In this regard , Idaho Power s equity ratio reflects the
challenges posed by its resource mix , as well as the burden of
significant capital spending requirements.
Idaho Power s proposed capital structure is just one
reflection of the Company s ongoing efforts to enhance its
credit standing and maintain access to capital on reasonable
terms in order to ensure its ability to meet its obligations
to cus tomers .The reasonableness of Idaho Power s requested
capital structure is reinforced by the ongoing uncertainties
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Idaho Power Company
associated with the electric power industry, the Company
relative risks and circumstances, the need to support
continued system investment, and the imperative of maintaining
continuous access to capital , even during times of adverse
industry and market conditions.
c. Return on Equity Recommendation
What then is your conclusion as to a fair rate of
return on equity for Idaho Power?
In evaluating the rate of return for Idaho Power, it
is important to consider investors' continued focus on the
unsettled conditions in restructured wholesale energy markets,
the Company s ongoing exposure to these markets to meet a
portion of its energy supply, as well as other risks
associated with the utility industry, such as heightened
exposure to regulatory uncertainties.
As explained earlier , based on the various capital
market oriented analyses described in my testimony, I
concluded that the fair rate of return on equity range was
11.2 percent to 12.2 percent.Considering capital market
expectations, the potential uncertainties faced by Idaho
Power , the Company s unique exposure to fluctuations in
hydroelectric generation , and the economic requirements
necessary to maintain financial integrity and support
additional capital investment even under adverse
circumstances, it is my opinion that this represents a fair
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Idaho Power Company
and reasonable ROE range for Idaho Power.
Does this conclude your pre-filed direct testimony?
Yes.
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Idaho Power Company
QUALIlJCA TIONS OF WILLIAM E. AVERA
I received a B.A. degree with a major in economics from Emory University. After serving in
the United States Navy, I entered the doctoral program in economics at the University of North
Carolina at Chapel Hill. Upon receiving my Ph., I joined the faculty at the University of North
Carolina and taught finance in the Graduate School of Business. I subsequently accepted a position
at the University of Texas at Austin where I taught courses in financial management and investment
analysis. I then went to work for International Paper Company in New York City as Manager of
Financial Education, a position in which I had responsibility for all corporate education programs in
finance, accounting, and economics.
In 1977, I joined the staff of the Public Utility Commission of Texas (PUCT) as Director of
the Economic Research Division. During my tenure at the PUCT, I managed a division responsible
for financial analysis, cost allocation and rate design, economic and financial research, and data
processing systems, and I testified in cases on a variety of financial and economic issues. Since
leaving the PUCT in 1979, I have been engaged as a consultant. I have participated in a wide range
of assignments involving utility-related matters on behalf of utilities, industrial customers
municipalities, and regulatory commissions. I have previously testified before the Federal Energy
Regulatory Commission, as well as the Federal Communications Commission, the Surface
Transportation Board (and its predecessor, the Interstate Commerce Commission), the Canadian
Radio- Television and Telecommunications Commission, and regulatory agencies, courts, and
legislative committees in over 30 states.
In 1995 , I was appointed by the PUCT, with the approval of the Governor, to the
Synchronous Interconnection Committee to advise the Texas legislature on the costs and benefits of
connecting Texas to the national electric transmission grid. In addition, I served as an outside
Exhibit No.
Case No. IPC-O7-
W. Avera
Page 1 of 8
director of Georgia System Operations Corporation, the system operator for electric cooperatives in
Georgia.
I have served as Lecturer in the Finance Department at the University of Texas at Austin and
taught in the evening graduate program at St. Edward's University for twenty years. In addition, I
have lectured on economic and regulatory topics in programs sponsored by universities and industry
groups. I have taught in hundreds of educational programs for financial analysts in programs
sponsored by the Association for Investment Management and Research, the Financial Analysts
Review, and local financial analysts societies. These programs have been presented in Asia, Europe
and North America, including the Financial Analysts Seminar at Northwestern University. I hold the
Chartered Financial Analyst (CFA lID) designation and have served as Vice President for Membership
ofthe Financial Management Association. I also have served on the Board of Directors ofthe North
Carolina Society of Financial Analysts. I was elected Vice Chairman ofthe National Association of
Regulatory Commissioners (NARUC) Subcommittee on Economics and appointed to NARUC'
Technical Subcommittee on the National Energy Act. I also have served as an officer of various
other professional organizations and societies. A resume containing the details of my experience and
qualifications is attached.
Exhibit No.
Case No. IPC-O7-
W. Avera
Page 2 of 8
FINCAP, INC.
Financial Concepts and Applications
Economic and Financial Counsel
WilLIAM E. AVERA
3907 Red River
Austin, Texas 78751
[phone]
FAX [phone]
fincap~texas.net
Summary of Qualifications
Ph.D. in economics and finance; Chartered Financial Analyst (CF A (jj)) designation; extensive expert
witness testimony before courts, alternative dispute resolution panels, regulatory agencies and
legislative committees; lectured in executive education programs around the world on ethics
investment analysis, and regulation; undergraduate and graduate teaching in business and
economics; appointed to leadership positions in government, industry, academia, and the military.
Employment
Principal
FINCAP, Inc.
(Sep. 1979 to present)
Director, Economic Research
Division
Public Utility Commission of Texas
(Dec. 1977 to Aug. 1979)
Manager, Financial Education
International Paper Company
New York City
(Feb. 1977 to Nov. 1977)
Financial, economic and policy consulting to business
and government. Perform business and public policy
research, costlbenefit analyses and financial modeling,
valuation of businesses (over 150 entities valued),
estimation of damages, statistical and industry studies.
Provide strategy advice and educational services in
public and private sectors, and serve as expert witness
before regulatory agencies, legislative committees
arbitration panels, and courts.
Responsible for research and testimony preparation on
rate of return, rate structure, and econometric analysis
dealing with energy, telecommunications, water and
sewer utilities. Testified in major rate cases and
appeared before legislative committees and served as
Chief Economist for agency. Administered state and
federal grant funds. Communicated frequently with
political leaders and representatives from consumer
groups, media, and investment community.
Directed corporate education programs in accounting,
finance, and economics. Developed course materials
recruited and trained instructors, liaison within the
company and with academic institutions. Prepared
operating budget and designed financial controls for
corporate professional development program.
Exhibit No.
Case No. IPC-O7-
W. Avera
Page 3 of 8
Lecturer in Finance
The University of Texas at Austin
(Sep. 1979 to May 1981)
Assistant Professor of Finance
(Sep. 1975 to May 1977)
Assistant Professor of Business
University of North Carolina at
Chapel Hill
(Sep. 1972 to Jul. 1975)
Education
Ph.D., Economics and Finance
University of North Carolina at
Chapel Hill
(Jan. 1969 to Aug. 1972)
B.A., Economics
Emory University, Atlanta, Georgia
(Sep. 1961 to Jun. 1965)
Taught graduate and undergraduate courses in financial
management and investment theory. Conducted research
in business and public policy. Named Outstanding
Graduate Business Professor and received various
administrative appointments.
Taught in BBA, MBA, and Ph.D. programs. Created
project course in finance, Financial Management for
Women, and participated in developing Small Business
Management sequence. Organized the North Carolina
Institute for Investment Research, a group of financial
institutions that supported academic research. Faculty
advisor to the Media Board, which funds student
publications and broadcast stations.
Elective courses included financial management, public
finance, monetary theory, and econometrics. A warded
the Stonier Fellowship by the American Bankers
Association and University Teaching Fellowship.
Taught statistics, macroeconomics, and microeconomics.
Dissertation: The Geometric Mean Strategy as a
Theory of Multiperiod Portfolio Choice
Active in extracurricular activities, president of the
Barkley Forum (debate team), Emory Religious
Association, and Delta Tau Delta chapter. Individual
awards and team championships at national collegiate
debate tournaments.
Professional Associations
Received Chartered Financial Analyst (CF A) designation in 1977; Vice President for Membership,
Financial Management Association; President, Austin Chapter of Planning Executives Institute;
Board of Directors, North Carolina Society of Financial Analysts; Candidate Curriculum Committee
Association for Investment Management and Research; Executive Committee of Southern Finance
Association; Vice Chair, Staff Subcommittee on Economics and National Association of Regulatory
Utility Commissioners (NARUC); Appointed to NARUC Technical Subcommittee on the National
Energy Act.
Teachina in Executive Education Proarams
University-Sponsored Programs:Central Michigan University, Duke University, Louisiana State
University, National Defense University, National University of Singapore, Texas A&M University,
University of Kansas, University of North Carolina, University of Texas.
Exhibit No.
Case No. IPC-O7-
W. Avera
Page 4 of 8
Business and Government-Svonsored Proflrams:Advanced Seminar on Earnings Regulation
American Public Welfare Association, Association for Investment Management and Research
Congressional Fellows Program, Cost of Capital Workshop, Electricity Consumers Resource
Council, Financial Analysts Association of Indonesia, Financial Analysts Review, Financial
Analysts Seminar at Northwestern University, Governor s Executive Development Program of
Texas, Louisiana Association of Business and Industry, National Association of Purchasing
Management, National Association of Tire Dealers, Planning Executives Institute, School of
Banking of the South, State of Wisconsin Investment Board, Stock Exchange of Thailand, Texas
Association of State Sponsored Computer Centers, Texas Bankers' Association , Texas Bar
Association, Texas Savings and Loan League, Texas Society of CP As, Tokyo Association of
Foreign Banks, Union Bank of Switzerland, u.S. Department of State, U.S. Navy, U.S. Veterans
Administration, in addition to Texas state agencies and major corporations.
Presented papers for Mills B. Lane Lecture Series at the University of Georgia and Heubner
Lectures at the University of Pennsylvania. Taught graduate courses in finance and economics in
evening program at St. Edward's University in Austin from January 1979 through 1998.
Expert Witness Testimony
Testified in over 200 cases before regulatory agencies addressing cost of capital, regulatory policy,
rate design, and other economic and financial issues.
Federal Agencies:Federal Communications Commission, Federal Energy Regulatory Commission
Surface Transportation Board Interstate Commerce Commission, and the Canadian
Radio- Television and Telecommunications Commission.
State Rezulatorv Azencies:Alaska, Arizona, Arkansas, California, Colorado, Connecticut
Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Kansas, Maryland, Michigan, Missouri
Nevada, New Mexico, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina
South Dakota, Texas, Utah, Virginia, Washington, West Virginia, and Wisconsin.
Testified in 40 cases before federal and state courts, arbitration panels, and alternative dispute
tribunals (75 depositions given) regarding damages, valuation, antitrust liability, fiduciary duties
and other economic and financial issues.
Board Positions and Other Professional Activities
Audit Committee and Outside Director, Georgia System Operations Corporation (electric system
operator for member-owned electric cooperatives in Georgia); Chairman, Board of Print Depot, Inc.
and FINCAP, Inc.; Co-chair, Synchronous Interconnection Committee, appointed by Public Utility
Commission of Texas and approved by governor; Operator of AAA Ranch, a certified organic
producer of agricultural products; Appointed to Organic Livestock Advisory Committee by Texas
Agricultural Commissioner Susan Combs; Appointed by Texas Railroad Commissioners to study
group for The UP/SP Merger: An Assessment of the Impacts on the State of Texas; Appointed by
Hawaii Public Utilities Commission to team reviewing affiliate relationships of Hawaiian Electric
Industries; Chairman, Energy Task Force, Greater Austin-San Antonio Corridor Council; Consultant
to Public Utility Commission of Texas on cogeneration policy and other matters; Consultant to
Public Service Commission of New Mexico on cogeneration policy; Evaluator of Energy Research
Grant Proposals for Texas Higher Education Coordinating Board.
Exhibit No.
Case No. IPC-O7-
W. Avera
Page 5 of 8
Community Activities
Board Member, Sustainable Food Center; Chair, Board of Deacons, Finance Committee, and Elder
Central Presbyterian Church of Austin; Founding Member, Orange-Chatham County (N.) Legal
Aid Screening Committee.
Military
Captain, U.S. Naval Reserve (retired after 28 years service); Commanding Officer, Naval Special
Warfare Engineering Support Unit; Officer-in-charge of SWIFT patrol boat in Vietnam; Enlisted
service as weather analyst (advanced to second class petty officer).
Biblioaraphv
Monographs
Ethics and the Investment Professional (video, workbook, and instructor s guide) and Ethics
Challenge Today (video), Association for Investment Management and Research (1995)
Definition of Industry Ethics and Development of a Code" and "Applying Ethics in the Real
World " in Good Ethics: The Essential Element of a Firm s Success Association for Investment
Management and Research (1994)
On the Use of Security Analysts' Growth Projections in the DCF Model " with Bruce H. Fairchild
in Earnings Regulation Under Inflation 1. R. Foster and S. R. Holmberg, eds. Institute for Study
of Regulation (1982)
An Examination of the Concept of Using Relative Customer Class Risk to Set Target Rates of Return
in Electric Cost-of-Service Studies with Bruce H. Fairchild, Electricity Consumers Resource
Council (ELCON) (1981); portions reprinted in Public Utilities Fortnightly (Nov. 11 , 1982)
Usefulness of Current Values to Investors and Creditors Research Study on Current-Value
Accounting Measurements and Utility, George M. Scott, ed., Touche Ross Foundation (1978)
The Geometric Mean Strategy and Common Stock Investment Management " with Henry A.
Latane in Life Insurance Investment Policies David Cummins, ed. (1977)
Investment Companies: Analysis of Current Operations and Future Prospects with 1. Finley Lee
and Glenn L. Wood, American College of Life Underwriters (1975)
Articles
Should Analysts Own the Stocks they Cover?" The Financial Journalist (March 2002)
Liquidity, Exchange Listing, and Common Stock Performance " with John C. Groth and Kerry
Cooper Journal of Economics and Business (Spring 1985); reprinted by National Association of
Security Dealers
The Energy Crisis and the Homeowner: The Grief Process Texas Business Review (Jan.Feb.
1980); reprinted in The Energy Picture: Problems and Prospects 1. E. Pluta, ed., Bureau of
Business Research (1980)
Use ofIFPS at the Public Utility Commission of Texas Proceedings of the IFPS Users Group
Annual Meeting (1979)
Production Capacity Allocation: Conversion, CWIP, and One-Armed Economics Proceedings of
the NARUC Biennial Regulatory Information Conference (1978)Exhibit No.
Case No. IPC-O7-
W. Avera
Page 6 of 8
Some Thoughts on the Rate of Return to Public Utility Companies " with Bruce H. Fairchild in
Proceedings of the NARUC Biennial Regulatory Information Conference (1978)
A New Capital Budgeting Measure: The Integration of Time, Liquidity, and Uncertainty," with
David Cordell in Proceedings of the Southwestern Finance Association (1977)
Usefulness of Current Values to Investors and Creditors " in Inflation Accounting/Indexing and
Stock Behavior (1977)
Consumer Expectations and the Economy,Texas Business Review (Nov. 1976)
Portfolio Performance Evaluation and Long-run Capital Growth " with Henry A. Latane in
Proceedings of the Eastern Finance Association (1973)
Book reviews in Journal of Finance and Financial Review. Abstracts for CF A Digest. Articles in
Carolina Financial Times.
Selected Papers and Presentations
The Who , What, When, How, and Why of Ethics , San Antonio Financial Analysts Society (Jan.
2002). Similar presentation given to the Austin Society of Financial Analysts (Jan. 17 2002)
Ethics for Financial Analysts " Sponsored by Canadian Council of Financial Analysts: delivered in
Calgary, Edmonton, Regina, and Winnipeg, June 1997. Similar presentations given to Austin
Society of Financial Analysts (Mar. 1994), San Antonio Society of Financial Analysts (Nov.
1985), and St. Louis Society of Financial Analysts (Feb. 1986)
Cost of Capital for Multi-Divisional Corporations " Financial Management Association, New
Orleans, Louisiana (Oct. 1996)
Ethics and the Treasury Function " Government Treasurers Organization of Texas, Corpus Christi
Texas (Jun. 1996)
A Cooperative Future " Iowa Association of Electric Cooperatives, Des Moines (December 1995).
Similar presentations given to National G & T Conference, Irving, Texas (June 1995), Kentucky
Association of Electric Cooperatives Annual Meeting, Louisville (Nov. 1994), Virginia
Maryland, and Delaware Association of Electric Cooperatives Annual Meeting, Richmond (July
1994), and Carolina Electric Cooperatives Annual Meeting, Raleigh (Mar. 1994)
Information Superhighway Warnings: Speed Bumps on Wall Street and Detours from the
Economy," Texas Society of Certified Public Accountants Natural Gas, Telecommunications and
Electric Industries Conference, Austin (Apr. 1995)
Economic/Wall Street Outlook " Carolinas Council of the Institute of Management Accountants
Myrtle Beach, South Carolina (May 1994). Similar presentation given to Bell Operating
Company Accounting Witness Conference, Santa Fe, New Mexico (Apr. 1993)
Regulatory Developments in Telecommunications " Regional Holding Company Financial and
Accounting Conference, San Antonio (Sep. 1993)
Estimating the Cost of Capital During the 1990s: Issues and Directions " The National Society of
Rate of Return Analysts, Washington, D.C. (May 1992)
Making Utility Regulation Work at the Public Utility Commission of Texas " Center for Legal and
Regulatory Studies, University of Texas, Austin (June 1991)
Can Regulation Compete for the Hearts and Minds ofIndustrial Customers " Emerging Issues of
Competition in the Electric Utility Industry Conference, Austin (May 1988)
Exhibit No.
Case No. IPC-O7-
W. Avera
Page 7 of 8
The Role of Utilities in Fostering New Energy Technologies " Emerging Energy Technologies in
Texas Conference, Austin (Mar. 1988)
The Regulators' Perspective " Bellcore Economic Analysis Conference, San Antonio (Nov. 1987)
Public Utility Commissions and the Nuclear Plant Contractor Construction Litigation
Superconference, Laguna Beach, California (Dec. 1986)
Development of Cogeneration Policies in Texas " University of Georgia Fifth Annual Public
Utilities Conference, Atlanta (Sep. 1985)
Wheeling for Power Sales " Energy Bureau Cogeneration Conference, Houston (Nov. 1985).
Asymmetric Discounting of Information and Relative Liquidity: Some Empirical Evidence for
Common Stocks" (with John Groth and Kerry Cooper), Southern Finance Association, New
Orleans (Nov. 1982)
Used and Useful Planning Models " Planning Executive Institute, 27th Corporate Planning
Conference, Los Angeles (Nov. 1979)
Staff Input to Commission Rate of Return Decisions " The National Society of Rate of Return
Analysts, New York (Oct. 1979)
Electric Rate Design in Texas " Southwestern Economics Association, Fort Worth (Mar. 1979)
Discounted Cash Life: A New Measure of the Time Dimension in Capital Budgeting," with David
Cordell, Southern Finance Association, New Orleans (Nov. 1978)
The Relative Value of Statistics of Ex Post Common Stock Distributions to Explain Variance,
with Charles G. Martin, Southern Finance Association, Atlanta (Nov. 1977)
An ANOV A Representation of Common Stock Returns as a Framework for the Allocation of
Portfolio Management Effort " with Charles G. Martin, Financial Management Association
Montreal (Oct. 1976)
A Growth-Optimal Portfolio Selection Model with Finite Horizon " with Henry A. Latane
American Finance Association, San Francisco (Dec. 1974)
An Optimal Approach to the Finance Decision " with Henry A. Latane, Southern Finance
Association, Atlanta (Nov. 1974)
A Pragmatic Approach to the Capital Structure Decision Based on Long-Run Growth " with Henry
A. Latane, Financial Management Association, San Diego (Oct. 1974)
Multi-period Wealth Distributions and Portfolio Theory," Southern Finance Association, Houston
(Nov. 1973)
Growth Rates, Expected Returns, and Variance in Portfolio Selection and Performance
Evaluation " with Henry A. Latane, Econometric Society, Oslo, Norway (Aug. 1973)
Exhibit No.
Case No. IPC-O7-
W. Avera
Page 8 of 8
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CAPITAL ASSET PRICING MODEL
FORWARD-LOOKING RISK PREMIUM
Market Rate of Return
Dividend Yield (a)
Growth Rate (b)11.2%
Market Return (c)
ess: Risk-Free Rate (d)
Long-term Treasury Bond Yield
Market Risk Premium (e)
Utility Proxy Group Beta (f)
Utility Proxy Group isk Premium (g)
Plus: Risk-free Rate (d)
Long-term Treasury Bond Yield
Implied Cost of Equity (h)
13.
12.
(a) Weighted average dividend yield for the dividend paying firms in the S&P 500 from
www.valueline.com (Retreived Feb. 9, 2007).
(b) Weighted average of IBES and Value Line growth rates for the dividend paying firms in the
S&P 500 based on data from Standard & Poor s Earnings Guide (Jan. 2007) and
www.valueline.com (Retreived Feb. 9, 2007).
(c) (a) + (b)
(d) Average yield on 20-year Treasury bonds for Mar. 2007 from the Federal Reserve Board at
http://www.federalreserve.gov/releases/h15/data.htm.
(e) (c) - (d).
(f) The Value Line Investment Survey (Feb. 9, Mar 2, & Mar. 30,2007)
(g)
(e) x (f).
(h) (d)
+ (g).
Exhibit No.
Case No. IPC-O7-
W. Avera, IPC
Page 1 of 1
CAPITAL ASSET PRICING MODEL
HISTORICAL RISK PREMIUM
Market Risk Premium
Long-Horizon Equity Risk Premium (a)7.1%
Utility Proxy Group Beta (b)
Utility Proxy Group Risk Premium (c)
Plus: Risk-free Rate (d)
Long-term Treasury Bond Yield
Implied Cost of Equity (e)11.
(a) Arithmetic mean risk premium on Large Company Stocks from 1926-2005 reported by
Ibbotson Associates Stocks, Bonds, Bills, and Inflation, Valuation Edition, 2006 Yearbook
Appendix C, Table C-, p. 262.
(b) The Value Line Investment Survey (Feb. 9, Mar 2, & Mar. 30, 2007)
(c) (a) x (b).
(d) Average yield on 20-year Treasury bonds for Mar. 2007 from the Federal Reserve Board at
h Up://wwwJederalreserve.gov/releases/h15/data.htm.
(e) (c) + (d).
Exhibit No.
Case No. IPC-O7-
W. Avera, IPC
1 of 1
COMP ARABLE EARNINGS APPROACH
UTILITY PROXY GROUP
(a)(b)(c)
Expected Return Adjustment Adjusted Return
Company on Common Equity Factor on Common Equity
Alliant Energy 9.5%1.0211
American Elec Pwr 12.5%0291 12.
CenterPoint Energy 20.1.0413 20.8%1
Dominion Resources 16.1.0540 16.
DPL, Inc.18.5%1.0534 19.5%1
DTE Energy 9.5%1.0147
Energy East Corp.9.5%0126
IDACORP, Inc.1.0236
Integrys Energy 10.0195 10.
NiSource Inc.1.0183
Northeast Utilities 8.5%1.0203
Pepco Holdings 11.0%1.0139 11.2%
PG&E Corp.11.0%1.0318 11.4%
PNM Resources 1.0278
PPL Corp.21.5%1.0303 22.2%1
Progress Energy 1.0069
P 5 Enterprise Group 13.5%1.0404 14.
Wisconsin Energy 11.0%0282 11.3%
Xcel Energy, Inc.11.0%0195 11.
Average (d)10.
(a) 3-5 year projections from The Value Line Investment Survey (Feb. 9, Mar. 2, & Mar. 30, 2007)
(b) See Exhibit 3.
(c) (a) x (b).
(d) Excludes highlighted figures.
Exhibit No.
Case No. IPC-O7-
W. Avera, IPC
1 of 1
UTILITY PROXY GROUP
CAPITAL STRUCTURE
At December 31 2006 (a)Value Line Projected (b)
Long-term Common Long-term Common
Company Debt Preferred Equity Debt Other Equity
Alliant Energy 34.5.5%60.43.5%52.5%
American Elec Pwr 59.40.57.43.
Black Hills Corp.44.55.47.53.
Constellation Energy 51.0%1.9%47.38.5%1.5%60.
Dominion Resources 53.45.44.1.0%55.
DTE Energy 57.42.57.43.
Edison International 51.9%43.46.5%4.5%49.
Empire District Elec.49.50.51.5%48.5%
Energy East Corp.58.0.4%41.7%54.5%0.5%45.
Entergy Corp.51.2%46.48.1.5%50.
FirstEnergy Corp.53.46.5%47.52.5%
Great Plains Energy 41.9%1.6%56.49.51.0%
Hawaiian Elec.50.1%1.5%48.4%46.1.5%52.
IDACORP, Inc.47.52.47.52.5%
NiSource Inc.51.1%48.47.5%52.5%
Northeast Utilities 50.47.49.1.5%49.
OGE Energy Corp.45.54.44.56.
Otter Tail Corp.33.64.49.1.5%49.5%
PG&E Corp.46.1.7%51.9%46.1.5%52.
PNM Resources 50.48.51.5%0.5%48.
PPL Corp.58.39.49.48.5%
Progress Energy 52.0.5%47.50.0.5%49.5%
PS Enterprise Group 57.1.6%41.3%49.0.5%50.5%
Puget Energy 55.43.52.48.
Sempra Energy 40.1.4%58.38.5%1.0%60.5%
Westar Energy 50.49.50.5%0.5%49.
Wisconsin Energy 53.0.5%45.48.5%0.5%51.0%
Xcel Energy, Inc.53.45.8%49.0.5%50.
Average 50.48.48.50.
(a) Company Form lO-K and Annual Reports.
(b) The Value Line Investment Survey (Feb. 9, Mar. 2, & Mar. 30, 2007).
Exhibit No.
Case No. IPC-07 -
W. Avera, IPC
Page 1 of 1