20080107Avera rebuttal.pdf

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IDf\HO PUBLIC
UTlUTIES COMMISS10;;
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF IDAHO POWER COMPAN FOR
AUTHORITY TO INCREASE ITS RATES
AN CHAGES FOR ELECTRIC SERVICE
TO ELECTRIC CUSTOMERS IN THE STATE
OF IDAHO.
CASE NO. IPC-E-07-8
IDAHO POWER COMPAN
REBUTTAL TESTIMONY
OF
WILLIAM E. AVERA
.
REBUTTAL TESTIMONY OF WILLIAM E. AVERA
TABLE OF CONTENS
:i . INTRODUCTION. .. . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1: i . TERRI c.K................................ .. e.. . . . . . . . . 4
:i 1::I. HA TTHEW 1:. KA . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
,.
1 I.INTRODUCTION
2 Q.Please state your name and business address.
3 A.William E. Avera, 3907 Red River, Austin, Texas,
4 78751.
5 Q.Are you the same William E. Avera that previously
6 submitted direct testimony in this case?
7 A.Yes, I am.
8 Q.What is the purpose of your rebuttal?
9 A.The purpose of my testimony is to respond to the
10 direct testimony of Ms. Terri Carlock, submitted on behalf of
11 the staff of the Idaho Public Utilities Commission ("IPUC").
12 In addition, I will also rebut the recommendations contained
13 in the direct testimony of Mr. Matthew I. Kahal, on behalf of
14 the United States Department of Energy, concerning the cost of
15 equity for the jurisdictional utility operations of Idaho
16 Power Company ("Idaho Power" or "the Company") .
17 Q.Please sumarize the conclusions of your testimony.
18 A.With respect to the testimony of Ms. Carlock, I
19 concluded that her recommendations were understated because of
20 her failure to consider the results of other accepted methods
21 of estimating the cost of equity. i Additionally, Ms.
22 Carlock's assessment of relative risks focused exclusively on
1 As I note subsequently, I was unable to review or evaluate the details of
the analyses supporting Ms. Carlock's conclusions because she provided no
schedules, workpapers, or other documentary support for her testimony.
AVERA, RE 3
Idaho Power Company
1 Idaho Power' s relatively low rates, while ignoring the
2 substantial uncertainties and higher investment risks that
3 investors must bear to provide the benefits of lower
4 electrici ty costs to customers. At a minimum, considering the
5 resul ts of the Capital Asset Pricing Model ("CAPM") approach,
6 investors' risk perceptions, and correcting Ms. Carlock's
7 flotation adjustment would support a rate of return from the
8 upper end the range of her resul ts .
9 Meanwhile, Mr. Kahal's recommendations are biased
10 downward because he failed to exclude illogical estimates in
11 evaluating the results of his analyses. Similarly, there is
12 no basis for Mr. Kahal' s criticisms of my proxy group and his
13 alternative application of the CAPM is flawed and should be
14 rej ected.
15 II . TERRI CACK
16 Q.How did Ms. Carlock arrive at her 10.25 percent cost
17 of equi ty recommendation for Idaho Power?
18 A.Ms. Carlock estimated the cost of equity by applying
19 the constant growth DCF model to a group of other utilities.
20 She concluded that the results of this DCF application
21 indicated a cost of equity in the 7.7 to 11.7 percent range.
22 Ms. Carlock also conducted a comparable earnings analysis,
23 which resulted in an indicated cost of equity in the 10.0 to
24 11.0 percent range. Based on these two analyses, Ms. Carlock
25 concluded that the cost of equity was in the 9.5 to 10.5
AVERA, RE 4
Idaho Power Company
1 percent range, selecting 10.25 percent as her point estimate
2 and recommendation for Idaho Power.
3 Q.Did you have the opportunity to review the details
4 of the analyses that underlie Ms. Carlock's conclusions?
5 A.No. Ms. Carlock's testimony contains no schedules
6 or exhibits presenting the results of her analyses. Ms.
7 Carlock's testimony does not identify the composition of the
8 proxy group of utilities she relied on to apply her methods or
9 the data inputs used in her calculations. Ms. Carlock has not
10 provided copies of workpapers or electronic worksheet files
11 that she relied on in developing her conclusions. As a
12 resul t, I was unable to verify the accuracy of Ms. Carlock's
13 calculations or otherwise review the details of her analyses
14 and my ability to respond to Ms. Carlock's testimony is
15 greatly limited.
16 Q.Did Ms. Carlock apply the CAPM to estimate the cost
17 of equi ty for Idaho Power?
18 A.No. While Ms. Carlock stated that "much of the
19 theoretical approach" that she used was consistent with my
20 testimony, Ms. Carlock did not use the CAPM to estimate the
21 cost of equity. As I explained in my direct testimony, the
22 CAPM method is widely recognized as a meaningful approach to
23 estimate investors' required rate of return. Unlike the
24 comparable earnings method, which depends on earned returns
25 derived from accounting information, the CAPM approach is
AVERA, RE 5
Idaho Power Company
1 based on capital market data indicative of investors' current
2 expectations. The IPUC has noted the importance of
3 "evaluating all the methods" and "using each as a check on the
4 other when setting the allowed rate of return.
"2
5 Q.Why is the use of multiple methods so important when
6 estimating the cost of equity?
7 A.Investors' expectations are unobservable, and there
8 is no methodology that provides a foolproof guide to their
9 required rate of return. Each method provides another facet
10 of examining investor behavior, with different assumptions and
11 premises.Investors do not necessarily subscribe to anyone
12 method, and no model can conclusively determine or estimate
13 the required return for an individual firm. If the cost of
14 equi ty estimation is restricted to certain methodologies,
15 while the results of other approaches are ignored, it may
16 significantly bias the outcome. Rather, all relevant evidence
17 should be weighed and evaluated in order to minimize the
18 potential for error.
19 Regulators have customarily considered the results of
20 al ternati ve approaches in determining allowed returns. 3 It is
21 widely recognized that no single method can be regarded as a
2 idaho Public Utilities Commission, Order No. 29505 (May 25, 2004) at 38.
3 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 Utility
Commissioners (December 1996).
AVERA, RE 6
Idaho Power Company
1 panacea; all approaches have advantages and shortcomings. For
2 example, a publication of the Society of Utility and Financial
3 Analysts (formerly the National Society of Rate of Return
4 Analysts), concluded that:
5 Each model requires the exercise of judgment as to
6 the reasonableness of the underlying assumptions of
7 the methodology and on the reasonableness of the
8 proxies used to validate the theory. Each model has
9 its own way of examining investor behavior, its own10 premises, and its own set of simplifications of
11 reality. Each method proceeds from different
12 fundamental premises, most of which cannot be13 validated empirically. Investors clearly do not14 subscribe to any singular method, nor does the stock15 price reflect the application of anyone single16 method by investors. 4
17 Q.Has the IPUC expressed reluctance to consider the
18 results of the CAPM approach?
19 A.Yes. I am aware that in the past the IPUC has
20 expressed concerns over the measurement and proper use of the
21 beta value necessary to apply the CAPM and has not routinely
22 focused on the results of this method. 5 Nevertheless, the
23 CAPM is a rigorous conceptual framework at the heart of modern
24 financial theory and it is widely used and referenced in the
25 investment community. Indeed, evidence suggests that reliance
26 on the DCF model as a tool for estimating investors' required
4 Parcell, David C., "The Cost of Capital - A Practitioner's Guide,"
Society of Utility and Regulatory Financial Analysts (1997) at Part 2, p.
4.
5 See, e.g., Order No. 29505 at 38.
AVERA, RE 7
Idaho Power Company
1 rate of return has declined outside the regulatory sphere,
2 with the CAPM being "the dominant model for estimating the
3 cost of equity.
"6 Of course, the CAPM is based on restrictive
4 assumptions and does not describe security returns perfectly
5 and there are controversies surrounding the measurement of key
6 variables, such as beta. But then exactly the same could be
7 said for the constant growth DcF model, which assumes a
8 single, static growth rate into perpetuity that has no
9 observable proxy in the capi tal markets. Moreover, I have
10 used The Value Line Investment Survey ("Value Line") as the
11 source of my betas, a reference cited by Ms. Carlock in her
12 data responses.
13 Q.What cost of equity is implied if the CAPM method is
14 used to check Ms. Carlock's conclusions?
15 A.As discussed in detail in my direct testimony (pp. 54-
16 58), the results of the CAPM approach implied a cost of equity
17 on the order of 11.5 percent to 12.8 percent, which is
18 consistent with a rate of return from the top of Ms. Carlock's
19 DCF range.
6 See, e.g., 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).
AVERA, RE 8
idaho Power Company
1 Q.What other evidence indicates that a return from the
2 top end of Ms. Carlock's range of results is warranted?
3 A.While Ms. Carlock did not provide the analyses
4 underlying her 10.0 to 11.0 percent comparable earnings range,
5 this method is typically implemented based on a review of
6 historical earned rates of return on book equity for the
7 companies or industry in question. But earned rates of return
8 based on historical information are not necessarily indicative
9 of investors' long-run perceptions of risk and expectations
10 for return going forward. Alternatively, reference to earned
11 rates of return expected from firms of comparable risk, which
12 I referenced in my direct testimony, can also provide a useful
13 guide that may better reflect the ongoing returns necessary to
14 assure financial integrity and attract capital.
15 The most recent projections from Value Line, which is the
16 largest and most widely circulated independent investment
17 advisory service, indicate that its analysts anticipate an
18 average rate of return on common equity for the electric
19 utility industry of 11.5 percent in 2007, 2008, and over its
20 three-to-five year forecast horizon.7 Based on Value Line's
21 estimates, investors would anticipate a return on equity from
22 the average electric utility above Ms. Carlock's DCF and
23 comparable earnings ranges.
7 The Value Line Investment Survey (Nov. 30, 2007) at 154.
AVERA, RE 9
Idaho Power Company
1 Q.Do you and Ms. Carlock agree on the benchmark for a
2 fair rate of return?
3 A.Yes. We agree that the authorized rate of return
4 should be competitive with returns available to investors from
5 investments of corresponding risk, as directed by landmrk
6 Supreme Court decisions. Ms. Carlock also correctly noted
7 that the opportunity to earn a return at least equal to those
8 expected in the capital markets for comparable investments is
9 required if a utility is to be able to attract capital. As
10 stated by Ms. Carlock:
11 ...if the return earned by a firm is not equal to the12 return being earned on other investments of similar13 risk, the flow of funds will be toward those14 investments earning the higher returns. Therefore,15 for a utility to be competi ti ve in the financial16 markets, it should be allowed to earn a return on17 equi ty equal to the average return earned by other18 firms of similar risk. 8
19 Ms. Carlock also noted the importance of testing any cost of
20 equity estimate against applicable standards:
21 ...three standards have evolved for determining a fair22 and reasonable rate of return: (1) the Financial23 Integrity or Credit Maintenance Standard; (2) the24 Capital Attraction Standard; and (3) the Comparable
25 Earnings Standard. 9
26 This is absolutely correct. If Idaho Power's return on equity
27 does not fully reflect the level of investment risks that
8 Carlock Direct at 6.
9 Id. at 4-5.
AVERA, RE 10
idaho Power Company
1 investors perceive, it will violate the risk-return tradeoff,
2 breach applicable standards, and impair the Company's ability
3 to attract necessary capital.
4 Q.Did Ms. Carlock recognize that the investment risks
5 associated with electric utilities have increased?
6 A.Yes. Ms. Carlock noted that a plethora of changes
7 have impacted investors risk perceptions, observing that:
8 The competi ti ve risks for some electric utili ties
9 and the industry as a whole have changed with10 increasing non-utility generation, deregulation in11 some states, open transmission access, and changes12 in eleètrici ty markets. 10
13 Ms. Carlock concluded that, because of these greater
14 uncertainties, the difference in the risk between industrial
15 firms operating in the competitive market and electric
16 utilities "is not as great as it used to be. "11
17 Q.Did Ms. Carlock consider this increase in risk in
18 her analysis of the cost of equity for Idaho Power?
19 A.No. Ms. Carlock ignored the implications of this
20 trend in investment risks for utilities, asserting instead
21 that Idaho Power's "competitive risks" are lower because of
22 its "low-cost source of power" and "low retail rates. "12 Ms.
23 Carlock also asserted that the Power Cost Adjustment ("PCA")
10 Id. at 8.
11 Id.
12 Id. at 8.
AVERA, RE 11
Idaho Power Company
1 and Fixed Cost Adjustment ("FCA") reduce Idaho Power's risks
2 relative to other electric utili ties. 13
3 Q.Does this represent an accurate assessment of the
4 investment risks investors' associate with Idaho Power?
5 A.No. While I agree with Ms. Carlock that relatively
6 low rates provide benefits to customers, this narrow view
7 ignores the substantial uncertainties that Idaho Power's
8 investors assume to realize these benefits. As explained in
9 detail in my direct testimony, because a high proportion of
10 the Company's energy needs is provided by hydroelectric
11 facilities, Idaho Power is exposed to a level of uncertainty
12 not faced by other utili ties, which are less dependent on
13 hydro generation.
14 Reduced hydroelectric generation due to below-average
15 water conditions forces idaho Power to rely on less efficient
16 thermal generating capacity and purchased power to meet its
17 resource needs. As the IPUC has noted, "there are no
18 guarantees about future stream flows or market prices, "14 and
19 in light of the recent past, this dependence on wholesale
20 markets entails significant risk in the minds of investors,
21 especially for a utility located in the West. Investors
22 recognize that volatile markets, unpredictable stream flows,
13 Id.
14 Idaho Power Granted $256 million deferral, but bond plan denied, Idaho
Public Utilities Commission (May 13, 2002).
AVERA, RE 12
idaho Power Company
1 and idaho Power's dependence on wholesale purchases to meet
2 the needs of its customers expose the Company to the risk of
3 reduced cash flows, increased need for financing, and
4 unrecovered power supply costs.
5 Apart from exposure to market uncertainties, Idaho Power
6 also confronts the complexities associated with maintaining
7 the necessary licenses to operate its hydroelect.ric stations.
8 The process of relicensing is prolonged and involved and often
9 includes the implementation of various studies and measures to
10 address environmental and stakeholder concerns. 15 These
11 measures can impose significant additional costs and/or lead
12 to reduced generating capacity and flexibility.
13 Q.Does the fact that Idaho Power has a PCA absolve
14 investors from risk of volatility, as Ms. Carlock seems to
15 imply?
16 A.No. The fact that Idaho Power had been granted a
17 PCA does not translate into lower risk vis-à-vis other
18 electric utili ties. First, adjustment mechanisms to account
19 for changes in power supply costs are the rule, rather than
20 the exception in the utility industry, so that the Company's
21 PCA merely moves its risks closer to those of other utili ties.
15 In 2004, for example, a federal court ordered the Federal Energy
Regulatory Commission to respond to a request for a formal review of Idaho
Power's Hells Canyon hydroelectric complex under the Endangered Species
Act. "Court orders FERC to answer seven-year-old request for study of
idaho dams' fish impact," Electric Utility Week (Jun. 28, 2004) at 14.
AVERA, RE 13
Idaho Power Company
1 Second, the PCA does not prevent the lag between the time that
2 Idaho Power actual ly incurs power supply expenses and when
3 those expenses are recovered from ratepayers. Investors are
4 well aware that the significant reduction in cash flows
5 associated with mounting deferrals can have a debilitating
6 impact on a utility's financial position:
7 Moreover, investors are aware that the PCA does not apply
8 to 100 percent of the difference between the actual cost of
9 purchased power and the amount collected through rates, with
10 Idaho Power's shareholders remaining at risk for 10 percent of
11 any discrepancy. Indeed, the Company and its investors have
12 already experienced the impact that chaotic market conditions
13 can have when the utility is forced to rely on wholesale
14 purchases to meet the gap in its resource needs created by
15 reduced hydro generation. As documented in my direct
16 testimony, investors cannot afford to discount the continuing
17 prospect of further turmoil in western power markets, with the
18 FERC Commission Staff recognizing the ongoing potential for
19 market disruption in a 2007 market assessment report:
20 Prices are likely to remain a concern. Last year we
21 monitored transactions above the $400 per megawatt22 hour Western soft cap due to scarcity at peak.23 Given the likelihood of higher-priced natural gas in24 the West this year, extreme weather could easily
AVERA, RE 14
Idaho Power Company
1
2
raise prices to the peak level again in summer
2007.16
3 Q.What other evidence indicates the importance of
4 reasonable regulatory decisions on Idaho Power's ability to
5 maintain its financial integrity?
6 A.Citing concerns over the impacts of a sustained
7 drought, the pressures of ongoing capital requirements, and
8 the outcome of Idaho Power's last rate proceeding in Case No.
9 IPC-E-03-13, Standard & Poor's Corporation ("S&P") lowered
10 Idaho Power's corporate credit rating from "A-" to "BBB+" in
11 November 2004.17 In explaining this action, S&P noted:
12 Following the IPUC staff's 3.1% rate increase
13 recommendation in February 2004, Standard & Poor's14 said that "a final decision by the commission that15 adopted a rate increase akin to that proposed by the
16 staff could have an adverse effect on bondholder17 protection measures." The final IPUC ruling is18 indeed substantially closer to the staff's position19 than the company's, and will weaken credit20 protection measures. 18
21 Similarly, Moody's Investors Service ("Moody's) also
22 downgraded the Company's issuer rating from "A3" to "Baal",
23 citing the risks associated with hydroelectric power and
24 ongoing capital commitments, as well as the need for
16 Federal Energy Regulatory Commission, Office of Market Oversight and
Investigations, "Summer Energy Market Assessment 2007," (May 17, 2007) at
14.
17 Standard & Poor's Corporation, "IDACORP and Unit Ratings Lowered,
Removed From CreditWatch Negative," RatingsDirect (Nov. 29, 2004).
18 Id.
AVERA, RE 15
idaho Power Company
1 addi tional regulatory support as key factors leading to lower
2 credi t ratings for Idaho Power:
3 The downgrade of IPC i S ratings reflects: 1) expected
4 weaker cash flow coverage of interest and debt; 2)
5 the likelihood for continued negative free cash flow
6 over the next few years, with internally generated
7 funds falling short of meeting the dividend
8 requirements of IDACORP and significant utility-
9 related capital spending; 3) persistent drought10 conditions that are likely to result in higher11 supply costs, not all of which are recoverable under12 the utility i s power cost adjustment mechanism; 4)13 the final resolution this fall of the company i s rate14 case, which resulted in a revenue increase of a
15 li ttle more than half of the company i s updated16 request; and 5) the likely need for additional17 support from the Idaho Public Utility Commission18 (IPUC) in future rate proceedings as IPC adds new
19 generation and transmission infrastructure to help20 meet customer and load growth and ensure reliability21 of service. 19
22 Considering the fact that S&P has already has assigned a
23 "nega ti ve" outlook to Idaho Power, warning investors of the
24 potential for further deterioration in the Company's credit
25 standing going forward, the perception of lack of regulatory
26 support would undoubtedly place further downward pressure on
27 current ratings. Such an outcome would be inconsistent with
28 the IPUC's stated desire to maintain Idaho Power's credit
29 ratings "at or above the current level "20 and lends further
30 support for a return on equity at the very top of the range of
31 Ms. Carlock's results.
19 Moody'S Investors Service, "Ratings Action: IDACORP, Inc.," Global
Credi t Research (Dec. 3, 2004).
20 Idaho Public Utilities Commission, Order No. 29505 (May 25, 2004) at 43.
AVERA, RE 16
Idaho Power Company
1 Q.Is there evidence regarding the importance of
2 regulatory support in determining a utility's financial
3 integri ty?
4 A.Yes. Investment publications and the trade press
5 are replete with examples that highlight the critical role
6 that a constructive regulatory environment plays in investors'
7 assessment of a utility's credit quality. In discussing the
8 outlook for the utility industry, for example, Fitch Ratings,
9 Ltd. recently noted that:
10 Regulatory risk remains a recurring theme in Fitch's11 2008 outlook. For regulated electric utilities,12 there is continuing event risk related to state13 regulatory and political reactions to higher energy
14 bills. ... The risk is heightened by the convergence15 of rising costs for fuel, equipment and maintenance16 materials, pension and medical benefits, and17 infrastructure investments. 21
18 Accordingly, it is critical to assure investors' confidence in
19 a balanced approach if reasonable access to capital is to be
20 maintained. This is particularly true in this case for Idaho
21 Power since the IPUC has such a significant role in this
22 utility's prospects. Staff witness Donn English is incorrect
23 at page 26 of his testimony when he suggests that Idaho Power
24 has less regulatory risk because its service terri tory is
25 concentrated in Idaho. Just as a diversified investment
26 portfolio reduces risk to an investor, so also does exposure
21 Fitch Ratings, Ltd., "U.S. Utilities, Power & Gas 2008 Outlook," at 5
(Dec. 11, 2007).
AVERA, RE 17
idaho Power Company
1 to diversified regulatory authorities attenuate the risk of
2 one jurisdiction adopting regulatory policies viewed as
3 uncons truc t i ve by inves tors.
4 Q.Did Ms. Carlock consider flotation costs in her DCF
5 analysis?
6 A.Partially. Ms. Carlock incorporated flotation costs
7 by increasing the dividend yield component of her DCF
8 analysis. While Ms. Carlock concluded that direct flotation
9 costs would warrant an adjustment equal to 2 percent of the
10 dividend yield component, she provided no support or
11 explanation for this figure. As documented in my direct
12 testimony, a review of related studies supports an adjustment
13 on the order of 3.6 percent to 10 percent. 22 In addition, Ms.
14 Carlock apparently did not adjust the results of her
15 comparable earnings approach to incorporate flotation costs.
16 Q.In light of the shortfalls in Ms. Carlock's analysis
17 and her failure to present a balanced assessment of idaho
18 Power's relative investment risks, what is your conclusion
19 regarding her recommendations in this case?
20 A.In my opinion, Ms. Carlock's recommended 10.25
21 percent cost of equity falls well short of the rate of return
22 that investors require from Idaho Power. In order to maintain
22 In prior testimony, Ms. Carlock has stated that direct flotation costs
equate to an adjustment factor of 4 percent applied to a utility's dividend
yield. Direct Testimony of Terri Carlock, Case Nos. AVU-E-04-1 & AVU-G-04-
1, at 11 (June 21, 2004).
AVERA, RE 18
idaho Power Company
1 and expand utility infrastructure, it is both reasonable and
2 necessary that the Company be provided the opportunity to
3 maintain its credit standing and ability to attract capital.
4 To meet these challenges successfully and economically, it is
5 crucial that Idaho Power receive adequate support for its
6 credit standing. Ms. Carlock i s recommendation is inadequate
7 to meet thi s goal.
8 At the very least, the IPUC should consider the results
9 of theCAPM, along with Ms. Carlock's approaches, in
10 evaluating the cost of equity. Ms. Carlock granted that, in
11 selecting a point estimate from within a range, "any point
12 within (the) range is reasonable. "23 Coupled with the ongoing
13 risks associated with Idaho Power's continued exposure to
14 wholesale power markets and the downward pressures on its
15 credi t standing, this would suggest a minimum cost of equity
16 from the upper end of Ms. Carlock's DCF and comparable
17 earnings ranges.18 II I. MATTH I. KA
19 Q.Briefly describe how Mr. Kahal arrived at his
20 recommended cost of equity for Idaho Power.
21 A.Mr. Kahal recommended a 10.25 percent ROE for Idaho
22 Power based primarily on the results of the constant growth
23 DCF model applied to al ternati ve groups of electric utili ties.
23 Carlock Direct at 12-13.
AVERA, RE 19
Idaho Power Company
1 Mr. Kahal developed his proxy groups based on the companies
2 included in Value Line's Electric Utility (West) industry
3 group, as well as a subset of the comparable utilities
4 developed in my direct testimony that Mr. Kahal characterized
5 as operating in "non-restructured" states. In addition to the
6 DCF model, Mr. Kahal also examined historical and projected
7 realized rates of return for his reference groups. Based on
8 the results of his analyses, Mr. Kahal concluded that a
9 reasonable "baseline" cost of equity would fall in the range
10 of 9.5 percent to 10.5 percent. In explaining his recommended
11 ROE of 10.25 percent for Idaho Power, Mr. Kahal claimed to
12 include "a small return premium for IPc."
13 Q.Did Mr. Kahal adequately recognize the importance
14 associated with reliance on multiple methods and approaches in
15 estimating the cost of equity?
16 A.No. Apart from passing reference to the comparable
17 earnings approach, which I address subsequently, Mr. Kahal
18 ignored the results of other methods, such as the CAPM, to
19 check or validate his results. As I explained in my direct
20 testimony, however, no single method or model should be relied
21 upon to determine a utility's cost of equity because no single
22 approach can be regarded as wholly reliable. Considering the
23 results of alternative methods and approaches provides greater
24 confidence that the end result is reflective of investors'
25 required rate of return. Regulatory Finance: Utili ties' Cost
AVERA, RE 20
idaho Power Company
1 of Capi tal (Public utili ties Reports, Inc., 1994) concluded
2 that:
3 When measuring equity costs, which essentially deal
4 with the measurement of investor expectations, no
5 one single methodology provides á foolproof panacea.
6 If the cost of equity estimation process is limited
7 to one methodology, such as DCF, it may severely8 bias the results. (p. 238)
9 Q.Do you believe that the results of Mr. Kahal' s
10 constant growth DCF analyses mirror investors' long-term
11 expectations in the capital markets?
12 A.No. There is every indication that Mr. Kahal' s
13 results are biased downward and fail to reflect investors'
14 required rate of return. Historical and short-term projected
15 growth rates used to apply the DCF model may be colored by
16 lingering economic uncertainties and the numerous challenges
17 faced in the utility industry. The impact of this short-term
18 focus is exemplified by Value Line, which has assigned its
19 Utilities sector the lowest ranking of all 10 sectors it
20 covers for year-ahead stock price performance, 24 while noting,
21 "We don' t totally discount the possibility that the industry
22 will be accorded higher sustainable valuations going
23 forward. "25 In other words, while Value Line does not
24 anticipate substantial near-term gains for investors, they
24 The Value Line Investment Survey, Selection & Opinion (Jan. 26, 2007) at
4910.
25 The Value Line Investment Survey (Mar. 2, 2007) at 153.
AVERA, RE 21
Idaho Power Company
1 recognize that investors' long-term view may be different. As
2 a result, while a cautious short-term outlook may be
3 indicative of relatively low near-term growth projections, it
4 does not necessarily reflect investors' long-term expectations
5 for the industry.
6 As Mr. Kahal correctly observed, the "g" component of the
7 DCF model should be prospective and must reflect "investor
8 expected future growth. "26 But as he went on to note,
9 environment presumed by the constant growth DCF approach he
10 employed does not exist in reality. Mr. Kahal granted the
11 significant dislocations recently faced by electric utilities,
12 noting that:
13 (M)y experience in recent years with utilities has14 been that these historic measures have been very15 volatile and are not reliable as long-run16 prospective measures. This may be due in part to17 extensive corporate restructuring in the energy18 industry. 27
19 And while Mr. Kahal noted that his projected growth rates
20 "should be considered and given substantial weight," he also
21 recognized that" (t)here are a number of reasons why investor
22 expectations of long-run growth could differ from the limited,
23 five-year proj ections from security analysts. "28 Considering
24 that investors' expectations could differ substantially from
26 Kahal Direct at 19.
n Kahal Direct at 19.
28 Kahal Direct at 20.
AVERA, RE 22
Idaho Power Company
1 the growth rates he relied on, Mr. Kahal concluded that the
2 resulting cost of equity estimates "should be subject to a
3 reasonableness test and corroboration. "29 If the growth
4 proj ections used to apply the DCF model do not fully reflect
5 the long-term expectations investors have built into stock
6 prices, the resulting cost of equity estimates will be biased
7 downward.
8 Q.Did Mr. Kahal test the reasonableness of the
9 individual growth estimates he relied on to reach his
10 recommended ROE for Idaho Power?
11 A.No. Mr. Kahal' s mechanical application of the
12 constant growth DCF model contradicts his own admonishment to
13 avoid simply plugging alternative growth rates into the DCF
14 formula with no consideration for the reasonableness of the
15 end results. In fact, many of the growth measures embodied in
16 Mr. Kahal' s constant growth DCF application make no economic
17 sense.
18 For example, consider the fact that three of the Value
19 Line growth rates reported on page 4 of Mr. Kahal' s Exhibit
20 No. 604 were equal to 2.0 percent or less. A growth rate of
21 2.0 percent, when combined with Mr. Kahal' s average dividend
22 yield of approximately 3.65 percent, 30 suggests a DCF cost of
23 equity estimate of approximately 5.7 percent. Meanwhile,
29 Id.
30 Exhibit No. 604, p. 3.
AVERA, RE 23
Idaho Power Company
1 several of the al ternati ve growth values that Mr. Kahal
2 referenced were equal to or less than zero,31 implying that the
3 utility's cost of equity is equal to or below its dividend
4 yield. Considering the risk-return tradeoff principle
5 fundamental to financial theory, it is clear that such results
6 violate economic logic and clearly tell us nothing about
7 investors' actual return requirements.
8 Q.Did Mr. Kahal offer any evidence to support his
9 contention that DCF results for your non-utility proxy group
10 should be rej ected?
11 A.No. Mr. Kahal simply asserted (p. 26) that, because
12 the obj ecti ve in this case was to determine an ROE for Idaho
13 Power's regulated utility operations, data for unregulated
14 companies have "no value at all." Although he provides no
15 detailed explanation for his position, Mr. Kahal apparently
16 contends that the investment risks of my non-utility group
17 were not comparable to Idaho Power or the utility proxy group
18 I developed in my testimony. In fact, however, participation
19 in competitive markets says nothing at all about the overall
20 investment risks perceived by investors, which is the very
21 basis for a fair rate of return. For example, consider 1) an
22 electric utility operating in regulated markets that has
23 experienced an inability to recover the costs incurred to
31 Exhibit No. 604, p. 5.
AVERA, RE 24
Idaho Power Company
1 provide service, and 2) United Parcel Service (UPS), which
2 faces competition on numerous fronts. Despite its lack of a
3 regulated monopoly, with a triple-A bond rating, the highest
4 Value Line Safety Rank, and a beta of 0.75, the investment
5 communi ty would undoubtedly regard UPS as the less risky
6 alternative.In fact, my review of objective indicators of
7 investment risk - which consider the impact of competition and
8 market share - demonstrated that, if anything, the non-utility
9 proxy group is less risky in the minds of investors than the
10 common stock of electric utilities, including Idaho Power. 32
11 Meanwhile, Mr. Kahal's contention (p. 24) that an
12 estimate of the required return for firms in the competitive
13 sector of the economy "is not reasonable for use in this case"
14 is wrong.In fact, returns in the competi ti ve sector of the
15 economy form the very underpinning for utility ROEs because
16 regulation purports to serve as a substitute for the actions
17 of competitive markets. The Supreme Court has recognized in
18 the Bluefield and Hope cases that it is the degree of risk,
19 not participation in particular business activities, which is
20 relevant in evaluating an allowed ROE for a utility.
32 As shown in Table 3 of my direct testimony, the non-utili ty proxy group
was less risky than Idaho Power and the utility proxy group across the four
major indicators of investment risk.
AVERA, RE 25
Idaho Power Company
1 Q.Do you agree with Mr. Kahal' s assertions regarding
2 the elimination of certain companies in analyzing the cost of
3 equity for Idaho Power?
4 A.No. Mr. Kahal argued for the elimination of
5 companies based on an assessment of the degree of regulatory
6 restructuring at the retail level or participation in non-
7 utility operations. However, he failed to demonstrate how his
8 subjective criteria translate into differences in the
9 investment risks perceived by investors. As I amply
10 demonstrated in my direct testimony,33 a comparison of
11 objective indicators demonstrates that investment risks for
12 the firms in my proxy groups are relatively homogeneous and
13 comparable to Idaho Power. Moreover, there are significant
14 errors and inconsistencies associated with Mr. Kahal' s
15 approach that justify rejecting his alternative proxy groups
16 altogether.
17 Q.Did Mr. Kahal demonstrate a nexus between the
18 subjective criteria he used to define his proxy groups and
19 objective measures of investment risk?
20 A.No. Under the regulatory standards established by
21 Hope and Bluefield, the salient criteria in establishing a
22 meaningful proxy group to estimate investors' required return
23 is relative risk, not the degree of regulatory restructuring.
33 Pages 36-38 and 51-53.
AVERA, RE 26
Idaho Power Company
1 Mr. Kahal presented no evidence to demonstrate a connection
2 between the subjective criteria that he employed and the views
3 of real-world investors in the capital markets.
4 Q.What objective evidence can be evaluated to confirm
5 the conclusion that these subjective criteria are not
6 synonymous with comparable risk in the minds of investors?
7 A.Bond ratings are perhaps the most objective guide to
8 utilities' overall investment risks and they are widely cited
9 in the investment communi ty and referenced by investors. .
10 While the bond rating agencies are primarily focused on the
11 risk of default associated with the firm's debt securities,
12 bond ratings and the risks of common stock are closely
13 related. As noted in Regulatory Finance: utilities' Cost of
14 Capital:
15 Concrete evidence supporting the relationship16 between bond ratings and the quality of a security
17 is abundant. ... The strong association between bond18 ratings and equity risk premiums is well documented
19 in a study by Brigham and Shome (1982).34
20 While credit ratings provide the most widely referenced
21 benchmark for investment risks, other quality rankings
22 published by investment advisory services and rating agencies
23 also provide relative assessments of risk that are considered
24 by investors in forming their expectations. For example, Mr.
34 Morin, Roger A., "Regulatory Finance: Utilities' Cost of Capital,"
Public Utility Reports (1994) at 81.
AVERA, RE 27
idaho Power Company
1 Kahal considered Value Line's Safety Rank, beta, and Financial
2 Strength Rating risk measured in evaluating his reference
3 group. 35
4 As I noted in my direct testimony (p. 36), my proxy group
5 of 21 electric utilities had an average corporate credit
6 ratings of triple-B, with ratings for the individual utilities
7 ranging from "BBB" to "A-". Similarly, credit ratings
8 assigned to the eight utilities excluded by Mr. Kahal based on
9 his subjective tests ranged from "BBB" to "BBB+" and were
10 entirely comparable to those assigned to the remainder of the
11 companies in my utility proxy group. Considering that credit
12 ratings provide one of the most widely referenced benchmarks
13 for investment risks, a comparison of this objective risk
14 indicator demonstrates that the range of risks for the
15 companies eliminated under the subjective criteria proposed by
16 Mr. Kahal are virtually identical to the remaining companies
17 that he accepted as comparable. A review of the key Value
18 Line risk indicators discussed in my direct testimony also
19 confirm the conclusion that the firms excluded by Mr. Kahal
20 are entirely comparable to the remainder of my utility proxy
21 group.
35 Exhibit No. 603.
AVERA, RE 28
Idaho Power Company
1 Q.What inconsistencies are associated with the
2 alternative tests proposed by Mr. Kahal?
3 A.While Mr. Kahal proposes to eliminate companies
4 based his assessment the proportion of revenues from regulated
5 utili ty operations, he presented no explanation or evidence
6 supporting his "test". Apart from the fact that it is often
7 impossible to accurately apportion financial measures between
8 utility and non-utility sources, Mr. Kahal's subjective
9 assessment is inconsistent with the companies he accepted in
10 his own reference group of western utilities. For example,
11 while Mr. Kahal argued to exclude companies with "substantial
12 unregulated operations," he included Black Hills Corporation
13 ("Black Hills") in his reference group. Black Hills reported
14 in its most recent Form 10-K Report that its utility
15 operations accounted for 41 percent of operating revenues,
16 wi th other operations - including oil and gas and coal mining,
17 making up the remaining 59 percent. Similarly, in addition to
18 its electric utili ty operations Hawaiian Electric Industries,
19 Inc. ("Hawaiian Electric") also owns and operates American
20 Savings Bank, which is the third largest financial institution
21 in Hawaii. Despite the fact that competitive banking
22 activities accounted for approximately 37 percent of operating
23 income in 2006, Mr. Kahal elected to include Hawaiian Electric
24 in his proxy group. Thus, Mr. Kahal' s evaluation of my proxy
25 companies is totally at odds with his own evaluation and
26 analyses.
AVERA, RE 29
Idaho Power Company
1 Similarly, Mr. Kahal' s assertions concerning the risks
2 associated with restructuring are ill-defined and inconsistent
3 with his arguments over the implications of competition. For
4 example, while Mr. Kahal argues that CenterPoint Energy should
5 be excluded because it operates in restructured power markets,
6 CenterPoint Energy is engaged almost exclusively in providing
7 regulated electric and gas distribution and transmission
8 services. 36 As CenterPoint Energy noted:
9 Neither CenterPoint Energy Houston nor any other10 subsidiary of CenterPoint Energy make sales of11 electric energy at retail or wholesale or owns any12 electric generating facilities. 37
13 While CenterPoint Energy does not participate in restructured
14 wholesale power markets, Avista Corp. - one of the companies
15 included in Mr. Kahal' s reference group - specifically
16 informed investors of its exposure to the risks of energy
17 commodi ty markets and reported that wholesale power market
18 purchases accounted for almost 30 percent of total energy
19 needs. 38 Again, the circumstances faced by the utilities in
20 Mr. Kahal' s own proxy group are inconsistent with the
21 subjective "tests" he proposes.
36 In Texas, where Centerpoint's operations are concentrated, utilities
providing transmission and distribution service are regulated by the Public
Utility Commission of Texas on a rate of return basis essentially the same
as the IPUC regulation of Idaho Power. Wholesale and retail sales are
subject to competitive markets.
37 CenterPoint Energy 2006 Form 10-K Report at 2.
38 Avista Corp. 2006 Form 10-K Report.
AVERA, RE 30
Idaho Power Company
1 Q.What market risk premium did Mr. Kahal use to apply
2 the CAPM?
3 A.While Mr. Kahal declined to consider the results of
4 the CAPM in arriving at his recommendation, he relied on a
5 market risk premium of 6.0 percent, which he derived from a
6 single journal article and two selected studies reported in a
7 finance textbook.
39
8 Q.What is the fundamental problem associated with the
9 approach underlying Mr. Kahal' s suggested application of the
10 CAPM?
11 A.Like the DCF model, the CAPM is an ex-ante, or
12 forward-looking model based on expectations of the future. As
13 a result, in order to produce a meaningful estimate of
14 investors' required rate of return, the CAPM must be applied
15 using data that reflects the expectations of actual investors
16 in the market. However Mr. Kahal' s application of the cAPM
17 method was premised only on historical - not projected - rates
18 of return. The primacy of current expectations was recognized
19 by Ibbotson Associates:
20 The cost of capital is always an expectational or21 forward-looking concept. While the past performance22 of an investment and other historical information23 can be good guides and are often used to estimate24 the required rate of return on capital, the
39 Rahal Direct at 32.
AVERA, RE 31
Idaho Power Company
1 expectations of future events are the only factors
2 that actually determine cost of capital. 40
3 By failing to look directly at the returns investors are
4 currently requiring in the capital markets, as I did on
5 Exhibi t 6, Mr. Kahal' s CAPM estimate significantly understates
6 investors' required rate of return.
7 Q.Are the selected references cited by Mr. Kahal
8 representative of investors' expectations?
9 A.No. Mr. Kahal claims that "real world" data
10 suggests that the market risk premium is significantly lower
11 than the values relied on in my analyses. First, Mr. Kahal' s
12 selected surveys from 2001 and 2003 do not examine the
13 forward-looking expectations of today's investors to estimate
14 the required market rate of return in current capital markets.
15 These studies reflect historical data, not the current
16 expectations of the future that form the basis of investors'
17 required returns today. This critical distinction was
18 recognized in a recent survey of risk premium research:
19 The debate surrounding the equity risk premium20 arises because theoretically such premia are21 concerned with the extent to which risky stocks are22 "expected" to outperform a (relatively) safe23 investment, whereas excess returns are estimated24 values of this outperformance derived from observed25 data. The lack of consensus regarding the true value26 of the equity risk premium arises from the fact that27 expectations are unobservable hence can only be28 estimated, and that such estimates will vary over
40 Ibbotson Associates, 2003 Yearbook, Valuation Edition at 23.
AVERA, RE 32
Idaho Power Company
1 time depending, in part at least, on the sample
2 period used. 41
3 In other words, instead of directly considering requirements
4 in today' scapi tal markets, Mr. Kahal is implicitly asserting
5 that events and expectations for the time periods covered by
6 his two surveys are more representative of what is likely to
7 occur going forward. This assertion runs counter to the
8 assumptions underlying the use of the CAPM to estimate
9 investors' required return, which is a purely forward-looking
10 model.
11 Moreover, even if historical studies were relevant in
12 this context, there are other such studies of equity risk
13 premiums published in academic journals that imply required
14 rates of return considerably in excess of those selected by
15 Mr. Kahal. For example, a study reported in the Financial
16 Analysts' Journal noted that the real risk premium for U. s.
17 stocks averaged 6.9 percent over the period 1889 through 2000
18 and concluded that:
19 Over the long term, the equity risk premium is20 likely to be similar to what it has been in the past21 and returns to investment in equity will continue to22 substantially dominate returns to investments in T-
23 bills for investors with a long planning horizon.42
41 Oyefeso, Oluwatobi, "Would There Ever Be Consensus Value and Source of
the Equity Risk Premium? A Review of the Extant Literature," International
Journal of Theoretical and Applied Finance, Vol. 9, NO.2 (2006) 199-215.
42 Mehra. Ranjnish, "The Equity Premium: Why Is It a Puzzle?", Financial
Analysts' Journal (January/February 2003) .
AVERA, RE 33
Idaho Power Company
..
1 Similarly, based on a study of ex-ante expected returns for a
2 sample of S&P 500 firms over the 1983-1998 period, a 2003
3 article in Financial Management found an expected market risk
4 premium of 7.2%.43
5 In contrast to the conclusions that Mr. Kahal draws from
6 his review of selected studies, other researchers are less
7 sanguine and recognize that the shortcomings of academic
8 methods can produce results that deviate from investors'
9 actual expectations and requirements:
10
11
12
13
14
15
The above discussion suggests that the equity
premium debate is far from over, and that the use of
excess returns as a proxy for such premia, while
convenient, may capture a substantial amount of
noise and be uncorrelated with equity risk premia
particularly over the short-run. 44
16 In fact, no selected historical study, or group of studies, is
17 a substitute for an analysis of investors' current
18 expectations in the capital markets, such as that incorporated
19 in my CAPM analysis shown on Exhibit 6.
43 Harris, R.S., Marston, F. C., Mishra, D. R., and O'Brian, T. J., "Ex
Ante Cost of Equity Estimates of S&P 500 Firms: The Choice Between Global
and Domestic CAPM," Financial Management (Autum 2003) at Table I.44 Oyefeso, Oluwatobi, "Would There Ever Be Consensus Value and Source of
the Equity Risk Premium? A Review of the Extant Literature," International
Journal of Theoretical and Applied Finance, Vol. 9, NO.2 (2006) 199-215.
AVERA, RE 34
Idaho Power Company
..
1 Q.Is there anything wrong with the approach that you
2 employed to determine the equity risk premium for your
3 forward-looking CAPM analysis (Exhibit 6)?
4 A.No. While Mr. Kahal criticizes historical risk
5 premium data published by Ibbotson Associates (now
6 Morningstar) , 45 I did not reference this data whatsoever in my
7 forward-looking CAPM analysis. As explained in my direct
8 testimony, I estimated the current equity risk premium by
9 first applying the DCF model to estimate investors' current
10 required rate of return for the firms in the S&P 500 and then
11 subtracting the yield on government bonds. Mr. Kahal contends
12 that this cAPM analysis is flawed because of an alleged upward
13 bias in the market risk premium. In fact, however, the use of
14 forward-looking expectations in estimating the market risk
15 premium is well accepted in the financial literature. For
16 example, in "The Market Risk Premium: Expectational Estimates
17 Using Analysts' Forecasts" (Journal of Applied Finance,
18 Vol. 11 No.1, 2001), Robert S. Harris and Felicia C. Marston
19 employed the DCF model and earnings growth proj ections from
20 IBES - just as I did in Exhibit 6.
21 Mr. Kahal' s complaint about my forward-looking CAPM
22 approach seem to hinge on the fact that this method produces
23 an equity risk premium for the S&P 500 that is considerably
24 higher than the unrealistic benchmarks he cites. But as I
45 Kahal Direct at pp. 30-31.
AVERA, RE 35
Idaho Power Company
.
1 explained earlier, estimating investors' required rate of
2 return by reference to current, forward-looking data, as I
3 have done, is entirely consistent with the theory underlying
4 the CAPM methodology, which is an ex-ante, or rorward-looking
ii
5 model based on expectations of the future. As a result, in
6 order to produce a meaningful estimate of required rates of
7 return, the CAPM is best-applied using data that reflects the
8 expectations of actual investors in the market. Rather than
9 look backwards to risk premiums based on historical literature
10 articles or surveys, my analysis appropriately focused on the
11 expectations of actual investors in today's capital markets.
12 Q.Is there any merit to Mr. Kahal' s contention that
13 the alternative beta values he references are "more plausible"
14 that those reported by Value Line?
15 A.None whatsoever. Application of any quanti tati ve
16 technique to estimate the cost of equity is an attempt to
17 determine the expectations and requirements of real-world
18 investors in the capital markets. In this regard, the Value
19 Line beta values I used to apply the CAPM are perhaps the best
20 indicator of the risks investors are likely to associate with
21 electric utili ties such as Idaho Power. As noted in
22 Regulatory Finance: Utilities' Cost of Capital:
23 Value Line betas are computed on a theoretically24 sound basis using a broadly-based market index, and25 they are adjusted for the regression tendency of26 betas to converge to 1. 00 . ...Val ue Line is the27 largest and most widely circulated independent28 investment advisory service, and exerts influence on
AVERA, RE 36
Idaho Power Company
.
i a large number of institutional and individual
2 investors and on the expectations of these
3 investors. 46
4 In my experience, Value Line betas are widely used, without
5 adjustment, to estimate the cost of equity in regulatory
6 proceedings.
7 Q.Did Mr. Kahal present any meaningful evidence to
8 support his claim (p. 29) that certain Value Line's beta
9 values are "clearly unreasonable"?
10 A.No. After noting that beta values for my proxy
11 group and IDACORP imply risks comparable to the stock market
12 as a whole," Mr. Kahal simply asserts, "This is clearly
13 unreasonable. "47 Missing from Mr. Kahal' s testimony is any
14 evidence to support his view that higher beta values for
15 utility stocks are somehow not reflective of underlying
16 investment risks. Moreover, it is the expectations and
17 requirement of investors that determine the relative
18 fluctuations in share prices on which Value Line's beta values
19 are based. But rather than view increased stock price
20 volatility relative to the market as a sign of increased risk,
21 as would be consistent with financial theory, Mr. Kahal offers
22 his unsupported assertion that this trend is "unreasonable."
46 Morin, Roger A., "Regulatory Finance: Utilities' Cost of Capital,"
Public Utilities Reports (1994) at 65.
47 Kahal Direct at 29.
AVERA, RE 37
Idaho Power Company
.
1 In fact, increasing beta values for the electric utility
2 industry are entirely consistent with the higher risks
3 perceived by investors, as described in my direct testimony. 48
4 Moreover, the greater risk implied by higher beta values are
5 also consistent with the general downward trend in utility
6 credit ratings. In my experience, Value Line is the most
7 widely referenced source for beta in regulatory proceedings
8 and Mr. Kahal has presented no evidence that would call these
9 values into question.
10 Q.What is the most telling indication that the data
11 Mr. Kahal cites in applying the CAPM do not reflect investors'
12 expectations?
13 A.The results of the CAPM method applied using the
14 data reported by Mr. Kahal do not make economic sense. The
15 surveys cited as support for Mr. Kahal' s conclusions implied
16 market equity risk premiums of 5.5 percent and 3.8 percent,
17 with his alternative beta values averaging 0.74 for his proxy
18 group.
49 But multiplying market equity risk premiums of 5.5
19 percent and 3.8 percent by Mr. Kahal' s beta of 0.74 for his
20 reference group, and combining the resulting 4.1 percent and
21 2.8 percent risk premiums with a 4.8 percent risk-free rate,
22 resul ts in indicated costs of equity of approximately 8.9
48 As noted earlier, Ms. Carlock also comments on investors' perceptions of
the increasing risk of the electric utility industry.
49 Kahal Direct at pp. 30 & 31.
AVERA, RE 38
Idaho Power Company
.
1 percent to 7.6 percent. These returns are barely above the
2 yields on utility bonds and dramatically lower than the
3 earnings Value Line expects utilities to earn in coming years.
4 By any objective measure, such results fall woefully short of
5 required returns from an investment in common equity. Mr.
6 Kahal' s interpretation has little relation to the expectations
7 of actual investors and no value as a benchmark in applying
8 the cAPM or evaluating the reasonableness of his DCF
9 recommendations.
10 Q.Please comment on Mr. Kahal' s application of the
11 comparable earnings approach.
12 A.By failing to evaluate the economic logic of the
13 individual returns for the companies in his reference group,
14 Mr. Kahal' s comparable earnings analysis suffers from the same
15 flaw explained earlier in connection with his DCF application.
16 Indeed, while Mr. Kahal suggested that a 17.5 percent return
17 on equity for Dominion Resources should be excluded as
18 implausible, he retained low-end estimates that are clearly
19 illogical. For example, Mr. Kahal' s comparable earnings
20 results included a number of values that fall below current
21 yields on public utility bonds,
50 while others are far below
22 any reasonable estimate of investors' required rate of
50 See. e.g., the 5.3 percent and 5.8 percent returns for Portland Energy
included on page 1 of Exhibit No. 606.
AVERA, RE 39
Idaho Power Company
.
1 return. 51 Thus, the resul ts of Mr. Kahal' s comparable earnings
2 approach are understated and should be ignored.
3 Q.Does Mr. Kahal' s reference to the ROE authorized by
4 the IPUC in Idaho Power's last rate proceeding support his
5 recommendations in this in proceeding?
6 A.No. Mr. Kahal argues that the IPUc should "reaffirm
7 and continue" the 10.25 percent ROE that it found to be
8 reasonable for Idaho Power in Case No. IPC-E-03-13, but this
9 ignores the fact that the Company's investment risks have
10 increased. As discussed earlier in response to Ms. Carlock,
11 Idaho Power was downgraded from single-A to triple-B following
12 the conclusion of the Company's last litigated rate
13 proceeding. Apart from the uncertainties associated with
14 Idaho Power's reliance on hydro generation and the financial
15 pressures attributable to increased capital requirements, S&P
16 and Moody's also noted the Company's weakened financial
17 standing in light of the I PUC ' s ruling. Because the record in
18 Case No. IPC-E-03-13 was predicated on idaho Power's former
19 single-A credit rating, the 10.25 percent ROE awarded by the
20 IPUC does not consider the higher risks that investors now
21 associate with the Company.
22 Q.Is there any direct capital market evidence
23 regarding the amount of the premium investors require from a
51 See, e.g., the 7.5 percent and 7.0 percent rates of return for DTE
Energy and NiSource Inc.
AVERA, RE 40
Idaho Power Company
.
1 firm that is rated triple-B, versus one with Idaho Power's
2 former single-A rating?
3 A.Al though rates of return on equity cannot be
4 directly observed, the observed yields on long-term bonds
5 provide direct evidence of the additional return that
6 investors require to bear the risks associated with weaker
7 credit ratings. Moody's recently reported an average yield on
8 single-A rated public utility bonds for November 2007 of 5.97
9 percent, versus an average yield of 6.27 percent for bonds
10 rated triple-B. Based on this evidence, the debt markets
11 would require approximately 30 basis points in additional
12 return in order to compensate for the greater risks associated
13 wi th Idaho Power's current triple-B rating. Equity investors
14 would undoubtedly require a significantly greater premium for
15 bearing the higher risk associated with the more junior common
16 stock of a utility with a triple-B rated company, versus one
17 that is rated single-A. As a result, reference to the IPUC's
18 findings in idaho Power's last litigated rate proceeding
19 confirms that Mr. Kahal' s recommended ROE is inadequate to
20 compensate for the level of investment risk that investors now
21 associate with Idaho Power.
22 Q.What are the implications of disregarding the
23 Company's higher investment risks in setting the allowed rate
24 of return on equity?
25 A.If the greater risks associated with Idaho Power's
26 weakened credit standing are not incorporated in the allowed
AVERA, RE 41
Idaho Power Company
"
1 rate of return on equity, the results will fail to meet the
2 comparable earnings standard that Ms. Carlock agrees is
-
3 fundamental in determining the cost of capital. From a more
4 practical perspective, failing to provide investors with the
5 opportunity to earn a rate of return commensurate with Idaho
6 Power's risks will only serve to further weaken its financial
7 integrity, while hampering the Company's ability to attract
8 the capital needed to meet the economic and reliability needs
9 of its service area.
10 Q.Do you agree with Mr. Kahal (p. 8) that changes in
11 dividend taxation enacted in 2003 have led to a significant
12 decline in investors' required rate of return on equity?
13 A.No. While dividend taxation is certainly one factor
14 that may be considered by investors, the impact of changes in
15 dividend taxation on the cost of equity for Idaho Power is
16 unclear. First, the important role that pension funds and tax
17 deferred accounts play in the capital markets dilutes any
18 effect that tax rate changes might have on investors' required
19 rate of return. This is because the reduction in the taxation
20 of dividends has no impact on the returns for tax-free
21 investors.
22 Moreover, using current capital market data to estimate
23 the cost of equity, such as my forward-looking CAPM approach
24 (Exhibi t 6), already incorporates any effects of changes in
25 tax policies. While Mr. Kahal implies that changes in
26 dividend taxation suggest a lower cost of equity than in the
AVERA, RE 42
Idaho Power Company
t.
1 past, this ignores other significant factors that influence
2 required returns. In particular, as a result of events during
3 the past several years, investors' risk perceptions for
4 electric utilities shifted sharply upward, which would more
5 than offset any decline in the equity risk premium due to
6 changes in dividend taxation. Finally, investors recognize
7 that ballooning federal budget deficits are apt to force
8 changes in fiscal policy and that there is no guarantee that
9 the reduction in dividend taxation will continue.
52
10 Q.Did Mr. Kahal incorporate an allowance for flotation
11 costs?
12 A.No. Based on his assertion that IDACORP has no
13 plans to issue common stock, Mr. Kahal rejected an allowance
14 for issuance costs.
15 Q.Is Mr. Kahal' s position consistent with financial
16 realities and the views of other practitioners?
17 A.No. The need for a flotation cost adjustment to
18 compensate for past equity issues is recognized in the
19 financial literature. In a Public Utili ties Fortnightly
20 article, for example, Brigham, Aberwald, and Gapenski
21 demonstrated that even if no further stock issues are
22 contemplated, a flotation cost adjustment in all future years
23 is required to keep shareholders whole, and that the flotation
52 The reduction in dividend taxation in the Jobs and Growth Tax Relief and
Reconciliation Act of 2003 will expire at the end of 2008 unless renewed by
Congress.
AVERA, RE 43
idaho Power Company
~
1 cost adjustment must consider total equity, including retained
2 earnings.53 Similarly, Regulatory Finance: Utilities' Cost of
3 Capi tal contains the following discussion:
4 Another controversy is whether the underpricing
5 allowance should still be applied when the utility
6 is not contemplating an imminent common stock issue.
7 Some argue that flotation costs are real and should8 be recognized in calculating the fair rate of return
9 on equity, but only at the time when the expenses10 are incurred. In other words, the flotation cost11 allowance should not continue indefinitely, but12 should be made in the year in which the sale of13 securities occurs, with no need for continuing14 compensation in future years. This argument implies
15 that the company has already been compensated for16 these costs and/or the initial contributed capital17 was obtained freely, devoid of any flotation costs,18 which is an unlikely assumption, and certainly not19 applicable to most utili ties. ... The flotation cost20 adjustment cannot be strictly forward-looking unless21 all past flotation costs associated with past issues22 have been recovered. (p. 175)
23 Q.Do you agree with Mr. Kahal' s assessment of a
24 reasonable flotation cost percentage?
25 A.No. As noted in my direct testimony, a review of
26 the finance literature indicated that the flotation cost
27 allowance requires an estimated adjustment to the return on
28 equity of approximately 5% to 10%, not the 3% advocated by Mr.
29 Kahal. Moreover, the purpose of the flotation cost adjustment
30 is not to amortize flotation costs over a predetermined
53 Brigham, E.F., Aberwald, D.A., and Gapenski, L.C., "Common Equity
Flotation Costs and Rate Making," Public Utili ties Fortnightly, May, 2,
1985.
AVERA, RE 44
Idaho Power Company
,,
lP
1 schedule. While this is one approach to cost recovery that
2 has been adopted for the financial reporting of debt issuance
3 costs, an equity flotation cost adjustment recognizes that
4 investors are unable to earn a rate of return on the portion
5 of their capital paid out as flotation costs on an ongoing
6 basis.
7 Q.Does this conclude your rebuttal testimony?
8 A.Yes.
AVERA, RE 45
Idaho Power Company