20080627Avera direct.pdf

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.
CASE NO. IPC-E-O8-
IDAHO POWER COMPANY
DIRECT TESTIMONY
WILLIAM E. AVERA
DIRECT TESTIMONY OF WILLIAM E. AVERA
TABLE OF CONTENTS
INTRODUCTION ...........................................
Overview.......................................... 3
Summary of Conclusions ............................
II.FUNDAMENTAL ANALYSES ...................................A. Idaho Power Company.............................. 10B. Utility Industry................................. 17
III. CAPITAL MARKET ESTIMATES ..............................
Overview......................................... 28
Discounted Cash Flow Analyses. .
. . . . . . . . . . . . . . . . ..
Capital Asset Pricing Model.
. . . . . . . . . . . . . . . . . . . ..
Comparable Earnings Method....................... 57
Summary of Results ...............................
Flotation Costs ..................................
IV.RETURN ON EQUITY FOR IDAHO POWER COMPANY.
. . . . . . . . . . . ..
ExhibitExhibitExhibitExhibitExhibit
Implications for Financial Integrity............. 62
capital Structure ................................
Return on Equity Recommendation.
. . . . . . . . . . . . . . . ..
No. 16:No. 17:
No. 18:No. 19:
No. 20:
Exhibit No. 21:Exhibit No. 22:
Exhibit No. 23:
Exhibit No. 24:Exhibit No. 25:
Exhibit No. 26:
Qualifications of William E. Avera
DCF Mode 1 - Ut i 1 i t Y Proxy Group
Sustainable Growth - Utility Proxy Group
DCF Model - Non-Utility Proxy Group
Sustainable Growth - Non-Utility Proxy
Group
Forward-Looking CAPM - Utility Proxy Group
Forward-Looking CAPM - Non-Utility Proxy
Group
Historical CAPM - Utility Proxy Group
Historical CAPM - Non-Utility Proxy Group
Comparable Earnings Approach
capi tal Structure
INTRODUCTION
Please state your name and business address.
william E. Avera, 3907 Red River , Austin , Texas,
78751.
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.
I received a B. A. degree with a maj or in economics
from Emory university.After serving in the U. S. Navy,
entered the doctoral program in economics at the University
of North Carolina at Chapel Hill.Upon receiving my Ph.D.,
I joined the faculty at the University of North Carolina and
taught finance in the Graduate School of Business.
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 (U PUCTH ) as Director of the Economic
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Idaho Power Company
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, 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
cus tomers, municipalities , and regulatory commissions.
have. previously testified before the Federal Energy
Regulatory Commission (U FERCH ), 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 40 states.
In 1995, I was appointed by the PUCT 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 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
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Idaho Power Company
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 Uni versi ty .I hold the Chartered
Financial Analyst (CFA ) designation and have served as Vice
President for Membership of the Financial Management
Association. I have also served on the Board of Directors of
the North Carolina Society of Financial Analysts.I was
elected Vice Chairman of the National Association of
Regulatory Commissioners (U NARUCH ) Subcommittee on Economics
and appointed to NARUC's Technical Subcommittee on the
National Energy Act.I have also served as an officer of
various other professional organizations and societies.
resume containing the details of my experience and
qualifications is attached as Exhibit No. 16.
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
IPUCH ) my independent evaluation of the fair rate of return
on equity (U ROEH ) for the jurisdictional utility operations
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Idaho Power Company
of Idaho Power Company (u Idaho PowerH or U the Company
) .
The overall rate of return applied to Idaho Power's 2008
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 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 FERC.
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, IDACORP , Inc.IDACORpll
) .
I also reviewed
information relating generally to current capital market
conditions and specifically to current investor perceptions,
requirements, and expectations for Idaho Power s 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
capital , and form the basis of my analyses and conclusions.
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Idaho Power Company
What is the role of ROE in setting a utility
rates?
The ROE serves to compensate investors for the use
of their capital to finance the plant and equipment
necessary to provide utility service.Investors commit
capital only if they expect to earn a return on their
investment commensurate with returns available from
alternative investments with comparable risks.To be
consistent with sound regulatory economics and the standards
set forth by the Supreme Court in the Bluefiel~ and Hope
cases, a utility s allowed ROE should be sufficient to:
fairly compensate the utility's investors, 2) enable the
utility to offer a return adequate to attract new capital on
reasonable terms, and . 3) maintain the utility's financial
integrity.
How did you go about developing your conclusions
regarding a fair rate of return for Idaho Power?
I first reviewed the operations and finances of
Idaho Power and the general conditions in the utility
industry and the economy.with this as a background, I
conducted various well-accepted quantitative analyses to
estimate the current cost of equity, including alternative
applications of the discounted cash flow DCFH model and
1 Bluefield Water Works & Improvement Co. v. Pub. Servo Comm , 262 U.679 (1923).
2 Fed. Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591 (1944).
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Idaho Power Company
the Capital Asset Pricing Model (U CAPMH ), 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 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 10.8 percent to 11.
percent range.The bases for my conclusion are summarized
below:
In order to reflect the risks and prospectsassociated with Idaho Power jurisdictional
utili ty operations , my analyses focused on a proxy
group of twenty-seven electric utilities with
comparable investment risks. Consistent with the
fact that utilities must compete for capital with
firms outside their own industry, I also referenced
a proxy group of comparable risk companies in the
non-utility sector of the economy;
I applied both the DCF and CAPM methods, as well asthe comparable earnings approach to estimate a
fair ROE for Idaho Power:
0 My application of the constant growth DCF modelconsidered three alternative growth measures
based on proj ected earnings growth, as well asthe sustainable "br+sv growth rate for each
firm in the respective proxy groups;
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Idaho Power Company
0 After eliminating low- and high-end outliers, my
DCF analyses implied a cost of equity of 11.
percent for the proxy group of electric
utilities and 12.6' percent for the group of non-utili ty companies;
0 Application of the CAPM approach using forward-
looking data that best reflects the underlying
assumptions of this approach implied a cost of
equi ty of 12.percent for the electric
utilities and 11.5 percent for the non-utility
companies;
0 Applying the CAPM method using historical
realized rates of return resulted in a cost of
equity of 10.8 percent for the proxy group of
utilities and 10.2 percent for the firms in the
non-utility proxy groupi
0 My evaluation of comparable earned rates
return expected for utilities suggested a cost
of equity on the order of at least 11.1 percent
for the proxy group of electric utilities;
Considering these results, and conservatively
giving less weight to the upper end of the
range, I concluded that the cost of equity for
the proxy groups of electric utili ties and non-utility companies is on the order of 10.
percent to 11.8 percent
Considering investors ' expectations for capitalmarkets and the need to support financialintegrity and fund crucial capital investmenteven under adverse circumstances, it is
opinion , that this 10.8 percent to 11.8 percentrange bounds a reasonable rate of return on
common equity for Idaho Power and,
While this ubare-bones H cost of equity range
does not consider issuance costs, a flotationcost adder is properly considered in
establishing an allowed ROE for Idaho Power from
wi thin this range.
What is your conclusion as to the reasonableness
of the Company's capital structure?
Based on my evaluation , I concluded that a common
equity ratio of approximately 49 percent represents a
reasonable basis from which to calculate Idaho Power'
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Idaho Power Company
overall rate of return.This conclusion was based on the
following findings:
Idaho Power proposed common equity ratio
entirely consistent with range of capitalizations
maintained by the firms in the proxy group of
electric utilities at year-end 2007 and based on
investors ' expectations
My conclusion is reinforced by the investment
community s focus on the need for a greater equity
cushion to accommodate higher operating risks,
including the uncertainties posed by exposure to
variable hydro conditions, and the pressures ofcapital investments. Financial flexibility plays a
crucial role in ensuring the wherewithal to meet
the needs of customers, and Idaho Power's capital
structure reflects the Company s ongoing efforts to
support its credit standing and maintain access to
capi tal on reasonable terms.
What other evidence did you consider in evaluating
your recommendation in this case?
findings:
My recommendation was reinforced by the following
Sensitivity to regulatory uncertainties hasincreased dramatically and investors recognize thatconstructi ve regulation is a key ingredient in
supporting utility credit standing and financialintegri ty;
Because of Idaho Power s reliance on hydroelectric
generation, the Company is exposed to relatively
greater risks of power cost volatility
Investors recognize that Idaho Power s Power Cost
Adjustment Mechanism (UpCA") provides some level of
support for the Company s financial integrity, but
they understand that the PCA does not apply to 100
percent of power costs nor does it insulate IdahoPower from the need to finance accrued power
production and supply costs or shield the Company
from potential regulatory disallowances.
Idaho Power must compete for investors' capitalwith other utilities and businesses of comparable
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Idaho Power Company
risk. If Idaho Power is not provided an
opportunity to earn a return that is sufficient to
compensate for the underlying risks , investors willbe unwilling to supply capitali
Providing Idaho Power with the opportuni ty to earnreturn that reflects these realities is essential ingredient to support the Companyfinancial position, which ultimately benefits
customers by ensuring reliable service at lowerlong-run costs
Past challenges confronting the utility industry
illustrate the need to ensure that Idaho Power has
the 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 equity.
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Idaho Power Company
A. Idaho Power Company
Briefly describe Idaho Power.
Idaho Power is a . wholly-owned subsidiary of
( U IDACORpH ) and is principally engaged inIDACORP, Inc.
providing integrated retail electric utility service in a
000 square mile area in southern Idaho and eastern
During 2007 , Idaho Power s energy deliveriesOregon.
totaled 17.3 million megawatt hours (UMWhH Sales to
residential customers comprised 36 percent of retail sales,
with 27 percent to commercial, 24 percent. to industrial end-
users, and 13 percent attributable to irrigation pumping.
Idaho Power also supplies firm wholesale power service to
various utilities and large customers under sales contracts.
IPC's service territory experienced record-setting high
temperatures during 2007 and due to these weather conditions
and continued customer growth, IPC set three new all-time
system peaks.At year-end 2007, Idaho Power had total
assets of $3.5 billion, with total revenues amounting to
approximately $ 875 million.
In addition to its thermal base load and peaking units
located in wyoming, Nevada and Idaho , Idaho Power s existing
generating units include 17 hydroelectric generating plants
located in southern Idaho and eastern Oregon.The
electrical output of these hydro plants , which has a
signif icant impact on total energy costs, is dependent on
streamflows.Although Idaho Power estimates that
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Idaho Power Company
hydroelectric generation is capable of supplying
approximately 55 percent of total system requirements under
normal conditions, the Company has experienced prolonged
periods of persistent below-normal water conditions in the
past.
Because approximately one-half of Idaho Power's total
energy requirements are provided by hydroelectric
facilities, the Company is exposed to a level of uncertainty
not faced by most utilities.While hydropower confers
advantages in terms of fuel cost savings and diversity,
reduced hydroelectric generation due to below-average water
conditions forces Idaho Power to rely more heavily on
wholesale power markets or more costly thermal generating
capacity to meet its resource needs.As Standard & Poor'
Corporation (~S&pH ) recently observed:
A reduction in hydro generation typically
increases an electric utility s costs by requiring
it to buy replacement power or run more expensive
generation to serve customer loads. Low hydro
generation can also reduce utilities ' opportunity
to make off-system sales. At the same time , low
hydro years increase regional wholesale power
prices, creating potentially a double impact -
companies have to buy more power than under normalconditions, paying higher prices.
Investors recognize that uncertainties over water conditions
are a persistent operational risk associated with Idaho
3 Standard & Poor s Corporation, "Pacific Northwest Hydrology And Its
Impact On Investor-Owned Utilities' Credit Quality, ff RatingsDirect (Jan.2008).
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Idaho Power Company
In addition to weather-related fluctuations in waterPower.
flows, Idaho Power is also exposed to uncertainties
regarding water rights and the administration of those
rights.
Idaho Power s retail electric operations are subj ect
the jurisdiction of the IPUC and the Oregon Public Utility
Commission, with the interstate jurisdiction regulated by
Addi tionally, Idaho Power's hydroelectric facilitiesFERC.
are subject 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
facili ties in the public interest , which includes adequately
addressing environmental concerns.The most significant of
Idaho Power s relicensing efforts concerns its Hells Canyon
Complex (U Hells CanyonH ), which represents 68 percent of the
Company s hydro capacity and 40 percent of its total
generating capability.
In June 2003, after a prolonged period of planning and
consultation with interested parties, Idaho Power 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
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Idaho Power Company
operate the proj ect under an annual license issued by FERC.
Apart from significant ongoing expenditures associated with
proposed environmental measures, the relicensing process is
complex , protracted, and expensive.As of December 31,
2007, Idaho Power had accumulated $96 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, rates are reduced when
increased hydroelectric generation leads to lower power
supply costs.Al though the PCA provides for rates to be
adjusted annually, it applies to 90 percent of the deviation
between actual power supply costs and normalized rates.
Are there other mechanisms that affect Idaho
Power rates for utility service?
Included in the provisions of Idaho Power'Yes.
PCA is a Load Growth Adjustment Rate (U LGARH The LGAR
subtracts the cost of serving new Idaho retail customers
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Idaho Power Company
from the power supply costs that the Company is allowed to
include in its PCA.The IPUC has recognized that Idaho
Power would nevertheless 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
equity return was set in a process that recognized
it would not recover the power supply costs of
load growth in the PCA mechanism.
In 2007 the IPUC also approved a Fixed Cost Adjustment
Mechanism (U FCAH ) for Idaho Power under a three-year pilot
program applicable to residential and small commercial
customer classes.The FCA adjusts rates upward or downward
to insulate the recovery of fixed costs from the volume of
Idaho Power s energy sales.The pilot program includes
various provisions related to customer count and weather
normalization methodology, reporting requirements , and
detailed disclosure of demand-side management activities.
What credit ratings have been assigned to Idaho
Power?
Citing concerns over deteriorating financial
metrics and the outcome of Idaho Power's last rate
proceeding before the IPUC , S&P lowered Idaho Power
4 Order No. 30215 at 10.
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Idaho Power Company
corporate credit rating from uBBB+H to U BBBH in January
2008. s While Moody s Investors Service (UMoody's) has so
far maintained the Company s issuer rating at u BaalH , it
recently revised its outlook for Idaho Power to U negati veH
based on similar concerns, warning investors of the
potential for a downgrade in the Company s credit standing
going forward.
( ~
Fi tchn ) has assignedFi tch Ratings Ltd.
the Company an issuer default rating of U BBBH and, like
Moody s, has revised Idaho Power s Ratings Outlook to
negative.
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.
5 standard & Poor s Corporation, uIDACORP , Idaho Power Co. Ratings
Lowered One Notch To 'BBB'; Outlook Stable ff RatingsDirect (Jan. 31
2008) .
6 Moody s Investors Service, uMoody s Changes Outlook Of Idacorp And Sub
To Negative,Press Release (June 3 , 2008).
7 Fitch Ratings Ltd., uIdaho Power Company,Global Power U.S. and
Canada Credit Analysis (Apr. 10, 2008).
8 Idaho Power Company, 2006 Integrated Resource Plan (Oct. 12 , 2006) at
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Idaho Power company
order to keep pace with customer growth, enhance
transmission infrastructure, and balance generation resource
uncertainty Idaho Power anticipates construction
expendi tures of approximately $ 9 0 0 million over the period
2008-2010.
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 base load generation, in
addition to other system upgrades. Moreover , as indicated
earlier, Idaho Power must also bear the costs of protection
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 proj ects in
an effective manner.
9 IDACORP, Inc., 2007 Form-10KReport at 27. This amount excludes
expenditures for a 250-MW combined cycle combustion turbine expected to
be operational in mid-2012 as well as any estimated costs attributable
to the Gateway West Project, which contemplates construction of two 500-
kV transmission lines with an estimated cost to Idaho Power of between$800 million and $1.2 billion.10 Idaho Power Company, 2006 Integrated Resource Plan (Oct. 12 , 2006) at
95.
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Idaho Power Company
B. utility Industry
How have investors ' risk perceptions for firms
involved in the utility industry evolved?
since the 1990s, the industry has experienced
significant structural change resulting from market forces
and legislative and regulatory initiatives.Implementation
of structural change and related events caused investors to
rethink their assessment of the relative risks associated
with the utility industry.The past decade 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.S&P recently reported that the majority of the
companies in the utility sector now fall in the triple-B
rating category, 11 with Fitch recently concluding that U the
long-term outlook is negative H for investor-owned electric
utili ties. Similarly, Moody s observed, U Material
negati ve bias appears to be developing over the intermediate
and longer term due to rapidly rising business and operating
risks. "
11 Standard & Poor s Corporation , ~u - S. Electric utility Sector
Continues To Benefit From Strong Liquidity Amid Current Credit Crunch
RatingsDirect (Mar. 27, 2008).
12 Fitch Ratings, Ltd.
, "
S. utilities , Power and Gas 2008 Outlook
Global Power North America Special Report (Dec. 11, 2007).
13 Moody s Investors Service, "U. S. Electric Utility Sector Industry
Outlook (Jan. 2008).
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Idaho Power Company
What other key factors are of concern to
investors?
In recent years , utilities and their customers
have also had to contend with dramatic fluctuations in
energy costs due to ongoing price volatility in the spot
markets.Investors recognize that the prospect of further
turmoil in energy markets is an ongoing concern.S &P has
reported continued spikes in wholesale energy market
prices,14 with Moody s warning investors of ongoing exposure
to Uextremely volatileH energy commodity costs, including
purchased power prices , which are heavily influenced by fuel
costs.Similarly, the FERC Staff has continued to
recognize the ongoing potential for market disruption.
2008 market assessment report recognized ongoing concerns
regarding tight supply and congestion and observed that
wholesale power prices across the nation are likely to be
significantly higher than the previous year. FERC
continues to warn of load pockets vulnerable to periods of
high peak demand and unplanned outages of generation or
transmission capacity and ongoing reliability concerns that
14 Standard & Poor s Corporation, uFuel and Purchased Power Cost
Recovery in the Wake of Volatile Gas and Power Markets - U. S. Electric
Utilities to Watch" RatingsDirect (Mar. 22, 2006).
15 Moody's Investors Service , U Storm Clouds Gathering on the Horizon for
the North American Electric Utility Sector,Special Comment at 6 (Aug.
2007) .
16 FERC, Office of Market Oversight and Investigations, u 2008 Summer
Market and Reliability Assessment," (May 15, 2008).
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Idaho Power Company
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
volatili ty in the spot markets. S&P observed that
natural gas prices have proven to be very volatile
warning of a U turbulent j ourneyH due to the uncertainty
associated with future fluctuations in energy costs,19 and
concluding:Cost pressures from natural gas are not likely
to recede in the near future. Fi tch also highlighted the
challenges that fluctuations in commodity prices can have
for utilities and their investors, concluding that gas
prices are subject to near-term and longer-term fluctuations
that contribute to an u adverse environmentH for electric
utilities.
In addition, while coal-fired generation has
historically provided relative stability with respect to
17 See Open Commission Meeting Sta temen of Chairman Joseph T. Kelliher,
Item E-13: Mandatory Reliability Standards for the Bulk-Power System
(Docket No. RM06-16-000) (Mar. 15, 2007).18 For example, the Department of Energy's Energy InformationAdministration ("EIA") reported that the average price of gas used by
electricity generators (regulated utilities and non-regulated power
producers) spiked from an average price of $7.18 per Mcf for the first
eight months of 2005 to over $11.00 per Mcf in September and October
2005 (http: Iitonto. eia. doe. gov/dnav/ng/hist/n3045us3m.htm) .19 Standard & Poor s Corporation
, "
Top Ten Credit Issues Facing u. Utilities,RatingsDirect (Jan. 29, 2007).
20 rd.
21 Fitch Ratings, Ltd., "U. S. Power and Gas 2008 Outlook Global Power
North American Special Report at 3 (Dec. 11 , 2007).
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Idaho Power Company
fuel costs , higher prices have raised investors ' concerns.
In a 2004 article entitled U Rising Coal Prices May Threaten
s. Utility Credit Profiles H S&P noted that:
More recently, several current and structural
developments for the coal mining industry have
resulted in a dramatic increase in spot coalprices.
The EIA reported that average delivered coal prices for
electric utilities increased 9.7 percent in 2006, the sixth
consecutive annual rise, 23 while Reuters Inc. reported in
May 2008 that benchmark coal prices exceeded $100 per ton,
or over twice the levels of the previous fall.
What are the key uncertainties considered by
investors in assessing their required rate of return for
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 utili ties.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
22 Standard & Poor s Corporation, URising Coal Prices May Threaten U.
Utility Credit Profiles,RatingsDirect (Aug. 12 , 2004).23 Energy Information Administration Annual Coal Report 2006 at 9 (Nov.
2007) .24 Nichols , Bruce
, "
US coal prices pass $100 a ton, twice last fall'
Reuters (May 9,2008).
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Idaho Power Company
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.As S&P noted, U hydro
resources expose the company to substantial replacement
power price risk in the event of low water flows. S&P
concluded that Idaho Power uhas the greatest hydro exposureH
of any utility and faces U the most substantial risks.
Investors recognize the significant financial burden that
constrained hydro generation imposes on Idaho Power , as
Moody s summarized:
The company I s recent financial metrics, including
its coverage of interest and debt by cash flow
from operations exclusive of working capital
changes (CFO Pre-W/C), have been pressured to a
level we often see for a regulated electricutili ty in the Ba rating category. These recent
metrics are the result of unfavorable hydro
conditions and the adverse effects the recent
increase to the load growth adjustment rate (LGAR)
has had on net power supply cost recovery under
the power cost adjustment (PCA) mechanism.
Similarly, Fitch concluded that its negative outlook on
Idaho Power s ratings uprimarily reflect persistent drought
2S Standard & Poor's corporation
, "
IDACORP , Idaho Power Co. Ratings
Lowered One Notch To 'BBB'Outlook Stable,RatingsDirect (Jan. 31,2008) .26 Standard & Poor's Corporation, "Pacific Northwest Hydrology And Its
Impact On Investor-Owned Utilities ' Credit Quality,RatingsDirect (Jan.
, 2008).
27 Moody s Investors Service, "Credit Opinion: Idaho Power Company,
Global Credit Research (June 4 , 2008).
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Idaho Power Company
conditions in recent years and their adverse impact on the
utility s cash flows , earnings and credit metrics.
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 unrecovered power supply costs.
The IPUC has recognized U the unique circumstances of Idaho
Power s highly variable power supply costs. The
Company's reliance on purchased power to meet shortfalls in
hydroelectric generation magnifies the importance of
strengthening financial flexibility to ensure 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.
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
100 percent of power costs.Moreover, even for utili ties
with permanent energy cost adjustment 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
28 Fitch Ratings, Ltd., "Idaho Power Company,Global Power U.S. and
Canada Credit Analysis (Apr. 10 , 2008).29 Order No. 30215 at 9.
AVERA , DI
Idaho Power Company
financial strength through reduced liquidity and higher
borrowings.As S&P observed:
Because increased purchases and higher prices are
not immediately met by increased retail revenues
from customers cash flows can decline in low
water years. While PCAs and annual power cost
updates can mitigate these effects, they are not
designed to completely insulate a utility from
poor hydro conditions. As a result, a large
annual deviation from normal streamflow typically
weakens cash coverage of debt and interest for autility.
S&P recently cited exposure to high deferred power
costs resulting from Uextremely variableH hydro generation
as a key challenge facing Idaho Power. Similarly, Moody'
observed that the Company s financial metrics U are pressured
relati ve to the current Baal rating and we expect that the
company 1 s financial performance will remain subj ect to the
vagaries of water flow conditions. Moreover, even wi th
an energy cost adjustment mechanism, investors continue to
recognize the ongoing potential for regulatory disallowances
if the IPUC determines that the amounts were not prudently
incurred.
30 Standard & Poor's Corporation, ~Pacific Northwest Hydrology And Its
Impact On Investor-Owned Utilities' Credit Quality/RatingsDirect (Jan.
, 2008).
31 Standard & Poor's corporation
, ~
Idaho Power Co.RatingsDirect (Feb.
, 2008).
32 Moody s Investors Service
, ~
Credit Opinion: Idaho Power Company,
Global Credit Research (June 4, 2008).
AVERA, DI
Idaho Power Company
What other considerations affect investors
evaluation of Idaho Power?
Investors are aware of the financial and
regulatory pressures faced by utilities associated with
rising costs ~nd the need to undertake significant capital
investments.As Moody's observed:
(T) here are concerns arising from the sector
sizeable infrastructure investment plans in the
face of an environment of steadily rising
operating costs. Combined, these costs and
investments can create a continuous need for
regulatory rate relief, which in turn can increase
the likelihood for political and/or regulatoryintervention.
Similarly, S&P noted that "onerous construction programs
" ,
along with rising operating and maintenance costs and
volatile fuel costs, were a significant challenge to the
utili ty industry. Moody s recently echoed this
assessment , concluding, u There are significant negative
trends developing over the longer-term horizon.
While providing the infrastructure necessary to meet
the energy needs of customers is certainly desirable , it
imposes additional fi~ancial responsibilities on Idaho
Power.As noted earlier , the Company s plans include
33 Moody s Iuvestors Service
, "
Storm Clouds Gathering ou the Horizon for
the North American Electric Utility Sector Special Comment (Aug.
2007) .34 Standard & Poor's Corporation, "U. s. Electric Utilities Continued
Their Long Shift To Stability In Third Quarter,RatingsDirect (Oct. 23
2007) .
35 Moody s Investors Service
, "
S. Utility Sector Industry Outlook
(Jau. 2008).
AVERA , DI
Idaho Power Company
substantial capital expenditures, including enhancements to
its transmission and distribution system and investment in
generating resources.Investors are aware that the
challenge of achieving timely regulatory recovery associated
with rising costs and burdensome capital expenditure
requirements impacts the Company's ability to earn a fair
rate of return.For example , S&P cited U (rJ egulatory
challenges in meeting rising costs and a large capital
expenditure program , resulting from high customer growth
as a key weakness for Idaho Power , 36 while Fitch noted that
the inability to increase base rates to recover anticipated
capital investment could lead to a downgrade in the
Company s credit standing.
In addition, electric utili ties are confronting
increased environmental pressures that are imposing
significant uncertainties and costs.Utilities required to
meet renewable portfolio standards and carbon reduction
goals generally must embrace energy efficiency and
conservation initiatives that lead to decreased demand and
revenue erosion.In early 2007, S&P cited environmental
mandates, including emissions , conservation, and renewable
resources, as one of the top ten credit issues facing U.
36 Standard & Poor's Corporation, ~Idaho Power Co.U RatingsDirect (Feb.
, 2008).
37 Fitch Ratings , Ltd.
, ~
Idaho Power Company, U Global Power U. S. and
Canada Credit Analysis (Apr. lO, 2008).
AVERA, DI
Idaho Power Company
utilities.More recently, S&P cited the long- term
challenge posed by climate change legislation and observed
that:
What the ultimate outcome will be is cloudy right
now, but legislation addressing carbon emissions
and other greenhouse gases is extremely probable
in the near future. The credit implications of
any policy will be vast due to the compliancecosts involved.
Similarly, Moody s noted that uincreasingly stringent
environmental compliance mandates will elevate cash outflow
recovery riskH , 40 while Fitch noted that the electric
utility industry would be Ua primary targetH of new
environmental legislation, and concluded:The murkiness of
the future policies and regulations on carbon emissions is
another factor clouding Fitch's long-term view of electric
utilities. ,,Compliance with these evolving standards
almost certainty will mean significant capital expenditures.
38 Standard & Poor s Corporation
, "
Top Ten Credit Issues Facing U. utilities RatingsDirect (Jan. 29, 2007).39 Standard & Poor s Corporation , "Upgrades Lead In U. S. Electric
utility Industry In 2007,RatingsDirect (Jan. 17, 2008).
40 Moody s Investors Service, "S. Electric Utility Sector Industry
Outlook (Jan. 2008).
41 Fitch Ratings, Ltd., "S. Utilities, Power and Gas 2008 Outlook
Global Power North America Special Report (Dec. 11 , 2007).
AVERA , DI
Idaho Power Company
Have investors recognized that electric utilities
face additional risks because of the impact of industry
restructuring on transmission operations?
Policy evolution in the transmission areaYes.
has been wide reaching and Idaho Power must address changes
in the electric transmission function of its business. S&P
confirmed a u continued lack of clarity from lawmakers and
regulators on the regulatory framework surrounding
transmission proj ects Transmission operations have
become increasingly complex and investors have recognized
that difficulties in obtaining permits and uncertainty over
the adequacy of allowed rates of return have contributed to
heightened risk and fueled concerns regarding the need for
addi tional investment in the transmission sector of the
electric -power industry.
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 and CAPM analyses conducted to estimate the cost of
equity for benchmark groups of comparable risk firms and
42 Standard & Poor's Corporation
, "
Capital spending On Electric
Transmission Is On The upswing Around The World RatingsDirect (Aug. 7 2006) .
AVERA, Dr
Idaho Power Company
21 .
evaluate comparable earned rates of return expected for
utilities.Finally, I examine other factors (e.g.
flotation costs) that are properly considered in evaluating
a fair rate of return on equity.
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 objectives of rates that are sufficient to:
fairly compensate capital investment in the utility,
enable the utility to offer a return adequate to attract new
capital on reasonable terms, and 3) maintain the utility
financial integrity.Meeting these obj ecti ves allows the
utility to fulfill its obligation to provide reliable
service while meeting the needs of customers through
necessary system expansion.
AVERA, DI
Idaho Power Company
What fundamental economic principle underlies any
evaluation of investors ' required return on equity?
The fundamental economic principle underlying the
cost of equity concept is the notion that investors are risk
In capital markets where relatively risk-freeaverse.
assets are available (e. U. S. Treasury securities),
investors can be induced to hold riskier assets only if they
are offered a premium, or additional return, above the rate
of return on a risk-free asset.Because all assets compete
wi th each other for investor funds, riskier assets must
yield a higher expected rate of return than safer assets to
induce investors to invest and hold them.
Given this risk-return tradeoff , the required rate of
return (k) from an asset (i) can be generally expressed as:
ki = Rf + RPi
where:Rf = Risk-free rate of return; and
RPi = 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.
AVERA , DI
Idaho Power Company
Is there evidence that the risk-return tradeoff
principle actually operates in the capital markets?
The risk-return tradeoff can be readilyYes.
documented in segments of the capital markets where required
rates of return can be directly inferred from market data
and where generally accepted measures of risk exist.Bond
yields, for example, reflect investors' expected rates of
return , and bond ratings measure the risk of individual bond
issues.The observed yields on government securities, which
are considered free of default risk, and bonds of various
rating categories demonstrate that the risk-return tradeoff
does, in fact, exist in the capital markets.
Does the risk-return tradeoff observed with fixed
income securities extend to common stocks and other assets?
It is generally accepted that the risk-return
tradeoff evidenced with long-term debt extends to all
assets.Documenting the risk-return tradeoff for assets
other than fixed income securities, however , is complicated
by two factors.First, there is no standard measure of risk
applicable to all assets.Second, for most assets -
including common stock - required rates of return cannot be
directly observed.Yet there is every reason to believe
that investors exhibit risk aversion in deciding whether or
not to hold common stocks and other assets, just as when
choosing among fixed-income securities.
AVERA , DI
Idaho Power Company
Is this risk-return tradeoff limited to
differences between firms?
The risk-return tradeoff principle appliesNo.
not only to investments in different firms, but also to
different securities issued by the same firm.The
securities issued by a utility vary considerably in risk
because they have different characteristics and priorities.
Long-term debt secured by a mortgage on property is senior
among all capital in its claim on a utility's net revenues
and is, therefore, the least risky.Following bonds are
other debt instruments also holding contractual claims on
the utility s net revenues, such as subordinated debentures.
The last investors in line are common shareholders.They
receive only the net revenues, if any, remaining after all
other claimants 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, must be
considerably higher than the yield offered by the utility
senior, long-term debt.
What does the above discussion imply with respect
to estimating the cost of equity for a utility?
Al though the cost of equity cannot be observed
directly, it is a function of the returns available from
other investment alternatives and the risks to which the
equi ty capital is exposed.Because it is unobservable , the
cost of equi ty for a particular utility must be estimated by
AVERA , DI
Idaho Power Company
analyzing information about capital market conditions
generally assessing the relative risks of the company
specifically, and employing various quantitative methods
that focus on investors' 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. I used both the DCF and CAPM methods to
estimate the cost of equity, as well as referencing
comparable earned rates of return expected for utilities.
In my opinion , comparing estimates produced by one method
with those produced by other approaches ensures that
estimates of the cost of equity pass fundamental tests of
reasonableness and economic logic. , In addition, I applied
the DCF and CAPM to alternative proxy groups of comparable
risk firms.
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 Umethods to evaluate a
common equity rate of return are imperfect predictors H and
AVERA, DI
Idaho Power Company
emphasized U 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 Anal ses
How are DCF models used to estimate the cost of
equi ty?
DCF models attempt to replicate the market
valuation process that sets the price investors are willing
to pay for a share of a company's stock.The model rests on
the assumption that investors evaluate the risks and
expected rates of return from all securities in the capital
markets.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 uback-intoH the discount
rate, or cost of equity, that investors implicitly used in
bidding the stock to that price.
43 Order No. 29505 at 38 (emphasis added).
AVERA , DI
Idaho Power Company
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. e ., future dividends and stock price) that
will be received while holding the stock, discounted at
investors' required rate of return.Thus, 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 from the stock.Notationally, the general form
of the DCF model is as follows:
j D2 D
+...+
(1 + kj (1 + )2 (1 + (1 +
where:Po = Current price per share
Pt = Expected future price per share in period
Dt = Expected dividend per share in period t
ke = Cost of equity.
AVERA , DI
Idaho Power Company
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:
0 -
where:Current price per share
Expected dividend per share in coming
Po =
Dl =
year
ke = Cost of equity;
g = Investors ' long- term growth expectations.
The cost of equity (Ke ) can be isolated by rearranging
terms:
k =---L+
This constant growth form of the DCF model recognizes
that the rate of return to stockholders consists of two
parts: 1) dividend yield (D1 !PO ), 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.
44 The constant growth DCF model is dependent on a number of strict
assumptions, which in practice are never strictly met. 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; aconstant price-earnings ratio; a constant discount rate (1. e.
changes in risk or interest rate levels and a flat yield curve); and all
of the above extend to infinity,
AVERA, DI
Idaho Power Company
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 activities.In order to reflect the risks
and prospects associated with Idaho Power s electric utility
operations, my utility proxy group was composed of those
dividend-paying companies included by The Value Line
Investment Survey (UValue Line ) in its Electric Utilities
Industry groups with:(1) S&P corporate credit ratings
between UBBB-H and uBBB+(2) a Value Line Safety Rank of
2H or and (3) a Value Line Financial Strength Rating
of BH to B++I excluded three firms that otherwise
would have been in the proxy group, but are not appropriate
for inclusion because they either do not pay common
dividends (El Paso Electric Company) or are in the process
of being acquired (Energy East Corporation and Puget Energy,
Inc.
) .
These cri teria resul ted in a proxy group composed of
27 comparable risk utilities.I refer to this group as the
Utili ty Proxy Group.
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.
AVERA , Dr
Idaho Power Company
Because the rating agencies' evaluation includes virtually
all of the factors normally considered important in
assessing a firm s relative credit standing, corporate
credi t ratings provide a broad measure of overall investment
risk that is readily available to investors.widely cited
in the investment community and referenced by investors as
an objective 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.Val ue Line
primary risk indicator is its Safety Rank , which ranges from
IH (Safest) to 5H (Riskiest).This overall risk measure
is intended to capture the total risk of a stock, and
incorporates elements of stock price stability and financial
strength.Given that Value Line is perhaps the most widely
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
AVERA, Dr
Idaho Power Company
Ratings range from UA++H (weakest)(strongest) down to
in nine steps.
As discussed earlier , Idaho Power is rated UBBBH by
S&P , which is identical to the average for the firms in the
Utility Proxy Group.Meanwhile , Value Line has assigned
IDACORP a Safety Rank of 3H and a Financial Strength Rating
of ". 45 Based on these criteria , which reflect
obj ective, 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.
What steps are required to apply the DCF model?
The first step in implementing the constant growth
DCF model is to determine the expected dividend yield
(Dl /PO ) 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 r long-term growth expectations
(g)
for the firm.
The final step is to sum the firm 1 s dividend yield and
estimated growth rate to arrive at an estimate of its cost
of equi ty
45 As noted earlier , Idaho Power is a wholly-owned subsidiary of
IDACORP. Because Value Line's risk indicators apply to publicly traded
common stock, I referenced published values for IDACORP in selecting arisk-comparable proxy group.
AVERA, DI
Idaho Power Company
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 Dl'This annual dividend was then divided
by the corresponding stock price tor 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 No.1 7 .
shown there , dividend yields for the firms in the Utility
Proxy Group ranged from 1. 2 percent to 6. 1 percent.
What is the next step in applying the constant
growth DCF model?
The next step is to evaluate long-term growth
expectations, or for the firm in question.In constant
growth DCF theory, earnings, dividends, book value, and
market price are all 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.A wide variety of techniques can be used to derive
growth rates, but the only gH that matters in applying the
DCF model is the value that investors expect.
AVERA , DI
Idaho Power Company
Are historical growth rates likely to be
representative of investors ' expectations for utilities?
If past trends in earnings , dividends, andNo.
book value are to be representative of investors
expectations for the future, then the historical conditions
giving rise to these growth rates should be expected to
continue.That is clearly not the case for utilities, where
structural and industry changes have led to declining
dividends, earnings pressure , and, in many cases,
significant write-offs.While these conditions serve to
depress historical growth measures, they are not
representative of long-term expectations for the utility
indus try.Moreover, to the extent historical trends for
utilities are meaningful, they are also captured in
proj ected growth rates, since securities analysts also
routinely examine and assess the impact and continued
relevance (if any) of historical trends.
What are investors most likely to consider in
developing their long-term growth expectations?
While the DCF model is technically concerned with
growth in dividend cash flows 1 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 altered their
AVERA, DI
Idaho Power Company
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 against
heightened uncertainties.
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
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
Reported Earnings published by the Association for
Investment Management and Research:
(EJ arnings, presumably, are the basis for the
investment benefits that we all seek. UHealthy
earnings equal healthy investment benefitsH 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.
46 For example , the payout ratio for electric utilities fell from
approximately 80 percent historically to on the order of 60 percent.
The Value Line Investment Survey (Sep. 15 , 1995 at 161 , Dec. 28, 2007 at
695) .
47 Association for Investment Management and Research, "Finding Reality
in Reported Earnings; An Overview , p. 1 (Dec. 4, 1996).
AVERA , DI
Idaho Power Company
Value Line s near-term projections and its Timeliness
Rank 48 which is the principal investment rating assigned to
each individual stock, are also based primarily on various
quanti tati ve 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 focus on
growth in earnings indicates that the investment community
regards this as a superior indicator of future long-term
growth.Indeed, UA 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. 50
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.
48 The Timeliness Rank presents Value Line's assessment of relative
price performance during the next six to twelve months based on a fivepoint scale.49 The Value Line Investment Survey, Subscriber s Guide, p. 53.
50 Block, Stanley B., "A Study of Financial Analysts: Practice and
Theory Financial Analysts Journal (July/August 1999).
51 Id. at 88.
AVERA, DI
Idaho Power Company
More recently, the Financial Analysts Journal reported the
results of a study of the relationship between valuations
based on alternative multiples and actual market prices,
which concluded , u rn all cases studied, earnings dominated
operating cash flows and dividends.
What are security analysts currently proj ecting in
the way of growth for the firms in the Utility Proxy Group?
The earnings growth proj ections for each of the
firms in the Utility Proxy Group reported by Value Line,
Thomson Financial (U ThomsonH ), 53 and Zacks Investment
Research (U Zacks ) are displayed on Exhibit No. 17.
How else are investors ' expectations of future
long-term growth prospects often estimated for use in the
constant growth DCF model?
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 within a firm.The
sustainable growth rate is calculated by the following
formula:
S2 Liu, Jing, Nissim, Doron, & Thomas, Jacob, "Is Cash Flow King in
Valuations? , H Financial Analysts Journal Vol. 63, No.2 (March/April
2007) at 56.
S3 Thomson Financial , an arm of The Thomson Corporation, compiles and
publishes consensus securities analyst growth rates under the IBES and
First Call brands.
AVERA, Dr
Idaho Power Company
:=;
br + sv
where::=; investors ' expected long-termgrowth rate;
b = expected retention ratio;
r = expected earned return on
equi ty ;
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 u H term?
Under DCF theory, the U svH 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 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 shareholders.This increase to the book value of
existing shareholders leads to higher expected earnings and
dividends, with the U H factor incorporating this
addi tional growth component.
What growth rate does the earnings retention
method suggest for the utility Proxy Group?
The sustainable, Ubr+svH growth rates for each
firm in the Utility Proxy Group are summarized on Exhibit
No. 17, with the underlying details being presented on
Exhibit No. 18.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
AVERA, Dr
Idaho Power Company
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 (8) 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 proj ected
market-to-book ratio.
What cost of equity estimates were implied for the
Utility Proxy Group using the DCF model?
After combining the dividend yields and respective
growth projections for each utility, the resulting cost of
equi ty estimates are shown on Exhibit No.1 7.
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
AVERA , DI
Idaho Power Company
considerably higher than the yield offered by senior , long-
term debt.Consistent with this principle , the DCF range
for the Utility Proxy Group must be adjusted to eliminate
cost of equity estimates that fail fundamental tests of
economic logic.
Have similar tests been applied by regulators?
The FERC has noted that adjustments areYes.
justified where applications of the DCF approach produce
illogical results.FERC evaluates DCF results against
observable yields on long- term public utility debt and has
recognized that it is appropriate to eliminate cost of
equity estimates that do not sufficiently exceed this
threshold.In a 2000 opinion establishing its current
precedent for determining ROEs for electric utili ties, for
example, FERC concluded:
An adjustment to this data is appropriate in the
case of PG&E's low-end return of 8.42%, which is
comparable to the average Moody s UAH grade public
utility bond yield of 8.06% for October 1999.
Because investors cannot be expected to purchase
stock if debt, which has less risk than stock
yields essentially the same return , this low-end
return cannot be considered reliable in thiscase.
similarly, in its October 2006 decision in Kern River Gas
Transmission Company, FERC noted that:
(T) he 7.31 and 7.32% costs of equity for EI Paso
and Williams found by the ALJ are only 110 and 122
54 Southern California Edison Company, 92 FERC ~ 61,070 (2000) at p. 22.
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Idaho Power Company
basis points above that average yield for publicutili ty debt.
FERC upheld the opinion of Staff and the Administrative Law
Judge that cost of equity estimates for these two proxy
group companies U were too low to be credible.
What does this test of logic imply with respect to
the DCF results for the Utility Proxy Group?
The average credit rating associated with the
firms in the Utility Proxy group is U BBBH Corporate credit
ratings of u BBB-, uBBBH , and UBBB+H are all considered part
of the triple-B rating category, with Moody s monthly yields
on triple-B bonds averaging approximately 6.9 percent in May
2008.As highlighted on Exhibit No. 17, eight of the
individual equity estimates for the firms in the Utility
Proxy Group fell below 8 percent. In light of the risk-
return tradeof f 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
utili ty ' s securities.AS a result, these values provide
Ii ttle guidance as to the returns investors require from the
common stock of an electric utility.
55 Kern River Gas Transmission Company, Opinion No. 486, 117 FERC ~
077 at P 140 & n. 227 (2006).
56 Id.
5? Moody s Investors Service, www.CreditTrends.com.58 As highlighted on Exhibit 2, these DCF estimates ranged from 6.percent to 7.8 percent.
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Idaho Power Company
Do you also recommend excluding cost of equity
estimates at the high end of the range of DCF results?
The upper end of the cost of equity rangeYes.
produced by the DCF analysis presented in Exhibit No. 17 was
set by a cost of equity estimate of 23.0 percent for
Allegheny Energy, with eleven other DCF estimates ranging
from 17.1 percent to 22.7 percent.Compared with the
balance of the remaining estimates, these results are
extreme outliers and should also be excluded in evaluating
the results of the DCF model for the Utility Proxy Group.
This is also consistent with the threshold adopted by FERC,
which established that a 17.7 percent DCF estimate for was
an extreme outlierH and should be disregarded.
What cost of equity is implied by your DCF results
for the Utility Proxy Group?
As shown on Exhibit No.1 7 and summarized in Table
1, 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 1
DCF RESULTS - UTILITY PROXY GROUP
Growth Rate
Value Line
IBES
Zacks
br+sv
Average Cost of Equity
11.
11.
11.
59 ISO New England, Inc., 109 FERC ~ 61 147 at P 205 (2004).
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Idaho Power Company
What did you conclude based on the results of the
DCF analyses for the Utility Proxy Group?
Taken together , and considering the relative
strengths and weaknesses associated with the alternative
growth measures, I concluded that the constant growth DCF
results for the Electric Utility Proxy Group implied a cost
of equity of 11.0 percent.
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 acti vi ty or
degree of regulation.Utilities must compete for capital,
not just against firms in their own industry, but with other
investment opportunities of comparable risk.with
regulation taking the place of competi ti ve market forces
required returns for utili ties 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.I refer to this group
as the UNon-utility Proxy GroupH
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Idaho Power Company
What criteria did you apply to develop the Non-
utili ty Proxy Group?
To reflect investors' risk perceptions in
developing the Non-Utility Proxy Group, my assessment of
comparable risk relied on three objective benchmarks for the
risks associated with common stocks - Value Line's Safety
Rank, Financial Strength Rating, and beta.Given that Value
Line is perhaps the most widely available source of
investment advisory information, its Safety Rank and
Financial Strength Rating provide useful guidance regarding
the risk perceptions of investors.These obj ecti ve,
published indicators incorporate consideration of a broad
spectrum of risks, including financial and business
position, relative size, and exposure to company-specific
factors.
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 3) have a Financial
Strength Rating of UAH or above; and 4) have beta values of
90 or less.Consistent with the development of my
Utility Proxy Group, I also eliminated firms with below-
investment grade credit ratings.Table 2 compares the Non-
60 This threshold corresponds to the average betas for the Electric
Utility P~oxy G~oup of 0.88.
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Idaho Power Company
Utility Proxy Group with the Utility Proxy Group and Idaho
Power across four key indicators of investment risk:
TABLE 2
COMPARISON OF RISK INDICATORS
S&P Value Line
Credi t Safety Financial
Rating Rank Strength Beta
Non-Utility Group
Utility proxy Group BBB
Idaho Power BBB
Considered along with S&P's corporate credit ratings, a
comparison of these Value Line indicators suggests that the
investment risks associated with the Non-utility Proxy Group
are below those of the group of utili ties and Idaho Power.
What were the results of your DCF analysis for the
Non-utility proxy Group?
As shown on Exhibit No. 19, I applied the DCF
model to the Non-Utility Proxy Group in exactly the same
manner described earlier for the Utility Proxy Group.
summarized in Table 3, below, after eliminating illogical
low- and high-end values, application of the constant growth
DCF model resulted in the following cost of equity
estimates:
61 Because Idaho Power has no publicly traded common stock, the Value
Line risk measures shown reflect those published for its parent
IDACORP. As explained earlier, in my opinion these risk measures are
indicative of the risk of Idaho Power.
62 Exhibit 5 contains the details underlying the calculation of the
br+sv growth rates for the Non-Utility Proxy Group.
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Idaho Power Company
TABLE 3
DCF RESULTS - NON-UTILITY PROXY GROUP
Growth Rate Average CDS t of Equi
Value Line
IBES
Zacks
br+sv
12.
12.
12.
12.
What did you conclude based on the results of the
DCF analyses for the Non-Utility Proxy Group?
Taken together, I concluded that the constant
growth DCF results for the Non-Utility Proxy Group implied a
cost of equity of 12.6 percent.As discussed earlier,
reference to the Non-Utility Proxy Group is consistent with
established regulatory principles and required returns for
utilities should be in line with those of non-utility firms
of comparable risk operating under the constraints of free
competition.
Do you believe the DCF model should be relied on
exclusively to evaluate a reasonable ROE for the proxy
groups or Idaho Power?
Because the cost of equity is unobservable,No.
no 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 widely recognized that no single method can be regarded
as definitive.For example, a publication of the society of
Utility and Financial Analysts (formerly the National
Society of Rate of Return Analysts), concluded that:
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Idaho Power Company
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 of reality. 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
equi ty . "
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
both 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.
Because investors are assumed to be fully diversified , the
63 Parcell, David C., "The Cost of Capital - A Practitioner s Guide
Society of Utility and Regulatory Financial Analysts (1997) at Part 2
p. 4.
64 See e.g., Bruner , R., Eades , K., 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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Idaho Power Company
20
relevant risk of an individual asset (e. g., common stock) is
its volatility relative to the market as a whole, with beta
reflecting the tendency of a stock's price to follow changes
in the market.The CAPM is mathematically expressed as:
Rj = Rf + ~ j (Rm - Rf)
where:Rj = required rate of return for stock j Rf = risk-free rate;
Rm = expected return on the market portfolio;
and,
~j = beta, or systematic risk , for stock
Like the DCF model, the CAPM is an ex-ante, or forward-
looking model based on expectations of the future.As a
resul t, in order to produce a meaningful estimate of
investors ' required rate of return, the CAPM should be
applied using estimates that reflect the expectations of
actual investors in the market, not with backward-looking,
historical data.
How did you apply the CAPM to estimate the cost of
equi ty?
Application of the CAPM to the utility proxy group
based on a forward-looking estimate for investors I required
rate of return from common stocks is presented on Exhibit
No. 21.In order to capture the expectations of today
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 Composite Index
S&P 500"
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Idaho Power Company
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 350 individual firms, current estimates
imply an average growth rate over the next five years of
10.6 percent.Combining this average growth rate with a
dividend yield of 2.4 percent results in a current cost of
equity estimate for the market as a whole of approximately
12 . 9 percent.Subtracting a 4.6 percent risk-free rate
based on the average yield on 20 -year Treasury bonds for May
2008 produced a market equity risk premium of 8.3 percent.
As shown on Exhibit No. 21, multiplying this risk premium by
the average Value Line beta of 0.88 for the Utility Proxy
Group, and then adding the resul ting 7.3 percent risk
premium to the average long-term Treasury bond yield
indicated an ROE of approximately 11.9 percent.
What cost of equity was indicated for the Non-
utility Proxy Group based on this forward-looking
application of the CAPM?
As shown on Exhibit No. 22 , applying the forward-
looking CAPM approach to the firms in the Non-utility Proxy
Group implied a cost of equity estimate of 11.2 percent.
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Idaho Power Company
What other CAPM analyses did you conduct to
estimate the cost of equity?
In addition, because it is frequently referenced
in regulatory proceedings , I also applied the CAPM using
risk premiums based on historical realized rates of return
published by Ibbotson Associates (now Morningstar) .
Reference to historical data represents one way to apply the
CAPM , but these realized rates of return reflect , at best,
an indirect estimate of investors' current requirements.
a result, forward-looking applications of the CAPM that look
directly at investors ' expectations in the capital 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?
Application firms thetheCAPMthe
utility and non-utility proxy groups using risk premiums
based on historical realized rates of return published by
Ibbotson Associates is presented on Exhibits Nos. 23 and 24
respectively.As shown there, this historical CAPM approach
implied a cost of equity of 10.8 percent for the Utility
Proxy Group and 10. 2 percent f or the firms in the Non-
Utili ty Proxy Group.
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Idaho Power Company
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
equi ty us ing 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
wi th the economic underpinnings for a fair rate of return
established by the United States Supreme Court and has been
tradi tionally 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
utili ties based on this approach?
With respect to expectations for electric
utilities generally, Value Line reports that its analysts
anticipate an average rate of return on common equity for
the electric utility industry of 11.5 percent in 2008 and
2009 and 13.0 percent over its three-to-five year forecast
horizon. Meanwhile Value Line expects that natural gas
65 The Value Line Investment Survey at 150 (May 30, 2008).
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Idaho Power Company
distribution utilities will earn an average rate of return
on common equity of 11.5 percent in 2008 and 12.0 percent in
2009 , and 12.5 percent over the years 2011-2013.
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 Exhibit
No. 25.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 adjustment factor developed in Exhibit No.
18.As shown on Exhibit No. 25 , after eliminating extreme
outliers, Value Line s projections suggested an average ROE
of 11. 1 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 at least 11.1 percent.
E. Summary of Resul
Please summarize the results of your quantitative
analyses.
The cost of equity estimates implied by my
quantitative analyses are summarized in Table 4 below:
66 The Value Line Investment Survey at 446 (Mar. 14, 2008 J .
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Idaho Power Company
TABLE 4
SUMMARY OF QUANTITATIVE RESULTS
Method
DCF
CAPM
Forward - Looking
Historical
Comparable Earnings
Utili ty
11.
Non-Utili ty
12.
11.
10.
11.
10.
11.
F. Flotation Costs
What other considerations are relevant in setting
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 U floatingH 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 H 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 onNo.
the books of the utility, amortized over the life of the
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Idaho Power Company
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.Alternatively, 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 sale of common stock used to pay flotation costs is
available to invest in plant and equipment , nor are flotation
costs capitalized 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 1 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
equi ty being the most logical mechanism.
What is the magnitude of the adj ustment to the
Ubare bones H 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
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Idaho Power Company
yield.Based on a review of the finance literature,
Regulatory Finance: Utilities ' Cost of Capital concluded:
The flotation cost allowance requires an estimatedadj ustment to the return on equity of
approximately 5% to 10%, depending on the size and
risk of the issue.
Alternatively, 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 percent. Applying these expense percentages to a
representati ve dividend yield for a utility of 3.9 percent
implies a flotation cost adjustment on the order of 14 to 39
basis points.
Has the IPUC Staff previously considered flotation
costs in establishing a fair ROE for Idaho Power?
For example, in Case No. IPC-07-, IPUCYes.
Staff witness Terri Carlock noted that she had adjusted her
DCF analysis to incorporate an allowance for flotation
costS.While issuance costs are a legitimate
consideration in setting the return on equity for a utility,
67 Roger A. Morin, Regula tory Finance: Utili ties t Cost of Capi tal 1994
at 166.
6B Applica tion of Yankee Gas Services Company for a Ra te Increase, DPUCDocket No. 04-06-01, Direct .Testimony of George J. Eckenroth (Jul. 2
2004) at Exhibit GJE-l1.1. Updating the results presented by Mr.
Eckenroth through April 2005 also resulted in an average flotation cost
percentage of 3. 6 percent.69 Case No. IPC-E-07-8, Direct Testimony of Terri Carlock at 10 (Dec.
10, 2007).
AVERA, DI
Idaho Power Company
a specific adjustment for flotation costs was not included
in defining my recommended ROE range.
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.While Idaho Power
remains committed to deliver reliable service, a utility
ability to fulfill its mandate can be compromised if it
lacks the necessary financial wherewithal.Coupled with the
ongoing 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
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Idaho Power Company
in order to maintain the high level of service that
customers have come to expect.
As documented earlier , the maj or rating agencies have
warned of exposure to uncertainties associated with
political and regulatory developments, especially in view of
the potential for high and volatile commodity costs in
competitive energy markets.Investors understand 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 capital
market condi tions .
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, supportive regulation remains crucial to Idaho
Power s access to capital.Investors recognize that
regulation has its own risks, and that cons tructi ve
regulation is a key ingredient in supporting utility credit
ratings and financial integrity particularly during times
AVERA, DI
Idaho Power Company
9 .
of adverse conditions.The politicalS&P concluded,
atmosphere will remain highly charged, fostering
uncertainty. ,,Moody's echoed these sentiments, noting
that U regulatory relationships are becoming more importantH
in an era of broadly rising costs and uncertainties, 71 and
concluding:
(TJ here are concerns arising from the sector'
sizeable infrastructure investment plans in the
face of an environment of steadily rising
operating costs. Combined , these costs and
investments can create a continuous need for
regulatory rate relief , which in turn can increase
the likelihood for political and/or regulatoryintervention.
The rapid rise in wholesale energy prices has
heightened investor concerns over the implications for
regulatory uncertainty.The Wall Street Journal reported in
May 2008 that escalating fuel costs were leading to soaring
utility bills across the nation, raising the specter that
social pressures could impact the outcome of regulatory
proceedings.S&P noted that, while timely cost recovery
was paramount to maintaining credit quality in the utility
sector, an uenvironment of rising customer tariffs, coupled
70 Standard & Poor s Corporation
, "
Top Ten Credit Issues Facing U.
utilities, H RatingsDirect (Jan. 29, 2007).
71 Moody s Investors Service, "Regulatory Pressures Increase for U. S.Electric Utilities,Special Comment (March 2007) .
72 Moody's Investors Service, "Storm Clouds Gathering on the Horizon for
the North American Electric Utility Sector,Special Comment (Aug.
2007) .73 Smith , Rebecca
, "
Expect a Jolt When Opening The Electric Bill," Wall
Street Journal at Dl (May 7, 2008).
AVERA, DI .
Idaho Power Company
with a sluggish economy, portend a difficult regulatory
environment in coming years.
What danger does an inadequate rate of return pose
to Idaho Power?
Given the pressure on Idaho Power s financial
metrics and its declining credit standing, which is
exemplified by the negative outlook assigned by Moody s and
Fitch, the perception of a lack of regulatory support would
almost certainly lead to further downgrades.As Moody
concluded
, "
A key consideration in order for (Idaho Power)
to stabilize its rating outlook and maintain its Baal senior
unsecured rating will be the extent to which the IPUC is
supportive in any future regulatory filings.
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.Fi tch noted that ' (m) eaningful price
increases will be required to recover planned capital
expenditures to meet infrastructure and growth
requirements,76 while S&P cited U (r) egulatory challenges in
meeting rising costs and a large capital expenditure
74 Standard & Poor's Corporation, "Top 10 U. S. Electric Utility Credit
Issues For 2008 And Beyond,RatingsDirect (Jan. 28, 2008).
75 Moody s Investors Service, "Credit Opinion: Idaho Power Company,
Global Credit Research (June 4 , 2008).
76 Fitch Ratings , Ltd., "Idaho Power Company,Global Power U.S. and
Canada Credit Analysis (Apr. 10, 2008).
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Idaho Power Company
programH as a key risk exposure. While providing the
infrastructure necessary to meet the energy needs of
customers is certainly desirable, it imposes additional
financial responsibilities on Idaho Power.To continue to
meet these challenges successfully and economically, it is
crucial that Idaho Power receive adequate support to
buttress 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 Bluefield 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.
77 Standard & Poor's Corporation, "Idaho Power Co.RatingsDirect (Feb.
, 2008).
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Idaho Power Company
B. Capi tal 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 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 49 percent
in this filing.
What was the average capitalization maintained by
the utility Proxy Group?
As shown on Exhibit No. 26, for the firms in the
utility Proxy Group, common equity ratios at December 31,
AVERA , DI
Idaho Power Company
2007 ranged from 13.8 percent to 57.9 percent and averaged
43.3 percent.Value Line expects that the average common
equi ty ratio for the proxy group of electric utili ties will
average 47.6 percent over the next three to five years, with
the individual common equity ratios ranging from 29.
percent to 59.5 percent.
What implication do the uncertainties facing the
utili ty industry have for the capital structures maintained
by electric utili ties?
As discussed earlier , utili ties are facing energy
market volatility, rising cost. structures, the need to
finance significant capital investment plans , uncertainties
over accommodating future environmental mandates, and
ongoing regulatory risks.Coupled with a decline in credit
quali ty, these considerations warrant a stronger balance
sheet to deal with an increasingly uncertain and competitive
market.A more conservative financial profile, in the form
of a higher common equity ratio, is consistent with
increasing uncertainties 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.
Moody s has warned investors of the risks associated
with debt leverage and fixed obligations and advised
utili ties not to squander the opportunity to strengthen the
AVERA, Dr
Idaho Power Company
balance sheet as a buffer against future uncertainties.
Moody s recently noted that, absent a stronger equity
cushion , utilities would be faced with lower credit ratings
in the face of rising business and operating risks:
There are significant negative trends developing
over the longer-term horizon. This developing
negative concern primarily relates to our view
that the sector s overall business and operating
risks are rising - at an increasingly fast pace -
but that the overall financial profile remainsrelatively steady. A rising risk profile
accompanied by a relatively stable balance sheet
profile would ultimately result in credit qualitydeterioration.
This is especially the case for electric utilities. that are
exposed to potential significant fluctuations in power
supply costs, such as Idaho Power.
What other factors do investors consider in their
assessment of a company s capital structure?
Because power purchase agreements . (u PPAs ) and
other contractual commitments typically obligate the utility
to make specified minimum payments akin to those associated
with traditional debt financing, investors consider a
portion of these obligations as debt in evaluating total
financial risks.Similarly, when a utility enters into a
mandated PPA with a Qualifying Facility under PURPA , the
78 Moody's Investors Service, ~Storm Clouds Gathering on the Horizon for
the North American Electric Utility Sector,Special Comment (Aug.
2007) .
79 Moody s Investors Service, ~U. S. Electric Utility Sector,Industry
Outlook (Jan. 2008).
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Idaho Power Company
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.
Reflecting the longstanding perception of investors
that the fixed obligations associated with off-balance sheet
obligations diminish a utility s creditworthiness and
financial flexibility, the implications of these commitments
have been repeatedly cited by maj or bond rating agencies in
connection with assessments of utility financial risks.For
example, in explaining its evaluation of the credit
implications of off-balance sheet obligations, S&P affirmed
its position that such agreements give rise to Udebt
equivalents H and that the increased financial risk must be
considered in evaluating a utility's credit risks.
What did you conclude with respect to the
Company s capital structure?
Based on my evaluation , I concluded that Idaho
Power's requested capital structure represents a reasonable
mix of capital sources from which to calculate the Company
overall rate of return.Idaho Power s requested common
equity ratio of approximately 49 percent is consistent with
the range of capitalizations implied for the Utility Proxy
80 Standard & Poor's Corporation
, "
Standard & Poor s Methodology For
Imputing Debt For U.S. Utilities' Power Purchase Agreements,
RatingsDirect (May 7 , 2007)-
AVERA, DI
Idaho Power Company
Group based on year-end 2007 data and Value Line s Line
near-term proj ections.
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
under reasonable terms so that it can meet the service
requirements of its customers.The need for access becomes
even more important when the company has capi tal
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
flexibili ty.Idaho Power s capital structure reflects the
Company s ongoing efforts to support its financial integrity
and maintain access to capital on reasonable terms.
indicated earlier , the challenges posed by significant
capi tal requirements, volatile energy prices, and reliance
on hydro generation and wholesale markets magnifies the
importance of preserving financial flexibility.The rating
agencies have observed that Idaho Power s financial metrics
have been under pressure, and utili ties with higher leverage
may be foreclosed from additional borrowing, especially
AVERA, DI
Idaho Power Company
during times of stress.In this regard, Idaho Power'
equity ratio reflects the challenges posed by its resource
mix , as well as the burden of significant capital spending
requirements.
C. Return on Equi ty Recommendation
Please summarize the results of your analyses.
Reflecting the fact that investors' required ROE
is unobservable and no single method should be viewed in
isolation, I considered the results of both the DCF and CAPM
methods and evaluated comparable earned rates of return
expected for utili ties.In order to reflect the risks and
prospects associated with Idaho Power s jurisdictional
electric utility operations, my analyses focused on a proxy
group of twenty- seven comparable risk electric utili ties.
Consistent with the fact that utili ties must compete for
capital with firms outside their own industry, I also
referenced a proxy group of comparable risk companies in the
non-utility sectors of the economy.
My application of the constant growth DCF model
considered three alternative growth measures based on
proj ected earnings growth , as well as the sustainable,
Ubr+svH growth rate for each firm in the respective proxy
groups.In addition , I evaluated the reasonableness of the
resulting DCF estimates and eliminated low- and high-end
outliers that failed to meet threshold tests of economic
logic.My CAPM analyses focused on forward-looking data
AVERA , DI
Idaho Power Company
that best reflects the underlying assumptions of this
approach, as well as considering historical risk premiums.
The results of my alternative analyses were summarized
earlier in Table 4, which is reproduced below:
TABLE 4
SUMMARY OF QUANTITATIVE RESULTS
Method
DCF
CAPM
Forward - Looking
Historical
Comparable Earnings
Utili ty
11.
Non-Utili ty
12.
11.11. 2%
10.10.
11.1%
Based on my assessment of the relative strengths and
weaknesses inherent in each method, and conservatively
giving less emphasis to the upper-most end of the range of
results, I concluded that the cost of equity indicated by my
analyses is in the 10.8 percent to 11.8 percent range.
What then is your conclusion as to a fair ROE
range for Idaho Power?
In evaluating the rate of return for Idaho Power
it is important to consider investors r 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.
AVERA, DI
Idaho Power Company
As explained above, I concluded that the fair rate of
return on equity range was 10.8 percent to 11.8 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 and reasonable ROE range for Idaho Power.
While this u bare-bonesH cost of equity range does not
consider issuance costs, a flotation cost adjustment is
properly considered in establishing an allowed ROE for Idaho
Power from within this range.
Does this conclude your pre-filed direct
testimony?
Yes.
AVERA, DI
Idaho Power Company