20081203Avera Rebuttal.pdf

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BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF IDAHO POWER COMPANY FOR
AUTHORITY TO INCREASE ITS RATES
AN CHAGES FOR ELECTRIC SERVICE.
CASE NO. IPC-E-08-10
IDAHO POWER COMPANY
DIRECT REBUTTAL TESTIMONY
OF
WILLIAM E. AVERA
DIRECT REBUTTAL TESTIMONY OF WILLIAM E. AVERA
TABLE OF CONTENTS
I . INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 1
II. THRESHOLD ISSUE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 3
III. CHAGES IN CAITAL ~T CONDITIONS................... 6
IV . TERRI CAOCK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 19
V . MATTHEW I. KA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 40
VI . DENNIS E. PESEAU...................................... 67
1 I. INTRODUCTION
2 Q.Please state your name and business address.
3 A.William E. Avera, 3907 Red River, Austin,
4 Texas, 78751.
5 Q.Are you the same William E. Avera that
6 previously submitted direct testimony in this case?
7 A.Yes, I am.
8 Q.What is the purpose of your rebuttal?
9 A.The purpose of my testimony is to respond to
10 the direct testimony of Terri Carlock, submitted on behalf
11 of the Staff of the Idaho Public Utilities Commission
12 (UIPUC"). In addition, I will also rebut the
13 recommendations contained in the direct testimony of Matthew
14 I. Kahal, on behalf of the United States Department of
15 Energy, and Dennis E. Peseau, on behalf of Micron
16 Technology, Inc., concerning the return on equity (UROE")
17 for the jurisdictional utility operations of Idaho Power
18 Company (UIdaho Power" or Uthe Company").
19 Q.Please summarize the conclusions of your
20 testimony.
21 A.With respect to the testimony of Ms. Carlock,
22 I concluded that her recommendations were understated
23 because of her failure to consider the implications of
24 current capital market conditions, as well as the fact that
25 her discounted cash flow (UDCF") analysis focused primarily
AVERA, DI REB 1
Idaho Power Company
1 on a single firm and her evaluation ignored the results of
2 other accepted methods of estimating the cost of equity.
3 Additionally, Ms. Carlock's assessment of relative risks
4 focused exclusively on Idaho Power's relatively low rates,
5 while ignoring the substantial uncertainties and higher
6 investment risks that investors must bear to provide the
7 benef its of lower electricity costs to customers. The
8 dramatic increase in the cost of long-term capital, the
9 upward shift in investors' risk perceptions, and the results
10 of the Capital Asset Pricing Model (UCAPM") all support a
11 rate of return above the upper end of Ms. Carlock's
12 recommended ROE range.
13 Similarly, Mr. Kahal' s recommendations are biased
14 downward because he failed to reflect current capital market
15 conditions or exclude illogical estimates in evaluating the
16 results of his analyses. Similarly, there is no basis for
17 Mr. Kahal's criticisms of my proxy group and his alternative
18 application of the CAPM is flawed and should be rej ected.
19 Meanwhile, Dr. Peseau mischaracterized the implications of
20 bond yield trends and - like Ms. Carlock and Mr. Kahal -
21 ignored the higher risks now associated with Idaho Power.
22 Considering the adverse conditions in today's capital
23 markets, the ROE recommendations of Ms. Carlock, Mr. Kahal,
24 and Dr. Peseau portend further deterioration in Idaho
25 Power's finances if adopted.
AVERA, DI REB 2
Idaho Power Company
1 II. THRESHOLD ISSUE
2 Q.Dr. Avera, is it possible to distill the many
3 complexities associated with estimating investors' required
4 rate of return into a single, threshold issue?
5 A.Yes. While the details underlying a
6 determination of the cost of equity are all significant to a
7 rate of return analyst, there is one fundamental requirement
8 that any ROE recommendation must satisfy before it can be
9 considered reasonable. Competition for capital is intense,
10 and utilities such as Idaho Power must be granted the
11 opportunity to earn an ROE comparable to contemporaneous
12 returns available from alternative investments if they are
13 to maintain their financial flexibility and ability to
14 attract capital.
15 Rather than becoming bogged down in lengthy,
16 academic arguments over the merits of one quantitative
17 approach versus another, the Commission can make a
18 determination on the key, threshold question: UDo the ROE
19 recommendations of Ms. Carlock, Mr. Kahal, and Dr. Peseau
20 meet the threshold test of reasonableness required by
21 established regulatory and economic standards governing a
22 fair rate of return on equity?" Based on the evidence
23 discussed subsequently, the answer is, UNo."
24 Q.What role does regulation play in ensuring
25 Idaho Power's access to capital?
AVERA, DI REB 3
Idaho Power Company
1 A.Considering investors' heightened awareness
2 of the risks associated with the electric power industry and
3 the implications of ongoing volatility in the markets for
4 long-term capital, supportive regulation remains crucial in
5 preserving Idaho Power's access to capital. Capital markets
6 recognize that constructive regulation is a key ingredient
7 in supporting utility credit ratings and financial
8 integrity, particularly during times of adverse conditions.
9 Moreover, considering the magnitude of the events that have
10 recently occurred, investors' sensitivity to market and
11 regulatory uncertainties has increased dramatically.
12 Q.Is it widely accepted that a utility's
13 ability to attract capital must be considered in
14 establishing a fair rate of return?
15 A.Yes. Ms. Carlock and I agree that the
16 authorized rate of return should be competitive with returns
17 available to investors from investments of corresponding
18 risk, as directed by landmark Supreme Court decisions. Ms.
19 Carlock also recognized that the opportunity to earn a
20 return at least equal to those expected in the capital
21 markets for comparable investments is required if a utility
22 is to be able to attract capital. Ms. Carlock also noted
23 the importance of testing any cost of equity estimate
24 against applicable standards:
AVERA, DI REB 4
Idaho Power Company
1 . . . three standards have evolved for
2 determining a fair and reasonable rate3 of return: (1) the Financial Integrity
4 or Credit Maintenance Standard; (2) the
5 Capital Attraction Standard; and (3) the
6 Comparable Earnings Standard. i
7
8 This is absolutely correct. If Idaho Power's return
9 on equity does not fully reflect the level of investment
10 risks that investors perceive, it will violate the risk-
11 return tradeoff, breach applicable standards, and impair the
12 Company's ability to attract necessary capital.
13 Q.What benchmarks are useful in evaluating the
14 extent to which the ROE recommendations meet this
15 fundamental regulatory requirement?
16 A.The comparable earnings standard recognizes
17 that Idaho Power must compete for capital with all firms in
18 the capital markets generally, and against firms in its own
19 industry specifically. The Value Line Investment Survey
20 (UValue Line") reports that electric utilities as a whole
21 are anticipated to earn a return of 11.5 percent in 2008,
22 2009, and over its 2011-2013 forecast horizon.2 A return
23 that is significantly below the level that Value Line
24 expects for electric utilities generally would undermine
25 confidence in the financial integrity of the firm and its
26 ability to attract capital.
i Carlock Direct at 5.
2 The Value Line Investment Survey at 2230 (Nov. 7, 2008).
AVERA, DI REB 5
Idaho Power Company
1 Q.What are the potential consequences of
2 authorizing a rate of return less than what is required to
3 meet the financial end-result test?
4 A.Considering the risks faced by Idaho Power,
5 the need to fund substantial investment in utility
6 infrastructure, and the imperative of maintaining access to
7 capital during times of adversity, setting an ROE that fails
8 to provide investors with an opportunity to earn returns
9 commensurate with companies of comparable risk would weaken
10 Idaho Power's financial integrity, violate the capital
11 attraction standard, and send the wrong signal to investors
12 at a time when access to capital markets is crucial for the
13 Company.
14 III. CHAGES IN CAITAL ~T CONDITIONS
15 Q.What are the implications of recent capital
16 market conditions?
17 A.Recent volatility in the debt and equity
18 markets linked to the ongoing financial crisis and the
19 weakening economy evidences investors' trepidation to commit
20 capital and marks a significant upward revision in their
21 perceptions of risk and required returns. Bloomberg
22 reported that the CBOE Volatility Index, commonly know as.
23 the VIX, recently surged 26 percent to almost triple its
24 average during the past year, indicating unprecedented price
AVERA, DI REB 6
Idaho Power Company
1 fluctuations and uncertainty. 3 With respect to utilities
2 specifically, as of November 14, 2008, the Dow Jones Utility
3 Average stock index has declined over 28 percent since June
4 2008, while yields on utility bonds have increased
5 precipitously. Figure 1 below plots the yields on triple-B
6 utility bonds reported by Moody's Investors Service
7 ("Moody's") from June 2008 through November 20, 2008:8 FIGUR 1
9 MOODY'S TRIPLE-B PUBLIC UTILITY BOND YIELDS
9.5%
9.0%
8.5%
8.0%
7.5%
7.0%
6.5%
6.0%
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10
11 At the time my direct testimony was prepared, the average
12 yield on triple-B rated utility bonds was 6.9 percent, or
13 approximately 6.8 percent in May 2004, when the IPUC issued
14 its decision in Case No. IPC-E-03-13. Meanwhile, Moody's
15 reported that for the month of October 2008, the average
16 yield on triple-B utility bonds had climbed to 8.6 percent,
17 with the month-average yield as of November 20, 2008 being
18 approximately 9.0 percent.
3 Kearns, Jeff, "VIX 'Exploding' as Stocks Plunge on Growing Recession
Concern," Bloomberg (Oct. 15, 2008).
AVERA, DI REB 7
Idaho Power Company
1 Q.What does this evidence indicate with respect
2 to establishing a fair ROE for Idaho Power?
3 A.The recent sell-off in common stocks and
4 sharp increase in utility bond yields are indicative of
5 higher costs for long- term capital, and the ongoing credit
6 crisis has spilled over into the utility industry. For
7 example, utilities have been forced to draw on short-term
8 credi t lines to meet debt retirement obligations because of
9 uncertainties regarding the availability of long-term
10 capital. 4 As the Edison Electric Insti tute (UEEI") noted in
11 a recent letter to congressional representatives, the
12 financial crisis has serious implications for utilities and
13 their customers:
14 In the wake of the continuing upheaval15 on Wall Street, capital markets are all16 but immobilized, and short-term17 borrowing costs to utilities have18 already increased substantially. If the19 financial crisis is not resolved20 quickly, financial pressures on21 utili ties will intensify sharply,22 resulting in higher costs to our23 customers and, ultimately, could24 compromise service reliability. 5
25 Similarly, an October 1, 2008, Wall Street Journal
26 report confirmed that dislocations in credit markets were
27 also impacting the utility sector:
4 Riddell, Kelly, "Cash-Starved Companies Scrap Dividends, Tap Credit,"
Pittsburgh Post-Gazette (Oct. 2, 2008).
5 Letter to House of Representatives, Thomas R. Kuhn, President, Edison
Electric Institute (Sep. 24, 2008).
AVERA, DI REB 8
Idaho Power Company'
1 Disruptions in credit markets are2 jolting the capital-hungry utility
3 sector, forcing companies to delay new
4 borrowing or come up with different-
5 often more costly-ways of raising cash. 6
6 An October 2008 report on the implications of credit
7 market upheaval for utilities noted that, while high-quality
8 companies can still issue debt, Uthey now have to pay an
9 unusually high risk premium over Treasuries. "7 Meanwhile, a
10 Managing Director with Fitch Ratings, Ltd. (UFitch")
11 recently observed that with debt costs at present levels,
12 Usignificantly higher regulated returns will be required to
13 attract equity capitai."8 As Fitch concluded:
14
15
16
17
18
19
20
21
The collapse in secondary market debtpricing and in equity valuations is
worrisome. We see new debt now priced at
around 9% or higher pushing up against
average authorized ROEs for utilities of
around 10.25% to 10.50%. Thus, raising
new equity, which is now priced close tobook value, is likely to be dilutive. 9
22 Q.Do the recommendations of Ms. Carlock and Mr.
23 Kahal reflect these economic realities?
24 A.No. While Ms. Carlock and Mr. Kahal both
25 touch on conditions in the capital markets, they either seek
26 to diminish the importance of the recent financial crisis or
6 Wall Street Journal "Turmoil in Credit Markets Send Jolt to Utility
Sector" (Oct. 1, 2008), p. B4.
.7 Rudden's Energy Strategy Report (Oct. 1, 2008).
8 Fitch Ratings Ltd., "EEI 2008 Wrap-Up: Cost of Capital Rising," Global
Power North America Special Report (Nov. 17, 2008).
9 Fitch Ratings Ltd., "Investing In An Unpredictable World," Fitch
Ratings' 20th Annual Global Power Breakfast (Nov. 10, 2008).
AVERA, DI REB 9
Idaho Power Company
1 mischaracterize the implications of the resulting economic
2 threats. For example, Ms. Carlock noted (p. 10) that
3 current market trends Uare making capitalization difficult
4 for all," but her assessment of short-term interest rate
5 trends leaves the false impression that capital costs have
6 somehow decreased.
7 For his part, Mr. Kahal grants (p. 9) that
8 ufinancial markets distress and equity market volatility has
9 increased drastically, with credit markets beginning in last
10 September freezing up," but nevertheless concludes that the
11 implications are udifficult to predict." Rather than
12 account for the economic realities facing today's investors,
13 he simply asserts that Ucost of capital data in this case
14 have not changed substantially," 10 and that the present
15 crisis Ulikely will be temporary". 11 As a result, he
16 recommends ignoring it altogether.
17 Q.Do the interest rate benchmarks cited by Ms.
18 Carlock and Mr. Kahal accurately reflect the current
19 expectations and requirements of Idaho Power's equity
20 inves tors?
21 A.No. In evaluating trends in interest rates,
22 Ms. Carlock concluded in her testimony that interest rates
23 have decreased, based solely on her observation that the
10 Kahal Direct at 6.
11 Kahal Direct at 10.
AVERA, DI REB 10
Idaho Power Company
1 prime rate and the federal funds rate have declined. 12 Of
2 course, the decline in the federal funds rate and prime
3 lending rate are a function of the Federal Reserve's actions
4 to increase liquidity in the face of a profound crisis in
5 credi t markets. Moreover these interest rate benchmarks
6 have virtually no relevance in an evaluation of long-term
7 capital costs for a utility such as Idaho Power.
8 While Mr. Kahal grants that trends in long-term
9 interest rates are indicative of the cost of equity,13 he
10 concludes that ufavorable trends" in long-term debt cost
11 rates support his recommendation. 14 As documented above,
12 however, Mr. Kahal' s conclusion is directly at odds with the
13 capital market realities faced by investors. Yields on
14 triple-B utility bonds are on the order of at least 200
15 basis points higher than those prevailing at the time the
16 IPUC issued its decision in Idaho Power's last litigated
17 rate proceeding. In contrast to the recommendations of Ms.
18 Carlock and Mr. Kahal, this implies a significant increase
19 the ROE for Idaho Power.
12 In response to IPC Request No. 22, which asked if Ms. Carlock had
evaluated trends in public utility bond yields from the time of Idaho
Power's last rate case until the present, she indicated that "Public
Utility bond yields floated within a closer range (versus prime rate),
decreasing at times and increasing at others. With the market
uncertainty this fall, they increased."
13 Kahal Direct at 9.
14 Kahal Direct at 10.
AVERA, DI REB 11
Idaho Power Company
1 Q.What increase in ROE is indicated by the
2 upward trend in long-term utility bond yields?
3 A.While the cost of equity generally moves in
4 the same direction as interest rates, it is widely accepted
5 that the cost of equity does not increase or decrease in
6 lockstep with changes in bond yields. Indeed, there is
7 substantial evidence that equity risk premiums tend to move
8 inversely with interest rates. In other words, when
9 interest rate levels are relatively high, equity risk
10 premiums narrow, and when interest rates are relatively low,
11 equity risk premiums widen. This inverse relationship has
12 been recognized in the financial literature and by
13 regulators. Based on a review of the financial literature,
14 Regula tory Finance: Utili ties Cost of Capi tal concluded
15 that: UThese studies imply that the cost of equity changes
16 only half as much as interest rates change." 15
17 Considering this inverse relationship and the fact
18 that triple-B utility bond yields have increased at least
19 200 basis points since the IPUC issued its decision in Case
20 No. IPC-E-03-13 implies a minimum upward adjustment to the
21 approved ROE of 100 basis points.
22 Q.Does it make sense to ignore current capi tal
23 market conditions, as Mr. Kahal recommends?
15 Morin, Roger A., "Regulatory Finance: Utilities' Cost of Capital,"
Public Utilities Reports, Inc. (1994)at 292.
AVERA, DI REB 12
Idaho Power Company
1 A.Absolutely not. Mr. Kahal may have gazed
2 into his crystal ball and determined that the demonstrable
3 increase in long-term capital costs uwill be temporary," but
4 his personal opinions have no bearing on the realities that
5 Idaho Power faces in raising capital. In fact, most of the
6 investment community are far less sanguine than Mr. Kahal
7 and there is very little indication that the dire conditions
8 confronting the economy and financial markets will be
9 resolved quickly. In contrast to Mr. Kahal' s rosy outlook,
10 in a review of the impact of the financial crisis for
11 utilities, a Managing Director for Fitch recently concluded,
12 UI do not believe that borrowing costs will come down from
13 current levels." 16 Even Mr. Kahal was forced to grant that
14 Uit is difficult to predict when normal conditions . .
15 will return to financial markets. "17
16 As noted earlier, the standards underlying a fair
17 rate of return require that Idaho Power's authorized ROE
18 reflect a return competitive with other investments of
19 comparable risk and preserve the Company's ability to
20 maintain access to capital on reasonable terms. This
21 standard can only be met by considering the requirements of
22 investors in today's capital markets. Past trends in
16 Grabel sky , Glen, "Surviving the Present, Preparing for the Future,"
Fitch Ratings' 20th Annual Global Power Breakfast (Nov. 10, 2008).
17 Kahal Direct at 9.
AVERA, DI REB 13
Idaho Power Company
1 interest rates or Mr. Kahal' s vague sense that conditions
2 may soon return to Unormal" are irrelevant.
3 Similarly, contrary to Mr. Kahal' s contention,18 the
4 fact that the current crisis may complicate the application
5 of the DCF model or CAPM to estimate the cost of equity
6 provides no basis to ignore the dramatic upward shift in
7 investors' risk perceptions and required rates of return for
8 long-term capital. Moreover, the fact that yields on long-
9 term utility bonds have increased over 200 basis points
10 since the IPUC's decision inCase No. IPC-E-03-13 is
11 directly observable in the capital markets. This evidence
12 alone - which does not depend on the DCF or CAPM approaches
13 - demonstrates that Idaho Power's ROE must be increased
14 substantially if the Supreme Court's standards underlying a
15 fair rate of return are to be met in today's economic
16 environment.
17 Q.What other evidence supports a finding that
18 Idaho Power's cost of equity capital has increased?
19 A.Apart from the dramatic upward shift in
20 investors' required rates of return generally, the
21 investment risks specific to Idaho Power have also
22 increased. Ms. Carlock's recommended ROE of 10.25 percent
23 is equal to that authorized by the IPUC in Case No. IPC-E-
18 Kahal Direct at 10.
AVERA, DI REB 14
Idaho Power Company
1 03-13, which Mr. Kahal cites as a benchmark. What both
2 these witnesses fail to address is the fact that Idaho
3 Power's bond ratings have declined since that time,
4 indicating higher risks and a higher required rate of return
5 on equity.
6 Based in large part on concerns stemming from the
7 outcome of Idaho Power's past rate proceedings and the
8 pressures of ongoing capital requirements, Standard & Poor's
9 Corporation (US&P") lowered the Company's corporate credit
10 rating from UA-" to UBBB+" in November 2004,19 and again
11 from UBBB+" to UBBB" in January 2008.20
12 Q.Is there any direct capital market evidence
13 regarding the amount of the premium investors require from a
14 firm that is rated triple-B, versus one with Idaho Power's
15 former single-A rating?
16 A.Al though rates of return on equity cannot be
17 directly observed, the observed yields on long-term bonds
18 provide direct evidence of the additional return that
19 investors require to bear the risks associated with weaker
20 credit ratings. Moody's recently reported an average yield
21 on single-A rated public utility bonds for October 2008 of
22 7.56 percent, versus an average yield of 8.58 percent for
19 Standard & Poor's Corporation, "IDACORP and Unit Ratings Lowered,
Removed From CreditWatch Negative," RatingsDirect (Nov. 29, 2004).
20 Standard & Poor's Corporation, "IDACORP, Idaho Power Co. Ratings
Lowered One Notch To 'BBB'; Outlook Stable," RatingsDirect (Jan. 31,
2008) .
AVERA, DI REB 15
Idaho Power Company
1 bonds rated triple-B. Based on this evidence, the debt
2 markets would now require approximately 100 basis points in
3 additional return in order to compensate for the greater
4 risks associated with Idaho Power's current triple-B rating.
5 Equity investors would undoubtedly require a significantly
6 greater premium for bearing the higher risk associated with
7 the more junior common stock of a utility with a triple-B
8 rated company, versus one that is rated single-A.
9 Coupled with the significant increase in long-term
10 capital costs discussed earlier, the higher risks that
11 investors associate with Idaho Power provide further
12 evidence that the ROE recommendations of Ms. Carlock and Mr.
13 Kahal are inadequate. Since the 1930s, there has not been a
14 time when the domestic and global financial markets have
15 experienced as much turmoil and uncertainty as they are now
16 undergoing. For a utility with an obligation to provide
17 reliable service, investors' increased reticence to supply
18 additional capital during times of crisis highlights the
19 necessity of preserving the flexibility necessary to
20 overcome periods of adverse capital market conditions. The
21 investment risks faced by utilities and their investors have
22 only been exacerbated in this uncertain environment. In
23 turn, the need for supportive regulation and an adequate ROE
24 may never have been greater.
AVERA, DI REB 16
Idaho Power Company
1 Q.What are the implications of disregarding the
2 Company's higher investment risks in setting the allowed
3 rate of return on equity?
4 A.If the greater risks associated with Idaho
5 Power's weakened credit standing are not incorporated in the
6 allowed rate of return on equity, the results will fail to
7 meet the comparable earnings standard that Ms. Carlock
8 agrees is fundamental in determining the cost of capital.
9 From a more practical perspective, failing to provide
10 investors with the opportunity to earn a rate of return
11 commensurate with Idaho Power's risks will only serve to
12 further weaken its financial integrity, while hampering the
13 Company's ability to attract the capital needed to meet the
14 economic and reliability needs of its service area.
15 Q.Does the importance of an adequate return to
16 attract investors' capital diminish if the utility is not
17 planning to issue new equity?
18 A.Not at all. First, it is not always within
19 the utility's control when it will have to access equity
20 markets. Due to its obligation to serve, a utility may have
21 to invest new capital even during adverse market conditions
22 and its ability to withstand such periods of stress depends
23 to a large degree on investors' confidence in supportive
24 regulation, including an adequate ROE.
AVERA, DI REB 17
Idaho Power Company
1 In the current crisis there has been much discussion
2 of the problems created for homeowners who were induced into
3 buying too much house by Uteaser" interest rates that were
4 very low at the outset, but then reset to higher rates after
5 the first few years of the mortgage. Many problems could
6 have been avoided if, at the outset, homeowners and lenders
7 had looked beyond the low initial paYments and focused on
8 the long- term costs and implications of their mortgage
9 terms. The long-term perspective is similarly important for
10 regulators. The cost to customers in the long-term may be
11 much higher if the allowed return in the near term limits
12 the financial resiliency of the utility and renders it
13 unable to raise capital on reasonable terms to fund crucial
14 infrastructure investments, especially in times of financial
15 stress.
16 If regulators opportunistically approve inadequate
17 returns when the utility seems to be financially sound, then
18 investor confidence is lost. As the western energy crisis
19 of 2000-2001 demonstrated, it cannot be easily or quickly
20 regained by simply granting higher returns in later years.
21 It would be both unfair to Idaho Power and against the long-
22 term interest of customers to adopt a downward-biased ROE,
23 such as those proposed by Ms. Carlock and Mr. Kahal.
AVERA, DI REB 18
Idaho Power Company
1 iv. TERRI CAOCK
2 Q.How did Ms. Carlock arrive at her 10.25
3 percent cost of equity recommendation for Idaho Power?
4 A.Ms. Carlock estimated the cost of equity by
5 applying the constant growth DCF model to Idaho Power's
6 parent, IDACORP, Inc. (UIDACORP"). 21 She concluded that the
7 results of this DCF application indicated a cost of equity
8 in the 8. 9 percent to 9. 8 percent range. Ms. Carlock also
9 conducted a comparable earnings analysis, which resulted in
10 an indicated cost of equity in the 9.5 percent to 10.5
11 percent range. Based on these two analyses, Ms. Carlock
12 concluded that the cost of equity was in the 9.5 to 10.5
13 percent range, selecting 10.25 percent as her point estimate
14 ROE recommendation for Idaho Power.
15 Q.Do you believe it is reasonable to rely on
16 the DCF results for a single company in evaluating a fair
17 ROE for Idaho Power?
18 A.No. Even for a firm with publicly traded
19 stock, such as IDACORP, the cost of equity is inherently
20 unobservable and can only be inferred indirectly by
21 reference to available capital market data. As a result,
22 applying quantitative models using observable market data
23 only produces an estimate that inherently includes some
21 In response to IPC Request No. 27, Ms. Carlock noted that, in
addition to her independent DCF analysis for IDACORP, she also reviewed
my DCF results.
AVERA, DI REB 19
Idaho Power Company
1 degree of observation error. Because any form of analysis
2 that depends on estimates is subj ect to measurement error,
3 the accepted approach to increase confidence in the results
4 is to apply the DCF model and other quantitative methods to
5 a proxy group of publicly traded companies that investors
6 regard as risk comparable. The results of the analysis on
7 the sample of companies are relied upon to establish a range
8 of reasonableness for the cost of equity for the specific
9 company at issue.
10 To the extent that the data used to apply the DCF
11 model does not capture the expectations that investors have
12 incorporated into current stock prices, the resulting cost
13 of equity estimate will be biased and unreliable.
14 Conceptually, the issue of proxy group size is directly
15 analogous to the use of sampling in statistical analyses.
16 In statistics, a Utrue" value is often estimated by
17 reference to sample observations, with the analyst having
18 greater confidence in the applicability of the estimated
19 results as the size of the sample increases. As Mr. Kahal
20 noted, UI believe that an appropriately selected proxy group
21 (preferably one reasonable in size) is likely to be more
22 reliable than a single company study. "22 By relying on a
23 single DCF value for IDACORP, Ms. Carlock unnecessarily
22 Kahal Direct at 18.
AVERA, DI REB 20
Idaho Power Company
1 compromises the ability of the DCF analysis to reflect
2 investors' actual expectations and requirements.
3 Q.Is there evidence of bias in Ms. Carlock's
4 DCF analysis for IDACORP?
5 A.Yes. Despite the fact that common equity is
6 considerably more risky than an investment in long-term
7 debt, the low end of Ms. Carlock's DCF range falls below
8 current yields on triple-B rated utility bonds. Similarly,
9 with triple-B utility bond yields averaging above 9 percent
10 so far in November 2008, the top end of her DCF range
11 implies an equity risk premium of less than 80 basis points.
12 In light of the risks that investors presently associate
13 with long-term capital generally and utilities specifically,
14 an equity risk premium of 80 basis points is far below what
15 is necessary to ensure Idaho Power's ability to attract
16 capital. 23
17 In addition, while Ms. Carlock contended that her
18 DCF conclusions were based in part on a review of my
19 analyses, 24 as noted in my direct testimony, all but one of
20 the average DCF estimates resulting for my proxy group
21 exceeded 11 percent.
23 At the time the IPUC authorized a 10.25 percent ROE for Idaho Power
in Case No. IPC-E-03-13, the six-month average single-A utility bond
yield was approximately 6.25 percent. This implies a risk premium of
400 basis points.
24 Response to IPC Request No. 27.
AVERA, DI REB 21
Idaho Power Company
1 Q.Did you have the opportunity to review the
2 details of the comparable earnings analysis that underlie
3 Ms. Carlock's conclusions?
4 A.No. Ms. Carlock's testimony contains no
5 schedules or exhibits presenting the results of her
6 comparable earnings analyses. In response to Idaho Power
7 Company's production Request No. 25, Ms. Carlock asserted
8 that the Ureturns are for utility companies shown in Company
9 wi tness Avera exhibits and workpapers."
10 Q.Does Ms. Carlock's comparable earnings range
11 correspond to the returns investors are anticipating for the
12 companies in your proxy group?
13 A.No. As indicated on my Exhibit No. 25,
14 expected earned rates of return for the firms in my proxy
15 group result in an average implied return on equity of 11.1
16 percent, which is considerably higher than the 9.5 percent
17 to 10.5 percent range cited in her testimony. In addition,
18 as noted earlier, Value Line expects that electric utilities
19 as a whole are anticipated to earn a return of 11.5 percent.
20 A return that is significantly below the level that Value
21 Line expects for electric utilities generally would
22 undermine confidence in Idaho Power's financial integrity
23 and its ability to attract capitaL.
24 Q.Do historical allowed rates of return support
25 Ms. Carlock's ROE recommendations?
AVERA, DI REB 22
Idaho Power Company
1 A.No. While I have no basis to dispute Ms.
2 Carlock's observation that authorized ROEs during 2007 and
3 the first quarter of 2008 may have ranged from 9.8 percent
4 to 11.25 percent, these historical figures completely ignore
5 the significant changes in capital market conditions since
6 the record in these various proceedings was established. As
7 indicated earlier, the increase in utility bond yields
8 translates to an upward adjustment in the cost of equity on
9 the order of 100 basis points. As a result, adjusting the
10 stale, historical figures underlying Ms. Carlock's analysis
11 of authorized returns would suggest a current range on the
12 order of 10.5 percent to 11.5 percent. As noted earlier,
13 this is consistent with the investment community's view that
14 Usignificantly higher regulated returns will be required to
15 attract equity capital. "25
16 Q.Did Ms. Carlock apply the CAPM to estimate
17 the cost of equity for Idaho Power?
18 A.No. While Ms. Carlock stated that Umuch of
19 the theoretical approach" that she used was consistent with
20 my testimony, Ms. Carlock did not use the CAPM to estimate
21 the cost of equity. As I explained in my direct testimony,
22 the CAPM method is widely recognized as a meaningful
23 approach to estimate investors' required rate of return.
25 Fitch Ratings Ltd., "EEI 2008 Wrap-Up: Cost of Capital Rising,"
Global Power North America Special Report (Nov. 17, 2008).
AVERA, DI REB 23
Idaho Power Company
1 Unlike the comparable earnings method, which depends on
2 earned returns derived from accounting information, the CAPM
3 approach is based on capital market data indicative of
4 investors' current expectations. The IPUC has noted the
5 importance of uevaluating all the methods" and Uusing each
6 as a check on the other when setting the allowed rate of
7 return.
"26
8 Q.Why is the use of multiple methods so
9 important when estimating the cost of equity?
10 A.Investors' expectations are unobservable, and
11 there is no methodology that provides a foolproof guide to
12 their required rate of return. Each method provides another
13 facet of examining investor behavior, with different
14 assumptions and premises. Investors do not necessarily
15 subscribe to anyone method, and no model can conclusively
16 determine or estimate the required return for an individual
17 firm. If the cost of equity estimation is restricted to
18 certain methodologies, while the results of other approaches
19 are ignored, it may significantly bias the outcome. Rather,
20 all relevant evidence should be weighed and evaluated in
21 order to minimize the potential for error.
26 Idaho Public Utilities Commission, Order No. 29505 (May 25, 2004) at
38.
AVERA~ DI REB 24
Idaho Power Company
1 Regulators have customarily considered the results
2 of alternative approaches in determining allowed returns. 27
3 It is widely recognized that no single method can be
4 regarded as a panacea; all approaches have advantages and
5 shortcomings. For example, a publication of the Society of
6 utility and Financial Analysts (formerly the National
7 Society of Rate of Return Analysts), concluded that:
8 Each model requires the exercise of
9 judgment as to the reasonableness of the10 underlying assumptions of the
11 methodology and on the reasonableness of12 the proxies used to validate the theory.
13 Each model has its own way of examining14 investor behavior, its own premises, and15 its own set of simplifications of
16 reality. Each method proceeds from17 different fundamental premises, most of18 which cannot be validated empirically.19 Investors clearly do not subscribe to20 any singular method, nor does the stock21 price reflect the application of anyone22 single method by investors. 28
23 Q.Has the IPUC expressed reluctance to consider
24 the results of the CAPM approach?
25 A.Yes. I am aware that in the past the IPUC
26 has expressed concerns over the measurement and proper use
27 of the beta value necessary to apply the CAPM and has not
27 For example, a NARUC survey reported that 26 regulatory jurisdictions
ascribe to no specific method for setting allowed ROEs, with the results
of all approaches being considered. "Utility Regulatory Policy in theu. s. and Canada, 1995-1996," National Association of Regulatory Utility
Commissioners (December 1996).
28 Parcell, David C., "The Cost of Capital - A Practitioner's Guide,"
Society of Utility and Regulatory Financial Analysts (1997) at Part 2,
p. 4.
AVERA, DI REB 25
Idaho Power Company
1 routinely focused on the results of this method. 29
2 Nevertheless, the CAPM is a rigorous conceptual framework at
3 the heart of modern financial theory and it is widely used
4 and referenced in the investment community. Indeed,
5 evidence suggests that reliance on the DCF model as a tool
6 for estimating investors' required rate of return has
7 declined outside the regulatory sphere, with the CAPM being
8 Uthe dominant model for estimating the cost of equity. "30
9 Of course, the CAPM is based on restrictive assumptions and
10 does not describe security returns perfectly and there are
11 controversies surrounding the measurement of key variables,
12 such as beta. But then exactly the same could be said for
13 the constant growth DCF model, which assumes a single,
14 static growth rate into perpetuity that has no observable
15 proxy in the capital markets. Moreover, I have used Value
16 Line as the source of my betas, a reference cited by Ms.
17 Carlock in her data responses.
18 Q.What cost of equity is implied if the CAPM
19 method is used to check Ms. Carlock's conclusions?
20 A.As discussed in detail in my direct testimony
21 and show on Table 4, the resul ts of the CAPM approach
22 implied cost of equity estimates ranging from 10.2 percent
29 See, e. g., Order No. 29505 at 38.
30 See, e.g., Bruner, R.F., Eades, K.M., Harris, R.S., and Higgins,
R. C., "Best Practices in Estimating Cost of Capital: Survey and
Synthesis," Financial Practice and Education (1998).
AVERA, DI REB 26
Idaho Power Company
1 to 11.9 percent, with the average of the individual values
2 being 11.0 percent. This result is consistent with my
3 finding that present capital market conditions imply an ROE
4 significantly above the 10.25 percent approved in Idaho
5 Power's last litigated rate case.
6 Q.Did Ms. Carlock recognize that the investment
7 risks associated with electric utilities have increased?
8 A.Yes. Ms. Carlock noted that a plethora of
9 changes have impacted investors risk perceptions, observing
10 that:
11 The competi ti ve risks for electric12 utilities have changed with increasing13 non-utility generation, deregulation in14 some states, open transmission access,15 and changes in electricity markets. 31
16 Ms. Carlock concluded that, because of these greater
17 uncertainties, the difference in the risk between industrial
18 firms operating in the competitive market and electric
19 utilities uis not as great as it used to be. "32
20 Q.Did Ms. Carlock consider this increase in
21 risk in her analysis of the cost of equity for Idaho Power?
22 A.No. Ms. Carlock ignored the implications of
23 this trend in investment risks for utilities, asserting
24 instead that Idaho Power's ucompetitive risks" are lower
25 because of its Ulow-cost source of power" and Ulow retail
31 Carlock Direct at 8.
32 Id.
AVERA, DI REB 27
Idaho Power Company
1 rates. "33 Ms. Carlock also asserted that the Power Cost
2 Adjustment (UpCA") and Fixed Cost Adjustment (UFCA") reduce
3 Idaho Power's risks relative to other electric utilities. 34
4 Q.Does this represent an accurate assessment of
5 the investment risks investors' associate with Idaho Power?
6 A.No. While I agree with Ms. Carlock that
7 relatively low rates provide benefits to customers, this
8 narrow view ignores the substantial uncertainties that Idaho
9 Power's investors assume to realize these benefits. As
10 explained in detail in my direct testimony, because a high
11 proportion of the Company's energy needs is provided by
12 hydroelectric facilities, Idaho Power is exposed to a level
13 of uncertainty not faced by other utili ties, which are less
14 dependent on hydro generation.
15 Reduced hydroelectric generation due to below-
16 average water conditions forces Idaho Power to rely on less
17 efficient thermal generating capacity and purchased power to
18 meet its resource needs. As the IPUC has noted, Uthere are
19 no guarantees about future stream flows or market prices, "35
20 and in light of the recent past, this dependence on
21 wholesale" markets entails significant risk in the minds of
22 investors, especially for a utility located in the West.
33 Id. at 9.
34 Id.
35 Idaho Power Granted $256 million deferral, but bond plan denied,
Idaho Public Utilities Commission (May 13, 2002).
AVERA, DI REB 28
Idaho Power Company
1 Investors recognize that volatile markets, unpredictable
2 stream flows, and Idaho Power's dependence on wholesale
3 purchases to meet the needs of its customers expose the
4 Company to the risk of reduced cash flows, increased need
5 for financing, and unrecovered power supply costs.
6 Apart from exposure to market uncertainties, Idaho
7 Power also confronts the complexities associated with
8 maintaining the necessary licenses to operate its
9 hydroelectric stations. The process of relicensing is
10 prolonged and involved and often includes the implementation
11 of various studies and measures to address environmental and
12 stakeholder concerns. 36 These measures can impose
13 significant additional costs and/or lead to reduced
14 generating capacity and flexibility.
15 Q.Does the fact that Idaho Power has a PCA
16 absolve investors from risk of volatility, as Ms. Carlock
17 seems to imply?
18 A.No. The fact that Idaho Power had been
19 granted a PCA does not translate into lower risk vis-à -vis
20 other electric utilities. First, adjustment mechanisms to
21 account for changes in power supply costs are the rule,
22 rather than the exception in the utility industry, so that
36 The current license for the Hells Canyon Complex, which accounts for
68 percent of Idaho Power's hydroelectric generating capacity, expired
in July 2005. Apart from significant ongoing expenditures associated
with proposed environmental measures, the relicensing process is
complex, protracted, and expensive.
AVERA, DI REB 29
Idaho Power Company
1 the Company's PCA merely moves its risks closer to those of
2 other utilities. Second, the PCA does not prevent the lag
3 between the time that Idaho Power actually incurs power
4 supply expenses and when those expenses are recovered from
5 ratepayers. As S&P noted:
6 The Company's PCA does not currently7 fully insulate it under very poor or
8 persistently low hydro conditions. In
9 exceptionally low water years, deferrals10 materially weaken cash flows and credit11 metrics. 37
12 Investors are well aware that the significant
13 reduction in cash flows associated with mounting deferrals
14 can have a debilitating impact on a utility's financial
15 position. Moreover, investors are aware that the PCA does
16 not apply to 100 percent of the difference between the
17 actual cost of purchased power and the amount collected
18 through rates, with Idaho Power's shareholders remaining at
19 risk for a portion of any discrepancy. 38 As documented in
20 my direct testimony, investors recognize that uncertainties
21 over water conditions are a persistent operational risk
22 associated with Idaho Power.
37 Standard & Poor's Corporation, "Summary: Idaho Power Co.,"
RatingsDirect (Aug. 29, 2008).
38 While the stipulation filed in October 2008 would improve Idaho
Power's PCA mechanism by allowing the Company to collect 95 percent of
under-collected power costs and providing a better match between actual
expenses and revenues, S&P concluded that, while positive, these
revisions would not result in an improvement to Idaho Power's credit
ratings. Standard & Poor's Corporation, "Bulletin: Proposed PCA Changes
Should Help Idaho Power Co. Recoup Costs, No Rating Change,"
RatingsDirect (Oct. 16, 2008).
AVERA, DI REB 30
Idaho Power Company
1 Q.Is there any merit to Ms. Carlock's position
2 that the FCA implies lower risks for Idaho Power than for
3 other electric utilities?
4 A.No. As explained in my direct testimony,
5 while adj ustment mechanisms such as the FCA help to preserve
6 Idaho Power's opportunity to earn its authorized return by
7 allowing the Company to recover reasonable and necessary
8 expenditures, they also address the investment community's
9 heightened concerns over the risks associated with rising
10 costs. Of particular concern to investors is the impact of
11 regulatory lag and cost-recovery on the utility's ability to
12 earn its authorized ROE. For example, Moody's has
13 emphasized the need for regulatory support uin an era of
14 broadly rising costs," noting that as cost pressures have
15 escalated for electric utilities, so too has the importance
16 of timely recovery through the regulatory process and the
17 risks associated with regulatory lag. 39
18 While the FCA attenuates Idaho Power's exposure to
19 attrition in an era of rising costs, this leveling of the
20 playing field will only serve to preserve the Company's
21 opportunity to earn its authorized return, as required by
22 established regulatory standards. Indeed, S&P recently
39 Moody's Investors Service, "Regulatory Pressures Increase For U. S.
Electric Utilities," Special Comment (March 2007) .
AVERA, DI REB 31
Idaho Power Company
1 observed that its risk analysis focuses on the utility's
2 ability to consistently earn a reasonable return:
3 Notably, the analysis does not revolve
4 around Uauthorized" returns, but rather
5 on actual earned returns. We note the
6 many examples of utili ties with heal thy
7 authorized returns that, we believe,
8 have no meaningful expectation of
9 actually earning that return because of10 rate case lag, expense disallowances,11 etc. 40
12 Since before the IPUC's 2004 decision authorizing Idaho
13 Power an ROE of 10.25 percent, the Company's actual earned
14 returns have fallen in the single digits, with Value Line
15 proj ecting an earned return on equity for IDACORP of 7.5
16 percent in 2008.41
17 Moreover, utilities increasingly benefit from a wide
18 variety of mechanisms designed to mitigate against the risks
19 associated with fluctuations in costs and regulatory lag .
20 While these mechanisms are not always directly analogous to
21 the specific provisions of Idaho Power's FCA, the objective
22 is similar; namely, to allow the utility an opportunity to
23 earn a fair rate of return and partially attenuate exposure
24 to attrition in an era of rising costs. Reflective of this
25 industry trend, the companies in my proxy group operate
26 under a variety of cost adjustment mechanisms, which range
40 Standard & Poor's Corporation, "Assessing u. S. Regulatory
Environments," RatingsDirect (Nov. 7, 2008).
41 The Value Line Investment Survey (Nov. 7, 2008).
AVERA, DI REB 32
Idaho Power Company
1 from riders to recover bad debt expense and post-retirement
2 employee benefit costs to ~djustment clauses designed to
3 address the rising costs of environmental compliance
4 measures.
5 For example, apart from revenue decoupling and other
6 attrition rate adjustments, Pacific Gas and Electric Company
7 benefits from a number of other balancing account mechanisms
8 that cover a significant portion of its revenue
9 requirements. Similarly, Xcel Energy, Inc., also benefits
10 from a transmission cost recovery adjustment that allows the
11 utility to recover incremental transmission investments
12 between rate cases, as well as an adjustment clause to
13 account for the impact of demand side management programs.
14 Moreover, in response to the heightened risk associated with
15 utilities' exposure to substantial costs for environmental
16 remediation, adjustment mechanisms designed to allow for
17 recovery of these costs outside a general rate case have
18 become increasingly prevalent. Considering that the impact
19 of various adjustment mechanisms is already reflected in the
20 cost of equity estimates for the proxy firms, there is no
21 basis for Ms. Carlock's contention that Idaho Power's risks
22 are lower than for other electric utilities.
23 Q.Does reference to obj ecti ve risk measures
24 confirm your conclusion that Idaho Power's investment risks
25 are comparable to the utilities in your proxy group?
AVERA, DI REB 33
Idaho Power Company
1 A.Yes. As discussed in my direct testimony,
2 Idaho Power is rated UBBB" by S&P, which is identical to the
3 average for the firms in the Utility Proxy Group.
4 Meanwhile, Value Line has assigned IDACORP a Safety Rank of
5 U3" and a Financial Strength Rating of uB+", which are also
6 the same as the proxy group average. These criteria, which
7 reflect objective, published indicators that incorporate
8 consideration of a broad spectrum of risks, including the
9 impact of regulatory adjustment clauses, financial and
10 business position, relative size, and exposure to company
11 specific factors, demonstrate that investors regard this
12 group as having comparable risks to Idaho Power.
13 Q.Do you believe that investment community risk
14 indicators, such as S&P's credit ratings, may not reflect an
15 informed assessment of regulatory risks?
16 A.No. Ms. Carlock indicated that in assigning
17 credit ratings Uregulatory risks may not be fully analyzed,"
18 and she asserted that Uregulatory mechanisms for example may
19 not be completely understood and may not be adequately"
20 reflected. "42 In fact, however, the investment community
21 clearly recognizes that an accurate evaluation of regulatory
22 climate, including the specific adjustment mechanisms
23 affecting a utility's cash flows, is critical in any
42 Response to IPC Request No. 23.
AVERA, DI REB 34
Idaho Power Company
1 assessment of investment risk. For example, S&P noted in a
2 recent publication entitled uAssessing U. S. Utility
3 Regulatory Environments " that,UThe assessment of
4 regulatory risk is perhaps the most important factor in
5 Standard & Poor's Ratings Services' analysis of aU. S.
6 regulated, investor-owned utility's business risk. "43
7 Credit rating agencies such as S&P devote considerable
8 resources towards their analyses of a utility's credit
9 risks, including the impact of regulation and related
10 adjustment mechanisms.
11 With respect to Idaho Power specifically, Moody's
12 concluded, UA key consideration in order for (Idaho Power)
13 to stabilize its rating outlook and maintain its Baal senior
14 unsecured rating will be the extent to which the IPUC is
15 supportive in any future regulatory filings. "44 Similarly,
16 Fi tch noted that U (m) eaningful price increases will be
17 required to recover planned capi tal expendi tures to meet
18 infrastructure and growth requirements,45 while S&P cited
19 U (r) egulatory challenges in meeting rising costs and a large
43 Standard & Poor's Corporation, "Assessing u. S. Regulatory
Environments," RatingsDirect (Nov. 7, 2008).
44 Moody's Investors Service, "Credit Opinion: Idaho Power Company,"
Global Credit Research (June 4, 2008).
45 Fitch Ratings, Ltd., "Idaho Power Company," Global Power u.s. and
Canada Credit Analysis (Apr. 10, 2008).
AVERA, DI REB 35
Idaho Power Company
1 capi tal expenditure program" as a key risk exposure. 46 The
2 investment community is aware of the impact that regulatory
3 decisions can have on Idaho Power's risks, and there is no
4 basis to conclude that their risk assessment is somehow
5 lacking.
6 Q.What other evidence indicates the importance
7 of reasonable regulatory decisions on Idaho Power's ability
8 to maintain its financial integrity?
9 A.As noted earlier, the outcome of Idaho
10 Power's last rate proceeding in Case No. IPC-E-03-13 was
11 instrumental in S&P's decision to downgrade Idaho Power's
12 corporate credit rating from UA- U to UBBB+" in November
13 2004. In explaining that action, S&P noted:
14 Following the IPUC staff's 3.1% rate
15 increase recommendation in February16 2004, Standard & Poor's said that Ua17 final decision by the commission that18 adopted a rate increase akin to that19 proposed by the staff could have an20 adverse effect on bondholder protection21 measures." The final IPUC ruling is22 indeed substantially closer to the23 staff's position than the company's, and24 will weaken credit protection25 measures. 47
26 Similarly, Moody's also downgraded the Company's issuer
27 rating from UA3" to UBaal", citing the risks associated with
46 Standard & Poor's Corporation, "Idaho Power Co.," RatingsDirect (Feb.
1, 2008).
47 Standard & Poor's Corporation, "IDACORP and Unit Ratings Lowered,
Removed From CreditWatch Negative," RatingsDirect (Nov. 29, 2004).
AVERA, DI REB 36
Idaho Power Company
1 hydroelectric power and ongoing capital commitments, as well
2 as the need for additional regulatory support as key factors
3 leading to lower credit ratings for Idaho Power:
4 The downgrade of IPC's ratings reflects:
5 1) expected weaker cash f low coverage of6 interest and debt; 2) the likelihood for
7 continued negative free cash flow over
8 the next few years, with internally
9 generated funds falling short of meeting
10 the dividend requirements of IDACORP and11 significant utility-related capital12 spending; 3) persistent drought13 condi tions that are likely to result in14 higher supply costs, not all of which15 are recoverable under the utility's
16 power cost adjustment mechanism; 4) the17 final resolution this fall of the18 company's rate case, which resulted in a19 revenue increase of a little more than20 half of the company's updated request;21 and 5) the likely need for additional22 support from the Idaho Public Utility23 Commission (IPUC) in future rate
24 proceedings as IPC adds new generation25 and transmission infrastructure to help
26 meet customer and load growth and ensure27 reliability of service. 48
28 Citing similar concerns over deteriorating financial
29 metrics, S&P again lowered Idaho Power's corporate credit
30 rating from uBBB+" to UBBB" in January 2008,49 with Moody's
48 Moody's Investors Service, "Ratings Action: IDACORP, Inc.," Global
Credit Research (Dec. 3, 2004).
49 Standard & Poor's Corporation, "IDACORP, Idaho Power Co. Ratings
Lowered One Notch To 'BBB'; Outlook Stable," RatingsDirect (Jan. 31,
2008) .
AVERA, DI REB 37
Idaho Power Company
1 and Fitch presently maintaining a Unegative" outlook for
2 Idaho Power's credit standing. 50
3 Considering these successive downgrades and the fact
4 that Moody's and Fitch have already assigned a Unegative"
5 outlook to Idaho Power, the perception of lack of regulatory
6 support would undoubtedly place further downward pressure on
7 current ratings. Such an outcome would be inconsistent with
8 the IPUC's stated desire to maintain Idaho Power's credit
9 ratings and lends further support for a return on equity
10 above the top of Ms. Carlock's recommended range. 51
11 Q.Is there evidence regarding the importance of
12 regulatory support in determining a utility's financial
13 integri ty?
14 A.Yes. Investment publications and the trade
15 press are replete with examples that highlight the critical
16 role that a constructive regulatory environment plays in
17 investors' assessment of a utility's credit quality. In
18 discussing the outlook for the utility industry, for
19 example, Fitch Ratings, Ltd. noted that:
20 Regulatory risk remains a recurring21 theme in Fitch's 2008 outlook. For22 regulated electric utili ties, there is23 continuing event risk related to state
50 Moody's Investors Service, "Moody's Changes Outlook Of Idacorp And
Sub To Negative," Press Release (June 3, 2008); Fitch Ratings Ltd.,
"Idaho Power Company," Global Power u.s. and Canada Credit Analysis
(Apr. 10, 2008).
51 Idaho Public Utilities Commission, Order No. 29505 (May 25, 2004) at
43.
AVERA, DI REB 38
Idaho Power Company
1 regulatory and political reactions to2 higher energy bills. .. The risk is
3 heightened by the convergence of rising
4 costs for fuel, equipment and
5 maintenance materials, pension and
6 medical benefits, and infrastructure7 investments. 52
8 More recently, S&P concluded Uthe quality of regulation is
9 at the forefront of our analysis of utility
10 creditworthiness. "53 Accordingly, it is critical to assure
11 investors' confidence in a balanced approach if reasonable
12 access to capital is to be maintained.
13 Q.In light of the shortfalls in Ms. Carlock's
14 analysis and her failure to present a balanced assessment of
15 Idaho Power's relative investment risks, what is your
16 conclusion regarding her recommendations in this case?
17 A.In my opinion, Ms. Carlock's recommended
18 10.25 percent cost of equity falls well short of the rate of
19 return that investors require from Idaho Power. In order to
20 maintain and expand utility infrastructure, it is both
21 reasonable and necessary that the Company be provided the
22 opportunity to maintain its credit standing and ability to
23 attract capital. To meet these challenges successfully and
24 economically - particularly during times of capital market
25 adversity - it is crucial that Idaho Power receive adequate
52 Fitch Ratings, Ltd., "U. S. Utilities, Power & Gas 2008 Outlook," at 5
(Dec. 11, 2007).
53 Standard & Poor's Corporation, "Assessing U. S. Utility Regulatory
Environments," RatingsDirect (Nov. 7, 2008).
AVERAt DI REB 39
Idaho Power Company
1 support for its credit standing. Ms. Carlock's
2 recommendation is inadequate to meet this goal.
3 At the very least, the IPUC should consider the
4 dramatic upward shift in long-term capital costs and the
5 deterioration in Idaho Power's credit ratings since it
6 approved a 10.25 percent ROE for the Company in Case No.
7 IPC-E-03-13. Ms. Carlock granted that, in selecting a point
8 estimate from within a range, Uany point within (the) range
9 is reasonable." 54 Coupled with the higher returns demanded
10 by investors, the ongoing risks associated with Idaho
11 Power's continued exposure to wholesale power markets, and
12 the downward pressures on its credit standing, this would
13 suggest a minimum cost of equity at the very top of Ms.
14 Carlock's 9.5 percent to 10".5 percent range.
15 V. MATTHEW I. KA
16 Q.Briefly describe how Mr. Kahal arrived at his
17 recommended cost of equity for Idaho Power.
18 A.Mr. Kahal recommended a iO.5 percent ROE for
19 Idaho Power based primarily on the results of the constant
20 growth DCF model applied to alternative groups of electric
21 utilities. Mr. Kahaldeveloped his proxy groups based on
22 the companies included in Value Linè's Electric Utility
23 (West) industry group, as well as a subset of the comparable
54 Carlock Direct at 15.
AVERA, DI REB 40
Idaho Power Company
1 utili ties developed in my direct testimony that Mr. Kahal
2 characterized as operating in Unon-restructured" states. In
3 addition to the DCF model, Mr. Kahal also examined
4 historical and proj ected earned rates of return for his
5 reference groups. Based on the results of his analyses, Mr.
6 Kahal concluded that a reasonable cost of equity would fall
7 in the range of 9.4 percent to 10.4 percent, although the
8 DCF results for his two proxy groups suggested a range of
9 9.9 percent to 10.4 percent and 9.6 percent to 10.6 percent,
10 respectively. In explaining his recommended ROE of 10.5
11 percent for Idaho Power, Mr. Kahal noted that it was Utoward
12 the upper end" of his DCF range ~ 55
13 Q.Did Mr. Kahal adequately recognize the
14 importance associated with reliance on multiple methods and
15 approaches in estimating the cost of equity?
16 A.No. Apart from passing reference to the
17 comparable earnings approach, which I address subsequently,
18 Mr. Kahal ignored the results of other methods, such as the
19 CAPM, to check or validate his results. As I explained
20 earlier, however, no single method or model should be relied
21 upon to determine a utility's cost of equity because no
22 single approach can be regarded as wholly reliable.
23 Considering the results of alternative methods and
55 Kahal Direct at 42.
AVERA, DI REB 41
Idaho Power Company
1 approaches provides greater confidence that the end result
2 is reflective of investors' required rate of return.
3 Regula tory Finance: Utili ties' Cost of Capi tal concluded
4 that:
5
6
7
8
9
10
11
12
When measuring equity costs, which
essentially deal with the measurement of
investor expectations, no one single
methodology provides a foolproofpanacea. If the cost of equity
estimation process is limited to one
methodology, such as DCF, it may
severely bias the results. 56
13 Q.Do you believe that the results of Mr.
14 Kahal' s constant growth DCF analyses mirror investors' long-
15 term expectations in the capital markets?
16 A.No. There is every indication that Mr.
17 Kahal' s results are biased downward and fail to reflect
18 investors' required rate of return. As Mr. Kahal correctly
19 observed, the Ug" component of the DCF model should be
20 prospective and must reflect the growth Uexpected by
21 investors. "57 But as he went on to note, the environment
22 presumed by the constant growth DCF approach he employed
23 does not exist in reality. Mr. Kahal granted the
24 significant dislocations recently faced by electric
25 utilities, noting that:
56 Morin, Roger, "Regulatory Finance: Utili ties' Cost of Capital,"
Public Utilities Reports, Inc. at 238 (1994).
57 Kahal Direct at 17 (emphasis original).
AVERA, DI REB 42
Idaho Power Company
1 (M) Y experience in recent years wi th2 utilities has been that these historic
3 measures have been very volatile and are
4 not reliable as long-run prospective
5 measures. This may be due in part to
6 extensive corporate restructuring in the7 energy industry. 58
8 And while Mr. Kahal noted that his proj ected growth rates
9 uwarrants substantial emphasis," he also recognized that
10 U (t) here are a number of reasons why investor expectations
11 of long-run growth could differ from the limited, five-year
12 projections from security analysts. "59 Considering that
13 investors' expectations could differ substantially from the
14 growth rates he relied on, Mr. Kahal concluded that the
15 resulting cost of equity estimates ushould be subject to a
16 reasonableness test and corroboration." 60 If the growth
17 projections used to apply the DCF model do not fully reflect
18 the long-term expectations investors have built into stock
19 prices, the resulting cost of equity estimates will be
20 biased downward.
21 Q.Did Mr. Kahal test the reasonableness of the
22 individual growth estimates he relied on to reach his
23 recommended ROE for Idaho Power?
24 A.No. Mr. Kahal' s mechanical application of
25 the constant growth DCF model contradicts his own
58 Kahal Direct at 21.
59 Kahal Direct at 22-23.
60 Kahal Direct at 23.
AVERA, DI REB 43
Idaho Power Company
1 admonishment to avoid simply plugging alternative growth
2 rates into the DCF formula with no consideration for the
3 reasonableness of the end results. In fact, many of the
4 growth measures embodied in Mr. Kahal' s constant growth DCF
5 application make no economic sense.
6 For example, consider the fact that four of the
7 Value Line growth rates reported on page 4 of Mr. Kahal' s
8 Exhibit No. 604 were 2.0 percent or less. A growth rate of
9 2 . 0 percent, when combined wi th Mr. Kahal' s average dividend
10 yield of approximately 3.9 percent, 61 suggests a DCF cost of
11 equity estimate of approximately 5.9 percent. Indeed, one
12 of the growth values that Mr. Kahal referenced was less than
13 zero,62 implying that the utility's cost of equity is below
14 its dividend yield. Similarly, almost one-third of the
15 individual growth rates contained on page 5 of Mr. Kahal' s
16 Exhibit No. 604 were 3.0 percent or less, implying a cost of
17 equity of at most 6.9 percent. These implied cost of equity
18 estimates fall far below the average yield on triple-B
19 public utility bonds reported by Moody's for October 2008 of
20 approximately 8.6 percent. 63 Clearly, the risks associated
21 with an investment in public utility common stocks exceed
61 Exhibit No. 604, p. 1. This actually overstates the dividend yield,
which Mr. Kahal has adjusted for one-half years' growth.
62 Exhibit No. 604, p. 4.
63 Moody's Investors Service, Credi tTrends. com (retrieved Nov. 14,
2008) .
AVERA, DI REB 44
Idaho Power Company
1 those of long - term bonds, and Mr. Kahal' s growth measures
2 result in a built-in downward bias to his DCF conclusions,
3 which provide no meaningful information regarding the
4 expectations and requirements of investors.
5 Q.What other evidence indicates that Mr.
6 Kahal' s DCF analysis fails to reflect the current
7 requirements of investors?
8 A.As indicated earlier, Mr. Kahal made no
9 attempt to reflect the impact of the ongoing financial
10 crisis on investors' required returns. Considering the
11 dramatic upward trend in long-term capital costs, this
12 omission virtually ensures that Mr. Kahal' s recommendations
13 are downward biased. Consider the dividend yield component
14 of Mr. Kahal's DCF analysis, for example. While Mr. Kahal
15 noted a Uslight upward trend" in dividend yields over the
16 six-month period ending September 2008,64 he nonetheless
17 elected to base his analysis Uon market conditions during
18 the second and third calendar quarters of 2008, "65 rather
19 than relying on the most recent information available to
20 him.
21 Q.How do current dividend yields for Mr.
22 Kahal' s proxy groups compare with the values used in his DCF
23 analysis?
64 Kahal Direct at 20.
65 Kahal Direct at 24.
AVERA, DI REB 45
Idaho Power Company
1 A.Since September 2008, utility stock prices
2 have continued to decline sharply in response to the upward
3 revision in investors' required returns. As a result,
4 dividend yields have also increased significantly. As shown
5 on Exhibit No. 81, based on average closing prices in
6 November 2008, the expected dividend yield for Mr. Kahal's
7 West Region proxy group is now approximately 4.7 percent,
8 versus the 3.9 percent calculated in his direct testimony.
9 Similarly, the indicated dividend yield for Mr. Kahal' s
10 Restricted West Region proxy group is now on the order of
11 5.1 percent, which is 50 basis points higher than the 4.6
12 percent figure used in his analysis.
13 Q.What cost of equity is indicated if current
14 dividend yields are incorporated into Mr. Kahal' s DCF
15 analysis?
16 A.As shown on Exhibi t No. 82, incorporating a
17 di vidend yield for Mr. Kahal' s proxy groups based on average
18 closing stock prices in November 2008 results in midpoint
19 cost of equity estimates for the West Region and Restricted
20 West Region groups of 10.95 percent and 10.61 percent,
21 respectively. Because these estimates rely on Mr. Kahal' s
22 growth rate ranges, which incorporate the impact of
23 illogical values discussed earlier, these results continue
24 to be downward biased. Nevertheless, they confirm my
25 earlier conclusion that a fair ROE for Idaho Power should be
AVERA, DI REB 46
Idaho Power Company
1 established above the 10.5 percent upper end of Ms.
2 Carlock's ROE range.
3 Q.Did Mr. Kahal offer any evidence to support
4 his contention that DCF results for your non-utility proxy
5 group should be rej ected?
6 A.No. Mr. Kahal simply asserted (p. 30) that,
7 because the obj ecti ve in this case was to determine an ROE
8 for Idaho Power's regulated utility operations, data for
9 unregulated companies have Uno value at all." Although he
10 provides no detailed explanation for his position, Mr. Kahal
11 apparently contends that the investment risks of my non-
12 utility group were not comparable to Idaho Power or the
13 utility proxy group I developed in my testimony. In fact,
14 however, participation in competi ti ve markets says nothing
15 at all about the overall investment risks perceived by
16 investors, which is the very basis for a fair rate of
17 return.
18 For example, consider (1) an electric utility
19 operating in regulated markets that has experienced an
20 inability to recover the costs incurred to provide service,
21 and (2) Wal-Mart Stores, Inc. (UWal-Mart"), which faces
22 competition on numerous fronts. Despite its lack of a
23 regulated monopoly, with a double-A bond rating, the highest
24 Value Line Safety Rank, and a beta of 0.70, the investment
25 community would undoubtedly regard Wal-Mart as the less
AVERA, DI REB 47
Idaho Power Company
1 risky alternative. In fact, my review of objective
2 indicators of investment risk - which consider the impact of
3 competi tion and market share - demonstrated that, if
4 anything, the non-utility proxy group is less risky in the
5 minds of investors than the common stock of electric
6 utilities, including Idaho Power. 66
7 Meanwhile, Mr. Kahal's contention (p. 27) that an
8 estimate of the required return for firms in the competitive
9 seotor of the economy U is not reasonable for use in this
10 case" is wrong. In fact, returns in the competitive sector
11 of the" economy form the very underpinning for utility ROEs
12 because regulation purports to serve as a substitute for the
13 actions of competitive markets. The Supreme Court has
14 recognized in the Bluefield and Hope cases that it is the
15 degree of risk, not participation in particular business
16 activities, which is relevant in evaluating an allowed ROE
17 for a utility.
18 Q.Do you agree with Mr. Kahal' s assertions
19 regarding the elimination of certain companies in analyzing
20 the cost of equity for Idaho Power?
21 A.No. Mr. Kahal argued for the elimination of
22 companies based on an assessment of the degree of regulatory
23 restructuring at the retail level or participation in non-
66 As shown in Table 2 of my direct testimony, the Non-Utility Proxy
Group was less risky than Idaho Power and the Utility Proxy Group across
the four major indicators of investment risk.
AVERA, DI REB 48
Idaho Power Company
1 utility operations. However, he failed to demonstrate how
2 his subjective criteria translate into differences in the
3 investment risks perceived by investors. As I amply
4 demonstrated in my direct testimony,67 a comparison of
5 objective indicators demonstrates that investment risks for
6 the firms in my proxy groups are relatively homogeneous and
7 comparable to Idaho Power. Moreover, there are significant
8 errors and inconsistencies associated with Mr. Kahal' s
9 approach that justify rejecting his alternative proxy groups
10 al together.
11 Q.Did Mr. Kahal demonstrate a nexus between the
12 subjective criteria he used 'to define his proxy groups and
13 obj ecti ve measures of investment risk?
14 A.No. Under the regulatory standards
15 established by Hope and Bluefield, the salient criteria in
16 establishing a meaningful proxy group to estimate investors'
17 required return is relative risk, not the degree of
18 regulatory restructuring. Mr. Kahal presented no evidence
19 to demonstrate a connection between the subjective criteria
20 that he employed and the views of real-world investors in
21 the capital markets.
22 Q.What objective evidence can be evaluated to
23 confirm the conclusion that these subjective criteria are
67 Pages 36-38 and 50-52.
AVERA, DI REB 49
Idaho Power Company
1 not synonYmous with comparable risk in the minds of
2 investors?
3 A.Bond ratings are perhaps the most obj ecti ve
4 guide to utilities' overall investment risks and they are
5 widely cited in the investment community and referenced by
6 investors. While the bond rating agencies are primarily
7 focused on the risk of default associated with the firm's
8 debt securities, bond ratings and the risks of common stock
9 are closely related. As noted in Regulatory Finance:
10 Utilities' Cost of Capital:
11 Concrete evidence supporting the12 relationship between bond ratings and13 the quality of a security is abundant14 The strong association between15 bond ratings and equity risk premiums is
16 well documented in a study by Brigham17 and Shome (1982).68
18 While credit ratings provide the most widely
19 referenced benchmark for investment risks, other quality
20 rankings published by investment advisory services and
21 rating agencies also provide relative assessments of risk
22 that are considered by investors in forming their
23 expectations. For example, Mr. Kahal considered Value
24 Line's Safety Rank, beta, and Financial Strength Rating in
25 evaluating his reference group. 69
68 Morin, Roger A., "Regulatory Finance: Utilities' Cost of Capital,"
Public Utility Reports (1994) at 81.
69 Exhibit No. 603.
AVERA, DI REB 50
Idaho Power Company
1 As I noted in my direct testimony (p. 38), my proxy
2 group of 27 electric utilities had an average corporate
3 credit rating of triple-B. Similarly, credit ratings
4 assigned to the eleven utilities excluded by Mr. Kahal based
5 on his subjective tests ranged from UBBB-" to UBBB+" and
6 were entirely comparable to those assigned to the remainder
7 of the companies in my utility proxy group. Considering
8 that credit ratings provide one of the most widely
9 referenced benchmarks for investment risks, a comparison of
10 this objective risk indicator demonstrates that the range of
11 risks for the companies eliminated under the subj ecti ve
12 cri teria proposed by Mr. Kahal are virtually identical to
13 the remaining companies that he accepted as comparable. A
14 review of the key Value Line risk indicators discussed in my
15 direct testimony also confirm the conclusion that the firms
16 excluded by Mr. Kahal are entirely comparable to the
17 remainder of my utility proxy group. In fact, PG&E
18 Corporation, which was one of my proxy companies deemed by
19 Mr. Kahal to be uless useful and appropriate, "70 was
20 included in his own West Region proxy group.
21 Q.What inconsistencies are associated with the
22 alternative tests proposed by Mr. Kahal?
70 Kahal Direct at 28.
AVERA, DI REB 51
Idaho Power Company
1 A.While Mr. Kahal proposes to eliminate
2 companies based on his assessment of the proportion of
3 revenues from regulated utility operations, he presented no
4 explanation or evidence supporting his Utest." Apart from
5 the fact that it is often impossible to accurately apportion
6 financial measures between utility and non-utility sources,
7 Mr. Kahal' s subj ecti ve assessment is inconsistent with the
8 companies he accepted in his own reference group of western
9 utilities. For example, while Mr. Kahal argued to exclude
10 companies with usubstantial unregulated operations," he
11 included Black Hills Corporation (UBlack Hills") in his
12 reference group. Black Hills reported in its most recent
13 " Form 10-K Report that its utility operations accounted for
14 44 percent of operating revenues, with other operations -
15 including oil and gas and coal mining, making up the
16 remaining 55 percent. Similarly, in addition to its
17 electric utility operations, Hawaiian Electric Industries,
18 Inc. (UHawaiian Electric") also owns and operates American
19 Savings Bank, which is the third largest financial
20 institution in Hawaii. Despite the fact that competitive
21 banking activities accounted for approximately 41 percent of
22 operating income in 2007, Mr. Kahal elected to include
23 Hawaiian Electric in his proxy group. Thus, Mr. Kahal' s
24 evaluation of my proxy companies is totally at odds with his
25 own evaluation and analyses.
AVERA, DI REB 52
Idaho Power Company
1 Similarly, Mr. Kahal' s assertions concerning the risks
2 associated with restructuring are ill-defined and
3 inconsistent with his arguments over the implications of
4 competition. For example, while Mr. Kahal argues that
5 CenterPoint Energy should be excluded because it operates in
6 restructured power markets, CenterPoint Energy is engaged
7 almost exclusively in providing regulated electric and gas
8 distribution and transmission services. 71 As CenterPoint
9 Energy noted:
10 It is a transmission and distribution11 electric utility that operates wholly12 within the state of Texas. Neither
13 CenterPoint Houston nor any other
14 subsidiary of CenterPoint Energy makes15 sales of electric energy at retail or16 wholesale, or owns or operates any17 electric generating facilities. 72
18 While CenterPoint Energy does not participate in
19 restructured wholesale power markets, Avista Corp. - one of
20 the companies included in Mr. Kahal' s reference group -
21 specifically informed investors of its exposure to the risks
22 of energy commodity markets and reported that wholesale
23 power market purchases accounted for almost 30 percent of
24 total energy needs. 73 Again, the circumstances faced by the
71 In Texas, where Centerpoint's operations are concentrated, utilities
providing transmission and distribution service are regulated by the
Public Utility Commission of Texas on a rate of return basis essentially
the same as the IPUC regulation of Idaho Power. Wholesale and retail
sales are subject to competitive markets.
72 CenterPoint Energy 2007 Form 10-K Report at 2.
73 Avista Corp. 2007 Form 10-K Report at 11.
AVERA, DI REB 53
Idaho Power Company
1 utilities in Mr. Kahal' s own proxy group are inconsistent
2 with the subjective Utests" he proposes.
3 Q.What market risk premium did Mr. Kahal use to
4 apply the CAPM?
5 A.While Mr. Kahal declined to consider the
6 results of the CAPM in arriving at his recommendation, he
7 relied on a market risk premium of 6.0 percent, which he
8 apparently derived from a single journal article and two
9 selected studies reported in a finance textbook. 74
10 Q.What is the fundamental problem associated
11 with the approach underlying Mr. Kahal' s suggested
12 application of the CAPM?
13 A.Like the DCF model, the CAPM is an ex-ante,
14 or forward- looking model based on expectations of the
15 future. As a result, in order to produce a meaningful
16 estimate of investors' required rate of return, the CAPM
17 must be applied using data that reflects the expectations of
18 actual investors in the market. However Mr. Kahal's
19 application of the CAPM method was premised only on
20 historical - not projected - rates of return. The primacy
21 of current expectations was recognized by Ibbotson
22 Associates:
74 Kahal Direct at 35-36.
AVERA, DI REB 54
Idaho Power Company
1 The cost of capital is always an
2 expectational or forward- looking
3 concept. While the past performance of
4 an investment and other historical
5 information can be good guides and are
6 often used to estimate the required rate
7 of return on capital, the expectations
8 of future events are the only factors
9 that actually determine cost of10 capital. 75
11 By failing to look directly at the returns investors are
12 currently requiring in the capital markets, as I did on
13 Exhibit No. 21, Mr. Kahal's CAPM estimate significantly
14 understates investors' required rate of return.
15 Q.Are the selected references cited by Mr.
16 Kahal representative of investors' expectations?
17 A.No. Mr. Kahal claims that ureal world" data
18 suggests that the market risk premium is significantly lower
19 than the values relied on in my analyses. First, Mr.
20 Kahal' s selected surveys from 2001 and 2003 do not examine
21 the forward-looking expectations of today's investors to
22 estimate the required market rate of return in current
23 capital markets. These studies reflect historical data, not
24 the current expectations of the future that form the basis
25 of investors' required returns today. This critical
26 distinction was recognized in a published survey of risk
27 premium research:
75 Morningstar, Ibbotson SBBI, 2008 Valuation Yearbook at 23.
AVERA, DI REB 55
Idaho Power Company
1 The debate surrounding the equity risk
2 premium arises because theoretically
3 such premia are concerned with the
4 extent to which risky stocks are
5 Uexpected" to outperform a (relatively)
6 safe investment, whereas excess returns
7 are estimated values of this
8 outperformance derived from observed
9 data. The lack of consensus regarding10 the true value of the equity risk11 premium arises from the fact that
12 expectations are unobservable hence can13 only be estimated, and that such14 estimates will vary over time depending,15 in part at least, on the sample period16 used.76
17 In other words, instead of directly considering requirements
18 in today's capital markets, Mr. Kahal is implicitly
19 asserting that events and expectations for the time periods
20 covered by his two surveys are more representative of what
21 is likely to occur going forward. This assertion runs
22 counter to the assumptions underlying the use of the CAPM to
23 estimate investors' required return, which is a purely
24 forward-looking model.
25 Moreover, even if historical studies were relevant
26 in this context, there are other such studies of equity risk
27 premiums published in academic journals that imply required
28 rates of return considerably in excess of those selected by
29 Mr. Kahal. For example, a study reported in the Financial
30 Analysts' Journal noted that the real risk premium for u.s.
76 Oyefeso, Oluwatobi, "Would There Ever Be Consensus Value and Source
of the Equity Risk Premium? A Review of the Extant Literature,"
International Journal of Theoretical and Applied Finance, Vol. 9, No. 2
(2006) 199-215.
AVERA, DI REB 56
Idaho Power Company
1 stocks averaged 6.9 percent over the period 1889 through
2 2000 and concluded that:
3 Over the long term, the equity risk
4 premium is likely to be similar to what
5 it has been in the past and returns to
6 investment in equity will continue to
7 substantially dominate returns to
8 investments in T-billsfor investors
9 with a long planning horizon.
77
10 Similarly, based on a study of ex-ante expected returns for
11 a sample of S&P 500 firms over the 1983-1998 period, a 2003
12 article in Financial Management found an expected market
13 risk premium of 7.2 percent. 78
14 In contrast to the conclusions that Mr. Kahal draws
15 from his review of selected studies, other researchers are
16 less sanguine and recognize that the shortcomings of
17 academic methods can produce results that deviate from
18 investors' actual expectations and requirements:
19 The above discussion suggests that the
20 equity premium debate is far from over,21 and that the use of excess returns as a22 proxy for such premia, while convenient,23 may capture a substantial amount of24 noise and be uncorrelated with equity25 risk premia particularly over the short-
26 run.
79
77 Mehra, Ranjnish, "The Equity Premium: Why Is It a Puzzle?", Financial
Analysts' Journal (January/February 2003) .
78 Harris, R.S., Marston, F. C., Mishra, D. R., and O'Brian, T. J., "Ex
Ante Cost of Equity Estimates of S&P 500 Firms: The Choice Between
Global and Domestic CAPM," Financial Management (Autumn 2003) at Tablei.
79 Oyefeso, Oluwatobi, "Would There Ever Be Consensus Value and Source
of the Equity Risk Premium? A Review of the Extant Literature,"
International Journal of Theoretical and Applied Finance, Vol. 9, No. 2
(2006) 199-215.
AVERA, DI REB 57
Idaho Power Company
1 In fact, no selected historical study, or group of studies,
2 is a substitute for an analysis of investors' current
3 expectations in the capital markets, such as that
4 incorporated in my CAPM analysis shown on Exhibit No. 21.
5 Q.Do the Ureal world" risk premiums relied on
6 by Mr. Kahal make economic sense?
7 A.No. As noted on page 36 of Mr. Kahal' s
8 testimony, the historical surveys included in his assessment
9 found market equity risk premiums of 5.5 percent and 3.8
10 percent. But multiplying these market equity risk premiums
11 by Mr. Kahal' s beta of 0.83, and combining the resulting
12 risk premiums with his 4.5 percent risk-free rate, results
13 in indicated cost of equity estimates of approximately 7.7
14 percent and 9.1 percent. These returns fall at or below
15 current yields on triple-B utility bonds and are
16 dramatically lower than the earnings Value Line expects
17 utilities to achieve in coming years. By any objective
18 measure, such results fall woefully short of required
19 returns from an investment in Idaho Power's common equity
20 and confirm that the inputs to Mr. Kahal' s CAPM cost of
21 equity have little relation to the expectation of real-world
22 investors.
23 Q.Is there anything wrong with the approach
24 that you employed to determine the equity risk premium for
25 your forward-looking CAPM analysis (Exhibit No. 21)?
AVERA, DI REB 58
Idaho Power Company
1 A.No. As explained in my direct testimony, I
2 estimated the current equity risk premium by first applying
3 the DCF model to estimate investors' current required rate
4 of return for the firms in the S&P 500 and then subtracting
5 the yield on government bonds. Mr. Kahal contends that this
6 CAPM analysis is flawed because of an alleged upward bias in
7 the market risk premium. In fact, however, the use of
8 forward- looking expectations in estimating the market risk
9 premium is well accepted in the financial literature. For
10 example, in uThe Market Risk Premium: Expectational
11 Estimates Using Analysts' Forecasts" (Journal of Applied
12 Finance, Vol. 11 No.1, 2001), Robert S. Harris and Felicia
13 C. Marston employed the DCF model and earnings growth
14 projections from IBES - just as I did in Exhibit No. 21.
15 Mr. Kahal' s complaint about my forward-looking CAPM
16 approach seems to hinge on the fact that this method
17 produces an equity risk premium for the S&P 500 that is
18 considerably higher than the unrealistic benchmarks he
19 cites. But as I explained earlier, estimating investors'
20 required rate of return by reference to current, forward-
21 looking data, as I have done, is entirely consistent with
22 the theory underlying the CAPM methodology, which is an ex-
23 ante, or forward-looking model based on expectations of the
24 future. As a result, in order to produce a meaningful
25 estimate of required rates of return, the CAPM is best-
AVERA, DI REB 59
Idaho Power Company
1 applied using data that reflects the expectations of actual
2 investors in the market. Rather than look backwards to risk
3 premiums based on historical literature articles or surveys,
4 my analysis appropriately focused on the expectations of
5 actual investors in today's capital markets.
6 Q.Is there any merit to Mr. Kahal' s contention
7 that the CAPM analysis should consider alternative beta
8 values?
9 A.No. Application of any quantitative
10 technique to estimate the cost of equity is an attempt to
11 determine the expectations and requirements of real-world
12 investors in the capital markets. In this regard, the Value
13 Line beta values I used to apply the CAPM are perhaps the
14 best indicator of the risks investors are likely to
15 associate with electric utilities such as Idaho Power. As
16 noted in Regulatory Finance: Utilities' Cost of Capital:
17 Value Line betas are computed on a18 theoretically sound basis using a19 broadly-based market index, and they are20 adjusted for the regression tendency of21 betas to converge to 1.00. ..' Value22 Line is the largest and most widely23 circulated independent investment24 advisory service, and exerts influence25 on a large number of institutional and26 individual investors and on the27 expectations of these investors. 80
80 Morin, Roger A., "Regulatory Finance: Utilities' Cost of Capital,"
Public Utilities Reports (1994) at 65.
AVERA, DI REB 60
Idaho Power Company
1 In my experience, Value Line is the most widely referenced
2 source for beta in regulatory proceedings and Mr. Kahal has
3 presented no evidence that would call these values into
4 question.
5 Q.Please comment on Mr. Kahal' s application of
6 the comparable earnings approach.
7 A.By failing to evaluate the economic logic of
8 the individual returns for the companies in his reference
9 group, Mr. Kahal' s comparable earnings analysis suffers from
10 the same flaw explained earlier in connection with his DCF
11 application. For example, Mr. Kahal' s comparable earnings
12 results included a number of values that fall below current
13 yields on public utility bonds. 81 Indeed, almost one-half
14 of the individual returns included in Mr. Kahal' s comparable
15 earnings approach for his West Region proxy group (Exhibit
16 No. 606, p. 1) were equal to 8.5 percent or less. With
17 triple-B public utility bonds yielding 8.6 percent in
18 October 2008, these values provide no meaningful guide to
19 investors' expected rate of return. As a result, Mr.
20 Kahal' s comparable earnings analysis is woefully understated
21 and should be ignored.
81 See, e. g., the 4.2 percent and 5.5 percent returns for Avista Corp.
and Black Hills Corp., respectively, included on page 1 of Exhibit No.
606.
AVERA, DI REB 61
Idaho Power Company
1 Q.Is there any merit to Mr. Kahal' s admonition
2 (p. 38) that market-to-book ratios for electric utilities
3 should be considered in establishing Idaho Power's allowed
4 rates of return?
5 A.No. Underlying Mr. Kahal' s argument is the
6 supposition that regulators should set a required rate of
7 return to produce a market~to-book value of approximately
8 1.0. This is fallacious. For example, Regulatory Finance:
9 Utili ties Cost of Capi tal noted that:
10 The stock price is set by the market,11 not by regulators. The M/B ratio is the12 end result of regulation, and not its13 starting point. The view that14 regulation should set an allowed rate of15 return so as to produce a M/B of 1. 0,16 presumes that investors are masochistic.17 They commit capital to a utility with a18 M/B in excess of 1.0, knowing full well19 that they will be inflicted a capital20 loss by regulators. This is not a21 realistic or accurate view of
22 regulation. 82
23 Indeed, while Mr. Kahal' s example supposes that
24 investors expect an earned return of 11.0 percent on the
25 common equity of his hypothetical utility, he suggests that
26 regulators only need to allow the utility an ROE of 7.3
27 percent. In other words, Mr. Kahal apparently believes that
28 regulators should establish equity returns that will cause
29 share prices to fall. Given the regulatory imperative of
82 Id. at 256.
AVERA, DI REB 62
Idaho Power Company
1 preserving a utility's ability to attract capital, this
2 would be a truly nonsensical result.
3 Q.Does Mr. Kahal' s reference to the ROE
4 authorized by the IPUC in Idaho Power's last fully litigated
5 rate proceeding support his recommendations in this in
6 proceeding?
7 A.No. Mr. Kahal cites the 10.25 percent ROE
8 approved for Idaho Power in Case No. IPC-E-03-13, presumably
9 as support for the reasonableness of his 10.5 percent ROE
10 recommendation here. But as discussed earlier in response
11 to Ms. Carlock, this ignores the dramatic changes in capital
12 market conditions and the fact that the Company's investment
l~ risks have increased. Because the record in Case No. IPC-E-
14 03-13 was predicated on Idaho Power's former single-A credit
15 rating, the 10.25 percent ROE awarded by the IPUC does not
16 consider the higher risks that investors now associate with
17 the Company. Nor does it consider the significant increase
18 in investors' required return on long-term capital, as
19 evidenced by sharply higher yields on public utility bonds.
20 Q.Do you agree with Mr. Kahal (p. 10) that
21 changes in dividend taxation enacted in 2003 have led to a
22 significant decline in investors' required rate of return on
23 equity?
24 A.No. In light of the unprecedented capital
25 market events of this year and the uncertainties associated
AVERA, DI REB . 63
Idaho Power Company
1 with the incoming administration's policy responses, it is
2 ironic that Mr. Kahal would choose to focus on 2003 tax
3 legislation as support for his recommendations. 83 While
4 dividend taxation is certainly one factor that may be
5 considered by investors, the impact of changes in dividend
6 taxation on the cost of equity for Idaho Power is unclear.
7 First, the important role that pension funds and tax
8 deferred accounts play in the capital markets dilutes any
9 effect that tax rate changes might have on investors'
10 required rate of return. This is because the reduction in
11 the taxation of dividends has no impact on the returns for
12 tax- free investors.
13 Moreover, using current capital market data to
14 estimate the cost of equity, such as my DCF and forward-
15 looking CAPM approaches, already incorporate any effects of
16 changes in tax policies. While Mr. Kahal implies that
17 changes in dividend taxation suggest a lower cost of equity
18 than in the past, this ignores other significant factors
19 that influence required returns. In particular, risk
20 perceptions in general, and for electric utilities
21 specifically, have shifted sharply upward, which would more
22 than offset any decline in the equity risk premium due to
23 changes in dividend taxation. Finally, investors are
83 The reduction in dividend taxation in the Jobs and Growth Tax Relief
and Reconciliation Act of 2003 will expire at the end of 2008 unlessrenewed by Congress.
AVERA, DI REB 64
Idaho Power Company
1 forward- looking and recognize that there is no guarantee
2 that the reduction in dividend taxation will continue.
3 Q.Did Mr. Kahal incorporate an allowance for
4 flotation costs?
5 A.No. Based on his assertion that IDACORP has
6 no plans to issue common stock, Mr. Kahal rej ected an
7 allowance for issuance costs.
8 Q.Is Mr. Kahal' s position consistent with
9 financial realities and the views of other practitioners?
10 A.No. The need for a flotation cost adjustment
11 to compensate for past equity issues is recognized in the
12 financial literature. In a Public Utili ties Fortnightly
13 article, for example, Brigham, Aberwald, and Gapenski
14 demonstrated that even if no further stock issues are
15 contemplated, a flotation cost adjustment in all future
16 years is required to keep shareholders whole, and that the
17 flotation cost adjustment must consider total equity,
18 including retained earnings. 84 Similarly, Regula tory
19 Finance: Utilities' Cost of Capital contains the following
20 discussion:
21 Another controversy is whether the22 underpricing allowance should still be23 applied when the utility is not
24 contemplating an imminent common stock25 issue. Some argue that flotation costs
84 Brigham, E.F., Aberwald, D.A., and Gapenski, L.C., "Common Equity
Flotation Costs and Rate Making," Public Utilities Fortnightly, May, 2,
1985.
AVERA, DI REB 65
Idaho Power Company
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
are real and should be recognized in
calculating the fair rate of return on
equi ty, but only at the time when the
expenses are incurred. In other words,
the flotation cost allowance should not
continue indefinitely, but should be
made in the year in which the sale ofsecuri ties occurs, with no need for
continuing compensation in future years.
This argument implies that the company
has already been compensated for these
costs and/or the initial contributedcapi tal was obtained freely, devoid of
any flotation costs, which is an
unlikely assumption, and certainly n~t
applicable to most utilities. ... The
flotation cost adjustment cannot be
strictly forward-looking unless all past
flotation costs associated with past
issues have been recovered. (p. 175)
21 Q.Do you agree with Mr. Kahal' s position your
22 testimony failed to support an adjustment for flotation
23 costs?
24 A.No. The rationale underlying an adjustment
25 for past flotation costs was discussed in detail in my
26 direct testimony at pages 59-61. Further, while Mr. Kahal
27 asserts (p. 12) that I did not calculate a flotation cost
28 adder, this is incorrect. As noted in my direct testimony
29 (p. 61), my evaluation indicated that the flotation cost
30 allowance requires an estimated adjustment to the return on
31 equity of approximately 3.6 percent to 10 percent, which
32 translated into a flotation cost adder of approximately 14
33 to 39 basis points at the time my testimony was prepared.
AVERA, DI REB 66
Idaho Power Company
1 VI . DENNIS E. PESEAU
2 Q.Did Dr. Peseau conduct an independent study
3 to estimate a fair ROE for Idaho Power?
4 A.No. Dr. Peseau did not perform any
5 independent analyses to support his assertions regarding
6 Idaho Power's requested ROE. Rather, his assessment was
7 based entirely on inaccurate comparisons between 2007 and
8 the present.
9 Q.Please discussed the flaws in Dr. Peseau' s
10 evaluation.
11 A.Dr. Peseau argues that a fair return to Idaho
12 Power does not exceed the 10.25 percent ROE established in
13 2007 based on (1) a comparison of bond yields, (2) a
14 comparison of beta values, and (3) a comparison of changes
15 in my forward-looking risk premium. In contrast to the
16 conclusions reached by Dr. Peseau, none of his comparisons
17 support his conclusion that investors' required return for
18 Idaho Power is equal to or below 10.25 percent.
19 First, while Dr. Peseau suggests that the decrease
20 in Treasury bond yields experienced since 2007 implies that
21 investors' required returns on common equity may have
22 fallen, the exact opposite is true. Treasury bond yields
23 have declined because of a Uflight to quality" as investors'
24 risk perceptions have mounted in the face of the ongoing
25 financial crisis. As the Wall Street Journal noted, uReal-
AVERA, DI REB 67
Idaho Power Company
1 world borrowing costs are in a different universe from
2 Treasury yields and Fed rates." 85 The fact that the prices
3 of Treasury bonds have been driven sharply higher is the
4 mirror image of higher, not lower returns for more risky
5 asset classes, such as the common stock of utilities like
6 Idaho Power. Moreover, as discussed in detail earlier, Dr.
7 Peseau's conclusion that yields for utilities such as
8 IDACORP uhave been essentially flat" is not true. 86 The
9 average triple-B utility bond yield during 2007 was
10 approximately 6.3 percent, versus 9.0 percent in November
11 2008, or an increase of 270 basis points.
12 Second, while Dr. Peseau speculates about the
13 potential impact of changes in beta values and the implied
14 market risk premium, he completely ignores the ramifications
15 of this market data. As documented in Exhibit No. 21 to my
16 direct testimony, employing current beta values and a
17 forward- looking estimate of the current market risk premium
18 implies a cost of equity for my Utility Proxy Group of 11.9
19 percent, which considerably exceeds Dr. Peseau's artificial
20 10.25 percent uceiling."
21 Third, Dr. Peseau - like Ms. Carlock and Mr. Kahal -
22 entirely ignores the fact that Idaho Power's risks have
85 Gongloff, Mark, "Ahead of the Tape: The Shocks Are Getting A
Workout," The Wall street Journal at CL (Sep. 17, 2008).
86 Peseau Direct at 26.
AVERA, DI REB 68
Idaho Power Company
1 increased, as exemplified by the decline in the Company's
2 credi t rating. The fact is that while the Commission
3 professed a goal of maintaining Idaho Power's bond ratings
4 at or above the single-A level in 2004,87 the authorized
5 return has been inadequate to achieve this obj ecti ve and the
6 Company has consistently been unable to earn an ROE above
7 the single digits. Unsurprisingly, the associated decline
8 in financial metrics has pushed Idaho Power's S&P credit
9 rating to UBBB", while Moody's and Fitch maintain a
10 Unegative" outlook, warning investors of the potential for
11 yet another downgrade. Considering these trends and the
12 adverse conditions in today's capital markets, the ROE
13 recommendations of Ms. Carlock, Mr. Kahal, and Dr. Peseau
14 are inadequate and portend further deterioration in Idaho
15 Power's finances if adopted.
16 Q.Does this conclude your rebuttal testimony?
17 A.Yes.
87 Idaho Public Utilities Commission, Order No. 29505 (May 25, 2004) at
43.
AVERA, DI REB 69
Idaho Power Company
RECENT DIVIDEND YIELD RECEIVED Exhibit No. 81
Z008 DEC-3 PM 3: 43 Page 1 ofl
KAHAL PROXY GROUPS
IDAHO PUBliC
UTILITIES r:O~:,~~f,ic:::;n'¡j .J . f, l I ¡¡ ì \..J.... l ..... l'~
(a)(b)
Stock Dividend
West Region Price Dividend Yield
1 Avista $18.44 $0.75 4.07%
2 Black Hils $25.12 $1.44 5.73%
3 Edison International $33.46 $1.29 3.86%
4 Hawaiian Electrc $26.45 $1.24 4.69%
5 IDACORP $28.12 $1.20 4.27%
6 MDU Resources $18.46 $0.62 3.36%
7 PG&ECorp.$29.24 $1.62 5.54%
8 Pinacle West $29.65 $2.10 7.08%
9 Portand General $18.06 $1.00 5.54%
10 Puget Energy $25.40 $1.02 4.02%
11 Sempra Energy $42.15 $1.55 3.68%
12 UniSource Energy $25.40 $0.96 3.78%
13 Xcel Energy $17.72 $0.97 5.47%
Average 4.70%
Restrcted West Region
1 Avista $18.44 $0.75 4.07%
2 Black Hils $25.12 $1.44 5.73%
3 Hawaiian Electrc $26.45 $1.24 4.69%
4 IDACORP $28.12 $1.20 4.27%
5 Pinacle West $29.65 $2.10 7.08%
6 Portland General $18.06 $1.00 5.54%
7 Puget Energy $25.40 $1.02 4.02%
8 Xcel Energy $17.72 $0.97 5.47%
Average 5.11%
(a) Average closing price for November 3-24,2008 from www.finance.yahoo.com.
(b) Estimated dividend for next 12 mos. from The Value Line Investment Survey. Summary and
Index (Nov. 28, 2008).
Exhibit No. 81
Case No. IPC-E-08-10
W. Avera, IPC
Page 1 of 1
REVISED DCF SUMMARY
KAHAL PROXY GROUPS
West Region
Adjusted Yield (a)
DCF Growth RatE (b)
Implied Cost of Equity
Midpoint
Restrcted West Region
Adjusted Yield (a)
DCF Growth RatE (c)
Implied Cost of Equity
Midpoint
(a) Exhibit 12.
(b) Kahal Exhibit No. 604, p. 1.
(c) Kahal Exhibit No. 604, p. 2.
RECEiVED
ion OEC -3 PM 3: 44
UTI~H~lkO t~~;~~\~SION
6.00%
10.70%
4.70%
Exhibit No. 82
Page 1 of1
6.50%
11.20%
5.00%
10.11%
10.95%
5.11%
6.00%
11.11%
10.61%
Exhibit No. 82
Case No. IPC-E-08-10
W. Avera, IPC
Page 1 of 1