20081203Keen Rebuttal.pdf

REc:i D
2008 DEC -3 PM 3: 44
IriAHI~' ~. "'.,1,..,l.1."\) ¡...tiL'::;!,..
UTILITir:p ('''-,ë ¡;,' i ii-V t.\..rfli(it~','
, ~
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF IDAHO POWER COMPANY FOR
AUTHORITY TO INCREASE ITS RATES
AND CHAGES FOR ELECTRIC SERVICE.
CASE NO. IPC-E-08-10
IDAHO POWER COMPANY
DIRECT REBUTTAL TESTIMONY
OF
STEVEN R. KEEN
1 Q.Please state your name.
2 A.My name is Steven R. Keen.
3 Q.Are you the same Steven R. Keen that has
4 previously presented direct testimony in this proceeding?
5 A.Yes.
6 Q.Have you reviewed the direct testimony and
7 exhibits filed by the Commission Staff relating to cost of
8 capi tal in this proceeding?
9 A.Yes. My comments will relate primarily to
10 the testimony provided by Staff Witness Ms. Carlock as well
11 as the testimony of Mr. Matthew I. Kahal on behalf of the
12 U. S. Department of Energy ("DOE") and testimony of Dr.
13 Dennis E. Peseau on behalf of Micron Technology, Inc.
14 ( "Micron") concerning return on equity ("ROE")
15 Q. What have you concluded based on your review
16 of these testimonies?
17 A.I would first state that I agree with the
18 representations made by the Company's expert witness, Dr.
19 Avera, in his rebuttal testimony. The conclusions drawn by
20 Ms. Carlock, Mr. Kahal, and Dr. Peseau are indeed biased
21 downward and I think the rebuttal testimony of Dr. Avera
22 does an excellent job of directly categorizing the
23 shortcomings of each of the other recommendations. I do
24 appreciate that Mr. Kahal acknowledges that Idaho Power's
KEEN, S., DI REB 1
Idaho Power Company
1 current risk profile is high by choosing a recommended rate
2 of return that is at the high end of his range of
3 estimates. His recommended rate of return is also higher
4 than the last return authorized for the Company by the
5 Idaho Public Utilities Commission ("IPUC") in the litigated
6 2003 rate case so as to reflect a relative shift higher,
7 albeit slight, based on increased risks.
8 Q.What are the primary drivers for your
9 assessment that the Staff-, DOE-, and Micron- recommended
10 returns on equity are too low?
11 A.I look to three factors. First of all,
12 history suggests that these recommended levels of return
13 will yield actual returns on equity in the single digits.
14 The returns from years 2003, 2004, 2005, 2006, and 2007,
15 illustrated in LaMont Keen's Exhibit No.1, speak for
16 themselves. In those years, granted or implied allowed
17 ROEs of 10.25 percent and 10.6 percent delivered actual
18 earnings well below 10 percent.
19 Second, the rating agencies have clearly indicated
20 that the Company has experienced significant stress and is
21 in a less secure position today than in the past. Since
22 the year 2000, as illustrated in LaMont Keen's Exhibit No.
23 2, credit ratings for Idaho Power have been on a steady
24 march downward. The ratings trend from A+ to A- to BBB+ to
KEEN, S., DI REB 2
Idaho Power Company
1 BBB again speaks for itself. This decline will not be
2 turned or halted without some improvement in the Company's
3 allowed return on equity. In 2003, the Company's allowed
4 ROE was 10.25 percent. In 2005, the Company's Idaho Case
5 No. IPC-E-05-28 was settled and resulted in an implied ROE
6 of 10.6 percent. Ms. Carlock, Mr. Kahal, and Dr. Peseau
7 all argue to reduce the allowed return on equity at the
8 very time an increase is required. The downgrades from the
9 rating agencies send a clear and united statement to the
10 regulating agencies that the Company is more at risk today,
11 from a bond holders perspective, than it was five years
12 ago. The interests of equity investors fall behind those
13 of the bond holders so their risks are at least equally
14 raised.
15 Finally, I look to the recent events in the
16 financial marketplace as indicators that the risks this
17 Company is facing now are greater than anyone considered
18 when original testimony was filed. Admittedly, much of the
19 market turmoil has been realized very recently and may not
20 have been adequately factored into prior direct testimony,
21 but current market conditions signal much higher levels of
22 risks in terms of both cost and availability for all
23 capital. Mr. Kahal indicates he did not include any impact
24 of the financial crisis in his 10.5 percent ROE
KEEN, S., DI REB 3
Idaho Power Company
1 recommendation. His reason for not doing so is that he
2 feels it would not be proper to set fair rate of return
3 based on a crisis which likely will be temporary. Yet how
4 could it be fair to completely ignore any impact from a
5 financial crisis that may well be the largest in more than
6 50 years? As Dr. Avera noted in Figure 1 of his rebuttal
7 testimony, bond yields have skyrocketed since September of
8 this year. Apparently, bond investors are choosing not to
9 ignore the implications of this particular crisis.
10 Q.If the Commission adopts Staff's
11 recommendations, will the Company be able to earn an
12 adequate and reasonable rate of return in the year 2009?
13 A.No. I do not believe the Staff's
14 recommended 10.25 percent return on equity is an adequate,
15 risk adj usted return for the Company. I also do not
16 believe the full compliment of Staff recommendations will
17 allow the Company to earn anywhere close to an actual
18 return of equity of 10.25 percent. The Staff has not
19 adequately reflected the risks associated with serving load
20 in an environment of rising costs, limited resources and
21 constrained capital, especially in light of the recent
22 turmoil in the financial markets.
23 Q.In its testimony, the Commission Staff makes
24 allowances for elements of a forecast test year that are
KEEN, S., DI REB 4
Idaho Power Company
1 intended to compensate for the effects of regulatory lag.
2 Do you agree with the conclusions of Staff witnesses that
3 Staff's recommendations will properly compensate the
4 Company for regulatory lag?
5 A.No. In my opinion, if the Commission adopts
6 the Staff's recommended approach to a forecast test year,
7 the Company will not be properly compensated for regulatory
8 lag and will not be able to earn an actual rate of return
9 anywhere near the allowed rate. The Company continues to
10 experience increasing costs and faces needed investment in
11 aging generation and transmission systems that will not be
12 recovered if the significant reductions in allowed costs
13 under the Staff's methodology are implemented.
14 Q.Do the recent economic challenges stemming
15 from the financial crisis offer relief from dealing with
16 growth issues and rising costs?
17 A.Partially. While the economy is certainly
18 expected to be negatively impacted by the financial crisis
19 and prospects for growth much lower, I have not heard a
20 single projection that would indicate that growth would
21 completely stop or reverse in the Company's service
22 territory.
KEEN, S., DI REB 5
Idaho Power Company
1 Q.Since you filed your direct testimony, has
2 any new data been presented which addresses Idaho's
3 construction and growth prospects?
4 A.Yes. In the October 2008 Idaho Economic
5 Forecast, housing starts are proj ected to range from
6 roughly 9,300 units in 2008 to slightly over 13,000 units
7 in 2011. While these projections are significantly lower
8 than the 18,000 to 20,000 unit figures in recent years,
9 they still portray growth that will require investment to
10 maintain infrastructure in Idaho. Significant generation
11 and transmission infrastructure investments are needed in
12 our service territory that cannot be completely eliminated
13 even if customer growth stops.
14 Q.Do you agree with Staff Witness Ms. Carlock
15 that the Company's low cost hydro generation is a benefit
16 to the Company?
17 A.No. In fact, Idaho Power's low cost hydro
18 generation exacerbates the Company's rate recovery
19 difficulties. The benefit of the Company's low cost hydro
20 is passed on to the Company's customers in the form of low
21 rates. When the Company must add new investment to serve
22 the new loads, the new costs are high when compared to the
23 Company's low embedded costs. The Company is met with
KEEN, S., DI REB 6
Idaho Power Company
1 price resistance and there is a considerable lag between
2 cost occurrence and cost recovery.
3 Q.Ms. Carlock also commented on the role of
4 rating agencies in the ratemaking process. Would you add
5 any additional comments to her observations?
6 A.Yes. I continue to appreciate that Ms.
7 Carlock recognizes that the services of rating agencies are
8 important to the Company. In addition to impacting the
9 borrowing costs and the costs of investor supplied capital,
10 as noted by Ms. Carlock, credit rating decisions can
11 actually impact a company's access to capital. Turmoil in
12 the financial markets in 2007 and again more significantly
13 in 2008 demonstrated that lower credit ratings could
14 actually result in limited or complete inability to utilize
15 some financial products such as commercial paper.
16 Rating agencies ultimately look at how commission
17 decisions manifest themselves in the actual financial
18 performance of a company. Risk reducing mechanisms and
19 adjustments established in a regulatory environment are
20 important and closely monitored by rating agencies. How
21 these mechanisms and adjustments actually affect the
22 financial health of a company is of even greater
23 importance. It is the effect of the regulatory decisions
24 on a company's actual financial performance that is most
KEEN, S., DI REB 7
Idaho Power Company
1 critical. In light of this, it is again hard to overlook
2 the recent downward ratings changes and actual earnings
3 results that are far below allowed rates of return and not
4 see the need for corresponding recommendations for higher
5 returns on equity.
6 Q.Do you have any specific information on the
7 commercial paper issue you just mentioned?
8 A.Yes. Idaho Power's current commercial
9 paper ("CP") rating of A-2, P-2 recently put the Company in
10 a difficult liquidity situation regarding the issuance of
11 CPo CP issuers carry a rating of A-1, A-2, or A-3 by
12 Standard and Poor's and P-1, P-2, or P-3 by Moody's, with
13 A-1 and P-1 being the most highly rated. Of the three
14 ratings criteria for CP issuance, Idaho Power is in the
15 middle tier. When CP markets became very volatile this
16 fall and rates skyrocketed, issuance of CP became nearly
17 impossible for all companies. A government program
18 designed to improve issuance of commercial paper was
19 implemented fairly quickly by the U. S. Federal Reserve but
20 it only included purchase allowances for companies in the
21 top tier rated A-1, P-1. As a result, companies with that
22 rating have had much less difficulty issuing commercial
23 paper and have done so at more competitive rates.
KEEN, S., DI REB 8
Idaho Power Company
1 CP in Idaho Power's category of A-2, P-2 has
2 experienced pricing increases from roughly 3 percent this
3 summer to in excess of 6 percent in October. Instead of
4 being able to issue CP with maturities of weeks or months,
5 the only available maturities at certain times in October
6 were 1 imi ted to days, or even overnight. As a result of
7 this credit squeeze, the Company was forced to utilize a
8 loan feature provided for in its credit facility. On
9 October 7, 2008, the Company drew down a swing-line loan of
10 $30 million to accommodate short-term liquidity needs. The
11 loan was subsequently repaid when issuance maturities
12 beyond overnight were again available.
13 Q.Is that an unusual circumstance for the
14 Company?
15 A.Yes. Drawing on credit facilities is very
16 rare and is a situation all companies try to avoid. To my
17 knowledge, this is the first time Idaho Power has been
18 forced to use this liquidity mechanism.
19 Q.Can you explain why this occurrence is
20 relevant here?
21 A.Yes. The reason I mention it here is that
22 it is a very direct signal that the Company is currently
23 operating in a time of significant financial stress. On
24 page 9 of his direct testimony, Mr. Kahal referred to the
KEEN, S., DI REB 9
Idaho Power Company
1 situation as "a serious economic crisis that has required
2 historical and remedial action by U. S. and foreign
3 governments." It is indeed serious and the Company-
4 specific liquidity issues point out that the impacts are
5 real and affecting Idaho Power today. It also points out
6 that having weaker credit can cause detrimental results.
7 The increased costs from this short-term borrowing is a
8 very real stress on the actual results for the Company and
9 it demonstrates why higher rates of return on equity are
10 warranted during times of financial distress.
11 Q.Do you have any comments regarding interest
12 rates and equity markets in light of comments made by Staff
13 Witness Carlock?
14 A.I do. In regard to interest rates, Ms.
15 Carlock cites a decline in the prime rate, which is one
16 benchmark for short-term borrowing, and also mentions that
17 the federal funds rate and other rates had also decreased.
18 I do not disagree with those observations; however,
19 benchmark rates are merely a starting point for interest
20 charges to be incurred by a regulated utility. Banks and
21 other lenders charge a spread above the benchmark rates
22 depending on perceived borrowing risks. That spread is
23 added to the benchmark treasury rate to form the coupon
24 rate of interest. This rate ignores an additional small
KEEN, S., DI REB 10
Idaho Power Company
1 increase for costs of issuance, but it is a good rate for
2 comparison purposes.
3 For example, on July 7, 2008, the Company issued
4 long-term debt with a ten-year term at a coupon rate of
5 6.025 percent. That rate included a spread to the Treasury
6 of 215 basis points over and above the benchmark ten-year
7 Treasury rate of 3.875 percent. Roughly six months
8 earlier, that spread to Treasury was closer to 100 basis
9 points and the trend of rising spreads has continued. At
10 the end of October 2008, the benchmark Treasury rate for
11 ten-year bonds was roughly the same as in July; however,
12 the spread to Treasury for Idaho Power would have added
13 over 400 basis points. The coupon rate would have been
14 close to 200 basis points higher than in' July of this year.
15 Since the end of October, the Treasury rates have declined
16 further but not nearly as much as the spread to Treasury
17 has risen.
18 The point is that the interest cost to the Company
19 has actually risen significantly over the course of the
20 year, which puts additional stress and risk on funding
21 future capital needs.
22 In addition to that stress on debt issuances, equity
23 prices have fallen significantly. On October 31, 2008, the
24 Company stock was trading 24 percent below its starting
KEEN, S., DI REB 11
Idaho Power Company
1 point for the year. While the Company's share price held
2 up relatively well compared to peer companies, that
3 significant decline in equity value is an additional stress
4 upon the Company's financial viability.
5 Q.What are industry experts saying in regard
6 to interest rates and the relative issuance spreads going
7 forward?
8 A.The consensus is that spreads will remain
9 wider and that the current higher level of coupon issuance
10 rates will not improve in the near term. As noted in
11 Figure 1 of Dr. Avera's rebuttal testimony, corporate bond
12 yields have seen precipitous increases since September of
13 this year. Those increases are primarily the result of
14 increased spread, or perceived risk, over benchmark
15 Treasuries. With Treasuries already extremely low,
16 reductions in debt costs will only come when the market
1 7 feels more confident about corporate debt in general, thus
18 allowing spreads to contract.
19 Q.Do you recommend any other changes to the
20 capital structure?
21 A.I do not recommend any change at this time
22 but note that there will be actual outcomes that differ
23 from the Company's proj ections. I continue to believe that
24 a forecast methodology is an appropriate and reasonable
KEEN, S., DI REB 12
Idaho Power Company
1 benchmark for setting our cost of capital. However, Staff
2 has introduced modifications for various components of this
3 filing based on a review of actual expenditures to date and
4 I feel compelled to acknowledge that changes have also
5 occurred in regard to cost of capital.
6 In my proposed capital structure, I have included
7 proj ected costs of debt related to planned debt issuances
8 for both taxable and non-taxable debt. One of those
9 lssuances occurred on July 7, 2008. The original
10 projection for this issuance was $125 million at a rate of
11 5.53 percent for ten-year bonds. The actual issuance was
12 for $120 million at a rate of 6.025 percent for ten years.
13 The other planned issuances relate to the Company's
14 Pollution Control Revenue bonds for both Sweetwater and
15 Humbolt Counties. The projected interest rates utilized in
16 the Company's embedded cost of debt schedule were derived
17 from pricing estimates as of April 10, 2008, and related to
18 planned issuances for these securities; Idaho Power
19 anticipated the bonds would be outstanding 'at fixed rates
20 until maturity of each bond. The rates Idaho Power is
21 currently being quoted for this type of issuance are
22 significantly higher than in the Company's forecast.
23 Estimates are now roughly 100 basis points higher than our
24 assumed 5.75 percent rate as originally filed.
KEEN, S., DI REB 13
Idaho Power Company
1 Q.Are there any other components of the
2 current debt structure that are impacted by market changes?
3 A.Yes, Idaho Power has one additional series
4 of variable rate debt outstanding, the Port of Morrow
5 Series 2000, due 2027, and that variable rate was
6 originally proposed based on a five-year historical
7 average. The updated average rate for five years through
8 September 30, 2008, would be 3.070 percent, which is
9 slightly higher than the filed rate of 2.978 percent.
10 Q.Do you wish to add any other comments
11 regarding the financial crisis and how it may potentially
12 impact ROE recommendations?
13 A.I do want to add some specifics to the quote
14 from Mr. Kahal' s testimony. While this certainly is a
15 "serious economic crisis," I think it is important to
16 reflect on the significance and magnitude of events that
17 occurred in September and October of this year before
18 dismissing too quickly that this situation is temporary or
19 that equity holders will not be factoring in higher risk
20 expectations going forward.
21 Here is a brief time line for perspective:
22
23
Sept. 7:Federal takeover of Fannie Mae and
Freddie Mac
24 Sept. 14:Bank of America buys Merrill Lynch
KEEN, S., DI REB 14
Idaho Power Company
1 Sept.15 :
Sept.17:
Sept.19:
Sept.25 :
Sept.29:
Sept.30 :
Oct.1:
Oct.3 :
2
3
4
5
6
7
8
9
10
11
12
13
14
Oct. 6:
15
16
Oct. 8:
17
18
Oct. 10:
19
20
Oct. 14:
21
22
Oct. 15:
23
24
Oct. 28:
25
26
27
Oct. 30:
28 Q.
29 A.
Lehman Brothers files for bankruptcy
Federal Reserve Loans $85 billion to
AIG to avoid bankruptcy
Paulsen rescue plan unveiled
WaMu seized by FDIC, sold to JP Morgan
Bailout defeated in the House of
Representati ves
CITI announces FDIC-backed acquisition
of Wachovia
Senate passes revised bailout
Wells Fargo announces merger with
Wachovia; Bailout signed into law
Federal Reserve announces $900 billion
in short - term loans to banks
Federal Reserve reduces emergency
lending to 1.75 percent
End of the worst week for stock market
in 75 years.
US Announces injection of $250 billion
into US banking system
US monthly retail sales drop 1.2
percent and DJIA drops 7.87 percent
US consumer confidence falls to record
low of 38
Federal Reserve announces Federal
Reserve Funds Rate cut of .5 percent to
1 percent
Have these events moderated since October?
The frequency of events may be slowing but
30 the reactions in the financial markets continue to be
KEEN, S., DI REB 15
Idaho Power Company
1 severe. On December 1, 2008, the U. S. economy was
2 officially deemed to have been in a recession and the Dow
3 Jones Industrial Average plunged 679 points. The fourth-
4 largest point decline since this index was created in 1986.
5 Q.Did you factor in any allowance for the type
6 of financial market changes outlined above that occurred
7 during 2008 when you filed your original testimony?
8 A.I did not foresee or account for the level
9 of volatility that has occurred in the financial sector.
10 The current financial turmoil is itself a risk factor that
11 was in no way considered when I filled my original
12 testimony.
13 Q.Are these levels of volatility unique?
14 A.Most certainly. Below is a chart that was
15 provided to me by J. P. Morgan and it represents the S&P 500
16 volatility index, or VIX. This index is commonly used in
17 the financial community as a measurement of volatility.
18 Typically volatility has the effect of increasing risk and
19 as you see, the level of volatility in the current
20 financial market is extreme. Recent levels depict
21 volatility as high as four times greater than the average
22 over last prior decade.
KEEN, S., DI REB 16
Idaho Power Company
1
80
4 50
1998.2007 average: 20.7
2 70
3 60
40
5
30
6 20
7 10
01'01'08 02121'08 04/13/08 06/04/08 07/26/08 09/'5/08 1'07/08
8 Q.In your original testimony, you make
9 reference to the difficulties of achieving actual earnings
10 that equal allowed levels of return. Will this current
11 financial turmoil impact the Company's ability to achieve
12 allowed earnings results?
13 A.The increased volatility raises uncertainty
14 and the market is currently translating that uncertainty
15 into higher risk-adjusted costs to all forms of capital,
16 which in turn will make it harder to achieve allowed
17 earnings results.
18 Q.In your direct testimony you indicated that
19 potential improvements in the mechanism utilized to recover
20 power supply costs ("PCA") could influence your recommended
21 rate or return on equity. Do you have any additional
22 comments to add in that regard?
KEEN, S., DI REB 17
Idaho Power Company
1 A.Yes. There has certainly been progress on
2 the PCA and assuming the new methodology is implemented, I
3 feel it will improve the risk profile of the Company. This
4 enhancement should deliver a very modest benefit to the
5 earnings ability of the Company and a greater benefit to
6 the management of cash flows. While this enhancement is
7 significant, it does not entirely close the gap between my
8 recommended return on equity and the 10.25 percent
9 recommended by Staff. I also did not anticipate the severe
10 changes that have occurred in the financial markets since
11 that testimony was filed and the significant negat~ve those
12 events introduced in the determination of equity return.
13 I would simply observe that these two events have
14 occurred, one positive and one negative. The positive
15 event is significant for the Company but did not remove 100
16 percent of the exposure Idaho Power experiences due to
17 weather and water related fluctuations in its hydroelectric
18 generation. The negative event is significant historically
19 to the entire world and I cannot predict what the ultimate
20 effect will be on Idaho Power. I will simply say that I
21 continue to feel the recommendations for rate of return on
22 equity by Staff, the DOE, and Micron are too low.
23 Q.Does this complete your direct rebuttal
24 testimony?
KEEN, S., DI REB 18
Idaho Power Company
1 A.Yes.
KEEN, S., DI REB 19
Idaho Power Company
A