20090309Smith Direct.pdf

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BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF IDAHO POWER
COMPANY'S APPLICATION FOR A
CERTIFICATE OF PUBLIC CONVENIENCE
AND NECESSITY FOR THE LAGLEY
GULCH POWER PLAT.
CASE NO. IPC-E-09-03
IDAHO POWER COMPANY
DIRECT TESTIMONY
OF
LORI SMITH
1 Q.Would you please state your name, business
2 address, and present occupation?
3 A.My name is Lori Smith and my business
4 address is 1221 West Idaho Street, Boise, Idaho. I am
5 employed by Idaho Power Company (" Idaho Power" or
6 "Company") as Vice President of Corporate Planning and
7 Chief Risk Officer.
8 Q.What is your educational background?
9 A.I graduated in 1983 from Boise State
10 University, Boise, Idaho, receiving a Bachelor of Business
11 Administration degree in Information Sciences. In 1999, I
12 was awarded the designation of Chartered Financial Analyst.
13 In 2008, I completed a two-part course in Decision Analysis
14 and Decision Quality in Organizations at the Stanford
15 Center for Professional Development. I have also attended
16 numerous seminars and conferences related to utility
17 accounting, corporate finance, and risk related topics.
18 Q.Would you please outline your business
19 experience?
20 A.From 1983 to 1986, I was employed by Idaho
21 Power Company and assigned to the Materials Management
22 Department. From 1986 to 1994, I served as a Financial
23 Accountant and later as a Budget Accountant. I was
24 promoted to Business Analyst in 1994. In 1996, I was
SMITH, DI 1
Idaho Power Company
1 promoted to Strategic Analysis Team Leader. In 2000, I
2 assumed the position of Director of Strategic Analysis. In
3 2003, I was named Director of Strategic Analysis and Risk
4 Management. In 2004, I was promoted to the position of
5 Vice President of Finance and Chief Risk Officer. In 2008,
6 I assumed my current position as Vice President of
7 Corporate Planning and Chief Risk Officer.
8 Q.What are your duties as Vice President of
9 Corporate Planning and Chief Risk Officer?
10 A.My responsibilities include the oversight of
11 corporate development,strategic planning,and risk
12 management processes for Idaho Power Company.Corporate
13 development includes acquisitions, divestitures, and joint-
14 ventures. Strategic planning includes development of
15 analyses, strategies, and operating plans. Risk management
16 includes activities related to managing market, credit, and
17 operational risk exposure from an enterprise perspective.
18 I am tasked with ensuring the best use of Idaho
19 Power's resources by defining and planning the Company's
20 strategic and long-range goals. I am also responsible for
21 the analysis of the financial impacts of regulatory
22 strategy to ensure successful implementation and provide
23 meaningful insight into strategic alignment. I direct the
24 development of operational forecasts and analysis both
SMITH, DI 2
Idaho Power Company
1 long- and short-term. In addition, I am the corporate
2 board representative for Ida-West Energy and IDACORP
3 Financial Services. I have subsidiary leadership
4 responsibilities that include setting goals and defining
5 investment criteria and performance requirements. I direct
6 the activities related to the organization's market risk
7 and credit exposure to protect against adverse movements in
8 net power supply costs. Finally, I am responsible for
9 designing, developing, and implementing an Enterprise Risk
10 Management process for IDACORP, Inc., and Idaho Power
11 Company.
12 Q.What is the purpose of your testimony in
13 this proceeding?
14 A.I describe how Idaho Power's need for
15 capital to fund infrastructure and maintenance investments
16 over the next three years exceeds the cash flow it receives
17 from operations. It will be very difficult for Idaho Power
18 to finance the Langley Gulch power plant with debt or
19 equity given the current conditions in the capital markets,
20 the restructuring of which has resulted in limited
21 availability of credit and devalued stock prices. Given
22 these adverse economic conditions, I believe the proposed
23 recovery of CWIP in rate base annually or the regulatory
24 ratemaking assurances described in Mr. Ric Gale's testimony
SMITH, DI 3
Idaho Power Company
1 will minimize Idaho Power's need to access the capital
2 markets and/or make the Company more attractive to lenders
3 if it does.
4 IDAHO POWER'S NEED FOR ADDITIONAL CAITAL
5 Q.What is Idaho Power's current ability to
6 fund plant investments required to meet its customers'
7 energy needs over the next three years?
8 A.Idaho Power has been diligent in its efforts
9 to continue to meet the energy needs of its customers.
10 This has been demonstrated in the Company's Integrated
11 Resource Plan ("IRP"), the most recent of which was filed
12 in 2006 and updated in June 2008. The IRP has identified
13 the need for a baseload resource to come on-line in 2012.
14 As Mr. Karl Bokenkamp describes in his testimony, the 330
15 MW Langley Gulch power plant project ("Project") identified
16 through the competitive bidding process will meet the
17 growing customer demand for electricity in 2012. However,
18 the expenditures associated with this Project combined with
19 the continued needs to upgrade existing facilities, expand
20 environmental controls, and maintain an aging
21 infrastructure, require the Company to expend a significant
22 amount of capital in order to meet these needs.
23 These capital requirements come at a time when the
24 Company's balance sheet has been weakened due to the
SMITH, DI 4
Idaho Power Company
1 impacts of drought conditions in six of the last seven
2 years and much higher historical capital expenditures since
3 2006 to meet the demands of customer growth. The cost of
4 the new infrastructure, to be built concurrently with
5 current maintenance capital expenditures, substantially
6 exceeds Idaho Power's cash flow from operations.
7 Q.What is cash flow from operations?
8 A.A simple measure of cash flow from
9 operations is seen in the average of depreciation expense
10 plus net operating income, a proxy for cash flow from
11 operations.During the time period 2006 through 2008,
12 Idaho Power Company generated on average approximately $190
13 million of cash flow from operations. The average of
14 construction expenditures during this time was $250
15 million. The shortage of internally generated cash flows
16 versus Idaho Power's infrastructure investments, on
17 average, from 2006-2008 is $60 million per year. The
18 additional construction expenditures above cash flow from
19 operations must be acquired from the capital markets in a
20 balanced combination of long-term debt financing and
21 issuances of common stock.
22 Q.What is the impact of inadequate cash flows?
23 A.Inadequate cash flows cause credit rating
24 agencies to be concerned. The credit rating community uses
SMITH, DI 5
Idaho Power Company
1 cash flow and other financial ratios with more subjective
2 evaluations, such as perceived regulatory support, to
3 assess the financial health and prospects for a utility.
4 If changes in such measures exceed a rating agency's
5 thresholds, such changes can affect bond ratings. Bond
6 ratings, in turn, directly affect both the cost and the
7 availability of debt, which are both important components
8 in determining the utility cost of capital.
9 Q.How much capital does the Company expect to
10 invest in its system over the next three years?
11 A.As reported on February 26, 2009, in
12 IDACORP's and Idaho Power's FORM 10-K, the Company expects
13 to spend between $220 and $230 million in 2009 and average
14 from $278 million to $295 million between 2010 and 2011
15 excluding the investment in the 2012 Langley Gulch Project.
16 The expected investment requirements to reliably maintain
17 and operate the system impose additional pressure on cash
18 flow coverage ratios during the next three years absent a
19 significant increase in operating cash flows.
20 Q.What is the impact of this shortage of cash
21 flow from operations?
22 A.The shortage must be financed with funds
23 raised in the capital markets. The Company must acquire
24 long-term debt and have the ability to issue common stock
SMITH, DI 6
Idaho Power Company
1 in order to make the required investments related to
2 providing reliable service . Given the current state of the
3 capital markets, Idaho Power has limited ability to access
4 the capital it needs to finance construction of the Langley
5 Gulch Proj ect and cannot predict when the market may return
6 to "normal."
7 CURNT STATE OF THE CAITAL MATS
8 Q.What is the current state of the capital
9 markets?
10 A.The current credit crisis in the capital
11 markets can be characterized by significant credit
12 contraction as a result of the fundamental restructuring of
13 the financial sector. This restructuring is evidenced by
14 fewer banks, increased regulatory requirements for capital
15 adequacy, and significant new requirements to de-leverage
16 bank balance sheets from their historical leverage
17 multiples of up to 30 times. Since Labor Day 2008, there
18 have been unprecedented market events from the credit
19 contraction, including the U. S. Treasury's efforts to
20 stabilize the U. S. banking industry by providing $350
21 billion through the Troubled Asset Relief Program ("TARP").
22 The U. S. Treasury's critical objectives are to stabilize
23 the financial markets and reduce systemic risk, support the
24 housing market by avoiding preventable foreclosures and
SMITH, DI 7
Idaho Power Company
1 facilitate mortgage finance, and to protect taxpayers. To
2 this end, the U. S. Treasury has thus far allocated a total
3 of $700 billion in the Emergency Economic Stabilization
4 Act, including the TARP funding.
5 Idaho Power has long-term banking relationships, a
6 high percentage of which are with banks that have received
7 TARP funding from the U. S. Treasury. These relationships
8 are in good working order ¡however, it is unknown whether
9 the market will be receptive to the Company's financing
10 needs when Idaho Power is ready to access the capital
11 markets. This access to capital markets cannot be
12 predicted at this time. The collapse of the credit markets
13 reduced the number of banks providing liquidity as a result
14 of bank failures, government interventions, and Mega
15 mergers. The result is increased volatility, increased de-
16 leveraging, and de-risking by the U. S. banking industry.
17 Q.Why is access to the capital markets so
18 important to this proceeding?
19 A.Idaho Power cannot internally fund the
20 required investment in plant, including the Langley Gulch
21 Project, necessary to reliably serve customers from its
22 existing operations. The impact of this crisis
23 significantly increases the value of an investment grade
24 credit rating as the lending capacity of the financial
SMITH, DI 8
Idaho Power Company
1 industry contracts and the selection criteria for borrowing
2 companies is more stringent. It is critical that our
3 continued efforts to maintain Idaho Power's corporate
4 credit rating of BBB with S&P and Baal with Moody's are
S successful.
6 Q.Why is Idaho Power's ability to maintain its
7 credit rating paramount in this uncertain credit
8 environment?
9 A.Maintaining our current credit rating
10 minimizes the interest rate spread between different rating
11 grades (investment grade versus below investment grade) and
12 allows the Company to access long-term maturities of debt.
13 The alternative would be to finance long-lived assets with
14 short-term duration bonds that subject our customers to
lS interest rate risk in the form of durations for bonds that
16 do not match the life of the asset.
17 For investment grade issuers, like Idaho Power, the
18 credit spreads (i. e., the yield spread, or difference in
19 yield between different securities due to different credit
20 quality) for issuers were at an all time low in 200S. This
21 relatively inexpensive liquidity and ability to access
22 long-term capital changed in October 2008 to a capital
23 market with short supply, with liquidity being non-existent
24 or very hard to obtain. The cost of funding across the
SMITH, DI 9
Idaho Power Company
1 capital structure increased for short-term and long-term
2 debt and the reduction in stock market values decreased the
3 overall ability to raise capital. Some companies that
4 currently have a credit rating below investment grade have
5 experienced complete exclusion from the market place from
6 October 30 through December 9, the longest period without
7 new issuance in 17 years. Additionally, issuers are
8 reluctant to launch a transaction without a high degree of
9 certainty around its success because of the negative
10 publicity associated with failed transactions. The
11 increase in credit spreads as a result of the rapid
12 deterioration in the U. S. banking industry and corporate
13 credit markets brought a historic wholesale widening of
14 credit spreads and a slowdown in supply of credit to high-
15 grade issuers. The market access to BBB issuers, like
16 Idaho -Power, has improved but access still remains credit
17 specific, volatile, and unpredictable.
18 The Company's access to credit at reasonable costs,
19 desired maturity of issue, and reasonable financing terms
20 is greatly dependent on the investment grade rating
21 currently in place.
22 Q.How do major credit rating agencies
23 determine Idaho Power's credit profile?
SMITH, DI 10
Idaho Power Company
1 A.The credit rating agencies begin their
2 assessment using a variety of financial ratios. The
3 calculation of these ratios varies between credit rating
4 agencies. In addition, the credit rating agencies evaluate
5 certain qualitative factors, including the regulatory
6 environment, management capability, and past operational
7 and financial performance. Please see Exhibit No. 5 for
8 the most recent Moody's and S&P publications on Idaho Power
9 Company.
10 Q.In the event the Commission selected a
11 different alternative to the Project, do credit rating
12 agencies view credit risk for purchase power agreements or
13 tolling agreements differently than a plant built by a
14 utility?
15 A.No. When a company decides to buy
16 generation thru a long-term purchase power agreement or a
17 tolling arrangement there is a risk transfer from the
18 seller of the energy to the buyer of the energy and its
19 customers and shareholders in the form of imputed debt.
20 Imputed debt is a measure of financial risk shifted to a
21 utility when it enters into a purchase power agreement
22 ("PPA") or tolling agreement ("TA"). The imputed debt
23 measurement is calculated by S&P, for example, and included
24 in the analysis of financial ratios used to measure the
SMITH, DI 11
Idaho Power Company
1 utility's creditworthiness. Because debt, actual or
2 imputed, is attributed to the utility that acquires power
3 through the construction of a new plant, PPA or TA,
4 regulatory support is needed to mitigate the impact on the
5 utility's financial ratios. The mitigation can take the
6 following forms:
7 1.Full and automatic regulatory support
8 which can reduce the financial risk imposed on a utility
9 from imputed debt by decreasing or eliminating the
10 uncertainty regarding full recovery of the costs of the
11 PPA.
12 2.Compensate the utility for the
13 increased financial risk by
14 a.Increasing the amount of equity in
15 the rate base, and/or
16 b.Increasing the allowed return on
1 7 equi ty, and/or
18 c.Restoring financial ratios to pre-
19 PPA or TA level with an adder to the PPA payment.
20 To further explain the ramifications of imputed debt
21 on utilities, I have included a white paper written by the
22 Brattle Group for the Edison Electric Institute and
23 regulatory staff called "Understanding Debt Imputation
24 Issues" as Exhibit No.6.
SMITH, DI 12
Idaho Power Company
1 Q.What are the risks of issuing common stock
2 during times when the market value of the stock is below
3 its book value, as Idaho Power's stock currently is?
4 A.The Company's stock has deteriorated in
5 value by 25.4 percent from December 2008 to March 5, 2009.
6 The Company has not seen a decline of this magnitude since
7 late 2000 in which IDACORP's telecommunications and energy
8 marketing affiliates helped drive down IDACORP's stock
9 price. Evidenced below is a chart of IDACORP' s trading
10 history since the end of 2000. The market value of
11 IDACORP's stock is trading below book value at a time when
12 the Company needs to raise capital to finance the
13 construction of the Proj ect. A corporation's book value is
14 used in fundamental financial analysis to help determine
15 whether the market value of corporate shares is above or
16 below the book value of corporate shares. Issuing new
17 equity below book value will cause dilution of existing
18 shareholders and invites shareholder lawsuits.
SMITH, DI 13
Idaho Power Company
II~ IDACORP Market Price vs. Book Value
$50.00 ..............................................................................Oecember3iï..2'O....~.....Mafch..5;.2009...........\
\$45.00
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$40.00 \ \
$35.00
$30.00
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$25.00
$20.00
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2 RELIEF REQUESTED
3 Q.Mr. Gale's testimony describes the Company's
4 ratemaking request in the form of two alternatives:( 1)
5 recovery of a portion of Construction Work in Progress
6 ("CWIP") the Company incurs as it constructs the Project to
7 be included in current rates on an annual basis or (2)
8 explicit findings on how the Commission intends to treat
9 the Company's Langley Gulch investment for ratemaking
10 purposes at the time it is placed in service. How would
11 the financial community view each of these alternatives?
12 A.The Proj ect is expected to take four years
13 to construct and require significant funding from the
SMITH, DI 14
Idaho Power Company
1 capital markets in terms of both debt and equity at a time
2 of substantial uncertainty related to accessing the capital
3 markets. CWIP, including AFUDC, in rate base during
4 construction will provide cash flow to construct the
5 Proj ect. This new cash flow will reduce the Company's need
6 to access the capital market at a time of great volatility
7 and unpredictable access.
8 It is my belief that financing the construction of
9 the Proj ect without regulatory assurance of rate recovery
10 or CWIP in rate base will endanger Idaho Power's ability to
11 maintain its current credit ratings. CWIP in rate base
12 would be a substantial benefit from a credit perspective
13 because cash would be collected currently versus the
14 assurance of cash collected in the future.
15 Q.If the Commission approves AFUDC and CWIP in
16 rate base, how does Idaho Power envision these accounts
17 would operate?
18 A.AFUDC is the capitalization costs associated
19 with the construction of an asset, whereas CWIP is the
20 accumulation of all costs associated with the construction
21 of an asset plus the cost of financing the construction
22 expenditures. AFUDC provides for the financial carrying
23 costs of an asset while it is being constructed and is
24 recorded in Account 107. During construction, AFUDC is a
SMITH, DI 15
Idaho Power Company
1 non-cash entry to Account 107 that represents the costs of
2 debt financing and an equity return as proscribed in the
3 FERC formula (CFR 18, Part 101, Subchapter C, Electric
4 Plant Instruction 3 (A) (17), as amended by a FERC letter
5 dated December 30, 1981). The AFUDC plus the accumulation
6 of all other costs associated with construction is then
7 closed to plant Account 101 as an asset upon completion of
8 the proj ect .
9 Once included in rate base, AFUDC is typically
10 recovered over the life of the asset through depreciation
11 expense and a return on investment earned. The asset and
12 AFUDC generate cash flow for the Company when included in
13 rate base in a revenue requirement proceeding.
14 Q.What benefit would the ratemaking assurances
15 and CWIP recovery mechanisms provide to Idaho Power
16 customers?
17 A.With CWIP, customers will help fund
18 construction of the Langley Gulch power plant as it is
19 built, thus avoiding financing costs that would otherwise
20 be depreciated over several decades. As with buying
21 furniture or a vehicle, paying for a power plant upfront
22 with cash is significantly less expensive than financing it
23 through debt or equity.
SMITH, DI 16
Idaho Power Company
1 CWIP in rate base reduces the rate shock experienced
2 by our customers by smoothing the rate increases over the
3 construction period versus a one-time large increase at the
4 end of the construction period. I will describe for
5 illustrative purposes an example that estimates the
6 customer impact of three recovery alternatives.
7 In Exhibit No. 7 I have compared two of the
8 al ternati ve rate recovery examples to a traditional plant
9 closing to a plant filing of the Langley Gulch power plant,
10 with ratemaking assurances described in Mr. Gale's
11 testimony resulting in a rate increase of 7.9 percent over
12 current rates in early 2013. The first comparison example,
13 "AFUDC: Pay Currently," is similar to Hells Canyon
14 Relicensing AFUDC granted in Order No. 30722. If customers
15 pay currently for AFUDC from 2010 to 2013, the cumulative
16 increase at the end of construction period would be 6.9
17 percent, comprised of a 1. 9 percent, 1. 9 percent, 1.1
18 percent, and 2.0 percent increase for the years 2010, 2011,
19 2012, and 2013, respectively. The key difference between
20 this method and the "CWIP Rate Base" method is that a
21 regulatory liability is established to collect and amortize
22 the collection over the life of the plant.
23 In the second example, "CWIP in Rate Base,"
24 customers paying for all CWIP expenditures including AFUDC
SMITH, DI 17
Idaho Power Company
1 would experience an estimated increase of 7.0 percent. The
2 CWIP in Rate Base example is comprised of a 1. 9 percent,
3 2.0 percent, 1.4 percent, and 1.8 percent rate increase in
4 the years 2010, 2011, 2012, and 2013 , respectively. These
5 examples demonstrate how the rate increases will be
6 softened and will allow customers time to adjust to the
7 increasing rates versus a one-time rate increase that is
8 preliminarily estimated to be 7.9 percent over current
9 rates beginning in 2013.
10 Q.Will the inclusion of CWIP in rate base or
11 ratemaking assurances guarantee access to the debt and
12 equity capital markets?
13 A.Answering this question with any specific
14 level of certainty is made more difficult in the current
15 climate of unprecedented bank failures, the speed of the
16 economic downturn, continued capital market uncertainty the
17 contraction of available financing capacity which has
18 shrunk the once liquid and deep capital markets that Idaho
19 Power has been able to access in the past. However, I
20 believe the granting CWIP for all or a portion of the
21 Company costs for construction of Langley Gulch and
22 ratemaking assurances as described by Mr. Gale in his
23 testimony are the kinds of regulatory support mechanisms
24 that will help to differentiate Idaho Power from other
SMITH, DI 18
Idaho Power Company
1 capital-seeking companies when the construction and
2 permanent financing of the Project is required.
3 Q.Does this conclude your direct testimony in
4 this case?
5 A.Yes, it does.
SMITH, DI 19
Idaho Power Company
BEFORE THE
IDAHO PUBLIC UTiliTIES COMM.ISSION
CASE NO. IPC-E-09-03
IDAHO POWER COMPANY
SMITH, 01
TESTIMONY
EXHIBIT NO.5
s.-MilødM".'n~"M~
Credit Opinion: Idaho Power Company
Idaho Power Coml!any_
Global Credit Research
Credit Opinion
4JUN2008
Boise, Idaho, United States
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Category
Outlook
Issuer Rating
First Mortgage Bonds
Senior Secure
Sr Unsee Bank Creit Facilit
Senior Unsecure Shelf
Commercial Paper
Parent: IDACORP, Inc.
Outlook
Issuer Rating
Sr Unsee Bank Creit Faclity
Senior Unsecured MTN
Commercial Paper
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Moody's Rating
Negative
Baa1
A3
A3
Baa1
(P)Baa1
P-2
Negative
Baa2
Baa2
Baa2
P-2
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Analyst
Kevin G. RoselNew York
Willam L. Hess/New York
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(1)Idaho Power Company
(CFO Pre-W/C + Interest) I Interest Expense
(CFO Pre-W/C) I Debt
(CFO Pre-W/C - Dividends) I Debt
(CFO Pre-W/C - Divdends) I Capex
Debt I Bok Capitalization
EBITA Margin %
Phone
212.553.0389
212.553.3837
.._..__._.__......
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LTM 1Q08 2007 2006 2005
2.3 2.4 3.3 3.4
7%7%13%13%
3%3%8%8%
13%14%41%42%
46%45%42%41%
18%19%20%17%
(1) All ratios calculated in accordance with the Global Regulated Electrc Utilties Rating Methodology using
Moody's standard adjustments
Note: For defnitions of Moody's most common ratio terms please see the accompanying VSJtlSiuide.
Company Profile
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Idaho Power Company (lPC) is a vertcåily integrated regulated investor-owned utility and the principal wholly-
owned subsidiary of IDACORP, Inc. (IDA), a holding company which also serves as parent for other modest-sized
non-utility businesses. As an ali-electric utilit, IPC provides retail electric servce to approximately 483,000
residential, irrigation, commercial and industrial customer wihin a 24,OOQ-square mile servlce'area encompassing
southwesern Idaho and eastern Oreon. The company operates a system wih 4,747 miles of transmission lines
and 26,394 miles of distribution lines. i PC relies heavily on hydro-elecric power for its generating needs, normally
generating nearly half of the electricit it sells from 17 hydro-elecric developments on the Snake River and its Exhibit NO.5
Case No. IPC-E-Q9-Q3
L Smith, IPC
Page 1 of 15
trbutaries. IPC also serves a portion of it electric load from three col-fired power plants in Wyoming, Nevaa,
and Oreon and from the natural gas-fire Bennett Mountain Power Plant, Danskin 1 Power Plant, and Evander
Andrews Power Complex in Mountain Home, Idaho. IPC is the parent of Idaho Energy Resources Co., a joint
venture partner in Bridger Coal Company, which supplies coal to the Jim Bridger generating plant owned in part by
¡PC. The utilty also buys electricity from the reional wholesale market to meet its customers' needs for electriciy.
On a stand-alone basis, ~PC represents the substantial majori of IDACORP's consolidated revenues, net Income,
and assets. IPC's customers have been weighted toward the residential class, wih about 46.1 % of 2007 general
business revenues derived frm sales to reidential customers, which are typically mora predictble and stble
sources of revenue. We do not expect this to change materially in the foreseeable fuure. The remainder of IPC's
2007 revenues were derived from electricity sales to commercial customers (25.4%), industril customers (15.2%),
and irrgation customers (13.3%).
IPC's retail rates are subjec to the regulatory jurisdiction of the Idaho Public Utilites Commission (IPUC) and the
Oregon Publfc Utilit Commission (OPUC) as it relates to rates charged to its retail customers and various
financing activity. Wholesale actvities and interste activities are subject to th jurisdiction of the Federal Energy
Regulatory Commission (FERC).
Recent Events
Effctive June 3, 2008, Mooy's affrmed the ratings of IDACORP, Inc. (Baa2 Issuer Rating and Prme-2 short term
debt rating) and its regulated utility subsidiary, Idaho Power Company (IPC; Baa1 senior unsecured and Prime-2
short-term debt rating). At the same time, Moody's changed the rating outlook to negative from stable for both
companies. See Press Release of June 3, 2008 for additinal commentary.
Rating Rationale
Key factors affecting IPC's Baa1 senior unsecured debt rating Include a relatively low business risk profile and lo
cot structure relative to national peers within a usually generally supportive regulatory environment combined with
an increasing level of capitl expenditure to add generation capacity, trnsmission infstrcture, and addres
other asset maintenance to ensure meeting servce safety and reliability stndards. The company's recent financial
metrics, including its coverage of interest and debt by cash flow frm operations exclusive of working capital
changes (CFO Pre-W/C), have been pressure to a level we often see for a reulated electc utilty in the Ba
rating cateory. These recent metrics are the result of unfavorable hydro conditons and the advers effecs the
recent increase to the load groh adjustment rate (LGAR) has had on net powr supply cost recover under the
power cost adjustment (PCA) mechanism. With repe to the latter conce, we note that the LGAR subtract the
cost of servng additional Idaho retail load fro the net por supply cots that IPC is allwed to incude in its
annual PCA filing. We addres the LGAR in more detail below; however, as IPC continues to diversif its resourc
portlio and works with the IPUC to adjust or replace the currnt LGAR, as called for as part of the settlement ofthe utilitys last general rate case, we are concerned about whether recent revenue increases approved by the
IPUC and the OPUC, when combined with the likely implementation of further general rate incrases assocIated
wih fuure rate fiings, wil be suffcient to allow ¡PC's cash flow coverage memes to reve hack to levels more
consistent with the currnt rating over the next 12 to 18 months. Meanwhile, IPC's Integrated Resource Plan (IRP),
and its access to suffcient liquidity are considere in line with the Baa rating cateory. IPC's raings also take into
accunt that IPC's retail raes remain below national averages, and that It is pursuing strategies to control
operating expenses and conservatively finance it invesbnents.
The most important drivers of IPC's currnt ratings and outlook are as follows:
DETERIORATION IN HYDRO CONDITONS RAISES OPERATING CHALLENGES AND PRESSURES
MAGINS
During 2007, there was a retum to the drought conditions that have persisted in Idaho in ali but one ofthe las
seven years. The one excepton was in 2006, when there wa a Mef nonnalization of water levels. Inflows into the
company's largest storage reservoir, the Brownlee Reservoir, were only 2.8 milHon acr feet (mat) during the
critical April through July 2007 runoff period, which was about 44% of average. Although hydro conditions are
somewhat better to date in 2008, they still remain below normal. The current expectations for runoff during the
critical April through July period in 2008 of about 4.8 maf is stil only about 76% of average. Based on this data,
¡PC is currnty expecting to generate beteen 6.0 and 8.0 milion megawatt hours (MWh) from its hydroelecric
facilties during 2008, compared to 6.2 milion MWh in 2007. The water conditions in the Snake River Basin this
year have enabled IPC's hydroelectric generation to contribute abot 46% of total system generation during the
first quartr, compared to about 51 % for the same period in 2007. When IPC experiences por hydrolecmc
generating conditons, it results in a heavier dependence on tyically more expensive thermal generation and
purchased power, and reduces wholesale sales while increasing operatIons and maintenance expenses and
pressuring margins.
It remains to be seen whether the drought conditions that have persisted for six out of the last seven years in the
U.S. Pacific northwest region may be viewed as an anomaly or as part of a larger more permanent or semi-
permanent climate shift that signals the need for reduced reRance upon hydro-eectrlc generation for a company
such as IPC that has relied fairly extensively upon hydro as the primary component of its genertion portolio.
Moody's ratings and negative outlook for IPC take into accunt these incrased operating challenges.
Exhibit No.5
Case No. IPC-E-09-03
L. Smith, IPC
Page 2 of 15
PARTiAl OFFSETS FROM POWER COST ADJUSTMENT (PCA) MECHANISM
Our ratings also take into consideration the long-standing existnce of a PeA mechanism in Idaho and the
generally supportve outcomes in annual fiings made before the IPUC. Under the terms of the PCA, (PC annually
adjusts Its rates charged to Idaho retail customers for 90% of the diffrence (wih interest) between the actual and
forecasted costs of fuel and purcased power less off-system sales, and the tre-p of the prior year's forecast.
We generally view the existenc of PCA mechanisms to be beneficial to a utiltys overall crit profile because
such a mechanism can help minimize th negat effts on earnings and cash flow when net powr supply costs
unexpectedly exced forest levels in existing rates. This is especially so when the cash recover period is
relatively short. We note that IPC's 2008-2009 PCA fifing initially requested an increase of $87.2 million to the PCA
component of customers' rates. Subsequent to this reuest, the IPUC Issued a ruling that reuire IPC to offet the
PCA reuest with $16.4 milion of proceeds frm an earlier sale of sulfur dioxide emission allownces. As a result,
it was expected that IPC's PCA rate increase, to be effective June 1, 2008, would be $70.7 millon (10.4%) for the
2008-2009 period. In a final PCA decision rendere May 30. 2008, the IPUC made positive adjustments that
brought the approved level of the PCA rate incrase efftie June 1, 2008 to $73.3 milion (10.7%).
¡PC HAS BEEN ACTIVE IN FILING GENERAL RATE CASES
On the heels of the 3.2% general rate case setement increase to IPC's Idaho retail base rates implemented on
June 1, 2006, which we generally viewed as a partlarly encouraging sign of a more transparent working
relationship between the IPUC and IPC, the utilit filed another general rate case on June 8, 2007. In the June
2007 filing, IPC sought a 10.35% rate increase ($63.9 millon annually), to addres revery of and retrn on
investments and to also compensate for higher operating costs. IPC also requested that the IPUC reuce the
LGAR to $29.16 per MWh frm $29.41 per MWh. As described in public filings, the significance of the LGAR is that
it adjusts IPC's net power supply cots that it Includes in the annual PCA fiings for difrences between actual load
and the load used In calating existing base rates. During periods of modest load growh andlor when there is
litte diference beteen assumed and actual load, the LGAR is a less material issue; however, in recent periods,
IPC's loads have grown considerably in exces of the assumed load in setting base rates. During such perids, the
marginal energy cot of servng new Idaho retail customers are subtrcted frm the PCA fdings. in effect, IPC must
walt unti its next general rae case to adjust the assumed load growth. From a credit perspective, Moody's
concern increase when the IPUC increases th LGA and/or there is a significant mismatch between the
assumed and actal load growth becuse of the potential negativ effct on IPC's earnings and cash flow under
those circumstnces.
As the June 2007 case proceeded, the partes setted in January 2008 on an average annual 5.2% rate increase
(about $32.1 mifion) and agree to pursue good faith effrt to develop a mechanism to adjust or repla thecurrnt LGAR. Importntly, the general rate case settement gave IPC an opportunity to reset the load growh
assumption use in the rate proce. Meanwhile, the setlement provided for use of the IPUC staff recommended
LGAR of $62.79 per MWh, which would only be applied to half of the lod growt in Idaho during each month
within the April 2008 - March 2009 PCA year. Anoter importnt aspec of the settlement called for good faith
discussion among the partes aimed at estblishing acptable terms for use of a forest test year in fuure
general rate cases which, if implemented, would address concems about regulator lag and be viewed as a crit
positive. The settement was ultimately approve by the IPUC in the fonn presented to them and new rates thatwere silent as to the allowed rate of return became effctive March 1, 2008. (See below for furter backgrond on
future general rate case plans).
OTHER REGULATORY INITIATIVES
Aside frm the recently concluded PCA filing and other general rate case actvity in Idaho, IPC recently wrappe
up a series of other proedings in Idaho and Oreon in May 2008, which collectively will provide an additional
$18.4 millon of reenue under rates that tok effec June 1,2008 and should contrbute to a rebound In financial
results. First, the IPUC approved IPC's request for a 1.4% rate increse ($9 millon) to address recovery of the
Danskin 1 natural gas fired plant that began commercial operation eariier this year. The IPUC also approved IPC's
requested increase in its Energy Effciency Rider to 2.5% from 1.5%. This 1 % increase translates into about a $7
mifion annual increase in revenue that wfi be collected from its Idaho customers to cover th cost of various
energy effciency programs. Furtermore, IPC will make Its first rate adjustment under the decupllng proram in
Idaho aimed at de-linking revenues frm volume. The net effct of the IPUC approval of this filing results In a $2.4
millon rate reuction. Lastly, the OPUC approved a $4.8 mlfion rate increase (15.7%), representing the first rate
adjustment under the recently implemented power cost adjustment mechanism In Oreon. Approvl of the rate
change Is, however, subject to refund. We understand that the OPUC staff requestd additional time to further
review data since this was the initial proceeding under this mechanism and the relative amount wa quite large.
Neverteless, there was a desire to implement a rate adjustment efftive June 1, 2008.
SIGNIFICANTLY HIGHER UTILITY CAPITAL EXPENDITURES REQUIRE EXTERNAL FUNDING
IPC faces significantly higher capital expenditure needs over the next few years for additions and upgrades to
existing generation, transmission, and distribution Infrastructure, primarily to meet customer and demand growth.
¡PC expect to continue financing its large utflt constructon program and other capitl requirements (excuding
new base load plant and large transmission projects), whic are estimated at $900 millon over the three-year
period spanning 2008-2010, with internally generated funds and externally financed capital. Its Internally generated
cash after dividends Is only expected to provide slightly more than half of its $270-290 mifion estimated 2008 Exhibit NO.5
Case No. IPC-E-Q9-03
L Smith, IPC
Page 3 of 15
capital requirements. In the face of extemal financing needs, it is anticipated that IPC wil seek to maintain
capitalization ratios close to the level of March 31, 2008, through periodIc additional common equity Infusions from
its parent company.
As originally artculated in IDA's 2006 Integrated Resourc Plan (lRP) reulatory filing, IPC is looking to reduce its
reliance on hydro, while also making investments into new trnsmission assets to help meet load growt and
improve it operating perfrmance/reliabilty. To that end, IPC signed a memorandum of understanding wih
PaciCorp on May 18, 2007, under which the companies will pursue the posible development of new high voltage
trnsmission lines frm Wyoming acrss soutern Idaho, with target completion set between 2012 and 2014.
Another groing component of the IRP is the exploration of potential invesents into geothermal power, as
evidenced by IPC's negotiations with U.S. Geothermal Inc. IPC named U.S. Geothrmal as the succssful bidder
for 45 MW of geothrmal poer frm the fuure development of U.S. Geothermal's Raft River geothermal power
plant in southeastern Idaho and the initial phase of U.S. Geothermal's Neal Hot Springs prject located in
souteast Oregon.
A notable shift in the 2006 IRP relales to a decision In April 2008 to not pursue a conventional pulverized col-fired
plant to meet a targeted capacit need in 2013, given concerns about escalating constrcton costs, ability to
obtain requisite permits, and lingering uncertnty related to greenhouse gas laws and regulations. Instead, IPC
has issued reques for proposals (RFP) for 250 to 600 megawatts of dispatchable, physically delivered or unit
contingent energy to be acquired under power purchase contracts or tollng agrements. We undersnd that IPC
wil us a self-build proposal for a combined cycle natural gas combustion turbine as the benchmark to compare
proposals against. Proposals are due by OCober 17, 2008. Meanwhile, IPC plans to offcially provide an update on
the status of Its 2006 IRP to the IPUC and the OPUC in June 2008 and then file a new IRP in June 2009.
Given the magnitude of some of the aforementioned investment considerations, it is poible that IPC's capital
budget over 2008 - 2010 could be substantially higher than the $900 milln figure cited above. To the extent that
IPC moves ahead with Investmnts into renewable and theral energ resources, as well as trnsmission line
expansion, that provide greater diversificatin of electri power sourcs bot as to ty of generation and
geographic locale, Moody's wold generally view thse investments as a positive for IPC's crit prfile, presuming
the investments are financed In a conservative manner and receive supportive treatment by the uUlit's regulators.
CONTINUING NEED FOR FURTHER GENERAL RATE CASE INCREASES AT ¡PC
Given the forecasted capital expenditure program, in order to maintain a creit metrics profile commensurate with
it currnt rang, it is essential that the utilty recive favorable rate case increases frm the Idaho and Oreon
reulatory authorities in its reulatory filings. IPC's management remains focuse on this objecive, as evidenced
by its notice of intent to file with the IPUC a general rate case on or after June 1, 2008. In addition to the level of
rate Increase that IPC might seek, key points to focs on in the propective case wil be whether the IPUC fully
embraces the forest test year concept that evolved frm work shop discussions with the IPUC staff and other
interested parties earlier this year and accpts the concept of including costrcton work in proress, particularly
as it relates to hydro plant rellcensing and other utility investments, as part of the utility rate base.
Separately, we would view any progress toward reucing or eliminating the cost sharing approch under the peA
so that IPC recoers 100% of any po cost under reveries and development of a mechanism to adjust or
replace the currnt LGAR as credit poitive steps (See above for more background on the LGAR solution as it was
incorporated into IPC's general rate case settement approved February 28, 2008).
RENEWED FOCUS ON CORE UTILITY OPERATIONS EMPHASIZES DESIRABILITY OF LOW BUSINESS RISK
Regulatory support Is all the mo Imporant as the conclusion of divestiture of non-cre unregulated businesss
previously owned by IDA has left IPC as the principal sourc of cash fiows, with lesser contrbutions from
independent power prouction at Ida-West Energy and afrdable housing investments through IDACORP
Financial Servces. This renewed fous on core electric utility operations is in line with the overall corprate
strategy of a decreased reliance on cash flow frm riskier non~utlit businesses and has placed greater emphasis
on the importance of having a low business risk profile.
Moody'S views this back-to-basics fous as being beneficial to IPC, as it helps to ensure that no exraneous capital
expenditure demands will detract from the large utilit capital program set forth in the IRP. Any deviation from this
stategy, such as a foray by the parent company into unregulated corprate acquisitions, would likely necessitte a
higher level of scrtiny as to whether IPC's fairly ambitious capital expenditure program will continue to be rolled
out without undue hindrance. We als believe that IPC will continue to beneft frm IDA's renewe focs on a back-
to~basics core energy-related straegy centere on its regulated utlity business, insofar as management stil may
decide to further support IPC's capital program and bolster capitalizaion and cash flow coverage of debt metrics
by periodic issuances of additional common equity.
RECENT PRESSURE ON CASH FLOW METRICS
IPC's CFO Pre-W/C for the 12-monts ended Marc 31, 2008 provided coverage of Interest and debt by 2.3x and
6.8%, repectively, reflectng a continuation of weakness evidenced during fical 2007 and a mark declIne frm
the 3.3x and 13%, repectvely, achieved for fiscal 2006. The decline since the start of 2007 reflects PCA rate Exhibit NO.5
Case No. IPC-E-09-03
L. Smith, IPC
Page 4 of 15
difference, less favorable hydro electric operating coditions, and the reduce sales of exce sulfur dioxide
emission allowances. Alough our prospective view takes into accunt that key credit metrics, including CFO Pre
W/C to debt and Interest, may reound over the next 18 months as the full benefits of recently approved rate
Increases materialize, the improvement may not be suffcient to re-establish the metrcs at levels cosistent with
what we typically observe for vertically integrted utilitis at the Baa1 senior unsecure rating levL. Although the
sale of sulfr dIoxide emission allownces had positive efect (to varying degres) on earnIngs and cash flow In
2005 - 2007, we do not factor in similar effec on a propectve basis.
As noted above, IPC's metrics for the 12-months ended March 31, 2008 are pressured relative to the currnt Baa1
rating and we expec that the company's financlal perfrmance will remain subject to the vagaries of weter flow
conditions. As a result, the adequacy and timeliness of rate relief afforded to IPC by the IPUC in likely fuure PCA
and general rate case proceings becomes increasingly more importnt, partcularly in light of the higher than
historical utilty capital expenditures planned for the near term. Our ratings and negative outlook are Intended to
convey the relative importnce that regulatory suppoive ness plays in IPC's fuure credit profile. A keyconsideration in order for IPC to stabllze its rating outlook and maintain it Baa1 senfor unsered ratng will be
the extent to which the I PUC is supporive in any future regulatory fiIngs by IPC (i.e. whether they provide
supportive rae base tratment of planned utllit capitl spending and relatively timely revery of net power supply
costs).
After considering Moody's standard adjustments, IPC has been able to maintain its overall debt leverage ratio at
45.6% as of March 31, 2008, which is slightly above the three-year average of 42.6% spanning the period of 2005
to 2007. The calculation of this ra includes deferred income taes as part of capitaliztion. The adjusted debt
ratio currentl leaves IPC comfortbly positioned relative to the range we tyicaHy observe for Baa-rated regulated
electrc utilities. Given the recent slight increase in IPC's debt ratio stemming frm higher than historil capital
spending, we see the possibilty that propecive debt leverage could still creep slightly higher.
Uquld!ty
On balance, fPC has generally maintained suffcient liquidit, Including cash on hand plus its unused capacy
under its revolvng bank credit facilit. In 2007, management negotited an increase in the amount of IPC's
revolver, in order to better cover the propective liquidity needs of the company as it undertkes a large capital
program while drought conditions have resurfced to pressure cash flow. Mor recntly, IPC also arrnged for a
$170 million term loan creit agreement as of April 1, 2008, and lons under the agreement are due Marc 31,
2009. IPC used loans dran under this facilty for a mandatry purchase of $166.1 million of pollutIon contr
revenue refunding bonds on April 3, 2008. The company took this voluntary step to eff an intere expense
savings through conversion of the bonds frm an aucton interest rae mode to a weekly interest rate mode.
Although IPC Is the current holder of the bonds, it expects to remarketthe bonds to Investors before the Marc 31,
2009 term loan due date.
The IPC revolving bank crdit facilit is a $300 million five-year credit agreement, which Is princpally use to
backstop comercial paper. The facility terminates on April 25, 2012. Similar to the amended IDA bank facility,IPC has the right to request an increse in the aggrgate princpal amount of the IPC facilty, in its case to $450
milion, and to reuest one-year extensions of the then existing termInation date. At March 31, 2008, there were no
borrwings under IPC's facilit but $186 milion of commercial paper was outstnding. As of May 7,2008, IPC had
$201 milion of commercial paper outstanding. It Is worth noting that IPC currentl has full availabilit under a $350
million secured medium-term note program, Series H, which It recently put In place. This proram provides
flexibilit for IPC to term out its short-term debt as managemant has typically done when balances reach levels
noted as of May 7, 2008.
Importntly, the IPC bank facility contains les restrctive terms and conditions than historical agrements, as it
does not reuire a representation and warrnty that no material adverse change has occurred as a prerequisite to
any. funding beyond the initial closing date and there are no rating trggers in the agreements that would cause
default, accleration, or puts. The only financIal covenant in the facilit limis the debt to total capitaliztion raio as
defined to 65%. At March 31, 2008, the leverage raio for fPC was 54%. The terms and conditions of the term loan
creit agreement essentially mirrr the bank revolver.
Beyond the existing commercial paper and term loan balance noted above, IPC has a modest sinking fund
payment due within the next year of $1.06 millon. Its next scheduled maturity of long term debt is $81 million dueDecember 2009. As noted above, IPC is facing a signifcant capital proram. When capital spending is taken into
account along with other expected calls on cash over the next four quartrs, we note that IPC wil need to accs
the debt markets and receive equity infusions from its parent to fund its expectd negative free cash flow in order
to maintain its targeted 50/50 debt/equit mix.
Moody's takes a certain amount of comfort from the relatrve size of IPC's average outstanding commercial paper
balances over the past 12-month period to its credit facility limit amount. For the 12-month period ended March 31,
2008, IPC's commercial paper balances averaged around $116 million, with the $186 millon peak balance
occurrng in March 2008 because of capital expenditures, tax deposits paid to IDA, and reuce operating cash
flows. The average balances outstanding were about $34 million during the comparable trailing 12-month period
ended March 31, 2007. We anticipate that IPC's commercial paper balance wil range between $70 milion and
$240 milion over the next four quarters. The peak amount will likely be dependent upon the timing of IPC's next
long-term debt issuance to term out its commercial paper, consistent with managemenfs ongoing prctice.Exhibit NO.5
Case No. IPC-E-09-03
L Smith, IPC
Page 5 of 15
Rating Outlook
IPC's negative rating outlook reflect Moody's concerns about weakness evidenced in the utility's key credit
memcs in recent periods, due to the adverse effects that poor hydro conditions and the load groh adjustment
rate (LGAR) have had on IPC's earnings and cash flow. Moreover, IPC faces a higher than historical average
capItal proram over the next several years, which wil reuire extrnal financing to fund the expected negative
free cash flow. Although recently implemented rate incrases during 2008 collectvely amount to approximately an
additional $120 milion of revenue on an annualized basis, these amounts may not be entirely suffcient to restore
key credit metrles to levels commensurate wih the current ratings.
What Could Change the Rating - Up
The negative outlook due to near term challenges related to a large capital program and th vagaries of operating
a large hydroelectric system make an upgrade unlikely in the ner term; however, IPC's outlook could be stbilzed
over the near to medium term through a combination of a return to normalized hydro conditions, strnger
regulatory support in fuure rate procedings, and improement In CFO PrW/C to interest and debt near 3.5x and
15%, respectively, on a sustainable basis.
What Could Change the Rating - Down
Lower than anticipated earings and cash flow, perhaps due to the potential continuatin of drought conditins
over the longer term or unanticipated lack of regulatory support in fuure PCA and/or general rae case
proedings, such that CFO Pre W/C to interest and adjusted debt stayed below 3.0x and 13%, respectIvely, for
an extended period of time, could result In a negative rating action. Additionally, negative pressure could stem frm
one or more of the following: signifcant incrases in hydro plant relicenslng cots and/or stringent operational
constrints imposed as part of the license renewal proces; any unexpected change that compromises the PCA
mechanism (I.e., inadequate cost recovery due to the effect of the LGAR as described above); any shift by
IDACORP to pursue sIgnificant, debt-finance investment In more risk non-rulated businesss that Increases
demand on IPC cash flow and increases IPC's debt level such that it adjusted debt/adjusted capitaliztion ratio is
inflated to well above 50% on a sustainable basis.
Rat(ngJ:a*li
Idaho Power Company
Select Key Ratis for Global Regulated E1ecmc
Utiities
~tl~g J.Aa l~j A.,J.A J Rll I e,n I,... .i:I'aai:é~~l ~få.~~ln~$Rl$k .' "IMedluml.i.owIMedluIlIJ:oÝ(IM$dlu.n1 i.owTM~CiumliQW'
CFO pre-W/C to Interest (x) (1)~6 ~5 3.5-.0 3.0-2.7~5.0 2-4.0 ~.5 ..25.7
CFO pre-W/C to Debt (%) (1)~30 ~22 22-3 12-22 13-25 5-13 ..13 ..
CFO pre-W/C - Dividends to Debt (%) (1);:25 ~20 13-25 9-20 8-20 3-10 ..10 -03
Total Debt to Bok Capitalization (%)-00 ..50 40-60 50-75 50-70 60-75 ;.60 ~70
(1) CFO preW/C, which fs also referrd to as FFO In the Global Regulated Electric Utilities Rating Methodology, is
equal to net cash flow frm operations less net changes in woking capitl items
(Ç Copyrght 2008, Mooy's Investrs Servce, Inc. and/or its licensors including Moody's Assurance Company, Inc.
(together, "MOODY'S"). All rights reserved.
ALL INFORMATION CONTAINED HEREIN is PROTECTD BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY SE
COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITD, TRNSFERRED, DISSEMINATED,
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FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITOUT MOODY'S PRIOR WRITN CONSENT. All
information contained herein is obtained by MOODY'S from sources believed by it to be accurate and reliable. Because of the
possibilty of human or mechanical error as well as other factors, however, such Information is provided "as is" without warranty
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and financial reporting analyss observations, if any, constituting part of the information contained herein are, and must be
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securities. NO WARRANl, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLEENESS, MERCHANTABILIT OR
FITNESS FOR ANY PARTICULA PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION is GIVEN OR MADE BY
Exhibit No.5
Case No. IPC-E-09-03
L. Smith, IPC
Page 6 of 15
MooDY'S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any
investent deision made by or on behalf of any user of the informatlon contained herein, and each such user must accordingly
make its own stdy and evaluation of each security and of each Issuer and guarantor of, and each provider of creit support for,
each security that it may consider purchasing, holding or sellng.
MOODY'S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debenture, notes and
commercial paper) and preferred stok rated by MOODY'S have, prIor to assignment of any rating, agreed to pay to MOODY'S for
appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,400,000. Moody's Corporation (MCO)
and Its wholly-owned credit rating agency subsidiary, Moody's Investors Service (MIS), also maIntain policies and procedures to
addres the Independence of MIS's ratings and rating procse. Informatlon regarding certin affliations that may exist
between direors of MCO and rated entities, and between entitles who hold ratings from MIS and have also publicly reorted to
the SEC an ownership Interest in MCO of more than 5%, is poted annually on Moody's website at www.moodys.com under the
heading "Shareholder Relations - Corporate Governance - Director and Shareholder Affliation policy.'
Exhibit NO.5
Case No. IPC-E-D9-D3
L Smith, IPC
Page 7 of 15
My Creit Profile
Idaho Power Co.
Publication date:
Primary Credit Analyst:
12-Feb-2009
Tony Bettnell, San Francisco (1) 415-371-5067;
antonio bettnell(§standardandpoors.com
Major Rating Factors
Strengths:
. A strong power cost adjustment (PCA) mechanism that allows 95% of uncollected
power costs to be deferred for timely collection;
. A low-cst hydro- and coal-based generating fleet;
. A generally supportve state regulatory regime; and
. The absence of material, unregulated busInesses.
u~ jfrvJe-1 ,";lr ~\ (( --í, ~;H; : ~~-1 H¡'r~ i
BBB/StablélA-2 .
Raings Detl ~~
Weaknesses:
. High exposure to hydroelectric generation volatilty on the Snake River, resulting in unpredictable power supplies and
costs, although ultimate recovery is higher due to the company's PCA mechanism;
. Average cash flow to debt persistently at the (ower range of currnt financial risk category; and
. Planning challenges related to generation and transmission needs due to the uncertinty offuture growth and recovery.
Rationale
The 'BBB' corporate credit rating on IDACORP is based on the consolidated credit profile of the company, consisting primarily of
integrated electric utilty Idaho Power Co. (IPC), which carres the same rating, and reflects a 'strong' business profile and
'aggressive' consolidated financial profile. IPC normally provides more than 90% of earnings and most of IDACORP's
consolidated cash from operations.
IPC's 'strong' business profile incorporates both its low-cst hydroelectric generation base, which exposes the company to
substantial replacement power price risk in the event of low water flows, and a credit-supportive regulatory environment In Idaho.
Under normal water conditions, hydrological generation provides about half of total generation needs, necessitatIng a robust cost
recovery mechanism.
The recently authorized Improvements to Idaho Power Company's annual power cost adjustment (PCA) mechanism support
credit quality and are expected to reduce the under-collection of power costs and reduce cash flow volatility. The most significant
credit-supportive modifications to the PCA indude a reduction in the sharing mechanism that halves power cost exposure to 5%
from 10%. a new forecasted cost methodology that Is expected to result in smaller tre-up balances. a beneficial change to the
Exhibit N .5
Case No. IPC-E-Q9-03
https:/Iw.myclprofile.standarndpoors.comlysmy...icleDel&rea=IndustrNewsAleLt&çJeJd=702295 (1 of 6)21009 1:28:44 PM L Smith, I PC
Page 8 of 15
My Credit Prfie
punitive load growth add-back adjustment, and the inclusion of third-part transmission costs that have become more onerous in
recent years. In exceptionally low water years, deferrals materially weaken cash flows and credit metrcs, but we view this
primarily as a liquidity matter since 95% of costs above base rates are collected with a carrying charge over 12 months.
The 'aggressive' financial profile is marked by gradual deterioration of cash flow coverage and volatile cash flows. Over time,
average credit metrlcs have deteriorated, but the company has taken steps to stabilze returns and cash flow with new updated
base rates and modifed power cost mechanisms. Ratios are expected to improve in 2009. As of Sept. 30,2008, IOACORP's
adjusted funds from operations (FFO) coverage of interest and FFO to total debt were 3.1x and 11.1 %, respectively, on a 12-
month rollng basis. (Credit metres are adjusted to Include the debt equivalent of leases, purchased power obligations, and
postretirement benefit obligations.) Cash flow-based coverage ratios have improved slightly but steadily over the past two
quarters, based on the Impact of multiple rate increases over the past 12 months. While leverge remains reasoble for the
ratlng, with an adjusted debHo-total-capltalization ratio at 57.3% as of Sept. 30, 2008, It has Increased slightly due to a higher
proportion of debt being used to fund capital expenditures. Management indicated in the August earnings call that additonal
equity may be used to maintain a balanced capital structure, however.
Short-term credit factors
IOACORP's 'A-2' short-term rating reflect its adequate liquidity. Liquidity is provided by a $100 millon, five-year crdit
agreement at IOACORP and a $300 milion, five-year credit facilty at IPC, primarily used for deferred power cost. At Nov. 5,
2008, $146 milion of commercial paper (CP) backed by the facilty was outstanding at IPC and $58 milion of CP and draws were
outstanding at IDACORP. Both facilties terminate on April 25, 2012. Cash flows are volatile and highly dependant on
hydrological conditions. Twelve-month rollng cash flows from operations as of Sept. 30, 2008, totaled $149 millon, versus only
$39.8 millon a year earlier. Cash and cash equIvalents as of Sept. 30, 2008, were $57.7 million.
Debt maturities are moderate at $87 milion in 2009, and $4 millon in 2010. A temporary $170 millon 12-month term loan was
recently renewed, as the company works to restructure some re-purchased tax-exempt debt.
Planned capital expenditures in 2008 had been reduced to $235 milJon-$250 milion from $280 millon-$300 ml1l1on and further
refinement would not be surprising, as the customer growth outlook has been reduced. Slower growh will reduce borrowing
needs, although generated cash, debt, and equity may be needed as capital sources to maintain a balanced capital strcture.
Outlook
The stable outlook reflects a requisite level of regulatory support and expected long-term financial metrcs that are adequate for
the ratings - above current levels. A downward rating action may occur if the company does not carefully manage costs and
investments to ensure full recovery, especially in light of a weakening economy. Improvement in credit ratings, although unlikely
In the near term, would require significantly stronger financial metrles over a longer-term horizon, in addition to solid regulatory
support.
Table 1 I Download Table
IDACORP Inc. .- Peer Comparison*
Industry Sector:
Electric
Rating as of
Feb. 5, 2009
--
BBB/Stable/A-2 BBB-/Stable/A-3 BB+/Stable/-- . BBB+/Negative/A-2 BBB/Stable/-
:~t~ì~;ilS~:t~il~~\~ti;~~~1~;tt~2g~;~;;,~1~'i;r%lÉ~~~;fr~~If~~~:~f~K,tf~'9,'ltPJ~i~~t(i~i~s!,¡~ii~~$.i!~ttfi::'~JljltKir¡~~);:l~
(Mil. $)
tl~~ìq9lf~!:'r'?~Š~~;;~:.~~m~~t~.~~~mr;'G¿~\;.~:~~111~t~~'~~.!I;~ê~?~f~;..5;;. .~.7z~i!?lli~;~~~l'~,:.
Exhibit NO.5
Case No. IPC-E-09-Q3htips;/Iw.mycritprfie.siadardandpoorscomlysplmy...icleDeiail&are-lndusNcwsAicleLisi&rtcleld=7029S (2 of 6)2121009 i :28:44 PM L Smith, I PC
Page 9 of 15
My Cidit Profie
Net income
from cont.
oper.
89.4 52.3 166.1 93.3 50.7
.Fully adjusted (Including postretirement obligations).
Table 2 I Download Table
IDACORP Inc. -- Financial Summary*
Indust Sector: Electric
b1tp/Iw.mycitprofile.standrdandpaors.commysmy...iclcDetal&aøIndustiN cwsAiclcLit&acleJd=10229S (3 of 6)21121009 1 :28:44 PM
5
Case No. IPC-E-Q9-Q3
L Smith, IPC
Page 10 of 15
My Crit Prfie
Capital
expenditures
279.8 225.8 192.9 196.8 153.6
Common
dividend
payout ratio
(un-adj.) (%)
*Fully adjusted (Including posretirement obligations).
64.4 51.2 59.1 56.7 139.1
Table 3 I Download Table
IDACORP Inc...Quarterly Data*
Industr Sector: Electric
l~1~1~iF5~~:;,g~g;;~g1i?:f~!t~~rËt"~tiil~(jt&.~~l1i:~1~;I~~~iJ?;J~fit!~~II!~1~~l~iE!~ßi~~?1JR!it~,e~t~ætl4iÔl~
(Mil. $)
"~~~n,~:~t~J~!~t~0~;;~f~i~~~'t~~~~~fl$1;2';~J~;~1~~~:W~Ji~T0~ll11~g~~~~~~~;~~lf\it"",;r~~i1f.~t1i;gi~!;"", """~1j~
Exhibit NO.5
Case No. IPC-E-09-03
hl1ps:llww.mycreitprole.stadaandpOO.comyspy...icleDetal&a=rndustrNewsAiceList&aicleld=7029S (4 of 6)1 2100 1:28:44 PM L Smith, fPC
Page 11 of 15
My Crit Profile
Net income from continuing operations 51.7 17.5 21.7 10.3 28.9
Common dividend payout ratio (un-adj.)
(%)
53.2 68.4 67.2 64.4 57.4
Table 4 I Download Table
Reconciliation Of IDACORP Inc. Reported Amounts With Standard & Poor's Adjusted Amounts (MiL. $)*
-Fiscal year ended Dec. 31, 2007-
htlp:l/ww.mycitprofie.stadarddporscomlinysplmy...ìcleDelail&aielndustiNewsAcleLisi&:cleld=702295 (5 of 6)121009 i :28:44 PM
Exhibit N .5
Case No. IPC-E-D9-D3
L Smith, IPC
Page 12 of 15
My Creit Profile
Asset retirement
obligations
9.4 0.7 0.7 0.7 0.7 (0.7)(0.7)
*IDACORP Inc. reportd amounts shown are taen from the company's financial sttements but might Include adjustents made by
data providers or reclassifications made by Standard & Poor's analyst. Please note that two reported amounts (operating Income
beore D&A and cash flow from operations) are used to derive more than one Stndard & Poor's-djust amount (operating Income
before D&A and EBITDA, and cash flow from operations and funds from operations, repectively). Consequently, the firs section In
some tables may feature duplicate descriptions and amounts.
~0;~i..:,., Qu,,,11';l",.- cJí i;;Li;:li".z;j$~:i;'
Idaho Powr Co.
Corraté Credit Raing
Commercial Paper
Local CU1Tncy .
Senior Secure (11 Issues)
Senior Secured (4 Issues)
Senior Unsecured (2 Isses)
Corpora Credit Ratings History
31-Jan-2008
27-Mar-2006
29-Nov-2004
15-Jun-2004
Related Entties
IDACORP Inc.
Issuer Credit Rating
Commeral PaperLocl Currncy A-2
*Unless otherwise noted, all ratings in this report are global scale ratings.
Standard & Poor's credit ratings on the global scale are comparable across
countries. Standard & Poor"s credit ratings on a national scale are relative to
obligors or obligations within that specific country.
BBB/Stable/A-2
A-2
A-
AlNegatie
BBBlA-2
BBB/Stable/A.2
BBB+/NegativelA-2
BBB+/StablelA-2
A.flatch NegA-2
BBB/Stable/A.2
Copyright (§ 2009 Stadard & Poor's. All rights reservd.i1 MrGmw'Hft.ç¡;p;nfi': : ' ':-i:~'"
Exhibit NO.5
Case No. IPC-E-09-Q3hUps:llww.inretprofie.siandarpoors.comfmysmy...icleDetail&an:-lndustrNewrtcleLisícleld~702295 (6 of6)211210091 :28:44 PM L Smith, I PC
Page 13 of 15
My Credit Profile
IDACORP Inc., ID - 'BBB/StablelA-2'
able of ContentsRs I
Summary: Idaho Power Co.
Publication date:
Primary Cre Anlyst:
12-Feb-00
Tony Betnelli, San Francisco (1) 415-371-506;
milo be!rill!hncmrdaMoI'
Rationale
The 'BSS' corporate credit rating on IDACORP Is base on the consolidated credit profile of the copany,
cosistng priarily of Integrate electric utilit Idaho Power Co. (IPC), which caries the same rating, and
reflets a 'strong' business prole and 'aggrssive' conslidatd financial prfil. ¡PC normally proides
more than 90% of earnings and mos of IOACORP's consolidated cah from operations.
IPC's 'strog' business proile incorprates both its low-cst hydrolecc generaton base, which
expo the company to substntial replacement power plice risk In the event of low water flows, and a
credit-sporte regulor environment In Idaho. Under nonnal watr condltons, hyrological geeraon
provides about half of tot genertion needs, necsitng a robust cost recery mechanism.
The recntl authorid Improvements to Idaho Power Company's annual power cost adjustent (PCA)
meanism support credit qualit and are expected to reduce th under-collecon of poer cos and
reduce cash flow volatilty. Th most signifcant cre-spporte modlns to the PCA Include a
reducllon in the sharig mecanis tht halves poer co exosure to 5% from 10%, a new forecas
co metodology that Is exed to reult In smaller tr-up balance, a beneficial change to the
punitve load gro add-back adustment, and the InclUSon of thlrd-pait trnsmIssion co tht have
becme more onerous in rect years. In exceptionally low water years, deferrls materially weaken cas
flows and credit metrics, but we view this primarily as a Iiauidlty matter sice 95% of cost above bas
rates are colected wit a carrying charge over 12 months.
The 'aggressive' financial proIle is mared by gradual deterioration of cah flow coverage and volatle
ca flows. Over tIme, average credi metrlcs have deter/orated, but the compay has tan stps to
stablize retums and cas flo with new updated base rates and modied power co mechanisms.
Ratos ar exped to Improv In 2009. As of Sept. 30, 2008. IOACORP's adjusted funds from
operatns (FFO) coverage of Interes and FFO to tota debt were 3.1x and 11.1%, repectively, on a 12-
monh roling bas. (Creit metrlcs are adjustd to include the debt equivaent of leases, purchased
power obligations, and potretireen benefit obligations.) Cash flow-base coverage ratis have
improved slightly but steadily over the pa two quarers, based on the impact of multiple rate increse
over the past 12 months. While leverage remans reasonable for the ratng. wi an adjus debt-to-totl-
capitlizion raio at 57.3% as of Sept 30. 2008, It has Increase slIghtl due to a higher prorton of
debt being usd to fund capita exenditures. Management Indicate In the August earnings call that
additonal equit may be used to maintain a balanced caital strure, however.
Short-term credit factors
IDACORP's 'A-2' short-lenn rating refles it adequa liquidi. Uquidit is provided by a $100 miRlon,
fie-yea crad" agreement at IDACORP and a $300 milion, fiveyea credit facDlty at ¡PC, primarily use
for deferre poer co At Nov. 5, 2008, $146 million of commercial paper (CP) backed by the facilit
was ounding at IPC and $58 millon of CP and draws were outstding at IDACORP. Both facilities
Exhibit NO.5
Case No. IPC-E-09-03
L Smith, IPC
Page 14 of 15
terminate on Apri 25, 2012. Ca flows are volatile and highly dendan on hydologica conditns.
Twelve-month ml6ng cas flows from operations as of Sept. 30,200, toted $149 miUlon, versus onl
$39.8 milion a year earlier. cash and cash equivlents as of Sept. 30, 2008. were $57.7 million.
.,
Debt maturities are moderate at $87 milion in 2009, and $4 millIon In 2010. A temporary $170 mlHion 12-
month teon lon was recently renewed, as the company work to restrture some re-purchased ta.
exempt debt.
Planned capital expenditres In 2008 had been reuced to $23 mllllon-$250 million from $20 minion-
$3 milion and further refinement would not be surprising, as the customer groh outlook has been
reduced. Slower growt wlH reduce borring needs, although generated cah, debt, and equity may be
needed as caital sorces to maintain a balanced caital structure.
Outlook
The stle outlook reflec a requisite level of reulatory support and expeced long-teon flnancial metres
that are adequate for the raings - abe current levels. A downward rating acon may occur If the
company doe not carefull manag cost and invesnt to ensure fun reovery, esally in light of a
wekening economy. Improvement In credit rangs, alough unlikely In the ner tenn. would require
significanty stronger financial mees over a longer-teon horion, In addition to solId regulator suport.
Coyright C 20 Stndar & Poos. AU righ reerv.
Exhibit NO.5
Case No. IPC-E-09-03
L Smith, IPC
Page 15 of 15
BEFORE THE
IDAHO PUBLIC UTILITIES COMMISSION
CASE NO. IPC-E-09-03
IDAHO POWER COMPANY
SMITH, 01
TESTIMONY
EXHIBIT NO.6
EDISON ELECTRIC INSTITUTE
WH PAPER
UNDERSTANING DEBT IMPUTATION ISSUES
BY
THE BRATTLE GROUP
FOR
THE EDISON ELECTRC INSTITUTE
The Brattle Group 44 Brattle Street Cambridge, Massachusetts 02138 617.864.7900
Final Draf: 3-Jun-08
Exhibit NO.6
Case No. IPC-E-09-Q3
L Smith, fPC
Page 1 of48
TABLE OF CONTENTS
Section Page #
EXECUTIVE SUMMRY .............................................................................................................3
i. INTRODUCTION....................................................................................................................7
II. WHOLESALE MARKET DEVELOPMENTS INCREASE THE IMPORTANCE OF
IMUTED DEBT .....................................................................................................................9
II. HOW is IMUTED DEBT CALCULATED? ......................................................................12
A. STANDARD & POOR'S IMPUTED DEBT METIODOLOGY ..................................................1 3
B. FINANCIAL RATIOS CONSIDERED BY S&P ......................................................................16
iv. is DEBT EQUIVALENCE A REAL PROBLEM?................................ ..............................17
V. HOW BIG A PROBLEM is IMPUTED DEBT? ..................................................................21
VI. MITIGATION OF THE IMPACT OF IMPUTED DEBT.....................................................23
A. METHODS TO MITGATE TI NEGATIVE FINANCIA EFFCTS OF
LONG-TERM PPAs .........................................................................................................24
1. Mitigation Focused on the Increased Financial Risk............................................ 26
2. Mitigation Focused On Restoring Financial Ratios.............................................. 31
B. COMPARSON OF MinGA nON METIODS............. ...........................................................35
VII. CONCLUSION ......................................................................................................................35
APPENDIX A................................................................................................................................38
ii
Exhibit NO.6
Case No. IPC-E-09"(3
L Smith, ¡PC
Page 2 of 48
EXECUTVE SUMMARY
The purpose of this white paper is to explore the issue of debt imputation. It is written for EEl
members and regulatory staff, to understand the issue, and review options for addressing it in the rate
making process.
Section I, Introduction, defines "imputed debt" as a measure of the financial risk shifted to a utilty
when it enters into a purchase power agreement ("PPA"). Use ofPPAs can undermine the utility's
credit wortiness, if no financial adjustment is made to its capital structure.
Section II, Wholesale Market Developments Increase the Importance of Imputed Debt, explains that the
use of PPAs was spurred by PURP A and the Energy Policy Act of 1992. With a few exceptions, the
original concept of a fully competitive wholesale market (i.e., in which all generation is owned by
independent power producers - IPP), has given way to a hybrid wholesale market in which generation is
owned both by regulated utilties and IPPs.
Section II, How is Imputed Debt Calculated?, reviews Standard & Poor's (S&P) updated methodology
for calculating the debt equivalence ofPPAs and imputing it onto a utilty's balance sheet and income
sttement for the purpose of assessing credit worthiness. The debt equivalence value is calculated as the
present value of the fixed (capacity) portion of annual payment, discounted at the utilty's average cost
of debt, and multiplied by a risk factor. The risk factor is intended to reflect the probabilty that PPA
costs wil be fully recovered in rates and varies depending on state-specific legislative and/or regulatory
policy. Greater certinty of recovery is reflected in a lower risk factor which results in a smaller amount
of equivalent debt per contrct. Imputed interest expense, calculated as the equivalent debt times the
embedded debt cost, is added to the utilty's interest expense. An annual amount of depreciation is also
estimated as the difference between the capacity payment and the imputed interest for the year. Imputed
debt, imputed interest expense and imputed depreciation affect the thee key ratios S&P uses to assess
credit wortiness (i.e., debt/total capital, funds from operations ("FFO")/average total debt, and
FFO/interest expense).
Section IV, Is Debt Equivalence a Real Problem?, demonstrates that imputed debt is a problem whose h'b' N 6Ex i it 0,
Case No. IPC-E-Q9-03
L. Smith, IPC
Page 30f48
3
potential severity should be of concern to regulatory authorities. Like debt, PPAs increase the utility's
financial risk by obligating future cash flow. Fixed payment obligations, like interest payments and the
payments for a PPA, reduce financial flexibilty and increase the probabilty that the utility wil default
on its obligations. For proof that PPAs transfer risk to utilties, we need only examine the reciprocal
effect that PPAs have on the suppliers (the counterparties to PPAs). According to S&P, PPAs reduce
supplier risk. This can only be tre if supplier risk is being trsferrd to the utilty and its customers
via the terms of the PPA. For policy makers, debt equivalence should be of concern because it can
affect credit ratings by either impeding upgrades and/or tnggenng down grades. Weaker credit ratings,
in turn, can increase borrowing costs and/or restnct borrowing capacity, both of which harm rate payers.
Section V, How Big A Problem is Imputed Debt?, shows that for utilities whose credit ratings are
marginally investment-grade, imputed debt can be a big problem. For such utilties, imputation ofPPA-
related debt equivalence could push their credit below investment-grade status. For the seven electric
utilties whose data S&P publishes, average debt to equity was 58% before imputation and 63% after.
Even for utilties with a business risk profie of "Excellent" or "Strong", a 58% ratio corrsponds to an
"aggressive" financial risk indicator and a low BBB to high BBB- credit rating, while a 63% ratio
corresponds to a "highly leveraged" financial risk indicator and a BB to BB- rating.
Section VI, Mitgation of the Impact of Imputed Debt, describes three options for addressing debt
imputation. These are summarized in Table ES-l.
4
Exhibit NO.6
Case No. IPC-E-09-03
L Smith,lPC
Page 4 of 48
Table ES- i: Options for Addressin9: Imputed Debt
Method Considerations
1. INCREASED EQUITY -Increase .Mitigates PPA financial risk
equity, decrease debt to restore .Does not completely restore FFO/interest,
pre-PP A capital strcture FFO/debt ratios.Expensive to use for each PPA.Incurs cost to issue new eauitv
2.INCREASED ROE - Increase .Compensates sharholders for increased risk
allowed ROE so that .Does not fully restore any ratios
pre-PPA ATWACC = post-PPA .Not suffcient for utilties with low credit
ATWACC ratinl!s
3. RATIO RESTORATION - Impute .Compensates shareholders for increased risk
new equity suffcient to restore .Mitigates financial risk
selected ratio to pre-PPA level,.Can be applied for each PPAcollect this via an adder to the .Helps utilties with low credit better thanPPApaymentmethods # 1 and 2.More expensive than methods # 1 and 2.Reauires choice of which ratio to restore
Section VII, Conclusions, suggests five overall conclusions for policy makers, as follows: (1) Long-
term purchase power agreements (PPA) transfer financial risk frm the seller to the buyer; (2) Policy
makers should be particularly sensitive to PPA-related risk trnsfer in situations where the utilty's credit
rating is minimally investment-grade; (3) Regulatory policies which provide assurance ofPPA cost
recovery can effectively mitigate the impact of imputed debt on the credit rating of purchasing utilties;
(4) There is no perfect solution to the problem ofPPA-related risk trnsfer and imputed debt; and (5)
In competitive procurement situations, it is important that imputed debt be addressed in a eompetitively-
neutrl way.
Appendix A, Treatment of Imputed Debt in Certain States, surveys recent precedent involving PPAs and
imputed debt. Recent state decisions are summarized in Table ES-2.
5
Exhibit NO.6
Case No. IPC-E-09-Q3
L. Smith, IPC
Page 50f48
Table ES-2: Recent State Precedent
CA Has retreated from an earlier policy that allowed IPP bids Opinion Adopting Pacifc Gas
to be adjusted to account for risk transfer. Now and Electric Company's,
considers debt equivalence after-the-fact in the utilities'Southern California Edison
costs of capitaL.Company's, and San Diego Gas
& Electric Company's Long-
Term Procurement Plans,
Decision 07-12-052, December
20.2007.
DE Allowed Delmarva to assign a cost adder to bid prices Order No. 7081,11/21/06
based on imputed equity equal to 30% of the NPV of
capacity payments, and a portion of the energy payment
if the Company concludes that energy payments wil be
imputed as debt by rating: ae:encies.
FL Allowed FPL to increase its equity thickness to offset Order Approving Stiplation and
PPA-related imputed debt. Also requires utilties to Settlement, Docket No. 990067-
include the cost of incremental equity in comparing PPAs EI, Order No. PSC-99-0519-AS-
to other resoure options.EI, 3/17/99. See also 70 F.A.C.
Rule 25-22.081, pargraph 7.71
Order No. PSC-99-1713-TRF-
EG, Docket No. 990249-ET,
912199. (n)
NY Promulgated rules that allow PPA adders tied to the cost NRS 704.7821(7) (b), issued
of offsetting equity. To date, no adders have been pursuant to Assembly Bil No.3,
approved.passed June 2005.
NM Denied a PPA adder tied to the cost of offsetting equity.Final Order on Exceptions, Case
Apparntly, the commission found insuffcient evidence No. 06-00340-UT, 12118/06
that the utility's credit rating would fall below
investment-e:rade as the result of imoutation.
WI Allowed WI Public Service Corp. to add new equity to Final Decision, 6690-UR- 1 18,
offset imputed debt from long term PPAs and operating 1115/08
leases.
6
Exhibit NO.6
Case No. IPC-E-Q9-03
L Smith, IPC
Page 6 of 48
I. INTRODUCTION
With the growt and importance of competitive wholesale markets, many regulated electric utilties
enter into iong~term purchased power contrcts ("PPAs") to meet the power supply needs of their
customers in a least cost and reliable manner. i Regulated utilities have traditionally passed (or
attempted to pass) all purchased power costs through to ratepayers on a dollar-far-dollar basis without
any compensation accruing to the utilty. However, full recovery is contingent on approval by the
utilty's regulatory body, including any regulatory lag.2 The financial community and the rating
agencies recognize that there ar different regulatory risks involved in the different state regulatory
approaches to the recovery of purchased power (and fuel) costs.3 This means that signing a long-term
PP A increases the financial risk of the purchasing utilty commensurate with the size and lengt of the
fixed-cost obligations in the contract. The amount of financial risk also depends on the likelihood of full
recovery of the costs of the contrct, which in tum depends on the supportiveness of the regulatory and
legislative climate.
The financial risk inherent in signing a long-term PPA is measured by the credit rating agencies and is
known as "imputed debt" or "debt equivalence".4 (This paper wil use the term "imputed debt" for ease
i The authors are aware of the currnt controversies about the fuctioning of the U.S. wholesale power marets but
believe that the issues discussed here wil continue to be important in whichever direion state and national
competitive policy moves.
2 In this context, regulatory lag refers to the delay beteen the time costs are incurrd and the time those costs ar
recovere in rates. If there is a substantial delay in recovery, the utlity would not be fully compensated for the cost
of the PP As unless the PP A balances receive a carring cost. In other words, the utilty would lose the time value of
money.
3 For example, S&P's, "Fuel and Purchased Power Cost Recovery in the Wake of Volatile Gas and Power Markets -
U.S. Utilities to Watch", Report March 22, 2006 and S&P's, "Request For Comments: Imputing Debt To Purchased
Power Obligations," November i, 2006.
4 Credit rating agencies have generally treated long-term PPA contracts differently from short-term power contrcts. In
the past, credit ratig agencies did not believe that short-term contrcts (in paricular those signed in reil aC;jlMbit NO.6
states for Provider of Las Resort ("POLR") service, which are generlly the-month to three-year coitdIàE-09-03
L Smith, IPC
Page 7 of 48
7
of exposition). One credit rating agency, Standard & Poor's (S&P), has clearly stated its view for many
years that long~term PPAs impose financial risk on the utilty and has developed and publicized a
standard procedure for calculating imputed debt and its impact on the financial ratios used to measure a
utilty's creditworthiness.s If nothing were done, the imputed debt resulting from a large portfolio of
PPAs may lead to a credit rating downgrde. In addition, the imputed debt resulting from a large
portolio of PP As could lead to a credit downgrade. In addition, the weakened credit ratings (Le.,
increased financial risk) would increase the purchaser's cost of equity and debt capital assessd by
financial markets.
In light of the continuing importnce of long-term PPAs, this paper reviews and ilustrtes the financial
risk of concern to the credit rating agencies. In particular, the paper addresses the issue of whether the
financial risk from long-term PPAs is a real concern, and if so, how big a problem it is likely to be. If
the problem is real and large enough to be of concern, what can regulators do to mitigate its effects?
Below, the paper discusses several alternative ways to mitigate the adverse effects of imputed debt on
the purchasing utilty. The goal of any mitigation effort should be to trat shareholders and rate payers
fairly, but mitigation wil also benefit ratepayers and shareholders by neutralizing the negative effects
from PPAs, including the weakening of the company's credit metrics and the increased cost of capitaL.
The rest of this paper is organized as follows: Section II briefly describes the development of the
wholesale generation market and the coming generation "build out", Section III describes the credit
rating agencies' views and ilustrates the calculation of imputed debt based upon the method published
rebid periodically to keep prices closer to the spot maret), caried the same negative financial impact as a long-term
PPAs. However, S&P recently announced that it is will impute debt from most such "evergren" contrcts going
forward. See, Imputed Debt Calculation for U.S. Utilities' Power Purchase Agreements, S&P RatigsDirect, March
30,2007. S&P excludes PPAs in which the utilty merely acts as a conduit for delivery of power. See Standard &
Poor's Encyclopedia Of Analytical Adjustments/or Corporate Entities, July 9, 2007 p. 24. . .
Exhibit NO.6S Periodically S&P has revised its procedures for calculating imputed debt. This paper reflects S&P's Cll~øtNij)1PC-E-09-03
L. Smith, IPC
Page 8of48
8
by S&P and its effect on a utiltfs credit ratios. Section IV addresses the issue of whether imputed debt
is a problem that should be of concern to regulators, and Section V ilustrates how large the problem
could be given the increase in PPA tye contracts. Section VI describes the approaches that a regulatory
agency might adopt to mitigate the effects of imputed debt on the financial ratios of a utilty should it
chose to do so, and Section VII provides concluding remarks. Appendix A contains a discussion of the
current tratment of imputed debt in the states of California, Delawar, Florida, Nevada, New Mexico
and Wisconsin. The appendix reports how these states have chosen to deal with the issue at this time.
ll. WHOLESALE MAT DEVELOPMENTS INCREASE THE IMPORTANCE OF
IMUTED DEBT
Long-term wholesale power purchase contracts have been a source of supply for regulated utilties for
many years, but before the i 980's, most utilties met their obligation to serve through their own
generation resources. Growt in longRterm purchased power contracts was spurred by PURPA6 policies
in the 1980s and became wide reaching after the Energy Policy Act of 1992 began the process of
providing open access to the FERC-regulated transmission grid. The Energy Policy Act also created the
category of exempt wholesale generator ("EWG") which is a generator that is permitted to sell electricity
only in the wholesale market. 7 Long-term contracting for supply from EWGs by regulated utilties
became a stndard part of wholesale power markets. In the early 1990s, S&P as well as some financial
analysts recognized that there is a risk transfer from the seller to the buyer inherent in long-term
purchased power contracts resulting from PURPA and the growt of the role of EWGs in the wholesale
6 The Public Utility Regulatoiy Policies Act of 1978
1 See U.S. Code, Title 15, Chapter 2C, Section 79z - Sa.
9
Exhibit NO.6
Case No. IPC-E-Q9-03
L. Smith, IPC
Page 9 of 48
power market. 8 Over the last twenty years, independent power producers ("IPPs") have become major
builders of power plants, owners of existing generation resources, and potential low-cost developers of
new resources. Many states now require that a utilty proposing to build its own plant demonstate that
the proposed plant is in the ratepayers' interest by being lower in expected future revenue requirments
than competitive bids for comparable supply from IPPs.
The original 1990's concept of a fully competitive wholesale power market envisioned that eventually all
electric generation plants (outside the public power sector) would be owned by independent power
producers (some of whom would possibly be affliated with regulated distibution utilties), sellng under
long-term contrcts, short-term contracts, or in the spot market.9 A corollar of that vision was that all
new electric generation assets would be built with private investment in the fonn of independent
merchant plants or plants with contrcts from retail marketers or large customers. There would be little
or no role for plants built under cost-of-service regulation.
In fact, the history of the development of a competitive wholesale market has not been smooth and
includes the California energy crisis (with eight FERC Settlements and $3-5 bilion in refunds) and the
heightened concerns about market power abuse and the need for its mitigation. Morever, there has not
been the full development of a competitive retail market for all customers in most retail access states
8 S&P first published its criteria for evaluating long-term PPAs in 1990, update them in 1993, and most recently in
early 2007. See" 'Buy Versus Build': Debt Aspects of Purchased-Power Agreements," Utilties & Perspectives, May
12, 2003, p. 2. See also "hnputed Debt Calculation for U.S. Utilities' Power Purchase Agreements," S&P
RatingsDirect, March 30, 2007, "Purhased Power - Hidden Cost or Benefits?", The Electricity Journal, September
1994, pp. 74-83, by A. L. Kolbe, S. Johnson, J.P. Pfeifenberger and D. M. Weinstein, and "A Simplified Prcedure
for Costing the Risks of Purchased Power Contracts," The Electricity Journal, April 1997, pp. 70-75 by Wiliam B.
Tye and Marin A. Hawtorne.
9 "Keeping up with retail access? Developments in U.S. Restrcturing for Regulated Retail Service," The Energy
Journal, December 2004, by J. Pfeifenberger, A. Schumacher and J. Wharon. The authors note that states in the u.S.
can be divided into thee groups: the retail access states shar this vision, the traditional regulation states do not share
this vision, and the transition states which staed toward retail competition and stopped (e.g., Californa) or did
partial retail acces for only large customers (Nevada and Oregon). The third grup and possibly the second proêuh1b't N 6
long-term resources for their portolios using PPAs or both PPAs and utility-owned generation plants. Case No. 1~¿~-09~3
L. Smith, IPC
Page 10 of 48
10
during the trnsition periods. Texas and some other states continue to pursue the original vision of
wholesale competition, generation investment by independent producers, and price rationing of scarce
supplies should a shortage come to pass. However, policy makers in many states have questioned the
effcacy of actual, or potential, shortge premiums in spot prices as effective and reasonable long-range
signals for new generation investment and resource adequacy. The majority of states never adopted
retail access and some of those that did are reviewing the policy in light of recent developments.!O
Fitch Ratings ("Fitch") has come to be skeptical about the amount of new generation that wil be built by
IPPs without long-term contrcts with regulated utilties. In a 2005 report, Fitch concluded that:!!
. . . states are unlikely to test the fourt alternative of competitive (wholesale) markets,
allowing the competitive market to work and waiting to see the result. . . . Evidently the
public is unwiling to accept the volatilty associated with a purely competitive wholesale
market. It would appear that competition is politically acceptable when it lowers prices,
but not when it raises them. (Emphasis added)
A "hybrid wholesale market' model has now emerged where, over the long term, policy makers wil
encourage a balance of new generation plants that are owned and operated (and sometimes built) by
regulated utilities and generation plants that are owned and operated by independent power producers
with or without long-term contracts. California is prominent in pursuing the hybrid market structure.12
Long-term contracts wil continue to playa major role in the hybrid wholesale markets, so imputed debt
wil continue to be an importnt issue in assessing utilty financial strength.13
10 See discussion of Delaware in the Appendix for a development in the direction.
II Fitch Ratings, "Stimulating Generation Additions in Deregulated States," Corporate Finance, Nov. 4, 2005.
12 See CPUC Decision 06-07-029, Opinion on New Generation and Long-Term Contract Proposals and Cost
Allocation, July 20,2006.
13 As is reflected in Appendix A, utilties' dependence on long-term PPA's is also incresing because of the imp~ R~'t N 6renewable resource portolio standards. Case No. I~C~~-09~3
L. Smith, IPC
Page 11 of48
11
ID. HOW is IMPUTED DEBT CALCULATED?
Imputed debt, or debt equivalence, is a term used by credit rating agencies and financial analysts to
describe and quantify the financial risk inherent in the fixed financial obligation resulting from signing
long-term contracts, such as purchased power agreements or operating leases. Under currnt F ASB
standards, these obligations are not reported on the company's balance sheet although the accompanying
notes do disclose these arrangements.14 However, these contracts have debt-like characteristics because
they commit the utilty to pay periodically a fixed amount to an outside part. Because these obligations
have features similar to debt, they are treated as such to some degree by the credit rating agencies. S&P
has developed and publicized a standard procedure for calculating the amount of imputed debt resulting
from signing a long-term PPA contract and for determining its impact on a utilty's creditwortiness.
Other credit rating agencies, such as Moody's or Fitch Ratings, have been less fortcoming in how they
evaluate the effect of a long-term PPA contract on a utilty's credit rating. Consequently, this paper
relies primarily on S&P's published materials to ilustte the calculation of imputed debt and its impact
on a utilty's financial ratios. is
Another way to view the risk characteristics of imputed debt is to recognize that building and operating
an electric generating plant entails substantial risk. This is tre whether the plant is built by a utility or
by an IPP. Frequently, the only wayan IPP developer can secure financing to construct a power plant is
by first contracting with a credit-worthy regulated utilty. The fixed, contractual PPA payments serve as
the basis for the developer to obtain financing at reasonable rates. If built by a utilty, the debt and
equity used to finance construction of the plant would appear on the regulatory books of the utilty, but
not if the same financial commitment is made through a PPA. The concept of imputed debt simply
14 Recent financial accounting standards appear to be moving in the direction of grer scrutiny of PPA contrcts that
has the potential for some contracts to be classified as capital leases which would require them to be reported on theutility's balance sheet. Exhibit NO.6
Case No. IPC-E-09-Q3
L. Smith, IPC
Page 12 of 48
12
recognizes that there is a risk trnsfer from the developer to the regulated utilty inherent in the
commitment to make the PPA payments and attempts to recognize the underlying economics of the
transaction. Without recognition of the increased financial risk from the PPA, signing a PPA would
have the ilogical result of seeming to make the risk of investing in electric generating plants disappear.
Moreover, all else equal, electric power plants proposed by IPPs may be incorrectly chosen as least
expensive in a head-to-head competition with a regulated utility if the risk trsfer were not
recognized.16 Thus, the calculation of imputed debt recognizes that the mechanism of a PPA does not
eliminate risk, but merely transfers the risk to the utilty and its ratepayers. The division of the risk
transfer between the utilty and its ratepayers depends upon the regulatory mechanisms in place for
recovery of the costs of the PPA as measured by S&P using its so-called "risk factor" which is described
below.
A. STANDARD & POOR'8 IMPUTED DEBT METIODOLOGY
In the electric industr. S&P imputes debt for purchased power contracts, operating leases, and the
unfunded portion of post-retirement obligations. S&P is specific about its calculations. To understand
how imputed debt is assessed, it is helpful to review S&P's explicit approach as it has been defined in
publications over the years. The calculation of imputed debt for PPAs parallels the tratment of
operating leases, which is discussed first.
IS Below, the other two credit ratig agencies, Moody's and Fitch, ar briefly discussed in comparison on some points.
16 There is not universal agrement on this point. For example, The Electic Power Supply Association ("EPSA")
believes that acknowledging the nsk of imputed debt risks tilting the competition between IPPs and regulated utilities
in favor of utilties if constrction risk and other nsks accepted by IPPs ar not recognized. See for example,
"Impacts of Credit Requirments, Cost of Capital and Debt Equivalency Issues on Power Supply Acquisition
(Remarks by EPSA President and CEO John E. SheIk at the Western Power Supply Forum - May 9, 2006), The
autors of this paper believe that an accurate judgment in the build-versus-buy decision requires consideration of all. N 6fth . k . I d' .. k d . d d b "Exhibit 0o e TIS s mc u mg construction ns an impute e t. Case No. IPC-E-09-03
L Smith, IPC
Page 13 of 48
13
For operating leases,l? S&P calculates the present value of future minimum lease payments using the
utilty's average embedded interest rate. The resulting amount is added to the utilty's reported long-
term debt for purposes of calculating the utilty's financial ratios.ls In addition, an implicit (or imputed)
interest expense is calculated as the average net present value of the contract payments multiplied times
the utilty's average interest rate. This implicit interest is added to the reported interest expense for the
purpose of calculating ratios. An imputed depreciation amount is also determined as the average of the
year-one minimum lease payment in the current and previous year minus the implicit interest expense. 19
This amount is added to the reported depreciation expense.20
Fitch Ratings also calculates adjusted ratios for operating leases. Fitch uses one of two methods to value
off-balance sheet lease obligations.21 One method relies on a multiple of the minimum annual lease
obligation (typically 8 times the annual obligation). A second method calculates the present value
("PV") of non-cancellable future lease obligations. When enough information is available to calculate
both estimates of the lease obligations, Fitch Ratings takes both into account. Fitch Ratings uses the
adjusted figures in calculating leverage and coverage ratios using the adjusted debt amount and
17 Under curnt accounting standards, capita leases are recognized on a company's balance sheet while operating
leases are not. A lease is classified as a capital lease if it satisfies one of four criteria: (i) ownership of the asset is
trnsferred to the lessee, (2) the lease contains a bargain purchase option - - Le., the lessee can purhase the asset at
below fair market value, (3) the lease tenn is equal to 75% or more of the asset's economic life, or (4) the preent
value of the minimum lease payments equals or exceeds 90% of the fair value of the leased propert. Leases that do
not meet any of these criteria ar operating leases.
18 This amount is also added to assets, to reflect the implicit value the utilty has from using the asset when calculating
ratios that involve assets.
19 To ensure that expenses properly reflect the imputed debt amount rather than the reported amount, the average of the
currnt and previous year's minimum lease payment minus the implicit interest expense is added to the reported
expenses. This is simply to avoid double-counting of any amount.
20 Moody's Investor Service appears to be using a similar approach. S&P's and Moody's use analytical models to
convert leases using present value of minimum lease payments. Moody's capitalizes full notional value of 'essential'
or 'core' assets, 1st Annual ELA/SEC Meeting, September 8, 2005.
21 Fitch Ratigs, Corporate Finance, "Operating Leases: Updated Implications for Lessees," Credit, Deceber 20ib.2006 Exhi it No.6. Case No. IPC-E-09-03
L. Smith, IPC
Page 14 of 48
14
including the total lease expense in the interest expense.22 Fitch states that the adjustment is significant
for about half the entities they follow. This paper focuses on imputed debt arising from PPAs; therefore,
the treatment of operating leases and unfunded pension liabilties is not discussed further.
S&P's metho,d for calculating imputed debt begins by determining the PV of the fixed payment
(capacity) portion of the PPAs, using the utilty's average embedded cost of debt as the discount rate.
"If capacity payments are not specified, S&P wil use a proxy capacity charge, stated in $/kW, to
calculate an implied capacity payment associated with the PPA. The $/kW figure is multiplied times the
number of kilowatts under contrct. ,,23
S&P next determines a so-called "risk-factor" which is a company-specific measure of the likelihood of
full recovery of the costs of the PP A. S&P determines the risk factor based upon characteristics of the
company and its regulatory environment. Risk factors vary between 0 and 100 percent, but they ar
typically in the range of 25 to 50 percent. For rate-regulated utilties, the risk factor depends primarily
on the regulatory environment and especially on the mechanism used to recover capacity costs. As a
benchmark, S&P states the risk factor "wil generally be 25% for capacity payments that are recovered
through fuel adjustment clauses and 50% før capacity payments that are recovere in base rates...i4,25
Unregulated energy companies that enter into a tollng arngement are generally assigned a risk factor
22 Fitch Ratings discusses a third method which is primarily applied to entities in banptcy or rerganizing. In this
case Fitch Ratings looks at the liquidation value.
23 See "Standard & Poor's Metodology for Imputing Debt for U.S. Utilities' Power Purchase Agreements," S&P
Commentary Report, May 7,2007, p. 5.
24 "Reques for Comments: Imputing Debt to Purchased Power Obligations," Standard & Poor's, November 1,2006.
25 Error! Main Document Only.S&P believes that vercally integrated regulated electrc utilties with a fuel
adjustment clause have moderate risk and recently adjust the risk factr for such utilties downward to 25% (from
30%). In jurisdictions with tre-up mechanism but no pure fuel adjustment clause, vertically integrated electic
utilties generally are assigned a risk factor between 25% and 50%. In jurisdictons where recovery of PP A-related
capacity costs is guarateed by a legislative mechanism, the timeliness of the mechanism affects the risk actor which
may be as low as 0%. See "Request for Comments: Imputing Debt to Purchased Power Obligations," Standard &
Poor's, November 1,2006. Merchant generators are assigned a higher risk factor than vertically integrted regulated
Exhibit NO.6
Case No. IPC-E-Q9-03
L. Smith, IPC
Page 15 of 48
15
of 100%.26 The risk factor multiplied by the PV of the fixed capacity payments equals the amount of
imputed debt that is added to the utilty's reported long-term debt for the purpose of calculating financial
ratios.
Imputed interest expense is calculated by multiplying the calculated amount of imputed debt by an
interest rate. S&P changed its methodology to use the utilty's average embedded cost of debt as the
discount rate instead of a stadard 10 percent.27 The imputed interest expense is added to the utilty's
interest expense for the purpose of computing ratios. Finally, S&P determines imputed depreciation as
the risk factor times the capacity payment minus the imputed interest expense. Example 1 below
ilustrates the process.
Example 1:
Assume that Utilty ABC enters into a 20-year PPA that has anual capacity payments of $39.2 milion. Utilty
ABC has embedded cost of debt of 6.7%. Finally assume that Utility ABC has been assigned a risk factor of 25%
from S&P.
Using a discount factor of 6.7%, the PV of the 20-annuity would be about $425 milion. In the first year, S&P
imputes debt of about $106 milion ($425 milion x 25%) and an interest expense of approximately $7 milion
($106 milion x 6.7%). Finally, S&P imputed depreciation would be about $2.7 milion ($39.2 x 25% -$7 millon
of interest expense) in the first year.
B. FIANCIAL RATIOS CONSIDERED BY S&P
The calculation of imputed debt and imputed interest expense results in an adjusted balance sheet and an
adjusted income statement that are then used to calculate the utilty's financial ratios. Currently, S&P
relies primarily on three ratios plus qualitative factors to evaluate a utility's credit wortiness or default
risk. The three key ratios28 are
utilties, and tolling contract are assigned a risk factr of 100%. See "Imputed Debt Calculations for U.S. Utilities'
Power Purchase Agreements," Standard & Poor's, March 30, 2007.
26 See, Standard & Poor's Encyclopedia of Analytical Aclustments for Corporate Entities, July 9,2007.
27 See, "Imputed Debt Calculations for u.S. Utilities' Power Purchase Agreements," Stadad & Poor's, March 30,
2007.
28 A detailed descnption of each ratio can be found in S&P's Corporate Ratings Criteria 2007.
16
Exhibit NO.6
Case No. IPC-E-09-03
L. Smith, IPC
Page 16 of 48
(1) Debt to total capital,
(2) Funds from Operations (FFO) to average total debt,29 and
(3) FFO interest coverage = FFO I (interest expense).
In the past, S&P also considered the Earnings before Interest and Taxes (EBin interest coverage ratio,
but this ratio has been de-emphasized.
While other credit rating agencies have been less fortcoming about their methodology, all have
publications that indicate that they take debt equivalence seriously. For example, "Fitch policy dictates
that operating leases be capitalized,,3o, and Moody's explicitly includes "operating lease adjustent,"
"under~funded pension liabilties" and "other debt-like items" in their adjusted debt amount.31 Both
Moody's and Fitch discuss the impact ofPPAs in their publications regarding electric utilties although
both seem to generally be less concerned about the impact ofPPAs than is S&P.32 In addition, it is
noteworthy that utilties generally have comparable ratings from the different rating agencies, and
utilties frequently furnish the same non-public information regarding their PPAs to all credit rating
agencies.
IV. is DEBT EQUIVALENCE A REAL PROBLEM?
A key concept in finance is that financial risk increases with leverage (i.e., the use of debt), and as a
company increases its financial leverage, its cost of equity also increases. Therefore, a company's
financial risk depends on the manner in which the company finances its operations. The more debt the
29 Average total debt is usually caculated as the average debt over the past 12 months.
30 Fitch Global Power Metodology and Criteria: Debt-like obligations and contracts other than funded debt, April
2004.
31 Moody's Investor Service, Ratings Methodology: Global Regulated Electric Utilities, Marh 2005.
32 See, for example, Moody's Investor Service, Ratings Methodology: Global Regulated Electric Utilties, March 2005,
and Fitch Ratings, U.S. Utilty Financial Peer Studies. Investor-Owned and Public Power Utilities, June 2005.. Exhibit No.6
Case No. IPC-E-09-03
L. Smith, IPC
Page 17 of 4817
company has in its capital strcture, the greater its financial risk. If a utilty builds a power plant, an
asset appears on its balance sheet along with the associated sources of financings, either equity, debt, or
both. If a utilty enters into a capital lease, an asset and an offsetting long-term liability appear on its
balance sheet. Similarly, if a utilty enters into a long-term operating lease or PPA, it has made a
commitment to make fixed payments as if it had incurred a debt obligation, but no debt appears on its
balance sheet.33 The addition ofa PPA (or portfolio ofPPAs) and the associated fixed payments create a
debt-like obligation and increases the utilty's financial risk just as would the addition of debt to the
utilty's capital strcture. The PPA payments decrease the utilty's financial flexibilty and increase the
variabilty of the return on the utility's equity. S&P merely recognizes the underlying economics of the
situation by adding a "debt equivalent" amount when it assesses the utilty's financial strengt.
Additional evidence of an increase in fmancial risk by the buyer of PPAs is the reduction of risk for the
seller. Electric generating plants built by IPPs without long-term PPAs are considered to be of high risk
(as discussed by Fitch, reported in Section II above). Signing a long-term contract with a credit-worthy
utilty considerably lowers the risk premium the plant's investors would have to pay to finance the
project. In fact, having a long-term contrct in place is often the only way a potential power plant
builder can finance the investment. Fitch recognizes this:34
The trditional method for independent generators was to rely on the strngt of a PPA
with a creditworty off-taers (usually a utilty) to help finance the constction cost of a
new power plant. . Take or pay contrcts or firm capacity payments under the PPA would
allow the developer to raise debt financing for the project, either using single asset project
financing or under a portolio financing approach. In general, power developers of this
Standard & Poor's, Fuel And Purchased Power Cost Recovery In The Wake of Volatile Gas And Power Markets - -
u.s. Electric Utilties To Watch, March 22, 2006,
33 The asset from the regulator's promise to allow the reovery of the PPA cost does not appear on the balance shee
either, but the PPA payments represent a contrctual obligation the utilty canot avoid while recovery of the PPA
cost is uncertin. It is precisely the contrt between the commitment to make the PP A payments and the uncernty
of full cost recovery that is creting the increased financial risk.
34 Fitch Rating, "Stimulating Generation Additions in Deregulated States," Corporate Finance, Nov. 4, 21l~selló. T~g~~~~9~O~
L Smith, IPC
Page 18 of 48
18
type have lower credit rating than those of the power purchaser. These developers can
raise financing on more favorable terms if they can take advantage of the credit
enhancement that comes from contractual cash flows from credit worty counterparties.
Clearly, if the PPA seller has less risk, the PPA buyer and its customers have more. Risk has been
transferred to the utilty and its customers. The distribution of the transferred risk between the utility
and its customers depends upon the strength of the cost recovery mechanisms in place. The more
uncertin is full recovery of the costs of the PP A, the more risk the utilty bears.
Although the use of leverage through fixed-cost capital, operating leases, or PPAs can be advantageous
and reduce costs, it also increases financial risk due to the fixed contractual obligations associated with
the leverage. PPAs, like debt, create a fixed obligation that revenues must support before any earnings
can be made available to common shareholders. The credit rating agencies (S&P, Moody's and Fitch)
have noted that the commitment to pay for these contract costs increases the financial risk of the utilties
involved. Although the rating agencies' specific concern is that the risk of default on the utilty's debt
could be adversely afected by the requirement to make payments on the PPAs, the increased financial
risk affects the risk (and required return) of the utilty's equity capital as well. Investors' recognition of
the presence of imputed debt affects the terms and cost under which the utilty can raise debt and equity
capitaL. 3S Therefore, it is essential that regulators also consider the presence of such obligations.
Because S&P (and possibly the other rating agencies) determine the risk factor for a utilty based in par
on the regulatory treatment of purchased-power costs in the jurisdiction in which the utilty operates,
legislative and regulatory policy directly afect the magnitude of the imputed debt.36 The additional
leverage frm PPAs influences the utilty's cost of equity, the terms under which it can raise debt, and
35 One indication that investors consider the presence of off-balance sheet obligations such as imputed debt to be
important is that Generally Accepted Accounting Principles ("GAA") curently require companies to disclose
inronnation about upcoming operting lease payments as well as the funding status of pension obligations.
36 Fitch Ratings and Moody's also consider the likelihood of cost recovery. See, Fitch Ratigs, Global Power
Methodology and Criteria: Debt-Like Obligations and Contracts Other Than Funded Debt, April 2004 and Moo~ìlit No.6Ratings Methodology: Global Regulated Utilties, Marh 2005. Case No. IPC-E-09-03
L Smith, IPC
Page 19 of 48
19
possibly the terms under which it can sign additional PPAs. At the margin, if a utilty is deemed not to
be creditworty, it may not be able to raise debt or sign PPAs under reasonable terms.
In a recent publication, S&P ilustrated how the regulatory environment and fuel/purchased power
interact. Rating the regulatory recovery mechanism frm "Historically Challenged" through "No or
Weak Fuel Adjustment" to "Rate Freeze" and operating risk from Low to High, S&P indicated that
entities with High Operating Risk in a "Rate Freeze" environment are at high risk for cash flow volatilty
and thus credit risk. The study identified six utilties as being at "considerable risk.,,37
The higher the level of purchased power and imputed debt, the greater the potential impact on adjusted
utilty financial ratios and ratings. The S&P adjustments to existing debt and the resulting calculation of
key ratios can have the following effects on a utility:
a. Consideration of the cost of imputed debt affects integrated resource planning in the buy-
versus-build decisions.
b. For some utilities, it may impede credit rating upgrades or lead to debt rating downgrdes
that would, in turn, lead to
i. Restricted borrowing capacity and/or higher costs of capital for utilties and
customers;
2. Restrictive prepayment tenns with fuel and purchased power counterparties; and
3. An overall decrease in market value as utilty common equity share price and debt
price may be ultimately impacted.
Because all of the above affect the utilty's financing and operating decisions, it is importnt to
recognize and to mitigate the potential adverse effects of imputed debt. In particular, the risk transfer
from power generators to utilties through long-term PP As must be acknowledged and taen into
account in regulatory proceedings.
37 Standard & Poor's Cr~dit ~~t~ngs, Fuel and Purchased Puwer Cost Recovery in the Wake of Volatile Gas and Pi~~lbit No.6Markets- - U.S. Electric Utilities to Watch, March 22. 2006. Case No. IPC-E-09-03
L Smith, IPC
Page 20 of 4820
V. HOW BIG A PROBLEM is IMPUTED DEBT?
Long-term wholesale power purchase contracts have been a source of supply for regulated utilties for
many years, but before the 1980's most traditionally regulated utilities planned to meet their obligation to
serve through their own generation resources. Growt in long-term purchased power contrcts was
spurred by PUR A policies in the 1980s and became wide reaching after the Energy Policy Act of 1992
began the process of opening access to the FERC-regulated transmission grid. Over the last twenty
years, IPPs have become major builders of power plants, owners of existing generation resources, and
potentially low~cost new resources although the progress in this regard has been neither as smooth nor
extensive as originally envisioned.
Regardless, the percentage of the power that utilties procure through PPAs has increased, paricularly in
jurisdictions where utilties have divested generation assets or where jurisdictions have levied a
requirement that a specified portion of a utilty's power supply be frm "renewable" energy resources.
Currntly 24 states and the Distict of Columbia have adopted renewable energy standards requiring that
a fraction of the state's electricity be supplied by renewable energy resources.38 California recently
advanced its goal of having 20 percent of its energy supply frm renewable resources to 2010 from 2017,
and it also increased the goal for 2020 to 33 percent from renewable energy sources. The vast majority,
if not all, renewable resources are expected to be developed under long-term, fixed-price PPAs. See
Appendix A for a review of recent state precedent on this issue.
38 Edison Electric Institute as of June 7, 2007.Exhibit NO.6
Case No. IPC-E-09-03
L. Smith, IPC
Page 21 of4821
Puchase Power as a Percentage
of Sales to Ultiate Cutomers
90.0%
70.00%
-"~ø -..ø
Restnotued States /0#"-
~y----
Il .. .. .""-~'Non-Restrtus State
'..
80.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2000 ZOOS
Soure: Velocity Suite. Data for 2001 dat Wli not included due to data inoonstenes.
The graph above clearly shows that the percentage of sales to ultimate customers from PPAs has
increased over time. In addition, S&P recently published tables that show how S&P adjusts a utility's
financial ratios to account for off-balance sheet liabilities.39 For the seven companies for which S&P
provides data in the report the average book debHo-capital ratio was about 58 percent prior to S&P's
adjustments and about 63 percent afer S&P's adjustments. In other words, the average debt-to-capital
ratio used by S&P to evaluate the companies' credit rating is five percentage points higher than prior to
S&P's adjustments. Depending on the business risk profile of the utilty in question, this increase in the
debt ratio could result in the utilty's ratios being consistent with a lower credit rating.
39 "S&P Introduces Reconcilation Tables to Show Analytical Adjustents to Global Utilties' Financial Stateents,"
S&P Credit.Ratings, Credi! i: A,?, October i i, 2006. This document was prepared prior to S&P's adoption of its W~fbit NO.6recent practices for determimng imputed debt. Case No. IPC-E-09-03
L Smith,lPC
Page 22 of4822
For example, if a utility currently bas an "Aggressive" financial risk indicator based upon its financial
ratios, a change frm a 58 percent to debt-to-capital to one with 63 percent places the utility in the
"Highly Leveraged" financial risk indicator category for that ratio. Even if the utilty had one of the two
highest S&P business risk profiles of "Excellent" or "Strong", the change from "Aggressive" to "Highly
Leveraged" changes the utilty's likely credit rating from a low BBB to a low BB.4o Other combinations
of changes in financial ratios that could result in a change in the financial risk indicator could have
similar effects. Of course, the rating agencies all caution against relying strictly on ratios to estimate the
company's likely credit rating, but because a credit downgrade (particularly one from BBB to BB)
would materially affect the terms and costs under which the utilty could raise capital, it is important for
ratepayers, the company and the regulator to be aware of the issue - imputed debt can be a big problem.
VI. MITIGATION OF THE IMACT OF IMUTED DEBT
Imputed debt increases a utilty's financial risk and weakens its financial ratios. If the credit ratios
weaken enough, the utilty's credit rating may be downgraded or may be prevented from being upgraded.
The increased cost of debt from a credit rating downgrade would be clear evidence of the adverse impact
of imputed debt, but if there were no credit down grade, is there any effect frm imputed debt?
Yes. Debt holders and equity holders wil require a higher return to compensate for the increased risk of
default and increased financial risk.41 Debt ratings are discrete, but the range of ratios for any paricular
rating is continuous. As a company's ratios weaken, the utilty's credit stength approaches the next
lower credit rating. If the ratios are allowed to continue to deteriorate, the credit rating wil ultimately be
40 See "U.S. Utilties Ratings Analysis Now Portyed in the S&P Corporate Ratings Matrx", Standard & Poor's,
Ratings Direct, November 30, 2007.
41 Even though both the cost of debt and the cost of equity incrse, the overall after-tax weighted-average cost of
capital ("ATWACC") wil remain constant unless the increase in fiancial risk is suffciently large to move the
Exhibit No.6
Case No. IPC-E-Ð9-Ð3
L. Smith, IPC
Page 23 of 4823
downgraded. Moreover, the utilty's credit ratios are known to the market. As the ratios weaken
(strngten), debt costs wil increase (decrease) commensurately even though the credit rating has not
yet been affected. The same logic applies to the cost of equity as acknowledged by, for example, the
California PUC.42 As financial risk increases, investors wil require a higher expected rate of return on
the company's stock. The increased cost of debt and equity frm imputed debt cannot be avoided
because the market wil require compensation one way or another.43
Recognition by the regulator of the increased financial risk resulting from signing long-term or
Evergreen PPAS44 leads to the question of "what the regulator can and should do to mitigate the effect of
imputed debt on the utility and rate payers?"
One task for regulators is to ensure that decisions regarding whether the utilty should build a generator
or sign a PP A are not unfairly weighted in favor of a PPA by ignoring the risk transfer to the utilty.
Ignoring the increased financial risk inherent in signing a long-term (or an evergreen) PPA would risk
skewing the competition in favor of the PP A.
A. METHODS TO MITIGATE THE NEGATIVE FINANCIAL EFFECT OF LONG-TERM PPAs
The overall goals of mitigating the negative effects of imputed debt should be to insure that investors,
bondholders and equity holders, ar treated fairly, while at the same time ensuring that the utilty's
company into financial distress. Companies in financial dists frquently have a higher co of capital than would
be possible if the company had an invesent grde creit rating.
42 See, for example, California PUC, Decision 04-12-048, Interim Decision, ("CA D.04-12-048"), Rulemaking 01-10-
024, Dec. 14,2004, p. 83. See Appendix A for furter explanations.
43 From a theoretical point of view, this statement is not generaly controversial, but it is diffcult to substantiate
empirically. The problem is that estimating the cost of capital is diffcult. All estimation methods ar subject to
estimation error so distinguishing the effect of imputed debt on the cost of capital from other factors is hard. A full
explanation of the reasons is beyond the scope of this paper.
44 As noted earlier, a series of short-term PPA contrcts is tened "evergreen" when it is expected that the contrcts.ill .
b I d'th . 1 . b' tr' Exhibit No. 6e rep ace wi an equiva ent contract on a continuous aslS as one con ct expirs. Case No. IPC-E-09-03
L. Smith, IPC
Page 24 of4824
customers are not overcharged. Although these goals are not controversial, the implementation of
mechanisms that achieve them requires balancing the needs of investors and customers.
One method by which regulators can reduce the amount of imputed debt that results from a PP A is by
adopting automatic cost recovery options that may influence S&P (and perhaps the other credit rating
agencies) to reduce the risk factor assigned to the utilty. For example, if the utilty's risk factor were
reduced from 50 percent to 25 percent, the amount of imputed debt would be reduced by 50 percent (i.e.,
25/50). In other words, the regulator can reduce or perhaps eliminate the financial risk imposed on a
utilty from PPAs by adopting measures that decrease the level of uncertinty regarding full recovery of
the costs of the PP A.
The remainder of the discussion focuses on mitigating the effects of imputed debt from having signed a
long-term PPA. Focusing on the increased financial risk or the weakened credit ratios suggests that
there are two broad approaches to mitigation.4s The first is to compensate the utilty for the increase in
financial risk, and the second is to restore one or more of the weakened financial ratios to its preexisting
level prior to entering into the PPA.
Compensating for financial risk is the simplest (and generally the leas expensive) way is to mitigate the
effect of imputed debt, and this method is usually appropriate for utilties that have an investent grade
credit rating. For non-investment grade utilties (or utilties that may suffer an imminent credit
downgrde without mitigation) additional compensation based upon restoring some of the company's
credit ratios may be appropriate. Regardless of the method chosen, it is essential that the utilty's credit
rating not be allowed to be adversely affected by signing long.term PPAs, because this would clearly
4S The credit rating agencies have taken no position on whether or how mitigation for the increased financial risk from
PP A contrcts could be provided. Some states such as Wisconsin, Colorado and Florida have essentially adogtecl .
mitigation in the fonn of an increse in the allowed regulatory equity ratio. Case No. It~~~~~9~i:~
L Smith, IPC
Page 25 of4825
increase the cost of the utilty's debt (and its equity). The remainder of this section discusses the two
broad approaches to mitigating the effects of imputed debt.
1. Mitigation Focused on the Increased Financial Risk
This first broad approach is best viewed a being part of a general rate proceeding. If a utilty's creit
rating is currently investment grade and not in danger of becoming non-investment grade, mitigation of
financial risk is suffcient. To understand this approach, keep in mind that the return on equity (or ROE)
investors require is a function of both the business risk and the financial risk of the utilty in question.
Imputed debt increases the financial risk of the company and thereby increases the required retur on
equity. There ar two basic ways to compensate for the increased financial risk: the company can
substitute equity for debt to restore the adjusted balance sheet (the balance sheet including imputed debt)
to its pre-contrct ratios of debt and equity, or the allowed ROE for the entire existing equity rate base
can be increased. These two methods are discussed in more detail below.
a) Increase the Amount of Equity in the Rate Base
Signing a long-term PPA is equivalent in some ways to financing a new investment completely wit
debt. As a result, the ratio of debt to equity in the company's "adjusted" balance sheet is increed. For
example, consider a utilty's whose rate base consists of 45 percent equity and 55 percent debt before a
contract was signed, and afer signing the contract, whose adjusted balance sheet consists of 4 i percent
equity and 59 percent debt. In other words, the imputed debt from the PPA increased the adjusted debt
26
Exhibit NO.6
Case No. IPC-E-u9-u3
L Smith, IPC
Page 26 of 48
ratio by four percentage points.46 An obvious solution is to add enough real equity and reduce real debt
to restore the adjusted capital structure to its pre-contract ratio of debt and equity.
To implement this approach, the utilty would first calculate the total amount of imputed debt from its
PPA contrcts.47 The utilty could then issue an amount of equity and reduce an equivalent amount of
actual debt that restores the adjusted capital strcture to the level before any debt was imputed or to a
level that is deemed appropriate for the utility in question.48
For this approach to work, the regulator must allow an increase in the equity component of the rate base
without simultaneously reducing the allowed ROE. The regulatory capital strcture (with no recognition
of imputed debt) now has a higher percentage of equity than it did before signing the PP A. The allowed
rate of return on the adjusted rate base must be suffcient to compensate the utility's investors for the
financial risk they carr from the "on the books" debt as well as the "off the books" (i.e., imputed) debt.
The mitigation benefit would be eliminated if the allowed rate of return were reduced as soon as
additional equity was issued by the utilty. This approach restores the utilty's debt ratio and its Earnings
Before Interest and Taxes (EBIT) interest coverage ratio but wil not restore its FFO/interest ratio and
FFO/average debt ratio exactly.49 The following example ilustrtes this point using S&P's calculation
for imputed debt, depreciationSO and interest expense.
46 In S&P's publication, S&P Introduces Reconcilation Tables to Show Analytical Adjustments to Global Utilties'
Financial Statements, op. cit., the average "S&P adjusted" capital strcture included approximately five percent more
debt than did the non-adjusted capital structure.
47 If the amount of imputed debt were expected to var substantially over tie, it may be more appropriate to estimate
an average or levelize amount of imputed debt, so that the amount of compensatig equity would not have to change
each year.
48 A variation on this method is to establish a hypothetical capital strcture and allow a return on the hypothetical equity
component that compensates for the increased fiancial risk. This wil be discussed in the second broad method.
49 In general, the FFO/Interest ratio wil be over or under retored depending upon the stag values of the ratio.
so In the examples, average imputed depreciation (equivalent to straight line depreciation) is used. This is a
simplification because in the S&P method imputed depreciation expense vares each year which makes thebOt N 6I I . i' d EXlìl I o.ca cu ations more comp icate . Case No. IPC-E-09-Q3
L Smith, IPC
Page 27 of 4827
Example 2: Recall Utilty ABC had entered into a PPA with an amount of imputed debt of $ i 06 millon
under S&P'S methodology. Assume that Utilty ABC had a $1,000 milion rate base consisting of 45
percent equity ($450 milion) and 55 percent debt ($550 milion).
Table 1
Relatory Capital Structure Without Imputed Debt
Debt
Equity
Tota
$550
$450
$1,000
55%
45%
100%
Adjusted Regulatory Capital Strcture Reßecting Imputed DebtDebt $656 59%Equity $450 41%Tota $1,106 100%
As shown in Table I, the "adjusted" rate base ($1,106 milion) consists of$4S0 milion in equity but now $656
milion in debt with an equity ratio of 4 1 percent and a debt ratio of 59 percent. To restore the adjusted rate base
to its pre-contract values would require that the utilty issue $47 milion in equity and recall $47 milion in debt
resulting in an adjusted balance sheet of$608 milion debt and $498 milion in equity. See Table 2.
Table 2
Restored Capital Structure to Pre-Contract Level (with imputed debt)
Debt
Equity
Total
$608
$498
$1,106
55%
45%
100%
Rate
6.70%
10.50%
ATWACC
2.21%
4.73%
6.94%
Debt
Equity
Total
Restored Capital Structure (without imputed debt)
Rate
6.70%
10.50%
$502
$498
$1,000
50%
50%
100%
ATWACC
2.02%
5.23%
7.25%
As can be seen in Table 3, the additional equity fully restores the Debt to Total Capital ratio and the
EBIT Interest Coverage ratios, but the other ratios are not fully restored.
28
Exhibit NO.6
Case No. IPC-E-09-03
L Smith.IPC
Page 28 of48
Table 3
Ratios Before and After PP A
Debt to Total Capital
FFO to Total Debt
FFO Interest Coverage
Adj. EBIT Interest Coverage
With PPAand With PPA and
BeforePPA No Mitigation Mitigation
55%590Ai 55%
0.27 0.23 0.26
5.0 4.5 4.9
3.14 2.8 3.14
While the approach of issuing compensating equity is financially sound, it cannot easily be implemented
on a contract by contrct basis, because the cost of issuing small amounts of equity would be prohibitive.
This method is best viewed as a means to mitigate a portolio of PPAs in the context of a general rate
case.
b) Increase the Allowed Return on Equity
The second method to mitigate the increased financial risk from imputed debt is to increase the allowed
return on equity. The increased return also mitigates some of the adverse impact on the utilty's
financial ratios, but does not fully restore any ratio. The question is how much to increase the allowed
return on equity? The answer to this question is relatively eas to estimate and is based upon the fact
that a company's after-ta weighted-average cost of capital or ATWACC is constat for changes in
capital strcture within a broad middle range of capital structures for the companies in an industr.51
Consider the following equation to calculate the ATWACC:52
ATWACC =rD x(l-Tc)xD+rE xE (1)
Where rn = market cost of debt,
51 For a complete discussion of this topic see "The Effect of Debt on the Cost of Equity in a Regulatory Settng,"
prepared by The Brattle Group for the Edison Electnc Institute, Januar 2005.
52 Note that this equation assumes that only debt and equity are in the capital stctue, but one ca add preferrd eQlIh! .h "f . Exlfibit No 6to t e equation 1 appropnate. Case No. IPC-E-U9-03
L Smith, (PC
Page 29 of4829
rE = market cost of equity,
Tc = corporate income ta rate,
D = percentage of debt in the capital strcture, and
E = percentage of equity in the capital strcture.
The cost of equity consistent with the ATW ACC, the market cost of debt and equity, the marginal
corporate income tax rate and the amount of debt and equity in the capital strcture can be determined
by solving the equation above for r£.
The change in the return on equity necessaiy to compensate for the increase financial risk from the PPA
can be determined by first, calculating the pre-contrct A TW ACC based upon the pre-contrct allowed
rate of return on equity, debt costs and tax rate, and then calculating the new allowed return on equity
that results in the same pre~contract A TW ACC after the amount of imputed debt is added to the capital
structure. This method results in exactly the same revenue requirement as the first method, but none of
the utilty's ratios would be fully restored to their pre-contract values because there is no reduction in
interest expense from substituting equity for debt. This method recognizes the increased financial risk as
if the utilty had financed its investment completely with debt. S3
Example 3
Recll Utilty ABC had a capital stctu consisting of $550 milion debt and $450 milion equity for a rate base
of $1,000 millon prior to entering into a PPA with an amount of imputed debt of $106 millon (using S&P's
methodology). Also assume that Utilty ABC prior to entering into the PPA had an allowed retu on equity of
10.50% and an embedded cost of debt of 6.7 percent. As shown in Table 2 above the pre-contract A TW ACC fro
Utilty ABC was 6.94%. Table 4 ilustrates how much the allowed return on equity should be increasd to
compensate the utilty for the financial risk represented by the PPA.
53 A depreciation expense equal to the anual capacity payment minus the imputed interest expense is added to the
numerator in the FFO ratios. Therefore, the impact on these ratios has been moderaed with S&P's reently revit3,\' N 6of its imputed debt methodology. Case No. I~C~~~09~3
L Smith, IPC
Page 30 of4830
Table 4
Regulatory Capital Structure Without Imputed Debt
Debt
Equity
Total
Dollar
$550
$450
$1,000
Percent
55%
45%
100%
Cost
6.70%
10.50%
ATWACC
2.21%
4.73%
6.94%
Adjusted Regulatory Capital Structure
Reflecting Imputed Debt and Constant ATW ACC
Debt
Equity
Tota
$656
$450
$1,106
59%
41%
100%
6.70%
11.19%
2.38%
4.55%
6.94%
Debt
Equity
Total
Regulatory Capital Structure Without Imputed Debt at Higher ROE
$550 55% 6.70% 2.21%
$450 45% 11.19% 5.03%
$1,000 100% 7.25%
Notice that the ATWACC is identical in Table 2 and Table 4, but the cost of equity has increased from 10.5QÐÆi
to I i .19%. Notice also the increase in the overall revenue requirement is $5.17 milion for both. The increase in
dollar return on equity is (I l.5% - 10.50%) multiplied by $450 or $3.10 milion after tax which result in $5.17
milion before ta ($3.10/ (I-ta rate)) assuming a marginal income tax rate of 40 percent.
Increasing the allowed return on equity does not fully restore any of the financial ratios as can be seen in
Table 5 below, but increased equity return is compensation for the increased financial risk. The
advantage of this method is that the cost of issuing new equity is avoided.
TableS
Ratios Before and After PP A
BeforePPA
Debt to Total Capital
FFO to Total Debt
FFO Interest Coverage
Adj. EBIT Interest Coverage:
55%
0.27
5.0
3.1
WithPPA and
No Mitigation
59%
0.23
4.5
2.8
WithPPA and
Mitigation
59%
0.24
4.5
2.9
2. Mitigation Focused On Restoring Financial Ratios
The second broad approach focuses on (partially) restoring some of the financial ratios to their pre-
31
Exhibit NO.6
Case No. IPC-E~9~3
L Smith, IPC
Page 31 of48
contract values. Because this approach is, in general, more expensive for rate payers than the first
approach, it is only appropriate for a utilty that does not have an investment grade credit rating or which
is in danger of a downgrade to a non-investment grade rating if the negative effects of signing long-term
PPAs are not addressed.
The distinguishing feature of the second approach is that mitigation is achieved by allowing a return on
an amount of "imputed equity" that is calculated to offset the negative effects of imputed debt. The
amount of imputed equity necessary can be targeted at compensating for any ofthe financial ratios.
Unfortnately, there is no one solution that wil restore all of the ratios that S&P relies on or the three
ratios most heavily relied upon because calculation of the ratios relies upon different part of the balance
sheet and income statement. Therefore, the second approach requires a decision on which ratio should
be restored or alternatively on what hypothetical capital structure to allow a return.
Because this method focuses on the utilty's financial ratios, it can be applied as a "contract adder" on a
contrct by contract basis. Unlike the case in which new equity is issued or the appropriate ROE for the
entire rate base is adjusted, the second method allows an equity return on an amount of imputed equity
so there are no additional trnsactions costs with this method other than the process of approving the
PPA and the determining the associated amount of imputed equity. Nor is it necessary to have a general
rate case because the equity return on the imputed equity is simply the most recent commission-allowed
ROE.
The "Financial Ratio Method," or ratio restoration, is designed to provide suffcient additional equity
return to restore the utilty's financial ratios to their pre-contract values over time. As mentioned above,
S&P focuses on three financial ratios when evaluating the impact of imputed debt. S4 Restoring each
54 S~~ has de-emphasized t,e E~IT r~tio. ~ee .S&P's ~ese~ch: ''New Business Profie Score Assigned for Ilx~ibit NO.6
Utility and Power Companies: Financial Guidelmes Revised, June 2, 2004. Case No. IPC-E-09-Q3
L Smith, IPC
Page 32 of 4832
particular ratio requires a different amount of imputed equity. Although the EBIT interest coverage ratio
is not currently among S&P's key financial ratios, it is the easiest (least expensive) ratio to restore to its
preexisting value. Restoring the EBIT ratio will also partally restore the other three ratios. Assuming
that the additional earnings are invested in additional assets that are recognized in the rate base, over
time the other three ratios wil also improve although they need not ever be fully restored. In general,
the most expensive ratio to restore is the FFO/debt ratio.
One way to view this approach is to convert the PPA and its resulting imputed debt into a "mini-firm't.
The PPA generates the imputed debt and depreciation. The task is to determine an amount of imputed
equity on which to earn an equity return that wil restore the taget ratio. Because the present value of
future contract payments declines over the life of the contract, so does the amount of imputed debt.
Therefore, the amount of imputed debt declines as well.
Implementing the financial ratio method requires the following steps:
First, calculate the amount of compensating equity return that restores the taget ratio when
imputed interest expense and imputed depreciation are considered. The return earned on the
compensating equity is assumed to be the same as the utility's allowed rate of return on equity
rate base frm the most recent rate case.
· Second, calculate an adder to the cost customers pay per MWh (rate) for the contract(s).
Example 4: Continuing the previous example, assume that the utilty expects to receive about 1.4
millon MWh per year from the PPA contrct. It is possible to calculate the additional cost per MWh for
each year the contract is in effect to restore the EBIT interest expense ratio. This is done in Table 6
below.
33
Exhibit NO.6
Case No. IPC-E-09-03
L Smith, IPC
Page 33 of48
Compensating Compensating
Present Value of Hypothetical Before- Tax Equity Contrct Adder
Year Capacity Payment Imputed Debt Equity Return ($IMWh)
1 $425.1 $106.29 $87.0 $15.2 $10.9
2 $414.4 $103.61 $84.8 $14.8 $10.6
3 $403.0 $100.75 $82.4 $14.4 $10.3
4 $390.8 $97.70 $79.9 $14.0 $10.0
5 $3778 $94.45 $77.3 $13.5 $9.7
6 $363.9 $90.97 $74.4 $13.0 $9.3
7 $349.1 $87.27 $71.4 $12.5 $8.9
8 $333.3 $83.32 $68.2 $11.9 $8.5
9 $316.4 $79.10 $64.7 $11.$8.1
10 $298.4 $74.60 $61.0 $10.7 $7.6
11 $279.2 $69.80 $57.1 $10.0 $7.1
12 $258.7 $64.67 $52.9 $9.3 $6.6
13 $236.8 $59.21 $48.4 $8.5 $6.1
14 $213.5 $53.37 $43.7 $7.6 $5.5
15 $188.6 $47.15 $38.6 $6.8 $4.8
16 $162.0 $40.51 $33.1 $5.8 $4.1
17 $133.7 $33.42 $27.3 $4.8 $3.4
18 $103.4 $25.86 $21.2 $3.7 $2.6
19 $71.2 $17.79 $14.6 $2.5 $1.
20 $36.7 $9.18 $7.5 $1.$0.9
Table 6
In the table, the imputed debt IS the present value of the capacity payments multiphed by 25% counting only the
remainder of the contract. The compensating equity is calculated as Utilty ABC's regulatory equity to debt
percentage multiplied by the imputed debt. Compensating equity return is caculated as the afer-ta cost of
equity (10.5%) divided by (i - tax rate) or (I - 40%). Finally, the contract adder is calculated as the
compensating equity return divided by the expected MW per year.
As noted above this method restores the EBIT interest coverage ratio but it does not fully restore other
ratios. Of course, as each year passes, the amount of imputed debt for a contract declines because there
are fewer future contract payments, so the dollar amount of compensation also declines. This happens
even though the fonnula to calculate the amount of mitigation is unchanged. Depending on the
individual utilty's circumstances, it may make sense to levelize the adder, so that the same dollar
amount is added to the cost of electricity each and every year during which the contrct is in effect. This
method can be adjusted to focus on any of the other financial ratios. The required compensation wil be
greater depending upon which ratio is the focus of the compensation.
Example 4 Continued: Table 7 below shows the amount of compensating equity that is needed to res~bit NO.6
Case No. IPC-E-09-03
L Smith, IPC
Page 34 of 4834
each of the four ratios in the first year. Because this method envisions using imputed equity, the debt
ratio is never affected.
Table 7
Equity Required to Resore Ratios
S&P Metholodogy
Debt to Tota Capital
FFO to Total Debt
FFO Interest Coverage
EBIT Interest Coverage
na
$220
$220
$87
The EBIT Interest Coverage ratio requir the least compensation to restore. The reson that the two FFO ratios
require the same amount of imputed equity is that the caculations assume imputed depreciation is recovered
straight line as opposed to S&P's method for ease of exposition.
B. COMPARISON OF MITIGATION METHODS
The advantage of the method utilzing imputed equity to offset imputed debt is it can be applied on a
contract-by contract basis between rate cases and does not require the utilty to issue additional equity.
Restoring the thee main financial ratios is generally more costly than compensating for financial risk,
but hypothetical equity can restore any particular financial ratio. For a utility with a non-investment
grade credit rating, restoring the financial ratios will help prevent a credit downgrade more than simply
compensating for financial risk. However, both methods compensate the utilty for the risk inherent in
PPAs and improve its financial ratios relative to doing nothing. Focusing solely on the increased
financial risk is less costly to consumers than is the financial ratio method, but it also takes longer to
restore the company's other financial ratios to their pre-contract levels.
VII. CONCLUSION
il Long-term purchase power agreements (PPA) transfer financial risk from the seller to the buyer.
This is because PPAs obligate the buyer's future cash flow, just like a debt service obligation.
35
Exhibit NO.6
Case No. IPC-E-09-03
L Smith,lPC
Page 35 of48
il Policy makers should be particularly sensitive to PPA-related risk trnsfer in situations where the
utilty's credit rating is minimally investment-grde. For such utilties, entering into PPAs without
addressing debt imputation could trigger credit downgrades which push the utilty below investment~
grade - with consequences that are far more harmful to customers than downgrades to levels that are
stil inveSbnent-grade. The risk transfer from PP A contracts must stil be considered for utilities
which are stongly invesbnent-grade although the consequences of a credit rating downgrade are not
likely to be as severe.
il Regulatory policies which provide assurance ofPPA cost recovery can effectively mitigate the
impact of imputed debt on the credit rating of purchasing utilties. S&P's methodology, in
particular, applies a risk factor to the debt calculation which is intended to reflect the probabilty that
PPA costs wil be fully recovered in rates. The greater the probabilty, the smaller the risk factor,
and the smaller the amount of imputed debt frm a particular set of contracts.
il There is no perfect solution to the problem ofPPA-related risk transfer and imputed debt. There are
at least thre possible approaches to addressing the problem. Unfortnately, none simultaneously
maximizes the protection of credit wortiness, while minimizing the cost to consumers.
il In competitive procurement situations. it is importnt that imputed debt be addressed in a
competitively-neutral way. Imputed debt should not be used to exclude merchant generators from
the market, but neither should it be ignored. Adjustments should be based on the true cost involved
(e.g., by increasing bid prices by no more than is required to restore interest coverage ratios to pre~
PPA levels).
36
Exhibit No. 6
Case No. IPC-E-09-Q3
L Smith, IPC
Page 36 of 48
37
Exhibit NO.6
Case No. IPC-E-09-03
L. Smith, IPC
Page 37 of48
APPENDIX A
TREATMENT OF IMUTED DEBT IN CERTAI STATES
This appendix discusses selected states where policy makers, i.e., legislatures or regulatory
commissions, have looked at the issue of imputed debt, or debt equivalence, for long~term purchased
power contracts. One application is in cost of capital hearings and deals with the impact of imputed debt
on the financial strength of the utilty, its regulatory capital structue, and the allowed return on equity.
A second application is the mitigation of increased financial risk with a cost adder to the price upon
signing specific long-term PPAs. A third area is in the evaluation of "buy versus build" situations55
comparing the competitive bids of independent power producers and regulated utilties for new
generation in states with hybrid generation markets.56 Policy makers analyzing imputed debt generally
recognize that credit rating agencies, especially S&P, calculate imputed debt and adjust critical financial
ratios accordingly. The policy outcomes are varied, with some states providing for explicit mitigation of
imputed debt, and some states choosing not to mitigate in the cases reviewed. States discussed here
(California, Delaware, Florida, Nevada, New Mexico, and Wisconsin) have all considered how and
SS A buy-versus-build situation occurs when a competitive procurement proceeding is held and the decision on which is
the lowest cost alternative (i.e., lowest present value of futue revenue reuirements) includes making a choice
between the lowest cost power purchase option in comparison with the utility's best self-build option. The utilty's
self-build option wil include its proposed capita strcture, which wil help determine its final cost. The new
generation addition would normally mirrr that of the utility as a whole and leave the utilty's financial risk profile
unchanged. If, purely hypothetically, the utilty were to use 100 percent debt financing with no additional equity and
equity retur, the utilty's financial risk would go up, as measured by the S&P financial ratios. As a generl
proposition (before looking at the specifics of a given situation), the signing of the long-term PPA has the effec of
increasing debt equivalence without increasing return (mediated through the imputed debt calculus discussed above).
Therefore, in comparing that PPA alterative with self-build options at allowed capital strcture, the mitigation of
cost of imputed debt to the utilty needs to be added to the contrct the utilty signs to make the comparison "apples to
apples." See Stadar & Poor's Utilties & Perspectives, "'Buy Versus Build': Debt Aspects of Purchased-Power
Agreements," May 2003 and, for an opposing view, Electric Power Supply Association, Electric Utility Resource
Planning - The Role of Competitive Procurement and Debt Equivalency, prepared by GF Energy LLC, July 2005.
S6-A hybrid generation market, which, as discussed below, California has become and Delawa could now beome
under new law, is where resource procuement for new supplies is accomplished with open bidding ania't N 6
independent power producers and regulated, cost-of-service utilities. Case No. I~C-~-09~03
L Smith, IPC
Page 38 of 4838
whether to address imputed debt.57 Brief summaries of these sttes' treatments are provided below.
There is first an indicative discussion of the reasons why many states have not addressed imputed debt.
States for which Imputed Debt is not Currently an Issue
Although S&P applies its imputed debt methodology to all utilties issuing debt, state regulatory
commissions or legislatures are not likely to consider imputed debt to be a material policy issue if the
state's utilties do not have significant existing or prospective long-term PPAs. States in this situation
include primarily states with a traditional industry structure where utilties own and continue to build all
generation necessar to meet their obligation to serve. Additionally, in "retail access" states, of which
there are currently seventeen, the utilities first obligation is to provide reliable, low-cost trsmission
and delivery service, and, in many such states, to purchase a substantial amount of electric power to
meet their obligations as Provider of Last Resort (UPOLR"). Most of the POLR contrcts have
historically been for short terms, generally thee years or less.58 Before S&P changed its methodology,
such shorter term contracts generated little or no imputed debt. This has changed, and S&P now trats
short-term contracts in an "evergreen" manner, i.e., assuming they wil be renewed indefinitely and
therefore warrant imputed debt tratment. Policy makers in retail access states ar now likely to be
asked to address the resulting effect of imputed debt on the credit ratings of the states' utilties.59
Moreover, heavy reliance on short-term contracts for power procurement does not appear to be a viable
long-term policy for all of the retail access states for two reasons. First, the higher level of electric price
volatilty may be unacceptable to ratepayers and regulators, as experienced in the recent period of
57 This discussion is not intended to be exhaustve. It omits discussion of several states where the discussion has begu,
but where the authors ar not aware of the final outcome, including OR, LA. UT is also omitted.
58 Note: the tenn "state" is always used in these discussions to include the District of Columbia (DC), for convenience
of exposition. The seventeen .'retail access" states are: CT, DE, DC, ME, MD, MA, MI, NH, NJ, NY, OH, OR, PA,
RI, TX, VA. The situation in DE may be changing, as discussed below.
59 Standard & Poor's, "Imputed Debt Calculation for U.S. Utilities' Power Purhase Agreements," Marh ~~O~6: ¡~~~~~~9~O~
L. Smith, IPC
Page 39 of 4839
natural gas price inflation and the resulting higher electric prices. Second, short-term contracts and spot
market sales do not appear to provide strong enough incentives for investment in adequate new
generation. The Fitch rating agency stated its view position on short-term contrcts: ". . . the one-to-
three-year term of such supply agreements is, in Fitch's view, too short to provide a financial foundation
on which to fund the construction of new independent power generation.',60
In contrast, there is little question that long-term contracts signed under regulatory guidance by
financially sound utilties can be used to finance new power plants. Fitch goes also predicts that retail
access states within regional transmission organizations (RTOs) may have to become more active and
may well move toward hybrid market structures, with long-term procurement processes more akin to
what are found in California. Moreover, the authors of this report conclude that the Fitch analysis
recognizes the transfer of risk from the power producer to the purchasing utilty by the signing of a long-
term purchased power contract. This risk transfer is related to the risk that S&P identifies in its
calculation of imputed debt for the contract buyer.
California
The Public Utilities Commission of California (CPU C) revised its policy recently so that utilties are no
longer allowed to adjust (increase) independent power producers' (IPP) bid prices to account for the cost
of risk transfer in comparing them to self-build options. The Commission continues to consider debt
equivalence in determining utilties' costs of capitai.61
60 Fitch Ratings,"Stimulating Generation Additions in Deregulated States," Op. Cit., November 4,2005, at p. 2. Ths
was discused above in Section II.
61 CPUC, Opinion Adopting Pacifc Gas and Electric Company's, Southern California Edison Compa's, and ¿'Wb"t N 6
Diego Gas & Electric Company's Long-Term Procurement Plans, Decision 07~ 12-052, December 20, 2~Jse No. IPC~~-o9~03
L. Smith, IPC
Page 40 of4840
The CPUC previously had recognized that debt equivalence is a real economic cost that can impact a
utilty's credit rating and cost of borrowing, and had allowed utilties to use a 20% debt equivalence
factor in comparing PPAs to self build options. In December, 2007 the Commission changed its policy
out of concern that explicitly recognizing the cost ofPPA risk trnsfer .....creates a disparity between
the treatment of PPAs and utilty-owned projects in the procurement process..." because no such adder
is applied to self-build options. For the 2005 test year, the Commission did approve a 4% increase in
southern California Edison's preferred equity ratio, and a corrsponding decline in seE's long-term debt
ratio (all measured on a ratemaking basis). More recently, the Commission has rejected attempts by San
Diego Gas & electric to establish an automatic mechanism to increase SDG&E's equity ratio to offset
the FIN(46) effects otPPAs.
In effect, the policy in California now is to ignore PPA risk trnsfer during procurement decision making
and address its consequences after the fact: "We recognize that at some point, DE may reach a point
where it can affect the utilties' credit rating and cost of capital, and it is not disputed in this proceeding
that the potential effect of DE on credit ratings, if any, is an appropriate topic for the utilities' cost of
capital proceedings." (Note that all three large California electric utilties have applied for rehearing of
this decisions, so it is possible that the Commission wil revise its policy once again.)
Delaware
Delaware has been among the states pursuing a policy of retail competition, but had the misfortne to
end its capped-price transition period on May i, 2006, after the recent inflation in electric prices.
Apparently, the majority of residential and small commercial customers were forced to move to a higher
priced "Standard Offer Service," which was procured through short-term auctions and that reflected the
volatilty that is inherent in a short-term strategy.Exhibit No.6
Case No. IPC-E-09-03
L Smith, IPC
Page 41 of 4841
The General Assembly passed a revision to the restructuring legislation entitled liThe Electric Utilties
Retail Supply Act of 2006.1/ The Act provides that all regulated electric distribution companies wil
hencefort be designated as the standard offer service supplier and retuing customer service supplier in
their respective territories. Moreover, the distibution companies now are given new opportunities and
responsibilities to enter into long-term and short-term supply contracts, to own and operate generation
facilties, to build generation and trnsmission facilties, to make investments in demand-side resources
and to take any other Commission approved action to diversify their retail load supply (emphasis added).
This has ushered in the issue of imputed debt in an essential way.
On August 1,2006, in response to Commission directives, Delmarva Power and Light (Delmarva) fied
a draft RFP. There has been a substantial amount of discussion about the terms and conditions of the
RFP, particular in three areas: imputed debt cost factors in bid evaluation, credit and operational
security requirements, and variable interest entity treatment under F ASS Interpretation No. 46.62
Delmara has proposed that in order to account for the effect of imputed debt on its balance sheet and
credit rating, there would be a cost adjustment added to each long-term bid. This adjustment would be
based on an S&P calculation of imputed debt.
Delmara argued that where a bid is compared with Delmarva's self-build option, the NPV of revenue
requirements would generally include the impact of additional debt and equity in proportion to
Delmarva's allowed capital structure and debt and equity costs from the most recent rate decision. The
need to maintain the appropriate equity thickness is built into the cost structure of the self-build options.
The cost adder puts contracts on a comparable footing in terms of mitigating the degradation in
Delmarva's financial ratios.
62 See New Energy Opportnities, Inc et aI., Analysis and Recommendations Regarding Delmarva Power and Light
Company's RFP, September 18, 2006, "Section viii. Imputed Debt Offset" and Concentric Energy Advisors,E.Ribit NO.6
Case No. IPC-E-Ð9-Ð3
L. Smith, IPC
Page 42 of 4842
On November 21, 2006, the Delaware Public Service Commission issued Order No. 7081, which found
that Delmarva's (DP&L) imputed debt adjustment should be used in their RFP. The Order says63
145. We believe that the RFP should provide that DP&L wil be permitted to assess the
incremental equity amount to be equal to 30% of the net present value of the bid's
capacity payment, and that a portion of the energy price may also be included if DP&L
concludes that a portion of the bids energy component would be imputed as debt by
rating agencies in their assessment of DP&L's creditwortiness.
Florida
The Florida Commission first addressed imputed debt in 1999 by approving a stipulation and settement
that explicitly mitigated the impact of imputed debt. The settlement did so by setting the level of equity
that Florida Power & Light (FP&L) was allowed in its capital strcture for surveilance reporting
requirements and all regulatory purposes, on a basis that was adjusted for imputed debt.64 This policy of
having an explicit equity adjustment in the capital strcture was continued with the approval of
subsequent orders, including that in 2005, where in Paragrph 15 states:65
15. For sueilance reporting requirements and all regulatory purposes, FPL's ROE wil
be calculated upon an adjusted equity ratio, as follows. FPL's adjusted equity ratio wil
be capped at 55.83% as included in FPL's projected 1998 Rate of Return Report fro
surveilance purposes. The adjusted equity ratio equals the common equity divided by
the sum of common equity, preferred equity, debt and off-balance sheet obligations. The
amount used for the off-balance sheet obligations wil be calculated per the Standard &
Poor's methodology. (Emphasis added)
Thus, the Florida Commission mitigates the financial impact of imputed debt by increasing the utilty's
Assessment of the Risks of the Independent Consultant's Proposed Modifcations to Delmarva's RFP for New
Generation Resources, Oct. 30, 2006.
63 Delaware PSC, PSC Docket No. 06-2111, Order No. 7081, Nov. 21, 2006, p. 4.
64 Florida Public Service Commission, Order Approving Stipulation and Settlement, Docket No. 990067-EI, Order No.
PSC-99-0519-AS-EI, issued on March 17,1999.
65 Florida PSC, Order Approving Stipulation and Settlement, Docket No. 050045-EI, Docket No. 050 i 88-EI, Order No.
PSC-05-0902-S-EI, Issued Sept. 14, 2005; and Stipulation and Settlement, Same Dockets, dated Aug. 22, 2g~~ibit NO.6Paragraph 15. Case No. IPC-E-09-03
L Smith, IPC
Page 43 of 4843
equity "thickness." The approach is based directly on the S&P methodology for calculating imputed
debt. The Commission explicitly recognized the effect that purchased power contracts have on the
utilty's financial ratios as calculated by S&P. The Commission approved the 1999 settlement that
capped FPL's adjusted equity ratio at 55.83 percent - which at that time equated to a ratio of 65.7
percent based on the regulatory books absent imputed debt. 66 Thus, to offset the greater financial
leverage associated with its imputed debt, FP&L was allowed to increase its actual equity ratio as long
as the "adjusted equity ratio" (Le., the equity ratio calculated to include imputed debt) did not exceed
55.83%.
The Florida Commission also considered imputed debt in its approach to making long-term resource
planing decisions. The Florida Commission requires its utilties to account for the costs that purchased
power contracts impose on utilties though imputed debt.67 To do this, FP&L employs an equity
adjustment to calculate the additional costs associated with the amount of imputed debt based on S&P's
imputed debt calculation for the specific contract under discussion. This cost is added to the cost of the
contract for making comparisons with other resource options. The i 999 order approved the use of a i 0
percent risk factor, noting that this was the factor then assigned by S&P.68 However, in 2004 the Florida
Commission increased the risk factor to 30 percent, explaining that six months earlier S&P had issued a
report stating that it now applied a 30 percent risk factor in the determination of the consolidated credit
profile of the FPL Group.69
Nevada
In 200 I, Nevada adopted what was at the time one of the countryls more aggressive renewable portolio
66 Order No. PSC-99-1713-TRF-EG, Docket No. 990249-ET, September 2, 1999, p. 9. See also Provision 4 of
Stipulation and Settlement, Before the Florida Public Service Commission, Docket No. 990067-EI, March 10, 1999.
67 F.AC. Rule 25-22.081, paragrph 7.
68 Order No. PSC-99- i 713- TRF-EG, Docket No. 990249-ET, September 2, i 999, p. 9.
69 Florida PSC, Order No. PSC-04-0249-TRF-EQ, issued on March 5, 2004, in Docket No. 031093-EQ Exhibit NO.6
Case No. IPC-E-09-03
L Smith, IPC
Page 44 of4844
standards ("RPS"). The law requires that 1 5 percent of all electricity generated in Nevada be derived
from new sources of renewable energy by the year 2013. This required that the state's utilties, Nevada
Power Corp and Sierra Pacific Power Corp, sign a substatial number of new, long-term contracts for
renewable power. Early progress was modest, in part because these utilties were emerging from a
period of financial distress with below investment grade bond ratings, stemming from the western
energy crisis.
In June 2005, the Nevada legislature passed Assembly Bil 3 ("AB3") that modified Nevada's RPS. The
new law increased the target percentages for energy from renewable resources, now requiring that by
2015, 20 percent of all electric power be from renewable energy resources. At the same time, the
legislature recognized that the goal of significantly increasing the number of renewable energy contracts
signed would be difficult without proactively addressing the issue of imputed debt. The utilities were
concurrently engaged in strong efforts to regain an investment grade bond rating. AB3 addresses
imputed debt directly by requiring the following?O
7. The Commission shall adopt regulations that establish:
(a) Standards for the determination of just and reasonable tenns And conditions for the
renewable energy contrcts and energy effciency contracts that a provider (of electric
service J must enter into to comply with its portolio standard.
(b) Methods to classif the financial impact of each long-term renewable energy contract
and energy effciency contract as an additional imputed debt of a utilty provider. The
regulations must allow the utiity provider to propose an amount to be added to the cost
of the contract, at the time the contract is approved by the Commission, equal to a
compensating component in the capital structure of the utilty provider. In evaluating
any proposal made by a utilty provider pursuant to this paragraph, the Commission
shall consider the effect that the proposal will have on the rate. (Emphasis added)
The Public Utilty Commission of Nevada (pUCN) implemented this requirement in a set of rules, NRS
704.7821(7) (b).
45
Exhibit NO.6
Case No. IPC-E-09-03
L Smith, fPC
Page 45 of48
In May 2006, Sierra Pacific Power Company (SPPC) fied for the approval of a renewable contract
negotiated to partially meet the renewal portolio standard. The filing included the request for mitigation
of imputed debt through a cost adder, which followed SPPC's interpretation of the AB3. However,
SPPC withdrew the request for mitigation of imputed debt of the contract in late summer of 2006,
reserving the right to re-fie. Therefore, at this time, there has been no test of whether the PUCN would
approve any particular cost adder on a renewable contract as imputed debt mitigation based upon their
interpretation of the 2005 law.
New Mexico
The New Mexico Renewable Energy Act (RA), at NMSA 1978, § 62- i 6-4), requires New Mexico's
investor-owned electic utilties to file a procurement plan each year that includes the cost of any new
renewable energy resource required to comply with the renewable portolio standard ("RPS"). The 2007
Plan of Public Service of New Mexico (PNM) requested that the New Mexico Public Regulation
Commission (N Commission) approve both the "Biomass PPA," a long-term purchased power
agreement for renewable energy from a biomass plant, and the recovery of the costs of the Biomass
PPA.71 In addition to the costs for capacity and energy, PNM sought approval to mitigate the financial
impacts of imputed debt though the approval of an adder, which would be later collected in rates when
the biomass plant was built and renewable power began to be supplied.
The statutory language on cost recovery for renewable energy, in NMSA 1978, § 62- i 6-6, states:
(A), A public utilty that procures or generates renewable energy shall recover, through
the rate-making process, the reasonable costs of complying with the renewable portolio
standard. Costs that are consistent with commission approval of procurement plans . . .
70 See State of Nevada, Assembly Bil No. 3 - Committee of the Whole, Section 29.7 (b), p. 21.
htt://www.leg.state.nv.us/2ndSpeciallills/ AB/ AB3 _EN .pdf.
71 Public Service Company of New Mexico, Notice of Filng of "Renewable Energy Portfolio Procurement Plan¿~'b't N 6
2007," Case No. 06-00340-UT, August 16,2006. Case No. I;C~~-o9~03
L Smith,lPC
Page 46 of4846
shall be deemed to be reasonable.
PNM's proposal analyzed the Biomass PPA's imputed debt impacts in terms of the S&P methodology,
which was used to determine the degree to which the three key financial ratios would be degraded
(Funds from Operations (FFO) interest coverage; the FFO to Debt ratio; and the Total Debt to Total
Capital ratio). The mitigation requested was a cost adder equal to the net return on a "compensating
equity adjustment." This is the amount of equity that, if PNM were to issue and use to retire real debt,
would restore PNM's debt-to-capital ratio to its pre-Biomass PPA leveL. The concept and formula used
were generally the same as used in the state of Florida to make imputed debt adjustments discussed
above.
However, the Commission approved only the energy and capacity costs of the Biomass Contract and
denied approval of the cost of imputed debt in the context of this proceeding, which covered renewable
plan and contrct approvaL. 72 No par contested the fact that signing the Biomass contract would
degrade PNM's financial ratios, other things equal. The Commission appears to have reasoned that the
degradation of financial ratios in the degre indicated is not suffcient without evidence that a bond
downgrade was likely to follow. Although PNM had an S&P rating ofBBBlNegative, the Company did
not contend that signing this long-term Biomass contract alone would be likely to change its credit
raning. The Commission also appeared to determine that the degrded financial ratios were also
insuffcient evidence that the cost of capital would increase, and therefore, rejected the cost adder
sought. In accordance with the Recommended Decision of the Hearing Examiner, PNM was left with
the opportnity to raise the issue of the financial impact resulting frin the Biomass contract (and
possibly other off balance sheets obligations) in another docket. The Recommended Decision states
"While we deny PNM's request in this case concerning imputed debt, PNM wil have a full and fair
72 New Mexico Public Regulation Commission, Final Order on Exceptions, Case No. 06-00340-UT, Dec. 18, 2006"b't N 6Th h. d' d Fxlii I o.ere are many ot er issues iscuse . Case No. IPC-E-09-03
L. Smith, IPC
Page 47 of 4847
opportunity to present this matter in its next rate case.,,73
Wisconsin
Wisconsin sets a common equity ratio taget based on what they call a "Financial Capital Strcture" that
includes off balance sheet items (including imputed debt on PPA's) that support. in their view. a given
rating. This then sets the amount of equity that wil be included in the "Regulatory Capital Strcture" in
setting rates. The effect is to aiio~ the company to carr a thicker equity ratio and have it considered
within the ratemaking process. In WPSC's last case its financial equity target was 52%. This ratio is
intended to support a credit rating between an A and an AA. and trnslated into a regulatory equity taret
ratio (close to GAAP) of57.46%. The difference (5.46%) represents equity that has been added to offset
imputed debt associated with purchase power and operating lease commitments.74
73 Lee Huffan, Recommended Decision of the Hearing Examiner. NMURC Case No. 06-00340-UT, Nov. 29. 2007, p.
20.
74 PSC of Wisconsin, Final Decision, 6690-UR-118, Januar 15,2008.Exhibit No.6
Case No. IPC-E-Q9-03
L Smith, IPC
Page 48 of 4848
BEFORE THE
IDAHO PUBLIC UTILITIES COMMISSION
CASE NO. IPC-E-09-03
IDAHO POWER COMPANY
SMITH, 01
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