20071210Kahal direct.pdf

Department of Energy
Washington, DC 20585 REeE
Zûû1 DEC I 0 ArIIO: 2 I
iDlU+O PUBLIC
UTILITIES COMMISSlOi"
December 7, 2007
VIA FEDERAL EXPRESS
Ms. Jean Jewell
Commission Secretary
Idaho Public Utilities Commission
P.O. Box 83720
Boise, ID 83720-0074
RE: Case No. IPC-E-07-8
Dear Ms. Jewell:
Enclosed please find an original and ten (10) copies of the Direct Testimony and Exhibits
of Matthew i. Kahal on Behalf of the United States Departent of Energy, and ten (10)
copies of the Direct Testimony and Exhibits of Dennis W. Goins on Behalf of the United
States Departent of Energy in the above-captioned proceeding. Also enclosed is an
additional copy of each of these items that I request be date-stamped and retued in the
enclosed stamped envelope. If you have any questions concerning this filing, please do
not hesitate to contact me at [phone].
Sincerely yours,
Arhur Perr B~
Attorney-Advisor
Office of the General Counsel
United States Departent of Energy
1000 Independence Avenue
Washington, D.C. 20585
Arhur.Bruder~hq.doe.gov
* Printed with soy ink on recycled paper
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STATE OF IDAHO
BEFORE THE
.PUBLIC UTILITIES COMMISSION
.IN THE MATTER OF THE APPLICATION
OF IDAHO POWER COMPAN FOR
AUTHORITY TO INCREASE ITS RATES
AND CHAGES FOR ELECTRIC
SERVICE TO ELECTRIC CUSTOMERS
IN THE STATE OF IDAHO
)
)
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R
10: 21
CASE NO. IPC-E-07-8
.
.
DIRCT TESTIMONY OF
MATTHEW i. KA
.
ON BEHAF OF THE.U.S. DEPARTMENT OF ENERGY
.
DECEMBER 10, 2007
.
EXETER
.
ASSOCIATES, INC.
5565 Sterrett Place
Suite 310
Columbia, Maryland 20904
.
.TABLE OF CONTENTS
PAGE
i. QUALIFICATIONS .............................................................................................................. 1.
II.OVERVIEW..........................................................................................................................3
A. Sumar of Recommendations........................................ ...................................,........ 3
B. Capital Cost Trends. ... ................... ................ .... ............................................................ 6
C. Cost of Equity Summary............................................................................................... 9
D. Testimony Organization..............................................................................................11
.
.III. COST OF COMMON EQUITY .......................................................................................... 12
A. Using the DCF Model.................................................................................................12
B. DCF Study Using the West Region Group of Electrc Utility Companies................. 16
C. DCF Sensitivity.........................,................................................................................. 22
D. Dr. Avera's DCF Estimates ........................................................................................ 23
.
.N. REVIEW OF DR. AVERA'S DCF, CAPM AND COMPARLE EARGS............ 26
A. DCF Analysis..............................................................................................................26
B. CAPM Results ............................................................................................................27
C. Comparable Eamings..................................................................................................32
.V. CONCLUSIONS ON FAI RATE OF RETUR .............................................................. 35
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1 A.Yes. I have testified before approximately two-dozen state and federal utility.2 commissions in more than 300 separate regulatory cases. My testimony has
3 addressed a varety of subjects including fair rate of retu, resource planing,
4 financial assessments, load forecasting, competitive restrcturig, rate design,.5 purchase power contracts, merger economics and other regulatory policy issues.
6 These cases have involved electrc, gas, water and telephone utilities. In 1989, I
7 testified before the U.S. House of Representatives, Committee on Ways and.Means, on proposed federal tax legislation affecting utilities.8
9 Q.WHAT PROFESSIONAL ACTIVITIES HAVE YOU ENGAGED IN
10 SINCE LEA VIG EXETER AS A PRICIPAL IN 2001?.
11 A.Since 2001, I have worked on a varety of consulting assignents pertining to
'11,
12 electrc restrctug, purchase power contracts, environmental controls, cost of
.13 capital and other regulatory issues. Curent and recent clients include the U.S.
14 Deparent of Justice, U.S. Air Force, U.S. Deparent of Energy, the Federal
15 Energy Regulatory Commission, Connecticut Attorney General, Pennsylvania
.16 Office of Consumer Advocate, New Jersey Division of Counsel, Rhode Island
17 Division of Public Utilities, Louisiana Public Service Commission, Arkansas
18 Public Service Commission, Marland Deparent of Natual Resources and.19 Energy Administrtion, -and Maine Office of the Public Advocate.
20 Q.HAVE YOU PREVIOUSLY TESTIFIED IN MATTERS BEFORE THIS
21 COMMISSION?.22 A.Yes. I have testified on cost of capital before the Idaho Public Utilities
23 Commission on previous occasions, including Idaho Power Company's (IPC or
24 the Company) base rate case in 1994 (IPC-E-94-5)..
.Matthew I. Kahal, Di 2
Deparent of Energy
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1 ll. OVERVIW.2 A.Summary of Recommendations
3 Q.WHAT IS THE PURPOSE OF YOUR TESTIMONY IN THIS
4 PROCEEDING?.
5 A.I have been asked by the U.S. Deparent of Energy (DOE) to develop a
6 recommendation concerning the fair rate of retu on the jursdictional electrc
7 utility rate base of Idaho Power Company (IPC or the Company). IPC is the.
8 electrc utility subsidiar of IdaCorp, Inc., and it accounts for the vast majority of
9 IdaCorp's invested capital and operations. My work in this case includes both a
.10 review of the Company's proposal concerning rate of retu and the preparation
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11 of an independent study of the cost of common equity.
12 Q.WHT IS THE COMPANY'S RATE OF RETUR PROPOSAL IN
- ".13 THIS CASE?
14 A.As presented on Exhibit 10 sponsored by Mr. Keen, the Company proposes an
15 overall rate of retu of8.56 percent, based on the projected capitalization and
r.16 debt costs at December 31, 2007. The capital strctue proposed in ths case
17 includes 50.3 percent common equity and 49.7 percent long-term debt, with no
18 preferred stock or short-term debt included in the capital strctue. The requested.19 overall rate of retu' is sponsored by the Company witness, Mr. Steven Keen, and
20 he selects a retu on common equity of 11.5 percent. IPC's outside cost of
21 capital witness, Dr. Wiliam A vera, recommends a retu on common equity.22 range of 11.2 to 12.2 percent.
23 Q.WHAT IS MR. KEEN'S APPROACH TO CAPITAL STRUCTU?
24 A.IPC is a wholly owned subsidiar of IdaCorp, Inc., a utility holding company, and.
25 is principally engaged in electrc utility retail operations in Idaho, with a small
Mattew I. Kaal, Di 3.Deparent of Energy
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1 amount of retail utility operations in Oregon. Mr. Keen bases the ratemakng.2 capital strctue on the projected Idaho Power Company capital strctue at
3 December 31, 2007.. As of this date, IPC expects to have no preferred stock
4 outstanding, and Mr. Keen includes the effects of expected long-term debt.5 issuances.
6 Mr. Keen also provides an estimate of the actual embedded cost of debt,
7 inclusive of the prospective cost rates for the Company's varable rate debt and its.8 projected new debt issuances. This produces an embedded cost of debt of
9 5.59 percent.
.10 Q.
11
12 A.
WHAT IS YOUR RECOMMNDATION AT THIS TIME ON RATE OF
1 . ~- . .
RETUR?
As presented on my Exhibit No. 601, I am recommending a retu on the IPC
";,1.13 jursdictional rate base of7.93 percent, which includes a 10.25 percent retu on
14 common equity. The 10.25 percent recommendation is based priarly upon
15 discounted cash flow (DCF) evidence using a proxy group of eleven electric
.16 utility companies operating in the West Region of the U.S. I also present DCF
17 evidence using a subset of Dr. Avera's proxy companies, i.e., those companies in
18 his group that operate as integrated, fully-regulated utilities. In addition, I have.19 reviewed and considered Dr. Avera's evidence using the Capital Asset Pricing
20 Model (CAPM), although I find the CAPM to be much less useful than the DCF
21 studies. Finally, I compare my DCF results to "comparble earings" evidence,.22 although this is not a market cost of equity estimation method. The 10.25 percent
23 is somewhat higher than my DCF midpoint results, providing IPC with a premium
24 over the "baseline" proxy group cost of equity estimate..
.Mattew i. Kahal, Di 4
Deparent of Energy
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1 In formulatig my overall rate of retu recommendation, I have accepted.2 the Company's proposed December 31,2007 capital strctue, subject to possible
3 updating. This capital strctue provides IPC with a slightly thicker equity ratio
4 than approved by the Commission in the 2004 rate case, and these percentages.5 appear to be consistent with IPC's financial objectives.
6 Q.WHAT RATE OF RETU DID THE COMMISSION APPROVE IN
7 THE LAST FULLY-LITIGATED RATE CASE?.8 A.In IPC's last fully-litigated case, decided in 2004 (Case No. IPC-E-03-13, May
9 25,2004), the Commission set the Company's rate of retu on equity (ROE) at
10 10.25 percent, in conjunction with a common equity ratio of 46 percent. In that.
11 rate order, the Commission concluded that the authorized 10.25 percent retu on
12 equity appropriately reflected the Company's business risks. The Commssion's
13 return on equity quantification in that Order relied primarly on DCF and.
14 comparable earings evidence. (Order, page 38)
15 I recommend that the Commission reaffrm and continue the 10.25 percent
.16 common equity award. This retu is consistent with the cost of capital evidence
17 at this time, provides IPC with at least a small premium over my "base line" DCF
18 results, and is also generally consistent with the comparable earings evidence..19 Moreover, the 10.25 percent retu would be applied to a larger common equity
20 basi~ in this case (50 percent) as compared to the 2004 case (46 percent).
21 Q.WHAT IS THE ASSESSMENT OF IPC BY THE RATING AGENCIES?.22 A.As sumarzed in Mr. Keen's testimony, all thee credit rating agencies rate IPC
23 high trple B, low single A, with the low single A applicable to the Company's
24 seciired debt. The recent reports from the three major credit rating agencies.25 (Standard & Poors, Moody's and FitchRatings) were provided in response to
Matthew i. Kahal, Di 5.Deparent of Energy
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1 DOE's first set of data requests, item 21, and all three organizations provide.2 generally similar business risk assessments. For example, FitchRatings notes the
3 "beneficial effects of the utility's power cost adjustment mechanism and a
4 reasonable regulatory environment." (June 15,2007) Standard & Poors identifies.5 the strengths as being "a strong power cost adjustment (PCA) mechanism,"
6 supportve regulation, low-cost generation and the absence of unegulated
7 , business. (Februar 8, 2006) Moody's refers to IPC's "generally low business.8 risk profie", reasonably supportive regulatory treatment and the power cost
9 adjustment mechanisms as being positive for ratings. (May 11, 2007)
10 Similarly, each of the three credit rating agencies mentions the same.
11 negative factors. The principal ratig concerns include IPC's large constrction
12 program (including the risks of rate disallowances) and the risk of adverse
13 hydrologic conditions. It appears that S&P indicates a negative outlook due to the.
14 high capital spending.
.
15 Q.
16 A.
WHAT DO YOU CONCLUDE?
Based on my review of the information submitted in this case, including the
17 recent credit rating reports, I conclude that IPC is an approximately average risk
18 electrc utility. Thus, the West Region group of vertically-integrated ,electrc.19 companies provide a generally reasonable risk proxy for IPC.
20
21 B.Capital Cost Trends.
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22 Q.
23
24 A.
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HAVE YOU REVIEWED TH TRNDS IN MAT CAPITAL
COSTS OVER THE PAST DECADE?
Yes. My Exhibit No. 602 shows capital cost indicators on an anual basis since
1992 and on a monthly basis durng Januar 2002 to September 2007. The
.Matthew i. Kahal, Di 6
Deparent of Energy
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1 indicators include inflation (as measured by the anual change in the Consumer
t 2 Price Index), short-term Treasur yields, ten-year Treasury yields and single A-
3 rated long-term utility bond yields (per Moody's).
4 This schedule shows that despite year-to-year fluctuations there has been a
~5 downward trend in capital costs over this time period, at least for long-term
6 securties. Short-term interest rates tend to be governed by Federal Reserve (Fed)
7 policy, and during the last two years the Fed has been "tightening" (i.e., raising
.8 short-term rates) in response to a strengthening U.S. economy. In response to a
9 slowing U.S. economy and distress in the housing market the Fed very recently
10 has reversed this trend and begu to reduce interest rates. As measured by utilityt
11 bond yields, it appears that capital costs "bottomed out" in mid-2005, with single
12 A utility bond yields reachig a low point in the mid 5 percent range. Long-term
13 interest rates remained relatively low through most of 2006 (i.e., long-term utilityt
14 bond yields at approximately 6 percent), and this has continued durg most of
15 2007. Long-term rates can move from month-to-month but the underlying trend
t 16 has been fairly stable. Single A utility bond yields have remained in the 6.0 to
17 6.5 percent range, with Ten-Year Treasur yields in the 4.5 to 5.0 percent range.
18 Based on my review ot this information, I would characterize the capital
t 19 cost environment as remaining quite favorable compared to past years. ' Capital
20 costs durng most of 2007 also appear to be favorable compared to the costs in
21 late 1990s.
t 22 Q.
23
24 A.
ACCORDING TO EXHIBIT NO. 602, THERE WAS AN UPWAR
MOVEMENT IN INLATION IN 2006. PLEASE COMMNT.
Inflation rates durg the 2006 moved upwards in response to price spikes for
t 25 energy. However, the underlying "core" inflation (excluding the volatile fuel and
.
Mattew i. Kahal, Di 7
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1 food sectors) remains relatively stable. For example, the long-term "consensus"
.2'forecast of the GDP Deflator mlue Chip Economic Indicators, March 10, 2007)
3 is 2.1 percent anually. The favorable "core" inflation outlook is based on strong
4 productivity growth in the U.S. economy, the expansion of global competition
l 5 which tends to hold down increases in U.S. product prices and Fed monetar
6 policy that emphasizes inflation control.
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7 Q.
8
9
YOUR EXHfflT NO. 602 PROVIES DATA ON LONG-TERM
INTEREST RATES. IS THIS INICATIV OF COMMON EQUITY
COST RATES?
10 A.At least in a general sense, I believe it is. The forces over time that lead to lower.
11 yields on long-term debt also favorably affect the cost of equity, although I would
12 acknowledge that equity and debt cost rates do not necessarly move together in
.13 lock step. The favorable trends over time in long-term debt cost rates are also
.( 3
14 likely to affect IPC's equity cost rate for providing electrc service.
15 There is another force at work that fuher contrbutes to a reduced cost
t 16 rate for equity -- federal tax policy. In mid-2003, Congress enacted legislation
17 granting favorable income ta treatment for dividend payments and capital gains.
18 (Legislation extendig this favorable tax treatment was enacted by Congress last
t 19 year.) Lower taxes.on retus to equity investments mean that investors are
20 wiling (or should be wiling) to accept lower retus for holding common stocks
21 (such as those of electrc and other utilities), parcularly as compared with bonds,
t 22 which do not enjdy this benefit. The DCF method, which uses relatively current
23 market data, can fully capture this effect. Other methods, such as historical risk
24 premium method (as used by Dr. Avera), may not be able to do so.
.25
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Matthew i. Kahal, Di 8
Deparent of Energy
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1 C.Cost of Equity Summary.2 Q.
3
4 A.
HOW DID DR. AVERA OBTAIN HIS RECOMMENDED COST OF
EQUITY RAGE?
Dr. Avera emphasized two cost of capital methodologies, the DCF and the.5 CAPM, and he also employed comparable earings evidence, a method which
6 does not directly measure the cost of equity. He reports the following results:
7.Dr. Avera's ROE Summary
1. DCF
2. CAP,M
.3.
4.
Coinp~able Earings,. .
Flotation Cost Adder
10.4 to 12.4%
11.5 - 12.8%
11.0%
0.2%
Source: Avera, page 59
.8
9 Dr. Avera concludes that this evidence support a "bare bones" cost of
10 equity rage of 11.0 to 12.0 percent based on these methods. He then adds 0.2
.11 percentage points to reçover "historical" flotation costs incured by IPC (or by its
12 parent on behalf ofIPC), thereby producing a final range of 11.2 to 12.2 percent.
.
13 Q.
14
WHAT ARYOUR COST OF EQUIY RESULTS?
As mentioÏiéd earlier, my recommendation (before considering the need .
15 for an IPC premium) is based primarly on the DCF evidence. I have applied the
16 DCF model to a proxy group of eleven West Region electrc utility companies..17 This group is very similar to the proxy group used by Dr. Avera in the 2004 rate
18 case. This analysis produces a range of9.3 to 10.3 percent with a midpoint of9.8
19 percent. Excluding two members of that group with Value Line Safety Ratings.20 of "1" (the most favorable rating), the range becomes 9.6 to 10.3 percent, with a
.Matthew i. Kahal, Di 9
Deparent of Energy
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1 midpoint of about 10.0 percent. Dr. Avera's own DCF evidence, based on a.2 subset of integrated electrc utilities operating in "non-restrctued" states,
3 support a DCF estimate in the range of about 9 to 10 percent. This is shown on
4 my Exhibit No. 604, pages 1 and 2, and on Exhibit No. 605..5 I also present evidence on comparble earing as additional background
6 information for the Commission. The recent historical and projected eared
7 retus for risk comparable companies are generally in the 9 to 10 percent range,.
8 on average, or somewhat higher.
9 Considering this cost of capital evidence, I believe a reasonable range for
.10 the "base line" cost of equity would be about 9.5 to 10.5 percent, with the best
11 evidence supporting retus toward the lower end of ths rage. Hence, my
12 recommendation of 10.25 percent is consistent with this baseline result plus a
.13 small retu premium for IPC.
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14 Q.
15
16 A.
HAVE YOU INCLUDED AN ADJUSTMNT FOR COMMON STOCK
ISSUANCE COSTS?
No, I have not done so since there is no indication of any curent or near-term
17 plans by IdaCorp to conduct a public issuance of common stock. The last such
18 public issuance occured in 2004. However, Dr. Avera's evidence would support.19 an "adder" to the baseline cost of equity of only about 0.1 percent (assuming any
20 adjustment factor flotation is appropriate), and therefore would not alter the
21 reasonable range of about 9.5 to 10.5 percent..
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.Matthew i. Kahal, Di 10
Deparent of Energy
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1 D.Testimony Organization
.2 Q.
3 A.
HOW IS THE REMAER OF YOUR TESTIMONY ORGANIZED?
Section III presents my DCF evidence based on the application of that model to
4 the West Region electrc utilities. Section N is my reply to Dr. Avera's cost of
.5 equity evidence. In presentig that reply I discuss his DCF evidence, Capital
6 Asset Pricing Model (CAPM) studies and his comparable earings data. In
7 Section N, I present alternative comparable earings information. Finally,
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8 Section V presents a summar of my conclusions and recommendations.
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operations on reasonable terms. Certainly, ths has been the case for IPC based on
the 10.25 percent equity retu granted by the Commission in its last rate case in
2004. Setting theretu on equity equal to a reasonable estimate of the cost of
equity also is fair to ratepayers.
I recognize that there can be exceptions to this general rule. For example, ,
in some instances, utilities have sought rate of retu adders as a reward for
asserted good management performance. In this case, the Company is seeking a
retu on equity that approximates the midpoint of Dr. Avera's cost of equity
range. Mr. Keen fuer justifies the 11.5 percent request (an increase of
125 basis points or about 12 percent compared to the 10.25 percent previously
awarded) on business risks that IPC curently faces.
,t: '
WHAT DETERMS A COMPAN'S COST OF EQUITY?
~.. 9 r :ii:
It should be understood that the cost of equity is essentially a market price, and as
such, it is ultimately determined by the forces of supply and demand operating in
fiancial markets. In that regard, there are two key factors that determine this
price. First, a company's cost of equity is determined by the fudamental
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conditions in capital markets (e.g., outlook for inflation, moneta policy, changes
in investor behavior, investor asset preferences, etc.). The second factor (or set of
factors) is the business and financial risks encountered by the utility in question.
For example, the fact that a utility company effectively operates as a regulated
monopoly, dedicated to providing an essential service (in ths case electrc utility
service), typically would imply low business risk and therefore a relatively low
cost of equity, as compared to most unegulated companies operating in
~ I C
competitive markets.
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Mattew i. Kahal, Di 13
Deparent of Energy
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1 Q.DOES DR. , AVERA INCORPORATE THESE PRICIPLES?.2 A.In general, he attempts to incorporate these priciples in conducting his DCF and
3 CAPM analyses. Hpwever, I disagree with his recommendation of a retu on
4 equity that is 125 basis points higher than that granted by the Commission in.5 2004. Moreover, I question whether his two "risk premium" analyses (i.e.,
6 CAPM studies) realistically measure the cost of equity, and I also question his use
7 of unegulated companies as being appropriate "risk proxies" for the fully:-.8 regulated IPC.
9 Q.
10 A.
WHAT METHODS AR YOU USING IN THIS CASE?
I employ both the DCF and comparable earings methods, applied to a proxy.,'"! '. r... ~....
11 . group of electrc utility companies to obtain a "baseline" cost of equity.i. f.;i'
12 However, for reasons discussed in my testimony, I emphasize the DCF model
;-":.l I..' '0",.13 results in formulating my. recommendation. It has been my experience that most
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14 utility regulatory commissions (federal and state) heavily emphasize the use of the
15 DCF model to determine the cost of equity when setting the fair retu. Whle I
. "-' ..16 do not rely on the,CAPM, the next section of my testimony provides a discussion
17 of this method and Dr. Avera's application of it.. ~': ~'.~'~~',,'
.18 Q.
19 A.
PLEASE DESCRIE THE DCF MODEL.I( ,
As mentioned, this model has been widely used in the regulatory community,
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20 including by this Commission. Its widespread acceptance is due to the fact that
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21 the model is markêt-based and is derived from stadard and accepted
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economic/financial theory. The model is transparent and readily understadable.
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The DCF theory begin~ by recognizing that any publicly-traded common
..- :'\."
24 stock (utility or otherwise) wil sell at a price reflecting the discounted stream of.25 cash flows expected by investors. The objective is to estimate that discount rate.
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~;- , "Mattew I. Kahal, Di 14
Deparent of Energy.
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Using certw.n simplifyg assumptions (that I believe are generally
reasonable for utilitie&), the DCF model for dividend paying stocks can be
distiled down as follows:
Ke = (Do/P9) (1t 0.5g) + g, where
Ke = cost of equity;
Do = the curent anualized dividend;
Po = stock price at the current time; and
g = the long-term anualized dividend growth rate.
As an example, assume a utility company has a curent share price of
'....
$20.00, pays a cur~ntanualized dividend per share of $1.00, and its dividend is
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expected to grow over time by 5 percent per year. The DCF formula would
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calculate the investor market rate of retu to be:
r~.,) '; .
($1.00/ $20.00) (1.025) + 5.0% = 10.13%
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This is referred to as the constant growt DCF model, because for
mathematical simplicity, itis assumed that the growth rate is constant for an
indefinitely long time period. While this constacy assumption may seem
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restrctive in many cases, for traditional utilities (which tend to be more stable
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than most unegulated companies) the assumption generally is reasonable,
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paricularly when'applied to a group of companies.
HOW HAVËYOU APPLIED THIS MODEL?
Strctly speakng,:the model can be applied only to publicly-traded companes,It '
i.e., companies wbùsemarket prices (and therefore market valuations) are
transparently revealed. Consequently, the model canot be applied to IPC, which
is a wholly-owned subsidiar of IdaCorp, and therefore, a market proxy is needed.
'too, '"
.;::Matthew i. Kahal, Di 15
Deparent of Energy. ,':"~ I
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In theory, IdaCorpCQuld serve as that market proxy, and I include IdaCorp as one
of my eleven West Region proxy companies.
In any case, Ibelieve that an appropriately selected proxy group
(preferably one reasonable in size) is likely to be more reliable than a single
company study. Ths is because there is "noise" or fluctuations in stock price (or
other) data that canot always be readily accounted for in a simple DCF study.
The use of an appropriate proxy group helps to allow such "data anomalies" to
cancel out in the averaging process.
For the same reason, I prefer to use market data that are relatively curent
but averaged over a period of several months (i.e., six months rather than purely
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relying upon "spot" market data). It is importt to recall that this is not an
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academic exercise bui involves the setting of "permanent" utility rates that are
likely to be in effect for several years. The practice of averagig market data over
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a period of several months can add stabilty to the results. Dr. Avera, by
comparson, appears to favor "spot" market data and has not indicated any plans
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to provide an update.
,¡1 --IT":'
'"' ~'; .~
DCF Study Using the West Region Group of Electric Utility Companies
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HOW DID YOU SELECT YOUR PROXY GROUP IN THIS CASE?
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I have applied the DCF model to a group of eleven companies listed in the Value
-. ~ .
Line Investment Surey as being West Region Electrc Utilities. Ths is the same
general approach as taken by Dr. Avera in the 2004 rate case. He employed at
that time eight West Region companies, and seven of his eight are part of my
proxy group. I include all of the Value Line West Region electrcs except (a) the
thee California utilities (Edison International, Sempra Energy and PG&E), since
'. ~"Matthew i. Kaal, Di 16
Deparent of Energy.',
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1 California is a restrctued state; and (b) two companies that do not pay dividends.2 (Sierra Pacific Resources and EI Paso). (Sierra just recently began to pay a very
3 small dividend after.several years of no dividend payments.)
4 I provide a listing of these eleven companies on Exhibit No. 603, along.5 with certain risk indicators (i.e., Value Line Safety Ratig, common equity ratio,
6 beta and financial strength rating). The "beta" measure is explained in detail later
7 in Section N of my testimony. Two of the West Region companies, MDU.8 Resources and Pinacle West, have the most favorable Value Line Safety Rating
9 ("1 "), and for that reason I show the averages with and without those two
, 7:-'.1., ~;'lj - .:.
10 companies. The other nine companies have Safety Ratings of "2" or "3," with
"'I" '.
11 IdaCorp being "3." The Safety Ratings range from "1" to "5". In general,
., f
12 IdaCorp appears to have risk attbutes generally similar to the nine-company
.13 average, perhaps slightly greater in risk.
.
14 Q.
15
16
17 A.
HAVE EITHER YOU OR DR. AVERA PROPOSED A SPECIFIC RISK
"
ADJUSTMENT TO THE COST OF EQUITY BETWEEN THE PROXY
COMPANIES AND IPC'S UTILITY OPERATIONS?'. \ j
No. Dr. Avera adopts a cost of equity range of 11.2 to 12.2 percent, and Mr.
. . t'.. :;".'("
18 Keen selects 11Spercent which is close to the midpoint. Whle Mr. Keen
e.~." .., ,"_,.19 discusses risk issues, he does not quantify or propose a specific cost of equity
20 adjustment. I also do not propose a risk adjustment relative to my DCF results,
21 although my 10.25 percent recommendation is slightly above my DCF midpoint..22 Q.
23 A.
HOW HAVE YOU APPLIED THE DCF MODEL TO THIS GROUP?
I have elected to use a six-month time period to measure the dividend yield
24 component (Do/Po) of the DCF formula. Using the Standard & Poor's Stock.25 Guide, I compiled the month-ending dividend yields for the six months ending
.1 '.
,:!
, .,¡
Matthew i. Kahal, Di. 17
Deparent of Energy.
.
1 September 2007, the most recent data available to me as of this time. The.2 dividend yields are month-ending, and since the October 2007 edition of the
3 Stock Guide is not yet available, I have used Yahoo Finance (month-ending) as
4 the data source for my September 2007 yields (i.e., as of September 29, 2007)..5 I show these dividend yield data on page 3 of Exhibit No. 604 for each
6 proxy company, April through September 2007. Over this six-month period,
7 the group average dividend yields were highly stable ranging from a high of.8 3.88 percent in August to a low of3.27 percent in April 2007, averaging
9 3.65 percent for the full six months. This indicates a mild upward trend over
....-..
10 this recent six-month period..
11 For DCF purposes and at this time, I am using a proxy group six-month
,~
12 average dividend yield of 3.65 percent.
".13 Q.
14 A.
IS 3.65 PERCENT YOUR FINAL DIVEND YIELD?
r rio
Not quite. Strctly spe~ng, the dividend yield used in the model should be the
15 value the investor expects over, the next 12 months. Using the standard "half
. _'I..16 year" growth rate adjustment technique, the DCF adjusted yield becomes 3.8
. ~- \
17 percent. This is based on assuming that half of a year of growt is 3.0 percent
18 (i.e., a full year gr0'Yis about 6.0 percent).
.19 Q.
20
21 A.
DOES DR: AVERA EMPLOY THE SAM GROWTH RATE
~ ".,. ~'..
ADmSTMENT?
.22
It appears that he uses a similar approach that would produce about the same end
result as my dividend adjustment. As best I can determine, he employs Value
." " J~
23 Line's estimate of the pet share dividend over the next 12 months. For a group of
24 companies, this wou,ld be roughly analogous to using the "0.5g" adjustment.25 factor.
.Matthew i. Kaal, Di 18
Deparent of Energy
~
1 Q.HOW HA VEYOU DEVELOPED YOUR GROWTH RATE
.2 COMPONENT?
3 A.Unlike the dividend yield, the investor growth rate canot be diectly observed
4 but instead must be inferred through a review of available evidence. The growth
5 rate in question is the long-ru dividend per share growt rate, but analysts
6 frequently use projected earings growth as a proxy for (long-term) dividend
7 growth. This is because in the long-ru earings are the ultimate source of
.
8 dividend payments to shareholders, and this is likely to be paricularly tre for a
9 large group of companies.
10 One possible approach is to examine historical growth as a guide to
.
11 investor expected futue growth, for example the recent five-year or ten-year
12 growth in earings, dividends and book value per share. However, my experience
13 in recent years with utilties has been that these historic measures have been very.
14 volatile and are not reliable as long-ru prospective measures. Ths may be due in
15 par to extensive corporate restrctug in the energy industr. I note that
.16 Dr. A vera also chooses to rely primarly on prospective rather than historical
17 growth measures. The DCF growth rate should be prospective, and one useful
18 source of informtiòn on prospective growt is the published projections of
~19 earings per share (typically five years) prepared by securties analysts.
20 Dr. Avera places priar weight on this information (along with earings
21 retention growth), using earings growth rates published by Value Line, IDES
.22 and Reuters, and I agree that this tye of evidence warants substantial emphasis.
23 Q.PLEASE DESCRIE YOUR EVIDENCE.
24 A.Exhibit No. 604, page 4 of 5, presents four well-known sources of projected
.25 earings growth rates. Three of these four sources -- First Call, Zacks and
Matthew i. Kaal, Di 19
.Deparent of Energy
.
.1
2
3
4
5
6
7
8
9
10
11
12 Q.
13
14 A.
15
16
17
18
19
20
21
22
23
24
25
.
.
.
.
.
.
.
.
.
Standard &.Poors (S&P) -- provide averages from securties analyst sureys
conducted by these organizations (tyically reporting the median value). The
fourh, Value Line, is that organization's own estimates. Value Line publishes its
own projections using annual average earings share for a base period of 2004-
2006 to a forecast period of2010-2012.
As this exhibit shows, the growth rates for individual companies vary
somewhat among the four sources, but the growth rate group averages are
generally similar. These group averages are 6.33 percent for S&P, 6.15 percent
for First Call, 6.62 percent for Zacks and 5.36 percent for Value Line. In this
case, I have calculated the average of these four sources, or about 6.2 percent, as
the best measure of expected growth, and a range of 5.5 to 6.5 percent.
IS THERE ANY OTHER EVIDENCE THAT SHOULD BE
CONSIDERED?
Yes. There are a number of reasons why investor expectations of long-ru growt
could differ from the limited, five-year earings projections from securties
analysts. Consequently, while securttesanalyst estimates should be considered
and given substantial weight, these growth rates should be subject to a
reasonableness test and corroboration, to the extent feasible.
On Exhbit No. 604, page 5 of 5, I have compiled thee other measures of
growth published by Value Line, i.e., growt rates of dividends and book value
per share and long-ru retained earings growth. (Retained earings growt
reflects the growth over time one would expect from the reinvestment of retained
earings, i.e., earings not paid out as dividends.) As shown on this Exhibit, these
growth measures tend to be similar to or less than analyst growt projections.
Dividend growth averages 5.36 percent, book value growth averages 4.27 percent,
Matthew i. Kahal, Di 20
Deparent of Energy
.
1 and earings retention growth averages 4.72 percent. Notably, each of these
~2 alternative measures of growt falls below the 5.5 to 6.5 percent range cited
3 above. This suggests that the growth rate range I have calculated for DCF
4 purposes may be conservatively high.
.5 Q.WHAT IS YOUR DCF CONCLUSION?
6 A.I summarze my DCF analysis on page 1 of Exhibit No. 604. The adjusted
7 dividend yield for the six months ending September 2007 is 3.8 percent for this
a 8 group. Published projections would support a long-ru growth rate in the range of
9 about 5.5 to 6.5 percent, as explained above. Suming the adjusted yield and
10 growth rate range produces a total retu of 9.3 percent to 10.3 percent, and a
It 11 midpoint result of9.8 percent.
.
12 Q.
13
14 A.
WHY DO YOU NOT INCLUDE AN ADmSTMENT FOR FLOTATION
COSTS?
If a utility issues new common stock through public óffering, it will likely incur
15 flotation expenses, principally underwting fees. Ths is potentially a recoverable
It 16 expense, and one way of providing recovery is through a rate of retu adder.
17 Dr. Avera proposes an adder of 0.2 percent, but it is not clear how he derives ths
18 figue. He seems to suggest that his adjustment (which he claims is based on
It 19 3.6 percent of the issuance proceeds) is for historically-incurred flotation costs.
20 However, he presents no data on costs actually incured historically by IPC.
21 The Company's response to DOE's first set of data requests, item 19,
.22 indicates that the most recent public issuance was in 2004. The response to DOE
23 Set I, item 20 does not identify any plans for a public stock issuance. In any
24 event, Dr. Avera's 3.6 percent cost factor would imply a flotation adder of about.25 0.1 percent, not the 0.2 percent that he suggests. I obtain the 0.1 percent figue by
.
Matthew i. Kahal, Di 21
Deparent of Energy
.
1 increasing the proxy group dividend yield (i.e., 3.65 percent) by 3.6 percent,
.2 (3.65% x 3.6% = 0.13 percent). At this time, given the absence of any
3 information on a public stock issuance for the foreseeable futue, I believe an
4 adjustment to the retu on equity would not be appropriate. However, if the
It 5 Commission believes it is appropriate to include a flotation adder as par of the
6 retu on equity award, I believe 0.1 percent would be suffcient.
7
a 8 C.DCF Sensitivity
9 Q.TWO OF YOUR WEST REGION ELECTRICS HAVE SAFETY
RATINGS MUCH BETTER THA IDACORP. WOULD REMOVIG
THOSE TWO COMPANIES FROM YOUR PROXY GROUP
SIGNIFICANLY ALTER THE RESULTS?
,10
11
12
13 A.I have tested for that effect by revising my DCF study removing the two West.
14 Region electrc companies (MU Resources and Pinnacle West) rated "1" for
15 Safety. I sumarze the revised DCF calculations on Exhibit No. 604, page 2,
.16 with the modified proxy group averages shown on pages 3-5 of that exhbit.
17 Removal of the two companies increases the proxy group dividend yield
18 slightly from 3.65 to 3.68 percent. As shown on Exhibit No. 604, page 4,
It 19 removing the two companies also slightly increases the earings growth rate
20 averages from 6.2 to 6.3 percent. For the analysis of this modified proxy group, a
21 reasonable growth rate range would be 5.8 to 6.3 percent. Using an adjusted yield
.22 of 3.8 percent, the total retu therefore becomes 9.6 to 10.3 percent, with a
23 midpoint of about 10.0 percent. Thus, the DCF sensitivity study is very similar to
24 my original DCF and fully supports the reasonableness of a retu on equity of.25 10.25 percent.
.Matthew i. Kahal, Di 22
Deparent of Energy
.
.
1 in the results of his two studies. Since he ultimately recommends a range of 11.2
t 2 to 12.2 percent, it appears that he is puttg considerable weight on his non-utility
3 DCF study. I believe that his non-utility study has little to do with IPC's actual
4 cost of equity and is not reasonable for use in this case.
.5 I have concerns regarding the comparability of the 19 companies.in his
6 electrc utility proxy group as well. Ths is because a number of his proxy group
7 electrc companies operate in competitively restrctued states, and some of the
.8 companies have substantial non-utility operations. The most appropriate risk
9 proxies for IPC would be electrc utility companies that are fully regulated and
10 vertically-integrated, such as the eleven companies in my West Region proxy.
11 group.
12 Q.
13
WHICH UTILITY COMPANIES SHOULD BE ELIMINATED FROM
HIS PROXY GROUP?
It
14 A.Companies in Dr. Avera's group operating in restrctued states or with
15 substantial unegulated operations would include:
.16 . CenterPoint Energy (Te~as)
17 . DPL, Inc. (Ohio)
18 . Energy East (New York, New England)
. Norteast Utilities (New England).19
.
21
22
. PEPCO Holdings (Marland, D.C., Delaware)
. PPL Corp. (pennsylvania)
20
. Public Service Enterprise Group (New Jersey)
.
23
24
25
. PG&E Corp. (California)
I believe these companies are less useful and appropriate as proxies for
IPC than his other electrc utility companies.
.
Matthew i. Kahal, Di 24
Deparent of Energy
.
1 Q.HOW WOULD THE REMOVAL OF THE COMPANS IN.2 RESTRUCTUD STATES AFFECT HIS DCF RESULTS?
3 A.On my Exhibit No. 605, I reproduce Dr. Avera's electrc utility DCF calculations
4 using his four growth rate measures but removing the companies from the.5 restrctued states and their non-utility operations. I have also excluded the West
6 Region companies in his group (i.e., IdaCorp, PNM, Xce1) since those thee
7 companies are already included in my DCF study. As Exhibit No. 605 shows, a.8 DCF study of the fully regulated and vertcally-integrated utility subset, provides
9 a retu range of about 9.0 to 9.5 percent. This is modestly lower than or toward
10 the low end.ofmy own DCF study results and is well below his 19-company.
11 average of 10.4 percent. Please note that these are Dr. Avera's own DCF
12 calculations but for an appropriate subset of his utility proxy group.
13 Q.IS IT REASONABLE TO REMOVE THE COMPANS FROM.
14 RESTRUCTURD STATES?
15 A.Yes. I believe the integrated, fully-regulated companies are a more appropriate
.16 risk proxy for IPC. In the 2004 case, the Commission recognized ths distinction
17 notig that, "Idaho is not likely to have deregulation risks like those experienced
18 in other states". (Order, page 43, Case No. IPC-E-03-13) Clearly, those "other
.19 states" would include California, the Norteast and Mid-Atlantic states, as
20 indicated above.
.
.
.Matthew I. Kahal, Di 25.
Deparent of Energy
.
1 IV. REVIW OF DR. AVERA'S DCF, CAPM AND COMPARBLE EARINGS
2.
3 A.DCF Analysis
4 Q.WHAT AR YOUR OBJECTIONS TO DR. AVERA'S DCF
5 ANALYSIS?.
6 A.Dr. Avera performs two DCF studies, one using a 19-company proxy group of
7 electrc companies and a second that uses a large group of unegulated companies
.8 operating in competitive markets. He obtains vastly different results for the two
9 proxy groups -- 10.4 percent for his electrc company group and 12.4 percent for
10 the unregulated companies. In my opinion, the DCF study for the unegulated.11 companies has no value at all in determining the regulated fair retu in this case
12 for IPC and therefore should be disregarded.
13 The DCF study for the electrc group is more on point, and it actually.14 produces a result reasonably close to the 10.25 percent figue authorized by the
15 Commission in the 2004 rate case. However, as noted earlier, even this analysis
16 is improperly burdened by the inclusion of electrc companies operating in.17 restrctued states. Some of these companies have substantial non-regulated
18 operations (e.g., PPL Corporation). Removing the "restrctured" companies
19 would reduce the group cost of equity to below 10 percent as I have shown on my.
20 Exhibit 605.
21 Q.DOES THE COMMISSION RELY ON DCF EVIENCE?
22 A.Yes, in conjunction with the comparables earing method. In parcular, the.
23 Commission's Order in Case No. IPC-E-03-13 (page 38) states:
24
25 The Commission has relied primarly on the discounted cash flow
26 method (DCF) and the comparable earings method in previous.27 cases, and we do so again in ths case.
.Mattew i. Kahal, Di 26
Deparent of Energy
.
.1
2
3
4 B.
5 Q.
6 A.
7
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12 Q.
13 A.
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. .
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That Order fuher observes tht IPC is not burdened by "deregulation risks" such
as those experienced in other states. (Id., page 43)
CAPM Results
WHAT RESULTS DOES DR. AVERA OBTAIN USING THE CAPM?
He obtains a range of 11.5 percent to 12.8 percent, using two approaches. The
11.5 percent is a "historical" approach based on the realized stock market risk
premiums experienced (on average) over the last 80 years. The second method,
producing the 12.8 percent result, is based on a "prospective" market retu
estimate for the overall stock market (or a large subset of the overall stock
market).
PLEASE DESCRIE THE CAPM APPROACH USED BY DR. AVERA.
The CAPM is a form of the "risk premium" approach and is based on modern
portfolio theory. According to this model, the cost of equity (Ke) is equal to the
yield on a risk-free asset plus an equity risk premium multiplied by a firm's
"beta" statistic. "Beta" is a firm-specific risk measure which is computed as the
movements in a company~s stock price (or market retu) relative to
contemporaneous movements in the broadly defined stock market. According to
CAPM theory, this measures the investment risk that canot be reduced or
eliminated through asset diversification (i.e., holding a broad portfolio of assets).
The overall market, by definition, has a beta of 1.0, and a company with lower
than average investment risk (e.g., a utilty company) normally would have a beta
below 1.0. The "risk premium" is defined as the expected retu on the overall
stock market minus the yield or return on a risk-free asset.
Matthew i. Kahal, Di 27
Deparent of Energy
.
.1
2
3
4
5
6
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8
9
10
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21 Q.
22 A.
23
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25
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.
The CAPM formula is:
Ke =Rf + ß (Rm - Rr), where
Ke =the fi's cost of equity;
Rm =the expected retu on the overall market;
Rf =the yield on the risk free asset; and
ß =the firm (or group of firms) risk measure.
Two of the three principal varables in the model are directly observable --
the yield on a risk-free asset (e.g., a Treasury securty yield) and the beta. For
example, Value Line publishes estimated betas for each of the companies that it
covers. The greatest area of controversy, however, is in the measurement of the
expected stock market retu (and therefore the risk premium), since that varable
canot be directly observed.
While the beta itself also is technically "observable," different investor
servce publications or sources provide differig estimates of betas depending on
the calculation methods that they use. These beta differences can have large
impacts on the CAPM cost of equity results. In this case, Dr. Avera employs
Value Line published betas, and I have used Value Line betas as well in past
cases. However, i note that other sources have very different utility betas, which
would yield lower results. I show an alternate source of betas, which I believe is
more plausible than the Value Line betas, in this subsection of my testimony.
HOW HAS DR. AVERA APPLIED THIS MODEL?
Dr. Avera uses a long-term Treasur yield as the risk-free retu (i.e.,
4.8 percent), and the average beta for his electrc proxy group is 0.95. His
"historic" and "perspective" risk premium values are 7 .1 percent and 8.5 percent,
respectively.
Mattew I. Kahal, Di 28
Deparent of Energy
.
.
1
2
3
4 Q.
5 A.
6
7
8
9
10
11
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13
14
15
16
.
.
.
.
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.
.
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These parameters yield the following CAPM results:
Ke = 4.8% + 0.95 (7.1) = 11.55%
Ke = 4.8 + 0.95 (8.5) = 12.88%
WH DO YOU QUESTION THE VALUE LIN BETA ESTIMATES?
Dr. Avera employs a beta of 0.95, which implies that electrc utilities generally
(and IPC specifically) are nearly identical in risk to the stock market as a whole
(i.e., largely unegulated compantes). In fact, Value Line assigns IdaCorp
(principally IPC) a beta of 1.05, implying that it is riskier than the stock market
as a whole and has a cost of equity exceedig the stock market average. This
clearly is uneasonable.
I compiled the table below which compares Value Line's betas for the
West Region electrcs with those recently published on the Yahoo Finance.com
website. The Value Line average is 0.93, while the Yahoo Finance average is
a far more realistic 0.74 -- correctly implying that electrcs (and IPC) are
significantly less risky than unegulated companies (i.e., the stock market as a
whole).
Matthew I. Kahal, Di 29
Deparent of Energy
.
Alternative Beta Estimates for the
West Region Electrics.
.
Value Line Yahoo Finance
Avista 0.90 0.78
Black Hills 1.10 0.90
Hawaiian 0.75 0.31
ldaCorp 1.05 0.67
MDU Resources 1.00 1.02
Pinnacle West 0.95 1.06
PNM Resources 1.00 0.72
Portland General NA 0.60
Puget Energy 0.85 0.67
UniSource 0.75 NM
Xcel 0.90 0.63
Average 0.93 0.74
.
.
.Source: Value Line Investment Survey, August 30,2007, YahooFinance.com,
September 2007.
1 Q.DO YOU FIN THE 7.1 TO 8.5 PERCENT RISK PREMIU TO BE
REASONABLE?.2
3 A.No. The "historical" 7.1 percent is a 1926-2006 stock market arthmetic average
4 risk premium, based on after-the-factmarket retus, compiled by Ibbotson.5 Associates. However, Dr. Avera overlooks a key flaw or limitation in that
6 estimate (as a measure of to day's risk premium) that Dr. Ibbotson himself has
7 discovered. His recent research has concluded that the 7.1 percent is biased.8 upward by a rising price/earings ratio over the historic period, and the
9 continuation of that trend would be inconsistent with standard financial theory.
10 He has corrected the historic data removing this upward bias, obtaining a.
11 corrected historic (arthmetic average) risk premium of 5.9 percent. (Roger
.Mattew i. Kahal, Di 30
Deparent of Energy
.
1 G. Ibbotson and Peng Chen, "Stock Market Retus in the Long Run:
Paricipating in the Real Economy", Financial Analyst Journal, 2003.).2
3 The 8.5 percent risk premium itself is based on Dr. Avera's very
4 questionable assumption that earings on unegulated companies (i.e., the.5 dividend paying stock in the S&P 500) wil increase by 11.2 percent per year.
6 I believe that this is excessively optimistic as an overall average expectation for
7 the long-term rate of growth in corporate earings. For example, the Value Line.8 Selection and Opinion, page 4559, projects the growt rate in Corporate
9 Economic Profits for 2007 to 2011 to rage from 6.6 to 8.0 percent per year. Blue
10 Chip Economic Indicators (March 10, 2007), a surey of major forecasts,.11 publishes a "consensus" forecast for U. S. pre-tax corporate profits (curent $)
12 grow by 5.1 percent anually for 2009-2013 and 5.4 percent anually for 2014-
13 2018. In light of these major forecasts, Dr. Avera's corporate forecast growth rate.
14 of 11.2 percent (and resultig 8.5 percent risk premium) makes no sense and is
15 implausibly high.
.16 Q.
17
18 A.
ARE YOU AWAR OF AN OTHR EVIDENCE THAT WOULD
CHALENGE THE 7.1 TO 8.5 PERCENT RISK PREMIU RAGE?
.19
Yes. The prominent textbook by Brealy, Myers and Allen (Principles of
Corporate Finance, 8th Edition, page 152) cites to surey data estimates of the
20 equity risk premiums. A 200 1 Yale University surey study of financial
21 economists finds a 5.5 percent risk premium, and a 2003 Duke University study.22 of corporate Chief Financial Offcers ("CFOs") obtains a 3.8 percent risk
23 premium. Whle surey estimates are not necessarly precise measures, this is
24 "real world" information that challenges the reasonableness of Dr. Avera's clearly.25 overstated equity risk premium range of 7.1 to 8.5 percent.
.Matthew I. Kahal, Di 31
Deparent of Energy
.
1 Q.AR YOU SPONSORIG A CAPM STUY?.2 A.No, I am not sponsoring such a study as a basis for establishing IPC's cost of
3 equity in this case for the reasons discussed above. It is also apparent that the
4 Commission has concerns about this method's usefulness and in paricular "the.5 measurement and proper use of Beta". (Order No. 29505, page 38, May 25,
6 2004) However, as a comparson and check on Dr. Avera's CAPM, I present a
7 CAPM calculation using: a risk-free rate of 4.8 percent (the same as used by Dr..8 Avera), a beta of 0.84 (the average of the Value Line and the Yahoo Finance
9 betas) and a 6.0 percent risk premium.
10.11 Ke = 4.8 + 0.84 (6.0) = 9.84 percent
12
13 While I do not advocate the use in this case of the CAPM method, I
14 believe the 9.84 percent result shown above for IPC is much more realistic than.15 Dr. Avera's 11.5 to 12.8 percent results.
16
17 C.Comparable Earnim!s.
18 Q.WHT RESULTS DID DR. AVERA OBTAI FROM HIS
19 COMPARLE EARGS STUY?
20 A.Dr. Avera focused on the Value Line projections of eared retu on equity for his.
21 electrc utility proxy group (10.6 percent). He also cites to the Value Line
22 estimated retu on equity of 11.0 percent for 2007 and 11.5 percent for the
.23 electrc industr as a whole for the three to five-year forecast horizon. Based on
24 this information, he derives a fial comparable earings estimate of 11.0 percent.
25 (Avera, page 56 and his Exhibit 608).26 Q.DOES HIS COMPARABLE EARGS ANALYSIS PROVIDE A
27 MAT COST OF EQUITY ESTIMATE?
Matthew i. Kahal, Di 32.Deparent of Energy
.
1 A.No, and he does not appear to claim that it does. Rather, these are one.2 organization's (i.e., Value Line's) estimates of the accounting retus on book
3 equity that electrc companies might ear. It does not measure either the retu
4 requirements or expectations for fInancial markets. One key reason why that is so.5 is because the electrc utility companies have stock prices selling at a premium-to-
6 book value, a fact that Dr. Avera does not mention.
7 Q.WHY DOES THE MAT-TO-BOOK RATIO MATTER?.Consider an electrc utility with earings per share of $2.20 and a book value of8A.
9 $20. This would equal Dr. Avera's 11.0 percent accounting retu on equity.
10 However, if the stock price is $30, then the investor is really earing $2.2/ $30 =.
11 7.3 percent on the market value of his investment. Put another way, the investor
12 is willing to pay $30 per share for the stock and receive $2.20 in curent eargs.
.13 The fact that the market value of the stock significantly exceeds book value
14 renders the usefulness of Dr. Avera's comparble earings study highly
15 questionable.
.16 Q.DO YOU HA VB AN ALTERNATIV CALCULATIONS OF
17 COMPARLE EARINGS?
18 A.Yes. As a comparson, I have compiled the historical (i.e., 2005 - 2007) and.19 projected (2010 - 2012) eared retus on equity, as published by Value Line, on
20 Exhibit No. 606 for my West Region electrc group and for Dr. Avera's electrc
21 group, i.e., the vertcally-integrated subset.(please note that 2007 is parly actual.22 and parly projected.)
23 As shown on page 1, the West Region eared retu on equity averages
24 about 9.0 percent for both the historic and projected period. For Dr. Avera's.25 vertically-integrated companies, the spread of results is much wider. (Page 2 of
.Matthew i. Kaal, Di 33
Deparent of Energy
.
1 Exhibit No. 606) Durng the historical period, the group average retu on ,equity.2 is about 10 percent but increases to 10.8 percent for the projected period.
3 However, the averages are heavily infuenced by one unusually profitable
4 company -- Dominion Resources. Absent Dominion, the projected average retu.5 for 2010-2012 declines to 9.8 percent.
6 If the two proxy groups on pages 1 and 2 of Exhibit No. 606 are
7 combined, the average eared retus on equity would generally fall in the 9 to.
8 10 percent range.
9 Q.WHAT DO YOU CONCLUDE?
10 A.While not a market cost of equity method, the comparable earings analysis.
11 results are roughly consistent with my DCF evidence and help to support a retu
12 on equity award in this case not to exceed 10.25 percent.
.13
.
.
.
.
.Matthew i. Kahal, Di 34
Deparent of Energy
.
1 V. CONCLUSIONS ON FAIR RATE OF RETUR
.2 Q.PLEASE SUME THE CONCLUSIONS THAT YOU HAVE
3 REACHED CONCERNG THE COMPAN'S RATE OF RETUR
4 REQUEST..5 A.IPC in this case is seeking an overall rate of retu of 8.56 percent, based on a
6 projected year-end 2007 capital strcture and embedded cost of debt and inclusive
7 of a retu on common equity of 11.5 percent. The requested retu on equity is.8 the approximate midpoint of Dr. Avera's study range of 11.2 to 12.2 percent.
9 IPC's 11.5 percent retu on equity request is a very large increase over the 10.25
10 percent retu on equity awarded by the Commission in the 2004 rate case, an.
11 award accompanied by a 46 percent common equity ratio.
12 Subject to possible updating, I find acceptable the proposed capital
13 strctue and embedded cost of debt. However, I do not agree with IPC's request.L._
14 and supporting evidence to increase the retu on common equity from 10.25
15 percent awarded in 2004 to 11.5 percent - a 12 percent increase. While capital
.16 cost conditions were favorable in 2004, the utility cost of capital remains low
17 today. IPC is a financially sound, credit worty utility with several favorable
,
18 business risk attbutes. Most of the evidence presented by Dr. Avera
.19 significantly overstates the IPC cost of equity and fair retu.
20 Q.PLEASE SUMMAE YOUR SPECIFIC DISAGREEMENTS WITH
21 DR. AVERA. .22 A.Dr. Avera presentsthtee types of studies:DCF, CAPM and comparble earings.
23 . My only significant disagreement with his DCF evidence is with his proxy
24 company selection.His non-utility DCF study obtained 12.4 percent, but clearly.25 non utilities from other industres are not proper risk or business proxies for IPC's
.Mattew i. Kahal, Di 35
Deparent of Energy
.
1 Idaho monopoly utility operations. These non-regulated companies from other
.2 industres are fudamentally different from IPC. His ''utility' DCF study yields a
3 more reasonable 10.4 percent, but even that study is impaired by its inclusion of
4 several "restrctued" companies. Some of those companies have risk profiles.5 and operating environments much different than ipc. His subset of vertcally-
6 integrated utilities yields DCF results less than 10.0 percent.
7 The CAPM significantly overstates the cost of equity by assuming a stock
".8 market risk premium in the 7 to 8 percent range, when a more realistic estimate is
9 6 percent or less, and he selects a "beta" value of 0.95. The latter figue is
10 tantamount to assuming that IPC's risks as a regulated utility approximate that of.11 the market as a whole. In addition to these shortcomings, the Commission has
12 expressed concerns over the reliability and applicability to IPC of the CAPM.
13 Finally, Dr. Avera obtains an 11.0 percent result based on Value Line.~ ,., ~.
14 projections of accounting retus on common equity for his utility proxy group
15 (and the industr as a whole). Ths evidence is problematic and overstated for the
.16 reason stated previously -- the utility group includes many companies that operate
17 in an unegulated environment in restrctued states. Moreover, his calculations
18 ignore the fact that these companies sell at a large premium to book value.
.19 Q.
20
21 A.
PLEASE SUME YOUR OWN EVIENCE ON COST OF
CAPITAL FOR IPC.
I recommend an overall retu of7.93 percent, which includes a 10.25 percent.22 cost of capitaL. I rely primarly on a DCF study of a group of West Region
23 electrc utilities (excluding California) obtaining a range of 9.3 to 10.3 percent (or
24 9.6 to 10.3 'percent if two companies are excluded). Consistent with Dr. Avera, I.25 have used the stadard, c~nstant growth DCF model, recent stock market data and
.Matthew i. Kahal, Di 36
Deparent of Energy
.
.
1
2
3
4
5
6
7
8
9
10
11
12 Q.
13 A.
.
.
.
.
.
.
.
.
.
securties analyst projections of earings growth. My nine-company proxy group
is reasonably comparable to IPC since all companies are vertcally integrated
electrcs primarily operating under standard regulation. This is similar to the
proxy group previously used by Dr. Avera in the 2004 IPC ratè case.
As a check and to respond to Dr. Avera, I have employed the comparable
earings method, using my proxy group and the vertcally-integrated porton of
Dr. Avera's proxy group. For these companies, the historical and projected
eared retus on equity display averages in the range of about 9.0 to 10.0
percent, with the exception of one unusual company. The comparable earings
evidence helps to support the reasonableness of my 10.25 percent
recommendation.
DOES THIS CONCLUDE YOUR DIRCT TESTIMONY
Yes, it does.
W: \5921 \mik\Direst\Direct.doc
Mattew i. Kahal, Di 37
Deparent of Energy
.
.STATE OF IDAHO
BEFORE THE
.PUBLIC UTILITIES COMMISSION
.IN THE MATTER OF THE APPLICATION
OF IDAHO POWER COMPAN FOR
AUTHORITY TO INCREASE ITS RATES
AN CHAGES FOR ELECTRIC
SERVICE TO ELECTRIC CUSTOMERS
IN THE STATEOF IDAHO
)
)
)
)
)
)
CASE NO. IPC-E-07-8
.
.~XiITS ACCOMPANING THE
DIRCT TESTIMONY OF
MA TTHEVV i. KAL
.ie .
ON BEHALF OF THE.U.S. DEPARTMNT OF ENERGY
.
DECMBER 10, 2007
.EXETER
.
ASSOCIATES, INC.
5565 Sterrett Place
Suite 310
Columbia, Maryland 20904
.
.
.
IDAHO POWER COMPAN
Rate of Retu Sumar
(Provisional Estimate for the Period Ending December 31, 2007))
.
Percent of
Capital Type Total
1 Cost Rate1
Long-Term Debt 49.74%5.59%
Preferred Stock 0.00 0.00
Common Equity 50.26 10.252
Total 100.00%
Weighted Cost.
2.78%
0.00
5.15
7.93%
1 IPC Exhibit 10 of witness Keen.
2 Schedule MI-4, page 1 of 4.
.
.
.
.
.Exhibit No. 601
Case No. IPC-E-07-8
M. Kahal, DOE
Page 1 of 1
.
.
.
IDAHO POWER COMPAN
Trends in Capital Costs.
Anualized 10-Year 3-Month Single A
Inflation (CPD Treasur Yield Treasur Yield Utility Yield.
1992 3.0%7.0%3.5%8.7%
1993 3.0 5.9 3.0 7.6
1994 2.6 7.1 4.3 8.3
1995 2.8 6.6 5.5 7.9.1996 3.0 6.4 5.0 7.8
1997 2.3 6.4 5.1 7.6
1998 1.6 5.3 4.8 7.0
1999 2.2 5.7 4.7 7.6
2000 3.4 6.0 5.9 8.2.2001 2.9 5.0 3.5 7.8
2002 1.6 4.6 1.6 7A
2003 1.9 4.1 1.0 6.6
2004 2.7 4.3 1.4 6.2
2005 3.4 4.3 3.0 5.6.2006 2.5 4.8 4.8 6.1
.
.
.Exhibit No. 602
Case No. IPC-E-07-8
M. Kah, DOE
Page 1 of4
.
.Exhibit No. 602
Case No. IPC-E-07-8-8
M. Kahal, DOE
Page 2 of4
.
.
.
IDAHO POWER COMPANY
Trends in Capital Costs (Continued)
.Anualized
Ination 10-Year 3-Month Single A
(CPD Treasur Yield Treasur Yield Utility Yield
2005
.Janua 3.0%4.2%2.4%5.8%Febru 3.0 4.2 2.6 5.6
March 3.1 4.5 2.8 5.8
April 3.5 4.3 2.8 5.6
May 2.8 4.1 2.9 5.5
June 2.5 4.0 3.0 5.4
July 3.2 4.2 3.3 5.5.August 3.6 4.3 3.5 5.5
September.4.7 4.2 3.5 5.5
October 4.3 4.5 3.8 5.8
November 3.5 4.5 4.0 5.9
December 3.4 4.5 4.0 5.8.2006
Januar 4.0%4.4%4.3%5.8%Febru 3.6 4.6 4.5 5.8
March 3.4 4.7 4.6 6.0
April 3.5 5.0 4.7 6.3.May 4.2 5.1 4.8 6.4
June 4.3 5.1 4.9 6.4
July 4.1 5.1 5.1 6.4
August 3.8 4.9 5.1 6.2
September 2.1 4.7 4.9 6.0
October 3.5 4.7 5.1 6.0.November 2.5 4.6 5.1 5.8
December 2.5 4.6 5.0 5.8
.
.Exhibit No. 602
Case No. IPC-E-07-8
M. Kahal, DOE
Page 3 of4
.
.
IDAHO POWER COMPANY.Trends in Capital Costs (Continued)
.
.
.
.
.
.
Exhibit No. 602
Case No. IPC-E-07-8
M. Kahal, DOE
Page 4 of4
.
.IDAHO POWER COMPAN
Value Line Risk Indicators for the Primar Group Proxy Companies
.
Exhbit No. 603
Case No. IPC-E-07-8
M. Kahal, DOE
Page 1 ofl.
.
.
IDAHO POWER COMPANY
DCF Sumar for Full Western Proxy Group.
(1)Dividend Yield (April-September 2007)3.65%
(2)Adjusted Yield (3.65 x 1.03)3.8
I.(3)DCF Growt Rate 5.5 - 6.5
(4)Flotation Adjustment 0.00
(5)Total Retu 9.3 - 10.3.(6)Midpoint 9.8
Recommendation 10.25%
.(1)DCF Model: Ke = (DJP 0) (1 + O.5g) + g, where
Ke = cost of equity
Do = curent anualized dividend
Po == curent share price
g = long-term dividend growt rate
.
.
.
.Exhibit No. 604
Case No. IPC-E-07-8
M. Kahal, DOE
Page 1 of5
.
.
IDAHO POWER COMPAN.
.DCF Summar for Full Western Proxy Group
Excluding Companies with Safety Rating of "1"
.
.
Exhibit No. 604
Case No. IPC-E-07-8
M. Kahal, DOE
Page 2 of5.
.
.
.
.
.
.
.
.
.
.
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.
IDAHO POWER COMPAN
.Analyst Projected Growt Rates
Five-Year Earings Per Share
.
.
.
.
.
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.
.
.
.
.
.
.
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.
.IDAHO POWER COMPAN
Historical/rojected Eared Retu on Equity
Eastern and Central Integrated Utility Companies.
Company 2005 2006 2007 2010-2012
(1)Alliant 13.1%9.1%11.5%10.0%.(2)American Electrc 11.3 12.0 11.5 '12.5
(3)Dominion 9.9 13.1 17.5 17.5
(4)DTE 10.5 7.5 11.5 9.5.
(5)Integrs 11.8 9.7 6.5 8.5
(6)NiSource 6.0 6.3 7.0 7.0
.(7)Progress 9.0 6.1 9.0 9.5
(8)Wisconsin 11.3 10.8 10.5 11.5
Average 10.4%9.3%10.6%10.8%.
Average 10.4%8.8%9.6%9.8%
(w/o Dominion)
Sources: Value Line Investment Surey, August 31 and September 28,2007..
.
.Exhibit No. 606
Case No. IPC-E-07-8
M. Kahal, DOE
Page 2 of2
.
.
.
.
July 10, 2007
.Ms. Jean Jewell
Commission Secretar
Idaho Public Utilities Commission
P.O. Box 83720
Boise, il 83720-0074.RE: Case No. IPC-E-07-8
Dear Ms. Jewell:
.Enclosed please fid the origial and seven (7) copies of the PETITION OF THE
UNTED STATES DEPARTMENT OF ENERGY FOR LEAVE TO INTERVENE in
the above-captioned proceeding. Also enclosed is an additional copy of the Petition for
Leave to Intervene that I ask be date staped and retued in the enclosed stamped
envelope.
.If you have any questions concerning this fiing, please do not hesitate to contact me at
[phone].
.
.
Arur Perr Bruder
Attorney-Advisor
United States Deparent of Energy
Office of the General Counsel
1000 Independence Avenue SW
Washigton, DC 20585
Telephone: [phone]
Facsimile: [phone]
.
.
.
CERTIFICATE OF SERVICE - CASE NO. IPC-E-07-8
.I hereby certify that I have ths 10th day of December, 2007, served or caused to be served
a tre and correct copy of the attached DIRCT TESTIMONY OF MATTHEW i.
KAHAL ON BEHALF OF THE UNTED STATES DEPARTMNT OF ENERGY upon
each of the pares listed below, by placing the same in the U.S. Mail, postage prepaid.
.Baron L. Kline
Lisa D. Nordstrom
Idaho Power Company
1221 W. Idao St. (83702)
P.O. Box 70
Boise, ID 83707~0070.
.
John R. Gale
Vice President, Regulatory Affairs
Idaho Power Company
1221 W. Idaho St. (83702)
P.O. Box 70
Boise, ID 83707-0070
.Weldon Stutzan
Donovan Walker
Deputy Attorney Generals
Idaho Public Service Commission
472 W. Washington (83702)
PO Box 83720
Boise, ID 83720-0074.
.
Peter J. Richardson
Richardson & O'Lear
515 N. 27th St.
P.O. Box 7218
Boise, ID 83702
.
Dr. Don Reading
Ben Johnson Associates
6070 Hil Road
Boise, ID 83703
.
Eric L. Olsen
Racine, Olson, Nye, Budge &
Bailey, Charered
P.O. Box 1390;
201 E. Center
Pocatello, ID 83204~1391
.
.Anthony Yanel
29814 Lake Road
Bay Vilage, OH 44140
Michael Kur, Esq..Kur J. Boehm, Esq.
Boehm, Kur & Lowr
36 E. Seventh Street, Suite 1510
Cincinnati, OR 45202
.Conley E. Ward
Michael c. Creamer
Givens Pursley LLP
601 W. Banock Street
PO Box 2720 .Bois, ID 83701-2720
Dennis E. Peseau, Ph.D.
Utility Resources, Inc.
1500 Libert Street, Suite 250.Salem, OR 97302
LotH. Cooke
Acting Assistant General Counsel
United States Deparent of Energy .1000 Independence Ave., SW
Washington, DC 20585
Dale Swan
Exeter Associates
5565 Sterrtt Place, Suite 310.Columbia, MD 21044
.Q-~ ~ J
Arhur Perr Brt~
Attorney-Advisor
Offce of the General Counsel
United States Deparent of Energy
Washigton, DC.
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