HomeMy WebLinkAbout20040622Carlock Direct.pdf,.'
"r-I\JEBh t~
. - -
I.- .
!~iLED
'/Pfn. tfA;.Ol~ J.
- -
UU'i Uf'i- rei 'i= -
.- .
iLi r~.U !Ut3tfC
UTILITIES CO~tMISSION
BEFORE THE
IDAHO PUBLIC UTiliTIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF A VISTA CORPORATION FOR
AUTHORITY TO INCREASE ITS RATES
AND CHARGES FOR ELECTRIC AND
NATURAL GAS SERVICE TO ELECTRIC
AND NATURAL GAS CUSTOMERS IN
THE STATE OF IDAHO.
) CASE NO. AVU-O4-) AVU-O4-
DIRECT TESTIMONY OF TERRI CARLOCK
IDAHO PUBLIC UTiliTIES COMMISSION
JUNE 21 , 2004
Please state your name and address for the
record.
My name is Terri Carlock.My business
address is 472 West Washington Street, Boise, Idaho.
By whom are you employed and in what
capaci ty?
I am employed by the Idaho Public Utilities
Commission as the Accounting Section Supervisor.
Please outline your educational background and
experlence.
I graduated from Boise State University in
May 1980, with a B.A. Degree in Accounting and in
Finance. I have attended various regulatory, accounting,
rate of return, economics, finance and ratings programs.
I chaired the National Association of Regulatory
Utilities Commissioners (NARUC) Staff Subcommittee
Economics and Finance for over 3 years.Under thi s
subcommittee, I also chaired the Ad Hoc Committee on
Diversification.I am currently a member of the NARUC
Staff Subcommittee on Accounting and Finance.I ha
been a presenter for the Institute of Public Utilities at
Michigan State University and for many other conferences.
Since joining the Commission Staff in May 1980, I have
participated in audits, performed financial analysis on
various companies and have presented testimony before
CASE NOS. AVU-04-1/AVU-04-
06/21/04
CARLOCK , T (Di) 1
STAFF
this Commission on numerous occasions.
What is the purpose of your testimony in
this proceeding?
The purpose of my testimony is to present
the Staff's recommendation related to the overall cost of
capi tal for Avista Corporation (Avista) to be used in the
revenue requirement in these case, AVU-04-1 and AVU-
04 -1 .I will address the appropriate capi tal structure,
cost rates and the overall rate of return.
Please summarize your recommendations.
I am recommending a return on common equity
in the range of 9.5% - 10.9% with a point estimate of
10.4%.The recommended overall weighted cost of capital
is in the range of 8.87% - 9.46% with a point estimate of
25% to be applied to the rate base for the test year.
Are you sponsoring any exhibits to accompany
your testimony?
Yes, I am sponsoring Staff Exhibit No. 135
consisting of 3 schedules.
Have you reviewed the testimony and exhibits
of Avista wi tnesses Avera and Malquist?
Yes.Much of the theoretical approach used
by wi tnesses Avera and Malquist in their testimonies and
exhibi t s is generally the same as I have used.
judgment in some areas of application results in
CASE NOS. AVU-04-1/AVU-04-
06/21/04
CARLOCK, T (Di) 2
STAFF
different outcomes.
What legal standards have been established
for determining a fair and reasonable rate of return?
The legal test of a fair rate of return for
a utility company was established in the Bluefield Water
Works decision of the United States Supreme Court and is
repeated specifically in Hope Natural Gas.
In Bluefield Water Works and Improvement Co.
v. West Virginia Public Service Commission, 262 U. S. 679,
692 , 43 S.Ct. 675, 67 L.Ed. 1176 (1923), the Supreme
Court stated:
A public utility is entitled to such
rates as will permit it to earn a return
on the value of the property which
employs for the convenience of the
public equal to that generally being
made at the same time and in the same
general part of the country on
investments in other business
undertakings which are attended by
corresponding risks and uncertainties;
but it has no constitutional right to
prof its such as are real i zed or
anticipated in highly profitable
enterprises or speculative ventures.
The return should be reasonably
sufficient to assure confidence in the
financial soundness of the utility andshould be adequate, under efficient and
economical management, to maintain andsupport its credi t and enable it to
raise the money necessary for the proper
discharge of its public duties. A rate
of return may be reasonable at one time
and become too high or too low by
changes affecting opportunities for
investment, the money market andbusiness conditions generally.
CASE NOS. AVU-04-1/AVU-04-06/21/04
CARLOCK , T (Di) 3
STAFF
The Court stated in FPC v. Hope Natural Gas Company, 320
U . S. 591, 603, 64 S. Ct. 281, 88 L. Ed . 333 1944)
From the investor or company point ofview it is important that there be
enough revenue not only for operatingexpenses but also for the capi tal costsof the business. These include service
on the debt and dividends on the stock.
. .
. By that standard the return to the
equity owner should be commensurate with
returns on investments in other
enterprises having corresponding risks.
That return , moreover , should be
sufficient to assure confidence in the
financial integrity of the enterprise,
so as to maintain its credi t and toattract capital. (Citations omitted.
The Supreme Court decisions in Bluefield
Water Works and Hope Natural Gas have been affirmed in In
re Permian Basin Area Rate Case, 390 U. S. 747, 88 S. Ct
1344 , 20 L.Ed 2d 312 (1968), and Duquesne Light Co.
Barasch, 488 U. S. 299,109 S.Ct. 609,102 L.Ed.2d. 646
(1989) .The Idaho Supreme Court has also adopted the
principles established in Bluefield Water Works and Hope
Na tural Gas.See In re Moun tain Sta tes Tel. Tel. Co.
76 Idaho 474 , 284 P. 2d 681 (1955)General Telephone Co.
v. IPUC, 109 Idaho 942, 712 P. 2d 643 1986)Hayden pines
Water Company v. IPUC, 122 ID 356, 834 P.2d 873 (1992)
As a result of these United States and Idaho
Supreme Court decisions, three standards have evolved for
determining a fair and reasonable rate of return:
CASE NOS. AVU-04-1/AVU-04-
06/21/04
CARLOCK , T (Di) 4
STAFF
(1) the Financial Integrity or Credit Maintenance
Standard;(2) the Capital Attraction Standard; and,
(3) the Comparable Earnings Standard.If the Comparable
Earnings Standard is met, the Financial Integri ty
Credi t Maintenance Standard and the Capi tal At tract ion
Standard will also be met, as they are an integral part
of the Comparable Earnings Standard.
Have you considered these standards in your
recommendation?
Yes.These criteria have been seriously
considered in the analysis upon which my recommendations
are based.It is also important to recognize that the
fair rate of return that allows the utility company to
maintain its financial integrity and to attract capital
is established assuming efficient and economic
management, as specified by the Supreme Court in
Bluefield Water Works.
Please summari ze the parenti subsidiary
relationships for Avista Utilities.
Avista Utilities' common stock is not
traded.Avista Utilities is wholly owned by Avista
Corporation (Avista Corp.. Due to this parenti subsidiary
relationship there is no direct market data available for
utility operations at Avista Utilities.The only direct
stock market information available to utilize in
CASE NOS. AVU-04-1/AVU-04-
06/21/04
CARLOCK, T (Di) 5
STAFF
determining the cost of equity capital is for Avista
Corp.
What approach have you used to determine the
cost of equity for Avista specifically?
I have primarily evaluated two methods:the
Discounted Cash Flow (DCF) method and the Comparable
Earnings method.
Please explain the Comparable Earnings
method and how the cost of equity is determined using
this approach.
The Comparable Earnings method for
determining the cost of equity is based upon the premlse
that a given investment should earn its opportunity
costs.In competitive markets, if the return earned by a
firm is not equal to the return being earned on other
investments of similar risk , the flow of funds will be
toward those investments earnlng the higher returns.
'flrere-ore---,-fo-r--a---t:rtH-t Y t 0--be-c-ompet-i-t-rve-rn--t-he
financial markets, it should be allowed to earn a return
on equity equal to the average return earned by other
firms of similar risk.The Comparable Earnings approach
is supported by the Bluefield Water Works and Hope
Natural Gas decisions as a basis for determining those
average returns.
Industrial returns tend to fluctuate with
CASE NOS. AVU-04-1/AVU-04-06/21/04 CARLOCK , T (Di) 6
STAFF
business cycles, increasing as the economy improves and
decreasing as the economy declines.Utility returns are
not as sensitive to fluctuations in the business cycle
because the demand for utility services generally tends
to be more stable and predictable.However, returns have
fluctuated since 2000 when prices in the electricity
markets dramatically increased.Electrici ty prices have
not seen the dramatic spikes lately so earnings are
beginning to stabilize again.
Please evaluate the recent price index
trends.
The trends for prlce indexes are shown on
Staff Exhibit No. 135, Schedule The consumer price
index percent change has averaged 1.9% for 2001-2003 and
was 1.9% for 2003.This is less than historical
averages.
Please evaluate interest rate trends.
The prime interest rate ranges by year are
shown on Staff Exhibit No. 135, Schedule Interest
rates continue to be near historical lows with prime
4% .
Please provide the current index levels for
the Dow Jones Industrial Average and the Dow Jones
Utility Average.
The Dow Jones Industrial Average (DJIA)
CASE NOS. AVU-04-1/AVU-04-
06/21/04
CARLOCK, T (Di) 7
STAFF
closed at 10,380 on June 16, 2004.The DJIA increased
31% since the beginning of 2003.The Dow Jones Utility
Average closed at 274 on June 16, 2004.
Please explain the risk differentials
between industrials and utili ties.
Risk is a degree of uncertainty relative to
a company.The lower risk level associated with
utilities is attributable to many factors even though the
difference is not as great as it used to be.Util i ties
continue to have limited competition for distribution of
utility serVlces within the certificated area.With
limited competition for regulated services, there is less
chance of losses related to pricing practices, marketing
strategy and advertising policies.The competitive risks
for electric utilities have changed with increasing non-
utility generation , deregulation in some states, open
transmission access,' and changes in electrici ty markets.
However , competitive risks are limited for Avista utility
operations.The demand for utility services
relatively stable and certain or increasing compared to
that of unregulated firms and even other utility
industries.
Competitive risks continue to be lower for
Avista than for many other electric companies primarily
because of the low- cost source of power and the low
CASE NOS. AVU-04-1/AVU-04-
06/21/04
CARLOCK, T (Di) 8
STAFF
retail rates.The investment risk for Avista is less due
to recovery levels for power supply costs reflected in
the Power Cost Adjustment mechanism (PCA)However, the
investment risk for Avista s other affiliates is higher
than for the utility, causing much of the risk investors
now see.The risk differential between Avista and other
electric utilities is based on the resource mix and the
cost of those resources.All resource mixes have risks
specific to resources chosen.The demand for electric
utility services of Avista is relatively stable.This
low demand risk is partially due to the low-cost power
and the customer mix of the power users.
Under regulation , utili ties are generally
allowed to recover through rates, reasonable, prudent and
justifiable cost expenditures related to regulated
services.Unregulated firms have no such assurance.
Utilities in general are sheltered by regulation for
reasonable cost recovery risks, making the average
utility less risky than the average unregulated
industrial firm.
Many of the risks experienced by Avista have
been and continue to be primarily due to non-regulated
operations and decisions that were made to expand those
affiliate activities.This is one reason Avista
restructured and sold some of the subsidiary operations.
CASE NOS. AVU-E- 04 -l/AVU-G- 04-06/21/04 CARLOCK, T (Di) 9
STAFF
Considering all of these comparlsons, I believe a
reasonable return on equity attributed to Avista
Utilities is 10.0% - 11.0% under the Comparable Earnings
method.Due to these various risk components, Avista
Utilities continues to experience high cost of debt with
refinancing requirements as the debt matures.
You indicated that the Discounted Cash Flow
method is utilized in your analysis.Please explain this
method.
The Discounted Cash Flow (DCF) method is
based upon the theory that (1) stocks are bought for the
income they provide (i. e ., both dividends and/ or galns
from the sale of the stock), and (2) the market price of
stocks equals the discounted value of all future incomes.
The discount rate , or cost of equi ty, equates the present
val ue of the stream of income to the current market price
of the stock.The formula to accomplish this goal is:
--------------------------
( 1 + ks ) 1 ( 1 + ks ) 2 (l+ks ) N (l+ks ) N
Po =Current Price
D =Di vidend
ks =Capi talization Rate, Discount Rate, or Required
Rate of Return
N =Latest Year Considered
CASE NOS. AVU-04 -l/AVU-G- 04-
06/21/04
CARLOCK, T (Di) 10
STAFF
The pattern of the future income stream
the key factor that must be estimated in this approach.
Some simplifying assumptions for ratemaking purposes can
be made without sacrificing the validity of the results.
Two such assumptions are:( 1) dividends per share grow
at a constant rate in perpetui ty and (2) prices track
earnlngs These assumptions lead to the simplif ied DCF
formula, where the required return is the dividend yield
plus the growth rate (g)
ks = -
- - + g
Have you factored flotation costs in wi
your cost of capital analysis?
Yes, I have considered direct flotation
costs in my analysis by increasing the dividend yield
component of the DCF analysis.Since only direct costs
should be considered, I have used a flotation factor
4% with 2% assigned to the utility operations.This
practice continues to be reasonable since all
subsidiaries of Avista Corp should be responsible for
some of actual flotation costs.I have therefore
adjusted the DCF formula to include the direct flotation
costs as "df"
CASE NOS. AVU-04-1/AVU-04-
06/21/04
CARLOCK, T (Di) 11
STAFF
ks =
( - - -
(1 + df) J +
What is your estimate of the current cost of
capital for Avista using the Discounted Cash Flow method?
The current cost of equi ty capi tal for
Avista, using the Discounted Cash Flow method is between
8% - 11.3% during various time intervals.Due to
ongoing capital requirements, including refinancing
maturities, I believe the projected dividend yield of
5% to 3.7% with a growth rate of 6% is the most
representati ve.
The dividend yield for the Value Line
Utility West Industry of 3.4% is comparable to the
dividend yield for Avista.The Dow Jones Public Utility
Average (DJUA) expected average dividend yield is 4.36%.
The higher dividend yield and a lower expected growth
rate of 5% for the DJUA produces a DCF return on equity
of 9.36%, also within the DCF range of 8.8% - 11.3% shown
above for Avista.
How is the growth rate (g) determined?
The growth rate is the factor that requlres
the most extensive analysis in the DCF method.It is
important that the growth rate used in the model be
consistent wi th the dividend yield so that investor
CASE NOS. AVU-E- 04 -l/AVU-G- 04-06/21/04
CARLOCK, T (Di) 12
STAFF
expectations are accurately reflected and the growth rate
is not too large or too small.
I have used an expected growth rate of
6% - 6.5%.This expected growth rate was derived from an
analysis of various historical and proj ected growth
indicators, including growth in earnings per share,
growth in cash dividends per share, growth in book value
per share, growth in cash flow and the sustainable growth
for Avista.
What is the capital structure you have used
for Avista to determine the overall cost of capi tal?
I have utilized the embedded capital
structure at December 31 , 2003 consisting of 50.08% debt,
57% trust preferred securities, 1.76% preferred stock
and 42.59% common equity as shown on Schedule 3 of Staff
Exhibi t No. 135.Avista witness Malquist reflects this
capi tal structure on Exhibi t No.I haven t accepted
the proforma capi tal structure recommended by Avista in
this case (also shown on Malquist Exhibit No.2) Slnce
the proforma changes are not adequately known to be
included as a known and measurable adjustment in this
case.This capital structure is shown on Staff Exhibit
No. 135, Schedule 2 , Columns 2 and 3.
What are the costs related to the capital
structure for debt, trust preferred securi ties and
CASE NOS. AVU-04-1/AVU-04-
06/21/04
CARLOCK, T (Di) 13
STAFF
preferred stock?
I have evaluated and accepted the embedded
cost rates used in Malquist Exhibi t No.2. The cost of
debt is 8.68%, the cost of trust preferred securities
15% and the cost of preferred stock is 7.35%.
You indicated the cost of common equi
range for Avista is 10.0% - 11.0% under the Comparable
Earnings method and 8.8% - 11.3% under the Discounted
Cash Flow method.What is the cost of common equity
capi tal you are recommending?
The fair and reasonable cost of common
equi ty capi tal I am recommending for Avista is in the
range of 9.5% - 10.9%.Although any point within this
range is reasonable, the return on equi ty granted would
not normally be at either extreme of the fair and
reasonable range.I utilized a point estimate of 10.
in calculating the overall rate of return for the revenue
requirement.
What the basis for your point estimate
being 10.when your range 10. 9%?
The 10.return equity point estimate
utilized is based on a review of the market data and
comparables, average risk characteristics for Avista,
including the past and current impact from non-regulated
operations and the capi tal structure.
CASE NOS. AVU-E- 04 -l/AVU-G- 04-06/21/04
CARLOCK, T (Di) 14
STAFF
What is the overall weighted cost of capital
you are recommending for Avista?
I am recommending an overall weighted cost
of capital in the range of 8.87% - 9.46%.For use in
calculating the revenue requirement, a point estimate
consisting of a return on equity of 10.4% and a resulting
overall rate of return of 9.25% was utilized as shown on
Schedule 3, Staff Exhibit No. 135.
~oes this conclude your direct testimony in
thi s proceeding?
Yes, it does.
CASE NOS. AVU-04-1/AVU-04-06/21/04
CARLOCK , T (Di) 15
STAFF
PRICE INDEXES
(A)(B)(C)(D)
Consumer CPI Producer PPI
Price Percent Price Percent
Index Chan Index Chan
1980 82.4 12.88.11.8
1981 90.96.
1982 96.100.
1983 99.101.6
1984 103.103.1.7
1985 107.104.1.8
1986 109.1.1 103.
1987 113.4.4 105.4 2.2
1988 118.4.4 108.
1989 124.113.
1990 130.119.
1991 136.121.7
1992 140.123.1.6
1993 144.124.
1994 148.125.1.7
1995 152.4 127.2.3
1996 156.3.3 131.3
1997 160.1.7 131.8 1.2
1998 163.1.6 130.
1999 166.133.
2000 172.3.4 138.
2001 177.1.6 140.1.6
2002 179.2.4 138.1.2
2003 184.1.9 143.
All items; Index, 1982 - 1984 = 100 (Ratio Scale)
Total Finished Goods; Index, 1982 = 100 (Ratio Scale)
Source: Economic Indicators, pages 22-24.
Exhibit No. 135
Case No. A VU-04-
A VU-04-
T. Carlock, Staff
6/21/04 Schedule
BANK PRIME INTEREST RATES
Year Rate
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004 Through 5/17/04
75%
11.50
10.
15.
11.
10.
10.
10.
10.
50%
10.
12.
10.
11.75
15.
21.50
20.
17.
11.
13.
10.
10.
11.
10.
Source: Federal Reserve Bulletin
Wall Street Journal
Exhibit No. 135
Case No. A VU-04-
A VU -04-
T. Carlock, Staff
6/21/04 Schedule
O\
~
(l
t
T
'
j
--
.
.
Po
'
~
N
-
.
f
Z
J
::
r
...
.
.
.
~
(l
)
,.
.
.
.
.
O~
8"
.
..
.
.
.
.
.
.
.-
+
~p
~
~
~
::
r
C
l
)
~
~
.
.
.
.
.
.
(l
)
S
-
c:
:
:
:
c:
:
:
:
I
J
,
)
0.
.
!
-
h
I
v-
.
E.
H
i
C1
tT
'
j
(l
)
IJ
,
)
o
.,J
:
:
:
.
.
I
...
.
.
.
""
"
--
.
VI
S
T
A
C
O
R
P
O
R
A
T
I
O
N
Ca
p
i
t
a
l
S
t
r
u
c
t
u
r
e
a
n
d
O
v
e
r
a
l
l
R
a
t
e
o
f
R
e
t
u
r
n
Em
b
e
d
d
e
d
C
o
s
t
o
f
C
a
p
i
t
a
l
as
of
D
e
c
e
m
b
e
r
31
,
20
0
3
(1
)
(2
)
(3
)
(4
)
(5
)
Li
n
e
Pe
r
c
e
n
t
o
f
No
.
Am
o
u
n
t
To
t
a
l
C
it
a
l
Co
s
t
Co
m
on
e
n
t
To
t
a
l
L
o
n
g
T
e
r
m
D
e
b
t
$
8
9
8
82
2
,
4
2
6
50
.
08
%
68
%
4.
3
5
%
Tr
u
s
t
P
r
e
f
e
r
r
e
d
S
e
c
u
r
i
t
i
e
s
10
0
00
0
00
0
57
%
15
%
34
%
Pr
e
f
e
r
r
e
d
S
t
o
c
k
50
0
00
0
1.
7
6
%
35
%
13
%
Co
m
m
o
n
E
q
u
i
t
y
76
4
87
5
42
.
59
%
10
.
4
0
%
4.
4
3
%
TO
T
A
L
10
0
.
00
%
25
%
CERTIFICATE OF SERVICE
HEREBY CERTIFY THAT I HAVE THIS 21ST DAY OF JUNE 2004
SERVED THE FOREGOING DIRECT TESTIMONY OF TERRI CARLOCK, IN
CASE NO. A VU-04-lIA VU-04-, BY MAILING A COpy THEREOF POSTAGE
PREP AID TO THE FOLLOWING:
DAVID J. MEYER
SR VP AND GENERAL COUNSEL
VISTA CORPORATION
PO BOX 3727
SPOKANE WA 99220-3727
KELLY NORWOOD
VICE PRESIDENT STATE & FED. REG.
VISTA UTILITIES
PO BOX 3727
SPOKANE WA 99220-3727
CONLEY E WARD
GIVENS PURSLEY LLP
PO BOX 2720
BOISE ID 83701-2720
DENNIS E PESEAU, PH. D.
UTILITY RESOURCES INC
1500 LIBERTY ST SE, SUITE 250
SALEM OR 97302
CHARLES L A COX
EVANS KEANE
111 MAIN STREET
PO BOX 659
KELLOGG ID 83837
BRAD M PURDY
ATTORNEY AT LAW
2019 N 17TH ST
BOISE ID 83702
SECRET AR
---
CERTIFICATE OF SERVICE