20080403Avera Direct.pdf

DAVID J. MEYER
VICE PRESIDENT, GENERA COUNSEL, REGULATORY &
GOVERNENTAL AFFAIRS
AVISTA CORPORATION
P.O. BOX 3727
1411 EAST MISSION AVENUE
SPOKAE, WASHINGTON 99220-3727TELEPHONE: [phone]FACSIMILE: [phone]
Rr-('..· f::", t: I VD
(!JOB APR.. 3
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF AVISTA CORPORATION FOR THE
AUTHORITY TO INCREASE ITS RATES
AN CHAGES FOR ELECTRIC AN
NATURA GAS SERVICE TO ELECTRIC
AN NATURA GAS CUSTOMERS IN THE
STATE OF IDAHO
CASE NO. AVU-E-08-01
CASE NO. AVU-G-08-01
DIRECT TESTIMONY
OF
WILLIAM E. AVERA
FOR AVISTA CORPORATION
(ELECTRIC AN NATURA GAS)
DIRECT TESTIMONY OF WILLIAM E. AVERA
TABLE OF CONTENTS
I. INTRODUCTION............................................. 1
A. Overview............................................. 1B. Surary of Conclusions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 4
II. RISKS OF AVISTA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 8
A. Operations & Finances... . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 8
B. Capital Structure................................... 21
III. CAPITAL MAKET ESTIMATES. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 29
A. Overview............................................ 29B. Results of Quantitative Analyses.. . . . . . . . . . . . . . . . . .. 31
IV. RETURN ON EQUITY FOR AVI STA CORP. . . . . . . . . . . . . . . . . . . . . . .. 41
A. Implications for Financial Integrity................ 41B. Flotation Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 46
C. Return on Equity Recommendation. . . . . . . . . . . . . . . . . . . .. 49
Schedule WEA- 1 -
Schedule WEA-2 -
Schedule WEA-3 -
Schedule WEA-4 -
Schedule WEA- 5 -
Schedule WEA- 6 -
Schedule WEA-7 -
Schedule WEA- 8 -
Schedule WEA-9 -
Schedule WEA-10
Schedule WEA-11
Schedule WEA- 12
Qualifications of william E. Avera
Description of Quantitative Analyses
Capi tal Structure
Constant Growth DCF Model - Utility Proxy
Group
Sustainable Growth Rate - Utility Proxy
Group
Constant Growth DCF Model - Non-Utility
Proxy Group
Sustainable Growth Rate - Non-Utility
Proxy Group
Forward-looking CAPM - Utility Proxy
Group
Forward-looking CAPM - Non-Utility Proxy
Group
- Historical CAPM - Utility Proxy Group
- Historical CAPM - Non-Utility Proxy Group
- Expected Earnings Approach
1 I.INTRODUCTION
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3
Q.
A.
Please state your name and business address.
William E. Avera, 3907 Red River, Austin, Texas,
4 78751.
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Q.
A.
In what capacity are you employed?
I am the President of FINCAP, Inc. , a firm
7 providing financial,economic,and policy consulting
8 services to business and government.
9 Q. Please describe your educational background and
10 professional experience.11 A. A description of my background and
12 qualifications, including a resume containing the details
13 of my experience, is attached as Schedule WEA-1.
14 A. Overview
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Q.What is the purpose of your testimony in this
case?
A.The purpose of my testimony is to present to the
18 Idaho Public Utilities Commission (the ~Commission" or
19 ~ IPUC") my independent evaluation of the fair rate of
20 return on equity (~ROE") for the jurisdictional electric
21 and gas utility operations of Avista Corp. ("Avista" or
22 ~the Company").In addition,I also examined the
23 reasonableness of Avista' s capital structure, considering
24 both the specific risks faced by the Company and other
25 industry guidelines.
Avera, Di 1
Avista Corporation
1 Q. Please suirize the informtion and materials
2 you relied on to support the opinions and conclusions
3 contained in your testimony.
4 A. To prepare my testimony, I used information from
5 a variety of sources that would normally be relied upon by
6 a person in my capaci ty .I am familiar with the
7 organization, finances, and operations of Avista from my
8 participation in prior proceedings before the I PUC , the
9 Washington Utilities and Transportation Commission, and the
10 Oregon Public Utility Commission.In connection with the
11 present filing, I considered and relied upon corporate
12 disclosures, publicly available financial reports and
13 filings, and other published information relating to
14 Avista.I also reviewed information relating generally to
15 current capital market conditions and specifically to
16 current investor perceptions,requirements,and
17 expectations for Avista' s utility operations.These
18 sources, coupled with my experience in the fields of
19 finance and utility regulation, have given me a working
20 knowledge of this issues relevant to investors' required
21 return for Avista, and they form the basis of my analyses
22 and conclusions.
23 Q. What is the role of the rate of return on common
24 equity in setting a utility's rates?
25 A. The ROE serves to compensate common equity
26 investors for the use of their capital to finance the plant
Avera, Di 2
Avista Corporation
1 and equipment necessary to provide utility service.
2 Inves tors commi t capi tal only if they expect to earn a
3 return on their investment commensurate with returns
4 available from alternative investments with comparable
5 risks.To be consistent with sound regulatory economics
6 and the standards set forth by the Supreme Court in the
7 Bluefield1 and Hope2 cases, a utility's allowed ROE should
8 be sufficient to: 1) fairly compensate the utility's
9 investors, 2) enable. the utility to offer a return adequate
10 to attract new capital on reasonable terms, and 3) maintain
11 the utility's financial integrity.
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Q. How did you go about developing your conclusions
regarding a fair rate of return for Avista?
A. I first reviewed the operations and finances of
15 Avista and the general conditions in the utility industry.
16 With this as a background, I conducted various well-
17 accepted quantitative analyses to estimate the current cost
18 of equity,including alternative applications of the
19 discounted cash flow (~DCF") model and the Capital Asset
20 Pricing Model (~CAPMtt), as well as reference to expected
21 earned rates of return for utilities. Based on the cost of
22 equity estimates indicated by my analyses, the Company's
23 ROE was evaluated taking into account the specific risks
1 Bluefield Water Works & Improvement Co. v. Pub. Servo Comm 'n, 262
U.8. 679 (1923).2 Fed. Power Comm 'n v. Hope Natural Gas Co., 320 U. 8. 591 (1944).
Avera, Di 3
Avista Corporation
1 and potential challenges for Avista' s utility operations in
2 Idaho.
3 B. Suiry of Conclusions
4 Q. What are your findings regarding the fair rate of
5 return on equity for Avista?
6 A. Based on the results of my analyses and the
7 economic requirements necessary to support continuous
8 access to capital under reasonable terms, I determined that
9 a fair ROE for Avista falls in the range of 10.7 percent to
10 12.2 percent.The bases for my conclusion are surarized
11 below:
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. In order to reflect the risks and prospects
associated with Avista' s jurisdictional utility
operations, my analyses focused on a proxy group of
twenty other utilities with comparable investment
risks. Consistent with the fact that utilities
must compete for capital with firms outside their
own industry, I also referenced a proxy group of
comparable risk companies in the non-utility sector
of the economy;
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. Because investors' required return on equity is
unobservable and no single method should be viewed
in isolation, I applied both the discounted cash
flow (~DCF") and capital asset pricing model
(~CAPM") methods, as well as the expected earnings
approach, to estimate a fair ROE for Avista:
o My application of the constant growth DCF model
considered four alternative growth measures
based on proj ected earnings growth, as well as
the sustainable, ~br+sv" growth rate for each
firm in the respective proxy groups;
o After eliminating low- and high-end outliers,
my DCF analyses implied a cost of equity of
10.7 percent for the proxy group of utilitiesand 12.6 percent for the group of non-utility
companies;
Avera, Di 4
Avista Corporation
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o Application of the CAPM approach using forward-
looking data that best reflects the underlying
assumptions of this approach implied a cost of
equity of 12.2 percent for the utility proxy
group and 11.4 percent for the firms in the
non-utility proxy group;
o Applying the CAPM method using historical
realized rates of return resulted in a cost of
equity of 10.7 percent for the utility proxygroup and 10.0 percent for the non-utility
proxy group;o My evaluation of earned rates of return
expected for utilities suggested a cost of
equi ty on the order of 11.0 percent;
o Based on these results, I concluded that the
cost of equity for the proxy groups of electric
utilities and non-utility companies is in the
10.7 percent to 12.2 percent range.
19 Considering investors'expectations for capital
20 markets and the need to support financial integrity and
21 fund crucial capital investment even under adverse
22 circumstances, I concluded that Avista' s requested ROE of
23 10.8 percent is reasonable.Based on my evaluation, I
24 determined that:
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. Because Avista' s requested ROE of 10.8 percent
barely exceeds the lower bound of my recommended
range, it represents a conservative estimate of
investors' required rate of return;
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. The reasonableness of a 10.8 percent minimum ROE
for Avista is also supported by the need to
consider the Company's credit standing, which
remains relatively weak:
o The pressures of funding significant capitalexpenditures and increased operating risks
heighten the uncertainties associated withAvista;
o Because of Avista' s reliance on hydroelectric
generation, the Company is exposed to
relatively greater risks of power costvolatility;
Avera, Di 5
Avista Corporation
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o Investors view the Power Cost Adjustment
Mechanism ( \\ PCA" ) as supportive of the
Company's financial integri ty, but they
understand that the PCA does not apply to 100percent of power costs; nor does it insulate
Avista from the need to finance accrued power
production and supply costs or shield theCompany from potential regulatorydisallowances;
o Given Avista' s present credit ratings, an
inadequate rate of return imposed in this
proceeding would further pressure the Company's
financial flexibility and credit standing;
o My conclusion that a 10.8 percent ROE for
Avista is a conservative estimate of investors'
required return is also reinforced by the
Company's relatively greater risks as comparedwith the proxy group, the greater uncertainties
associated with Avista' s relatively small size,
and the fact that my recommended ROE range doesnot consider flotation costs.
22
23 Q. What is your conclusion as to the reasonableness
24 of the Company's capital structure?
25 A. Based on my evaluation, I concluded that a common
26 equi ty ratio of 47.94 percent represents a reasonable basis
27 from which to calculate Avista' s overall rate of return.
28 This conclusion was based on the following findings:
29 . Avista' s requested capitalization is consistent30 with the Company's need to strengthen its credit31 standing and financial flexibility as it seeks to32 raise additional capital to fund significant system33 investments and meet the requirements of its34 service territory;
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. Avista' s proposed common equity ratio is entirely
consistent with the 47.8 percent and 49.0 percent
average equity ratio maintained by the firms in my
utility proxy group, based on year-end 2007 data
and near-term expectations, respectively.
Avera, Di 6
Avista Corporation
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. My conclusion is reinforced by the investment
community's focus on the need for a greater equity
cushion to accommodate higher operating risks andthe pressures of funding significant capital
investments, as well as the impact of off-balance
sheet commi tments such as purchased poweragreements.
8 Q. What other evidence did you consider in
9 evaluating your recommendation in this case?
10 A. My recommendation was reinforced by the following
11 findings:
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.Sensitivity to regulatory uncertainties has
increased dramatically and investors recognize
that constructive regulation is a key ingredient
in supporting utility credit standing andfinancial integrity;
Providing Avista with the opportunity to earn a
return that reflects these realities is an
essential ingredient to strengthen the Company's
financial position, which ultimately benefits
customers by ensuring reliable service at lowerlong-run cos ts ;
My conclusion is reinforced by the economicreali ty that Avista' s actual returns have fallen
systematically short of the allowed ROE; and the
financial impact of an ROE below the minimum level
requested by Avista would threaten the Company's
ability to maintain an investment grade creditrating;
Investors are aware of the near-term challenges
posed by upward pressure on costs and rising
capital expenditures. For Avista, these concerns
are magnified by the fact that financial metrics
continue to be anemic and its credit standing,
accordingly, remains relatively weak;
Regulatory support, including a reasonable ROE,
will be a key driver in securing additional
progress towards restoring the Company's financial
heal th. Further strengthening Avista' s financial
integrity is imperative to ensure that the Company
has the capability to maintain an investment grade
rating while confronting potential challenges
.
.
.
.
Avera, Di 7
Avista Corporation
1
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associated with funding infrastructure development
necessary to meet the needs of its customers.
3 II. RISKS OF AVISTA
4 Q. What is the purpose of this section?
5 A. As a predicate to my economic and capital market
6 analyses, this section examines the investment risks that
7 investors consider in evaluating their required rate of
8 return for Avista.
9 A. Operations & Finances
10
11
Q.
A.
Briefly describe Avista.
Avista is engaged primarily in the procurement,
12 transmission, and distribution of natural gas and electric
13 energy.Avista's generating facilities include 8
14 hydroelectric generating stations with a combined capacity
15 of approximately 980 megawatts (~MW") and the electrical
16 output of these plants, which has a significant impact on
17 total energy costs, is dependent on streamflows. Although
18 Avista estimates that. hydroelectric generation is capable
19 of supplying approximately 50 percent of total system
20 requirements under normal conditions, the Company has
21 experienced prolonged periods of persistent below-normal
22 water conditions in the past.
23 Because close to one-half of Avista' s total energy
24 requirements are provided by hydroelectric facilities, the
25 Company is exposed to a level of uncertainty not faced by
26 most utilities.While hydropower confers advantages in
Avera, Di 8
Avista Corporation
1 terms of fuel cost savings and di vers i ty ,reduced
2 hydroelectric generation due to below-average water
3 condi tions forces Avista to rely more heavily on wholesale
4 power markets or more costly thermal generating capacity to
5 meet its resource needs. As S&P recently observed:
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A reduction in hydro generation typically
increases an electric utility's costs by
requiring it to buy replacement power or run more
expensive generation to serve customer loads.
Low hydro generation can also reduce utilities'
opportunity to make off-system sales. At thesame time, low hydro years increase regional
wholesale power prices, creating potentially a
double impact - companies have to buy more powerthan under normal conditions, paying higher. 3prices.
17 Additionally, all but one of Avista's hydroelectric
18 facilities are subject to licensing under the Federal Power
19 Act, which is administered by FERC.After agreeing to
20 institute various protections, mitigation, and enhancement
21 measures in order to address environmental concerns, Avista
22 received new 45-year operating licenses covering its two
23 largest hydroelectric facilities - Cabinet Gorge and Noxon
24 Rapids - in 2001.The license covering five hydroelectric
25 plants on the Spokane River expired in August 2007, with an
26 annual permit being issued to temporarily extend the
27 current license.Relicensing is not automatic under
28 federal law, and Avista must demonstrate that it has
3 Standard & Poor's Corporation, uPacific Northwest Hydrology And Its
Impact On Investor-Owed Utilities' Credit Quality, II RatingsDirect
(Jan. 28, 2008).
Avera, Di 9
Avista Corporation
1 operated its facilities in the public interest, which
2 includes adequately addressing environmental concerns.
3
4
5
6
Q. How are fluctuations in
expenses caused by varying hydro
conditions accommdated in its rates?
Avista's operating
and power market
A. Under the PCA, Avista's Idaho jurisdictional
7 rates are adjusted periodically to reflect changes in
8 variable power production and supply costs.When
10 rise above those included in base rates, the PCA allows
9 hydroelectric generation is reduced and power supply costs
11 Avista to increase rates to recover a portion of its
12 additional costs.Conversely, if increased hydroelectric
13 generation were to lead to lower power supply costs, rates
14 would be reduced.Although the PCA provides for rates to
15 be adjusted periodically, it applies to 90 percent of the
16 deviation between actual power supply costs and normalized
17 rates.
18 Q. Does the PCA completely eliminate the risk
19 associated with fluctuations in power supply costs?
20 A. No. The PCA is viewed as supportive of the
21
22 constructive regulation, but it does not apply to 100
Company's financial integrity and example of
23
an
24 utilities with permanent energy cost adjustment mechanisms
percent of Avista' s power costs.Moreover, even for
25 in place, there can be a significant lag between the time
26 the utility actually incurs the expenditure and when it is
Avera, Di 10
Avista Corporation
1 recovered from ratepayers.The PCA does not insulate
2 Avista from the need to finance deferred power production
3 and supply costs, with Moody's observing, ~The historical
4 financial metrics for Avista have been pressured by debt
5 added to fund energy cost deferrals during times when
6 drought conditions prevailed and this has caused us to
7 consider the metrics in line with the Ba rating category.
"4
8 Moreover, even with a PCA, investors recognize the ongoing
9 potential for regulatory disallowances if the Commission
10 determines that the amounts were not prudently incurred.
11 Q. Are there other mechanisms that affect Avista's
12 Idaho jurisdictional rates for utility service?13 A. Yes. With respect to its Idaho gas utility
14 operations, Avista is allowed to adjust natural gas rates
15 to reflect the difference between actual purchased natural
16 gas costs and amounts collected through rates under a
17 Purchased Gas Adjustment (~PGA") clause.
18 Q. Does Avista anticipate the need to access the
19 capital markets going forward?20 A. Most definitely. Avista will require capital
21 investment to meet customer growth, provide for necessary
22 maintenance and replacements of its natural gas utility
23 systems, as well as fund new investment in electric
24 generation, transmission and distribution facilities.As
· Moody's Investors Service, UCredit Opinion: Avista Corp., II Global
Credit Qpinion (Dec. 21, 2007).
Avera, Di 11
Avista Corporation
1 discussed by Company witness Mr. Malquist, planned capital
2 expenditures for 200S total approximately $190 million, and
3 approximately $200 million annually going forward.in
4 addition to funding investment in utility infrastructure,
5 Avista will also be required to refinance $31S million of
6 its long-term debt outstanding in 200S and will need to
7 issue new securities to fund a significant portion of these
S requirements.
9 Continued support for Avista's financial integrity and
10 flexibility will be instrumental in attracting the capital
11 necessary to fund these projects in an effective manner.
12 Similarly, bolstering Avista' s financial position will also
13 support the Company's efforts to refinance securities at
14 favorable terms, thereby lowering costs for customers in
15 the future.Avista's reliance on purchased power to meet
16 shortfalls in hydroelectric generation magnifies the
17 importance of strengthening financial flexibility, which is
1S essential to guarantee access to the cash resources and
19 interim financing required to cover inadequate operating
20 cash flows, as well as fund required investments in the
21 utility system.
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23
Q.
A.
What credit ratings have been assigned to Avista?
Standard & Poor's Corporation (~S&P") recently
24 raised the Company's corporate credit rating from ~BB+" to
25 ~BBB-~, in large part due to improved financial metrics
Avera, Di 12
Avista Corporation
1 resulting from the settlement of Avista' s last general rate
2 case in Washington. 5 Similarly, Moody's Investors Service
3 (~Moody' s") upgraded Avista' s issuer credit rating from
4 "Ba1" to ~Baa3" in December 2007.6 Fitch Ratings, Ltd.
5 ("Fitch") upgraded its issuer default rating for Avìsta one
6 notch to ~BB+", and has assigned the Company a ~positive
7 Outlook", indicating the potential for higher ratings going
8 forward.
7 The ratings assigned by S&P and Moody's
9 represent the lowest rung on the ladder of the investment
10 grade scale.
11 Q. How have investors' risk perceptions for firms
12 involved in the utility industry evolved?
13 A. Implementation of structural change and related
14 events caused investors to rethink their assessment of the
15 relative risks associated with the utility industry.The
16 past decade witnessed steady erosion in credit quality
17 throughout the utility industry, both as a result of
18 revised perceptions of the risks in the industry and the
19 weakened finances of the utilities themselves.S&P
20 recently reported that the majority of the companies in the
5 Standard & Poor's Corporation, UAvista Corp.'s Corporate Credit
Rating Raised One Notch To 'BBB-', II RatingsDirect (Feb. 7, 2008).6 Moody's Investors Service, uCredi t Opinion: Avista Corp., II Global
Credit Research (Dec. 21, 2007).7 Fitch Ratings, Ltd, UFitch Upgrades Avista Corp.'s IDR to 'BB+' from
'BB'; Outlook positive, II Press Release (Aug. 9, 2007).
Avera, Di 13
Avista Corporation
10
1 utili ty sector now fall in the triple-B rating category, 8
2 with Fitch recently concluding that ~the long-term outlook
3 is negative"investor-owned electric utilities.9for
4 Similarly,observed,~Material negative biasMoody's
5 appears to be developing over the intermediate and longer
6 term due to rapidly rising business and operating risks. "10
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Q. Is the potential for energy market volatility an
ongoing concern for investors?
A.Most definitely.Investors recognize the ongoing
prospect for further turmoil in energy markets.S&P has
11 reported continued spikes in wholesale market prices, 11 with
12
13 contribute to a ~challenging environment" for electric
Fitch noting that ~elevated energy commodity prices"
14 utili ties. 12 Similarly, the FERC Commission Staff has
15 continued to recognize the ongoing potential for market
16 disruption in the West, as a 2007 market assessment report
17 concluded:
18 Prices are likely to remain a concern. Last year19 we monitored transactions above the $400 per20 megawatt hour Western soft cap due to scarcity at21 peak . Given the likelihood of higher-priced22 natural gas in the West this year, extreme
BStandard & Poor's Corporation, uUpgrades Lead In U.. S. Electric
Utility Industry In 2007," RatingsDirect (Jan. 17, 2008).9 Fitch Ratings, Ltd., UU.S. Utilities, Power and Gas 2008 Outlook,"
Global Power North America Special Report (Dec. 11, 2007).10 Moody's Investors Service, uu. S. Electric Utility Sector," Industry
Outlook (Jan. 2008).11 Standard & Poor's Corporation, U Fuel and Purchased Power Cost
Recovery In The Wake Of Volatile Gas And Power Markets - U. S. Electric
Utilities To Watch," (Mar. 22, 2006).12 Fitch Ratings, Ltd., uU.S. Power and Gas 2007 Outlook," Global Power
North American Special Report (Dec. 15, 2006) at 1.
Avera, Di 14
Avista Corporation
1
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weather could easily raise prices to the peak
level again in surer 2007.13
3 The report noted that other regional electricity
4 markets were experiencing double-digit price increases and
5 expressed ongoing concern regarding tight supply and
6 . 14congestion.
7 In recent years utilities and their customers have
8 also had to contend with dramatic fluctuations in gas costs
9 due to ongoing price volatility in the spot markets. 15 S&P
10 concluded that "natural gas prices have proven to be very
11 volatilett and warned of a ~turbulent journey" due to the
12 uncertainty associated with future fluctuations in energy
13 costS.16 Fitch also highlighted the challenges that
14 fluctuations in commodity prices can have for utilities and
15 their investors, concluding that gas prices are subject to
16 near-term and longer-term fluctuations that contribute to
17 an ~adverse environment" for electric utilities. 17
18 In addition,while coal-fired generation has
19 historically provided relative stability with respect to
13 Federal Energy Regulatory Commission, Office of Market Oversight and
Investigations, uSumer Energy Market Assessment 2007," (May 17, 2007)
at 14.14 Id. at 4 and 15.
15 For example, the Energy Information Administration reported that the
average price of gas used by electricity generators (regulated
utili ties and non-regulated power producers) spiked from an average
price of $7.18 per Mcf for the first eight months of 2005 to over
$11.00 per Mcf in Septemer and October
(http://tonto.eia.doe.gov/dnav/ng/ng-pri_sum_dcu_ nus_m.htm) .16 Standard & Poor's Corporation, uTop Ten Credit Issues Facing U. S.
Utilities," RatingsDirect (Jan. 29, 2007).17Fitch Ratings, Ltd., UU.S. Power and Gas 2008 Outlook," Global Power
North American Special Report, at 3 (Dec. 11, 2007).
Avera, Di 15
Avista Corporation
1 fuel costs, rising prices for this energy source has raised
2 inves tors' concerns.In a 2004 article entitled ~Rising
3 Coal Prices May Threaten U.S. Utility Credit Profiles," S&P
4 noted that:
5 (S) everal current and structural developments for
6 the coal mining industry have resulted in a
7 dramatic increase in spot coal prices. 18
8 More recently,the Energy Information Administration
9 (~EIAtt), a statistical agency of the U. S. Department of
10 Energy, reported that average delivered coal prices for
11
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electric utilities increased 9.7 percent in 2006, the sixth
consecutive annual rise.19
Q. What are the key uncertainties considered by
investors in assessing their required rate of return for
Avista?
A. Because close to one-half of Avista' s total
energy requirements provided by hydroelectricare
facili ties,the Company is exposed to a level of
uncertainty not faced by most utilities.Investors
21 stream flows, and Avista' s reliance on wholesale purchases
recognize that volatile energy markets,unpredictable
22 to meet a significant portion of its resource needs can
23 expose the Company to the risk of reduced cash flows and
24 unrecovered power supply costs. S&P cited this exposure as
18 Standard & Poor's Corporation, uRising Coal Prices May Threaten U. S.
Utility Credit Profiles," RatingsDirect (Aug. 12, 2004).19 Energy Information Administration, Annual Coal Report 2006 at 9
(Nov. 2007).
Avera, Di 16
Avista Corporation
1 the ~key utility risk"confronting the 20Company,and
2 concluded that Avista, along with Idaho Power Company,
3 "face the most substantial risks despite their PCAs and
4 d h. 21cost-up ate mec anisms."Similarly, Fitch concluded, ~The
5 potential negative cash flow impact from a prolonged period
6 of below normal hydro conditions and high natural gas
7 prices are primary sources of concern"for Avista' s
8 inves tors. 22
9 In addition, investors are aware of the financial and
10 regulatory pressures faced by utilities associated with
11 rising costs and the need to undertake significant capital
12 investments. As Moody's observed:
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(T) here are concerns arising from the sector's
sizeable infrastructure investment plans in the
face of an environment of steadily rising
operating costs. Combined, these costs and
investments can create a continuous need for
regulatory rate relief, which in turn can
increase the likelihood for political and/or
regulatory intervention.
23
21 Similarly, S&P noted that ~onerous construction programs",
22 along with rising operating and maintenance costs and
23 volatile fuel costs, were a significant challenge to the
20 Standard & Poor's Corporation, UAvista Corp.'s Corporate Credit
Rating Raised One Notch to 'BBB-'," RatingsDirect (Feb. 7, 2008).21 Standard & Poor' sCorporation, uPacific Northwest Hydrology And Its
Impact On Investor-Owed Utilities' Credit Quality," RatingsDirect
(Jan. 28, 2008).22 Fitch Ratings, Ltd., "Fitch Affirms Avista Corp.'s IDR at 'BB+';
Outlook positive," Press Release (Feb. 6, 2008).23 Moody's Investors Service, UStorm Clouds Gathering on the Horizon
for the North American Electric Utility Sector," Special Comment (Aug.
2007) .
Avera, Di 17
Avista Corporation
1 utility . d 24in ustry.Moody's recently echoed this
2 assessment, concluding, ~There are significant negative
3 trends developing over the longer-term horizon. "25
4 While providing the infrastructure necessary to meet
5 the energy needs of customers is certainly desirable, it
6 imposes additional financial responsibilities on Avista.
7 As noted earlier, the Company's plans include capital
8 expendi tures of approximately $200 million annually,
9 including enhancements to its transmission and distribution
10 system and investment in generating resources.Investors
11 are aware that the challenge of achieving timely regulatory
12 recovery associated with rising costs and burdensome
13 capital expenditure requirements impacts Avista's ability
14 to earn a fair rate of return.
15
16
17
Q.What other considerations affect investors'
evaluation of Avista?
A. Avista and other utilities are confronting
18 increased environmental pressures that could impose
19 significant uncertainties and costs.In 2007 S&P cited
20 environmental mandates, including emissions, conservation,
24 Standard & Poor's Corporation, uu. S. Electric Utilities Continued
Their Long Shift To Stability In Third Quarter," RatingsDirect (Oct.
23, 2007).25 Moody's Investors Service, "U. S. Utility Sector," Industry Outlook
(Jan. 2008).
Avera, Di 18
Avista Corporation
1 and renewable resources as one of the top ten credit issues
2 f . U St' l" 26acing . . u i ities.More recently, S&P observed that:
3
4
5
6
7
8
What the ultimate outcome will be is cloudy right
now, but legislation addressing carbon emissions
and other greenhouse gases is extremely probable
in the near future. The credit implications of
any policy will be vast due to the compliance
costs involved.
27
9 Similarly, Moody's noted that ~ increasingly stringent
10 environmental compliance mandates will elevate cash outflow
11 recovery risk", 28 while Fitch noted that the electric
12 utility industry would be "a primary target" of new
13 environmental legislation, and concluded, ~The murkiness of
14
15
16
17
18
19
20
21
the future policies and regulations on carbon emissions is
another factor clouding Fitch's long-term view of electric
utili ties. "29
Q. Does Avista also face additional risks because of
the impact of industry restructuring on transmission
operations?
A.Yes.Policy evolution in the transmission area
has been wide reaching and Avista must address changes in
22 the electric transmission function of its business. S&P
23 confirmed a ~continued lack of clarity from lawmakers and
24 surroundingregulatorstheregulatoryframeworkon
26 Standard & Poor's Corporation, "Top Ten Credit Issues Facing U. S.
Utilities," RatingsDirect (Jan. 29, 2007).27 Standard & Poor's Corporation, "Upgrades Lead In U. S. Electric
Utility Industry In 2007," RatingsDirect (Jan. 17, 2008).28 Moody's Investors Service, "U. S. Electric Utility Sector," Industry
Outlook (Jan. 2008).29 Fitch Ratings, Ltd., UU.S. Utilities, Power and Gas 2008 Outlook,"
Global Power North America Special Report (Dec. 11, 2007).
Avera, Di 19
Avista Corporation
1 transmission . 30proJects. "Transmission operations have
2 become increasingly complex and investors have recognized
3 that difficulties in obtaining permits and uncertainty over
4 the adequacy of allowed rates of return have contributed to
5 heightened risk and fueled concerns regarding the need for
6 additional investment in the transmission sector of the
7 electric power industry.
8
9
10
Q. Would investors consider Avista's relative size
in their assessment of the Comany's risks and prospects?
A. Yes. A firm's relative size has important
11 implications for investors in their evaluation of
12 alternative investments, and it is well established that
13 smaller firms are more risky than larger firms.With a
14 market capitalization of approximately $1.1 billion, Avista
15 is one of the smallest publicly traded electric utili ties
16 followed by Value Line,which have an average
17 capitalization of approximately $8.1 billion.31
18 The magnitude of the size disparity between Avista and
19 other firms in the utility industry has important practical
20 implications with respect to the risks faced by investors.
21 All else being equal, it is well accepted that smaller
22 firms are more risky than their larger counterparts, due in
23 part to their relative lack of diversification and lower
30 Standard & Poor's Corporation, "Capital Spending On Electric
Transmission Is On The Upswing Around The World," RatingsDirect (Aug.
7, 2006).31 ww.valueline.com (Retrieved Feb. 13, 2008).
Avera, Di 20
Avista Corporation
10
11
12
13
14
15
1 f. . 1 . l' 32inancia resi iency.These greater risks imply a higher
2 required rate of return, and there is ample empirical
3 evidence that investors in smaller firms realize higher
4 f h. 1 f' 33rates 0 return t an in arger irms.Common sense and
5 accepted financial doctrine hold that investors require
6 higher returns from smaller companies, and unless that
7 compensation is provided in the rate of return allowed for
8 a utility,the legal tests embodied in the Hope and
9 Bluefield cases cannot be met.
B. capital Structure
Q. Is an evaluation of the capital structure
maintained by a utility relevant in assessing its return on
equity?
A. Yes. Other things equal, a higher debt ratio, or
16 financial risk for all investors. A greater amount of debt
lower common equity ratio,translates into increased
17 means more investors have a senior claim on available cash
18 flow, thereby reducing the certainty that each will receive
19 his contractual paYfents.This increases the risks to
20 which lenders are exposed, and they require correspondingly
21 higher rates of interest.From common shareholders'
32 It is well established in the financial literature that smaller
firms are more risky than larger firms. See, e.g., Eugene F. Fama and
Kenneth R. French, "The Cross-Section of Expected Stock Returns", The
Journal of Finance (June 1992); George E. Pinches, J. Clay Singleton,
and Ali Jahankhani, "Fixed Coverage as a Determinant of Electric
Utility Bond Ratings", Financial Management (Sumer 1978).33 See for example Rolf W. Banz, "The Relationship Between Return and
Market Value of Common Stocks", Journal of Financial Economics
(Septemer 1981) at 16.
Avera, Di 21
Avista Corporation
1 standpoint, a higher debt ratio means that there are
2 proportionately more investors ahead of them, thereby
3 increasing the uncertainty as to the amount of cash flow,
4 if any, that will remain.
5
6
7
Q.
requested
A.
What common equity ratio is implicit in Avista's
capi tal structure?
Avista's capital structure is presented in the
8 testimony of Mr. Malquist. As surarized in his testimony,
9 the pro-forma common equity ratio used to compute Avista' s
10 overall rate of return was 47.94 percent in this filing.
11 Q. What was the average capitalization maintained by
12 the utility proxy group?
13 A. As shown on Schedule WEA-3, for the twenty firms
14 in the utility proxy group, common equity ratios at
15 December 31, 2007 ranged between 40.1 percent and 57.9
16 percent and averaged 47.8 percent.
17 Q. What capitalization is representative for the
18 proxy group of utilities going forward?
19 A. As shown on Schedule WEA-3, The Value Line
20 Investment Survey (~Value Line") expects an average common
21 equity ratio for the proxy group of utilities of 49.0
22 percent for its three-to-five year forecast horizon, with
23 the individual common equity ratios ranging from 42.5
24 percent to 60.5 percent.
Avera, Di 22
Avis ta Corporation
1 Q. How does Avista' s common equity ratio compare
2 with those maintained by the reference group of utilities?
3 A. The 47.94 percent common equity ratio requested
4 by Avista is entirely consistent with the 47.8 percent and
5 49.0 percent average equity ratios for the firms in the
6 proxy group at year-end 2007 and based on Value Line's
7 near-term expectations , respectively.
8 Q. What implication does the increasing risk of the
9 utility industry have for the capital structures maintained
10 by utilities?
11 A. As discussed earlier, the average credit rating
12 associated with firms in the electric industry has fallen
13 to triple-B, with Avista's "BBB-~ rating occupying the
14 lowest rung on the ladder of the investment grade scale.
15 At the same time, electric utili ties are facing rising cost
16 structures,the need to finance significant capital
17 investment plans, uncertainties over accommodating future
18 environmental mandates,and ongoing regulatory risks.
19 Coupled with the decline in credit quality,these
20 considerations warrant a stronger balance sheet to deal
21 wi th an increas ingly uncertain and competi ti ve market.A
22 more conservative financial profile, in the form of a
23 higher common equity ratio, is consistent with increasing
24 uncertainties and the need to maintain the continuous
25 access to capital that is required to fund operations and
26 necessary system investment, even during times of adverse
Avera, Di 23
Avista Corporation
1 capi tal market condi tions .This is especially the case if
2 electric utilities are to be successful in raising the
3 substantial funds necessary to boost investments for
4 network reliability.
5 Moody's has warned investors of the risks associated
6 with debt leverage and fixed obligations and advised
7 utilities not to squander the opportunity to strengthen the
8 balance sheet as a buffer against future uncertainties. 34
9 Moody's recently noted that, absent a stronger equity
10 cushion, utilities would be faced with lower credit ratings
11 in the face of rising business and operating risks:
12 There are significant negative trends developing13 over the longer-term horizon. This developing14 negative concern primarily relates to our view15 that the sector's overall business and operating16 risks are rising - at an increasingly fast pace -17 but that the overall financial profile remains18 relatively steady. A rising risk profile19 accompanied by a relatively stable balance sheet20 profile would ultimately result in credit quality
21 deterioration.
35
22 This is especially the case for electric utilities that are
23 exposed to the potential for significant fluctuations in
24 power supply costs, such as Avista.
34 Moody's Investors Service, UStorm Clouds Gathering on the Horizon
for the North American Electric Utility Sector," Special Comment (Aug.
2007) .35 Moody's Investors Service, "u. S. Electric Utility Sector," Industry
Outlook (Jan. 2008).
Avera, Di 24
Avista Corporation
1
2
3
Q. What other factors do investors consider in their
assessment of a company's capital structure?
A. Depending on their specific attributes,
4 contractual agreements or other obligations that require
5 the utility to make specified paYfents may be treated as
6 debt in evaluating Avista' s financial risk.Because power
7 purchase agreements (~PPAs") and leases typically obligate
8 the utility to make specified minimum contractual paYfents
9 akin to those associated with traditional debt financing,
10 investors consider a portion of these commitments as debt
11 in evaluating total financial risks.Because investors
12 consider the debt impact of such fixed obligations in
13 assessing a utility's financial position,they imply
14 greater risk and reduced financial flexibility.In order
15 to offset the debt equivalent associated with off-balance
16 sheet obligations, the utility must rebalance its capital
17 structure by increasing its common equity in order to
18 restore its effective capitalization ratios to previous
19 levels. 36
20 Reflecting the longstanding perception of investors
21 that the fixed obligations associated with PPAs, leases,
22 and other off-balance sheet obligations diminish a
23 utility's creditworthiness and financial flexibility, the
36 The capital structure ratios presented earlier do not include
imputed debt associated with power purchase agreements or the impact
of other off-balance sheet obligations.
Avera, Di 25
Avista Corporation
1 implications of these commitments have been repeatedly
2 ci ted by maj or bond rating agencies in connection with
3 assessments of utility financial risks.For example, in
4 explaining its evaluation of the credit implications of
5 PPAs, S&P affirmed its position that such agreements give
6 rise to ~debt equivalents" and that the increased financial
7 risk must be considered in evaluating a utility's credit
8 risks. 37 As the rating' agency explained:
9
10
11
12
13
14
15
16
17
18
19
20
21
22
For many years, Standard & Poor's Ratings
Services has viewed power supply agreements (PPA)
in the U. S. utility sector as creating fixed,
debt-like, financial obligations that represent
substitutes for debt-financed capital investments
in generation capacity. In a sense, a utility
that has entered into a PPA has contracted with a
supplier to make the financial investment on its
behalf. Consequently, PPA fixed obligations, in
the form of capacity paYfents, merit inclusion in
a utility's financial metrics as though they are
part of a utility's permanent capital structure
and are incorporated in our assessment of a
utility's creditworthiness. 38
23 Apart from reaffirming the importance of imputed debt in
24 its analysis of credit standing, S&P also noted that it has
25 refined its methodology to include imputed debt associated
26 with shorter-term PPAs. 39 Similarly, S&P recently affirmed
27 its policy of modifying a utility's balance sheet to
37 Standard & Poor's Corporation, u Standard & Poor's Methodology For
Imputing Debt For U.S. Utilities' Power Purchase Agreements,"
RatingsDirect (May 7, 2007).38 Id.
39 Id.
Avera, Di 26
Avista Corporation
10
1 include the debt equivalents associated with operating
2 leases. 40
3 As discussed earlier, a significant portion of the
4 Company's power requirements are currently obtained through
5 purchased power contracts.These contractual paYfent
6 obligations, along with operating leases and obligations
7 associated with postretirement benefits,fixedare
8 commitments with debt-like characteristics and are properly
9 considered when evaluating the financial risks implied by
Avista's capital structure.S&P reported that it adjusts
11 Avista' s capitalization to include approximately $226
12
13
million in imputed debt from off-balance sheet
bl' . 41o igations.Unless the Company takes action to offset
14 this additional financial risk by maintaining a higher
15 equity ratio, the resulting leverage will weaken Avista's
16
17
18
19
20
21
creditworthiness, implying a higher required rate of return
to compensate investors for the greater risks. 42
Q. What did you conclude with respect to the
Company's capital structure?
A. Based on my evaluation, I concluded that Avista' s
requested capital structure represents a reasonable mix of
40 Standard & Poor's Corporation, "Implications Of Operating Leases On
Analysis Of u.s. Electric Utilities," RatingsDirect (Jan. 15, 2008).41 Standard & Poor's Corporation, "Avista Corp.," RatingsDirect (Aug.
1, 2007).42 Apart from the immediate impact that the fixed obligation of
purchased power costs has on the utility's financial risk, higher
fixed charges also reduce ongoing financial flexibility, and the
utility may face other uncertainties, such as potential replacement
power costs in the event of supply disruption.
Avera, Di 27
Avista Corporation
1 capital sources from which to calculate the Company's
2 overall rate of return.Avista's requested common equity
3 ratio is entirely consistent with the average capital
4 structure for the utility proxy group, based on year-end
5 2007 data and Value Line's near-term projections.
6 While industry averages provide one benchmark for
7 comparison, each firm must select its capitalization based
8 on the risks and prospects it faces, as well its specific
9 needs to access the capital markets. A public utility with
10 an obligation to serve must maintain ready access to
11 capital under reasonable terms so that it can meet the
12 service requirements of its customers. The need for access
13 becomes even more important when the company has capital
14 requirements over a period of years, and financing must be
15 continuously available, even during unfavorable capital
16 market conditions.
17 Avista's capital structure reflects the Company's
18 ongoing efforts to strengthen its credit standing and
19 support access to capital on reasonable terms.As
20 indicated earlier, the challenges posed by significant
21 capi tal requirements, volatile energy prices, and reliance
22 on hydro generation and wholesale markets magnifies the
23 importance of preserving financial flexibility.Moody's
24 observed that Avista's financial metrics have been
25 pressured by the need to finance power cost deferrals
Avera, Di 28
Avista Corporation
1 during low-water years,and noted that its ratings
2 anticipate ~conservative financing strategies. ,,43 Financial
3 flexibili ty plays a crucial role in ensuring the
4 wherewithal to meet the needs of customers, and utilities
5 wi th higher leverage may be foreclosed from addi tional
6 borrowing, especially during times of stress.In this
7 regard, Avista' s equity ratio reflects the challenges posed
8 by its resource mix, as well as the burden of significant
9 capital spending requirements.
10 III. CAPITAL MAT ESTIMATES
11
12
Q.
A.
What is the purpose of this section?
This section presents capital market estimates of
13 the cost of equity.The details of my quantitative
14 analyses are contained in Schedule WEA-2, with the results
15 being sumarized below.
16 A. Overview
17
18
19
Q. What role does the rate of
equity play in a utility's rates?
A. The return on common equity
return on common
is the cost of
20 inducing' and retaining investment in the utility's physical
21 plant and assets.This investment is necessary to finance
22 the asset base needed to provide utility service.
23 Investors will commit money to a particular investment only
43 Moody's Investors Service, UCredit Opinion: Avista Corp.," Global
Credit Research (Dec. 21, 2007).
Avera, Di 29
Avista Corporation
1 if they expect it to produce a return commensurate with
2 those from other investments with comparable risks.
3 Moreover, the return on common equity is integral in
4 achieving the sound regulatory objectives of rates that are
5 sufficient to: 1) fairly compensate capital investment in
6 the utility, 2) enable the utility to offer a return
7 adequate to attract new capital on reasonable terms, and 3)
8 maintain the utility's financial integrity. Meeting these
9 objectives allows the utility to fulfill its obligation to
10 provide reliable service while meeting the needs of
11 customers through necessary system expansion.
12 Q. Did you rely on a single method to estimate the
13 cost of equity for Avista?
14 A. No. In my opinion, no single method or model
15 should be relied upon to determine a utility's cost of
16 equity because no single approach can be regarded as wholly
17 reliable.As the Federal Communications Commission
18 recognized:
19 Equity prices are established in highly volatile20 and uncertain capital markets. Different
21 forecasting methodologies compete with each other
22 for eminence, only to be superceded by other23 methodologies as conditions change. . .. In these24 circumstances, we should not restrict ourselves
25 to one methodology, or even a series of26 methodologies, that would be applied27 mechanically. Instead, we conclude that we
Avera, Di 30
Avista Corporation
1
2
should adopt a more accommodating and flexible.. 44position.
3 Therefore, I used both the DCF and CAPM methods to estimate
4 the cost of equity.In addition, I also evaluated a fair
5 ROE return us ing an earnings approach based on inves tors'
6 current expectations in the capital markets.In my
7 opinion, comparing estimates produced by one method with
8 those produced by other approaches ensures tha t the
9 estimates of the cost of equity pass fundamental tests of
10 reasonableness and economic logic.
11 Q. What was your conclusion regarding a fair rate of
12 return on equity for the proxy companies?
13 A. Based on the results of my quantitative analyses,
14 and my assessment of the relative strengths and weaknesses
15 inherent in each method, I concluded that the cost of
16
17
18
19
20
21
22
23
24
equity for the proxy companies is in the 10.7 percent 12.2
percent range.
B. Results of Quantitative Anlyses
Q. How did you define the proxy groups you used to
implement the DCF model?
A. In estimating the cost of equity, the DCF model
is typically applied to publicly traded firms engaged in
similar business activities or with comparable investment
risks.As described in detail in Schedule No. WEA-2, I
44 Federal Communications Commission, Report and Order 42-43, CC Docket
No. 92-133 (1995).
Avera, Di 31
Avista Corporation
1 applied the DCF model to a utility proxy group composed of
2 those dividend-paying companies included by Value Line in
3 its Electric Utilities Industry groups with:(1) S&P
4 corporate credit ratings between ~BBB-" and "BBB+," (2) a
5 Value Line Safety Rank of ~2tt or ~3tt, (3) a Value Line
6 Financial Strength Rating of ~B+" to ~B++" , and (4)
7 published growth estimates from IBES,45 Value Line, Reuters,
8 Inc. (~Reuters"), and Zacks Investment Research (~Zacks").
9 I excluded two companies that otherwise would have been in
10 the proxy group because they are in the process of being
11 acquired.
12 Under the regulatory standards established by Hope and
13 Bluefield,the salient criteria in establishing a
14 meaningful benchmark to evaluate a fair rate of return is
15 relative risk, not the particular business activity or
16 degree of regulation.Consistent with this accepted
17 regulatory standard, I also applied the DCF model to a
18 reference group of comparable risk companies in the non-
19 utility sector of the economy. My assessment of comparable
20 risk relied on three objective benchmarks for the risks
21 associated with common stocks -- Value Line's Safety Rank,
22 Financial Strength rating, and beta. My non-utility proxy
23 group was composed of those U. S. companies followed by
45 IBES growth rates are compiled and reported by Thompson Financial,
an arm of The Thompson Corporation, which also publishes consensussecuri ties analyst growth rates under the First Call brand.
Avera, Di 32
Avista Corporation
8
9
10
11
12
13
14
15
1 Value Line that 1) pay common dividends, 2) have a Safety
2 Rank of ~ 1", 3) have a Financial Strength Rating of ~A" or
3 above, 4) have beta values of 0.90 or less,46 and 5) have
4 published data from IBES, Value Line, Reuters, and Zacks.
5
6
Consistent with the development of my utility proxy group,
I also eliminated firms with below-investment grade credit
7 ratings.
Q. How do the overall risks of your proxy groups
compare with Avista?
A. As shown below, Table 1 compares the non-utility
proxy group with the utility proxy group and Avista across
four key indicators of investment risk:
TABLE 1
COMPARISON OF RISK INDICATORS
S&P Value Line
Credit Safety Financial
Rating Rak Strength ~
Non-Utility Group A+i A+0.80
Utility Proxy Group BBB 3 B++0.89
Avista Corp.BBB-3 B+0.95
16 Considered together, a comparison of these objective
17 measures indicates that the risks investors associate with
18
19 result, the cost of equity estimates indicated by my
Avista generally exceed those of the proxy groups.As a
46 This threshold corresponds to the average beta of 0.89 for the
utili ty proxy group discussed earlier.
Avera, Di 33
Avista Corporation
1 analyses provide a conservative estimate of investors'
2 required rate of return for Avista.
3 Q. What cost of equity is implied by your DCF
4 resul ts for the utility proxy group?
5 A. My application of the DCF model, which is
6 discussed in greater detail in Schedule No. WEA-2,
7 considered four alternative measures of expected earnings
8 growth, as well as the sustainable growth rate based on the
9 relationship between expected retained earnings and earned
10 rates of return ("br + sv").As shown on Schedule WEA-4
11 and sumarized below in Table 2,after eliminating
12 illogical low- and high-end values, application of the
13 constant growth DCF model resulted in the following cost of
14 equity estimates:15 TABLE 2
16 DCF RESULTS - UTILITY PROXY GROUP
Growth Rate
IBES
Value LineReuters
Zacks
br+sv
Average Cost of Equity
11'.3%
10.4%
10.6%
10.9%
9.2%
17
18 Taken together, and considering the relative strengths and
19 weaknesses associated with the alternative growth measures,
20 I concluded that the constant growth DCF results for the
21 utility proxy group implied a cost of equity of 10.8
22 percent.
Avera, Di 34
Avista Corporation
1
2
3
Q. What were the results of your DCF analysis for
the non-utility reference group?
A. As shown on Schedule WEA-6, I applied the DCF
4 model to the non-utility companies in exactly the same
5 manner described earlier for the utility proxy group.As
6 surarized below in Table 3, after eliminating illogical
7 low- and high-end values, application of the constant
8 growth DCF model resulted in the following cost of equity
9 estimates:10 TABLE 311 DCF RESULTS - NON-UTILITY GROUP
Growth Rate
IBES
Value LineReuters
Zacks
br+sv
Average Cost of Equity
12.9%
12.2%
12.5%
12.7%
13.0%
12
13 Based on my assessment of these results, I concluded that
14 the constant growth DCF results for the non-utility proxy
15 group implied a cost of equity of 12.6 percent.
16 Q.Do you believe the constant growth DCF model
17 should be relied on exclusively to evaluate a reasonable
18
19
ROE for Avista?
A. No.Because the cost of equity is unobservable,
20 no single method should be viewed in isolation. While the
21 DCF model has been routinely relied on in regulatory
22 proceedings as one guide to investors' required return, it
23 is a blunt tool that should not be used exclusively.
Avera, Di 35
Avista Corporation
1 Regulators have customarily considered the results of
2 alternative approaches in determining allowed returns. 47 It
3 is widely recognized that no single method can be regarded
4 as a panacea; all approaches having their own advantages
5 and shortcomings.For example, a publication of the
6 society of Utility and Financial Analysts (formerly the
7 National Society of Rate of Return Analysts), concluded
8 that:
9 Each model requires the exercise of judgment as
10 to the reasonableness of the underlying
11 assumptions of the methodology and on the12 reasonableness of the proxies used to validate13 the theory. Each model has its own way of14 examining investor behavior, its own premises,15 and its own set of simplifications of reality.
16 Each method proceeds from different fundamental17 premises, most of which cannot be validated18 empirically. Investors clearly do not subscribe19 to any singular method, nor does the stock price20 reflect the application of anyone single method21 by investors. 48
22 Moreover, evidence suggests that reliance on the DCF
23 model as a tool for estimating investors' required rate of
24 return has declined outside the regulatory sphere, with the
25 CAPM being ~the dominant model for estimating the cost of
47 For example, a NARUC survey reported that 26 regulatory
jurisdictions ascribe to no specific method for setting allowed ROEs,
with the results of all approaches being considered. "Utility
Regulatory Policy in the U.S. and Canada, 1995-1996," National
Association of Regulatory Utility Commissioners (Decemer 1996).4B Parcell, David C., "The Cost of Capital - A Practitioner's Guide,"
Society of Utility and Regulatory Financial Analysts (1997) at Part 2,
p. 4.
Avera, Di 36
Avista Corporation
1 . 49equity. "Regulatory Finance: Utilities Cost of Capital
2 noted the inherent difficulties of the DCF approach:
3 (C) aution and judgment are required in
4 interpreting the results of DCF models because of
5 (1) the questionable applicability of the DCF
6 model to utility stocks in certain market
7 environments, (2) the effect of declining
8 earnings and dividends on financial inputs to the
9 DCF model and biases caused by the effect of10 changes in risk and growth, and (3) the11 conceptual and practical difficulties associated
12 wi th the growth component of the DCF model. 50
13 The publication concluded,~If the cost of equity
14 estimation process is limited to one methodology, such as
15 DCF, it may severely bias the results. ,,51
16
17
18
Q. How did you apply the CAPM to estimate the cost
of equity?
A. Like the DCF model, the CAPM is an ex-ante, or
19 forward-looking model based on expectations of the future.
20 As a result, in order to produce a meaningful estimate of
21 investors' required rate of return, the CAPM is best
22 applied using estimates that reflect the expectations of
23 actual investors in the market, not with backward-looking,
24 historical data.
25 I applied the CAPM to the utility proxy group based on
26 a forward-looking estimate for investors' required rate of
49See, e.g., Bruner, R.F., Eades, K.M., Harris, R.S., and Higgins,
R. C., "Best Practices in Estimating Cost of Capital: Survey and
Synthesis," Financial Practice and Education (1998).50 Morin, Roger A., "Regulatory Finance: Utilities' Cost of Capital,"
Public Utilities Reports, Inc. (1994) at 238.51 Id.
Avera, Di 37
Avista Corporation
1 return from common stocks.In addition, because it is
2 frequently referenced in regulatory proceedings, I also
3 applied the CAPM using risk premiums based on historical
4 realized rates of return published by Ibbotson Associates
5 (now Morningstar). Reference to historical data represents
6 one way to apply the CAPM, but these realized rates of
7 return reflect, at best, an indirect estimate of investors'
8 current requirements.As a result,forward-looking
9 applications of the CAPM that look directly at investors'
10 expectations in the capital markets are apt to provide a
11 more meaningful guide to investors' required rate of
12 return.
13 Q. What cost of equity was indicated by the CAPM
14 approach?
15 A. As shown on Schedule WEA-8, my forward-looking
16 application of the CAPM model indicated an ROE of
17 approximately 12.2 percent for the utility proxy group.
18 Applying the forward-looking CAPM approach to the firms in
19 the non-utility proxy group (Schedule WEA-9) implied a cost
20 of equity of 11.4 percent.
21 Application of the CAPM to the firms in the utility
22 and non-utility proxy groups using risk premiums based on
23 historical realized rates of return published by Ibbotson
24 Associates is presented on Schedules WEA-10 and WEA-11,
25 respectively.As shown there,this historical CAPM
26 approach implied a cost of equity of 10.7 percent for the
Avera, Di 38
Avista Corporation
1 utility proxy group and 10.0 percent for the firms in the
2 non-utility proxy group.
3 Q. Wht other analyses did you conduct to estimate
4 the cost of equity?
5 A. As I noted earlier, I also evaluated the cost of
6 equi ty using the expected earnings method.Reference to
7 rates of return available from alternative investments of
8 comparable risk can provide an important benchmark in
9 assessing the return necessary to assure confidence in the
10 financial integrity of a firm and its ability to attract
11 capital.This expected earnings approach is consistent
12 wi th the economic underpinnings for a fair rate of return
13 established by the Supreme Court. Moreover, it avoids the
14 complexities and limitations of capital market methods and
15 instead focuses on the returns earned on book equity, which
16 are readily available to investors.
17 Q. What rates of return on equity are indicated for
18 utilities based on the expected earnings approach?
19 A. Value Line reports that its analysts anticipate
20 an average rate of return on common equity for the electric
21 utility industry of 11.5 percent over its forecast
22 horizon,
52 with natural gas distribution utilities expected
23 to earn an average rate of return on common equity of 11.5
52 The Value Line Investment Survey at 1776 (Feb. 8, 2008).
Avera, Di 39
Avista Corporation
1 percent to 12.0 percent. 53 As shown on Schedule WEA- 12,
2 Value Line's projections for the utility proxy group
3 suggested an average ROE of 10.5 percent after eliminating
4 potential outliers. 54 Based on the results discussed above,
5 I concluded that the expected earnings approach implies a
6 fair rate of return on equity of 11.0 percent.
7
8
9
Q. Wht did you
equi ty implied by your
A. The cost of
conclude
analyses
equity
wi th respect to the cost
for the proxy groups?
estimates implied by
of
my
10 quantitative analyses are sumarized in Table 4, below:11 TABLE 412 SUMY OF QUANITATIVE RESULTS
Method
DCF
CAPM
Forward - looking
Historical
Expected Earnings
Cost of Equity Estimates
utility Non-utility
Proxy Group Proxy Group
10.7%12.6%
12.2%
10.7%
11. 0%
11.4%
10.0%
13 Based on the results of my quantitative analyses, and
14 my assessment of the relative strengths and weaknesses
15 inherent in each method, I concluded that the cost of
16 equi ty is in the 10.7 percent to 12.2 percent range.
53 The Value Line Investment Survey 445 (Dec. 14, 2007).54 As highlighted on Schedule WEA-12, I eliminated two low-end
estimates of 7.1 percent, as well as an extreme high-end outlier of24.4%. While these three Value Line proj ections may accurately
reflect expectations for actual earned rates of return on common
equity over the forecast horizon, they are unlikely to berepresentati ve of investors' required rate of return.
Avera, Di 40
Avista Corporation
1 iv. RETUR ON EQUITY FOR AVISTA CORP.
2
3
Q.
A.
What is the purpose of this section?
In addition to presenting the conclusions of my
4 evaluation of a fair rate of return on equity range for
5 Avista,this section also discusses the relationship
6 between ROE and preservation of a utility's financial
7 integrity and the ability to attract capital under
8 reasonable terms on a sustainable basis.
9 A. implications for Financial integrity
10 Q. Why is it important to allow Avista an adequate
11 return on equity?
12 A. Given the importance of the utility industry to
13 the economy and society, it is essential to maintain
14 reliable and economical service to all consumers.While
15 Avista remains committed to provide reliable utility
16 service, a utility's ability to fulfill its mandate can be
17 compromised if it lacks the necessary financial wherewithal
18 or is unable to earn a return sufficient to attract
19 capital.Coupled with the ongoing potential for energy
20 market volatility,Avista's plans for infrastructure
21 investment and ongoing exposure to regulatory uncertainty
22 pose a numer of potential challenges that might require
23 the relatively swift commitment of significant capital
24 resources in order to maintain the high level of service
25 that customers have come to expect.
Avera, Di 41
Avista Corporation
1 As documented earlier, the maj or rating agencies have
2 warned of exposure to uncertainties associated with
3 poli tical and regulatory developments, especially in view
4 of the pressures associated with large capital expenditure
5 programs and the potential for high and volatile commodity
6 costs in wholesale energy markets.Inves tors unders tand
7 just how swiftly unforeseen circumstances can lead to
8 deterioration in a utility's financial condition, and
9 stakeholders have discovered first hand how difficult and
10 complex it can be to remedy the situation after the fact.
11 While providing the infrastructure necessary to enhance the
12 power system and meet the energy needs of customers is
13
14
15
certainly desirable,it imposes additional financial
responsibili ties on Avista.For a utility with an
16 increased reticence to supply additional capital during
obligation provide reliable service,investors'to
17 times of crisis highlights the necessity of preserving the
18 flexibility necessary to overcome periods of adverse
19
20
21
22
23
24
25
These considerations heightencapi tal market conditions.
the importance of allowing Avista an adequate return on the
fair value of its investment.
Q. What role does. regulation play in ensuring that
Avista has access to capital under reasonable terms and on
a sustainable basis?
A. Considering investors' heightened awareness of
26 the risks associated with the utility industry and the
Avera, Di 42
Avista Corporation
1 damage that results when a utility's financial flexibility
2 is compromised, supportive regulation remains crucial to
3 Avista's access to capital.Investors recognize that
4 regulation has its own risks,and that constructive
5 regulation is a key ingredient in supporting utility credit
6 ratings and financial integrity, particularly during times
7 of adverse conditions. S&P noted that:
8
9
10
11
12
13
14
Regulatory rulings have returned to center stage
as a dominant factor in assessing companies'
credit quality. These decisions will be critical
for an industry that in many jurisdictions is
nearing the end of extended transition periods
and will be making significant capital investment
in infrastructure during the next several years. 55
15 with respect to Avista specifically, the major bond
16 rating agencies have noted the near-term challenges posed
17 by upward pressure on costs and rising capital
18 expendi tures, while explicitly citing the potential that
19 adverse regulatory rulings could compromise the Company's
20 credi t standing. 56 Of particular concern to investors is
21 the impact of regulatory lag and cost-recovery on Avista' s
22 ability to earn its authorized ROE and maintain its
23 financial metrics, with Moody's noting an ongoing need for
55 Standard & Poor's Corporation, U Industry Report Card: U. S.
Electric/Gas/Water," RatingsDirect (May 3,2005).56 See, e.g., Standard & Poor's Corporation, UAvista Corp.'s Corporate
Credit Rating Raised One Notch To 'BBB-'," RatingsDirect (Feb 7,
2008); Moody's Investors Service, "Credit Opinion: Avista Corp.,"
Global Credit Research (Dec. 21, 2007).
Avera, Di 43
Avista Corporation
1 supportive regulation in light of a significant capital
2 investment program.
57 Moody's concluded:
3 Continuation of supportive treatment in future
4 PGA and general rate cases would be particularly
5 important in helping Avista continue to make
6 progress towards consistently earning at the7 utility division's allowed level of return on its
8 inves tmen t . 58
9 S&P concluded that Avista' s credit outlook could be revised
10 to "negative" if the Company's financial profile is
11 weakened due to an inability to obtain timely rate relief. 59
12 Moreover, the negative impact of declining credit
13 quality on a utility's capital costs and financial
14 flexibility becomes more pronounced as debt ratings move
15 down the scale from investment to non-investment grade. In
16 light of Avista' s present ratings, an inadequate rate of
17 return imposed in this proceeding would further pressure
18 the Company's financial flexibility and credit standing.
19
20
21
22
Q.
highlight
financial
Do the potential exposures
the need for ongoing support
strength and ability to attract
Most definitely. Avista must
faced by Avista
of the Company's
capital?
finance a maj orA.
23 construction program and a numer of potential challenges
24 might require the relatively swift commitment of capital
25 resources in order to maintain the high level of service to
57 Moody's Investors Service, "Credit Opinion: Avista Corp.," Global
Credit Research (Dec. 21, 2007).58 Id..
59 Standard & Poor's Corporation, UAvista Corp.' s Corporate Credit
Rating Raised One Notch To 'BBB-'," RatingsDirect (Feb. 7, 2008).
Avera, Di 44
Avista Corporation
1 which its customers have become accustomed.Avista faces
2 the potential for fluctuating stream flows and significant
3 volatili ty in wholesale fuel and energy markets.S&P
4 concluded that Avista' s ~key utility risk going forward is
5 its exposure to high-cost replacement power, particularly
6 in low water years. ,,60 Given utili ties' lack of control
7 over the timing of such events, the Company must have the
8 wherewi thal to meet these challenges even when capital and
9 energy market conditions are unfavorable.
10 For Avista, these concerns are magnified by the fact
11 that its credit standing remains relatively weak.While
12 the Company's efforts to regain an investment grade credit
13 rating have been successful, Avista' s financial metrics
14 remain pressured.As Mr. Malquist confirms in his
15 testimony, regulatory support will be a key driver in
16 securing additional progress towards restoring the
17 Company's financial health. Further strengthening Avista's
18 financial integrity is imperative to ensure that the
19 Company has the capability to maintain an investment grade
20 rating while confronting potential challenges.
60 Standard & Poor's Corporation, "Avista Corp.'s Corporate Credit
Rating Raised One Notch To 'BBB-'," RatingsDirect (Feb. 7, 2008).
Avera, Di 45
Avista Corporation
1 Q. Do customers benefit by enhncing the utility's
2 financial flexibility?
3 A. Yes. While providing an ROE that is sufficient
4 to maintain Avista's ability to attract capital, even in
5 times of financial and market stress, is consistent with
6 the economic requirements embodied in the Supreme Court' s
7 Hope and Bluefield decisions, ¡t is also in customers' best
8 interests.Ultimately, it is customers and the service
9 area economy that enjoy the benefits that come from
10 ensuring that the utility has the financial wherewithal to
11 take whatever actions are required to ensure reliable
12 service.By the same token, customers also bear a
13 significant burden when the ability of the utility to
14 attract necessary capital is impaired and service quality
15 is compromised.
16 B. Flotation Costs
17 Q. Wht other considerations are relevant in setting
18 the return on equity for a utility?
19 A. The common equity used to finance the investment
20 in utility assets is provided from either the sale of stock
21 in the capi tal markets or from retained earnings not paid
22 out as dividends.When equity is raised through the sale
23 of common stock, there are costs associated with ~floating"
24 the new equity securities.These flotation costs include
25 services such as legal, accounting, and printing, as well
26 as the fees and discounts paid to compensate brokers for
Avera, Di 46
Avista Corporation
1 selling the stock to the public. Also, some argue that the
2 "market pressure" from the additional supply of common
3 stock and other market factors may further reduce the
4 amount of funds a utility nets when it issues common
5 equity.
6 Q.Is there an established mechanism for a utility
7 to recognize equity issuance costs?
8 A. No. While debt flotation costs are recorded on
9 the books of the utility, amortized over the life of the
10 issue, and thus increase the effective cost of debt
11 capital, there is no similar accounting treatment to ensure
12 that equity flotation costs are recorded and ultimately
13 recognized. Alternatively, no rate of return is authorized
14 on flotation costs necessarily incurred to obtain a portion
15 of the equity capital used to finance plant.In other
16 words, equity flotation costs are not included in a
17 utility's rate base because neither that portion of the
18 gross proceeds from the sale of common stock used to pay
19 flotation costs is available to invest in plant and
20 equipment, nor are flotation costs capitalized as an
21 intangible asset.Unless some provision is made to
22 recognize these issuance costs,a utility's revenue
23 requirements will not fully reflect all of the costs
24 incurred for the use of investors' funds. Because there is
25 no accounting convention to accumulate the flotation costs
26 associated with equity issues, they must be accounted for
Avera, Di 47
Avista Corporation
10
11
1 indirectly, with an upward adjustment to the cost of equity
2 being the most logical mechanism.
3
4
5
Q. What is the magnitude of the adjustment to the
"bare bones" cost of equity to account for issuance costs?
A. There are any numer of ways in which a flotation
6 cost adjustment can be calculated, and the adjustment can
7 range from just a few basis points to more than a full
8 One of the most common methods used to accountpercent.
9 for flotation costs in regulatory proceedings is to apply
an average flotation-cost percentage to a utility's
di vidend yield.Based on a review of the finance
12 li terature, Regulatory Finance: Utili ties' Cost of Capi tal
13
14
15
16
17
18
concluded:
allowance requires anthe return on equi ty of
depending on the size
The flotation costestimated adjustment to
approximately 5% to 10%,
and risk of the issue. 61
Al ternati vely,a study of data from Morgan Stanley
19 regarding issuance costs associated with utility common
20 stock issuances flotation costsuggestsanaverage
21 percentage of 3.6%.62 Applying these expense percentages to
22 a representative dividend yield for a utility of 4.0
61 Roger A. Morin, Regulatory Finance: Utilities' Cost of Capital, 1994,
at 166.62 Application of Yankee Gas Services Company for a Rate Increase, DPUC
Docket No. 04-06-01, Direct Testimony of George J. Eckenroth (Jul. 2,
2004) at Exhibit GJE-11.1. Updating the results presented by Mr.
Eckenroth through April 2005 also resulted in an average flotation
cost percentage of 3.6%.
Avera, Di 48
Avista Corporation
i percent implies a flotation cost adjustment on the order of
2 14 to 40 basis points.
3
4
5
Q. Has
flotation costs
A. Yes.
the i PUC Staff previously considered
in estimating a fair ROE?
For example, in Case No. IPC-E-07-8, IPUC
6 Staff witness Terri Carlock noted that she had adjusted her
7 DCF analysis to incorporate an allowance for flotation
8 costS.63 While issuance costs are a legitimate
9 consideration in setting the return on equity for a
10 utility, a specific adjustment for flotation costs was not
11 included in defining my recommended ROE range.
12 c. Return on EQUity Recommendation
13 Q. What then is your conclusion as to a fair rate of
14 return on equity range for Avista?
15 A. As explained above,. based on the capital market
16 oriented analyses for the utility and non-utility proxy
17 groups described in my testim~ny, I concluded that the fair
18 rate of return on equity range was 10.7 percent to 12.2
19 percent.Considering capital market expectations, the
20 potential exposures faced by Avista, and the economic
21 requirements necessary to maintain financial integrity and
22 support additional capital investment even under adverse
23 circumstances, it is my opinion that this represents a fair
24 and reasonable ROE range for Avista.
63 Case No. IPC-E-07-8, Direct Testimony of Terri Carlock at 10 (Dec.
10, 2007).
Avera, Di 49
Avista Corporation
1 Q. Based on the results of your evaluation, what is
2 your opinion regarding the reasonaleness of the ROE
3 requested by Avista in this case?
4 A. My evaluation indicates that Avista' s requested
5 ROE of 10.8 percent represents a conservative estimate of
6 investors' required rate of return.Given the fact that
7 the Company's requested ROE falls barely above the lower
8 bound of my recommended range, it should be viewed as an
9 absolute floor in establishing rates for Avista.This
10 conclusion is reinforced by the need to buttress the
11 Company's credit standing, which remains relatively weak,
12 as well as the pressures of funding significant capital
13 expendi tures and meeting increased operating risks,
14 including those associated with Avista' s reliance on
15 hydroelectric generation and wholesale energy markets. The
16 reasonableness of a minimum 10.8 percent ROE for Avista is
17 also supported by the Company's relatively greater risks as
18 compared with the proxy groups, the higher uncertainties
19 associated with Avista' s relatively small size, and the
20 fact that my recommended ROE range does not consider
21 flotation costs.
22
23
24
Q. Does
testimony?
A. Yes.
this conclude your pre-filed direct
Avera, Di 50
Avista Corporation
DAVID J. MEYER
VICE PRESIDENT, GENERA COUNSEL, REGULi~R&3 lNf2=41
GOVERNENTAL AFFAIRS
AVISTA CORPORATION
P.O. BOX 3727
1411 EAST MISSION AVENUE
SPOKAE, WASHINGTON 99220-3727
TELEPHONE: [phone]
FACSIMILE: [phone]
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION ) CASE NO. AVU-E-08-01
OF AVISTA CORPORATION FOR THE ) CASE NO. AVU-G-08-01
AUTHORITY TO INCREASE ITS RATES )
AND CHARGES FOR ELECTRIC AN )
NATURAL GAS SERVICE TO ELECTRIC ) EXHIBIT NO. 3
AN NATURAL GAS CUSTOMERS IN THE )STATE OF IDAHO ) WILLIAM E. AVERA
)
FOR AVISTA CORPORATION
(ELECTRIC AND NATURAL GAS)
SCHEDULE WE-l
QUALIFICATIONS OF WILLIAM E. AVERA
1 Q.What is the purpose of this exhibit?
2 A.This exhibi t describes my background and exerience
3 and contains the details of my qualifications.
4 Q.What are your qualifications?
5 A.I received a B. A. degree wi th a maj or in economics
6 from Emory University.After serving in the U. S. Navy, I
7 entered the doctoral program in economics at the University
8 of North Carolina at Chapel Hill. Upon receiving my Ph.D., I
9 joined the faculty at the University of North Carolina and
10 taught finance in the Graduate School of Business.I
11 subsequently accepted a position at the university of Texas
12 at Austin where I taught courses in financial management and
13 investment analysis. I then went to work for International
14 Paper Company in New York City as Manager of Financial
15 Education, a position in which I had responsibility for all
16 corporate education programs in finance, accounting, and
17 economics.
18 In 1977, I joined the staff of the Public Utility
19 Commission of Texas (PUCT) as Director of the Economic
20 Research Division. During my tenure at the PUCT, I managed a
21 division responsible for financial analysis, cost allocation
22 and rate design, economic and financial research, and data
23 processing systems, and I testified in cases on a variety of
Exhibi t No. 3
Case Nos AVU-E-08-01 &
AVU-U-08-01
W. Avera, Avista
Schedule WEA-1 p. 1 of 10
1 financial and economic issues.Since leaving the PUCT, I
2 have been engaged as a consultant. I have participated in a
3 wide range of assignents involving utility-related matters
4 on behalf of utilities, industrial customers, municipalities,
5 and regulatory commissions.I have previously testified
6 before the Federal Energy Regulatory Commission (~FERC"), as
7 well as the Federal Communications Commission ("FCC"), the
8 Surface Transportation Board (and its predecessor, the
9 Interstate Commerce Commission) ,the Canadian Radio-
10 Television and Telecommunications Commission, and regulatory
11 agencies, courts, and legislative committees in 39 states.
12 In 1995, I was appointed by the PUCT to the SYnchronous
13 Interconnection Committee to advise the Texas legislature on
14 the costs and benefits of connecting Texas to the national
15 electric transmission grid.In addition, I served as an
16 outside director of Georgia System Operations Corporation,
17 the system operator for electric cooperatives in Georgia.
18 I have served as Lecturer in the Finance Department at
19 the University of Texas at Austin and taught in the evening
20 graduate program at St. Edward's University for twenty years.
21 In addition, I have lectured on economic and regulatory
22 topics in programs sponsored by universities and industry
23 groups.I have taught in hundreds of educational programs
24 for financial analysts in programs sponsored by the
25 Association for Investment Management and Research, the
Exhibi t No. 3
Case Nos AVU-E-08-01 &
AVU-U-08-01
W. Avera, Avista
Schedule WEA-1 p. 2 of 10
1 Financial Analysts Review, and local financial analysts
2 societies.These programs have been presented in Asia,
3 Europe, and North America, including the Financial Analysts
4 Seminar at Northwes tern Uni vers i ty .I hold the Chartered
5 Financial Analyst (CFA~) designation and have served as Vice
6 President for Membership of the Financial Management
7 Association. I have also served on the Board of Directors of
S the North Carolina Society of Financial Analysts.I was
9 elected Vice Chairman of the National Association of
10 Regulatory Commissioners (~NARUC") Subcommittee on Economics
11 and appointed to NARUC's Technical Subcommittee on the
12 National Energy Act.I have also served as an officer of
13 various other professional organizations and societies. A
14 resume containing the details of my experience and
15 qualifications is attached.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-U-OS-01
W. Avera, Avista
Schedule WEA- 1 p. 3 of 10
WILLIAM E. AVERA
FINCAP i INC.
Financial Concepts and Applications
Economic and Financial Counsel
3907 Red River
Austin, Texas 78751
[phone]
FAX [phone]
fincap&texas. net
Sumry of Qualifications
Ph.D. in economics and finance; Chartered Financial Analyst (CFA~)designation; extensive expert witness testimony before courts,al ternati ve dispute resolution panels, regulatory agencies and
legislative committees; lectured in executive education programs around
the world on ethics, investment analysis, and regulation; undergraduate
and graduate teaching in business and economics; appointed to
leadership positions in government, industry, academia, and themilitary.
Employment
Principal,
FINCAP, Inc.
(Sep. 1979 to present)
Director, EconomicResearch Division,
Public Utility
Commission of Texas
(Dec. 1977 to Aug. 1979)
Financial, economic and policy
consul ting to business and governent.
Perform business and public policy
research, cost/benefit analyses and
financial modeling, valuation of
businesses (over 150 entities valued),
estimation of damages, statistical and
industry studies. Provide strategyadvice and educational services in
public and private sectors, and serve
as expert witness before regulatory
agencies, legislative committees,arbi tration panels, and courts.
Responsible for research and testimony
preparation on rate of return, rate
structure, and econometric analysisdea ling wi th energy ,
telecommunications, water and sewer
utilities. Testified in major rate
cases and appeared before legislativecommittees and served as Chief
Economist for agency. Administered
state and federal grant funds.
Communicated frequently with politicalleaders and representatives from
consumer groups, media, and investment
community.
Exhibi t No. 3
Case Nos AVU-E-08-01 &
AVU-U-08-01
W. Avera, Avista
Schedule WEA-1 p. 4 of 10
Manager, FinancialEducation,
International Paper
CompanyNew York ci ty
(Feb. 1977 to Nov. 1977)
Lecturer in Finance,
The University of Texas
at Austin
(Sep. 1979 to May 19S1)
Assistant Professor ofFinance,
(Sep. 1975 to May 1977)
Assistant Professor of
Business,
University of North
Carolina at ChapelHill
(Sep. 1972 to Jul. 1975)
Education
Ph. D., Economi cs and
Finance,
University of North
Carolina at ChapelHill
(Jan. 1969 to Aug. 1972)
B.A., Economics,
Emory Uni versi ty,
Atlanta, Georgia
(Sep. 1961 to Jun. 1965)
Directed corporate education programs
in accounting, finance, and economics.
Developed course materials, recruitedand trained instructors, liaison
within the company and with academic
institutions. Prepared operating
budget and designed financial controls
for corporate professional development
program.
Taught graduate and undergraduate
courses in financial management and
investment theory. Conducted research
in business and public policy. Named
Outstanding Graduate Business
Professor and received various
administrative appointments.
Taught in BBA, MBA, and Ph. D.programs. Created proj ect course in
finance, Financial Management for
Women, and participated in developing
Small Business Management sequence.
Organized the North Carolina Institute
for Investment Research, a group of
financial institutions that supported
academic research. Faculty advisor to
the Media Board, which funds studentpublications and broadcast stations.
Elective courses included financial
management, public finance, monetary
theory, and econometrics. Awarded the
Stonier Fellowship by the American
Bankers i Association and University
Teaching Fellowship. Taught
statistics, macroeconomics, andmicroeconomics.
Dissertation: The Geometric Mean
Strategy as a Theory of Multiperiod
Portfolio Choice
Active in extracurricular activities,
President of the Barkley Forum (debateteam), Emory Religious Association,and Del ta Tau Del ta chapter.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-U-OS-01
W. Avera, Avista
Schedule WEA-1 p. 5 of 10
Indi vidual awards and team
championships at national collegiate
debate tournaments.
Professional Associations
Received Chartered Financial Analyst (CFA) designation in 1977; Vice
President for Membership, Financial Management Association; President,
Austin Chapter of Planning Executives Institute; Board of Directors,
North Carolina Society of Financial Analysts; Candidate Curriculum
Committee, Association for Investment Management and Research;
Executive Committee of Southern Finance Association; Vice Chair, Staff
Subcommittee on Economics and National Association of Regulatory
Utility Commissioners (NARUC) ; Appointed to NARUC Technical
Subcommittee on the National Energy Act.
Teaching in Executive Education Programs
University-Sponsored Programs: Central Michigan University, Duke
University, Louisiana State University, National Defense University,
National University of Singapore, Texas A&M University, University of
Kansas, University of North Carolina, university of Texas.
Business and Government-Sponsored Programs: Advanced Seminar on
Earnings Regulation, American Public Welfare Association, Association
for Investment Management and Research, Congressional Fellows Program,
Cost of Capital Workshop, Electricity Consumers Resource Council,
Financial Analysts Association of Indonesia, Financial Analysts Review,
Financial Analysts Seminar at Northwestern University, Governor's
Executive Development Program of Texas, Louisiana Association of
Business and Industry, National Association of Purchasing Management,National Association of Tire Dealers, Planning Executives Institute,
School of Banking of the South, State of wisconsin Investment Board,
Stock Exchange of Thailand, Texas Association of State Sponsored
Computer Centers, Texas Bankers' Association, Texas Bar Association,
Texas Savings and Loan League, Texas Society of CPAs, Tokyo Association
of Foreign Banks, Union Bank of Switzerland, U.S. Department of State,
U.S. Navy, U.S. Veterans Administration, in addition to Texas stateagencies and major corporations.
Presented papers for Mills B. Lane Lecture Series at the University of
Georgia and Heubner Lectures at the University of Pensylvania. Taught
graduate courses in finance and economics in evening program at St.
Edward's University in Austin from January 1979 through 1995.
Exert Witness Testimony
Testified in over 250 cases before regulatory
of capital, regulatory policy, rate design,
financial issues.
Federal Acrencies: Federal Communications Commission, Federal Energy
Regulatory Commission, Surface Transportation Board, Interstate
Commerce Commission, and the Canadian Radio-Television and
Telecommunications Commission.
agencies addressing cost
and other economic and
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-U-OS-01
W. Avera, Avista
Schedule WEA-1 p. 6 of 10
State Regulatory Agencies: Alaska, Arizona, Arkansas, California,
Colorado, Connecticut, Delaware, Florida, Georgia, Hawaii, Idaho,
Illinois, Indiana, Kansas, Maryland, Michigan, Missouri, Nevada, New
Mexico, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, South
Carolina, South Dakota, Texas, Utah, Virginia, Washington, West
virginia, Wisconsin, and Wyoming.
Testified in 41 cases before federal and state courts, arbitration
panels, and alternative dispute tribunals (86 depositions given)
regarding damages, valuation, anti trust liability, fiduciary duties,
and other economic and financial issues.
Board positions and Other Professional Acti vi ties
Audit Committee and Outside Director, Georgia System Operations
Corporation (electric system operator for member-owned electric
cooperatives in Georgia); Chairman, Board of Print Depot, Inc. and
FINCAP, Inc.; Co-chair, SYnchronous Interconnection Committee,
appointed by Public Utility Commission of Texas and approved by
governor; Appointed by Hays County Commission to Citizens Advisory
Committee of Habitat Conservation Plan, Operator of AA Ranch, a
certified organic producer of agricultural products; Appointed to
Organic Livestock Advisory Committee by Texas Agricultural Commissioner
Susan Combs; Appointed by Texas Railroad Commissioners to study group
for The UP/SP Merger: An Assessment of the Impacts on the State of
Texas i Appointed by Hawaii Public Utili ties Commission to team
reviewing affiliate relationships of Hawaiian Electric Industries;Chairman, Energy Task Force, Greater Austin-San Antonio Corridor
Council; Consultant to Public Utility Commission of Texas on
cogeneration policy and other matters; Consultant to Public Service
Commission of New Mexico on cogeneration policy; Evaluator of Energy
Research Grant Proposals for Texas Higher Education Coordinating Board.
Community Activities
Board Memer, Sustainable Food Center; Chair, Board of Deacons, Finance
Commi ttee, and Elder, Central Presbyterian Church of Austin; Founding
Memer, Orange-Chatham County (N. C.) Legal Aid Screening Committee.
Military
Captain, U. S. Naval Reserve (retired after 28 years service);
Commanding Officer, Naval Special Warfare Engineering Support Unit;
Officer-in-charge of SWIFT patrol boat in Vietnam; Enlisted service asweather analyst (advanced to second class petty officer) .
Bibliography
Monographs
Ethics and the Investment Professional (video, workbook, and
instructor's guide) and Ethics Challenge Today (video), Association
for Investment Management and Research (1995)
"Definition of Industry Ethics and Development of
~Applying Ethics in the Real World," in Good Ethics:
a Code" and
The Essential
Exhibi t No. 3
Case Nos AVU-E-08-01 &
AVU-U-08-01
W. Avera, Avista
Schedule WE-1 p. 7 of 10
Element of a Firm 's Success, Association for Investment Management
and Research (1994)
"On the Use of Security Analysts' Growth Projections in the DCF
Model," with Bruce H. Fairchild in Earnings Regulation Under
Inflation, J. R. Foster and S. R. Holmberg, eds. Institute for Study
of Regulation (1982)
An Examination of the Concept of using Relative Customer Class Risk to
Set Target Rates of Return in Electric Cost-of-Service Studies, with
Bruce H. Fairchild, Electricity Consumers Resource Council (ELCON)
(1981); portions reprinted in Public Utilities Fortnightly (Nov. 11,
1982 )
~Usefulness of Current Values to Investors and Creditors," Research
Study on Current-Value Accounting Measurements and Utility, George M.
Scott, ed., Touche Ross Foundation (1978)
~The Geometric Mean Strategy and Common Stock Investment Management,"
with Henry A. Latané in Life Insurance Investment Policies, David
Cumins, ed. (1977)
Investment Companies: Analysis of Current Operations and Future
Prospects, with J. Finley Lee and Glen L. Wood, American College of
Life Underwriters (1975)
Articles
~Should Analysts Own the Stocks they Cover?" The Financial Journalist,
(March 2002)
~Liquidity, Exchange Listing, and Common Stock Performance," with John
C. Groth and Kerry Cooper, Journal of Economics and Business (Spring
1985); reprinted by National Association of Security Dealers
~The Energy Crisis and the Homeowner: The Grief Process, II Texas
Business Review (Jan. -Feb. 1980); reprinted in The Energy Picture:
Problems and Prospects, J. E. Pluta, ed., Bureau of Business Research
(1980)
~Use of IFPS at the Public Utility Commission of Texas," Proceedings
of the IFPS Users Group Anual Meeting (1979)
"Production Capacity Allocation: Conversion, CWIP, and One-Ared
Economics," Proceedings of the NARUC Biennial Regulato~ Information
Conference (1978)
"Some Thoughts ~m the Rate of Return to Public Utility Companies, II with
Bruce H. Fairchild in Proceedings of the NARUC Biennial Regulatory
Information Conference (1978)
"A New Capital Budgeting Measure: The Integration of Time, Liquidity,
and Uncertainty," with David Cordell in Proceedings of the
Southwestern Finance Association (1977)
"Usefulness of Current Values to Investors and Creditors, II in Inflation
Accounting/indexing and Stock Behavior (1977)
"Consumer Expectations and the Economy, II Texas Business Review (Nov.
1976)
Exhibi t No. 3
Case Nos AVU-E-08-01 &
AVU-U-08-01
W. Avera, Avista
Schedule WEA-1 p. 8 of 10
"Portfolio Performance Evaluation and Long-run Capital Growth, If with
Henry A. Latané in Proceedings of the Eastern Finance Association
(1973)
Book reviews in Journal of Finance and Financial Review. Abstracts for
CFA Digest. Articles in Carolina Financial Times.
Selected Papers and Presentations
"The Who, What, When, How, and Why of Ethics", San Antonio FinancialAnalysts Society (Jan. 16, 2002). Similar presentation given to the
Austin Society of Financial Analysts (Jan. 17, 2002)
~Ethics for Financial Analysts, If Sponsored by Canadian Council of
Financial Analysts: delivered in Calgary, Edmonton, Regina, and
Winnipeg, June 1997. Similar presentations given to Austin Society ofFinancial Analysts (Mar. 1994), San Antonio Society of Financial
Analysts (Nov. 1985), and St. Louis Society of Financial Analysts
(Feb. 1986)
"Cost of Capital for Multi-Divisional Corporations," Financial
Management Association, New Orleans, Louisiana (Oct. 1996)
"Ethics and the Treasury Function, If Government Treasurers Organization
of Texas, Corpus Christi, Texas (Jun. 1996)
"A Cooperative Future, It Iowa Association of Electric Cooperatives, Des
Moines (December 1995). Similar presentations given to National G & T
Conference, Irving, Texas (June 1995), Kentucky Association ofElectric Cooperatives Anual Meeting, Louisville (Nov. 1994) ,
Virginia, Maryland, and Delaware Association of Electric CooperativesAnual Meeting, Richmond (July 1994), and Carolina Electric
Cooperatives Anual Meeting, Raleigh (Mar. 1994)
"Information Superhighway warnings: Speed Bumps on Wall Street andDetours from the Economy," Texas Society of Certified Public
Accountants Natural Gas, Telecommunications and Electric Industries
Conference, Austin (Apr. 1995)
"Economic/Wall Street Outlook, If Carolinas Council of the Institute of
Management Accountants, Myrtle Beach, South Carolina (May 1994).
Similar presentation given to Bell Operating Company Accounting
Witness Conference, Santa Fe, New Mexico (Apr. 1993)
"Regulatory Developments in Telecommunications, It Regional Holding
Company Financial and Accounting Conference, San Antonio (Sep. 1993)
~Estimating the Cost of Capital During the 1990s: Issues and
Directions," The National Society of Rate of Return Analysts,
Washington, D.C. (May 1992)
~Making Utility Regulation Work at the Public Utility Commission of
Texas," Center for Legal and Regulatory Studies, University of Texas,
Austin (June 1991)
"Can Regulation Compete for the Hearts and Minds of Industrial
Customers," Emerging Issues of Competition in the Electric Utility
Industry Conference, Austin (May 1988)
"The Role of Utilities in Fostering New Energy Technologies, It Emerging
Energy Technologies in Texas Conference, Austin (Mar. 1988)
Exhibi t No. 3
Case Nos AVU-E-08-01 &
AVU-U-08-01
W. Avera, Avista
Schedule WEA-1 p. 9 of 10
"The Regulators' Perspective, II Bellcore Economic Analysis Conference,
San Antonio (Nov. 1987)
"Public Utility Commissions and the Nuclear Plant Contractor, II
Construction Litigation Superconference, Laguna Beach, California
(Dec. 1986)
"Development of Cogeneration Policies in Texas, II University of Georgia
Fifth Annual Public Utilities Conference, Atlanta (Sep. 1985)
"Wheeling for Power Sales, II Energy Bureau Cogeneration Conference,Houston (Nov. 1985).
"AsYmetric Discounting of Information and Relative Liquidity: Some
Empirical Evidence for Common Stocks" (with John Groth and Kerry
Cooper), Southern Finance Association, New Orleans (Nov. 1982)
~Used and Useful Planning Models," Planning Executive Institute, 27th
Corporate Planning Conference, Los Angeles (Nov. 1979)
"Staff Input to Commission Rate of Return Decisions, II The National
Society of Rate of Return Analysts, New York (Oct. 1979)
"Electric Rate Design in Texas, II Southwestern Economics Association,
Fort Worth (Mar. 1979)
"Discounted Cash Life: A New Measure of the Time Dimension in Capital
Budgeting," with David Cordell, Southern Finance Association, New
Orleans (Nov. 1978)
"The Relative Value of Statistics of Ex Post Common Stock
Distributions to Explain Variance," with Charles G. Martin, Southern
Finance Association, Atlanta (Nov. 1977)
"An ANOVA Representation of Common Stock Returns as a Framework for
the Allocation of Portfolio Management Effort, II with Charles G.
Martin, Financial Management Association, Montreal (Oct. 1976)
~A Growth-Optimal Portfolio Selection Model with Finite Horizon," with
Henry A. Latané, American Finance Association, San Francisco (Dec.
1974)
~An Optimal Approach to the Finance Decision," with Henry A. Latané,
Southern Finance Association, Atlanta (Nov. 1974)
~A Pragmatic Approach to the Capital Structure Decision Based on
Long-Run Growth," with Henry A. Latané, Financial Management
Association, San Diego (Oct. 1974)
~Multi-period Wealth Distributions and Portfolio Theory, II Southern
Finance Associàtion, Houston (Nov. 1973)
~Growth Rates, Expected Returns, and Variance in Portfolio Selection
and Performance Evaluation," with Henry A. Latané, Econometric
Society, Oslo, Norway (Aug. 1973)
Exhibi t No. 3
Case Nos AVU-E-08-01 &
AVU-U-08-01
W. Avera, Avista
Schedule WEA-1 p. 10 of 10
SCHEDULE WE-2
DESCRIPTIONS OF QUANITATIVE ANYSES
1
2
Q.
A.
What is the purpose of this schedule?
Schedule WEA-2 presents capital market estimates
3 of the cost of equity. First, I examine the concept of the
4 cost of equity, along with the risk-return tradeoff
5 principle fundamental to capital markets. Next, I describe
6 DCF, CAPM, and expected earnings analyses conducted to
7 estimate the cost of equity for reference groups of
S comparable risk firms.
9
10
11
12
A. Overview
Q. What role does the rate of return on commn
equity play in a utility's rates?
A. The return on common equity is the cost of
inducing and retaining investment in the utility's physical
13 plant and assets.This investment is necessary to finance
14 the asset base needed to provide utility service.
15 Investors will commit money to a particular investment only
16 if they expect it to produce a return commensurate with
17 those from other investments with comparable risks.
lS Moreover, the return on common equity is integral in
19 achieving the sound regulatory objectives of rates that are
20 sufficient to: 1) fairly compensate capital investment in
21 the utility, 2) enable the utility to offer a return
22 adequate to attract new capital on reasonable terms, and 3)
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 1 of 27
1 maintain the utility's financial integrity. Meeting these
2 obj ectives allows the utility to fulfill its obligation to
3 provide reliable service while meeting the needs of
4 customers through necessary system expansion.
5 Q. What fundamntal economic principle underlies any
6 evaluation of investors' required return on equity?
7 A. The fundamental economic principle underlying the
S cost of equity concept is the notion that investors are
9 risk averse. The required rate of return for a particular
10 asset at any point in time is a function of: 1) the yield
11 on risk-free assets, and 2) its relative risk, with
12 investors demanding correspondingly larger risk premiums
13 for assets bearing greater risk. Given this risk-return
14 tradeoff, the required rate of return (k) from an asset (i)
15 can be generally expressed as:
16 ki = Rf + RPi
17
lS
19
where:Rf = Risk-free rate of return; and
RPi = Risk premium required to holdrisky asset i.
20 Thus, the required rate of return for a particular asset at
21 any point in time is a function of: 1) the yield on risk-
22 free assets, and 2) its relative risk, with investors
23 demanding correspondingly larger risk premiums for assets
24 bearing greater risk.
25 Because common shareholders have the lowest priority
26 claim on a firm's cash flows, they receive only the
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 2 of 27
1 residual that remains after all other claimants (employees,
2 suppliers, governments, lenders) have been paid. As a
3 result, the rate of return that investors require from a
4 utility's common stock, the most junior and riskiest of its
5 securi ties, is considerably higher than the yield on the
6 utili ty' s long-term debt.
7 Q. Is the cost of equity observable in the capital
S markets?
9 A. No. Unlike debt capital, there is no
10 contractually guaranteed return on common equity capital
11 since shareholders are the residual owners of the utility.
12 Because it is unobservable, the cost of equity for a
13 particular utility must be estimated by analyzing
14 information about capital market conditions generally,
15 assessing the relative risks of the company specifically,
16 and employing various quantitative methods that focus on
17 investors' current required rates of return. These various
lS quantitative methods typically attempt to infer investors'
19 required rates of return from stock prices, interest rates,
20 or other capital market data.
21
22
23
Q.
equity?
A.
A. Discounted Cash Flow Analvses
How are DCF models used to estimate the cost of
DCF models attempt to replicate the market
24 valuation process that sets the price investors are willing
25 to pay for a share of a company's stock. The model rests
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 3 of 27
1 on the assumption that investors evaluate the risks and
2 expected rates of return from all securities in the capital
3 markets. Given these expectations, the price of each stock
4 is adjusted by the market until investors are adequately
5 compensated for the risks they bear. Therefore, we can
6 look to the market to determine what investors believe a
7 share of common stock is worth. By estimating the cash
S flows investors expect to receive from the stock in the way
9 of future dividends and capital gains, we can calculate
10 their required rate of return. In other words, the cash
11 flows that investors expect from a stock are estimated, and
12 given its current market price, we can ~back-into" the
13 discount rate, or cost of equity, that investors implicitly
14 used in bidding the stock to that price.
15
16
17
Q.
models?
A.
Wht market valuation process underlies DCF
DCF models assume that the price of a share of
lS common stock is equal to the present value of the expected
19 cash flows (i. e., future dividends and stock price) that
20 will be received while holding the stock, discounted at
21 investors' required rate of return. That is, the cost of
22 equi ty is the discount rate that equates the current price
23 of a share of stock with the present value of all expected
24 cash flows from the stock.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 4 of 27
1 Q. What form of the DCF model is customarily used to
2 estimate the cost of equity in rate cases?
3 A. Rather than developing annual estimates of cash
4 flows into perpetuity, the DCF model can be simplified to a
5 "constant growth" f~rm: 1
6
p _ 010- ke-g
7
S
9
10
11
12
where: Po = Current price per share;
D1 = Expected dividend per share in the
coming year;
ke = Cost of equity;
g = Investors' long-term growthexpectations.
13 The cost of equity (Ke) can be isolated by rearranging
14 terms:
15 ok =-1+ge p
o
16 This constant growth form of the DCF model recognizes that
17 the rate of return to stockholders consists of two parts:
lS 1) dividend yield (D1/PO)' and 2) growth (g).In other
19 words, investors expect to receive a portion of their total
20 return in the form of current dividends and the remainder
21 through price appreciation.
1 The constant growth DCF model is dependent on a numer of strict
assumptions, which in practice are never strictly met. These include
a constant growth rate for both dividends and earnings; a stable
dividend payout ratio; the discount rate exceeds the growth rate; a
constant growth rate for book value and price; a constant earned rate
of return on book value; no sales of stock at a price above or below
book value; a constant price-earnings ratio; a constant discount rate(i. e., no changes in risk or interest rate levels and a flat yield
curye); and all of the above extend to infinity.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 5 of 27
1
2
3
Q. How did you define the utility proxy group you
used to implement the DCF model?
A. As discussed in my testimony, my utility proxy
4 group was composed of those dividend-paying companies
5 included by Value Line in its Electric Utilities Industry
6 groups with: (1) S&P corporate credit ratings between ~BBB-
7 "and ~BBB+," (2) a Value Line Safety Rank of ~2" or ~3",
Sand (3) a Value Line Financial Strength Rating of ~B+" to
9 ~B++", and (4) published growth estimates from IBES, Value
10 Line, Reuters, and Zacks. I excluded two companies that
11 otherwise would have been in the proxy group (Energy East
12 Corporation and Puget Energy, Inc.) because they are in the
13 process of being acquired.
14 Q. Do these criteria provide objective evidence that
15 investors would view the fir.s in the utility proxy group
16 as risk-comparable to Avista?
17 A. Yes. Credit ratings are assigned by independent
lS rating agencies to provide investors with a broad
19 assessment of the creditworthiness of a firm. Because the
20 rating agencies' evaluation includes virtually all of the
21 factors normally considered important in assessing a firm's
22 relative credit standing, corporate credit ratings provide
23 a broad measure of overall investment risk that is readily
24 available to investors. Widely cited in the investment
25 community and referenced by investors as an objective
26 measure of risk, credit ratings are also frequently used as
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 6 of 27
1 a primary risk indicator in establishing proxy groups to
2 estimate the cost of equity.
3 Apart from the broad assessment of investment risk
4 provided by credit ratings, other quality rankings
5 published by investment advisory services also provide
6 relative assessments of risk that are considered by
7 investors in forming their expectations. Given that Value
S Line is perhaps the most widely available source of
9 investment advisory information, its Safety Rank and
10 Financial Strength Rating provide useful guidance regarding
11 the risk perceptions of investors.
12 The Safety Rank is Value Line's primary risk indicator
13 and ranges from ~1" (Safest) to ~S" (Riskiest). This
14 overall risk measure is intended to capture the total risk
15 of a stock, and incorporates elements of stock price
16 stability and financial strength. The Financial Strength
17 Rating is designed as a guide to overall financial strength
lS and creditworthiness, with the key inputs including
19 financial leverage, business volatility measures, and
20 company size. Value Line's Financial Strength Ratings
21 range from ~A++" (strongest) down to "C" (weakest) in nine
22 steps.
23 As discussed earlier, Avista is rated "BBB-" by S&P,
24 which indicates slightly greater risk than the ~BBB"
25 average rating for the firms in the utility proxy group.
26 Meanwhile, Value Line has assigned Avista a Safety Rank of
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 7 of 27
9
10
1 ~3" and a Financial Strength Rating of ~B+" versus averages
2 of "3" and ~B++", respectively for the utility proxy group.
3 Based on my screening criteria, which reflect objective,
4 published indicators that incorporate consideration of a
5 broad spectrum of risks, including financial and business
6 position, relative size, and exposure to company specific
7 factors, investors are likely to regard this group as
S having risks and prospects generally comparable to Avista.
Q.
A.
What steps are required to apply the DCF model?
The first step in implementing the constant
11 growth DCF model is to determine the expected dividend
12 yield (D1/Po) for the firm in question. This is usually
13
14
15
16
17
lS
19
20
21
22
23
calculated based on an estimate of dividends to be paid in
the coming year divided by the current price of the stock.
The second, and more controversial, step is to estimate
investors i long-term growth expectations (g) for the firm.
The final step is to sum the firm's dividend yield and
estimated growth rate to arrive at an estimate of its cost
of equity.
Q. How was the dividend yield for the utility proxy
group det er.i ned ?
A. Estimates of dividends to be paid by each of
these utili ties over the next twelve months, obtained from
24 Value Line, served as D1. This annual dividend was then
25 divided by the corresponding stock price for each utility
26 to arrive at the expected dividend yield. The expected
Exhibi t No. 3
Case -Nos AVU-E-OS-01 &
AVU-G-08-01
W. Avera, Avista
Schedule WEA-2, p. S of 27
1 dividends, stock prices, and resul ting dividend yields for
2 the firms in the utility proxy group are presented on
3 Schedule WEA-4. As shown there, dividend yields for the
4 twenty firms in the utility proxy group ranged from 2.4
5 percent to 6.0 percent.
6
7
S
Q. What is the next step in applying the constant
growth DCF model?
A. The next step is to evaluate long-term growth
9 expectations, or "g", for the firm in question. In
1 0 cons tan t growth DCF theory, earnings , dividends, book
11 value, and market price are all assumed to grow in
12 lockstep, and the growth horizon of the DCF model is
13 infinite. But implementation of the DCF model is more than
14 just a theoretical exercise; it is an attempt to replicate
15 the mechanism investors used to arrive at observable stock
16 prices. A wide variety of techniques can be used to derive
1 7 growth rates, but the only ~ g" that matters in applying the
lS DCF model is the value that investors expect.
19 Q. Are historical growth rates likely to be
20 representative of investors' expectations for utilities?
21 A. No. If past trends in earnings, dividends, and
22 book value are to be representative of investors'
23 expectations for the future, then the historical conditions
24 giving rise to these growth rates should be expected to
25 continue. That is clearly not the case for utili ties,
26 where structural and industry changes have led to declining
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 9 of 27
1 dividends, earnings pressure, and, in many cases,
2 significant write-offs. While these conditions serve to
3 depress historical growth measures, they are not
4 representative of long-term expectations for the utility
5 industry. Moreover, to the extent historical trends for
6 utili ties are meaningful, they are also captured in
7 proj ected growth rates, since securities analysts also
S routinely examine and assess the impact and continued
9 relevance (if any) of historical trends.
10 Q. What are investors most likely to consider in
11 developing their long-term growth expectations?
12 A. While the DCF model is technically concerned with
13 growth in dividend cash flows, implementation of this DCF
14 model is solely concerned with replicating the forward-
15 looking evaluation of real-world investors. In the case of
16 electric utilities, dividend growth rates are not likely to
17 provide a meaningful guide to investors i current growth
lS expectations. This is because utilities have significantly
19 altered their dividend policies in response to more
20 accentuated business risks in the industry. 2 As a result
21 of this trend towards a more conservative payout ratio,
22 dividend growth in the utility industry has remained
23 largely stagnant as utilities conserve financial resources
24 to provide a hedge against heightened uncertainties.
2 For example, the payout ratio for electric utilities fell from
approximately 80% historically to on the order of 60%. The Value Line
Investment Survey (Sep. 15, 1995 at 161, Dec. 28, 2007 at 695).
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avis ta
Schedule WEA-2, p. 10 of 27
1 As payout ratios for firms in the utility industry
2 trended downward, investors' focus has increasingly shifted
3 from dividends to earnings as a measure of long-term
4 growth. Future trends in earnings, which provide the
5 source for future dividends and ultimately support share
6 prices, playa pivotal role in determining investors' long-
7 term growth expectations. The importance of earnings in
8 evaluating investors' expectations and requirements is well
9 accepted in the investment community. As noted in Finding
10 Reali ty in Reported Earnings published by the Association
11 for Investment Management and Research:
12 (E) arnings, presumably, are the basis for the13 investment benefits that we all seek. ~Healthy14 earnings equal healthy investment benefits" seems15 a logical equation, but earnings are also a16 scorecard by which we compare companies, a filter
17 through which we assess management, and a crystal18 ball in which we try to foretell future19 performance. 3
20 Value Line's near-term projections and its Timeliness
21 Rank, which is the principal investment rating assigned to
22 each individual stock, are also based primarily on various
23 quantitative analyses of earnings. As Value Line
24 explained:
25 The future earnings rank accounts for 65% in the26 determination of relative price change in the27 future; the other two variables (current earnings28 rank and current price rank) explain 35%.4
3 Association for Investment Manag~ent and Research, uFinding Reality
in Reported Earnings: An Overview", p. 1 (Dec. 4, 1996).4 The Value Line Investment Survey, Subscriber i s Guide, p. 53.
Exhibi t No. 3
Case Nos AVU-E-08-01 &
AVU-G-08-01
W. Avera, Avista
Schedule WEA-2, p. 11 of 27
1 The fact that investment advisory services, such as Value
2 Line, Thompson, and Reuters, focus on growth in earnings
3 indicates that the investment community regards this as a
4 superior indicator of future long-term growth. Indeed, ~A
5 Study of Financial Analysts: Practice and Theory,"
6 published in the Financial Analysts Journal, reported the
7 resul ts of a survey conducted to determine what analytical
S techniques investment analysts actually use. 5 Respondents
9 were asked to rank the relative importance of earnings,
10 dividends, cash flow, and book value in analyzing
11 securities. Of the 297 analysts that responded, only 3
12 ranked dividends first while 276 ranked it last. The
13 article concluded:
14 Earnings and cash flow are considered far more15 important than book value and dividends. 6
16 More recently, the Financial Analysts Journal reported
17 the results of a study of the relationship between
lS valuations based on alternative multiples and actual market
19 prices, which concluded, ~ In all cases studied, earnings
20 dominated operating cash flows and dividends.
"7
5 Block, Stanley B., UA Study of Financial Analysts: Practice and
Theory", Financial Analysts Journal (July/August 1999).6 Id. at 88.
7 Liu, Jing, Nissim, Doron, & Thomas, Jacob, "Is Cash Flow King in
Valuations?," Financial Analysts Journal, Vol. 63, NO.2 (March/April
2007) at 56.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 12 of 27
9
10
11
12
13
14
15
16
1
2
3
4
Q. What are security analysts currently projecting
in the way of growth for the firms in the utility proxy
group?
A. The IBES earnings growth projections for each of
5 the firms in the utility proxy group reported by Thomson
6 Financial are displayed on Schedule WEA-4. Also presented
7 are the earnings per share (~EPS") growth projections
S reported by Value Line, Reuters, and Zacks.
Q. How else are investors' expectations of future
long-term growth prospects often estimated for use in the
constant growth DCF model?
A. Based on the assumptions underlying constant
growth theory, conventional applications of the constant
growth DCF model often examine the relationship between
retained earnings and earned rates of return as an
indication of the sustainable growth investors might expect
17 from the reinvestment of earnings within a firm. The
lS sustainable growth rate is calculated by the formula, g =
19 br+sv, where ~b" is the expected retention ratio, ~r" is
20 the expected earned return on equity, ~s" is the percent of
21 common equity expected to be issued annually as new common
22 stock, and "v" is the equity accretion rate.
23
24
Q.
A.
What is the purpose of the "sv" term?
Under DCF theory, the ~sv" factor is a component
25 of the growth rate designed to capture the impact of
26 issuing new common stock at a price above, or below, book
27 value. When a company's stock price is greater than its
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 13 of 27
1 book value per share, the per-share contribution in excess
2 of book value associated with new stock issues will accrue
3 to the current shareholders. This increase to the book
4 value of existing shareholders leads to higher expected
5 earnings and dividends, with the ~sv" factor incorporating
6 this additional growth component.
7 Q. How did you apply the earnings retention method
S for the proxy group of utilities?
9 A. The sustainable, . ~br+sv" growth rates for each
10 firm in the proxy group are sumarized on Schedule WEA-4,
11 with the underlying details being presented on
12 Schedule WEA-S. For each firm, the expected retention
13 ratio (b) was calculated based on Value Line's projected
14 dividends and earnings per share. Likewise, each firm's
15 expected earned rate of return (r) was computed by dividing
16 projected earnings per share by projected net book value.
17 Because Value Line reports end-of-year book values, an
lS adjustment was incorporated to compute an average rate of
19 return over the year, consistent with the theory underlying
20 this approach to estimating investors' growth expectations.
21 Meanwhile, the percent of common equity expected to be
22 issued annually as new common stock (s) was equal to the
23 product of the projected market-to-book ratio and growth in
24 common shares outstanding, while the equity accretion rate
25 (v) was computed as 1 minus the inverse of the projected
26 market-to-book ratio.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 14 of 27
7
S
9
10
11
12
13
1 Q. What cost of equity estimates were implied for
2 the utility proxy group using the DCF model?
3 A. After combining the dividend yields and
4 respective growth projections for each utility, the
5 resulting cost of equity estimates are shown on
6 Schedule WEA-4.
Q. In evaluating the results of the constant growth
DCF model, is it appropriate to eliminate cost of equity
estimates that fail to meet threshold tests of economic
logic?
A. Yes. It is a basic economic principle that
investors can be induced to hold more risky assets only if
they expect to earn a return to compensate them for their
14 risk bearing. As a result, the rate of return that
15 investors require from a utility's common stock, the most
16 junior and riskiest of its securities, must be considerably
17 higher than the yield offered by senior, long-term debt.
lS Consistent with this principle, the DCF range for the proxy
19 group of electric utilities must be adjusted to eliminate
20 cost of equity estimates that fail fundamental tests of
21 economic logic.
22
23
Q.
A.
Have similar tests been applied by regulators?
Yes. The FERC has noted that adjustments are
24 justified where applications of the DCF approach produce
25 illogical results. FERC evaluates DCF results against
26 observable yields on long-term public utility debt and has
27 recognized that it is appropriate to eliminate cost of
Exhibi t No. 3
Case Nos AVU-E-08-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 15 of 27
1 equity estimates that do not sufficiently exceed this
2 threshold. In a 2002 opinion establishing its current
3 precedent for determining ROEs for electric utili ties, for
4 example, FERC concluded:
5 An adjustment to this data is appropriate in the
6 case of PG&E's low-end return of 8.42 percent,
7 which is comparable to the average Moody's "A"S grade public utility bond yield of S. 06 percent,
9 for October 1999. Because investors cannot be10 expected to purchase stock if debt, which has11 less risk than stock, yields essentially the same12 return, this low-end return cannot be considered13 reliable in this case. 8
14 More recently, in its October 2006 decision in Kern River
15 Gas Transmission Company, FERC noted that:
16 (T)he 7.31 and 7.32 percent costs of equity for
17 El Paso and Williams found by the ALJ are only
lS 110 and 122 basis points above that average yield19 for public utility debt. 9
20 FERC upheld the opinion of Staff and the Administrative Law
21 Judge that cost of equity estimates for these two proxy
22 group companies ~were too low to be credible. ,,10
23 Q. What does this test of logic imply with respect
24 to the DCF results for the utility proxy group?
25 A. The average bond rating associated with the firms
26 in the utility proxy group is triple-B, with Moody's
27 monthly yields on triple-B bonds averaging approximately
2S 6.4 percent in January 200S. 11 As highlighted on
29 Schedule WEA-4, six of the individual equity estimates for
8 Southern California Edison Company, 92 FERC î 61,070 (2000) at p. 22.
9 Kern River Gas Transmission Company, Opinion No. 486, 117 FERC î
61,077 at P 140 & n. 227 (2006).10 Id.
11 Moody's Investors Service, Credit Perspectives (Feb. 11, 2008).
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 16 of 27
1 the firms in the utility proxy group exceeded this
2 threshold by 120 basis points or less. 12 In light of the
3 risk-return tradeoff principle and the test applied in Kern
4 River Gas Transmission Company, it is inconceivable that
5 investors are not requiring a substantially higher rate of
6 return for holding common stock, which is the riskiest of a
7 utility's securities. As a result, these values provide
S little guidance as to the returns investors require from
9 the common stock of an electric utility.
10 Q. Do you also recommend excluding cost of equity
11 estimates at the high end of the range of DCF results?
12 A. Yes. As highlighted on Schedule WEA-4, I also
13 eliminated cost of equity estimates at the upper end of the
14 range of DCF results.Compared with the balance of the
15 remaining estimates, these values are extreme outliers and
16 should also be excluded in evaluating the results of the
17 DCF model for the utility proxy group. This is also
lS consistent with the approach and threshold adopted by FERC,
19 which established that a 17.7 percent DCF estimate for an
20 electric utility was ~an extreme outlier" and should be
21 disregarded. D
12 As highlighted on Schedule WEA-4, these DCF estimates ranged from
5.7 percent to 7.5 percent.13 iso New England, Inc., 109 FERC 'J 61,147 at P 205 (2004).
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 17 of 27
1 Q. What cost of equity is implied by your DCF
2 results for the utility proxy group?
3 A. As shown on Schedule WEA-4 and sumarized in
4 Table 1, below, after eliminating illogical low- and high-
5 end values, application of the constant growth DCF model
6 resulted in the following cost of equity estimates:7 TABLE 1S DCF RESULTS - UTILITY PROXY GROUP
Growth Rate
IBES
Value Line
Reuters
Zacksbr+sv
Average Cost of Equity
11. 3%
10.4%
10.6%
10.9%
9.2%
9 Q. What did you conclude based on the results of the
10 DCF analyses for the utility proxy group?
11 A. Taken together, and considering the relative
12
13
14
15
16
17
lS
19
20
21
strengths and weaknesses associated with the alternative
growth measures, I concluded that the constant growth DCF
results for the utility proxy group implied a cost of
equi ty of 10.7 percent.
Q. How else can the DCF model be applied to estimate
the ROE for Avista?
A. Under the regulatory standards established by
Hope and Bluefield, the salient criteria in establishing a
meaningful benchmark to evaluate a fair rate of return is
relative risk, not the particular business activity or
22 degree of regulation. Utilities must compete for capital,
23 not just against firms in their own industry, but with
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. lS of 27
1 other investment opportunities of comparable risk. with
2 regulation taking the place of competitive market forces,
3 required returns for utili ties should be in line with those
4 of non-utility firms of comparable risk operating under the
5 constraints of free competition. Consistent with this
6 accepted regulatory standard, I also applied the DCF model
7 to a reference group of comparable risk companies in the
S non-utility sector of the economy.
9 Q. What criteria did you apply to evaluate
10 investors' risk perceptions?
11 A. As discussed in my testimony, my assessment of
12 comparable risk relied on three objective benchmarks for
13 the risks associated with common stocks -- Value Line's
14 Safety Rank, Financial Strength rating, and beta. My
lS
comparable risk proxy group was composed of those U.S.
companies followed by value Line that 1)pay common
dividends,2 )have a Safety Rank of ~ 1 It ,2 )have a
Financial Strength Rating of ~AIt or above,and 3)have beta
values of 0.90 or less,14 and (4 )have published data from
15
16
17
19
20 IBES, Value Line, Reuters, and Zacks. Cons is ten t wi th the
21 development of my utility proxy group, I also eliminated
22 firms with below-investment grade credit ratings.
14 This threshold corresponds to the average beta of 0.89 for the
utility proxy group discussed earlier.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 19 of 27
1 Q. What were the results of your DCF analysis for
2 the non-utility reference group?
3 A. As shown on Schedule WEA-6, I applied the DCF
4 model to the non-utility proxy group in exactly the same
5 manner described earlier for the utility proxy group.
15 As
6 sumarized in Table 2, below, after eliminating illogical
7 low- and high-end values, application of the constant
S growth DCF model resulted in the following cost of equity
9 estimates:
10 TABLE 2
11 DCF RESULTS - NON-UTILITY PROXY GROUP
Growth RateI/B/E/S
Value LineReuters
Zacksbr+sv
Average Cost of EQUity
12.9%
12.2%
12.5%
12.7%
13.0%
12 Taken together, I concluded that the constant growth DCF
13 results for the non-utility proxy group implied a cost of
14 equity of 12.6 percent.
15
16
Q
A.
B. Capi tal Asset Pricing Model
Please describe the CAPM.
The CAPM is a theory of market equilibrium that
17 measures risk using the beta coefficient. The CAPM assumes
lS that investors are fully diversified, so the relevant risk
19 of an individual asset (e.g., common stock) is its
20 volatility relative to the market as a whole. Beta
15 Schedule WEA-7 contains the details underlying the calculation of
the br+sv growth rates for the non-utility proxy group.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 20 of 27
S
9
10
11
12
13
14
15
16
17
lS
19
20
21
22
23
24
1 reflects the tendency of a stock's price to follow changes
2 in the market. A stock that tends to respond relatively
3 less to market movements has a beta less than 1.00, while
4 stocks that tend to move more than the market have betas
5 greater than 1.00. The CAPM is mathematically expressed
6 as:
7 Rj = Rf + e j (Rm - Rf)
where: Rj = required rate of return for stock j;
Rf = risk-free rate;
R. = expected return on the market
portfolio; and,ej = beta, or systematic risk, for stock j.
Like the DCF model, the CAPM is an ex-ante, or
forward-looking model based on expectations of the future.
As a result, in order to produce a meaningful estimate of
investors' required rate of return, the CAPM must be
applied using estimates that reflect the expectations of
actual investors in the market, not with backward-looking,
historical data.
Q. How did you apply the CAPM to estimate the cost
of equity?
A. Application of the CAPM to the utility proxy
group based on a forward-looking estimate for investors'
25 Schedule WEA-S. In order to capture the expectations of
required rate of return from common stocks is presented on
26 today's investors in current capital markets, the expected
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 21 of 27
1 market rate of return was estimated by conducting a DCF
2 analysis on the dividend paying firms in the S&P 500.
3 The dividend yield for each firm was obtained from
4 Value Line, with the growth rate being equal to the average
5 of the earnings growth proj ections for each firm compiled
6 by IBES and Value Line, with each firml s dividend yield and
7 growth rate being weighted by its proportionate share of
S total market value. Based on the weighted average of the
9 proj ections for the 354 individual firms, current estimates
10 imply an average growth rate over the next five years of
11 11.0 percent. Combining this average growth rate with a
12 dividend yield of 2.2 percent results in a current cost of
13 equity estimate for the market as a whole of approximately
14 13.2 percent. Subtracting a 4.4 percent risk-free rate
15 based on the average yield on 20-year Treasury bonds for
16 January 200S produced a market equity risk premium of S. S
17 percent. Multiplying this risk premium by the average
lS Value Line beta of O. S9 for the utility proxy group, and
19 then adding the resulting 7. S percent risk premium to the
20 average long-term Treasury bond yield, indicated an ROE of
21 approximately 12.2 percent.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 22 of 27
1 Q. What cost of equity was indicated for the non-
2 utility proxy group based on this forward-looking
3 application of the CAPM?
4 A. As shown on Schedule WEA-9, applying the forward-
5 looking CAPM approach to the firms in the non-utility proxy
6 group implied a cost of equity of 11.4 percent.
7 Q. What other CAPM analyses did you conduct to
S estimate the cost of equity?
9 A. I also applied the CAPM using risk premiums based
10 on historical realized rates of return. This approach to
11 estimating investors' equity risk premiums is premised on
12 the notion that past experience heavily conditions future
13 expectations. The essential assumption of the historical
14 risk premium when used in the CAPM approach is that, while
15 historical returns do not predict the future, investors
16 form expectations of future stock returns based on
17 observable debt yields and the historical experience of
lS returns from common stock investments relative to debt
19 investments.
20 While reference to historical data represents one way
21 to apply the CAPM, these realized rates of return reflect,
22 at best, an indirect estimate of investors' current
23 requirements. The cost of capital is a forward-looking, or
24 expectational concept that is focused on the perceptions of
25 today's capital market investors. Past investment returns
26 are frequently referenced and may provide a useful
27 benchmark, but the only factors that actually determine the
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avis ta
Schedule WEA-2, p. 23 of 27
1 current required rate of return are investors' expectations
2 for the future. As a result, forward-looking applications
3 of the CAPM that look directly at investors' expectations
4 in the capi tal markets are apt to provide a more meaningful
5 guide to investors' required rate of return.
6 Q. What CAPM cost of equity is produced based on
7 historical realized rates of return for stocks and long-
S term governent bonds?
9 A. I applied the CAPM using data published by
10 Ibbotson Associates, which is perhaps the most exhaustive
11 and widely referenced annual study of realized rates of
12 return. Application of the CAPM based on historical
13 realized rates of return is presented in Schedule WEA-10.
14 In their 2007 Yearbook, Valuation Edition, Ibbotson
15 Associates reported that, over the period from 1926 through
16 2006, the arithmetic mean realized rate of return on the
17 S&P 500 exceeded that on long-term government bonds by 7.1
lS percent.
16 Multiplying this historical market risk
19 premium by the average Value Line beta of O. S9
20 produced an equity risk premium of 6.3 percent for the
21 utility proxy group. As shown on Schedule WEA-10,
22 adding this equity risk premium to the January 200S
23 average yield on 20-year Treasury bonds of 4.4 percent
24 resulted in an implied cost of equity of 10.7 percent.
16 Ibbotson Associates computes the equity risk premium by subtracting
the income return (not the total return) on long-term Treasury bonds
from the return on common stocks.
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 24 of 27
10
11
12
13
14
15
16
17
lS
19
20
21
22
23
24
25
26
1
2
3
Wht cost of equity was indicated for the non-
proxy group based on the historical CAPM approach?
As shown on Schedule WEA-11, applying the
Q.
utility
A.
4 historical CAPM approach to the firms in the non-utility
5 proxy group implied a cost of equity of 10.0 percent.
C. Exected Earnings Method
6 Q. What other analyses did you conduct to estimate
7 the cost of equity?
S A. As I noted earlier, I also evaluated the ROE
9 using the expected earnings method. Reference to rates of
return available from alternative investments of comparable
risk can provide an important benchmark in assessing the
return necessary to assure confidence in the financial
integrity of a firm and its ability to attract capital.
This expected earnings approach is consistent with the
economic underpinnings for a fair rate of return
established by the Supreme Court in Hope and Bluefield.
Moreover, it avoids the complexities and limitations of
capi tal market methods and instead focuses on expected
earned returns on book equi ty, which are more readily
available to investors.
Q. What rates of return are indicated for utili ties
based on this approach?
A. with respect to expectations for electric
utilities generally, the February S, 200S edition of Value
Line reports that its analysts anticipate an average rate
of return on common equity for the electric utility
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 25 of 27
1 industry of 11.5 percent in 200S and over its three-to-five
2 year forecast horizon.17 Meanwhile, Value Line expects that
3 natural gas utilities will earn an average rate of return
4 on common equity of 11.5 percent in 200S and 12.0 percent
5 over the years 2010 through 2012. 18
6 For the firms in the utility proxy group specifically,
7 the returns on common equity proj ected by Value Line over
Sits three-to-five year forecast horizon are shown on
9 Schedule WEA-12. Consistent with the rationale underlying
10 the development of the br+sv growth rates, these year-end
11 values were converted to average returns using the same
12 adjustment factor discussed earlier. As shown on Schedule
13 WEA-12, after eliminating potential outliers, Value Line's
14 projections suggested an average ROE of 10.5 percent for
15 the utility proxy group.
16 Q. What return on equity is indicated by the results
17 of the expected earnings approach?
lS A. Based on the results discussed above, I concluded
19 that the comparable earnings approach implies a fair rate
20 of return on equity of 11.0 percent.
D. Sumry of Quantitative Results
21 Q. Please sumrize the results of your quantitative
22 analyses.
23 A. The cost of equity estimates implied by my
24 quantitative analyses are sumarized in Table 3 below:
17 The Value Line Investment Survey, at 1776 (Feb. 8, 2008).
18 The Value Line Investment Survey, at 445 (Dec. 14, 2007).
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 26 of 27
1
2
TABLE 3
SUMY OF QUANITATIVE RESULTS
Method
DCF
CAPM
Forward-looking
Historical
Expected Earnings
Cost of Egui ty Estimates
Utility Non-utility
ProxY Group ProxY Group
10.7%12.6%
12.2%
10.7%
11.0%
11. 4%
10.0%
Exhibi t No. 3
Case Nos AVU-E-OS-01 &
AVU-G-OS-01
W. Avera, Avista
Schedule WEA-2, p. 27 of 27
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2
FORWARD-LOOKING CAPM Schedule WEA-8
Page 1 of 1
UTILITY PROXY GROUP
Market Rate of Return
Dividend Yield (a)2.2%
Growt Rate (b)11.0%
Market Return (c)13.2%
Less: Risk-Free Rate (d)
Long-term Treasury Bond Yield 4.4%
Market Risk Premium (e)8.8%
Proxy Group Beta (f 0.89
Proxy Group Risk Premium (g)7.8%
Plus: Risk-free Rate (d)
Long-term Treasury Bond Yield 4.4%
Implied Cost of Equity (h)12.2%
(a) Weighted average dividend yield for the dividend paying firms in the S&P 500 from
www.valueline.com(RetreivedDec.11. 2007).
(b) Weighted average of IBES and Value Line growth rates for the dividend payig firms in the
S&P 500 based on data from Standard & Poor's Earnings Guide (Nov. 2007) and
www.valueline.com(RetreivedDec.11. 2007).
(c) (a) + (b)
(d)
Average yield on 20-year Treasury bonds for January 2008 from the Federal Reserve Board at
http://www.federalreserve.gov/releaseslh15/data/onthlylH15 _ TCMNOM_ Y20.txt.
(e) (c) - (d).
(f) The Value Line Investment Survey (Nov. 30 & Dec. 28,2007, Feb. 8, 2008).
(g) (e) x (f).
(h) (d) + (g).
Exhibit No. 3
Case Nos AVU-E-08-01 AVU-G-08-01
W. Avera, Avista
Schedule WEA-8, p. 10f 1
FORWARD-LOOKING CAPM Schedule WEA-9
Page 1 ofl
NON-UTILITY PROXY GROUP
Market Rate of Return
Dividend Yield (a)2.2%
Growth Rate (b)11.0%
Market Return (c)13.2%
Less: Risk-Free Rate (d)
Long-term Treasury Bond Yield 4.4%
Market Risk Premium (e)8.8%
Proxy Group Beta (f)0.80
Proxy Group Risk Premium (g)7.0%
Plus: Risk-free Rate (d)
Long-term Treasury Bond Yield 4.4%
Implied Cost of Equity (h)11.4%
(a) Weighted average dividend yield for the dividend paying firms in the S&P 500 from
ww.valueline.com(RetreivedDec.11. 2007).
(b) Weighted average of IBES and Value Line growth rates for the dividend paying firms in the
S&P 500 based on data from Standard & Poor's Earings Guide (Nov. 2007) and
www.valueline.com(RetreivedDec.11. 2007).
(c) (a) + (b)
(d)
Average yield on 20-year Treasury bonds for January 2008 from the Federal Reserve Board at
http://www .federalreserve.gov /releases/hlS/data/onthly /IUS _ TCMNOM_ Y20. txt.
(e) (c) - (d).
(f) www.valueline.com (retreved Feb. 6, 2008).
(g) (e) x (f).
(h) (d) + (g).
Exhibit No. 3
Case Nos AVU-E-OS-01 AVU-G-oS-01
W. Avera, Avista
Schedule WEA-9, p. 10f 1
HISTORICAL CAPM Schedule WEA-10
Page 1 of1
UTILITY PROXY GROUP
Market Risk Premium
Long-Horizon Equity Risk Premium (a)7.1%
Proxy Group Beta (b)0.89
Proxy Group Risk Premium (e)6.3%
Plus: Risk-free Rate (d)
Long-term Treasury Bond Yield 4.4%
Implied Cost of Equity (e)10.7%
(a) Arithmetic mean risk premium on Large Company Stocks from 1926-2006 reported by
Ibbotson Associates, Stocks, Bonds, Bills, and Inflation, Valuation Edition, 2007 Yearbook, at
Appendix C, Table C-1, p. 262.
(b) The Value Line Investment Survey (Nov. 30 & Dec. 28, 2007, Feb. 8, 2008).
(c) (a) x (b).
(d)
Average yield on 20-year Treasury bonds for January 2008 from the Federal Reserve Board at
http://www.federalreserve.gov /releases/h15/data/onthly/H15 _ TCMNOM_ Y20.txt.
(e) (c) + (d).
Exhibit NO.3
Case Nos AVU-E-08-01 AVU-G-08-01
W. Avera, Avista
Schedule WEA-10, p. 10f 1
HISTORICAL CAPM Schedule WEA-ll
Page 1 ofl
NON-UTILITY PROXY GROUP
Market Risk Premium
Long-Horizon Equity Risk Premium (a)7.1%
Proxy Group Beta (b)0.80
Proxy Group Risk Premium (c)5.6%
Plus: Risk-free Rate (d)
Long-term Treasury Bond Yield 4.4%
Implied Cost of Equity (e)10.0%
(a) Arithetic mean risk premium on Large Company Stocks from 1926-2006 reported by
Ibbotson Associates, Stocks, Bonds, Bils, and Inflation, Valuation Edition, 2007 Yearbook, at
Appendix C, Table C-1, p. 262.
(b) ww.valueline.com (retreved Feb. 6, 2008).
(c) (a) x (b).
(d)
Average yield on 20-year Treasury bonds for January 2008 from the Federal Reserve Board at
http://ww.federalreserve.gov/releases/h15/data/Monthy/H15_ TCMNOM_ Y20.txt.
(e) (c) + (d).
Exhibit No. 3
Case Nos AVU-E-08-01 AVU-G-08-01
W. Avera, Avista
Schedule WEA-11, p. 10f 1
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