20150601McKenzie Direct.pdf

DAVID J. MEYER VICE PRESIDENT AND CHIEF COUNSEL OF
REGULATORY & GOVERNMENTAL AFFAIRS AVISTA CORPORATION P.O. BOX 3727 1411 EAST MISSION AVENUE SPOKANE, WASHINGTON 99220-3727
TELEPHONE: [phone] FACSIMILE: [phone]

BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION

IN THE MATTER OF THE APPLICATION ) CASE NO. AVU-E-15-05 OF AVISTA CORPORATION FOR THE ) CASE NO. AVU-G-15-01
AUTHORITY TO INCREASE ITS RATES ) AND CHARGES FOR ELECTRIC AND ) DIRECT TESTIMONY
NATURAL GAS SERVICE TO ELECTRIC ) OF AND NATURAL GAS CUSTOMERS IN THE ) ADRIEN M. MCKENZIE STATE OF IDAHO )
)

FOR AVISTA CORPORATION
(ELECTRIC AND NATURAL GAS)

DIRECT TESTIMONY OF ADRIEN M. MCKENZIE
TABLE OF CONTENTS
I. INTRODUCTION ............................................. 1
C. Overview ............................................. 1 D. Summary of Conclusions ............................... 5
II. RISKS OF AVISTA ......................................... 15
A. Operating Risks ..................................... 15 B. Outlook for Capital Costs ........................... 19
C. Support for Avista’s Credit Standing ................ 30 D. Capital Structure ................................... 33
III. CAPITAL MARKET ESTIMATES ............................ 38
A. Overview ............................................ 39 B. Results of Primary Methods .......................... 43 C. Flotation Costs ..................................... 49 D. Other ROE Benchmarks ................................ 54
IV. IMPACT OF REGULATORY MECHANISMS ......................... 60

Exhibit No. 3 Schedule 1 – Qualifications of Adrien M. McKenzie Schedule 2 – Description of Quantitative Analyses
Schedule 3 – ROE Analyses – Summary of Results Schedule 4 – Capital Structure
Schedule 5 – Constant Growth DCF Model – Utility Group Schedule 6 – Sustainable Growth Rate – Utility Group Schedule 7 – Empirical Capital Asset Pricing Model
Schedule 8 – Electric Utility Risk Premium Schedule 9 – Capital Asset Pricing Model
Schedule 10 – Expected Earnings Approach Schedule 11 – Constant Growth DCF Model – Non-Utility Group Schedule 12 – Regulatory Mechanisms

I. INTRODUCTION 1
Q. Please state your name and business address. 2
A. Adrien M. McKenzie, 3907 Red River, Austin, Texas, 3
78751. 4
Q. In what capacity are you employed? 5
A. I am a Vice President of FINCAP, Inc., a firm 6
providing financial, economic, and policy consulting services 7
to business and government. 8
Q. Please describe your educational background and 9
professional experience. 10
A. A description of my background and qualifications, 11
including a resume containing the details of my experience, 12
is attached as Exhibit No. 3, Schedule 1. 13
C. Overview 14
Q. What is the purpose of your testimony in this case? 15
A. The purpose of my testimony is to present to the 16
Idaho Public Utility Commission (the “Commission” or “IPUC”) 17
my independent evaluation of the fair rate of return on 18
equity (“ROE”) for the jurisdictional electric and gas 19
utility operations of Avista Corp. (“Avista” or “the 20
Company”). In addition, I also examined the reasonableness 21
McKenzie, Di 1 Avista Corporation

of Avista’s capital structure, considering both the specific 1
risks faced by the Company and other industry guidelines. 2
Q. Please summarize the information and materials you 3
relied on to support the opinions and conclusions contained 4
in your testimony. 5
A. To prepare my testimony, I used information from a 6
variety of sources that would normally be relied upon by a 7
person in my capacity. I am familiar with the organization, 8
finances, and operations of Avista from my participation in 9
prior proceedings before the IPUC, the Washington Utilities 10
and Transportation Commission (“WUTC”) and the Oregon Public 11
Utility Commission. In connection with the present filing, I 12
considered and relied upon corporate disclosures, publicly 13
available financial reports and filings, and other published 14
information relating to Avista. I have also visited the 15
Company’s corporate headquarters and had discussions with 16
management in order to better familiarize myself with 17
Avista’s utility operations. My evaluation also relied upon 18
information relating to current capital market conditions and 19
investor perceptions, requirements, and expectations for 20
utilities. These sources, coupled with my experience in the 21
fields of finance and utility regulation, have given me a 22
working knowledge of the issues relevant to investors’ 23
McKenzie, Di 2 Avista Corporation

required return for Avista, and they form the basis of my 1
analyses and conclusions. 2
Q. How is your testimony organized? 3
A. After first summarizing my conclusions and 4
recommendations, my testimony reviews the operations and 5
finances of Avista and industry-specific risks and capital 6
market uncertainties perceived by investors. With this as a 7
background, I present the application of well-accepted 8
quantitative analyses to estimate the current cost of equity 9
for a reference group of comparable-risk utilities. These 10
included the discounted cash flow (“DCF”) model, the 11
empirical form of Capital Asset Pricing Model (“ECAPM”), and 12
an equity risk premium approach based on allowed ROEs for 13
electric utilities, which are all methods that are commonly 14
relied on in evaluating investors’ required rate of return. 15
Based on the cost of equity estimates indicated by my 16
analyses, the Company’s ROE was evaluated taking into account 17
the specific risks and potential challenges for Avista’s 18
utility operations in Idaho, as well as other factors (e.g., 19
flotation costs) that are properly considered in setting a 20
fair ROE for the Company. 21
In addition, I tested my recommendations for Avista 22
against the results of alternative ROE benchmarks, including 23
reference to applications of the traditional Capital Asset 24
McKenzie, Di 3 Avista Corporation

Pricing Model (“CAPM”) and expected rates of return for 1
electric utilities. Further, I corroborated my utility 2
quantitative analyses by applying the DCF model to a group of 3
low risk non-utility firms. Finally, my testimony addresses 4
the impact of regulatory mechanisms on an evaluation of a 5
fair ROE for Avista. 6
Q. What is the role of the ROE in setting a utility's 7
rates? 8
A. The ROE is the cost of attracting and retaining 9
common equity investment in the utility’s physical plant and 10
assets. This investment is necessary to finance the asset 11
base needed to provide utility service. Investors commit 12
capital only if they expect to earn a return on their 13
investment commensurate with returns available from 14
alternative investments with comparable risks. Moreover, a 15
fair and reasonable ROE is integral in meeting sound 16
regulatory economics and the standards set forth by the U.S. 17
Supreme Court in the Bluefield1 and Hope2 cases, which state 18
that a utility’s allowed ROE should be sufficient to: 1) 19
fairly compensate the utility’s investors, 2) enable the 20
utility to offer a return adequate to attract new capital on 21
1 Bluefield Water Works & Improvement Co. v. Pub. Serv. Comm'n, 262 U.S.
679 (1923). 2 Fed. Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591 (1944).
McKenzie, Di 4 Avista Corporation

reasonable terms, and 3) maintain the utility’s financial 1
integrity. These standards should allow the utility to 2
fulfill its obligation to provide reliable service while 3
meeting the needs of customers through necessary system 4
replacement and expansion, but they can only be met if the 5
utility has a reasonable opportunity to actually earn its 6
allowed ROE. 7
D. Summary of Conclusions 8
Q. Please summarize the results of your analyses. 9
A. The results of my analyses are presented on page 1 10
of Exhibit No. 3, Schedule 3, and in Table 1, below: 11
McKenzie, Di 5 Avista Corporation

TABLE 1 1 SUMMARY OF RESULTS 2

DCF Average Midpoint
Value Line 9.9%10.6%
IBES 9.2%8.9%
Zacks 8.9%9.2%
Internal br + sv 8.4%9.6%
Empirical CAPM - Historical Bond Yield
Unadjusted 10.0%10.2%
Size Adjusted 11.1%10.9%
Empirical CAPM - Projected Bond Yield
Unadjusted 10.3%10.4%
Size Adjusted 11.4%11.1%
Utility Risk Premium
Historical Bond Yields
Projected Bond Yields
Cost of Equity Recommendation
Cost of Equity Range 9.4%--10.8%
Flotation Cost Adjustment
Dividend Yield
Flotation Cost Percentage
Adjustment
ROE Recommendation 9.5%--10.9%
0.10%
10.1%
3.6%
11.3%
3.6%
McKenzie, Di 6 Avista Corporation

Figure 1, below, presents the 18 cost of equity estimates 1
presented in Table 1 in rank order, and compares them with 2
Avista’s 9.9% ROE request: 3
FIGURE 1 4 RESULTS OF ANALYSES VS. AVISTA REQUEST 5
6
Q. What are your findings regarding the 9.9 percent 7
ROE requested by Avista? 8
A. Based on the results of my analyses and the 9
economic requirements necessary to support continuous access 10
to capital under reasonable terms, I determined that 9.9 11
percent is a fair and reasonable estimate of investors’ 12
required ROE for Avista. The bases for my conclusion are 13
summarized below: 14
• In order to reflect the risks and prospects associated 15
with Avista’s jurisdictional utility operations, my 16 analyses focused on a proxy group of 19 other 17 utilities with comparable investment risks. 18
• Because investors’ required return on equity is 19 unobservable and no single method should be viewed in 20
McKenzie, Di 7 Avista Corporation

isolation, I applied the DCF, ECAPM, and risk premium 1 methods to estimate a fair ROE for Avista; 2
• Based on the results of these analyses, and giving 3 less weight to extremes at the high and low ends of 4 the range, I concluded that the cost of equity for the 5 proxy group of utilities is in the 9.4 percent to 10.8 6 percent range, or 9.5 percent to 10.9 percent after 7
incorporating an adjustment to account for the impact 8 of common equity flotation costs; and, 9
• As reflected in the testimony of Mark T. Thies, Avista 10 is requesting an ROE of 9.9 percent, which falls below 11
the 10.2 percent midpoint of my recommended range. 12
Considering capital market expectations, the exposures 13 faced by Avista, and the economic requirements 14 necessary to maintain financial integrity and support 15
additional capital investment even under adverse 16 circumstances, it is my opinion that 9.9 percent 17
represents a conservative ROE for Avista. 18
Q. What other evidence did you consider in evaluating 19
your ROE recommendation in this case? 20
A. My recommendation is reinforced by the following 21
findings: 22
• The reasonableness of a 9.9 percent ROE for Avista is 23 supported by the need to consider the challenges to 24
the Company’s credit standing: 25
o The pressure of funding significant capital 26 expenditures of approximately $375 million planned 27
for 2015, and over $1.8 billion during the next 28 five years heighten the uncertainties associated 29
with Avista, especially given that the Company’s 30 existing rate base is approximately $2.6 billion; 31
o Because of Avista’s reliance on hydroelectric 32
generation and increasing dependence on natural 33 gas fueled capacity, the Company is exposed to 34
relatively greater risks of power cost volatility, 35 even with the power cost adjustment (“PCA”); 36
o Widespread expectations for higher interest rates 37
emphasize the implication of considering the 38 impact of projected bond yields in evaluating the 39
results of the ECAPM and risk premium methods; 40 and, 41
McKenzie, Di 8 Avista Corporation

o My conclusion that a 9.9 percent ROE for Avista is 1 a reasonable estimate of investors’ required 2
return is also reinforced by the greater 3 uncertainties associated with Avista’s relatively 4 small size. 5
• Sensitivity to financial market and regulatory 6 uncertainties has increased dramatically and investors 7
recognize that constructive regulation is a key 8 ingredient in supporting utility credit standing and 9 financial integrity; 10
• Providing Avista with the opportunity to earn a return 11 that reflects these realities is an essential 12 ingredient to support the Company’s financial 13 position, which ultimately benefits customers by 14 ensuring reliable service at lower long-run costs; 15
• Continued support for Avista’s financial integrity, 16 including a reasonable ROE, is imperative to ensure 17
that the Company has the capability to maintain or 18 enhance its credit standing while confronting 19 potential challenges associated with funding 20
infrastructure development necessary to meet the needs 21 of its customers. 22
• Regulatory mechanisms, including Avista’s requested 23
Fixed Cost Adjustment Mechanism (“FCA”) are viewed as 24 supportive by investors, but they do not warrant a 25
downward adjustment to the Company's ROE: 26
 The implications of regulatory mechanisms, 27
including measures comparable to the FCA, are 28 fully reflected in Avista's credit ratings, which 29 are comparable to those of the proxy group used 30 to estimate the cost of equity; 31
 Because the utilities in my proxy group operate 32 under a wide variety of regulatory mechanisms, 33 including provisions akin to Avista’s requested 34
FCA, the effects of the Company’s approved and 35 proposed regulatory mechanisms are already 36
reflected in the results of my analyses, and no 37 separate adjustment to Avista's electric or gas 38 ROE is necessary or warranted. 39
These findings indicate that the 9.9 percent ROE requested by 40
Avista is reasonable and should be approved. 41
McKenzie, Di 9 Avista Corporation

Q. What did the results of alternative ROE benchmarks 1
indicate with respect to your evaluation? 2
A. The results of alternative ROE benchmarks are 3
presented on page 2 of Exhibit No. 3, Schedule 3, and in 4
Table 2, below: 5
TABLE 2 6 SUMMARY OF ROE BENCHMARKS 7
8
Figure 2, below, presents these 17 alternative benchmark 9
results presented in Table 2 in rank order, and compares them 10
with Avista’s 9.9% ROE request: 11
Average Midpoint
CAPM - Historical Bond Yield
Unadjusted 9.5%9.7%
Size Adjusted 10.6%10.4%
CAPM - Projected Bond Yield
Unadjusted 9.9%10.1%
Size Adjusted 11.0%10.8%
Expected Earnings
Industry
Proxy Group 10.3%10.8%
Non-Utility DCF
Value Line 10.1%10.3%
IBES 9.4%9.2%
Zacks 9.8%10.1%
10.6%
McKenzie, Di 10 Avista Corporation

FIGURE 2 1 ALTERNATIVE BENCHMARKS VS. AVISTA REQUEST 2
3
As summarized below, these results confirm the conclusion 4
that the 9.9 percent ROE requested for Avista is reasonable: 5
• Applying the traditional CAPM approach implied a 6
current cost of equity on the order of 9.5 percent 7
to 11.0 percent; 8
• Expected returns for electric utilities suggested 9
an ROE range of 10.3 percent 10.8 percent, 10
excluding any adjustment for flotation costs; 11
• DCF estimates for a low-risk group of non-utility 12
firms resulted in average ROE values in the range 13
of 9.4 percent to 10.1 percent. 14
These tests of reasonableness confirm that a 9.9 percent ROE 15
falls in the lower end of the reasonable range to maintain 16
Avista’s financial integrity, provides a return commensurate 17
with investments of comparable risk, and supports the 18
Company’s ability to attract capital. 19
McKenzie, Di 11 Avista Corporation

Q. Would any adjustment to Avista’s ROE be warranted 1
due to the Company’s proposed FCA mechanism? 2
A. No. Investors recognize that Avista is exposed to 3
significant risks associated with rising costs and stagnant 4
sales volumes, and concerns over these risks have become 5
increasingly pronounced in the industry. Avista’s proposed 6
FCA mechanism represents an important means of mitigating 7
those risks, but it does not eliminate them. The addition of 8
the FCA mechanism would contribute towards leveling the 9
playing field and serves to address factors that could 10
otherwise impair Avista’s opportunity to earn its authorized 11
return, as required by established regulatory standards. 12
Reflective of this industry trend, the companies in the 13
Utility Group operate under a wide variety of cost adjustment 14
mechanisms, which range from riders to recover bad debt 15
expense and post-retirement employee benefit costs to revenue 16
decoupling and adjustment clauses designed to address the 17
rising costs of environmental compliance measures. 18
Similarly, the firms in the Non-Utility Group also have the 19
ability to alter prices in response to rising production 20
costs, with the added flexibility to withdraw from the market 21
altogether. As a result, the mitigation in risks associated 22
with the proposed FCA mechanism is already reflected in the 23
McKenzie, Di 12 Avista Corporation

cost of equity range determined earlier, and no separate 1
adjustment to Avista’s ROE is necessary or warranted. 2
Q. What other factors should be considered in 3
evaluating the ROE requested by Avista in this case? 4
A. Apart from the results of the quantitative methods 5
summarized above, it is crucial to recognize the importance 6
of supporting the Company’s financial position so that Avista 7
remains prepared to respond to unforeseen events that may 8
materialize in the future. Recent challenges in the economic 9
and financial market environment highlight the imperative of 10
continuing to build the Company’s financial strength in order 11
to attract the capital needed to secure reliable service at a 12
reasonable cost for customers; these challenges include 13
interest rate risk and capital market volatility. The 14
reasonableness of the Company’s requested ROE is reinforced 15
by the operating risks associated with Avista’s reliance on 16
hydroelectric generation, the higher uncertainties associated 17
with Avista’s relatively small size, and the fact that, due 18
to broad-based expectations for higher bond yields, current 19
cost of capital estimates are likely to understate investors’ 20
requirements at the conclusion of this proceeding and beyond. 21
McKenzie, Di 13 Avista Corporation

Q. Does an ROE of 9.9 percent represent a reasonable 1
cost for Avista’s customers to pay? 2
A. Yes. Investors have many options competing for 3
their money. They make investment capital available to 4
Avista only if the expected returns justify the risk. 5
Customers will enjoy reliable and efficient service so long 6
as investors are willing to make the capital investments 7
necessary to maintain and improve Avista’s utility system. 8
Providing an adequate return to investors is a necessary cost 9
to ensure that capital is available to Avista on reasonable 10
terms now and in the future. If regulatory decisions 11
increase risk or limit returns to levels that are 12
insufficient to justify the risk, investors will look 13
elsewhere to invest capital. 14
Q. What is your conclusion as to the reasonableness of 15
the Company’s capital structure? 16
A. Based on my evaluation, I concluded that a common 17
equity ratio of 50.0 percent represents a reasonable basis 18
from which to calculate Avista’s overall rate of return. 19
This conclusion was based on the following findings: 20
• Avista’s requested capitalization is consistent with 21 the Company’s need to maintain its credit standing and 22
financial flexibility as it seeks to raise additional 23 capital to fund significant system investments and 24
meet the requirements of its service territory; 25
McKenzie, Di 14 Avista Corporation

• Avista’s proposed common equity ratio is entirely 1 consistent with the range of capitalizations for the 2 proxy utilities and is in-line with the average equity 3 ratios at year-end 2014 and based on the near-term 4 expectations of the Value Line Investment Survey 5
(“Value Line”), respectively; 6
• The requested capitalization reflects the importance 7
of an adequate equity layer to accommodate Avista’s 8 operating risks and the pressures of funding 9 significant capital investments. This is reinforced 10
by the need to consider the impact of uncertain 11 capital market conditions, as well as off-balance 12 sheet commitments such as purchased power agreements, 13 which carry with them some level of imputed debt. 14
II. RISKS OF AVISTA 15
Q. What is the purpose of this section? 16
A. As a predicate to my capital market analyses, this 17
section examines the investment risks that investors consider 18
in evaluating their required rate of return for Avista. 19
A. Operating Risks 20
Q. How does Avista’s generating resource mix affect 21
investors’ risk perceptions? 22
A. Because over 40 percent of Avista’s total energy 23
requirements are provided by hydroelectric facilities, the 24
Company is exposed to a level of uncertainty not faced by 25
most utilities. While hydropower confers advantages in terms 26
of fuel cost savings and diversity, reduced hydroelectric 27
generation due to below-average water conditions forces 28
Avista to rely more heavily on wholesale power markets or 29
McKenzie, Di 15 Avista Corporation

more costly thermal generating capacity to meet its resource 1
needs. As S&P has observed: 2
A reduction in hydro generation typically increases 3 an electric utility’s costs by requiring it to buy 4 replacement power or run more expensive generation 5
to serve customer loads. Low hydro generation can 6 also reduce utilities’ opportunity to make off-7 system sales. At the same time, low hydro years 8
increase regional wholesale power prices, creating 9 potentially a double impact – companies have to buy 10
more power than under normal conditions, paying 11 higher prices.3 12
Investors recognize that the potential for energy market 13
volatility, unpredictable stream flows, and Avista’s reliance 14
on wholesale purchases to meet a significant portion of its 15
resource needs can expose the Company to the risk of reduced 16
cash flows and unrecovered power supply costs. 17
S&P has noted that Avista, along with Idaho Power 18
Company, “face the most substantial risks despite their PCAs 19
and cost-update mechanisms,”4 and concluded that Avista’s 20
“Northwest hydropower has been subject to significant 21
volatility in recent years, so [Avista] is exposed to 22
purchased power costs.”5 23
Similarly, Moody’s Investors Service (“Moody’s”) has 24
recognized that, “Avista’s high dependency on hydro resources 25
3 Standard & Poor’s Corporation, “Pacific Northwest Hydrology And Its
Impact On Investor-Owned Utilities’ Credit Quality,” RatingsDirect (Jan. 28, 2008). 4 Id. 5 Standard & Poor’s Corporation, “Industry Report Card,” RatingsDirect (Apr. 19, 2013).
McKenzie, Di 16 Avista Corporation

(approximately 50% of its production comes from hydro fueled 1
electric generation resources) is viewed as a supply 2
concentration risk . . . especially since hydro levels, due 3
to weather, is a factor outside of management's control.”6 4
More recently, S&P affirmed the importance of constructive 5
regulation in light of the potential need “to purchase power 6
for customers when hydro power is unavailable.”7 Avista’s 7
reliance on purchased power to meet shortfalls in 8
hydroelectric generation magnifies the importance of 9
strengthening financial flexibility. 10
Q. Do financial pressures associated with Avista’s 11
planned capital expenditures also impact investors’ risk 12
assessment? 13
A. Yes. Avista will require capital investment to 14
meet customer growth, provide for necessary maintenance and 15
replacements of its natural gas utility systems, as well as 16
fund new investment in electric generation, transmission and 17
distribution facilities. Utility capital additions are 18
expected to total approximately $375 million for 2015, and 19
$350 million for each of the years 2016 through 2019. This 20
6 Moody’s Investors Service, “Credit Opinion: Avista Corp.,” Global Credit
Research (Mar. 17, 2011). 7 Standard & Poor’s Corporation, “Avista Corp.,” RatingsDirect (May 9, 2014).
McKenzie, Di 17 Avista Corporation

represents a substantial investment given Avista’s current 1
rate base of approximately $2.6 billion. 2
Continued support for Avista’s financial integrity and 3
flexibility will be instrumental in attracting the capital 4
necessary to fund these projects in an effective manner. 5
Investors are aware of the challenges posed by burdensome 6
capital expenditure requirements, especially in light of 7
ongoing capital market and economic uncertainties, and 8
Moody’s has noted that increasing capital expenditures are a 9
primary credit concern for Avista.8 10
Q. Would investors consider Avista’s relative size in 11
their assessment of the Company’s risks and prospects? 12
A. Yes. A firm’s relative size has important 13
implications for investors in their evaluation of alternative 14
investments, and it is well established that smaller firms 15
are more risky than larger firms. With a market 16
capitalization of approximately $2.0 billion, Avista is one 17
of the smallest publicly traded utility holding companies 18
followed by Value Line, which have an average capitalization 19
of approximately $12.6 billion.9 20
8 Moody’s Investors Service, “Credit Opinion: Avista Corp.,” Global Credit
Research (Mar. 28, 2014). 9 www.valueline.com (retrieved May 5, 2015).
McKenzie, Di 18 Avista Corporation

The magnitude of the size disparity between Avista and 1
other firms in the utility industry has important practical 2
implications with respect to the risks faced by investors. 3
All else being equal, it is well accepted that smaller firms 4
are more risky than their larger counterparts, due in part to 5
their relative lack of diversification and lower financial 6
resiliency.10 These greater risks imply a higher required 7
rate of return, and there is ample empirical evidence that 8
investors in smaller firms realize higher rates of return 9
than in larger firms.11 Accepted financial doctrine holds 10
that investors require higher returns from smaller companies, 11
and unless that compensation is provided in the rate of 12
return allowed for a utility, the legal tests embodied in the 13
Hope and Bluefield cases cannot be met. 14
B. Outlook for Capital Costs 15
Q. Do current capital market conditions provide a 16
representative basis on which to evaluate a fair ROE? 17
A. No. Current capital market conditions continue to 18
reflect the Federal Reserve's unprecedented monetary policy 19
10 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 (Summer 1978). 11 See for example Rolf W. Banz, “The Relationship Between Return and
Market Value of Common Stocks”, Journal of Financial Economics (September 1981) at 16.
McKenzie, Di 19 Avista Corporation

actions in the aftermath of the Great Recession, and are not 1
representative of what investors expect in the future. 2
Investors have had to contend with a level of economic 3
uncertainty and capital market volatility that has been 4
unprecedented in recent history. The ongoing potential for 5
renewed turmoil in the capital markets has been seen 6
repeatedly, with common stock prices exhibiting the dramatic 7
volatility that is indicative of heightened sensitivity to 8
risk. In response to heightened uncertainties in recent 9
years, investors have repeatedly sought a safe haven in U.S. 10
government bonds. As a result of this “flight to safety,” 11
Treasury bond yields have been pushed significantly lower in 12
the face of political, economic, and capital market risks. 13
In addition, the Federal Reserve has implemented measures 14
designed to push interest rates to historically low levels in 15
an effort to stimulate the economy and bolster employment. 16
Q. How do current yields on public utility bonds 17
compare with what investors have experienced in the past? 18
A. The yields on utility bonds remain near their 19
lowest levels in modern history. Figure 3, below, compares 20
the April 2015 average yield on long-term, triple-B rated 21
utility bonds with those prevailing since 1968: 22
McKenzie, Di 20 Avista Corporation

FIGURE 3 1 BBB UTILITY BOND YIELDS – CURRENT VS. HISTORICAL 2

As illustrated above, prevailing capital market conditions, 3
as reflected in the yields on triple-B utility bonds, are an 4
anomaly when compared with historical experience. Similarly, 5
while 10-year Treasury bond yields may reflect a modest 6
increase from all-time lows of less than 2.0 percent, they 7
are hardly comparable to historical levels.12 Federal Reserve 8
President Charles Plosser recently observed that U.S. 9
interest rates are unprecedentedly low, and “outside 10
historical norms.”13 11
12 The average yield on 10-year Treasury bonds for the six-months ended April 2015 was 2.06 percent. Over the 1968-2015 period illustrated on Figure 2, 10-year Treasury bond yields averaged 6.71 percent. 13 Barnato, Katy, “Fed’s Plosser: Low rates ‘should make us nervous’,” CNBC (Nov. 11, 2014).
2.0%
4.0%
6.0%
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April 2015 - 4.51%
McKenzie, Di 21 Avista Corporation

Q. Are these very low interest rates expected to 1
continue? 2
A. No. Investors continue to anticipate that interest 3
rates will increase significantly from present levels. 4
Figure 4 below compares current interest rates on 30-year 5
Treasury bonds, triple-A rated corporate bonds, and double-A 6
rated utility bonds with near-term projections from Value 7
Line, IHS Global Insight, Blue Chip Financial Forecasts 8
(“Blue Chip”), and the Energy Information Administration 9
(“EIA”): 10
FIGURE 4 11 INTEREST RATE TRENDS 12

These forecasting services are highly regarded and 13
widely referenced, with FERC incorporating forecasts from IHS 14
Source:
Value Line Investment Survey, Forecast for the U.S. Economy (Feb. 20, 2015)
IHS Global Insight, The U.S. Economy: The 30-Year Focus (Third-Quarter 2014)
Energy Information Administration, Annual Energy Outlook 2015 (April 2015)Blue Chip Financial Forecasts, Vol. 33, No. 12 (Dec. 1, 2014)
1.5%
2.5%
3.5%
4.5%
5.5%
6.5%
Apr. 2015 2015 2016 2017 2018 2019
AA Utility AAA Corp.30-Yr Govt.10-Yr Govt.
McKenzie, Di 22 Avista Corporation

Global Insight and the EIA in its preferred DCF model for 1
natural gas and oil pipelines, as well as for electric 2
transmission utilities. As evidenced above, there is a clear 3
consensus in the investment community that the cost of long-4
term capital will be significantly higher over the 2015-2019 5
period. 6
Q. Do recent actions of the Federal Reserve support 7
the contention that current low interest rates will continue 8
indefinitely? 9
A. No. Citing improvement in the outlook for the 10
labor market and increasing strength in the broader economy, 11
the Federal Reserve elected to discontinue further purchases 12
under its bond-buying program at its October 2014 meeting. 13
While the Federal Reserve continues to express support for 14
maintaining a highly accommodative monetary policy and an 15
exceptionally low target range for the federal funds rate, 16
elimination of additional bond purchases under the Federal 17
Reserve’s program of “Quantitative Easing” should ultimately 18
exert upward pressure on long-term interest rates. As The 19
Wall Street Journal observed: 20
The Fed’s decision to begin trimming its $85 21
billion monthly bond-buying program is widely 22 expected to result in higher medium-term and long-23
term market interest rates. That means many 24
McKenzie, Di 23 Avista Corporation

borrowers, from home buyers to businesses, will be 1 paying higher rates in the near future.14 2
While the Federal Reserve’s conclusion of new asset 3
purchases has moderated uncertainties over just when, and to 4
what degree, the stimulus program would be altered, investors 5
continue to face ongoing uncertainties over future 6
modifications that could ultimately affect how quickly and by 7
how much interest rates are affected. 8
Q. Does the cessation of further asset purchases by 9
the Federal Reserve mark a return to “normal” in capital 10
markets? 11
A. No. The Federal Reserve continues to exert 12
considerable influence over capital market conditions through 13
its massive holdings of Treasuries and mortgage-backed 14
securities. Prior to the initiation of the stimulus program 15
in 2009, the Federal Reserve’s holdings of U.S. Treasury 16
bonds and notes amounted to approximately $400 - $500 17
billion. With the implementation of its asset purchase 18
program, balances of Treasury securities and mortgage backed 19
instruments climbed steadily, and their effect on capital 20
market conditions became more pronounced. Table 3 below 21
14 Jon Hilsenrath, “Fed Dials Back Bond Buying, Keeps a Wary Eye on Growth,” The Wall Street Journal at A1 (Dec. 19, 2013).
McKenzie, Di 24 Avista Corporation

charts the course of the Federal Reserve’s asset purchase 1
program: 2
TABLE 3 3 FEDERAL RESERVE BALANCES OF 4 TREASURY BONDS AND MORTGAGE-BACKED SECURITIES 5 (Billion $)

Far from representing a return to normal, the Federal 6
Reserve’s holdings of Treasury bonds and mortgage-backed 7
securities now amount to more than $4 trillion,15 which is an 8
all-time high. 9
For now, the Federal Reserve is maintaining its policy 10
of reinvesting principal payments from these securities – 11
about $16 billion a month – and rolling over maturing 12
Treasuries at auction. As the Federal Reserve recently 13
noted: 14
The Committee is maintaining its existing policy of 15 reinvesting principal payments from its holdings of 16
agency debt and agency mortgage-backed securities 17 in agency mortgage-backed securities and of rolling 18 over maturing Treasury securities at auction. This 19
policy, by keeping the Committee's holdings of 20
15 Federal Reserve Statistical Release, “Factors Affecting Reserve Balances
of Depository Institutions and Condition Statement of Federal Reserve Banks,” H.4.1.
2008 410$
2009 1,618$
2010 1,939$
2011 2,423$
2012 2,512$
2013 3,597$
2014 4,097$
McKenzie, Di 25 Avista Corporation

longer-term securities at sizable levels, should 1 help maintain accommodative financial conditions.16 2
3 This continued investment maintains the downward 4
pressure on interest rates that is the hallmark of the 5
stimulus program and the anomalous conditions currently 6
characterizing capital markets. 7
Of course, the corollary to these observations is that 8
changes to this policy of reinvestment would further reduce 9
stimulus measures and could place significant upward pressure 10
on bond yields, especially considering the unprecedented 11
magnitude of the Federal Reserve’s holdings of Treasury bonds 12
and mortgage-backed securities. The International Monetary 13
Fund noted, “A lack of Fed clarity could cause a major spike 14
in borrowing costs that could cause severe damage to the U.S. 15
recovery and send destructive shockwaves around the global 16
economy,” adding that, “[a] smooth and gradual upward shift 17
in the yield curve might be difficult to engineer, and there 18
could be periods of higher volatility when longer yields jump 19
sharply—as recent events suggest.”17 As a Financial Analysts 20
Journal article noted: 21
Because no precedent exists for the massive 22 monetary easing that has been practiced over the 23
16 Press Release, Board of Governors of the Federal Reserve System, (Mar. 18, 2015), http://www.federalreserve.gov/newsevents/press/monetary/20150318a.htm. 17 Talley, Ian, “IMF Urges ‘Improved’ U.S. Fed Policy Transparency as It Mulls Easy Money Exit,” The Wall Street Journal (July 26, 2013).
McKenzie, Di 26 Avista Corporation

past five years in the United States and Europe, 1 the uncertainty surrounding the outcome of central 2
bank policy is so vast. . . . Total assets on the 3 balance sheets of most developed nations’ central 4 banks have grown massively since 2008, and the 5 timing of when the banks will unwind those 6 positions is uncertain.18 7
8 These developments highlight continued concerns for 9
investors and support expectations for higher interest rates 10
as the economy and labor markets continue to recover. With 11
the Federal Reserve curtailing the expansion of its enormous 12
portfolio of Treasuries and mortgage bonds, ongoing concerns 13
over political stalemate in Washington, the threat of renewed 14
recession in the Eurozone, and political and economic unrest 15
in Ukraine, the Middle East, and emerging markets, the 16
potential for significant volatility and higher capital costs 17
is clearly evident to investors. 18
Q. Have other regulators recognized the importance of 19
considering the implications of current capital market 20
conditions when evaluating a fair ROE for a utility? 21
A. Yes. In its June 19, 2014 order in Docket No. 22
EL11-66-001, FERC explicitly noted the need to “consider the 23
extent to which economic anomalies may have affected the 24
reliability of DCF analyses in determining where to set a 25
public utility’s ROE within the range of reasonable 26
18 Poole, William, “Prospects for and Ramifications of the Great Central Banking Unwind,” Financial Analysts Journal (November/December 2013).
McKenzie, Di 27 Avista Corporation

returns.”19 FERC ultimately determined that due to 1
unrepresentative capital market conditions, an upward 2
adjustment to the 9.39 percent midpoint of its DCF range was 3
required in order to meet the regulatory standards 4
established by Hope and Bluefield. Based on its examination 5
of alternatives to the DCF approach, FERC authorized an ROE 6
from the upper end of its DCF range, or 10.57 percent.20 7
Q. What do these events imply with respect to the ROE 8
for Avista more generally? 9
A. Current capital market conditions continue to 10
reflect the impact of unprecedented policy measures taken in 11
response to recent dislocations in the economy and financial 12
markets. As a result, current capital costs are not 13
representative of what is likely to prevail over the near-14
term future. As FERC recently concluded: 15
[W]e also understand that any DCF analysis may be 16 affected by potentially unrepresentative financial 17 inputs to the DCF formula, including those produced 18
by historically anomalous capital market 19 conditions. Therefore, while the DCF model remains 20
the Commission’s preferred approach to determining 21 allowed rate of return, the Commission may consider 22 the extent to which economic anomalies may have 23 affected the reliability of DCF analyses …21 24
19 Martha Coakley et al., v. Bangor Hydro-Electric Company, et al., Opinion No. 531, 147 FERC ¶ 61,234 at P 41 (2014) (“Opinion No. 531”). 20 Id. at PP 145, 146, 148, & 152. 21 Opinion No. 531, 147 FERC ¶ 61,234 at P 41 (2014).
McKenzie, Di 28 Avista Corporation

This conclusion is supported by comparisons of current 1
conditions to the historical record and independent 2
forecasts. As demonstrated above, recognized economic 3
forecasting services project that long-term capital costs 4
will increase from present levels. 5
To address the reality of current capital markets, the 6
IPUC should consider forecasts for higher public utility bond 7
yields in assessing the reasonableness of individual cost of 8
equity estimates and in evaluating a fair ROE for Avista from 9
within the range of reasonableness. As discussed in Exhibit 10
No. 3, Schedule 2, this result is supported by economic 11
studies that show that equity risk premiums are higher when 12
interest rates are at very low levels. 13
Q Do ongoing economic and capital market 14
uncertainties also influence the appropriate capital 15
structure for Avista? 16
A Yes. Financial flexibility plays a crucial role in 17
ensuring the wherewithal to meet funding needs, and utilities 18
with higher financial leverage may be foreclosed from 19
additional borrowing, especially during times of stress. As 20
a result, the Company’s capital structure must maintain an 21
equity “cushion” that preserves the flexibility necessary to 22
maintain continuous access to capital even during times of 23
unfavorable market conditions. 24
McKenzie, Di 29 Avista Corporation

C. Support for Avista’s Credit Standing 1
Q. What credit ratings have been assigned to Avista? 2
A. S&P has assigned Avista a corporate credit rating 3
of “BBB”, while Moody’s has set Avista’s Issuer Rating at 4
“Baa1”. 5
Q. What considerations impact investors’ assessment of 6
the firms in the utility industry? 7
A. Numerous factors have the potential to impact 8
investors’ perceptions of the relative risks inherent in the 9
utility industry and have implications for the financial 10
standing of the utilities themselves. These include the 11
possibility of volatile fuel or purchased power costs, 12
uncertain environmental mandates and associated costs, the 13
implications of declining demand associated with economic 14
weakness or structural changes in usage patterns, and 15
increased reliance on distributed generation or other 16
alternatives to the incumbent utility. Apart from these 17
considerations, utilities may face increasing costs of 18
operating their systems, as well as the financial pressures 19
associated with large capital expenditure programs, which are 20
magnified during periods of turmoil in capital markets. 21
McKenzie, Di 30 Avista Corporation

Q. What are the implications for Avista, given the 1
potential for further dislocations in the capital markets? 2
A. The pressures of significant capital expenditure 3
requirements reinforce the importance of supporting continued 4
improvement in Avista’s credit standing. Investors 5
understand from past experience in the utility industry that 6
large capital needs can lead to significant deterioration in 7
financial integrity that can constrain access to capital, 8
especially during times of unfavorable capital market 9
conditions. Considering the uncertain state of financial 10
markets, competition with other investment alternatives, and 11
investors’ sensitivity to the potential for market 12
volatility, greater credit strength is a key ingredient in 13
maintaining access to capital at reasonable cost. As Mr. 14
Thies confirms in his testimony, continued regulatory support 15
will be a key driver in continuing to build Avista’s 16
financial health. 17
Q. What role does regulation play in ensuring that 18
Avista has access to capital under reasonable terms and on a 19
sustainable basis? 20
A. Investors recognize that constructive regulation is 21
a key ingredient in supporting utility credit ratings and 22
financial integrity, particularly during times of adverse 23
conditions. As Moody’s noted, “the regulatory environment is 24
McKenzie, Di 31 Avista Corporation

the most important driver of our outlook because it sets the 1
pace for cost recovery,”22 With respect to Avista 2
specifically, the major bond rating agencies have explicitly 3
cited the potential that adverse regulatory rulings could 4
compromise the Company’s credit standing. S&P observed that 5
management of Avista’s regulatory relationships “is a 6
critical underpinning of its investment-grade credit 7
quality.”23, and concluded that “greater borrowing or 8
increased rate lag, a large deferral, or adverse regulatory 9
decisions” could lead to a downgrade. Similarly, Moody’s 10
concluded that “Avista’s ratings could be negatively impacted 11
if the level of regulatory support wanes.”24 Further 12
strengthening Avista’s financial integrity is imperative to 13
ensure that the Company has the capability to maintain an 14
investment grade rating while confronting large capital 15
expenditures and other potential challenges.25 16
22 Moody’s Investors Service, “Regulation Will Keep Cash Flow Stable As Major Tax Break Ends,” Industry Outlook (Feb. 19, 2014). 23 Standard & Poor’s Corporation, “Avista Corp.,” RatingsDirect (May 9, 2014). 24 Moody’s Investors Service, “Credit Opinion: Avista Corp.,” Global Credit
Research (Mar. 28, 2014). 25 As noted in the testimony of Mr. Thies, continued regulatory support will be instrumental in achieving Avista’s objective of a BBB+ rating, which is consistent with the average credit standing in the electric utility industry.
McKenzie, Di 32 Avista Corporation

Q. Do customers benefit by enhancing the utility’s 1
financial flexibility? 2
A. Yes. Providing an ROE that is sufficient to 3
maintain Avista’s ability to attract capital under reasonable 4
terms, even in times of financial and market stress, is not 5
only consistent with the economic requirements embodied in 6
the U.S. Supreme Court’s Hope and Bluefield decisions, it is 7
also in customers’ best interests. Customers enjoy the 8
benefits that come from ensuring that the utility has the 9
financial wherewithal to take whatever actions are required 10
to ensure reliable service. 11
D. Capital Structure 12
Q. Is an evaluation of the capital structure 13
maintained by a utility relevant in assessing its return on 14
equity? 15
A. Yes. Other things equal, a higher debt ratio, or 16
lower common equity ratio, translates into increased 17
financial risk for all investors. A greater amount of debt 18
means more investors have a senior claim on available cash 19
flow, thereby reducing the certainty that each will receive 20
his contractual payments. This increases the risks to which 21
lenders are exposed, and they require correspondingly higher 22
rates of interest. From common shareholders’ standpoint, a 23
McKenzie, Di 33 Avista Corporation

higher debt ratio means that there are proportionately more 1
investors ahead of them, thereby increasing the uncertainty 2
as to the amount of cash flow that will remain. 3
Q. What common equity ratio is implicit in Avista’s 4
requested capital structure? 5
A. Avista’s capital structure is presented in the 6
testimony of Mr. Thies. As summarized in his testimony, the 7
proposed common equity ratio used to compute Avista’s overall 8
rate of return is 50.0 percent in this filing. 9
Q. What was the average capitalization maintained by 10
the Utility Group? 11
A. As shown on Exhibit No. 3, Schedule 4, for the 19 12
firms in the Utility Group, common equity ratios at December 13
31, 2014 ranged between 30.2 percent and 54.8 percent and 14
averaged 48.3 percent. 15
Q. What capitalization is representative for the proxy 16
group of utilities going forward? 17
A. As shown on Exhibit No. 3, Schedule 4, Value Line 18
expects an average common equity ratio for the proxy group of 19
utilities of 49.7 percent for its three-to-five year forecast 20
horizon, with the individual common equity ratios ranging 21
from 34.5 percent to 58.0 percent. 22
McKenzie, Di 34 Avista Corporation

Q. How does Avista’s common equity ratio compare with 1
those maintained by the reference group of utilities? 2
A. The 50.0 percent common equity ratio requested by 3
Avista is consistent with the range of equity ratios 4
maintained by the firms in the Utility Group and is in-line 5
with the 48.3 percent and 49.7 percent average equity ratios 6
at year-end 2014 and Value Line’s near-term expectations, 7
respectively. 8
Q. What implication do the uncertainties inherent in 9
the utility industry have for the capital structures 10
maintained by utilities? 11
A. As discussed earlier, utilities are facing rising 12
costs, the need to finance significant capital investment 13
plans, uncertainties over accommodating economic and 14
financial market uncertainties, and ongoing regulatory risks. 15
Coupled with the potential for turmoil in capital markets, 16
these considerations warrant a financial profile that 17
accommodates the need to deal with an increasingly uncertain 18
environment and to maintain the continuous access to capital 19
under reasonable terms that is required to fund operations 20
and necessary system investment, including times of adverse 21
capital market conditions. 22
Moody’s has repeatedly warned investors of the risks 23
associated with debt leverage and fixed obligations and 24
McKenzie, Di 35 Avista Corporation

advised utilities not to squander the opportunity to 1
strengthen the balance sheet as a buffer against future 2
uncertainties.26 Similarly, S&P noted that, “we generally 3
consider a debt to capital level of 50% or greater to be 4
aggressive or highly leveraged for utilities.”27 5
Q. What other factors do investors consider in their 6
assessment of a company’s capital structure? 7
A. Depending on their specific attributes, contractual 8
agreements or other obligations that require the utility to 9
make specified payments may be treated as debt in evaluating 10
Avista’s financial risk. Power purchase agreements (“PPAs”), 11
leases, and pension obligations typically require the utility 12
to make specified minimum contractual payments akin to those 13
associated with traditional debt financing and investors 14
consider a portion of these commitments as debt in evaluating 15
total financial risks. Because investors consider the debt 16
impact of such fixed obligations in assessing a utility’s 17
financial position, they imply greater risk and reduced 18
26 Moody’s Investors Service, “Storm Clouds Gathering on the Horizon for the North American Electric Utility Sector,” Special Comment (Aug. 2007);
“U.S. Electric Utility Sector,” Industry Outlook (Jan. 2008); “U.S. Electric Utilities Face Challenges Beyond Near-Term,” Industry Outlook (Jan. 2010); Moody’s Investors Service, “U.S. Electric Utilities:
Uncertain Times Ahead; Strengthening Balance Sheets Now Would Protect Credit,” Special Comment (Oct. 28, 2010). 27 Standard & Poor’s Corporation, “Ratings Roundup: U.S. Electric Utility
Sector Maintained Strong Credit Quality In A Gloomy 2009,” RatingsDirect (Jan. 26, 2010).
McKenzie, Di 36 Avista Corporation

financial flexibility. In order to offset the debt 1
equivalent associated with off-balance sheet obligations, the 2
utility must rebalance its capital structure by increasing 3
its common equity in order to restore its effective 4
capitalization ratios to previous levels. 5
These commitments have been repeatedly cited by major 6
bond rating agencies in connection with assessments of 7
utility financial risks.28 The capital structure ratios 8
presented earlier do not include imputed debt associated with 9
power purchase agreements or the impact of other off-balance 10
sheet obligations. 11
Q. What does this evidence indicate with respect to 12
the Company’s capital structure? 13
A. Based on my evaluation, I concluded that Avista’s 14
requested capital structure represents a reasonable mix of 15
capital sources from which to calculate the Company’s overall 16
rate of return. While industry averages provide one 17
benchmark for comparison, each firm must select its 18
capitalization based on the risks and prospects it faces, as 19
28 See, e.g., Standard & Poor’s Corporation, “Standard & Poor’s Methodology For Imputing Debt For U.S. Utilities’ Power Purchase Agreements,” RatingsDirect (May 7, 2007); Standard & Poor’s Corporation, “Implications
Of Operating Leases On Analysis Of U.S. Electric Utilities,” RatingsDirect (Jan. 15, 2008); Standard & Poor’s Corporation, “Top 10 Investor Questions: U.S. Regulated Electric Utilities,” RatingsDirect (Jan. 22, 2010); Standard & Poor’s Corporation, “Utilities: Key Credit Factors For The Regulated Utilities Industry,” RatingsDirect (Nov. 19, 2013).
McKenzie, Di 37 Avista Corporation

well its specific needs to access the capital markets. A 1
public utility with an obligation to serve must maintain 2
ready access to capital under reasonable terms so that it can 3
meet the service requirements of its customers. Financial 4
flexibility plays a crucial role in ensuring the wherewithal 5
to meet the needs of customers, and utilities with higher 6
leverage may be foreclosed from additional borrowing under 7
reasonable terms, especially during times of stress. 8
Avista’s capital structure is consistent with industry 9
benchmarks and reflects the challenges posed by its resource 10
mix, the burden of significant capital spending requirements, 11
and the Company’s ongoing efforts to strengthen its credit 12
standing and support access to capital on reasonable terms. 13
III. CAPITAL MARKET ESTIMATES 14
Q. What is the purpose of this section? 15
A. This section presents capital market estimates of 16
the cost of equity. The details of my quantitative analyses 17
are contained in Exhibit No. 3, Schedule 2, with the results 18
being summarized below. 19
McKenzie, Di 38 Avista Corporation

A. Overview 1
Q. What fundamental economic principle underlies any 2
evaluation of investors’ required return on equity? 3
A. The fundamental economic principle underlying the 4
cost of equity concept is the notion that investors are risk 5
averse. In capital markets where relatively risk-free assets 6
are available (e.g., U.S. Treasury securities), investors can 7
be induced to hold riskier assets only if they are offered a 8
premium, or additional return, above the rate of return on a 9
risk-free asset. Since all assets compete with each other 10
for investor funds, riskier assets must yield a higher 11
expected rate of return than safer assets to induce investors 12
to hold them. 13
Given this risk-return tradeoff, the required rate of 14
return (k) from an asset (i) can be generally expressed as: 15
ki = Rf +RPi 16
where: Rf = Risk-free rate of return, and 17
RPi = Risk premium required to hold 18 riskier asset i. 19
Thus, the required rate of return for a particular asset at 20
any point in time is a function of: 1) the yield on risk-free 21
assets, and 2) its relative risk, with investors demanding 22
correspondingly larger risk premiums for assets bearing 23
greater risk. 24
Q. Is there evidence that the risk-return tradeoff 25
principle actually operates in the capital markets? 26
McKenzie, Di 39 Avista Corporation

A. Yes. The risk-return tradeoff can be readily 1
documented in segments of the capital markets where required 2
rates of return can be directly inferred from market data and 3
where generally accepted measures of risk exist. Bond 4
yields, for example, reflect investors’ expected rates of 5
return, and bond ratings measure the risk of individual bond 6
issues. Comparing the observed yields on government 7
securities, which are considered free of default risk, to the 8
yields on bonds of various rating categories demonstrates 9
that the risk-return tradeoff does, in fact, exist. 10
Q. Does the risk-return tradeoff observed with fixed 11
income securities extend to common stocks and other assets? 12
A. Yes. It is widely accepted that the risk-return 13
tradeoff evidenced with long-term debt extends to all assets. 14
Documenting the risk-return tradeoff for assets other than 15
fixed income securities, however, is complicated by two 16
factors. First, there is no standard measure of risk 17
applicable to all assets. Second, for most assets – 18
including common stock – required rates of return cannot be 19
directly observed. Yet there is every reason to believe that 20
investors exhibit risk aversion in deciding whether or not to 21
hold common stocks and other assets, just as when choosing 22
among fixed-income securities. 23
McKenzie, Di 40 Avista Corporation

Q. Is this risk-return tradeoff limited to differences 1
between firms? 2
A. No. The risk-return tradeoff principle applies not 3
only to investments in different firms, but also to different 4
securities issued by the same firm. The securities issued by 5
a utility vary considerably in risk because they have 6
different characteristics and priorities. As noted earlier, 7
long-term debt is senior among all capital in its claim on a 8
utility’s net revenues and is, therefore, the least risky. 9
The last investors in line are common shareholders. They 10
receive only the net revenues, if any, remaining after all 11
other claimants have been paid. As a result, the rate of 12
return that investors require from a utility’s common stock, 13
the most junior and riskiest of its securities, must be 14
considerably higher than the yield offered by the utility’s 15
senior, long-term debt. 16
Q. What does the above discussion imply with respect 17
to estimating the cost of common equity for a utility? 18
A. Although the cost of common equity cannot be 19
observed directly, it is a function of the returns available 20
from other investment alternatives and the risks to which the 21
equity capital is exposed. Because it is unobservable, the 22
cost of equity for a particular utility must be estimated by 23
analyzing information about capital market conditions 24
McKenzie, Di 41 Avista Corporation

generally, assessing the relative risks of the company 1
specifically, and employing various quantitative methods that 2
focus on investors’ current required rates of return. These 3
various quantitative methods typically attempt to infer 4
investors’ required rates of return from stock prices, 5
interest rates, or other capital market data. 6
Q. Did you rely on a single method to estimate the 7
cost of equity for Avista? 8
A. No. In my opinion, no single method or model 9
should be relied upon to determine a utility’s cost of equity 10
because no single approach can be regarded as wholly 11
reliable. Therefore, I used the DCF, CAPM, and risk premium 12
methods to estimate the cost of common equity. In addition, 13
I also evaluated a fair ROE using an earnings approach based 14
on investors’ current expectations in the capital markets. 15
In my opinion, comparing estimates produced by one method 16
with those produced by other approaches ensures that the 17
estimates of the cost of equity pass fundamental tests of 18
reasonableness and economic logic. 19
Q. Are you aware that the IPUC has traditionally 20
relied primarily on the DCF and comparable earnings methods? 21
A. Yes, although the Commission has also evidenced a 22
willingness to weigh alternatives in evaluating an allowed 23
McKenzie, Di 42 Avista Corporation

ROE. For example, while noting that it had not focused on 1
the CAPM for determining the cost of equity, the IPUC 2
recognized in Case No. IPC-E-03-13, Order No. 29505 that 3
“methods to evaluate a common equity rate of return are 4
imperfect predictors” and emphasized “that by evaluating all 5
the methods presented in this case and using each as a check 6
on the other,” the Commission had avoided the pitfalls 7
associated with reliance on a single method.29 8
B. Results of Primary Methods 9
Q. What specific proxy group of utilities did you rely 10
on for your analysis? 11
A. In estimating the cost of equity, the DCF model is 12
typically applied to publicly traded firms engaged in similar 13
business activities or with comparable investment risks. As 14
described in detail in Exhibit No. 3, Schedule 2, I applied 15
the DCF model to a utility proxy group composed of those 16
dividend-paying companies included by Value Line in its 17
Electric Utilities Industry groups with: 18
1. S&P corporate credit ratings of “BBB-” to “BBB+;” 19
2. Moody’s issuer ratings of Baa2, Baa1, or A3, 20
3. Value Line Safety Rank of “2” or “3”; 21
29 Case No. IPC-E-03-13, Order No. 29505 at 38 (2004).
McKenzie, Di 43 Avista Corporation

4. No involvement in a major merger or acquisition; 1
and, 2
5. Currently paying common dividends with no recent 3
dividend cuts. 4
I refer to this group of 19 comparable-risk firms as the 5
“Utility Group.” 6
Q. How do the overall risks of your proxy groups 7
compare with Avista? 8
A. Table 4 compares the Utility Group with Avista 9
across four key indicators of investment risk: 10
TABLE 4 11 COMPARISON OF RISK INDICATORS 12
Value Line
Proxy Group S&P Moody’s Safety Rank Financial Strength Beta
Utility BBB+ Baa1 2 B++ 0.77
Avista BBB Baa1 2 A 0.80
Q. Do these comparisons indicate that investors would 13
view the firms in your proxy groups as risk-comparable to the 14
Company? 15
A. Yes. Considered together, a comparison of these 16
objective measures, which consider of a broad spectrum of 17
risks, including financial and business position, and 18
exposure to firm-specific factors, indicates that investors 19
would likely conclude that the overall investment risks for 20
McKenzie, Di 44 Avista Corporation

Avista are generally comparable to those of the firms in the 1
Utility Group. 2
Q. What cost of equity is implied by your DCF results 3
for the Utility Group? 4
A. My application of the DCF model, which is discussed 5
in greater detail in Exhibit No. 3, Schedule 2, considered 6
three alternative measures of expected earnings growth, as 7
well as the sustainable growth rate based on the relationship 8
between expected retained earnings and earned rates of return 9
(“br+sv”). As shown on page 3 of Exhibit No. 3, Schedule 5 10
and summarized below in Table 5, after eliminating illogical 11
values,30 application of the constant growth DCF model 12
resulted in the following cost of equity estimates: 13
30 I provide a detailed explanation of my DCF analysis, including the evaluation of individual estimates, in Exhibit No. 3, Schedule 2.
McKenzie, Di 45 Avista Corporation

TABLE 5 1 DCF RESULTS – UTILITY GROUP 2
3
Q. How did you apply the ECAPM to estimate the cost of 4
equity? 5
A. Like the DCF model, the ECAPM is an ex-ante, or 6
forward-looking model based on expectations of the future. 7
As a result, in order to produce a meaningful estimate of 8
investors’ required rate of return, the ECAPM is best applied 9
using estimates that reflect the expectations of actual 10
investors in the market, not with backward-looking, 11
historical data. Accordingly, I applied the ECAPM to the 12
Utility Group based on a forward-looking estimate for 13
investors' required rate of return from common stocks. 14
Because this forward-looking application of the ECAPM looks 15
directly at investors’ expectations in the capital markets, 16
it provides a more meaningful guide to the expected rate of 17
return required to implement the ECAPM. 18
Empirical research indicates that the ECAPM does not 19
fully account for observed differences in rates of return 20
attributable to firm size. The need for an adjustment to 21
Growth Rate Average Midpoint
Value Line 9.9%10.6%
IBES 9.2%8.9%
Zacks 8.9%9.2%
br + sv 8.4%9.6%
Cost of Equity
McKenzie, Di 46 Avista Corporation

account for relative market capitalization arises because 1
differences in investors’ required rates of return that are 2
related to firm size are not fully captured by beta. 3
Accordingly, my ECAPM analyses incorporated an adjustment to 4
recognize the impact of size distinctions, as developed by 5
Morningstar. 6
Q. What cost of equity was indicated by the ECAPM 7
approach? 8
A. As shown on page 1 of Exhibit No. 3, Schedule 7, my 9
forward-looking application of the ECAPM model indicated an 10
ROE of 10.0 percent for the Utility Group. Adjusting the 11
10.0 percent theoretical ECAPM result to incorporate the size 12
adjustment results in an indicated cost of common equity of 13
11.1 percent. 14
Q. Did you also apply the ECAPM using forecasted bond 15
yields? 16
A. Yes. As discussed earlier, there is widespread 17
consensus that interest rates will increase materially as the 18
economy continues to strengthen. Accordingly, in addition to 19
the use of current bond yields, I also applied the CAPM based 20
on the forecasted long-term Treasury bond yields developed 21
based on projections published by Value Line, IHS Global 22
Insight and Blue Chip. As shown on page 2 of Exhibit No. 3, 23
McKenzie, Di 47 Avista Corporation

Schedule 7, incorporating a forecasted Treasury bond yield 1
for 2015-2019 implied a cost of equity of approximately 10.3 2
percent for the Utility Group, or 11.4 percent after 3
adjusting for the impact of relative size. 4
Q. How did you implement the risk premium method? 5
A. I based my estimates of equity risk premiums for 6
electric utilities on surveys of previously authorized rates 7
of return on common equity, which are frequently referenced 8
as the basis for estimating equity risk premiums. My 9
application of the risk premium method also considered the 10
inverse relationship between equity risk premiums and 11
interest rates, which suggests that when interest rate levels 12
are relatively high, equity risk premiums narrow, and when 13
interest rates are relatively low, equity risk premiums 14
widen. 15
Q. What cost of equity was indicated by the risk 16
premium approach? 17
A. As shown on page 1 of Exhibit No. 3, Schedule 8, 18
adding an adjusted risk premium of 5.51 percent to the 19
average yield on triple-B utility bonds for April 2015 of 20
4.55 percent resulted in an implied cost of equity of 21
approximately 10.1 percent. As shown on page 2 of Exhibit 22
No. 3, Schedule 8, incorporating a forecasted yield for 2015-23
McKenzie, Di 48 Avista Corporation

2019 and adjusting for changes in interest rates since the 1
study period implied a cost of equity of approximately 11.3 2
percent. 3
C. Flotation Costs 4
Q. What other considerations are relevant in setting 5
the return on equity for a utility? 6
A. The common equity used to finance the investment in 7
utility assets is provided from either the sale of stock in 8
the capital markets or from retained earnings not paid out as 9
dividends. When equity is raised through the sale of common 10
stock, there are costs associated with “floating” the new 11
equity securities. These flotation costs include services 12
such as legal, accounting, and printing, as well as the fees 13
and discounts paid to compensate brokers for selling the 14
stock to the public. Also, some argue that the “market 15
pressure” from the additional supply of common stock and 16
other market factors may further reduce the amount of funds a 17
utility nets when it issues common equity. 18
Q. Is there an established mechanism for a utility to 19
recognize equity issuance costs? 20
A. No. While debt flotation costs are recorded on the 21
books of the utility, amortized over the life of the issue, 22
and thus increase the effective cost of debt capital, there 23
McKenzie, Di 49 Avista Corporation

is no similar accounting treatment to ensure that equity 1
flotation costs are recorded and ultimately recognized. No 2
rate of return is authorized on flotation costs necessarily 3
incurred to obtain a portion of the equity capital used to 4
finance plant. In other words, equity flotation costs are not 5
included in a utility’s rate base because neither that portion 6
of the gross proceeds from the sale of common stock used to 7
pay flotation costs is available to invest in plant and 8
equipment, nor are flotation costs capitalized as an 9
intangible asset. Unless some provision is made to recognize 10
these issuance costs, a utility’s revenue requirements will 11
not fully reflect all of the costs incurred for the use of 12
investors’ funds. Because there is no accounting convention 13
to accumulate the flotation costs associated with equity 14
issues, they must be accounted for indirectly, with an upward 15
adjustment to the cost of equity being the most appropriate 16
mechanism. 17
Q. Is there a theoretical and practical basis to 18
include a flotation cost adjustment in this case? 19
A. Yes. First, an adjustment for flotation costs 20
associated with past equity issues is appropriate, even when 21
the utility is not contemplating any new sales of common 22
stock. The need for a flotation cost adjustment to 23
compensate for past equity issues has been recognized in the 24
McKenzie, Di 50 Avista Corporation

financial literature. In a Public Utilities Fortnightly 1
article, for example, Brigham, Aberwald, and Gapenski 2
demonstrated that even if no further stock issues are 3
contemplated, a flotation cost adjustment in all future years 4
is required to keep shareholders whole, and that the 5
flotation cost adjustment must consider total equity, 6
including retained earnings.31 Similarly, New Regulatory 7
Finance contains the following discussion: 8
Another controversy is whether the flotation cost 9
allowance should still be applied when the utility 10 is not contemplating an imminent common stock 11
issue. Some argue that flotation costs are real 12 and should be recognized in calculating the fair 13 rate of return on equity, but only at the time when 14
the expenses are incurred. In other words, the 15 flotation cost allowance should not continue 16
indefinitely, but should be made in the year in 17 which the sale of securities occurs, with no need 18 for continuing compensation in future years. This 19
argument implies that the company has already been 20 compensated for these costs and/or the initial 21
contributed capital was obtained freely, devoid of 22 any flotation costs, which is an unlikely 23 assumption, and certainly not applicable to most 24
utilities. … The flotation cost adjustment cannot 25 be strictly forward-looking unless all past 26
flotation costs associated with past issues have 27 been recovered.32 28
31 Brigham, E.F., Aberwald, D.A., and Gapenski, L.C., “Common Equity Flotation Costs and Rate Making,” Public Utilities Fortnightly, May, 2, 1985. 32 Morin, Roger A., “New Regulatory Finance,” Public Utilities Reports, Inc. (2006) at 335.
McKenzie, Di 51 Avista Corporation

Q. What is the magnitude of the adjustment to the 1
“bare bones” cost of equity to account for issuance costs? 2
A. While there are a number of ways in which a 3
flotation cost adjustment can be calculated, one of the most 4
common methods used to account for flotation costs in 5
regulatory proceedings is to apply an average flotation-cost 6
percentage to a utility’s dividend yield. Based on a review 7
of the finance literature, New Regulatory Finance concluded: 8
The flotation cost allowance requires an estimated 9
adjustment to the return on equity of approximately 10 5% to 10%, depending on the size and risk of the 11 issue.33 12
Alternatively, a study of data from Morgan Stanley regarding 13
issuance costs associated with utility common stock issuances 14
suggests an average flotation cost percentage of 3.6 15
percent.34 16
Issuance costs are a legitimate consideration in setting 17
the ROE for a utility, and applying these expense percentages 18
to the average dividend yield for the Utility Group of 3.6 19
33 Roger A. Morin, “New Regulatory Finance,” Public Utilities Reports, Inc. at 323 (2006). 34 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 percent.
McKenzie, Di 52 Avista Corporation

percent implies a flotation cost adjustment on the order of 1
10 basis points.35 2
Q. Has the IPUC Staff previously considered flotation 3
costs in estimating a fair ROE? 4
A. Yes. For example, in Case No. IPC-E-08-10, IPUC 5
Staff witness Terri Carlock noted that she had adjusted her 6
DCF analysis to incorporate an allowance for flotation 7
costs.36 8
Q. Have other regulators previously recognized that 9
flotation costs are properly considered in setting the 10
allowed ROE? 11
A. Yes. For example, in Docket No. UE-991606 the WUTC 12
concluded that a flotation cost adjustment of 25 basis points 13
should be included in the allowed return on equity: 14
The Commission also agrees with both Dr. Avera and 15
Dr. Lurito that a 25 basis point markup for 16 flotation costs should be made. This amount 17 compensates the Company for costs incurred from 18
past issues of common stock. Flotation costs 19 incurred in connection with a sale of common stock 20
are not included in a utility's rate base because 21 the portion of gross proceeds that is used to pay 22 these costs is not available to invest in plant and 23 equipment.37 24
35 Calculated as the product of the 3.6 percent average dividend yield and
a flotation cost percentage of 3.6 percent. 3.6% x 3.6% = 0.1% 36 Case No. IPC-E-08-10, Direct Testimony of Terri Carlock at 12-13 (Oct. 24, 2008). 37 Third Supplemental Order, WUTC Docket No. UE-991606, et al., p. 95 (September 2000).
McKenzie, Di 53 Avista Corporation

D. Other ROE Benchmarks 1
Q. What other analyses did you conduct to estimate the 2
cost of equity? 3
A. As indicated earlier, I also conducted alternative 4
tests to demonstrate that the end results of the analyses 5
discussed above are reasonable and do not exceed a fair ROE. 6
The first test is based on applications of the traditional 7
CAPM analysis using current and projected interest rates. 8
The second test is based on expected earned returns for 9
electric utilities. Finally, I present a DCF analysis for a 10
low risk group of non-utility firms, with which Avista must 11
compete for investors’ money. 12
Q. What cost of equity estimates were indicated by the 13
traditional CAPM? 14
A. My applications of the traditional CAPM were based 15
on the same forward-looking market rate of return, risk-free 16
rates, and beta values discussed earlier in connections with 17
the ECAPM. As shown on page 1 of Exhibit No. 3, Schedule 9, 18
applying the forward-looking CAPM approach to the firms in 19
the Utility Group results in an average cost of equity 20
estimate of 9.5 percent prior to adjusting for firm size, or 21
10.6 percent after incorporating the size adjustment 22
corresponding to the market capitalization of the individual 23
utilities. 24
McKenzie, Di 54 Avista Corporation

As shown on page 2 of Exhibit No. 3, Schedule 9, 1
incorporating a forecasted Treasury bond yield for 2015-2019 2
implied a cost of equity of approximately 9.9 percent for the 3
Utility Group, or 11.0 percent after adjusting for the impact 4
of relative size. 5
Q. Please summarize the results of the expected 6
earnings approach. 7
A. Reference to rates of return available from 8
alternative investments of comparable risk can provide an 9
important benchmark in assessing the return necessary to 10
assure confidence in the financial integrity of a firm and 11
its ability to attract capital. This expected earnings 12
approach is consistent with the economic underpinnings for a 13
fair rate of return established by the U.S. Supreme Court. 14
Moreover, it avoids the complexities and limitations of 15
capital market methods and instead focuses on the returns 16
earned on book equity, which are readily available to 17
investors. 18
Q. What rates of return on equity are indicated for 19
utilities based on the expected earnings approach? 20
A. Value Line’s projections imply an average rate of 21
return on common equity for the electric utility industry of 22
McKenzie, Di 55 Avista Corporation

10.6 percent over its 2018-2020 forecast horizon.38 As shown 1
on Exhibit No. 3, Schedule 10, Value Line’s projections for 2
the Utility Group suggest an average ROE of approximately 3
10.3 percent, with a midpoint value of 10.8 percent. 4
Q. What other proxy group did you consider in 5
evaluating a fair ROE for Avista? 6
A. Under the regulatory standards established by Hope 7
and Bluefield, the salient criterion in establishing a 8
meaningful benchmark to evaluate a fair ROE is relative risk, 9
not the particular business activity or degree of regulation. 10
With regulation taking the place of competitive market 11
forces, required returns for utilities should be in line with 12
those of non-utility firms of comparable risk operating under 13
the constraints of free competition. Consistent with this 14
accepted regulatory standard, I also applied the DCF model to 15
a reference group of low-risk companies in the non-utility 16
sectors of the economy. I refer to this group as the “Non-17
Utility Group”. 18
Q. Do utilities have to compete with non-regulated 19
firms for capital? 20
A. Yes. The cost of capital is an opportunity cost 21
based on the returns that investors could realize by putting 22
38 The Value Line Investment Survey (Feb. 20, Mar. 20, & May 1, 2015).
Value Line reports return on year-end equity so the equivalent return on average equity would be higher.
McKenzie, Di 56 Avista Corporation

their money in other alternatives. Clearly, the total 1
capital invested in utility stocks is only the tip of the 2
iceberg of total common stock investment, and there are a 3
plethora of other enterprises available to investors beyond 4
those in the utility industry. Utilities must compete for 5
capital, not just against firms in their own industry, but 6
with other investment opportunities of comparable risk. 7
Indeed, modern portfolio theory is built on the assumption 8
that rational investors will hold a diverse portfolio of 9
stocks, not just companies in a single industry. 10
Q. Is it consistent with the Bluefield and Hope cases 11
to consider required returns for non-utility companies? 12
A. Yes. Returns in the competitive sector of the 13
economy form the very underpinning for utility ROEs because 14
regulation purports to serve as a substitute for the actions 15
of competitive markets. The Supreme Court has recognized 16
that it is the degree of risk, not the nature of the 17
business, which is relevant in evaluating an allowed ROE for 18
a utility. The Bluefield case refers to “business 19
undertakings attended with comparable risks and 20
uncertainties.”39 It does not restrict consideration to other 21
utilities. Similarly, the Hope case states: 22
39 Bluefield Water Works & Improvement Co. v. Pub. Serv. Comm’n, 262 U.S. 679 (1923).
McKenzie, Di 57 Avista Corporation

By that standard the return to the equity owner 1 should be commensurate with returns on investments 2
in other enterprises having corresponding risks.40 3
As in the Bluefield decision, there is nothing to restrict 4
“other enterprises” solely to the utility industry. 5
Q. Does consideration of the results for the Non-6
Utility Group make the estimation of the cost of equity using 7
the DCF model more reliable? 8
A. Yes. The estimates of growth from the DCF model 9
depend on analysts’ forecasts. It is possible for utility 10
growth rates to be distorted by short-term trends in the 11
industry or the industry falling into favor or disfavor by 12
analysts. The result of such distortions would be to bias 13
the DCF estimates for utilities. Because the Non-Utility 14
Group includes low risk companies from many industries, it 15
diversifies away any distortion that may be caused by the ebb 16
and flow of enthusiasm for a particular sector. 17
Q. What criteria did you apply to develop the Non-18
Utility Group? 19
A. My comparable risk proxy group of non-utility firms 20
was composed of those U.S. companies followed by Value Line 21
that: 22
1) pay common dividends; 23
2) have a Safety Rank of “1”; 24
40 Federal Power Comm’n v. Hope Natural Gas Co. (320 U.S. 391, 1944).
McKenzie, Di 58 Avista Corporation

3) have a Financial Strength Rating of “B++” or 1
greater; 2
4) have a beta of 0.70 or less; and 3
5) have investment grade credit ratings from S&P. 4
Q. How do the overall risks of this Non-Utility Group 5
compare with the Utility Group and Avista? 6
A. Table 6 compares the Non-Utility Group with the 7
Utility Group and Avista across the four key risk measures 8
discussed earlier: 9
TABLE 6 10 COMPARISON OF RISK INDICATORS 11
Value Line
Proxy Group S&P Moody’s Safety Rank Financial Strength Beta
Non-Utility A A2 1 A++ 0.66
Electric Group BBB+ Baa1 2 B++ 0.77
Avista BBB Baa1 2 A 0.80
As shown above, the average credit ratings, Safety Rank, 12
Financial Strength Rating, and beta for the Non-Utility Group 13
suggest less risk than for Avista and the proxy group of 14
utilities. These objective indicators suggest that investors 15
would likely conclude that the overall investment risks for 16
the Utility Group and Avista are greater than those of the 17
firms in the Non-Utility Group. 18
McKenzie, Di 59 Avista Corporation

Q. What were the results of your DCF analysis for the 1
Non-Utility Group? 2
A. As shown on Exhibit No. 3, Schedule 11, I applied 3
the DCF model to the non-utility companies using the same 4
analysts’ EPS growth projections described earlier for the 5
Utility Group. As summarized below in Table 7, after 6
eliminating illogical values, application of the constant 7
growth DCF model resulted in the following cost of equity 8
estimates: 9
TABLE 7 10 DCF RESULTS – NON-UTILITY GROUP 11
12
Considering that the investment risks of the Non-Utility 13
Group are lower than those of the Utility Group and Avista, 14
these results understate investors’ required rate of return 15
for the Company. 16
IV. IMPACT OF REGULATORY MECHANISMS 17
Q. Does the fact that Avista is requesting an FCA in 18
this case warrant any adjustment in your evaluation of a fair 19
ROE? 20
A. No. As discussed earlier, investors recognize that 21
Avista is exposed to significant risks associated with the 22
Growth Rate Average Midpoint
Value Line 10.1%10.3%
IBES 9.4%9.2%
Zacks 9.8%10.1%
Cost of Equity
McKenzie, Di 60 Avista Corporation

ability to recover rising costs and investment on a timely 1
basis, and concerns over these risks have become increasingly 2
pronounced in the industry. While the regulatory mechanisms 3
approved and proposed for Avista would contribute towards 4
leveling the playing field, this only serves to address 5
factors that could otherwise impair the Company’s opportunity 6
to earn its authorized return, as required by established 7
regulatory standards. 8
Q. Is there any evidence that approval of the FCA 9
would result in a measureable change to Avista’s relative 10
investment risks? 11
A. No. There is no evidence to suggest that 12
implementation of the FCA would alter the relative risk of 13
Avista enough to warrant any adjustment to its ROE. As noted 14
earlier, the investment community and the major credit rating 15
agencies in particular, pay close attention to the regulatory 16
framework, including cost adjustment mechanisms. Based 17
largely on the expanded use of ratemaking mechanisms such as 18
revenue decoupling and cost-recovery riders, Moody’s upgraded 19
most regulated utilities in January 2014.41 Recognizing this 20
industry trend, Moody’s premised its assessment of Avista’s 21
risks on the expectation that “similar treatment will be 22
41 Moody’s Investors Service, “US utility sector upgrades driven by stable and transparent regulatory frameworks,” Sector Comment (Feb. 3, 2014).
McKenzie, Di 61 Avista Corporation

afforded to Avista and that the company will have improved 1
cost recovery mechanisms (e.g., decoupling).”42 In other 2
words, the implications of the FCA and other regulatory 3
mechanisms are already fully reflected in Avista’s credit 4
ratings, which are comparable to those of the proxy group 5
used to estimate the cost of equity. 6
Q. Would approval of the FCA set Avista apart from 7
other firms operating in the utility industry? 8
A. No. Adjustment mechanisms and cost trackers have 9
been increasingly prevalent in the utility industry in recent 10
years. In response to the increasing risk sensitivity of 11
investors to uncertainty over fluctuations in costs and the 12
importance of advancing other public interest goals such as 13
reliability, energy conservation, and safety, utilities and 14
their regulators have sought to mitigate some of the cost 15
recovery uncertainty and align the interest of utilities and 16
their customers through a variety of adjustment mechanisms. 17
Reflective of this trend, the companies in the electric 18
and gas utility industries operate under a wide variety of 19
cost adjustment mechanisms, which range from riders to 20
recover bad debt expense and post-retirement employee benefit 21
costs to revenue decoupling and adjustment clauses designed 22
42 Moody’s Investors Service, “Avista Corp.,” Global Credit Research (Mar. 28, 2014).
McKenzie, Di 62 Avista Corporation

to address rising capital investment outside of a traditional 1
rate case and increasing costs of environmental compliance 2
measures. As Regulatory Research Associates concluded in its 3
recent review of adjustment clauses, “some form of decoupling 4
is in place in the vast majority of jurisdictions.”43 5
Similarly, the majority of gas utilities benefit from 6
mechanisms analogous to the Company’s proposed FCA, along 7
with a variety of other provisions that enhance their ability 8
to recover operating and capital costs on a timely basis.44 9
The firms in the Non-Utility Group also have the ability to 10
alter prices in response to rising production costs, with the 11
added flexibility to withdraw from the market altogether. As 12
a result, the mitigation in risks associated with utilities’ 13
ability to adjust revenues and attenuate the risk of cost 14
recovery is already reflected in the cost of equity range 15
determined earlier, and no separate adjustment to Avista’s 16
ROE is necessary or warranted. 17
Q. Have you summarized the various tracking mechanisms 18
available to the other firms in the Utility Group? 19
A. Yes. I evaluated the regulatory mechanisms 20
approved for the other utilities in the Utility Group using 21
43 Regulatory Research Associates, “Adjustment Clauses, A State-by-State Overview,” Regulatory Focus (Jul. 1, 2014). 44 See, e.g., American Gas Association, Innovative Rates, Non-Volumetric Rates, and Tracking Mechanisms: Current List (Jan. 2015).
McKenzie, Di 63 Avista Corporation

data reported in the most recent Form 10-K reports filed with 1
the Securities and Exchange Commission, which is publicly 2
available and free of charge to investors. Reflective of 3
industry trends, the companies in the Utility Group operate 4
under a variety of regulatory adjustment mechanisms.45 As 5
summarized on Exhibit No. 3, Schedule 12, these mechanisms 6
are ubiquitous and wide ranging. For example, apart from 7
Avista, twelve of the firms benefit from some form of FCA or 8
decoupling mechanism or operate in jurisdictions that allow 9
the use of future test years. Many of these utilities 10
operate under mechanisms that allow for cost recovery of 11
infrastructure investment outside a formal rate proceeding, 12
as well as the ability to implement periodic rate adjustments 13
to reflect changes in a diverse range of operating and 14
capital costs, including expenditures related to 15
environmental mandates, conservation programs, transmission 16
costs, and storm recovery efforts. 17
Q. Have other regulators recognized that approval of 18
adjustment mechanisms do not warrant an adjustment to the 19
ROE? 20
A. Yes. For example, the Staff of the Kansas State 21
Corporation Commission concluded that no ROE adjustment was 22
45 Because this information is widely referenced by the investment
community, it is also directly relevant to an evaluation of the risks and prospects that determine the cost of equity.
McKenzie, Di 64 Avista Corporation

justified in the case of certain tariff riders because the 1
impact of similar mechanisms is already accounted for through 2
the use of a proxy group: 3
Those mechanisms differ from company to company and 4
jurisdiction to jurisdiction. Regardless of their 5 nuances, the intent is the same; reduce cash-flow 6 volatility year to year and place recent capital 7
expenditures in rates as quickly as possible. 8 Investors are aware of these mechanisms and their 9
benefits are a factor when investors value those 10 stocks. Thus, any risk reduction associated with 11 these mechanisms is captured in the market data 12 (stock prices) used in Staff’s analysis.46 13
Similarly, the effects of Avista’s existing and proposed 14
regulatory mechanisms are already reflected in the results of 15
the quantitative methods presented in my testimony. 16
Q. What does this imply with respect to the evaluation 17
of a fair ROE for Avista? 18
A. While investors would consider approval of the FCA 19
and Avista’s regulatory mechanisms to be supportive of the 20
Company’s financial integrity and credit ratings, there is 21
certainly no evidence to suggest that these mechanisms alone 22
would alter Avista’s relative risk enough to warrant an ROE 23
adjustment. The purpose of regulatory mechanisms is to 24
better match revenues to the underlying costs of providing 25
service. This levels the playing field and improves Avista’s 26
46 Direct Testimony Prepared by Adam H. Gatewood, State Corporation Commission of the State of Kansas, Docket No. 12-ATMG-564-RTS, pp. 8-9 (June 8, 2012). This proceeding was ultimately resolved through a stipulated settlement.
McKenzie, Di 65 Avista Corporation

ability to attract capital and actually earn its authorized 1
ROE, but it does not result in a “windfall” or otherwise 2
penalize customers. Utilities across the U.S. that Avista 3
competes with for new capital are increasingly availing 4
themselves of similar adjustments. As a result, the impact 5
of utilities’ ability to mitigate the risk of cost recovery 6
is already reflected in the cost of equity estimates 7
determined in this case, and no separate adjustment to 8
Avista’s ROE is necessary or warranted. 9
Q. Does this conclude your pre-filed direct testimony? 10
A. Yes. 11
McKenzie, Di 66 Avista Corporation