20170609McKenzie 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-17-01
OF AVISTA CORPORATION FOR THE ) CASE NO. AVU-G-17-01
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
A. Overview ............................................. 1
B. Summary of Conclusions ............................... 5
II. RISKS OF AVISTA ......................................... 12
A. Operating Risks ..................................... 13
B. Other Factors ....................................... 17
C. Outlook for Capital Costs ........................... 19
D. Support for Avista’s Credit Standing ................ 28
E. Capital Structure ................................... 32
III. CAPITAL MARKET ESTIMATES ............................ 38
A. Quantitative Analyses ............................... 38
B. Flotation Costs ..................................... 47
C. Non-Utility DCF Model ............................... 55
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 – Capital Asset Pricing Model
Schedule 8 – Empirical Capital Asset Pricing Model
Schedule 9 – Electric Utility Risk Premium
Schedule 10 – Expected Earnings Approach
Schedule 11 – Constant Growth DCF Model – Non-Utility Group
Schedule 12 – Regulatory Mechanisms – Utility Group

McKenzie, Di 1
Avista Corporation

I. INTRODUCTION 1
Q. Please state your name and business address. 2
A. Adrien M. McKenzie, 3907 Red River, Austin, Texas,
78751.
Q. In what capacity are you employed? 5
A. I am President of FINCAP, Inc., a firm engaged in
financial, economic, and policy consulting services to
business and government.
Q. Please describe your educational background and 9
professional experience. 10
A. A description of my background and qualifications,
including a resume containing the details of my experience,
is attached as Exhibit No. 3, Schedule 1.
A. 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
Idaho Public Utilities Commission (the “Commission” or 17
“IPUC”) my independent evaluation of the fair rate of return
on equity (“ROE”) for the jurisdictional electric and natural
gas utility operations of Avista Corp. (“Avista” or “the 20
Company”). In addition, I also examined the reasonableness 21

McKenzie, Di 2
Avista Corporation

of Avista’s capital structure, considering both the specific 1
risks faced by the Company and other industry guidelines.
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
variety of sources that would normally be relied upon by a
person in my capacity. I am familiar with the organization,
finances, and operations of Avista from my participation in
prior proceedings before the IPUC, the Washington Utilities
and Transportation Commission (“WUTC”) and the Oregon Public
Utility Commission. In connection with the present filing, I
considered and relied upon corporate disclosures, publicly
available financial reports and filings, and other published
information relating to Avista. I have also visited the
Company’s main offices and had discussions with management in
order to better familiarize myself with Avista’s utility 17
operations. My evaluation also relied upon information
relating to current capital market conditions and
specifically to current investor perceptions, requirements,
and expectations for electric and natural gas utilities.
These sources, coupled with my experience in the fields of
finance and utility regulation, have given me a working
knowledge of the issues relevant to investors’ required 24

McKenzie, Di 3
Avista Corporation

return for Avista, and they form the basis of my analyses and
conclusions.
Q. How is your testimony organized? 3
A. After first summarizing my conclusions and
recommendations, my testimony reviews the operations and
finances of Avista and industry-specific risks and capital
market uncertainties perceived by investors. With this as a
background, I present the application of well-accepted
quantitative analyses to estimate the current cost of equity
for a reference group of comparable-risk utilities. These
included the discounted cash flow (“DCF”) model, the Capital
Asset Pricing Model (“CAPM”), the empirical form of Capital
Asset Pricing Model (“ECAPM”), an equity risk premium 13
approach based on allowed ROEs for electric utilities, and
reference to expected rates of return for electric utilities,
which are all methods that are commonly relied on in
regulatory proceedings. Based on the cost of equity
estimates indicated by my analyses, the Company’s ROE was
evaluated taking into account the specific risks and
potential challenges for Avista’s electric and natural gas
utility operations in Idaho, as well as flotation costs,
which are properly considered in setting a fair ROE for the
Company.

McKenzie, Di 4
Avista Corporation

In addition, I corroborated my utility quantitative
analyses by applying the DCF model to a group of low risk
non-utility firms. Finally, my testimony addresses the
impact of regulatory mechanisms on an evaluation of a fair
ROE for Avista.
Q. What is the role of the ROE in setting a utility's 6
rates? 7
A. The ROE is the cost of attracting and retaining
common equity investment in the utility’s physical plant and 9
assets. This investment is necessary to finance the asset
base needed to provide utility service. Investors commit
capital only if they expect to earn a return on their
investment commensurate with returns available from
alternative investments with comparable risks. Moreover, a
fair and reasonable ROE is integral in meeting sound
regulatory economics and the standards set forth by the U.S.
Supreme Court in the Bluefield1 and Hope2 cases, which state
that a utility’s allowed ROE should be sufficient to: 1) 18
fairly compensate the utility’s investors, 2) enable the 19
utility to offer a return adequate to attract new capital on
reasonable terms, and 3) maintain the utility’s financial 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 5
Avista Corporation

integrity. These standards should allow the utility to
fulfill its obligation to provide reliable service while
meeting the needs of customers through necessary system
replacement and expansion, but they can only be met if the
utility has a reasonable opportunity to actually earn its
allowed ROE.
B. Summary of Conclusions 7
Q. Please summarize the results of your analyses. 8
A. The results of my analyses are presented on page 1
of Exhibit No. 3, Schedule 3, and in Table 1, below:

McKenzie, Di 6
Avista Corporation

TABLE 1 1
SUMMARY OF RESULTS 2

DCF Average Midpoint
Value Line 9.1%5 9.3%12
IBES 10.0%6 11.3%15
Zacks 9.5%4 10.1%8
S&P Capital/IQ 9.4%3 9.4%7
Internal br + sv 8.0%1 8.2%2Internal br + sv 9.1%10.7%
CAPM
Historical Bond Yield 9.9%9 9.9%10
Projected Bond Yields 10.2%13 10.3%14Projected Bond Yield 10.7%28 10.6%
Empirical CAPM
Historical Bond Yield 10.5%18 10.6%17
Projected Bond Yields 10.7%20 10.8%21Projected Bond Yield 11.2%35 11.2%36
Utility Risk Premium
Current Bond Yields
Projected Bond Yields
Expected Earnings
Industry
Proxy Group 10.3%16 11.1%23
Cost of Equity Recommendation
Cost of Equity Range 9.5%--10.7%
Flotation Cost Adjustment
ROE Recommendation 9.6%--10.8%
0.10%
10.9% 22
10.7% 19
10.1% 11

McKenzie, Di 7
Avista Corporation

Figure 1, below, presents the 23 cost of equity
estimates presented in Table 1 in rank order, and compares
them with Avista’s 9.9 percent ROE request:
FIGURE 1 4
RESULTS OF ANALYSES VS. AVISTA REQUEST 5

Q. What are your findings regarding the 9.9 percent 6
ROE requested by Avista? 7
A. Based on the results of my analyses and the
economic requirements necessary to support continuous access
to capital under reasonable terms, I determined that 9.9
percent is a conservative estimate of investors’ required ROE 11
for Avista. The bases for my conclusion are summarized
below:
 In order to reflect the risks and prospects associated
with Avista’s jurisdictional utility operations, my 15
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
10.0%
10.5%
11.0%
11.5%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
ROE Methods Avista Request

McKenzie, Di 8
Avista Corporation

analyses focused on a proxy group of 18 other
utilities with comparable investment risks.
 Because investors’ required return on equity is 3
unobservable and no single method should be viewed in
isolation, I applied the DCF, CAPM, ECAPM, and risk
premium methods to estimate a fair ROE for Avista; as
well as referencing the expected earnings approach.
 Based on the results of these analyses, and giving
less weight to extremes at the high and low ends of
the range, I concluded that the cost of equity for the
proxy group of utilities is in the 9.5 percent to 10.7 11
percent range, or 9.6 percent to 10.8 percent after
incorporating an adjustment to account for the impact
of common equity flotation costs.
 As reflected in the testimony of Mr. Thies, Avista is
requesting an ROE of 9.9 percent, which falls below
the 10.2 percent midpoint of my recommended range.
Considering capital market expectations, the exposures
faced by Avista, and the economic requirements
necessary to maintain financial integrity and support
additional capital investment even under adverse
circumstances, it is my opinion that 9.9 percent
represents a conservative ROE for Avista.
Q. What other evidence did you consider in evaluating 24
your ROE recommendation in this case? 25
A. My recommendation is reinforced by the following
findings:
 The reasonableness of a 9.9 percent ROE for Avista is
supported by the need to consider the challenges to
the Company’s credit standing:
o The pressure of funding significant capital
expenditures of approximately $1.2 billion over
the next three years heighten the uncertainties
associated with Avista, especially given that the
Company’s existing rate base is approximately $2.9
billion.
o Because of Avista’s reliance on hydroelectric 37
generation and increasing dependence on natural
gas fueled capacity, the Company is exposed to
relatively greater risks of power cost volatility,

McKenzie, Di 9
Avista Corporation

even with the Power Cost Adjustment Mechanism
(“PCA”).
o Avista’s opportunity to actually earn a fair ROE 3
and mitigate exposure to earnings attrition is an
important objective.
o Widespread expectations for higher interest rates
emphasize the implication of considering the
impact of projected bond yields in evaluating the
results of the CAPM, ECAPM and risk premium
methods, particularly in light of the Two-Year
Rate Plan proposed by Avista.
o My conclusion that a 9.9 percent ROE for Avista is
a conservative estimate of investors’ required
return is also reinforced by the greater
uncertainties associated with Avista’s relatively 15
small size.
 Sensitivity to financial market and regulatory
uncertainties has increased dramatically and investors
recognize that constructive regulation is a key
ingredient in supporting utility credit standing and
financial integrity.
 Providing Avista with the opportunity to earn a return
that reflects these realities is an essential
ingredient to support the Company’s financial 24
position, which ultimately benefits customers by
ensuring reliable service at lower long-run costs.
 Continued support for Avista’s financial integrity, 27
including a reasonable ROE, is imperative to ensure
that the Company has the capability to maintain and
build its credit standing while confronting potential
challenges associated with funding infrastructure
development necessary to meet the needs of its
customers.
 Regulatory mechanisms approved for Avista, are viewed
as supportive by investors, and the implications of
the Fixed Cost Adjustment Mechanism (“FCA”) and other
mechanisms are fully reflected in Avista's credit
ratings, which are comparable to those of the proxy
group used to estimate the cost of equity. Because
the utilities in my proxy group operate under a wide
variety of regulatory mechanisms, including provisions
akin to the FCA, the effects of the Company’s 42
regulatory mechanisms are already reflected in the
results of my analyses.

McKenzie, Di 10
Avista Corporation

These findings indicate that the 9.9 percent ROE requested by
Avista is reasonable and should be approved.
Q. What did the DCF results for your select group of 3
non-utility firms indicate with respect to your evaluation? 4
A. Average DCF estimates for a low-risk group of firms
in the competitive sector of the economy ranged from 10.5
percent to 10.7 percent, and averaged 10.6 percent. These
results confirm that a 9.9 percent ROE falls in the lower end
of the reasonable range to maintain Avista’s financial 9
integrity, provide a return commensurate with investments of
comparable risk, and support the Company’s ability to attract 11
capital.
Q. What other factors should be considered in 13
evaluating the ROE requested by Avista in this case? 14
A. Apart from the results of the quantitative methods
summarized above, it is crucial to recognize the importance
of supporting the Company’s financial position so that Avista 17
remains prepared to respond to unforeseen events that may
materialize in the future. Recent challenges in the economic
and financial market environment (such as interest rate
increases and capital market volatility) highlight the
imperative of continuing to build the Company’s financial 22
strength in order to attract the capital needed to secure
reliable service at a reasonable cost for customers. The

McKenzie, Di 11
Avista Corporation

reasonableness of the Company’s requested ROE is reinforced 1
by the operating risks associated with Avista’s reliance on 2
hydroelectric generation, the higher uncertainties associated
with Avista’s relatively small size, and the fact that, due
to broad-based expectations for higher bond yields, current
cost of capital estimates are likely to understate investors’ 6
requirements at the time the outcome of this proceeding
becomes effective and beyond.
Q. Does an ROE of 9.9 percent represent a reasonable 9
cost for Avista’s customers to pay? 10
A. Yes. Investors have many options vying for their
money. They make investment capital available to Avista only
if the expected returns justify the risk. Customers will
enjoy reliable and efficient service so long as investors are
willing to make the capital investments necessary to maintain
and improve Avista’s utility system. Providing an adequate 16
return to investors is a necessary cost to ensure that
capital is available to Avista on reasonable terms now and in
the future. If regulatory decisions increase risk or limit
returns to levels that are insufficient to justify the risk,
investors will look elsewhere to invest capital.

McKenzie, Di 12
Avista Corporation

Q. What is your conclusion as to the reasonableness of 1
the Company’s capital structure? 2
A. Based on my evaluation, I concluded that a common
equity ratio of 50.0 percent represents a reasonable basis
from which to calculate Avista’s overall rate of return. 5
This conclusion was based on the following findings:
 Avista’s requested capitalization is consistent with
the Company’s need to maintain its credit standing and 8
financial flexibility as it seeks to raise additional
capital to fund significant system investments,
refinance maturing debt securities, and meet the
requirements of its service territory.
 Avista’s proposed common equity ratio is consistent
with the range of capitalizations for the proxy
utilities, both for year-end 2016 and based on the
near-term expectations of the Value Line Investment
Survey (“Value Line”).
 The requested capitalization reflects the importance
of an adequate equity layer to accommodate Avista’s 19
operating risks and the pressures of funding
significant capital investments. This is reinforced
by the need to consider the impact of uncertain
capital market conditions, as well as off-balance
sheet commitments such as purchased power agreements,
which carry with them some level of imputed debt.
II. RISKS OF AVISTA 26
Q. What is the purpose of this section? 27
A. As a predicate to my capital market analyses, this
section examines the investment risks that investors consider
in evaluating their required rate of return for Avista.

McKenzie, Di 13
Avista Corporation

A. Operating Risks 1
Q. How does Avista’s generating resource mix affect 2
investors’ risk perceptions? 3
A. Because approximately 45 percent of Avista’s total 4
energy requirements are provided by hydroelectric facilities,
the Company is exposed to a level of uncertainty not faced by
most utilities. While hydropower confers advantages in terms
of fuel cost savings and diversity, reduced hydroelectric
generation due to below-average water conditions forces
Avista to rely more heavily on wholesale power markets or
more costly thermal generating capacity to meet its resource
needs. As Standard & Poor’s Corporation (“S&P”) has
observed:
A reduction in hydro generation typically increases
an electric utility’s costs by requiring it to buy 15
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 the same time, low hydro years
increase regional wholesale power prices, creating
potentially a double impact – companies have to buy
more power than under normal conditions, paying
higher prices.3
Investors recognize that volatile energy markets,
unpredictable stream flows, and Avista’s reliance on 25
wholesale purchases to meet a significant portion of its

3 Standard & Poor’s Corporation, “Pacific Northwest Hydrology And Its
Impact On Investor-Owned Utilities’ Credit Quality,” RatingsDirect (Jan.
28, 2008).

McKenzie, Di 14
Avista Corporation

resource needs can expose the Company to the risk of reduced
cash flows and unrecovered power supply costs.
S&P has noted that Avista, along with Idaho Power
Company, “face the most substantial risks despite their PCAs 4
and cost-update mechanisms,”4 and concluded that Avista’s 5
“Northwest hydropower has been subject to significant
volatility in recent years, so [Avista] is exposed to
purchased power costs.”5 Similarly, Moody’s Investors Service 8
(“Moody’s”) has recognized that, “Avista’s high dependency on 9
hydro resources (approximately 50% of its production comes
from hydro fueled electric generation resources) is viewed as
a supply concentration risk which also lends to the potential
for metric volatility, especially since hydro levels, due to
weather, is a factor outside of management's control.”6 More
recently, S&P affirmed the importance of constructive
regulation in light of the potential need to “maintain
operating cash flow after purchasing power for customers when
the hydroelectric generation is unavailable.”7 Avista’s 18
reliance on purchased power to meet shortfalls in

4 Id.
5 Standard & Poor’s Corporation, “Industry Report Card,” RatingsDirect
(Apr. 19, 2013).
6 Moody’s Investors Service, “Credit Opinion: Avista Corp.,” Global Credit
Research (Mar. 17, 2011).
7 Standard & Poor’s Corporation, “Avista Corp.,” RatingsDirect (May 26,
2016).

McKenzie, Di 15
Avista Corporation

hydroelectric generation magnifies the importance of
strengthening financial flexibility, which is essential to
guarantee access to the cash resources and interim financing
required to cover inadequate operating cash flows.
Q. Do financial pressures associated with Avista’s 5
planned capital expenditures also impact investors’ risk 6
assessment? 7
A. Yes. Avista will require capital investment to
meet customer growth, provide for necessary maintenance, as
well as fund new investment in electric generation,
transmission and distribution facilities. Utility capital
additions are expected to total approximately $405 million
for each of the years 2017 through 2021. This represents a
substantial investment given Avista’s current rate base of 14
approximately $2.9 billion. In addition, as discussed in the
testimony of Mr. Thies, beginning in 2018 through 2022 the
Company is obligated to repay maturing long-term debt
totaling $654.5 million
Continued support for Avista’s financial integrity and 19
flexibility will be instrumental in attracting the capital
necessary to fund these projects in an effective manner.
Investors are aware of the challenges posed by burdensome
capital expenditure requirements, especially in light of
ongoing capital market and economic uncertainties, and

McKenzie, Di 16
Avista Corporation

Moody’s has noted that increasing capital expenditures are a
primary credit concern for Avista.8
Q. Would investors consider Avista’s relative size in 3
their assessment of the Company’s risks and prospects? 4
A. Yes. A firm’s relative size has important 5
implications for investors in their evaluation of alternative
investments, and it is well established that smaller firms
are more risky than larger firms. With a market
capitalization of approximately $2.7 billion, Avista is one
of the smallest publicly traded electric utility holding
companies followed by Value Line, which have an average
capitalization of approximately $17.0 billion.9
The magnitude of the size disparity between Avista and
other firms in the utility industry has important practical
implications with respect to the risks faced by investors.
All else being equal, it is well accepted that smaller firms
are more risky than their larger counterparts, due in part to
their relative lack of diversification and lower financial

8 Moody’s Investors Service, “Credit Opinion: Avista Corp.,” Global Credit
Research (Mar. 11, 2015).
9 www.valueline.com (retrieved May 24, 2017).

McKenzie, Di 17
Avista Corporation

resiliency.10 These greater risks imply a higher required
rate of return, and there is ample empirical evidence that
investors in smaller firms realize higher rates of return
than in larger firms.11 Accepted financial doctrine holds
that investors require higher returns from smaller companies,
and unless that compensation is provided in the rate of
return allowed for a utility, the legal tests embodied in the
Hope and Bluefield cases cannot be met.
B. Other Factors 9
Q. Would investors consider the potential impact of 10
Avista’s exposure to earnings attrition? 11
A. Yes. Attrition is the deterioration of actual
return below the allowed return that occurs when the
relationships between revenues, costs, and rate base used to
establish rates (e.g., using a historical test year without
adequate adjustments) do not reflect the actual costs
incurred to serve customers during the period that rates are
in effect. Investors are concerned with what they can expect

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 18
Avista Corporation

in the future, not what they might expect in theory if a
historical test year were to repeat. To be fair to investors
and to benefit customers, a regulated utility must have a
reasonable opportunity to actually earn a return that will
maintain financial integrity, facilitate capital attraction,
and compensate for risk. In other words, it is the end
result in the future that determines whether or not the Hope 7
and Bluefield standards are met.
Ratemaking practices that allow the utility an
opportunity to actually earn its authorized ROE are
consistent with fundamental regulatory principles. The
Supreme Court has reaffirmed that the end result test must be
applied to the actual returns that investors expect if they
put their money at risk to finance utilities.12 That end
result would maintain the utility’s financial integrity, 15
ability to attract capital and offer investors fair
compensation for the risk they bear.

12 Verizon Communications, et al v. Federal Communications Commission, et
al, 535 U.S. 467 (2002). While I cannot comment on the legal significance
of this case, I found the economic wisdom of looking to the reasonable
expectations of actual investors compelling. Economic logic and common
sense confirm that a utility cannot attract capital on reasonable terms if
investors expect future returns to fall short of those offered by
comparable investments.

McKenzie, Di 19
Avista Corporation

C. Outlook for Capital Costs 1
Q. Please summarize current capital market conditions. 2
A. Current capital market conditions continue to be
affected by the Federal Reserve's unprecedented monetary
policy actions, which were designed to push interest rates to
historically and artificially low levels in an effort to
support economic growth and bolster employment. Since the
Great Recession, investors have also had to contend with a
heightened level of economic uncertainty. The ongoing
potential for renewed turmoil in the capital markets has been
seen repeatedly and investors have reacted to such periods of
“risk off” behavior by seeking a safe haven in U.S.
government bonds. As a result of this “flight to safety,” 13
Treasury bond yields have been pushed significantly lower in
the face of political, economic, and capital market risks.
While serving as President of the Federal Reserve Bank of
Philadelphia, Charles Plosser observed that U.S. interest
rates were unprecedentedly low, and “outside historical 18
norms.”13

13 Barnato, Katy, “Fed’s Plosser: Low rates ‘should make us nervous’,” CNBC
(Nov. 11, 2014). The average yield on 10-year Treasury bonds for the six-
months ended April 2017 was 2.38 percent, which is nearly the same as the
2.3 percent yields prevailing at the time of Mr. Plosser’s observations.

McKenzie, Di 20
Avista Corporation

Q. Have there been any fundamental shifts in Federal 1
Reserve monetary policies? 2
A. No. The Federal Reserve continues to exert
considerable influence over capital market conditions through
its massive holdings of Treasuries and mortgage-backed
securities. Prior to the initiation of the stimulus program
in 2009, the Federal Reserve’s holdings of U.S. Treasury 7
bonds and notes amounted to approximately $400-$500 billion.
With the implementation of its asset purchase program,
balances of Treasury securities and mortgage backed
instruments climbed steadily, and their effect on capital
market conditions became more pronounced. Table 2 below
charts the course of the Federal Reserve’s asset purchase
program:

McKenzie, Di 21
Avista Corporation

TABLE 2 1
FEDERAL RESERVE BALANCES OF 2
TREASURY BONDS AND MORTGAGE-BACKED SECURITIES 3
(BILLION $) 4
5
Far from representing a return to normal, the Federal
Reserve’s holdings of Treasury bonds and mortgage-backed
securities continue to exceed $4.2 trillion. The Federal
Reserve has announced its intention to maintain these
balances by reinvesting principal payments from these
securities “until normalization of the level of the federal 11
funds rate is well under way.”14
Of course, the corollary to these observations is that
changes to this policy of reinvestment would further reduce
stimulus measures and could place significant upward pressure
on bond yields, especially considering the unprecedented
magnitude of the Federal Reserve’s holdings of Treasury bonds

14 Press Release, Federal Reserve, Federal Open Market Committee (May 3,
2017), www.federalreserve.gov/monetarypolicy/files/monetary20170503a1.pdf.
2008 458$
2009 1,668$
2010 1,993$
2011 2,501$
2012 2,598$
2013 3,702$
2014 4,211$
2015 4,215$
2016 4,217$
Source: Factors Affecting Reserve Balances, H.4.1
http://www.federalreserve.gov/releases/h41/

McKenzie, Di 22
Avista Corporation

and mortgage-backed securities. As a Financial Analysts 1
Journal article noted:
Because no precedent exists for the massive
monetary easing that has been practiced over the
past five years in the United States and Europe,
the uncertainty surrounding the outcome of central
bank policy is so vast. . . . Total assets on the
balance sheets of most developed nations’ central 8
banks have grown massively since 2008, and the
timing of when the banks will unwind those
positions is uncertain.15
Similarly, a report from the global investment
management firm BlackRock cited the potential for yield
spikes and the exposure of the utilities sector to rising
yields, concluding that, “We are in uncharted territory,” 15
when it comes to the implications of unwinding the Federal
Reserve’s balance sheet holdings.16 The Wall Street Journal
echoed these concerns:
A great deal is at stake with the bond decision.
Shrinking the portfolio could jolt financial
markets, pushing up interest costs on government
debt and mortgage bonds and reverberating through
the broader economy.
Officials don’t know how markets will react when 24
they shrink the holdings because they have never
done it before. But they know plenty about the
skittishness of investors. When they signaled they
would end bond purchases in 2013, they sparked a

15 Poole, William, “Prospects for and Ramifications of the Great Central
Banking Unwind,” Financial Analysts Journal (November/December 2013).
16 BlackRock, “When the Fed Yields,” BlackRock Investment Institute (May
2015).

McKenzie, Di 23
Avista Corporation

market “taper tantrum” that sent interest rates 1
higher and hurt emerging markets.17
More recently, the Wall Street Journal observed the potential
for “considerable upward pressure on long-term interest
rates” if the need to finance higher deficits associated with
stimulative fiscal policies coincides with a higher supply of
Treasury securities as the Federal Reserve unwinds its
balance sheet holdings.18
Q. Does the Federal Reserve’s three quarter-point 9
moves in the target range for the federal funds rate mark a 10
return to “normal” in the capital markets? 11
A. No. The Federal Reserve’s long-anticipated moves
to increase the federal funds rate represent a modest step
towards implementing the process of monetary policy
normalization outlined in its September 17, 2014 press
release.19 While the Federal Reserve’s action marks a 16
continuation of the normalization process that began with its
initial 25 basis point rate rise in the federal funds rate in
December 2015, these gradual moves do not result in a

17 Michael S. Derby, “Fed Grapples With Massive Portfolio,” The Outlook,
The Wall Street Journal, http://www.wsj.com/articles/fed-grapples-with-
massive-portfolio-1485717712 (last visited Jan. 30, 2017).
18 Josh Zumbrun, “Trump’s Fiscal Plans, Fed’s Asset Unwinding Could Fuel
Rate Rise,” The Outlook, The Wall Street Journal (May 8, 2017).
19 Press Release, Fed. Reserve, Policy Normalization Principles and Plans
(Sept. 17, 2014),
http://www.federalreserve.gov/newsevents/press/monetary/20140917c.htm.

McKenzie, Di 24
Avista Corporation

fundamental alteration of its highly accommodative monetary
policy. Nor have they removed uncertainty over the
trajectory of further interest rate increases or the
overhanging implications of the Federal Reserve’s enormous 4
holdings of long-term securities. Uncertainties over just
how the process of normalizing the Federal Reserve’s 6
unprecedented monetary policies will affect capital markets
further support the consideration of alternative DCF analyses
and ROE benchmarks when evaluating a just and reasonable ROE
for the Company.
Q. Is there evidence that investors anticipate 11
significantly higher interest rates in the foreseeable 12
future? 13
A. Yes. Investors continue to anticipate that
interest rates will increase significantly from present
levels. With apprehension surrounding future Federal Reserve
actions, uncertainties regarding future fiscal policies,
world-wide geopolitical exposures, and the overhanging risk
of a global economic slowdown, the potential for significant
volatility and higher capital costs is clearly evident to
investors.
For example, the December 1, 2016 long-term consensus
forecast of economists published in the Blue Chip Financial
Forecast (“Blue Chip”) anticipates that corporate bond yields

McKenzie, Di 25
Avista Corporation

will increase approximately 150 basis points between 2016 and
2022.20 Figure 2 below compares six-month average interest
rates on 10-year and 30-year Treasury bonds, triple-A rated
corporate bonds, and double-A rated utility bonds as of April
2017 with the respective near-term projections from Value
Line, IHS Global Insight, Blue Chip, and the Energy
Information Administration (“EIA”), which are sources that 7
are highly regarded and widely referenced:
FIGURE 2 9
INTEREST RATE TRENDS 10

As evidenced above, projections by investment advisors,
forecasting services, and government agencies support the

20 Wolters Kluwer, Blue Chip Financial Forecast, Vol. 35, No. 12 (Dec. 1,
2016).
Source:
Value Line Investment Survey, Forecast for the U.S. Economy (Mar. 3, 2017)
IHS Global Insight (Feb. 2017)
Energy Information Administration, Annual Energy Outlook 2017 (Jan. 5, 2017)
Wolters Kluwer, Blue Chip Financial Forecasts, Vol. 35, No. 12 (Dec. 1, 2016)
1.5%
2.5%
3.5%
4.5%
5.5%
6.5%
Apr. 2017 2018 2019 2020 2021
Aa Utility Aaa Corp.30-Yr Govt.10-Yr Govt.
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
Apr. 2017 2018 2019 2020 2021 2022
Aa Utility Aaa Corp.30-Yr Govt.10-Yr Govt.

McKenzie, Di 26
Avista Corporation

general consensus in the investment community that the
present artificial low level of long-term interest rates will
not be sustained.
Q. What do these events imply with respect to the ROE 4
for Avista more generally? 5
A. Current capital market conditions continue to
reflect the impact of unprecedented policy measures taken in
response to recent dislocations in the economy and financial
markets. As a result, current capital costs are not
representative of what is likely to prevail over the near-
term future. As the Federal Energy Regulatory Commission
(“FERC”) recently concluded:
[W]e also understand that any DCF analysis may be
affected by potentially unrepresentative financial
inputs to the DCF formula, including those produced
by historically anomalous capital market
conditions. Therefore, while the DCF model remains
the Commission’s preferred approach to determining 18
allowed rate of return, the Commission may consider
the extent to which economic anomalies may have
affected the reliability of DCF analyses.21
This conclusion is supported by comparisons of current
conditions to the historical record and independent
forecasts. As demonstrated above, recognized economic
forecasting services project that long-term capital costs
will increase from present levels.

21 Opinion No. 531, 147 FERC ¶ 61,234 at P 41 (2014).

McKenzie, Di 27
Avista Corporation

Thus, while the DCF model is a recognized approach to
estimating the ROE, it is not without shortcomings and does
not otherwise eliminate the need to ensure that the “end 3
result” is fair. The Indiana Utility Regulatory Commission
has also recognized this principle:
There are three principal reasons for our
unwillingness to place a great deal of weight on
the results of any DCF analysis. One is . . . the
failure of the DCF model to conform to reality.
The second is the undeniable fact that rarely if
ever do two expert witnesses agree on the terms of
a DCF equation for the same utility – for example,
as we shall see in more detail below, projections
of future dividend cash flow and anticipated price
appreciation of the stock can vary widely. And,
the third reason is that the unadjusted DCF result
is almost always well below what any informed
financial analysis would regard as defensible, and
therefore require an upward adjustment based
largely on the expert witness’s judgment. In these 20
circumstances, we find it difficult to regard the
results of a DCF computation as any more than
suggestive.22
Given investors’ expectations for rising interest rates and
capital costs, the Commission should consider near-term
forecasts for higher public utility bond yields in assessing
the reasonableness of individual cost of equity estimates and
in evaluating the ROE for Avista. As discussed in Exhibit
No. 3, Schedule 2, this result is supported by economic

22 Ind. Michigan Power Co., Cause No. 38728, 116 PUR4th, 1, 17-18 (IURC
8/24/1990).

McKenzie, Di 28
Avista Corporation

studies that show that equity risk premiums are higher when
interest rates are at very low levels.
Q Do ongoing economic and capital market 3
uncertainties also influence the appropriate capital 4
structure for Avista? 5
A Yes. Financial flexibility plays a crucial role in
ensuring the wherewithal to meet funding needs, and utilities
with higher financial leverage may be foreclosed from
additional borrowing, especially during times of stress. As
a result, the Company’s capital structure must maintain 10
adequate equity to preserve the flexibility necessary to
maintain continuous access to capital even during times of
unfavorable market conditions.
D. Support for Avista’s Credit Standing 14
Q. What credit ratings have been assigned to Avista? 15
A. S&P has assigned Avista a corporate credit rating
of “BBB”, while Moody’s has set Avista’s Issuer Rating at 17
“Baa1”.
Q. What considerations impact investors’ assessment of 19
the firms in the utility industry? 20
A. Numerous factors have the potential to impact
investors’ perceptions of the relative risks inherent in the 22
utility industry and have implications for the financial

McKenzie, Di 29
Avista Corporation

standing of the utilities themselves. These include the
possibility of volatile fuel or purchased power costs,
uncertain environmental mandates and associated costs, the
implications of declining demand associated with economic
weakness or structural changes in usage patterns, and
increased reliance on distributed generation or other
alternatives to the incumbent utility. Apart from these
considerations, utilities may face increasing costs of
operating their systems, as well as the financial pressures
associated with large capital expenditure programs, which are
magnified during periods of turmoil in capital markets.
Q. What are the implications for Avista, given the 12
potential for further dislocations in the capital markets? 13
A. The pressures of significant capital expenditure
requirements, along with the need to refinance maturing debt,
reinforce the importance of supporting continued improvement
in Avista’s credit standing. Investors understand from past 17
experience in the utility industry that large capital needs
can lead to significant deterioration in financial integrity
that can constrain access to capital, especially during times
of unfavorable capital market conditions. Considering the
uncertain state of financial markets, competition with other
investment alternatives, and investors’ sensitivity to the 23
potential for market volatility, greater credit strength is a

McKenzie, Di 30
Avista Corporation

key ingredient in maintaining access to capital at reasonable
cost. As Mr. Thies confirms in his testimony, ongoing
regulatory support will be a key driver in continuing to
build Avista’s financial health.
Q. What role does regulation play in ensuring that 5
Avista has access to capital under reasonable terms and on a 6
sustainable basis? 7
A. Investors recognize that constructive regulation is
a key ingredient in supporting utility credit ratings and
financial integrity, particularly during times of adverse
conditions. As Moody’s noted, “the regulatory environment is 11
the most important driver of our outlook because it sets the
pace for cost recovery.”23 With respect to Avista
specifically, the major bond rating agencies have explicitly
cited the potential that adverse regulatory rulings could
compromise the Company’s credit standing. S&P observed that 16
the stable outlook on Avista Corp. is due in part to their
expectation that the company “will continue to effectively 18
manage regulatory risks,” and concluded that “greater 19
borrowing or increased rate lag, a large deferral, or adverse

23 Moody’s Investors Service, “Regulation Will Keep Cash Flow Stable As
Major Tax Break Ends,” Industry Outlook (Feb. 19, 2014).

McKenzie, Di 31
Avista Corporation

regulatory decisions” could lead to a downgrade.24 Similarly,
Moody’s concluded that “Avista’s ratings could be considered
for downgrade with less supportive regulatory relationships
over a sustained period of time...”25 Further strengthening
Avista’s financial integrity is imperative to ensure that the
Company has the capability to maintain an investment grade
rating while confronting large capital expenditures and other
potential challenges.26
Q. Do customers benefit by enhancing the utility’s 9
financial flexibility? 10
A. Yes. Providing an ROE that is sufficient to
maintain Avista’s ability to attract capital under reasonable
terms, even in times of financial and market stress, is not
only consistent with the economic requirements embodied in
the U.S. Supreme Court’s Hope and Bluefield decisions, it is
also in customers’ best interests. Customers enjoy the 16
benefits that come from ensuring that the utility has the
financial wherewithal to take whatever actions are required
to ensure safe and reliable service.

24 Standard & Poor’s Corporation, “Avista Corp.,” RatingsDirect (May 26,
2016).
25 Moody’s Investors Service, “Credit Opinion: Avista Corp.,” Global
Opinion (Mar. 22, 2017).
26 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

E. Capital Structure 1
Q. Is an evaluation of the capital structure 2
maintained by a utility relevant in assessing its return on 3
equity? 4
A. Yes. Other things equal, a higher debt ratio, or
lower common equity ratio, translates into increased
financial risk for all investors. A greater amount of debt
means more investors have a senior claim on available cash
flow, thereby reducing the certainty that each will receive
his contractual payments. This increases the risks to which
lenders are exposed, and they require correspondingly higher
rates of interest. From common shareholders’ standpoint, a 12
higher debt ratio means that there are proportionately more
investors ahead of them, thereby increasing the uncertainty
as to the amount of cash flow that will remain.
Q. What common equity ratio is implicit in Avista’s 16
requested capital structure? 17
A. Avista’s capital structure is presented in the
testimony of Mr. Thies. As summarized in his testimony, the
proposed capital structure used to compute Avista’s overall 20
rate of return consists of 50.0 percent equity / 50 percent
long-term debt in this filing.

McKenzie, Di 33
Avista Corporation

Q. What was the average capitalization maintained by 1
the Utility Group? 2
A. As shown on page 1 of Exhibit No. 3, Schedule 4,
for the 18 firms in the Utility Group, common equity ratios
at December 31, 2016 ranged between 31.1 percent and 75.7
percent and averaged 47.3 percent.
Q. What capitalization is representative for the proxy 7
group of utilities going forward? 8
A. As shown on page 1 of Exhibit No. 3, Schedule 4,
Value Line expects an average common equity ratio for the
proxy group of utilities of 48.8 percent for its three-to-
five year forecast horizon, with the individual common equity
ratios ranging from 29.5 percent to 76.0 percent. After
eliminating a single low-end outlier (Dominion Energy at 29.5
percent), the average equity ratio corresponding to Value
Line’s three-to-five year forecast horizon is 49.9 percent.
Q. How does Avista’s proposed equity ratio compare 17
with those of the operating companies held by the proxy group 18
parent companies? 19
A. The individual operating company capital
structures are presented on page 2 of Exhibit No. 3, Schedule
4. As shown there, the operating company equity ratios
ranged from 41.5 percent to 61.0 percent. The simple average

McKenzie, Di 34
Avista Corporation

of these results points to an equity ratio of 51.7 percent;
the average weighted by total capitalization for each
operating entity was 51.4 percent.
Q. In summary, how does Avista’s common equity ratio 4
compare with those maintained by the reference group of 5
utilities? 6
A. The 50.0 percent common equity ratio requested by
Avista is entirely consistent with the range of equity ratios
maintained by the parent firms in the Utility Group and their
operating subsidiaries, and is in-line with the average
equity ratios based on Value Line’s near-term expectations.
Q. What implication do the uncertainties inherent in 12
the utility industry have for the capital structures 13
maintained by utilities? 14
A. As discussed earlier, utilities are facing rising
cost structures, the need to finance significant capital
investment plans, uncertainties over accommodating economic
and financial market uncertainties, and ongoing regulatory
risks. Coupled with the potential for turmoil in capital
markets, these considerations warrant a stronger balance
sheet to deal with an increasingly uncertain environment. A
more conservative financial profile, in the form of a higher
common equity ratio, is consistent with increasing
uncertainties and the need to maintain the continuous access

McKenzie, Di 35
Avista Corporation

to capital under reasonable terms that is required to fund
operations and necessary system investment, including times
of adverse capital market conditions.
Moody’s has repeatedly warned investors of the risks 4
associated with debt leverage and fixed obligations and
advised utilities not to squander the opportunity to
strengthen the balance sheet as a buffer against future
uncertainties.27 Similarly, S&P noted that, “we generally 8
consider a debt to capital level of 50% or greater to be
aggressive or highly leveraged for utilities.”28
Q. What other factors do investors consider in their 11
assessment of a company’s capital structure? 12
A. Depending on their specific attributes, contractual
agreements or other obligations that require the utility to
make specified payments may be treated as debt in evaluating
Avista’s financial risk. Power purchase agreements (“PPAs”),
leases, and pension obligations typically require the utility
to make specified minimum contractual payments akin to those

27 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).
28 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

associated with traditional debt financing and investors
consider a portion of these commitments as debt in evaluating
total financial risks. Because investors consider the debt
impact of such fixed obligations in assessing a utility’s 4
financial position, they imply greater risk and reduced
financial flexibility. In order to offset the debt
equivalent associated with off-balance sheet obligations, the
utility must rebalance its capital structure by increasing
its common equity in order to restore its effective
capitalization ratios to previous levels.
These commitments have been repeatedly cited by major
bond rating agencies in connection with assessments of
utility financial risks.29 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.
Q. What does this evidence indicate with respect to 17
the Company’s capital structure? 18
A. Based on my evaluation, I concluded that Avista’s 19
requested capital structure represents a reasonable mix of
capital sources from which to calculate the Company’s overall 21

29 Standard & Poor’s Corporation, “Utilities: Key Credit Factors For The
Regulated Utilities Industry,” RatingsDirect (Nov. 19, 2013).

McKenzie, Di 37
Avista Corporation

rate of return. While industry averages provide one
benchmark for comparison, each firm must select its
capitalization based on the risks and prospects it faces, as
well its specific needs to access the capital markets. A
public utility with an obligation to serve must maintain
ready access to capital under reasonable terms so that it can
meet the service requirements of its customers. Financial
flexibility plays a crucial role in ensuring the wherewithal
to meet the needs of customers, and utilities with higher
leverage may be foreclosed from additional borrowing under
reasonable terms, especially during times of stress.
Avista’s capital structure is consistent with industry 12
benchmarks and reflects the challenges posed by its resource
mix, the burden of significant capital spending requirements,
and the Company’s ongoing efforts to strengthen its credit 15
standing and support access to capital on reasonable terms.
The reasonableness of a 50 percent common equity / 50 percent
long-term debt capital structure for Avista is reinforced by
the importance of supporting continued investment in system
improvements and the Company’s debt repayment obligations,
even during times of adverse capital market conditions.

McKenzie, Di 38
Avista Corporation

III. CAPITAL MARKET ESTIMATES 1
Q. What is the purpose of this section? 2
A. This section presents capital market estimates of
the cost of equity. The details of my quantitative analyses
are contained in Exhibit No. 3, Schedule 2, with the results
being summarized below.
A. Quantitative Analyses 7
Q. Did you rely on a single method to estimate the 8
cost of equity for Avista? 9
A. No. In my opinion, no single method or model
should be relied upon to determine a utility’s cost of equity 11
because no single approach can be regarded as wholly
reliable. Therefore, I used the DCF, CAPM, ECAPM, and risk
premium methods to estimate the cost of common equity. In
addition, I also evaluated a fair ROE using an earnings
approach based on investors’ current expectations in the 16
capital markets. In my opinion, comparing estimates produced
by one method with those produced by other approaches ensures
that the estimates of the cost of equity pass fundamental
tests of reasonableness and economic logic.

McKenzie, Di 39
Avista Corporation

Q. Are you aware that the IPUC has traditionally 1
relied primarily on the DCF and comparable earnings methods? 2
A. Yes, although the Commission has also evidenced a
willingness to weigh alternatives in evaluating an allowed
ROE. For example, while noting that it had not focused on
the CAPM for determining the cost of equity, the IPUC
recognized in Case No. IPC-E-03-13, Order No. 29505 that
“methods to evaluate a common equity rate of return are 8
imperfect predictors” and emphasized “that by evaluating all 9
the methods presented in this case and using each as a check
on the other,” the Commission had avoided the pitfalls
associated with reliance on a single method.30
Q. What specific proxy group of utilities did you rely 13
on for your analysis? 14
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 Exhibit No. 3, Schedule 2, I applied
the DCF model to a utility proxy group composed of those
dividend-paying companies included by Value Line in its
Electric Utilities Industry groups with:
1. S&P corporate credit ratings of BBB-, BBB, or BBB+.

30 Case No. IPC-E-03-13, Order No. 29505 at 38 (2004) (emphasis added).

McKenzie, Di 40
Avista Corporation

2. Moody’s issuer ratings of Baa2, Baa1, or A3.
3. Value Line Safety Rank of 2 or 3.
4. No involvement in a major merger or acquisition.
5. Currently paying common dividends with no recent
dividend cuts.
I refer to the group of 18 comparable-risk firms meeting
these criteria as the “Utility Group.”
Q. How do the overall risks of your proxy group 8
compare with Avista? 9
A. Table 3 compares the Utility Group with Avista
across four key indicators of investment risk:
TABLE 3 12
COMPARISON OF RISK INDICATORS 13

Q. Do these comparisons indicate that investors would 14
view the firms in your proxy groups as risk-comparable to the 15
Company? 16
A. Yes. Considered together, a comparison of these
objective measures, which consider a broad spectrum of risks,
including financial and business position, and exposure to
firm-specific factors, indicates that investors would likely
conclude that the overall investment risks for Avista are
Safety Financial
S&P Moody's Rank Strength Beta
Utility Group BBB Baa1 2 B++0.71
Avista BBB Baa1 2 A 0.70
Credit Rating
Value Line

McKenzie, Di 41
Avista Corporation

generally comparable to those of the firms in the Utility
Group.
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
in greater detail in Exhibit No. 3, Schedule 2, considered
four alternative measures of expected earnings growth, as
well as the sustainable growth rate based on the relationship
between expected retained earnings and earned rates of return
(“br+sv”). As shown on page 3 of Exhibit No. 3, Schedule 5
and summarized below in Table 4, after eliminating illogical
values,31 application of the constant growth DCF model
resulted in the following cost of equity estimates:
TABLE 4 14
DCF RESULTS – UTILITY GROUP 15

31 I provide a detailed explanation of my DCF analysis, including the
evaluation of individual estimates, in Exhibit No. 3, Schedule 2.
Growth Rate Average Midpoint
Value Line 9.1%9.3%
IBES 10.0%11.3%
Zacks 9.5%10.1%
S&P Capital/IQ 9.4%9.4%
br + sv 8.0%8.2%
Cost of Equity

McKenzie, Di 42
Avista Corporation

Q. How did you apply the CAPM to estimate the cost of 1
equity? 2
A. 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 is best applied 6
using estimates that reflect the expectations of actual
investors in the market, not with backward-looking,
historical data. Accordingly, I applied the CAPM to the
Utility Group based on a forward-looking estimate for
investors' required rate of return from common stocks.
Because this forward-looking application of the CAPM looks
directly at investors’ expectations in the capital markets, 13
it provides a more meaningful guide to the expected rate of
return required to implement the CAPM.
Q. What cost of equity was indicated by the CAPM 16
approach? 17
A. As shown on page 1 of Exhibit No. 3, Schedule 7, my
forward-looking application of the CAPM model indicated an
ROE of 9.9 percent for the Utility Group after adjusting for
the impact of firm size.

McKenzie, Di 43
Avista Corporation

Q. Did you also apply the CAPM using forecasted bond 1
yields? 2
A. Yes. As discussed earlier, there is widespread
consensus that interest rates will increase materially as the
economy continues to strengthen. Accordingly, in addition to
the use of current bond yields, I also applied the CAPM based
on the forecasted long-term Treasury bond yields developed
based on projections published by Value Line, IHS Global
Insight and Blue Chip. As shown on page 2 of Exhibit No. 3,
Schedule 7, incorporating a forecasted Treasury bond yield
for 2018-2022 implied an average cost of equity of 10.2
percent after adjusting for the impact of relative size.
Q. What cost of equity was indicated by the ECAPM 13
approach? 14
A. Empirical tests of the CAPM have shown that low-
beta securities earn returns somewhat higher than the CAPM
would predict, and high-beta securities earn less than
predicted. The ECAPM incorporates a refinement to address
this observed relationship documented in the financial
research. My applications of the ECAPM were based on the
same forward-looking market rate of return, risk-free rates,
and beta values discussed above in connection with the CAPM.
As shown on page 1 of Exhibit No. 3, Schedule 8, applying the
forward-looking ECAPM approach to the firms in the Utility

McKenzie, Di 44
Avista Corporation

Group results in an average cost of equity estimate of 10.5
percent after incorporating the size adjustment corresponding
to the market capitalization of the individual utilities. As
shown on page 2 of Exhibit No. 3, Schedule 8, incorporating a
forecasted Treasury bond yield for 2018-2022 implied an
average cost of equity of 10.7 percent after adjusting for
the impact of relative size.
Q. How did you implement the risk premium method? 8
A. I based my estimates of equity risk premiums for
electric utilities on surveys of previously authorized rates
of return on common equity, which are frequently referenced
as the basis for estimating equity risk premiums. My
application of the risk premium method also considered the
inverse relationship between equity risk premiums and
interest rates, which suggests that when interest rate levels
are relatively high, equity risk premiums narrow, and when
interest rates are relatively low, equity risk premiums
widen. This relationship is illustrated in the figure below,
which is based on three-year rolling averages for the utility
bond yields and risk premiums shown on page 3 of Exhibit No.
3, Schedule 9.

McKenzie, Di 45
Avista Corporation

FIGURE 3 1
INVERSE RELATIONSHIP 2

Q. What cost of equity was indicated by the risk 3
premium approach? 4
A. As shown on page 1 of Exhibit No. 3, Schedule 9,
adding an adjusted risk premium of 5.44 percent to the
average yield on triple-B utility bonds for April 2017 of
4.63 percent resulted in an implied cost of equity of
approximately 10.1 percent.32 As shown on page 2 of Exhibit
No. 3, Schedule 9, incorporating a forecasted yield for 2018-
2022 and adjusting for changes in interest rates over the

32 Moody’s yield averages are based on seasoned bonds with a remaining
maturity of at least 20 years.

McKenzie, Di 46
Avista Corporation

1974-2016 study period implied a cost of equity of 10.9
percent.
Q. Please summarize the results of the expected 3
earnings approach. 4
A. Reference to rates of return available from
alternative investments of comparable risk 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. The simple, but powerful
concept underlying the expected earnings approach is that
investors compare each investment alternative with the next
best opportunity. If the utility is unable to offer a return
similar to that available from other opportunities of
comparable risk, investors will become unwilling to supply
the capital on reasonable terms. For existing investors,
denying the utility an opportunity to earn what is available
from other similar risk alternatives prevents them from
earning their opportunity cost of capital. This expected
earnings approach is consistent with the economic
underpinnings for a fair rate of return established by the
U.S. Supreme Court. Moreover, it avoids the complexities and
limitations of capital market methods and instead focuses on
the returns earned on book equity, which are readily
available to investors.

McKenzie, Di 47
Avista Corporation

Value Line’s projections imply an average rate of return 1
on common equity for the electric and gas utility industries
of 10.7 percent and 10.6 percent, respectively, over its
three- to five-year forecast horizon.33 As shown on Exhibit
No. 3, Schedule 10, Value Line’s projections for the Utility 5
Group suggest an average ROE of approximately 10.3 percent,
with a midpoint value of 11.1 percent.
B. Flotation Costs 8
Q. What other considerations are relevant in setting 9
the return on equity for a utility? 10
A. The common equity used to finance the investment in
utility assets is provided from either the sale of stock in
the capital markets or from retained earnings not paid out as
dividends. When equity is raised through the sale of common
stock, there are costs associated with “floating” the new 15
equity securities. These flotation costs include services
such as legal, accounting, and printing, as well as the fees
and discounts paid to compensate brokers for selling the
stock to the public.

33 The Value Line Investment Survey (Mar. 3, Mar. 17, Apr. 28, & May 19,
2017). Value Line reports return on year-end equity so the equivalent
return on average equity would be higher.

McKenzie, Di 48
Avista Corporation

Q. Is there an established mechanism for a utility to 1
recognize equity issuance costs? 2
A. No. While debt flotation costs are recorded on the
books of the utility, amortized over the life of the issue,
and thus increase the effective cost of debt capital, there
is no similar accounting treatment to ensure that equity
flotation costs are recorded and ultimately recognized. No
rate of return is authorized on flotation costs necessarily
incurred to obtain a portion of the equity capital used to
finance plant. In other words, equity flotation costs are not
included in a utility’s rate base because neither that portion 11
of the gross proceeds from the sale of common stock used to
pay flotation costs is available to invest in plant and
equipment, nor are flotation costs capitalized as an
intangible asset. Unless some provision is made to recognize
these issuance costs, a utility’s revenue requirements will 16
not fully reflect all of the costs incurred for the use of
investors’ funds. Because there is no accounting convention
to accumulate the flotation costs associated with equity
issues, they must be accounted for indirectly, with an upward
adjustment to the cost of equity being the most appropriate
mechanism.

McKenzie, Di 49
Avista Corporation

Q. Is there a sound basis to include a flotation cost 1
adjustment in this case? 2
A. Yes, the financial literature and evidence in this
case supports an adjustment to include consideration of
flotation costs. An adjustment for flotation costs
associated with past equity issues is appropriate, even when
the utility is not contemplating any new sales of common
stock. The need for a flotation cost adjustment to
compensate for past equity issues has been recognized in the
financial literature. In a Public Utilities Fortnightly 10
article, for example, Brigham, Aberwald, and Gapenski
demonstrated that even if no further stock issues are
contemplated, a flotation cost adjustment in all future years
is required to keep shareholders whole, and that the
flotation cost adjustment must consider total equity,
including retained earnings.34 Similarly, New Regulatory 16
Finance contains the following discussion:
Another controversy is whether the flotation cost
allowance should still be applied when the utility
is not contemplating an imminent common stock
issue. Some argue that flotation costs are real
and should be recognized in calculating the fair
rate of return on equity, but only at the time when
the expenses are incurred. In other words, the
flotation cost allowance should not continue

34 Brigham, E.F., Aberwald, D.A., and Gapenski, L.C., “Common Equity
Flotation Costs and Rate Making,” Public Utilities Fortnightly, May, 2,
1985.

McKenzie, Di 50
Avista Corporation

indefinitely, but should be made in the year in
which the sale of securities occurs, with no need
for continuing compensation in future years. This
argument implies that the company has already been
compensated for these costs and/or the initial
contributed capital was obtained freely, devoid of
any flotation costs, which is an unlikely
assumption, and certainly not applicable to most
utilities. . . . The flotation cost adjustment
cannot be strictly forward-looking unless all past
flotation costs associated with past issues have
been recovered.35
Q. Can you illustrate why investors will not have the 13
opportunity to earn their required ROE unless a flotation 14
cost adjustment is included? 15
A. Yes. Assume a utility sells $10 worth of common
stock at the beginning of year 1. If the utility incurs
flotation costs of $0.48 (5 percent of the net proceeds),
then only $9.52 is available to invest in rate base. Assume
that common shareholders’ required rate of return is 11.5
percent, the expected dividend in year 1 is $0.50 (i.e., a
dividend yield of 5 percent), and that growth is expected to
be 6.5 percent annually. As developed in Table 5 below, if
the allowed rate of return on common equity is only equal to
the utility’s 11.5 percent “bare bones” cost of equity, 25
common stockholders will not earn their required rate of

35 Morin, Roger A., “New Regulatory Finance,” Public Utilities Reports,
Inc. (2006) at 335.

McKenzie, Di 51
Avista Corporation

return on their $10 investment, since growth will really only
be 6.25 percent, instead of 6.5 percent:
TABLE 5 3
NO FLOTATION COST ADJUSTMENT 4

The reason that investors never really earn 11.5 percent
on their investment in the above example is that the $0.48 in
flotation costs initially incurred to raise the common stock
is not treated like debt issuance costs (i.e., amortized into
interest expense and therefore increasing the embedded cost
of debt), nor is it included as an asset in rate base.
Including a flotation cost adjustment allows investors
to be fully compensated for the impact of these costs. One
commonly referenced method for calculating the flotation cost
adjustment is to multiply the dividend yield by a flotation
cost percentage. Thus, with a 5 percent dividend yield and a
5 percent flotation cost percentage, the flotation cost
adjustment in the above example would be approximately 25
basis points. As shown in Table 6 below, by allowing a rate
of return on common equity of 11.75 percent (an 11.5 percent
cost of equity plus a 25 basis point flotation cost
Common Retained Total Market M/B Allowed Earnings Dividends Payout
Year Stock Earnings Equity Price Ratio ROE Per Share Per Share Ratio
1 9.52$ -$ 9.52$ 10.00$ 1.050 11.50%1.09$ 0.50$ 45.7%
2 9.52$ 0.59$ 10.11$ 10.62$ 1.050 11.50%1.16$ 0.53$ 45.7%
3 9.52$ 0.63$ 10.75$ 11.29$ 1.050 11.50%1.24$ 0.56$ 45.7%
Growth 6.25%6.25%6.25%6.25%

McKenzie, Di 52
Avista Corporation

adjustment), investors earn their 11.5 percent required rate
of return, since actual growth is now equal to 6.5 percent:
TABLE 6 3
INCLUDING FLOTATION COST ADJUSTMENT 4

The only way for investors to be fully compensated for
issuance costs is to include an ongoing adjustment to account
for past flotation costs when setting the return on common
equity. This is the case regardless of whether or not the
utility is expected to issue additional shares of common
stock in the future.
Q. What is the magnitude of the adjustment to the 11
“bare bones” cost of equity to account for issuance costs? 12
A. The most common method used to account for
flotation costs in regulatory proceedings is to apply an
average flotation-cost percentage to a utility’s dividend 15
yield. Based on a review of the finance literature, New 16
Regulatory Finance concluded:
The flotation cost allowance requires an estimated
adjustment to the return on equity of approximately
Common Retained Total Market M/B Allowed Earnings Dividends Payout
Year Stock Earnings Equity Price Ratio ROE Per Share Per Share Ratio
1 9.52$ -$ 9.52$ 10.00$ 1.050 11.75%1.12$ 0.50$ 44.7%
2 9.52$ 0.62$ 10.14$ 10.65$ 1.050 11.75%1.19$ 0.53$ 44.7%
3 9.52$ 0.66$ 10.80$ 11.34$ 1.050 11.75%1.27$ 0.57$ 44.7%
Growth 6.50%6.50%6.50%6.50%

McKenzie, Di 53
Avista Corporation

5% to 10%, depending on the size and risk of the
issue.36
Alternatively, a study of data from Morgan Stanley regarding
issuance costs associated with utility common stock issuances
suggests an average flotation cost percentage of 3.6
percent.37 Applying a 3.6 percent expense percentage to the
proxy group dividend yield of 3.3 percent implies a flotation
cost adjustment on the order of 10 basis points. I thus
recommend the Commission increase the cost of equity by 10
basis points in arriving at a fair ROE for Avista.
Q. Has the IPUC Staff previously considered flotation 11
costs in estimating a fair ROE? 12
A. Yes. For example, in Case No. IPC-E-08-10, IPUC
Staff witness Terri Carlock noted that she had adjusted her
DCF analysis to incorporate an allowance for flotation
costs.38 More recently, in Case No. INT-G-16-02 the IPUC
Staff supported the use of the same flotation cost
methodology that I recommend above, concluding:

36 Roger A. Morin, “New Regulatory Finance,” Public Utilities Reports, Inc.
at 323 (2006).
37 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.
38 Case No. IPC-E-08-10, Direct Testimony of Terri Carlock at 12-13 (Oct.
24, 2008).

McKenzie, Di 54
Avista Corporation

[I]s the standard equation for flotation cost
adjustments and is referred to as the
“conventional” approach. Its use in regulatory 3
proceedings is widespread, and the formula is
outlined in several corporate finance textbooks.39
Q. Have other regulators previously recognized that 6
flotation costs are properly considered in setting the 7
allowed ROE? 8
A. Yes. For example, in Docket No. UE-991606 the WUTC
concluded that a flotation cost adjustment of 25 basis points
should be included in the allowed return on equity:
The Commission also agrees with both Dr. Avera and
Dr. Lurito that a 25 basis point markup for
flotation costs should be made. This amount
compensates the Company for costs incurred from
past issues of common stock. Flotation costs
incurred in connection with a sale of common stock
are not included in a utility's rate base because
the portion of gross proceeds that is used to pay
these costs is not available to invest in plant and
equipment.40
The South Dakota Public Utilities Commission has
recognized the impact of issuance costs, concluding that,
“recovery of reasonable flotation costs is appropriate.”41
Another example of a regulator that approves common stock
issuance costs is the Mississippi Public Service Commission,

39 Case No. INT-G-16-02, Direct Testimony of Mark Rogers at 18 (Dec. 16,
2016).
40 Third Supplemental Order, WUTC Docket No. UE-991606, et al., p. 95
(September 2000).
41 Northern States Power Co, EL11-019, Final Decision and Order at P 22
(2012).

McKenzie, Di 55
Avista Corporation

which routinely includes a flotation cost adjustment in its
Rate Stabilization Adjustment Rider formula.42 The Public
Utilities Regulatory Authority of Connecticut43 and the
Minnesota Public Utilities Commission44 have also recognized
that flotation costs are a legitimate expense worthy of
consideration in setting a fair ROE.
C. Non-Utility DCF Model 7
Q. What other proxy group did you consider in 8
evaluating a fair ROE for Avista? 9
A. As indicated earlier, I also present a DCF analysis
for a low risk group of non-utility firms, with which Avista
must compete for investors’ money. Under the regulatory
standards established by Hope and Bluefield, the salient
criterion in establishing a meaningful benchmark to evaluate
a fair ROE is relative risk, not the particular business
activity or degree of regulation. With regulation taking the
place of competitive market forces, required returns for
utilities should be in line with those of non-utility firms
of comparable risk operating under the constraints of free

42 See, e.g., Entergy Mississippi, Inc., Formula Rate Plan Rider (Apr. 15,
2015), http://www.entergy-
mississippi.com/content/price/tariffs/emi_frp.pdf (last visited Mar. 16,
2017).
43 See, e.g., Docket No. 14-05-06, Decision (Dec. 17, 2014) at 133-134.
44 See, e.g., Docket No. E001/GR-10-276, Findings of Fact, Conclusions, and
Order at 9.

McKenzie, Di 56
Avista Corporation

competition. Consistent with this accepted regulatory
standard, I also applied the DCF model to a reference group
of low-risk companies in the non-utility sectors of the
economy. I refer to this group as the “Non-Utility Group”.
Q. Do utilities compete with non-regulated firms for 5
capital? 6
A. Yes. The cost of capital is an opportunity cost
based on the returns that investors could realize by putting
their money in other alternatives. Clearly, the total
capital invested in utility stocks is only the tip of the
iceberg of total common stock investment, and there are a
plethora of other enterprises available to investors beyond
those in the utility industry. Utilities must compete for
capital, not just against firms in their own industry, but
with other investment opportunities of comparable risk.
Q. Is it consistent with the Bluefield and Hope cases 16
to consider required returns for non-utility companies? 17
A. Yes. Returns in the competitive sector of the
economy form the very underpinning for utility ROEs because
regulation purports to serve as a substitute for the actions
of competitive markets. The Supreme Court has recognized
that it is the degree of risk, not the nature of the
business, which is relevant in evaluating an allowed ROE for

McKenzie, Di 57
Avista Corporation

a utility. The Bluefield case refers to “business 1
undertakings attended with comparable risks and
uncertainties.”45 It does not restrict consideration to other
utilities. Similarly, the Hope case states:
By that standard the return to the equity owner
should be commensurate with returns on investments
in other enterprises having corresponding risks.46
As in the Bluefield decision, there is nothing to
restrict “other enterprises” solely to the utility industry.
Q. Does consideration of the results for the Non-10
Utility Group make the estimation of the cost of equity using 11
the DCF model more reliable? 12
A. Yes. The estimates of growth from the DCF model
depend on analysts’ forecasts. It is possible for utility 14
growth rates to be distorted by short-term trends in the
industry or the industry falling into favor or disfavor by
analysts. The result of such distortions would be to bias
the DCF estimates for utilities. Because the Non-Utility
Group includes low risk companies from many industries, it
diversifies away any distortion that may be caused by the ebb
and flow of enthusiasm for a particular sector.

45 Bluefield Water Works & Improvement Co. v. Pub. Serv. Comm’n, 262 U.S.
679 (1923).
46 Federal Power Comm’n v. Hope Natural Gas Co. (320 U.S. 391, 1944).

McKenzie, Di 58
Avista Corporation

Q. How do the overall risks of this Non-Utility Group 1
compare with the Utility Group and Avista? 2
A. Table 7 compares the Non-Utility Group with the
Utility Group and Avista across the four key risk measures
discussed earlier: 5
TABLE 7 6
COMPARISON OF RISK INDICATORS 7

As shown above, the average credit ratings, Safety Rank, and
Financial Strength Rating for the Non-Utility Group suggest
less risk than for Avista and the proxy group of utilities.
These objective indicators suggest that investors would
likely conclude that the overall investment risks for the
Utility Group and Avista are greater than those of the firms
in the Non-Utility Group.
Q. What were the results of your DCF analysis for the 15
Non-Utility Group? 16
A. As shown on Exhibit No. 3, Schedule 11, I applied
the DCF model to the non-utility companies using analysts’
earnings per share (“EPS”) growth projections, as described
earlier for the Utility Group. As summarized below in
Safety Financial
S&P Moody's Rank Strength Beta
Non-Utility Group A A2 1 A+0.73
Utility Group BBB Baa1 2 B++0.71
Avista BBB Baa1 2 A 0.70
Value Line
Credit Rating

McKenzie, Di 59
Avista Corporation

Table 8, after eliminating illogical values, application of
the constant growth DCF model resulted in the following cost
of equity estimates:
TABLE 8 4
DCF RESULTS – NON-UTILITY GROUP 5

Q. How can you reconcile these DCF results for the 6
Non-Utility Group against the lower estimates produced for 7
your comparable-risk group of utilities? 8
A. First, it is important to be clear that the higher
DCF results for the Non-Utility Group cannot be attributed to
risk differences. As documented in Table 7 above, the risks
that investors associate with the group of non-utility firms
- as measured by credit ratings and Value Line’s Safety Rank
and Financial Strength – are lower than the risks investors
associate with the Utility Group and Avista. The objective
evidence provided by these observable risk measures rules out
a conclusion that the higher non-utility DCF estimates are
associated with higher investment risk.
Rather, the divergence between the DCF results for these
two groups of utility and non-utility firms can be attributed
to the fact that DCF estimates invariably depart from the
Growth Rate Average Midpoint
Value Line 10.7%11.3%
IBES 10.5%11.0%
Zacks 10.6%11.4%
Cost of Equity

McKenzie, Di 60
Avista Corporation

returns that investors actually require because their
expectations may not be captured by the inputs to the model,
particularly the assumed growth rate. Because the actual
cost of equity is unobservable, and DCF results inherently
incorporate a degree of error, the cost of equity estimates
for the Non-Utility Group provide an important benchmark in
evaluating a fair ROE for Avista. There is no basis to
conclude that DCF results for a group of utilities would be
inherently more reliable than those for firms in the
competitive sector, and the divergence between the DCF
estimates for the Utility and Non-Utility Groups suggests
that both should be considered to ensure a balanced end-
result.
IV. IMPACT OF REGULATORY MECHANISMS 14
Q. Does the fact that, starting in January 2016, 15
Avista’s electric and gas rates in Idaho include an FCA 16
warrant any adjustment in your evaluation of a fair ROE? 17
A. No. Investors recognize that the ability to adjust
rates to recover certain costs incurred to provide utility
service is universally prevalent in the industry. Such
adjustment mechanisms act to level the playing field, placing
the Company on equal footing with its peers in the industry.

McKenzie, Di 61
Avista Corporation

As a result, no adjustment to the ROE is justified or
warranted.
The Commission’s approval of an FCA is supportive of
Avista’s financial integrity, but there is no evidence to 4
suggest that implementation of these mechanisms has altered
the relative risk of Avista enough to warrant any adjustment
to its ROE. As noted earlier, the investment community and
the major credit rating agencies in particular, pay close
attention to the regulatory framework, including various
adjustment mechanisms.
Based largely on the expanded use of ratemaking
mechanisms such as revenue decoupling and cost-recovery
riders, Moody’s upgraded most regulated utilities in January 13
2014.47 Recognizing this industry trend, Moody’s premised its 14
assessment of Avista’s risks on the expectation that “similar 15
treatment will be afforded to Avista and that the company
will have improved cost recovery mechanisms (e.g.,
decoupling).”48 In other words, the implications of revenue
decoupling and other regulatory mechanisms are already fully
reflected in Avista’s credit ratings, which are comparable to 20
those of the proxy group used to estimate the cost of equity.

47 Moody’s Investors Service, “US utility sector upgrades driven by stable
and transparent regulatory frameworks,” Sector Comment (Feb. 3, 2014).
48 Moody’s Investors Service, “Avista Corp.,” Global Credit Research (Mar.
28, 2014).

McKenzie, Di 62
Avista Corporation

Thus, while investors would consider the FCA to be supportive
of the Company’s financial integrity and credit ratings, 2
regulatory mechanisms do not provide a basis to distinguish
the risks of Avista from the utilities in my Utility Group.
Moreover approval of the FCA does not remove overhanging
regulatory risks. Avista remains exposed to future
determinations as to the prudency of its expenditures and
investments, and investors continue to evaluate expectations
for balance in the regulatory framework and in establishing
allowed ROEs.
Q. Do the regulatory mechanisms approved for Avista 11
set the Company apart from other firms operating in the 12
utility industry? 13
A. No. Adjustment mechanisms and cost trackers have
been increasingly prevalent in the utility industry in recent
years. In response to the increasing risk sensitivity of
investors to uncertainty over fluctuations in costs and the
importance of advancing other public interest goals such as
reliability, energy conservation, and safety, utilities and
their regulators have sought to mitigate some of the cost
recovery uncertainty and align the interest of utilities and
their customers through a variety of adjustment mechanisms.
Reflective of this trend, the companies in the electric
and gas utility industries operate under a wide variety of

McKenzie, Di 63
Avista Corporation

cost adjustment mechanisms, which range from riders to
recover bad debt expense and post-retirement employee benefit
costs to revenue decoupling and adjustment clauses designed
to address rising capital investment outside of a traditional
rate case and increasing costs of environmental compliance
measures. As Regulatory Research Associates concluded in its
most recent review of adjustment clauses, “some form of 7
decoupling is in place in the vast majority of
jurisdictions.”49 Similarly, the majority of gas utilities
benefit from revenue decoupling, along with a variety of
other provisions that enhance their ability to recover
operating and capital costs on a timely basis.50 The firms in
the Non-Utility Group also have the ability to alter prices
in response to rising production costs, with the added
flexibility to withdraw from the market altogether. As a
result, the mitigation in risks associated with utilities’ 16
ability to adjust revenues and attenuate the risk of cost
recovery is already reflected in the cost of equity range
determined earlier, and no separate adjustment to Avista’s 19
ROE is necessary or warranted.

49 Regulatory Research Associates, “Adjustment Clauses, A State-by-State
Overview,” Regulatory Focus (Aug. 22, 2016).
50 See, e.g., American Gas Association, Innovative Rates, Non-Volumetric
Rates, and Tracking Mechanisms: Current List (Aug. 2016).

McKenzie, Di 64
Avista Corporation

Q. Have you summarized the various tracking mechanisms 1
available to the other firms in the Utility Group? 2
A. Yes. As summarized on Exhibit No. 3, Schedule 12,
reflective of industry trends, the companies in the Utility
Group operate under a variety of regulatory adjustment
mechanisms.51 For example, fourteen of the firms benefit from
some form of revenue decoupling or operate in jurisdictions
that allow the use of future test years. Many of these
utilities operate under mechanisms that allow for cost
recovery of infrastructure investment outside a formal rate
proceeding, as well as the ability to implement periodic rate
adjustments to reflect changes in a diverse range of
operating and capital costs, including expenditures related
to environmental mandates, conservation programs,
transmission costs, and storm recovery efforts.
Q. Have other regulators recognized that approval of 16
adjustment mechanisms do not warrant an adjustment to the 17
ROE? 18
A. Yes. For example, the Staff of the Kansas State
Corporation Commission concluded that no ROE adjustment was
justified in the case of certain tariff riders because the

51 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 65
Avista Corporation

impact of similar mechanisms is already accounted for through
the use of a proxy group:
Those mechanisms differ from company to company and
jurisdiction to jurisdiction. Regardless of their
nuances, the intent is the same; reduce cash-flow
volatility year to year and place recent capital
expenditures in rates as quickly as possible.
Investors are aware of these mechanisms and their
benefits are a factor when investors value those
stocks. Thus, any risk reduction associated with
these mechanisms is captured in the market data
(stock prices) used in Staff’s analysis.52
Similarly, the mitigation in risks associated with Avista’s 13
ability to recover its costs in a more timely manner through
various adjustment mechanisms is already reflected in the
results of the quantitative methods presented in my
testimony.
Q. What does this imply with respect to the evaluation 18
of a fair ROE for Avista? 19
A. While investors would consider Avista’s regulatory
mechanisms to be supportive of the Company’s financial 21
integrity and credit ratings, there is certainly no evidence
to suggest that these mechanisms alone have altered Avista’s 23
relative risk enough to warrant an ROE adjustment. The
purpose of regulatory mechanisms is to better match revenues

52 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 66
Avista Corporation

to the underlying costs of providing service. This levels
the playing field and improves Avista’s ability to attract 2
capital and actually earn its authorized ROE, but it does not
result in a “windfall” or otherwise penalize customers.
Utilities across the U.S. that Avista competes with for new
capital are increasingly availing themselves of similar
adjustments. As a result, the impact of utilities’ ability 7
to mitigate the risk of cost recovery is already reflected in
the cost of equity estimates determined in this case, and no
separate adjustment to Avista’s ROE is necessary or 10
warranted.
Q. Does this conclude your pre-filed direct testimony? 12
A. Yes.