20040715Prehearing Memo from Potlatch.pdf

Conley E. Ward (ISB No. 1683)
Deborah E. Nelson (ISB No. 5711)
GIVENS PURSLEY LLP
601 W. Bannock Street
O. Box 2720
Boise, ID 83701-2720
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Attorneys for Potlatch Corporation
S:\CLIENTS\54\Trial Memorandum GPO2.DOC
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MATTER OF THE APPLICATION
OF A VISTA CORPORATION FOR THE
AUTHORITY TO INCREASE ITS RATES
AND CHARGES FOR ELECTRIC AND
NATURAL GAS SERVICE TO ELECTRIC
AND NATURAL GAS CUSTOMERS IN THE
STATE OF IDAHO.
Case Nos. A VU-04-
A VU -04-
PREHEARING MEMORANDUM
VISTA HAS NOT MET ITS BURDEN OF PROVING ITS PURCHASE OF
COYOTE SPRINGS 2 FROM AN AFFILIATE "AT COST" WAS REASONABLE
AND PRUDENT. THEREFORE, SUCH COST SHOULD NOT BE WHOLLY
INCLUDED IN RATE BASE.
A regulated entity has the right to collect a return only on "necessary and prudent
investments.Utah Power Light Co. v. IPUC 105 Idaho 822, 826, 673 P.2d 422 426 (1983)
Utah Power Light IF'(citing Citizens Uti/. Co. v. IPUC 99 Idaho 164, 171 , 579 P.2d 110
117 (1978)). A vista Corporation s ("A vista ) at-cost purchase of half of Coyote Springs 2
CS2") from its subsidiary, A vista Power, was not a prudent investment given the exorbitant
OR' GINAL
PREHEARING MEMORANDUM -
underlying costs that greatly exceeded the plant's fair value. 1 A vista s purchase of CS2 is
especially suspect because the seller was an A vista affiliate. Thus, A vista bears the burden
proving the purchase was reasonable and prudent and the Commission must carefully scrutinize
the purchase to prevent potential self-dealing at ratepayers' expense. Boise Water Corporation
v. IPUC 97 Idaho 832, 836, 555 P.2d 163 (1976) Boise Water I'
Affiliate Transactions Are Subject To Heightened Commission Scrutiny,
With The Burden Of Proof On The Utility.
Costs paid by utilities to their affiliates are subject to heightened Commission scrutiny,
and the utility bears the burden of proving such costs are reasonable. The seminal Idaho case for
this legal standard is Boise Water I. There, the Idaho Supreme Court reviewed a utility s request
to recover from ratepayers certain costs paid to its parent corporation. The Court stated that the
company had the burden of producing evidence to show that costs paid to an affiliate were
reasonable. Id. at 836. The Court then cited authority from other jurisdictions for the
proposition that costs paid to an affiliate must be subjected to greater scrutiny to ensure such
costs are reasonable and are not improperly allocated to ratepayers. Id. at 837. Using these legal
standards, the Court found the company did not meet its burden of reasonableness simply by
demonstrating the incurrence of the expense. Id.
In Washington Water Power Co. v. IPUC 105 Idaho 276, 668 P.2d 1007 (1983) WWP
If'
),
the Idaho Supreme Court reiterated the need for heightened scrutiny of affiliate transactions.
In WWP II the Court held that Washington Water Power ("WWP") did not carry its burden of
proving the cost of its coal purchase from an affiliate was reasonable. The Court explained that
WWP's evidence of arms length bargaining was insufficient by itself to show reasonableness
1 In this Trial Memorandum
, "
A vista" refers to A vista Corporation, the regulated public utility and parent
company to Avista Power, an unregulated subsidiary. For further explanation of these entities see Direct Testimony
of Dennis E. Peseau on BehalfofPotlatch Corporation (June 21 , 2004) Peseau Direct Testimony
),
pp. 5-
PREHEARING MEMORANDUM - 2
where the deal involved an affiliate. Id. at 279 668 P.2d at 1010. "In such a transaction there
arises the potential for two separate threats to a reasonable price: collusion and inhibited
competition.Id.
The Federal Energy Regulatory Commission ("FERC") also subjects affiliate transactions
to heightened scrutiny in order to protect ratepayers against the potential self-dealing of a buyer
choosing the more expensive product from its affiliate. Southern California Edison Co.106
FERC 61 183 (Feb. 25 2004); Boston Edison Co. Re: Edgar Electric Co.55 FERC 61 382
190-91 (June 7 1991). Specifically, FERC seeks, through its heightened scrutiny, to ensure
that the buyer in an affiliated transaction "has chosen the lowest cost supplier from among the
options presented, taking into account both price and non-price terms (i., that it has not
preferred its affiliate without justification).Edgar 55 FERC at 61 190-91.
In this case , A vista paid an affiliate the "at cost" price for the CS2 plant even though that
price exceeded the fair market value of the plant. The burden of proof is on A vista to prove that
the CS2 purchase price was reasonable, and the Commission must carefully scrutinize the deal to
make sure A vista has not improperly colluded with or benefited its affiliate. A vista cannot meet
this burden in this case.
Avista s Purchase Of CS2 At Avista Power s Cost Was Not Necessary And
Economically Desirable.
In Utah Power Light II the Idaho Supreme Court ruled that in order to rate base
certain property held for future use a utility must demonstrate that the expenditures were
necessary and desirable from an economic standpoint." 105 Idaho at 826, 673 P.2d at 426. The
Court explained the expenditures in question met this standard because "they allow the company
to take advantage of land opportunities that might otherwise be unavailable, allow the company
PRE HEARING MEMORANDUM - 3
to escape purchasing property at inflationary prices, and are conducive to lower customer rates in
the long run.Id.
A vista s purchase of CS2 was not "necessary and desirable from an economic
standpoint." Contrary to the facts in Utah Power Light II Avista s purchase ofCS2 at cost
did not allow the company to escape making expenditures at inflationary prices and was not
conducive to lower customer rates in the long run. Rather, Avista s purchase at cost was in
excess ofCS2's fair market value because the at-cost price included both an unreasonable initial
price paid by A vista Power for CS2 and the overrun costs associated with numerous construction
problems and delays while owned by A vista Power.
The initial price A vista Power paid sellers Portland General Electric and Enron for the
partially completed CS2 and its turbine was unreasonably high. The total purchase price for the
deal was approximately $59.5 million for property that had an all-in cost (book value), including
development costs, of approximately $42 million. Direct Testimony of Dennis E. Peseau on
Behalf of Potlatch Corporation (June 21 , 2004) Peseau Direct Testimony
),
p. 10. This price
included a questionable $3.5 million payment for a two-week put option agreement on the
turbine just in case Avista Power wanted to back out of the deal. Peseau Direct Testimony at 9-
10.
Cost overruns continued throughout A vista Power s ownership of CS2 (July 2000
December 2003) as it attempted to get the plant constructed and operational. Numerous
construction and operational problems caused the estimated cost of A vista s half of the plant to
swell from approximately $94 million to $109 million. Peseau Direct Testimony at 11. Also
during Avista Power s ownership, imprudent natural gas swaps (discussed infra) produced losses
in excess of$62 million. Peseau Direct Testimony at 11-12.
PREHEARING MEMORANDUM - 4
Dr. Peseau concludes Avista s at cost purchase price ofCS2 "is well in excess of fair
market value.Peseau Direct Testimony at 13. Based on the Commission s own
contemporaneous investigation into determining the cost of a comparable facility (with input
from Avista), Avista s share of the fair market value ofCS2 is $84 560 000. Peseau Direct
Testimony at 15. Yet Avista paid at least $109 million for its half of the property. The excess
costs (caused by the imprudent initial purchase by Avista Power and the problems that arose
during Avista Power s ownership) are not properly included in rate base to be passed on to
A vista s ratepayers.
A vista Power originally purchased CS2 as a merchant plant. Although A vista indicated
its intention to purchase CS2 from A vista Power after screening responses to its 2000 RFP, the
fact is that A vista did not make the purchase until January 1 , 2003. During the intervening
period that Avista Power owned the plant, Avista was under no legal obligation to buy and
A vista Power was under no legal obligation to sell CS2. In fact, A vista Power tried to sell the
plant to third parties prior to closing the eventual deal with A vista. Had this been an arms length
transaction, Avista would never have volunteered to pay a price equivalent to the plant'
excessive costs as of January 1 , 2003. But for the need to relieve its affiliate of a no longer cost
effective plant, A vista should have, and presumably would have, re-evaluated its options in early
2003 and selected a more cost effective course of action. The Commission should treat this
transaction as if A vista had fulfilled its duty to the ratepayers by limiting the CS2 purchase price
to fair market value at the time the purchase was made.
The Underlying Initial Cost Of CS2 Exceeded Net Book Value.
The fact that the initial purchase price of CS2 exceeded book value by $17.5 million is
further proof that the underlying cost of the initial purchase of CS2 by A vista Power is
unreasonable (which directly contributes to the unreasonable at-cost price later paid by A vista).
PREHEARING MEMORANDUM - 5
Peseau Direct Testimony at 10. When a utility buys another utility, the Commission typically
restricts the rate base additions to the purchased utility s rate base (i.e. net book value) even
though the sale price often includes a premium for good will. Yet, un-refuted testimony by Dr.
Peseau establishes that A vista Power paid $59.5 million for a plant with a net book value of
approximately $42 million. Peseau Direct Testimony at 10. If A vista Power were a regulated
entity, it would only have been able to recover the $42 million in rate base. Now that a regulated
entity, A vista, has purchased half of the property and wants to include the total cost in its rate
base, the same rule should apply. Avista s rate base must be limited to the net book value of the
asset it is acquiring.
At Cost" Is Not Sufficient By Itself To Show A Purchase Was Reasonable
And Prudent.
Due to the affiliate relationship between A vista and A vista Power, evidence showing
A vista s purchase of CS2 occurred and was "at cost" is not sufficient to show it was reasonable
and prudent. In Boise Water I discussed supra the Idaho Supreme Court reviewed the
Commission s denial of the utility company s request to recover from ratepayers certain costs
paid to its parent corporation. The Court found the company did not meet its burden of
reasonableness simply by demonstrating the incurrence of the expense. Id. at 837. The Court
explained:
The expenses charged to (the affiliate) in this appeal were largely for salaries paid
to their employees, determined by (the affiliate J, representing its own opinion of
the reasonable value of the services rendered. There was no evidence supplied to
substantiate that such charges-though "at cost"-reflected the reasonable market
value for the services rendered.
Id. (emphasis added).
Likewise, here, A vista is attempting to include its full purchase price of CS2 in its rate
base on the basis that the price reflects actual costs. Yet, A vista has not supplied evidence
PREHEARING MEMORANDUM - 6
sufficient to substantiate that the price paid to an affiliate for CS2-though "at cost"-reflected
the reasonable market value for the property purchased. In fact, as explained above, the "at cost"
price paid for CS2 exceeded the plant's value at the time of purchase. Peseau Direct Testimony
at 13-15.
Ratepayers Are Not Responsible For Excess Costs Incurred Before Avista
Bought CS2.
In Boise Water Corporation v. IPUC 99 Idaho 158 578 P.2d 1089 (1978) (Boise Water
II), the Idaho Supreme Court examined the proper way to allocate the increased value of property
between shareholders and ratepayers. "Which class of persons receives the benefit of such
revenue depends on who has borne the financial burdens and risks of that property.Id. at 1092.
The Court explained that, other than for real property, ratepayers acquire an interest in the value
of property through depreciation payments. But, where ratepayers have not made such
payments, as was the case for the real property at issue in Boise Water II ratepayers are not
entitled to reap the rewards or losses on its sale or other transfer.Id. at 1093. In Boise Water II
therefore, the Court concluded that the gain on the sale of real estate accrued to the stockholders
not the ratepayers.
Likewise, determining which class of persons receives the burden of a property
decreased value "depends on who has borne the financial burdens and risks of that property.
Avista s ratepayers did not hold any equitable interest in CS2, through depreciation payments or
other investment, during the time in which the value of CS2 decreased (i.e. costs exceeded
value). Therefore, A vista s ratepayers are not "entitled" to receive the decreased value of this
plant in the form of higher rates.
Instead, a pre-sale decrease in value is properly borne by the seller. Just as ratepayers
would not earn an equitable interest in the increased value of property that occurred before the
PREHEARING MEMORANDUM - 7
utility purchased that property (because a fair market value sales price would allocate any pre-
sale profit margin to the seller), they also do not inherit any escalation in the costs over value of
that property that occurred before its purchase (because a fair market value sales price would
allocate any pre-sale losses to the seller). In other words, a purchase price properly reflects
current value, not total costs. These concepts are not complicated or unusual; rather, they are the
assumed basic underpinnings of every fair, negotiated purchase transaction.
A vista s purchase of CS2 should have been no different. A vista should h~ve paid the
current value of the plant regardless of the plant's costs to date. Overruns in costs over value
should have been borne by the seller, Avista Power. The fact that Avista is a regulated entity
means that the Commission has a duty to make sure A vista s ratepayers are responsible only for
reasonable expenditures for fair value. The fact that the seller here was an A vista affiliate
intensifies the Commission s scrutiny of the deal to enforce that standard and places the burden
on A vista to prove its price was fair and reasonable.
Avista s purchase ofCS2 did not reflect these basic concepts of a fair, negotiated
purchase. A vista bought CS2 from its unregulated affiliate after the affiliate seller had overpaid
for the facility as an initial matter and after the construction costs associated with CS2 had
escalated even further over its fair market value. Peseau Direct Testimony at 11-12. Yet, A vista
improperly paid its affiliate a price based on the total costs of the plant, not based on its lesser
fair value. This escalated purchase price is not properly included in rate base.
In sum, A vista has not met its burden to show the cost paid to its affiliate for CS2 was
reasonable and prudent, and, thus, the "at cost" price is not appropriately included in rate base.
PREHEARING MEMORANDUM - 8
II.DEAL A" AND "DEAL B" WERE UNNECESSARY AND IMPRUDENT
EXPENDITURES, WHICH THE COMMISSION MUST DISALLOW.
1\.Profecf epayers f1'rom nreasonableRates TlieCommission Must
Disallow Unnecessary Or Imprudent Expenses.
To ensure rates are reasonable, a regulating commission has the authority and duty to
oversee a utility s underlying operating expenses. Chicago Grand T. Ry. v. Wellman 143 U.
339 345-46 (1892) ("While the protection of vested rights of property is a supreme duty of the
courts, it has not come to this: that the legislative power rests subservient to the discretion of any
railroad corporation which may, by exorbitant and unreasonable salaries, or in some other
improper way, transfer its earnings into what it is pleased to call' operating expenses. "'
Given such commission oversight, a public utility company s managerial discretion over
operating expenses, though broad, is not limitless. If a utility company spends money
unnecessarily or imprudently, then a commission should not allow such expenditures to be
passed on to ratepayers. Acker v. United States 298 U.S. 426 (1936) (rejecting certain marketing
costs incurred for stockyards on the grounds that they were extravagant and wasteful); Smith
Illinois Bell Tel. Co.282 U.S. 133 (1930) (finding that telephone company s annual depreciation
charge was excessive). In Acker the United States Supreme Court explained the role a
commission plays in protecting ratepayers from unnecessary and imprudent expenses:
The contention is that the amount to be expended for these purposes is purely a
question of managerial judgment. But, this overlooks the consideration that the
charge is for a public service, and regulation cannot be frustrated by a requirement
that the rate be made to compensate extravagant or unnecessary costs for these or
any other purposes.
Id. at 430-31.
Likewise, the Idaho Supreme Court has recognized the Commission s broad authority to
supervise and regulate every public utility in the state and to do all things necessary to carry out
the spirit and intent of the Public Utilities Law.Industrial Customers of Idaho Power v. IPUC
PREHEARING MEMORANDUM - 9
134 Idaho 285 , 289, 1 P.3d 786 , 790 (2000) (citing Idaho Code 9 61-501). The Court
specifically recognized the Commission s authority and responsibility to ensure rates are just and
reasonable. Id. (citing Idaho Code 9 61-222).
Although the initial burdens of proof differ in a commission s review of affiliate versus
nonaffiliated expenses, the legal standard to which a commission must hold those expenses is the
same. Regardless of who receives the money, a commission must determine whether a regulated
entity s expenditures are necessary and prudent and thus properly borne by ratepayers.
Thus, here, the necessary and prudent legal standard controls the Commission s review of
both Deal A expenses (paid by A vista to a non-affiliate) and Deal B expenses (paid by A vista to
an affiliate, A vista Energy). In Deal A, the Commission bears the initial burden of showing the
expenditures were either unnecessary or imprudent, and, in Deal B A vista bears the initial burden
of showing the Deal B expenditures were both necessary and prudent. Boise Water II 99 Idaho
at 1091; Boise Water 1 97 Idaho at 836. Deal B also calls for heightened Commission scrutiny
to protect ratepayers from potential intra-company self-dealing. Boise Water I 97 Idaho at 837.
Deal A and Deal B Expenses Were Unnecessary And Imprudent.
Based on the extreme market conditions and prices at the time, a reasonable investor
would not have bought the long-term hedge bets of Deals A and B. Indeed, all of the reasons for
which PUC staff found Deal B to be economically unreasonable also apply to Deal A. Both
deals involved hedged bets on the same fixed price of gas. Both deals took place when that price
was at a near record level. Peseau Direct Testimony at 23. Both deals involved purely financial
hedges and no actual physical purchase of gas. Peseau Direct Testimony at 24-25. In fact, Deal
s longer timeframe makes it more economically unreasonable than Deal B (36 months versus
17 months).
PREHEARING MEMORANDUM -
Therefore, it is no surprise that Deals A and B resulted in excess natural gas costs of $62
million and that at no time were Deals A and B profitable to Avista. Peseau Direct Testimony
17. To the contrary, Deals A and B were very profitable to the counter parties in the deals
(including Avista shareholders who were counter parties to Deal B) at the expense of Avista
ratepayers, if allowed. Peseau Direct Testimony at 17.
Significantly, Avista cannot demonstrate that it pre-evaluated the cost-effectiveness of
Deals A and B. In Industrial Customers the Idaho Supreme Court held that certain demand side
management ("DSM") expenditures were prudent based on evidence showing the utility had pre-
evaluated the cost-effectiveness of the DSM programs. Id. at 292-, 1 P.3d at 793-94. This
evidence included company reports of the DSM programs' cost-effectiveness and Commission
testimony that the company sought Commission approval before making the expenditures.
A vista has not provided any evidence showing that it pre-evaluated the cost-effectiveness
of Deals A and B. In fact, as discussed already, a reasonable person could not have determined
these expenses would be cost-effective given the market and price conditions at that time and the
unprecedented length of the purely financial hedges. Rebuttal Testimony of Dennis E. Peseau on
Behalf of Potlatch Corporation (July 14 2004) (Peseau Rebuttal Testimony), p. 5. And, as this
Commission has stated in another case
, "
it is inappropriate to lock in high prices solely for the
sake of stability.In the Matter of the Application of Intermountain Gas Company for Authority
to Increase its Purchased Gas Cost Adjustment (OGA) Rate Order No. 29540 , p. 4.
A vista argues that it pre-evaluated the deals in dispute and determined they could cost
effectively generate electricity at then prevailing forward prices. But this argument only makes
sense as a lustification for the underlying physical purchases of the gas. An evaluation of the
hedges at issue in this case would have required a detailed analysis of the propriety of taking a
PREHEARING MEMORANDUM -
price position, as well as the costs and benefits of doing so. A vista conducted no such analysis
on its ratepayers behalf.
The only analysis it undertook was on behalf of its shareholders when it decided to take
the opposite side of the Deal B hedge. Perhaps the most significant fact showing the imprudence
of Deals A and B, as well as the improper self-dealing of Deal B, is that A vista itself expected
gas prices to go down, as evidenced by the opposing hedge of its supposed expert purchasing
arm (A vista Energy) in a deal with similar price terms and market conditions (Deal B). Yet
even with this knowledge, Avista still gambled (with ratepayers money) that gas prices would
continue to rise and then stay high for the length of the hedge.
In sum, the Commission has no basis for finding that costs associated with Deals A and B
can be passed on to ratepayers as necessary and prudent expenditures. The Commission has no
evidence, from A vista or otherwise, that A vista s purchase of high-priced hedges for
unprecedented terms was either reasonable or subjected to any pre-evaluation review as being
cost-effective. Therefore, both Deal A and Deal B costs are inappropriate for recovery from
ratepayers.
RESPECTFULLY SUBMITTED This 15th day of July 2004.
nley ard
Attorneys for Potlatch Corporation
PREHEARING MEMORANDUM - 12
CERTIFICATE OF SERVICE
I HEREBY CERTIFY that on this 15th day of July 2004 , I caused to be served a true and
correct copy of the foregoing document by the method indicated below, and addressed to the
following:
Jean Jewell
Idaho Public Utilities Commission
472 W. Washington Street
O. Box 83720
Boise, ID 83720-0074
) U.S. Mail
( ./) Hand Delivered
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) Facsimile
Scott Woodbury
Lisa Nordstrom
Idaho Public Utilities Commission
472 W. Washington Street
O. Box 83720
Boise, ID 83720-0074
swoodbu(fYpuc. state .id. us
Inordst(fYpuc.state.id. us
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David J. Meyer
Senior Vice President and General Counsel
A vista Corporation
O. Box 3727
1411 E. Mission Ave., MSC-
Spokane, W A 99220-3727
da vi d. meyer~avistacorp. com
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Kelly Norwood
Vice President, State and Federal Regulation
A vista Utilities
O. Box 3727
1411 E. Mission Ave., MSC- 7
Spokane, WA 99220-3727
kelly .norwood(fYavistacorp. com
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Dennis E. Peseau, Ph.
Utility Resources, Inc.
1500 Liberty Street SE, Ste. 250
Salem, OR 97302
dpeseau(fYexcite.com
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PRE HEARING MEMORANDUM - 13
Charles L.A. Cox
EV ANS , KEANE
III Main Street
O. Box 659
Kellogg, ID 83837
ccox(fYusamedia. tv
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Brad M. Purdy
Attorney at Law
2019 N. 17th Street
Boise, ID 83702
bmpurdy(fYhotmail.com
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Michael Karp
147 Appaloosa Lane
Bellingham, W A 98229
michael~awish.net
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Anthony J. Yankel
29814 Lake Road
Bay Village, OH 44140
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PREHEARING MEMORANDUM - 14