April 4, The Detroit Edison Company MPSC Case Nos. U-16472/U (e-file/paperless)

Transcription

1 STATE OF MICHIGAN DEPARTMENT OF ATTORNEY GENERAL MERCANTILE, STE. LANSING, MICHIGAN BILL SCHUETTE ATTORNEY GENERAL April, 0 Mary Jo Kunkle Executive Secretary Michigan Public Service Commission Mercantile Way P.O. Box 0 Lansing, Michigan 0 Dear Ms. Kunkle: Re: The Detroit Edison Company MPSC Case Nos. U-/U- (e-file/paperless) The Michigan Public Service Commission Staff (Staff) submits Mr. Brian Welke's revised direct testimony for filing in Case Nos. U- & U-. Mr. Welke's revised direct testimony reflects a correction made to page, lines -. The rest of Mr. Welke's direct testimony remains unchanged. Additionally, Mr. Welke's exhibits remain unchanged and have not been revised or re-filed. Additionally, Staff submits Mr. Kirk Megginson's direct testimony and exhibit for filing in Case Nos. U- & U-. Mr. Megginson's direct testimony and exhibit were inadvertently omitted from Staff's April, 0 filing. Please feel free to contact me with any questions or concerns. Thank you. Sincerely, AMU:la Atts. Anne M. Uitvlugt (P) Assistant Attorney General Public Service Division

2 S T A T E OF M I C H I G A N BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION * * * * In the matter of the application of THE DETROIT EDISON COMPANY ) for authority to increase its rates, amend ) Case No. U- its rate schedules and rules governing the ) distribution and supply of electric energy, ) and for miscellaneous accounting authority. ) ) In the matter of the application of THE DETROIT EDISON COMPANY ) for approval to defer certain pension and ) Case No. U- post-employment benefits expense for future ) amortization and recovery. ) ) QUALIFICATIONS AND REVISED DIRECT TESTIMONY OF BRIAN A. WELKE MICHIGAN PUBLIC SERVICE COMMISSION April, 0

3 QUALIFICATIONS OF BRIAN A. WELKE CASE NUMBER U-/U- PART I 0 Q. Please state your name and business address. A. My name is Brian A. Welke and my business address is Mercantile Way, Suite, Lansing, Michigan,. Q. By whom are you employed and in what capacity? A. I am employed by the Michigan Public Service Commission as an auditor in the Regulated Energy Division, Revenue Requirements Section. Q. Please describe your educational background. A. I graduated from Eastern Michigan University with a Bachelor of Science Degree in Business Administration, Accounting in 00. In August 00, I attended the National Association of Regulatory Utility Commissioners (NARUC) Annual Regulatory Studies Program held at Michigan State University. I have also attended several continuing education classes presented by NARUC. Q. Do you belong to any professional organizations? A. Yes. I am a member of the Institute of Public Utilities and the Institute of Internal Auditors. I am also a member of an honors fraternity, Beta Gamma Sigma. Q. Please describe your professional background. A. I have been employed by the State of Michigan for eight years, first for the Department of Corrections and most recently as an auditor for the Public Service Commission. As an auditor, I have filed testimony in the following cases: 0 Case No. Case Description U- Consumers Energy Electric Rate Case U- Detroit Edison Electric Rate Case U- Wisconsin Electric Power Company Electric Rate Case

4 QUALIFICATIONS OF BRIAN A. WELKE CASE NUMBER U-/U- PART I U- Consumers Energy Gas Rate Case U-00 Compliant Case against Detroit Edison Company U-0 Indiana and Michigan Company Electric Rate Case U- Consumers Energy Electric Rate Case U- Upper Peninsula Power Company Electric Rate Case U- SEMCO Energy Gas Rate Case

5 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 Q. What is the purpose of your testimony? A. The purpose of my testimony is to present Staff s revenue deficiency for Detroit Edison s projected month period ending March, 0 based on the rate base, adjusted net operating income (NOI), and overall rate of return used in determining return on rate base. Further, I provide a computational comparison between Staff s and the Company s revenue deficiencies and identify Staff members supporting each of the differences. Finally, I support Staff s recommended level of projected administrative and general (A&G) expenses and an accounting policy relating to certain Operations and Maintenance (O&M) expenses. Q. Are you sponsoring any exhibits? A. Yes, I am sponsoring the following Exhibits: Exhibit Schedule Title 0 S- A Projected Revenue Deficiency (Sufficiency) for the Months Ending March, 0 S- C Adjusted Net Operating Income for the Months Ending March, 0 S- C Revenue Conversion Factor for the Months Ending March, 0 S- C Projected Operation and Maintenance (O&M) Expense for the Months Ending March, 0 S- C. December, 00 Actuary Report

6 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 S- C. July 0, 00 and September, 00 Actuary Report Comparison for the Months Ending March, 0 S- C. July 0, 00 Actuary Report S- C. September, 00 Actuary Report Q. Please describe Exhibit S-, Schedule A. A. Exhibit S-, Schedule A presents Staff s total company projected revenue deficiency of $,0,000 for the month period ending March, 0, a reduction of $,0,000 from the Company s application. Projections were developed through the categories listed in column (a.). Column (c.) presents the Company s projection and column (e.) presents Staff s projection, with the difference shown in column (d.). The differences in column (d.) represent Staff adjustments and are supported by corresponding exhibits listed in column (b.). Column (f.) presents Staff s jurisdictional revenue deficiency of $,0,000. Q. Please provide a summary of Staff s $,0,000 difference in revenue requirement compared to the Company s application. A. The $,0,000 difference in Staff s revenue requirement is due to a change in rate base, change in rate of return (ROR), O&M, revenue, fuel and purchased power, depreciation and amortization, property and other taxes, state and federal taxes and allowance for funds used during construction (AFUDC) as follows: Rate Base (,,000) Change in ROR (,,000) O&M (,0,000) Revenue (,,000)

7 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 Fuel and Purchased Power,0,000 Depreciation and Amortization (,,000) Property and Other Taxes (,,000) State and Federal Taxes (0,,000) AFUDC (,000) Total $ (,0,000) Q. Please describe Staff s recommended Rate Base adjustments that relate to the reduction in the revenue requirement of $,,000. A. The revenue requirement reduction of $,,000 is the result of five adjustments. The first adjustment relates to the depreciation reserve. Staff decreased the depreciation reserve to reflect Staff s recommended depreciation rates from Case No. U-. The second adjustment relates to the transfer of the Bell River fly ash site, the Greenwood site and four other distribution sites to non-utility accounts. The third adjustment recognizes the balance sheet impact of Staff s recommended removal of certain O&M expenses. These adjustments are supported by Staff witness Yerva Talbert. The fourth adjustment relates to the reclassification of Smart Grid capital expenditures to construction work in progress, which is supported by Staff witness Nicholas Evans. The final adjustment relates to reliability indexes, which is supported by Staff witness Jordan Reasoner. Q. Please describe Staff s recommended ROR that relates to the decrease in revenue requirement of $,,000.

8 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 A. The revenue requirement reduction of $,,000 is the result of Staff s recommended ROR of.%, which is.0% lower than the Company s requested ROR. This adjustment is supported by Staff witness Kavita Bankapur. Q. Please describe the O&M expense adjustments that relate to the reduction of the revenue requirement of $,0,000. A. The revenue requirement reduction of $,0,000 is the result of Staff adjustments to pension and other post-employment benefits (OPEB), active health care, other benefit, bonus, board of director, MGM Grand parking, uncollectible, short-term debt collection and inflation expenses. The revenue requirement impact of each of these components is as follows: Pension & OPEB Benefits (,,000) Active Health Care Benefits (,0,000) Other Benefits (,,000) Incentive Compensation (,,000) Board of Directors (,,000) MGM Rent (,0,000) Uncollectibles (,0,000) Short-Term Debt,0,000 Inflation (,,000) Total $ (,0,000) These adjustments are presented on Staff Exhibit S-, Schedule C and are individually described as follows.

9 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 Q. Please describe Staff s recommended adjustment to Pension and OPEB Benefits expense that relates to the reduction in the revenue requirement of $,,000. A. Staff s recommended adjustment to Pension and OPEB expense was the result of using a more current Detroit Edison actuarial report than was used by the Company in its filing. The report, dated December, 00, used more current discount rate and return on asset assumptions. The more current assumptions reduced the Company s projected pension and OPEB expense by $,,000. Q. Does Staff s pension and OPEB adjustment take into account a 0 forecast? A. No. Staff did not take into account a 0 forecast for two reasons. First, the December, 00 Detroit Edison actuarial report did not include a 0 projection. (See Exhibit S-, Schedule C.) Second, Staff reviewed other actuarial reports that pre-dated the December report and found none to offer a reliable estimate of 0 expense. For example, two previous reports dated 0 days apart forecasted 0 pension and OPEB expenses that differed by as much as $ million. (See Exhibit S- Schedules C., C. and C.) The use of one report would have reduced base rates by $ million while the use of the other would have increased base rates by $ million. Therefore, without a current and reliable forecast of 0, Staff recommends using 0 pension and OPEB expense from the December, 00 report for the projected test year ending March, 0. Q. Does Staff support the Company s proposal to defer its forecasted increase in 0 and 0 pension and OPEB expenses that are over the expense levels currently in base rates?

10 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 A. No. Staff recommends that the Commission deny the requested deferral of 0 pension and OPEB expense because the most current actuarial report forecasted pension and OPEB expense below the amount currently included in base rates. Therefore, no deferral is needed. Staff also recommends that the Commission deny the requested deferral of 0 pension and OPEB expense because the pre- December, 00 forecasts provided to Staff are unreliable. Staff also points out that one such prior forecast would have also resulted in pension and OPEB expense below that amount currently included in base rates. Q. Please describe Staff s recommended adjustment to Active Health Care Benefits expense that relates to the reduction in revenue requirement of $,0,000. A. Staff s recommended adjustment to Active Health Care benefits was the result of using actual 00 expense amounts in lieu of 00 amounts used by the Company in its filing. Actual 00 expense is a more current representation of these expenses than those projected by the Company in its filing. Q. Please describe Staff s recommended adjustment to Other Benefits expense that relates to the reduction in revenue requirement of $,,000. A. Staff s recommended adjustment to Other Benefits results primarily from the removal of non-qualified pensions, dividends, performance shares and other perquisites offered to select and already highly compensated employees. These expenses were removed because the Commission has found that these expenses are not commensurate with the costs to ratepayers in previous cases. (Case No. U-, Order dated December, 00, page & Case No U-, Order dated January, 00). Similarly, Staff recommends the disallowance of these

11 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 expenses in this case for the same reasons. Other benefits expense was also adjusted to reflect actual 00 expenses for certain expense categories. Q. Please describe Staff s recommended adjustment to Incentive Compensation expense that relates to the reduction in revenue requirement of $,,000. A. Staff s recommended adjustment to Incentive Compensation expense is based on Commission policy. This policy has been to exclude all incentive compensation from the cost of providing service to ratepayers on the grounds that any purported ratepayer benefits are not commensurate with the cost of the program. Likewise, the Commission has repeatedly found that utilities must quantify the benefits to ratepayers of employee incentive compensation plans that are tied to non-financial metrics and demonstrate that the benefits to customers of such plans outweigh the costs, (Case No. U-, Commission Order dated December, 00, page.) In addition, the Commission has found that incentive compensation plans that are tied to company earnings and cash flow, financial considerations that largely benefit shareholders, should not be paid for by ratepayers, Case No. U-, Commission Order dated December, 00, page. Q. In which past cases has the Commission disallowed incentive compensation expenses? A. The Commission has removed 00 percent of incentive compensation expenses in the following cases: - Case No. U-, dated //00, (Consumers Energy electric rate case) - Case No. U-, dated //00, (Consumers Energy gas rate case) - Case No. U-, dated /0/00, (Consumers Energy electric rate case)

12 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U Case No. U-, dated //00, (Detroit Edison electric rate case) - Case No. U-, dated //00, (Detroit Edison electric rate case) Q. Is the incentive compensation proposed by the Company in this case tied to financial metrics? A. Yes. According to the 00 Rewarding Employees Plan (REP or incentive compensation plan) information booklet provided to Staff, The 00 REP is based on Corporate and business unit (i.e. Detroit Edison, MichCon, and Nuclear Generation) financial and nonfinancial measures. (page ). Q. Did the Company provide a comprehensive analysis quantifying the benefits to ratepayers of its employee incentive compensation plan in its application? A. No. No comprehensive analysis was filed or is on the record in this case. Q. What is Staff's position regarding Detroit Edison's current request for inclusion of incentive compensation expenses within O&M in this case? A. Staff is recommending 00 percent exclusion of incentive compensation expenses. This adjustment is consistent with past Commission disallowances. These plans continue to include financial measures and the Company has not demonstrated that the remaining criteria for payout are quantifiable or shown that costs are commensurate with benefits to ratepayers. Q. Please describe Staff s recommended adjustment to Board of Director s expense that relates to the reduction in the revenue requirement of $,,000. A. Detroit Edison s parent, DTE Energy, bills Detroit Edison for expenses relating to DTE Energy s Board of Director functions. Staff has removed a portion of these expenses from O&M. This portion is related to stock based compensation. Stock 0

13 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 based compensation is a mechanism to enhance the financial performance of the company, which mainly benefits its shareholders, not ratepayers. This treatment is consistent with Staffs previous positions in Case No. s U- and was adopted by the Commission in that case. Q. Please describe Staff s recommended adjustment to MGM Rent expense that relates to the reduction in the revenue requirement of $,0,000. A. Detroit Edison owned land, with improvements, that was used for employee parking. In 00, Detroit Edison sold this land to the MGM Casino for a $. million gain, which they booked below the line. MGM Casino constructed a parking structure on that land. Edison entered into an agreement with the MGM Casino to use that parking structure for its employees. Currently, Detroit Edison has deferred the pre-tax gain of $. million related to the parking agreement. Because the parking agreement is classified as an operating lease for accounting purposes, $ million of rental expense is expected to be incurred during the projected test year. While these expenses are booked to ratepayers, the projected portion of the gain remains below the line, which is exclusively to the investors. This creates a mismatch. Q. How does Staff recommend that the Company account with the $ million for rate making purposes? A. Staff recommends the $ million of rental expense associated with the MGM Parking agreement be treated as a below the line expense. This adjustment was adopted by the Commission in Case No. U-, Order dated December, 00, page and Case No. U-, Order dated January, 00.

14 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 Q. Please describe Staff s recommended adjustment to Uncollectibles expense that relates to the reduction in the revenue requirement of $,0,000. A. Staff recommends a projected uncollectible expense of $,,. This projection is the Company s actual 00 uncollectible expense, less charitable donations. It is $,0,00 less than the Company s projection. Q. Why is the Company s projected uncollectible expense higher than Staff s? A. The Company s projections are overstated. Company witness D.W. Broome projected an uncollectible expense of 0 - $ million for calendar year 00. (D.W. Broome Direct Testimony, page DWB-). Actual uncollectible expense was $,, for calendar year 00. Therefore, the Company witness s projection of 00 uncollectible expense overstated actual 00 expense by approximately $ - $ million. Q. Did the Company use their projection of 00 uncollectible expense as a basis for their test year projections? A. The Company witness did not explicitly use 00 uncollectible expense as support for its test year projections. However, such a material difference in a period preceding its test year suggests that their subsequent projections are overstated and are at the very least unreliable. Q. How is Staff s uncollectible expense projection reasonable? A. Staff s projection is the actual and most current, (00) expense, which is not subject to material overstatements. Actual expense experience is more reliable than forecasts. It also recognizes that the Company is aggressively working to

15 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 reduce uncollectible expense and captures the savings these programs are now generating. (D.W. Broome Direct Testimony, page DWB-). Q. Has the Company supported use of an actual and most current uncollectible expense to be used in setting base rates? A. Yes. Co. Witness Stanzak stated that The Company has consistently supported use of projected uncollectible expense, consistent with actual amounts booked to Account No. 0 (Uncollectible Expenses), for setting Edison s base rates and that uncollectible expense reflected in rates be based on as current as experience as possible (Case No. U- D.M. Stanczak Rebuttal page DMS Rebuttal & ). Q. Has the Commission agreed that projecting uncollectibles using an actual, most up to date expense reasonable in a previous Edison Case? A. Yes. The Commission determined that the 00 year ending uncollectible expense, (less a one-time charge) to be a reasonable estimate of future uncollectible expense in Case No. U-. (Case No. U- Commission Order dated January, 00, page 0.) Q. What is the purpose of using a historical average of uncollectible accounts? A. The purpose of using an average for uncollectible expense is to mitigate the effects of forecasting error and high volatility from one period to the next. Q. Is the purpose of using a historical average of uncollectible accounts to produce an accurate forecast of uncollectible expense? A. No. It is an imperfect measure of future uncollectible expense by design. Uncollectible expenses are difficult to forecast and are highly volatile, as is

16 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 evidenced by Company witness Broome s overstatement of $ - $ million in his 00 projection and the $0 million difference between actual 00 and actual 00 uncollectible expense. Averaging mitigates this potential for forecasting error and high period over period volatility. Using a historical average, the Company may under-recover during a test year of higher than average uncollectibles, but may over-recover in subsequent years when uncollectible expense falls below that average. This makes the Company whole over time and protects ratepayers from an overstated forecast or unusually high year of expense permanently built in to rates. Q. Why is Staff not recommending the use of an average in this case? A. The Commission approved an uncollectible expense tracking mechanism, (UETM) in Edison s last rate case, which will allow the Company the opportunity to recover its actual 00 expense. Therefore, the company will be made whole through the UETM, and not over time using an average. Q. Why did Staff remove amounts related charitable donations from uncollectible expense? A. Staff removed expenses for low income match write-offs, which are charitable donations, from uncollectible expense because including these expenses would place ratepayers in the position of becoming involuntary contributors to charity. Q. Please describe Staff s recommended adjustment to Short-Term Commitment Fees expense that relates to the increase in the revenue requirement of $,0,000.

17 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 A. Staff s recommended adjustment to Short-Term Commitment Fees results from moving these fees from AFUDC to O&M. This adjustment is supported by Staff witness Kavita Bankapur. Q. Please describe Staff s recommended adjustment to Inflation expense that relates to the decrease in the revenue requirement of $,,000. A. Staff s recommended adjustment to Inflation expense results from the use of actual 00 inflation and general inflation (CPI All Urban) across all A&G O&M accounts for 0 and 0. The Company used a general labor escalator of % within certain A&G O&M accounts. Applying CPI All Urban inflation factors across all A&G O&M accounts has been consistently adopted by the Commission in prior rate cases. Q. Please describe Staffs recommended Revenue adjustment that relates to the reduction in the revenue requirement of $,,000. A. Staff s recommended adjustment to Revenue recognizes the forecasted revenue from the contract renewal with Public Lighting of Detroit, (PLD), which was not included in the Company s filing. This adjustment is supported by Staff witness Poornima Jayasheela. Q. Please describe Staffs recommended Fuel and Purchased Power adjustment that relates to the increase in the revenue requirement of $,0,000. A. Staff s recommended adjustment to Fuel and Purchased Power expense recognizes the increase in expense resulting from the contract renewal with PLD, which was not included in the Company s filing. This adjustment is supported by Staff witness Raushawn Bodiford.

18 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 Q. Please describe Staffs recommended Depreciation and Amortization adjustment that relates to the decrease in the revenue requirement of $,,000. A. Staff s recommended adjustment to Depreciation and Amortization incorporates Staff s proposed depreciation rates from Case No. U-. The proposed depreciation rates are supported by Staff witness Daniel Birkam and their inclusion within this case is supported by Staff witness Yerva Talbert. Q. Please describe Staffs recommended Property, State, Federal and Other Taxes adjustments that relate to the combined decrease in the revenue requirement of $,,000. A. Staff s recommended adjustment to Taxes results primarily from updated revenue, depreciation and O&M expenses. These adjustments are supported by Staff witness Kevin Liu. Q. Please describe Staffs recommended AFUDC adjustment that relates to the decrease in the revenue requirement of $,000. A. Staff s recommended adjustment to AFUDC results from using Staff s proposed ROR in lieu of the Company s. It also reflects the removal of short-term commitment fees, short-term debt commitments and intercompany loans. These adjustments are supported by Staff witness Daniel Birkam. ACCOUNTING RECOMMENDATION Q. What is Staff s proposed accounting recommendation concerning the applicants recording of certain O&M expenses? A. Staff is recommending that Detroit Edison be required to book the following O&M expenses in account :

19 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U Rewarding Employees Plans (REP or incentive compensation) - Supplemental Employee Retirement Plan, (SERP) - Executive Supplemental Retirement Plan, (ESRP) Q. Why is Staff making this recommendation? A. The Uniform System of Accounts (USofA) is clear: All amounts included in the accounts prescribed herein for electric plant and operating expenses shall be just and reasonable and any payments or accruals by the utility in excess of just and reasonable charges shall be included in account. Other deductions. (Uniform System of Accounts for Major and Non- Major Electric Utilities, page.) Q. How does this language in the USofA relate to the types of expenses Staff is recommending be booked in account? A. The Commission has also made clear that each of the preceding expenses is neither just nor reasonable costs for the provision of service to ratepayers in the following cases: - Case No. U-, dated //00, (Consumers Energy electric rate case) - Case No. U-, dated //00, (Consumers Energy gas rate case) - Case No. U-, dated /0/00, (Consumers Energy electric rate case) - Case No. U-, dated //00, (Detroit Edison electric rate case) - Case No. U-, dated //00, (Consumers Energy electric rate case) - Case No. U-, dated //00, (Detroit Edison electric rate case) - Case No. U-, dated //00, (Consumers Energy gas rate case)

20 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- 0 0 Q. Why is it important that the Commission adopt Staff s recommendation to require Detroit Edison to record Commission disallowances in a non-utility operating expense account, specifically account? A. The Company s recording of these expenses as utility operating costs violate the instructions of the USofA. In some instances, their inclusion in utility operating expense accounts also violates Commission orders by seeking recovery of these costs from ratepayers, despite continued determination by the Commission that they are not just and reasonable costs to be recovered from the ratepayers. Staff believes that the USofA and Commission orders are the proper authorities that Detroit Edison is required to follow and the proper authorities the ratepayer relies on for protection from unnecessary costs included in their bills. That protection should not be allowed to transfer to the auditor s ability to weed out such costs from the mass of utility operating costs. The protection should be systematic and not rely upon whatever auditor is assigned to review O&M expense for that rate case. Q. Are there other reasons why Staff is recommending this accounting change? A. Yes. Staff spends an inordinate amount of time reviewing O&M accounts for items that the Commission has determined, per the USofA, to not be just and reasonable costs for the provision of service to ratepayers. Adoption of this accounting recommendation will allow Staff additional time to review emerging aspects of the applicants O&M expenses by not needing to re-evaluate previously determined issues. Adopting this recommendation will also allow Staff to compare the Company s historical earned rate of return consistent with

21 REVISED DIRECT TESTIMONY OF BRIAN A. WELKE CASE NUMBER U-/U- Commission determinations of just and reasonable expenses without burdensome normalizations. Q. Do you have anything else to add? A. Yes. Subsequent to Staff s preparation of this case, Staff received an updated capital expenditure amount related to reliability from Staff Witness Jordan Reasoner. This update is discussed in his testimony on page. The change in revenue deficiency will be reflected prospectively. Q. Does this complete your testimony? A. Yes.

22 S T A T E OF M I C H I G A N BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION * * * * In the matter of the application of In the matter of the application of ) THE DETROIT EDISON COMPANY ) Case No. U- for authority to increase its rates, amend ) its rate schedules and rules governing ) the distribution and supply of electric ) energy, and for miscellaneous accounting ) authority ) ) In the matter of the application of THE DETROIT EDISON COMPANY ) for approval to defer certain pension and ) Case No. U- post-employment benefits expense for future ) amortization and recovery. ) ) QUALIFICATIONS AND DIRECT TESTIMONY OF KIRK D. MEGGINSON MICHIGAN PUBLIC SERVICE COMMISSION April, 0

23 QUALIFICATIONS OF KIRK D. MEGGINSON CASE NUMBER U- PART I 0 0 Q. Please state your name, business address and occupation. A. My name is Kirk D. Megginson and my business address is Mercantile Way, Suite, Lansing, Michigan. I am employed by the Michigan Public Service Commission (MPSC or Staff) as a Financial Specialist in the Financial Analysis and Customer Choice Section of the Regulated Energy Division. Q. Please describe your educational and professional background. A. I graduated with a Bachelor of Science degree in Mechanical Engineering from Michigan State University in March and received my Masters of Business Administration degree in Finance from Clark Atlanta University in May 00. Prior to graduate school, I worked for the Michigan Consolidated Gas Company as a commercial accounts manager from to 000, primarily responsible for managing natural gas transportation accounts of certain industrial and commercial clients in the Wayne and Washtenaw County areas. From to while attending Michigan State University, I worked for the MPSC as a Research Analyst. In that role, I researched the technical and financial standards of utility energy conservation programs throughout Michigan. In December 00, I began work as a Financial Analyst at the MPSC. As a Financial Analyst, I analyzed and reported on the financial statistics of regulated Michigan jurisdictional utility companies and assisted the MPSC Financial Analysis and Customer Choice Staff in utility rate case hearings. In October 00, I became a Financial Specialist and provide Staff with expert testimony on ratemaking capital structure development, debt and equity costing, business and credit risk analysis, overall rate of return matters, and other

24 QUALIFICATIONS OF KIRK D. MEGGINSON CASE NUMBER U- PART I 0 0 finance issues in rate case proceedings and other Staff assignments. Q. Have you received additional training since joining the MPSC? A. Yes. In addition to my academic training, I have attended several seminars and workshops on gas and electric marketing and rate analysis, utility financial analysis and ratings methodology while employed at the MPSC. In August 00, I attended the introductory two-week regulatory studies program offered by the Michigan State University, Institute of Public Utilities, which covered various aspects of utility regulation and have attended credit rating framework and methodology training sessions provided by Standard & Poor s. Q. Have you provided testimony in requested rate increase cases prior to this case? A. Yes, I have. I have participated in the following rate increase request cases: Case Number Company Name Description U-0 Michigan Gas Utilities Capital Structure U- SEMCO Gas Co. Capital Structure U- Wisconsin Public Service Corp. Capital Structure U-0 Detroit Edison Corp. Capital Structure/Rate of Return U- Michigan Consolidated Gas Co. Capital Structure/Rate of Return U- SEMCO Energy Co. Capital Structure/Rate of Return U- Consumers Energy (Electric Div.) Capital Structure/Rate of Return U- Consumers Energy (Gas Div.) Capital Structure/Cost of Capital U- Detroit Edison Corp. Capital Structure/Debt Cost Rate U- SEMCO Energy Co. Capital Structure/Cost of Capital

25 QUALIFICATIONS OF KIRK D. MEGGINSON CASE NUMBER U- PART I U-0 Consumers Energy (Gas Div.) Capital Structure/Cost of Capital U- Consumers Energy (Electric Div.) Capital Structure/Cost of Capital U-0 Consumers Energy (Gas Div.) Capital Structure/Cost of Capital U- Michigan Consolidated Gas Co. Capital Structure/Cost of Capital U- Consumers Energy (Gas Div.) Capital Structure/Cost of Capital U- Consumers Energy (Electric Div.) DOE Liability Trust Fund U- Consumers Energy (Gas Div.) ROE Recommendation

26 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- 0 0 Q. What is the purpose of your testimony in this proceeding? A. The purpose of my testimony is to offer a recommendation on behalf of the Michigan Public Service Commission Staff (Staff) regarding the recommended return on common equity (ROE) that The Detroit Edison Company (Detroit Edison or the Company) should be allowed to earn on its Michigan jurisdictional electric utility investment. The test year for this case begins April, 0 and ends March, 0. My testimony will also provide a recommendation with respect to Detroit Edison s proposal to lower its nuclear decommissioning surcharge for the future decommissioning of the Company s Fermi nuclear plant. The recommendations provided in this testimony are based on technical expertise in the area of financial analysis. Q. Are you supporting any exhibits on behalf of Staff in this proceeding? A. Yes. I am supporting the following Staff Exhibit No. S-, Schedule D-: Schedule Page Title D- Electric Utility Proxy Group Corporate Statistics D- Proxy Group Rating s Criteria D- Electric Proxy Group Common Equity Ratios D- Electric Proxy Group Return on Common Equity D- Electric Proxy Group -Month Average Stock Price and Dividend Yield D- Electric Proxy -Year Estimated Growth Rates D- Discounted Cash Flow Model (DCF) D- Capital Asset Pricing Model (CAPM) D- Risk Premium Method Cost of Equity D- 0 Electric Utility Historical Market Return & A-rated Bond Yields ( 00)

27 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- 0 0 D- Electric Utility ROE Decisions (0-00) D- Staff s Recommended Cost of Equity Range Q. Was the proposed Exhibit S-, Schedule D- prepared by you or under your direction? A. Yes, it was. Q. What is Staff s return on common equity recommendation? A. Staff recommends a return on common equity of 0.%, which is slightly above the midpoint of Staff s recommended range of.% - 0.%. Staff s ROE recommendation is derived from the analysis of certain cost of equity methodologies, including the Discounted Cash Flow model ( DCF ) and the Capital Asset Pricing Model ( CAPM ). These methods incorporate the statistics of a proxy group of eleven publicly traded electric utilities. In addition, Staff employed a Risk Premium model along with the review of electric ROE determinations in the past five years to establish an ROE recommendation for Detroit Edison. Staff believes that its recommendation properly takes into account the business risks involved with Detroit Edison s electric utility business, the current business climate in Michigan, the service territory Detroit Edison operates within, and the Company s ability to maintain a stable credit rating and sufficient access to capital markets. Q. Has Detroit Edison s credit rating been revised by any one of the three major rating s agencies since Staff performed its ROE analysis in this case? A. Yes. At the time Staff developed its ROE recommendation, Staff was aware that Detroit Edison s credit rating on its senior secured debt was A minus from

28 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- 0 0 Standard & Poor s, A from Moody s and A minus from Fitch Ratings. Since that time, the Company s credit rating was upgraded one notch to A by Standard & Poor s in December 00 and the Company s outlook was changed from stable to positive by Fitch Ratings. Q. Did Staff modify the electric proxy group used in its ROE analysis to account for S&P s credit rating upgrade? A. No. As discussed later in this testimony, the proxy group used in Staff s ROE analysis met certain eligibility criteria. One condition was that the utility had to be within two-notches of Detroit Edison s credit rating. Staff used Detroit Edison s credit ratings submitted in its case, per Company witness D. Goshorn s Exhibit No. A-, Schedule I. Q. Please briefly explain the business and financial risk considerations that are factored into a credit rating for a utility company. A. When ratings agencies decide on a credit rating for a utility they take into consideration a multitude of business and financial factors, including but not limited to, the business climate of the utility s service territory, the state the utility operates within, the current and forecasted economic conditions of the state, the regulatory environment the utility operates within, relevant legislation that currently affects or may affect the utility, peer group comparisons, sector comparisons, as well as internal company characteristics such as company management, cash flow adequacy, leverage, capital on hand, available access to capital markets, key financial ratios, and other relevant items. Credit rating agencies do not make ratings recommendations in a vacuum and endeavor to take

29 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- as many relevant factors into account as possible when delivering a rating s action. The due diligence imposed by rating agencies when deciding on a utility rating gives Staff confidence that its ROE recommendation based on the use of a comparable utility proxy group is a solid representation of the required return on equity required for the Michigan jurisdictional utility under review. 0 0 Staff s ROE Analysis Q. In establishing a legal base for Staff s return on equity analysis in this rate case, what considerations did Staff take into account? A. Traditionally, when considering a return on equity recommendation for a utility company, Staff takes into account the legal guidelines of the landmark Supreme Court decisions in the Hope and Bluefield cases. Those decisions described various methods such as the Attraction of Capital and the Returns Commensurate with Those on Investments in Enterprises of Comparable Risks that the Supreme Court found to be lawful and prudent. In the Bluefield Water Works and Improvement Co. vs. Public Service Commission, U.S., - () case, the Court stated: A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. Furthermore, in in the Federal Power Commission vs. Hope Natural Gas Company, 0 U.S., 0 () case, the Court stated:

30 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- 0 0 From the investor or company point of view, it is important that there be enough revenue not only for operating expenses but also for the capital costs of the business. These include service on the debt and dividends on the stock. By that standard the return to the equity owner should be commensurate with returns on investment in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital. The Supreme Court established an end result doctrine which surmised that how a capital structure and rate of return was determined was not so important as long as the end result was appropriate and reasonable for the case at hand. It is understood that no one particular methodology provides an exact measure of a fair rate of return on equity, but some methods provide good estimates. The Discounted Cash Flow method (DCF), the Capital Asset Pricing Model (CAPM), and other risk premium approaches are the primary models most utility financial analysts use in rate cases to determine a fair and reasonable cost of equity for a regulated utility company. Staff employed those same methods in this rate case, as well as reviewed other electric utility ROE decisions. The models were used as a check to determine if each method produced reasonable return on common equity results within range of one another based on available market data. Detroit Edison s common stock is not traded publicly, which initiated Staff s use of a representative proxy group of electric utilities to help in determining an appropriate ROE for the Company in this case. Q. Please explain the rationale in the development of Staff s electric proxy to aid in Detroit Edison s ROE recommendation.

31 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- 0 0 A. Staff looked at five criteria in selecting a proxy group of comparable electric utility companies used in its ROE analysis: ) each electric company had to have net plant in excess of $ billion to better compare to the size and footprint of Detroit Edison; ) each company had to derive approximately 0% or more of its revenues from regulated electric service; ) each utility had to have a minimum investment grade credit rating within two notches of Detroit Edison s rating based on ratings from Standard & Poor s (S&P) and Moody s; ) each company had to currently be paying dividends to shareholders; and ) each company could not be currently involved in a merger, buyout or major acquisition. With these selection criteria, Staff came up with a list of electric utility companies, which are outlined in Schedule D-, page. Based on the logical criteria used in the development of this electric proxy group, the proxy group s data should provide a reasonable approximation of Detroit Edison s cost of equity in this rate case. Q. How does Staff s proxy group compare to Detroit Edison on an average credit rating s basis? A. On an average credit ratings basis, the proxy group is essentially equivalent to Detroit Edison. The average S&P rating for the proxy group is A-, which is equal to Detroit Edison s rating, and Moody s average rating is A, which is one notch below Detroit Edison s rating of A. Detroit Edison s ROE witness used a proxy group of companies but did not specify any ratings proximity to Detroit Edison other than the fact that the companies had to have an investment grade credit rating. Thus, from a credit risk perspective, Staff s proxy group is much more indicative of Detroit Edison than the Company s proxy group. The

32 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- 0 0 Staff s proxy group provides for a representative ROE without the need for further modification based on Michigan-specific or national economic conditions. As discussed earlier, the major rating s agencies take into account all relevant factors when determining a utility credit rating, so there is no need to place additional emphasis on the status of Michigan s economy or Detroit Edison s service territory when determining a reasonable return on equity for the Company.. Discounted Cash Flow Model Analysis Q. Please start your ROE analysis with a brief explanation of the DCF model and how it s used in this analysis. A. The DCF method has been a widely used approach for estimating equity investors return demand since the 0s. It was introduced after the stock market crash by I. Fisher in 0 and expanded upon by J.B. Williams in before being elaborated on by M.J. Gordon and E. Shapiro. The approach derives its basis by surmising how investors evaluate stocks for potential investment. The formula assesses that investors value securities by discounting to the present the expected future cash flows attributed to those securities. The expected cash flows include dividends, the projected market value of the security at liquidation, and the discount or capitalization rate investors apply to the future cash flows. The DCF approach takes into account the security s investment risks exposed to the market at a certain point in time. The basic DCF formula is the mathematical equation that states that the discount rate is equal to the security s expected dividend yield plus a projected future growth rate. Its formula is: K = D/P + g where: 0

33 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- 0 0 K= Cost of Equity D = Expected Quarterly Dividend Rate Annualized P = Market Price of the Security (D/P = Dividend Yield) g = Expected Growth Rate Q. Please explain Staff s dividend yield and growth rate averages and how they were derived in this rate case. A. Schedule D-, page indicates the average dividend yields for the proxy group. The average stock price for each utility was obtained by taking the closing stock prices from November 00 through January 0 from financial data obtained from Yahoo Finance. The proxy group s quarterly dividends were annualized and incorporated into the dividend yield calculation. Column (i) represents the dividend yield figures used in the DCF analysis. The following page highlights the projected growth rates in the electric group s earnings and book value for a projected -year period. The growth estimates were gathered from well-known sources such as the Institutional Brokers Estimate System (I/B/E/S), Zacks and Value Line. The average five year growth rate for the proxy group was.%. Q. What is Staff s DCF cost of equity estimate? A. The DCF cost of equity was determined using current results and the constant model, as noted on Schedule D-, page. The current method simply adds the average dividend yields to the expected growth rates of the proxy group. The group s cost of equity using this model was.%. The constant model adjusts the dividend yield by the semi-annually compounded projected growth rate based

34 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- on the formula DCF = (D/P)*[ + 0.g] + g. This is the model used for ratemaking purposes. The adjusted DCF cost of equity estimate is.%.. Capital Asset Pricing Model Analysis Q. Please discuss Staff s CAPM method of determining a cost of common equity. A. The CAPM model was derived from the study and analysis of economists Sharpe, Lintner and Treynor and in its simplified form is expressed by the equation: E(R i ) = R f + B i *[E(Rm) R f ] 0 Where: E(R i ) = Expected rate of return on risky security I R f = Risk free rate of return E(Rm) = Expected rate of return on the market B i = The systematic risk or beta for security I. 0 In theory the CAPM model suggests that an investor s required return is based on risk free and risky investment. The CAPM assumes that an investor is invested in a wide portfolio of assets and thus an investor s exposure to risk is risk that cannot be diversified away or risk that is systemic in the market. The risk imposed by investing in a risky asset is the risk that asset imposes on the market. This risk is characterized by the beta coefficient. Thus, the investors required rate of return using the CAPM is a function of risk free investment, an estimate of beta and the market return of a wide portfolio of assets. Q. Please describe the components in the CAPM model. A. The CAPM equation in its simple form is E(R) = R f + b[e(rm) R f ]. The [E(Rm)- R f ] function is referred to as the risk premium (Rp) and is the applicable market risk premium investors expect for their investment in risky securities.

35 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- 0 0 This risk premium is multiplied by the beta coefficient (b), which measures the volatility associated with a particular security s risk in relation to the market. The equation also incorporates the risk-free security (R f ). U.S. federal government securities are commonly considered to be risk-free. Long-term U.S. government bonds are commonly used as the risk-free security R f. Q. Please elaborate on the beta coefficient that is used in this rate case. A. Schedule D, page, column (i), highlights the Value Line beta coefficient used in this case. The beta coefficient is a measure of the volatility of a security s stock price as it relates to changes in the market, which is derived from a regression analysis of that security s market return. The market, as interpreted by Value Line, is the approximately 00 companies that are covered by the New York Stock Exchange. By definition, the market beta is. The Value Line beta is a forward looking beta, which measures a 0 month average raw beta on a weekly basis and adjusts that raw beta by a convergence factor towards the market beta. The theory subscribes that on a forward looking basis, a stock s beta will tend towards the market beta regardless of whether it s on the high side or low side of that benchmark. Stocks with betas less than are considered less volatile and thus less risky than stocks with betas greater than. The electric group s average beta is 0. and this data is used in Staff s CAPM analysis. Q. What risk premium estimate was used in the CAPM analysis? A. Staff reviewed the latest edition of the Morningstar/Ibbotson Associates study entitled Stocks, Bonds, Bills and Inflation: The 00 Yearbook, which gives historical values for market return indices used in the estimation of risk premiums

36 DIRECT TESTIMONY OF KIRK D. MEGGINSON CASE NUMBER U- 0 0 and common equity costs. The study is updated annually. Staff reviewed return data from the period -00 and for the period of -00. The latter period covers a number of economic cycles yet excludes the periods of administered interest rates that were not based on market forces. Taking the difference between the average stock return and government bond return indicated.% as the risk premium over the year period and.0% over the year period. Q. What risk free rate did Staff employ in its CAPM model? A. The risk free rate used in the CAPM analysis was the yield associated with that of a long-term U.S. government treasury bond. Staff used Value Line s and Global Insight s 0-year Treasury bond yield estimate for 0 to obtain an average risk free rate of.%. Q. What is the CAPM cost of common equity estimate? A. Combining the average risk free rate of.% with the calculated historical risk premiums of.% and.0% and the electric group s beta of 0. in the CAPM formula [Rf + (Rp)b], Staff computed an average CAPM cost of equity of.0% for the -year period and.0% for the -year period, as noted on Schedule D-, page.. Risk Premium Method Analysis Q. Please explain the risk premium approach and the cost of equity estimate obtained from that approach. A. The equity cost estimate using the risk premium approach was obtained by looking at the Electric Utility Realized Market Return Average from