STATE OF MICHIGAN DEPARTMENT OF ATTORNEY GENERAL BILL SCHUETTE ATTORNEY GENERAL. January 4, 2018

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1 STATE OF MICHIGAN DEPARTMENT OF ATTORNEY GENERAL P.O. BOX LANSING, MICHIGAN BILL SCHUETTE ATTORNEY GENERAL January 4, 2018 Kavita Kale Executive Secretary Michigan Public Service Commission 7109 W. Saginaw Highway Lansing, MI Dear Ms. Kale: RE: MPSC Case No. U Enclosed for filing in the above-captioned case is the Michigan Department of Attorney General, Special Litigation Division s Reply Brief on behalf of the Attorney General with a proof of service. This filing is being submitted electronically pursuant to the Commission's Paperless Electronic Filings Program. Sincerely, Enclosures c: Service List ALJ Cummins by and first-class mail. Celeste R. Gill (P52484) Assistant Attorney General Environment, Natural Resources and Agriculture Division (517)

2 STATE OF MICHIGAN BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION In the matter of the Application of Indiana Michigan Power Company for Authority to Increase its Rates for the Sale of Electric Energy and for Approval of Depreciation Accrual Rates and Other Related Matters. / MPSC Case No. U The Michigan Department of Attorney General, Special Litigation Division s Reply Brief on behalf of the Attorney General Bill Schuette Attorney General Celeste R. Gill (P52484) Assistant Attorney General Michigan Department of Attorney General, Special Litigation Division Sixth Floor Williams Bldg. 525 W. Ottawa Street P. O. Box Lansing, MI (517) Gillc1@michigan.gov January 4,

3 Table of Contents Introduction... 3 Arguments... 5 I&M applies the wrong legal standards I&M fails to prove that it is entitled to all of its proposed capital expenditures Major projects Contingencies Environmental projects I&M fails to demonstrate that it should recover an authorized return on investment of 10.6% The Company s Forecasted O&M Expenses are not reasonable and prudent and should be reduced for the test year I&M fails to prove that its proposed incentive compensation plans are reasonable and prudent Short-term incentive Plan Long-term stock incentive plans Relief Requested

4 INTRODUCTION On December 18, 2017, the Michigan Department of Attorney General, Special Litigation Division by and through Celeste R. Gill, Assistant Attorney General, filed an Initial Brief in this matter on behalf of the Attorney General of Michigan (the Attorney General) before the Michigan Public Service Commission ( Commission ) responding to the Application filed by Indiana Michigan Power Company seeking rate relief for its electric business. Also on December 18, 2017 other parties to this proceeding filed their Initial Briefs including, Indiana Michigan Power Company (I&M or the Company), Michigan Public Service Commission Staff (MPSC Staff or Staff), and the Association of Businesses Advocating Tariff Equity (ABATE). The Attorney General files this Reply Brief to respond to or otherwise address arguments made by the other parties in their briefs. The Attorney General s decision not to address certain issues in this Reply Brief is not a waiver of those issues. All of the Attorney General s briefs, testimony and exhibits should be considered in evaluating his position on the issues appearing in this case. On May 15, 2017, I&M filed its application seeking $51.72 million in rate relief for the 12-month period ending December 31, 2018 ( projected test year or test year ). As part of its case, I&M is also requesting a return on equity ( ROE ) of As noted in the Attorney General s Initial Brief, this represents an overall 3

5 increase in rates of 17.13% with residential ratepayers receiving on average a 19.36% increase in rates. 1 The Attorney General participates in this rate case in part as an advocate for ratepayers and as such, strives to ensure that the Company is held to its burden to prove that its requests are reasonable and prudent. This Reply Brief will address the following issues: 1. I&M s use of the wrong legal standards. 2. I&M s failure to support its proposed capital expenditures. 3. I&M s failure to prove that it is entitled to an authorized return on equity of 10.60%. 4. I&M s failure to prove its incentive compensation plans are reasonable and prudent. For the reasons provided in this Brief and the Attorney General s Initial Brief, at least $28.6 million of the Company s proposed revenue deficiency should be disallowed and it should not receive and authorized ROE higher than 9.5%. 1 The Michigan Department of Attorney General, Special Litigation Division s Initial Brief on behalf of the Attorney General of Michigan (hereinafter, the Attorney General s Initial Brief ), p 3. 4

6 ARGUMENTS I&M applies the wrong legal standards. As noted in the Attorney General s Initial Brief, I&M bears the burden of proof to demonstrate that its requested rate increase and other proposals are just and reasonable. That as the applicant, I&M must prove its case including any fact upon which it affirmatively relies on an issue. 2 The Michigan Supreme Court has held that in administrative cases, a party seeking relief must prove his, her, or its claim by a preponderance of evidence. The Comparative degree of proof by which a case must be established is the same in an administrative as in a judicial proceeding that is, a preponderance of the evidence. It is not satisfied by proof creating equipoise, but it does not require proof beyond a reasonable doubt. No essential issue may be left to surmise, guess, or conjecture, for an administrative body cannot base an award or decision upon conjecture or speculation 3 More recently the Supreme Court held, that it is generally well established that issues of fact in civil cases are to be determined in accordance with the preponderance of evidence with the burden of persuasion placed upon the party asserting the claim. In Aquilina v. General Motors Corp, 403 Mich 206, 210, 267 N.W.2d 923 (1978), this Court stated that the same burden of persuasion applies to proceedings before an administrative agency. Accord, Cooper, State Administrative Law, p.355. Proof by a preponderance of the evidence requires that the factfinder believe that 2 White v Campbell, 25 Mich 463, 475 (1872). 3 Dillon v Lapeer State Home & Training School, 364 Mich 1, 8; 110 NW2d 588 (1961) (emphasis added). 5

7 the evidence supporting the existence of a contested fact outweighs the evidence supporting its nonexistence. 4 Likewise, in MPSC cases, a utility has the burden of proof by a preponderance of evidence. 5 Therefore, to prevail, I&M must prove its proposals are reasonable and prudent by a preponderance of the evidence. I&M either misapprehends or intentionally misstates the standard of review the Commission must use to render its decision in this contested case. According to the Company: [t]he Michigan Constitution requires the Commission s findings to be supported by competent, material and substantial evidence on the whole records. Const 1963, Art 6 [sec] 28. Expert testimony is substantial only if it is offered by a qualified expert who has an informed and rational basis for his or her view, even if other experts disagree. Therefore, substantial evidence is evidence that a reasoning mind would accept as sufficient to support a conclusion. However, substantial evidence is more than a mere scintilla but less than a preponderance of the evidence. The applicable standard of proof for purposes of determining whether the Company s proposals or recommendations are reasonable and prudent is, therefore, the substantial evidence standard, which is a lighter standard than even the preponderance of evidence standard, which is a lighter standard than the beyond a reasonable doubt standard reflected in the record. 6 4 BCBSM v Governor, 422 Mich 1, 88-89; 367 NW2d 1 (1985) (emphasis added). 5 In re Michigan Gas Utilities Co, MPSC Case No. U-7484, Opinion & Order dated August 30, 1983; In re Detroit Edison Co, MPSC Case No. U-8030-R, Opinion & Order dated July 9, 1987, pp See also, SBC Mich v PSC (in re Complaint of Rovas), 482 Mich 90, (2008). 6 Indiana Michigan Power Company s Initial Brief, p.12 (internal citations and quotations removed) (emphasis added). 6

8 For the reasons stated herein, the Company s proposed standard of review before the Commission is wrong. I&M quotes the standard of review for an agency decision on appeal and then asserts it is the standard that the Commission should use. Although the standard of review on appeal for a commission decision is whether it is based on competent, material and substantial evidence on the whole record, it is not the burden of proof standard for I&M to support its rate increase and other proposals before the Commission. Other than situations in which the Commission reviews rulings of the administrative law judge in a case, it is not serving in an appellate role. 7 In contested case proceedings, the Commission renders the final agency decision. An ALJ s proposal for decision is a recommendation, not a ruling. The Commission is not subject to the constraints imposed by a legal standard of appellate review in deciding whether to accept, reject, or modify the ALJ s assessment of the evidence or legal analysis. See, MCL (3); MSA 3.560(181)(3), ( On appeal from or review of a proposal of decision the agency, except as it may limit the issue upon notice, or by rule, shall have all of the powers which it would have if it had presided at the hearing. ) 8 Therefore, the Commission must determine whether the Company meets its burden of proof by a preponderance of the evidence. 7 See, R In the matter of the Complaint of AT&T Communications of Michigan, Inc., MPSC Case No. U (August 31, 2000), p 13. 7

9 Moreover, as stated in the Attorney General s Initial Brief, the Commission may disbelieve even uncontradicted evidence. 9 When the burden of proving a fact falls on one party, then the other party does not have the burden of proving the opposite fact. 10 So presenting substantial evidence alone, is not enough. A Plaintiff has the burden of proof or risk of nonpersuasion for all elements necessary to establish its case and that burden never shifts during the trial. 11 Therefore, I&M always has the burden of proof to support the requests that make up its application. It is also appropriate for an intervenor to argue that I&M has not presented sufficient evidence to support is burden of proof for a project as well as for the Commission to find that I&M has not presented sufficient evidence to support is burden of proof for some project or proposal. [I]f the utility realistically expects inclusion of the total projected costs, it must supply the Commission with enough evidence to support a finding that the costs are just and reasonable in the absence of thorough, detailed, and meaningful evidence, the Commission s hands are tied. 12 The implication in the Company s brief that an award by the Commission of anything less than its filed position amounts to a taking is baseless and lacks 9 Woodin v Durfee, 46 Mich 424, 427; 9 NW 457 (1881); Accord, Yonkus v McKay, 186 Mich 203, 211; 152 NW 1031 (1915); Cuttle v Concordia Mut Fire Ins Co, 295 Mich 514, 519; 295 NW 246 (1940). 10 S.C. Gary, Inc v Ford Motor Co, 92 Mich App 789, ; 286 NW2d 34 (1979). 11 Kar v Hogan, 399 Mich (1976). 12 See, In the matter of the application of Consumers Energy Company for authority to increase its rates for generation and distribution of electricity and for other relief, June 7, 2012, MPSC Order U-16794, p 13. 8

10 support. 13 It is the utility that has the obligation to support its projections in a general rate case. Section 6a(1) of Act 286, MCL 460.6a(1) provides that a utility may use projected costs and revenues for a future consecutive 12-month period to develop its requested rates and charges. In the statute providing for the use of a projected test year, nothing eliminated the requirement that all rate increases must be shown to be just and reasonable. 14 As the Commission has previously stated: In a case where a utility decides to base its filing on a fully projected test year, the utility bears the burden to substantiate its projections. Given the time constraints under Act 286, all evidence (or sources of evidence) in support of the company s projections should be included in the company s initial filing. If the Staff or intervenors find insufficient support for some of the utility s projections they may endeavor to validate the company s projection through discovery and audit requests. If the utility cannot or will not provide sufficient support for a particular revenue or expense item (particularly for an item that substantially deviates from the historical data) the Staff, intervenors, or the Commission may choose an alternative method for determining the projection See, Indiana Michigan Power Company s Initial Brief, pp Cases cited by the Company involve situations where the Commission ordered refunds of revenues received by the utility before it rendered a final decision, which the Company has not shown is likely to occur in this case, especially in light of the current statutory scheme as amended effective April 20, See, In the matter of the application of Consumers Energy Company for authority to increase its rates for generation and distribution of electricity and for other relief, June 7, 2012, MPSC Order U-16794, p September 8, 2016 order in Case No. U-17895, page 4, citing January 11, 2010 order in Case No. U-15768, pages

11 The Company also argues that [t]he Commission has an obligation to facilitate I&M s financial health for the benefit of its customers and shareholders. 16 As discussed in the Attorney General s Initial Brief and this Reply Brief, the Company is entitled to a fair return on its investment. However, it has the burden of proving that its investments are reasonable and prudent and it is ultimately responsible for the efficient operation of its utility. To require otherwise would make ratepayers guarantors of the Company s success even if the Company does not perform in a reasonable and prudent manner. The Attorney General s position continues to be that I&M has not proven its overall cost of service supports a $51.72 million rate increase. 17 I&M fails to prove that it is entitled to all of its proposed capital expenditures. In its Initial Brief, the Company s disagreed with the Attorney General s recommendations with regard to its proposed capital expenditures, which were based on the testimony of its expert witness, George Evans. The disagreements relate to proposed reductions to fossil fuel generation related capital expenditures, contingency cost, and expenditures related to environmental projects at the Rockport plant. None of the Company s criticism refute the Attorney General s position as explained in his brief on pages 6 to 14, that the Company s proposed capital expenditures should be reduced. As noted above, the Attorney General s role 16 Indiana Michigan Power Company s Initial Brief, p MCL 460.6a(2)(b) was eliminated effective April 20,

12 in this case is to ensure that rate payers are not unfairly burdened. It is the Company s burden to make its projections as accurate and supportable as possible and to produce evidence supporting those projections and it fails to do so. Major projects. The Company identified ten major fossil generation projects that each require capital expenditures in excess of $1 million. 18 Three of the ten projects (numbered 5, 8 and 10 in Figure TCK-5) were required by regulatory or environmental requirements. Two of the ten projects (numbered 1 and 7 in Figure TCK-5) are the construction of the SCRs for Rockport units 1 and 2. Of the remaining five projects, the Company produced cost/benefit analyses for only three projects (numbered 2, 3, 4 in Figure TCK-5). This leaves two projects (numbered 6 and 9 in Figure TCK-5) for which the Company failed to perform any cost/benefit analysis 19. In addition, the Attorney General s expert was unable to fully evaluate the cost/benefit analysis performed by the Company for projects 2, 3 and 4 and validate the analysis because the Company failed to provide the spreadsheet analyses with all formulas intact, and did not provide all data and assumptions used in the analyses TR and Figure TCK See the Company s response to data request No AG, which is included as Exhibit AG See Exhibit AG-2 and 3 TR

13 The Attorney General recommends that the Commission disallow the costs for any projects for which the Company has not provided verifiable cost/benefit analyses these are the projects numbered 2, 3, 4, 6 and 9. This adjustment would reduce the Company s claimed revenue deficiency by $2.1 million, the Michigan jurisdictional impact. 21 The Company asserts that its proposed capital investments in its major projects are reasonable and prudent. 22 According to the Company, all of the Company s generation Major Capital Projects were forecasted to be prudent capital investments that would be used by I&M to provide safe and reliable electric service to its customers. 23 According to the Company, the projects challenged by the Attorney General will replace worn out plant, improve efficiency, or enhance reliability. 24 And, that these investments were based on work plans that were heavily vetted by the plant, I&M staff and AEPSC s Environmental, Engineering, and Project Management teams and that cost benefit analysis may or may not have been performed for particular projects. 25 The Company then asserts that [t]he results of cost/benefit analyses are not the sole driver to perform projects, as I&M relies on its long experience with and knowledge of its generating facilities in 21 3 TR Indiana Michigan Power Company s Initial Brief pp Id at Id. 25 Id. 12

14 assessing the cost and benefits of potential capital investments. 26 However, the Company readily admit that it only performed cost-benefit analysis for three of ten major capital projects. Moreover, as noted with regard to those three projects, it failed to provide sufficient supporting data or worksheets to allow other parties to verify the results. 27 The Company s explanation is not sufficient. If the projects were as thoroughly vetted as described by the Company, it should be able to provide fuller analysis and supporting cost/benefit analysis documentation. Ratepayers deserve a complete and thorough review and analysis of the costs to ensure that the path chosen by the Company is the most reasonable and prudent. Without evidence of such analysis, the Company fails to prove its proposals are reasonable and prudent. Contingencies. In addition, as noted in the Attorney General s initial brief, contingency reserves should not be recoverable in rates. 28 The Company s attempt to justify recovery of such costs by asserting that the contingency reserves in this case are intended to address known risks as opposed to management reserve funds used to address unknown risks is a distinction without a difference. Ratepayers are not insurance companies and should not cover such risks. They should only be required to cover reasonably and prudently incurred costs. The Company has still 26 Indiana Michigan Power Company s Initial Brief p See, Exhibits AG-2 and AG-3 and 3 TR Attorney General s Initial Brief, pp

15 not demonstrated that these risks are certain to occur. Ratepayers should not be charged for costs that may never be incurred. Consistent with the Commission s past practices, any cost attributable to contingencies should be disallowed. Environmental projects. According to the Company it s proposed capital expenditures for its environmental projects represent the most reasonable and prudent approach for ensuring environmental compliance. 29 However, as noted above, it is the Company s obligation to demonstrate that all capital expenditures are reasonable and prudent. This includes providing data sufficient to support its case. In analyzing the cost of each option upgrade and operate or retire, the Company assumed that the Rockport Units would operate through the year I&M used a simulation model to compare the projected cost scenario of either retiring the Rockport Units to the scenario in which the DSI, SCR and eventually the FGD systems are installed with the Rockport Units operating to Despite its assertions that it analyzed the economic viability of three options, 31 the Company s analyses only support the installation of the DSI and Unit 1 SCR systems if the Rockport units operate through at least However, the Company s plans as described by its witness, Toby Thomas are inconsistent with 29 Indiana Michigan Power Company s Initial Brief p Table JFT-1, 3 TR 308 and 3 TR Indiana Michigan Power Company s Initial Brief, p TR

16 that analysis. Mr. Thomas, testifies in support of the Company s request to change it depreciation rates to accelerate the depreciation of Rockport Unit 1 through 2028 rather than This is in addition to the Company possibly not renewing the Rockport Unit 2 lease in The earlier depreciation or termination of the lease of Rockport Units 1 and 2 invalidates the assumptions underlying the studies I&M relies upon to support the cost of installing the DSI and Unit 1 SCR systems at Rockport. 35 As noted in the Attorney General s Initial Brief, given the Company s plans for the Rockport units, it was unreasonable for the Company to perform analyses only with the underlying assumption that the Rockport units would operate through 2040 and beyond when evaluating the economics of installing the DSI and SCR systems. It apparently knew that the units may be retired sooner than The Consent Decree requires that, even with the installation of the DSI and SCR systems, FGD systems are required to be installed by 2025 on one unit and by 2028 on the other unit 36. But rather than considering an alternative without the FGD systems, the Company made the simplifying assumption that the Rockport units 33 3 TR See, 3 TR TR TR

17 would operate through 2040, thus failing to examine the reasonable scenario of retiring the units before the FGD systems are required. 37 It is not enough to provide some information or analysis that does not address all options or possible outcomes. The Company s failure to provide a thorough evaluations leaves it to other parties and the Commission to fill in the gaps. The Attorney General recommends that the Commission disallow the inclusion of the costs for the Rockport DSI and Rockport Unit 1 SCR systems in the Company s rate request because the Company has failed to provide analyses that support the installation of the systems under the Company s revised retirement date for Rockport Unit 1. The Company should have evaluated the impact of an earlier retirement date, but failed to do so. This disallowance reduces the Company s claimed revenue deficiency by $7.4 million (the Michigan jurisdictional impact). I&M fails to demonstrate that it should recover an authorized return on investment of 10.6%. A utility company is entitled to a fair return that will allow it to attract capital and be sufficient to assure investors of its financial soundness. In its opinion in Bluefield Water Works and Improvement Company v Public Service Commission of West Virginia (the Bluefield Case ) 262 U.S. 679 (1923), the United States Supreme Court indicated that: 37 Attorney General s Initial Brief pp

18 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 being made at the same time on investments in other business undertakings which are attended by corresponding risks and uncertainties; but it has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties 38 The principals of the Bluefield Case were re-affirmed by the U.S. Supreme Court in 1944 in the case FPC v Hope Natural Gas Company, 320 U.S This regulatory standard provides the utility an opportunity to earn a rate of return sufficient to: (1) fairly compensate capital currently invested in the utility; (2) enable the utility to attract new capital on reasonable terms; and (3) maintain the utility s financial integrity. 39 Regulatory authorities must strike a balance to ensure that customers will be able to obtain services at reasonable rates, and utilities can still earn a fair return for their investors and investments. 40 The Attorney General s ROE witness, Dr. Zhen Zhu notes that several standards have been set from these guidelines: 1. The most important factor in determining the required return on equity of a utility is risk. As utilities face smaller degree of risks compared to most of other businesses, a utility s return therefore should be lower than other riskier businesses. 38 (emphasis added.) 39 3 TR TR

19 2. Utilities should earn comparable returns to other businesses with similar degree of risk in order to maintain its financial soundness including maintain its credit standing, attract capital for investment and so on. 41 Consistent with the legal principles stated above and the proper application of recognized models, the Attorney General s expert recommends a reasonable ROE of 9.50%. A complete discussion of Dr. Zhu s analysis is provided in the Attorney General s Initial Brief at pages The Company continues to seek an excessive return on equity (ROE). In its brief on page 56, the Company reiterated its request for an authorized ROE of 10.60% citing the risk of the Company s generation portfolio, capital investment program, customer concentration, comparatively small size, flotation costs associated with equity issuances and the Company s cost recovery mechanism, and changing capital market environment and potential increase in interest rates. 42 None of the proffered reasons support the Company s requested ROE, which is 40 basis points higher than the Company s most recently authorized rate of return of 10.20%. The requested ROE is also at least 50 basis points higher than ROEs recently authorized by the Commission TR Indiana Michigan Power Company s Initial Brief p See, orders issued in Consumers Energy s electric rate case U-17990, p 76; DTE Gas s rate case U-17999; DTE Electric s rate case U-18014, p 66; and Consumers Energy s gas rate case U-18124, pp

20 Contrary to the Company s assertions, the recommendations of Staff, the Attorney General and ABATE do appropriately balance the needs of investors with those of customers. 44 The assertion that economic, financial, and public policy considerations with regard to: (i) maintaining the positive track record established by the Company and the Commission over the past several years with investors and rating agencies; (ii) the scope of I&M s investment plans; (iii) investor ROE expectations; and (iv) risk aversion and cost of equity, 45 require an exorbitant ROE is simply untrue. None of the reasons offered by the Company support such an excessive ROE. The reality is that the Company continues to be a low risk investment alternative with above average earnings potential. I&M is also subject to the same risks that other firms in its industry face, including variation in demand, limits on growth, environmental compliance costs, employee benefit costs, the cost of infrastructure improvements, regulatory decisions, capital market conditions (interest rates), and the availability to credit and access to capital markets. 46 The Company has not presented any credible evidence that its operations have a greater risk profile than other similarly situated utilities. The Company points to the end of the federal reserve s accommodative monetary policies to support its claim that it has a riskier profile and therefore is entitled to a higher ROE. However, the United States is still experiencing low 44 See, Indiana Michigan Power Company s Initial Brief p Id TR

21 interest rates. Further, the Company has presented no evidence or analysis that demonstrate that any likely increase in interest rates support a 40 to 50 basis point increase over its current ROE or other recently authorized ROEs. Dr. Zhu thoroughly addressed the likely impact from a change in monetary policy and concluded that the Company s position lacks support. He testifies that there are two kinds of interest rates in the market place: short-term interest rate and long-term interest rate. The injection of a large amount of liquidity into the financial market has caused short-term interest rates to fall to a historically low level. In addition, the interest rates are cyclical as they respond to the Federal Reserve s monetary policy manipulations, but the long-term interest rate is significantly less so. 47 Exhibit AG-4 provides actual data demonstrating that the long-term interest rates continued a downward trend while short-term interest rates fluctuated significantly in response to federal monetary policy changes during the 2000 to 2005 and 2007 to 2017 periods. More importantly, the Federal Reserve s actions to the tighten money supply or increase short-term interest rates should not necessarily increase required returns for investors. Investors in utility industry face long-term investment decisions, rather than short-term investment decisions. Therefore, it is the longterm interest rate that matters most to investors TR TR

22 As the Federal Reserve tightens money supply, interest rates generally will increase. However, the Federal Reserve policies that were used to counteract business cycles are generally considered short-term policies and they mainly influence short-term interest rates. Dr. Zhu does not expect that monetary policy to have much effect on the long-term interest rates, and thus no effect in the required return on capital. The Company even invokes the investor expectation argument as a basis for it proposed excessive rates, alluding to the investors view that an authorized ROE 9.8% or below will signal that Michigan is a volatile regulatory environment in which investors cannot depend upon consistent or fair regulatory treatment. 49 There is nothing volatile, inconsistent or unfair about the gradual reduction in authorized ROEs that have occurred under the Commission. The higher ROEs that Michigan experienced were a product of the perception that Michigan was a higher risk place to invest. However, given the rebound in Michigan s economy, the Commission willingness to lower ROEs should signal to investors that it has confidence in the state s economic strength. 50 Recently, the Commission has authorized ROEs near the 10% range. With the exception of Michigan Gas Utilities Co in 2015 (9.90%) 51, the Commission has been reluctant to breach the sub-10.0% ROE level, however its own analysis does 49 Indiana Michigan Power Company s Initial Brief, p See Commission Order dated July 31, 2017 in MPSC Case No. U-18014, p See Exhibit AG

23 not foreclose that possibility. And based on the evidence put forth in this case by witnesses for the Attorney General, MPSC Staff and ABATE there is more than sufficient evidence to reach that conclusion in this case. As discussed above, and in his Initial Briefs, the Attorney General s proposed ROEs are based on the principled application of commonly accepted models. While models alone do not tell the whole story and outcomes from the models may vary, the wider economic analysis performed by Dr. Zhu also supports the Attorney General s recommendation. The Company s proposed ROE is not based on reality. It is no coincidence that all of the parties to this proceeding, except the Company, have calculated an ROE at least 80 basis points lower than the Company s proposed ROE. The Company s accusations are nothing more than a scare tactic based on unsubstantiated claims and should be rejected. The rate proposed by the Attorney General for the Company ROE is a very conservative estimate and is consistent with recent trends especially with regard to other vertically integrated utilities. In fact, there is a reasonable basis for a ROE several basis points lower. The average required return on equity is 8.23% which Dr. Zhu believes reflects the Company s true required return on equity. 52 Dr. Zhu recommend an ROE of 9.50% as a gradual transition to the true cost of equity. To confirm his analysis Dr. Zhu compared his recommended ROE of 9.5% and his overall cost of capital of 7.21% to allowed ROEs and costs of capital recently granted 52 See, the Attorney General s Initial Brief, p

24 by the public service commissions in the U.S. The 2016 average allowed ROE for electric utilities is 9.77%. The neighboring states recently had similar allowed ROEs for 2016: IL: 8.64%, OH 9.84%. 53 Further, the Michigan Public Service Commission recently authorized ROEs of 10.10% in other electric rate cases. 54 The Company s Forecasted O&M Expenses are not reasonable and prudent and should be reduced for the test year. In his Initial Brief, the Attorney General recommended reductions to this category of expenses. 55 The Attorney General continues to support the proposed reductions discussed in his Initial Brief. With regard to the incentive compensation expense, the Attorney General provides additional arguments or comments below in response to the Company s Initial Brief. I&M fails to prove that its proposed incentive compensation plans are reasonable and prudent. The Company has two incentive compensation plans the annual or shortterm incentive compensation plan ( STI ) and the long-term incentive compensation plan ( LTI ). The STI provides annual incentive compensation payments to all employees, while the LTI applies only to the Company s senior management. Both plans provide compensation above the employees base compensation. Senior 53 Regulatory Research Associates (RRA) through 54 See Commission orders in U-17990, U-18014, and U See, the Attorney General s Initial Brief, pp

25 management personnel receive both the STI and LTI incentives, as additions to base compensation. 56 I&M is requesting $21.3 million dollars on a company-wide basis for shortterm and long-term incentive compensation plans. The Michigan jurisdictional amount that the Company is seeking in rates is $5.1 million. The Attorney General s Initial Brief includes an extensive analysis of the Company s incentive compensation plans. Based on the evidentiary record and applicable Commission standards, the Company is not entitled to recovery any of its proposed expenses related to its STI and LTI. Both, MPSC Staff and the Attorney General recommend disallowing most if not all of the costs attributable to the STI and LTI. In response, the Company asserts that the Staff and the Attorney General s proposals would either impede the Company from earning the rate of return the Commission establishes in this case, or if incentive compensation were to be reduced or eliminated without offsetting increase in base pay, it would result in below market total compensation that would disadvantage I&M and its customers in the long run because I&M would no longer be able to attract or retain employees with the skills and experience needed to efficiently and effectively provide service to customers. 57 The Company also argues that the Commission should evaluate employee compensation in the 56 3 TR Indiana Michigan Power Company s Initial Brief p

26 same manner it evaluates all other elements of the Company s cost of providing electric service. In doing so, the Commission should determine whether the Company s cost are reasonably and prudently incurred in the provision of electric service. The Commission should not simply review how the compensation is structured, but should instead look at the level of compensation in making such a determination. Separately analyzing the incentive compensation component of compensation and setting a higher standard for such costs is inappropriate and undermines the utility s ability to make decisions regarding how to properly compensate and motivate its employees. 58 The Company s arguments are meritless. First, the entire premise is faulty. The focus of rate cases is not designing incentive pay plans or deciding how much to pay in incentive compensation that is the Company s prerogative. The focus is on evaluating whether the plans are reasonable and prudent and therefore should be included in rates. The real question is not whether the Company can provide compensation to its employees that includes incentive pay, but who should bear the cost of the incentive pay. And, given the nature of incentive pay and the measures of achievement used by the Company to award incentive pay to employees, the Commission has rightly focuses on whether such plans actually benefit the people the Company wants to pay the cost ratepayers. The Commission s test is not 58 Indiana Michigan Power Company s Initial Brief, p

27 another or additional requirement, it is a measure of the reasonableness and prudence of the expense. The reality is that the Company s plans fail the test. The Commission established the proper inquiry for allowing the recovery of incentive compensation pay in its Opinion and Order in the Matter of the Application of Consumers Energy Company for Authority to Increase its Rates for the Generation and Distribution of Electricity and for Other Relief, Case No. U-14347, dated December 22, 2005 (December 22 Order): [E]xecutive bonus and employee incentive plans require a showing that the benefits to ratepayers from the bonus and incentive plans, at a minimum, will be commensurate with the programs costs. Moreover, the utility has the burden of establishing how the proposed programs benefit ratepayers. P. 34. [Emphasis added]. The Commission also noted in its December 22 Order, while the utility in the case characterized its incentive pay plan as an overall part of its compensation package, it was clear that those payments were significantly related to improving the Company s bottom line. The benefits of improved employee performance because of Consumers incentive programs accrue to investors in the form of higher prices and dividends but benefit rate payers only tangentially. P. 34. Like the incentive pay program presented in case number U-14347, the current plans do not meet the Commissions standard. Short-term incentive Plan There is a two-step process for funding and awarding incentive compensation under the STI. Payments under the plan are heavily weighted and dependent on 26

28 achievement of financial goals that mostly benefit shareholders and not ratepayers. The funding and therefore the first step in the awarding of incentive compensation is based on AEP, the parent corporation of I&M, achieving certain financial measures. In addition to incentive pay awarded to the Company s employees under the STI, employees can also receive merit pay based on a combination of factors including, individual performance, performance relative to peers, salary position and the size of the merit budget. 59 Employees have historically received merit pay increases at roughly 3% a year, which is consistent with the market median. 60 The existence of a merit based pay system in addition to the incentive pay program also indicates that incentive compensation is an additional cost above and beyond market pay. More importantly, I&M s customers already fund the Company s operations and capital expenditures through the rates they pay for service. They should not be burdened with the added cost of incentive pay. The Company has failed to demonstrate how the STI influences employee performance in a way that benefits rate payers commensurate with the cost. In other words, it has failed to prove that such costs are reasonable and prudent. Long-term stock incentive plans TR TR

29 The Company is also requesting that ratepayers cover the cost of its longterm stock incentive plan (LTI) that awards performance units and AEP restricted stock units (RSU) to senior level employees. The criteria used to qualify for an award under the LTI are based on I&M achieving three-year total shareholder return relative to a peer group of similar utility companies ( relative TSR) and three-year cumulative operating EPS relative to an approved target level. 61 In its Initial Brief, the Company states that the Attorney General s argument does not address the Company s restricted stock units granted under the Companies long term incentive plan, which are not tied to any performance measures. 62 This is not true. On page 26 of his initial brief, the Attorney General clearly refers to the restricted stock units. And, he states that the persons awarded LTI are the ones least likely to have a direct beneficial impact on ratepayers. And, the criteria used to determine the awards are not customer focused. The Commission has consistently rejected requests to recover similar costs in rates. In Case No. U (p.78), it found that with regard to a long-term incentive compensation plan similar to the LTI in this case, the company failed to demonstrate benefits to ratepayers commensurate with the costs, explaining that the long-term plan was tied closely to company earnings and cash flow measurements that overwhelmingly benefitted shareholders. In Case No , 61 3 TR Indiana Michigan Power Company s Initial Brief, p

30 the Commission reiterated that conclusion. P In this case, the Company did not present any evidence demonstrating that increasing returns and value to shareholders and company management benefits ratepayers. The recovery of costs for the LTI should be rejected. RELIEF REQUESTED The Attorney General respectfully requests the Administrative Law Judge to issue a proposal for decision that is consistent with the positions set forth in the Attorney General s Initial Brief and this Reply Brief. Respectfully submitted, Bill Schuette Attorney General Celeste R. Gill Assistant Attorney General Michigan Department of Attorney General Special Litigation Division Sixth Floor, Williams Bldg. 525 W. Ottawa Street P. O. Box Lansing, MI (517) Dated: January 4, See also, the Commission s July 31, 2017 Order in Case No. U-18124, p

31 PROOF OF SERVICE - U The undersigned certifies that a copy of the Michigan Department of Attorney General s Reply Brief on behalf of the Attorney General was served upon the parties listed below by ing the same to them at their respective addresses on the 4 th day of January Celeste R. Gill Indiana Michigan Power Company: Richard J. Aaron Jason T. Hanselman raaron@dykema.com jhanselman@dykema.com Administrative Law Judge: Hon. Mark Cummins Cumminsm1@michigan.gov AEP Matthew McKenzie msmckenzie@aep.com MPSC Staff: Spencer Sattler Michael Orris Meredith R. Beidler Lori Mayabb sattlers@michigan.gov orrism@michigan.gov beidlerm@michigan.gov mayabbl@michigan.gov Attorney General: Celeste R. Gill GillC1@michigan.gov ag-enra-spec-lit@michigan.gov ABATE: Sean P. Gallagher Michael J. Pattwell sgallagher@clarkhill.com mpattwell@clarkhill.com 1