June 29, Ms. Mary Jo Kunkle Executive Secretary Michigan Public Service Commission 6545 Mercantile Way, P.O. Box Lansing, MI 48909

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1 Founded in 1852 by Sidney Davy Miller SHERRI A. WELLMAN TEL (517) FAX (517) Miller, Canfield, Paddock and Stone, P.L.C. One Michigan Avenue, Suite 900 Lansing, Michigan TEL (517) FAX (517) June 29, 2010 MICHIGAN: Ann Arbor Detroit Grand Rapids Kalamazoo Lansing Saginaw Troy FLORIDA: Naples ILLINOIS: Chicago NEW YORK: New York OHIO: Cincinnati CANADA: Toronto Windsor CHINA: Shanghai MEXICO: Monterrey POLAND: Gdynia Warsaw Wrocław Ms. Mary Jo Kunkle Executive Secretary Michigan Public Service Commission 6545 Mercantile Way, P.O. Box Lansing, MI Re: SEMCO Energy Gas Company 2011 Rate Case MPSC Case No. U Dear Ms. Kunkle: Attached for electronic filing are SEMCO Energy Gas Company s Application, Draft Notice of Hearing, and supporting Direct Testimony, Exhibits and Workpapers of George A. Schreiber, Bruce H. Fairchild, James VanSickle, John R. Alger, Marc A. Simone, Mark A. Moses, Paul R. Carpenter, Paul H. Raab, Steven W. Warsinske, and Timothy J. Lubbers, as well as Part II of the MPSC filing requirements. In accordance with MPSC filing requirements, electronic files on CDs and Part III have been transmitted to the Commission staff and will be made available to all parties upon request. Should you have any questions, please advise. Very truly yours, Miller, Canfield, Paddock and Stone, P.L.C. Enclosure cc: Thomas Connelly, SEMCO SAW/tmb 18,112,013.2\ /29/10 9:40 AM By: Sherri A. Wellman

2 S T A T E O F M I C H I G A N BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION * * * * In the matter of the application of ) SEMCO ENERGY GAS COMPANY ) Case No. U to combine its MPSC Division and Battle Creek Division rates and for authority to redesign and increase its rates, on a combined basis, for the sale and transportation of natural gas and for other relief. ) ) ) ) ) APPLICATION Now comes SEMCO ENERGY GAS COMPANY ( SEMCO Gas or the Company ), a division of SEMCO Energy, Inc., and hereby requests authority from the Michigan Public Service Commission (the MPSC or the Commission ) to (i) combine its MPSC Division and Battle Creek Division base and depreciation rates, (ii) increase rates, on a combined basis, for the sale, transportation and distribution of natural gas, (iii) redesign the way in which the Company charges its customers for natural gas service, (iv) implement an Infrastructure Replacement Program for unprotected metallic mains and related cost recovery mechanism, (v) recover in rates the discounts associated with special transportation contracts pursuant to MCL 460.6a(5), and (vi) obtain other related approvals and relief. I. INTRODUCTION 1. SEMCO Gas is a division of SEMCO Energy, Inc., with its principal offices located at 1411 Third Street, Suite A, Port Huron, Michigan. The Company is engaged as a

3 public utility in the business of selling, transmitting, and distributing natural gas to the public in service areas throughout the State of Michigan. 2. The Company currently serves customers in two divisions. SEMCO Gas s Battle Creek Division, which became subject to the Commission s jurisdiction pursuant to its June 26, 2007 Order issued in Case No. U-14882, is defined as including the environs of the City of Battle Creek and several adjacent municipalities, the City of Springfield and the Townships of Assyris, Athens, Baltimore, Battle Creek, Bedford, Convis, Emmett, Johnstown, Leroy, Newton and Pennfield. The Company s MPSC Division is comprised of various non-contiguous areas in Michigan, including areas in and around Port Huron, Richmond, Chesterfield, Sandusky, Romeo, Albion, Niles, Three Rivers, Holland, St. Ignace, Newberry, Engadine, Manistique, Negaunee, Houghton and Ontonagon. On a combined division basis, SEMCO Gas serves approximately 285,000 residential, commercial and industrial customers, with residential customers comprising approximately 91% of the Company's customer base. 3. SEMCO Gas s retail natural gas business is subject to the jurisdiction of the Commission pursuant to 1909 PA 300, as amended, MCL et seq.; 1919 PA 419, as amended, MCL et seq.; and 1939 PA 3, as amended, MCL et seq. Pursuant to these statutory provisions, the Commission has jurisdiction to regulate the Company s retail natural gas sales, transportation and distribution rates in its Battle Creek and MPSC Divisions. This includes jurisdiction over the ways in which such rates are designed to provide the Company with a fair opportunity to recover the costs of providing service to its customers. 4. SEMCO Gas s last MPSC Division base rate case was Case No. U That case was concluded by a Commission Order dated January 9, The revised base rates established in that case were established based on an adjusted test year ending December 31, 2

4 2007, and an authorized rate of return on common equity of 11.00%. SEMCO Gas s base rates for its Battle Creek Division were adopted in Case No. U The Company also recovers its booked cost of gas sold for both its MPSC and Battle Creek Divisions pursuant to its Gas Cost Recovery ( GCR ) clauses authorized by the Commission pursuant to 1982 PA 304, MCL 460.6h et seq. 5. This Application is accompanied and supported by the written testimony, exhibits and workpapers of 10 witnesses. The Company s presentation in this case was prepared in accordance with the Rate Case Filing Requirements established by the Commission s Orders dated December 23, 2008, and February 20, 2009, issued in Case No. U II. COMBINATION OF DIVISION RATES 6. SEMCO Gas seeks authority to combine its MPSC Division and Battle Creek Division rates into one set of common base rates, one GCR clause, and one tariff book. The Company represents that the proposed combination will promote operating efficiencies and reduce the number of GCR and other annual filings before the Commission. 7. The base rate increase proposed in this case is based on the cost of service of serving customers in the combined divisions. 8. SEMCO Gas also seeks to combine the now separate depreciation rates for the MPSC Division and the Battle Creek Division as approved in Case No. U-15778, by using an average deprecation rate for each asset type as the rate to be applied to these asset types on a combined basis. SEMCO Gas seeks approval of these new depreciation rates. 1 The rates adopted in Case No. U reflect the rates established by the Battle Creek City Commission on February 15,

5 III. REQUESTED BASE RATE INCREASE 9. (i) Because the costs of providing service to the Company's customers have increased, and (ii) due, in large part, to a substantial and continuing decline in per customer natural gas usage resulting from the recession and conservation, the Company s existing retail base rates for natural gas services are unreasonably low and inadequate, and SEMCO Gas has not been earning its authorized return on common equity. In fact, in 2009, SEMCO Gas earned 7.69% and 5.32% rates of return for its MPSC Division and Battle Creek Division respectively, as compared to an MPSC-authorized return on equity for the MPSC Division of 11.00%. 10. This rate filing presents data for a historical year ended December 31, 2009, as required by the Commission Orders in Case No. U SEMCO Gas proposes, however, that rates be established based upon a test year ending December 31, 2011, adjusted for known and measurable changes in the costs of providing service to customers. Use of this adjusted test year data allows the revised base rates established in this case to more closely reflect conditions that will likely exist at and after the time the revised base rates set by the final order in this case are placed in effect. 11. Several factors have, and are expected to continue to have, a significant impact upon the Company s costs of providing service to its customers, rendering existing base rates unreasonably low and inadequate and precluding the Company from earning a reasonable return on its investments used and useful in providing service to customers. The most significant factor contributing to the Company s revenue shortfall, as discussed in greater detail in Section IV herein and the testimony accompanying this Application, is declining per customer use of natural gas, including the effects of the recent recession and reduced usage of natural gas now encouraged by State-mandated conservation and energy efficiency programs. Among other things, SEMCO Gas s existing base rates do not reflect recent increases in (i) inflation, (ii) 4

6 operations and maintenance ( O&M ) expenses (including the Service Valve Replacement Program), and (iii) necessary capital investments. The level of capital investment (such as replacement of aging unprotected metallic mains) and O&M expenses necessary to maintain, strengthen, and expand the existing natural gas transportation and distribution system and to assure safe and reliable service to customers have increased significantly beyond the levels currently reflected in the Company s base rates. These and other factors, as described in more detail in the supporting testimony and exhibits, necessitate an increase in SEMCO Gas s current retail natural gas rates. 12. Unless timely rate relief is granted by the Commission, the Company will experience a revenue deficiency of $19,847,589 in This 2011 test year revenue deficiency represents the results of a complete examination of the relevant items of investment, expense, and revenues for the determination of just and reasonable retail natural gas rates for SEMCO Gas s customers. 13. SEMCO Gas proposes that retail natural gas rates be established that reflect an overall rate of return on total rate base of 7.50% and a rate of return on common equity of 11.00%. The capital structure ratios used are based upon the Company s actual capital structure as of December 31, SEMCO Gas represents that, without taking into account the rate design changes proposed by the Company, the proposed rate increase of not less that $19,847,589 annually is required in order for the Company to maintain an adequate, reliable, and safe natural gas transportation and distribution system and to allow SEMCO Gas a reasonable opportunity to earn the return to which the Company is entitled by law. 5

7 IV. PROPOSED IMPROVEMENTS IN RATE DESIGN 15. Reflecting an industry-wide trend as well as local economic conditions, a sharp and continued decline in per customer natural gas use continues to be a major cause for the Company s revenue shortfall and inadequate earnings over the last several years. Actual use per customer is substantially below levels used to establish rates in Case No. U-14893, 2 and this difference between the Company s actual experience and the assumptions used to establish the Company s base rates has adversely affected the Company s collection of revenues through its volumetric distribution rates. In sum, the Company s existing rate design, which provides for the recovery of fixed costs through a combination of fixed charges and volumetric distribution rates based on estimates of customer natural gas use, effectively precludes the Company from earning sufficient revenues to cover the cost of providing service to customers, including a reasonable return on its investments used and useful in providing such service. Under current conditions, the logic of continuing to collect the Company's fixed costs this way is questionable, especially when there are simple ways to sever the recovery of fixed costs from usage. 16. In this case, the Company is proposing that the Commission adopt a different rate design for SEMCO Gas base rates, on a pilot program basis, including: (i) a single fixed monthly charge applied to residential and commercial customers whose usage exceeds a specified level per year and for all transportation customers, thereby replacing the existing combined fixed monthly customer charge and the volume-based distribution charge; or (ii), alternatively, establishing rates for all customers using appropriate rate effective year billing determinants. 2 This is also true regarding the rates established for the Battle Creek Division as initially established in February 2005 by the Battle Creek City Commission which were later adopted by the MPSC in its June 26, 2007 order issued in Case No. U

8 17. The Company is also proposing that the Commission permit SEMCO Gas to collect certain capital costs associated with the accelerated replacement of certain unprotected and bare metallic mains. In view of the Company s (i) relatively small size, (ii) its already substantial capital spending program, and (iii) the non-revenue producing nature of these needed projects, it would be an appropriate exercise of ratemaking discretion for the Commission to authorize the Company to collect the capital-related costs on this project before they are placed in rate base. V. SPECIAL CONTRACTS 18. Section 6a(5) of 2008 PA 286, MCL 460.6a(5) provides as follows: The commission shall, if requested by a gas utility, establish load retention transportation rate schedules or approve gas transportation contracts as required for the purpose of retaining industrial or commercial customers whose individual annual transportation volumes exceed 500,000 decatherms on the gas utility s system. The commission shall approve these rate schedules or approve transportation contracts entered into by the utility in good faith if the industrial or commercial customer has the installed capability to use an alternative fuel or otherwise has a viable alternative to receiving natural gas transportation service from the utility, the customer can obtain the alternative fuel or gas transportation from an alternative source at a price which would cause them to cease using the gas utility s system, and the customer, as a result of their use of the system and receipt of transportation service, makes a significant contribution to the utility s fixed costs. The commission shall adopt accounting and rate-making policies to ensure that the discounts associated with the transportation rate schedules and contracts are recovered by the gas utility through charges applicable to other customers if the incremental costs related to the discounts are no greater than the costs that would be passed on to those customers as the result of a loss of the industrial or commercial customer s contribution to a utility s fixed costs. 19. Pursuant to MCL 460.6a(5) SEMCO Gas is seeking approval of 5 special gas transportation contracts entered into in good faith with industrial customers for the purpose of retaining their load, and for which, as demonstrated in the testimony and exhibits supporting this 7

9 application, the Company is seeking to recover the discounts associated with the contracts through rates charged to its other customers as the discounts are not greater than the costs that would be passed onto the other customers as the result of the loss of the industrial customers contribution to SEMCO Gas s fixed costs. VI. OTHER RELIEF 20. The Company is proposing, among other things, to (i) replace defectively designed service valves on an accelerated basis (known as the Service Valve Replacement Program) to ensure public safety and system reliability, (ii) adopt heat value, or therm-based, billing for all classes of customers, (iii) combine the current Balancing Charge and Capacity Demand Charge into a single Balancing and Demand Charge, (iv) revise its general rules, and (v) revise or implement charges for certain services. This other relief sought by SEMCO Gas is more fully described in the accompanying testimony and exhibits. The relief more fully described in the testimony and exhibits is an integral part of this Application and should be considered as if specifically requested in this Application. VII. SELF-IMPLEMENTATION 21. In accordance with MCL 460.6a(1), if the Commission has not acted on the Company s application within 180 days after the filing is determined to be complete, SEMCO Gas intends to implement for service rendered on and after January 1, 2011, up to the amount of the proposed annual rate request at equal percentage increases applied to all rates. The accompanying testimony and exhibits support an alternative proposal for self-implementation that reflects the fact that current Battle Creek Division and MPSC Division base rates are 8

10 different. This alternative proposal is equitable and should be approved by the Commission for implementation. VIII. REQUEST FOR RELIEF 22. SEMCO Gas s presently-effective retail rates for the sale, transportation and distribution of natural gas are now, and in the future will continue to be, unjust and unreasonable. Such rates are not sufficient to permit the Company to recoup the costs of providing service to its customers, including a reasonable return on investments used and useful in providing such service, to which SEMCO Gas is entitled by law. SEMCO Gas s retail natural gas rates are, and are expected to remain, so low as to deprive it of a reasonable return on its property and to amount to confiscation of the Company s property contrary to SEMCO Gas s rights under the Constitution of the United States and the Constitution and laws of the State of Michigan. The inadequacy of these natural gas rates reduced the Company s revenues and overall rate of return below a proper and reasonable level, and it is unjust and unreasonable to require SEMCO Gas to render natural gas service to its customers at such rates. WHEREFORE, SEMCO Energy Gas Company requests the Commission to: A. Issue and publish its Notice of Hearing setting an early hearing date; B. Combine MPSC Division and Battle Creek Division rates, including the terms and conditions of service to customers; C. Find and determine that existing rates and charges are unreasonably low and inadequate and should be increased to protect the constitutional rights of the Company to earn a reasonable and non-confiscatory return; 9

11 D. Authorize the Company to adjust its existing rates and charges so as to produce additional revenue of not less that $19,847,589 annually, without taking into account the rate design changes proposed by the Company. E. Redesign rates as requested in this Application and addressed in the supporting testimony and exhibits; F. Authorize all other changes and suggestions made and supported in the Company s testimony and exhibits; and G. Grant such other further relief as may be lawful and proper. Respectfully submitted, SEMCO ENERGY GAS COMPANY Dated: June 29, 2010 By: One of its Attorneys Harvey J. Messing (P23309) Sherri A. Wellman (P38989) Paul M. Collins (P69719) MILLER, CANFIELD, PADDOCK AND STONE, P.L.C. One Michigan Avenue, Suite 900 Lansing, Michigan ,049,021.1\ Peter F. Clark (P69185) SEMCO Energy Gas Company 1411 Third Street, Suite A P.O. Box 5004 Port Huron, MI

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13 STATE OF MICHIGAN BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION NOTICE OF HEARING FOR THE CUSTOMERS OF SEMCO ENERGY GAS COMPANY CASE NO. U SEMCO Energy Gas Company may combine its MPSC Division and Battle Creek Division and may increase its retail natural gas rates for sales and transportation service on a combined basis by $19,847,589 annually, or 18.19%, if the Michigan Public Service Commission approves it requests. A TYPICAL RESIDENTIAL CUSTOMER IN THE MPSC DIVISION WHO USES 100 DTH OF NATURAL GAS PER YEAR MAY SEE AN ANNUAL INCREASE OF $82.69, OR ABOUT 29.9%, IF THE REQUESTED RATE RELIEF IS GRANTED. A TYPICAL RESIDENTIAL CUSTOMER IN THE BATTLE CREEK DIVISION WHO USES 100 DTH OF NATURAL GAS PER YEAR MAY SEE AN ANNUAL INCREASE OF $48.51, OR ABOUT 15.6%, IF THE REQUESTED RATE RELIEF IS GRANTED. The information below describes how a person may participate in this case. You may call or write SEMCO Energy Gas Company, 1411 Third Street, Suite A, Port Huron, Michigan 48060, (800) for a free copy of its application. Any person may review the application at the offices of SEMCO Gas. The first public hearing in this matter will be held: DATE/TIME: BEFORE: LOCATION: PARTICIPATION:, 2010, at.m. This hearing will be a prehearing conference to set future hearing dates and decide other procedural matters. Administrative Law Judge. Michigan Public Service Commission 6545 Mercantile Way, Suite 7 Lansing, Michigan Any interested person may attend and participate.

14 The hearing site is accessible, including handicapped parking. Persons needing any accommodation to participate should contact the Commission s Executive Secretary at (517) in advance to request mobility, visual, hearing or other assistance. The Michigan Public Service Commission (Commission) will hold a public hearing to consider the June 29, 2010 application of SEMCO Energy Gas Company (SEMCO Gas), which seeks Commission approval, among other things, to (i) combine its MPSC and Battle Creek Divisions, (ii) increase revenues for the sale, transportation and distribution of natural gas, (iii) redesign the way in which SEMCO Gas charges its customers for natural gas service, (iv) implement an Infrastructure Replacement Program for unprotected metallic mains and related cost recovery mechanism, and (v) recover in rates the discounts associated with special transportation contracts pursuant to MCL 460.6a(5). SEMCO Gas states that based on a 2011 test year it has a jurisdictional revenue deficiency of $19,847,589, or 18.19%. All documents filed in this case shall be submitted electronically through the Commission s E-Dockets Website at: michigan.gov/mpscedockets. Requirements and instructions for filing can be found in the User Manual on the E-Dockets help page. Documents may also be submitted, in Word or PDF format, as an attachment to an sent to mpscedockets@michigan.gov. If you require assistance prior to e-filing, contact Commission staff at (517) or by at mpscedockets@michigan.gov. Any person wishing to intervene and become a party to the case shall electronically file a petition to intervene with this Commission by, (Interested person may elect to file using the traditional paper format.) The proof of service shall indicate service upon SEMCO Gas s attorney, Sherri A. Wellman, Miller, Canfield, Paddock & Stone, P.L.C., One Michigan Avenue, Suite 900, Lansing, Michigan Any person wishing to make a statement of position without becoming a party to the case may participate by filing an appearance. To file an appearance, the individual must attend the hearing and advise the presiding administrative law judge of his/her wish to make a statement of position. All information submitted to the Commission in this matter will become public information: available on the Michigan Public Service Commission s Web site, and subject to disclosure. Requests for adjournment must be made pursuant to the Commission s Rules of Practice and Procedure R and R Requests for further information on adjournment should be directed to (517) A copy of SEMCO Gas s request may be reviewed on its website at or on the Commission s Web site at michigan.gov/mpscedockets, and at the office of SEMCO Energy Gas Company, 1411 Third Street, Suite A, Port Huron, Michigan. For more information on how to participate in a case, you may contact the Commission at the above address or by telephone at (517)

15 Jurisdiction is pursuant to 1909 PA 300, as amended, MCL et seq.; 1919 PA 419, as amended MCL et seq.; 1939 PA 3, as amended, MCL et seq.; 1982 PA 304, as amended, MCL 460.6h et seq.; 1969 PA 306, as amended, MCL et seq.; and the Commission s Rules of Practice and Procedure, as amended, 1999 AC, R et seq., \

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17 SEMCO Energy Gas Company Rate Case No. U Exhibit Summary Exhibit No. Section A Schedule No. Witness A-1 Revenue Deficiency Revenue Deficiency A-1 BHF for Year Ended December 31, 2009 Computation of Revenue Multiplier A-2 BHF for Year Ended December 31, 2009 Comparative Earnings Schedule A-3 BHF A-2 Rate Base Average Rate Base & Capital B-1 BHF Rate Base - Average Net Plant B-2 BHF Rate Base - Balance Sheet Working Capital B-3 BHF A-3 Adjusted Net Operating Income Adjusted Net Operating Income C-1 BHF Net Operating Income C-2 BHF Tax Effect of Interest C-3 BHF Synchronization Adjusment JDITC Adjustment C-4 BHF Advertising Classification C-5 JAV Non-Utility Expenditures C-6 JAV A-4 Rate of Return Overall Rate of Return Summary D-1 BHF Long Term Debt Cost D-2 BHF Cost of Short-term Debt D-3 BHF Preferred Stock Cost D-4 BHF Cost of Common Equity D-5 BHF Financial Metrics - Financial Basis D-6 BHF Financial Metrics - Rate Making Basis D-7 BHF A-5 Summary of Historical Year Revenues E-1 JAV Historical Year Customers and Volumes E-2 JAV Historical Year Operating Revenues E-3 JAV Historical Cost of Service Study E-4 PHR A-6 Rate Design Affiliated Company Transactions Corporate Structure of the Affiliated Group F-1 SWW Summary of Costs Billed To and From F-2 SWW Affiliated Companies Affiliated Companies Rate of Return F-3 SWW on Common Equity Consolidating Balance Sheets F-4 SWW Consolidating Income Statement F-5 SWW

18 SEMCO Energy Gas Company Rate Case No. U Exhibit Summary Exhibit No. Section B Schedule No. Witness A-7 Revenue Revenue Deficiency A-1 BHF Comparison of Revenue Deficiency between the A-2 BHF Historical Period and 2011 Test Year Reconciliation of Revenue Deficiency A-3 BHF for the 2011 Test Year to the Historical Period A-8 Rate Base Rate Base for the 2011 Test Year B-1 BHF Utility Plant for the 2011 Test Year B-2 BHF Accumulated Depreciation B-3 BHF Balance Sheet Working Capital B-4 BHF Cost of Gas B-5 JAV Gas Stored Underground B-6 JAV Short Term Energy Outlook B-7 PRC Historical & Proposed Plant Additions B-8 MAS Infrastructure Replacement Program B-9 MAS Service Valve Replacement Program B-10 MAS Service Valve Compaint B-11 MAS Environmental Expenditures B-12 MAS A-9 Adjusted Net Operating Income Net Operating Income Adjustments C-1 BHF Computation of Revenue Multiplier C-2 BHF for the 2011 Test Year Revenues C-3 BHF Cost of Gas Sold C-4 BHF Other Operations & Maintenance Expense C-5 MAM Depreciation & Amortization Expense C-6 BHF Taxes Other than Income C-7 MAM Michigan Business Tax C-8 SWW Federal Income Taxes C-9 BHF Interest Syncronization C-10 BHF Operating Income Adjustments C-11 BHF LAUF and Company Use C-12 JAV Amortization of Pension and Other Post-Retirement C-13 SWW Benefit Expenses

19 SEMCO Energy Gas Company Rate Case No. U Exhibit Summary A-10 Rate of Return Overall Rate of Return Summary D-1 BHF Cost of Long Term Debt D-2 BHF Cost of Short Term Debt D-3 BHF Cost of Preferred Stock D-4 BHF Cost of Common Equity D-5 BHF Credit Ratings D-6 BHF Recent Utility Bond Issuances D-7 MAM Financial Metrics D-8 BHF Capital Structure D-9 BHF DCF Model - Dividend Yield D-10 BHF DCF Model - Earnings Growth D-11 BHF DCF Model - Sustainable Growth D-12 BHF DCF Model - Other Growth Rates D-13 BHF Capital Asset Pricing Model D-14 BHF Risk Premium Method D-15 BHF Comparable Earnings Method D-16 BHF IRP Capital Charge Rate D-17 BHF A-11 Rate Design Summary of Proposed Rate Increase E-1 PHR Test Year Volumes, Customers and Adjustments E-2 JAV Reduced Volumes Due to Energy Optimization E-3 JRA Calculation of Pro Forma and Proposed Revenues E-4 PHR Comparison of Current and Proposed Rates E-5 PHR Cost of Service Study E-6 PHR Summary of Proposed Tariff Sheet Changes E-7 JAV Proposed Tariff Sheets E-8 JAV Alternative Definitions of Normal Weather E-9 PHR Usage Level Rate Desighns E-10 PHR A-12 Self-Implementation of Rate Increase F-1 JRA Weather Normalized Residential Use per Customer F-2 GAS Not Used F-3 Special Contract F-4 TLJ Special Contract F-5 TLJ Special Contract F-6 TLJ Special Contract F-7 TLJ Map F-8 TLJ Special Contract F-9 TLJ Map F-10 TLJ Special Contract Summary F-11 TLJ

20 STATE OF MICHIGAN BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION ***** In the matter of the application of ) Case No. U SEMCO ENERGY GAS COMPANY to combine its ) MPSC Division and Battle Creek Division rates and ) for authority to redesign and increase its rates, on a ) combined basis, for the sale and transportation of ) natural gas and for other relief. ) DIRECT TESTIMONY AND EXHIBIT OF GEORGE A. SCHREIBER, JR. ON BEHALF OF SEMCO ENERGY GAS COMPANY 1

21 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Introduction Q. Please state your name, title, current employer, and business address. A. My name is George A. Schreiber, Jr. I am President and Chief Executive Officer of Continental Energy Systems LLC ( Continental ) and serve on Continental s Board of Managers. Continental is headquartered in Troy, Michigan. In addition, I am President and Chief Executive Officer of SEMCO Energy, Inc. ( SEMCO ). I also serve on SEMCO s Board of Directors, as Chairman. SEMCO is headquartered at 1411 Third Street, Suite A, Port Huron, Michigan Q. Please describe the ownership of SEMCO. A. In 2007, after a series of transactions, SEMCO became a wholly-owned indirect subsidiary of Continental. Continental is controlled by affiliates of Lindsay Goldberg LLC. Lindsay Goldberg LLC is a private equity investment fund based in New York and currently has approximately $10 billion of capital under management. Q. On whose behalf are you testifying in this proceeding? In responding, please describe those entities. A. I am testifying on behalf of SEMCO Energy Gas Company. SEMCO Energy Gas Company is a division of SEMCO. SEMCO Energy Gas Company has two divisions known as the MPSC Division and Battle Creek Division. Those divisions provide retail natural gas service to approximately 285,000 customers in service areas located in the Upper and Lower peninsulas of Michigan. The retail natural gas distribution and transportation businesses of both the MPSC Division and Battle Creek Division are subject to the regulatory jurisdiction of the Michigan Public Service Commission (the MPSC or the Commission ). For convenience, and also because it is proposed in this proceeding to combine the MPSC Division and Battle Creek Division rates, I refer to both divisions as SEMCO Gas or the Company in this testimony. 2

22 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Q. Please describe your educational background. A. I received both my Bachelor of Science (1970) and Masters of Business Administration (1971) degrees from Arizona State University. Arizona State University is located in Tempe, Arizona. Q. Please describe your professional experience prior to joining SEMCO. A. Before joining SEMCO in April 2004, I spent most of my career as an investment banker with various firms based in New York. As an investment banker, I was a financial advisor to regulated, investor-owned public utilities. Among other things, I provided financial advice relating to capital structures, credit quality and rating agency perspectives, asset acquisitions and dispositions, mergers and other business combinations, and financing plans. I also was involved, in various roles, in numerous transactions in both the domestic and international capital markets. Immediately prior to joining SEMCO, I was Chairman of the Global Energy Group of Credit Suisse First Boston. At other points in my career, I was President of Pinnacle West Capital Corporation and Manager of Regulatory Affairs at Arizona Public Service Company. A copy of my current resume is attached to this testimony as Attachment 1. Q. Have you previously testified in any regulatory proceedings before the MPSC or other state or federal regulatory agencies? A. I have not previously testified before the Commission. I have provided expert testimony before regulatory agencies in ten other states as well as before the Federal Energy Regulatory Commission and a federal bankruptcy court. Role, Purpose, and Topics Addressed Q. What is your role in this proceeding? A. I am the Company s chief policy witness, which means that, with substantial input from others, I set the overall direction for this filing. That included making various policy choices, 3

23 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company identified in this testimony. Witnesses did their work on this filing based on those choices, consistent with exercising their own professional judgment. Q. What is the purpose of your testimony in this proceeding? A. The purpose of my testimony is three-fold. First, I summarize the Company s proposals, so that the Commission will have, in one place, the essential elements of what SEMCO Gas is asking the Commission to do. Other witnesses provide additional detailed information the Commission should find useful in evaluating those proposals. Second, I identify the other witnesses appearing on behalf of SEMCO Gas in this proceeding and describe, in general terms, the topics they address in the case. In a sense, that testimony is a roadmap to this filing. Finally, I discuss what I believe are key issues or policy decisions raised by this filing. I detail the Company s proposals on these subjects, set the proposals in context, and explain the Company s overall thinking to the Commission. Again, other witnesses in the case also testify on these topics. Q. What specific topics do you address in your testimony? A. I discuss the following topics in my testimony: A summary of SEMCO Gas s proposals, including the base rate relief requested by the Company based on the combination of MPSC Division and Battle Creek Division rates. SEMCO Gas s rate design proposal for collecting the Company s revenue requirement, on a pilot program basis. The Company s primary proposal is to use a single fixed monthly charge rate design for collecting revenue from residential and commercial customers whose usage exceeds a specified therm level per year and for all transportation service customers. Alternatively, rates should be established for all customers using appropriate rate effective year billing determinants. Who is sponsoring prefiled direct testimony on behalf of the Company and on what topics. 4

24 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company The recommended return on equity (the ROE ) the Commission should allow SEMCO Gas a fair opportunity to earn during the period when revised base rates will be in effect. Q. Please identify the exhibits which you are sponsoring in this case. A. In addition to the exhibit summarizing my credentials, I am sponsoring the following: 5 Exhibit A-12 Schedule F-2 Weather Normalized Residential Use per Customer Q. Was this exhibit prepared by you or under your direction? A. Yes. Summary of SEMCO Gas Proposals Q. Please summarize SEMCO Gas s proposals in this proceeding. A. SEMCO Gas respectfully proposes, based on my testimony and the testimony of the other witnesses for the Company, that the Commission: Authorize the combination of the Company s MPSC Division and Battle Creek Division into one division with one set of common base rates, one Gas Cost Recovery ( GCR ) clause and one tariff book with the terms and conditions of service for all of the Company s Michigan customers. Authorize an overall annual base rate increase of $19.8 million (or approximately 5.3% on a total bill basis) in combined MPSC and Battle Creek Division rates for SEMCO Gas on the basis of a test year ending December 31, 2011, adjusted for known and measurable changes in the costs of providing service to customers. Absent issuance of a Commission order, the Company plans to self-implement rates for service rendered on or after January 1, 2011, up to the amount of the proposed request at equal percentage increases applied to all rates. The Company is also proposing, however, an alternative proposal for selfimplementation. This alternative proposal reflects the fact that current MPSC and Battle Creek Division base rates are different, making implementation of an across-the-board equal percentage self-implemented rate increase problematic. 5

25 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Approve, on a three-year pilot program basis, a single fixed monthly charge rate design for residential customers whose usage is greater than 900 therms per year, all commercial customers (formerly rate class GS-1) whose usage is greater than 1,750 therms per year, and all for transportation service customers. These single fixed monthly charges would replace the combination of a fixed monthly charge and a volumetric-based distribution charge now used to collect the fixed costs of service from these customers. To accommodate concerns about the impact of such a rate design on lower-usage customers, for residential customers whose usage is below 900 therms per year and commercial (formerly rate class GS-1) customers whose usage is below 1,750 therms per year, the Company is proposing to maintain the traditional combination of a monthly customer charge and usage-based distribution charge. As an alternative, if the Commission does not elect to approve the proposed single fixed monthly charge rate design as proposed and a traditional rate design is used in which some portion of the Company s fixed costs are to be collected volumetrically, set the billing determinant for residential rates based on a use per customer of 899 therms per year and the billing determinant for the GS-1 commercial rate at 1,767 therms per year. Approve the Infrastructure Replacement Program for unprotected metallic main replacement and recovery of the associated costs. Approve the Company s Service Valve Replacement Program and recovery of the associated costs. Allow the Company a fair opportunity to earn a return on equity of 11.0%. Approve the use of therms as the basis of billing all customer classes. Approve all of the proposed adjustments and tariff changes sponsored by the Company s witnesses. Witnesses for SEMCO Gas in this Proceeding; Subjects Addressed 6

26 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Q. What witnesses are appearing on behalf of SEMCO Gas in this proceeding and what is the subject-matter of their prefiled testimony? A. The following witnesses are sponsoring prefiled testimony on behalf of SEMCO Gas on the topics I describe: Bruce H. Fairchild Dr. Fairchild is sponsoring testimony and exhibits that constitute the schedules required by the Commission s standardized rate case filing requirements for both the historical and the forecast test years. He also sponsors the Company s requested rate of return and the Company s cost of debt and capital structure. James A. Van Sickle Mr. Van Sickle is sponsoring testimony and exhibits on the Company s Lost and Unaccounted for Gas, Company Use Gas, Gas in Storage, various adjustments to operating expenses, test year customer data, and various proposed tariff changes. John R. Alger Mr. Alger is sponsoring testimony and exhibits on the combination of the MPSC Division and Battle Creek Division, the Company s proposal to combine the current Balancing Charge and Capacity Demand Charge, the use of therms (or heat value) as the basis for billing all customer classes, the Company s self implementation of revised base rates, the ratemaking mechanics of the Infrastructure Replacement Program, and certain sales and transportation volume adjustments arising from the Company s Energy Optimization program and related legislative mandates to reduce gas usage by SEMCO Gas customers. Marc A. Simone Mr. Simone is sponsoring testimony and exhibits in support of SEMCO Gas s projected capital expenditures for 2010 and He also discusses the need for the Infrastructure Replacement Program for unprotected metallic mains. He also supports the Company s Service Valve Replacement Program and the Company s expenditures for environmental compliance. 7

27 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Mark A. Moses Mr. Moses is sponsoring testimony and exhibits in support of the methodology used by the Company to forecast Operations and Maintenance expense, Property and Other Tax expense, and Other Gas Revenues. Paul R. Carpenter Dr. Carpenter is sponsoring testimony and exhibits in support of the forecasted price of natural gas in The price of gas is the basis for a number of revenue requirement items, given how those items are currently recovered in SEMCO Gas s base rates. Paul H. Raab Mr. Raab is sponsoring testimony and exhibits on the Company s proposed rate design, the Company s revenue and sales and transportation volume forecast, and weather normalization. He also sponsors the Company s cost of service study. Steven W. Warsinske Mr. Warsinske is sponsoring testimony and exhibits on intracompany transactions and allocations, the implementation of new depreciation rates approved in Case No. U and a proposal to combine those new depreciation rates into a single set of depreciation rates for the combined MPSC and Battle Creek Divisions, the recovery of the amortization of pension and post-retirement costs, and income and other taxes, including the Michigan Business Tax. Timothy J. Lubbers Mr. Lubbers is sponsoring testimony supporting the continuation of Special Transportation Agreements for certain customers and the recovery in base rates of the discounts in such contracts. Proposal to Combine the MPSC Division and Battle Creek Division Rates Q. Please describe the Company s proposal to combine MPSC and Battle Creek Division rates into a single set of rates and terms and conditions of service. A. The Company currently has two divisions that provide natural gas service to customers in various areas throughout Michigan. Rates and terms and conditions of service to customers in both divisions are regulated by the MPSC, though service to customers in the Battle 8

28 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Creek Division was once regulated by the City Commission of Battle Creek. As a result of this now-ended separation in regulatory authority, the divisions currently have separate rates, tariffs and other terms and conditions of service. In June 2007, the MPSC assumed jurisdiction over the Battle Creek Division in Case No. U Now that the Commission has jurisdiction over both divisions, the Company is proposing to combine the rates, tariffs and other terms and conditions of service for these divisions into a single set of rates, tariffs and other terms and conditions of service. As such, the base rates proposed in this proceeding are based on the cost of service to all of the Company s Michigan customers, as if the historical divisional structure did not exist. Q. What is the thinking behind this change? A. The fact that there are different rates, tariffs and terms and conditions of service for customers in each division currently leads to confusion on the part of customers. Combining rate and terms and conditions of service should end this confusion. The Company believes that combining the existing separate sets of rates is appropriate and that a single set of rates will be better understood and accepted by customers. Mr. Alger discusses this in more detail in his testimony. Proposed Base Rate Revenue Increase Q. Please summarize SEMCO Gas s proposed annual base revenue increase. A. SEMCO Gas is requesting an annual base revenue increase of $19,847,589 for the combined MPSC and Battle Creek Divisions at the 11.0% authorized return on equity sponsored by Dr. Fairchild. This proposed annual revenue increase is based on a projected test year ending December 31, The Company s future revenues are expected to be negatively impacted due to a continued reduction in use per customer, as discussed by Mr. Raab, as well as further reductions in usage expected as a result of the State-mandated energy optimization programs and customer losses. Unless current base rates are adjusted, 9

29 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company the Company will not have a fair opportunity to recoup its costs of providing service to customers, including a reasonable return on its investments. Q. When did SEMCO Gas last increase its base rates? A. SEMCO Gas last filed a general rate case for its MPSC Division in May In its January 9, 2007 order, the MPSC approved a settlement agreement that, among other things, provided for an estimated annual revenue increase of $12.6 million based on a test year ending December 31, In February 2005, the Battle Creek Division was granted an annual revenue increase of $3.55 million by the Battle Creek City Commission. No base rate increase has been granted to the Battle Creek Division since the Commission assumed jurisdiction over the Battle Creek Division in June Since those cases, various factors have resulted in the need for the revenue increase requested in this proceeding, including the continued decline in use per customer as a result of the recession and conservation and increases in operations and maintenance expenses due to inflation and other factors, as discussed by Mr. Moses in his testimony. Q. Does SEMCO Gas plan to self-implement the proposed revenue increase? A. Yes, as permitted by Section 6a(1) of Public Act 286 of 2008, SEMCO Gas plans to selfimplement rates up to the amount of the proposed revenue increase request for service rendered on or after January 1, The Company has filed tariffs based on the statutory requirement that the proposed annual rate request be applied through equal percentage increases across all base rates. The Company is requesting, however, that the Commission approve an alternative methodology for self-implementation of the proposed revenue increase that reflects the fact that current MPSC Division and Battle Creek Division rates are different. For example, the monthly service charge and distribution charges are different in each division, and the Battle Creek Division rates currently include an additional monthly charge for certain costs that were included in cost of gas when this division operated under 10

30 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company the jurisdiction of the City Commission of Battle Creek but which are now included in base rates under the Commission s rules. Applying equal percentage increases to such different rates would result in further confusion on the part of customers as well as result in a situation in which certain customer classes would be over-charged and due a refund while others would be under-charged once final rates are determined in this proceeding. For these reasons, the Company is proposing to self-implement the rate changes in the alternative manner more fully described in Mr. Alger s testimony. Proposed Single Monthly Fixed Charge Rate Design; Pilot Program Q. Please discuss the Company s rate design proposal. A. SEMCO Gas proposes that the Commission authorize the Company to collect the revenue requirement assigned to certain customer classes through a single fixed monthly charge. This single fixed charge methodology would apply to residential customers whose usage is greater than 900 therms per year, all commercial customers (rate class GS-1) whose usage is greater than 1,750 therms per year, and all transportation service customers. These single fixed charges would replace the combination of a fixed monthly charge and a volumetric-based distribution charge now used to collect revenues from these customers. For residential customers whose usage is below 900 therms per year and commercial (rate class GS-1) customers whose usage is below 1,750 therms per year, the Company is proposing to maintain the traditional combination of a monthly charge and usage based distribution charge. I will refer to this aspect of the Company s proposal as the "usage level exception." In my view, while I am persuaded that it makes sense to collect a utility s fixed costs of providing service in a fixed monthly charge, this usage level exception addresses a common concern that lower usage customers will object to paying for service on a fixed charge basis. Q. Would this be a pilot program, subject to later Commission evaluation? 11

31 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company A. Yes. In this case, the Company is proposing that the Commission adopt the proposed rate design, including the usage level exception element of the proposal, for SEMCO Gas base rates, on a pilot program basis. The Company proposes to conduct such a pilot program over a period of three years and report to the Commission periodically and at the end of three years on its experience with this rate design. Q. What if the Commission exercises its discretion to maintain the current rate design? A. I recognize that the Commission may prefer to maintain the current two-part rate design. As an alternative, if the Commission elects to keep the current rate design, SEMCO Gas is proposing the Commission set base rates for all customers using appropriate billing determinants. Let me illustrate, using residential and small commercial customers as an example. In my view, the Commission should (1) conclude that, under normal weather conditions, the effects of volatile gas prices and ongoing conservation on consumption will cause residential and small commercial customers to use 899 and 1,767 therms of gas, respectively, on average, each year, and (2) order base rates to be set with those expected levels of usage as the billing determinants. Mr. Raab testifies on various aspects of these recommended usage figures as well as the consumption estimates to be used for all other classes of customers in his testimony. Q. Is the single fixed monthly charge rate design with the usage level exception designed to separate the recovery of fixed costs from usage? A. Yes. Adopting the single fixed monthly charge proposal would sever the Company s collection of fixed costs of service from the level of customer gas usage. That, in turn, would align Company and customer interests when it comes to the conservation of natural gas. I would call it a pro-conservation rate design. Such a rate design also would align Commission rate design policy and the legislative policy mandating the implementation of energy optimization programs by natural gas utilities in the State of Michigan. 12

32 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Q. Describe in more detail how SEMCO Gas proposes to collect its base rate revenue from its customers. A. SEMCO Gas is requesting a rate design that separates the revenues needed to cover the cost of service from the volumetric consumption of most, but not all, of its customers. Except for residential customers whose annual usage is less that 900 therms and small commercial customers whose annual usage is less than 1,750 therms, the method that the Company is proposing is a singled fixed charge, paid by customers monthly, that recovers all the fixed costs of providing service to them. These fixed costs include preparing and transmitting customer bills, interacting with customers over the telephone and in-person (such as on service calls), maintaining meters, regulators, service lines, and recovering the Company s capital costs (including cost of the investments in facilities used to serve customers and an appropriate return on those investments) in sum, everything needed for a customer to receive natural gas from the Company s system for use in a home or business and for the Company to interact with that customer about his or her natural gas service. Q. How much are the proposed single fixed monthly charges? A. SEMCO Gas is proposing a fixed monthly charge of $29.94 for residential customers (Residential A), $63.19 for small commercial (GS-1A) customers, $ for GS-2 customers, $ for GS-3 customers, $1, for TR-1 customers, $8, for TR-2 customers and $31, for TR-3 customers. Q. How do these proposed charges compare to current charges paid by residential customers? A. For residential customers, the $29.94 monthly charge would replace the monthly customer charge (currently $10.00 for MPSC Division customers and $11.00 for Battle Creek Division customers) and the monthly distribution charge (currently $ per Mcf of usage for the MPSC Division and $ per Dth of usage for the Battle Creek Division). The new single 13

33 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company fixed monthly charges include all of the costs associated with serving these customers that were formerly collected through these two charges. The proposed single fixed monthly charges include the base rate increase proposed in this filing. To the extent the Commission alters SEMCO Gas s requested base rate increase, the proposed single fixed monthly charges would be altered accordingly. In discussing this topic, I am putting aside any separate surcharges and other similar amounts the Commission has authorized the Company to collect. Q. What rates is the Company proposing for those residential and commercial customers that would not be billed via single fixed monthly charges? A. For those residential customers whose usage does not exceed 900 therms per year (Residential B), the Company is proposing a monthly charge of $13.03 and a distribution charge of $ per therm. For those commercial customers whose usage does not exceed 1,750 therms per year (GS-1B), the Company is proposing a monthly charge of $23.24 and a distribution charge of $ per therm. Q. In your view, what are the primary reasons for adopting a single fixed monthly charge rate design for many of the Company s customers? A. The primary reasons for adopting a single fixed charge rate design are to: 1. Align Company and customer interests with respect to conservation, in this case by harmonizing a State of Michigan policy to encourage conservation through energy optimization programs with Commission-sponsored ratemaking policies that will give SEMCO Gas a fair opportunity to recover the costs of service, including the cost of capital. 2. Levelize SEMCO Gas s collection of its costs, by eliminating most volumebased distribution charges that are highest in the winter heating season when customers consume the most natural gas and therefore experience the highest bills. 14

34 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Address, other than by implementing the proposed adjusted billing determinants, the effect of a substantial and continuing decline in use per customer on SEMCO Gas s collection of its revenue requirement. 4. Provide customers with a bill that is easier to understand, because volumetric recovery of SEMCO Gas s revenue requirement (the distribution charge) will be eliminated for most customer classes. 5. Clarify for most customers, on the face of their bills, the fact that SEMCO Gas makes no additional money on the gas cost commodity portion of a customer s bill. 6. Employ a rate design that reflects sound economic and ratemaking principles, as discussed by Mr. Raab, because fixed costs are collected through fixed charges, and for other reasons that are addressed at length in his testimony. Q. Why is SEMCO Gas proposing a set of fixed monthly charges for most customers? A. I believe that a single fixed monthly charge for most customers is the best overall rate design this time, primarily because: 1. A single fixed monthly charge should be easy for customers to understand. On its face, the customer s bill would clearly differentiate the costs of SEMCO Gas s providing service from the cost of the natural gas consumed by the customer. In that sense, the proposed bill makes it clearer that the Company does not profit on the gas commodity portion of the bill, since all of the Company s costs (including its return on investments in rate base) would be collected in a single fixed monthly charge. Under SEMCO Gas s current rate design, because revenue collection varies with the volumetric distribution rate, the Company collects more revenue to cover fixed costs when customers use more gas and less revenue to cover fixed costs when customers use less gas. So, it is understandable, given how they are charged, that 15

35 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company some customers find it difficult to believe that the Company is not profiting on the gas they consume. 2. Fixed monthly charges are familiar to, and accepted by, customers. It should be kept in mind that customers are already familiar with many forms of fixed charge bills, such as bills for internet service and cellular phone usage. 3. A single fixed monthly charge is a simpler, lower-cost method to achieve the same pro-conservation public policy objectives that other decoupling mechanisms are designed to address, in terms of regulatory oversight, accounting complexity, and billing system information technology changes. 4. Customers would no longer over-pay for the cost of Company-provided gas delivery services in colder-than-normal winters and under-pay for those services in warmer-than-normal winters. By definition, since there is a volumetric component in the Company s current rate design in the form of the distribution charge, the collection of SEMCO Gas s base rate revenue requirement is affected by the weather, making the Company a seasonal, weather-dependent business. Because of the resulting effects on revenue collection, and putting aside other factors affecting usage, the Company over-collects its revenue requirement in colder-than-normal periods and under-collects its revenue requirement in warmer-than-normal periods. Under the Company s preferred proposed rate design, the volumetric component is eliminated for most customers, thus taking weather "out of the equation" from the perspectives of both customers and the Company. 5. Volatility in customer bills will be reduced since a larger portion of the total bill would be fixed each month and would not be dependent on changes in weather or usage patterns. That said, as Mr. Raab confirms, customers would still receive an appropriate price signal, based on their consumption of natural gas, because they 16

36 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company would be charged in the gas cost commodity, or GCR, portion of their bill for their actual gas usage. Q. Why does SEMCO Gas believe that single fixed monthly charges are fair for customers? A. Let me add my perspective to what Mr. Raab says in his testimony. The elements that comprise the cost to provide service are essentially the same for all of the customers in each class, irrespective of the volume of gas those customers consume. For example, the cost to prepare and transmit a bill does not vary with usage in various customer groups. Similarly, all customer classes are provided the safety-related services by the Company, such as leak surveys and emergency response to potential leaks on customer premises, and the costs of these services do not vary with usage. SEMCO Gas s current rate design collects approximately 63% of these charges volumetrically from all customers, effectively allowing lower-usage customers to pay less than their full cost of service. Mr. Raab discusses this subject in detail. Q. Does a single fixed monthly charge disadvantage low-income residential customers? A. No. As mentioned earlier, within each class, the cost to serve these customers is essentially the same. A single fixed charge eliminates subsidies between different customers within each class regardless of socio-economic factors. In truth, most customers will not see much of a change in their overall bills, since the single fixed monthly charge is a replacement for both the monthly charge and the volumetric distribution charge. The small group of highusage customers should favor this change; it will eliminate what is, in effect, an intra-class subsidy provided to lower-usage customers. Q. Discuss the impact of the usage option rate design on lower-usage residential and small commercial customers. A. Again, Mr. Raab discusses this topic in his testimony. These groups of customers might consider themselves to be disadvantaged by a change to a single fixed monthly charge 17

37 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company method for recovering the Company s fixed costs of providing service. To address this perception, the Company proposes to maintain the traditional rate design for such customers (a fixed monthly service charge and a variable distribution charge). Under this approach, these lower-usage customers will continue to pay based on their level of consumption, thereby avoiding any perceived "over-charging" based on their lower usage compared to other customers within their class. Q. What customer response does the Company expect from a changeover to a single fixed monthly charge rate design for most of its customers? A. None; I do not expect a significant negative reaction from customers. Many customers are accustomed to fixed charges for other services and have frequently demonstrated a preference for this sort of fixed charge. Examples of monthly fixed charge services now paid by residential customers include: basic local telephone (including access taxes), mobile telephone, cable service, home alarm monitoring services, internet access, automobile leases, and apartment rent. SEMCO Gas is proposing a $29.94 per month fixed charge for certain residential customers. That proposed charge is comparable in concept to some of the examples given here and on a par with, or substantially below, the fixed charges customers pay for other services. In fact, in my experience, people are surprised to learn that the cost of the service the Company provides is so low, generally because they mistakenly believe that SEMCO Gas keeps the gas cost or GCR revenues it collects as profits as opposed to what the Company actually does, which is use that money to pay various producers for the gas customers use. Also, commonsense tells me that customers are likely to prefer a charge that reduces the amount they will pay during the months when their bills are the highest (i.e., during heating season), rather than a volumetric charge that effectively adds to the highest 18

38 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company bills they experience. Given customer acceptance of fixed charges, I do not expect a significant negative customer response from those customers who would be impacted by the proposed change. Q. Do you have anything to add on the subject of your expectations about the customer response to the Company s proposed single fixed monthly charges for most customers? A. Yes, I should add that the Company would propose to educate customers about the new single fixed charge rate design, if the Commission were to adopt it. There would be opportunities to do so at the time of approval, in materials included in each affected customer s monthly bill. It also is important to make it unattractive, financially through the use of re-connection charges, for customers to avoid the monthly single fixed charges by disconnecting and re-connecting service. Q. Do SEMCO Gas customers voluntarily participate in a budget bill program? A. Yes, as of April 30, 2010, approximately 44,000 SEMCO Gas residential customers participated in budget billing (which is a levelized payment plan for the entire bill for gas service). This number of customers represents about 17% of all current residential customers. Q. Does the Company believe that this participation in a levelized payment option indicates that customers are receptive to single fixed monthly charges? A. Yes. As an optional program, budget billing requires customers to make the effort to contact the Company and request to what is, in effect, levelized billing for their entire bill. In my opinion, the fact that about 17% of all residential customers took it upon themselves to make this choice indicates that customers are not adverse to the concept of single fixed monthly charges. Q. What does the next series of questions and answers in your testimony address? 19

39 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company A. The next series of questions and answers addresses common criticisms of the proposed single fixed monthly charge rate design. Q. Does SEMCO Gas believe that single fixed monthly charges are a disincentive to conservation? A. No. Even after changing over completely to a single fixed monthly charge, approximately 72% of the average total residential customer bill would still vary with usage and thus provide a sufficient incentive for conservation. The GCR or commodity portion of the bill is volumetric, and thus this percentage grows in winter months, when residential customers typically consume more gas when they heat their homes during Michigan s cold winters. As noted, this high percentage portion of the customer bill will continue to rise and fall with volumetric use, which is what a customer is trying to affect by conserving. In my view, having a bill that is 72% (or more in colder months) tied to consumption is such a significant component of the bill that conservation efforts will not be impacted by the comparatively minor percentage change that results from shifting the volumetric recovery of the Company s costs to a single fixed monthly charge, as proposed. Q. How does a fixed monthly service charge affect SEMCO Gas s perspective with respect to conservation and energy efficiency? A. The collection of the Company s revenue requirement from most customer classes through a single fixed monthly charge rate design aligns Company and customer interests with respect to conservation and energy efficiency. As noted earlier in my testimony, aligning Company and customer interests is especially important when the State of Michigan requires all utilities to offer energy optimization programs to all classes of customers. To me, state policy should be consistent if a state is encouraging conservation by legislative mandate, utility rate design should reflect that public policy. 20

40 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Q. Does a single fixed monthly charge guarantee that the Company will earn its Commissionauthorized rate of return? A. No. The proposed single fixed charge, pro-conservation rate design does not guarantee that SEMCO Gas will recover its costs and earn its Commission-authorized return on equity. This is because there are other factors that affect the Company s ability to recoup its costs and earn its authorized return on equity. For example, increases in operations and maintenance costs resulting from increases in general inflation will affect the Company s financial performance. The state of the economy in Michigan and the absence of, or minimal, customer growth is another risk factor. SEMCO Gas continues to make expenditures for system improvements, main and service extensions and replacements, new vehicles and work equipment, and all of the other goods and services necessary or useful in providing safe, efficient, and reliable natural gas service to customers. Inflation tends to drive many of these costs higher each year. Q. Is the Company s rate design proposal, to implement single fixed monthly charges for most customers, dependent on either gas prices being more volatile or higher than in the past or a continuing pattern of declining per customer use? A. No. The proposed single fixed monthly charge rate design makes sense, whether gas prices are higher and more volatile, or not, and irrespective of whether use per customer continues to decline. If natural gas prices trend higher and exhibit volatility as they have in the past, or (2) use per customer continues to decline, customers will not be harmed by the proposed single fixed monthly charge rate design. In fact, SEMCO Gas would be harmed, in the sense that it had given up additional revenues that would be produced when a volumetric charge was applied to higher-than-expected consumption levels. Q. If the Commission does not approve the Company s preferred rate design, what is SEMCO Gas s rate design proposal? 21

41 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company A. SEMCO Gas s other rate design proposal is to maintain the traditional two-part rate design for all customer classes using appropriate billing determinants. That is the way in which the last MPSC Division rate increase was resolved. Q. What is a billing determinant? A. A billing determinant is, in this context, the assumed level of weather-normalized usage by an average customer in the rate class. This figure is used to determine what rate would be sufficient to collect the revenue requirement, or costs of providing service, allocated to the customer class in the cost-of-service study sponsored by Mr. Raab. I think of this as determining the rate per unit of consumption, in this case in therms, times an assumed level of consumption, with the assumed consumption level serving as the billing determinant. Q. Why is selecting the right billing determinants important? A. If the assumed level of usage, or billing determinant, for a particular customer class is too high, a volumetric distribution rate will not produce the revenue allocated to the customer class and the utility will not recoup its costs of providing service. Similarly, if the billing determinant is too low, too much revenue will be collected from the customer class by the utility. Q. Why is selecting the right billing determinant so important now? A. Because, as depicted on Exhibit A-12, Schedule F-2, weather-normalized customer usage at SEMCO Gas has been declining, consistent with trends elsewhere in the country (as Mr. Raab points out in his testimony). The Commission should explicitly take this declining usage pattern into account in setting SEMCO Gas s revised base rates if the Company s preferred rate design is not approved. To me, there is a commonsense set of reasons for this decline in per customer usage. (Mr. Raab also discusses these reasons at length in his testimony.) Energy equipment and appliance efficiency has improved, partly as a result of changed 22

42 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company governmental standards. Consumers simply cannot buy the kinds of inefficient equipment and appliances that used to be available in the market. Similarly, new and rehabilitated homes and buildings have more insulation and more efficient windows and doors; they are constructed to have tighter thermal envelopes. In addition, the Michigan legislature enacted and the Governor signed Public Act 286 of 2008, which requires all utilities to implement energy optimization programs that will support the conservation of natural gas and thus, in my view, reinforce the declining usage trend. As discussed by Mr. Raab, higher natural gas prices also have prompted customers to conserve gas, including by dialing back their thermostats, closing off unused rooms, and using supplemental energy sources. Where such a pattern of declining use per customer exists, SEMCO Gas s revised base rates will not collect enough revenue to cover the cost of service during the rate effective period, unless the Commission ensures that the correct billing determinants are used to calculate those rates or severs rates from volumetric usage as proposed in this filing. Q. Please discuss the residential use per customer experienced by SEMCO Gas. A. In 2009, weather-normalized residential per customer usage for SEMCO Gas s customers was 94.1 Dekatherms ( Dth ). This is down from an average per customer usage of Dth per residential customer in 2005, or an average annual decline of approximately 2.3%. Q. What billing determinants does SEMCO Gas propose to use to calculate revised base rates if the Commission does not approve the usage level option? A. For residential customers, SEMCO Gas has proposed to use a billing determinant of 899 therms per year. While I highlight this proposed billing determinant in discussing this topic, billing determinants for all rate classes have been adjusted using the methodology discussed by Mr. Raab. Q. Are there additional factors that could effect this usage level? 23

43 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company A. Yes, as discussed by Mr. Raab, there are two factors that could effect the future billing determinant proposed in this case. The normal weather estimates that indicate that future weather could be warmer than even the 15-year normal weather would indicate and price elasticity impact or repression adjustment could reduce residential use per customer to approximately 821 therms for the forecasted test year which supports the use of a billing determinant at such level.special Transportation Contracts Q. Please explain the special transportation agreements that SEMCO Gas has entered into. A. As discussed in more detail by Mr. Lubbers, SEMCO Gas has entered into special transportation agreements with certain of its large volume transportation customers. Most of these customers are located in the Company s Battle Creek Division, and the current contracts provide for a discounted transportation rate relative to a traditional cost of service based rate. Q. What is SEMCO Gas proposing with respect to such discounted transportation rate? A. Mr. Lubbers supports the Company s position that the contracts meet the requirements prescribed by the Michigan legislature and that the discounts in the special transportation contracts should be recovered from the Company s other customers. Infra-structure Replacement Program Q. Please discuss the Company s proposal for an Infrastructure Replacement Program. A. The Company is proposing an Infrastructure Replacement Program ( IRP ) to support the accelerated replacement of unprotected metallic mains in service in the SEMCO Gas 21 system. As described in detail in Mr. Simone s testimony, the 25-year program proposed by the Company is intended to speed up the replacement of about 13 miles of unprotected steel and cast iron pipe per year. The program is intended to add to the miles of unprotected metallic pipe that are routinely replaced by the Company each year in conjunction with public improvement projects. A substantial benefit associated with this 24

44 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company program is the reduction in leaks that would result from these non-revenue producing improvements. The program costs are offset by leak-related savings. Q. Please describe the ratemaking proposal for this program. A. The Company is proposing that the capital-related costs (including return on investment, depreciation expense and property taxes) for the approximate annual $4 million investment in unprotected and bare steel be surcharged to the Company s customers on an annual basis. When subsequent rate cases are filed and the IRP capital investments are included in rate base, the portion of the surcharge associated with the capital-related costs of those capital investments will cease. Mr. Simone explains how the surcharge is calculated and administered throughout the IRP in his testimony. Dr. Fairchild discusses the capital-related costs for the program in his testimony, and Mr. Alger discusses the annual surcharge mechanism in his testimony. Service Valve Replacement Program Q. Please discuss the Company s Service Valve Replacement Program. A. As described in more detail in Mr. Simone s testimony, it is necessary for the Company to remove and replace approximately 40,000 service line riser valves purchased and installed in the 1980 s and 1990 s. SEMCO Gas has experienced some failures of these valves and is proposing to replace all of these valves by 2015, with the objective of eliminating the risks to employees, customers, and the public from these facilities. The Company is requesting the Commission approve the recovery of the costs associated with the Service Valve Replacement Program. Q. How much does the Company expect to expend for the replacement of the service valves? A. Mr. Simone s testimony supports the Company s forecast of additional operation and maintenance expenses of approximately $2.0 million per year for the period 2011 through 2015 for the Service Valve Replacement Program. 25

45 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Q. Is there anything else you wish to say about this valve replacement program? A. Yes. A lawsuit has been filed seeking recovery of the costs of the valve replacement program and other damages. To the extent that the Company is successful, by settlement or in trying the case, SEMCO Gas proposes to defer the proceeds from this lawsuit, net of legal fees and costs, so that the Commission can credit this sum to base rates at the next appropriate opportunity. Requested Rate of Return Q. Has the financial condition of SEMCO Gas improved since its last rate case? A. Yes. In 2004, SEMCO was rated below investment grade by major bond rating agencies and its financial position was precarious. In connection with SEMCO's acquisition by Continental in 2007, $100 million in additional equity was invested in the Company, which strengthened its balance sheet considerably. In April 2010, both Moody's and Standard & Poor's assigned investment grade ratings to SEMCO and its newly-issued senior debt. Q. What steps has SEMCO recently taken to ensure that it will continue to maintain a sound financial condition? A. Since 2007, the interest rate on SEMCO's debt has been variable, adjusting with changes in major short-term borrowing benchmarks. While this has been beneficial because of government actions keeping interest rates low to stimulate economic activity, I do not expect low interest rates to continue indefinitely. To lock in what appeared to be a favorable interest rate, SEMCO refinanced in April 2010 the majority of its variable rate debt, which was scheduled to mature in November 2014, and replaced it with $300 million in senior notes maturing in April 2020 that bear a fixed interest rate of 5.15%. Of course, another action being taken to maintain SEMCO's financial integrity is filing this case. Base rates should not lag rising costs and the necessary investments made to improve the SEMCO Gas system. In addition, the proposed single fixed monthly charge 26

46 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company rate design is intended to help SEMCO Gas maintain its sound financial condition going forward. Q. What rate of return is SEMCO Gas requesting in this case? A. SEMCO Gas is requesting an overall rate of return of 7.50%, which compares to the 7.75% authorized in Case No. U This reduction is largely the result of using SEMCO Gas's projected cost of debt, which is lower than the local distribution company (or "LDC") industry cost of debt used in the last general rate case. The requested rate of return is based on SEMCO Gas's actual capital structure, which is virtually identical that of the LDC industry, and includes an 11% return on equity. Q. Please comment on SEMCO Gas's requested 11% return on equity. A. From my perspective, SEMCO Gas is requesting that the currently-authorized return on equity of 11% be continued. The reasonableness of the requested 11% return on equity is supported by Dr. Fairchild. The 11% return on equity authorized SEMCO Gas in its last case, along with various steps taken by SEMCO Energy, Inc. has enabled it to make progress in regaining its financial health. To lower SEMCO Gas's authorized return on equity in this case would undermine that progress and hinder further improvement. The Commission recently recognized in Case No. U that gas utilities in Michigan face considerable economic challenges and that a sufficient return on equity is necessary to maintain investor confidence. It is my view that for SEMCO Gas to maintain its recently regained financial integrity, be able to attract capital on reasonable terms, and compete for capital with other utilities nationally and in Michigan, a return on equity of no less than 11% return is necessary. Proposed Therm-Based Billing 27

47 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company Q. Please discuss the Company s proposal to adopt therm-based billing for all classes of customers. A. As discussed by Mr. Alger, the Company currently bills all gas consumption in the Battle Creek Division and all transportation customers in the MPSC Division in therms, which is a measure of heat content. The Company is proposing to adopt therm-based billing for all those customers in the MPSC Division who are currently billed on a volumetric basis. Transactions throughout the natural gas industry, from the wellhead to the delivery of the gas to the local distribution company, are transacted in therms or dekatherms. Extending this practice to all SEMCO Gas customers will move them to the industry standard and ensure that they are billed for the heat content of the natural gas necessary to meet their requirements. Description of Continental Q. Please describe the positions held by the executive officers of Continental and their responsibilities. A. In addition to myself as President and Chief Executive Officer, there are three additional employees of Continental who serve in the following positions: Executive Vice President, Chief Operating Officer and Chief Financial Officer; Executive Vice President and General Counsel; and Senior Vice President, Human Resources and Administration. As executive officers of Continental, their responsibilities include not only the management of SEMCO Gas but also that of ENSTAR Natural Gas Company in Alaska and New Mexico Gas Company in New Mexico. Q. Do you and the other employees of Continental hold similar positions at SEMCO Gas? A. Yes. Although similar positions exist at SEMCO Gas, they are not held by other executives, thereby avoiding redundancy and duplication of costs. Q. Are there other cost benefits to such a structure? 28

48 Direct Testimony of George A. Schreiber, Jr. On Behalf of SEMCO Energy Gas Company A. Yes, since the Continental executives also have responsibilities for companies other than SEMCO Gas, the costs for their services are allocated to the other companies, thereby minimizing the costs to SEMCO Gas. Q. Does this complete your direct testimony at this time? A. Yes, it does. 29

49 Attachment 1 Case No. U George A. Schreiber, Jr. EMPLOYMENT HISTORY President and Chief Executive Officer Continental Energy Systems, Troy, MI November 2007 to Present Member of the Board of Managers of Continental Energy Systems Chairman and Member of the Board of Directors of SEMCO Energy, Inc. President and Chief Executive Officer of SEMCO Energy, Inc. Member of the Board of Directors of Energy Conversion Devices, Inc. Member of the Board of Directors of the American Gas Association President and Chief Executive Officer SEMCO Energy, Inc., Port Huron, MI March 2004 to November 2007 Member of the Board of Directors of SEMCO Energy, Inc. Member of the Board of Directors of American Gas Association Chairman, Global Energy Group Credit Suisse First Boston, New York, NY September 1999 to March 2004 President Pinnacle West Capital Corp, Phoenix, AZ February 1997 to August 1999 Member of the Board of Directors of Arizona Public Service Company Member of the Board of Directors of Pinnacle West Capital Corporation Managing Director and Group Head of Infrastructure Finance PaineWebber, New York, NY February 1990 to January 1997 Director and Group Head, Utilities and Telecommunications Group The First Boston Corporation, New York, NY February 1987 to January 1990 Vice President and Stockholder Kidder Peabody & Co., New York, NY , Manager Regulatory Affairs Arizona Public Service Company, Phoenix, AZ Associate, Corporate Finance Division The First Boston Corporation, New York, NY EDUCATION BS, Arizona State University, 1970 MBA, Arizona State University, 1971 College of Business Hall of Fame Inductee, Arizona State University, 2000

50 STATE OF MICHIGAN BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION ***** In the matter of the application of ) SEMCO ENERGY GAS COMPANY ) to combine its MPSC Division and ) Battle Creek Division rates and for ) Case No. U authority to redesign and increase ) its rates, on a combined basis, for ) the sale and transportation of ) natural gas and for other relief. ) DIRECT TESTIMONY AND EXHIBITS OF BRUCE H. FAIRCHILD ON BEHALF OF SEMCO ENERGY GAS COMPANY June 2010

51 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company I. INTRODUCTION 1 2 Q. Please state your name and business address. A. Bruce H. Fairchild, 3907 Red River, Austin, Texas Q. By whom are you employed and in what position? A. I am a principal in Financial Concepts and Applications, Inc. ( FINCAP ), a firm engaged in financial, economic, and policy consulting to business and government. A. Qualifications Q. Describe your educational background, professional qualifications, and prior experience. A. I hold a BBA degree from Southern Methodist University and MBA and PhD degrees from the University of Texas at Austin. I am also a Certified Public Accountant. My previous employment includes working in the Controller's Department at Sears, Roebuck and Company and serving as Assistant Director of Economic Research at the Public Utility Commission of Texas ( PUCT ). I have also been on the business school faculties at the University of Colorado at Boulder and the University of Texas at Austin where I taught undergraduate and graduate courses in finance and accounting Q. Briefly describe your experience in utility-related matters. A. While at the PUCT, I assisted in managing a division comprised of approximately twenty-five professionals responsible for financial analysis, cost allocation and rate design, economic and financial re- 1

52 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company search, and data processing systems. I testified on behalf of the PUCT staff in numerous cases involving most major investor-owned and cooperative electric, telephone, and water/sewer utilities in the state on a variety of financial, accounting, and economic issues. Since forming FINCAP in 1979, I have participated in a wide range of analytical assignments involving utility-related matters on behalf of utilities, industrial consumers, municipalities, and regulatory commissions. I have also prepared and presented expert witness testimony before a number of regulatory authorities addressing revenue requirements, cost allocation, and rate design issues involving gas, electric, telephone, and water/sewer service. I have been a frequent speaker at regulatory conferences and seminars and have published research concerning various regulatory issues. A resume that contains the details of my experience and qualifications is attached as Attachment A, with Attachment B listing my prior testimony before regulatory agencies since leaving the PUCT. B. Overview Q. What is the purpose of your testimony? A. The purpose of my testimony is to sponsor a number of the schedules for the base rate filing being submitted by SEMCO Energy Gas Company ( SEMCO Gas ) to the Michigan Public Service Commission (the MPSC or Commission ). In addition, I will sponsor several adjustments to rate base and operating expenses, recommend a rate of return on rate base, and develop a capital carrying cost for use in SEMCO Gas s proposed Infrastructure Replacement Program ( IRP ). 2

53 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. Please summarize the basis of your knowledge and conclusions concerning the issues on which you are testifying in this case. A. In preparing my analyses and testimony in this case, I utilized a variety of sources of information that would normally be relied upon by a person in my capacity. I am generally knowledgeable about the natural gas industry from my prior work with many of the major gas distribution and transmission companies in the Southwest and elsewhere in the U.S. I am generally familiar with the organization, finances, and operations of SEMCO Energy, Inc. ( SEMCO ) from my participation in SEMCO Gas s last three rate cases before the Commission (Case Nos. U-13575, U-14338, and U-14893) and previous work with 12 SEMCO s Alaskan utilities (collectively ENSTAR ). In connection with the present filing, I reviewed and relied on a variety of accounting and financial data from the books and records of SEMCO Gas and SEMCO, and had extensive conversations with management in the course of preparing this filing. In addition, I examined information regarding capital markets generally and current investor perceptions, requirements, and expectations for gas utilities specifically. These sources, coupled with my experience in the fields of finance, accounting, economics, and utility regulation, enabled me to acquire a working knowledge of SEMCO Gas and formed the basis for my conclusions. 3

54 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. What time periods served as the basis for SEMCO Gas s rate filing? A. Section A of this filing is based on actual experience during the historical year ended December 31, Section B is predicated on a projected year ended December 31, II. SECTION A Q. Please describe Section A of SEMCO Gas s filing. A. Section A reflects the results of SEMCO Gas s Michigan utility operations (including both its MPSC Division and Battle Creek Division) for the twelve months ended December 31, 2009 using the Commission s standardized filing requirements. All of the information shown in this portion of the filing omits adjustments to normalize data, eliminate non-recurring items, account for known and measurable changes, and, except for interest synchronization, reflect other regulatory conventions. Accordingly, while Section A provides historical per books data that serves as the starting point for evaluating existing base rates, SEMCO Gas s proposed base rates are ultimately determined using the data and information contained in Section B of the rate filing for the projected year ended December 31, Q. Which schedules in Section A of SEMCO Gas s filing are you sponsoring? A. I am sponsoring following schedules for the historical year ended December 31, 2009: 4

55 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Exhibit Schedule Title Exhibit A-1 Schedule A-1 Revenue Deficiency Schedule A-2 Revenue Multiplier Schedule A-3 Comparative Earnings Schedule Exhibit A-2 Schedule B-1 Average Rate Base and Capital Schedule B-2 Rate Base Average Net Utility Plant Schedule B-3 Rate Base Balance Sheet Working Capital Exhibit A-3 Schedule C-1 Adjusted Net Operating Income Schedule C-2 Net Income Schedule C-3 Interest Synchronization Schedule C-4 JD ITC Adjustment Exhibit A-4 Schedule D-1 Overall Rate of Return Summary Schedule D-2 Cost of Long-term Debt Schedule D-3 Cost of Short-term Debt Schedule D-4 Cost of Preferred Stock Schedule D-5 Cost of Common Equity Schedule D-6 Financial Metrics Financial Basis Schedule D-7 Financial Metrics Ratemaking Basis All of these schedules were prepared by me from the books, records, and MPSC Annual Reports of SEMCO Gas s MPSC and Battle Creek Divisions. Except for the last two schedules, which were added to comply with the Commission s order in Case No. U-15895, the other schedules are the same as those included in Section A of SEMCO Gas s last three rate cases. 5

56 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. What were the results of the unadjusted historical data contained in the various Section A schedules? A. As shown on Schedule A-1 of Exhibit A-1, based on the rate of return on equity ( ROE ) approved in its last general rate case of 11%, SEMCO Gas s current rates are deficient by $4,886,677 on an annual basis. Again, this historical year deficiency is based on data that has not been adjusted for normal conditions, does not reflect projected levels of revenues, investment, and operating expenses, and does not incorporate other regulatory conventions necessary to determine proper prospective base rates for SEMCO Gas. III. SECTION B Q. Briefly describe Section B of SEMCO Gas s rate filing? A. In Section B, SEMCO Gas s results of operations for the projected year ended December 31, 2011 are developed. These schedules incorporate adjustments and projections for the period when rates will become effective and serve as the basis for SEMCO Gas s proposed base rates Q. Which schedules in Section B are you sponsoring? A. I am sponsoring, in whole or in part, the following exhibits and schedules, all of which are for the projected year ended December 31, 2011: 6

57 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Exhibit Schedule Title Exhibit A-7 Schedule A-1 Revenue Deficiency Schedule A-2 Comparison of Revenue Deficiency Schedule A-3 Reconciliation of Rev. Deficiency Exhibit A-8 Schedule B-1 Rate Base Schedule B-2 Utility Plant Schedule B-3 Accumulated Depreciation Schedule B-4 Balance Sheet Working Capital Exhibit A-9 Schedule C-1 Net Operating Income Schedule C-2 Revenue Multiplier Schedule C-3 Revenues Schedule C-4 Cost of Gas Sold Schedule C-5 Operation & Maintenance Exp. Schedule C-6 Depreciation & Amortization Exp. Schedule C-9 Federal Income Taxes Schedule C-10 Interest Synchronization Schedule C-11 Net Operating Income Adjustments Exhibit A-10 Schedule D-1 Overall Rate of Return Schedule D-2 Cost of Long-term Debt Schedule D-3 Cost of Short-term Debt Schedule D-4 Cost of Preferred Stock Schedule D-5 Cost of Common Equity Schedule D-6 Credit Ratings Schedule D-8 Financial Metrics Schedule D-9 Capital Structure Schedule D-10 DCF Model - Dividend Yield Schedule D-11 DCF Model - Earnings Growth Rates Schedule D-12 DCF Model Sustainable Growth Schedule D-13 DCF Model Other Growth Rates Schedule D-14 Capital Asset Pricing Model Schedule D-15 Risk Premium Method Schedule D-16 Comparable Earnings Method Schedule D-17 IRP Capital Charge Rate 7

58 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. What are the results of Section B? A. As shown on Exhibit A-7, Schedule A-1, after incorporating the various adjustments described by me and other witnesses and reflecting my recommended overall rate of return of 7.50%, SEMCO Gas s current rates are deficient by $19,847,589. This revenue deficiency was calculated by comparing the income required, calculated by multiplying SEMCO Gas s requested rate base times its requested rate of return, with its adjusted net operating income under current rates, and then grossing up the income deficiency by a revenue multiplier. Schedules A-2 and A-3 of Exhibit A-7 compare and reconcile, respectively, SEMCO Gas s requested base rate increase using the projected year ended December 31, 2011 with the results of operations for the historical year ended December 31, C. Exhibit A Q. What is the purpose of Exhibit A-8? A. SEMCO Gas s 2011 rate base is developed in Exhibit A-8, with Schedules B-1, B-2, B-3, and B-4 summarizing projected total 2011 rate base, 2011 utility plant, 2011 accumulated depreciation, and 2011 working capital, respectively Q. Please describe how projected 2011 utility plant in service was determined. A. Developed on Exhibit A-8, Schedule B-2, projected 2011 utility plant was calculated as the average of projected year-end 2010 and 2011 utility plant. Beginning with the 13-month average 2009 utility plant 8

59 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company from Section A (Exhibit A-2, Schedule B-2), the first step was to move average 2009 plant forward to year-end 2009 balances and include construction work in progress ( CWIP ) that had been placed in service by year-end Next, the 2010 capital additions described by Mr. Simone were added and projected 2010 plant retirements were removed. Finally, 2010 manufactured gas plant (MGP) environmental investigation and remediation expenditures, which are also discussed by Mr. Simone, were added to arrive at a projected 2010 year-end utility plant balance of $612,591,645. A similar process was followed to calculate 2011 year-end utility plant, with 2011 capital additions and 2011 MGP expenditures being added and retirements being subtracted from the projected 2010 plant balance. The resulting projected 2011 year-end plant balance of $636,141,602 was then averaged with the projected 2010 year-end plant balance of $612,591,645 to arrive at a projected 2011 average utility plant in service balance of $624,366, Q. How was projected 2011 accumulated depreciation determined? A. Projected 2011 accumulated depreciation is developed on Exhibit A-8, Schedule B-3 and, like utility plant, was calculated as the average of projected year-end 2010 and 2011 accumulated depreciation. Again the 13-month average 2009 accumulated depreciation from Section A (Exhibit A-2, Schedule B-2) served as the starting point. After moving average 2009 accumulated depreciation to year-end 2009, 2010 depreciation expense on utility plant and amortization on 2009 MGP expenditures were added and amounts associated with retirements were 9

60 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company removed to arrive at a projected 2010 year-end accumulated depreciation balance of $269,252,412. This 2010 year-end balance was then moved forward to year-end 2011 by adding 2011 depreciation expense on utility plant and amortization on 2009 and 2010 MGP expenditures and subtracting retirements. Averaging the resulting 2011 year-end accumulated depreciation of $285,603,352 with the 2010 year-end balance of $269,252,412 produced a projected 2011 average accumulated depreciation balance of $277,427, Q. How was projected 2011 working capital determined? A. SEMCO Gas s projected 2011 working capital requirements were based on those developed in Section A (Exhibit A-2, B-3) for the historical year ended December 31, 2009, adjusted for the projected decrease in the level of investment in gas stored underground. Described in the testimony of Mr. Van Sickle, the projected 2011 average balance of gas stored underground is $48,039,111, which results in SEMCO Gas s projected 2011 working capital requirements being $72,879,879 (Exhibit A-8, Schedule B-4) Q. What, then, is SEMCO Gas s projected 2011 rate base? A. As summarized on Exhibit A-8, Schedule B-1, combining projected 2011 utility plant in service of $624,366,623 with CWIP, calculated as the average 2009 balance less that transferred to plant by year-end 2009, produced total utility plant of $630,464,691. From this total, projected 2011 accumulated depreciation was subtracted along with the average 2009 balance of customer advances and asset retirement 10

61 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company obligation ( ARO ) liabilities to arrive at net utility plant of $349,113,600. Projected 2011 working capital of $72,879,879 was added to this amount to produce SEMCO Gas s projected 2011 rate base of $421,993,479. D. Exhibit A Q. What is the purpose of Exhibit A-9? A. Exhibit A-9 develops SEMCO Gas's adjusted net operating income for 2011, which is compared to its required income (computed as rate base times rate of return) on Exhibit A-7, Schedule A-1 to determine SEMCO Gas s income deficiency and, in turn, revenue deficiency Q. Please describe Exhibit A-9, Schedule C-1. A. Exhibit A-9, Schedule C-1 is the summary schedule that combines projected 2011 revenues and expenses to calculate 2011 adjusted net operating income at current rates. Details underlying the revenues and expenses shown there are contained in Exhibit A-9, Schedules C- 1 through C Q. What is shown on Exhibit A-9, Schedule C-3? A. Exhibit A-9, Schedule C-3 develops projected 2011 revenues at current rates, broken down between Sales Revenues, Transportation Revenues, and Other Revenues. In each instance, historical experience during 2009 from Section A (Exhibit A-1, Schedule A-2) served as the starting point, with adjustments then being made to arrive at projected 2011 revenues. Except for the Bill Proration" adjustment that I sponsor, the other adjustments to Sales and Transportation 11

62 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Revenues are described in the testimonies of Mr. Alger and Mr. Van Sickle. The adjustments to Other Revenues are sponsored by Mr. Moses Q. What is the Bill Proration adjustment on Exhibit A-9, Schedule C-3? A. For customers discontinuing and initiating service, SEMCO Gas s cur- rent practice is to bill each a full month s service charge during the 7 month service is transferred. Although this practice can be cost justified because of the additional costs associated with reading meters off regular cycle, revising accounts, and issuing final bills, SEMCO Gas is proposing to prorate the monthly customer charge between old and new customers going forward. In my experience, this is what most other utilities do. If this change in billing practices is approved, based on 2009 experience and current monthly service charges, SEMCO Gas s revenues would be reduced by $600,809 per year Q. Please describe Exhibit A-9, Schedule C-4. A. The purpose of this schedule is to separate SEMCO Gas s historical 2009 total Cost of Gas into two amounts: 1) those recovered through the Gas Cost Recovery ( GCR ) process, and 2) those included in base rates as lost and unaccounted-for ( LAUF ) and company-use gas. In the upper portion of the schedule, LAUF and company-use gas during 2009 was removed from SEMCO Gas s 2009 cost of gas. No other adjustments were made to the resulting 2009 cost of gas because gas costs are recovered separately through SEMCO Gas s GCR 12

63 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company and not included in the base rates being reviewed in this case. Next, 2009 historical 2009 LAUF and company-use gas was adjusted to the projected 2011 level developed by Mr. Van Sickle. As is the practice in Michigan, this adjusted amount was then included in the calculation of base rates Q. Is there any portion of Exhibit A-9, Schedule C-5 that your are sponsoring? A. Yes. Mr. Moses describes and discusses the components of SEMCO Gas s projected 2011 Other Operating and Maintenance Expenses. However, because projected 2011 Uncollectible Accounts is a function of the projected 2011 revenues, which include SEMCO Gas s requested rate increase, I will describe the calculation of that expense. As shown in footnote (b) of Exhibit A-9, Schedule C-5, projected 2011 Gas Sales Revenues at current rates, based on projected 2011 sales volumes and 2011 cost of gas, total $349,195,369. Adding to this amount projected 2011 Transportation Revenues of $10,005,219, Other Revenues of $8,067,520, and SEMCO Gas s requested rate increase of $19,847,589 produced total projected 2011 revenues of $387,115,735. For the reasons discussed by Mr. Moses, the 3-year average uncollectible expense ratio of % was applied to calculate projected 2011 Uncollectible Accounts expense of $2,959, Q. What is shown on Exhibit A-9, Schedule C-6? A. Exhibit A-9, Schedule C-6 develops projected 2011 Depreciation and Amortization Expense. Beginning with depreciation expense for the 13

64 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company historical year 2009, that associated with SEMCO Gas s 2009 utility plant was removed and replaced with projected 2011 depreciation expense on 2011 utility plant. As discussed by Mr. Warsinske, projected 2011 depreciation expense on utility plant was calculated by applying the depreciation rates approved by the Commission in Case No. U for the MPSC and Battle Creek Divisions to the average of each division s projected 2010 and 2011 year-end plant balances. Next, amortization expense on the 2009 and 2010 MGP expenditures was added, with the amortization of 1999 and 2000 MGP expenditures being removed because they will have been fully amortized in As shown at the bottom of Exhibit A-9, Schedule C-6, this series of calculations resulted in projected 2011 Depreciation and Amortization Expense of $19,284, Q. Please describe Schedules C-7 and C-8 of Exhibit A-9. A. Exhibit A-9, Schedule C-7 develops projected 2011 Taxes Other than Income and is sponsored by Mr. Moses. Exhibit A-9, Schedule C-8 is sponsored by Mr. Warsinkse and calculates the projected 2011 Michigan Business Tax ( MBT ) Expense. The MBT is based not only on taxable income, but also includes a gross receipts tax component, tax credits, and a surcharge. Accordingly, the income tax portion of the 2011 projected MBT was calculated based on projected 2011 revenues at current rates less the projected 2011 expenses developed in Exhibit A-9, Schedules C-3 through C-7 and allowable interest expense calculated as rate base times the weighted cost of debt. The other components of the MBT were based on applicable projected 14

65 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company amounts. The details of the projected 2011 MBT are presented on Exhibit A-9, Schedule C-8. As shown there, projected MBT Ex- pense at current rates totals $1,574, Q. What is shown on Exhibit A-9, Schedule C-9? A. Exhibit A-9, Schedule C-9 shows the calculation of projected 2011 Federal Income Taxes at current rates. Federal Income Taxes were computed by applying the corporate income tax rate of 35% to projected 2011 taxable income. Projected 2011 taxable income was calculated based on projected 2011 revenues at current rates less the projected 2011 expenses (Exhibit A-9, Schedules C-3 through C-7), less projected 2011 MBT Expense from Exhibit A-9, Schedules C-8, allowable interest expense calculated as rate base times the weighted cost of debt, and permanent timing differences. As shown at the bottom of Exhibit A-9, Schedule C-9, projected 2011 Federal Income Taxes total $5,637, Q. What is the end-result of the various calculations shown on Schedules C-3 through C-9 in Exhibit A-9 described above? A. The projected 2011 revenues from Exhibit A-9, Schedule C-3 and projected 2011 expenses from Exhibit A-9, Schedules C-4 through C-9 are summarized on Exhibit A-9, Schedule C-1. Because MBT Expense and Federal Income Taxes were calculated using allowable interest expense, an adjustment for interest synchronization is not required. As shown there, SEMCO Gas s projected 2011 net operating income at current rates is $19,653,

66 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. What is the purpose of Exhibit A-9, Schedules C-10 and 11? A. Schedules C-10 and C-11 of Exhibit A-9 calculate projected 2011 net operating income in a slightly different manner than was done on Schedules C-1 through C-9. In particular, changes to individual items in the historical year 2009 to reflect projected 2011 amounts are taxadjusted using marginal MBT and federal income tax rates, with the tax effect (i.e., the difference between Section A allowable interest expense and projected 2011 allowable interest expense) being calculated on Exhibit A, Schedule C-10. Because the MBT is not based solely on income, the method of calculating projected 2011 operating income on Exhibit A-9, Schedule C-11 is different from that calculated on Exhibit A-9, Schedule C-1 by about $90,000. SEMCO Gas s requested base rate increase of $19,847,589 is calculated using projected 2011 operating income of $19,653,504 developed on Exhibit A- 9, Schedule C-1. E. Exhibit A Q. What is the purpose of Exhibit A-10? A. Exhibit A-10 develops a fair rate of return to apply to SEMCO Gas s rate base. This overall rate of return is calculated using the Commission s balance sheet approach Q. What rate of return do you recommend be used to establish SEMCO Gas s rates? A. As reflected in column 8 of Exhibit A-10, Schedule D-1, I recommend that SEMCO Gas be authorized an overall rate of return of 7.50%. 16

67 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company This rate of return is based on investor-supplied capital ratios of 44.85% debt and 55.15% common equity, an average cost of debt of 5.17%, and an ROE of 11.00%. It is also based on non-investor supplied capital consisting of customer deposits having a 7% cost and deferred income taxes having a zero cost. There are no job development investment tax credits ( JDITC ) in SEMCO Gas s capital structure because they have been fully amortized. Support for this capital structure and the component capital costs is contained in the next section of my testimony Q. Please describe Schedules D-6 through D-8 of Exhibit A-10. A. Exhibit A-10, Schedules D-6 through D-8, present some of the additional information specified in the Commission s order in Case No. U In particular, Exhibit A-10, Schedule D-6 provides SEMCO s current and historical credit ratings, Schedule D-7 provides information on recent utility bond issuances and is sponsored by Mr. Moses, and Schedule D-8 develops financial metrics with and without SEMCO Gas s requested rate relief. IV. RATE OF RETURN Q. How did you go about developing your recommended rate of return for SEMCO Gas? A. My evaluation began with a brief review of the operations and finances of SEMCO Gas and general conditions in the natural gas industry and capital markets. I then developed a mix of capital for use in calculating an overall rate of return using the Commission s bal- 17

68 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company ance sheet approach. Costs applicable to debt and non-investor sup- plied capital were then determined and various analyses were con- ducted to estimate the cost of equity to a group of local natural gas 4 distribution companies ( LDCs ). This industry cost of equity was then evaluated in light of the specific circumstances of SEMCO Gas and the present filing. Finally, the findings of these various analyses were combined to calculate an overall rate of return to be applied to SEMCO Gas s rate base Q. What is the role of the rate of return in setting a utility's rates? A. Rate of return generally serves to compensate investors for the use of their capital to finance the plant and equipment necessary to provide utility service. Investors only commit money in anticipation of earning a return on their investment commensurate with that from other investment alternatives having comparable risks. Consistent with both sound regulatory economics and the standards specified in the U.S Supreme Court cases of Bluefield Water Works & Improvement Co. (1923) and Hope Natural Gas Co. (1944), the return on investment allowed a utility must be sufficient to: 1) fairly compensate capital presently invested in the utility, 2) enable the utility to offer a return adequate to attract new capital on reasonable terms, and 3) maintain the utility's financial integrity. 18

69 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company A. Operations and Finances Q. Briefly describe SEMCO Gas. A. As indicated earlier, SEMCO Gas presently consists of two divisions of SEMCO the MPSC Division and the Battle Creek Division that distribute and transport natural gas to approximately 285,000 customers in Michigan. SEMCO also has natural gas utilities in Alaska the ENSTAR Natural Gas Company Division and Alaska Pipeline Company subsidiary that serve some 131,000 customers in the Cook Inlet area around Anchorage. SEMCO also owns and operates relatively small businesses involved in propane distribution, intrastate pipelines, and a natural gas storage facility. At December 31, 2009, SEMCO had total assets of approximately $1.1 billion and its 2009 revenues totaled some $719 million Q. How does SEMCO Gas compare with Michigan s other major gas distribution companies? A. SEMCO Gas s 285,000 customers make it the third largest gas company in the state, but it is considerably smaller than either Consumers Energy ( Consumers ), which serves 1.7 million gas customers, and Michigan Consolidated Gas Company ( MichCon ), which has 1.3 million gas customers. This difference in size is also evident in SEMCO Gas s 2009 gas revenues of approximately $376 million versus Consumer s $2.6 billion and MichCon s $1.8 billion, and SEMCO Gas s approximately $600 million in assets versus Consumer s and Mich- Con s gas assets of $4.6 billion and $3.9 billion, respectively. 19

70 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 1 2 Whereas Consumers and MichCon both have electric utility affiliates, SEMCO does not have electric utility operations Q. Where does SEMCO Gas obtain the capital used to finance its investment in property, plant, and equipment? A. SEMCO Gas s capital is provided by SEMCO, which is a privately owned company. While its stock was previously publicly traded on the New York Stock Exchange ( NYSE ), all of SEMCO s outstanding common and preferred stock was purchased in November 2007 by SEMCO Holdings, Inc., which is a subsidiary of Continental Energy Systems, LLC ( Continental ). Continental is owned by affiliates of private equity firm Lindsay Goldberg LLC. At December 31, 2009, SEMCO s balance sheet reflected approximately $400 million in common equity and $350 million in long-term debt. Most of this debt was in the form of a variable rate, secured term loan, the majority of which was refinanced in April 2010 with $300 million in senior secured notes bearing a fixed interest rate of 5.15%. In connection with this refinancing, the two major bond rating agencies -- Moody's Investor Services ( Moody's ) and Standard & Poor's Corporation ( S&P ) -- assigned SEMCO corporate ratings of Baa2 and BBB-, respectively, and rated the senior notes A3 and BBB+, respectively. 20

71 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company B. Natural Gas Utility Industry Q. Please describe conditions in the gas industry over the last two decades. A. Beginning in approximately 1980, the natural gas industry was buffetted by decreasing demand and prices, a gas glut, an ever-changing federal regulatory environment, and increased competition among in- 6 dustry participants and with other fuels. These developments spawned striking structural changes, not only within the pipeline segment of the industry but for LDCs as well. At least initially, this process was largely driven by regulatory changes at the federal level, with the Federal Energy Regulatory Commission ( FERC ) promoting greater competition in markets for wholesale energy supply. While FERC made the natural gas industry more competitive and broadened the market for gas supplies through its Order Nos. 436, 500, and 636, this dramatic restructuring also introduced considerable uncertainties and dislocations felt heavily by conventional utility systems. These structural changes on both the demand and supply sides eroded gas utilities' traditional monopoly status, with both pipelines and LDCs experiencing "bypass" as large commercial, industrial, and wholesale customers sought to acquire gas supplies at the lowest possible cost and, in the process, abandoned traditional "full-service" utility suppliers. (Mr. Lubbers discusses the bypass threats faced by SEMCO Gas and the special transportation contracts put in place to retain contributions to fixed cost recovery from these customers). LDCs have had to confront new complexities and risks entailed in ac- 21

72 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 1 tively contracting for an economical, secure gas supply. Further, changes in transportation rate design mandated by FERC Order No. 636 shifted greater cost responsibility for pipeline demand costs to low load factor customers and, particularly, to LDCs who purchase transportation services from interstate pipelines. Coupled with an increasingly competitive market environment, the end-result of these structural changes is that LDCs face greater business risks than in the past Q. What other factors are of concern to investors? A. LDCs and their customers have had to contend with dramatic fluctuations in gas costs due to extraordinary price volatility in gas markets. Besides discouraging potential customers from choosing natural gas, causing certain existing users to substitute alternative fuels, and leading to decreased customer usage, volatile natural gas prices have increased the risks of investing in natural gas distribution utilities and placed additional pressure on their bond ratings. In addition, recent state conservation mandates have accelerated, or soon will likely accelerate, the trend of declining use per customer, which is discussed by other SEMCO Gas witnesses Q. Does this exposure highlight the need for ongoing support of a gas utility s financial strength and ability to attract capital? A. Yes. Given the significant volatility in natural gas markets and a utility s lack of control over market prices for gas, LDCs must have the financial wherewithal to weather the uncertainties caused by unfavor- 22

73 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 1 able energy market conditions. Because of investors heightened 2 3 awareness of the risks associated with higher and more volatile gas prices, supportive regulation remains crucial in preserving gas utili- 4 ties financial integrity and access to capital. In Regulation and Credit Quality in the U.S. Utility Sector, RatingsDirect (January 30, 2003), S&P noted that: When examining the quality of regulation, Standard & Poor s factors in what level of support the utility might get in times of distress, when its needs are most acute. In Prolonged High Natural Gas Prices May Increase Credit Risk For U.S. Gas Distribution Companies, RatingsDirect (January 17, 2006), S&P subsequently stated that regulatory decisions have become a dominant factor in their assessment of credit quality and concluded that [c]ontinued regulatory support is paramount to credit quality for LDCs, especially during periods of prolonged high natural gas prices Q. What other risks are faced by natural gas distribution utilities, such as SEMCO Gas? A. Although utilities may have fared somewhat better during the recent recession than their counterparts in the unregulated sector, they have not been immune to the global and domestic economic slowdowns. As described by The Value Line Investment Survey (Value Line) in its June 11, 2010 discussion of the Natural Gas Utility industry: The macroeconomic climate continues to pressure this group. The dormant construction sector, reduced industrial demand, and unfavorable gas prices have hurt results in recent months. Weakness in the housing market has also weighed on demand in this industry. Indeed, new customer growth has been uninspiring of late. And 23

74 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company existing customers are increasingly focusing on conservation, further dampening this sector s performance. Moreover, bill collection will likely continue to be challenging due to weak household income. (p. 445) LDCs, such as SEMCO Gas, continue to face the same ongoing challenges and risks that have confronted them in the past, including those related to inflation, weather, rate regulation, declining customer usage, growth in required capital expenditures, non-rate regulatory changes, tax law changes, environmental laws and regulations, operating hazards, general economic conditions, and capital market changes, as well as extraordinary risks such as legal liabilities and natural disasters. C. Capital Markets Q. What has been the pattern of interest rates over the last two decades? A. Average long-term public utility bond rates, the monthly average prime rate, and inflation as measured by the Consumer Price Index (CPI) since 1990 are plotted in the graph below. After rising to approximately 10% in mid-1990, the average yield on long-term public utility bonds generally fell because of monetary and fiscal policies designed to keep the economy growing. This ended abruptly with the 2008 financial market meltdown and global recession. Investors became exceedingly risk averse, causing interest rates on corporate bonds to spike, while government policies pushed down the prime rate and depressed economic conditions and lower energy prices reduced inflation: 24

75 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Average Public Utility 8 Percent 6 Prime Rate Inflation J-90-2 J-92 J-94 J-96 J-98 J-00 J-02 J-04 J-06 J-08 J Q. How has the market for common equity capital performed? A. Between 1990 and early 2000, stock prices climbed steadily higher as the longest bull market in United States history continued unabated. In mid-2000, mounting concerns over prospects for future growth, particularly for firms in the high technology and telecommunications sectors, pushed equity prices lower, in some cases precipitously. Common stock prices then generally recovered and reached record highs, buoyed in large part by widespread acquisition activity, until the capital market crisis and global recession hit in Stock prices tumbled by some 40% in 2008, and although 2009 and 2010 have seen a partial recovery, the market remains volatile, with share values routinely changing in full percentage points during a single day s trading. The graph below plots the performances of the Dow-Jones Industrial Average, the S&P 500, and the Dow Jones Utility Average since 1990 (the latter two indices were scaled for comparability): 25

76 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 16,500 14,500 12,500 S&P 500 (x10) Index 10,500 8,500 6,500 DJIA 4,500 2,500 DJUA (x10) 500 J-90 J-92 J-94 J-96 J-98 J-00 J-02 J-04 J-06 J-08 J Q. What is the outlook for the U.S. economy? A. While there are signs that the U.S. economy is beginning to recover from the recession, unemployment is at record highs, business and consumer spending remains cautious, and economic activity is guarded. There are questions whether the federal stimulus package is having its desired effects and whether the government s bailout and restructuring of the financial and auto industries will succeed (this especially affects Michigan, where SEMCO Gas operates). Indeed, the outlook remains tenuous, with persistent stock and bond price volatility providing tangible evidence of the uncertainties faced by the U.S. economy Q. How do these economic uncertainties affect LDCs? A. Uncertainties over an economic recovery heighten the risks faced by LDCs, which, as described earlier, already face a variety of operating and financial challenges. Current levels of unprecedented federal deficit spending portend higher inflation and interest rates, which will 26

77 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company place additional pressure on existing rates for utility service. Meanwhile, more volatile energy prices not only have a negative impact on utilities but the general economy as well. The capital markets continue to be in a state of turmoil, adversely affecting both the availability and cost of debt and equity that utilities rely on to fund their capital spending requirements. Overshadowing everything, the U.S. and global economies remain precarious, which only increases the risks faced by the natural gas industry, including LDCs. D. Capital Structure Q. What is the purpose of this section of your testimony? A. This section develops a mix of capital for use in calculating an overall rate of return using the Commission s balance sheet approach. Initially, my testimony discusses the implications of capital structure on rate of return, and then it examines the capital structure ratios maintained by SEMCO Gas, SEMCO, and other gas companies. Based on these analyses, a mix of capital is developed for use in weighting the respective cost of each source of capital to arrive at an overall rate of return Q. What is the role of capital structure in setting a utility's rate of return? A. Capital structure reflects the mix of capital used to finance a utility s assets. The proportions of total capitalization attributable to each source of capital are typically used to weight the costs of investorsupplied capital (e.g., debt and common equity) and, where the balance sheet approach is used to determine rate base, non-investor- 27

78 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 1 2 supplied capital (e.g., customer deposits and deferred taxes) in calcu- lating an overall rate of return Q. Why does this weighting matter? A. The capital structure ratios determine how much weight is given to a particular source of capital. For investor-supplied capital, because the cost of debt and the rate of return on common equity are not the same, this affects the weighted average cost, or overall rate of return, of all sources of capital Q. How does the use of greater amounts of debt affect the rates of return required by investors? A. A higher debt ratio, or lower common equity ratio, translates into increased financial risk for all investors. A greater amount of debt, and preferred stock, means more investors have a senior claim on available cash flow, thereby reducing the certainty that each will receive his contractual payments. This, in turn, increases the risks to which lenders and preferred stockholders are exposed, and they require correspondingly higher rates of interest and dividends, respectively, for their risk bearing. From common shareholders' viewpoint, higher debt and preferred stock ratios mean that there are proportionately more investors ahead of them in terms of their claims on cash flow (and assets), thereby increasing the uncertainty as to the amount of cash flow, if any, that will remain. Again, in accordance with the fundamental risk-return trade-off principle to be discussed in greater detail later, common shareholders require a correspondingly higher rate of 28

79 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 1 2 return to compensate them for bearing the greater financial risk asso- ciated with a lower common equity ratio Q. What sources of investor-supplied capital are used to finance SEMCO Gas? A. The capital supplied by SEMCO to finance SEMCO Gas s investment in assets used to provide utility service is recorded as debt and equity on the books of the MPSC and Battle Creek Divisions. As developed in Section A, Exhibit No. A-4, Schedule D-1, the combined 13-month average investor-supplied capital recorded on the MPSC and Battle Creek Divisions books during 2009 was as follows (thousands): Capital Component Amount % Long-term Debt $ 204, % Common Equity 251, % Total $ 456, % Q. How do these 2009 average capital structure ratios for SEMCO Gas compare with those of SEMCO? A. At December 31, 2009, SEMCO s permanent capital structure was as follows (thousands): Capital Component Amount % Long-term Debt $ 349, % Common Equity 399, % Total $ 749, % A comparison of the above illustrates that SEMCO Gas capital struc- ture ratios largely mirror those of SEMCO. 29

80 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. How do SEMCO Gas s 2009 average capital structure ratios compare with how LDCs are normally financed? A. Based on data published by the American Gas Association ( AGA ), the gas distribution industry maintained the following composite structure ratios between 2004 and 2008 (in percents): Capital Component Long-term Debt Preferred Stock Common Equity Total This table indicates that gas distribution companies currently finance their investments in utility plant with approximately 44% long-term debt and 56% common and preferred equity. Q. Is there other information showing how LDCs are financed? A. Yes. Exhibit A-10, Schedule D-9 displays the capital structure ratios over the period for a group of ten LDCs with publicly traded stock. These are the firms included in Value Line s Natural Gas Utility industry that are predominantly involved in natural gas distribution. The average capital structure ratios for this group of LDCs at their last five fiscal year-ends are summarized in the following table (in percents): 30

81 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Capital Component Long-term Debt Preferred Stock Common Equity Total As evidenced above, there has been a steady trend by these LDCs to rely less on debt financing and increase the amount of common equity used to finance gas utility plant, to where they are currently also financed with an average of approximately 44% debt and 56% equity Q. What investor-supplied capital structure ratios do you recommend be used to calculate a rate of return for SEMCO Gas? A. Because SEMCO Gas s 2009 average capital structure ratios of approximately 45% debt and 55% equity are almost identical to those for the two LDC industry groups shown above and not appreciably different from those of SEMCO, I recommend that they be used to calculate the rate of return for SEMCO Gas Q. How were these 2009 average capital structure ratios applied to arrive at the investor-supplied capital structure for SEMCO Gas for its projected year 2011? A. SEMCO Gas s projected 2011 rate base was reduced by non-investor supplied capital (i.e., customer deposits and deferred income taxes) 17 to calculate the amount of 2011 investor-supplied capital. This amount was then multiplied by the 2009 average capital structure ra- tios of 44.85% debt and 55.15% equity to determine the dollar amount attributable to each source of investor-supplied capital. Combining 31

82 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company these investor-supplied capital amounts and the non-investor-supplied sources of capital shown on Exhibit A-4, Schedule D-1 produced the following projected 2011 capital structure for SEMCO Gas, which is also shown on Exhibit A-10, Schedule D-1: Capital Component Amount % Debt $ 168,293, Equity 206,925, Total Investor-Supplied $ 375,219, Customer Deposits 3,229, Deferred Income Taxes 43,544, Total Non-Investor Supplied 46,774, Total $ 421,993, E. Embedded Costs Q. What is the purpose of this section? A. This section identifies the costs applicable to the debt and non-investor-supplied capital in the projected 2011 capital structure developed above Q. How did you calculate the projected 2011 cost of debt? A. Because SEMCO Gas s debt is provided by SEMCO, the projected 2011 average cost of debt for SEMCO was assigned to the debt in SEMCO Gas s projected 2011 capital structure Q. What debt is SEMCO projected to have outstanding in 2011? A. As shown on Exhibit A-10, Schedule D-2, SEMCO is projected to have 15 three issues of debt outstanding in The first is its credit 16 agreement with Royal Bank of Canada ( RBC ), which consists of a 32

83 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 1 revolving credit facility and a secured term loan. The projected amount of revolving credit in 2011 was set equal to the average amount outstanding in 2009 of $15,900,000. The amount of the secured term loan was calculated by reducing the $345 million outstanding at year-end 2009 million by the $300 million refinanced with senior notes in April 2010, leaving $45 million. The interest rate on both the RBC revolver and term loan is variable and basically the London Interbank Offered Rate ( LIBOR ) plus 125 basis points. Projections by Blue Chip Financial Forecasts (May 1, 2010) are that LIBOR will be approximately 1.75% in 2011, which implies a projected 2011 cost for these borrowings of 3.00%. SEMCO s second debt issue is $5 million in senior notes that bear a fixed interest rate of 7.03%. Its last issue of debt is the $300 million issued in April 2010, which bears a fixed rate of 5.15% Q. Is there anything else properly considered in calculating the projected 2011 cost of debt? A. Yes. In connection with managing its debt capital, SEMCO, Inc. incurs costs in connection with issuing new debt and refunding expensive debt and replacing it with cheaper debt. The amount and amortization of these debt expenses are properly considered in calculating the cost of SEMCO s 2011 cost of debt. 33

84 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. What is SEMCO s projected 2011 average cost of debt? A. As developed in Exhibit A-10, Schedule D-2, weighting the cost of each of the debt issues and adjusting for debt expenses produced a projected 2011 average cost of debt for SEMCO of 5.17%. 5 6 Q. What is the cost of customer deposits? A. SEMCO Gas presently pays 7% interest on deposits from customers Q. What is the cost of deferred income taxes? A. Deferred income taxes arise from timing differences between financial and tax accounting (e.g., straight-line versus accelerated depreciation), and are generally regarded as interest-free loans from the government. Therefore, they have a zero cost for purposes of this filing. F. Rate of Return on Equity Q. What is the purpose of this section of your testimony? A. In this section, I will estimate the cost of equity for a group of publicly traded gas utilities, which will serve as the benchmark for determining a fair ROE for SEMCO Gas. This section begins by introducing the cost of equity concept, explaining the risk-return tradeoff principle fundamental to capital markets, and discussing the importance of us- 18 ing multiple approaches to estimate the cost of equity. The dis counted cash flow ( DCF ) model is then developed and applied to a group of LDCs with publicly traded stock to estimate their cost of eq- 21 uity using this method. Next, the capital asset pricing model ( CAPM ) is described and alternative cost of equity estimates devel- oped using this method. Because the results of the CAPM are sus- 34

85 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company pect, the cost of equity is also estimated using the risk premium method based on ROEs previously authorized LDCs and the comparable earnings method. The results of these analyses are combined to arrive at a cost of equity range for LDCs, from which a point estimate is selected taking into account flotation costs and the outlook for capi- 6 tal costs. Finally, this industry cost of equity is evaluated in light of 7 8 the specifics circumstances of SEMCO Gas to arrive at my recom- mended ROE Q. How is a rate of return on common equity customarily determined? A. Unlike debt capital, there is no contractually guaranteed return on common equity capital, because shareholders are the residual owners of the utility. Nonetheless, common equity investors still require a return on their investment, with the "cost of equity" being the minimum rent that must be paid for the use of their money Q. What fundamental economic principle underlies this cost of equity concept? A. The cost of equity concept is predicated on the notion that investors are risk averse, and will willingly accept additional risk only if they expect to be compensated for their bearing that risk. In capital markets where relatively risk-free assets are available, such as U.S. Treasury securities, investors can be induced to hold more risky assets only if they are offered a premium, or additional return, above the rate of return on a risk-free asset. Since all assets compete with each other for investors' funds, riskier assets must yield a higher ex- 35

86 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company pected rate of return than less risky assets in order for investors to be willing to hold them. Given this risk-return tradeoff, the minimum required rate of return ( k ) from an asset ( i ) can be generally expressed as: k i = R f + RPi where: R f = Risk-free rate of return; and RP I = Risk premium required to hold more risky asset i. Thus, the minimum required rate of return for a particular asset at any point in time is a function of: 1) the yield on risk-free assets, and 2) its relative risk, with investors demanding correspondingly larger risk premiums for assets bearing greater risk Q. Is there evidence that the risk-return tradeoff principle actually operates in the capital markets? A. Yes. The risk-return tradeoff can be readily documented in certain segments of the capital markets where required rates of return can be directly inferred from market data and generally accepted measures of risk exist. For example, bond yields are reflective of investors' expected rates of return, and bond ratings are indicative of the risk of fixed income securities. The observed yields on government securities and bonds of various rating categories demonstrate that the risk-return tradeoff does, in fact, exist in the capital markets. To illustrate, average yields during May 2010 on 30-year U.S. Treasury bonds and public utility bonds of different ratings reported by Moody's are shown in the following table. As evidenced there, as 36

87 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company risk increases (measured by progressively lower bond ratings), the required rate of return (measured by yields) rises accordingly. Also shown are the indicated risk premiums over long-term government securities for the additional risk associated with each bond rating category: Bond and Rating U.S. Treasury 30-Year Public Utility Aa A Baa May 2010 Yield 4.29% 5.34% 5.57% 6.15% Risk Premium Over Long-term Treasury % 1.28% 1.86% Q. Does the risk-return tradeoff observed with fixed income securities extend to common stocks and other assets? A. Yes, but documenting the risk-return tradeoff for assets other than fixed income securities is complicated by two factors. First, there is no standard measure of risk applicable to all assets. Second, for most assets (e.g., common stock), required rates of return cannot be directly observed. Yet there is every reason to believe that investors exhibit risk aversion in deciding whether to hold common stocks and other assets, just as when choosing among fixed income securities. Accordingly, it is generally accepted that the risk-return tradeoff evidenced with long-term debt extends to all assets. The extension of the risk-return tradeoff from assets with observable required rates of return (e.g., bonds) to other assets is represented by the concept of a "capital market line." In particular, com- 37

88 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company petition between securities and among investors in the capital markets drives the prices of assets to equilibrium, such that the expected rate of return from each is commensurate with its risk. Thus, the expected rate of return from any asset is a risk-free rate of return plus a corresponding risk premium. This concept of a capital market line is illustrated below. The vertical axis represents required rates of return and the horizontal axis indicates relative riskiness, with the intercept of the capital market line being the risk-free rate of return. Return Risk- Free Rate Risk Q. Is this risk-return tradeoff limited to differences between firms? A. No. The risk-return tradeoff principle applies not only to investments in different firms, but also to different securities issued by the same firm. As discussed earlier, the securities issued by a utility vary considerably in risk because they have different characteristics and priorities. Long-term debt secured by a mortgage on property is senior among all capital in its claim on a utility's net revenues and is, therefore, the least risky because mortgage bondholders have a direct 38

89 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 1 2 claim on the utility s property. Following first mortgage bonds are other debt instruments also holding contractual claims on the utility's 3 net revenues, such as debentures. The last investors in line are common shareholders. They only receive the net revenues, if any, that remain after all other claimants have been paid. As a result, the minimum rate of return that investors require from a utility's common stock, the most junior and riskiest of its securities, must be considerably higher than the yield offered by the utility's senior, long-term debt Q. What does the above discussion imply with respect to estimating the cost of equity for a utility? A. Although the cost of equity cannot be observed directly, it is a function of the returns available from other investment alternatives and the risks to which the equity capital is exposed. Because it is unobservable, the cost of equity for a particular utility must be estimated by analyzing information about capital market conditions generally, assessing the relative risks of the utility specifically, and employing various quantitative methods that focus on investors' required rates of return. These various quantitative methods typically attempt to infer investors' required rates of return from stock prices, by extrapolating interest rates, or through an analysis of other financial data Q. Did you rely on a single method to estimate the cost of equity? A. No. Despite the theoretical appeal of or precedent for using a par- ticular method to estimate the cost of equity, no single approach can 39

90 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company be regarded as wholly reliable in all instances. Therefore, I used multiple methods to estimate the cost of equity. Indeed, it is essential that estimates of investors' minimum required rate of return produced by one method be compared with those produced by other methods, and that all cost of equity estimates be required to pass fundamental tests of reasonableness and economic logic Q. Please describe how the first method you employed, the DCF model, is used to estimate the cost of equity. A. The use of DCF models to estimate the cost of equity is essentially an attempt to replicate the market valuation process which led to the price investors are willing to pay for a share of a company's common stock. It is predicated on the assumption that investors evaluate the risks and expected rates of return from all securities in the capital markets. Given these expected rates of return, the price of each share of stock is adjusted by the market so that investors are adequately compensated for the risks to which they are exposed. Therefore, we can look to the market to determine what investors believe a share of common stock is worth, and by estimating the cash flows they expect to receive from the stock in the way of future dividends and stock price, their required rate of return can be mathematically imputed. In other words, the cash flows that investors expect from a stock are estimated, and given its current market price, we can "back-into" the discount rate, or cost of equity, investors presumably used in arriving at that price. 40

91 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. What market valuation process underlies DCF models? A. DCF models are derived from a theory of valuation which posits that the price of a share of common stock is equal to the present value of the expected cash flows (i.e., future dividends and stock price) that will be received while holding the stock, discounted at investors' required rate of return, or the cost of equity. Notationally, the general form of the DCF model is as follows: 8 9 D 1 D 2 D t P t P 0 = (1+K e ) 1 + (1+K e ) (1+K e ) t + (1+K e ) t where: P 0 = Current price per share; P t = Future price per share in period t; D t = Expected dividend per share in period t; K e = Cost of equity Q. Has this general form of the DCF model customarily been used to estimate the cost of equity in rate cases? A. No. In an effort to reduce the number of required estimates and computational difficulties, the general form of the DCF model has been simplified to a "constant growth" form. But converting the general form of the DCF model to the constant growth DCF model requires that a number of assumptions be made. These include: A constant growth rate for both dividends and earnings; A stable dividend payout ratio; The discount rate exceeds the growth rate; A constant growth rate for book value and price; A constant earned rate of return on book value; No sales of stock at a price above or below book value; A constant price-earnings ratio; 41

92 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company A constant discount rate (i.e., no changes in risk or interest rate levels and a flat yield curve); and All of the above extend to infinity. Given these assumptions, the general form of the DCF model can be reduced to the more manageable formula of: 6 P 0 D1 = k g e 7 where: g = Investors long-term growth expectations. 8 The cost of equity ( K e ) can be isolated by rearranging terms: k D = P 1 e + 0 g The constant growth form of the DCF model recognizes that the rate of return to stockholders consists of two parts: 1) dividend yield (D 1 /P 0 ), and 2) growth (g). In other words, investors expect to receive a portion of their total return in the form of current dividends and the remainder through price appreciation Q. Are the assumptions underlying the constant growth form of the DCF model met in the real world? A. No. The assumptions required to convert the general form of the DCF model to the constant growth form are never strictly met in practice. In some instances, where earnings are derived solely from stable activities, and earnings, dividends, and book value track fairly closely, the constant growth form of the DCF model may be a reasonable working approximation of stock valuation. However, in other cases, where the circumstances cause the required assumptions to be se- 42

93 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company verely violated, the constant growth DCF model may produce widely divergent and meaningless results. This is especially the case if the firm's earnings or dividends are unstable, or if investors are expecting the stock price to be affected by factors other than earnings and dividends Q. How did you estimate the cost of equity using the DCF model? A. The DCF model was applied to the group of ten publicly traded LDCs identified earlier; namely, those firms included in Value Line s Natural Gas Utility industry that are predominantly engaged in natural gas distribution Q. How is the constant growth form of the DCF model typically used to estimate the cost of equity? A. The first step in implementing the constant growth DCF model is to determine the expected dividend yield (D 1 /P 0 ) for the firm in question. This is usually calculated based on an estimate of dividends to be paid in the coming year divided by the current price of the stock Q. How did you calculate the dividend yield component of the constant growth DCF model for the gas utility group? A. Because estimating the cost of equity using the DCF model is an attempt to replicate how investors arrived at an observed stock price, all of its components should be contemporaneous. Price, dividend, and growth data from different points in time or averaged over long time periods violate the matching principle underlying the DCF model. Therefore, dividend yield was calculated by dividing an estimate of 43

94 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company dividends to be paid by each of the LDCs in the group over the next twelve months, obtained from the index to Value Line s June 11, 2010 edition, by the average closing price of each firm s stock for the month between May 10, 2010 and June 8, The expected dividends, representative price, and resulting dividend yield for each of the ten gas utilities are displayed on Exhibit A-10, Schedule D-10. As also shown there, the average dividend yield for the industry group is 4.2% Q. Explain how estimates of investors' long-term growth expectations are customarily developed for use in the constant growth DCF model. A. In constant growth DCF theory, earnings, dividends, book value, and market price are all assumed to grow in lockstep, and the growth horizon of the DCF model is infinite. But implementation of the DCF model is more than just a theoretical exercise; it is an effort to replicate the mechanism investors used to arrive at observable stock prices. Therefore, the only g that matters in using the DCF model to estimate the cost of equity is that which investors expect and have embodied in current market prices Q. What drives investors growth expectations? A. Trends in earnings, which ultimately support future dividends and share price, play a pivotal role in determining investors long-term growth expectations. The 5-year earnings growth projections by security analysts for each of the ten gas utilities reported by Value Line, Thomson Reuters Institutional Brokers Estimate System (I/B/E/S), 44

95 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company and Zacks Investment Research (Zacks) are displayed on Exhibit A- 10, Schedule D-11, with the averages for the group being summarized in the following table: Value Line 4.6% I/B/E/S 4.4% Zack s 5.0% Also shown on Exhibit A-10, Schedule D-11 are the 10-year and 5- year historical earnings growth rates for each of the ten gas utilities, which average 6.1% and 7.6%, respectively Q. How else are investor expectations of future long-term growth prospects for a firm often estimated for use in the constant growth DCF model? A. In DCF theory and practice, growth in book equity comes from the reinvestment of earnings within the business and the effects of external 12 financing. Accordingly, conventional applications of the constant growth DCF model often examine the relationships between variables that determine the sustainable growth attributable to these two fac- tors Q. How is a firm s sustainable growth estimated? A. The sustainable growth rate is calculated by the formula: g = br + sv where b is the expected earnings retention ratio (one minus the dividend payout ratio), r is the expected rate of return earned on book equity, s is the percent of common equity expected to be is- 45

96 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company sued annually as new common stock, and v is the equity accretion ratio. The br term represents the growth from reinvesting earnings within the firm while the sv term represents the growth from external 4 financing. This external financing growth results because existing 5 6 shareholders share in a portion of any excess received from selling new shares at a price above book value Q. What growth rate does the sustainable growth method suggest for the gas utility group? A. The sustainable growth rate for each of the gas utilities in the industry group based on Value Line's projections for is developed in Exhibit A-10, Schedule D-12. As shown there, the sustainable growth method implies an average long-term growth rate for the gas utility group of 5.7% Q. What are other projected and historical growth rates for the industry group? A. Exhibit A-10, Schedule D-13 displays Value Line projected growth rates and 10- and 5-year historical growth rates in book value per share, dividends per share, and stock price for each of the ten gas utilities in the industry group. The averages for the LDC group range from 2.9% to 6.7%. Besides the fact that several of these growth rates, when combined with the group s 4.2% dividend yield, imply implausible cost of equity estimates, the variation in these other growth rates results in them providing limited guidance as to the prospective growth that investors expect. 46

97 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. What is your conclusion as to the growth that investors are expecting from the industry group? A. After excluding clearly unreliable indicators of growth, the plausible growth rates shown on Exhibit A-10, Schedules D-11 through D-13 indicated a range for the LDC group of between approximately 4.75% and 6.75%. Meanwhile, Yahoo Finance and Zacks report projected earnings growth rates for the gas distribution industry of 5.06% and 8.7%, respectively. Taken together, I concluded that investors expect long-term growth from the LDC group in the 5.5% to 6.5% range Q. What DCF cost of equity estimate do these growth rate range imply for the gas utility group? A. Summing the LDC group s average dividend yield of 4.2% with a 5.5% to 6.5% growth rate range indicates a cost of equity for the industry group of between 9.7% and 10.7% Q. How else did you estimate the cost of equity? A. The cost of equity to the gas utility group was also estimated using the CAPM, which is a theory of market equilibrium that serves as the 18 basis for current financial education and management. Under the CAPM, investors are assumed to be fully diversified, so that the relevant risk of an individual asset (e.g., common stock) is its volatility relative to the market as a whole, which is measured using a "beta" coefficient. Beta reflects the tendency of a stock's price to follow changes in the market, with stocks having a beta less than 1.00 being 47

98 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company considered less risky and stocks with a beta greater than 1.00 being regarded as more risky. The CAPM is mathematically expressed as: R j = R f +β j (R m - R f ) where: R j = required rate of return for stock j; R f = risk-free interest rate; R m = expected return on the market portfolio; and β j = beta, or systematic risk, for stock j. While the CAPM is not without controversy, it is routinely referenced in the financial literature and regulatory proceedings, and firms beta values are widely reported Q. How did you apply the CAPM? A. I applied the CAPM in a conventional manner using two methods to determine the risk premium for the market as a whole, or the (R m - R f ) term in the CAPM formula. The first was based on historical rates of return and the second was based on forward-looking estimates of investors required rates of return. In both instances, the companies included in the S&P 500 index were used as a proxy for the market portfolio and the 30-year U.S. Treasury bond served as the risk-free investment Q. Please describe the first method based on historical rates of return. A. Under the historical rate of return approach, equity risk premiums are calculated by first measuring the rate of return (including dividends and capital gains and losses) actually realized on an investment in common stocks over historical time periods. The historical return on bonds is then subtracted from that earned on common stocks to 48

99 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company measure equity risk premiums. Widely used in academia, the historical rate of return approach is based on the assumption that, given a sufficiently large number of observations over long historical periods, average market rates of return will converge to investors' required rates of return. From a more practical perspective, investors may base their expectations for the future on, or may have come to expect that they will earn, rates of return corresponding to those in the past Q. What is the market risk premium based on historical rates of return? A. Perhaps the most exhaustive study of historical rates of return, and the one most frequently cited in regulatory proceedings, is that contained in Morningstar's (formerly Ibbotson Associates) Stocks, Bonds, Bills and Inflation. In their 2010 Valuation Yearbook, Morningstar reports that the annual rate of return realized on the S&P 500 averaged 11.80% over the period 1926 through 2009, while the annual average income rate of return on 30-year Treasury bonds over this same period averaged 5.20%. Thus, the market risk premium based on historical average annual rates of return is 6.60% Q. Please describe the second method based on forward-looking required rates of return. A. Consistent with the CAPM being an expectational (i.e., forwardlooking) model, the second method estimated the market risk premium using current indicators of investors required rates of return. For the market portfolio, the cost of equity was estimated by applying the DCF model to the firms in the S&P 500 paying cash dividends, with each 49

100 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company firm s dividend yield and growth rate being weighted by its proportionate share of total market value. The expected dividend yield for each firm was obtained from Value Line, with the expected growth rate being based on the earnings forecasts published for each firm by Value Line, I/B/E/S, and Zacks. As shown in footnote (b) on Exhibit A-10, Schedule D-14, summing the 2.30% expected dividend yield for this market group, which is composed primarily of non-regulated firms, with the average Value Line, I/B/E/S, and Zacks projected growth rate of 8.77% produced a required rate of return from the market portfolio (R m ) of 11.07% Q. What is the market risk premium based on forward-looking required rates of return? A. From the 11.07% required rate of return on the market portfolio, a market risk premium was calculated by subtracting the average yield on 30-year Treasury bonds during May 2010 of 4.29%. This produced a forward-looking market risk premium of 6.78% Q. What was the next step in applying the CAPM? A. Having calculated market risk premiums of 6.60% and 6.78% using historical rates of return and forward-looking rates of return, respectively, the next step was to calculate specific risk premiums for the LDC industry group. This was done by multiplying the alternative market risk premium estimates by the group s average beta of 0.66, which was calculated using firm betas obtained from Value Line and shown in footnote (e) of Exhibit A-10, Schedule D

101 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. What cost of equity estimate is produced for the LDC group using the CAPM? A. As developed in Exhibit A-10, Schedule D-14, summing the 4.36% and 4.21% industry risk premiums with the 30-year Treasury bond yield of 4.29% produced CAPM cost of equity estimates for the LDC industry group of 8.65% and 8.76% Q. Are these CAPM results plausible estimates of investors required rate of return? A. No. To me, the 8.65% and 8.76% CAPM cost of equity estimates for the LDC group are not credible measures of the return that investors require from an investment in the common stock of an LDC. This is especially the case given investors experiences during the financial crisis and capital market meltdown of 2008 and early 2009 and the volatility in stock prices that has continued into 2010, all of which amply demonstrate and bring home the risks of investing in common stocks Q. Why is the CAPM producing implausible cost of equity estimates? A. Aside from inherent problems with the CAPM widely discussed in the financial literature, the capital market crisis and ensuing recovery have created a number of problems in applying the CAPM. First, the CAPM is geared off of a risk-free interest rate, which appears twice in the CAPM formula. Because of investors' "flight to safety" during the financial crisis, the yields on U.S. government bonds dropped to abnormally low levels (e.g., the 30-year Treasury bond yield was 2.87% 51

102 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company in December 2008) and are also affected by the extensive government borrowing required to finance increasing deficit spending. Although 30-year Treasury bond yields have returned to more normal levels of late, distortions not only impact the absolute level of the CAPM cost of equity estimate, but affect estimated risk premiums. Second, the beta in CAPM theory is a measure of the investors expected relationship of a firm's stock price to the market as a whole. Because investors' expected beta for a firm is not known, reported betas are estimated based on historical relationships. The precipitous drop and subsequent partial recovery in stock prices over the last year or so have caused many firms' historical betas to become unstable, so that reported betas may or may not reflect investors expected beta. Third, application of the CAPM based on historical rates of return was affected by the dramatic decline in stock prices during 2008 that pushed down average realized rates of return on stocks significantly (e.g., the 1929-to-present average annual rate of return fell from 12.3% in 2007 to 11.7% in 2008). Whether there has been a corresponding drop in investors' expected rate of return from the market going forward, which is the relevant measure in the CAPM, is problematic. Meanwhile, forward-looking estimates of the market required rate of return may be distorted by the recent run-up in stock prices. It is not clear whether reported security analysts dividend and growth projections have kept pace with the economic recovery expectations presumably pushing up stock prices; if not, there is a mismatch that under-estimates the market required rate of return. 52

103 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. Have you attempted to modify the conventional application of the CAPM to account for these factors and calculate more plausible cost of equity estimates? A. No. Various methods designed to correct for weaknesses in the CAPM or problems created by recent capital market turmoil (e.g., using an "empirical CAPM", which includes an adjustment to compensate for the observed difference between theory and practice, or a projected yield on long-term Treasury bonds) do not significantly improve the CAPM results. Therefore, I gave the CAPM cost of equity estimates only limited credence and primarily relied on the other methods to estimate investors required rate of return from LDCs Q. How else did you estimate the cost of equity? A. The cost of equity was also estimated using a risk premium method based on ROEs previously authorized various LDCs. The risk premium method to estimate investors' required rate of return is an extension of the risk-return tradeoff observed with bonds to common stocks. The cost of equity is estimated by determining the additional return investors require to forego the relative safety of a bond and bear the greater risks associated with common stock, and then adding this equity risk premium to the current yield on bonds Q. Generally describe the application of the risk premium method using authorized ROEs. A. Application of the risk premium method based on authorized ROEs is predicated on the presumption that allowed returns reflect regulatory 53

104 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company commissions' best estimates of the cost of equity, however determined, at the time they issued their final orders. A current risk premium is estimated based on the difference between past authorized ROEs and then-prevailing interest rates. This risk premium is then added to current interest rates to estimate the cost of equity Q. What was the principal source of the data used to apply this risk premium method? A. Regulatory Research Associates, Inc. (RRA) and its predecessor have compiled the ROEs authorized major electric, gas, and telephone utilities by regulatory commissions across the U.S. The average ROE authorized natural gas utilities published by RRA in each quarter between 1980 and the first quarter of 2010 are displayed in Exhibit A- 10, Schedule D-15. As shown there, the ROEs granted LDCs over this approximately 30-year period have averaged 12.17% Q. Is this 12.17% average the relevant benchmark for estimating the cost of equity? A. No. Over this same approximately 30-year period, the yield on single- A public utility bonds has averaged 9.13%, which is considerably higher than the May 2010 yield of 5.57%. Therefore, it is necessary to adjust the historical data for current interest rate levels and also to account for the fact that authorized ROEs do not move in lockstep with interest rates. In particular, when interest rate levels are relatively high, ROEs tend to be lower (i.e., equity risk premiums narrow), 54

105 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 1 2 and when interest rates are relatively low, authorized ROEs are greater (i.e., equity risk premiums increase) Q. How did you account for these factors in estimating the cost of equity for the LDC group using past authorized ROEs? A. To account for current interest rate levels and that authorized returns on equity do not move in lockstep with interest rates, I developed a regression equation relating authorized ROEs to bond yields. Shown at the bottom of Exhibit A-10, Schedule D-15, substituting the May 2010 yield of 5.57% on single-a public utility bonds (corresponding to the average bond rating of the group) into the regression equation indicated a cost of equity for the LDCs of 10.24% Q. What was the last method that you used to estimate the cost of equity? A. Often referred to as the comparable earnings method, this approach looks to the rates of return that other firms of comparable risk and that compete for investors capital are expected to earn on their book 17 equity. Reference to the expected return on book equity of other LDCs demonstrates the level of earnings that SEMCO Gas needs in order to offer investors a competitive return, be able to attract capital on reasonable terms, and maintain its financial integrity Q. What return on book equity are other LDCs expected to earn? A. Exhibit A-10, Schedule D-16 displays the return on book equity projected for each of the ten LDCs in the industry group for the 2010, 2011, and timeframes, calculated by dividing Value Line s 55

106 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company projected earnings per share by average book value per share. As shown there, the average expected book ROE for the group is 11.5% in 2010, 11.7% for 2011, and 11.7% for Q. What is your conclusion as to the cost of equity range for the LDC industry group? A. For the LDC industry group, the DCF method indicated a cost of equity range of between 9.7% and 10.7%, while the CAPM indicated a cost of equity range of approximately 8.6% to 8.8%, which for the reasons discussed earlier should be largely disregarded. Meanwhile, the risk premium method based on the authorized ROEs for LDCs indicated a cost of equity of 10.24%, while the comparable earnings method showed that other LDCs are expected to earn between 11.5% and 11.8% on their book equity. Taken together, but giving the most weight to the DCF results, these analyses indicate that investors require a return on their investment in the equity of LDCs group in the 10% to 11% range Q. Are there any other factors properly considered in determining a utility s ROE? A. Yes. The common equity used to finance utility assets is provided from either the sale of stock in the capital markets or from retained earnings not paid out as dividends. When equity is raised through the sale of common stock, there are costs associated with "floating" the new equity securities. These flotation costs include services such as legal, accounting, and printing, as well as the fees and discounts paid 56

107 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company to compensate brokers for selling the stock to the public. Also, some argue that the "market pressure" from the additional supply of common stock and other market factors may further reduce the amount of funds a utility nets when it issues common equity Q. Is there an established mechanism for a utility to recognize common equity flotation costs? A. No. While debt flotation costs are recorded on the books of the utility and amortized over the life of the issue, serving to increase the effective cost of debt capital, there is no similar accounting treatment to ensure that common equity flotation costs are recorded and ultimately recognized. Alternatively, no rate of return is authorized on flotation costs necessarily incurred to obtain a portion of the common equity capital used to finance plant. In other words, equity flotation costs are not included in a utility's rate base because that portion of the gross sale proceeds is not available to invest in plant and equipment and is not capitalized as an intangible asset. Even though there is no accounting convention to accumulate and amortize the flotation costs associated with past common equity issues, flotation costs are nevertheless a very real expense necessarily incurred in the sale of equity capital. Therefore, unless some provision is made to recognize these past issuance costs in a utility s ROE, its revenue requirements will not fully reflect all of the costs actually incurred for the use of investors' funds. 57

108 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. How can common equity flotation costs be recognized in revenue requirements? A. As indicated above, unlike the transactional costs incurred to issue and sell debt, there is no direct mechanism to recognize flotation costs necessarily incurred in the issuance and sale of common stock. Therefore, flotation costs must be accounted-for indirectly. An upward adjustment to the "bare-bones" cost of equity is the most logical and widely accepted mechanism for recognizing these costs Q. How is the magnitude of the flotation cost adjustment to the cost of equity determined? A. There are any number of ways in which a flotation cost adjustment can be calculated, with the adjustment ranging from just a few basis points to more than a full percent. For example, relating past flotation costs to total book common equity normally results in a nominal flotation cost adjustment of a few basis points, while adjusting the bare-bones cost of equity to encourage a target market-to-book ratio of, say, 110%, typically produces a flotation cost in excess of one percent. More modest approaches to calculating flotation cost adjustments, such as applying an average flotation cost expense percentage (i.e., 3% to 5%) to a utility's dividend yield, or its bare-bones cost of equity, usually result in flotation cost adjustments of between 15 and 50 basis points. Because the precise calculation of a flotation cost adjustment is problematic, unrecovered flotation costs are often recognized by selecting the ROE from above the mid-point of the cost 58

109 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company 1 2 of equity range, rather than make a specific adjustment to the cost of equity Q. Is there anything else that should be considered in selecting a specific point estimate from within the cost of equity range? A. Yes. As illustrated earlier, interest rates dropped to historic lows following the financial crisis of 2008 and early This was a direct result of reduced loan demand due to the recession, reluctance by lenders to make loans, and the U.S. government having extended credit to financial institutions at artificially suppressed interest rates approaching zero. Simultaneously, the federal government authorized hundreds of billions in spending to stimulate the economy, which it is 12 borrowing to finance. As the recession ends and the government subsidies subside, long-term interest rates are expected to rise in response to market forces and inflationary pressures. This rise in interest rates will in turn increase the cost of permanent capital, including common equity, above current levels Q. Can you provide evidence of these expectations for rising interest rates? A. Yes. Projections by investment advisors, forecasting services, and government agencies all show long-term interest rates increasing over the next few years. The table below compares current interest rates on 30-year Treasury, triple-a corporate bonds, and double-a utility bonds with those projected for 2011 through 2014 by Value Line in its Forecast for the U.S. Economy (May 28, 2010), Global Insight in its 59

110 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company The U.S. Economy: The 30-Year Focus (Third Quarter 2009), and the Energy Information Administration in its Annual Energy Outlook 2010 (May 11, 2010): May Year Treasury Value Line Global Insight AA-Utility Global Insight EIA AAA Corporate Value Line Global Insight These projections evidence a clear consensus that the cost of permanent capital will be higher in the timeframe than it is today. If an LDC is to be able offer investors a competitive return, attract capital on reasonable terms, and maintain its financial integrity, its ROE needs to reflect capital market requirements during the time when rates are in effect Q. How should this outlook for increased capital costs be incorporated into the ROE? A. So that an LDC s rates reflect the capital costs prevailing when those rates are in effect, an adjustment to the current cost of equity is necessary to account for the higher capital costs expected in 2011 and beyond. However, while there is a consensus that capital costs will be higher in the timeframe than they are currently, there is some disagreement about the magnitude of that increase. Therefore, 60

111 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company as in the case of flotation costs, I recommend that the higher capital costs expected when rates are in effect be accommodated by selecting an ROE from the upper end of the cost of equity range, rather than make a specific adjustment to the cost of equity Q. What is your conclusion as to an ROE for the LDC group? A. To account for flotation costs and the outlook for increased capital costs when rates would be in effect, it is my opinion that the ROE for the LDC industry group is 11.00%, which is at the top of my 10% to 11% cost of equity range. G. ROE for SEMCO Gas Q. How do the changes that SEMCO Gas is proposing in its rate design impact its investment risk? A. SEMCO Gas is proposing two principal changes in the structure of its rates: 1) Fixed monthly service charge for most residential and commercial customers; and 2) Infrastructure replacement program ( IRP ) As will be explained below, these proposed changes do not have a material impact on SEMCO Gas s overall investment risk, and any reduced risk is largely already accounted for in the ROE developed for the LDC industry group Q. What about SEMCO Gas s proposed IRP? A. SEMCO Gas s proposed IRP is essentially a substitute for allowance for funds used during construction ( AFUDC ) on specific incremental 61

112 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company investment and is intended to keep it whole between rate cases. The IRP would reduce regulatory lag associated with SEMCO Gas s additional investment in infrastructure replacements and allow it to recover its capital carrying costs in a more timely fashion. Gas utilities across the U.S. are increasingly being allowed similar recovery mechanisms for capital costs on selected investments. Moreover, because these provisions typically apply to only a small percentage of new investment, they do not have a significant impact on investors perceptions of overall risk and, in turn, the cost of equity Q. How would SEMCO Gas s proposed fixed monthly service charge affect investors perceptions of its investment risk? A. In my view, SEMCO Gas s proposed fixed monthly service charge would have two fundamental effects on investors perceptions of its investment risk. First, a fixed monthly service charge would basically substantially reduce the impact that colder- or warmer-than-normal weather has on sales margins and earnings. Second, it would reduce much of the revenue and earnings losses due to declining use per customer between rate cases Q. Should an adjustment to SEMCO Gas s rate of return on common equity be made because the fixed monthly service charge would reduce much of SEMCO Gas s weather risk? A. No. The investment community regards virtually all of the LDCs in the industry group used to estimate the cost of equity as having a weather mitigant (e.g., weather normalization adjustment ( WNA ) clause and 62

113 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company decoupled rates); therefore, the reduced weather risk associated with SEMCO Gas s proposed fixed monthly service charge is, for all intents and purposes, already accounted-for in the industry ROE developed above. This notwithstanding, weather mitigants do not have a dramatic impact on a gas company s overall investment risk and, in turn, cost 7 of capital. Although generally viewed favorably by the investment community, any impact that a weather mitigant might have on the cost of equity would be measured in just basis, not percentage, points. It is also noteworthy that WNAs and other weather mitigants are not viewed as entirely positive by the investment community. The reason for this is that, while they dampen the volatility of revenues, they also largely preclude the prospects of exceptional earnings due to an extended cold spell. Thus, reductions in the cost of equity due to a weather mitigant tend to be partially offset by an increase in investors' required rate of return to compensate for the loss of upside potential Q. What about the effect that the fixed monthly service charge would have with respect to loss of revenues and earnings due to declining use per customer? A. It is important to recognize that the revenue and earnings losses due to declining use per customer that SEMCO Gas s proposed fixed monthly service charge would reduce are only those that occur between rate cases. Use per customer is essentially reset in each rate case, so that the loss of revenues and earnings due to declining use 63

114 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company per customer can also be ameliorated by more frequent rate cases or other common ratemaking techniques (e.g., recognizing known and measurable changes). As a result, the benefit of a fixed monthly service charge with respect to declining customer is that it reduces regulatory lag, with its value depending on the frequency that the utility would otherwise file rate cases to address other expense, investment, and revenue issues Q. Does a fixed monthly service charge eliminate the risks faced by SEMCO Gas? A. Not at all. Weather and declining use per customer are but two of the many risks faced by SEMCO Gas. For example, operating and financing risks related to rate regulation, gas costs, loss of industrial customers, costs disallowances, customer growth, bypass, non-rate regulatory changes, asset impairment, tax laws, environmental laws and regulations, operating hazards, industry restructuring, general economic conditions, inflation, credit requirements, and capital market conditions, just to name a few, remain. Thus, while a fixed monthly service charge may largely reduce the revenue risks associated with the consumption patterns of certain customers, it does nothing to reduce the multitude of other risks faced by SEMCO Gas. 64

115 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company Q. What is the basis for your earlier statement that any reduced risk associated with the fixed monthly service charge proposed by SEMCO Gas is largely already accounted for in the ROE developed for the LDC industry group? A. As discussed by Mr. Raab, gas utilities throughout the U.S. are decoupling rates from customer usage in various ways. In my review of the Form 10-Ks of the LDCs included in the industry group identified earlier, most have rate provisions that are viewed by investors as achieving end-results similar to SEMCO Gas s proposed rate design. For example, AGL Resources principal LDC, Atlanta Gas Light, has a straight-fixed-variable rate that is paid by marketers who sell gas to retail customers, and its Virginia Natural Gas LDC has both decoupled and performance based rates (PBR). The rates for over 90% of Atmos Energy s rate base include WNAs, with rates for approximately 60% being revised under annual review provisions. Rates are decoupled in three of the jurisdictions in which Atmos operates and its has PBRs in three others. The rates of New Jersey Resources LDC have a provision that permit it to adjust rates to recover Its allowed margins regardless of weather or customer usage, and Northwest Natural has a conservation tariff in its primary Oregon service area (90% of revenues) that also decouples customer usage from its earnings with periodic adjustments. Piedmont Natural Gas rates in North Carolina adjust monthly to recover its approved margins independent of consumption, while its rates in South Carolina are adjusted annually pursuant to state statute and those in both South Caroline and Tennessee are 65

116 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company covered by WNAs. The rates of South Jersey Industries LDC include a conservation incentive program that preserves its profit margin per customer through annual adjustments, and Southwest Gas rates are decoupled in California and Nevada, with regulators in Arizona cur- 5 rently reviewing proposals for decoupling. While Washington Gas Light has a performance based rate plan in Virginia, it has not been approved in the District of Columbia or Maryland. Only Laclede and Nicor have no rate provisions that investors likely regard as being similar to SEMCO Gas s proposed rate design, although a bad debt rider was recently approved for NICOR and the AGA reports Laclede has an infrastructure cost recovery mechanism in place. It is because of this prevalence of similar rate provisions that no adjustment to the industry ROE because of SEMCO Gas s proposed rate design changes is warranted Q. Is there anything else that should be considered in arriving at an ROE for SEMCO Gas? A. Yes. As the Commission recognized in its final order in Case No. U for MichCon, economic conditions in Michigan, which includes all of SEMCO Gas s service territory, are weak and, despite financial markets beginning to stabilize, there has not been a noticeable improvement in the economy. SEMCO Gas, like MichCon, faces considerable economic challenges, and authorizing it a sufficient ROE will maintain investor confidence in SEMCO Gas s financial soundness. This will, in turn, allow SEMCO Gas to continue to attract capital on reasonable terms, as it did recently when SEMCO raised $300 million 66

117 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company in debt at a coupon rate of 5.15%. Maintaining the financial health, integrity, and creditworthiness of all Michigan utilities, including SEMCO Gas, ultimately benefits customers Q. What ROE do you recommend for SEMCO Gas? A. I recommend that SEMCO Gas be allowed to maintain its currently authorized ROE of 11%. This is consistent with the Commission s decision in the recent MichCon case, and it is the same as my estimate of the ROE for the LDC industry group before taking into account the additional risks faced by SEMCO Gas because of the weak Michigan economy Q. Are there any qualifications attached to your recommended ROE? A. Yes. First, my recommended ROE is predicated on SEMCO Gas s investor-supplied capital structure ratios of approximately 45% debt and 55% equity, which are the same as those maintained by the LDC industry group used to estimate the cost of equity. If capital structure ratios were used to calculate SEMCO Gas s rate of return that imply greater financial risk, then a corresponding upward adjustment to my recommended ROE would be necessary. Second, my recommended ROE is predicated on the adoption of 20 SEMCO Gas s proposed rate design. Because virtually all of the LDCs in the industry group have rate design features that achieve end-results similar to SEMCO Gas s proposed rate design, no down- 23 ward adjustment to the industry ROE is warranted. However, if 24 SEMCO Gas s proposed fixed charge is not adopted, SEMCO Gas re- 67

118 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company mains exposed to both weather risk and that attributable to the weak Michigan economy. Accordingly, a higher ROE would be required to compensate for this greater risk. H. Overall Rate of Return Q. What overall rate of return do you recommend by applied to SEMCO Gas s rate base? A. I recommend an overall rate of return of 7.50%. As developed below, this overall rate of return is the result of combining SEMCO Gas s capital structure developed earlier with the costs of debt and noninvestor-supplied capital, and an 11% ROE: Capital Component Percent of Total Component Cost (%) Weighted Cost (%) Long-term Debt Common Equity Customer Deposits Deferred Income Taxes Total V. IRP CAPITAL COST RATE Q. You noted earlier that SEMCO Gas s proposed IRP is intended to allow it to recover the capital-related costs associated with selected incremental investment until the plant is placed in rate base in a subsequent rate case. How should the capital charge rate, which would be applied to the incremental capital investment, be determined? A. For ease of administering the IRP, I recommend that the capital charge rate included in the IRP tariff be established in each rate case. 68

119 Direct Testimony of Bruce H. Fairchild On Behalf of SEMCO Energy Gas Company This capital charge rate would remain fixed until it was re-established in the next rate case. Besides simplifying administration, such a fixed capital charge rate would disadvantage neither SEMCO Gas nor its customers Q. How would the fixed capital charge rate be determined in a rate case? A. There are three principal costs associated with capital investment return on investment (including related income taxes), depreciation expense, and property taxes. I recommend the return on investment portion of the capital charge rate be based on the authorized rate of return, with the non-tax deductible capital components being grossedup using the revenue multiplier. Meanwhile, the depreciation rate and property tax rate portions of the capital charge rate would be based on the average depreciation rate on plant investment and an average property tax, both determined from 2011 data in the rate case Q. What capital charge rate do recommend in the present instance? A. As developed in Exhibit A-10, Schedule D-17, I recommend a capital charge rate for use in SEMCO Gas proposed IRP of 15.85%. This rate consists of the sum of an 11.03% pre-tax rate of return (based on my recommended rate of return of 7.50% adjusted by a revenue multiplier), an average depreciation rate of 2.91%, and an average property tax rate of 1.91% Q. Does that conclude your direct testimony in this case? A. Yes, it does. 69

120 APPENDIX A BRUCE H. FAIRCHILD FINCAP, INC Red River Financial Concepts and Applications Austin, Texas Economic and Financial Counsel (512) FAX (512) fincap2@texas.net Summary of Qualifications M.B.A. and Ph.D. in finance, accounting, and economics; Certified Public Accountant. Extensive consulting experience involving regulated industries, valuation of closely-held businesses, and other economic analyses. Previously held managerial and technical positions in government, academia, and business, and taught at the undergraduate, graduate, and executive education levels. Broad experience in technical research, computer modeling, and expert witness testimony. Employment Principal, FINCAP, Inc. (Sep to present) Adjunct Assistant Professor, University of Texas at Austin (Sep to May. 1981) Assistant Director, Economic Research Division, Public Utility Commission of Texas (Sep to Aug. 1979) Economic consulting firm specializing in regulated industries and valuation of closely-held businesses. Assignments have involved electric, gas, telecommunication, and water/sewer utilities, with clients including utilities, consumer groups, municipalities, regulatory agencies, and cogenerators. Areas of participation have included revenue requirements, rate of return, rate design, tariff analysis, avoided cost, forecasting, and negotiations. Other assignments have involved some seventy valuations as well as various economic (e.g., damage) analyses, typically in connection with litigation. Presented expert witness testimony before courts and regulatory agencies on over one hundred occasions. Taught undergraduate courses in finance: Fin. 370 Integrative Finance and Fin. 357 Managerial Finance. Division consisted of approximately twenty-five financial analysts, economists, and systems analysts responsible for rate of return, rate design, special projects, and computer systems. Directed Staff participation in rate cases, presented testimony on approximately thirty-five occasions, and was involved in some forty other cases ultimately settled. Instrumental in the initial development of rate of return and financial policy for newly-created agency. Performed independent research and managed State and Federal funded projects. Assisted in preparing appeals to the Texas Supreme Court and testimony presented before the Interstate Commerce Commission and Department of Energy. Maintained communications with financial community, industry representatives, media, and consumer groups. Appointed by Commissioners as Acting Director.

121 BRUCE H. FAIRCHILD Page 2 of 5 Assistant Professor, College of Business Administration, University of Colorado at Boulder (Jan to Dec. 1978) Teaching Assistant, University of Texas at Austin (Jan to Dec. 1976) Internal Auditor, Sears, Roebuck and Company, Dallas, Texas (Nov to Aug 1972) Accounts Payable Clerk, Transcontinental Gas Pipeline Corp., Houston, Texas (May to Aug. 1969) Taught graduate and undergraduate courses in finance: Fin. 305 Introductory Finance, Fin. 401 Managerial Finance, Fin. 402 Case Problems in Finance, and Fin. 602 Graduate Corporate Finance. Taught undergraduate courses in finance and accounting: Acc. 311 Financial Accounting, Acc. 312 Managerial Accounting, and Fin. 357 Managerial Finance. Elected to College of Business Administration Teaching Assistants' Committee. Performed audits on internal operations involving cash, accounts receivable, merchandise, accounting, and operational controls, purchasing, payroll, etc. Developed operating and administrative policy and instruction. Performed special assignments on inventory irregularities and Justice Department Civil Investigative Demands. Processed documentation and authorized payments to suppliers and creditors. Education Ph.D., Finance, Accounting, and Economics, University of Texas at Austin (Sep to May 1980) Doctoral program included coursework in corporate finance, investment theory, accounting, and economics. Elected to honor society of Phi Kappa Phi. Received University outstanding doctoral dissertation award Dissertation: Estimating the Cost of Equity to Texas Public Utility Companies M.B.A., Finance and Accounting, University of Texas at Austin, (Sep to Aug. 1974) B.B.A., Accounting and Finance, Southern Methodist University, Dallas, Texas (Sep to Dec. 1971) Awarded Wright Patman Scholarship by World and Texas Credit Union Leagues. Professional Report: Planning a Small Business Enterprise in Austin, Texas Dean s List and member of Phi Gamma Delta Fraternity. Other Professional Activities Certified Public Accountant, Texas Certificate No. 13,710 (October 1974); entire exam passed in May Member of the American Institute of Certified Public Accountants and Texas Society of Certified Public Accountants. Member of Financial Management Association, Southwestern Finance Association, and American Finance Association. Participated as session chairman, moderator, and paper discussant at annual meetings of these and other professional associations. Visiting lecturer in Executive M.B.A program at the University of Stellenbosch Graduate Business School, Belleville, South Africa (1983 and 1984). Associate Editor of Austin Financial Digest, Wrote and edited a series of investment and economic articles published in a local investment advisory service.

122 BRUCE H. FAIRCHILD Page 3 of 5 Military Texas Army National Guard, Feb to Sep Specialist 5th Class with duty assignments including recovery vehicle operator for armor unit and company clerk for finance unit. Bibliography Monographs On the Use of Security Analysts Growth Projections in the DCF Model, with William E. Avera, Earnings Regulation Under Inflation, J. R. Foster and S. R. Holmberg, eds., Institute for Study of Regulation (1982). An Examination of the Concept of Using Relative Customer Class Risk to Set Target Rates of Return in Electric Cost-of-Service Studies, with William E. Avera, Electricity Consumers Resource Council (ELCON) (1981); portions reprinted in Public Utilities Fortnightly (Nov. 11, 1982). The Spring Thing (A) and (B) and Teaching Notes, with Mike E. Miles, a two-part case study in the evaluation, management, and control of risk; distributed by Harvard's Intercollegiate Case Clearing House; reprinted in Strategy and Policy: Concepts and Cases, A. A. Strickland and A. J. Thompson, Business Publications, Inc. (1978) and Cases in Managing Financial Resources, I. Matur and D. Loy, Reston Publishing Co., Inc. (1984). Energy Conservation in Existing Residences, Project Director for development of instruction manual and workshops promoting retrofitting of existing homes, Governor's Office of Energy Resources and Department of Energy ( ). Linear Algebra, Calculus, Sets and Functions, and Simulation Techniques, contributed to and edited four mathematics programmed learning texts for MBA students, Texas Bureau of Business Research (1975). Articles and Notes How to Value Personal Service Practices, with Keith Wm. Fairchild, The Practical Accountant (August 1989). The Impact of Regulatory Climate on Utility Capital Costs: An Alternative Test, with Adrien M. McKenzie, Public Utilities Fortnightly (May 25, 1989). North Arctic Industries, Limited, with Keith Wm. Fairchild, Case Research Journal (Spring 1988). Regulatory Effects on Electric Utilities' Cost of Capital Reexamined, with Louis E. Buck, Jr., Public Utilities Fortnightly (September 2, 1982). Capital Needs for Electric Utility Companies in Texas: , Texas Business Review (January-February 1979), reprinted in The Energy Picture: Problems and Prospects, J. E. Pluta, ed., Bureau of Business Research (1980). Some Thoughts on the Rate of Return to Public Utility Companies, with William E. Avera, Proceedings of the NARUC Biennial Regulatory Information Conference (1978). Regulatory Problems of EFTS, with Robert McLeod, Issues in Bank Regulation (Summer 1978) reprinted in Illinois Banker (January 1979). Regulation of EFTS as a Public Utility, with Robert McLeod, Proceedings of the Conference on Bank Structure and Competition (1978). Equity Management of REA Cooperatives, with Jerry Thomas, Proceedings of the Southwestern Finance Association (1978). Capital Costs Within a Firm, Proceedings of the Southwestern Finance Association (1977). The Cost of Capital to a Wholly-Owned Public Utility Subsidiary, Proceedings of the Southwestern Finance Association (1977).

123 BRUCE H. FAIRCHILD Page 4 of 5 Selected Papers and Presentations Legislative Changes Affecting Texas Utilities, Texas Committee of Utility and Railroad Tax Representatives, Fall Meeting, Austin, Texas (September 1995). Rate of Return, Origins of Information, Economics, and Deferred Taxes and ITC's, New Mexico State University and National Association of Regulatory Utility Commissioners Public Utility Conferences on Regulation and the Rate-Making Process, Albuquerque, New Mexico (October 1983, 1984, 1985, 1986, 1987, 1988, 1990, 1991, 1992, 1994, and 1995, and September 1989); Pittsburgh, Pennsylvania (April 1993); and Baltimore, Maryland (May 1994 and 1995). Developing a Cost-of-Service Study, 1994 Texas Section American Water Works Association Annual Conference, Amarillo, Texas (March 1994). Financial Aspects of Cost of Capital and Common Cost Considerations, Kidder, Peabody & Co. Two-Day Rate Case Workshop for Regulated Utility Companies, New York, New York (June 1993). Cost-of-Service Studies and Rate Design, General Management of Electric Utilities (A Training Program for Electric Utility Managers from Developing Countries), Austin, Texas (October 1989 and November 1990 and 1991). Rate Base and Revenue Requirements, The University of Texas Regulatory Institute Fundamentals of Utility Regulation, Austin, Texas (June 1989 and 1990). Determining the Cost of Capital in Today's Diversified Companies, New Mexico State University Public Utilities Course Part II, Advanced Analysis of Pricing and Utility Revenues, San Francisco, California (June 1990). Estimating the Cost of Equity, Oklahoma Association of Tax Representatives, Tulsa, Oklahoma (May 1990). Impact of Regulations, Business and the Economy, Leadership Dallas, Dallas, Texas (November 1989). Accounting and Finance Workshop and Divisional Cost of Capital, New Mexico State University Current Issues Challenging the Regulatory Process, Albuquerque, New Mexico (April 1985 and 1986) and Santa Fe, New Mexico (March 1989). Divisional Cost of Equity by Risk Comparability and DCF Analyses, NARUC Advanced Regulatory Studies Program, Williamsburg, Virginia (February 1988) and USTA Rate of Return Task Force, Chicago, Illinois (June 1988). Revenue Requirements, Revenue, Pricing, and Regulation in Texas Water Utilities, Texas Water Utilities Conference, Austin, Texas (August 1987 and May 1988). Rate Filing Basic Ratemaking, Texas Gas Association Accounting Workshop, Austin, Texas (March 1988). The Effects of Regulation on Fair Market Value: P.H. Robinson A Case Study, Annual Meeting of the Texas Committee of Utility and Railroad Tax Representatives, Austin, Texas (September 1987). How to Value Closely-held Businesses, TSCPA 1987 Entrepreneurs Conference, San Antonio, Texas (May 1987). Revenue Requirements and Determining the Rate of Return, New Mexico State University Regulation and the Rate-Making Process, Southwestern Water Utilities Conference, Albuquerque, New Mexico (July 1986) and El Paso, Texas (November 1980). How to Evaluate Personal Service Practices, TSCPA CPE Exposition 1985, Houston and Dallas, Texas (December 1985). How to Start a Small Business Accounting and Record Keeping, University of Texas Management Development Program, Austin, Texas (October 1984). Project Financing of Public Utility Facilities, TSCPA Conference on Public Utilities Accounting and Ratemaking, San Antonio, Texas (April 1984).

124 BRUCE H. FAIRCHILD Page 5 of 5 Valuation of Closely-Held Businesses, Concho Valley Estate Planning Council, San Angelo, Texas (September 1982). Rating Regulatory Performance and Its Impact on the Cost of Capital, New Mexico State University Seminar on Regulation and the Cost of Capital, El Paso, Texas (May 1982). Effect of Inflation on Rate of Return, Cost of Capital Conference and Workshop, Pinehurst, North Carolina (April 1981). Original Cost Versus Current Cost Regulation: A Re-examination, Financial Management Association, New Orleans, Louisiana (October 1980). Capital Investment Analysis for Electric Utilities, The University of Texas at Dallas, Richardson, Texas (June 1980). The Determinants of Capital Costs to the Electric Utility Industry, with Cedric E. Grice, Southwestern Finance Association, San Antonio, Texas (March 1980). The Entrepreneur and Management: A Case Study, Small Business Administration Seminar, Austin, Texas (October 1979). Capital Budgeting by Public Utilities: A New Perspective, with W. Clifford Atherton, Jr., Financial Management Association, Boston, Massachusetts (October 1979). Issues in Regulated Industries Electric Utilities, University of Texas at Dallas 4th Annual Public Utilities Conference, Dallas, Texas (July 1979). Investment Conditions and Strategies in Today's Markets, American Society of Women Accountants, Austin, Texas (January 1979). Attrition: A Practical Problem in Determining a Fair Return to Public Utility Companies, Financial Management Association, Minneapolis, Minnesota (October 1978). The Cost of Equity to Wholly-Owned Electric Utility Subsidiaries, with William L. Beedles, Financial Management Association, Minneapolis, Minnesota (October 1978). PUC Retrofitting Program, Texas Electric Cooperatives Spring Workshop, Austin, Texas (May 1978). The Economics of Regulated Industries, Consumer Economics Forum, Houston, Texas (November 1977). Public Utilities as Consumer Targets Is the Pressure Justified?, University of Texas at Dallas 2nd Annual Public Utilities Conference, Dallas, Texas (July 1977).

125 APPENDIX B BRUCE H. FAIRCHILD SUMMARY OF TESTIMONY BEFORE REGULATORY AGENCIES No. Utility Case Agency Docket Date Nature of Testimony 1. Arkansas Electric Cooperative Arkansas PSC U-3071 Aug-80 Wholesale Rate Design 2. East Central Oklahoma Electric Cooperative Oklahoma CC Sep-80 Retail Rate Design 3. Kansas Gas & Electric Company Kansas CC U Nov-80 PURPA Rate Design Standards 4. Kansas Gas & Electric Company Kansas CC U May-81 Attrition 5. City of Austin Electric Department City of Austin -- Jun-81 PURPA Rate Design Standards 6. Tarrant County Water Control and Improvement District No. 1 Texas Water Commission -- Oct-81 Wholesale Rate Design 7. Owentown Gas Company Texas RRC 2720 Jan-82 Revenue Requirements and Retail Rate Design 8. Kansas Gas & Electric Company Kansas CC U Aug-82 Attrition 9. Mississippi Power Company Mississippi PSC U-4190 Sep-82 Working Capital 10. Lone Star Gas Company Texas RRC 3757; 3794 Feb-83 Rate of Return on Equity 11. Kansas Gas & Electric Company Kansas CC U Feb-83 Rate of Return on Equity 12. Southwestern Bell Telephone Company Oklahoma CC Oct-83 Rate of Return on Equity 13. Morgas Company Texas RRC 4063 Nov-83 Revenue Requirements 14. Seagull Energy Texas RRC 4541 Jul-84 Rate of Return 15. Southwestern Bell Telephone Company 16. Kansas Gas & Electric Company, Kansas City Power & Light Company, and Kansas Electric Power Cooperatives FCC Nov-84 Rate of Return on Equity Kansas CC U; U; U May-85 Nuclear Plant Capital Costs and Allowance for Funds Used During Construction 17. Lone Star Gas Company Texas RRC 5207 Oct-85 Overhead Cost Allocation 18. Westar Transmission Company Texas RRC 5787 Nov-85 Jan-86 Jul City of Houston Texas Water Commission RC-022; RC ENSTAR Natural Company Alaska PUC TA 50-4; R-87-2; U Brazos River Authority Texas Water Commission RC-020 Rate of Return, Rate Design, and Gas Processing Plant Economics Nov-86 Line Losses and Known and Measurable Changes Nov-86 May-87 May-87 Cost Allocation, Rate Design, and Tax Rate Changes Jan-87 Revenue Requirements and Rate Design 22. East Texas Industrial Gas Company Texas RRC 5878 Feb-87 Revenue Requirements and Rate Design 23. Seagull Energy Texas RRC 6629 Jun-87 Revenue Requirements 1

126 Bruce H. Fairchild Summary of Testimony Before Regulatory Agencies (Continued) No. Utility Case Agency Docket Date Nature of Testimony 24. ENSTAR Natural Company Alaska PUC U Jul-87 Sep-87 Sep-87 Cost Allocation, Rate Design, and Contracts 25. High Plains Natural Gas Company Texas RRC 6779 Sep-87 Rate of Return 26. Hughes Texas Petroleum Texas RRC 2-91,855 Jan-88 Interim Rates 27. Cavallo Pipeline Company Texas RRC 7086 Sep-88 Revenue Requirements 28. Union Gas System, Inc. Kansas CC U Mar-89 Aug-89 Rate of Return 29. ENSTAR Natural Gas Company Alaska PUC U Mar-89 Cost Allocation and Bypass 30. Morgas Co. Texas RRC 7538 Aug-89 Rate of Return and Cost Allocation 31. Corpus Christi Transmission Company Texas RRC 7346 Sep-89 Revenue Requirements 32. Amoco Gas Co. Texas RRC 7550 Oct-89 Rate of Return and Cost Allocation 33. Iowa Southern Utilities Iowa Utilities Board 34. Southwestern Bell Telephone Company RPU-89-7 Nov-89 Mar-90 FCC Feb-90 Apr Lower Colorado River Authority Texas PUC 9427 Mar-90 Aug-90 Aug-90 Rate of Return on Equity Rate of Return on Equity Revenue Requirement 36. Rio Grande Valley Gas Company Texas RRC 7604 May-90 Consolidated FIT and Depreciation 37. Southern Union Gas Company El Paso PURB -- Oct-90 Disallowed Expenses and FIT 38. Iowa Southern Utilities Iowa Utilities Board RPU-90-8 Nov-90 Feb-91 Rate of Return on Equity 39. East Texas Gas Systems Texas RRC 7863 Dec-90 Revenue Requirements 40. San Jacinto Gas Transmission Texas RRC 7865 Dec-90 Revenue Requirements 41. Southern Union Gas Company Austin; Texas RRC 42. Southern Union Gas Company Port Arthur; Texas RRC Feb-91 Feb-91 Mar-91 Aug-91 Oct-91 Rate of Return and Acquisition Adjustment Rate of Return and Acquisition Adjustment 43. Cavallo Pipeline Company Texas RRC 8016 Jun-91 Revenue Requirements 44. New Orleans Public Service Inc. New Orleans City Council CD-91-1 Jun-91 Mar-92 Rate of Return on Equity 45. Houston Pipe Line Company Texas RRC 8017 Jul-91 Rate of Return 2

127 Bruce H. Fairchild Summary of Testimony Before Regulatory Agencies (Continued) No. Utility Case Agency Docket Date Nature of Testimony 46. Southern Union Gas Company El Paso PURB -- Aug-91 Sep Southwestern Gas Pipeline, Inc. Texas RRC 8040 Jan-92 Feb City of Fort Worth Texas Water Commission 49. Southern Union Gas Company Oklahoma Corp. Com A 9261-A 50. Minnegasco Minnesota PUC G-008/GR Mar-92 Aug-92 Dec-92 Oct-94 Nov-94 Acquisition Adjustment Rate Design and Settlement Interim Rates, Revenue Requirements, and Public Interest -- Jun-92 Rate of Return Jul-92 Dec-92 Rate of Return 51. Guadalupe-Blanco River Authority Texas PUC Sep-92 Cost Allocation and Bond Funds 52. Dorchester Intra-State Gas System Texas RRC 8111 Oct-92 Nov Corpus Christi Transmission Company GP and GPII Texas RRC Oct-92 Oct-92 Rate Impact of System Upgrade Revenue Requirements 54. East Texas Industrial Gas Company Texas RRC 8326 Mar-93 Revenue Requirements 55. Arkansas Louisiana Gas Company Arkansas PSC U Apr-93 Oct Texas Utilities Electric Company Texas PUC Jun-93 Jul Minnegasco Minnesota PUC G-008/GR Nov-93 Apr Gulf States Utilities Company Municipalities -- May-94 Oct-94 Nov Louisiana Power & Light Company Louisiana PSC U Aug-94 Feb-95 Rate of Return on Equity Impact of Nuclear Plant Construction Delay Rate of Return Rate of Return on Equity Rate of Return on Equity 60. San Jacinto Gas Transmission Texas RRC 8429 Sep-94 Revenue Requirements 61. Cavallo Pipeline Company Texas RRC 8465 Sep-94 Revenue Requirements 62. Eastrans Limited Partnership Texas RRC 8385 Oct-94 Revenue Requirements 63. Gulf States Utilities Company Louisiana PSC U Oct-94 Rate of Return on Equity 64. Entergy Services, Inc. FERC ER Mar-95 Nov-95 Rate of Return on Equity 65. East Texas Gas Systems Texas RRC 8435 Apr-95 Revenue Requirements 66. System Energy Resources, Inc. FERC ER May-95 Dec-95 Jan-96 Rate of Return on Equity 3

128 Bruce H. Fairchild Summary of Testimony Before Regulatory Agencies (Continued) No. Utility Case Agency Docket Date Nature of Testimony 67. Minnegasco Minnesota PUC G-008/GR Aug-95 Dec-95 Rate of Return 68. Entex Louisiana PSC U Aug-95 Rate of Return 69. City of Fort Worth Texas NRCC SOAH Nov-95 Public Interest of Contract 70. Seagull Energy Corporation Texas RRC 8589 Nov-95 Revenue Requirements 71. Corpus Christi Transmission Company LP Texas RRC 8449 Feb-96 Revenue Requirements 72. Missouri Gas Energy Missouri PSC GR Apr-96 Sep-96 Oct-96 Rate of Return 73. Entex Mississippi PSC 96-UA-202 May-96 Rate of Return 74. Entergy Gulf States, Inc. Louisiana PSC U May-96 Rate of Return on Equity (Gas) 75. Entergy Gulf States, Inc. Louisiana PSC U May-96 Oct-96 Rate of Return on Equity 76. American Gas Storage, L.P. Texas RRC 8591 Sep-96 Revenue Requirements 77. Entergy Louisiana, Inc. Louisiana PSC U Sep-96 Oct Lone Star Pipeline and Gas Company Texas RRC 8664 Oct-96 Jan Entergy Arkansas, Inc. Arkansas PSC U Oct-96 Sep-97 Rate of Return on Equity Rate of Return Rate of Return on Equity 80. East Texas Gas Systems Texas RRC 8658 Nov-96 Revenue Requirements 81. Entergy Gulf States, Inc. Texas PUC Nov-96 Jul-97 Rate of Return on Equity 82. Eastrans Limited Partnership Texas RRC 8657 Nov-96 Revenue Requirements 83. Enserch Processing, Inc. Texas RRC 8763 Nov-96 Interim Rates 84. Entergy New Orleans, Inc. City of New Orleans UD-97-1 Feb-97 Mar-97 May ENSTAR Natural Gas Company Alaska PUC U Mar-97 Apr-97 Rate of Return on Equity Service Area Certificate 86. San Jacinto Gas Transmission Texas RRC 8741 Sep-97 Revenue Requirements 87. Missouri Gas Energy Missouri PSC GR Nov-97 Apr-98 May Corpus Christi Transmission Company LP Rate of Return Texas RRC 8762 Dec-97 Revenue Requirements 89. Texas-New Mexico Power Company Texas PUC Feb-98 Excess Cost Over Market 90. Southern Union Gas Company Texas RRC 8878 May-98 Rate of Return 4

129 Bruce H. Fairchild Summary of Testimony Before Regulatory Agencies (Continued) No. Utility Case Agency Docket Date Nature of Testimony 91. Entergy Louisiana, Inc. Louisiana PSC U May-98 Jul Entergy Gulf States, Inc. Louisiana PSC U May-98 Jul-98 5 Financial Integrity Financial Integrity 93. ACGC Gathering Company, LLC Texas RRC 8896 Sep-98 Cost-based Rates 94. American Gas Storage, L.P. Texas RRC 8855 Oct-98 Revenue Requirements 95. Duke Energy Intrastate Network Texas RRC 8940 Jun-99 Rate of Return 96. Aquila Energy Corporation Texas RRC 8970 Aug-99 Revenue Requirements 97. San Jacinto Gas Transmission Texas RRC 8974 Sep-99 Revenue Requirements 98. Southern Union Gas Company El Paso PURB -- Oct-99 Rate of Return 99. TXU Lone Star Pipeline Texas RRC 8976 Oct-99 Feb-00 Rate of Return 100. Sharyland Utilities, L.P. Texas PUC Nov-99 Rate of Return 101. TXU Lone Star Gas Distribution Texas RRC 9145 Apr-00 Aug-00 Rate of Return 102. Rotherwood Eastex Gas Storage Texas RRC 9136 May-00 Revenue Requirements 103. Eastex Gas Storage & Exchange, Inc Eastex Gas Storage & Exchange, Inc. Texas RRC 9137 May-00 Revenue Requirements Texas RRC 9138 Jul-00 Revenue Requirements 105. East Texas Gas Systems Texas RRC 9139 Jul-00 Revenue Requirements 106. Eastrans Limited Partnership Texas RRC 9140 Aug-00 Revenue Requirements 107. Reliant Energy Entex City of Tyler -- Oct-00 Rate of Return 108. City of Fort Worth Texas NRCC SOAH Dec-00 CCN Rates and Financial Ability 109. Entergy Services, Inc. FERC RTO1-75 Dec-00 Rate of Return on Equity 110 ENSTAR Natural Gas Company Alaska PUC U Jun-01 Aug-01 Nov-01 Sep-02 Dec-02 Revenue Requirements, Cost Allocation, and Rate Design 111. TXU Gas Distribution Texas RRC 9225 Jul-01 Rate of Return 112. Centana Intrastate Pipeline LLC Texas RRC 9243 Aug-01 Rate of Return 113. Maxwell Water Supply Corp. Texas NRCC SOAH Oct-01 Mar-02 Apr Reliant Energy Arkla Arkansas PSC U Dec-01 Jun Entergy Services, Inc. FERC ER Reasonableness of Rates Rate of Return Mar-02 Rate of Return on Equity

130 Bruce H. Fairchild Summary of Testimony Before Regulatory Agencies (Continued) No. Utility Case Agency Docket Date Nature of Testimony 116. TXU Lone Star Pipeline Texas RRC 9292 Apr-02 Rate of Return 117. Southern Union Gas Company El Paso PURB -- Apr-02 Rate of Return 118. San Jacinto Gas Transmission Co. Texas RRC 9301 May-02 Rate of Return 119. Duke Energy Intrastate Network Texas RRC 9302 May-02 Rate of Return 120. Reliant Energy Arkla Oklahoma CC May-02 Rate of Return 121. TXU Gas Distribution Texas RRC 9313 Jul-02 Sep-02 Rate of Return 122. Entergy Mississippi, Inc. Mississippi PSC 2002-UN-256 Aug-02 Rate of Return on Equity 123. Aquila Storage & Transportation LP Texas RRC 9323 Sep-02 Revenue Requirements 124. Panther Pipeline Ltd. Texas RRC 9291 Oct-02 Revenue Requirements 125. SEMCO Energy Michigan PSC U Nov-02 Revenue Requirements 126. CenterPoint Energy Entex Louisiana PSC U Jan-03 Rate of Return 127. Crosstex CCNG Transmission Ltd. Texas RRC 9363 May-03 Revenue Requirements 128. TXU Gas Company Texas RRC 9400 May-03 Jan-04 Rate of Return 129. Eastrans Limited Partnership Texas RRC 9386 May-03 Rate of Return 130. CenterPoint Energy Entex City of Houston Jun-03 Rate of Return 131. East Texas Gas Systems, L.P. Texas RRC 9385 Jun-03 Rate of Return 132. ENSTAR Natural Gas Company Alaska RCA U Aug-03 Nov-03 Line Extension Surcharge 133. CenterPoint Energy Arkla Louisiana PSC Nov-03 Rate of Return 134. ENSTAR Natural Gas Company Alaska RCA U Feb-04 Cost Separation and Taxes 135. Sid Richardson Pipeline, Ltd. Texas RRC 9532 Jun-04 Nov-04 Revenue Requirements 136. ETC Katy Pipeline, Ltd. Texas RRC 9524 Sep-04 Revenue Requirements 137. CenterPoint Energy Entex Mississippi PSC 03-UN-0831 Sep-04 Rate Formula 138. Centana Intrastate Pipeline LLC Texas RRC 9527 Sep-04 Rate of Return 139. SEMCO Energy Michigan PSC U Dec-04 Revenue Requirements 140. Atmos Energy Energas Texas RRC 9539 Feb-05 Regulatory Policy 141. Crosstex North Texas Pipeline, L.P. Texas RRC 9613 Sep-05 Revenue Requirements 142. SiEnergy, L.P. Texas RRC 9604 Dec-05 Rate of Return, Income Taxes, and Cost Allocation 143. ENSTAR Natural Gas Company Alaska RCA TA Feb-06 Connection Fees 144. SEMCO Energy Michigan PSC U May-06 Dec-06 Revenue Requirements 6

131 Bruce H. Fairchild Summary of Testimony Before Regulatory Agencies (Continued) No. Utility Case Agency Docket Date Nature of Testimony 145. Atmos Energy Mid-Tex Texas RRC 9676 May-06 Oct-06 Revenue Requirements 146. EasTrans Limited Partnership Texas RRC 9659 Jun-06 Rate of Return 147. Kinder Morgan Texas Pipeline, L.P. Texas RRC 9688 Jul-06 Rate of Return 148. Crosstex CCNG Transmission Ltd. Texas RRC 9660 Aug-06 Revenue Requirements 149. Enbridge Pipelines (North Texas), LP Texas RRC 9691 Oct-06 Rate of Return 150. Panther Interstate Pipeline Energy FERC CP Mar-07 Revenue Requirements 151. El Paso Electric Company Texas PUC Jul-07 CCN 152. El Paso Electric Company NM PRC UT Jul-07 CCN 153. Atmos Energy Kansas CC 08-ATMG- 280-RTS Sep-07 Feb-08 Rate of Return on Equity 154. Centana Intrastate Pipeline LLC Texas RRC 9759 Sep-07 Rate of Return 155. Texas Gas Service Company Texas RRC 9770 Nov-07 Rate of Return 156. ENSTAR Natural Gas Company Alaska RCA U Jun-08 Rate Class Switching 157. ConocoPhillips Transportation Alaska Alaska RCA TL Oct-08 Rate of Return 158. ExxonMobil Pipeline Co. Alaska RCA TL Nov-08 Rate of Return 159. Crosstex North Texas Pipeline, L.P. Texas RRC 9843 Dec-08 Revenue Requirements 160. Koch Alaska Pipeline Company Alaska RCA TL Dec-08 Rate of Return 161. Unocal Pipeline Company Alaska RCA TL Dec-08 Rate of Return 162. ETC Katy Pipeline, Ltd. Texas RRC 9841 Dec-08 Revenue Requirements 163. Oklahoma Natural Gas Oklahoma CC Jan-09 Rate of Return on Equity 164. Entergy Mississippi, Inc. Mississippi PSC EC Mar 09 Rate of Return on Equity 165. ENSTAR Natural Gas Company Alaska RCA U U Jun-09 Jul-09 Oct-09 Revenue Requirements, Cost Allocation, and Rate Design 166. EasTrans, LLC Texas RRC 9857 Jun-09 Rate of Return 167. Oklahoma Natural Gas Oklahoma CC Jun-09 Rate of Return 168. Crosstex CCNG Transmission Ltd. Texas RRC 9858 Jun-09 Revenue Requirements 169. ConocoPhillips Transportation Alaska Alaska RCA TL Jul-09 Rate of Return 170. ENSTAR Natural Gas Company Alaska RCA U Jul-09 Gas Cost Adjustment 171. Kinder Morgan Texas Pipeline, LLC Texas RRC 9889 Jul-09 Rate of Return 172. Koch Alaska Pipeline Company Alaska RCA TL Jul-09 Rate of Return 173. ExxonMobil Pipeline Co. Alaska RCA TL Nov-09 Rate of Return 174. Texas Gas Service Company El Paso PURB -- Dec-09 Rate of Return 175. Unocal Pipeline Company Alaska RCA TL Dec-09 Rate of Return 7

132 Bruce H. Fairchild Summary of Testimony Before Regulatory Agencies (Continued) 176. Kuparuk Transportation Company Alaska RCA P Apr-10 Rate of Return 177. Trans-Alaska Pipeline System FERC ISO Apr 10 Rate of Return 178. Texas Gas Service Texas RRC 9988 May 10 Rate of Return 8

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248 STATE OF MICHIGAN BEFORE THE MICHIGAN PUBLIC SERVICE COMMISSION ***** In the matter of the application of ) SEMCO ENERGY GAS COMPANY to combine its ) MPSC Division and Battle Creek Division rates and ) Case No. U for authority to redesign and increase its rates, ) on a combined basis, for the sale and transportation ) of natural gas and for other relief ) DIRECT TESTIMONY AND EXHIBITS OF JAMES VAN SICKLE ON BEHALF OF SEMCO ENERGY GAS COMPANY June 2010

249 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company Q. Please state your name and business address. A. My name is James A. Van Sickle. My business address is 1411 Third Street, Port Huron, Michigan Q. By whom are you employed and what is your position with that employer? A. My present position is Rates Analyst in the Rates and Regulatory Department at SEMCO Energy Gas Company ( SEMCO Gas or the Company ), a division of SEMCO Energy, Inc. that provides natural gas sales and tranportation service to approximately 285,000 customers in areas throughout the State of Michigan, in what are known as the MPSC Division and Battle Creek Division. The Company currently serves Michigan customers in two divisions, the "MPSC Division" and "Battle Creek Division," and I occasionally refer to these divisions in my testimony. Q. What are your responsibilities as Rates Analyst? A. Under the supervision of the Manager of Regulatory Affairs, I have responsibility for participating in Michigan Public Service Commission (the MPSC or the Commission ) proceedings, including preparing exhibits and workpapers, writing testimony, submitting to cross-examination, and otherwise presenting the Company's positions to the MPSC. I am also responsible for the preparation and filing of MPSC case applications, communication of tariff changes and other regulatory assignments. My additional responsibilities include monitoring and analyzing Federal Energy Regulatory Commission activity related to matters affecting the 1

250 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company Company s interests and researching regulatory topics that arise at the Company from time to time. Q. Please summarize your academic background. A. In 1981, I graduated from St. Clair County Community College with an Associates degree in Arts. In 1984, I graduated from Michigan State University with a Bachelor of Arts Humanities/Pre-Law degree. In 1990, I received an Associates degree in Paralegal Studies from Mountain West Junior College. Q. Please summarize your relevant employment and professional experience. A. In 1997, I joined SEMCO Gas as a Marketing Analyst. While with the Marketing Department, I developed and implemented procedural changes that streamlined several aspects of that department s activities. In 1999, I moved into the position of Manager of Process and Analysis with SEMCO Energy Ventures ( Ventures ), a subsidiary of SEMCO Energy, Inc. Under the direction of the president of Ventures, I gathered and prepared information for the construction and engineering companies, as well as the production facilities that were then held by Ventures. I then worked in the Training Department for SEMCO Gas, tracking training documentation and developing various training-related processes. I have been in the Rates and Regulatory Department since June 2004 with the duties I described earlier, including data gathering and presentation, reporting, and various support roles. 2

251 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company Q. Have you previously filed testimony with the MPSC? A. Yes, I filed testimony on behalf of SEMCO Gas in Case Nos. U-14338, U , U-14726, U-14718, U-14893, U-15043, U-15130, U15452, U , U-15702, U-15703, U and U The topics I covered included forecasting volumes, tariff changes and Gas Cost Recovery planning. Q. What is the purpose of your testimony in this proceeding? A. The purpose of my testimony is to (1) discuss the Company s Lost and Unaccounted for Gas ( LAUF ), Company Use ( CU ) gas, Gas in Storage, Advertising Classifications and Non Utility Expenses, (2) sponsor Test Year Volumes, Customers and Adjustments based on a review of Historic Customer Data, and (3) sponsor tariff sheets which reflect all of the Company s proposed tariff changes. Q. Are you sponsoring any exhibits in this proceeding? A. Yes. I am sponsoring the following exhibits: Exhibit A-3, Schedule C-5 Exhibit A-3, Schedule C-6 Exhibit A-5, Schedule E-1 Exhibit A-5, Schedule E-2 Advertising Classifications Non-Utility Expenditures Summary of Historical Base Year Revenues Historic Test Year Volumes and Customers Exhibit A-5, Schedule E-3 Historic Test Year Revenues and Adjustments Excluding Gas Costs Exhibit A-8, Schedule B-5 Cost of Gas Exhibit A-8, Schedule B-6 Gas Stored Underground 3

252 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company Exhibit A-9, Schedule C-12 Exhibit A-11, Schedule E-2 Exhibit A-11, Schedule E-7 Exhibit A-11, Schedule E-8 LAUF and CU Summary of 2011 Customers, Volumes and Revenue Summary of Proposed Tariff Changes Proposed Tariff Sheets Q. Were these exhibits prepared by you or under your direction? A. Yes they were. Q. Does this list of exhibits also show the order in which you will discuss various topics in your testimony? A. Yes Q. Does the data you discuss in your testimony come from the books and records of the Company, subject to the adjustments you also describe in your testimony? A. Yes. RATE CASE DATA, INCLUDING ADJUSTMENTS Q. Please explain Exhibit A-3, Schedule C-5, Advertising Classifications. A. Exhibit A-3, Schedule C-5, lists advertising expenses that have been booked as utility expense during the 2009 historic year. These costs have typically been adjusted by the Commission for ratemaking purposes. The gross amount is used by Mr. Moses in Exhibit A-9, Schedule C-5. Q. Please explain Exhibit A-3, Schedule C-6, Non-Utility Expenditures. A. Exhibit A-3, Schedule C-6, lists the dues paid to certain organizations by the Company during the historic year ended December 31, The Commission has in the past adjusted these dues payments, in whole or in part, in establishing SEMCO Gas rates. While these dues payments are a legitimate cost of doing business, the Company has recognized this past 4

253 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company Commission ratemaking practice and not included these dues payments in the cost of service used to calculate the proposed base rates in this proceeding. The gross adjusted amount is used by Mr. Moses in Exhibit A-9, Schedule C-5. Q. Please explain Exhibit A-5, Schedule E-1. A. Exhibit A-5, Schedule E-1 is a summary of Historical Base year Revenues. The data in Exhibit A-5, Schedule E-1 does not distinguish between sales and gas customer choice ( GCC ) since, for rate purposes, with the exception of the Gas Cost Recovery ( GCR ) mechanism/factor, both types of services are billed at identical rates. Q. Please explain Exhibit A-5, Schedule E-2. A. This schedule is a summary of actual 2009 customers and volumes. As discussed by Mr. Alger, the Company is proposing to change the billing units for its MPSC sales and customer choice customers to a themal basis from a volumetric per hundreds of cubic feet, of Ccf, basis. (All of the Company s MPSC Division transportation customers and its Battle Creek Division transportation customers, GCR and GCC customers are currently billed on a thermal basis.) For this reason, historic volumetric data for MPSC Division GCR and GCC customers has been converted to dekatherms in this exhibit, using the MPSC Division Btu average by month. Q. Please explain Exhibit A-5, Schedule E-3. A. Exhibit A-5, Schedule E-3 breaks out 2009 revenue by customer class and type of revenue. Q. Please explain Exhibit A-8, Schedule B-5. A. This exhibit shows the projected 2011 cost of gas. This projection was developed using the forecasted 2011 Henry Hub price of $6.25/Dth as supported by Dr. Carpenter, and includes the forecasted fuel percentages 5

254 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company used in the Company s GCR plans, Case Nos. U and U and a monthly basis (a regional market adjustment to NYMEX prices), updated as of May 3, Finally, the fixed costs as projected in Case Nos. U and U were used and divided by the projected volumes from Exhibit A-11, Schedule E-2, page 1, column (F) to obtain the per Dth fixed cost. The resulting estimated 2011 average gas cost is $7.1275/Dth. This 2011 average cost is used to determine the Company s cost of gas in storage adjustment to working capital requirements and for pricing the test year LAUF adjustment. For the cost of gas in storage, I removed fixed costs of $0.7976/Dth resulting in an average cost of $6.3299/Dth. Q. Please explain Exhibit A-8, Schedule B-6, Working Capital Adjustment for Gas Stored Underground. A. Exhibit A-8, Schedule B-6, shows the projected working capital impact to the cost of gas stored underground for 2011 compared to the cost of gas stored underground in During 2009, SEMCO Gas had a combined 13-month average balance of gas stored underground of 8,591,919 Dth (see Column (A)) at a combined 13-month average cost of $49,816,313 (see Column (C)). Column (D) shows that the anticipated month average balance of gas in storage will be slightly less than the 2009 figure, at 8,424,346 Dth. This month average is based on the storage estimates included in the Company s GCR plans in Case Nos. U and U The plan figures were adjusted for actual March 2010 balances and the cost of gas as developed in Exhibit A-8, Schedule B-5, less the fixed costs. The cost of the month average gas in storage is projected to be $48,039,111. This amount is used by Dr. Fairchild in Exhibit A-8, Schedule B-4. The decrease in the 13-month average storage dollar balance is the result of the lower average cost of gas in storage in 2011 and a lower average storage volume. 6

255 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company Q. Please explain Exhibit A-9, Schedule C-12, LAUF. A. Page 1 of 2 of Exhibit A-9, Schedule C-12, shows the 2009 Company Use gas percentage of 0.327% and the five-year average of Lost and Unaccounted-for, or LAUF, gas and total throughput, for the period from September through August in , , , and , in Dth. The resulting five-year average percentage of LAUF gas was 0.725%. Page 2 of 2, line 1, of Exhibit A-9, Schedule C-12, shows the adjusted and normalized Total Throughput Dth for Line 2 shows the adjusted and normalized transportation Dth for Line 4 shows the 2009 Company Use gas percentage compared to total throughput. Line 5 shows the five-year average percentage of LAUF gas compared to total throughput. Line 6 shows the sum of lines 4 and 5 for the total percentage of gas used for developing the Gas In Kind ( GIK ) percentage, which is 1.053%. The Company is proposing that the GIK percentage charged to transportation customers be changed from the current GIK percentage of 1.17% to a GIK percentage of 1.053%. Line 8 shows the calculated Company Use gas for 2011 and Line 9 shows the calculated five-year average for the 2011 LAUF gas, in dekatherms. Line 10 shows the calculated 2011 GIK amount, in dekatherms, by applying the GIK percentage on line 6 to the 2011 transportation amounts on line 2. Line 12 shows the net sum of lines 8, 9 and 10 for the total 2011 Net Company Use gas and LAUF gas, in dekatherms. These amounts are then priced at the 2011 Cost of Gas. Lines 16, 17, and 18 show the actual 2009 amounts of Company Use gas, LAUF gas, and GIK, in dekatherms, which are then totaled on line 20. Also on lines 16, 17 and 18 are the 2009 booked dollar amounts of Company Use gas, LAUF gas and GIK, which are also totaled on line 20. Line 23 shows the 2009 net 7

256 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company cost of Company Use, LAUF gas, and GIK subtracted from the 2011 net cost of Company Use, LAUF gas and GIK. These calculations produce a test year revenue deficiency adjustment of $700,093. This amount is used by Dr. Fairchild on Exhibit A-9, Schedule C-11. Q. Please describe Exhibit A-11, Schedule E-2. A. Exhibit A-11, Schedule E-2, page 1 of 2 shows 2011 projected customer counts, volumes and adjustments. The exhibit begins with nonnormalized 2009 volumes and adjusts them for weather-normalized usage, as discussed by Mr. Raab. The next adjustment uses the difference in 2011 Projected Volumes, as developed by Mr. Raab. The Energy Optimization adjustment reflects that reduced usage associated with Energy Optimization plan programs as developed by Mr. Alger. The final adjustment is due to changes in customer counts. The change in the customer count was developed by Mr. Raab. These normalizations and adjustments produce the Company s 2011 Normalized and adjusted dekatherms of usage and numbers of customers. Q. Please continue. A. Exhibit A-11, Schedule E-2, page 2 of 2, begins with booked volumetric revenue from 2009 and adjusts that revenue to normalize the data for the effects of weather (volume change X distribution rate), projected 2011 volumes (volume change X distribution rate), and reduced usage due to Energy Optimization plan programs (reduced volumes X distribution rate). The exhibit then shows the per-books number of customers and meter charge revenue. This data is adjusted for projected customer changes and the effects of bill proration. The proration adjustment was sponsored by Dr. Fairchild. Total Revenue combines the volumetric and customer and meter charge revenue adjustments for total 2011 normalized revenue of $101,024,934. 8

257 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company PROPOSED TARIFF CHANGES Q. Please give an overview of the Company s proposed tariff changes. A. The Company based its tariff changes on the current MPSC tariff. It made changes necessary to combine the Battle Creek and MPSC Divisions. In addition to those necessary changes, the Company is proposing changes to its transportation tariff section, changes that reflect its witness s testimony as well as administrative changes in various sections. I should note that Exhibit A-11, Schedule E-8, is presented in Redline in Microsoft Word, and Exhibit A-11, Schedule E-7, lists the proposed tariff changes and the sponsor of the change. Q. Please describe Exhibit A-11, Schedule E-7. A. Exhibit A-11, Schedule E-7, is a summary of the tariff changes proposed by the Company in this proceeding. In addition to the changes I am sponsoring, Messrs. Raab, Fairchild and Alger are also sponsoring various changes to the Company s tariff. Changes were made to reflect the proposed combination of the MPSC and Battle Creek Divisions and to reflect changes in units of measurement from hundreds of cubic feet to Therms. Q. Please describe the changes to Sheet A-9 of Exhibit A-11, Schedule E-8. A. Sheet A-9 of the SEMCO Gas Tariff has been updated to show the addition of the Battle Creek Division service area to the existing MPSC Division service area map. Q. Please describe the changes to Sheet A-14 of Exhibit A-11, Schedule E-8. A. Sheet A-14 now reflects the addition of the Battle Creek counties, villages, towns and townships to the list of areas served by the Company. Q. Please describe the changes to Sheet C-18 of Exhibit A-11, Schedule E-8. A. Sheet C-18 of Exhibit A-11, Schedule E-8 has had language deleted from C4.1 to comport with the rate design proposed by the Company. 9

258 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company Q. Please describe the changes to Sheet C-24 of Exhibit A-11, Schedule E-8. A. Sheet C-24 contains a change in the amount that may be charged for the Turn-On charge when a customer requests a turn-off and turn-on within one year. The Company believes that it is important to make it unattractive, financially through the use of turn-on charges, for customers to avoid the monthly Single Fixed charges by disconnecting and re-connecting service. Q. Please describe the changes to Sheet C-31 of Exhibit A-11, Schedule E-8. A. The change to Sheet C-31 clarifies the definition of a Customer Attachment Program ( CAP ) Project. Q. Please describe the changes to Sheet C-33 of Exhibit A-11, Schedule E-8. A. The CAP projects on Sheet C-33 have been updated and Battle Creek projects have been added. Q. Please describe the changes to Sheet D-3 of Exhibit A-11, Schedule E-8. A. The Capacity Demand Charge and Balancing Charge have been removed and combined into a single charge Balancing and Demand Charge. Q. Please describe the changes to Sheet D-7 of Exhibit A-11, Schedule E-8. A. On Sheet D-7, the Residential Service has been redefined as Residential A and Residential B. The Single Fixed charge has been added to Residential A and for Residential B, the Customer Charge and Distribution Charge have been updated. Dr. Raab develops these charges. With the change to a Single Fixed charge rate design, the Distribution Charge has been removed from the Residential A tariff and a definition for each residential rate has been added. Q. Please describe the changes to Sheet D-8 of Exhibit A-11, Schedule E-8. A. On Sheet D-8, GS-1 Service has been defined as GS-1A and GS-1B service, consistent with the rate design proposal for these customers. The Distribution Charge has been removed from the GS-1A, GS-2 and GS-3 10

259 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company service categories, and the proposed Single Fixed charges have been added. With the rate design proposed in this case, the language regarding crossing points has been removed. A definition has been added for each Service Category and language has been added regarding the Company s proposed annual review. Also, the Customer Charge Billing Option, which allows a customer to contract with the Company to be billed the annual sum of the 12 monthy Customer Charges, evenly divided, over whichever billing months during the year that are agreeable to the Company and the customer, has been removed since it has not been used by the GS rate class. Q. Please continue. A. On Sheets E-2 through E-4 of Exhibit A-11, Schedule E-8, there are some minor corrections to labeling and a clarification to the definition of Shipper. Q. Please describe the changes to Sheet E-5 of Exhibit A-11, Schedule E-8. A. On Sheet E-5, the words including failure to pay an invoice, have been added to Part E, Limitations of Service. This phrase has been added to reiterate what is also stated in Section C1.2, Sheet C-2.00, on the discontinuance of supply or services. The phrase is not intended to expand the reasons for which the Company may discontinue or limit transportation service. Q. Please describe the changes to Sheet E-9 of Exhibit A-11, Schedule E-8. A. On Sheet E-9, the addition of the word "analog" to section C is required for compatibility with the Company s data system. The Company s mechanism for receiving daily measurement information from its Metretek units in the field does not support communications received from digital phone systems. Q. Please describe the changes to Sheet E-11 of Exhibit A-11, Schedule E-8. 11

260 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company A. On Sheet E-11, the Nomination deadline has been extended to 12:30 p.m., ECT. This is the Nomination deadline in the current Battle Creek Division tariff. Q. Please describe the changes to Sheet E-12 of Exhibit A-11, Schedule E-8. A. The first change to Sheet E-12 is the addition of the heading "Measurement/Communication Malfunction" to make it easier to locate such information on the page. The second change is the relocation of the language on Balancing Recovery Costs and revenue from this sheet to the area of the tariff that discusses balancing charges. Q. Please describe the changes to Sheet E-13 of Exhibit A-11, Schedule E-8. A. On Sheet E-13.00, a heading has been added to the section of the tariff that discusses balancing requirements. Q. Please describe the changes to Sheet E-14 of Exhibit A-11, Schedule E-8. A. There are two material changes proposed for Sheet E Referring to the section with the heading "Interruptible Balancing Restriction Notice (IBR Notice)," the phrase due to capacity constraints has been deleted. The Company s tariff, Section C, addresses the issue of curtailment and refers to capacity constraints in relation to physical capacity of its city gate stations and distribution system. IBR Notices are issued if the Company s ability to balance its transportation customers is restricted, and capacity constraints are not the only cause. Such balancing is managed through utilization of the Company s pipeline transportation and storage assets. The second change deals with pipeline charges. The pipelines that serve the Company require balancing on a daily basis. When the Company s imbalance falls outside of the pipeline balancing parameters, the pipeline assesses balancing charges to the Company. Those charges are made up of overrun charges and penalties. The current language in the Company s transportation tariff allows for the passing through of pipeline 12

261 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company penalties to transportation customers whose activities during an IBR cause the Company to incur such penalties. The revenue collected is then credited to the GCR. The Company is proposing to add pipeline overrun charges to the charges which may be passed on to transportation customers during an IBR if their activity results in the issuance of such charges by the pipeline. As with the pipeline penalties, the revenue collected will be credited to the GCR. Q. Please describe the changes to Sheet E-16 of Exhibit A-11, Schedule E-8. A. On Sheet E under the heading of "Pooling," the Company is specifying that customers wishing to join a balancing pool must have the same required daily and monthly balancing parameters with all members of the balancing pool. For example, the Company s tariff allows for a daily balancing tolerance of 20% of the nomination. If a customer, wishing to join a pool, contracts for a different daily balancing tolerance, such as 30%, and the rest of the pool has a 20% daily balancing tolerance, the customer will not be allowed to be a member of the pool utilizing the 20% tolerance. If more than one customer has a daily balancing tolerance of 30%, they will be allowed to pool together. Q. Please describe the changes to Sheet E-17 of Exhibit A-11, Schedule E-8. A. On Sheet E-17.00, GS-1A and GS-1B have been added to paragraph B. In paragraph C, language has been removed regarding the conversion of Mcf to Dth for aggragated GS accounts under transportation master accounts. The Customer Charge has been removed from each transportation rate. The Single Fixed charge has been added and the volumetric transportation rates have been removed. Q. Please describe the changes to Sheet E-18 of Exhibit A-11, Schedule E-8. 13

262 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company A. On Sheet E the Selection of Service Category and Transportation Rate sections have been removed and a definition has been added for each Service Category and language has been added regarding the Company s proposed annual review. The reference to the Customer Charge has been removed and the Single Fixed charge has been added. Finally, the Gas in Kind rate has been changed as proposed by the Company. Q. Please describe the changes to Sheet E-19 of Exhibit A-11, Schedule E-8. A. On Sheet E-19.00, the language added to Section E, Sheet No. E is the section discussed above regarding Balancing Recovery Costs that was moved from Sheet No. E Q. Please describe the changes to Sheet E-20 of Exhibit A-11, Schedule E-8. A. On Sheet E-20, the Company is proposing to revise the language under the heading Discontinuation of Service. Currently, a Shipper balancing its load individually is subject to service termination if the customer has failed to arrange for delivery of its own gas supply for two consecutive days. In such a situation, the shipper "leans" on the system by burning system supply gas rather than gas supplies for which it has arranged. The Company proposes to begin the process of notification of the discontinuation of service on the first day that the shipper has failed to arranged for the delivery of its own gas supply (i.e., that gas is not being received by the Company on behalf of the Shipper). Q. If a Shipper, balancing its load individually, burns system supply gas, what are the consequences to that Shipper? A. The Company s tariff provides for the assessment of balancing charges and penalties for a Shipper s daily imbalance activity. If, for example, a Shipper is required to balance within 20% of the supply nominated to the Company on its behalf, and the Shipper s daily imbalance exceeds 20%, the Shipper incurs excess balancing charges and potential penalties. In 14

263 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company the instance where a Shipper has no supply nominated to the Company, the tolerance effectively becomes 0%, and thus the Shipper may incur penalty charges (with $10/Dth being the minimum penalty rate). A Shipper in that situation that burns 1,000 dekatherms but has not arranged for the delivery of its own gas supplies would be assessed at least a $10,000 penalty. Reducing the period during which the Shipper is able to burn system supply limits the Shipper s risk of penalties and may provide earlier notice to the shipper of the failure of its gas supply arrangements. Q. What is the impact to Shippers who are part of a balancing pool if the Pooling Agent fails to deliver gas for the pool members? A. If the Pooling Agent fails to deliver gas on behalf of the pool members, the usage of Shippers in that pool is balanced individually. In addition, the Pooling Agent may be immediately suspended from pooling on the Company s system. Q. Please describe the changes to Sheet E-21 of Exhibit A-11, Schedule E-8. A. The language of the Non Sufficient Funds provision of C.5 has been placed in Sheet E-21. Q. Please describe the changes to Sheet E-23 of Exhibit A-11, Schedule E-8. A. On Sheet E-23, the addition of the words "active analog" to section C is required for compatibility with the Company s data system. The Company s mechanism for receiving daily measurement information from its Metretek units in the field, does not support communications received from digital phone systems. Q. Can you summarize the changes to Sheets F-1 through F-16 of Exhibit A- 11, Schedule E-8? A. Yes I can. These pages are from the Gas Customer Choice section of the current tariff. The changes are mainly administrative or related to changing units of measurement. The changes on Sheet F

264 Testimony Of James Van Sickle On Behalf of SEMCO Energy Gas Company represent the combining of the Company s current Balancing Charge and Capacity Demand Charge into a single Balancing Charge. Mr. Alger discusses this topic further. Q. Does this conclude your direct testimony at this time? A. Yes it does. 16

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