National Grid. Niagara Mohawk Power Corporation INVESTIGATION AS TO THE PROPRIETY OF PROPOSED ELECTRIC TARIFF CHANGES. Testimony and Exhibits of:

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1 National Grid Niagara Mohawk Power Corporation INVESTIGATION AS TO THE PROPRIETY OF PROPOSED ELECTRIC TARIFF CHANGES Testimony and Exhibits of: Roger A. Morin Andrew E. Dinkel Book 2 January 29, 2010 Submitted to: New York Public Service Commission Docket No. 10-E- Submitted by:

2 Testimony of Roger A. Morin

3 Before the Public Service Commission NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID Direct Testimony of Roger A. Morin, PhD Dated: January 29,

4 Testimony of Dr. Roger A. Morin, PhD Table of Contents I. Introduction and Purpose...1 II. III. Regulatory Framework and Rate of Return...7 Cost of Equity Estimates...17 A. DCF Estimates...20 B. CAPM and Risk Premium Estimates...39 C. Historical Risk Premium Estimate...57 D. Flotation Cost Adjustment...62 IV. Summary and Cost of Equity Recommendation

5 Testimony of Dr. Roger A. Morin, PhD I. Introduction and Purpose Q. Please state your name, address, and occupation. A. My name is Dr. Roger A. Morin. My business address is Georgia State University, Robinson College of Business, University Plaza, Atlanta, Georgia, I am Emeritus Professor of Finance at the Robinson College of Business, Georgia State University and Professor of Finance for Regulated Industry at the Center for the Study of Regulated Industry at Georgia State University. I am also a principal in Utility Research International, an enterprise engaged in regulatory finance and economics consulting to business and government Q. Please describe your educational background. A. I hold a Bachelor of Engineering degree and an MBA in Finance from McGill University, Montreal, Canada. I received my Ph.D. in Finance and Econometrics at the Wharton School of Finance, University of Pennsylvania Q. Please summarize your academic and business career. A. I have taught at the Wharton School of Finance, University of Pennsylvania, Amos Tuck School of Business at Dartmouth College, Drexel University, University of Montreal, McGill University, and Page 1 of 76 3

6 Testimony of Dr. Roger A. Morin, PhD Georgia State University. I was a faculty member of Advanced Management Research International, and I am currently a faculty member of The Management Exchange Inc. and Exnet, Inc., where I continue to conduct frequent national executive-level education seminars throughout the United States and Canada. In the last thirty years, I have conducted numerous national seminars on Utility Finance, Utility Cost of Capital, Alternative Regulatory Frameworks, and on Utility Capital Allocation, which I have developed on behalf of The Management Exchange Inc. and Exnet in conjunction with Public Utilities Reports, Inc I have authored or co-authored several books, monographs, and articles in academic scientific journals on the subject of finance. They have appeared in a variety of journals, including The Journal of Finance, The Journal of Business Administration, International Management Review, and Public Utilities Fortnightly. I published a widely-used treatise on regulatory finance, Utilities' Cost of Capital, Public Utilities Reports, Inc., Arlington, Va In late 1994, the same publisher released Regulatory Finance, a voluminous treatise on the application of finance to regulated utilities. A revised and expanded edition of this book entitled The New Regulatory Finance was published in August I have engaged in extensive consulting activities on behalf of numerous corporations, legal Page 2 of 76 4

7 Testimony of Dr. Roger A. Morin, PhD firms, and regulatory bodies in matters of financial management and corporate litigation. Exhibit (RAM-1) describes my professional credentials in more detail Q. Have you previously testified on cost of capital before utility regulatory commissions? A. Yes, I have been a cost of capital witness before some fifty (50) regulatory bodies in North America, including the New York Public Service Commission (Commission). I have testified before the following federal, state, provincial, and other local regulatory commissions: Alabama Florida Missouri Ontario Alaska Georgia Montana Oregon Alberta Hawaii Nevada Pennsylvania Arizona Illinois New Brunswick Quebec Indiana New Hampshire South Carolina British Columbia Iowa New Jersey South Dakota California Kentucky New Mexico Tennessee City of New Orleans Louisiana New York Texas Colorado Maine Newfoundland Utah CRTC Manitoba North Carolina Vermont Delaware Maryland North Dakota Virginia District of Columbia Michigan Nova Scotia Washington FCC Minnesota Ohio West Virginia FERC Mississippi Oklahoma The details of my participation in regulatory proceedings are provided in Exhibit (RAM-1). Q. What is the purpose of your testimony in this proceeding? Page 3 of 76 5

8 Testimony of Dr. Roger A. Morin, PhD A. The purpose of my testimony in this proceeding is to present an independent appraisal of the fair and reasonable rate of return on Niagara Mohawk Power Corporation s ( Niagara Mohawk or the Company ) electricity delivery operations in the State of New York, with particular emphasis on the fair return on the Company s common equity capital or book equity (ROE) committed to that business. Based upon this appraisal, I have formed my professional judgment as to a return on such capital that would: (1) be fair to the customer, (2) allow the Company to attract capital on reasonable terms, (3) maintain the Company s financial integrity, and (4) be comparable to returns offered on comparable risk investments. I will testify in this proceeding as to that opinion. I have also been asked to comment on the reasonableness of the Company s capital structure This testimony and accompanying exhibits and appendices were prepared by me or under my direct supervision and control. The source documents for my testimony are Company records, public documents, commercial databases, and my personal knowledge and experience Q. Please briefly identify the exhibit and appendices accompanying your testimony. Page 4 of 76 6

9 Testimony of Dr. Roger A. Morin, PhD A. I have attached to my testimony Exhibit (RAM-1) through Exhibit (RAM-14) and Appendices A and B. These exhibits and Appendices relate directly to points in my testimony, and are described in further detail in connection with the discussion of those points in my testimony Q. Please summarize your findings concerning Niagara Mohawk s cost of common equity. A. I have examined Niagara Mohawk s risks and concluded that the Company s risk environment, including the impact of adopting the Company s proposal to adopt a revenue decoupling mechanism, is comparable to the industry average. It is my opinion that a just and reasonable rate of return on common equity ( ROE ) invested in Niagara Mohawk s electric utility operations is 10.85%. In the event that rates are established for a three-year period in this proceeding, it is my opinion that this ROE should be raised by 25 basis points to 11.1% to compensate investors for the risk of a three year plan Q. What methods have you employed in arriving at such an opinion? A. My opinion derives from studies I performed using the Discounted Cash Flow (DCF), Capital Asset Pricing Model (CAPM), and Risk Premium methods. I performed DCF analyses on two surrogates for the Company. Page 5 of 76 7

10 Testimony of Dr. Roger A. Morin, PhD They are a group of investment-grade, dividend-paying, combination electric and gas electric utilities and a group consisting of the electric utilities that make up Standard & Poor s Electric Utility Index. The companies in both groups were required to have the majority of their revenues from regulated electric utility operations. I performed two CAPM analyses: a traditional CAPM and a method using an empirical approximation of the CAPM (ECAPM). I also performed a historical risk premium analysis on the electric utility industry My recommended rate of return reflects the application of my professional judgment to the indicated returns from my DCF, Risk Premium, and CAPM analyses, to the Company s current risk environment which I estimate to be comparable on balance to the industry average, and to capital market conditions that continue to reflect uncertainty Q. Dr. Morin, please describe how your testimony is organized. A. The remainder of my testimony is divided into three (3) sections: I. Regulatory Framework and Rate of Return 19 II. Cost of Equity Estimates 20 III. Summary and Cost of Equity Recommendation Page 6 of 76 8

11 Testimony of Dr. Roger A. Morin, PhD The first section discusses the rudiments of rate of return regulation and the basic notions underlying rate of return. The second section contains the application of DCF, CAPM, and Risk Premium tests. In the third section, the results from the various approaches used in determining a fair return are summarized. 6 7 II. Regulatory Framework and Rate of Return Q. Please explain how a regulated company's rates should be set under traditional cost of service regulation. A. Under the traditional regulatory process, a regulated company s rates should be set so that the company recovers its costs, including taxes and depreciation, plus a fair and reasonable return on its invested capital. The allowed rate of return must necessarily reflect the cost of the funds obtained, that is, investors' return requirements. In determining a company's required rate of return, the starting point is investors' return requirements in financial markets. A rate of return can then be set at a level sufficient to enable the company to earn a return commensurate with the cost of those funds Funds can be obtained in two general forms, debt capital and equity capital. The cost of debt funds can be easily ascertained from an Page 7 of 76 9

12 Testimony of Dr. Roger A. Morin, PhD examination of the contractual interest payments. The cost of common equity funds, that is, investors' required rate of return, is more difficult to estimate. It is the purpose of the next section of my testimony to estimate Niagara Mohawk s cost of common equity capital Q. What fundamental principles underlie the determination of a fair and reasonable ROE? A. The heart of utility regulation is the setting of just and reasonable rates by way of a fair and reasonable return. There are two landmark United States Supreme Court cases that define the legal principles underlying the regulation of a public utility s rate of return and provide the foundations for the notion of a fair return: 1) Bluefield Water Works & Improvement Co. v. Public Service Commission of West Virginia, 262 U.S. 679 (1923), and 2) Federal Power Commission v. Hope Natural Gas Company, 320 U.S. 591 (1944). The Bluefield case set the standard against which just and reasonable rates of return are measured: A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties... The return should be Page 8 of 76 10

13 Testimony of Dr. Roger A. Morin, PhD reasonable, sufficient to assure confidence in the financial soundness of the utility, and should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise money necessary for the proper discharge of its public duties. Bluefield Water Works & Improvement Co. v. Pub. Serv. Comm n of W. Va, 262 U.S. at 692 (emphasis added) The Hope case expanded on the guidelines to be used to assess the reasonableness of the allowed return. The Court reemphasized its statements in the Bluefield case and recognized that revenues must cover capital costs. The Court stated: From the investor or company point of view it is important that there be enough revenue not only for operating expenses but also for the capital costs of the business. These include service on the debt and dividends on the stock... By that standard the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and attract capital. Fed. Power Comm n v. Hope Natural Gas Co., 320 U.S. at 603 (Emphasis added). The United States Supreme Court reiterated the criteria set forth in Hope in Federal Power Commission v. Memphis Light, Gas & Water Division, 411 U.S. 458 (1973), in Permian Basin Rate Cases, 390 U.S. 747 (1968), and most recently in Duquesne Light Co. vs. Barasch, 488 U.S. 299 Page 9 of 76 11

14 Testimony of Dr. Roger A. Morin, PhD (1989). In the Permian Basin Rate Cases, the Supreme Court stressed that a regulatory agency's rate of return order should reasonably be expected to maintain financial integrity, attract necessary capital, and fairly compensate investors for the risks they have assumed. Permian Basin Rate Cases, 390 U.S. at Therefore, the end result of this Commission's decision should be to allow Niagara Mohawk the opportunity to earn a return on equity that is: (1) commensurate with returns on investments in other firms having corresponding risks, (2) sufficient to assure confidence in the Company s financial integrity, and (3) sufficient to maintain the Company s creditworthiness and ability to attract capital on reasonable terms Q. How is the fair rate of return determined? A. The aggregate return required by investors is called the cost of capital. The cost of capital is the opportunity cost, expressed in percentage terms, of the total pool of capital employed by the Company. It is the composite weighted cost of the various classes of capital (e.g., bonds, preferred stock, common stock) used by the utility, with the weights reflecting the proportions of the total capital that each class of capital represents. The fair return in dollars is obtained by multiplying the rate of return set by the Page 10 of 76 12

15 Testimony of Dr. Roger A. Morin, PhD regulator by the utility s rate base. The rate base is essentially the net book value of the utility s plant and other assets used to provide utility service in a particular jurisdiction While utilities like Niagara Mohawk enjoy varying degrees of monopoly in the sale of public utility services, they must compete with everyone else in the free, open market for the input factors of production, whether labor, materials, machines, or capital. The prices of these inputs are set in the competitive marketplace by supply and demand, and it is these input prices that are incorporated in the cost of service computation. This is just as true for capital as for any other factor of production. Since utilities and other investor-owned businesses must go to the open capital market and sell their securities in competition with every other issuer, there is obviously a market price to pay for the capital they require, for example, the interest on debt capital, or the expected return on equity Q. How does the concept of a fair return relate to the concept of opportunity cost? A. The concept of a fair return is intimately related to the economic concept of opportunity cost. When investors supply funds to a utility by buying its stocks or bonds, they are not only postponing consumption or giving up Page 11 of 76 13

16 Testimony of Dr. Roger A. Morin, PhD the alternative of spending their dollars in some other way; they are also exposing their funds to risk and forgoing returns from investing their money in alternative comparable risk investments. The compensation they require is the price of capital. If there are differences in the risk of the investments, competition among firms for a limited supply of capital will bring different prices. These differences in risk are translated by the capital markets into differences in required return, in much the same way that differences in the characteristics of commodities are reflected in different prices The important point is that the required return on capital is set by supply and demand, and is influenced by the relationship between the risk and return expected for those securities and the risks expected from the overall menu of available securities Q. What economic and financial concepts have guided your assessment of the Company s cost of common equity? A. Two fundamental economic principles underlie the appraisal of the Company s cost of equity, one relating to the supply side of capital markets, the other to the demand side. 21 Page 12 of 76 14

17 Testimony of Dr. Roger A. Morin, PhD On the supply side, the first principle asserts that rational investors maximize the performance of their portfolios only if they expect the returns on investments of comparable risk to be the same. If not, rational investors will switch out of those investments yielding lower returns at a given risk level in favor of those investment activities offering higher returns for the same degree of risk. This principle implies that a company will be unable to attract capital funds unless it can offer returns to capital suppliers that are comparable to those achieved on competing investments of similar risk On the demand side, the second principle asserts that a company will continue to invest in real physical assets if the return on these investments equals, or exceeds, the company's cost of capital. This principle suggests that a regulatory board should set rates at a level sufficient to create equality between the return on physical asset investments and the company s cost of capital Q. How does the Company obtain its capital and how is its overall cost of capital determined? A. The funds employed by the Company are obtained in two general forms, debt capital and equity capital. The cost of debt funds can be ascertained Page 13 of 76 15

18 Testimony of Dr. Roger A. Morin, PhD easily from an examination of the contractual interest payments. The cost of common equity funds, that is, equity investors required rate of return, is more difficult to estimate because the dividend payments received from common stock are not contractual or guaranteed in nature. They are uneven and risky, unlike interest payments Once a cost of common equity estimate has been developed, it can then easily be combined with the embedded cost of debt based on the utility s capital structure, in order to arrive at the overall cost of capital (overall rate of return) Q. What is the market required rate of return on equity capital? A. The market required rate of return on common equity, or cost of equity, is the return demanded by the equity investor. Investors establish the price for equity capital through their buying and selling decisions in capital markets. Investors set return requirements according to their perception of the risks inherent in the investment, recognizing the opportunity cost of forgone investments in other companies, and the returns available from other investments of comparable risk Q. What must be considered in estimating a fair ROE? Page 14 of 76 16

19 Testimony of Dr. Roger A. Morin, PhD A. The basic premise is that the allowable ROE should be commensurate with returns on investments in other firms having corresponding risks. The allowed return should be sufficient to assure confidence in the financial integrity of the firm, in order to maintain creditworthiness and ability to attract capital on reasonable terms. The attraction of capital standard focuses on investors' return requirements that are generally determined using market value methods, such as the Risk Premium, CAPM, or DCF methods. These market value tests define fair return as the return investors anticipate when they purchase equity shares of comparable risk in the financial marketplace. This is a market rate of return, defined in terms of anticipated dividends and capital gains as determined by expected changes in stock prices, and reflects the opportunity cost of capital. The economic basis for market value tests is that new capital will be attracted to a firm only if the return expected by the suppliers of funds is commensurate with that available from alternative investments of comparable risk Q. How does Niagara Mohawk s cost of capital relate to that of its parent company? A. Niagara Mohawk is a wholly owned subsidiary of Niagara Mohawk Holdings, Inc., which is a wholly owned subsidiary of National Grid USA, Page 15 of 76 17

20 Testimony of Dr. Roger A. Morin, PhD which in turn is an indirect, wholly owned subsidiary of United Kingdombased National Grid plc ( National Grid ). I am treating Niagara Mohawk s electric utility operations as a separate stand-alone entity, distinct from its holding company, National Grid, because it is the cost of capital for Niagara Mohawk s electric utility business that we are attempting to measure and not the cost of capital for National Grid s consolidated activities. Financial theory establishes that the true cost of capital depends on the use to which the capital is put, which, in this case, is Niagara Mohawk s electric utility operations in the State of New York. The specific source of funding an investment and the cost of funds to the investor are irrelevant considerations For example, if an individual investor borrows money at the bank at an after-tax cost of 5% and invests the funds in a speculative oil extraction venture, the required return on the investment is not the 5% cost but rather the return foregone in speculative projects of similar risk, say 20%. Similarly, the required return on Niagara Mohawk is the return foregone in comparable risk electric utility operations, and is unrelated to the parent s cost of capital. In other words, the cost of capital is governed by the risk to which the capital is exposed and not by the source of funds. The identity of the shareholders has no bearing on the cost of equity. Page 16 of 76 18

21 Testimony of Dr. Roger A. Morin, PhD Just as individual investors require different returns from different assets in managing their personal affairs, corporations should behave in the same manner. A parent company normally invests money in many operating companies of varying sizes and varying risks. These operating subsidiaries pay different rates for the use of investor capital, such as longterm debt capital, because investors recognize the differences in capital structure, risk, and prospects between subsidiaries. Therefore, the cost of investing funds in an operating utility subsidiary such as Niagara Mohawk is the return foregone on investments of similar risk and is unrelated to the identity of the investor. This is particularly true with respect to Niagara Mohawk and other New York State utilities that are owned by corporate holding company parents with multiple businesses in other states and/or countries III. Cost of Equity Estimates Q. How did you estimate the fair ROE for Niagara Mohawk? A. I employed three methods: (1) the DCF, (2) the CAPM, and (3) the Risk Premium. All three are market-based methods and are designed to estimate the return required by investors on the common equity capital committed to Niagara Mohawk. Page 17 of 76 19

22 Testimony of Dr. Roger A. Morin, PhD Q. Why did you use more than one approach for estimating the cost of equity? A. No one individual method provides the necessary level of precision for determining a fair return, but each method provides useful evidence to facilitate the exercise of an informed judgment. Reliance on any single method or preset formula is inappropriate when dealing with investor expectations because of possible measurement errors and vagaries in individual companies market data. Examples of such vagaries include insufficient or unrepresentative historical data due to a recent merger, impending merger or acquisition, and a new corporate identity due to restructuring activities. The advantage of using several different approaches is that the results of each one can be used to check the others As a general proposition, it is dangerous to rely on only one generic method to estimate equity costs. The difficulty is compounded when only one variant of that method is employed. It is compounded even further when that one method is applied to a single company. Hence, several methods applied to several comparable risk companies should be employed to estimate the cost of capital. 20 Page 18 of 76 20

23 Testimony of Dr. Roger A. Morin, PhD As I have stated, there are three broad generic methods available to measure the cost of equity: DCF, CAPM, and Risk Premium. All three of these methods are accepted and used by the financial community and firmly supported in the financial literature. The weight accorded to any one method may very well vary depending on unusual circumstances in capital market conditions Each method requires the exercise of considerable judgment on the reasonableness of the assumptions underlying the method and on the reasonableness of the proxies used to validate the theory and apply the method. Each method has its own way of examining investor behavior, its own premises, and its own set of simplifications of reality. Investors do not necessarily subscribe to any one method, nor does the stock price reflect the application of any one single method by the price-setting investor. There is no guarantee that a single DCF result is necessarily the ideal predictor of the stock price and of the cost of equity reflected in that price, just as there is no guarantee that a single CAPM or Risk Premium result constitutes the perfect explanation of a stock s price or the cost of equity. 20 Page 19 of 76 21

24 Testimony of Dr. Roger A. Morin, PhD Q. Are there any practical difficulties in applying cost of capital methods in the current environment of turmoil in capital markets? A. Yes, there are. All the traditional cost of equity estimation methods are difficult to implement when you are dealing with the unprecedented conditions of instability and volatility in the capital markets and the fastchanging circumstances of the utility industry. This is not only because stock prices are extremely volatile at this time, but also utility company historical data have become less meaningful for an industry experiencing considerable volatility. Past earnings and dividend trends may simply not be indicative of the future. For example, historical growth rates of earnings and dividends have been depressed by eroding margins due to a variety of factors including the sluggish economy, restructuring, and the transition to a more competitive environment. Moreover, historical growth rates may not be representative of future trends for several utilities involved in mergers and acquisitions, as these companies going forward are not the same companies for which historical data are available A. DCF Estimates Q. Please describe the DCF approach to estimating the cost of equity capital. Page 20 of 76 22

25 Testimony of Dr. Roger A. Morin, PhD A. According to DCF theory, the value of any security to an investor is the expected discounted value of the future stream of dividends or other benefits. One widely used method to measure these anticipated benefits in the case of a non-static company is to examine the current dividend plus the increases in future dividend payments expected by investors. This valuation process can be represented by the following formula, which is the traditional DCF model: K e = D 1 /P o + g where: K e = investors expected return on equity D 1 = expected dividend at the end of the coming year P o = current stock price g = expected growth rate of dividends, earnings, book value, stock price The traditional DCF formula states that under certain assumptions, which are described in the next paragraph, the equity investor s expected return, K e, can be viewed as the sum of an expected dividend yield, D 1 /P o, plus the expected growth rate of future dividends and stock price, g. The returns anticipated at a given market price are not directly observable and must be estimated from statistical market information. The idea of the Page 21 of 76 23

26 Testimony of Dr. Roger A. Morin, PhD 1 2 market value approach is to infer K e from the observed share price, the observed dividend, and an estimate of investors' expected future growth The assumptions underlying this valuation formulation are well known, and are discussed in detail in Chapter 8 of my new text, The New Regulatory Finance. The standard DCF model requires the following main assumptions: a constant average growth trend for both dividends and earnings, a stable dividend payout policy, a discount rate in excess of the expected growth rate, and a constant price-earnings multiple, which implies that growth in price is synonymous with growth in earnings and dividends. The standard DCF model also assumes that dividends are paid at the end of each year when in fact dividend payments are normally made on a quarterly basis Comparable Groups Q. How did you estimate Niagara Mohawk s cost of equity with the DCF model? A. I applied the DCF model to two proxies for Niagara Mohawk. As a first proxy, I started with the universe of electric utilities covered by Value Line (SIC Codes ). From this original group, I eliminated foreign companies, private partnerships, private companies, and Page 22 of 76 24

27 Testimony of Dr. Roger A. Morin, PhD companies below investment-grade (i.e., companies with a bond rating below Baa3 under Moody s Investor Service s ratings). From this narrowed group, I further eliminated companies that do not pay dividends and companies with market capitalization less than $500 million (to minimize any stock price anomalies due to thin trading). I eliminated companies that derive less than 50% of their revenues from regulated electric utility operations. Finally, from this restricted group, I retained those companies designated as combination electric and gas utilities by AUS Utility Reports, meaning that these companies all possess large amounts of energy distribution assets As a second proxy for Niagara Mohawk, I examined a group consisting of the electric utilities that make up S&P s Electric Utility Index. The two groups are displayed on Exhibit (RAM-2) and Exhibit (RAM-3), respectively Q. Are you aware that the Commission has expressed some reservations with your comparable groups in the past, and, if so, how do you respond? A. In the past, the Commission has expressed concern that my comparable groups of electric and combination utilities were riskier than New York Page 23 of 76 25

28 Testimony of Dr. Roger A. Morin, PhD electric utilities because their bond ratings were superior to the average bond rating for my comparable groups. But as I show later, there is little relationship between bond ratings and equity risk for entities that hold investment grade bond ratings. Credit ratings examine risk from a bondholder viewpoint rather than from a shareholder viewpoint. The former is concerned mainly with the ability to service debt and creditworthiness while the latter is concerned with variability and uncertainty of return. Moreover, this criticism is essentially moot because the vast majority of the companies in my two groups of utilities are also members of the comparable groups that have been relied upon by the Commission in recent decisions. Also, my beta risk estimate for Niagara Mohawk of 0.74 is virtually identical to the average beta of the group of companies relied upon by the Commission in other cases, implying comparability of risk The Commission has also criticized my two groups of companies because I employed a 50% minimum regulated revenues screening criterion instead of 70%. Again, this criticism is not justified because the average percentage of regulated electric revenues in my two comparable groups of utilities are 71% and 74%, respectively. Page 24 of 76 26

29 Testimony of Dr. Roger A. Morin, PhD In practical terms, there are only minor differences between the groups of companies that the Commission has relied upon in other cases and my own, and I am confident that the comparable groups that I utilize are regarded by investors as utility businesses that are similar to Niagara Mohawk DCF Dividend Yield Component Q. How did you estimate the two components of the DCF model? A. In order to apply the DCF model, two components are required: the expected dividend yield (D 1 /P 0 ) and the expected long-term growth (g). The expected dividend D 1 in the annual DCF model can be obtained by multiplying the current indicated annual dividend rate by the growth factor (1 + g) From a conceptual viewpoint, the stock price to employ in calculating the dividend yield is the current price of the security at the time of estimating the cost of equity. This is because the current stock prices provide a better indication of expected future prices than any other price in an efficient market. An efficient market implies that prices adjust rapidly to the arrival of new information. Therefore, current prices reflect the fundamental economic value of a security. A considerable body of Page 25 of 76 27

30 Testimony of Dr. Roger A. Morin, PhD empirical evidence indicates that capital markets are efficient with respect to a broad set of information. This implies that observed current prices represent the fundamental value of a security, and that a cost of capital estimate should be based on current prices In implementing the DCF model, I have used the dividend yields reported in the November 2009 edition of Value Line s VLIA software. Basing dividend yields on average results from a large group of companies reduces the concern that the vagaries of individual company stock prices will result in an unrepresentative dividend yield Q. Dr. Morin, are you aware that in recent decisions, the Commission has criticized the dividend yield component of your DCF methodology? A. Yes, I am. In recent cases, the Commission has relied on the average stock price over either three months or six months periods to compute the dividend yield component of the DCF model. I disagree with the use of stock prices reaching back three to six months. The proper stock price to employ is the current price of the security at the time of estimating the cost of equity, rather than some historical average stock price reaching back three or six months. The reason is that the analyst is attempting to Page 26 of 76 28

31 Testimony of Dr. Roger A. Morin, PhD determine a utility s cost of equity in the future, and since current stock prices provide a better indication of expected future prices than any other price according to the basic tenets of the Efficient Market Hypothesis, the most relevant stock price is the most recent one. The Efficient Market Hypothesis, which is widely accepted, states that capital markets, at least as a practical matter, incorporate into security prices relevant publicly available information, such that current security prices reflect the most recent information and thus are the best representation of investor expectations. Use of any other price violates market efficiency principles There is yet another justification for using current stock prices. In measuring the cost of equity as the sum of dividend yield and growth, the period used in measuring the dividend yield component must be consistent with the estimate of growth with which it is paired. Since the current stock price is caused by the growth foreseen by investors at the present time and not at any other time, it is clear that the use of spot prices is preferable. It is inappropriate to match an average stock price reaching back three to six months with a current estimate of expected growth. This not only violates market efficiency principles, but also constitutes a mismatch in the application of the DCF model. An average stock price Page 27 of 76 29

32 Testimony of Dr. Roger A. Morin, PhD 1 2 dating back three to six months reflects stale information and may not be representative of current market conditions Q. As a practical matter at this point in time, does it matter if one relies on current stock prices or on average stock prices going back three months? A. As a practical matter, it does not. This is because utility stock prices have been relatively constant over the past three months, as the graph below illustrates over the September-December 2009 period. The Dow Jones Utility Index has remained relatively stable over the period, suggesting that DCF estimates based on current stock prices would not differ markedly from estimates based on the past three months Page 28 of 76 30

33 Testimony of Dr. Roger A. Morin, PhD DCF Growth Component Q. How did you estimate the growth component of the DCF model? A. The principal difficulty in calculating the required return by the DCF approach is in ascertaining the growth rate that investors currently expect. Because no explicit estimate of expected growth is observable, proxies must be employed As proxies for expected growth, I examined the consensus growth estimates developed by professional analysts employed by large investment brokerage institutions. Projected long-term growth rates actually used by institutional investors to determine the desirability of investing in different securities influence investors' growth anticipations. These forecasts are made by large reputable organizations, and the data are readily available to investors and are representative of the consensus view of investors. Because of the dominance of institutional investors in investment management and security selection, and their influence on individual investment decisions, analysts' growth forecasts influence investor growth expectations and provide a sound basis for estimating the cost of equity with the DCF model. 20 Page 29 of 76 31

34 Testimony of Dr. Roger A. Morin, PhD Growth rate forecasts of several analysts are available from published investment newsletters and from systematic compilations of analysts forecasts, such as those tabulated by Zacks Investment Research Inc. (Zacks). I used analysts' long-term growth forecasts contained in Zacks as proxies for investors' growth expectations in applying the DCF model. The latter are also conveniently provided in the Value Line software. I also used Value Line s growth forecasts as additional proxies Q. Why did you reject the use of historical growth rates in applying the DCF model to electric utilities? A. The average historical growth rates in earnings and dividends for electric utilities are 3.2%, and 2.0% over the past 5 years, respectively. Please see Exhibit (RAM-4), columns 2 and 3, for the historical growth in earnings and dividends per share over the last five years for the electric utility companies that make up Value Line s Electric Utility composite group. Several companies have experienced negative earnings growth rates, as evidenced by the numerous historical growth rates reported on the table that are negative. If we eliminate the negative growth rates, the corresponding growth rates are 5.1% and 3.6%. 20 Page 30 of 76 32

35 Testimony of Dr. Roger A. Morin, PhD Historical growth rates have little relevance as proxies for future long-term growth at this time. They are downward-biased by the sluggish earnings performance in the last five/ten years, due to the structural transformation of the electric utility industry from a fully integrated regulated monopoly to a more competitive environment. These anemic historical growth rates are certainly not representative of these companies long-term earning power, and produce unreasonably low DCF estimates, well outside reasonable limits of probability and common sense. To illustrate, adding the historical growth rates of 3.2% and 2.1% to the average dividend yield of approximately 4.8% prevailing currently for those same companies, produces preposterous cost of equity estimates of 8.0% and 6.9% using earnings and dividends growth rates, respectively. Of course, these estimates of equity costs are unreasonable as they are barely above or below the cost of long-term debt for these companies. A similar pattern emerges if ten-year instead of five-year historical growth rates are examined I have therefore rejected historical growth rates as proxies for expected growth in the DCF calculation. In any event, historical growth rates are somewhat redundant because such historical growth patterns are already incorporated in analysts growth forecasts that should be used in the DCF Page 31 of 76 33

36 Testimony of Dr. Roger A. Morin, PhD 1 model Q. Did you consider any other method of estimating expected growth to apply the DCF model? A. Yes, I did. I considered using the so-called sustainable growth method, also referred to as the retention growth method. I am aware that this method has been used by the Commission in its DCF analyses in past cases. According to this method, future growth is estimated by multiplying the fraction of earnings expected to be retained by the company, 'b', by the expected return on book equity, ROE. That is, g = b x ROE where: g = expected growth rate in earnings/dividends b = expected retention ratio ROE = expected return on book equity As described below, I am not a proponent of this method because it is inherently circular, for it requires an estimate of the projected ROE, which is the very quantity we are trying to determine in this case Q. Please describe your reservations in regards to the sustainable growth method. Page 32 of 76 34

37 Testimony of Dr. Roger A. Morin, PhD A. First, the sustainable growth method of predicting growth is only accurate under the assumptions that the return on book equity (ROE) is constant over time and that no new common stock is issued by the company, or if so, it is sold at book value. Second, and more importantly, the sustainable growth method contains a logic trap: the method requires an estimate of ROE to be implemented. But if the ROE input required by the model differs from the recommended return on equity, a fundamental contradiction in logic follows. Third, the empirical finance literature demonstrates that the sustainable growth method of determining growth is not as significantly correlated to measures of value, such as stock price and price/earnings ratios, as are other measures of growth. Other proxies for growth, such as analysts' growth forecasts, outperform retention growth estimates. A summary of this literature is available in The New Regulatory Finance, Chapter Q. Did you consider using analysts forecasts of dividend growth in applying the DCF model? A. No, not at this time. This is because it is widely expected that some utilities will continue to lower their dividend payout ratio over the next several years in response to heightened business risk and the need to fund very large construction programs over the next decade. In other words, Page 33 of 76 35

38 Testimony of Dr. Roger A. Morin, PhD 1 2 earnings and dividends are not expected to grow at the same rate in the future Whenever the dividend payout ratio is expected to change, the intermediate growth rate in dividends cannot equal the long-term growth rate, because dividend/earnings growth must adjust to the changing payout ratio. The assumptions of constant perpetual growth and constant payout ratio are clearly not met. Thus, the implementation of the standard DCF model is of questionable relevance in this circumstance Dividend growth rates are unlikely to provide a meaningful guide to investors growth expectations for utilities in general. This is because utilities dividend policies have become increasingly conservative as business risks in the industry have intensified steadily. Dividend growth has remained largely stagnant in past years as utilities are increasingly conserving financial resources in order to hedge against rising business risks. As a result, investors attention has shifted from dividends to earnings. Therefore, earnings growth provides a more meaningful guide to investors long-term growth expectations. Indeed, it is growth in earnings that will support future dividends and share prices. Page 34 of 76 36

39 Testimony of Dr. Roger A. Morin, PhD 1 2 Moreover, as a practical matter, while earnings growth forecasts are widely available, there are very few dividend growth forecasts Q. Dr. Morin, are you aware that the Commission has employed forecasts of dividend growth in determining the DCF-derived cost of equity in past cases? A. Yes. I am. For the reasons described above, I disagree. In fact, as displayed on the table below, the current and projected dividend payout of the electric utility industry is declining. Utility dividend policies have, and will continue to be, increasingly conservative in response to growing needs of internal financing that are in turn driven by massive capital expenditure budgets over the next decade. 13 Composite Statistics: Electric Utility Industry Div'ds to Profit 65% 59% 56% Source: Value Line 12/209 Q. Is there any empirical evidence documenting the importance of earnings in evaluating investors' expectations? Page 35 of 76 37

40 Testimony of Dr. Roger A. Morin, PhD A. Yes, there is an abundance of evidence attesting to the importance of earnings in assessing investors expectations. First, the sheer volume of earnings forecasts available from the investment community relative to the scarcity of dividend forecasts attests to their importance. To illustrate, Value Line, Zacks Investment, First Call Thompson, Reuters, Yahoo Finance, and Multex provide comprehensive compilations of investors earnings forecasts. The fact that these investment information providers focus on growth in earnings rather than growth in dividends indicates that the investment community regards earnings growth as a superior indicator of future long-term growth. Second, Value Line s principal investment rating assigned to individual stocks, Timeliness Rank, is based primarily on earnings, which accounts for 65% of the ranking DCF Estimates Q. What DCF results did you obtain for the combination utilities group? A. Exhibit (RAM-5) provides the DCF results for the proxy group of combination utilities using the average long-term growth forecast obtained from Value Line. No growth projection was available for Pepco, and ALLETE was eliminated from the computation on account of its negative growth rate. As shown on Column 2 of Exhibit (RAM-5), the average long-term growth forecast obtained from Value Line is 6.6% for this Page 36 of 76 38

41 Testimony of Dr. Roger A. Morin, PhD group. Adding this growth rate to the average expected dividend yield of 5.2% shown in Column 3 produces an estimate of equity costs of 11.9% for the group. Recognition of flotation costs brings the cost of equity estimate to 12.2%, shown in Column 5. Using the median instead of the average, the estimate of equity costs is 11.8% for the group Exhibit (RAM-6) presents the DCF results using the Zacks growth forecast for each company. Using the Zacks analysts consensus forecast of long-term earnings instead of the Value Line forecast, the cost of equity for the group is 10.9% unadjusted for flotation costs. Recognition of flotation costs brings the cost of equity estimate to 11.2%, shown in Column 5 of Exhibit (RAM-6). Using the median instead of the average, the cost of equity estimate for the group is 10.9% Q. What DCF results did you obtain for the S&P utility index group? A. Exhibit (RAM-7) displays the DCF analysis using Value Line growth projections for the electric utilities that make up Standard & Poor s Utility Index. As shown on Column 2 of Exhibit (RAM-7), the average longterm growth forecast obtained from Value Line is 5.6% for this group. Coupling this growth rate with the average expected dividend yield of 5.2% shown in Column 3 for each company produces an estimate of Page 37 of 76 39

42 Testimony of Dr. Roger A. Morin, PhD equity costs of 10.8% for the group, unadjusted for flotation costs. Adding an allowance for flotation costs to the results of Column 4 brings the cost of equity estimate to 11.1%, as shown in Column 5. The median estimate is 10.9%. If we limit the sample to those companies with a majority of their revenues that are regulated utility operations, the median cost of equity estimate is 10.6%. This analysis is shown on Exhibit (RAM-8) Using the consensus analysts growth forecast from Zacks instead of the Value Line growth forecast, the median cost of equity estimate for the entire S&P group is 11.7%. This analysis is displayed on Exhibit (RAM-9). If we limit the sample to those companies with a majority of their revenues that are regulated utility operations, the median cost of equity estimate is 11.6%. This analysis is shown on Exhibit (RAM- 10) Q. Please summarize your DCF estimates. A. The table below summarizes the DCF estimates: Page 38 of 76 40

43 Testimony of Dr. Roger A. Morin, PhD 1 DCF STUDY ROE Comb. Elec. & Gas Utilities Value Line Growth 11.8% Comb. Elec. & Gas Utilities Zacks Growth 10.9% S&P Electric Utilities Value Line Growth 10.6% S&P Electric Utilities Zacks Growth 11.6% B. CAPM and Risk Premium Estimates Q. Dr. Morin, please provide an overview of your risk premium analyses. A. In order to quantify the risk premium for Niagara Mohawk, I performed three risk premium studies. The first two studies deal with aggregate stock market risk premium evidence using two versions of the CAPM method and the third study deals directly with the utility industry CAPM Estimates Q. Please describe your application of the CAPM risk premium approach. A. My first two risk premium estimates are based on the CAPM and on ECAPM, an empirical approximation to the CAPM. The CAPM is a fundamental paradigm of finance. The fundamental idea underlying the CAPM is that risk-averse investors demand higher returns for assuming additional risk, and higher-risk securities are priced to yield higher expected returns than lower-risk securities. The CAPM quantifies the Page 39 of 76 41

44 Testimony of Dr. Roger A. Morin, PhD additional return, or risk premium, required for bearing incremental risk. It provides a formal risk-return relationship anchored on the basic idea that only market risk matters, as measured by beta (β) According to the CAPM, securities are priced such that: Expected Return = Risk-Free Rate + Risk Premium Denoting the risk-free rate by R F and the return on the market as a whole by R M, the CAPM is stated as follows: K = R F + β(r M - R F ) This is the seminal CAPM expression, which states that the return required by investors is made up of a risk-free component, R F, plus a risk premium given by β times the market risk premium (R M - R F ). The latter bracketed expression is known as the market risk premium (MRP). To derive the CAPM risk premium estimate, three quantities are required: the risk-free rate (R F ), beta (β), and the MRP, (R M - R F ). For the risk-free rate, I used 4.7%, based on current and projected interest rates on long-term U.S. Treasury bonds. For beta, I used 0.74, and for the MRP I used 6.5%. These inputs to the CAPM are explained below. 21 Page 40 of 76 42

45 Testimony of Dr. Roger A. Morin, PhD Q. How did you derive the risk free rate of 4.7%? A. To implement the CAPM and Risk Premium methods, an estimate of the risk-free return is required as a benchmark. As a proxy for the risk-free rate, I have relied on the current yields of 30-year Treasury bonds. The yields on interest-bearing and zero-coupon U.S. Treasury 30-year longterm bonds prevailing in December 2009 as reported in Value Line are 4.6% and 4.8%, respectively. Moreover, it is widely expected that interest rates will rise in 2010 in response to the recovering economy and recordhigh federal deficits. Value Line s quarterly economic forecast dated November 27 th, 2009, calls for an increase of 40 basis points on long-term Treasury bonds at the end of 2010 and higher still in Bloomberg calls for a similar increase. Based on all these considerations, I use 4.7% as my estimate of the risk-free rate component of the CAPM The appropriate proxy for the risk-free rate in the CAPM is the return on the longest term Treasury bond possible, which is the 30-year Treasury bond. This is because common stocks are very long-term instruments more akin to very long-term bonds rather than to short-term or intermediate-term Treasury notes. In a risk premium model, the ideal estimate for the risk-free rate has a term to maturity equal to the security being analyzed. Common stock is a very long-term investment because Page 41 of 76 43

46 Testimony of Dr. Roger A. Morin, PhD the cash flows to investors in the form of dividends last indefinitely. Accordingly, the yield on the longest-term possible government bonds, that is, the yield on 30-year Treasury bonds, is the best measure of the risk-free rate for use in the CAPM. The expected common stock return is based on very long-term cash flows, regardless of an individual s holding time period. Moreover, utility asset investments generally have very longterm useful lives and should correspondingly be matched with very longterm maturity financing instruments While long-term Treasury bonds are potentially subject to interest rate risk, this is only true if the bonds are sold prior to maturity. A substantial fraction of bond market participants, usually institutional investors with long-term liabilities (pension funds, insurance companies), in fact hold bonds until they mature, and therefore are not subject to interest rate risk. Moreover, institutional bondholders neutralize the impact of interest rate changes by matching the maturity of a bond portfolio with the investment planning period, or by engaging in hedging transactions in the financial futures markets. The merits and mechanics of such immunization strategies are well documented by both academicians and practitioners. 20 Page 42 of 76 44

47 Testimony of Dr. Roger A. Morin, PhD Another reason for utilizing the longest maturity Treasury bond possible is that common equity has an infinite life span, and the inflation expectations embodied in its market-required rate of return will therefore be equal to the inflation rate anticipated to prevail over the very long-term. The same expectation should be embodied in the risk free rate used in applying the CAPM model. It stands to reason that the actual yields on 30-year Treasury bonds will more closely incorporate within their yield the inflation expectations that influence the prices of common stocks than do short-term or intermediate-term U.S. Treasury notes Q. Dr. Morin, are there other reasons why you reject short-term interest rates as a proxies for the risk-free rate in implementing the CAPM? A. Yes. Short-term rates are volatile, fluctuate widely, and are subject to more random disturbances than are long-term rates. Short-term rates are largely administered rates. For example, as was seen recently in an attempt to combat the weak economy, Treasury bills are used by the Federal Reserve as a policy vehicle to stimulate the economy and to control the money supply, and are used by foreign governments, companies, and individuals as a temporary safe-house for money. 20 Page 43 of 76 45

48 Testimony of Dr. Roger A. Morin, PhD As a practical matter, it makes no sense to match the return on common stock to the yield on 90-day Treasury Bills. This is because short-term rates, such as the yield on 90-day Treasury Bills, fluctuate widely, leading to volatile and unreliable equity return estimates As a conceptual matter, short-term Treasury Bill yields reflect the impact of factors different from those influencing the yields on long-term securities such as common stock. For example, the premium for expected inflation embedded into 90-day Treasury Bills is likely to be far different than the inflationary premium embedded into long-term securities yields. On grounds of stability and consistency, the yields on long-term Treasury bonds match more closely with common stock returns Q. Dr. Morin, are you aware that the commission has in the past relied on an average of 10-year and 30-year treasury bond yields over a three-month period as a proxy for the risk-free rate in the CAPM? A. Yes, I am Q. Do you agree with this procedure? Page 44 of 76 46

49 Testimony of Dr. Roger A. Morin, PhD A. Not quite, for two reasons. First, yield estimates computed over a three- month period are stale. I discussed this issue earlier. Second, only the yields on 30-year bonds are relevant proxies in the CAPM The Commission s rationale for effectively assigning equal weight to both the 10-year and 30-year bond yield is that some investors may have a 10- year investment horizon. The expected common stock return is based on very long-term cash flows, regardless of an investor's holding time period. This is fundamentally different than an investor s expected return on a debt security which is, in part, depended upon the amount of time that investor chooses to loan money to a borrower. Thus, in contrast to a debt investor, an equity investor will require a return that reflects the risk of the stock, irrespective of holding period, whether it is one month, ten years, thirty years, or fifty years. It is a well known fact that the DCF model is insensitive to holding period because it is based on a uniform discount of expected future cash flows. The latter point is formally demonstrated in Chapter 8 of my latest book, The New Regulatory Finance. The important point is that common stock is a very long-term investment, and accordingly, the yield on the longest-term possible government bonds is the best proxy for the risk-free rate for use in the CAPM. Because utility Page 45 of 76 47

50 Testimony of Dr. Roger A. Morin, PhD 1 2 asset investments have very long-term useful lives, they should be matched with very long-term financing instruments Q. Dr. Morin, if one were to rely on an average of 10-year and 30-year treasury bond yields over a three-month period as a proxy for the risk-free rate in the CAPM, what would that estimate be? A. The average risk-free rate would be 3.9% using the procedure on which the Commission has relied upon in the past. This estimate compares with the current yield of 4.7% on 30-year Treasury Bonds, and is clearly stale and unrepresentative of current capital market conditions Q. How did you select the beta for your CAPM analysis? A. A major thrust of modern financial theory as embodied in the CAPM is that perfectly diversified investors can eliminate the company-specific component of risk, and that only market risk remains. The latter is technically known as beta, or systematic risk. The beta coefficient measures change in a security's return relative to that of the market. The beta coefficient states the extent and direction of movement in the rate of return on a stock relative to the movement in the rate of return on the market as a whole. The beta coefficient indicates the change in the rate of return on a stock associated with a one percentage point change in the rate Page 46 of 76 48

51 Testimony of Dr. Roger A. Morin, PhD of return on the market, and thus measures the degree to which a particular stock shares the risk of the market as a whole. Modern financial theory has established that beta incorporates several economic characteristics of a corporation that are reflected in investors' return requirements Niagara Mohawk is not publicly traded and, therefore, proxies must be used for Niagara Mohawk. In the earlier discussion of DCF estimates, I developed two samples of comparable companies. As shown on Exhibit (RAM-11) and Exhibit (RAM-12), the average beta for the combination gas and electric group and the S&P Electric Utility Index group are 0.72 and 0.75, respectively. Removing the companies with less than the majority of their revenues from regulated electric operations, the average beta is Based on these results, I shall use the average beta of the two groups, 0.74, as an estimate for the beta applicable to the electric utility industry business. It is important to note that betas are estimated on five-year historical periods and, therefore, do not fully capture the increase in capital costs that have occurred since the commencement of the financial crisis in October Page 47 of 76 49

52 Testimony of Dr. Roger A. Morin, PhD Q. What MRP estimate did you use in your capm analysis? A. For the MRP, I used 6.5%. This estimate was based on the results of historical studies of long-term risk premiums, and on the general findings of the academic literature on the subject. First, the Morningstar (formerly Ibbotson Associates) study, Stocks, Bonds, Bills, and Inflation, 2009 Yearbook, compiling historical returns from 1926 to 2008, shows that a broad market sample of common stocks outperformed long-term U. S. Treasury bonds by 5.6%. The historical MRP over the income component of long-term Treasury bonds rather than over the total return is 6.5%. Morningstar recommends the use of the latter as a more reliable estimate of the historical MRP, and I concur with this viewpoint. The historical MRP should be computed using the income component of bond returns because the intent, even using historical data, is to identify an expected MRP. This is because the income component of total bond return (i.e., the coupon rate) is a far better estimate of expected return than the total return (i.e., the coupon rate + capital gain), as realized capital gains/losses are largely unanticipated by bond investors. The long-horizon ( ) MRP (based on income returns, as required) is specifically calculated to be 6.5% rather than 5.6%. 20 Page 48 of 76 50

53 Testimony of Dr. Roger A. Morin, PhD Q. On what maturity bond does the Morningstar historical risk premium data rely? A. Because 30-year bonds were not always traded or even available throughout the entire period covered in the Morningstar Study of historical returns, the latter study relied on bond return data based on 20-year Treasury bonds. Because the yield curve is virtually flat above maturities of 20 years over most of the period covered in the Morningstar study, the difference in yield is not material Q. Why did you use long time periods in arriving at your historical MRP estimate? A. Because realized returns can be substantially different from prospective returns anticipated by investors when measured over short time periods, it is important to employ returns realized over long time periods rather than returns realized over more recent time periods when estimating the MRP with historical returns. Therefore, a risk premium study should consider the longest possible period for which data are available. Short-run periods during which investors earned a lower risk premium than they expected are offset by short-run periods during which investors earned a higher risk premium than they expected. Only over long time periods will investor return expectations and realizations converge. Page 49 of 76 51

54 Testimony of Dr. Roger A. Morin, PhD I have therefore ignored realized risk premiums measured over short time periods. Instead, I relied on results over periods of enough length to smooth out short-term aberrations, and to encompass several business and interest rate cycles. The use of the entire study period in estimating the appropriate MRP minimizes subjective judgment and encompasses many diverse regimes of inflation, interest rate cycles, and economic cycles To the extent that the estimated historical equity risk premium follows what is known in statistics as a random walk, one should expect the equity risk premium to remain at its historical mean. Since I found no evidence that the MRP in common stocks has changed over time, that is, no significant serial correlation in the Morningstar study, it is reasonable to assume that these quantities will remain stable in the future Q. Did you base your MRP estimate on any other source? A. Yes, I did. I examined a 2003 comprehensive article published in Financial Management, Harris, Marston, Mishra, and O Brien (HMMO) that provides estimates of the ex ante expected returns for S&P 500 companies over the period HMMO measure the expected 1 Harris, R. S., Marston, F. C., Mishra, D. R., and O Brien, T. J., Ex Ante Cost of Equity Estimates of S&P 500 Firms: The Choice Between Global and Domestic CAPM, Fin l Mgt., Fall 2003, pp Page 50 of 76 52

55 Testimony of Dr. Roger A. Morin, PhD rate of return (cost of equity) of each dividend-paying stock in the S&P 500 for each month from January 1983 to August 1998 by using the constant growth DCF model. The prevailing risk-free rate for each year was then subtracted from the expected rate of return for the overall market to arrive at the MRP for that year. The average MRP estimate for the overall period is 7.2%, which is reasonably close to the historical estimate of 6.5% and almost identical to the historical estimate of 7.1% if the disastrous performance of the capital markets during 2008 is excluded from the historical average Q. Dr. Morin, is your MRP estimate of 6.5% consistent with the academic literature on the subject? A. Yes, it is. In their authoritative corporate finance textbook, Professors Brealey, Myers, and Allen 2 conclude from their review of the fertile literature on the MRP that a range of 5% to 8% is reasonable for the MRP in the United States. My own survey of the MRP literature, which appears in Chapter 5 of my latest textbook, The New Regulatory Finance, is also quite consistent with this range. Moreover, I deem my MRP estimate of 2 Richard A. Brealey, Stewart C. Myers, and Paul Allen, Principles of Corporate Finance, 8 th Edition, Irwin McGraw-Hill, Page 51 of 76 53

56 Testimony of Dr. Roger A. Morin, PhD % conservative, given the unsettled conditions in the equity market following the financial crisis that commenced in Q. Are you familiar with the methodology for determining the MRP component of the CAPM used by the commission in recent cases? A. Yes, I am. In the past, the Commission has relied on Merrill Lynch s estimate of the MRP, which has generally been in the 7% - 9% range. This range is higher than historical estimates as a result of the financial crisis that began in October If we were to duplicate the Commission s approach of specifying the MRP, that estimate would be 8%, that is, the current Merrill Lynch forecast market return of 11.95% minus the Commission risk-free rate proxy of 3.9%. I anticipate a reversion to historical MRP levels as the financial crisis subsides, and view my own estimate as very conservative at this time Q. What is your risk premium estimate of the Company s cost of equity using the CAPM approach? A. Inserting those input values in the CAPM equation, namely a risk-free rate of 4.7%, a beta of 0.74, and a MRP 6.5%, the CAPM estimate of the cost of common equity is: 4.7% x 6.5% = 9.5%. This estimate becomes 9.8% with flotation costs, discussed later in my testimony. Page 52 of 76 54

57 Testimony of Dr. Roger A. Morin, PhD Q. What is your risk premium estimate using the empirical version of the CAPM? A. With respect to the empirical validity of the plain vanilla CAPM, there have been numerous empirical tests of the CAPM to determine to what extent security returns and betas are related in the manner predicted by the CAPM. This literature is summarized in Chapter 6 of my latest book, The New Regulatory Finance, published by Public Utilities Report Inc. The results of the tests support the idea that beta is related to security returns, that the risk-return tradeoff is positive, and that the relationship is linear. The contradictory finding is that the risk-return tradeoff is not as steeply sloped as the CAPM would predict. That is, empirical research has long shown that low-beta securities earn returns somewhat higher than the CAPM would predict, and high-beta securities earn less than predicted A CAPM-based estimate of cost of capital underestimates the return required from low-beta securities and overstates the return required from high-beta securities, based on the empirical evidence. This is one of the most well-known results in finance, and it is displayed graphically below. Page 53 of 76 55

58 Testimony of Dr. Roger A. Morin, PhD A number of variations on the original CAPM theory have been proposed to explain this finding. The ECAPM makes use of these empirical findings. The ECAPM estimates the cost of capital with the equation: K = R F + α + β x (MRP-α ) where the symbol alpha, α, represents the constant of the risk-return line, MRP is the market risk premium (R M R F ), and the other symbols are defined as usual Inserting the long-term risk-free rate as a proxy for the risk-free rate, an alpha in the range of 1% - 2%, and reasonable values of beta and the Page 54 of 76 56

59 Testimony of Dr. Roger A. Morin, PhD MRP in the above equation produces results that are indistinguishable from the following more tractable ECAPM expression: K = R F (R M - R F ) β (R M - R F ) An alpha range of 1% - 2% is somewhat lower than that estimated empirically. The use of a lower value for alpha leads to a lower estimate of the cost of capital for low-beta stocks such as regulated utilities. This is because the use of a long-term risk-free rate rather than a short-term risk-free rate already incorporates some of the desired effect of using the ECAPM. In other words, the long-term risk-free rate version of the CAPM has a higher intercept and a flatter slope than the short-term risk-free version that has been tested. This is also because the use of adjusted betas rather than the use of raw betas also incorporates some of the desired effect of using the ECAPM 3. Thus, it is reasonable to apply a conservative alpha adjustment The regression tendency of betas to converge to 1.0 over time is very well known and widely discussed in the financial literature. As a result of this beta drift, several commercial beta producers adjust their forecasted betas toward 1.00 in an effort to improve their forecasts. Value Line, Bloomberg, and Merrill Lynch betas are adjusted for their long-term tendency to regress toward 1.0 by giving approximately 66% weight to the measured raw beta and approximately 33% weight to the prior value of 1.0 for each stock: β adjusted = β raw Page 55 of 76 57

60 Testimony of Dr. Roger A. Morin, PhD Appendix A contains a full discussion of the ECAPM, including its theoretical and empirical underpinnings. In short, the following equation provides a viable approximation to the observed relationship between risk and return, and provides the following cost of equity capital estimate: K = R F (R M - R F ) β (R M - R F ) Inserting 4.7% for the risk-free rate R F, an MRP of 6.5% for (R M - R F ) and a beta of 0.74 in the above equation, the return on common equity is 9.9%. This estimate becomes 10.2% with flotation costs, discussed later in my testimony Q. Please summarize your CAPM estimates. A. The table below summarizes the common equity estimates obtained from the CAPM studies. CAPM Method % ROE Traditional CAPM 9.8% Empirical CAPM 10.2% Q. How do your CAPM estimates compare with those derived from the Commission s approach? A. Using the Commission s approach to estimating the risk-free rate component (3.9%) and MRP component (8%) of the CAPM/ECAPM, the Page 56 of 76 58

61 Testimony of Dr. Roger A. Morin, PhD 1 2 estimates would be 9.9% and 10.4% without flotation costs, coincidentally almost identical to my own estimates of 9.8% and 10.2% C. Historical Risk Premium Estimate Q. What is currently happening in the debt and equity markets? A. Since the financial crisis began in 2008, the financial markets, both in the U.S. and abroad, have become extremely volatile, unpredictable, and have displayed unusual behavior. In light of a fundamental structural upward shift in risk aversion as capital markets are re-pricing risk, equity capital has become, and will continue to be, more expensive for all market participants, including utilities, relative to government bond yields Q. Dr. Morin, given the current state of the capital markets at this time, is a historical risk premium analysis using government bond yields appropriate? A. No, I do not believe it is. Trends in utility cost of capital are not directly captured by a risk premium estimate tied to government bond yields. Because a utility s cost of capital is determined by its business and financial risks, it is reasonable to surmise that its cost of equity will track its cost of debt more closely than it will track the government bond yield. Therefore, in contrast to past testimonies prior to the financial crisis, I have performed a Page 57 of 76 59

62 Testimony of Dr. Roger A. Morin, PhD 1 2 historical premium analysis using the utility bond yield instead of the government bond yield Q. Please describe your historical risk premium analysis of the electric utility industry using utility bond yields. A. A historical risk premium for the electric utility industry was estimated with an annual time series analysis applied to the utility industry as a whole over the period, using Standard and Poor s Utility Index as an industry proxy. The analysis is depicted on Exhibit (RAM-13). The risk premium was estimated by computing the actual realized return on equity capital for the S&P Utility Index for each year, using the actual stock prices and dividends of the index, and then subtracting the long-term utility bond return for that year. As the average Moody s bond rating in the electric utility industry is Baa, the analysis was performed using the yields on utility bonds rated Baa by Moody s As shown on Exhibit (RAM-13), the average risk premium over the period was 4.1% over historical long-term utility bond returns and 4.5% over long-term utility bond yields. Given that the current yield on Baarated utility bonds is 6.6%, and using the historical estimate of 4.1%, the implied cost of equity for the average risk utility from this particular Page 58 of 76 60

63 Testimony of Dr. Roger A. Morin, PhD method is 6.6% + 4.1% = 10.7% without flotation costs and 11.0% with the flotation cost allowance. The need for a flotation cost allowance is discussed at length later in my testimony Q. Dr. Morin, are risk premium studies widely used? A. Yes, they are. Although the Commission has not relied on this approach in the past, risk premium analyses of the type I am describing here are widely used by analysts, investors, economists, and expert witnesses. Most college-level corporate finance and/or investment management texts, including Investments by Bodie, Kane, and Marcus, McGraw-Hill Irwin, 2002, which is a recommended textbook for Chartered Financial Analyst certification and examination, contain detailed conceptual and empirical discussion of the risk premium approach. The latter is typically recommended as one of the three leading methods of estimating the cost of capital. Professor Brigham s best-selling corporate finance textbook, for example, Corporate Finance: A Focused Approach, 3 rd ed., South- Western, 2008, recommends the use of risk premium studies, among others. Techniques of risk premium analysis are widespread in investment community reports. Professional certified financial analysts are certainly well versed in the use of this method. Page 59 of 76 61

64 Testimony of Dr. Roger A. Morin, PhD Q. Are you concerned about the realism of the assumptions that underlie the historical risk premium method? A. No, I am not, for they are no more restrictive than the assumptions that underlie the DCF model or the CAPM. While it is true that the method looks backward in time and assumes that the risk premium is constant over time, these assumptions are not necessarily restrictive. By employing returns realized over long time periods rather than returns realized over more recent time periods, investor return expectations and realizations converge. Realized returns can be substantially different from prospective returns anticipated by investors, especially when measured over short time periods. By ensuring that the risk premium study encompasses the longest possible period for which data are available, short-run periods during which investors earned a lower risk premium than they expected are offset by short-run periods during which investors earned a higher risk premium than they expected. Only over long time periods will investor return expectations and realizations converge; otherwise, investors would never invest any money Q Dr. Morin, the Commission has criticized the historical risk premium approach in recent cases. How do you respond? Page 60 of 76 62

65 Testimony of Dr. Roger A. Morin, PhD A. The Commission has stated in the past that the historical risk premium approach is inappropriate because New York electric utilities may be more or less risky than the companies that make up the S&P Electric Utility Index over the period. I disagree. Over most of the long period that covers my historical risk premium study, , the electric utility was relatively homogenous in risk and under the umbrella of regulatory protection for all of its functions (power generation, transmission, distribution) The Commission also critiqued the risk premium method on the grounds that the method assumes that the risk premium is constant over time, that is, that the risk premium has remained at the same level relative to the risks of the electric utility stocks. This criticism is unwarranted. To the extent that the historical equity risk premium estimated follows what is known in statistics as a random walk, one should expect the equity risk premium to remain at its historical mean. The best estimate of the future risk premium is the historical mean. This approach is no different than using long term historical earning results to calculate the market risk premium used in the CAPM analyses. Page 61 of 76 63

66 Testimony of Dr. Roger A. Morin, PhD As discussed earlier, the Risk Premium approach is conceptually sound and firmly rooted in the conceptual framework of Capital Market Theory. It is widely used by analysts, investors, and expert witnesses D. Flotation Cost Adjustment Q. Please describe the need for a flotation cost allowance. A. All the market-based estimates reported above include an adjustment for flotation costs. Common equity capital is not free, and flotation costs associated with stock issues are similar to the flotation costs associated with bonds and preferred stocks. Flotation costs are not expensed at the time of issue, and therefore must be recovered via a rate of return adjustment. This is done routinely for bond and preferred stock issues by most regulatory boards, including the Commission. Clearly, the common equity capital accumulated by the Company is not cost-free. The flotation cost allowance to the cost of common equity capital is discussed and applied in most corporate finance textbooks; it is unreasonable to ignore the need for such an adjustment Flotation costs are very similar to the closing costs on a home mortgage. In the case of issues of new equity, flotation costs represent the discounts that must be provided to place the new securities. Flotation costs have a Page 62 of 76 64

67 Testimony of Dr. Roger A. Morin, PhD direct and an indirect component. The direct component is the compensation to the security underwriter for marketing/consulting services, for the risks involved in distributing the issue, and for any operating expenses associated with the issue (printing, legal, prospectus, etc.). The indirect component represents the downward pressure on the stock price as a result of the increased supply of stock from the new issue. The latter component is frequently referred to as market pressure Investors must be compensated for flotation costs on an ongoing basis to the extent that such costs have not been expensed in the past, and therefore the adjustment must continue for the entire time that these initial funds are retained in the firm. Appendix B discusses flotation costs in detail, and shows: (1) why it is necessary to apply an allowance of 5% to the dividend yield component of equity cost by dividing that yield by 0.95 (100% - 5%) to obtain the fair return on equity capital; (2) why the flotation adjustment is permanently required to avoid confiscation even if no further stock issues are contemplated; and (3) that flotation costs are only recovered if the rate of return is applied to total equity, including retained earnings, in all future years. 20 Page 63 of 76 65

68 Testimony of Dr. Roger A. Morin, PhD Q. Would you provide an example to illustrate the flotation cost allowance concept? A. Yes. Assume a stock is sold for $100, and investors require a 10% return, that is, $10 of earnings. But if flotation costs are 5%, the Company nets $95 from the issue, and its common equity account is credited by $95. In order to generate the same $10 of earnings to the shareholders, from a reduced equity base, it is clear that a return in excess of 10% must be allowed on this reduced equity base, here 10.52% According to the empirical finance literature discussed in Appendix B, total flotation costs amount to 4% for the direct component and 1% for the market pressure component, for a total of 5% of gross proceeds. This in turn amounts to approximately 30 basis points, depending on the magnitude of the dividend yield component. To illustrate, dividing the average expected dividend yield of around 5.0% for utility stocks by 0.95 yields 5.3%, which is 30 basis points higher Sometimes, the argument is made that flotation costs are real and should be recognized in calculating the fair return on equity, but only at the time when the expenses are incurred. In other words, the flotation cost allowance should not continue indefinitely, but should be made in the year Page 64 of 76 66

69 Testimony of Dr. Roger A. Morin, PhD in which the sale of securities occurs, with no need for continuing compensation in future years. This argument is valid only if the Company has already been compensated for these costs. If not, the argument is without merit. My own recommendation is that investors be compensated for flotation costs on an on-going basis rather than through expensing, and that the flotation cost adjustment continue for the entire time that these initial funds are retained in the firm There are several sources of equity capital available to a firm including: common equity issues, conversions of convertible preferred stock, dividend reinvestment plan, employees savings plan, warrants, and stock dividend programs. Each carries its own set of administrative costs and flotation cost components, including discounts, commissions, corporate expenses, offering spread, and market pressure. The flotation cost allowance is a composite factor that reflects the historical mix of sources of equity. The allowance factor is a build-up of historical flotation cost adjustments associated and traceable to each component of equity at its source. It is impractical and prohibitively costly to start from the inception of a company and determine the source of all present equity. A practical solution is to identify general categories and assign one factor to each category. My recommended flotation cost allowance is a weighted Page 65 of 76 67

70 Testimony of Dr. Roger A. Morin, PhD 1 2 average cost factor designed to capture the average cost of various equity vintages and types of equity capital raised by the Company Q. Is a flotation cost adjustment required for an operating subsidiary like Niagara Mohawk that does not trade publicly? A. Yes, it is. It is sometimes alleged that a flotation cost allowance is inappropriate if the utility is a subsidiary whose equity capital is obtained from its ultimate parent, in this case, National Grid. This objection is unfounded since the parent-subsidiary relationship does not eliminate the costs of a new issue, but merely transfers them to the parent. It would be unfair and discriminatory to subject parent shareholders to dilution while individual shareholders are absolved from such dilution. Fair treatment must consider that, if the utility-subsidiary had gone to the capital markets directly, flotation costs would have been incurred Q. What flotation cost treatment does the Commission rely upon? A. The Commission has only provided for recovery of flotation costs when a public common issuance is planned during the rate year. The standard flotation cost allowance used in my direct testimony is designed to recover the flotation costs associated with all past issues that were not expensed, but rather written off against common equity. Page 66 of 76 68

71 Testimony of Dr. Roger A. Morin, PhD By analogy, in the case of a debt issue, flotation costs are amortized over the life of the debt, and the annual amortization charge usually is embedded in the cost of debt for ratemaking purposes. This is done whether the company intends to issue debt in the future or not. The recovery of debt flotation expense continues year after year irrespective of whether the company issues new debt capital until recovery is complete, in the same way that the recovery of past investments in plant and equipment through depreciation allowances continues in the future even if no new construction is contemplated. Unlike the case of bonds, common stock has no finite life so that flotation costs cannot be amortized and must therefore be recovered via an upward adjustment to the allowed return on equity. As in the case of bonds, the recovery continues year after year regardless of whether the utility raises new equity capital until the recovery process is terminated To the extent that Niagara Mohawk s flotation costs associated with past common equity issues have not been recovered, the only recovery mechanism available for the recovery of such costs is an upward adjustment to the return on equity Page 67 of 76 69

72 Testimony of Dr. Roger A. Morin, PhD 1 IV. Summary and Cost of Equity Recommendation Q. Can you summarize your results and recommendation? A. To arrive at my final recommendation, I performed three risk premium analyses. For the first two risk premium studies, I applied the CAPM and an empirical approximation of the CAPM using current market data. The other risk premium analysis was performed on historical data from electric utility industry aggregate data, using the yield on long-term utility bonds. I also performed DCF analyses on two surrogates for Niagara Mohawk: a group of investment-grade dividend-paying combination electric and gas utilities, and a group of electric utilities that make up the S&P Utility Index. The results are summarized in the table below STUDY ROE CAPM 9.80% Empirical CAPM 10.20% Hist. Risk Premium Elec Utility Industry 11.00% DCF Comb. Elec & Gas Utilities Value Line Growth 11.80% DCF Comb. Elec & Gas Utilities Zacks Growth 10.90% DCF S&P Elec Utilities Value Line Growth 10.60% DCF S&P Elec Utilities Zacks Growth 11.60% The results range from 9.8% to 11.8% with a midpoint of 10.8%. The overall average result is 10.8% and the truncated mean is 10.9%. From these results, I conclude that a ROE of 10.85% is reasonable. 18 Page 68 of 76 70

73 Testimony of Dr. Roger A. Morin, PhD Q. Dr. Morin, if you were to rely on weighting of 2/3 for the DCF results and 1/3 for the CAPM results, what would be Niagara Mohawk s cost of common equity estimate? A. From the above table, the average CAPM result is 10.0%. The average DCF result is 11.2%. Giving one-third weight to the CAPM result of 10.0% and two-thirds weight to the DCF result of 11.2%, the weighted average result is 10.82%, which is almost identical to the average result reported in the above summary table Q. Did you adjust your proxy group cost of equity results to reflect the risk differential between the proxy group and the Company? A. No, I did not. The Company s investment risk is average in my view Because the cost of equity estimates derived from the various comparable groups reflect the risk of the average investment grade utility and because Niagara Mohawk s investment risks are broadly comparable to those of the industry, the expected equity returns developed above are applicable to Niagara Mohawk. 19 Page 69 of 76 71

74 Testimony of Dr. Roger A. Morin, PhD Q. Did you consider the impact of the Company s proposal to implement a revenue decoupling mechanism (RDM) on the Company s cost of equity? A. No, I did not. Any risk-mitigating impact such mechanisms may have on the Company s risk profile is largely reflected in the capital market data of the comparable companies. RDMs or similar margin adjustment mechanisms are becoming increasingly commonplace in the energy utility industry. A number of electric companies in my comparable groups possess some form of revenue decoupling and/or similar margin adjustment rider mechanism. At the same time, revenue decoupling, depending on how it is implemented, might not reduce risk for certain companies in my comparable group that do not have such mechanisms and serve growing markets. Such utilities depend on increases in revenue to offset increases in cost of service and this may be less risky without a RDM. For all these reasons, it is unnecessary to account for the impact a RDM has on the Company s ROE Q. Did you include a return adjustment to your results to account for any credit rating differential between the proxy group and the Company? A. No, I did not. This is because credit ratings and debt rate differentials are not directly related to required equity returns. As shown on the graph Page 70 of 76 72

75 Testimony of Dr. Roger A. Morin, PhD 1 2 below, there is no correlation between the DCF results for the companies in my two sample groups and the bond ratings of these companies Moreover, the table below displays the DCF results for each bond rating category. There is no positive relationship between return and declining credit quality for these companies, which are all investment grade. I also point out that there is no correlation between equity risk as measured by beta and the credit ratings of the companies in the two sample groups as evidenced by the data in the last column in the table below. Bond DCF Beta Rating Estimates Estimates Aa % 0.65 Page 71 of 76 73

76 Testimony of Dr. Roger A. Morin, PhD A % 0.70 A % 0.60 Baa % 0.71 Baa % 0.70 Baa % 0.76 Q. Why isn t it logical to assume that an entity with a higher credit rating and therefore a lower cost of debt will not have a lower cost of equity as well? A. The primary reason is that credit ratings are intended to reflect an estimate of the likelihood that a company will fulfill its debt obligations. Such ratings do not attempt to estimate the likelihood of whether an equity investor will realize the appropriate return on equity. Moreover, for companies that are considered investment grade, as an entity takes steps to increase its credit quality, it may create additional risks for equity investors. For example, one of the actions that a company can undertake in order to increase credit quality is to reduce the amount of debt as a percentage of its total capital. However, as long term debt becomes less risky, it is quite possible that a further equity investment becomes somewhat riskier. My point here is not that an entity with better credit quality will experience an increase in the cost of equity, but that there is no evidence that improvements in credit quality necessarily reduce the Page 72 of 76 74

77 Testimony of Dr. Roger A. Morin, PhD 1 2 cost of equity for investment grade utilities. Thus, it is inappropriate to apply a credit quality adjustment to the cost of equity results in this case Q. Dr. Morin, do you consider your recommendation conservative? A. Yes, I do. Yields on 20-year Treasury bonds are projected to increase by 50 basis points (0.5%) by December Value Line s Quarterly Economic Review dated August 2009 also projects the yields on 10-year Treasury bonds to increase by 50 basis points in Because long-term interest rates generally move in unison, an increase (decrease) in the yield on 10/20-year Treasury bonds should be accompanied by a parallel increase (decrease) in the yield on 30-year bonds. A projected increase in interest rates, if materialized, would clearly increase my CAPM and Risk Premium estimates, and therefore ROE. I therefore view my ROE recommendation as conservative Q. Dr. Morin, what capital structure assumption underlies your recommended ROE for Niagara Mohawk? A. My recommended ROE for Niagara Mohawk is predicated on the adoption of a rate year capital structure consisting of 50% common equity capital.. Page 73 of 76 75

78 Testimony of Dr. Roger A. Morin, PhD Q. Did you examine the reasonableness of the Company s capital structure? A. Yes, I did. I have compared Niagara Mohawk s rate year capital structure with: 1) the capital structures adopted by regulators for electric utilities, and 2) the actual capital structures of electric utilities The October 2009 edition of SNL Energy s (formerly Regulatory Research Associates) Regulatory Focus: Major Rate Case Decisions reports an average percentage of common equity in the adopted capital structure of 48.4% for electric utilities for 2008 and 48% for 2009, which is quite close to the Company s proposed common equity ratio in this case. I have also examined the actual capital structures of my comparable group of combination electric and as utilities as reported by Value Line. As shown on Exhibit (RAM-14), the average common equity ratio for the group is 47%, which is very close to the Company s proposal. I conclude that the Company s requested common equity ratio is reasonable for ratemaking purposes Q. Dr. Morin, what is your final conclusion regarding Niagara Mohawk s cost of common equity capital? A. Based on the results of all my analyses, the application of my professional Page 74 of 76 76

79 Testimony of Dr. Roger A. Morin, PhD judgment, and the risk circumstances of Niagara Mohawk, it is my opinion that a just and reasonable return on the common equity capital of Niagara Mohawk s electric utility operations is 10.85%. My recommended rate of return reflects the application of my professional judgment to the results in light of the indicated returns from my Risk Premium, CAPM, and DCF analyses. My recommended ROE assumes the approval of the Company s rate year capital structure Q. Would you now discuss the implications for the allowed ROE of a stayout for Niagara Mohawk? A. The Company has informed me that it is proposing a three-year rate plan. This exposes Niagara Mohawk to the risk that the cost of equity may go up during the course of the rate plan, without the Company having an opportunity to reset the allowed return to reflect such an increase. I am informed that in the past, the Commission has used the differential between 3-year and 1-year Treasury securities to provide guidance as to what the stayout premium in such circumstances should be. More specifically, I am informed that the Commission has used one-half of the five-year average differentials between (1) a Treasury security reflecting the length of the rate plan and (2) a 1-year Treasury security. The fiveyear average differential, through the end of October 2009, between 3-year Page 75 of 76 77

80 Testimony of Dr. Roger A. Morin, PhD and 1-year Treasury securities is approximately 50 basis points, excluding those months where the differential was negative, that is, when the yield curve was negative. Half of this differential is about 25 basis points. Thus, a stayout premium in the neighborhood of 25 basis points would be reasonable for Niagara Mohawk, and that brings my recommended ROE to 11.1% Q. Finally, Dr. Morin, if capital market conditions change significantly between the date of filing your prepared testimony and the date your oral testimony is presented, would this cause you to revise your estimated cost of equity? A. Yes. Interest rates and security prices do change over time, and risk premiums change also, although much more sluggishly. If substantial changes were to occur between the filing date and the time my oral testimony is presented, I will update my testimony accordingly Q. Does this complete your direct testimony? A. Yes, it does. Page 76 of 76 78

81 Appendix A Page 1 of 16 APPENDIX A CAPM, EMPIRICAL CAPM The Capital Asset Pricing Model (CAPM) is a fundamental paradigm of finance. Simply put, the fundamental idea underlying the CAPM is that risk-averse investors demand higher returns for assuming additional risk, and higher-risk securities are priced to yield higher expected returns than lower-risk securities. The CAPM quantifies the additional return, or risk premium, required for bearing incremental risk. It provides a formal risk-return relationship anchored on the basic idea that only market risk matters, as measured by beta. According to the CAPM, securities are priced such that their: EXPECTED RETURN = RISK-FREE RATE + RISK PREMIUM Denoting the risk-free rate by R F and the return on the market as a whole by R M, the CAPM is: K = R F + β(r M - R F ) (1) Equation 1 is the CAPM expression which asserts that an investor expects to earn a return, K, that could be gained on a risk-free investment, R F, plus a risk premium for assuming risk, proportional to the security's market risk, also known as beta, β, and the market risk premium, (R M - R F ), where R M is the market return. The market risk premium (R M - R F ) can be abbreviated MRP so that the CAPM becomes: K = R F + β x MRP (2) The CAPM risk-return relationship is depicted in the figure below and is typically labeled as the Security Market Line (SML) by the investment community. 79

82 Appendix A Page 2 of 16 CAPM and Risk - Return in Capital Markets Return Average Stock Market Risk Premium SML R f R f = Risk-free rate Treasury Bills Corporate Bonds Utility Stock Average Stock Beta Risk A myriad empirical tests of the CAPM have shown that the risk-return tradeoff is not as steeply sloped as that predicted by the CAPM, however. That is, low-beta securities earn returns somewhat higher than the CAPM would predict, and high-beta securities earn less than predicted. In other words, the CAPM tends to overstate the actual sensitivity of the cost of capital to beta: low-beta stocks tend to have higher returns and high-beta stocks tend to have lower risk returns than predicted by the CAPM. The difference between the CAPM and the type of relationship observed in the empirical studies is depicted in the figure below. This is one of the most widely known empirical findings of the finance literature. This extensive literature is summarized in Chapter 13 of Dr. Morin s book [Regulatory Finance, Public Utilities Report Inc., Arlington, VA, 1994]. 80

83 Appendix A Page 3 of 16 Risk vs Return Theory vs. Practice Return Theory Average Return CAPM lower than Empirical Line for low Beta Stocks Market Risk Premium Practice Risk-Free Beta < 1.0 Beta = 1.0 Beta A number of refinements and expanded versions of the original CAPM theory have been proposed to explain the empirical findings. These revised CAPMs typically produce a risk-return relationship that is flatter than the standard CAPM prediction. The following equation makes use of these empirical findings by flattening the slope of the risk-return relationship and increasing the intercept: K = R F + α + β (MRP- α ) (3) where α is the "alpha" of the risk-return line, a constant determined empirically, and the other symbols are defined as before. Alternatively, Equation 3 can be written as follows: K = R F + a MRP + (1-a) β MRP (4) where a is a fraction to be determined empirically. Comparing Equations 3 and 4, it is easy to see that alpha equals a times MRP, that is, α =ax MRP 81

84 Appendix A Page 4 of 16 Theoretical Underpinnings The obvious question becomes what would produce a risk return relationship which is flatter than the CAPM prediction, or in other words, how do you explain the presence of alpha in the above equation. The exclusion of variables aside from beta would produce this result. Three such variables are noteworthy: dividend yield, skewness, and hedging potential. The dividend yield effects stem from the differential taxation on corporate dividends and capital gains. The standard CAPM does not consider the regularity of dividends received by investors. Utilities generally maintain high dividend payout ratios relative to the market, and by ignoring dividend yield, the CAPM provides biased cost of capital estimates. To the extent that dividend income is taxed at a higher rate than capital gains, investors will require higher pre-tax returns in order to equalize the after-tax returns provided by high-yielding stocks (e.g. utility stocks) with those of low-yielding stocks. In other words, high-yielding stocks must offer investors higher pre-tax returns. Even if dividends and capital gains are undifferentiated for tax purposes, there is still a tax bias in favor of earnings retention (lower dividend payout), as capital gains taxes are paid only when gains are realized. Empirical studies by Litzenberger and Ramaswamy (1979) and Litzenberger et al. (1980) find that security returns are positively related to dividend yield as well as to beta. These results are consistent with after-tax extensions of the CAPM developed by Breenan (1973) and Litzenberger and Ramaswamy (1979) and suggest that the relationship between return, beta, and dividend yield should be estimated and employed to calculate the cost of equity capital. As far as skewness is concerned, investors are more concerned with losing money than with total variability of return. If risk is defined as the probability of loss, it appears more logical to measure risk as the probability of achieving a return which is below the expected return. The traditional CAPM provides downward-biased estimates of cost of capital to the extent that these skewness effects are significant. As shown by Kraus and Litzenberger (1976), expected return depends on both on a stock's systematic risk (beta) 82

85 and the systematic skewness. Empirical studies by Kraus and Litzenberger (1976), Appendix A Page 5 of 16 Friend, Westerfield, and Granito (1978), and Morin (1981) found that, in addition to beta, skewness of returns has a significant negative relationship with security returns. This result is consistent with the skewness version of the CAPM developed by Rubinstein (1973) and Kraus and Litzenberger (1976). This is particularly relevant for public utilities whose future profitability is constrained by the regulatory process on the upside and relatively unconstrained on the downside in the face of socio-political realities of public utility regulation. The process of regulation, by restricting the upward potential for returns and responding sluggishly on the downward side, may impart some asymmetry to the distribution of returns, and is more likely to result in utilities earning less, rather than more, than their cost of capital. The traditional CAPM provides downward-biased estimates of cost of capital to the extent that these skewness effects are significant. As far as hedging potential is concerned, investors are exposed to another kind of risk, namely, the risk of unfavorable shifts in the investment opportunity set. Merton (1973) shows that investors will hold portfolios consisting of three funds: the risk-free asset, the market portfolio, and a portfolio whose returns are perfectly negatively correlated with the riskless asset so as to hedge against unforeseen changes in the future risk-free rate. The higher the degree of protection offered by an asset against unforeseen changes in interest rates, the lower the required return, and conversely. Merton argues that low beta assets, like utility stocks, offer little protection against changes in interest rates, and require higher returns than suggested by the standard CAPM. Another explanation for the CAPM's inability to fully explain the process determining security returns involves the use of an inadequate or incomplete market index. Empirical studies to validate the CAPM invariably rely on some stock market index as a proxy for the true market portfolio. The exclusion of several asset categories from the definition of market index mis-specifies the CAPM and biases the results found using only stock market data. Kolbe and Read (1983) illustrate the biases in beta estimates which result from applying the CAPM to public utilities. Unfortunately, no comprehensive and easily accessible data exist for several classes of assets, such as 83

86 Appendix A Page 6 of 16 mortgages and business investments, so that the exact relation between return and stock betas predicted by the CAPM does not exist. This suggests that the empirical relationship between returns and stock betas is best estimated empirically (ECAPM) rather than by relying on theoretical and elegant CAPM models expanded to include missing assets effects. In any event, stock betas may be highly correlated with the true beta measured with the true market index. Yet another explanation for the CAPM's inability to fully explain the observed risk-return tradeoff involves the possibility of constraints on investor borrowing that run counter to the assumptions of the CAPM. In response to this inadequacy, several versions of the CAPM have been developed by researchers. One of these versions is the so-called zero-beta, or two-factor, CAPM which provides for a risk-free return in a market where borrowing and lending rates are divergent. If borrowing rates and lending rates differ, or there is no risk-free borrowing or lending, or there is risk-free lending but no risk-free borrowing, then the CAPM has the following form: K = R Z + β(r m - R F ) The model, christened the zero-beta model, is analogous to the standard CAPM, but with the return on a minimum risk portfolio which is unrelated to market returns, R Z, replacing the risk-free rate, R F. The model has been empirically tested by Black, Jensen, and Scholes (1972), who found a flatter than predicted CAPM, consistent with the model and other researchers' findings. The zero-beta CAPM cannot be literally employed in cost of capital projections, since the zero-beta portfolio is a statistical construct difficult to replicate. Empirical Evidence A summary of the empirical evidence on the magnitude of alpha is provided in the table below. 84

87 Appendix A Page 7 of 16 Empirical Evidence on the Alpha Factor Author Range of alpha Period relied Black (1993) -3.6% to 3.6% Black, Jensen and Scholes (1972) -9.61% to 12.24% Fama and McBeth (1972) 4.08% to 9.36% Fama and French (1992) 10.08% to 13.56% Litzenberger and Ramaswamy (1979) 5.32% to 8.17% Litzenberger, Ramaswamy and Sosin (1980) 1.63% to 5.04% Pettengill, Sundaram and Mathur (1995) 4.6% Morin (1994) 2.0% Harris, Marston, Mishra, and O Brien (2003) 2.0% Given the observed magnitude of alpha, the empirical evidence indicates that the risk-return relationship is flatter than that predicted by the CAPM. Typical of the empirical evidence is the findings cited in Morin (1989) over the period indicating that the observed expected return on a security is related to its risk by the following equation: K = β Given that the risk-free rate over the estimation period was approximately 6 percent, this relationship implies that the intercept of the risk-return relationship is higher than the 6 percent risk-free rate, contrary to the CAPM's prediction. Given that the average return on an average risk stock exceeded the risk-free rate by about 8.0 percent in that period, that is, the market risk premium (R M - R F ) = 8 percent, the intercept of the observed relationship between return and beta exceeds the risk-free rate by about 2 percent, suggesting an alpha factor of 2 percent. Most of the empirical studies cited in the above table utilize raw betas rather than Value Line adjusted betas because the latter were not available over most of the time 85

88 Appendix A Page 8 of 16 periods covered in these studies. A study of the relationship between return and adjusted beta is reported on Table 6-7 in Ibbotson Associates Valuation Yearbook If we exclude the portfolio of very small cap stocks from the relationship due to significant size effects, the relationship between the arithmetic mean return and beta for the remaining portfolios is flatter than predicted and the intercept slightly higher than predicted by the CAPM, as shown on the graph below. It is noteworthy that the Ibbotson study relies on adjusted betas as stated on page 95 of the aforementioned study. 25 CAPM vs ECAPM Return vs Risk 2002 NYSE Stocks 20 Return Observed Fitted CAPM Beta Another study by Morin in May 2002 provides empirical support for the ECAPM. All the stocks covered in the Value Line Investment Survey for Windows for which betas and returns data were available were retained for analysis. There were nearly 2000 such stocks. The expected return was measured as the total shareholder return ( TSR ) reported by Value Line over the past ten years. The Value Line adjusted beta was also retrieved from the same data base. The nearly 2000 companies for which all data were available were ranked in ascending order of beta, from lowest to highest. In order to palliate measurement error, the nearly 2000 securities were grouped into ten portfolios of 86

89 Appendix A Page 9 of 16 approximately 180 securities for each portfolio. The average returns and betas for each portfolio were as follows: Portfolio # Beta Return portfolio portfolio portfolio portfolio portfolio portfolio portfolio portfolio portfolio portfolio It is clear from the graph below that the observed relationship between DCF returns and Value Line adjusted betas is flatter than that predicted by the plain vanilla CAPM. The observed intercept is higher than the prevailing risk-free rate of 5.7 percent while the slope is less than equal to the market risk premium of 7.7 percent predicted by the plain vanilla CAPM for that period. 25 Return vs Risk 2002 NYSE Stocks 20 Return Observed Fitted CAPM Beta In an article published in Financial Management, Harris, Marston, Mishra, and O Brien ( HMMO ) estimate ex ante expected returns for S&P 500 companies over the 87

90 Appendix A Page 10 of 16 period HMMO measure the expected rate of return (cost of equity) of each dividend-paying stock in the S&P 500 for each month from January 1983 to August 1998 by using the constant growth DCF model. They then investigate the relation between the risk premium (expected return over the 20-year U.S. Treasury Bond yield) estimates for each month to equity betas as of that same month (5-year raw betas). The table below, drawn from HMMO Table 4, displays the average estimate prospective risk premium (Column 2) by industry and the corresponding beta estimate for that industry, both in raw form (Column 3) and adjusted form (Column 4). The latter were calculated with the traditional Value Line Merrill Lynch Bloomberg adjustment methodology by giving 1/3 weight of to a beta estimate of 1.00 and 2/3 weight to the raw beta estimate. Table A-1 Risk Premium and Beta Estimates by Industry Raw Adjusted Industry DCF Risk Premium Industry Beta Industry Beta (1) (2) (3) (4) 1 Aero Autos Banks Beer BldMat Books Boxes BusSv Chems Chips Clths Cnstr Comps Drugs ElcEq Energy Fin Food Fun Gold Hlth Hsld Harris, R. S., Marston, F. C., Mishra, D. R., and O Brien, T. J., Ex Ante Cost of Equity Estimates of S&P 500 Firms: The Choice Between Global and Domestic CAPM, Financial Management, Autumn 2003, pp

91 Raw Adjusted Industry DCF Risk Premium Industry Beta Industry Beta (1) (2) (3) (4) 23 Insur LabEq Mach Meals MedEq Pap PerSv Retail Rubber Ships Stee Telc Toys Trans Txtls Util Whlsl MEAN 7.19 Appendix A Page 11 of 16 The observed statistical relationship between expected return and adjusted beta is shown in the graph below along with the CAPM prediction: DCF Risk Premium vs Beta DCF Risk Premium Beta Observed CAPM 89

92 Appendix A Page 12 of 16 If the plain vanilla version of the CAPM is correct, then the intercept of the graph should be zero, recalling that the vertical axis represents returns in excess of the risk-free rate. Instead, the observed intercept is approximately 2 percent, that is approximately equal to 25 percent of the expected market risk premium of 7.2 percent shown at the bottom of Column 2 over the period, as predicted by the ECAPM. The same is true for the slope of the graph. If the plain vanilla version of the CAPM is correct, then the slope of the relationship should equal the market risk premium of 7.2 percent. Instead, the observed slope of close to 5 percent is approximately equal to 75 percent of the expected market risk premium of 7.2 percent, as predicted by the ECAPM. In short, the HMMO empirical findings are quite consistent with the predictions of the ECAPM. Practical Implementation of the ECAPM The empirical evidence reviewed above suggests that the expected return on a security is related to its risk by the following relationship: K = R F + α + β (MRP- α ) (5) or, alternatively by the following equivalent relationship: K = R F + a MRP + (1-a) β MRP (6) The empirical findings support values of α from approximately 2 percent to 7 percent. If one is using the short-term U.S. Treasury Bills yield as a proxy for the risk-free rate, and given that utility stocks have lower than average betas, an alpha in the lower range of the empirical findings, 2 percent - 3 percent is reasonable, albeit conservative. Using the long-term U.S. Treasury yield as a proxy for the risk-free rate, a lower alpha adjustment is indicated. This is because the use of the long-term U.S. 90

93 Appendix A Page 13 of 16 Treasury yield as a proxy for the risk-free rate partially incorporates the desired effect of using the ECAPM 2. An alpha in the range of 1 percent - 2 percent is therefore reasonable. To illustrate, consider a utility with a beta of The risk-free rate is 5 percent, the MRP is 7 percent, and the alpha factor is 2 percent. The cost of capital is determined as follows: K = R F + α + β (MRP- α ) K = 5% + 2% (7% - 2%) = 11% A practical alternative is to rely on the second variation of the ECAPM: K = R F + a MRP + (1-a) β MRP With an alpha of 2 percent, a MRP in the 6 percent - 8 percent range, the a coefficient is 0.25, and the ECAPM becomes 3 : K = R F MRP β MRP Returning to the numerical example, the utility s cost of capital is: K = 5% x 7% x 0.80 x 7% = 11% For reasonable values of beta and the MRP, both renditions of the ECAPM 2 The Security Market Line (SML) using the long-term risk-free rate has a higher intercept and a flatter slope than the SML using the short-term risk-free rate 3 Recall that alpha equals a times MRP, that is, alpha = a MRP, and therefore a = alpha/mrp. If alpha is 2 percent, then a =

94 Appendix A Page 14 of 16 produce results that are virtually identical 4. 4 In the Morin (1994) study, the value of a was actually derived by systematically varying the constant "a" in equation 6 from 0 to 1 in steps of 0.05 and choosing that value of 'a' that minimized the mean square error between the observed relationship between return and beta: K = β The value of a that best explained the observed relationship was

95 Appendix A Page 15 of 16 REFERENCES Black, Fischer, "Beta and Return," The Journal of Portfolio Management, Fall 1993, Black, Fischer, Michael C. Jensen and Myron Scholes, "The Capital Asset Pricing Model: Some Empirical Tests, from Jensen, M. (ed.) Studies in the Theory of Capital Markets, Praeger, New York, 1972, Breenan, M. (1973) Taxes, Market Valuation, and Corporate Financial Policy, National Tax Journal, 23, Fama, Eugene F. and James D. MacBeth, "Risk, Returns and Equilibrium: Empirical Tests," Journal of Political Economy, September 1972, pp Fama, Eugene F. and Kenneth R. French, "The Cross-Section of Expected Stock Returns," Journal of Finance, Vol. 47, June 1992, pp Friend, I., Westerfield, R., and Granito, M. (1978) New Evidence on the Capital Asset Pricing Model, Journal of Finance, 23, Harris, R. S., Marston, F. C., Mishra, D. R., and O Brien, T. J., Ex Ante Cost of Equity Estimates of S&P 500 Firms: The Choice Between Global and Domestic CAPM, Financial Management, Autumn 2003, pp Kraus, A. and Litzenberger, R.H. (1976) Skewness Preference and the Valuation of Risk Assets, Journal of Finance, 31, Litzenberger, R. H. and Ramaswamy, K. "The Effect of Personal Taxes and Dividends on Capital Asset Prices: Theory and Empirical Evidence." Journal of Financial Economics, June 1979, Litzenberger, R. H., Ramaswamy, K. and Sosin, H. (1980) "On the CAPM Approach to the Estimation of a Public Utility s Cost of Equity Capital, Journal of Finance, 35, May 1980, Merton, R.C. (1973) An Intertemporal Capital Asset Pricing Model, Econometrica, 41, Morin, R.A. (1981) "Intertemporal Market-Line Theory: An Empirical Test," Financial Review, Proceedings of the Eastern Finance Association, Morin, R.A. (1989) Arizona Corporation Commission, Rebuttal Testimony of Dr. Ra. Morin on behalf of US West Communications, Appendix B,

96 Appendix A Page 16 of 16 Pettengill, Glenn N., Sridhar Sundaram and Ike Mathur, "The Conditional Relation between Beta and Returns," Journal of Financial and Quantitative Analysis, Vol. 30, No. 1, March 1995, pp Rubinstein, M.E. (1973) A Mean-Variance Synthesis of Corporate Financial Theory, Journal of Financial Economics, March 1973,

97 Appendix B Page 1 of 9 APPENDIX B FLOTATION COST ALLOWANCE To obtain the final cost of equity financing from the investors' expected rate of return, it is necessary to make allowance for underpricing, which is the sum of market pressure, costs of flotation, and underwriting fees associated with new issues. Allowance for market pressure should be made because large blocks of new stock may cause significant pressure on market prices even in stable markets. Allowance must also be made for company costs of flotation (including such items as printing, legal and accounting expenses) and for underwriting fees. 1. MAGNITUDE OF FLOTATION COSTS According to empirical studies, underwriting costs and expenses average at least 4% of gross proceeds for utility stock offerings in the U.S. (See Logue & Jarrow: "Negotiations vs. Competitive Bidding in the Sale of Securities by Public Utilities", Financial Management, Fall 1978.) A study of 641 common stock issues by 95 electric utilities identified a flotation cost allowance of 5.0%. (See Borum & Malley: "Total Flotation Cost for Electric Company Equity Issues", Public Utilities Fortnightly, Feb. 20, 1986.) Empirical studies suggest an allowance of 1% for market pressure in U.S. studies. Logue and Jarrow found that the absolute magnitude of the relative price decline due to market pressure was less than 1.5%. Bowyer and Yawitz examined 278 public utility stock issues and found an average market pressure of 0.72%. (See Bowyer & Yawitz, "The Effect of New Equity Issues on Utility Stock Prices", Public Utilities Fortnightly, May 22, 1980.) Eckbo & Masulis ("Rights vs. Underwritten Stock Offerings: An Empirical Analysis", University of British Columbia, Working Paper No. 1208, Sept., 1987) found an average flotation cost of 4.175% for utility common stock offerings. Moreover, flotation costs increased progressively for smaller size issues. They also found that the relative price decline due to market pressure in the days surrounding the announcement amounted to slightly more than 1.5%. In a classic and monumental study published in the prestigious Journal of Financial Economics by a prominent scholar, a market pressure effect of 3.14% for industrial stock issues and 0.75% 95

98 Appendix B Page 2 of 9 for utility common stock issues was found (see Smith, C.W., "Investment Banking and the Capital Acquisition Process," Journal of Financial Economics 15, 1986). Other studies of market pressure are reported in Logue ("On the Pricing of Unseasoned Equity Offerings, Journal of Financial and Quantitative Analysis, Jan. 1973), Pettway ("The Effects of New Equity Sales Upon Utility Share Prices," Public Utilities Fortnightly, May ), and Reilly and Hatfield ("Investor Experience with New Stock Issues," Financial Analysts' Journal, Sept.- Oct. 1969). In the Pettway study, the market pressure effect for a sample of 368 public utility equity sales was in the range of 2% to 3%. Adding the direct and indirect effects of utility common stock issues, the indicated total flotation cost allowance is above 5.0%, corroborating the results of earlier studies. As shown in the table below, a comprehensive empirical study by Lee, Lochhead, Ritter, and Zhao, The Costs of Raising Capital, Journal of Financial Research, Vol. XIX, NO. 1, Spring 1996, shows average direct flotation costs for equity offerings of 3.5% - 5% for stock issues between $60 and $500 million. Allowing for market pressure costs raises the flotation cost allowance to well above 5%. 96

99 Appendix B Page 3 of 9 FLOTATION COSTS: RAISING EXTERNAL CAPITAL (Percent of Total Capital Raised) Amount Raised Average Flotation Average Flotation in $ Millions Cost: Common Stock Cost: New Debt $ % 4.39% and Up Note: Flotation costs for IPOs are about 17 percent of the value of common stock issued if the amount raised is less than $10 million and about 6 percent if more than $500 million is raised. Flotation costs are somewhat lower for utilities than others. Source: Lee, Inmoo, Scott Lochhead, Jay Ritter, and Quanshui Zhao, The Costs of Raising Capital, The Journal of Financial Research, Spring Therefore, based on empirical studies, total flotation costs including market pressure amount to approximately 5% of gross proceeds. I have therefore assumed a 5% gross total flotation cost allowance in my cost of capital analyses. 2. APPLICATION OF THE FLOTATION COST ADJUSTMENT The section below shows: 1) why it is necessary to apply an allowance of 5% to the dividend yield component of equity cost by dividing that yield by 0.95 (100% - 5%) to obtain the fair return on equity capital, and 2) why the flotation adjustment is permanently required to avoid confiscation even if no further stock issues are contemplated. Flotation costs are only recovered 97

100 Appendix B Page 4 of 9 if the rate of return is applied to total equity, including retained earnings, in all future years. Flotation costs are just as real as costs incurred to build utility plant. Fair regulatory treatment absolutely must permit the recovery of these costs. An analogy with bond issues is useful to understand the treatment of flotation costs in the case of common stocks. In the case of a bond issue, flotation costs are not expensed but are rather amortized over the life of the bond, and the annual amortization charge is embedded in the cost of service. This is analogous to the process of depreciation, which allows the recovery of funds invested in utility plant. The recovery of bond flotation expense continues year after year, irrespective of whether the company issues new debt capital in the future, until recovery is complete. In the case of common stock that has no finite life, flotation costs are not amortized. Therefore, the recovery of flotation cost requires an upward adjustment to the allowed return on equity. Roger A. Morin, Regulatory Finance, Public Utilities Reports Inc., Arlington, Va., 1994, provides numerical illustrations that show that even if a utility does not contemplate any additional common stock issues, a flotation cost adjustment is still permanently required. Examples there also demonstrate that the allowance applies to retained earnings as well as to the original capital. expressed as: From the standard DCF model, the investor's required return on equity capital is K = D 1 /P o + g If P o is regarded as the proceeds per share actually received by the company from which dividends and earnings will be generated, that is, P o equals B o, the book value per share, then the company's required return is: r = D 1 /B o + g Denoting the percentage flotation costs 'f', proceeds per share B o are related to market price P o as follows: P - fp = B o P(1 - f) = B o 98

101 Appendix B Page 5 of 9 Substituting the latter equation into the above expression for return on equity, we obtain: r = D 1 /P(1-f) + g that is, the utility's required return adjusted for underpricing. For flotation costs of 5%, dividing the expected dividend yield by 0.95 will produce the adjusted cost of equity capital. For a dividend yield of 6% for example, the magnitude of the adjustment is 32 basis points:.06/.95 = In deriving DCF estimates of fair return on equity, it is therefore necessary to apply a conservative after-tax allowance of 5% to the dividend yield component of equity cost. Even if no further stock issues are contemplated, the flotation adjustment is still permanently required to keep shareholders whole. Flotation costs are only recovered if the rate of return is applied to total equity, including retained earnings, in all future years, even if no future financing is contemplated. This is demonstrated by the numerical example contained in pages 7-9 of this Appendix. Moreover, even if the stock price, hence the DCF estimate of equity return, fully reflected the lack of permanent allowance, the company always nets less than the market price. Only the net proceeds from an equity issue are used to add to the rate base on which the investor earns. A permanent allowance for flotation costs must be authorized in order to insure that in each year the investor earns the required return on the total amount of capital actually supplied. The example shown on pages 7-9 shows the flotation cost adjustment process using illustrative, yet realistic, market data. The assumptions used in the computation are shown on page 7. The stock is selling in the market for $25, investors expect the firm to pay a dividend of $2.25 that will grow at a rate of 5% thereafter. The traditional DCF cost of equity is thus k = D/P + g = 2.25/ = 14%. The firm sells one share stock, incurring a flotation cost of 5%. The traditional DCF cost of equity adjusted for flotation cost is thus ROE = D/P(1-f) + g =.09/ = 14.47%. The initial book value (rate base) is the net proceeds from the stock issue, which are $23.75, that is, the market price less the 5% flotation costs. The example demonstrates that only 99

102 Appendix B Page 6 of 9 if the company is allowed to earn 14.47% on rate base will investors earn their cost of equity of 14%. On page 8, Column 1 shows the initial common stock account, Column 2 the cumulative retained earnings balance, starting at zero, and steadily increasing from the retention of earnings. Total equity in Column 3 is the sum of common stock capital and retained earnings. The stock price in Column 4 is obtained from the seminal DCF formula: D 1 /(k - g). Earnings per share in Column 6 are simply the allowed return of 14.47% times the total common equity base. Dividends start at $2.25 and grow at 5% thereafter, which they must do if investors are to earn a 14% return. The dividend payout ratio remains constant, as per the assumption of the DCF model. All quantities, stock price, book value, earnings, and dividends grow at a 5% rate, as shown at the bottom of the relevant columns. Only if the company is allowed to earn 14.47% on equity do investors earn 14%. For example, if the company is allowed only 14%, the stock price drops from $26.25 to $26.13 in the second year, inflicting a loss on shareholders. This is shown on page 9. The growth rate drops from 5% to 4.53%. Thus, investors only earn 9% % = 13.53% on their investment. It is noteworthy that the adjustment is always required each and every year, whether or not new stock issues are sold in the future, and that the allowed return on equity must be earned on total equity, including retained earnings, for investors to earn the cost of equity. 100

103 Appendix B Page 7 of 9 ASSUMPTIONS: ISSUE PRICE = $25.00 FLOTATION COST = 5.00% DIVIDEND YIELD = 9.00% GROWTH = 5.00% EQUITY RETURN = 14.00% (D/P + g) ALLOWED RETURN ON EQUITY = 14.47% (D/P(1-f) + g) 101

104 Appendix B Page 8 of 9 MARKET / COMMON RETAINED TOTAL STOCK BOOK STOCK EARNINGS EQUITY PRICE RATIO EPS DPS PAYOUT Yr (1) (2) (3) (4) (5) (6) (7) (8) $23.75 $0.000 $ $ $3.438 $ % 2 $23.75 $1.188 $ $ $3.609 $ % 3 $23.75 $2.434 $ $ $3.790 $ % 4 $23.75 $3.744 $ $ $3.979 $ % 5 $23.75 $5.118 $ $ $4.178 $ % 6 $23.75 $6.562 $ $ $4.387 $ % 7 $23.75 $8.077 $ $ $4.607 $ % 8 $23.75 $9.669 $ $ $4.837 $ % 9 $23.75 $ $ $ $5.079 $ % 10 $23.75 $ $ $ $5.333 $ % 5.00% 5.00% 5.00% 5.00% 102

105 Appendix B Page 9 of 9 MARKET/ COMMON RETAINED TOTAL STOCK BOOK STOCK EARNINGS EQUITY PRICE RATIO EPS DPS PAYOUT Yr (1) (2) (3) (4) (5) (6) (7) (8) $23.75 $0.000 $ $ $3.325 $ % 2 $23.75 $1.075 $ $ $3.476 $ % 3 $23.75 $2.199 $ $ $3.633 $ % 4 $23.75 $3.373 $ $ $3.797 $ % 5 $23.75 $4.601 $ $ $3.969 $ % 6 $23.75 $5.884 $ $ $4.149 $ % 7 $23.75 $7.225 $ $ $4.337 $ % 8 $23.75 $8.627 $ $ $4.533 $ % 9 $23.75 $ $ $ $4.738 $ % 10 $23.75 $ $ $ $4.952 $ % 4.53% 4.53% 4.53% 4.53% 103

106 Exhibit (RAM-1)

107 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-1) 104

108 Exhibit (RAM-1) Page 1 of 20 RESUME OF ROGER A. MORIN (Fall 2009) NAME: Roger A. Morin ADDRESS: 9 King Ave. Jekyll Island, GA 31527, USA 87 Paddys Head Rd Peggy s Cove Hway Nova Scotia, Canada B3A 3N6 TELEPHONE: (912) business office (912) business fax (404) cellular (902) summer office ADDRESS: profmorin@mac.com DATE OF BIRTH: 3/5/1945 PRESENT EMPLOYER: Georgia State University Robinson College of Business Atlanta, GA RANK: Emeritus Professor of Finance HONORS: Professor of Finance for Regulated Industry Director Center for the Study of Regulated Industry, Robinson College of Business, Georgia State University. EDUCATIONAL HISTORY - Bachelor of Electrical Engineering, McGill University, Montreal, Canada, Master of Business Administration, McGill University, Montreal, Canada, PhD in Finance & Econometrics, Wharton School of Finance, University of Pennsylvania,

109 Exhibit (RAM-1) Page 2 of 20 EMPLOYMENT HISTORY - Lecturer, Wharton School of Finance, Univ. of Pennsylvania, Assistant Professor, University of Montreal School of Business, Associate Professor, University of Montreal School of Business, Professor of Finance, Georgia State University, Professor of Finance for Regulated Industry and Director, Center for the Study of Regulated Industry, Robinson College of Business, Georgia State University, Visiting Professor of Finance, Amos Tuck School of Business, Dartmouth College, Hanover, N.H., Emeritus Professor of Finance, Georgia State University, OTHER BUSINESS ASSOCIATIONS - Communications Engineer, Bell Canada, Member of the Board of Directors, Financial Research Institute of Canada, Co-founder and Director Canadian Finance Research Foundation, Vice-President of Research, Garmaise-Thomson & Associates, Investment Management Consultants, Executive Visions Inc., Board of Directors, Member - Board of External Advisors, College of Business, Georgia State University, Member

110 Exhibit (RAM-1) Page 3 of 20 PROFESSIONAL CLIENTS AGL Resources AT & T Communications Alagasco - Energen Alaska Anchorage Municipal Light & Power Alberta Power Ltd. Allete Ameren American Water Works Company Ameritech Arkansas Western Gas Baltimore Gas & Electric Constellation Energy Bangor Hydro-Electric B.C. Telephone B C GAS Bell Canada Bellcore Bell South Corp. Bruncor (New Brunswick Telephone) Burlington-Northern C & S Bank Cajun Electric Canadian Radio-Television & Telecomm. Commission Canadian Utilities Canadian Western Natural Gas Cascade Natural Gas Centel Centra Gas Central Illinois Light & Power Co Central Telephone Central & South West Corp. 107

111 Exhibit (RAM-1) Page 4 of 20 Chattanoogee Gas Company Cincinnatti Gas & Electric Cinergy Corp. Citizens Utilities City Gas of Florida CN-CP Telecommunications Commonwealth Telephone Co. Columbia Gas System Consolidated Natural Gas Constellation Energy Delmarva Power & Light Co Deerpath Group Detroit Edison Company DTE Energy Edison International Edmonton Power Company Elizabethtown Gas Co. Emera Energen Engraph Corporation Entergy Corp. Entergy Arkansas Inc. Entergy Gulf States, Inc. Entergy Louisiana, Inc. Entergy Mississippi Power Entergy New Orleans, Inc. First Energy Florida Water Association Fortis Garmaise-Thomson & Assoc., Investment Consultants Gaz Metropolitain 108

112 Exhibit (RAM-1) Page 5 of 20 General Public Utilities Georgia Broadcasting Corp. Georgia Power Company GTE California - Verizon GTE Northwest Inc. - Verizon GTE Service Corp. - Verizon GTE Southwest Incorporated - Verizon Gulf Power Company Havasu Water Inc. Hawaiian Electric Company Hawaiian Elec & Light Co Heater Utilities Aqua - America Hope Gas Inc. Hydro-Quebec ICG Utilities Illinois Commerce Commission Island Telephone Jersey Central Power & Light Kansas Power & Light KeySpan Energy Manitoba Hydro Maritime Telephone Maui Electric Co. Metropolitan Edison Co. Minister of Natural Resources Province of Quebec Minnesota Power & Light Mississippi Power Company Missouri Gas Energy Mountain Bell National Grid PLC Nevada Power Company 109

113 Exhibit (RAM-1) Page 6 of 20 New Brunswick Power Newfoundland Power Inc. - Fortis Inc. New Market Hydro New Tel Enterprises Ltd. New York Telephone Co. Niagara Mohawk Power Corp Norfolk-Southern Northeast Utilities Northern Telephone Ltd. Northwestern Bell Northwestern Utilities Ltd. Nova Scotia Power Nova Scotia Utility and Review Board NUI Corp. NYNEX Oklahoma G & E Ontario Telephone Service Commission Orange & Rockland PNM Resources Pacific Northwest Bell People's Gas System Inc. People's Natural Gas Pennsylvania Electric Co. Pepco Holdings Potomac Electric Power Co. Price Waterhouse PSI Energy Public Service Electric & Gas Public Service of New Hampshire Public Service of New Mexico Puget Sound Energy 110

114 Exhibit (RAM-1) Page 7 of 20 Quebec Telephone Regie de l Energie du Quebec Rockland Electric Rochester Telephone SNL Center for Financial Execution San Diego Gas & Electric SaskPower Sierra Pacific Power Company Sierra Pacific Resources Southern Bell Southern States Utilities Southern Union Gas South Central Bell Sun City Water Company TECO Energy The Southern Company Touche Ross and Company TransEnergie Trans-Quebec & Maritimes Pipeline TXU Corp US WEST Communications Union Heat Light & Power Utah Power & Light Vermont Gas Systems Inc. 111

115 Exhibit (RAM-1) Page 8 of 20 MANAGEMENT DEVELOPMENT AND PROFESSIONAL EXECUTIVE EDUCATION - Canadian Institute of Marketing, Corporate Finance, Hydro-Quebec, "Capital Budgeting Under Uncertainty, Institute of Certified Public Accountants, Mergers & Acquisitions, Investment Dealers Association of Canada, Financial Research Foundation, bi-annual seminar, Advanced Management Research (AMR), faculty member, Financial Analysts Federation, Educational chapter: "Financial Futures Contracts" seminar - Exnet Inc. a.k.a. The Management Exchange Inc., faculty member : National Seminars: Risk and Return on Capital Projects Cost of Capital for Regulated Utilities Capital Allocation for Utilities Alternative Regulatory Frameworks Utility Directors Workshop Shareholder Value Creation for Utilities Fundamentals of Utility Finance in a Restructured Environment Contemporary Issues in Utility Finance - SNL Center for Financial Education. faculty member National Seminars: Essentials of Utility Finance - Georgia State University College of Business, Management Development Program, faculty member,

116 Exhibit (RAM-1) Page 9 of 20 EXPERT TESTIMONY & UTILITY CONSULTING AREAS OF EXPERTISE Corporate Finance Rate of Return Capital Structure Generic Cost of Capital Costing Methodology Depreciation Flow-Through vs Normalization Revenue Requirements Methodology Utility Capital Expenditures Analysis Risk Analysis Capital Allocation Divisional Cost of Capital, Unbundling Incentive Regulation & Alternative Regulatory Plans Shareholder Value Creation Value-Based Management REGULATORY BODIES Alabama Public Service Commission Alaska Public Utility Commission Alberta Public Service Board Arizona Corporation Commission Arkansas Public Service Commission British Columbia Board of Public Utilities California Public Service Commission Canadian Radio-Television & Telecommunications Comm. Colorado Public Utilities Board Delaware Public Utility Commission District of Columbia Public Service Commission Federal Communications Commission 113

117 Exhibit (RAM-1) Page 10 of 20 Federal Energy Regulatory Commission Florida Public Service Commission Georgia Public Service Commission Georgia Senate Committee on Regulated Industries Hawaii Public Service Commission Illinois Commerce Commission Indiana Utility Regulatory Commission Iowa Board of Public Utilities Louisiana Public Service Commission Maine Public Service Commission Manitoba Board of Public Utilities Michigan Public Service Commission Minnesota Public Utilities Commission Mississippi Public Service Commission Missouri Public Service Commission Montana Public Service Commission National Energy Board of Canada Nevada Public Service Commission New Brunswick Board of Public Commissioners New Hampshire Public Utility Commission New Jersey Board of Public Utilities New Mexico Public Regulatory Commission New Orleans City Council New York Public Service Commission Newfoundland Board of Commissioners of Public Utilities North Carolina Utilities Commission Ohio Public Utilities Commission Oklahoma State Board of Equalization Ontario Telephone Service Commission Ontario Energy Board Pennsylvania Public Service Commission 114

118 Exhibit (RAM-1) Page 11 of 20 Quebec Natural Gas Board Quebec Regie de l Energie Quebec Telephone Service Commission South Carolina Public Service Commission Tennessee Regulatory Authority Texas Public Utility Commission Utah Public Service Commission Virginia Public Service Commission Washington Utilities & Transportation Commission West Virginia Public Service Commission SERVICE AS EXPERT WITNESS Southern Bell, So. Carolina PSC, Docket #81-201C Southern Bell, So. Carolina PSC, Docket #82-294C Southern Bell, North Carolina PSC, Docket #P Metropolitan Edison, Pennsylvania PUC, Docket #R Pennsylvania Electric, Pennsylvania PUC, Docket #R Georgia Power, Georgia PSC, Docket # 3270-U, 1981 Georgia Power, Georgia PSC, Docket # 3397-U, 1983 Georgia Power, Georgia PSC, Docket # 3673-U, 1987 Georgia Power, F.E.R.C., Docket # ER , Georgia Power, F.E.R.C., Docket # ER , Georgia Power, F.E.R.C., Docket # ER , Bell Canada, CRTC 1987 Northern Telephone, Ontario PSC GTE-Quebec Telephone, Quebec PSC, Docket B Newtel., Nfld. Brd of Public Commission PU CN-CP Telecommunications, CRTC Quebec Northern Telephone, Quebec PSC Edmonton Power Company, Alberta Public Service Board 115

119 Exhibit (RAM-1) Page 12 of 20 Kansas Power & Light, F.E.R.C., Docket # ER NYNEX, FCC generic cost of capital Docket # Bell South, FCC generic cost of capital Docket # American Water Works - Tennessee, Docket #7226 Burlington-Northern - Oklahoma State Board of Taxes Georgia Power, Georgia PSC, Docket # 3549-U GTE Service Corp., FCC Docket # Mississippi Power Co., Miss. PSC, Docket U-4761 Citizens Utilities, Ariz. Corp. Comm., Docket U Quebec Telephone, Quebec PSC, 1986, 1987, 1992 Newfoundland L & P, Nfld. Brd. Publ Comm. 1987, 1991 Northwestern Bell, Minnesota PSC, Docket P-421/CI GTE Service Corp., FCC Docket # Anchorage Municipal Power & Light, Alaska PUC, 1988 New Brunswick Telephone, N.B. PUC, 1988 Trans-Quebec Maritime, Nat'l Energy Brd. of Cda, '88-92 Gulf Power Co., Florida PSC, Docket # EI Mountain States Bell, Montana PSC, # Mountain States Bell, Arizona CC, #E Georgia Power, Georgia PSC, Docket # 3840-U, l989 Rochester Telephone, New York PSC, Docket # 89-C-022 Noverco - Gaz Metro, Quebec Natural Gas PSC, #R GTE Northwest, Washington UTC, #U Orange & Rockland, New York PSC, Case 89-E-175 Central Illinois Light Company, ICC, Case Peoples Natural Gas, Pennsylvania PSC, Case Gulf Power, Florida PSC, Case # EI ICG Utilities, Manitoba BPU, Case 1989 New Tel Enterprises, CRTC, Docket #90-15 Peoples Gas Systems, Florida PSC Jersey Central Pwr & Light, N.J. PUB, Case ER J 116

120 Exhibit (RAM-1) Page 13 of 20 Alabama Gas Co., Alabama PSC, Case Trans-Quebec Maritime Pipeline, Cdn. Nat'l Energy Board Mountain Bell, Utah PSC, Mountain Bell, Colorado PUB South Central Bell, Louisiana PS Hope Gas, West Virginia PSC Vermont Gas Systems, Vermont PSC Alberta Power Ltd., Alberta PUB Ohio Utilities Company, Ohio PSC Georgia Power Company, Georgia PSC Sun City Water Company Havasu Water Inc. Centra Gas (Manitoba) Co. Central Telephone Co. Nevada AGT Ltd., CRTC 1992 BC GAS, BCPUB 1992 California Water Association, California PUC 1992 Maritime Telephone 1993 BCE Enterprises, Bell Canada, 1993 Citizens Utilities Arizona gas division 1993 PSI Resources CILCORP gas division 1994 GTE Northwest Oregon 1993 Stentor Group Bell Canada PSI Energy 1993, 1994, 1995, 1999 Cincinnati Gas & Electric 1994, 1996, 1999, 2004 Southern States Utilities, 1995 CILCO 1995, 1999, 2001 Commonwealth Telephone 1996 Edison International 1996,

121 Exhibit (RAM-1) Page 14 of 20 Citizens Utilities 1997 Stentor Companies 1997 Hydro-Quebec 1998 Entergy Gulf States Louisiana 1998, 1999, 2001, 2002, 2003 Detroit Edison, 1999, 2003 Entergy Gulf States, Texas, 2000, 2004 Hydro Quebec TransEnergie, 2001, 2004 Sierra Pacific Company, 2000, 2001, 2002, 2007 Nevada Power Company, 2001 Mid American Energy, 2001, 2002 Entergy Louisiana Inc. 2001, 2002, 2004 Mississippi Power Company, 2001, 2002, 2007 Oklahoma Gas & Electric Company, Public Service Electric & Gas, 2001, 2002 NUI Corp (Elizabethtown Gas Company), 2002 Jersey Central Power & Light, 2002 San Diego Gas & Electric, 2002 New Brunswick Power, 2002 Entergy New Orleans, 2002 Hydro-Quebec Distribution 2002 PSI Energy 2003 Fortis Newfoundland Power & Light 2002 Emera Nova Scotia Power 2004 Hydro-Quebec TransEnergie 2004 Hawaiian Electric 2004 Missouri Gas Energy 2004 AGL Resources 2004 Arkansas Western Gas 2004 Public Service of New Hampshire 2005 Hawaiian Electric Company 2005, 2008 Delmarva Power & Light Company 2005,

122 Exhibit (RAM-1) Page 15 of 20 Union Heat Power & Light 2005 Puget Sound Energy 2006, 2007, 2009 Cascade Natural Gas 2006 Entergy Arkansas Bangor Hydro Delmarva 2006, 2007, 2009 Potomac Electric Power Co. 2006, 2007, 2009 Duke Energy Ohio, 2007, 2008, 2009 Duke Energy Kentucky 2009 PROFESSIONAL AND LEARNED SOCIETIES - Engineering Institute of Canada, Canada Council Award, recipient 1971 and Canadian Association Administrative Sciences, American Association of Decision Sciences, American Finance Association, Financial Management Association, ACTIVITIES IN PROFESSIONAL ASSOCIATIONS AND MEETINGS - Chairman of meeting on "New Developments in Utility Cost of Capital", Southern Finance Association, Atlanta, Nov Chairman of meeting on "Public Utility Rate of Return", Southeastern Public Utility Conference, Atlanta, Oct Chairman of meeting on "Current Issues in Regulatory Finance", Financial Management Association, Atlanta, Oct Chairman of meeting on "Utility Cost of Capital", Financial Management Association, Toronto, Canada, Oct Committee on New Product Development, FMA, Discussant, "Tobin's Q Ratio", paper presented at Financial Management Association, New York, N.Y., Oct Guest speaker, "Utility Capital Structure: New 119

123 Exhibit (RAM-1) Page 16 of 20 Developments", National Society of Rate of Return Analysts 18th Financial Forum, Wash., D.C. Oct Opening address, "Capital Expenditures Analysis: Methodology vs Mythology," Bellcore Economic Analysis Conference, Naples Fla., Guest speaker, "Mythodology in Regulatory Finance", Society of Utility Rate of Return Analysts (SURFA), Annual Conference, Wash., D.C. February PAPERS PRESENTED: "An Empirical Study of Multi-Period Asset Pricing," annual meeting of Financial Management Assoc., Las Vegas Nevada, "Utility Capital Expenditures Analysis: Net Present Value vs Revenue Requirements", annual meeting of Financial Management Assoc., Denver, Colorado, October "Intervention Analysis and the Dynamics of Market Efficiency", annual meeting of Financial Management Assoc., San Francisco, Oct "Intertemporal Market-Line Theory: An Empirical Study," annual meeting of Eastern Finance Assoc., Newport, R.I "Option Writing for Financial Institutions: A Cost-Benefit Analysis", 1979 annual meeting Financial Research Foundation "Free-lunch on the Toronto Stock Exchange", annual meeting of Financial Research Foundation of Canada, l978. "Simulation System Computer Software SIMFIN", HP International Business Computer Users Group, London, "Inflation Accounting: Implications for Financial Analysis." Institute of Certified Public Accountants Symposium,

124 Exhibit (RAM-1) Page 17 of 20 OFFICES IN PROFESSIONAL ASSOCIATIONS - President, International Hewlett-Packard Business Computers Users Group, Chairman Program Committee, International HP Business Computers Users Group, London, England, Program Coordinator, Canadian Assoc. of Administrative Sciences, Member, New Product Development Committee, Financial Management Association, Reviewer: Journal of Financial Research Financial Management Financial Review Journal of Finance PUBLICATIONS "Risk Aversion Revisited", Journal of Finance, Sept "Hedging Regulatory Lag with Financial Futures," Journal of Finance, May (with G. Gay, R. Kolb) "The Effect of CWIP on Cost of Capital," Public Utilities Fortnightly, July "The Effect of CWIP on Revenue Requirements" Public Utilities Fortnightly, August "Intervention Analysis and the Dynamics of Market Efficiency," Time-Series Applications, New York: North Holland, (with K. El-Sheshai) "Market-Line Theory and the Canadian Equity Market," Journal of Business Administration, Jan. l982, M. Brennan, editor "Efficiency of Canadian Equity Markets," International Management Review, Feb "Intertemporal Market-Line Theory: An Empirical Test," Financial Review, Proceedings of the Eastern Finance Association,

125 Exhibit (RAM-1) Page 18 of 20 BOOKS Utilities' Cost of Capital, Public Utilities Reports Inc., Arlington, Va., Regulatory Finance, Public Utilities Reports Inc., Arlington, Va., 2004 Driving Shareholder Value, McGraw-Hill, January The New Regulatory Finance, Public Utilities Reports Inc., Arlington, Va., MONOGRAPHS Determining Cost of Capital for Regulated Industries, Public Utilities Reports, Inc., and The Management Exchange Inc., (with V.L. Andrews) Alternative Regulatory Frameworks, Public Utilities Reports, Inc., and The Management Exchange Inc., (with V.L. Andrews) Risk and Return in Capital Projects, The Management Exchange Inc., (with B. Deschamps) Utility Capital Expenditure Analysis, The Management Exchange Inc., Regulation of Cable Television: An Econometric Planning Model, Quebec Department of Communications, An Economic & Financial Profile of the Canadian Cablevision Industry, Canadian Radio-Television & Telecommunication Commission (CRTC), Computer Users' Manual: Finance and Investment Programs, University of Montreal Press, 1974, revised Fiber Optics Communications: Economic Characteristics, Quebec Department of Communications, "Canadian Equity Market Inefficiencies", Capital Market Research Memorandum, Garmaise & Thomson Investment Consultants,

126 Exhibit (RAM-1) Page 19 of 20 MISCELLANEOUS CONSULTING REPORTS Operational Risk Analysis: California Water Utilities, Calif. Water Association, "Cost of Capital Methodologies for Independent Telephone Systems", Ontario Telephone Service Commission, March "The Effect of CWIP on Cost of Capital and Revenue Requirements", Georgia Power Company, "Costing Methodology and the Effect of Alternate Depreciation and Costing Methods on Revenue Requirements and Utility Finances", Gaz Metropolitan Inc., "Simulated Capital Structure of CN-CP Telecommunications: A Critique", CRTC, "Telecommunications Cost Inquiry: Critique, CRTC, "Social Rate of Discount in the Public Sector", CRTC Policy Statement, "Technical Problems in Capital Projects Analysis", CRTC Policy Statement, RESEARCH GRANTS "Econometric Planning Model of the Cablevision Industry," International Institute of Quantitative Economics, CRTC. "Application of the Averch-Johnson Model to Telecommunications Utilities, Canadian Radio-Television Commission. (CRTC) "Economics of the Fiber Optics Industry", Quebec Dept. of Communications. "Intervention Analysis and the Dynamics of Market Efficiency", Georgia State Univ. College of Business, "Firm Size and Beta Stability", Georgia State University College of Business,

127 Exhibit (RAM-1) Page 20 of 20 "Risk Aversion and the Demand for Risky Assets", Georgia State University College of Business, Chase Econometrics, Interactive Data Corp., Research Grant, $50,000 per annum,

128 Exhibit (RAM-2)

129 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-2) 125

130 Exhibit (RAM-2) Page 1 of 1 COMBINATION GAS & ELEC UTILITIES DCF ANALYSIS: VALUE LINE GROWTH PROJECTIONS Company % Current Proj EPS Divid Growth Yield (1) (2) 1 ALLETE Alliant Energy Ameren Corp Avista Corp CMS Energy Corp Consol. Edison DTE Energy Duke Energy Empire Dist. Elec Entergy Corp Exelon Corp MGE Energy Northeast Utilities NorthWestern Corp NSTAR Pepco Holdings PG&E Corp Public Serv. Enterprise TECO Energy UniSource Energy Wisconsin Energy Xcel Energy Inc Notes: Column 1, 2: Value Line Investment Analyzer, 11/2009 No growth forecast available for Pepco Holdings 126

131 Exhibit (RAM-3)

132 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-3) 127

133 Exhibit (RAM-3) Page 1 of 1 S&P UTILITY INDEX ELECTRIC UTILITIES DCF ANALYSIS: VALUE LINE GROWTH PROJECTIONS Company % Current Proj EPS Divid Growth Yield (1) (2) 1 Allegheny Energy Ameren Corp CenterPoint Energy CMS Energy Corp Consol. Edison Dominion Resources DTE Energy Duke Energy Edison Int'l Entergy Corp Exelon Corp FirstEnergy Corp FPL Group Integrys Energy Pepco Holdings PG&E Corp Pinnacle West Capital PPL Corp Progress Energy Public Serv. Enterprise Sempra Energy Southern Co TECO Energy Wisconsin Energy Xcel Energy Inc Notes: Column 1, 2: Value Line Investment Analyzer, 11/2009 No growth forecast available for Pepco Holdings 128

134 Exhibit (RAM-4)

135 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-4) 129

136 Exhibit RAM-4 Electric Utility Industry Historical Growth Rates Exhibit (RAM-4) Page 1 of 1 (1) (2) (3) Earnings Dividend Line Growth Growth No. Company Name 5-Year 5-Year 1 Allegheny Energy ALLETE 3 Alliant Energy Amer. Elec. Power Ameren Corp Avista Corp Black Hills Cen. Vermont Pub. Serv CenterPoint Energy CH Energy Group Cleco Corp CMS Energy Corp Consol. Edison Constellation Energy Dominion Resources DPL Inc DTE Energy Duke Energy 19 Edison Int'l El Paso Electric Empire Dist. Elec Entergy Corp Evergreen Energy Inc 24 Exelon Corp FirstEnergy Corp FPL Group G't Plains Energy Hawaiian Elec IDACORP Inc Integrys Energy ITC Holdings 32 Maine & Maritimes Corp MGE Energy Northeast Utilities NorthWestern Corp 36 NSTAR NV Energy Inc OGE Energy Otter Tail Corp Pepco Holdings PG&E Corp Pinnacle West Capital PNM Resources Portland General 45 PPL Corp Progress Energy Public Serv. Enterprise SCANA Corp Sempra Energy Southern Co TECO Energy U.S. Energy Sys Inc 53 UIL Holdings 54 UniSource Energy UNITIL Corp Vectren Corp Westar Energy Wisconsin Energy Xcel Energy Inc AVERAGE Source: Value Line Investment Analyzer 11/2009 AVERAGE w/o negative growt

137 Exhibit (RAM-5)

138 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-5) 131

139 COMBINATION GAS & ELEC UTILITIES DCF ANALYSIS: VALUE LINE GROWTH PROJECTIONS Company % Current Proj EPS % Expected Cost of ROE Divid Growth Divid Equity Yield Yield (1) (2) (3) (4) (5) 1 Alliant Energy Ameren Corp Avista Corp CMS Energy Corp Consol. Edison DTE Energy Duke Energy Empire Dist. Elec Entergy Corp Exelon Corp MGE Energy Northeast Utilities NorthWestern Corp NSTAR PG&E Corp Public Serv. Enterprise TECO Energy UniSource Energy Wisconsin Energy Xcel Energy Inc AVERAGE MEDIAN 11.8 Exhibit (RAM-5) Page 1 of 1 Notes: Column 1, 2: Value Line Investment Analyzer, 11/2009 Column 3 = Column 1 times (1 + Column 2/100) Column 4 = Column 3 + Column 2 Column 5 = (Column 3 /0.95) + Column 2 No growth forecast available for Pepco 132

140 Exhibit (RAM-6)

141 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-6) 133

142 Exhibit (RAM-6) Page 1 of 1 COMBINATION GAS & ELECTRIC UTILITIES DCF ANALYSIS: ANALYSTS' GROWTH FORECASTS Company % Current Proj EPS % Expected Cost of ROE Divid Growth Divid Equity Yield Yield (1) (2) (3) (4) (5) 1 ALLETE Alliant Energy Ameren Corp Avista Corp CMS Energy Corp Consol. Edison DTE Energy Duke Energy Empire Dist. Elec Entergy Corp Exelon Corp MGE Energy Northeast Utilities NorthWestern Corp NSTAR Pepco Holdings PG&E Corp Public Serv. Enterpris TECO Energy UniSource Energy Wisconsin Energy Xcel Energy Inc AVERAGE MEDIAN 10.9 Notes: Column 1: Value Line Investment Analyzer, 11/2009 Column 2: Zacks long-term earnings growth forecast, 11/200 Column 3 = Column 1 times (1 + Column 2/10 Column 4 = Column 3 + Column Column 5 = (Column 3 /0.95) + Column 2 134

143 Exhibit (RAM-7)

144 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-7) 135

145 S&P UTILITY INDEX ELECTRIC UTILITIES DCF ANALYSIS: VALUE LINE GROWTH PROJECTIONS Exhibit (RAM-7) Page 1 of 1 Company % Current Proj EPS% Expected Cost of ROE Divid Growth Divid Equity Yield Yield (1) (2) (3) (4) (5) 1 Allegheny Energy Ameren Corp CenterPoint Energy CMS Energy Corp Consol. Edison Dominion Resources DTE Energy Duke Energy Edison Int'l Entergy Corp Exelon Corp FirstEnergy Corp FPL Group Integrys Energy PG&E Corp Pinnacle West Capital PPL Corp Progress Energy Public Serv. Enterprise Sempra Energy Southern Co TECO Energy Wisconsin Energy Xcel Energy Inc AVERAGE MEDIAN 10.9 Notes: Column 1, 2: Value Line Investment Analyzer, 11/2009 Column 3 = Column 1 times (1 + Column 2/100) Column 4 = Column 3 + Column 2 Column 5 = (Column 3 /0.95) + Column 2 No Growth Forecast For PEPCO 136

146 Exhibit (RAM-8)

147 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-8) 137

148 Exhibit (RAM-8) Page 1 of 1 S&P UTILITY INDEX ELECTRIC UTILITIES DCF ANALYSIS: VALUE LINE GROWTH PROJECTIONS Companies With More Than 50% Regulated Revenues Company % Current Proj EPS% Expected Cost of ROE Divid Growth Divid Equity Yield Yield (1) (2) (3) (4) (5) 1 Allegheny Energy Ameren Corp CMS Energy Corp Consol. Edison DTE Energy Duke Energy Edison Int'l Entergy Corp Exelon Corp FirstEnergy Corp FPL Group PG&E Corp Pinnacle West Capita Progress Energy Public Serv. Enterpris Southern Co TECO Energy Wisconsin Energy Xcel Energy Inc AVERAGE MEDIAN 10.6 ` Notes: Column 1, 2: Value Line Investment Analyzer, 11/2009 Column 3 = Column 1 times (1 + Column 2/100) Column 4 = Column 3 + Column 2 Column 5 = (Column 3 /0.95) + Column 2 No growth forecast available for Pepco Holdings ` 138

149 Exhibit (RAM-9)

150 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-9) 139

151 S&P UTILITY INDEX ELECTRIC UTILITIES DCF ANALYSIS: ANALYSTS' GROWTH PROJECTIONS Exhibit (RAM-9) Page 1 of 1 Company % Current Proj EPS % Expected Cost of ROE Divid Growth Divid Equity Yield Yield (1) (2) (3) (4) (5) 1 Allegheny Energy Ameren Corp CenterPoint Energy CMS Energy Corp Consol. Edison Dominion Resources DTE Energy Duke Energy Edison Int'l Entergy Corp Exelon Corp FirstEnergy Corp FPL Group Integrys Energy Pepco Holdings PG&E Corp Pinnacle West Capita PPL Corp Progress Energy Public Serv. Enterpris Sempra Energy Southern Co TECO Energy Wisconsin Energy Xcel Energy Inc AVERAGE MEDIAN 11.7 Notes: Column 1: Value Line Investment Analyzer, 11/2009 Column 2: Zacks Investment Research, 11/2009 Column 3 = Column 1 times (1 + Column 2/100) Column 4 = Column 3 + Column 2 Column 5 = (Column 3 /0.95) + Column 2 140

152 Exhibit (RAM-10)

153 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-10) 141

154 S&P UTILITY INDEX ELECTRIC UTILITIES DCF ANALYSIS: ANALYSTS' GROWTH PROJECTIONS Companies With More Than 50% Regulated Revenues Exhibit (RAM-10) Page 1 of 1 Company % Current Proj EPS % Expected Cost of ROE Divid Growth Divid Equity Yield Yield (1) (2) (3) (4) (5) 1 Allegheny Energy Ameren Corp CMS Energy Corp Consol. Edison DTE Energy Duke Energy Edison Int'l Entergy Corp Exelon Corp FirstEnergy Corp FPL Group Pepco Holdings PG&E Corp Pinnacle West Capita Progress Energy Public Serv. Enterpris Southern Co TECO Energy Wisconsin Energy Xcel Energy Inc AVERAGE MEDIAN 11.6 Notes: Column 1: Value Line Investment Analyzer, 11/2009 Column 2: Zacks Investment Research, 11/2009 Column 3 = Column 1 times (1 + Column 2/100) Column 4 = Column 3 + Column 2 Column 5 = (Column 3 /0.95) + Column 2 Companies with less than 50% regulated revenues: CenterPoint, Dominion, Integrys, PPL, Sempra. 142

155 Exhibit (RAM-11)

156 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-11) 143

157 Exhibit (RAM-11) Page 1 of 1 COMBINATION ELEC & GAS UTILITIES BETA ESTIMATES Company Name Beta 1 ALLETE Alliant Energy Ameren Corp Avista Corp CMS Energy Corp Consol. Edison DTE Energy Duke Energy Empire Dist. Elec Entergy Corp Exelon Corp MGE Energy Northeast Utilities NorthWestern Corp NSTAR Pepco Holdings PG&E Corp Public Serv. Enterprise TECO Energy UniSource Energy Wisconsin Energy Xcel Energy Inc AVERAGE 0.72 Source: VLIA 11/

158 Exhibit (RAM-12)

159 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-12) 145

160 Exhibit (RAM-12) Page 1 of 1 S&P UTILITY INDEX ELECTRIC UTILITIES BETA ESTIMATES Company Name Beta Beta (1) (2) (3) 1 Allegheny Energy Ameren Corp CenterPoint Energy CMS Energy Corp Consol. Edison Dominion Resources DTE Energy Duke Energy Edison Int'l Entergy Corp Exelon Corp FirstEnergy Corp FPL Group Integrys Energy Pepco Holdings PG&E Corp Pinnacle West Capital PPL Corp Progress Energy Public Serv. Enterprise Sempra Energy Southern Co TECO Energy Wisconsin Energy Xcel Energy Inc AVERAGE Source: VLIA 11/2009 Notes: Column (3) Betas of companies with >50% Regulated Revenues 146

161 Exhibit (RAM-13)

162 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-13) 147

163 Exhibit (RAM-13) Utility Industry Historical Risk Premium Page 1 of 2 (1) (2) (3) (4) (5) (6) (7) (8) Utlity 20 year S&P Equity Equity Baa-Rated Maturity Bond Utility Risk Risk Bond Bond Total Index Premium Premium Line No. Year Yield Value Gain/Loss Interest Return Return Over Bond Returns Over Bond Yields % 1, % % -0.54% 6.17% -9.74% % 1, % % % % % 1, % % % % % 1, % 76.63% 63.59% 70.88% % 1, % 20.69% 2.40% 15.92% % % % % % % % 22.45% 26.46% 16.65% % 1, % 11.26% -5.12% 6.30% % 1, % % % % % 1, % % % % % 1, % 15.39% 10.39% 11.11% % 1, % 46.07% 36.69% 42.16% % 1, % 18.03% 9.87% 14.42% % 1, % 53.33% 45.06% 50.04% % 1, % 1.26% -5.60% -1.79% % % % % % % % 4.01% 4.07% 0.54% % 1, % 31.39% 27.20% 27.97% % 1, % 3.25% -2.80% 0.01% % % 18.63% 17.84% 15.22% % % 19.25% 17.41% 15.73% % % 7.85% 7.27% 4.12% % 1, % 24.72% 17.85% 21.21% % % 11.26% 8.04% 7.73% % % 5.06% 6.37% 1.18% % % 6.36% 13.16% 1.65% % % 40.70% 36.25% 35.97% % % 7.49% 6.76% 2.44% % % 20.26% 16.94% 15.07% % 1, % 29.33% 22.77% 24.25% % 1, % -2.44% -8.27% -7.46% % 1, % 12.36% 5.31% 7.50% % 1, % 15.91% 10.67% 11.08% % % 4.67% 0.35% -0.20% % % -4.48% 0.15% % % % -0.63% 0.05% -6.86% % % 10.32% 11.71% 3.38% % % % % % % % 16.56% 20.62% 7.45% % 1, % 2.41% % -6.15% % 1, % 8.15% -4.32% -0.01% % % % % % % % % % % % % 44.49% 44.13% 33.88% % 1, % 31.81% 13.69% 22.06% % 1, % 8.64% -8.30% -0.33% % % -3.71% -8.06% % % % 13.58% 13.92% 2.89% % % 15.08% 24.64% 1.41% % % 11.74% 12.17% -4.30% % % 26.52% 10.89% 10.41% % 1, % 20.01% % 6.46% % % 26.04% 16.71% 11.85% % 1, % 33.05% 8.28% 20.33% % 1, % 28.53% -3.66% 18.14% % % -2.92% % % % % 18.27% 9.72% 7.44% % 1, % 47.80% 31.46% 37.62% % % -2.57% % % % 1, % 14.61% -0.62% 4.81% % 1, % 8.10% -9.26% -0.88% % 1, % 14.41% -5.02% 6.48% % % -7.94% -9.35% % % 1, % 42.15% 29.43% 33.95% % 1, % 3.14% -6.54% -4.91% % 1, % 24.69% 14.74% 16.83% 148

164 Exhibit (RAM-13) Utility Industry Historical Risk Premium Page 2 of 2 (1) (2) (3) (4) (5) (6) (7) (8) Utlity 20 year S&P Equity Equity Baa-Rated Maturity Bond Utility Risk Risk Bond Bond Total Index Premium Premium Line No. Year Yield Value Gain/Loss Interest Return Return Over Bond Returns Over Bond Yields % 1, % 14.82% 0.24% 7.60% % % -8.85% -9.57% % % % 59.70% 56.55% 51.34% % 1, % % % % % 1, % % % % % 1, % 26.11% 7.11% 19.34% % 1, % 24.22% 13.19% 17.83% % 1, % 16.79% 6.60% 10.73% % % 20.95% 19.56% 14.47% % 1, % 19.36% 11.19% 13.03% Mean 4.1% 4.5% Source: Bloomberg Web site: Standard & Poors Utility Stock Index % Annual Change, Dec. to Dec. Bond yields from Bloomberg 149

165 Exhibit (RAM-14)

166 Testimony of Dr. Roger A. Morin, PhD Exhibit (RAM-14) 150

167 Exhibit (RAM-14) Page 1 of 1 COMBINATION ELECTRIC & GAS UTILITIES COMMON EQUITY RATIOS Company Name % Com Equity 1 ALLETE Alliant Energy Ameren Corp Avista Corp CMS Energy Corp Consol. Edison DTE Energy Duke Energy Empire Dist. Elec Entergy Corp Exelon Corp MGE Energy Northeast Utilities NorthWestern Corp NSTAR Pepco Holdings PG&E Corp Public Serv. Enterprise TECO Energy UniSource Energy Wisconsin Energy Xcel Energy Inc AVERAGE 46.9 Source: Value Line Investment Analyzer 11/

168 Testimony of Andrew E. Dinkel

169 Before the Public Service Commission NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID Direct Testimony of Andrew E. Dinkel III Director of Cost of Capital Dated: January 29,

170 Testimony of Andrew E. Dinkel III Q. Please state your name and business address. A. My name is Andrew E. Dinkel III. I am the Director of Cost of Capital of the U.S. Regulation and Pricing Organization of National Grid USA, Inc. My business address is 1 MetroTech Center, Brooklyn, NY Q. Please describe your educational and professional background. A. I received a Bachelor of Science degree in Electrical Engineering from the Polytechnic Institute of Brooklyn in In 1983, I successfully completed the Power System Engineering Course given by General Electric. In addition, I have attended various industry seminars addressing advanced engineering economics and financial and accounting issues. I joined the Long Island Lighting Company as an engineer in the Distribution Engineering Section in Since then I have held various managerial positions within LILCO and its successor companies KeySpan Corporation ( KeySpan ) and National Grid plc ( National Grid ), including Manager of the Financial Analysis Division and later, Manager of Financial Planning. In September 2001, I became Director of Financial Strategy at KeySpan reporting to the Assistant Treasurer. In 2006, I transferred to the position of Director of Revenue Requirements in the Regulation and Pricing Gas Distribution organization. In May 2009, I became the Director of Cost of Capital in the U.S. Regulation and Pricing Page 1 of

171 Testimony of Andrew E. Dinkel III organization of National Grid s United States-based operations. In my current position, I am familiar with the financing of Niagara Mohawk Power Corporation d/b/a National Grid ( Niagara Mohawk or the Company ) Q. Have you previously testified or submitted prepared testimony in a regulatory proceeding? A. Yes, I have previously testified and submitted testimony before the New York Public Service Commission ( Commission ) in Cases 28252, 29029, 29484, 89-G-030, 90-E-1185, 91-G-0112, 91-G-1328, 93-G-002, 93-E and 96-E-0132, presenting the Long Island Lighting Company s historic and projected rate year cost of capital, capitalization, financial statistics, ratemaking principles and quality indicators. More recently, I testified before the Commission in Case 08-G-0609 presenting Niagara Mohawk s historic and projected rate year cost of capital, capitalization and financial statistics. I have also submitted testimony before the Federal Energy Regulatory Commission in Docket Nos. ER and ER on issues pertaining to National Grid Generation LLC s cost of service and cost of capital Q. What is the purpose of your testimony? Page 2 of

172 Testimony of Andrew E. Dinkel III A. In support of Niagara Mohawk s electric base rate filing, the purpose of my testimony is to present the Company s proposed capital structure and overall cost of capital in this proceeding. My testimony provides information for both the historic test or base year ending September 30, 2009 and the forecast rate years ending December 31, 2011, December 31, 2012 and December 31, All forecast material has been developed from the historical base. Also, due to the continuing turmoil in the debt auction markets, I am recommending that a variable rate debt true-up mechanism applicable to the Company s variable rate pollution control revenue bonds issued through the New York State Energy Research and Development Authority ( NYSERDA ) be implemented for variable rate debt interest expense and associated fees allocated to the Company s electric operations. Under this mechanism, the Company would fully reconcile its actual interest costs, insurance premiums and remarketing fees associated with the NYSERDA auction rate debt to the corresponding costs, premiums and fees that are reflected in the Company s electric revenue requirements in this proceeding. Cost increases or decreases compared to the levels reflected in the revenue requirement would be deferred and included in the Electric Delivery Adjustment Mechanism to be recovered from or passed back to customers as explained in the testimony of the Revenue Requirements Panel. Page 3 of

173 Testimony of Andrew E. Dinkel III Q. Do you sponsor any exhibits as part of your testimony in this proceeding? A. Yes. I sponsor the following exhibits, which were prepared or compiled under my supervision and direction: (i) Exhibit (AED-1), entitled Niagara Mohawk Power Corporation Capitalization And Weighted Average Cost Of Capital; Exhibit (AED-2) which are the workpapers supporting Exhibit (AED-1); and (iii) Exhibit (AED-3), which consists of the most recent evaluations of Niagara Mohawk by Standard & Poor s ( S&P ) and Moody s Investors Service ( Moody s ) Q. Please describe Exhibit (AED-1). A. Schedule 1 of Exhibit (AED-1) sets forth Niagara Mohawk s historic cost of long-term debt and preferred stock. Schedule 2 contains the projected capitalization and weighted average cost of capital that I am proposing be adopted for Niagara Mohawk in this proceeding. Schedule 3 sets forth a forecast Sources and Uses of Funds statement and projected financial statistics for the rate years ending December 31, 2011, 2012 and 2013, respectively. Workpapers supporting this Exhibit have been provided as Exhibit (AED-2). Page 4 of

174 Testimony of Andrew E. Dinkel III Q. What are the weighted average costs of capital that you are proposing be adopted for Niagara Mohawk for each of the three rate years in this proceeding? A. The Company s proposal in this case is to establish rates for three years, the calendar years ending 2011, 2012 and The Weighted Average Costs of Capital that I am proposing, as shown on Schedule 2, Pages 5, 6 and 7 of Exhibit (AED-1) are 8.03% for the 2011 rate year, 8.27% for the 2012 rate year and 8.50% for the 2013 rate year. These overall rates of return are based on the following capitalization ratios and cost rates: 10 NIAGARA MOHAWK OVERALL COST OF CAPITAL Capitalization Cost Weighted Capitalization Cost Weighted Capitalization Cost Weighted Ratio (%) Rate (%) Cost (%) Ratio (%) Rate (%) Cost (%) Ratio (%) Rate (%) Cost (%) Long-Term Debt Short-Term Debt Customer Deposits Preferred Stock Common Equity Total In calculating the capitalization ratios shown above, all of the goodwill recorded on Niagara Mohawk s books was excluded from the Company s total capitalization and common equity balances Q. How did you determine Niagara Mohawk s capitalization ratios? Page 5 of

175 Testimony of Andrew E. Dinkel III A. Niagara Mohawk s weighted average cost of capital for each of the three rate years reflects a capital structure comprising 50% common equity exclusive of goodwill. This approximates Niagara Mohawk s current capital structure and is the targeted structure that the Company plans on maintaining going forward to minimize its overall cost of capital, maintain the Company s current A range credit/bond rating, and provide it with ready access to the financial markets at a reasonable cost Q. Has the Company modified its capital structure since its acquisition by National Grid in 2002? A. Yes. Since its acquisition by National Grid in 2002, the Company s common equity ratio exclusive of goodwill has increased from approximately 25% at the end of the first quarter immediately following the transaction, to approximately 50% as of September 30, This significant achievement was accomplished by using virtually all of the Company s cash earnings and other sources of internally generated cash to increase the Company s common equity balance, pay down debt and fund construction expenditures. Since the acquisition, the Company has increased its common equity exclusive of goodwill by $1.0 billion and reduced its total debt outstanding by $2.3 billion. Page 6 of

176 Testimony of Andrew E. Dinkel III Q. Has the improvement in the Company s capital structure since its acquisition by National Grid improved Niagara Mohawk s credit ratings? A. Yes. The steady and continuing reduction in the Company s leverage that has occurred since its acquisition by National Grid has been one of the key factors that has prompted Moody s to upgrade Niagara Mohawk s corporate credit rating twice; from Baa3 prior to the acquisition to Baa1 in October 2004, and from Baa1 to A3 in November In its February 1, 2008 Credit Opinion on the Company, Moody s stated that the significant reduction in debt levels that Niagara Mohawk was able to achieve over the past three years and the corresponding favorable improvements in key credit metrics that resulted were major factors in its decision to upgrade the Company s credit rating from Baa1 to A3 in November Furthermore, in announcing the upgrade to A3 in November 2007, Moody s also stated that in addition to the improvement in the Company s financial profile that has occurred, the rating action was also premised on Moody s belief that this trend could be sustained and the fact that the Company agreed to adopt a version of the regulatory financial protections that apply to KeySpan s New York-based utility subsidiaries. In a more recent Credit Opinion on the Company issued on July 22, 2009, Moody s again points out that the Company s use of its free cash flow to Page 7 of

177 Testimony of Andrew E. Dinkel III significantly reduce its debt level over the last several years has contributed to corresponding favorable improvements in key credit metrics. Moody s also states in this Opinion that they view the financial protections put in place at Niagara Mohawk as a credit positive Q. Please outline the financial protections you just alluded to. A. When it was acquired by National Grid in 2002, the Company agreed to a number of financial protections that were adopted by the Commission when it approved the Merger Joint Proposal in Case 01-M These protections are designed to financially insulate or ring fence Niagara Mohawk from National Grid and its other affiliates. Except for its participation as a borrower or lender in the corporate money pool, these protections prohibit the Company from providing any financial assistance to its affiliates through loans, loan guarantees, letters of credit or other commitments, as well as using its assets to collateralize affiliate debt. These protections also prohibit the Company from paying dividends under certain circumstances. More recently, in approving the merger between National Grid and KeySpan, the Commission ordered that the Company adopt additional protections to further insulate it from National Grid and its affiliates. One of these new protections is that there can be no cross default provisions that would require Niagara Mohawk to indemnify any Page 8 of

178 Testimony of Andrew E. Dinkel III lender, supplier or other counter-party for or as a result of a default of any affiliate. Also, if any cross default provisions currently exist that cannot be eliminated, National Grid is required to obtain indemnification from an investment grade entity that fully protects Niagara Mohawk from the effects of such existing cross default provisions, the cost of which will not be borne by customers. In addition, the Company will modify its certificate of incorporation to establish a golden share to prevent a bankruptcy of National Grid, National Grid USA or any affiliate from automatically triggering a bankruptcy of Niagara Mohawk without the approval of the holder of the golden share, an entity that is charged with acting in accordance with the best interests of New York. These new protections also require that National Grid create separate regulated and unregulated money pools and further require that the regulated money pool expressly prohibit its participants from directly or indirectly loaning or transferring funds borrowed from the money pool to National Grid USA, National Grid and all non-participants in the regulated money pool. Another new restriction prohibits the Company from paying common dividends without Commission approval if its or National Grid s bond rating on their least secure form of debt falls below investment grade as determined by one or more U.S. nationally recognized rating agencies, or either entity s bond rating falls to the lowest investment grade rating and is Page 9 of

179 Testimony of Andrew E. Dinkel III on negative watch or review for a further downgrade. Finally, no debt associated with the KeySpan merger may be reflected as an obligation of Niagara Mohawk or on its regulatory or US GAAP books and records Q. Since the acquisition by National Grid has Niagara Mohawk s credit rating from Standard & Poor s ( S&P ) also improved? A. Yes. Just prior to the acquisition, Niagara Mohawk s credit rating from S&P was BBB. Today, it is A Q. Is the maintenance of a low A credit rating consistent with the results of the so-called Generic Financing Proceeding that is often referred to by the Commission in determining the cost of capital for utilities in New York? A. Yes. The so-called Generic Financing Proceeding Case 91-M-0509 resulted in a 1994 recommended decision that, although never acted upon by the Commission, has often been referred to by it when determining the cost of capital to be used in setting rates. In that proceeding, the electric and gas group, which included utilities, Commission Staff, the Consumer Protection Board and Multiple Intervenors, agreed that while a BBB rating was most often the least costly on a purely quantitative basis, the cost of a slip from BBB to BB was substantial, while the increased Page 10 of

180 Testimony of Andrew E. Dinkel III cost of achieving an A rating was only slightly greater than that of a BBB rating. Thus, the group concluded that the A rating goal was the more cost effective, when qualitative factors were added to the equation. The recommended decision in the General Financing Proceeding proposed that the Commission continue to offer utilities ratemaking support for an A rating Q. Is there other evidence that supports the use of the Company s standalone capital structure for the purposes of setting electric rates in this proceeding? A. Yes. Exhibit (AED-3) sets forth the most recent evaluations of Niagara Mohawk by S&P and Moody s. The fact that these evaluations reflect higher unsecured debt ratings for Niagara Mohawk than National Grid demonstrates that these rating agencies take into account Niagara Mohawk s credit quality on a stand-alone basis, separate and distinct from National Grid. If the credit rating agencies determine that the Company on a standalone basis is significantly less risky because of ring fencing, stronger credit metrics and/or other factors, they will rate the Company higher than its parent, National Grid. 20 Page 11 of

181 Testimony of Andrew E. Dinkel III Q. Does Niagara Mohawk have higher unsecured debt ratings than National Grid? A. Yes. The Company s senior unsecured debt ratings assigned to it by Moody s and S&P are both one notch higher those assigned to National Grid. The Company s senior unsecured debt is currently rated A3 by Moody s and A- by S&P whereas National Grid s ratings are Baa1 and BBB+, respectively. Also, the issuer rating assigned to the Company by Moody s is one notch higher than that assigned to National Grid. The current issuer ratings of Niagara Mohawk and National Grid are A3 and Baa1, respectively. As will be discussed below, the Company s standalone credit strength, which has contributed to its higher credit ratings compared to National Grid has provided significant benefits to customers in terms of lower financing costs Q. Under certain circumstances, the Commission has used the capital structure of the parent company in determining the overall cost of capital for utilities under its jurisdiction that are owned by holding companies. Do you believe it is appropriate for the Commission to use National Grid s capital structure to set rates for Niagara Mohawk in this proceeding? Page 12 of

182 Testimony of Andrew E. Dinkel III A. No, I do not. National Grid s common equity ratio under Generally Accepted Accounting Principles recognized in the United States ( US GAAP ) for the fiscal year ending March 31, 2009 was 31.7%. The capital structure of Niagara Mohawk bears no relationship to that of National Grid, nor will it going forward. In addition, National Grid s capital structure has been significantly affected by several recent transactions that have had no impact on the Company s stand alone capital structure. These transactions included the National Grid/KeySpan merger that was consummated in August 2007, the sale of National Grid s wireless communications business that was completed in April 2007 and the sale of the Ravenswood generating station that was completed in the summer of National Grid s US GAAP capital structure is influenced by a variety of factors, including the nature of National Grid s international businesses and changes in foreign exchange rates that have nothing to do with Niagara Mohawk or its standing in the financial community In addition, the financial community recognizes that there is financial separation between National Grid and Niagara Mohawk. The financial protections that were adopted by the Commission when it approved the National Grid/KeySpan merger prohibit the pushdown or assignment of Page 13 of

183 Testimony of Andrew E. Dinkel III responsibility of any merger-related debt to the Company. It would be inappropriate for the Commission to reflect any impact of parent company transactions in the Company s revenue requirements through the imputation of the parent company s capital structure when it cannot be demonstrated that these transactions have any bearing on the Company. It is my understanding that in establishing the proper capital structure for ratemaking purposes, the Commission seeks to determine the amount of debt and equity capital that the Company is dedicating to public service in order to be assured that customers are paying only the costs to support regulated operations. The capital structure that I am proposing is one that will ensure that Niagara Mohawk s customers receive the benefits of the Company s improved financial profile and pay rates that reflect the capital actually being used to support Niagara Mohawk s regulated operations Q. Are there any other reasons that a capital structure other than that proposed by the Company should not be used to set electric rates in proceeding? A. Yes. A capital structure with a common equity ratio of less than 50% would contain a level of debt in excess of that required to support Niagara Mohawk s current credit rating based on the benchmarks used by S&P in the credit rating process. According to S&P, Niagara Mohawk has an Page 14 of

184 Testimony of Andrew E. Dinkel III excellent business risk profile and a significant financial risk profile. Based upon the business and financial risk matrix published by S&P that is shown below, a company with excellent business and significant financial risk scores would be assigned an A- rating. BUSINESS AND FINANCIAL RISK PROFILE MATRIX Financial Risk Profile Business Risk Profile Minimal Modest Intermediate Significant Aggressive Highly Leveraged Excellent AAA AA A A- BBB - Strong AA A A- BBB BB BB- Satisfactory A- BBB+ BBB BB+ BB- B+ Fair - BBB- BB+ BB BB- B Weak - - BB BB- B+ B And indeed, Niagara Mohawk has an A- corporate credit rating ( CCR ) from S&P, which is compatible with an excellent business profile and a significant financial profile. Niagara Mohawk s unsecured debt issuances are also rated A- by S&P Q. What is the degree of debt leverage that is associated with this rating under S&P s benchmark? A. According to the indicative ratios expected by S&P for a company with a significant financial risk score, the total debt, including short- and longterm debt, should be in the range of 45% to 50%. These indicative values are shown below. Page 15 of

185 Testimony of Andrew E. Dinkel III FINANCIAL RISK INDICATIVE RATIOS (CORPORATE) Financial Risk Profile FFO/Debt (%) Debt/EBITDA (x) Debt/Capital (%) Minimal greater than 60 less than 1.5 less than 25 Modest Intermediate Significant Aggressive FFO/Debt is the ratio of the Company s funds from operations to its total debt. Debt/EBITDA is the ratio of total debt to earnings before interest, taxes, depreciation and amortizations. Debt/Capital is the ratio of total debt to total capital Based upon the debt ratios shown above, equity ratios (including common equity and preferred stock) for companies with A- credit ratings should be within the range of 50% to 55%. This is one of the key parameters that should be used to gauge the reasonableness of the common equity ratio proposed in this case. The Company s proposed common equity ratio of 50% is already at the low end of this range and anything lower would not be consistent with its current credit rating Q. If the Commission wishes to consider whether to use National Grid s capital structure to set rates in this proceeding, how should the equity component of its capital structure be determined? A. As discussed more fully below, the effect of using National Grid s capital structure to set rates in this proceeding will be to jeopardize Niagara Mohawk s ability to maintain its current credit ratings. Moreover, there Page 16 of

186 Testimony of Andrew E. Dinkel III are a number of differences between National Grid and Niagara Mohawk that must be recognized before the Commission can even consider using National Grid s capital structure. First, differences in the methodology used to set rates for National Grid s regulated businesses in the United Kingdom ( UK ) compared to that used in New York make it inappropriate to use National Grid s capital structure as determined in accordance with US GAAP to establish the Company s revenue requirements in this proceeding. The regulator of National Grid s UK businesses does not utilize the level of capital represented in its US GAAP accounts when setting rates. These accounts, in turn, do not reflect the value of the UK businesses on which the UK regulator allows them to earn a return. In the UK, rates are set based on a Regulatory Asset Value ( RAV ), rather than a rate base based on book value per US GAAP. RAV has no direct relationship to the book value of these businesses and was initially derived from a combination of replacement cost and market value. In addition, under the UK regulatory framework, the RAV is increased by inflation every year. Thus, the equity component as determined in accordance with US GAAP must be adjusted to recognize the difference between the RAV and the US GAAP book value of the UK regulated businesses. This is necessary to ensure that National Grid s consolidated capital structure reflects the regulatory value of assets in both Page 17 of

187 Testimony of Andrew E. Dinkel III the US and UK on an equal and consistent basis. This adjustment increases National Grid s consolidated common equity ratio determined in accordance with US GAAP by 6 percentage points from 31.7% to 37.8% Q. Are there any other factors that affect National Grid s capital structure which need to be taken into account if the Commission wishes to consider using it to set rates in this proceeding? A. Yes. Changes in currency exchange rates which are beyond the control of the Company and National Grid can have a significant impact on National Grid s capital structure and thus its capitalization ratios as determined in accordance with US GAAP. The reason for this is that approximately two-thirds of National Grid s outstanding debt has been issued in US dollars and thus its weighting in the overall capital structure of National Grid is heavily dependent on the currency exchange rate between the US dollar and the British pound. Over the course of National Grid s last fiscal year ending March 31, 2009, the exchange rate from US dollars to British pounds decreased by approximately 27% from 1.98 US dollars per British pound at fiscal year end 2008 to 1.44 US dollars per British pound at fiscal year-end Had the exchange rate remained the same as at fiscal year end 2008, National Grid s common equity ratio after adjusting for RAV would have been 40.9% as compared to 37.8% as noted above. For Page 18 of

188 Testimony of Andrew E. Dinkel III comparative purposes, National Grid s US GAAP common equity ratio at fiscal year end 2008 after adjusting for RAV and based on the actual exchange rate at that time of 1.98 US dollars per British pound was 43.7%. Because the Company and National Grid cannot control currency exchange rates it would be inappropriate for the Commission to consider a common equity ratio of less than 40.9% for National Grid Q. Please outline the financing activity and dividend payment policy that you used in developing Niagara Mohawk s projected costs of capital for the 2011, 2012 and 2013 rate years A. Current projections indicate that the Company will need to issue $350 million of additional long-term debt in June 2010, $400 million in October 2012 and $500 million in June 2013 to fund its capital expenditure program, redeem maturing long-term debt and maintain a capital structure comprised of 50% common equity exclusive of goodwill. The projected costs of capital for each of the three rate years assume that the Company will issue this debt as 10-year senior unsecured debt at forecasted interest rates of 5.0% in 2010, 5.6% in 2012 and 6.3% in It has been assumed that the costs to issue this debt will be 1% of the principal amounts issued and that these costs will be amortized over the lives of the debt which effectively increases the interest rates on these securities by 10 Page 19 of

189 Testimony of Andrew E. Dinkel III basis points. Pursuant to the Commission Order in Case 08-M-1352, the Company currently has authorization to issue $750 million of this debt through March 31, Q. Have customers benefited from the Company s higher senior unsecured debt ratings compared to those of National Grid? A. Yes. In the summer of 2009 the Company issued a total of $1.25 billion of new long-term debt. The Company s higher credit ratings resulting from its stronger credit profile (its higher equity ratio and the financial protections described above), coupled with the fact that the $1.25 billion of new debt was issued by Niagara Mohawk and thus placed closest to the assets it is funding, resulted in a lower cost to customers than would have been the case if National Grid had issued comparable debt. Based on interest rate spreads at the time of issuance, had National Grid issued the $750 million of 10-year debt instead of Niagara Mohawk, it is estimated that interest rate on this debt would have been about 50 basis points higher. Similarly, the interest rate on the $500 million of 5 year debt issued by the Company would have been about 40 basis points higher had it been issued by National Grid. Thus, by having the Company issue the $1.25 billion of new debt, customers will save an estimated total of $47.5 million in interest expense over the lives of the debt compared to its Page 20 of

190 Testimony of Andrew E. Dinkel III issuance by National Grid. This cost differential is a clear benefit of the financial separation between the Company and National Grid. This benefit justifies the use of Company s stand alone capital structure for ratemaking purposes in this proceeding Q. How were the projected cost rates of long-term debt for Niagara Mohawk shown on Exhibit (AED-1) derived? A. The long-term debt component of Niagara Mohawk s capital structure consists of long-term notes payable to Niagara Mohawk s parent company Niagara Mohawk Holdings, Inc., fixed rate taxable bonds and fixed and variable rate tax-exempt bonds issued through NYSERDA that are currently supporting electric and gas transmission and distribution investments. Included in the costs of these bonds are the direct coupon expense, as well as the amortization of debt discounts or premiums, and the amortization of issuance costs where applicable. Furthermore, it was assumed that the variable rate bonds would continue to be supported by direct pay letter of credit facilities in order to obtain the most advantageous interest rates for these bonds. The associated fees for these letters of credit, the amortization of debt discounts or premiums, the amortization of issuance costs, and the remarketing fees are added to the direct interest expense when computing the cost of debt for these issues. Page 21 of

191 Testimony of Andrew E. Dinkel III Because of the ongoing turmoil in the auction rate bond markets caused by the financial crisis that continues to cause numerous remarketing auctions to fail, it is difficult at this time to make reliable projections of the interest rates that the Company s variable rate Pollution Control Revenue bonds will pay during the rate years. Therefore, for the time being, I have assumed that the interest rates on these bonds will be set at the rates they would revert to if auctions continue to fail during the rate years. I propose to update these rates if market conditions normalize by the time a decision is about to be reached in this proceeding In the event that markets do not return to normal, I recommend that the interest expense on auction rate debt that is allocated to electric operations be fully reconciled whereby differences between the actual expense and the level reflected in rates are deferred for future disposition by the Commission. This true-up mechanism would be identical to that approved by the Commission in Case 08-G-0609 for interest expense on the same variable rate debt that is allocated to the Company s gas operations Also included in the cost of the Company s long-term debt are the amortizations of call premiums and debt discounts and expenses (DD&E) associated with several debt issues that were retired before maturity Page 22 of

192 Testimony of Andrew E. Dinkel III because it was economically advantageous to do so. These costs are being amortized over the remaining life of the respective bonds as if they had not been retired early. It is estimated that on a present value basis, the early retirement of these bonds will save in excess of $75 million net of the recovery of call premiums and unamortized DD&E Dividing the total interest, fee and amortization expense for the notes and bonds by the average principal outstanding yields an effective rate of 5.03% for the long-term debt component of Niagara Mohawk s capitalization for the 2011 rate year, 5.58% for the 2012 rate year and 6.12% for the 2013 rate year Q. How were the projected cost rates of preferred stock and short-term debt shown on Exhibit (AED-1) derived? A. The Company currently has three perpetual issues of preferred stock that will remain outstanding during the three proposed rate years. The total annual dividend requirement for these three issues was divided by the total average net proceeds outstanding during the rate years, yielding an effective rate of 3.62% for the preferred stock component of Niagara Mohawk s capitalization. Also, during the rate years, it was assumed that the Company would be charged National Grid s commercial paper rate on Page 23 of

193 Testimony of Andrew E. Dinkel III the forecasted average balance of short-term debt borrowed from National Grid s regulated money pool. Those rates are projected to be 2.21% for the 2011 rate year, 3.28% for the 2012 rate year and 4.28% for the 2013 rate year Q. How were the balances and the cost rate for customer deposits shown on Exhibit (AED-1) determined? A. Niagara Mohawk s forecasted balances of customer deposits were assumed to remain equal to the actual monthly balance as of September 30, 2009, the end of the test year. The cost rate is the customer deposit interest rate currently mandated by the Commission in a memo on this matter Q. Do you believe that it would be appropriate for the Company to update its projections of both new debt issuances and cost rates later in this proceeding? A. Yes. Given the continuing uncertainty of the financial markets I believe that it is in both the Company s and its customers best interests for the Company to update its filing to reflect the most recent information available concerning both the Company s financial plans and its cost projections near the time of a Commission decision in this case. Page 24 of

194 Testimony of Andrew E. Dinkel III Q. What cost rate are you using for the common equity component of Niagara Mohawk s capital structure? A. I am using a required rate of return of 11.1% as supported by Dr. Morin in his testimony consistent with a 50% common equity ratio in the capital structure Q. Does this conclude your direct testimony? A. Yes. It does. Page 25 of

195 Exhibits of Andrew E. Dinkel

196 Index of Exhibits Exhibit (AED-1) Exhibit (AED-2) Exhibit (AED-3) Capitalization and Weighted Average Cost of Capital Analysis Workpapers Supporting Exhibit (AED-1) Standard & Poor s and Moody s Investors Service Evaluations 178

197 Exhibit (AED-1)

198 Testimony of Andrew E. Dinkel III Exhibit (AED-1) Capitalization and Weighted Average Cost of Capital Analysis 179

199 Testimony of Andrew E. Dinkel III Schedule 1 180

200 Exhibit (AED-1) Schedule 1 Page 1 of 2 Exhibit (AED-1) Schedule 1 Page 1 of 2 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID WEIGHTED AVERAGE COST OF LONG-TERM DEBT At September 30, 2009 ($000) ANNUAL TOTAL ANNUAL AMORTIZATION INTEREST LONG-TERM DEBT RATE PRINCIPAL INTEREST DEBT DISCOUNT AND ANNUAL EFFECTIVE % AMOUNT & FEES AND EXPENSE AMORTIZATION RATE 4.881% Senior Notes due 2019 (Issued August 2009) 4.88% 750,000 36, , % 3.553% Senior Notes due 2014 (Issued September 2009) 3.55% 500,000 17, , % 1991 Series A Pollution Control Revenue Bonds 0.97% 45, % 1985 Series A Pollution Control Revenue Bonds 0.96% 100, , % 1988 Series A Pollution Control Revenue Bonds 0.97% 69, % 5.15% Pollution Control Tax Exempt 5.15% 75,000 3, , % 1985 Series B Pollution Control Revenue Bonds 0.97% 37, % 1985 Series C Pollution Control Revenue Bonds 0.97% 37, % 1986 Series A Pollution Control Revenue Bonds 0.97% 50, % 1987 Series A Pollution Control Revenue Bonds 1.00% 25, % 1987 Series B-1 Pollution Control Revenue Bonds 0.97% 68, % 1987 Series B-2 Pollution Control Revenue Bonds 0.99% 25, % 2004 Series A Pollution Control Revenue Bonds 0.97% 115,705 1, , % Note Payable to NMHI 5.80% 500,000 29, , % Note Payable to NMHI 3.83% 350,000 13, , % Amortization of Reaquired Debt Call Premiums & DD&E 6,576 6,576 $2,750,065 $106,201 $8,997 $115, % Notes The interest rates on the variable rate pollution control revenue bonds include 25 basis points for remarketing fees and 10 basis points for annual insurance premiums. 181

201 Exhibit (AED-1) Schedule 1 Page 2 of 2 Exhibit (AED-1) Schedule 1 Page 2 of 2 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID WEIGHTED AVERAGE COST OF PREFERRED STOCK At September 30, 2009 ($000) ANNUAL AMORTIZATION TOTAL NET ISSUANCE EXP. DIVIDEND PREFERRED STOCK RATE PROCEEDS ANNUAL AND DISCOUNT AND ANNUAL EFFECTIVE % OUTSTANDING DIVIDEND OR PREMIUM AMORTIZATION RATE NMK 3.40% 3.41% 5, % NMK 3.60% 3.56% 13, % NMK 3.90% 3.83% 9, % $29,286 $1,060 $0 $1, % 182

202 Testimony of Andrew E. Dinkel III Schedule 2 183

203 Exhibit (AED-1) Schedule 2 Page 1 of 7 Exhibit (AED-1) Schedule 2 Page 1 of 7 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID ESTIMATED COST OF SENIOR SECURITIES AND RATE OF RETURN ($000) Total Interest Principal Effective and Annual Estimated Cost of Long-Term Debt for year ending December 31, 2011 Amount Rate Amortization As of September 30, 2009 (Per Exhibit Schedule 1, Page 1) 2,750, % $115,198 Variable Rate Changes: 1991 Series A Pollution Control Revenue Bonds 3.91% 1, Series A Pollution Control Revenue Bonds 3.92% 3, Series A Pollution Control Revenue Bonds 3.91% 2, Series B Pollution Control Revenue Bonds 3.91% 1, Series C Pollution Control Revenue Bonds 3.91% 1, Series A Pollution Control Revenue Bonds 3.91% 1, Series A Pollution Control Revenue Bonds 3.88% 1, Series B-1 Pollution Control Revenue Bonds 3.91% 2, Series B-2 Pollution Control Revenue Bonds 3.89% Series A Pollution Control Revenue Bonds 3.91% 4,529 Refundings: 3.83% Note Payable To NMHI Maturing on 6/30/10 (350,000) 3.83% (13,405) New Issuances: $350 million of 5.0% 10-Year Senior Notes Issued 6/1/ , % 17,850 Amortization of Reaquired Debt Call Premiums & DD&E (3,860) Total Long-Term Debt $2,750, % $138,

204 Exhibit (AED-1) Schedule 2 Page 2 of 7 Exhibit (AED-1) Schedule 2 Page 2 of 7 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID ESTIMATED COST OF SENIOR SECURITIES AND RATE OF RETURN ($000) Total Interest Principal Effective and Annual Estimated Cost of Long-Term Debt for year ending December 31, 2012 Amount Rate Amortization As of December 31, 2011 (Per Exhibit Schedule 2, Page 1) 2,750, % $138,285 Variable Rate Changes: 1991 Series A Pollution Control Revenue Bonds 2.66% 1, Series A Pollution Control Revenue Bonds 2.66% 2, Series A Pollution Control Revenue Bonds 2.66% 1, Series B Pollution Control Revenue Bonds 2.66% Series C Pollution Control Revenue Bonds 2.66% Series A Pollution Control Revenue Bonds 2.66% 1, Series A Pollution Control Revenue Bonds 2.66% Series B-1 Pollution Control Revenue Bonds 2.66% 1, Series B-2 Pollution Control Revenue Bonds 2.66% Series A Pollution Control Revenue Bonds 2.66% 3,075 Refundings: 5.80% Note Payable To NMHI Maturing on 11/1/12 (83,562) 5.80% (4,847) New Issuances: $400 M of 5.60% 10-Year Senior Notes Issued 10/1/ , % 5,747 Amortization of Reaquired Debt Call Premiums & DD&E 0 Total Long-Term Debt $2,767, % $154,

205 Exhibit (AED-1) Schedule 2 Page 3 of 7 Exhibit (AED-1) Schedule 2 Page 3 of 7 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID ESTIMATED COST OF SENIOR SECURITIES AND RATE OF RETURN ($000) Total Interest Principal Effective and Annual Estimated Cost of Long-Term Debt for year ending December 31, 2013 Amount Rate Amortization As of December 31, 2012 (Per Exhibit Schedule 2, Page 2) 2,650, % $147,371 Variable Rate Changes: 1991 Series A Pollution Control Revenue Bonds 2.50% 1, Series A Pollution Control Revenue Bonds 2.50% 2, Series A Pollution Control Revenue Bonds 2.50% 1, Series B Pollution Control Revenue Bonds 2.50% Series C Pollution Control Revenue Bonds 2.50% Series A Pollution Control Revenue Bonds 2.50% 1, Series A Pollution Control Revenue Bonds 2.50% Series B-1 Pollution Control Revenue Bonds 2.50% 1, Series B-2 Pollution Control Revenue Bonds 2.50% Series A Pollution Control Revenue Bonds 2.50% 2,893 Refundings: 1991 Series A Pollution Control Revenue Bonds on 10/1/13 (11,494) 10.04% (1,154) New Issuances: $500 M of 6.30% 10-Year Senior Notes Issued 6/1/ , % 18,762 Amortization of Reaquired Debt Call Premiums & DD&E (3) Total Long-Term Debt $2,931, % $179,

206 Exhibit (AED-1) Schedule 2 Page 4 of 7 Exhibit (AED-1) Schedule 2 Page 4 of 7 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID ESTIMATED COST OF SENIOR SECURITIES AND RATE OF RETURN ($000) Total Interest Principle Effective and Annual Estimated Cost of Preferred Stock for year ended December 31, 2011 Amount Rate Amortization As of September 30, 2009 (Per Exhibit Schedule 1, Page 2) 29, % $1,060 Sinking Funds 0 Refundings 0 New Issuances 0 Total Preferred Stock $29, % $1,060 Estimated Cost of Preferred Stock for year ended December 31, 2012 Sinking Funds 0 Refundings 0 New Issuances 0 Total Preferred Stock $29, % $1,060 Estimated Cost of Preferred Stock for year ended December 31, 2013 Sinking Funds 0 Refundings 0 New Issuances 0 Total Preferred Stock $29, % $1,

207 Exhibit (AED-1) Schedule 2 Page 5 of 7 Exhibit (AED-1) Schedule 2 Page 5 of 7 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID ESTIMATED COST OF SENIOR SECURITIES AND RATE OF RETURN ($000) Total Long-Term Short-Term Preferred Common Retained Less Common Customer Total Debt Debt Stock Stock Earnings Goodwill Equity Deposits Capitalization Balance as of September 30, ,750, ,286 3,100, ,422 1,268,004 2,736,923 36,794 5,553,068 Changes to December 31, , , ,244 Balance as of December 31, ,750, ,286 3,100,505 1,003,666 1,268,004 2,836,167 36,794 5,652,312 January ,750, ,286 3,100,505 1,042,424 1,268,004 2,874,925 36,794 5,691,070 February ,750, ,286 3,100,505 1,078,924 1,268,004 2,911,425 36,794 5,727,570 March ,750, ,286 3,100,505 1,108,935 1,268,004 2,941,436 36,794 5,757,581 April ,750, ,286 3,100,505 1,137,046 1,268,004 2,969,547 36,794 5,785,692 May ,750, ,286 3,100,505 1,161,849 1,268,004 2,994,350 36,794 5,810,495 June ,750, ,286 3,100, ,188 1,268,004 2,762,689 36,794 5,578,834 July ,750, ,286 3,100, ,782 1,268,004 2,783,283 36,794 5,599,428 August ,750, ,286 3,100, ,162 1,268,004 2,797,663 36,794 5,613,808 September ,750, ,559 29,286 3,100, ,614 1,268,004 2,808,115 36,794 5,839,819 October ,750, ,133 29,286 3,100, ,110 1,268,004 2,818,611 36,794 5,803,889 November ,750, ,003 29,286 3,100,505 1,001,635 1,268,004 2,834,136 36,794 5,800,284 Eleven Months Total 30,250, , ,146 34,105,555 11,338,669 13,948,044 31,496, ,734 63,008,470 December ,750, ,286 3,100,505 1,003,666 1,268,004 2,836,167 36,794 5,652,312 December ,750,065 51,692 29,286 3,100,505 1,023,081 1,268,004 2,855,582 36,794 5,723,419 Total December 2010 & ,500,130 51,692 58,572 6,201,010 2,026,747 2,536,008 5,691,749 73,588 11,375,731 December 2010 & 2011 Average 2,750,065 25,846 29,286 3,100,505 1,013,374 1,268,004 2,845,875 36,794 5,687,866 Twelve Months Total 33,000, , ,432 37,206,060 12,352,043 15,216,048 34,342, ,528 68,696,336 Annual Average 2,750,065 46,712 29,286 3,100,505 1,029,337 1,268,004 2,861,838 36,794 5,724,695 Capitalization Ratios 48.0% 0.8% 0.5% 50.0% 0.6% 100.0% Cost Rates 5.03% 2.21% 3.62% 11.10% 2.45% Return Components 2.42% 0.02% 0.02% 5.55% 0.02% 8.03% 188

208 Exhibit (AED-1) Schedule 2 Page 6 of 7 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID ESTIMATED COST OF SENIOR SECURITIES AND RATE OF RETURN ($000) Total Long-Term Short-Term Preferred Common Retained Less Common Customer Total Debt Debt Stock Stock Earnings Goodwill Equity Deposits Capitalization Balance as of December 31, ,750,065 51,692 29,286 3,100,505 1,023,081 1,268,004 2,855,582 36,794 5,723,419 January ,750, ,286 3,100,505 1,042,546 1,268,004 2,875,047 36,794 5,691,192 February ,750, ,286 3,100,505 1,059,849 1,268,004 2,892,350 36,794 5,708,495 March ,750, ,286 3,100,505 1,072,967 1,268,004 2,905,468 36,794 5,721,613 April ,750, ,286 3,100,505 1,102,177 1,268,004 2,934,678 36,794 5,750,823 May ,750, ,286 3,100,505 1,126,077 1,268,004 2,958,578 36,794 5,774,723 June ,750, ,286 3,100,505 1,098,830 1,268,004 2,931,331 36,794 5,747,476 July ,750,065 27,834 29,286 3,100,505 1,124,398 1,268,004 2,956,899 36,794 5,800,878 August ,750, ,286 3,100,505 1,147,462 1,268,004 2,979,963 36,794 5,796,108 September ,750, ,861 29,286 3,100,505 1,167,222 1,268,004 2,999,723 36,794 6,270,729 October ,150,065 74,544 29,286 3,100,505 1,187,585 1,268,004 3,020,086 36,794 6,310,775 November ,650, ,315 29,286 3,100,505 1,213,151 1,268,004 3,045,652 36,794 6,295,112 Eleven Months Total 30,550,715 1,090, ,146 34,105,555 12,342,264 13,948,044 32,499, ,734 64,867,924 December ,750,065 51,692 29,286 3,100,505 1,023,081 1,268,004 2,855,582 36,794 5,723,419 December ,650, ,763 29,286 3,100,505 1,245,514 1,268,004 3,078,015 36,794 6,288,923 Total December 2011 & ,400, ,455 58,572 6,201,010 2,268,595 2,536,008 5,933,597 73,588 12,012,342 December 2011 & 2012 Average 2,700, ,228 29,286 3,100,505 1,134,298 1,268,004 2,966,799 36,794 6,006,171 Twelve Months Total 33,250,780 1,363, ,432 37,206,060 13,476,562 15,216,048 35,466, ,528 70,874,095 Annual Average 2,770, ,648 29,286 3,100,505 1,123,047 1,268,004 2,955,548 36,794 5,906,175 Exhibit (AED-1) Schedule 2 Page 6 of 7 Capitalization Ratios 46.9% 1.9% 0.5% 50.0% 0.6% 100.0% Cost Rates 5.58% 3.28% 3.62% 11.10% 2.45% Return Components 2.62% 0.06% 0.02% 5.55% 0.02% 8.27% 189

209 Exhibit (AED-1) Schedule 2 Page 7 of 7 Exhibit (AED-1) Schedule 2 Page 7 of 7 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID ESTIMATED COST OF SENIOR SECURITIES AND RATE OF RETURN ($000) Total Long-Term Short-Term Preferred Common Retained Less Common Customer Total Debt Debt Stock Stock Earnings Goodwill Equity Deposits Capitalization Balance as of December 31, ,650, ,763 29,286 3,100,505 1,245,514 1,268,004 3,078,015 36,794 6,288,923 January ,650, ,548 29,286 3,100,505 1,282,764 1,268,004 3,115,265 36,794 6,186,958 February ,650, ,737 29,286 3,100,505 1,317,600 1,268,004 3,150,101 36,794 6,237,983 March ,650, ,629 29,286 3,100,505 1,347,881 1,268,004 3,180,382 36,794 6,368,156 April ,650, ,283 29,286 3,100,505 1,381,302 1,268,004 3,213,803 36,794 6,370,231 May ,650, ,370 29,286 3,100,505 1,400,963 1,268,004 3,233,464 36,794 6,341,979 June ,150, ,286 3,100,505 1,419,361 1,268,004 3,251,862 36,794 6,468,007 July ,150,065 15,907 29,286 3,100,505 1,442,062 1,268,004 3,274,563 36,794 6,506,615 August ,150, ,286 3,100,505 1,461,794 1,268,004 3,294,295 36,794 6,510,440 September ,150, ,963 29,286 3,100,505 1,478,467 1,268,004 3,310,968 36,794 6,786,076 October ,104, ,435 29,286 3,100,505 1,495,292 1,268,004 3,327,793 36,794 6,788,773 November ,104, ,852 29,286 3,100,505 1,515,767 1,268,004 3,348,268 36,794 6,823,665 Eleven Months Total 32,059,515 2,901, ,146 34,105,555 15,543,253 13,948,044 35,700, ,734 71,388,883 December ,650, ,763 29,286 3,100,505 1,245,514 1,268,004 3,078,015 36,794 6,288,923 December ,104, ,861 29,286 3,100,505 1,543,902 1,268,004 3,376,403 36,794 6,783,809 Total December 2012 & ,754, ,624 58,572 6,201,010 2,789,416 2,536,008 6,454,418 73,588 13,072,732 December 2012 & 2013 Average 2,877, ,812 29,286 3,100,505 1,394,708 1,268,004 3,227,209 36,794 6,536,366 Twelve Months Total 34,936,780 3,267, ,432 37,206,060 16,937,961 15,216,048 38,927, ,528 77,925,249 Annual Average 2,911, ,295 29,286 3,100,505 1,411,497 1,268,004 3,243,998 36,794 6,493,771 Capitalization Ratios 44.8% 4.2% 0.5% 50.0% 0.6% 100.0% Cost Rates 6.12% 4.28% 3.62% 11.10% 2.45% Return Components 2.74% 0.18% 0.02% 5.55% 0.01% 8.50% 190

210 Testimony of Andrew E. Dinkel III Schedule 3 191

211 Exhibit (AED-1) Schedule 3 Page 1 of 3 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID Sources and Use of Funds Statement And Financial Statistics ($000) Rate Year Sources of Funds Ending 12/31/11 Internal Net Income 269,475 Depreciation & Amortization 497,208 Deferred Taxes (18,301) Changes in Working Capital/Other (110,577) Total Internal Sources 637,805 External Long-Term Debt 0 Money Pool Borrowings 372,664 Total External Sources 372,664 Total Sources of Funds 1,010,469 Uses of Funds Capital Expenditures 760,409 Dividend Payments 250,060 Redemptions Long-Term Debt 0 Money Pool Debt 0 Total Uses of Funds 1,010,469 Pre-Tax Interest Coverage Ratio (x) 3.6 FFO Interest Coverage Ratio (x) 5.3 FFO/Debt 22.5% Debt/EBITDA (x)

212 Exhibit (AED-1) Schedule 3 Page 2 of 3 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID Sources and Use of Funds Statement And Financial Statistics ($000) Rate Year Sources of Funds Ending 12/31/12 Internal Net Income 271,992 Depreciation & Amortization 470,927 Deferred Taxes (120,959) Changes in Working Capital/Other (61,576) Total Internal Sources 560,384 External Long-Term Debt 400,000 Money Pool Borrowings 443,071 Total External Sources 843,071 Total Sources of Funds 1,403,455 Uses of Funds Capital Expenditures 853,895 Dividend Payments 49,560 Redemptions Long-Term Debt 500,000 Money Pool Debt 0 Total Uses of Funds 1,403,455 Pre-Tax Interest Coverage Ratio 3.3 FFO Interest Coverage Ratio 4.1 FFO/Debt 18.9% Debt/EBITDA (x)

213 Exhibit (AED-1) Schedule 3 Page 3 of 3 NIAGARA MOHAWK POWER CORPORATION d/b/a NATIONAL GRID Sources and Use of Funds Statement And Financial Statistics ($000) Rate Year Sources of Funds Ending 12/31/13 Internal Net Income 299,448 Depreciation & Amortization 454,863 Deferred Taxes (17,201) Changes in Working Capital/Other (32,762) Total Internal Sources 704,348 External Long-Term Debt 500,000 Money Pool Borrowings 0 Total External Sources 500,000 Total Sources of Funds 1,204,348 Uses of Funds Capital Expenditures 899,786 Dividend Payments 1,060 Redemptions Long-Term Debt 45,600 Money Pool Debt 257,902 Total Uses of Funds 1,204,348 Pre-Tax Interest Coverage Ratio 3.6 FFO Interest Coverage Ratio 4.9 FFO/Debt 21.5% Debt/EBITDA (x)

214 Exhibit (AED-2)

215 Testimony of Andrew E. Dinkel III Exhibit (AED-2) Workpapers Supporting Exhibit (AED-1) 195

216 Exhibit (AED-2) Workpapers for Schedule 2 Page 1 of 27 3m$ LIBOR 2009/ / / / /2014 Dec % Jan % Money Pool Interest Rates Feb % Calendar Year Mar % Apr % 2.21% 3.28% 4.28% May % Jun % Money pool interest rates are National Jul % Grid's commercial paper rate which is Aug % assumed to equal the 3 month LIBOR Sep % plus 40 basis points. Oct % Nov % Dec % Jan % Feb % Variable Rate Tax Exempt Debt Interest Rates Mar % Calendar Year Q1 1.50% 4.53% 7.19% 9.69% Q2 2.00% Q3 2.25% Rates assume debt auction markets Q4 2.50% continue to fail. Under these conditions, tax exempt debt rates are Q1 2.75% set at 2.5 times LIBOR Q2 3.00% Q3 3.25% Q4 3.50% Q1 3.75% Q2 4.00% Q3 4.25% Q4 4.50% 10-Year Long-Term Debt Interest Rates June October June Year Treasury Interest Rate 3.54% 4.27% 4.91% Spread Above Treasuries 126 BP 126 BP 126 BP New Issuance Premium BP BP BP Approximate Total Spread 140 BP 140 BP 140 BP 10 Year Bond Coupon Rate 5.0% 5.6% 6.3% 196

217 Exhibit (AED-2) Workpapers for Schedule 2 Page 2 of

218 Exhibit (AED-2) Workpapers for Schedule 2 Page 3 of

219 Exhibit (AED-2) Workpapers for Schedule 2 Page 4 of

220 Exhibit (AED-2) Workpapers for Schedule 2 Page 5 of

221 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 6 of 27 Niagara Mohawk Power Corp Total Total Total Calender Calender Calender Income Statement Operating Revenue 3,772,478 3,737,186 3,683,574 Other Revenue 173, , ,333 Total Revenue 3,946,359 3,973,905 3,985,907 Total Staff & Other Exp 1,318,767 1,343,579 1,333,614 Purchased Power - Electricity 973, , ,002 Wheeling Depreciation 240, , ,225 Amortization 256, , ,768 Purchased Gas 389, , ,592 Operating Taxes 170, , ,998 Total Operating Expenses 3,349,598 3,339,074 3,307,577 Operating Income 596, , ,330 Net Interest Expense (144,743) (178,366) (178,204) Current Taxes 200, , ,879 Deferred Taxes (18,301) (120,959) (17,201) Total Taxes 182, , ,678 Profit After Taxes 269, , ,448 Preferred Dividends 1,060 1,060 1,060 Profit Attributed to Shareholders 268, , ,388 Common Dividends 249,000 48,500 - Retained Profit 19, , ,

222 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 7 of 27 Niagara Mohawk Power Corp 2011 Calendar 2012 Calendar 2013 Calendar Cash Flow Statement Year Year Year Operating Profit of Group 596, , ,330 Total Depreciation and Amortization 497, , ,863 Decrease/(increase) in stocks (8,115) (5,697) (3,636) Decrease/(increase) in debtors 126, , ,236 Increase/(decrease) in creditors (28,221) (27,361) (41,058) Increase/(decrease) in provisions (26,525) (23,276) (18,695) Pensions (205,863) (197,289) (187,461) Net Cash From Operating Activities 951, ,252 1,046,579 Interest Received 4,067 1, Interest Paid (134,175) (136,051) (142,307) Preferred Dividends (1,060) (1,060) (1,060) Net Interest and Preferred Dividend Payments (131,167) (135,196) (143,001) Common Dividends Paid (249,000) (48,500) 0 Corporate Income Taxes Paid (200,844) (305,432) (217,879) Net Capex (760,409) (853,895) (899,786) Share Capital Movements 15,074 15,320 15,211 Total Cash Movement in Net Debt (375,044) (345,450) (198,877) 202

223 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 8 of 27 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 8 of 27 Niagara Mohawk Power Corp Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Balance Sheet Current Current Current Current Current Current Current Current Current Current Current Current Current FY2011 FY2011 FY2011 FY2011 FY2012 FY2012 FY2012 FY2012 FY2012 FY2012 FY2012 FY2012 FY2012 Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec ASSETS_IN_CONST 393, , , , , , , , , , , , ,864 Land & Buildings 471, , , , , , , , , , , , ,261 Portable & Freestanding 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 Plant & Machinery 8,572,191 8,292,210 8,326,751 8,380,301 8,418,049 8,467,166 8,520,573 8,567,734 8,622,885 8,682,318 8,738,124 8,786,290 8,833,643 Land & Buildings Accum Depr 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 Portable & Free Accum Depr 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 Plant & Machinery Accum Depr 2,763,942 2,779,100 2,794,662 2,808,566 2,819,214 2,829,193 2,838,529 2,848,561 2,865,355 2,881,761 2,898,599 2,916,491 2,934,249 Tangible Fixed Assets 6,601,790 6,326,987 6,367,855 6,431,148 6,497,745 6,576,832 6,661,270 6,738,978 6,817,549 6,901,825 6,981,181 7,051,508 7,121,321 GOODWILL 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 Other Intangibles 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 Other Intangibles Accum Amort 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 Software Intang Accum Amort 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 Intangible Assets 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 Equity Investments 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 Other Fixed Asset Investments 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 Fixed Asset Investments 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 FIXED_ASSETS 7,898,698 7,623,894 7,664,762 7,728,055 7,794,653 7,873,739 7,958,178 8,035,885 8,114,456 8,198,732 8,278,088 8,348,416 8,418,229 Total Stocks 110,370 84,134 62,095 45,267 53,294 70,420 90, , , , , , ,485 Customer AR 468, , , , , , , , , , , , ,706 Other AR 37, , , , , , , , , , , , ,662 AR_FROM_ASSOC 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 Debtors Ledger 512, , , , , , , , , , , , ,961 Accum Prov for Uncoll Accts-CR 178, , , , , , , , , , , , ,511 Unbilled Revenue 153, , , , , , , , , , , , ,370 Misc Curr & Accrued Assets 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 Accrued Debtors (22,789) (25,486) (31,173) (22,447) (26,381) (23,200) (35,787) (16,537) (13,192) (34,786) (31,007) (41,450) (22,050) PREPAYMENTS 88, , , , ,224 89,246 67,177 49,210 24, , , ,899 87,850 INT_DIV_REC NOTES_REC 321, , , , , , , , , Misc Debtors - Current 391, , , , , , , , , , , , ,255 Misc Debtors Non-Current 1,184,015 1,119,596 1,054, , , , , , , , , , ,261 Unamortized Debt Exp 21,694 21,496 21,298 21,100 20,901 20,703 20,505 20,307 20,108 19,910 19,712 19,514 19,315 Miscellaneous Debtors 1,596,964 1,532,347 1,467,233 1,405,623 1,350,252 1,295,887 1,244,331 1,188,973 1,132,517 1,079,118 1,020, , ,831 Total Debtors 2,496,747 2,720,641 2,738,645 2,654,419 2,596,211 2,566,038 2,247,171 2,126,469 2,121,949 1,987,648 1,849,265 1,829,744 1,790,731 Cash and Cash Equivilants 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 Financial Investments 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 TOT_CASH 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 Accts Payable 366, , , , , , , , , , , , ,665 AP_TO_ASSOC 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 Trade Creditors 433, , , , , , , , , , , , ,

224 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 9 of 27 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 9 of 27 Niagara Mohawk Power Corp Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Balance Sheet Current Current Current Current Current Current Current Current Current Current Current Current Current FY2011 FY2011 FY2011 FY2011 FY2012 FY2012 FY2012 FY2012 FY2012 FY2012 FY2012 FY2012 FY2012 Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Interest Accrued 56,592 62,602 50,308 56,318 52,547 57,658 62,770 68,480 55,887 61,597 58,725 64,734 70,744 Interest Accrued NM Holdings 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 INTEREST_ACCR_ASSOC Total Interest Accrued 69,751 75,761 63,467 69,477 65,706 70,818 75,929 81,639 69,046 74,978 72,279 78,221 84,111 Notes Payable to NM Holdings 500, , , , , , , , , , , NOTES_PAYABLE_ASSOC , , ,003 51,692 NOTES_PAYABLE 500, , , , , , , , , , , ,003 51,692 LTD Due in One Year , ,000 Commercial Paper Borrowings , ,000 Current Tax Liabilities 113, , , , , , , , , , , , ,231 Other Tax 14,188 (38,578) (27,597) (16,719) (5,613) 6,387 15,479 20,468 32,037 (61,580) (49,508) (37,436) (25,364) Other Taxes <1Yr 127, , ,163 96, , , , , ,123 51,651 72,466 96,635 87,866 Misc Curr & Accr Liabilities 87,466 80,020 72,574 65,129 57,683 92,315 87,466 80,020 72,574 65,129 57,683 92,315 87,466 CAP_LEASES < 1YR Misc Other Creditors 88,061 80,615 73,169 65,724 58,278 92,910 88,061 80,615 73,169 65,724 58,278 92,910 88,061 CUST_DEPOSITS 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 DIVS_DECL_PREF Misc Payroll 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 Subtotal Misc Creditors 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 Total Creditors 1,305,436 1,209,647 1,229,755 1,183,118 1,189,440 1,249,396 1,285,030 1,261,925 1,359,229 1,330,763 1,289,008 1,338,377 1,343,267 Net Current Assets 1,369,983 1,663,430 1,639,287 1,584,871 1,528,368 1,455,364 1,120,542 1,044, , , , , ,252 Long-Term Debt 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 UNAMORT_DISC_DEBT (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) BORROW_LONG_TERM 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 DEFERRED_ITC 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 Other Non Current Liabilities 270, , , , , , , , , , , , ,196 Capitalized leases 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 Other Credit (LTD) 272, , , , , , , , , , , , ,279 DEFERRED_REV_LT Deferred Taxes Prov 1,363,426 1,361,900 1,360,375 1,358,850 1,357,325 1,355,800 1,354,275 1,352,750 1,351,225 1,349,700 1,348,175 1,346,649 1,345,124 Hazardous Waste Prov 386, , , , , , , , , , , , ,037 ARO Provisions 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 Post Employment Benefit Prov 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 Pension Prov (91,197) (104,964) (118,731) (132,498) (146,814) (161,129) (175,445) (189,761) (204,076) (218,392) (232,708) (247,023) (261,339) Postretirement Health Prov 876, , , , , , , , , , , , ,365 PROVISIONS 2,576,573 2,555,204 2,534,174 2,511,784 2,492,511 2,472,534 2,452,556 2,431,875 2,410,723 2,389,337 2,367,952 2,346,800 2,325,884 CREDITORS (5,126,472) (5,105,102) (5,084,072) (5,061,683) (5,042,409) (5,022,432) (5,002,454) (4,981,773) (4,960,622) (4,939,236) (4,917,850) (4,896,699) (4,875,782) NET_ASSETS 4,142,209 4,182,222 4,219,977 4,251,244 4,280,611 4,306,671 4,076,266 4,098,117 4,113,753 4,125,461 4,137,214 4,153,995 4,176,698 Common Stock 187, , , , , , , , , , , , ,365 OCI FAS Pension 10,457 11,713 12,968 14,223 15,480 16,736 17,993 19,249 20,506 21,762 23,019 24,275 25,532 Other Paid-in Capital 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 Unapp Undist Sub Earnings 1,003,666 1,042,424 1,078,924 1,108,935 1,137,046 1,161, , , , , ,110 1,001,635 1,023,081 Unrealized Appreciation on Inv (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) Equity Shareholders Funds 4,112,923 4,152,936 4,190,691 4,221,958 4,251,325 4,277,385 4,046,980 4,068,831 4,084,468 4,096,175 4,107,928 4,124,709 4,147,413 Preferred Stock 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 Total Capitalization 4,142,209 4,182,222 4,219,977 4,251,244 4,280,611 4,306,671 4,076,266 4,098,117 4,113,753 4,125,461 4,137,214 4,153,995 4,176,

225 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 10 of 27 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 10 of 27 Niagara Mohawk Power Corp Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Balance Sheet Current Current Current Current Current Current Current Current Current Current Current Current FY2012 FY2012 FY2012 FY2013 FY2013 FY2013 FY2013 FY2013 FY2013 FY2013 FY2013 FY2013 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec ASSETS_IN_CONST 860, , , ,560 1,025,203 1,069,291 1,113,604 1,157,529 1,202,554 1,246,664 1,290,417 1,334,346 Land & Buildings 471, , , , , , , , , , , ,261 Portable & Freestanding 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 Plant & Machinery 8,420,028 8,464,336 8,589,869 8,631,809 8,686,272 8,745,395 8,796,113 8,857,047 8,923,825 8,986,616 9,040,738 9,093,540 Land & Buildings Accum Depr 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 Portable & Free Accum Depr 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 Plant & Machinery Accum Depr 2,948,544 2,963,436 2,976,511 2,991,381 3,005,482 3,019,090 3,033,537 3,047,399 3,060,822 3,077,544 3,092,288 3,107,233 Tangible Fixed Assets 6,732,119 6,800,208 6,951,820 7,022,051 7,106,056 7,195,660 7,276,243 7,367,240 7,465,620 7,555,799 7,638,930 7,720,716 GOODWILL 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 Other Intangibles 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 Other Intangibles Accum Amort 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 Software Intang Accum Amort 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 Intangible Assets 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 Equity Investments 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 Other Fixed Asset Investments 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 Fixed Asset Investments 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 FIXED_ASSETS 8,029,027 8,097,116 8,248,728 8,318,958 8,402,964 8,492,568 8,573,150 8,664,147 8,762,528 8,852,707 8,935,838 9,017,624 Total Stocks 89,351 64,878 46,191 54,478 72,135 92, , , , , , ,182 Customer AR 600, , , , , , , , , , , ,318 Other AR 307, , , , , , , , , , , ,662 AR_FROM_ASSOC 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 Debtors Ledger 914, , , , , , , , , , , ,572 Accum Prov for Uncoll Accts-CR 177, , , , , , , , , , , ,396 Unbilled Revenue 150, , , , , , , , , , , ,370 Misc Curr & Accrued Assets 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 Accrued Debtors (25,279) (31,356) (23,160) (27,193) (24,164) (36,893) (17,763) (14,476) (35,926) (31,851) (41,753) (21,935) PREPAYMENTS 129, , , ,051 86,893 63,800 45,023 19, , , ,256 84,021 INT_DIV_REC NOTES_REC 176, ,229 66,347 96, ,536 86, , Misc Debtors - Current 391, , , , , , , , , , , ,255 Misc Debtors Non-Current 432, , , , , , , , , , , ,818 Unamortized Debt Exp 19,117 18,919 18,721 18,522 18,324 18,126 17,927 17,729 17,531 17,333 17,134 16,936 Miscellaneous Debtors 843, , , , , , , , , , , ,009 Total Debtors 2,039,114 2,002,356 1,827,260 1,762,674 1,729,411 1,617,042 1,503,295 1,491,118 1,547,715 1,436,865 1,449,476 1,441,808 Cash and Cash Equivilants 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 Financial Investments 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 TOT_CASH 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 Accts Payable 301, , , , , , , , , , , ,164 AP_TO_ASSOC 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 Trade Creditors 368, , , , , , , , , , , ,

226 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 11 of 27 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 11 of 27 Niagara Mohawk Power Corp Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Balance Sheet Current Current Current Current Current Current Current Current Current Current Current Current FY2012 FY2012 FY2012 FY2013 FY2013 FY2013 FY2013 FY2013 FY2013 FY2013 FY2013 FY2013 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Interest Accrued 77,278 65,509 73,876 73,661 82,328 90,995 99,961 90,624 99,590 99, , ,672 Interest Accrued NM Holdings 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 INTEREST_ACCR_ASSOC ,535 Total Interest Accrued 90,491 78,668 87,036 86,820 95, , , , , , , ,342 Notes Payable to NM Holdings NOTES_PAYABLE_ASSOC , ,861 74, , ,763 NOTES_PAYABLE , ,861 74, , ,763 LTD Due in One Year 500, , , , , , , , , ,000 45,600 45,600 Commercial Paper Borrowings 500, , , , , , , , , ,000 45,600 45,600 Current Tax Liabilities 136, , , , , , , , , , , ,231 Other Tax (80,660) (68,779) (57,009) (45,212) (32,469) (22,794) (17,433) (5,144) (103,678) (90,860) (78,042) (65,224) Other Taxes <1Yr 55,830 89,529 56,222 97, , , , ,297 9,553 46,299 86,514 48,006 Misc Curr & Accr Liabilities 80,020 72,574 65,129 57,683 92,315 87,466 80,020 72,574 65,129 57,683 92,315 87,466 CAP_LEASES < 1YR Misc Other Creditors 80,615 73,169 65,724 58,278 92,910 88,061 80,615 73,169 65,724 58,278 92,910 88,061 CUST_DEPOSITS 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 DIVS_DECL_PREF Misc Payroll 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 Subtotal Misc Creditors 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 Total Creditors 1,182,063 1,199,598 1,173,229 1,183,372 1,253,989 1,304,842 1,294,544 1,394,538 1,569,432 1,208,855 1,300,331 1,348,808 Net Current Assets 1,014, , , , , , , , , , , ,485 Long-Term Debt 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,250,065 2,604,465 2,604,465 2,604,465 UNAMORT_DISC_DEBT (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) BORROW_LONG_TERM 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,249,567 2,603,967 2,603,967 2,603,967 DEFERRED_ITC 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 Other Non Current Liabilities 270, , , , , , , , , , , ,196 Capitalized leases 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 Other Credit (LTD) 272, , , , , , , , , , , ,279 DEFERRED_REV_LT Deferred Taxes Prov 1,335,044 1,324,964 1,314,884 1,304,805 1,294,725 1,284,645 1,274,565 1,264,485 1,254,405 1,244,325 1,234,245 1,224,165 Hazardous Waste Prov 357, , , , , , , , , , , ,760 ARO Provisions 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 Post Employment Benefit Prov 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 Pension Prov (275,655) (289,970) (304,286) (318,214) (332,143) (346,071) (359,999) (373,927) (387,855) (401,784) (415,712) (429,640) Postretirement Health Prov 837, , , , , , , , , , , ,378 PROVISIONS 2,296,413 2,267,176 2,237,001 2,210,295 2,182,894 2,155,493 2,127,396 2,098,835 2,070,042 2,041,249 2,012,688 1,984,360 CREDITORS (4,846,311) (4,817,074) (4,786,899) (4,760,194) (4,732,792) (4,705,391) (4,677,294) (4,648,733) (4,619,940) (4,945,548) (4,916,987) (4,888,658) NET_ASSETS 4,197,420 4,215,979 4,230,353 4,260,847 4,286,030 4,260,066 4,286,918 4,311,266 4,332,309 4,353,955 4,380,805 4,414,451 Common Stock 187, , , , , , , , , , , ,365 OCI FAS Pension 26,788 28,045 29,301 30,584 31,868 33,151 34,435 35,718 37,002 38,285 39,568 40,852 Other Paid-in Capital 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 Unapp Undist Sub Earnings 1,042,546 1,059,849 1,072,967 1,102,177 1,126,077 1,098,830 1,124,398 1,147,462 1,167,222 1,187,585 1,213,151 1,245,514 Unrealized Appreciation on Inv (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) Equity Shareholders Funds 4,168,134 4,186,693 4,201,067 4,231,561 4,256,744 4,230,780 4,257,632 4,281,980 4,303,023 4,324,669 4,351,519 4,385,165 Preferred Stock 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 Total Capitalization 4,197,420 4,215,979 4,230,353 4,260,847 4,286,030 4,260,066 4,286,918 4,311,266 4,332,309 4,353,955 4,380,805 4,414,

227 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 12 of 27 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 12 of 27 Niagara Mohawk Power Corp Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Balance Sheet Current Current Current Current Current Current Current Current Current Current Current Current FY2013 FY2013 FY2013 FY2014 FY2014 FY2014 FY2014 FY2014 FY2014 FY2014 FY2014 FY2014 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec ASSETS_IN_CONST 1,376,668 1,418,954 1,461,751 1,505,628 1,550,067 1,595,024 1,640,243 1,685,010 1,731,060 1,776,042 1,820,610 1,865,382 Land & Buildings 471, , , , , , , , , , , ,261 Portable & Freestanding 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 11,355 Plant & Machinery 8,738,415 8,787,189 8,865,229 8,907,408 8,962,319 9,021,968 9,073,070 9,134,561 9,201,991 9,265,369 9,319,934 9,373,156 Land & Buildings Accum Depr 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 74,749 Portable & Free Accum Depr 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 7,804 Plant & Machinery Accum Depr 3,119,392 3,132,226 3,143,030 3,156,702 3,173,217 3,189,075 3,205,806 3,221,930 3,237,677 3,253,901 3,271,028 3,288,323 Tangible Fixed Assets 7,395,754 7,473,981 7,584,012 7,656,396 7,739,231 7,827,980 7,907,571 7,997,704 8,095,437 8,187,573 8,269,579 8,350,277 GOODWILL 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 1,268,004 Other Intangibles 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 6,360 Other Intangibles Accum Amort 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 2,052 Software Intang Accum Amort 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 7,403 Intangible Assets 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 1,264,910 Equity Investments 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 5,581 Other Fixed Asset Investments 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 26,417 Fixed Asset Investments 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 31,998 FIXED_ASSETS 8,692,662 8,770,889 8,880,920 8,953,304 9,036,139 9,124,888 9,204,479 9,294,612 9,392,345 9,484,481 9,566,487 9,647,185 Total Stocks 96,685 65,696 46,462 54,847 72,696 93, , , , , , ,818 Customer AR 608, , , , , , , , , , , ,550 Other AR 307, , , , , , , , , , , ,674 AR_FROM_ASSOC 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 6,592 Debtors Ledger 922, , , , , , , , , , , ,817 Accum Prov for Uncoll Accts-CR 176, , , , , , , , , , , ,456 Unbilled Revenue 150, , , , , , , , , , , ,370 Misc Curr & Accrued Assets 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 2,091 Accrued Debtors (24,298) (29,912) (21,145) (25,013) (21,707) (34,182) (14,823) (11,261) (32,604) (28,553) (38,633) (18,995) PREPAYMENTS 129, , , ,702 82,140 57,861 38,184 11, , , ,257 78,615 INT_DIV_REC NOTES_REC , , Misc Debtors - Current 391, , , , , , , , , , , ,255 Misc Debtors Non-Current 125, ,625 99,386 86,434 74,318 64,919 51,628 37,210 25,928 9,341 (7,833) (23,833) Unamortized Debt Exp 16,738 16,540 16,341 16,143 15,945 15,747 15,548 15,350 15,152 14,954 14,755 14,557 Miscellaneous Debtors 533, , , , , , , , , , , ,978 Total Debtors 1,562,111 1,555,268 1,541,901 1,452,012 1,370,560 1,408,076 1,307,654 1,310,384 1,184,157 1,075,957 1,094,292 1,090,555 Cash and Cash Equivilants 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 21,439 Financial Investments 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 46,863 TOT_CASH 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 68,302 Accts Payable 311, , , , , , , , , , , ,707 AP_TO_ASSOC 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 67,178 Trade Creditors 378, , , , , , , , , , , ,

228 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 13 of 27 Exhibit (AED-2) Workpapers for Schedules 2 & 3 Page 13 of 27 Niagara Mohawk Power Corp Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Current_Plan Balance Sheet Current Current Current Current Current Current Current Current Current Current Current Current FY2013 FY2013 FY2013 FY2014 FY2014 FY2014 FY2014 FY2014 FY2014 FY2014 FY2014 FY2014 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Interest Accrued 120, , , , , , , , , , , ,423 Interest Accrued NM Holdings 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 13,134 INTEREST_ACCR_ASSOC 1,274 1,093 1,264 1,744 1, ,061 1,147 1,046 Total Interest Accrued 135, , , , , , , , , , , ,604 Notes Payable to NM Holdings NOTES_PAYABLE_ASSOC 355, , , , ,370-15, , , , ,861 NOTES_PAYABLE 355, , , , ,370-15, , , , ,861 LTD Due in One Year 45,600 45,600 45,600 45,600 45,600 45,600 45,600 45,600 45, Commercial Paper Borrowings 45,600 45,600 45,600 45,600 45,600 45,600 45,600 45,600 45, Current Tax Liabilities 139, , , , , , , , , , , ,231 Other Tax (124,201) (111,400) (98,716) (85,922) (72,111) (61,583) (55,656) (42,328) (147,501) (133,609) (119,717) (105,825) Other Taxes <1Yr 15,536 53,237 14,514 51,290 79, ,502 74, ,333 (34,271) (7,644) 21,417 7,405 Misc Curr & Accr Liabilities 80,020 72,574 65,129 57,683 92,315 87,466 80,020 72,574 65,129 57,683 92,315 87,466 CAP_LEASES < 1YR Misc Other Creditors 80,615 73,169 65,724 58,278 92,910 88,061 80,615 73,169 65,724 58,278 92,910 88,061 CUST_DEPOSITS 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 36,794 DIVS_DECL_PREF Misc Payroll 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 49,635 Subtotal Misc Creditors 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 86,694 Total Creditors 1,097,801 1,121,526 1,187,771 1,161,179 1,177, , , , , , ,371 1,040,510 Net Current Assets 629, , , , , , , , , , , ,166 Long-Term Debt 2,604,465 2,604,465 2,604,465 2,604,465 2,604,465 3,104,465 3,104,465 3,104,465 3,104,465 3,104,465 3,104,465 3,104,465 UNAMORT_DISC_DEBT (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) (498) BORROW_LONG_TERM 2,603,967 2,603,967 2,603,967 2,603,967 2,603,967 3,103,967 3,103,967 3,103,967 3,103,967 3,103,967 3,103,967 3,103,967 DEFERRED_ITC 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 28,018 Other Non Current Liabilities 270, , , , , , , , , , , ,196 Capitalized leases 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 2,083 Other Credit (LTD) 272, , , , , , , , , , , ,279 DEFERRED_REV_LT Deferred Taxes Prov 1,222,732 1,221,298 1,219,865 1,218,431 1,216,998 1,215,564 1,214,131 1,212,697 1,211,264 1,209,831 1,208,397 1,206,964 Hazardous Waste Prov 334, , , , , , , , , , , ,066 ARO Provisions 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 10,149 Post Employment Benefit Prov 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 31,547 Pension Prov (443,568) (457,496) (471,424) (484,378) (497,332) (510,286) (523,240) (536,194) (549,148) (562,101) (575,055) (588,009) Postretirement Health Prov 809, , , , , , , , , , , ,285 PROVISIONS 1,964,677 1,945,227 1,924,848 1,907,636 1,889,918 1,872,199 1,853,976 1,835,415 1,816,685 1,797,956 1,779,395 1,761,002 CREDITORS (4,868,975) (4,849,525) (4,829,146) (4,811,934) (4,794,216) (5,276,498) (5,258,274) (5,239,713) (5,220,983) (5,202,254) (5,183,693) (5,165,301) NET_ASSETS 4,452,984 4,489,104 4,520,668 4,555,351 4,576,275 4,595,935 4,619,899 4,640,893 4,658,829 4,676,916 4,698,653 4,728,050 Common Stock 187, , , , , , , , , , , ,365 OCI FAS Pension 42,135 43,419 44,702 45,964 47,227 48,489 49,751 51,014 52,276 53,538 54,801 56,063 Other Paid-in Capital 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 2,913,140 Unapp Undist Sub Earnings 1,282,764 1,317,600 1,347,881 1,381,302 1,400,963 1,419,361 1,442,062 1,461,794 1,478,467 1,495,292 1,515,767 1,543,902 Unrealized Appreciation on Inv (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) (1,706) Equity Shareholders Funds 4,423,698 4,459,818 4,491,383 4,526,066 4,546,989 4,566,649 4,590,613 4,611,607 4,629,543 4,647,630 4,669,368 4,698,765 Preferred Stock 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 29,286 Total Capitalization 4,452,984 4,489,104 4,520,668 4,555,351 4,576,275 4,595,935 4,619,899 4,640,893 4,658,829 4,676,916 4,698,653 4,728,

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235 Exhibit (AED-2) Workpapers for Testimony Page 20 of 27 National National Consolidating schedules Grid Grid as at 31 March 2009 plc plc US GAAP US GAAP consolidated consolidated 'm $'m Condensed balance sheet Goodwill 7,570 10,877 Other intangible assets Property, plant & equipment 30,937 44,450 Investments in subsidiaries - - Investments Non-current regulatory assets 4,689 6,737 Non Current Financial Derivative assets 1,533 2,203 Other non-current assets Intercompany receivables - Inventories Receivables and other current assets 2,636 3,787 Regulatory assets Current Financial Derivative assets Financial and other investments Cash and cash equivalents 2,574 3,698 Assets of businesses held for sale - Total assets 52,572 75,535 Borrowings (including bank overdrafts) (2,872) (4,126) Current Financial Derivative liabilities (307) (441) Current liabilities (3,618) (5,198) Current tax liabilities (328) (471) Intercompany payables 0 Non-current borrowings (22,764) (32,707) Non Current Financial Derivative liabilities (633) (909) Other non-current liabilities (4,212) (6,052) Deferred tax liabilities (4,762) (6,842) Pensions and other post-retirement benefits (3,093) (4,444) Liabilities of businesses held for sale 0 0 Total liabilities (42,589) (61,192) Shareholders' equity (9,945) (14,289) Minority interests (38) (55) Total liabilities and equity (52,572) (75,535) Share holders equity 9,945 Net Debt (21,435) Equity Ratio 31.7% 215

236 Exhibit (AED-2) Workpapers for Testimony Page 21 of 27 'm Remove NGGas and After NGGas and NGET Add Add Add Add NGGas Metering RAV NGET equity NGET NGGas D NGGas T Net Asset adjusted US GAAP equity removal RAV RAV RAV Value US GAAP Share holders equity 9,945 (15,045) (5,100) 6,720 6,550 4, ,054 Net Debt (21,435) (21,435) (21,435) (21,435) (21,435) (21,435) (21,435) (21,435) Equity Proportion 31.7% 37.8% 216

237 Exhibit (AED-2) Workpapers for Testimony Page 22 of 27 Retranslation of 31/3/09 gross assets at 31/3/08 exchange rate US GAAP IFRS adj US GAAP NGUSA gross assets (excluding debt, intercompany, investment in subs) USD 20,961 2,276 23,237 At March 08 rate GBP 10,562 11,709 At March 09 rate GBP 14,589 16,173 Impact on gross assets 4,026 4,463 March 08 rate March 09 rate Retranslation of 31/3/09 debt at 31/3/08 exchange rate US IFRS GAAP adj US GAAP Closing net debt - IFRS USD (5,732) 546 (5,186) UK USD debt USD (14,035) (14,035) Total USD debt USD (19,767) 546 (19,221) At March 08 rate GBP (9,961) (9,686) At March 09 rate GBP (13,758) (13,378) Impact on net debt (3,797) (3,692) March 08 rate March 09 rate IFRS US GAAP Impact on gross assets (4,026) (4,463) Impact on net debt 3,797 3,692 Impact on Net Assets/Shareholders equity (229) (771) 217

238 Exhibit (AED-2) Workpapers for Testimony Page 23 of 27 Exhibit (AED-2) Workpapers for Testimony Page 23 of 27 'm US GAAP at closing FX = FX impact on yearly movment US GAAP at closing FX = 1.98 (as per March 2008) Remove NGGas and NGET equity After NGGas and NGET equity removal Add NGET RAV Add NGGas D RAV Add NGGas T RAV Add NGGas Metering Net Asset Value RAV adjusted US GAAP Share holders equity 9,945 (771) 9,174 (15,045) (5,871) 6,720 6,550 4, ,283 Net Debt (21,435) 3,692 (17,743) (17,743) (17,743) (17,743) (17,743) (17,743) (17,743) (17,743) Equity Proportion 31.7% 34.1% 40.9% 218

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243 Exhibit (AED-3)

244 Testimony of Andrew E. Dinkel III Exhibit (AED-3) Standard & Poor s and Moody s Investors Service Evaluations 223

245 Testimony of Andrew E. Dinkel III Schedule 1 224

246 Exhibit (AED-3) Schedule 1 Page 1 of 5 Global Credit Research Credit Opinion 22 JUL 2009 Credit Opinion: Niagara Mohawk Power Corporation Niagara Mohawk Power Corporation Syracuse, New York, United States Ratings Category Moody's Rating Outlook Stable Issuer Rating A3 Senior Secured A2 Senior Unsecured MTN A3 Preferred Stock Baa2 Ult Parent: National Grid Plc Outlook Stable Issuer Rating Baa1 Senior Unsecured Baa1 Commercial Paper P-2 Other Short Term P-2 Parent: National Grid USA Outlook Stable Issuer Rating A3 Senior Unsecured A3 Commercial Paper P-2 Contacts Analyst Phone Kevin G. Rose/New York William L. Hess/New York Key Indicators [1][2] Niagara Mohawk Power Corporation FY 2009 FY 2008 FY 2007 FY 2006 (CFO Pre-W/C + Interest) / Interest Expense (CFO Pre-W/C) / Debt 28% 28% 31% 21% (CFO Pre-W/C - Dividends) / Debt 28% 28% 31% 21% (CFO Pre-W/C - Dividends) / Capex 165% 225% 306% 316% Debt / Book Capitalization 30% 35% 37% 42% EBITA Margin % 23% 24% 24% 24% [1] All ratios calculated in accordance with the Global Regulated Electric Utilities Rating Methodology using Moody's standard adjustments [2] Fiscal Year End March 31st Note: For definitions of Moody's most common ratio terms please see the accompanying User's Guide. Opinion Rating Drivers Generally low risk electric and gas transmission and distribution (T&D) operations Regulatory support under performance-based rate plans in New York 225

247 Sound financial performance expected to continue Exhibit (AED-3) Schedule 1 Page 2 of 5 Significant financial and operational interdependencies within the National Grid family Corporate Profile Niagara Mohawk Power Corporation (NiMo), is a wholly-owned subsidiary of National Grid USA (NG USA), which is the United States-based intermediate level holding company for the U.S. regulated utility businesses ultimately owned by National Grid plc, a holding company headquartered in the United Kingdom (UK) for a range of largely regulated T&D businesses in the U.S. and the UK. NiMo provides electric T&D service in upstate New York and delivers natural gas in eastern, northern, and central New York. NiMo's retail rates are subject to the jurisdiction of the New York Public Service Commission (NYPSC). SUMMARY RATING RATIONALE Using the Moody's Rating Methodology for Global Regulated Electric Utilities in concert to some degree with the Rating Methodology for European Complex Holding Company Structures as a framework, NiMo's A3 senior unsecured rating reflects its favorable business and operating risk profile; support provided by the NYPSC which has allowed NiMo to institute a performance-based rate (PBR) plan that provides a means for the utility to receive cash recovery of its significant regulatory assets; key financial metrics in recent periods that are typical of A-rated electric T&D utility peers; and a liquidity position that is viewed as sufficient, albeit taking into account that NiMo has historically supplemented its internally generated cash flow by being an active borrower under the NG USA money pool. DETAILED RATING CONSIDERATIONS FAVORABLE BUSINESS, OPERATING, AND REGULATORY RISK PROFILES NiMo's business activities remain entirely focused on the transmission and distribution of electricity and delivery of natural gas, which contributes to its generally low business risk profile. Since divesting its generation assets, NiMo has been recovering the significant regulatory assets created by the sales under the terms provided by the tenyear merger rate plan, which runs through February In particular, the rate plan provides for accelerated amortization of the regulatory assets in the latter years, which is apparent in the favorable trend noted for key credit metrics (see Financial Metrics below for more specifics). Also, NiMo is able to retain a portion of excess earnings above the allowed 10.6% return on equity as defined in the agreement. Meanwhile, NiMo retains the provider of last resort (POLR) role for its electric customers. Supplies have been routinely arranged by purchasing power under long-term purchase power agreements (PPAs) and other open market purchases through the New York Independent System Operator. The arrangements with the NYPSC have been providing for generally timely and virtually full recovery of the costs associated with serving as the POLR. This is a heavily weighted consideration in our overall assessment of the degree of support provided to NiMo by the NYPSC. Since commodity prices can tend to be volatile at times, any shift by the NYPSC to restrict timely and full recovery of these costs could contribute to weaker financial results and downward rating pressure. Although revenues generated by delivery of natural gas comprised only 20% of NiMo's consolidated revenues for FY'08, it is still important for NiMo to maintain sufficient access to the lowest possible cost supplies in fulfilling its responsibility to meet gas demands of retail customers in its franchise service territory. The company has done reasonably well in this regard, thanks in part to the multiple points of direct connections with interstate pipelines. The future financial performance of NiMo's gas distribution operations is expected to benefit from a recent gas distribution rate case, which resulted in approval of a two-year settlement granting a $39.4 million rate increase in the first year (new rates effective May 20, 2009) and rate adjustments in the second year to address a variety of changes in costs related to pension and post-retirement plans and environmental remediation, and to true up the actual cost of any new long-term debt. This outcome, resulting in the first gas delivery rate increase since 1996, also included approval of a revenue decoupling mechanism and expanded capital infrastructure investments, among other requests. We note that strengthened regulatory ring fencing was introduced as required by the NYPSC when it approved the Keyspan acquisition in 2007, which affords additional insulation from the potential need for cash elsewhere within the family. While the ring fencing changes did not contribute to a change in NiMo's rating level, they are viewed as a credit positive, albeit to the possible detriment of creditworthiness elsewhere within the National Grid family. Prospectively, we anticipate that NiMo will prepare to file a general electric rate case probably towards Q in anticipation of expiration of its long-term merger rate plan in February 2012 and to address recovery of capital expenditures that will likely be in excess of recent periods. Our ratings assume that Niagara Mohawk will be successful in these filings, with new rates anticipated to take effect by January 2011, thereby establishing a reasonable opportunity to earn on its utility investments and maintain earnings and cash flow levels to help sustain key metrics at levels commensurate with what is typically seen for regulated utilities at the A3 senior unsecured level. In the event that settlement negotiations are part of the process for future rate filings, we would likely expect 226

248 shorter tenors given current market dynamics and a desire to retain more flexibility with respect to timing of future rate cases. STRONG FINANCIAL METRICS EXPECTED TO BE THE NORM FOR MEDIUM TERM Exhibit (AED-3) Schedule 1 Page 3 of 5 Profitable utility operations and cash recovery through accelerated amortization of regulatory assets under the tenyear rate plan have resulted in healthy levels of positive free cash flow for NiMo over the past four years. NiMo has used this cash to achieve significant reduction in the utility's gross debt level, which has contributed to corresponding favorable improvements in key credit metrics. For FY 2009, NiMo's cash flow from operations (exclusive of changes in working capital) covered its interest and debt by 6.3x and 31.5%, respectively (subject to potential further adjustments upon clarification of underfunded pension obligations). Also, as of March 31, 2009, NiMo's adjusted debt to adjusted capitalization, calculated in accordance with Moody's Global Rating Methodology for Regulated Electric Utilities (i.e., including non-current deferred income taxes as part of total capitalization) was 30.8% (subject to potential further adjustments upon clarification of underfunded pension obligations). These levels leave NiMo comfortably positioned relative to peers. We note that the ultimate parent has not historically relied upon NiMo for dividends; however, prospectively we would not be surprised to see the parent take dividends from NiMo, consistent with financial strategies to realign the utility's capital structure with an equity level closer to that used as a basis for establishing revenue requirements in rate case proceedings (i.e. 43.7% in NiMo's recently concluded gas rate case). At the same time, it is our understanding that management will manage this realignment process in a credit neutral way and we will be wary of any unexpected change in support provided to NiMo by the NYPSC that might jeopardize achieving this objective. Liquidity NiMo maintains sufficient liquidity by supplementing its cash on hand and internally generated cash flow from operating activities with borrowings from other NG USA companies through the inter-company money pool. Cash management in the NG USA system is conducted through an inter-company pool, which serves as an investment vehicle for the participants' excess cash as well as a relatively inexpensive short-term liquidity reserve. The quality of alternate liquidity could, however, be improved upon in our opinion by arranging for more substantial committed standalone multi-year bank credit facilities not burdened by a material adverse change clause. Participating regulated utility subsidiary companies contribute their excess cash to the pool. The surplus cash invested in the pool is first used to meet the short-term borrowing needs of eligible subsidiaries. Companies borrowing from the pool pay rates linked to A1/P-1 30-day commercial paper rates. Any remaining cash is typically invested into Aaa rated money funds with same day liquidity. As a measure of additional security, NG USA's parent, the UK-based National Grid plc, has the ability to increase the amount of cash in the pool through direct loans to NG USA. Alternatively, NG USA can also issue commercial paper and medium term notes in lieu of or to supplement direct loans from the UK parent. NiMo has historically been a borrower under the money pool and, while we expect that it will continue to take advantage of that source of short term funds, we anticipate that NiMo will revert in the near term to issuance of third party long-term debt to repay the large borrowings outstanding under the money pool as of March 31, 2009 and as it moves ahead with its T&D utility capital expenditure plans. At this stage, NiMo has no standalone bank credit facility. It does, however, have $100 million of sub-limit availability for letters of credit under a joint arrangement among NG USA and several other affiliates in the US, which expires November 29, We expect that the need for this facility will be addressed within the context of an ongoing consolidated liquidity planning strategy ahead of its expiration date. We are particularly focused on liquidity for corporate rated issuers, particularly in light of current bank market conditions, which make it likely that pricing will increase and tenors will be shortened along with the possibility of stricter covenants and other conditionality. The existing joint arrangement has a traditional material adverse change clause that does not apply beyond closing and does not contain any rating triggers that would result in any acceleration or put of obligations. The arrangement also contains a 65% maximum allowable debt level (as defined) that applies to NiMo. As of March 31, 2009, there was significant headroom versus the 65% level allowed for NiMo and we expect that to remain the norm for the foreseeable future. As of March 31, 2009, NiMo had about US$23.1 million of unrestricted cash on hand, while owing about US$650.6 million to affiliates under the money pool and reporting US$350 million as the current portion of long-term debt (CPLTD). The significantly higher than typical amount of short term borrowing under the money pool results from use of that source to repay a $600 million long-term senior note issue that matured in October 2008 and the $350 million CPLTD relates to $350 million intercompany note due July 31, With regard to recent past practices, NiMo has been repaying debt with positive free cash flow or otherwise refinancing with inter-company instead of third party debt. Going forward, we expect NiMo to again begin issuing third party long-term debt once it receives clarification from the NYPSC on its May 2009 decision authorizing NiMo to issue up to $2.0 billion of long-term debt through March 31, Although we expect that NiMo will address the impending inter-company note maturity with internal borrowing, we anticipate a long-term debt issue later this year to address repayment of a substantial portion of borrowings under the money pool. In addition to the US$350 million inter-company note due July 31, 2009, NiMo's next material long-term debt maturity is another US$350 million inter-company note due June 30, In considering NiMo's other near term calls on cash, the company is following through on a Reliability Enhancement Program (REP) aimed at improving the utility's overall performance and reliability as well as enhancing opportunities to achieve financial benefits under performance based regulation currently in place. Setting aside long-term debt maturities, but taking into account spending for the REP, which could result in NiMo again making capital expenditures in excess of US$400 million in FY 2010, and the likely commencement of dividends to be paid to National Grid USA, we anticipate that NiMo will still be cash flow positive, albeit considerably less so than in recent years. As a result, we would expect the pace of NiMo's debt reduction to taper 227

249 Exhibit (AED-3) Schedule 1 Page 4 of 5 off considerably going forward. Rating Outlook The stable rating outlook for NiMo mirrors the stable rating outlook for its ultimate parent National Grid plc and all the other rated entities in the group, largely reflecting the significant interdependencies that exist within the National Grid group of companies and our view that on the whole the National Grid Group's credit quality will strengthen during FY 2010, thereby solidifying ratings for NiMo and those of the other rated entities within the family. Under this scenario, we believe that there would be additional headroom within existing ratings, thereby providing a degree of flexibility that does not currently exist. What Could Change the Rating - Up Assuming some guidance under the Moody's Rating Methodology for Complex European Holding Company Structures, it is unlikely that the ratings for NiMo will go up in the near future, unless there is a change in the view of the overall group rating for the National Grid plc family. While we do not anticipate upward rating pressure in the near to medium term, ratings would become more strongly positioned if the consolidated National Grid performance improves as expected during FY What Could Change the Rating - Down NiMo's ratings could go down if there is a downgrade to our assessment of the overall group credit quality for National Grid plc or if there is significant change to the standalone financial metrics resulting from an increase in its dividend obligation. Ratings could also be pressured if National Grid plc decides to increase the leverage at the company as part of its further expansion in the US. For example, ratings could be pressured down if NiMo's coverage of interest and debt by cash flow from operations (exclusive of the effects of changes in working capital) falls below 4.5x and 22%, respectively, for a sustained period. Rating Factors Niagara Mohawk Power Corporation Select Key Ratios for Global Regulated Electric Utilities Rating Aa Aa A A Baa Baa Ba Ba Level of Business Risk Medium Low Medium Low Medium Low Medium Low CFO pre-w/c to Interest (x) [1] >6 > <2.5 <2 5.7 CFO pre-w/c to Debt (%) [1] >30 > <13 <5 CFO pre-w/c - Dividends to Debt (%) [1] >25 > <10 <3 Total Debt to Book Capitalization (%) <40 < >60 >70 [1] CFO pre-w/c, which is also referred to as FFO in the Global Regulated Electric Utilities Rating Methodology, is equal to net cash flow from operations less net changes in working capital items CREDIT RATINGS ARE MOODY'S INVESTORS SERVICE, INC.'S (MIS) CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MIS DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEET ITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT. CREDIT RATINGS DO NOT ADDRESS ANY OTHER RISK, INCLUDING BUT NOT LIMITED TO: LIQUIDITY RISK, MARKET VALUE RISK, OR PRICE VOLATILITY. CREDIT RATINGS ARE NOT STATEMENTS OF CURRENT OR HISTORICAL FACT. CREDIT RATINGS DO NOT CONSTITUTE INVESTMENT OR FINANCIAL ADVICE, AND CREDIT RATINGS ARE NOT RECOMMENDATIONS TO PURCHASE, SELL, OR HOLD PARTICULAR SECURITIES. CREDIT RATINGS DO NOT COMMENT ON THE SUITABILITY OF AN INVESTMENT FOR ANY PARTICULAR INVESTOR. MIS ISSUES ITS CREDIT RATINGS WITH THE EXPECTATION AND UNDERSTANDING THAT EACH INVESTOR WILL MAKE ITS OWN STUDY AND EVALUATION OF EACH SECURITY THAT IS UNDER CONSIDERATION FOR PURCHASE, HOLDING, OR SALE. Copyright 2009, Moody's Investors Service, Inc. and/or its licensors including Moody's Assurance Company, Inc. (together, "MOODY'S"). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY'S PRIOR WRITTEN CONSENT. All 228

250 Exhibit (AED-3) Schedule 1 Page 5 of 5 information contained herein is obtained by MOODY'S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided "as is" without warranty of any kind and MOODY'S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances shall MOODY'S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY'S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY'S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings and financial reporting analysis observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY'S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. MOODY'S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY'S have, prior to assignment of any rating, agreed to pay to MOODY'S for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,400,000. Moody's Corporation (MCO) and its wholly-owned credit rating agency subsidiary, Moody's Investors Service (MIS), also maintain policies and procedures to address the independence of MIS's ratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually on Moody's website at under the heading "Shareholder Relations - Corporate Governance - Director and Shareholder Affiliation Policy." 229

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