A. My name is Lisa J. Gast. My business address is Integrys Energy Group, Inc.

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1 BEFORE THE PUBLIC SERVICE COMMISSION OF WISCONSIN Application of Wisconsin Public Service Corporation for ) Authority to Adjust Electric and Natural Gas Rates ) 0-UR- Revised Direct Testimony of Lisa J. Gast for Wisconsin Public Service Corporation April 1, 01 1 Q. Please state your name, business address and position. A. My name is Lisa J. Gast. My business address is Integrys Energy Group, Inc. ( Integrys ), 00 North Adams Street, P.O. Box 01, Green Bay, WI I am the Manager, Financial Planning and Analysis for Integrys Business Support, LLC ( IBS ) a wholly owned subsidiary of Integrys and am testifying on behalf of Wisconsin Public Service Corporation ( WPSC ) in support of its application for authority to adjust its electric and natural gas rates Q. Please describe your educational, professional, and utility background. A. I graduated from the University of Wisconsin Green Bay with a Bachelor s Degree in Accounting. I received a Master s Degree in Business Administration from the University of Wisconsin - Oshkosh. My professional designations are Certified Public Accountant and Certified Treasury Professional. I joined WPSC s Treasury Department in April of 001. As Manager Financial Planning and Analysis, I direct the long-term financial analysis and forecasting for Integrys and its affiliates, including WPSC. I am also responsible for the capital structure and the cost of debt forecasts for each of Integrys five regulated electric and natural gas utilities. Direct-WPSC-Gast-1

2 Q. What is the purpose of your testimony? A. The purpose of this testimony is: 1. To present WPSC's projected capital structure and cost of capital for the 01 test year.. To address the requirements of Order Point 1 from the Commission s December 1, 0 Final Decision in Docket 0-UR- ( 01 Rate Order ) regarding Off-Balance Sheet ( OBS ) obligations,. To address the requirements of Order Point 1 of the 01 Rate Order regarding a ten year financial forecast, and. To discuss WPSC s proposal for the recovery of carrying costs on Construction Work in Progress ( CWIP ). Q. Does WPSC present any other evidence on cost of capital? A. Yes, we do. Mr. Paul R. Moul of P. Moul & Associates provides expert analysis and testimony on WPSC's cost of equity. Based on analytical studies employing the Discounted Cash Flow ( DCF ) model, the Risk Premium ( RP ) model, and the Capital Asset Pricing Model ( CAPM ), Mr. Moul estimates WPSC s cost of equity at.0%. Q. Are you sponsoring any exhibits with your pre-filed direct testimony? A. Yes, I am. I am sponsoring Exhibit Ex.-WPSC-Gast-1, which is comprised of schedules; and Confidential Exhibit Ex.-WPSC-Gast-, which is comprised of schedules. 0 1 The schedules of Ex.-WPSC-Gast-1 are as follows: 1. Cost of Preferred Stock. Cost of Long-Term Debt Actual 0 & Test Year 01. Forecasted Cost of Short-Term Debt. Utility Capital Structure & Weighted Cost. Historic Cost of Long-Term Debt Direct-WPSC-Gast-

3 Financial Capital Structure Actual 0 & Test Year 01. Off-Balance Sheet Obligations Summary of Data Provided and Assumptions 01 Rate Order Point 1 re OBS Obligations S&P Publications. Corporate Methodology -1-. Key Credit Factors For The Regulated Utilities Industry -1-. Corporate Methodology: Ratios And Adjustments -1-. Standard & Poor s Methodology for Imputing Debt For U.S. Utilities Power Purchase Agreements --0 Moody s Publications. Rating Methodology/Regulated Electric and Gas Utilities --. Moody s Approach to Global Standard Adjustments in the Analysis of Financial Statements for Non-Financial Corporations -1- The schedules of Confidential Exhibit Ex.-WPSC-Gast- are as follows: 1. Off-Balance Sheet Obligations Calculations and Supporting Data. Year Financial Forecast Q. Were these exhibits prepared by you or under your supervision? A. Yes, they were. Capital Structure and Cost of Capital Q. What is the forecasted average embedded cost of WPSC s preferred stock for the 01 test year? A. As shown in Schedule 1 of Exhibit Ex.-WPSC-Gast-1, the test year average cost of preferred stock is.0%. 0 1 Q. What is WPSC s forecasted average embedded cost of long-term debt for the 01 test year? A. As shown in Schedule of Exhibit Ex.-WPSC-Gast-1, that cost is.%. The actual Direct-WPSC-Gast-

4 cost of long-term debt for 0 was.%. The 01 test year does not have any forecasted activity. However, 01 has forecasted activity which includes the maturity of $ million.% debt in December and a new issue of $0 million 0 year debt in November at a rate of.0%. The November debt issuance will fund the December maturity and maintain short-term debt within currently authorized limits. Q. What is the forecasted average cost of WPSC s short-term debt during the 01 test year? A. As shown in Schedule of Exhibit Ex.-WPSC-Gast-1, this cost is 1.% Q. What factors affect WPSC's capital costs? A. Factors affecting WPSC's capital costs include: 1. Business risks, particularly uncertainties WPSC and the industry currently face from increasingly stringent air emission limits and renewable and energy efficiency mandates.. Financial risks such as prevailing interest rates and returns expected on alternative investments of similar risk. Q. Why are business risks important to investors? A. Business risks create uncertainty for which the investor must be reasonably compensated to accept. The risks associated with regulatory treatment are important business risks for investors in regulated companies. The investor, in considering alternatives, will evaluate these risks and the degree to which they apply to the companies that are being examined for purposes of investment. In selecting a particular investment vehicle, the investor will then make a judgment as to where the best return is available for the given level of risk that the investor is willing to assume. Therefore, in order for a utility, or any other company, to be able to attract the capital required to support its operations, it must offer potential investors the prospect of Direct-WPSC-Gast-

5 earning a return on their investment that is at least equal to the potential returns offered by other investments of comparable perceived risk Q. Please explain financial risk. A. Financial risk, specifically "leverage", is caused by having debt in the capital structure. Fixed payment obligations of any kind create financial risks similar to the effect of debt. Debt therefore may be imputed to reflect other long-term commitments such as operating leases and purchased power contracts. Servicing these arrangements constitutes financial commitments WPSC and its investors must meet. It is necessary to focus on the additional risks to the earnings stream caused by WPSC s capital structure and the character of prior claims on its earnings by the holders of debt. A measure of a company's financial risk for debt securities is its credit rating. This credit rating is directly related to a company's ability to pay interest expenses and other fixed charges if variability in net income occurs. A major factor in maintaining the ability to pay fixed interest charges, when due, is having an adequate amount of equity in a company's capital structure and an adequate allowed return on that equity Q. Why is the amount of equity and the allowed return on equity important to maintaining strong credit ratings? A. In establishing credit ratings, the rating agencies consider multiple qualitative and quantitative factors. Standard & Poor s Corporation ( S&P ) has identified two core ratios they use in assessing a company s financial risk when assigning a credit rating. The ratios are Funds from Operations ( FFO ) to debt and debt to Earnings before Interest, Taxes, Depreciation, and Amortization ( EBITDA ). These two metrics compare various measures of cash flow available to service outstanding debt. The amount of cash flow available to service debt is a function of both the Direct-WPSC-Gast-

6 amount of equity allowed in the capital structure and the return allowed on that equity. Therefore, in order for WPSC to maintain a given credit rating, this relationship must be considered. If the amount of equity is maintained, but the allowed return is substantially decreased, it may be necessary to increase the equity level further to protect the rating. Q. What do you propose for the financial common equity ratio in this case? A. The 01 test year rate case is financed within a common equity range of % - %, on a financial basis, in accordance with Finding of Fact of the docket 0- UR- Final Decision. This is an appropriate range because it supports our current credit ratings by S&P and Moody s and helps to maintain the company s financial strength Q. What benefits does an adequate equity ratio provide? A. An adequate equity ratio provides the utility with the ability to resist negative financial pressures, and also creates a buffer to protect against unexpected adverse developments so that distortions can be quickly remedied without impairing either the orderly conduct of the business, or the credit quality of present or future securities issues. Maintaining a financial common equity ratio within the range of % - % will help ensure that WPSC has access to the capital markets at reasonable rates when WPSC needs it, thereby benefiting its customers. Q. What is WPSC s forecasted cost of common equity for 01? A. The instant rate case reflects a.0% forecasted cost of common equity for 01. Q. Based on WPSC s proposed common equity ratio and cost of equity, what is the resulting cost of capital for WPSC? Direct-WPSC-Gast-

7 A. Schedule of Exhibit Ex.-WPSC-Gast-1 indicates that WPSC s 01 estimated weighted average cost of capital is.%, which equates to an estimated pre-tax weighted average cost of capital of.%. The underlying forecasted costs for preferred stock, long-term debt, and short-term debt are shown in Schedules 1,, and of Exhibit Ex.-WPSC-Gast-1. Q. What is the relationship between the ability to sell common stock and the ability to sell debt? A. It is generally recognized that being able to sell debt at a reasonable cost depends on a company s ability to sell additional common equity because that is indicative of credit quality Q. Is the market responsive to alternative investment opportunities? A. Investors have a full field of investment choices that include the stock market or other markets such as bonds, treasury securities, money funds, real estate, etc. If investors choose the stock market, they may select a utility stock or equities from other industries. If investors prefer utility stocks, they have many to select from within the industry. Therefore, it is imperative that the regulator provides a competitive return to a utility s investors that is consistent with the return they expect on investments of comparable risk. If investors are not provided a competitive return, the utility s ability to raise capital on reasonable terms and its financial integrity will be at risk, which in turn will threaten its ability to meet its service obligations. Consequently, an adequate return on common equity is also of major importance and benefit to customers. Under the utility's obligation to serve, the utility must stand ready to purchase more power with long-term contracts or to finance capital- Direct-WPSC-Gast-

8 intensive power plants. Our capital structure and return must be protected to assure this capability. Q. In summary, what is your request in regard to the common equity ratio? A. The average regulatory common equity ratio in this filing is set at 0.%, as shown on Schedule of Exhibit Ex.-WPSC-Gast-1, which translates to an average financial common equity ratio of 0.%, as shown on Schedule of Exhibit Ex.-WPSC-Gast- 1. Based on my prior recommendation of a % % financial capital structure common equity range, WPSC requests a target level for the test year average common equity of 0.% measured on a financial basis. See Schedule of Exhibit Ex.-WPSC-Gast-1 for our recommended financial capital structure. 1 1 Q. How does the pending Wisconsin Energy Corporation merger with Integrys impact the cost of capital and the proposed capital structure? A. The pending merger should have no impact on the proposed cost of capital or capital structure at WPSC Q. Please summarize your conclusions regarding the proper return on capital. A. My conclusion is that WPSC requires a return on capital that adequately reflects the following factors: - It is necessary to provide a fair return commensurate with competitive investment vehicles available to investors. - There is notable business risk associated with federal and state environmental regulation, changes in the MISO market and WPSC s capital spending requirements. - WPSC has delivered and will continue to deliver reliable and low cost service to its customers and thus the shareholder should be rewarded for delivering on its commitment to those customers. Direct-WPSC-Gast-

9 1 01 Rate Order Point 1 Regarding Off-Balance Sheet Obligations Q. Do you have any comments on Order Point 1 of the 01 Rate Order regarding OBS obligations? A. Yes, I do. In Schedule 1 of Confidential Exhibit Ex.-WPSC-Gast-, WPSC calculates $.1 million of OBS obligations for the 01 test year for PPAs and operating leases only. Schedule 1 of Confidential Exhibit Ex.-WPSC-Gast- further shows the detail of operating leases and PPAs to which WPSC is contractually obligated and the detail of our OBS obligation calculations. Schedule of Exhibit Ex.-WPSC-Gast- 1 summarizes the data we ve provided in Schedule 1 of Confidential Exhibit Ex.- WPSC-Gast- and our assumptions for these calculations, and notes the S&P methodology sources. Schedules - of Exhibit Ex.-WPSC-Gast-1 are S&P methodology reference documents. Schedules - of Exhibit Ex.-WPSC-Gast-1 are Moody s methodology reference documents. As in past rate cases, WPSC s methodology to calculate OBS obligations is based on the application of S&P s current methodologies Q. Does WPSC exclude any items included in S&P s imputed debt total? A. Yes, WPSC has excluded amounts for wind and parallel generation PPAs, pension and other post-retirement employee benefits and asset retirement obligations from its imputed debt calculation. WPSC has accepted Staff s exclusion of these items in past rate cases and continues to do so. 01 Rate Order Point 1 Regarding a Ten Year Financial Forecast Q. Does your filing include a ten-year financial forecast? A. Yes, Schedule of Confidential Exhibit Ex.--WPSC-Gast- includes the required - year financial forecast. Direct-WPSC-Gast-

10 1 1 The Recovery of Carrying Costs on CWIP Q. What is WPSC s proposed treatment of Construction Work in Progress ( CWIP )? A. CWIP is the accounting term for funds the utility uses to support new construction. When building a new asset, a utility has two options for recovering the carrying costs on CWIP. Under one option, the utility can accumulate these carrying costs as Allowance for Funds Used During Construction ( AFUDC ) which is capitalized and recovered over the life of the asset through depreciation. In this manner, the utility effectively earns a return on a return. Alternatively, the utility can, with the Commission s authorization, earn a current return on its CWIP during the construction period. This method avoids the return on the return and recovers more of the costs of the asset up-front. A current return on CWIP benefits customers by reducing the total rate impacts of capital projects, and reduces the rate shock associated with the initial placement of major projects in rate base. It also improves the utility s cash flow, which in turn supports its credit rating and access to capital at a reasonable cost In the case of large, capital intensive electric generation construction projects that have lengthy construction periods, WPSC has in the past recovered a current return on 0 percent of CWIP. Examples of such large projects include the replacement of the Kewaunee Nuclear Power Plant steam generator and construction of Weston Unit. In the instant rate case proceeding, WPSC is not requesting 0% current return on CWIP for any such projects. In accordance with WPSC s past practice, the instant rate case proceeding reflects: 0% current return on CWIP and 0% AFUDC on general construction projects 0% current return on CWIP and 0% AFUDC on: Direct-WPSC-Gast-

11 o Environmental upgrade projects at electric generating facilities per Finding of Fact of the Commission s January, 00 Final Decision in Docket 0-UR-. o The System Modernization and Reliability Project per the total project cost portrayed in the Commission s July 1, 0 Final Decision in Docket 0-CE-1. o Fox Energy Center Units 1 and Technology upgrade. o Columbia Units 1 and Transformer upgrades. Q. Does WPSC request any delayed exhibits in this docket? A. Yes, WPSC proposes to provide updated financial information to aid the Commission in determining the proper cost of equity, long-term debt and short-term debt via delayed exhibit, approximately seven days prior to the Discussion of Record in this docket Q. Does this complete your revised pre-filed direct testimony? A. Yes, it does. Direct-WPSC-Gast-