DOCKET NO. BEFORE THE PUBLIC UTILITY COMMISSION OF TEXAS APPLICATION OF TEXAS-NEW MEXICO POWER COMPANY FOR AUTHORITY TO CHANGE RATES

Transcription

1 DOCKET NO. BEFORE THE PUBLIC UTILITY COMMISSION OF TEXAS APPLICATION OF TEXAS-NEW MEXICO POWER COMPANY FOR AUTHORITY TO CHANGE RATES PREPARED DIRECT TESTIMONY AND EXHIBITS OF DIRECT TESTIMONY AND EXHIBITS OF ELLEN LAPSON MAY 0, 0

2 0 0 0 TABLE OF CONTENTS Glossary of Defined Terms I. INTRODUCTION AND PURPOSE... II. EXECUTIVE SUMMARY... III. IMPORTANCE OF MAINTAINING FINANCIAL STRENGTH... IV. TNMP S CURRENT FINANCIAL STATUS... V. EXPECTED IMPACT OF TAX REFORM ON CASH FLOW METRICS... VI. REGULATORY TREATMENTS REQUESTED BY TNMP... VII. ANALYSIS OF FINANCIAL SCENARIOS... 0 VIII. CONCLUSION... TNMP EXHIBIT EL-: Lapson Qualifications and Professional Experience TNMP EXHIBIT EL-: Long-Term Credit Rating Correspondences TNMP EXHIBIT EL-: Credit Ratings of U.S. Utility Operating Companies TNMP EXHIBIT EL-: Moody s Credit Opinion: Texas-New Mexico Power Company, June 0 TNMP EXHIBIT EL-: S&P Research, Summary: Texas-New Mexico Power Co, April 0 TNMP EXHIBIT EL--A: S&P Research, Summary: Texas-New Mexico Power Co, May 0 TNMP EXHIBIT EL-: Moody s Release, Rating Action: Moody s Changes Outlooks on U.S. Regulated Utilities Primarily Affected by Tax Reform, January 0 TNMP EXHIBIT EL-A: Moody s Sector Comment, Regulated Utilities, US, Tax Reform is Credit Negative for Sector, but Impact Varies by Company, January 0 TNMP EXHIBIT EL-: S&P Global Market Intelligence, U.S. Tax Reform: For Utilities' Credit Quality, Challenges Abound, January 0 TNMP EXHIBIT EL-: Fitch Ratings, Tax Reform Creates Near-Term Credit Pressure for Regulated Utilities and Holding Companies, January 0 TNMP EXHIBIT EL-: Highly Confidential Financial Forecast Scenarios i

3 GLOSSARY OF DEFINED TERMS AND ACRONYMS Term Cash Flow Leverage Metrics CFO CFO pre-wc CFO pre-wc/debt Commission Company Debt/ EBITDA EBITDA FFO FFO/Total Debt Fitch LT Moody s PNMR ROE S&P SACP Definition Ratios used by credit rating agencies to assess debt leverage by comparing the level of debt and debt-like liabilities with a measure of operating cash flow, such as CFO, FFO, or EBITDA. Specifically, such ratios are: FFO/Total Debt (S&P); Debt/EBITDA (S&P); and CFO pre WC/Debt (Moody s). Cash flow from operations derived from the statement of cash flows (S&P and Moody s); the base upon which Moody s calculates CFO pre-wc Cash flow from operations as derived from the statement of cash flows, but excluding changes in short-term working capital accounts (Moody s) Ratio of Cash from Operations Pre-Working Capital to Total Debt (Moody s) Public Utility Commission of Texas TNMP Ratio of total debt divided by Earnings Before Interest, Taxes, Depreciation and Amortization (one of two S&P core financial ratios) Earnings Before Interest, Taxes, Depreciation and Amortization Funds from Operations, calculated as: EBITDA less net interest expense and less current taxes (S&P) Ratio of FFO to Total Debt (one of two S&P core financial ratios) Fitch Ratings Long-term Moody s Investors Service PNM Resources, Inc. Return on common equity Standard & Poor s, Inc. Stand-alone credit profile (a component in S&P s credit rating process that is intended to reflect the credit quality of a subsidiary or affiliate in a corporate group separate from support from or support to its corporate group or affiliates) Short-term ST TCJA Tax Cuts and Jobs Act of 0 TNMP Texas-New Mexico Power Company

4 I. INTRODUCTION AND PURPOSE 0 0 Q. PLEASE STATE YOUR NAME, POSITION AND BUSINESS ADDRESS. A. My name is Ellen Lapson, CFA, and I am the principal of Lapson Advisory. My business address is 0 Riverside Drive, New York, New York 00. Q. WHAT IS THE PURPOSE OF YOUR DIRECT TESTIMONY AND EXHIBITS? A. I am filing direct testimony and related exhibits as a financial expert on behalf of Texas-New Mexico Power Company ( TNMP ), a subsidiary of PNM Resources, Inc. ( PNMR ). My testimony relates to TNMP s application to change rates, and specifically to the financial condition, capital structure, cash flow, and financial strength of TNMP currently and during the period the rates will be in effect, including the impact of the rates requested on TNMP s ability to attract capital. Q. PLEASE DESCRIBE YOUR EDUCATIONAL AND PROFESSIONAL CREDENTIALS. A. I earned a Bachelor s degree from Barnard College and an MBA with a concentration in Accounting from New York University s Stern School of Business. I am also qualified as a Chartered Financial Analyst ( CFA ), and I am a member of the CFA Institute. Q. PLEASE DESCRIBE YOUR EXPERIENCE IN UTILITY FINANCE. A. My entire career has been in the financial market. I began my career as a securities analyst at Argus Research Corporation analyzing utility company equity securities. For the next 0 years, I held several posts at a predecessor of J.P. Morgan as a corporate banker and investment banker structuring and executing financial transactions for utility and infrastructure companies. Thereafter, I worked for years, first as a senior director, and then as a managing director at Fitch Ratings, a major credit rating agency, where I managed analysts who rated credits in the sectors of electricity and natural gas and project finance and chaired rating committees. After leaving Fitch Ratings six years ago, I founded Lapson Advisory. My professional credentials and experience are summarized in Exhibit EL-.

5 0 Q. WHAT ARE THE RESPONSIBILITIES OF YOUR CURRENT POSITION AT LAPSON ADVISORY? A. At Lapson Advisory, I advise companies in the utility and infrastructure sector on how to improve their access to capital. This often includes expert witness testimony on utility financial matters. Also, I develop and conduct professional training programs in corporate finance, project finance, and credit analysis for the gas and electric sector. Q. HAVE YOU PREVIOUSLY SUBMITTED ANY TESTIMONY IN PROCEEDINGS BEFORE THIS COMMISSION OR OTHER JURISDICTIONS? A. Yes. I am currently a financial expert witness on behalf of Southwestern Public Service Company in Docket No. and on behalf of Entergy Texas, Inc. in Docket No.. Previously, I submitted testimony on behalf of Oncor Electric Delivery Co. LLC in Docket No. and on behalf of Entergy Texas, Inc. in Docket No.. Exhibit EL- includes a list of all of my expert witness assignments in a number of jurisdictions. II. EXECUTIVE SUMMARY 0 Q. WHAT SUBJECTS DOES YOUR TESTIMONY ADDRESS? A. I testify herein regarding the soundness of TNMP s financial condition and the projected impact of the requested rate increase on TNMP s future financial strength. TNMP requires the revenues and capital structure it has requested in its rate application in order to maintain sound credit ratings so that it can fund projects to construct and extend the life of utility infrastructure, attract capital, and refinance outstanding debt. Application of Southwestern Public Service Company for Authority to Change Rates, Docket No., (pending). Application of Entergy Texas, Inc. for Authority to Change Rates, Docket No., (pending). Application of Oncor Electric Delivery Company LLC for Authority to Change Rates, Docket No., Oct., 0. Application of Entergy Texas Inc. to Amend its Certificate of Convenience and Necessity to Construct Montgomery County Power Station in Montgomery County, Docket No., Jul, 0.

6 0 0 My direct testimony and exhibits also take into consideration the likely reduction in TNMP s cash flow and financial condition that will result from the implementation of the Tax Cuts and Jobs Act of 0 ( TCJA ), which provide further support for the cost of capital components requested by TNMP. TNMP witness Elisabeth Eden recommends an authorized capital structure comprised of 0% equity and 0% debt, representing an increase from the % equity component authorized by the Commission in the order of February, 0, approving the settlement stipulation in TNMP s last prior base rate case Docket No. 0 and from TNMP s actual % equity component. The proposed higher equity ratio will offset the forecasted reduction in TNMP s operating cash flow and enable TNMP to maintain acceptable Cash Flow Leverage Metrics to satisfy credit rating agencies during the effective period of the rates. Q. WHAT MEASURES OF FINANCIAL STRENGTH DO YOU CONSIDER AND WHY? A. Ratios of operating cash flow to debt are key credit metrics cited by Moody s Investors Service ( Moody s ) and Standard & Poor s ( S&P ) in the agencies financial evaluations of TNMP as well as other utilities. Throughout this testimony, I use the term Cash Flow Leverage Metrics to signify financial ratios used to assess debt leverage by comparing the level of debt and debt-like liabilities with a measure of cash flow, such as CFO, FFO, or EBITDA. Specifically, such ratios are: FFO/Total Debt (S&P); Debt/EBITDA (S&P); and CFO pre-wc/debt (Moody s). Bond investors and bankers also use these Cash Flow Leverage Metrics in their internal credit analyses and decisions to measure a company s financial strength and resilience. Cash Flow Leverage Metrics are always a matter of importance for utilities due to their significance to fixed income investors, and because long-term debt comprises approximately half of the capital structure. Efficient and low cost Application of Texas-New Mexico Power Company for Authority to Change Rates, Docket No. 0, Jan., 0. Please refer to the Glossary of Defined Terms and Acronyms ( Glossary ). See Glossary.

7 0 0 access to debt financing makes utility infrastructure available and affordable to customers. Thus, cash flow and measures of cash flow leverage are a valid consideration in the determination of utility rates. In past years, with a % tax rate and the availability of bonus depreciation and other forms of deferral available as a source of cash flow, utilities such as TNMP have attracted the confidence of fixed income investors. The challenge under changing circumstances is to maintain strong access to fixed income investment. It is timely in this proceeding for the Commission to consider methods to mitigate the erosion of the Cash Flow Leverage Metrics that will result from the implementation of the TCJA. The TCJA will reduce corporate tax rates and eliminate bonus depreciation, among other things. While the flow through of the lower tax rate will be beneficial to utility consumers, my testimony and that of Company witness Robert Hevert will explain why the implementation of the TCJA will be detrimental to TNMP s cash flow and potentially its credit ratings, unless the Commission provides some offsetting mechanisms to increase TNMP s cash flow from operations and/or to reduce its debt leverage. I recommend that the Commission adopt the financial mechanisms that are requested by TNMP in this proceeding to support adequate cash flow and mitigate the likely deterioration in the Company s primary Cash Flow Credit Metrics that will otherwise result from several factors, including the implementation of the TCJA. In my Direct Testimony I review how each of these regulatory treatments will enhance operating cash flow or reduce debt to stem the erosion in TNMP s Cash Flow Credit Metrics. By authorizing the requested mechanisms, including but not limited to the proposed capital structure, the Commission will maintain and support the sound investment grade credit ratings of TNMP, protecting the Company s financial strength and its ability to serve its customers with reliable service. Q. HOW IS THE REMAINDER OF YOUR DIRECT TESTIMONY ORGANIZED? A. The remainder of my Direct Testimony is organized as follows:

8 0 0 III. Q. Section III. Addresses the importance of maintaining sound financial condition and creditworthiness, and the benefits that confers upon TNMP s customers. Section IV. Explains the relevance of credit ratings as indicators of a company s financial strength, and specifically the role of Moody s issuer credit rating and Standard & Poor s stand-alone credit profile as measures of TNMP s current financial condition. The section discusses TNMP s financial credit metrics prior to the impact of TCJA and the benchmark credit ratios that must be met to maintain the current credit ratings, subject the standards of Moody s and Standard & Poor s. Section V. Explains why the implementation of the recent tax reform act is likely to reduce the Cash Flow Leverage Metrics of utilities in general and of TNMP, and the likely impact of weaker Cash Flow Leverage Metrics on credit ratings and the assessment of TNMP s financial strength by investors and bankers. Section VI. Discusses regulatory treatments requested by the Company to mitigate or offset the decline in Cash Flow Leverage Metrics that would otherwise occur in Section VII. Presents the results of an analysis of TNMP s projected financial condition and key Cash Flow Leverage Metrics over the period in which the rates will be in effect under two scenarios. The results of the first scenario show that the requested rate relief including the mitigating mechanisms proposed in this application will maintain TNMP s Cash Flow Leverage Metrics at or close to the current level and sustain TNMP s current credit ratings. In the second scenario, without the requested rate relief, TNMP s financial condition is weaker, its key credit ratios decline, and the credit rating agencies would be likely to downgrade TNMP s individual credit ratings. Section VIII. Presents my conclusions and recommendation. IMPORTANCE OF MAINTAINING FINANCIAL STRENGTH WHY IS THE ONGOING FINANCIAL STRENGTH OF TNMP OF IMPORTANCE TO THE COMMISSION AND TO UTILITY CUSTOMERS?

9 0 0 A. Financial strength is a resource that is the foundation for TNMP to carry out its obligation to meet the needs of electricity consumers. The electricity delivery and transmission business is capital intensive. TNMP is obligated to make ongoing investments in long-lived fixed assets to serve growth in connections, comply with changing governmental mandates and safety regulations, replace infrastructure at the end of its useful life, and enhance the resilience and reliability of its systems. These needs will require steady access to bank credit facilities and the bond market for short-term and long-term financing. A sound financial condition enables a company to meet its operating expenses and to attract capital on favorable terms during all phases of the capital market cycle, in good times and bad. Q. PLEASE EXPLAIN WHY TNMP HAS AN ONGOING NEED TO MAINTAIN ACCESS TO THE INVESTMENT MARKET. A. First, TNMP s public service obligation includes the mandate to make needed investments to meet customers demands and maintain reliable service. To do so, TNMP has ongoing capital replacement and expansion projects. TNMP s forecasted capital expenditures for the five years 0-0 are $ million (approximately $ million per annum), % greater than the total for the five years 0-0 ($0 million, or approximately $ million per annum). The projected capital expenditures will exceed internal cash flow and require TNMP to access new funding. In addition to funding capital investment projects, TNMP also must obtain external financing to refund maturities of long-term debt and to pay down borrowings under its revolving credit. $ million of TNMP s long-term debt will mature in 0; thus, over a third of TNMP s total long-term debt at year-end 0 will have to be refinanced in 0, and the outcome of this regulatory proceeding and TNMP s future cash flow will influence investors views about committing funds to TNMP for the long term. Finally, TNMP needs ongoing access to bank credit facilities to fund capital expenditures prior to financing in PNM Resources SEC Form 0-K for the year ended Dec.. 0 at page B ( Construction Program ).

10 0 the capital markets and to manage seasonal mismatches between revenues and expenses. The latter needs are currently met by a $ million revolving credit facility with external lenders (in addition to borrowings from the PNMR group.) Q. ARE THERE OTHER REASONS THAT TNMP MUST MAINTAIN SOUND FINANCIAL CONDITION AND ACCESS TO FUNDING IN THE CAPITAL MARKET? A. Yes, natural disasters such as tornadoes or ice storms occasionally require TNMP to make extraordinary and unexpected expenditures to restore service, and to do so, the Company must maintain strong credit with its counterparties, including the vendors of equipment, work crews, and providers of emergency services and its banks, so that it can carry out an immediate restoration effort. Maintaining sound credit ratings will assure customers that their utility has the financial capability to expand service to new customers as needed, maintain safe and reliable service, comply with government mandates, and respond promptly to emergencies. A financially sound utility is able to finance at reasonable terms in all parts of the capital market cycle, not only in good times, but also when capital markets are stressed, as was the case in In summary, electric consumers and the public interest will benefit from the utility s financial soundness, liquidity, and open access to capital. 0 IV. TNMP S CURRENT FINANCIAL STATUS 0 Q. WHAT OBJECTIVE MEASURES OF CORPORATE FINANCIAL STRENGTH ARE RECOGNIZED BY BANKERS, CREDIT COUNTERPARTIES, AND INVESTORS? A. Credit rating agencies evaluate the business and financial characteristics and risks of companies against transparent criteria, taking into consideration key factors such as the stability and predictability of operating cash flow and the amount of debt and other financial commitments. They express their evaluation of a company s credit-worthiness by assigning a long-term credit rating that informs investors and bankers of the agencies view of each rated company s risk of default on payments. Such credit ratings by recognized credit rating agencies

11 0 permit the comparison of companies relative to one another by reference to known and transparent standards. Credit ratings from major rating agencies are widely accepted in the financial marketplace as indicators of credit-worthiness and as a means to compare companies financial soundness and liquidity. Q. WHAT ARE TNMP S CURRENT LONG-TERM CREDIT RATINGS BY MOODY S AND S&P? A. Moody s publishes a Long-Term ( LT ) Issuer Rating and S&P publishes a longterm Issuer Credit Rating, each of which represents the credit agency s view of the unsecured creditworthiness of the Company. In the case of Moody s, the LT Issuer Rating reflects TNMP s stand-alone financial condition. S&P s Issuer Credit Rating for TNMP reflects its view of the consolidated financial condition of all the companies in the PNMR ownership group, but S&P also reports a Stand- Alone Credit Profile ( SACP ) for TNMP that investors and bankers use as a relevant indicator of an operating subsidiary s individual financial condition and credit-worthiness. S&P s SACP of a for TNMP is one rating notch higher than Moody s A LT Issuer Credit Rating for TNMP, but these ratings are sufficiently close that they corroborate one another. Table below lists TNMP s credit ratings. Exhibit EL- shows the correspondence of the rating scales and symbols used by Moody s and S&P. 0

12 0 0 Q. Table : TNMP's Current Credit Ratings * S&P s Stand-Alone Credit Profile reflects the individual financial condition of TNMP, separate from credit influence from its parent or affiliates; in effect, this is comparable to Moody s Issuer Rating. ** Changed to Negative from Stable on Jan., 0. CURRENTLY, HOW DO TNMP S INDIVIDUAL CREDIT RATINGS COMPARE WITH THOSE OF OTHER U.S. INVESTOR-OWNED ELECTRIC UTILITIES? A. As shown in Table below, TNMP s Issuer Rating of A from Moody s (effectively similar to a rating of A- from S&P) is in the middle-tier of investment grade ratings. Moody s S&P Issuer Rating A BBB+ Stand-Alone a Credit Profile (S&P); * Unsecured Debt none none Secured Debt A A Rating Outlook Stable Negative ** Compared with its peer rate-regulated U.S. utility operating companies, these ratings indicate a sound financial condition that is consistent with the average for its sector. Thirty-eight percent of companies in the universe of utility operating companies are more highly rated, and % of the companies in the sector have lower ratings than TNMP. Additional details on the credit ratings of the universe of peer utilities appear in Exhibit EL-.

13 Table : Moody's Ratings Distribution, U.S. Utility Operating Companies Moody's LT Issuer Ratings at March 0, 0 Size of Sample: utility operating companies* Companies % A or A % A (Sector Median) % Baa % Baa % Baa or lower % Total 00% 0 0 Average A Median A * Investor-owned U.S. rate-regulated utilities, including integrated electric utilities, electric distribution utilities, combination electric & gas companies, and natural gas distribution companies. Q. HAS TNMP ALWAYS ENJOYED STRONG INDIVIDUAL CREDIT RATINGS? A. No. In fact, in the decade prior to May 00, TNMP s credit ratings by Moody s were in the sub-investment category for seven out of ten years, and were no higher than Baa (Moody s lowest investment grade category) from 00 until November 0. TNMP s financial status has improved considerably since 0, with the Moody s rating rising two notches from Baa to Baa in January 0 and to A in 0, where it is currently. There have been benefits to TNMP s customers from the improvement in the Company s financial status. TNMP s unsecured debt rating was Baa by Moody s in 00-00, during a period of financial distress. Because of its low credit rating at that time, TNMP was not able to carry out needed bond financing in 00, and had to wait until 00 in order to enter the debt market. TNMP issued secured debt rather than unsecured debt and paid a high coupon rate, due to investors reluctance to lend to low-rated companies. TNMP has much better financial flexibility today due to its improved financial status since 0. TNMP s increasing the equity portion of its actual capital structure, following authorization of the %/% structure in 0

14 0 0 early 0, to its actual level of % today, has been a significant factor in that improvement. Q. WHY IS IT DESIRABLE FOR A UTILITY TO MAINTAIN CREDIT RATINGS THAT ARE AT LEAST EQUAL TO THE MEDIAN AMONG ITS PEER GROUP? A. Companies with ratings that are in the middle range of the investment grade (in the single-a category of each of the rating agencies) and in the middle of the range of companies within the utility sector have good access to funding in all parts of the capital market cycle. At the trough of the financial cycle, companies with weaker financial condition and lower ratings may not be able to extend or expand their credit facilities or refund maturing bonds in sizable amounts, or will pay a stiff price to do so. Q. PLEASE EXPLAIN THE FINANCIAL BENCHMARK RATIOS USED BY THE CREDIT RATINGS AGENCIES TO EVALUATE TNMP S FINANCIAL STRENGTH AND SUSTAINABILITY. A. S&P and Moody s each have published rating criteria that specify the benchmark financial ratios that the agency uses to evaluate a utility s financial strength or financial risk. Although each rating agency uses its own terminology to describe its benchmark ratios, nonetheless there are common elements in both sets of financial guidelines. The most important financial ratios considered by each rating agency and most often cited in explaining the rationale for future rating changes are debt leverage ratios, generally based upon ongoing cash flow. For convenience, I call these the Cash Flow Leverage Metrics; they are ratios that compare a company s debt with an annual measure of cash flow from operations. Table lists the most important financial ratios in the rating rationales and commentaries of S&P and Moody s. Of the five ratios, four are Cash Flow Leverage Metrics, while Moody s adds one balance sheet capitalization ratio. The ratios indicated in Table are worthy of note, because they are most frequently cited by the credit rating agencies in explaining the

15 0 Q. rationale for rating decisions. In addition, S&P and Moody s each maintain ancillary financial ratio guidelines for supplemental financial ratios. Rating Name of Ratio Agency Moody s CFO pre-wc / Debt Moody s Moody s CFO pre-wc less Dividends/ Debt Debt to Total Capital Table : Key Financial Ratios Ratio Components Numerator: Cash flow from operations before changes in working capital ( CFO per-wc ) derived from the accounting Statement of Cash Flows; Denominator: Total debt and debt-like obligations Numerator: Same as above, less dividends; Denominator Total debt and debt-like obligations Numerator: Total debt; Denominator: Total debt plus equity [plus deferred taxes?] S&P Debt/EBITDA Numerator: Total debt and debt-like obligations; Denominator: Earnings before interest, income tax, depreciation & amortization ( EBITDA ), a measure of cash flow derived from the Income Statement. S&P FFO/Debt Numerator: Funds from operations ( FFO ) is EBITDA less interest and income taxes paid. Denominator: Total debt and debt-like obligations. S&P CFO/ Debt Numerator: Operating cash flow from Statement of Cash Flow. Denominator: Total debt and debt-like obligations. ARE TNMP S RECENT FINANCIAL METRICS CONSISTENT WITH THE COMPANY S CURRENT CREDIT RATINGS? A. Yes. TNMP s most important Cash Flow Leverage Metrics as calculated by the rating agencies are set forth in Table below, along with the agencies benchmarks for the current Issuer Rating in the case of Moody s and the current SACP in the case of S&P. For example, both agencies have benchmark interest coverage ratios that are based on measures of cash flow: EBITDA divided by interest expense (S&P), and CFO pre-wc divided by interest expense (Moody s). The interest coverage guidelines are not influential in determining the ratings of investment grade companies in the prevailing low interest rate environment, except in the case of highly leveraged companies.

16 0 Table : TNMP Key Ratios and Rating Agency Benchmarks Moody's Benchmarks Low Business Risk Table Baa Moody's (a) 0 0 A Category Category CFO pre WC/ Debt.%.% -% -% (CFO pre WC Div.)/ Debt.%.% -% -% S&P Benchmarks: Medial Volatility Table S&P (b) 0 Est. 0 Est. 0 Intermediate Significant Aggressive FFO/ Debt -% -%.% -% -% - % Debt/EBITDA to.. to.. to. Corresponding SACP rating with Excellent business risk a a- bbb (a) Moody's Credit Opinion, June 0. (b) S&P Research Summary, May 0. Table illustrates that TNMP s cash flow leverage metrics for 0-0 were in the middle of Moody s benchmarks for the A-rating category, suggesting a rating of A. However, Moody s Credit Opinion of June 0 explains that Moody s expected that TNMP s cash flow leverage metrics would likely weaken in 0-0 because of heightened capital expenditures and related external financing needs. Moody s Credit Opinion comments that the rating was set at A rather than A; TNMP s financial ratios were strong for the current A rating. We expect TNMP s financial metrics to moderately decline from these levels going forward as TNMP increases its debt levels to help fund higher capital expenditures. 0 Moody s discloses in this Credit Update that the rating would be lowered if the regulatory environment were seen to be less supportive, or if the ratio of CFO pre-wc/ Debt were to shrink to the mid-teens for a sustained time. 0 Exhibit EL-: Moody s Investors Service, Credit Opinion: Texas-New Mexico Power Company, June 0, at. Ibid., Factors that Could Lead to a Downgrade, at.

17 0 0 Comparing TNMP s financial ratios with S&P s benchmarks using the medial volatility grid, TNMP s ratio of FFO/Debt was consistent with a financial assessment of Intermediate, and the ratio of Debt/EBITDA was very favorably positioned within the Intermediate range. S&P noted that it placed the Company s SACP rating at a, rather than a+, because S&P expected TNMP s financial measures will trend toward the lower end of the intermediate financial risk profile category beginning in 0. Q. WHEN MOODY S AND S&P STATED IN 0 CREDIT REPORTS THEIR EXPECTATIONS THAT TNMP S CREDIT METRICS WOULD WEAKEN IN 0-00, WAS THIS BASED ON ANTICIPATING THE IMPACTS OF THE PASSAGE OF TAX REFORM LEGISLATION AND RELATED EFFECTS TNMP S REGULATORY ACCOUNTS AND FUTURE CASH FLOWS? A. No. Neither Moody s nor S&P had advance knowledge in 0 about the passage of a sweeping tax reform law when they wrote, and they certainly had no way to predict the details of the law, TCJA, as it would affect rate-regulated utilities. The known factors in 0 when S&P and Moody s published their credit reviews of TNMP were: () the projected increase in TNMP s annual capital expenditures; and () the expectation of 0% bonus depreciation in effect for federal income taxes for 0, followed by the elimination of bonus depreciation in 0. V. EXPECTED IMPACT OF TAX REFORM ON CASH FLOW METRICS Q. HOW DOES THE PASSAGE OF THE TCJA AFFECT RATE REGULATED UTILITIES? A. The TCJA sets in place a permanent reduction in the statutory tax rate for corporations to %, with statutory provisions requiring that excess tax reserves associated with public utility property be normalized. Under the law, there are limits on the deduction for interest expense, with an exception for interest expense appropriately allocated to property subject to public service rate regulation. While the TCJA will expand first-year bonus depreciation for most Exhibit EL-: Standard & Poor s Research, Summary: Texas-New Mexico Power Co, April 0, at.

18 0 0 0 industries, it does not permit the use of bonus depreciation for rate regulated utility properties (i.e., properties eligible for the deduction of interest expense without limit.) Q. ARE UTILITIES CASH FLOW AND CREDIT-WORTHINESS AFFECTED BY THE PASSAGE OF TCJA? A. Yes. For a company that is not a rate-regulated utility, the reduction of the corporate tax rate from % to % means that if the company maintains its existing pricing to customers after tax reform, it will earn additional after-tax profits due to the lower tax rate. In many or most cases, this will result in increased cash flow coverage of the company s debt and improve such a company s credit quality. On the other hand, for utilities whose prices are determined by a regulatory authority based upon the cost-of-service model, the tax reduction will typically be flowed back to customers in the form of lower customer rates. For TNMP, directing the benefits of the tax reform to customers rates will benefit TNMP s utility customers, but the related reduction in deferred taxes will have the consequence of reducing TNMP s operating cash flow available to cover payments of interest or principal on the Company s debt obligations. That may expose TNMP to future credit rating downgrades and reduce the Company s financial strength and resilience. Q. HAVE CREDIT RATING AGENCIES IDENTIFIED RISKS TO THE FINANCIAL WELL-BEING OF RATE-REGULATED UTILITIES STEMMING FROM THE TCJA AND THE RESULTING CHANGES IN THE CORPORATE INCOME TAX? A. Yes. All three of the leading credit rating agencies, Moody s, S&P, and Fitch Ratings, published sector reports in January 0 predicting that rate-regulated utilities would experience lower cash flow in the period 0-0 following the implementation of the TCJA, and in some cases this would result in lower rating for utilities if the companies had no way to offset the reduction in operating cash flow resulting from tax reform.

19 0 0 0 For example, in a release published on January, 0, Moody s explains why TCJA will have adverse credit consequences for rate-regulated U.S. utilities: Tax reform is credit negative for US regulated utilities because the lower % statutory tax rate reduces cash collected from customers, while the loss of bonus depreciation reduces tax deferrals, all else being equal. Moody's calculates that the recent changes in tax laws will dilute a utility's ratio of cash flow before changes in working capital to debt by approximately 0-0 basis points on average, depending to some degree on the size of the company's capital expenditure programs. From a leverage perspective, Moody's estimates that debt to total capitalization ratios will increase, based on the lower value of deferred tax liabilities. S&P published a report on January, 0 stating that the tax reform act will likely have negative rating consequences for many rate-regulated utilities: The impact of tax reform on utilities is likely to be negative to varying degrees depending on a company's tax position going into 0, how its regulators react, and how the company reacts in return. It is negative for credit quality because the combination of a lower tax rate and the loss of stimulus provisions related to bonus depreciation or full expensing of capital spending will create headwinds in operating cash-flow generation capabilities as customer rates are lowered in response to the new tax code. The impact could be sharpened or softened by regulators depending on how much they want to lower utility rates immediately instead of using some of the lower revenue requirement from tax reform to allow the utility to retain the cash for infrastructure investment or other expenses. Regulators must also recognize that tax reform is a strain on utility credit quality, and we expect companies to request stronger capital structures and other means to offset some of the negative impact. Fitch Ratings, the third major U.S. credit rating agency, reported on January, 0, that the TCJA has negative credit implications for U.S. regulated utilities and will reduce the financial credit measures of utilities, unless the utilities and Moody s. Rating Action: Moody s Changes Outlooks on U.S. Regulated Utilities Primarily Affected by Tax Reform, January 0, at. (Exhibit EL-). See also: Moody s Sector Comment, Regulated Utilities, US, Tax Reform is Credit Negative for Sector, but Impact Varies by Company, January 0, (Exhibit EL-A). S&P Global Market Intelligence, U.S. Tax Reform: For Utilities' Credit Quality, Challenges Abound, January 0, at (Exhibit EL-).

20 0 0 their regulatory bodies take actions that preserve the credit-worthiness of the utility. Fitch states that for a broad sample of 0 companies in the utility sector, the revenue reduction associated with the tax reduction translates to an approximately % reduction in FFO that drives a basis point increase in FFO-adjusted leverage across our sample. Q. IF MANY OR MOST RATE-REGULATED UTILITIES WILL EXPERIENCE REDUCED OPERATING CASH FLOWS DUE TO TCJA, WILL RATING AGENCIES ADJUST THEIR CREDIT METRIC BENCHMARKS TO MAKE THEIR BENCHMARKS MORE LENIENT FOR UTILITIES? A. No. They will not change their benchmarks. Rating agencies evaluate the credit of companies in many countries and across different sectors using published benchmarks, with the goal of applying known standards in an objective way across all companies and thus providing objective information to investors. Investors are not obliged to invest in the bonds of U.S. utilities, and may choose to shun that sector and to prefer companies in other sectors who are in more favorable circumstances. Q. EACH OF THE REPORTS YOU HAVE JUST CITED STATES THAT THE ADVERSE CASH FLOW EFFECT COULD BE OFFSET IN PART OR IN WHOLE BY ACTIONS BY REGULATORY COMMISSIONS. WHAT SORTS OF ACTIONS BY REGULATORY AUTHORITIES WOULD PROVIDE SUCH OFFSETS? A. Moody s comments in its release of January, 0: Potential regulatory offsets to tax-related cash leakage could include: accelerated cost recovery of certain regulatory assets or future investment; changes to the equity layer or allowed ROEs in rates, and other actions. On a similar theme, S&P comments: Fitch Ratings, Tax Reform Creates Near-Term Credit Pressure for Regulated Utilities and Holding Companies, January 0 at. (Exhibit EL-). Exhibit EL- at -.

21 0 0 VI. The impact [of reduced utility cash flow] could be sharpened or softened by regulators depending on how much they want to lower utility rates immediately instead of using some of the lower revenue requirement from tax reform to allow the utility to retain the cash for infrastructure investment or other expenses. Regulators must also recognize that tax reform is a strain on utility credit quality, and we expect companies to request stronger capital structures and other means to offset some of the negative impact. The Fitch report lists a number of measures that utilities may request and regulatory authorities may implement to offset in part the adverse cash flow effects of tax reform: Some jurisdictions may be open to a negotiated outcome that focuses more on benefits of rate stability and creditworthy utilities rather than immediate rate reductions. In the former, many tools could be employed, including the following: Deferral of lower tax expense to use as an offset to expected future rate increases, either from the recovery of regulatory deferrals or rate base growth Return of excess unprotected Accumulated Deferred Income Taxes ( ADIT ) over a longer-term horizon Increase in authorized equity ratio and/or return on equity Accelerated depreciation on some assets Lower capex. REGULATORY TREATMENTS REQUESTED BY TNMP 0 Q. IN THIS RATE PROCEEDING, HAS TNMP REQUESTED ANY REGULATORY TREATMENTS OR MECHANISMS THAT MAY MITIGATE OR OFFSET THE LIKELY DECLINE IN TNMPS KEY CASH FLOW CREDIT METRICS? A. Yes. The requested mechanisms include the following: () Deferred Taxes: Flow back excess deferred taxes for the benefit of customers by amortizing non-plant unprotected ADIT over years; () Capital Structure: Increase the ratio of common equity to capital to 0%; Exhibit EL- at. Exhibit EL- at. Protected ADIT will be amortized over the remaining life of the assets, protecting the ability to use normalization and avoiding related penalties. Unprotected ADIT related to plant also will be amortized over the remaining life of those assets.

22 0 0 () Cost of Equity: Determine the cost of equity of 0.% as recommended by Company witness Robert Hevert. In addition to the above, there are several factors involved in this proceeding that could have important cash flow implications, although they are not stimulated by the TCJA or cash flow motivations. An unfavorable determination by the Commission could have adverse effects on TNMP s operating cash flow and Cash Flow Leverage Metrics. These are: () Depreciation: Implement the revised depreciation schedule as in the testimony of Company witness Dane Watson; () Advanced metering systems ( AMS ): Move the recovery of remaining AMS revenue requirement from the current rider into base rates and amortize the balance over five years, and amortize under-collection of reconciled AMS costs over five years; () Storm Costs: Amortize the restoration costs associated with Hurricane Harvey over five years; Q. PLEASE EXPLAIN HOW EACH OF THE TREATMENTS YOU HAVE LISTED WILL AFFECT TNMP S CASH FLOW LEVERAGE METRICS. A. All of the requested regulatory treatments will boost Cash Flow Leverage Metrics, either by reducing debt or by enhancing operating cash flow (EBITDA, FFO, and CFO pre-wc). Reducing debt is a powerful way to reduce debt leverage, since debt appears as either numerator or denominator in each of the key ratios used in the rating agencies financial evaluation. Since cash flow measures of EBITDA, FFO, and CFO pre-wc appear either as the numerator or denominator in all Cash Flow Leverage Metrics, enhancing cash flow will also improve the rating agencies key measures of leverage. The table below summarizes the effects of each requested regulatory treatment.

23 Table : Regulatory Treatments Requested: Impact on Cash Flow Leverage Metrics Excess Deferred Taxes Impact of Requested Treatment Increase Reduce EBITD A, FFO CFO PRE- WC Debt year amortization of excess non-plant unprotected ADIT (versus faster amortization) Capital Structure Increase in equity ratio to 0% reduces debt from -% to 0% * * Cost of Equity Implement requested ROE * Increasing the equity ratio by % and reducing debt by a like amount would also have a very small secondary effect to increase EBITDA and CFO pre-wc. VII. ANALYSIS OF FINANCIAL SCENARIOS 0 0 Q. WHAT IS THE STUDY YOU PERFORMED OF THE EXPECTED FUTURE OPERATING CASH FLOW AND RELATED CREDIT METRICS OF TNMP SHOWING THE EFFECTS WITH AND WITHOUT THE REQUESTED RATE CASE? A. I conducted an analysis based on a financial forecast using TNMP s forecasting model, in two forecast scenarios, whose assumptions are compared in Table. Scenario : Implements TNMP s requested rate increase and the regulatory treatments TNMP has proposed, as described in the prior section of my testimony. Scenario : This forecast assumes that the requested rate increase and regulatory mechanisms that TNMP has requested in its application are not implemented, but unlike the No Rate Case scenario that is portrayed in TNMP s Highly Confidential Schedule II-C-., this scenario assumes that TNMP would nonetheless be required to flow back to customers the lower tax rate and other changes relating to the TCJA. Highly Confidential Exhibit EL- presents the full study. 0

24 0 Q. Table : Comparing Assumptions in Scenarios and Scenario Scenario With rate increase Without rate increase TCJA - Tax Rate %, passed to customers %, passed to customers TCJA - Excess Deferred Protected ADIT and Plant-Related Unprotected ADIT Amortize years Amortize years TCJA -Excess Deferred Unprotected ADIT (nonplant) Amortize years Amortize years Capital Structure Equity % of Capital 0% % Depreciation schedule Proposed Rates Current Rates AMS Rider 0 Shift to Base Rates, AMS True-up Regulatory Asset amortize years Amortize over years, starting 00 Continue current rider Extend current rider ROE () 0.0% 0.% ROE ().% Storm Costs - Harvey Rider, amortize years Continue to defer PLEASE SUMMARIZE THE RESULTS OF SCENARIO IN TERMS OF TNMP S KEY FINANCIAL RATIOS. A. In Scenario, we applied the requested rate increase and regulatory treatments, Q. and equity contributions from TNMP s parent to increase the common equity ratio; this reduced the balance of debt. In this scenario, TNMP s credit metrics decline in 0, before the effective date of the rate changes, but the credit metrics are restored in 0-00 to levels that are consistent with the current credit ratings. With a dip in the financial ratios for only one year, it is probable that Moody s and S&P would retain the current ratings. WHAT ARE THE RESULTS OF SCENARIO? A. In Scenario, without the requested rate increase and regulatory mechanisms, there is a notable decline in TNMP s cash flow and a more pronounced deterioration of the key Cash Flow Leverage Metrics. The decline in the credit 0 See testimony of TNMP witness Emmanuel J. Lopez for explanation of AMS Rider and AMS True Up Regulatory Asset.

25 0 0 metrics is driven by an increase of debt by 00 and a reduction in cash flow relating to tax reform in 0 and 00, as in Highly Confidential Exhibit EL-.A. Q. WHAT ARE THE IMPLICATIONS OF SCENARIO FOR TNMP S CREDIT RATINGS? A. The lower credit metrics in 0-00 would justify a downgrade by Moody s from A to Baa, and a decline in TNMP s stand-alone credit profile by S&P from a to a- or bbb+ Moody s: In its June 0 report, Moody s expressed a stable rating outlook for TNMP based on the expectation that financial metrics will remain stable including a ratio of CFO pre-w/c to debt of about 0% ; furthermore, the Moody s analyst assumed that planned capital expenditures will be financed in a balanced manner that is consistent with TNMP's current capital structure. In Scenario, neither of these expectations would be met. Without the addition to equity capital that is reflected in Scenario, debt leverage in TNMP s capital structure would increase materially, as illustrated in Highly Confidential Exhibit EL-.B. S&P: We compared the forecasted credit ratios that result in Scenario, to the credit ratios that S&P s analyst expected for 0 and 00 in a credit research summary published in May 0. The forecasted key credit ratios in Scenario are significantly weaker than the ratios predicted by the S&P analyst for 0, and they stay well below those predicted for 0 and 00. The two S&P core ratios (FFO/Debt and Debt/EBITDA) continue to worsen from year to year. The ratios in Scenario are consistent with the S&P rating of a-, at least a one notch downgrade from the current rating of a, and the important ratio of Debt/EBITDA is consistent with the rating of bbb+. Exhibit EL- at. Exhibit EL -A at.

26 In summary, the elements sought by TNMP in its rate application would likely preserve and maintain the Company s current sound financial condition and strong individual credit ratings through a period of expected continued substantial capital expenditures. In Scenario, with the loss in cash flow relating to TCJA and without the mitigating regulatory treatments requested in the rate application, TNMP s financial condition would weaken, and its credit ratings would likely decline by one or two notches. Table : Comparing the Credit Rating Implications of Scenarios and Current Scenario Scenario with Rate Case No Rate Case* Rating S&P SACP a a a- or bbb+ Outlook Negative Moody's Issuer Rating A A Baa or Baa Outlook Stable SACP - Stand-alone Credit Profile * Assumes net tax effects of TCJA are returned to customers 0 VIII. CONCLUSION 0 Q. PLEASE SUMMARIZE YOUR RECOMMENDATIONS. A. Since the constructive settlement that was reached in Docket No. 0 in 00, TNMP has progressively strengthened its financial condition and standing in the financial market, and this has been to the benefit of its customers. Increasing the common equity ratio to % at that time permitted TNMP to improve its financial standing and achieve higher credit ratings. As a result, TNMP obtained access to capital on a favorable basis and without constraints, which has allowed the Company to invest in improving its network and raising the quality and reliability of service to its customers. Financial strength and stability are fundamental to the task of running an electric distribution utility with an ongoing obligation to meet customers needs for high quality and reliable service. The implementation

27 of tax reform will lower TNMP s cash flows over the years 0-00, which may cause TNMP to reverse some of the progress that it has made to achieve its current sound financial status. It is important for the Commission to use this opportunity to prevent erosion of TNMP s cash flow and financial standing by approving the requested regulatory mechanisms that will sustain TNMP s Cash Flow Leverage Ratios and individual financial strength. Q. DOES THIS CONCLUDE YOUR DIRECT TESTIMONY? A. Yes.