BEFORE THE PENNSYLVANIA PUBLIC UTILITY COMMISSION METROPOLITAN EDISON COMPANY DOCKET NO. R Direct Testimony of Jeffrey L.

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1 Met-Ed Statement No. 5 BEFORE THE PENNSYLVANIA PUBLIC UTILITY COMMISSION METROPOLITAN EDISON COMPANY DOCKET NO. R Direct Testimony of Jeffrey L. Adams List of Topics Addressed Cash Working Capital

2 TABLE OF CONTENTS Page I. INTRODUCTION AND PURPOSE... 1 II. CASH WORKING CAPITAL - OVERVIEW... 3 III. SUMMARY OF CASH WORKING CAPITAL REQUIREMENTS i-

3 1 2 3 DIRECT TESTIMONY OF JEFFREY L. ADAMS 4 5 I. INTRODUCTION AND PURPOSE Q. Please state your name and business address. A. My name is Jeffrey L. Adams and my business address is Fairmont Avenue, 7 Fairmont, West Virginia Q. By whom are you employed and in what capacity? A. I am employed by FirstEnergy Service Company as a State Regulatory 9 Analyst in the Rates and Regulatory Affairs Department West Virginia/Maryland Q. What are your responsibilities as a State Regulatory Analyst? A. My duties and responsibilities include analysis of rates and regulatory 12 activities primarily in West Virginia and Maryland as well as regulatory activities13throughout the FirstEnergy 14 Corp. ( FirstEnergy ) service territories. 15 Q. What is your educational background? A. I am a 1980 graduate of Fairmont State University (then College) 16 with a Bachelor of Science degree in Business Administration and a 1990 graduate 17 of West Virginia Wesleyan College with a Master s in Business Administration. 18 I am a Certified Public Accountant in West Virginia and a member of the West Virginia 19 Society of Certified Public Accountants. I have been awarded the professional designation 20 Certified Rate of Return Analyst ( CRRA ) by the Society of Utility and Regulatory 21 Financial Analysts.

4 The CRRA designation is awarded based upon experience and1successful completion of a written examination. I have been employed by FirstEnergy or 2its predecessor companies since 1981 when I began my employment with Monongahela Power 3 Company as an Accounting Technician in Plant Accounting. I have worked as4 an Accountant or Analyst in various departments including Rates and Customer Accounting 5 and as the Staff 6 Assistant to the Controller. 7 8 Q. Have you previously testified in Pennsylvania Public Utility Commission ( Commission ) proceedings? A. While I have not testified before this Commission, I have presented 9 testimony on behalf of several other FirstEnergy operating companies before the Public 10 Service Commission of West Virginia, the New Jersey Board of Public Utilities, and 11the Public Utilities 12 Commission of Ohio. 13 Q. On whose behalf are you testifying in this proceeding? A. I am testifying on behalf of Metropolitan Edison Company ( Met-Ed 14 or the 15 Company ). 16 Q. Mr. Adams, have you prepared any exhibits to accompany your testimony? A. Yes. Met-Ed Exhibit JLA-1 was prepared by me or under my17supervision and is 18 described in detail in my testimony. 19 Q. What is the purpose of your direct testimony? 2

5 A. The purpose of my direct testimony is to describe the process used 1 to determine the total 2 cash working capital requirement of the Company, as shown on page 1 of Exhibit JLA-1. 3 II. CASH WORKING CAPITAL - OVERVIEW 4 Q. Please define cash working capital as it pertains to ratemaking. A. For ratemaking purposes, cash working capital is generally defined 5 as the average amount of capital provided by investors, over and above the investment 6 in plant and other specifically identified rate base items, to bridge the gap between 7 the time expenditures are required to be made by the Company to provide service and8 the time collections are received for that service from customers. Cash working capital 9 is determined for ratemaking purposes by a lead/lag study. Q. Please define the terms lead and lag as used in your testimony and explain how each is calculated. A. In general, a lead or a lag measures the time that elapses between 13 receipt of a product or service and receipt of compensation by the party providing that 14product or service. A lead occurs when payment is made in advance of receiving a 15 product or service. A lag occurs when payment for a product or service occurs after the16 product has been received or service has been rendered. Exhibit JLA-1, page 1, quantifies 17 lead or lag time in days; positive net lags shown in column 9 increase cash working capital 18 while negative net leads shown in column 9 reduce cash working capital. Q. What time period was used for the Company s lead/lag study? 3

6 A. The individual leads and lags were developed using data for the 1 twelve months ended December 31, The leads and lags thus developed were applied 2 to the projected financial data for the twelve months ending December 31, Q. What was the source of the relevant data used to calculate cash working capital? A. For the most part, I used financial data for the fully projected future 5 test year that underlie the development of the Company s revenue requirement shown6 in exhibits accompanying Met-Ed Statement No. 2, the direct testimony of Richard A. D Angelo. 7 However, the determination of cash working capital and the development of 8revenue requirement are interdependent because changes in cash working capital will affect 9 rate base and net income. Performing the cash working capital and revenue requirement 10 calculations on an iterative basis reduces, but does not eliminate, the impact of that 11 interdependence. Appropriate adjustments to the pro forma distribution revenue, 12federal and state income taxes, and Pennsylvania gross receipts taxes were made in my13cash working capital 14 calculations to account for that interdependence Q. Have you prepared a summary showing each of the components that comprise the total cash working capital for the Company? A. Yes, I have. Page 1 of Exhibit JLA-1 shows each component17 of the total cash working capital requirement. The Revenue Lag of days, as shown 18 at line 4, column 7, is a weighted composite of Electric Revenue lag of 68.39, Sales for 19Resale lag of 15.74, and Other Operating Revenue lag of The leads or lags for 20 the various grouping of expenses and taxes are shown in column 8. The net leads or lags, 21 as shown in column 9, are the result of subtracting column 8 from column 7. The net 22leads or lags are then 4

7 multiplied by the average daily amounts for each of the various1 expenses or tax items. The results are added and the sum is the Net Cash Working Capital 2 requirement of $80,049,000, as shown at line 23, column 10 of Exhibit JLA-1. 3 Interest on Long Term Debt, Interest Expense on Customer Deposits, Prepayments and 4 Unamortized Cash Pension Contributions are also elements of cash working capital, 5 as shown at lines The sum of these items brings the Company s Total Cash Working 6 Capital requirement to $134,868,000, as shown at line 28, column 10 of the lead/lag7 study summary on 8 Exhibit JLA-1. 9 Q. How did you calculate the lag associated with Electric Revenue? A. Payment for electric service occurs after service is provided, which 10 produces a lag in receipt of revenues. To calculate total revenue lag, Electric Revenue 11 lag was calculated separately for the periods: (1) from billing to cash collection 12 ( Collection Lag ); (2) from meter reading to billing ( Billing Lag ); and (3) from the 13mid-point of the service 14 period to meter reading ( Service Period Lag ). Collection Lag is the period from mailing a customer s bill until 15 payment is received for that bill. This lag was calculated based on the turnover 16 in accounts receivable. The ratio of accounts receivable to total billed revenues 17 is divided into 365 days to derive the average number of days accounts receivable 18 are outstanding or, in other words, the average time between issuing 19 a bill and collecting a bill. That figure, in days, is the Collection Lag, which 20 is days 21 for Met-Ed. 5

8 Billing Lag is the period from the reading of a customer s meter 1 until the bill is mailed. Generally, the bill is prepared the same day the meter 2is read and is mailed the next day. However, there are exceptions. Reading 3the meters of large industrial customers can take an additional day because there is4 more work involved given the nature of the service such customers receive. 5 Also, weekends, holidays, and severe weather may add to the time to read and bill 6 customers. Accounting for these exceptions, the Company s Billing Lag is days. Service Period Lag is measured from the midpoint of the service 8 period to the date a meter is read. The service period lag covers the period in 9 which electric service was rendered, and was calculated using the Company s Meter Reading work schedule. That schedule shows that meters are11 typically read or estimated once a month, or twelve times per year, so the average 12 service period was determined to be days. The lag from the midpoint13 of the service period to the meter reading date was calculated to be days. This 14 calculation 15 assumes that electric usage is uniform throughout the month. The overall Electric Revenue lag, calculated as the sum of the16 Collection, Billing and Service Period Lags, as shown on page 2, at line 1 of Exhibit 17 JLA-1, is days. 19 Q. How did you calculate the lead or lag associated with Other Operating Revenue? A. The calculation of the Other Operating Revenue lag is shown20 on page 2 of Exhibit JLA-1, which lists each of the individual components of Other Operating 21 Revenue and their 6

9 respective lead or lag. Because late payment charges are included 1 in the accounts receivable used to calculate the Electric Revenue lag, the overall 2 Electric Revenue lag 3 was used for this component of Other Operating Revenues. 4 Q. Please explain the lead and lag associated with the Company s expenses. A. The Company tracks the various types of expenses through the5use of cost elements. Cost elements are groupings of similar type charges such as energy 6 purchases, payroll, contract labor, labor overheads, expenses for materials and supplies, 7 utilities, taxes, etc. The cost elements are then allocated to the appropriate FERC system 8 of accounts for reporting purposes. The payment patterns of the individual cost 9 elements are used to develop the expense portion of the study. The lags for the cost 10elements were dollar- weighted to develop weighted lags (expressed in dollar-days) 11 for each FERC account. Through the use of various methods, such as statistical sampling, 12 stratification and percentage of total charges, the study examined a substantial portion 13 of the charges for each cost element to ensure the data developed was reasonable 14and accurate. The leads and lags for the FERC accounts are shown on page 3 of Exhibit 15 JLA-1. Composite expense lead/lag factors were developed for the expense categories 16 shown on page 1 of Exhibit JLA-1. The development of the composite expense factors 17 are shown on page 3, 18 at lines 3, 41, 46, 52, and 64 of Exhibit JLA Q. How did you develop the lag in payment of pole rentals made to telecommunications companies and the lag in receipt of the rental revenues from those companies? A. The Company s payments to telecommunications companies 21 for its use of their poles and its receipts from telecommunications companies for their use22 of its poles are based on 7

10 contracts. The contracts and actual payment information were1analyzed and the lags were developed. The same lags were used for both revenues and expense. 2 3 Q. How did you calculate the lag for Uncollectible Accounts expense? A. The lag for uncollectible accounts has been recognized in the calculation 4 of the Collection Lag. The accounts receivable are reduced when uncollectible 5 accounts are written off, and thus reduces the Collection Lag. To also include 6 a lag for uncollectible accounts expense would lead to a double counting of this component. 7 8 Q. How did you calculate the leads and lags associated with Taxes? A. The weighted average lead or lag for each tax cost element was9 calculated in the same fashion as cost elements for all other expenses. The individual 10taxes are listed on page 4 of Exhibit JLA-1 for Taxes Other Than Income and page 5 of11 Exhibit JLA-1 for Federal and State Income taxes. The calculation of each weighted average 12 lead or lag is set forth on those pages. While the individual lags were used for Federal 13 and State Income taxes, a composite weighted lag of (86.20) was developed for Taxes14 Other Than Income and is 15 shown on page 4, at line 14, in column 2 of Exhibit JLA Q. Did you reflect the interest expense on customer deposits as a separate item in the study? A. Yes. Interest on customer deposits is reflected in the study as18 an expense with an average payment lag of days (365/2) because such interest is paid 19annually. Reflecting interest expense on customer deposits with a day lag results 20 in a reduction of $393,000 to cash working capital, as shown on page 1, at line21 25, in column 10 of Exhibit 8

11 1 2 3 JLA-1. Q. Why did you assign Depreciation, Amortization, Provision for Deferred Income Taxes and Investment Tax Credit a zero lag? A. These are considered non-cash items by the Commission. Therefore, 4 they were not included in calculating the cash working capital requirement, as 5 shown on page 1, at lines 6 10, 11, 17, 18, and 19 of Exhibit JLA-1. 7 Q. Why are Prepayments included in the Company s cash working capital claim? A. The Company pays certain costs before they are actually charged 8 to expense for accounting and ratemaking purposes. Prepayments are cash expenditures 9 that, while made in one period, are not charged to expense until a future 10 period due to accrual accounting. The claim for Prepayments is based on a thirteen-month 11 average of the various prepaid items, including Prepaid Commission Assessments, 12 Prepaid Property and Liability Insurance, Prepaid Edison Electric Institute Dues Assessments, 13 and Other Prepaid items, which include rating agency fees, financing fees, 14 line of credit fees, and trustee fees. The detailed calculations of Prepayments are shown 15 on page 6 of Exhibit 16 JLA Q. Please explain the basis for including Unamortized Cash Pension Contributions in the Company s cash working capital claim. A. In Met-Ed s 2006 base rate case, the Commission approved the 19recovery of pension expense calculated on the basis of a ten-year historical average 20of actual cash contributions. In its Final Order in that case, the Commission21 stated: 9

12 10 Fundamentally, we believe that, regarding the recovery1 of pension expense, the alternative method requested by MEPN [the 2 Companies] in this proceeding is fair to both ratepayers and stockholders. 3 The Companies normalization methodology will provide a more 4 consistent and less variable expense claim to be included within base 5 rates as compared to the more significant sums contributed in the 6 two years preceding the 2006 test year in this proceeding. Additionally, 7 we should not ignore this significant benefit to current and former employees 8 just because the Companies did not make a contribution to the 9 pension fund during any given year Q. How does recovering a cash contribution to the pension plan over a ten-year period create a working capital need? A. The Company has made large cash contributions to its pension 13trust fund over the last ten years. For ratemaking purposes, the Company recovers those14 cash outlays over ten years. Throughout those ten years, the Company bore the carrying costs 15 associated with the prior period expenditures that it made but has not recovered in16base rates. That unrecovered amount constitutes the Unamortized Cash Pension 17Contribution that forms the basis for the Company s claim, as shown on page 7 of Exhibit 18 JLA Q. Did you consider the effect of the earnings on the pension trust fund in your cash working capital claim? A. Yes. The average earnings on the pension trust fund are reflected 21 in the calculation of the amount of cash contributions and, in that way, reduce the cash22contribution. Stated another way, earnings on the cash contributions accrue to the23 benefit of the fund, reduce the Company s contribution obligations, and thereby provide24 an upfront benefit to 25 customers. 1 Pa. PUC v. Metropolitan Edison Company, Pennsylvania Electric Company, Docket Nos. R , et. al., p. 92 (Order entered January 11, 2007). 10

13 1 2 Q. Was Pension expense included in the Company s cash working capital requirement as a component of its lead/lag study? A. No, it was not. Pension expense is reflected in the cash working 3 capital requirement only once, through the Unamortized Cash Pension Contribution Balance 4 I described above. 5 III. SUMMARY OF CASH WORKING CAPITAL REQUIREMENTS 6 Q. Please summarize your testimony and recommendations. A. Met Ed has supported a total cash working capital requirement7of $134,868,000, as 8 shown on page 1, at line 28 of Exhibit JLA Q. Mr. Adams, does this complete your direct testimony? A. Yes, it does. DB1/

BEFORE THE PENNSYLVANIA PUBLIC UTILITY COMMISSION. PENNSYLVANIA POWER COMPANY Docket No. R Direct Testimony of Richard A.

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