Before the Minnesota Public Utilities Commission State of Minnesota. Docket No. E002/GR Exhibit (JMC-2) Return on Equity

Transcription

1 Rebuttal Testimony James M. Coyne Before the Minnesota Public Utilities Commission State of Minnesota In the Matter of the Application of Northern States Power Company for Authority to Increase Rates for Electric Service in Minnesota Docket No. E00/GR-1- Exhibit (JMC-) Return on Equity September, 01

2 Table of Contents I. Introduction 1 II. Response to the Direct Testimony of Mr. Lebens i i Docket No. E00/GR-1-

3 I. INTRODUCTION Q. PLEASE STATE YOUR NAME AND BUSINESS ADDRESS. A. My name is James M. Coyne, and I am employed by Concentric Energy Advisors, Inc. ( Concentric ) as a Senior Vice President. Concentric is a management consulting and economic advisory firm, focused on the North American energy and water industries. Based in Marlborough, Massachusetts and Washington D.C., Concentric specializes in regulatory and litigation support, financial advisory services, energy market strategies, market assessments, energy commodity contracting and procurement, economic feasibility studies, and capital market analyses. My business address is Boston Post Road West, Suite 00, Marlborough, MA 01. Q. HAVE YOU PREVIOUSLY PROVIDED TESTIMONY IN THIS PROCEEDING? A. Yes. I filed Direct Testimony on behalf of Northern States Power Company ( Xcel Energy or the Company ) presenting evidence and providing a recommendation regarding an appropriate return on equity ("ROE") 1 for the Company s regulated electric utility operations in Minnesota. Q. DID ANY INTERVENORS PROVIDE DIRECT TESTIMONY REGARDING ROE TOPICS INCLUDED IN YOUR DIRECT TESTIMONY? A. Yes. The following witnesses provided testimony related to the Company s proposed ROE as discussed in my Direct Testimony: 1 I use the terms ROE and cost of equity interchangeably throughout my Rebuttal Testimony. 1 Docket No. E00/GR-1-

4 Minnesota Department of Commerce, Division of Energy Resources ( Department ) witness Craig M. Addonizio; Office of the Attorney General Antitrust and Utilities Division ( OAG ) witness Brian Philip Lebens; Xcel Large Industrial Customers ( XLI ) witness Billie S. LaConte; The Commercial Group ( CG ) witness Steve W. Chriss; and Minnesota Chamber of Commerce ( MCC ) witness Kavita Maini. Q. SINCE THE FILING OF THAT TESTIMONY, HAS THE COMPANY REACHED AGREEMENT WITH SEVERAL OF THE INTERVENORS ON THE ISSUES RELATED TO THE COMPANY S OVERALL REVENUE REQUIREMENTS, INCLUDING THE OVERALL COST OF CAPITAL FOR THE COMPANY AND THE RETURN ON EQUITY? A. Yes. It is my understanding that the Company and eight of the intervening parties, including the Department, XLI, CG and MCC, have entered into a Settlement resolving several of the issues between them, including the Company s revenue requirements and return on equity. It is also my understanding that the OAG did not join in the Settlement. Q. WHAT IS THE PURPOSE OF YOUR REBUTTAL TESTIMONY? A. The purpose of my Rebuttal Testimony is to respond to the ROE recommendations presented in the testimony of OAG witness Mr. Brian Philip Lebens, who recommended an ROE of. percent for the Company basis points lower than the Company s currently authorized ROE and far below any authorized ROE for an electric utility in the United States at any time in at least the past 0 years. Docket No. E00/GR-1-

5 II. RESPONSE TO THE DIRECT TESTIMONY OF MR. LEBENS Q. IF THE COMMISSION WERE TO APPROVE AN AUTHORIZED ROE FOR NSPM AT THE LEVEL PROPOSED BY OAG WITNESS MR. LEBENS, WHAT EFFECT WOULD THAT RETURN HAVE ON THE COMPANY S ABILITY TO ATTRACT CAPITAL ON REASONABLE TERMS? A. An authorized ROE at the level proposed by OAG witness Mr. Lebens would significantly affect the credit metrics of Northern States Power Company- Minnesota ("NSPM") and the Company s ability to attract capital on reasonable terms. In particular, credit rating agencies place significant weight on the predictability and consistency of the regulatory environment. The ability to attract capital is especially important given the level of capital investments the Company has planned over the next few years. If approved by the Commission, a ROE recommendation near the level recommended by Mr. Lebens would represent a significant departure from previous Commission decisions, and would cause rating agencies and equity investors to question whether Minnesota continues to be a supportive regulatory environment from an investment perspective. Q. PLEASE SUMMARIZE MR. LEBENS TESTIMONY AND RECOMMENDATION AS IT RELATES TO THE ROE FOR NSPM IN THIS PROCEEDING. A. Mr. Lebens recommends an ROE for NSPM of. percent, within a range of results from all methods of.1 percent to. percent. Mr. Lebens recommendation is based entirely on his Multi-Stage Discounted Cash Flow ("DCF") analysis, which uses a long-term growth rate of only. percent. Mr. Lebens reports the results for his Capital Asset Pricing Model ("CAPM") analysis and his Constant Growth DCF analysis, but determines that his Docket No. E00/GR-1-

6 version of the Multi-Stage DCF model provides the most reasonable and accurate estimate of NSPM s equity costs, and these results are. percent to.0 percent. Q. DOES MR. LEBENS ROE RECOMMENDATION MEET THE REQUIREMENTS OF HOPE AND BLUEFIELD? A. No, it does not. Although Mr. Lebens cites the importance of the comparable return requirement, the financial integrity requirement, and the capital attraction requirement, his ROE recommendation falls well below any authorized ROE for a domestic vertically-integrated electric utility in the past 0 years. As such, Mr. Lebens ROE recommendation is entirely inconsistent with the ROE awards for other integrated electric utilities and does not meet the Hope and Bluefield requirements. Further, Mr. Lebens offers no evidence as to why he believes the Company s cost of equity has decreased by basis points since the Commission issued its decision in the previous rate case in March 01 in Docket No. E00/GR-1-. He does not question the reasonableness of his results; rather, he mechanically applies financial models using flawed inputs and assumptions, and then relies on those results to establish his return recommendation without considering whether it provides NSPM with the ability to compete for capital on reasonable terms, to maintain its financial integrity, and to offer investors returns that are comparable to those available in companies with similar risk. Direct Testimony of Brian P. Lebens, at. Source: Regulatory Research Associates. Docket No. E00/GR-1-

7 Q. WHAT IS YOUR OVERARCHING CONCERN WITH MR. LEBENS TESTIMONY? A. The central problem with Mr. Lebens testimony is that it is detached from economic reality. The reason for this disconnect is several-fold, including Mr. Lebens failure to meaningfully consider current and expected economic and capital market conditions, errors in his application of the Constant Growth and Multi-Stage DCF models which lead to unreasonable results, improper inputs and assumptions used in his CAPM analysis, and his failure to consider the relevance of the Bond Yield Plus Risk Premium analysis. I discuss each of these issues in the following sections of my Rebuttal Testimony. Q. WHY IS IT IMPORTANT TO TAKE INTO CONSIDERATION THE EFFECTS OF CURRENT ECONOMIC AND CAPITAL MARKET CONDITIONS ON THE COST OF EQUITY FOR NSPM? A. The ROE authorized in this proceeding is intended to provide a reasonable return to investors over the forward-looking period during which rates will be in effect a period of four years under the Settlement. For that reason, the Commission must consider prospective financial market conditions, and analysts must have these same considerations in mind when presenting a recommendation. Mr. Lebens, however, focuses on capital market conditions over the past few years and does not adequately consider the changes that have occurred in recent months or the prospects for financial markets on a going-forward basis. Extraordinary federal intervention in capital markets followed by a flight to quality by investors, exacerbated by Britain s vote on June, 01 to leave the European Union ( Brexit ), have produced the lowest government bond yields in the -year history of U.S. bond rates. However, market data Docket No. E00/GR-1-

8 suggest that investors perceive greater risk in the current market environment, and there is a great deal of uncertainty around the path and timing of interest rate movements. Therefore, it is important to consider the current and prospective market conditions and investor expectations, all of which may put upward pressure on utility capital costs going forward. Mr. Lebens recommendation fails to reflect such critical considerations. Q. BUT DON T THE CURRENTLY LOW BOND YIELDS SUPPORT A LOW AUTHORIZED ROE FOR NSPM? A. Not at anything approaching the level recommended by Mr. Lebens. The currently low bond yields are impacting the results of all ROE models, and must be treated with caution. During periods of equity market volatility, as risk aversion increases, investors seek out the relative safety of Treasury securities and other relatively low-risk debt securities, essentially bidding up prices and forcing down yields. Accordingly, the current yields on U.S. Treasury securities are being driven by a flight to quality by investors and the Federal Reserve s highly accommodative monetary policy. The current low bond yields are transitory and not reflective of unfettered market interactions. In addition, there is a well-established inverse relationship between equity risk premiums and prevailing risk-free rates. Equity investors tend to require higher-risk premiums during periods of lower interest rates. Thus, low See e.g., S. Keith Berry, Interest Rate Risk and Utility Risk Premia during 1-, Managerial and Decision Economics, Vol. 1, No. (March, 1), in which the author used a regression analysis, including using allowed ROEs as the relevant data source, and concluded that there was an inverse relationship between equity risk premia and interest rates. See also Robert S. Harris, Using Analysts Growth Forecasts to Estimate Shareholders Required Rates of Return, Financial Management, Spring 1, at page, and Farris M. Maddox, Donna T. Pippert, and Rodney N. Sullivan, An Empirical Study of Ex Ante Risk Premiums for the Electric Utility Industry, Financial Management, Volume, No., Autumn 1, at pages -. Docket No. E00/GR-1-

9 interest rates set by the Federal Reserve are not reliable indicators of investment risk or the cost of capital in equity markets. Mr. Lebens recommendation fails to recognize this inverse relationship between interest rates and the equity risk premium. Q. WHAT IS THE FINANCIAL MARKET S PERSPECTIVE ON THE LIKELIHOOD FOR FUTURE INCREASES IN SHORT-TERM INTEREST RATES BY THE FEDERAL RESERVE? A. At present, there is great uncertainty around the Fed s policy for future increases in short-term interest rates. In mid-december 01, the Fed announced the first increase in short-term interest rates since the financial market collapse in 00. In its statement, the Fed indicated that further increases in short-term interest rates would be gradual as the economy strengthens further and inflation rises from undesirably low levels. The August 01 issue of the Blue Chip Financial Forecasts ( Blue Chip ) surveyed leading economists and market participants concerning their views about the likelihood of future increases in short-term interest rates by the Fed. Blue Chip reports that approximately percent of market participants surveyed expect the Federal Reserve to raise short-term interest rates again before the end of 01. Yields on 0-year Treasury bonds are forecast to increase to.0 percent between 01 and 0. Significant changes in the global economy, led by Great Britain s Brexit have resulted in unsettled financial markets and heightened volatility. It remains unclear at this time how Brexit will affect export markets and the overall Blue Chip Financial Forecasts, Volume, No., August 1, 01, at 1. Blue Chip Financial Forecasts, Volume, No., June 1, 01, at 1. Docket No. E00/GR-1-

10 growth of the U.S. economy, which again serves to increase market uncertainty and risk. This sort of uncertainty in global financial markets impacts interest rates, monetary policy, risk premiums, and credit spreads, all of which affect the return requirements of investors. Q. ARE CREDIT SPREADS INCREASING? A. Yes. Even before the Brexit vote, credit spreads were increasing. As shown in Figure of my Direct Testimony, credit spreads between government and utility bonds had increased to 1 basis points (A-rated) and 0 basis points (Baa-rated). Since the filing of my Direct Testimony, the spreads between 0- year Treasury bonds and utility bonds have increased to 1 basis points (A- rated) and basis points (Baa-rated). I also compared current credit spreads with those at the time of the Commission s decision in NSPM s previous rate case. As shown in Table 1 below, credit spreads for both A-rated and Baa- rated utility bonds are wider now than in March 01, when the Commission determined that a ROE of. percent was appropriate for NSPM. These higher credit spreads are evidence that investor risk sentiment has increased since March 01. Moody s Baa-rated utility bond yield less 0-year Treasury bond yield Moody s A-rated utility bond yield less 0-year Treasury bond yield Moody s Baa-rated utility bond yield less Moody s A-rated utility bond yield Table 1 Spread as of /0/01 Spread as of /0/01 Spread as of //01.%.0% 1.% 1.% 1.% 1.0% 1.0% 0.% 0.% Direct Testimony of James M. Coyne, at 1. Docket No. E00/GR-1-

11 As discussed in my Direct Testimony, increasing credit spreads are an indicator that investors are becoming more concerned about future economic conditions, which directionally suggests higher equity costs. Q. AREN T EXPECTATIONS FOR HIGHER INTEREST RATES, WIDER CREDIT SPREADS, LOWER DIVIDEND YIELDS, AND HIGH STOCK VALUATIONS FOR UTILITY COMPANIES ALREADY REFLECTED IN THE COST OF EQUITY PRODUCED BY A DCF ANALYSIS OF THE SORT PRESENTED BY MR. LEBENS? A. In theory, and during times of general economic and capital market stability, a sound DCF analysis should reflect market conditions and investor expectations. However, in the current market environment, DCF models produce results that are being distorted by the uncommonly low level of interest rates. Value Line recently observed that dividend yields for electric utilities are currently well below the historical average and that high valuations on utility shares are not expected to be sustained over the three-to-five year period. In order to assess how low interest rates are affecting the dividend yields for utility stocks, I have performed an analysis comparing the current dividend yield for the electric utilities in my proxy group to the historical dividend yields for these same companies from 00-01, as well as to yields on 0-year Treasury bonds in each year, as shown in the following figure: Direct Testimony of James M. Coyne, at 1-1. Value Line Investment Survey, Electric Utility (West) Industry, April, 01, at. Docket No. E00/GR-1-

12 As shown above, the average dividend yield for the companies in the proxy group is at its lowest level since 00, driven lower by yields on 0-year Treasury bonds and federal monetary policy. Given the important role that dividend yields play in the DCF model, this is evidence that anomalous capital market conditions are causing the DCF model to understate equity costs for regulated utilities at this time, a point Mr. Lebens fails to recognize. Figure 1 Average Proxy Group Dividend Yields and U.S. Treasury Bond Yields: The Federal Energy Regulatory Commission ("FERC") has recently recognized this phenomenon, stating: Docket No. E00/GR-1-

13 As is discussed, infra, the level of the dividend yield affects the reliability of the DCF process when that level is lower than the level acceptable to investors that value utility stocks based on their estimated long-term dividend growth. The record creates cause for concern that during a period including the Study Period, investors valuing utility stocks based solely or primarily on their current yield bid the prices of the proxy group stocks up to levels that rendered their Total Returns unacceptable to investors that valued such stocks based on their estimated long-term dividend growth. The FERC also observed that due to anomalous conditions in capital markets (i.e., low Treasury bond yields) the results of the DCF model may not be a reasonable estimate of the cost of equity at this time, stating: The yields of -year Treasury Bonds during the Study Period continue to reflect economic conditions that could render inputs to the DCF analysis unrepresentative. During the study period, the yields of -year Treasury Bonds averaged.1 percent. That yield was basis points higher than the average yield of those bonds during the Opinion No. 1 study period, but basis points below the.0 percent level that so concerned the Commission in Opinion No. 1. If the average -year Treasury-Bond yields for the Opinion No. 1 study period reflected economic conditions that could serve to render financial inputs into the DCF model unrepresentative, the average bond yields for the study period in this proceeding are close enough to the earlier yields to reflect the same conditions. Accordingly, the level of -year Treasury Bond yields during the Study Period create sufficient doubt regarding the representativeness of DCF inputs to warrant an examination of alternative metrics prior to making a final determination as to the level of the MISO TOs Base ROE. Federal Energy Regulatory Commission, 1 FERC,00, June 0, 01, at paragraph 1. Ibid, at paragraph 1. Docket No. E00/GR-1-

14 Q. TURNING TO THE SPECIFICS OF HIS ANALYSES, DO YOU HAVE ANY COMMENTS ON THE PROXY GROUP THAT MR. LEBENS USES TO ESTIMATE THE COST OF EQUITY FOR NSPM? A. Yes. According to Mr. Lebens, he used my Original Proxy Group with the exception of Great Plains Energy and Westar Energy, both of which are involved in mergers. If Mr. Lebens intent was to exclude companies that were involved in merger activity at the time his testimony was filed, he also should have excluded Duke Energy (which is acquiring Piedmont Natural Gas) and Empire District Electric (which is being acquired by Algonquin Energy). As such, all of Mr. Lebens analyses are impacted by his failure to exclude two additional companies that are engaged in mergers. Q. PLEASE SUMMARIZE MR. LEBENS CONSTANT GROWTH DCF ANALYSIS AND RESULTS. A. Mr. Lebens conducts a Constant Growth DCF analysis using only earnings growth rates from First Call, and implies that using multiple sources of growth rate forecasts could result in double counting some analyst estimates. 1 Mr. Lebens establishes his range of DCF results by taking the mean growth rate for his proxy group companies, and computing the growth rates that are +/- one standard deviation above and below the mean. He then adds these low, mean and high growth rates to the dividend yield, which is calculated using average closing stock prices from May through May, 01. The mean result of Mr. Lebens' Constant Growth DCF model is. percent within a range from. percent to. percent. 1 Direct Testimony of Brian P. Lebens, at -. 1 Docket No. E00/GR-1-

15 Q. DO YOU HAVE ANY CONCERNS WITH MR. LEBENS APPLICATION OF THE CONSTANT GROWTH DCF MODEL? A. Yes. I do not agree with Mr. Lebens concern regarding the use of multiple sources of consensus earnings growth rates. In my experience, these growth rates can differ, even though they are consensus estimates. For example, Schedule to my Direct Testimony, Exhibit (JMC-1), illustrates differences up to 1.0 percent (PNM Resources) between consensus estimates from Yahoo! Finance and Zacks. However, a more important point is that the traditional approach in a DCF analysis is to consider the high and low growth rate estimates for each company in the proxy group to establish the high and low ranges, rather than using +/- one standard deviation from the mean growth rate, as Mr. Lebens has done. However, since Mr. Lebens only has one source of growth rates, he cannot establish a range using high and low estimates from multiple sources of market data. Mr. Lebens offers no testimony or support for his use of +/- one standard deviation around the mean growth rate as being a reasonable means to establish the range for the proxy group companies, and I have not seen any regulatory agency adopt such an approach in my years of experience in providing expert testimony on this issue. Q. WHAT IS YOUR CONCLUSION REGARDING MR. LEBENS CONSTANT GROWTH DCF ANALYSIS? A. The results of Mr. Lebens Constant Growth DCF analysis are well below the results of other Risk Premium based models and well below comparable returns in other jurisdictions. Based on the FERC s logic in Opinion No. 1, the midpoint of the DCF model results is currently understated and does not represent a reasonable estimate of the cost of equity for NSPM at this time. 1 Docket No. E00/GR-1-

16 Q. PLEASE ALSO DESCRIBE MR. LEBENS MULTI-STAGE DCF MODEL. A. Mr. Lebens also presents a Multi-Stage DCF analysis based on earnings growth rates from Thomson First Call in the first stage, and long-term projections of gross domestic product ("GDP") growth from the Organization for Economic Cooperation and Development ( OECD ). Based on this analysis, Mr. Lebens computes an ROE range of. percent to.0 percent. Mr. Lebens relies on the results of this analysis in support of his ROE recommendation for NSPM. Q. ARE THE RESULTS OF MR. LEBENS MULTI-STAGE DCF ANALYSIS REASONABLE IN COMPARISON TO AUTHORIZED RETURNS FOR COMPARABLE RISK INTEGRATED ELECTRIC UTILITIES IN OTHER JURISDICTIONS? A. No. Mr. Lebens Multi-Stage DCF results defy any economic or financial logic, and should be given no weight by the Commission. Mr. Lebens Multi- Stage DCF analysis produces an ROE estimate that is more than 0 basis points lower than the average ROE for a vertically integrated electric utility in 01 and 01. Mr. Lebens offers no explanation as to why he believes that his Multi-Stage DCF analysis is the most reliable indicator of equity costs. Mr. Lebens also offers no explanation regarding why he believes NSPM s cost of equity has fallen by basis points since the Commission s decision in March 01 when it was determined that an ROE of. percent was reasonable. Q. WHAT IS DRIVING THE EXTRAORDINARILY LOW RESULTS OF MR. LEBENS MULTI-STAGE DCF ANALYSIS? A. The main reason for these extraordinarily low results is the long-term GDP growth rate that Mr. Lebens utilizes in the third stage. As explained in Mr. Lebens Direct Testimony, this long-term growth rate is based on an OECD 1 Docket No. E00/GR-1-

17 forecast of real GDP growth for the United States through 00 of. percent. 1 For years beyond 00, Mr. Lebens considers two alternative growth rates. The first approach uses the OECD s 00 real GDP growth rate of 1. percent throughout the remaining years of the analysis (through Year 00); the second approach extrapolates the growth rate trend beyond 00 using OECD s real GDP growth rates from 0 to To this real GDP growth rate, Mr. Lebens adds projected inflation rates based on the spread between 0-year Treasury Inflation-Protected Securities ( TIPS ) and the yield on -, 0- and 0-year Treasury bonds. The resulting nominal GDP growth rate starting in Year of his analysis is. percent. Q. PLEASE COMMENT ON THE LONG-TERM GDP GROWTH RATE USED IN MR. LEBENS MULTI-STAGE DCF ANALYSIS. A. Commonly-cited sources of forecasted real GDP growth include: Blue Chip Economic Indicators, Consensus Economics, the Social Security Administration, the Energy Information Administration, and the Congressional Budget Office. I am not aware of any cost-of-capital expert in utility rate proceedings relying on the OECD s annual country-level real GDP growth forecasts for the United States, and I certainly have not seen another witness try to apply a different long-term growth rate starting years out (i.e., after 00). While Mr. Lebens characterizes this as being more precise, I am surprised that anyone would believe that additional precision could be achieved by using an economic forecast pertaining to the very distant future. 1 Direct Testimony of Brian P. Lebens, at Ibid. 1 Docket No. E00/GR-1-

18 I have the same concerns with the inflation rates used by Mr. Lebens, all of which are based on the TIPs spread against various Treasury bond yields. While I use the TIPs spread as one measure of inflation in my computation of nominal GDP growth, there are other reliable sources of projected inflation rates such as Blue Chip that are projecting inflation rates of.1-. percent, as compared with TIPS spreads ranging from 1. percent to 1. percent depending on the Treasury bond used for comparison. In addition to these concerns with Mr. Lebens projected GDP growth rate, it is also reasonable to consider historical real GDP growth in conjunction with projected inflation rates to develop a nominal GDP growth rate for use in the Multi-Stage DCF model. As shown in Schedule to my Direct Testimony, Exhibit (JMC-1), this approach produces a nominal GDP growth rate of approximately. percent, or 1 basis points higher than the long-term growth rate used by Mr. Lebens. As a point of comparison, XLI witness Ms. LaConte conducted a Multi-Stage DCF analysis in her Direct Testimony in which she used a long-term growth rate of. percent. Q. WHAT IS YOUR CONCLUSION REGARDING MR. LEBENS MULTI-STAGE DCF ANALYSIS? A. Rather than basing his ROE recommendation on the results of his Multi-Stage DCF analysis, Mr. Lebens should have recognized that his inputs and assumptions were causing the model to produce ROE estimates that are totally detached from economic reality, and which do not meet his own stated criteria that the equity return must meet the requirements of Hope and Bluefield, including the comparable return, capital attraction and financial integrity 1 Docket No. E00/GR-1-

19 requirements. Mr. Lebens Multi-Stage DCF analysis, on which his ROE recommendation is based, should be given no weight by the Commission. Q. DID MR. LEBENS ALSO PERFORM CAPM AND ECAPM ANALYSES? A. Yes. Mr. Lebens presents both a CAPM and ECAPM analysis. Similar to his Multi-Stage DCF analysis, Mr. Lebens CAPM and Empirical CAPM ("ECAPM") analyses contain fundamental flaws and should be given no weight in this proceeding. He uses current average yields on, 0 and 0- year Treasury bonds as the risk-free rate, raw beta coefficients from Yahoo! Finance, and a forward-looking market risk premium. Due to Mr. Lebens choice of the risk-free rate based on current Treasury bond yields, and especially due to his use of raw, rather than adjusted betas, his CAPM results are similar to debt costs. As shown on page 0 of his Direct Testimony, his CAPM results range from. percent to. percent depending on the term of the Treasury bond, and his ECAPM results range from.0 percent to. percent. Mr. Lebens fails to recognize that these CAPM results are not reasonable, because equity owners bear more risk than debt holders and must receive higher compensation for that additional risk. Q. WHAT ARE YOUR SPECIFIC AREAS OF DISAGREEMENT WITH MR. LEBENS CAPM ANALYSES? A. I have two primary areas of disagreement with Mr. Lebens CAPM analysis: (1) his sole use of current Treasury bond yields as the risk-free rate; and () his use of raw betas rather than adjusted betas. 1 Docket No. E00/GR-1-

20 Q. WHAT IS YOUR CONCERN WITH MR. LEBENS SOLE RELIANCE ON CURRENT TREASURY BOND YIELDS AS THE RISK-FREE RATE? A. Current yields are not appropriate in an environment where interest rates on government bonds are near historical lows, are not being set by the market alone, and are expected to increase over the next several years. For these reasons, Mr. Lebens should also consider the use of projected yields on 0- year Treasury bonds as a way to normalize the interest rate he uses as the riskfree rate in his CAPM analysis. Q. WHAT IS YOUR CONCERN WITH THE USE OF RAW BETAS RATHER THAN ADJUSTED BETAS? A. Mr. Lebens uses a raw beta from Yahoo! Finance of 0., which is multiplied by the market risk premium to derive the utility equity risk premium. He is the only witness in this proceeding that did not use an adjusted beta coefficient. The other ROE witnesses supported adjusted betas in the range of 0. to 0.. There are two primary reasons to adjust raw betas. First, empirical studies have shown that an individual company beta is more likely than not to move toward the market average of 1.0 over time. 1 Second, adjusting beta serves a statistical purpose. Because betas are statistically estimated and have associated error terms, betas greater than 1.0 tend to have positive estimated errors and thus tend to overestimate future returns. Betas below the market 1 Commonly referred to as the Blume Adjustment for papers written by Marshall Blume documenting evidence of autoregressive properties of beta towards the market average of 1.0. See Marshall E. Blume, On the Assessment of Risk, The Journal of Finance, Vol. XXVI, No. 1 (March ) and Marshall E. Blume, Betas and Their Regression Tendencies, The Journal of Finance, Vol. XXX, No. (June 1), where Blume found that there was strong evidence that beta regressed toward the market mean, and that tendency was strongest in the case of the lowest risk portfolios. 1 Docket No. E00/GR-1-

21 average of 1.0 tend to have negative error terms and underestimate future returns. Consequently, it is necessary to adjust betas toward 1.0 in an effort to improve forecasts. 1 Because current stock prices reflect expected risk, one must use an expected beta to appropriately reflect investors expectations. A raw beta reflects only where the stock price has been relative to the market historically and is an inferior proxy for the expected returns when compared to the adjusted beta. Mr. Lebens failure to recognize this fact skews his CAPM analyses. Q. WHAT IS YOUR RESPONSE TO MR. LEBENS CRITICISM OF THE MARKET RISK PREMIUM USED IN YOUR CAPM ANALYSIS? A. Mr. Lebens characterizes my total market return, which is based on a Constant Growth DCF analysis of the companies in the S&P 00 using growth rate estimates provided by Bloomberg, as a proprietary projection and therefore not readily accessible to the public. 1 The actual difference in our total market return estimates, however, is that my analysis is based on growth rates for each individual company in the S&P 00, weighted by the market capitalization, while Mr. Lebens is based on a composite estimate of earnings growth for the S&P 00 as reported on Yahoo! Finance. In his testimony, Mr. Addonizio points out the difference between his total market return and mine, but concludes that both methods are reasonable. Furthermore, the FERC has endorsed the use of the Constant Growth DCF model to estimate the total market return for purposes of calculating the market risk premium in the CAPM analysis. 1 1 Roger A. Morin, New Regulatory Finance, at p.. 1 Direct Testimony of Brian P. Lebens, at. 1 Federal Energy Regulatory Commission, Opinion No. 1-B, March, 01, at paragraph. 1 Docket No. E00/GR-1-

22 Q. IN REPLYING TO YOUR DIRECT TESTIMONY, MR. LEBENS CLAIMS THAT THE COMMISSION HAS NOT TRADITIONALLY RELIED ON RETURNS IN OTHER JURISDICTIONS. WHAT IS YOUR RESPONSE? A. Authorized returns are a relevant benchmark that investors consider to assess whether the return for NSPM is comparable to the returns available for comparable risk integrated electric utilities in other jurisdictions. While I do not necessarily believe that returns in other jurisdictions should be considered as primary evidence, I do believe they are relevant as a check on the reasonableness of the other ROE estimation models. In particular, under current market conditions, when the DCF model is producing unusually low results due to anomalous capital market conditions (i.e., low interest rates on Treasury bonds), returns in other jurisdictions can be used as an important indicator of investors return requirements and expectations. This is also the approach taken in Opinion No. 1-B, where the FERC determined that it was reasonable to consider state-level returns for electric utilities when estimating the cost of equity. 1 Q. FROM YOUR PERSPECTIVE, WHAT WOULD BE THE PRACTICAL EFFECT IF THE COMMISSION WERE TO ADOPT MR. LEBENS ROE RECOMMENDATION? A. Mr. Lebens ROE recommendation of. percent is below any authorized ROE for a U.S. electric utility, and is an astonishing basis points lower than NSPM s current authorized ROE of. percent approved less than two years ago. If the Commission were to adopt an equity return at this level, it would place significant downward pressure on NSPM s credit metrics and would jeopardize the Company s A- rating, ultimately leading to higher debt costs for customers. Moreover, it would fail to meet the legal standards of a 1 Federal Energy Regulatory Commission, Opinion No. 1-B, March, 01, at paragraphs 0 and. 0 Docket No. E00/GR-1-

23 Fair Return. His recommendation is simply not reasonable and should be rejected. Q. DOES THIS CONCLUDE YOUR REBUTTAL TESTIMONY? A. Yes, it does. 1 Docket No. E00/GR-1-