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

0 0 PUC DOCKET NO. 0 BEFORE THE PUBLIC UTILITY COMMISSION OF TEXAS APPLICATION OF TEXAS-NEW MEXICO POWER COMPANY FOR AUTHORITY TO CHANGE RATES DIRECT TESTIMONY AND EXHIBITS OF RONALD N. DARNELL ON BEHALF OF TEXAS-NEW MEXICO POWER COMPANY AUGUST, 0

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 0 TABLE OF CONTENTS I. INTRODUCTION AND QUALIFICATIONS... II. PURPOSE AND SUMMARY OF DIRECT TESTIMONY... III. OVERVIEW OF RATE FILING... IV. TNMP S REQUEST SHOULD BE EVALUATED IN THE CONTEXT OF ITS PARTICULAR CIRCUMSTANCES... V. TNMP RETURN SHOULD BE BASED ON A 0/0 CAPITAL STRUCTURE... VI. A FRESH LOOK AT TNMP FACTS AND POLICY WEIGH AGAINST CONSOLIDATED TAX SAVINGS ADJUSTMENT... VII. TNMP SUPPORTS RATEMAKING IMPROVEMENTS, INCLUDING PROPOSED STORM HARDENING RIDER... VIII. RATE DESIGN... IX. RATE FILING PACKAGE... X. CONCLUSION... EXHIBIT EXHIBIT RND-R- Educational and Professional Summary of Ronald N. Darnell

DIRECT TESTIMONY OF RON N. DARNELL EXECUTIVE SUMMARY TNMP seeks approval of revised rates that will enable it to recover its projected cost of service of approximately $ 0. million. That cost is comprised of TNMP s reasonable and necessary expenses for the year ended March, 0, adjusted for known and measureable changes, and an overall return of.% on its rate base of $. million. TNMP s return is based on actual debt cost of.%, a proposed equity return of.0%, and a capital structure of 0% debt and 0% equity. TNMP s proposed rates and fees cover a revenue deficiency of $0. million, an increase of.% over annualized revenues at current base rates. include: Several factors account for the revenue gap that makes this filing necessary. They current returns on invested capital that fail to include substantial investments over the last two years in distribution plant, do not reflect TNMP s real cost of equity, and rest on a hypothetical 0/0 capital structure; substantial depreciation expense that is not recovered under current rates, as confirmed by recent study; and additional vegetation management expense, corresponding with raised expectations to protect TNMP s system against catastrophic storm damage. For many years, TNMP managed investment and operations against level rates. With the settlement of Docket 0, TNMP increased rates for the first time in over a decade. Importantly, that settlement provided for recovery of Hurricane Ike restoration costs and TNMP s post-refinancing cost of long-term debt. It allowed TNMP to begin to use the interim TCOS adjustment process. Still, TNMP has found itself continuing to operate under significant financial constraint and facing the need for continued substantial capital expenditures, including more than $ 0 million for distribution plant over five years. TNMP s credit metrics continue to be substandard, reflected in its Moody s BB- rating. In short, TNMP needs rates that, together with continued strong cost management, will provide the opportunity to earn something closer to its true cost of capital and to raise its financial metrics in the interest of improving its access to capital. ES

DIRECT TESTIMONY OF RON N. DARNELL TNMP s proposed equity return and capital structure address this need most directly. These items, and an enlarged rate base capturing recent net investment in distribution plant, account for approximately $ million out of the $ 0. million revenue deficiency. Closing the $. million gap between current rates and actual depreciation expense also is important to TNMP s ability to generate the cash required to replace aging plant. And it will be essential to avoid undercutting a reasonable determination of TNMP s expenses and cost of capital by unreasonable application of a consolidated tax savings adjustment. As proposed, TNMP s rates will be somewhat higher than the rates of its much larger counterparts, but consistent with them in light of the fact that TNMP operates in four geographically diverse service territories and must manage its costs across the smaller base of customers who populate its less dense service areas. TNMP s rates will continue to represent a small fraction of the price of electricity to end user customers (.% of a typical residential bill), even at today s natural gas prices. TNMP recognizes that covering its revenue deficiency and realigning its rates to better reflect cost causation will result in a significant increase for the residential class in percentage terms. Based on its class cost of service study, TNMP s proposals would increase TNMP s revenues from the residential class by.%. In practical terms, however, the proposal would increase a 0 kwh/month customer s TNMP charge by less than $, out of an average retail monthly bill of over $ 0 (assuming a rate of. cents/kwh). Five classes would receive rate decreases in order to equalize rates of return. These changes reflect correction of interclass subsidies and mis-assignment of costs, as well as recovery of TNMP s revenue deficiency. TNMP has calculated an alternative allocation that would eliminate decreases for classes other than transmission, if the Commission should choose to consider some level of gradualism. More significantly, TNMP has proposed to restructure its Residential and Secondary < kw rates to recover 0% of the class revenue requirement through a flat monthly customer charge. The restructured charge will better match TNMP s largely fixed costs to serve ES

DIRECT TESTIMONY OF RON N. DARNELL these classes, will provide more predictable and stable TDU charges as a component of retail bills, will offer end use customers some protection against usage increases due to extreme weather, and provide an increased transparency that should serve retail price competition. Finally, TNMP submits that residential and other customers will be better served in the future by procedures that reduce the occasion for TDUs to build up revenue deficiencies of more than % and provide instead for more regular, more gradual changes in rates, with less cost consumed in the ratemaking process. The process for determining the relatively small component of ERCOT retail prices that remains regulated should be simplified, without sacrifice of Commission oversight and within the Commission s statutory authority. TNMP commends the Commission for its recent improvements to the interim TCOS adjustment mechanism, and supports the proposal to develop a parallel distribution cost of service adjustment mechanism in Project No.. TNMP includes here a complementary proposal for a storm hardening rider to recover (but not over-recover) increased O&M expenses based on heightened expectations for vegetation management and pole inspection. In sum, TNMP seeks rates that will match its cost of service today and provide the real opportunity to earn a return that reflects its reasonable cost of the capital invested to serve its customers. TNMP seeks tariff terms that, together with other ratemaking improvements, will provide for a better ongoing match in the future between regulated TDU charges and changes in the cost of service. The relief requested should serve to improve the terms of TNMP s access to capital, so that it can make the infrastructure investments and operational improvements to deliver smart, safe, reliable service at the lowest reasonable cost of serving its unique mix of territories and customers. ES

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 I. INTRODUCTION AND QUALIFICATIONS Q. PLEASE STATE YOUR NAME, BUSINESS ADDRESS, AND PLACE OF EMPLOYMENT. A. My name is Ronald N. Darnell. I serve as Vice President for Regulatory Policy of PNM Resources, Inc. ( PNMR ) and as Vice President of Texas New Mexico Power ( TNMP or Company ). My business address is Alvarado Square, Albuquerque, NM. Q. PLEASE DESCRIBE YOUR EDUCATIONAL BACKGROUND AND PROFESSIONAL EXPERIENCE. A. Exhibit RND-R- describes my background and experience, including proceedings in which I have provided testimony. Q. PLEASE DESCRIBE YOUR RESPONSIBILITES AS VICE-PRESIDENT FOR REGULATORY POLICY FOR PNMR AND VICE PRESIDENT OF TNMP. A. My responsibilities include strategic direction, development and implementation of regulatory policies for TNMP as well as for Public Service Company of New Mexico ( PNM ), its affiliated utility operating under New Mexico s regulatory structure. II. PURPOSE AND SUMMARY OF DIRECT TESTIMONY 0 0 Q. WHAT IS THE PURPOSE OF YOUR TESTIMONY IN THIS PROCEEDING? A. I will provide an overview of TNMP s rate request and the principal factors driving it. I will put TNMP s request in the context of the territories that it serves, its past ratemaking proceedings before this Commission, and its substantial ongoing capital expenditure requirements. I will address the importance of setting base rates that fairly reflect TNMP s true cost of capital and depreciation expense. I will explain how TNMP s proposed rates, which reflect those costs, will provide the opportunity, with effective cost management, to execute its capital expenditure program and make needed improvements in TNMP s credit metrics, bringing them more in line with other ERCOT TDUs. I will provide an overview of TNMP s showing, based on facts specific to the Company and the companies with which it has been affiliated, that no consolidated tax savings adjustment is warranted here. And I will put TNMP s request in the context of the need, from a practical and policy standpoint, to reduce the pricing peaks and valleys, as well as the expense and effort, that continue to be associated with ERCOT TDU 0

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 ratemaking proceedings. In that regard, I will explain that TNMP s proposed storm hardening rider should be adopted as one beneficial step toward making changes in the still-regulated component of ERCOT electric prices more regular and more gradual. Finally, I will introduce the witnesses who provide the detailed support for TNMP s request. III. OVERVIEW OF RATE FILING 0 Q. WHY HAS THE COMPANY FILED THIS ELECTRIC RATE CASE? A. TNMP has filed this case as a result of increases in its cost of service experienced since the close of the test year from its most recent rate proceeding, Docket No. 0. I will introduce the components of those cost increases below. TNMP also seeks, as part of this proceeding, a reasonable review and updating of its cost of capital, taking account of the Company s capital expenditure needs and obligations and the imperative to improve, over time, the terms on which TNMP can access capital. The ultimate objective of the case, of course, is to provide for revised electric rates that will allow TNMP to recover in a timely manner its costs and to earn a fair rate of return on its investments necessary to provide reliable and affordable electric transmission and distribution service to its Texas retail customers. Q. PLEASE SUMMARIZE WHAT TNMP SEEKS IN THIS FILING. A. As testified to by TNMP s witnesses, TNMP has a projected cost of service of approximately $0. million, which is based on its reasonable and necessary expenses and a return of. percent on its rate base of $. million. This cost of service results in a revenue deficiency of $ 0. million, and requires an increase of.% over annualized revenues at current base rates. To recover this cost of service TNMP, seeks approval of its wholesale tariff and six retail tariffs (Residential Service, Secondary Service Less than kw, Secondary Service Greater than kw, Primary Service, Transmission Service, and Lighting Service), several riders, and discretionary services, as described in detail by TNMP witnesses Stacy Whitehurst and Michael Montgomery. TNMP also proposes certain modifications to the terms of these tariffs apart from revised rates, also described by Mr. Whitehurst. These include Stacy Whitehurst, Elisabeth Eden, and Robert Hevert.

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 0 Q. WHAT IS THE TEST YEAR UPON WHICH THE COMPANY'S RATE FILING IS BASED? A. TNMP s rate filing is based on the test year for the twelve months ended March, 0 adjusted for known and measurable changes. Q. WHAT IS THE CAPITAL STRUCTURE AND COST OF CAPITAL THE COMPANY IS PROPOSING IN THIS PROCEEDING? A. According to TNMP s witness Elisabeth Eden, TNMP s actual debt/equity ratio as of March, 0 was /. The Company is employing a 0/0 debt/equity ratio for test year purposes, for reasons that I will highlight below and that Ms. Eden, along with TNMP witnesses Robert Hevert and Julie Cannell, will present in detail. The average cost of debt as of March, 0 was. percent, again as described by Ms. Eden. As Mr. Hevert explains, the requested return on equity is.0 percent. Accordingly, the requested overall rate of return is. percent. That proposed return represents an increase of less than one percentage point from the.% weighted average cost of capital provided for under the stipulation approved in Docket No. 0. Q. WHAT FACTORS HAVE INCREASED TNMP S COST OF SERVICE OR CONTRIBUTED TO ITS REVENUE DEFICIENCY? A. Since the March, 00 close of the test year in TNMP s previous case, several factors have contributed substantial increases to TNMP s cost of service or reduced TNMP revenues, contributing to TNMP s revenue deficiency as illustrated below:

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 Rate Increase Drivers March 0 vs March 00 $,0,0 $,,00 $,, $(,) $,0, O&M, A&G Expense adjusted for Increase in revenues* Taxes Other Than Federal Income Tax Return on Rate Base Depreciation & Amortization Expenses Federal Income Tax 0 * O&M includes increased ERCOT wholesale matrix payments that are offset by annualized March 0 TCRF rates and test year ESI ID counts First, TNMP s current rates fall short of recovering its actual depreciation and amortization expenses by approximately $. million. A depreciation study called for in the settlement of TNMP s prior rate case and conducted by Dane Watson confirms that TNMP s current depreciation rates substantially understate its actual depreciation expense. His study shows that the Company is experiencing both longer service lives for many assets and an increase cost of removal resulting in increasingly negative net salvage values. The net result is an increase in depreciation rates. Applied to the Company s property account balances at the end of the test year, these updated depreciation rates result in an increased annual expense of approximately $. million over test-year depreciation expense. Other substantial adjustments to depreciation and amortization expense are required in order to reflect properly the allocation of certain assets to TNMP and to recover accelerated depreciation expense as a result of replacing mechanical meters with advanced meters. Mr. Whitehurst explains these additional depreciation items. Second, another $.0 million of TNMP s revenue deficiency represents components of return on rate base. That amount includes return on TNMP s increased net investment in distribution plant by $. million, and in total retail plant by $.0 million. That investment is and has been serving customers, without any return to TNMP to date, and needs to be recognized in rate base. TNMP s Vice-President of Texas Operations, Neal Walker, describes the additions that the Company has made to its distribution plant.

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 0 0 TNMP s proposed return also reflects an updated assessment of its cost of capital, including Mr. Hevert s conservative estimate of TNMP s cost of equity at.0 percent, and a 0/0 capital structure. All of these are proper components of return on invested capital that should be authorized for TNMP, for reasons I will discuss further below and that Mr. Hevert, Ms. Eden, and Ms. Cannell will support in more detail. The remainder of TNMP s revenue deficiency represents the sum of increases and decreases in a variety of expense categories addressed by other witnesses (as well as the taxes associated with an increased revenue requirement). Included among these is an increase of approximately $. million for vegetation management. As Mr. Walker explains, these expenses represent increased tree trimming activity, in the interest of reducing the vulnerability of TNMP s system to extreme storms. These expenses, and related items, actually are expected to increase further as TNMP prepares and implements its storm hardening plan required under new P.U.C. Subst. R.. for the five years beginning January, 0. The expenses included in TNMP s base rate proposal cover only TNMP s actual increase in vegetation management as of the testyear end. TNMP proposes to recover additional O&M expenses associated with storm hardening efforts through the rider I will introduce below. Q. WHAT IS THE RELATIVE IMPACT OF THE COMPANY'S PROPOSED RATE INCREASE ON THE BILL TO RETAIL ELECTRIC PROVIDERS ( REPS ) FOR T&D SERVICE? A. As developed in the testimony of Michael Montgomery, the requested increase will result in an increase of $. per month to a residential customer using 0 kwh per month. Customers in the Secondary > kw will receive a.% decrease as a class. Four other classes will receive limited decreases, and two others limited increases. As Mr. Montgomery explains, a substantial portion of the increase to residential customers is the result of re-assigning costs across customer classes based on cost causation to eliminate current subsidies and bring all classes to equalized rates of return. Mr. Montgomery also describes an alternative set of allocations that would eliminate decreases outside of the transmission class, if that degree of gradualism is preferred. Q. WHAT PORTION OF THE REP'S TYPICAL BILL TO RESIDENTIAL END USE CUSTOMERS IS COMPOSED OF THE COST OF T&D SERVICE?

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 As shown on Mr. Montgomery s Table, TNMP s total charges on a residential end use customer bill at 0 kwh are $. at today s rates, or approximately.0 percent out of a total REP bill of $., assuming a rate of. cents/kwh. TNMP s proposed rates would add $. and result in a monthly charge of $. or approximately. percent of a total REP bill of $. at that same. cents/kwh. Q. HOW DO TNMP S PROPOSED RESIDENTIAL RATES COMPARE TO THOSE OF OTHER ERCOT TDU S? A. TNMP s proposed rates will be at the high end to somewhat higher than other ERCOT TDUs, as shown Mr. Montgomery s Exhibit MDM-. Given TNMP s relatively small size and the characteristics of its service areas, it would be surprising if TNMP s costs per customer were not higher than those of its larger ERCOT counterparts. TNMP s proposed rates should be seen as consistent with those of other ERCOT TDUs. IV. TNMP S REQUEST SHOULD BE EVALUATED IN THE CONTEXT OF ITS PARTICULAR CIRCUMSTANCES 0 0 Q. DESCRIBE TNMP AND THE CHALLENGES IT FACES IN MANAGING ITS COST OF SERVICE. A. TNMP is the smallest ERCOT TDU. With an adjusted test-year proposed cost of service of $ 0 million, it is an order of magnitude smaller than Oncor or Centerpoint, and substantially smaller than the AEP companies. TNMP operates grid facilities in four geographically separate areas, with a large proportion of suburban and rural communities. Mr. Walker describes TNMP s service area in more detail. Delivering service to these separate, low-density territories from a smaller base of personnel and resources poses real efficiency challenges. Q. HOW HAS CURRENT MANAGEMENT ADDRESSED THOSE CHALLENGES? A. TNMP has prudently managed its direct expenditures, attempting to do more with less, and making do on fixed or even reduced rates for many years. Since the PNMR acquisition, TNMP has received the benefit of services delivered more efficiently from its shared services affiliate, as described by TNMP witnesses Rebecca Teague and Thomas Flaherty of the Booz firm. TNMP s more recent rate case, Docket No. 0, was its first application for a rate increase for more than a decade, excluding the UCOS proceedings required by

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 0 0 restructuring. During that time TNMP has had to manage its business against a set of rates that were effectively flat, and it experienced a rate reduction at the time of the PNM acquisition. Industry costs, both personnel and equipment, increased over this same period. TNMP capital expenditures came under pressure. TNMP s financial condition became seriously weakened, and its performance on credit metrics substandard. Q. WHAT RELEVANCE DOES THAT HISTORY HAVE TO TNMP S CURRENT REQUEST, SINCE THE COMPANY AGREED TO SETTLE DOCKET 0 WITH A RATE INCREASE THAT TOOK EFFECT SEPTEMBER, 00? A. It provides the context for that request, its outcome and more recent developments. TNMP did turn to the Commission for rate relief in Docket No. 0 in August 00, based on a test year ending March, 00. That case was resolved by settlement and provided three important components of relief it lifted a restriction that had prevented TNMP from using the interim TCOS adjustment mechanism, it provided for recovery of Hurrican Ike restoration costs through a five-year rate rider, and it gave full recognition to TNMP s actual revised cost of debt, at.%, resulting from TNMP s requirement to refinance its long-term debt during the chaotic capital markets of late 00 and early 00. The settlement included a black box base rate increase of $. million. TNMP has sought to maximize its return under the revised rates. In accordance with the settlement, it obtained approval of and implemented an energy efficiency rider. It has utilized the interim TCOS adjustment mechanism. But TNMP s financial perfomance has continued to be strained, reflected in its split ratings and its below-investment grade BBfrom Moody s. Contributing to that strain are the dollars that TNMP has been able to invest in its distribution plant, but unable to put into rate base, and the expense of its increased vegetation management activity. TNMP must continue to make capital expenditures, significantly so for its distribution plant. As Mr. Walker describes, TNMP capital expenditures in distribution facilities are expected to exceed $ 0 million over the next five years. In this environment, it is essential that TNMP s base rates reflect its true cost of capital and depreciation expense in order for the Company to execute needed capital expenditures and to have any reasonable opportunity to improve its credit metrics.

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 It also is relevant here that the Docket No. 0 settlement left in place the hypothetical 0/0 capital structure that had been utilized in the UCOS proceedings, and it left unresolved the issues associated with the very large consolidated tax savings adjustments that had been proposed by some parties. To its credit, the Commission has since invited fresh, fact-based inquiries into both these issues. TNMP proposes to use a 0/0 capital structure, at a limited cost that will be dedicated to actual increases in TNMP equity. And it has become clear to TNMP that, in order to bring its financial performance and credit ratings more into the ERCOT mainstream,as well as to support the capital expenditures needed to support an infrastructure in keeping with the expectations of customers and this Commission, TNMP must have the opportunity to earn its reasonable cost of invested capital, without artificial reduction by an excessive and unjustified CTSA. 0 0 V. TNMP RETURN SHOULD BE BASED ON A 0/0 CAPITAL STRUCTURE Q. WHAT CAPITAL STRUCTURE DOES TNMP PROPOSE? A. TNMP has used a capital structure of 0% debt and 0% equity in calculating its adjusted test-year total cost of service. Ms. Eden explains in more detail TNMP s proposal for using the 0/0 structure, rather than TNMP s actual test-year end ratio of / (or the 0/0 hypothetical structure used in the past). Q. WHY SHOULD THE COMMISSION CONSIDER USING AN INCREASED EQUITY COMPONENT TO CALCULATE TNMP S COST OF CAPITAL? A. Some increase in equity for TNMP is needed as part of restoring a financial foundation that will be recognized as consistent with investment grade ratings, as Ms. Eden and Ms. Cannell discuss. TNMP intends to raise its equity level. In that regard, a 0/0 structure better reflects TNMP s current and ongoing cost of capital. Without a change in capital structure for ratemaking purposes, actual increases in equity will result in immediate underrecovery of authorized return, beginning again the pressure to recognize a revenue deficiency and return to the Commission. Increasing TNMP s equity component to 0% has a limited impact in this case, but it will deliver a valuable message to investors that the Commission will provide TNMP a reasonable opportunity to achieve healthier performance. Use of the 0/0 structure will promote an actual increase in utility equity, desirable for credit metrics and long-term access to capital.

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 Q. CAN THE COMMISSION EXPECT A MODIFIED CAPITAL STRUCTURE AS PROPOSED BY TNMP TO RESULT IN ACTUAL INCREASED EQUITY AT TNMP? A. Yes. If TNMP s proposal to use a 0/0 structure is adopted, then PNM Resources, TNMP s parent company, will contribute equity annually to TNMP (or allow TNMP to retain equity), in an amount at least equal to the increment of return associated with the difference between 0% equity and actual TNMP equity, for so long as the rates adopted in this case remain in effect or until a 0/0 structure is achieved, as Ms. Eden explains. VI. A FRESH LOOK AT TNMP FACTS AND POLICY WEIGH AGAINST CONSOLIDATED TAX SAVINGS ADJUSTMENT 0 0 Q. WHY ARE YOU RAISING THE CONSOLIDATED TAX SAVINGS ADJUSTMENT ISSUE? A. In Docket 0, Commission Staff proposed a CTSA that would have required a $. million reduction to TNMP revenues, equivalent in that case to an basis point penalty on TNMP s return on rate base. In the present case, a proposed adjustment of that size would more than wipe out TNMP s entire proposed increase in return on invested capital the return associated with bringing increased net plant investment into rate base, fairly reflecting TNMP s cost of equity, and using the 0/0 capital structure. The real impact of an adjustment of that magnitude, the lack of any real relationship between the savings presumed by such an adjustment and TNMP s actual cost of providing regulated utility service to Texas customers, and the Commission s recent Oncor decision are some of the factors that call for the Commission, Staff, and all parties to take a fresh and careful look at the potential application of a CTSA in the particular circumstances presented by TNMP. Q. HOW SHOULD THE COMMISSION APPROACH THE CTSA ISSUE IN THIS CASE? A. I will leave the detail to the experts. TNMP s witnesses on this subject include former PUC Chairman Robert Gee, utility tax and accounting expert James Warren, and PNMR Services tax professional Matt Harland. I will begin with what is undisputed in theory that any adjustment is discretionary. The decision not to impose any CTSA in Oncor s recent case, based on the unique facts presented there, further invites a careful examination of whether a CTSA makes sense or serves any economic, tax, or policy objective, either generally or based on the facts presented by an individual utility and its

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 0 0 affiliates. It does not, for all the reasons described by witnesses Gee, Warren, and Harland. Q. PLEASE SUMMARIZE THE REASONS WHY APPLICATION OF A CTSA TO TNMP IS UNWARRANTED. A. Mr. Warren and Mr. Harland offer a host of reasons why the Commission should exclude any consideration of tax losses associated with unregulated affiliates in calculating a Texas TDU s cost of service, just as it excludes consideration of all other categories of unregulated affiliate expenses why, in short, application of a CTSA is a remote outlier among utility ratemaking authorities, bears no meaningful relationship to determining a TDU s real cost of providing regulated utility service, and should be rejected generally in today s restructured Texas marketplace. At a minimum, the Commission s decision regarding a CTSA in any case should be based on a careful examination of the facts and the economic substance of the relationships among the individual utility before the Commission and its affiliates, and should be sensitive to the public policy implications of different outcomes. That is the approach taken in last year s Oncor decision. As Mr. Gee describes, the Commission has favored a fact-based, policy-sensitive approach as far back as Docket No., not an automatic, formulaic approach. There is no justification in precedent or policy for applying the spreadsheet formula from that docket to arrive at adjustments so large today that they undercut rate of return determinations, as he explains. Mr. Warren and Mr. Harland look more closely at relevant facts and data regarding TNMP and its affiliates. As they explain, the mechanical application of the -year lookback produces material changes to TNMP s calculated cost of service based on factors that are demonstrably unrelated to TNMP s actual cost of serving Texas customers, and unrelated to any benefit actually realized by or available to TNMP. For example, the size of adjustment for TNMP under the formula depends heavily on the profitability of its New Mexico utility affiliate, PNM. Relatively minor changes in PNM profitabiity make large differences in the percentage of time value savings that the formula attributes to TNMP, as they explain. The result is to make TNMP s CTSA heavily dependent on ratemaking deterinations by the New Mexico Public Service Commission regarding a New Mexico utility, rather than real changes in TNMP s cost of service in Texas.

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 0 0 Indeed, mechanical application of the -year lookback implies a policy preference for stand-alone TDUs. Such a preference would run contrary to PURA, which expressly left it open to utilities to retain an affiliation between an unbundled TDU and an unbundled retail provider or power generation company. Moreover, creating an incentive for TDUs to avoid the CTSA by becoming independent, stand-alone entities would be economically counterproductive, at least based on TNMP s facts. A study conducted by the Booz consulting firm shows that for TNMP to operate as a stand-alone company would increase its cost of service, to the detriment of end-user customers. That study accompanies the testimony of Thomas Flaherty. Yet a CTSA that negates one or two percentage points of return on rate base, such as proposed in TNMP s most recent case, would send a very strong message that operating is a stand-alone company, or restructuring into a partnership that is ineligible for consolidated tax reporting, provide the only options for earning a reasonable return on TDU invested capital. Q. ARE THERE OTHER REASONS TO REJECT OR LIMIT APPLICATION OF A CTSA TO TNMP? A. A hard and fair look at the facts related to TNMP and its affiliates confirms that TNMP has not received any economic benefit, directly or indirectly, from accelerated realization of consolidated tax savings, that justifies any adjustment to its test-year cost of service. Ultimately, any CTSA must be squared with TNMP s right to a reasonable opportunity to earn reasonable return on prudently invested capital over and above reasonable and necessary operating expenses, under PURA and the Hope and Bluefield Supreme Court decisions. The Hearing Examiner provided a recent statement of this right in discussing return on equity in last year s Oncor case: A public utility s right to a ROE was clarified in two Supreme Court cases: Bluefield Water Works & Improvement Co. v. Public Service Commission (Bluefield) and Federal Power Commission v. Hope Natural Gas Co. (Hope). In Bluefield, the Supreme Court held that a public utility is entitled to earn a return equal to that of investments in other businesses at the same time and same part of the country with similar risks and uncertainties. The return must be sufficient under efficient and economical management to maintain the utility s ability to attract capital and its financial integrity. But the Supreme Court emphasized that a public utility has no constitutional right to profits and recognized that what constitutes a reasonable rate of return could change over time. U.S., - (). 0 U.S., 0 (). 0

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 Likewise, the Supreme Court in Hope acknowledged that the ratemaking process requires a balancing of the competing interests of ratepayers and investors. Both cases establish that a utility and its investors must be afforded an opportunity, not a guarantee, to earn a return equal to returns achieved by investments with similar risks. For all the reasons expressed by Mr. Harland, Mr. Warren, and Mr. Gee, and in keeping with the requirements of Hope and Bluefield, no CTSA should be applied in this case. VII. TNMP SUPPORTS RATEMAKING IMPROVEMENTS, INCLUDING PROPOSED STORM HARDENING RIDER 0 0 Q. DOES TNMP HAVE ANY RECOMMENDATIONS TO REDUCE THE SIZE OF FUTURE PROPOSED RATE ADJUSTMENTS? A. TNMP has no crystal ball. TNMP would prefer not to find it necessary to apply for a rate increase of percent or more. TNMP lived for a decade on flat and reduced rates. TNMP negotiated a rate increase in Docket No. 0 that it believed would avoid what it considered to be the real threat of a further ratings downgrade and provide it some opportunity to move forward. As a result of the factors I have touched on and others will suport in detail, TNMP finds itself with a serious revenue deficiency. The proposed rates are well justified factually and legally. We consider them essential for TNMP to execute its substantial and needed capital expenditure program and to progress toward restoration of full investment grade ratings and reasonable financial health. That is why we are here. We strongly believe that it is in all stakeholders interests to transition away from a pattern of long periods of flat rates interrupted by large increases determined in costly, lengthy adversary proceedings. The issues that must be decided to determine cost of service for an ERCOT TDU are narrower than the issues presented by an integrated utility, and the amounts in controversy are much smaller, certainly so in the case of a TNMP. There needs to be a way to adjust the relatively small component of ERCOT retail prices that remains subject to regulation, so that changes may occur more regularly and more gradually, and closer in time to the changes in cost that trigger them. Commission oversight should remain plenary, but less time, effort, and money should be devoted to rate cases. PUC Docket No., Proposal For Decision at - (June, 00).

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 0 0 Ratemaking mechanisms that will serve these objectives will not only reduce the customer impact of rate changes, they will reduce the regulatory lag between changes in utility cost and changes in utility price. That lag is a key factor in investor evaluaton of utilities, as Mr. Hevert and Ms. Cannell address in more detail. The interim TCOS mechanism provides an important example of a forward-looking procedure that adjust rates to implement what are largely non-controversial changes in cost of service with less regulatory lag, substantial avoidance of rate case expenses, and preservation of Commission oversight. TNMP commends the Commission s recent decisions to make that mechanism, and corresponding adjustments by distribution service providers, available two times per year. TNMP also submits that the parallel DCOS adjustment mechanism proposed in Project No. is a critical next step in streamlining TDU ratemaking. Indeed, that mechanism would have provided an outlet for one of the factors driving TNMP s current application. Based on the preliminary order in Centerpoint s pending rate case, TNMP understands that Project No. is the Commssion s preferred venue for determination of the DCOS mechanism, and has not proposed a specific rider to implement that mechanism here. However, TNMP fully supports adoption of a proposed interim DCOS adjustment mechanism, and would expect to apply to implement an appropriate tariff provision at the appropriate first interval. TNMP s proposed tariff terms do include one additional mechanism that TNMP submits will serve to reduce regulatory lag for cost changes associated with activity that is the subject of broad consensus. This is TNMP s proposed Storm Hardening Rider, described in Mr. Whitehurst s testimony. Under new P.U.C. Subst. R.., TNMP and each electric utility will be required to file next spring a summary of its Storm Hardening Plan, providing for cost-effective strategies to increase the ability of its transmission and distribution system to withstand extreme weather conditions. The plan will have to cover the five years beginning January, 0, and must address a list of specified elements, including such items as a tree pruning cycle for its distribution facilities and a pole testing schedule. Utility storm hardening plan summaries will be subject to comment from interested persons. TNMP s proposed Storm Hardening Rider provides for an annual adjustment to allow TNMP to recover (but not over-recover) the difference between its test-year expenses for vegetation management and pole inspection, and the actual expenses incurred to

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 implement the Storm Hardening Plan. The proposed rider will facilitate TNMP s meeting raised expectations related to storm hardening, with transparency to the Commission and interested parties, and without contributing to a mismatch between costs and authorized revenues. TNMP urges adoption of its proposed Storm Hardening Rider as a modest step toward more timely, efficient recovery of relatively uncontroversial costs, while reserving plenary review to Commission. VIII. RATE DESIGN 0 Q. IS TNMP PROPOSING ANY CHANGE IN THE RATE STRUCTURES USED IN ITS CURRENT RATES? A. Yes. For the Residential and Secondary < kw classes, TNMP is proposing to use a fixed customer charge to recover 0% of the total revenue requirement for each class, including all customer and metering costs and a portion of distribution costs. Mr. Montgomery explains and quantifies this proposal in detail. Q. WHY IS TNMP PROPOSING TO RELY MORE HEAVING ON A FIXED CUSTOMER CHARGE FOR THESE CLASSES? A. The proposed customer charges better reflect the largely fixed nature of TNMP s costs to serve these classes. For TNMP, REP, and end use customer alike, TNMP s proposed restructuring will provide more predictability and stability in TDU charges. For TNMP, this means greater predictability and stability on the revenue side, as well as a better match to our costs. For the end use customer, this means more predictable, stable TDU charges on a retail bill, and some opportunity for protection against increases in bills when usage climbs due to extremes of weather. For REP and end use customer alike, TNMP submits that this structure will provide greater transparency in the TDU component of the retail bill, potentially enhancing retail price competition. IX. RATE FILING PACKAGE 0 Q. WHAT ARE THE GENERAL PUCT RATE SETTING STANDARDS UPON WHICH TNMP RELIED IN PREPARING THIS FILING? A. TNMP is filing the rate case filing package with a test year of April, 00 through March, 0. This represents the most recent twelve months for which operating and financial data is available for TNMP and commences with a calendar quarter and a fiscal

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 0 year quarter. Several TNMP witnesses address the requirements of PURA and the Commission s substantive rules as those requirements apply to the costs they sponsor. These witnesses state that TNMP has adhered to the rate setting standards set out in Chapter of PURA and P.U.C. SUBST. R.., which requires that rates be set based on historical test year costs, adjusted for known and measurable changes. Rates established consistent with TNMP s request should allow TNMP the opportunity to recover a reasonable return on its used and useful invested capital, in excess of its reasonable and necessary operating expenses, consistent with the requirements of PURA.0. Q. HAS TNMP PROVIDED ALL THE SCHEDULES AND WORKPAPERS TO COMPLY WITH THE COMMISSION S REQUIREMENTS FOR T&D BASE RATE PROCEEDINGS? A. As presented in the testimony of Mr. Whitehurst, TNMP has made its filing consistent with the Commission s RFP and the requirements of P.U.C. PROC. R... TNMP, PNMR Services, and TNMP s outside witnesses have also pre-filed supporting direct testimony, consistent with P.U.C. PROC. R..(a)(). Q. PLEASE PROVIDE A DESCRIPTION OF TNMP S FILING PACKAGE. A. As detailed in the testimony of TNMP s witnesses below, TNMP s filing package ( Filing ) has been prepared and assembled in compliance with PURA and the Commission s Substantive and Procedural Rules. In addition to my own testimony, the Filing includes the direct testimony, exhibits, and related Schedules prepared and sponsored by the following witnesses: Thomas Flaherty, Carol Graebner, Kevin Judice, Les Luithle, Rebecca Teague and Stacy Whitehurst. Id.

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 0 James Neal Walker (TNMP Vice President Operations) TNMP service territory and operations; transmission and distribution investment; operations and management expenses; storm hardening Stacy Whitehurst (Supervisor of Regulatory Policy) Cost of service; services provided to TNMP by Regulatory, Communications, and External Affairs Departments; tariffs Michael Montgomery (Regulatory Project Manager) - Customer class cost-of-service and rate design. Elisabeth A. Eden (Assistant Treasurer) TNMP financial performance; capital structure; cost of debt; services provided to TNMP by Treasury and Risk Department Matthew Harland (Director of Income Tax) federal income taxes; other taxes; consolidated taxes Rebecca Teague (Assistant Controller, Shared Services) Overview of services provided by PNMR Services to TNMP and related charges; specific services provided by Accounting Services and other departments Carol Graebner (Deputy General Counsel) Legal services provided to TNMP by the General Counsel group Kevin Judice (Vice President, Chief Information Officer) Services provided to TNMP by Business Technology Services and Center For Innovation and Technology Les Luithle (Director of Compensation, Benefits and Human Resources Information Systems) -- Services provided to TNMP by Enterprise Process Management and People Services Thomas Flaherty (Booz & Company) Reasonableness of services provided by PNMR Services to TNMP and related costs A. Joseph Van Den Berg (Booz & Company) -- Call center services Robert B. Hevert (Concentric Energy Advisors) cost of capital; return on equity Julie M. Cannell (Julie M. Cannell, Inc.) cost of capital; capital structure; investor perception Dane A. Watson (Alliance Consulting Group) -- depreciation Robert W. Gee (Gee Strategies Group) consolidated taxes

DIRECT TESTIMONY OF RON N. DARNELL PUC DOCKET NO. 0 James I. Warren (Winston & Strawn) consolidated taxes Greg Wilson (Lewis & Elkin) catastrophe reserve X. CONCLUSION Q. DOES THIS CONCLUDE YOUR DIRECT TESIMONY? Yes, it does.

Exhibit RND-R- RONALD N. DARNELL EDUCATIONAL AND PROFESSIONAL SUMMARY Address: Position: Public Service Company of New Mexico Alvarado Square, MS-00 Albuquerque, New Mexico Vice President of Regulatory Affairs, 00 to Present Previous Positions: Excel Energy, 000-00 Director, Regulatory Administration South, 00-00 * Responsible for regulatory policy, administration and pricing for Xcel- Colorado s retail and wholesale operations Director, Pricing and Planning, 000-00 * Responsible for electric, gas and thermal regulatory pricing and load forecasting for regulated utility services in all states New Century Energy, -000 Director, Electric Rates and Regulatory Services * For utility operations in Wyoming, Colorado, New Mexico, Texas and under the jurisdiction of the Federal Energy Regulatory Commission, -000 * For utility operations in Wyoming and Colorado, - Public Service Company of Colorado, - Pricing Consultant, Marketing Department, - Unit Manager, Electric Rate Design and Regulatory Policy, - Supervisor, Revenue Requirements, - Senior Rate Accountant, - Rate Accountant, - Junior Rate Accountant, - Testimony Presented before: Colorado Public Utility Commission Wyoming Public Service Commission Federal Energy Regulatory Commission Education: California State University, Bachelor of Science in Business Administration Accounting Emphasis