Clark Hill PLC East Grand River venue Lansing, Michigan 0 Sean P. Gallagher T..00 T..00 F..0 F..0 Email: sgallagher@clarkhill.com clarkhill.com V I E L E C TRO N IC C S E FIL IN G Ms. Kavita Kale Executive Secretary Michigan Public Service Commission 0 W. Saginaw Highway Lansing, Michigan October, 0 Re: M P S C C ase N o.u-0 :In the matterof the application of IndianaM ichigan P owerc ompanyforau thorityto increase its rates forthe sale of electric energy and forapprovalof d epreciation accru alrates and otherrelated matters. Dear Ms. Kale: Enclosed for filing is the ssociation of B u sinesses dvocating Tariff E qu ity s D irect Testimony and E xhibits of C hristopherc.w alters along with the a P roof of S ervice with regard to in the above case. Respectfully, CLRK HILL PLC SPG/lkm Sean P. Gallagher cc w/enc.: Parties of Record LJ, Hon. Mark E. Cummins. 0/
STTE OF MICHIGN BEFORE THE MICHIGN PUBLIC SERVICE COMMISSION In the matter of the application of INDIN MICHIGN POWER COMPNY for uthority to Increase Its Rates for the Sale of Electric Energy and for pproval of Depreciation ccrual Rates and Other Related Matters. ) ) ) ) ) ) ) ) ) Case No. U-0 Direct Testimony and Exhibits of On behalf of ssociation of Businesses dvocating Tariff Equity October, 0 Project 0
Table of Contents STTE OF MICHIGN BEFORE THE MICHIGN PUBLIC SERVICE COMMISSION In the matter of the application of INDIN MICHIGN POWER COMPNY for uthority to Increase Its Rates for the Sale of Electric Energy and for pproval of Depreciation ccrual Rates and Other Related Matters. ) ) ) ) ) ) ) ) ) Case No. U-0 Table of Contents for the Direct Testimony of I. SUMMRY... II. RTE OF RETURN... II.. Electric Industry uthorized Returns on Equity,... II.B. Regulated Utility Industry Market Outlook... II.C. I&M Investment Risk... 0 III. I&M S PROPOSED CPITL STRUCTURE... III.. Embedded Cost of Debt... IV. RETURN ON EUITY... IV.. Risk Proxy Group... IV.B. Discounted Cash Flow Model... IV.C. Sustainable Growth DCF... IV.D. Multi-Stage Growth DCF Model... IV.E. Risk Premium Model... IV.F. Capital sset Pricing Model ( CPM )... IV.G. Return on Equity Summary... IV.H. Financial Integrity... V. RESPONSE TO I&M WITNESS MR. ROBERT B. HEVERT... V.. Summary of Rebuttal... V.B. Small Size djustment... 0 V.B.. Flotation Costs... V.C. Hevert DCF... V.C.. Hevert Constant Growth DCF...
Table of Contents Table of Contents for the Direct Testimony of (Continued) V.C.. Hevert Multi-Stage Growth DCF... V.D. Mr. Hevert s CPM Studies... V.D.. Mr. Hevert s Traditional CPM... V.D.. Mr. Hevert s Empirical CPM (ECPM)... V.E. Bond Yield Plus Risk ( BYP ) Premium... 0 V.E.. dditional Risks... ualifications of... ppendix
Page STTE OF MICHIGN BEFORE THE MICHIGN PUBLIC SERVICE COMMISSION In the matter of the application of INDIN MICHIGN POWER COMPNY for uthority to Increase Its Rates for the Sale of Electric Energy and for pproval of Depreciation ccrual Rates and Other Related Matters. ) ) ) ) ) ) ) ) ) Case No. U-0 Direct Testimony of PLESE STTE YOUR NME ND BUSINESS DDRESS.. My business address is 0 Swingley Ridge Road, Suite 0, Chesterfield, MO 0. WHT IS YOUR OCCUPTION? I am a consultant in the field of public utility regulation with the firm of Brubaker & ssociates, Inc. ( BI ), energy, economic and regulatory consultants. PLESE DESCRIBE YOUR EDUCTIONL BCKGROUND ND EXPERIENCE. This information is included in ppendix to my testimony. 0 ON WHOSE BEHLF RE YOU PPERING IN THIS PROCEEDING? I am appearing on behalf of ssociation of Businesses dvocating Tariff Equity ( BTE ). BTE s members are customers of Indiana Michigan Power Company ( I&M or Company ).
Page WHT IS THE SUBJECT MTTER OF YOUR TESTIMONY? My testimony will address the current market cost of equity, and resulting overall rate of return, for I&M. In my analyses, I consider the results of several market models and the current economic environment and outlook for the electric utility industry as well as the financial integrity of I&M given my recommended return on equity, the Company s capital structure, and overall rate of return. My silence in regard to any issue should not be construed as an endorsement of I&M s position. 0 0 I. SUMMRY PLESE SUMMRIZE YOUR RECOMMENDTIONS ND CONCLUSIONS ON RTE OF RETURN. I recommend the Michigan Public Service Commission (the Commission ) award a return on common equity of.0%, which is the approximate midpoint of my recommended range of.00% to.0%. My recommended return on equity will fairly compensate I&M for its current market cost of common equity, and it will mitigate the claimed revenue deficiency in this proceeding by fairly balancing the interests of all stakeholders. The overall rate of return produced by my recommended return on common equity, and ratemaking capital structure for I&M produces an overall rate of return of.%, as shown on my Exhibit B-. Finally, I will show that I&M witness Mr. Hevert s recommended range of 0.00% to.00%, and his point estimate of 0.0% are excessive and unreasonable.
Page 0 0 DO YOU BELIEVE MRKET-BSED MODELS PRODUCE RESONBLE ESTIMTES OF I&M S CURRENT COST OF EUITY? Yes. I believe the application of a Discounted Cash Flow ( DCF ) analysis, risk premium, and Capital sset Pricing Model ( CPM ) produces reasonable and accurate estimates of the current market cost of equity for I&M and other companies of similar investment risk. More specifically, I disagree with I&M witness Robert Hevert s suggestion that more weight should be given to the risk premium based models because DCF model is at odds with the current market environment. (Hevert Direct at and ). The DCF model currently is producing an economically logical estimate of the current market cost of equity. The DCF model reflects the observable dividend yield on utility stocks, and adds to that an estimate of expected growth. Utility dividend yields can be compared to yields on Treasuries and utility bonds. Specifically, the yield component of a utility stock (.%) exceeds the current yield of Treasury bonds (.%) and approaches the yields on rated utility bonds (.%). Utility dividend yields are based directly on utility dividend payments and observable stock prices. The growth component of utility stocks exceeds what would reasonably be expected as long-term sustainable growth, which is also an economically logical result in light of the utility industry s very large capital expenditure programs, which are producing abnormally high growth outlooks. Further, utility dividend payouts are reasonably consistent with historical average and industry target payout ratios, and the dividend cost can be supported at the current estimates of market cost of equity in the % to.% range. In other words, if a utility s authorized returns on equity are in the range of % to.%, it can afford its dividend, and it can produce dividend growth reasonably consistent with market analysts outlooks.
Page For these reasons, I believe a reasonably conducted DCF analysis produces a reasonable estimate of the current market cost of equity for a utility stock investor. 0 0 II. RTE OF RETURN PLESE DESCRIBE THIS SECTION OF YOUR TESTIMONY. In this section of my testimony, I will explain the analysis I performed to determine the reasonable rate of return in this proceeding and present the results of my analysis. I begin my estimate of a fair return on equity by reviewing the authorized returns approved by the regulatory commissions in various jurisdictions, the market assessment of the regulated utility industry investment risk, credit standing, and stock price performance. I used this information to get a sense of the market s perception of the risk characteristics of regulated electric utility investments in general, which is then used to produce a refined estimate of the market s return requirement for assuming investment risk similar to I&M s utility operations. s described below, I find the credit rating outlook of the industry to be strong and supportive of the industry s financial integrity and access to capital. Further, regulated utilities stocks have exhibited strong price performance over the last several years, which is evidence of utility access to capital. Based on this review of credit outlooks and stock price performance, I conclude that the market continues to embrace the regulated utility industry as a safe-haven investment and views utility equity and debt investments as low-risk securities.
Page II.. Electric Industry uthorized Returns on Equity, ccess to Capital, and Credit Strength PLESE DESCRIBE THE OBSERVBLE EVIDENCE ON TRENDS IN UTHORIZED RETURNS ON EUITY FOR ELECTRIC ND GS UTILITIES, UTILITIES CREDIT STNDING, ND UTILITIES CCESS TO CPITL TO FUND INFRSTRUCTURE INVESTMENT. 0 uthorized returns on equity for both electric and gas utilities have been steadily declining over the last 0 years, as illustrated in Figure below. More recent authorized returns on equity for electric utilities have declined down to about.0%, and local gas delivery utilities returns on equity have declined to.0%. Further, authorized returns for local gas delivery utilities have consistently trended at or below the returns authorized for electric utilities. FIGURE uthorized Returns on Equity (Excludes Limited Issue Riders).00% 0.0% 0.00% 0.% 0.% 0.% 0.0% 0.% 0.% 0.% 0.% 0.% 0.0% 0.% 0.%.%.%.%.%.0%.0%.%.0%.%.%.0%.0%.0%.00%.0% 00 00 00 00 00 0 0 0 0 0 0 0 Electric Gas Source and Note: S&P Global Market Intelligenc e, RR Regulatory Focus, Major Rate Case Decisions -- January - June 0, July, 0 at pages and.
Page While the declines in authorized returns on equity are public knowledge, and align with declining capital market costs, utilities are maintaining stable investment grade credit standing, and have been able to attract large amounts of capital at low costs to fund very large capital programs. PLESE DESCRIBE THE TREND IN CREDIT RTING CHNGES IN THE ELECTRIC UTILITY INDUSTRY OVER THE LST FIVE YERS. s shown in Figure below, over the period 00, 0, the electric utility industry has experienced a significant number of upgrades in credit ratings by all of the major credit rating agencies (Fitch Ratings, Moody s, and Standard & Poor s). FIGURE Credit Rating Changes (U.S. Investor-Owned Electric Utility Industry) 00 0 0 0 0 0 0 0 Upgrades 0 0 Downgrades 0 % Upgrades.%.0%.%.0%.% 0.0%.%.% Total Rating ctivity 0 0 0 0 0 00%.% 0 % 0% % 0% 0.0% 0.% 0.0%.%.0% 0 0.% 0.% 00 0 0 0 0 0 0 0 % Upgrades Total Rating ctivity 00 0 0 0 0 0 Source: EEI 0 Credit Ratings. Tab IV. Direction of Rating ction.
Page s noted above in Figure, the upgrades in utility credit ratings started outpacing downgrades in 0, and more recently, the number of upgrades has substantially exceeded the number of downgrades. For example, in 0, there were 0 upgrades and only three downgrades. In 0, the number of upgrades was more than twice the number of downgrades ( upgrades and downgrades). This trend was even more profound in 0 and continued with data available for early 0. 0 HOW DID THIS CREDIT RTING CTIVITY IMPCT THE CREDIT RTING OF THE ELECTRIC UTILITY INDUSTRY? The credit rating changes for the electric utility industry reflected a significant strengthening of the electric utility industry credit rating as shown below in Table. s shown in this table, in 00, approximately % of the electric utility industry was rated from BBB- to BBB+, % had a bond rating better than BBB+, and around % of the industry was below investment grade. This industry rating improved steadily over the subsequent eight years. By 0, none of the industry is below investment grade, around % continue to be in the range of BBB- to BBB+, and approximately % of the industry has a bond rating at or above BBB+. Overall, the improvement to the credit rating of the electric utility industry has been very significant.
Page TBLE S&P Ratings by Category (Year End) Description 00 00 00 0 0 0 0 0 0 0 Regulated or higher % % % % % % % % % % 0% % % % % 0% % % % % BBB+ % % % % % % % % % % BBB % % % % % % % % % 0% BBB % 0% % % % % % % % % Below BBB % 0% % % % % % % 0% 0% Total 00% 00% 00% 00% 00% 00% 00% 00% 00% 00% Source: EEI 0 Credit Ratings. Tab V. S&P Rating by Comp. Category. 0 HVE CREDIT RTING GENCIES COMMENTED ON DECLINING UTHORIZED RETURNS ON EUITY? Yes. Credit rating agencies recognize the declining trend in authorized returns and the expectation that regulators will continue lowering the returns for U.S. utilities while maintaining a stable credit profile. Specifically, Moody s states: Lower uthorized Equity Returns Will Not Hurt Near-Term Credit Profiles The credit profiles of US regulated utilities will remain intact over the next few years despite our expectation that regulators will continue to trim the sector s profitability by lowering its authorized returns on equity (ROE). Further, in a recent report, Standard & Poor s ( S&P ) states:. Earned returns will remain in line with authorized returns uthorized returns on equity granted by U.S. utility regulators in rate cases this year have been steady at about.%. Utilities have been adept at earning at or very near those authorized returns in today s economic and fiscal environment. slowly recovering economy, natural gas and electric prices coming down and then stabilizing at Moody s Investors Service, US Regulated Utilities: Lower uthorized Equity Returns Will Not Hurt Near-Term Credit Profiles, March 0, 0.
Page 0 fairly low levels, and the same experience with interest rates have led to a perfect non-storm for utility ratepayers and regulators, with utilities benefitting alongside those important constituencies. Utilities have largely used this protracted period of favorable circumstances to consolidate and institutionalize the regulatory practices that support earnings and cash flow stability. We have observed and we project continued use of credit-supportive policies such as short lags between rate filings and final decisions, up-to-date test years, flexible and dynamic tariff clauses for major expense items, and alternative ratemaking approaches that allow faster rate recognition for some new investments. 0 HVE UTILITIES BEEN BLE TO CCESS EXTERNL CPITL TO SUPPORT INFRSTRUCTURE CPITL PROGRMS? Yes. While cost of capital and authorized returns on equity were declining, the utility industry has been able to fund substantial increases in capital investments needed for infrastructure modernization and expansion. The Edison Electric Institute ( EEI ) reported in a 0 financial review of the electric industry financial performance that electric industry-wide capex has more than doubled since 00. EEI also observed that, despite this significant increase in capital expenditures during the period 00-0, a majority of the funding for utilities capital expenditures has been provided by internal funds. EEI reports that approximately % of funding needed to meet these increasing capital expenditures has been derived from external sources and % of these capital expenditures have been funded by internal cash. Further, despite nearly tripling capital expenditures and increases in the amount of outstanding debt, the electric utility industry s debt interest expense has declined by approximately.%. This fact is clear evidence that Standard & Poor s Ratings Services: Corporate Industry Credit Research: Industry Top Trends 0, Utilities, December, 0, at, emphasis added. Edison Electric Institute, 0 Financial Review, nnual Report of the U.S. Investor-Owned Electric Utility Industry, page. Id., pages and.
Page 0 0 0 utilities have enjoyed access to large amounts of capital, since it shows utilities are paying less over time to borrow because the costs of capital have declined. Similarly, in its March, 0 Capital Expenditure Update report, RR Financial Focus, a division of S&P Global Market Intelligence, made several relevant comments about utility investments generally: Capital expenditures throughout the U.S. power and gas sectors in 0 are projected to reach an all-time high of $. billion. The nation's largest electric and gas utilities are investing in infrastructure to comply with sweeping environmental regulations, implement new technologies, build new natural gas, solar and wind generation and upgrade aging transmission and distribution systems. Moreover, their near-term capital spending forecasts continue to escalate see below for individual examples. Total CapEx in 0 for the companies in the RR utility universe was $0. billion. We expect considerable levels of spending to serve as the basis for solid profit expansion for the foreseeable future, although our data indicates that CapEx in the industry may fall modestly in 0 and 0. Indeed, historical versus projected outlooks for the electric and gas industries capital investments are shown in Figure below. s shown in this graph, electric industry investment outlooks are expected to be considerably higher relative to the last 0-year historical period. s noted by S&P Global Market Intelligence, this capital investment is exceeding internal sources of funds to the electric utilities, requiring them to seek external capital to fund capital investments. S&P Global Market Intelligence, RR Financial Focus: Capital Expenditure Update, March, 0 at.
Page 0,000 Figure Electric Utility Capital Expenditures ctual Forecast Dollars (in millions) 00,000 0,000 0,000 0,000 0,000 0 00 00 00 00 00 00 0 0 0 0 0 0 0 0 0 00 Source:S&P Global Market Intelligence, Financial Focus, Capital Expenditure Update, March, 0, Page 0 IS THERE EVIDENCE OF ROBUST VLUTIONS OF ELECTRIC UTILITY EUITY SECURITIES? Yes. On my Exhibit B-, I show the historical valuation of the electric utility industry followed by Value Line based on price-to-earnings ratio, price-to-cash flow ratio and market price-to-book value ratio indicators. These electric utility industry security valuation metrics show that current electric utility stock valuations are very strong and robust relative to the last 0 to years. These robust valuations are an indication that utilities can sell equity securities at high prices, which is a strong indication that they can access capital under reasonable terms and conditions, and at relatively low cost. HOW SHOULD THE COMMISSION USE THIS MRKET INFORMTION IN SSESSING FIR RETURN FOR I&M? Market evidence is quite clear that capital market costs are near historically low levels. uthorized returns on equity have fallen to the mid.0% range; utilities
Page continue to have access to large amounts of external capital to fund large capital programs; and utilities investment grade credit standings are stable and have improved due, in part, to supportive regulatory treatment. The Commission should carefully weigh all this important observable market evidence in assessing a fair return on equity for I&M. II.B. Regulated Utility Industry Market Outlook 0 0 0 PLESE DESCRIBE THE CREDIT RTING OUTLOOK FOR REGULTED UTILITIES. Regulated utilities credit ratings have improved over the last few years and the outlook has been labeled Stable by credit rating agencies. Credit analysts have also observed that utilities have strong access to capital at attractive pricing (i.e., low capital costs), which has supported very large capital programs. S&P recently published a report titled Corporate Industry Credit Research: Industry Top Trends 0, Utilities. In that report, S&P noted the following: Ratings Outlook: Rating trends across regulated utilities remain mostly stable supported by stable regulatory oversight, slow but steady demand for utility services, and tempered by aggressive capital spending that will keep credit metrics from improving. Emerging new political trends in historically stable regions like Europe and the U.S. may have far-reaching effect on utilities over time, but S&P Global Ratings sees little immediate influence from those factors in 0. Sovereign rating developments can influence utility ratings in some countries and we expect them to vary in different parts of the globe. Forecasts: Credit ratios are likely to be stable in 0 with some slight downside risk as revenue growth will be modest in most regions in keeping with the slow demand growth in regions where the utility industries are mature. In contrast, growth can be higher in countries and regions where utility services have not fully penetrated the market offset by large investment needs. We expect margins across the industries globally to be flat to improving slightly as operating conditions and favorable fuel cost trends are maintained. ssumptions: Sales growth at most utilities is closely tied to the general economic outlook in its service territory, which can vary
Page 0 0 0 0 considerably from utility to utility. We project solid regulatory support for utility earnings and cash flow, with the occasional exception due to specific political or policy issues at the local level. Capital spending will continue to be elevated in most areas, with substantial infrastructure needs. Risks: Transformative risks abound in utility industries. Corporate transformations (M&) are an ever-present risk to ratings. Electric generation transformation is ongoing as carbon concerns and other environmental considerations lead utilities to change the mix of fuel sources. Grid transformation is becoming more prominent as utilities react to technological advances and the need for greater attention to cyber security. Industry Trends: The utility industry in most regions is stable, consistent with our general ratings outlook and the nature of the essential products and services utilities sell. The unsettled state of the world economy, buffeted by political volatility and uncertain capital flows as international trade and tax reform emerge as urgent issues, could spill over into the utility space. However, the industry as a whole is well positioned to withstand mild shocks, and we see steady growth and stable credit quality overall. Moody s recent comments on the U.S. Utility Sector state as follows: 0 Outlook - Timely Cost-Recovery Drives Stable Outlook Our outlook for the US regulated utilities industry is stable. This outlook reflects our expectations for the fundamental business conditions in the industry over the next to months. credit-supportive regulatory environment is the main driver of our stable outlook. Our stable outlook for the US regulated utility industry is based on our expectation that utilities will continue to recover costs in a timely manner and maintain stable cash flows. CFO-to-debt ratios will hold steady in 0. Utilities are contending with flat to lower power demand and lower allowed returns on equity. However, we expect that the continued use of cost-recovery mechanisms, the ongoing management of operating costs and extension of bonus depreciation will support cash flow, such that the industrywide average ratio of CFO to debt will remain at about % next year, in line with the 0-year average. * * * What could change our outlook. We could consider shifting our outlook to positive if the sector s average ratio of CFO to debt rose toward % on a sustainable basis, which could happen if utilities Standard & Poor s Global Ratings: Industry Top Trends 0: Utilities, February, 0, at, emphasis added.
Page de-lever significantly, which we do not expect. more contentious regulatory environment resulting in a material deterioration in cash flow, such that the ratio fell toward %, could cause us to take a negative view. 0 PLESE DESCRIBE UTILITY STOCK PRICE PERFORMNCE OVER THE LST SEVERL YERS. s shown in Figure below, SNL Financial has recorded utility stock price performance compared to the market. The industry s stock performance data from 00 through the first half of 0 shows that the SNL Electric Company Index has outperformed the market in downturns and trailed the market during recovery. This relatively stable price performance for utilities supports my conclusion that utility stock investments are regarded by market participants as a moderate- to low-risk investment. 0.0% FIGURE Index Comparison 0.0% Percent Return 0.0% 0.0% 0.0% 0.0% 0.0% SNL Electric Company S&P 00 0.0% 0.0% 0.0% 00 00 00 00 00 00 00 0 0 0 0 0 0 0* Source: SNL Financial. *Data through June 0, 0 Moody s Investors Service: Regulated Utilities - US: 0 Outlook Timely Cost-Recovery Drives Stable Outlook, November, 0, at, emphasis added.
Page 0 0 0 HVE ELECTRIC UTILITY INDUSTRY TRDE ORGNIZTIONS COMMENTED ON ELECTRIC UTILITY STOCK PRICE PERFORMNCE? Yes. In its th uarter 0 Financial Update, the EEI stated the following concerning the EEI Electric Utility Stock Index ( EEI Index ): Industry Fundamentals Remain Stable There was little meaningful change in the industry s fundamental picture during 0. Electricity demand remained virtually flat; total electric output rose only 0.% over the level in 0 in the lower states. Nationwide power demand has, in fact, been about flat for a decade... In response, a number of state utility commissions have adapted rate designs that help utilities cope with flat demand while still enabling investment required to comply with environmental requirements, grid modernization and upgrades to vital infrastructure. Nevertheless, the outlook for flat demand is a new normal that represents a departure from the consistent demand growth that characterized the industry s experience for more than a century. * * * While utility regulation largely occurs at the state level and must be analyzed state by state, industry analysts at yearend generally viewed regulation as largely fair and balanced overall for the industry taken as a whole. While allowed return on equity has come down in recent years, so have interest rates. Moody s in early 0 called the industry s credit outlook stable based on expectation that utilities will continue to recover costs in a timely manner and maintain stable cash flows. * * * The industry is now focused largely on regulated businesses with a strong.% dividend yield (at December, 0), healthy balance sheets and the chance to drive the nation s ongoing transition to cleaner energy and a modernized grid. The classic 0th century utility formula slow earnings and dividend growth should continue to attract investors. Provided inflation doesn t surge and produce sharply higher interest rates, utility shares should continue to do well on a relative (and possibly absolute) basis when bearish sentiment dominates the broader stock market. EEI 0 Financial Update: Stock Performance at -, emphasis added.
Page WHT RE THE IMPORTNT TKEWY POINTS FROM THIS SSESSMENT OF UTILITY INDUSTRY CREDIT ND INVESTMENT RISK OUTLOOKS? Credit rating agencies consider the regulated utility industry to be Stable and believe investors will continue to provide an abundance of low-cost capital to support utilities large capital programs at attractive costs and terms. ll of this reinforces my belief that utility investments are generally regarded as safe-haven or low-risk investments and the market continues to demand low-risk investments such as utility securities. The ongoing demand for low-risk investments can reasonably be expected to continue to provide attractive low-cost capital for regulated utilities. 0 0 HVE YOU CONSIDERED CONSENSUS MRKET OUTLOOKS FOR CHNGES IN INTEREST RTES IN FORMING YOUR RECOMMENDED RETURN ON EUITY IN THIS CSE? Yes. The outlook for changes in interest rates has been highly impacted by expectations that the Federal Reserve Bank Open Market Committee ( FOMC ) will raise short-term interest rates, and outlooks for inflation and GDP growth after the recent Presidential election. The consensus economists are expecting continued increases in the Federal Funds Rate as the FOMC continues to normalize interest rates in response to the strengthening of the U.S. economy. This is evident from a comparison of current and forecasted changes in the Federal Funds Rate, as shown in Table below. However, while the Federal Funds Rate is expected to increase over the next several years, consensus economists are not projecting significant increases in long-term interest rates. This is also illustrated in Table below.
Page TBLE Blue Chip Financial Forecasts Projected Federal Funds Rate, 0-Year Treasury Bond Yields, and GDP Price Index Publication Date 0 0 0 0 0 0 0 0 0 0 Federal Funds Rate Dec- 0. 0. 0. 0..0.. Jan- 0. 0. 0..0... Feb- 0. 0. 0..0... Mar- 0. 0. 0..0... pr- 0. 0...... May- 0..0..... Jun- 0..0..... Jul- 0....... T-Bond, 0 yr. Dec-...0.... Jan-....... Feb-....... Mar-....... pr-....... May-.0...... Jun-.0.0..... Jul-..0..... GDP Price Index Dec-....... Jan-..0..... Feb-..0..0... Mar-...0.... pr-....... May-....... Jun-...0.... Jul-...0.... Source and Note: Blue Chip Financial Forecasts, December 0 through July 0. ctual Yields in Bold I note that the four increases in the Federal Funds Rate experienced over the last few years have not caused comparable changes in outlooks for changes in long-term interest rates. This is illustrated on my attached Exhibit B-. s shown on that schedule, the actions taken by the FOMC to increase the Federal Funds Rate
Page 0 0 have simply flattened the yield curve, and have not resulted in an increase in long-term interest rates. This is significant because cost of common equity is impacted by long-term interest rates, not short-term interest rates. s a result, the recent increases in the Federal Funds Rate, and the expectation of continued increases in the Federal Funds Rate, have not, and are not expected to, significantly impact long-term interest rates. In the most recent Federal Reserve meeting, it also announced a strategy to begin to unwind its balance sheet position in long-term securities toward the end of this year. Currently, the Federal Reserve has built up over approximately $. trillion of Treasury and mortgage-backed securities as part of a quantitative easing ( E ) program that spanned 00 to 0. During this E program, the Federal Reserve procured long-term securities in an effort to support the Federal Reserve s monetary policy and mitigate long-term interest rates. There has been concern that if the Federal Reserve starts to unwind this balance sheet position, it will cause an increase in long-term interest rates. However, the Federal Reserve announced that if it does unwind its balance sheet position, it will do so in small increments so as to not have a significant impact on long-term interest rates. For these reasons, the Federal Reserve actions on short-term interest rates have not resulted in increases in long-term interest rates. Further, the Federal Reserve s proposed plan for unwinding its balance sheet position is not expected to have a significant impact on long-term interest rates. ll this indicates that the Federal Reserve E monetary policy changes related to a strengthening economy have not and are not expected to increase long-term interest rates. Further, this Board of Governors of the Federal Reserve System, Press Release, Federal Reserve Issues FOMC Statement, June, 0.
Page outlook is reflected in consensus economists forecasts of long-term interest rates, which indicate a relatively low capital market cost period for at least the intermediate period. 0 HVE PROJECTIONS OF INTEREST RTES MODERTED MORE RECENTLY RELTIVE TO THE LST FEW YERS? Yes. This is shown below in Table. There, I show the prevailing quarterly average Treasury bond yield, and the projections of Treasury bond yields two years out, and five to ten years out. Significantly, current Treasury bond yields in 0 have been relatively moderate and comparable to those in 0 and 0; however, projections of future Treasury bond yields are now much lower five to ten years out than they were over the last three years. Indeed, in 0 Treasury bond yields five to ten years out were projected to increase to.% from.% to.% prevailing yields. These five to ten-year projections have been steadily declining through 0 and 0. Most recently, long-term projected Treasury bond yields are now expected to remain relatively low in the.% to.% area. While the accuracy of projected increases in interest rates is uncertain, what is significant is that consensus market economists now are projecting out relatively low levels of capital market costs over the next five to ten years. This outlook represents a material moderation in capital market costs over this intermediate forecast period.
Page 0 TBLE 0-Year Treasury Bond Yield ctual Vs. Projection Description uarterly verage -Year Projected - to 0-Year Projected 0.%.%.0% -.%.%.%.%.%.% -.%.%.% 0.%.0%.% -.%.%.%.%.0%.% -.0%.%.% 0.%.%.% -.%.%.%.%.%.% -.%.0%.% 0.%.%.% -.%.0%.% Sources: Blue Chip Financial Forecasts, December 0 through June, 0. II.C. I&M Investment Risk PLESE DESCRIBE THE MRKET S SSESSMENT OF THE INVESTMENT RISK OF I&M.. The market s assessment of I&M s investment risk is described by credit rating analysts reports. I&M s current corporate bond ratings from S&P and Moody s are -
Page and Baa, respectively. 0 The Company s outlook from S&P is Stable. Moody s 0 0 recently upgraded the Company s outlook from Stable because it recognized I&M various tracker mechanisms as credit-supportive and its historically strong financial credit metrics. Earlier this year, S&P upgraded EP and all of its regulated subsidiaries. In its most recent report S&P specifically stated: Overview merican Electric Power Co. Inc. (EP) completed the sale of,00 megawatts (MW) of merchant generation capacity raising about $. billion in after-tax proceeds. Divesting the high-risk assets improves EP's credit profile that will now be dominated by regulated utilities. We are raising our issuer credit ratings on EP and all its utility subsidiaries--ppalachian Power Co., Indiana Michigan Power Co., Kentucky Power Co., Ohio Power Co., Public Service Co. of Oklahoma, Southwestern Electric Power Co., EP Texas Inc., EP Transmission Co. LLC, and Wheeling Power Co.--to '-' from 'BBB+'. t the same time, we are removing the ratings from CreditWatch, where we placed them with positive implications on Sept., 0. The outlook is stable. The stable outlook on EP and its subsidiaries reflects the company's improved business risk profile that now benefits from a preponderance of regulated utility operations, expectations that nonutility operations will remain a modest part of EP, and that the company's financial profile will remain robust, with funds from operations (FFO) to debt of about % on a consistent basis. Similarly, Moody s states the following: 0 RTINGS RTIONLE "Today's outlook revision recognizes the significant number of automatic and transparent rate recovery mechanisms that have been put in place at I&M over the years which greatly enhance cash flow predictability for the utility", said Laura Schumacher, Vice President/Senior Credit Officer. The positive outlook also recognizes financial credit metrics that have been historically strong for the company's Baa rating. lthough now moderating, when considered in light of the cash flow predictability produced by I&M's numerous rider 0 Messner Direct Testimony at. Standard & Poor's RatingsDirect, Research Update: "merican Electric Power Co. Inc. nd Subsidiaries Upgraded To '-', Off Watch; Outlook Stable" February, 0 at, emphasize added.
Page 0 and tracking recovery mechanisms, metrics are expected to remain robust. Our analysis considers I&M's relatively low-risk operating profile as a vertically integrated electric utility company operating under two above average state regulatory jurisdictions, in Indiana (about % of system demand) and Michigan (%), as well as the Federal Energy Regulatory Commission (FERC) (0%). Both state jurisdictions offer a transparent suite of recovery mechanisms which provide consistent cash flows for I&M while rates for its FERC jurisdictional wholesale contracts are set via predictable formula rates. Over the next several years, approximately one third of the company's capital budget will be recovered via various automatic adjustment mechanisms, while the balance is almost entirely covered by depreciation and deferred taxes. In both Indiana and Michigan, I&M's approved rate structures incorporate a comprehensive suite of formulaic recovery mechanisms, including adjustment clauses and trackers for recovery of fuel and purchased power, energy efficiency initiatives, the cost of renewable energy, and recovery of open access transmission tariffs. 0 III. I&M S PROPOSED CPITL STRUCTURE WHT IS I&M S PROPOSED CPITL STRUCTURE? I&M s proposed capital structure is shown below in Table. The -month average forecasted capital structure ending on December, 0 is sponsored by I&M witness Mr. Franz Messner. Exhibit IM 0 (FDM-), at, emphasize added.
Page TBLE I&M's Proposed Capital Structure (December, 0) Description Regulatory Weight Permanent Weight Long-Term Debt 0.0%.% Common Equity.%.% Short-Term Debt.0%.% ITC 0.% DIT.0% Total 00.00% 00.00% Source: Exhibit IM- (FDM-), Schedule D-. IS I&M S PROPOSED CPITL STRUCTURE RESONBLE? Yes. I&M s proposed capital structure contains a reasonable amount of common equity capital. I am not taking any issues with I&M s proposed capital structure at this time. However, I reserve the right to comment further based on additional evidence and testimony offered by the parties to this proceeding. III.. Embedded Cost of Debt WHT IS THE COMPNY S EMBEDDED COST OF DEBT? I&M is proposing an embedded cost of debt of.% as developed on its Direct Schedule D-.
Page RE YOU TKING ISSUE WITH I&M S PROPOSED EMBEDDED COST OF LONG-TERM DEBT? Not at this time. However, I reserve the right to comment further based on additional evidence and testimony offered by the parties to this proceeding. 0 IV. RETURN ON EUITY PLESE DESCRIBE WHT IS MENT BY UTILITY S COST OF COMMON EUITY. utility s cost of common equity is the expected return that investors require on an investment in the utility. Investors expect to earn their required return from receiving dividends and through stock price appreciation. 0 PLESE DESCRIBE THE FRMEWORK FOR DETERMINING REGULTED UTILITY S COST OF COMMON EUITY. In general, determining a fair cost of common equity for a regulated utility has been framed by two hallmark decisions of the U.S. Supreme Court: Bluefield Water Works & Improvement Co. v. Pub. Serv. Comm n of W. Va., U.S. () and Fed. Power Comm n v. Hope Natural Gas Co., 0 U.S. (). These decisions identify the general financial and economic standards to be considered in establishing the cost of common equity for a public utility. Those general standards provide the authorized return should: () be sufficient to maintain financial integrity; () attract capital under reasonable terms; and () be commensurate with returns investors could earn by investing in other enterprises of comparable risk.
Page PLESE DESCRIBE THE METHODS YOU HVE USED TO ESTIMTE I&M S COST OF COMMON EUITY. I have used several models based on financial theory to estimate I&M s cost of common equity. These models are: () a constant growth Discounted Cash Flow ( DCF ) model using consensus analysts growth rate projections; () a constant growth DCF using sustainable growth rate estimates; () a multi-stage growth DCF model; () a Risk Premium model; and () a Capital sset Pricing Model ( CPM ). I have applied these models to a group of publicly traded utilities with investment risk similar to I&M. 0 IV.. Risk Proxy Group PLESE DESCRIBE HOW YOU IDENTIFIED PROXY UTILITY GROUP THT COULD BE USED TO ESTIMTE I&M S CURRENT MRKET COST OF EUITY. I relied on the same proxy group developed by I&M witness Mr. Hevert with one exception. I excluded vista Corp. because on July, 0, it reached a definitive agreement to be purchased by Hydro One, Ltd. 0 WHY IS IT PPROPRITE TO EXCLUDE COMPNIES WHICH RE INVOLVED IN MERGER ND CUISITION ( M& ) CTIVITY FROM THE PROXY GROUP? M& activity can distort the market factors used in DCF and risk premium studies. M& activity can have impacts on stock prices, growth outlooks, and relative volatility in historical stock prices if the market was anticipating or expecting the M& activity prior to it actually being announced. This distortion in the market data thus impacts the reliability of the DCF and risk premium estimates for a company involved in M&.
Page 0 Moreover, companies generally enter into M& in order to produce greater shareholder value by combining companies. The enhanced shareholder value normally could not be realized had the two companies not combined. When companies announce a merger or acquisition, the public assesses the proposed merger and develops outlooks on the value of the two companies after the combination based on expected synergies or other value adds created by the M&. s a result, the stock value before the merger is completed may not reflect the forward-looking earnings and dividend payments for the company absent the merger or on a stand-alone basis. Therefore, an accurate DCF return estimate on companies involved in M& activities cannot be produced because their stock prices do not reflect the stand-alone investment characteristics of the companies. Rather, the stock price more likely reflects the shareholder enhancement produced by the proposed transaction. For these reasons, it is appropriate to remove companies involved in M& activities from a proxy group used to estimate a fair return on equity for a utility. PLESE DESCRIBE WHY YOU BELIEVE YOUR PROXY GROUP IS RESONBLY COMPRBLE IN INVESTMENT RISK TO I&M. 0 The proxy group shown in Exhibit B-, has an average corporate credit rating from S&P of BBB+, which is a notch lower than I&M s - credit rating from S&P. The proxy group has an average corporate credit rating from Moody s of Baa, which is identical to I&M s credit rating from Moody s. Based on this information, I believe my proxy group is reasonably comparable in investment risk to I&M. I also note that the proxy group has an average common equity ratio of.% (including short-term debt) from SNL Financial ( SNL ) and.% (excluding
Page short-term debt) from The Value Line Investment Survey ( Value Line ) in 0. The Company s proposed common equity ratio of.% (including short-term debt) and.% (excluding short-term debt) is comparable to the average proxy group common equity ratio. For these reasons, I believe my proxy group is reasonably comparable to I&M. IV.B. Discounted Cash Flow Model 0 0 PLESE DESCRIBE THE DCF MODEL. The DCF model posits that a stock price is valued by summing the present value of expected future cash flows discounted at the investor s required rate of return or cost of capital. This model is expressed mathematically as follows: P 0 = D + D.... D (Equation ) (+K) (+K) (+K) P 0 = Current stock price D = Dividends in periods - K = Investor s required return This model can be rearranged in order to estimate the discount rate or investor-required return, known as K. If it is reasonable to assume that earnings and dividends will grow at a constant rate, then Equation can be rearranged as follows: K = D /P 0 + G (Equation ) K = Investor s required return D = Dividend in first year P 0 = Current stock price G = Expected constant dividend growth rate Equation is referred to as the annual constant growth DCF model.
Page PLESE DESCRIBE THE INPUTS TO YOUR CONSTNT GROWTH DCF MODEL. s shown in Equation above, the DCF model requires a current stock price, expected dividend, and expected growth rate in dividends. 0 WHT STOCK PRICE HVE YOU RELIED ON IN YOUR CONSTNT GROWTH DCF MODEL? I relied on the average of the weekly high and low stock prices of the utilities in the proxy group over a -week period ending on ugust, 0. n average stock price is less susceptible to market price variations than a price at a single point in time. Therefore, an average stock price is less susceptible to aberrant market price movements, which may not reflect the stock s long-term value. -week average stock price reflects a period that is still short enough to contain data that reasonably reflects current market expectations but the period is not so short as to be susceptible to market price variations that may not reflect the stock s long-term value. In my judgment, a -week average stock price is a reasonable balance between the need to reflect current market expectations and the need to capture sufficient data to smooth out aberrant market movements. WHT DIVIDEND DID YOU USE IN YOUR CONSTNT GROWTH DCF MODEL? 0 I used the most recently paid quarterly dividend as reported in Value Line. This dividend was annualized (multiplied by ) and adjusted for next year s growth to produce the D factor for use in Equation above. In other words, I calculate D by multiplying the annualized dividend (D 0 ) by (+G). The Value Line Investment Survey, May, June, and July, 0.
Page 0 0 WHT DIVIDEND GROWTH RTES HVE YOU USED IN YOUR CONSTNT GROWTH DCF MODEL? There are several methods that can be used to estimate the expected growth in dividends. However, regardless of the method, for purposes of determining the market-required return on common equity, one must attempt to estimate investors consensus about what the dividend, or earnings growth rate, will be and not what an individual investor or analyst may use to make individual investment decisions. s predictors of future returns, securities analysts growth estimates have been shown to be more accurate than growth rates derived from historical data. That is, assuming the market generally makes rational investment decisions, analysts growth projections are more likely to influence investors decisions, which are captured in observable stock prices, than growth rates derived only from historical data. For my constant growth DCF analysis, I have relied on a consensus, or mean, of professional securities analysts earnings growth estimates as a proxy for investor consensus dividend growth rate expectations. I used the average of analysts growth rate estimates from three sources: Zacks, SNL, and Reuters. ll such projections were available on ugust, 0, and all were reported online. Each consensus growth rate projection is based on a survey of securities analysts. There is no clear evidence whether a particular analyst is most influential on general market investors. Therefore, a single analyst s projection does not as reliably predict consensus investor outlooks as does a consensus of market analysts projections. The consensus estimate is a simple arithmetic average, or mean, of surveyed analysts earnings growth forecasts. simple average of the growth See, e.g., David Gordon, Myron Gordon, and Lawrence Gould, Choice mong Methods of Estimating Share Yield, The Journal of Portfolio Management, Spring.
Page 0 forecasts gives equal weight to all surveyed analysts projections. Therefore, a simple average, or arithmetic mean, of analyst forecasts is a good proxy for market consensus expectations. WHT RE THE GROWTH RTES YOU USED IN YOUR CONSTNT GROWTH DCF MODEL? The growth rates I used in my DCF analysis are shown in Exhibit B-. The average growth rate for my proxy group is.%. 0 WHT RE THE RESULTS OF YOUR CONSTNT GROWTH DCF MODEL? s shown in Exhibit B-0, the average and median constant growth DCF returns for my proxy group for the -week analysis are.% and.%, respectively. DO YOU HVE NY COMMENTS ON THE RESULTS OF YOUR CONSTNT GROWTH DCF NLYSIS? Yes. The constant growth DCF analysis for my proxy group is based on a group average long-term sustainable growth rate of.%. The three- to five-year growth rates are higher than my estimate of a maximum long-term sustainable growth rate of.0%, which I discuss later in this testimony. I believe the constant growth DCF analysis produces a reasonable high-end return estimate. 0 HOW DID YOU ESTIMTE MXIMUM LONG-TERM SUSTINBLE GROWTH RTE? long-term sustainable growth rate for a utility stock cannot exceed the growth rate of the economy in which it sells its goods and services. Hence, the long-term
Page 0 maximum sustainable growth rate for a utility investment is best proxied by the projected long-term Gross Domestic Product ( GDP ). Blue Chip Financial Forecasts projects that over the next and 0 years, the U.S. nominal GDP will grow at an annual rate of approximately.0%. These GDP growth projections reflect a real growth outlook of around.% and an inflation outlook of around.% going forward. s such, the average growth rate over the next 0 years is around.0%, which I believe is a reasonable proxy of long-term sustainable growth. In my multi-stage growth DCF analysis, I discuss academic and investment practitioner support for using the projected long-term GDP growth outlook as a maximum sustainable growth rate projection. Hence, using the long-term GDP growth rate as a conservative projection for the maximum sustainable growth rate is logical, and is generally consistent with academic and economic practitioner accepted practices. IV.C. Sustainable Growth DCF 0 PLESE DESCRIBE HOW YOU ESTIMTED SUSTINBLE LONG-TERM GROWTH RTE FOR YOUR SUSTINBLE GROWTH DCF MODEL. sustainable growth rate is based on the percentage of the utility s earnings that is retained and reinvested in utility plant and equipment. These reinvested earnings increase the earnings base (rate base). Earnings grow when plant funded by reinvested earnings is put into service, and the utility is allowed to earn its authorized return on such additional rate base investment. The internal growth methodology is tied to the percentage of earnings retained in the company and not paid out as dividends. The earnings retention ratio is minus Blue Chip Financial Forecasts, June, 0, at.
Page 0 the dividend payout ratio. s the payout ratio declines, the earnings retention ratio increases. n increased earnings retention ratio will fuel stronger growth because the business funds more investments with retained earnings. The payout ratios of the proxy group are shown in my Exhibit B-. These dividend payout ratios and earnings retention ratios then can be used to develop a sustainable long-term earnings retention growth rate. sustainable long-term earnings retention ratio will help gauge whether analysts current three- to five-year growth rate projections can be sustained over an indefinite period of time. The data used to estimate the long-term sustainable growth rate is based on the Company s current market-to-book ratio and on Value Line s three- to five-year projections of earnings, dividends, earned returns on book equity, and stock issuances. s shown in Exhibit B-, the average sustainable growth rate for the proxy group using this internal growth rate model is.%. 0 WHT IS THE DCF ESTIMTE USING THESE SUSTINBLE LONG-TERM GROWTH RTES? DCF estimate based on these sustainable growth rates is developed in Exhibit B-. s shown there, and using the same formula in Equation above, a sustainable growth DCF analysis produces proxy group average and median DCF results for the -week period of.0% and.%, respectively.