STATE OF WEST VIRGINIA BEFORE THE PUBLIC SERVICE COMMISSION

STATE OF WEST VIRGINIA BEFORE THE PUBLIC SERVICE COMMISSION GENERAL INVESTIGATION TO ) DETERMINE WHETHER WEST ) VIRGINIA SHOULD ADOPT A ) PLAN FOR OPEN ACCESS TO ) CASE NO. -0-E-GI THE ELECTRIC POWER ) SUPPLY MARKET AND FOR ) THE DEVELOPMENT OF A ) DEREGULATION PLAN ) DIRECT TESTIMONY OF RANDY M. ALLEN ON BEHALF OF THE CONSUMER ADVOCATE DIVISION OF THE PUBLIC SERVICE COMMISSION OF WEST VIRGINIA JULY, RMA UTILITY CONSULTING REGULATORY MANAGEMENT ACCOUNTING

-M Centre Park Drive PMB No. Columbia, Maryland 0 (0) - TABLE OF CONTENTS Page INTRODUCTION AND SCOPE... CONCLUSIONS... DEFERRED TAXES... ACCUMULATED DEFERRED INCOME TAXES... SFAS NO. 0...0 EXCESS DEFERRED INCOME TAXES... UNAMORTIZED INVESTMENT TAX CREDITS... OVER-FUNDED PENSION PLANS... OTHER UNAMORTIZED BALANCES... OTHER MITIGATING CIRCUMSTANCES...0

TESTIMONY OF RANDY M. ALLEN 0 0 0 INTRODUCTION AND SCOPE Q. PLEASE PROVIDE YOUR NAME AND BUSINESS AFFILIATION. A. My name is Randy M. Allen and I am the founder and president of RMA Utility Consulting at PMB No., -M Centre Park Drive, Columbia, Maryland, 0. RMA Utility Consulting is a firm that specializes in litigation support, negotiation, and technical expertise in public utility accounting, taxation, and regulation. Q. ON WHOSE BEHALF ARE YOU APPEARING? A. I am appearing on behalf of the Consumer Advocate Division (CAD) of the Public Service Commission of West Virginia (PSC). Q. WHAT IS THE PURPOSE OF YOUR TESTIMONY IN THIS PROCEEDING? A. RMA Utility Consulting was engaged by the CAD to assist in its participation in the Electric Restructuring Task Force. Specifically, RMA Utility Consulting was retained by CAD to provide independent analysis and expert testimony as to the appropriateness of including certain deferred federal income tax items as a part of stranded investment, and to comment on other accounting issues as they arise. My analysis addresses: (a) the accumulated deferred income tax reserve (ADIT); (b) the Statement of Financial Accounting Standards (SFAS) No. 0 asset/liability; (c) excess deferred federal income taxes (EDITs); (d) unamortized investment tax credits (UITCs); and (e) other issues. This testimony is presented on a conceptual basis as I have not analyzed the individual proposals of the various utilities involved in this proceeding. These proposals will apparently be filed at the same time as this testimony. Q. PLEASE PROVIDE A SUMMARY OF YOUR EDUCATIONAL BACKGROUND AND PUBLIC UTILITY REGULATORY EXPERIENCE. A. I have 0 years of direct public utility accounting, taxation, ratemaking and regulatory experience, and have testified or presented reports in approximately 0 gas, electric, telephone, water and wastewater cases before the Federal Energy Regulatory Commission and regulatory agencies in Arizona, Connecticut, Florida, Georgia, Idaho, Louisiana, Maine, Nevada, New Jersey, New York, North Dakota, Pennsylvania, Rhode Island, TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 Texas, Utah, Vermont, Virginia and West Virginia. I have also testified before legislative committees, district courts and various municipalities in Texas. I received a Bachelor of Science Degree in Accounting from Bentley College in Waltham, Massachusetts in June. I am a Certified Public Accountant licensed in the States of Maryland and Texas, and I am a member of the American Institute of Certified Public Accountants and the Maryland Association and Texas Society of Certified Public Accountants. I served as the Chairman of the National Association of State Utility Consumer Advocates (NASUCA) Accounting and Tax Committee for two years (-0) and was an observation member of the National Association of Regulatory Utility Commissioners (NARUC) Staff Subcommittee on Accounts (-0). I have presented numerous papers and participated on panels before state and national professional associations and societies on utility ratemaking issues. Q. WOULD YOU PLEASE PROVIDE A SUMMARY THAT DESCRIBES THE SPECIFIC JOB RESPONSIBILITIES YOU HAVE HAD OVER YOUR REGULATORY CAREER? A. From June to August, I was employed by Dallas Power & Light Company (Texas Utilities Electric Company) as an accountant. For approximately two years, my duties included various general accounting functions, preparation of rate filing schedules, and review of written testimony for rate increase applications brought before the Public Utility Commission of Texas. During my last two and one-half years with the Company, I served as Supervisor of Corporate Taxation where I was responsible for federal tax research and accounting, including the calculation and recording of deferred taxes, and all state and local tax research, reporting and accounting. In September, I was employed by the Public Utility Commission of Texas and obtained the position of Manager of Electric Accounting as a Chief Accountant III. In this position, I was responsible for supervising the electric accounting staff, assisting in the development of ratemaking procedures and policies, and testifying on cost of service and invested capital issues in rate cases brought before the Commission. In June, I joined the engineering and consulting firm of R.W. Beck and Associates as a Supervising Analyst. In this position, I was responsible for supervising the day-to-day TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 accounting activities associated with rate increase analyses of gas and electric investorowned utilities and presenting testimony and/or reports before municipal and state jurisdictional agencies. In July, I was employed by Pannell Kerr Forster (PKF), an international certified public accounting and consulting firm, as a Managing Supervisor. In this position, my responsibilities included the examination, review and analysis of rates and rate increase applications of municipal and investor-owned electric, gas, telephone, water and wastewater utilities, and the presentation of testimony on accounting matters. Following a merger between PKF and a local accounting firm, my department was disbanded and the office eventually closed. For approximately six months, I worked as an Executive Consultant for Resource Management International, Inc., performing municipal rate studies and forecasting results of operations for municipal revenue bond financings. In December, I joined the Texas Office of Public Utility Counsel as the Director of Regulatory Accounting. In this position, I was responsible for managing and formulating expert testimony regarding electric and telephone utility regulatory accounting issues, assisting Public Counsel in developing policies and negotiating positions, and presenting policies and negotiating settlements on behalf of the Public Counsel. I also provided outside independent consulting services regarding gas and water utility matters when my schedule permitted. In October 0, I joined Exeter Associates, Inc., as a Senior Regulatory Accountant. In this position, I analyzed various rate and regulatory issues and provided testimony in electric, gas, telephone and water proceedings. In December, I founded RMA Utility Consulting. CONCLUSIONS Q. WOULD YOU PLEASE SUMMARIZE YOUR CONCLUSIONS? A. Yes. The following provides a brief summary of my testimony: Accumulated deferred income taxes represent temporary tax benefits under normalization from expenses recovered from ratepayers in advance of payment to the IRS. Therefore, such amounts should not be treated as stranded costs, and may need to be passed onto ratepayers under certain circumstances. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 Deferred income taxes under SFAS No. 0 do not represent stranded costs or investments. SFAS No. 0 deferred income tax amounts in excess of traditional accumulated deferred taxes do not represent regulatory assets or liabilities, but are merely accounting assets or liabilities for financial reporting purposes. Excess deferred income taxes resulting from the Tax Reform Act of should be recognized as negative stranded costs to prevent such amounts from inappropriately inuring to the benefit of shareholders upon deregulation. Accumulated Investment Tax Credits should be recognized as negative stranded costs to prevent such amounts from inappropriately inuring to the benefit of shareholders upon deregulation. Over-funded pension plan amounts should be returned to ratepayers as a refund or credit, be recognized as negative stranded costs to prevent such amounts from inappropriately inuring to the benefit of shareholders upon deregulation. All unamortized balances resulting from decisions of the Commission should be recognized as negative stranded costs to prevent such amounts from inappropriately inuring to the benefit of shareholders upon deregulation. The accounting books and records should be reviewed to insure the appropriateness of any reallocation of common costs to generating functions. DEFERRED TAXES Q. WOULD YOU PLEASE EXPLAIN DEFERRED TAXES? A. Deferred taxes, whether positive or negative, represent the tax effect of temporary timing differences between the recognition of income and deductions for tax purposes and ratemaking purposes. Deferred taxes are not limited to regulated enterprises. For regulated entities, the single largest cause of deferred income taxes generally relates to depreciation method and life differences between ratemaking and tax basis accounting. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 Another cause of deferred taxes include prior tax deductibility of construction period interest and overhead costs. Q. WOULD YOU PLEASE PROVIDE AN EXAMPLE OF HOW DEFERRED INCOME TAXES WORK? A. Deferred income taxes allow an entity which takes advantage of accelerated depreciation for tax deduction purposes to temporarily keep the difference between the tax calculated at the accelerated deduction level and the more evenly recognized straight-line depreciation expense recognized for ratemaking purposes. These timing differences are of a temporary nature and reverse over the useful life of the asset that gives rise to the deferred tax. The following example is based on a $,000 asset with a 0-year straightline book depreciation life and an accelerated -year tax depreciation life. For ease of understanding, I have assumed a 0% tax rate. USEFUL TAX TAX RATE TAX DEFERRED DFIT LIFE DEPR EFFECT DEPR EFFECT TAX RESERVE 0 0 0 0 0 0 Year 0 0 0 0 0 0 Year 0 0 0 0 0 0 Year 0 0 0 0 0 0 Year 0 0 0 0 0 0 Year 0 0 $ (00) 0 Year 0 0 $ (00) 0 Year 0 0 $ (00) 0 Year 0 0 $ (00) 0 Year 0 0 $ (00) Year 0 $,000 $,000 $,000 $,000 Total TESTIMONY OF RANDY M. ALLEN PAGE OF 0

Q. WOULD YOU PLEASE EXPLAIN YOUR EXAMPLE? TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 A. In the example on the previous page, the columns labeled Tax Effect show the tax savings resulting from use of either accelerated depreciation (labeled Tax Depr ) or straight line depreciation (labeled Rate Depr, short for Ratemaking Depr ) in any particular year. In year one, the tax savings using accelerated depreciation are $00 higher than with the use of straight-line depreciation. The additional $00 tax saving attributable to accelerated depreciation is accounted for as a deferred tax, and is placed in the deferred tax reserve ( DFIT Reserve ). In year two, another additional $00 tax savings results, and the $00 deferred tax for that year is added to the DFIT reserve, making a total of $00 in the reserve. The DFIT reserve continues to increase every year that tax depreciation exceeds ratemaking depreciation. After year five, the accelerated tax depreciation is used up, and the DFIT reserve begins to reverse. For example, in year six, the tax savings under accelerated depreciation are $00 lower than under straight-line depreciation. As a result, $00 in deferred taxes is removed from the DFIT reserve to pay the tax liability produced by straight-line depreciation. Over the ten year life of the asset, the DFIT reserve is reduced to zero. As seen, accelerated depreciation results in a larger tax deduction in the earlier years, with the opposite effect in latter years. The deferred taxes resulting from accelerated deductions in the earlier years provides for a cost-free source of capital that can be invested in additional revenue producing plant. With the help of this additional revenue producing plant, the company will pay back the IRS for this cost-free capital in the later years when the straight-line deduction exceeds the accelerated tax deduction. These amounts represent a cost-free source of capital because the Company pays no return to the ratepayers or IRS for the use of these funds. While accumulated deferred income taxes are treated as a reduction from rate base, this treatment does not offset the cost-free capital status of these advanced funds. Rather, the rate base reduction is required to directly offset the rate base addition of the plant in service paid for with these advance funds for which the Company charges a return to its customers. Many believe that over time, the deferred tax reserve continues to rise in perpetuity as more and more plant investments are made. This has certainly been the case in the electric utility industry, at least until restructuring. Q. WHY DID CONGRESS INSTITUTE THE NORMALIZATION RULES FOR REGULATED UTILITIES? TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 A. Remembering that deferred taxes represent a cost-free source of funds created specifically to invest in revenue producing plant, most entities actually used these funds for their intended investment purposes. In the regulation of public utilities, where the current cost to ratepayers is of some importance, some regulators required utilities to flow-through the immediate deferred tax benefits to ratepayers through rates. This provided ratepayers with the same reduced tax bill actually paid by the utility. Because this treatment did not allow the utilities to obtain deferred taxes to invest in revenue producing plant at zero cost, Congress enacted the normalization rules in the early 0's. These rules were designed to require regulators to allow the utilities to invest this cost-free capital, or lose its ability to receive accelerated deductions. Q. DO DEFERRED INCOME TAXES REPRESENT AN EXPENSE OVER AND ABOVE CURRENT INCOME TAX EXPENSE? A. Total tax expense for ratemaking purposes includes both current and deferred taxes. However, deferred taxes do not represent an expense over and above current income tax expense in light of the overall tax liability paid by the Company to the IRS over the entire life of any given depreciable plant asset. Deferred income taxes represent a temporary account for recording the effects of method and life timing differences. These method and life timing differences are related to the tax deduction allowed for depreciation expense. These deductions are reflected in rates as depreciation expense, and result in a lower tax liability than if the tax code did not allow for depreciation deductions. Deferred taxes are not an additive cost, but rather an accounting classification for reflecting the timing of taking a tax deduction for depreciation expense. In fact, deferred taxes are recorded on the books under the FERC Uniform System of Accounts in the income accounts, not the expense accounts. Assuming no change in statutory tax rates, deferred income taxes do not increase or decrease the total amount of federal income taxes to be paid over the useful life of related assets. Instead, deferred taxes only relate to the year when the deductions will be taken for tax return purposes. No actual income taxes are paid on revenues collected to cover accelerated depreciation expense. Rather, accelerated depreciation for tax purposes simply reduces income taxes payable to the IRS in the early years, and then increases the taxes payable in the later years of an assets life. At the end, deferred taxes are netted to $0. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 ACCUMULATED DEFERRED INCOME TAXES Q. DESCRIBE THE NATURE AND ORIGIN OF ACCUMULATED DEFERRED INCOME TAXES? A. Accumulated Deferred Income Taxes (ADITs) simply represent the accumulated balance of deferred income taxes retained by the utility at a given point in time pending reversal or transfer to the ratepayer s benefit. They arise from the deferred tax mechanism discussed above. The calculation and treatment from year-to-year are reflected in the previously presented example of deferred taxes. Q. HOW SHOULD ADITs BE TREATED UNDER RESTRUCTURING? A. ADITs generally reflect accumulated over-recoveries from ratepayers under normalization for accelerated tax benefits that will not be passed on to ratepayers until future years. The treatment of ADITs under restructuring depends greatly on how the Commission structures the treatment of electric utilities in West Virginia. Because that decision has not yet been made, one can only discuss this matter from a conceptual standpoint. Q. HOW SHOULD ADITs BE TREATED IF THE COMMISSION REQUIRES DIVESTITURE? A. If the Commission requires divestiture of generation assets through open sale, ADITs would become due and payable to the IRS in the year of sale through recapture of accelerated benefits. Recapture would relieve the owner of any future tax liabilities related to these ADITs. Recapture simply eliminates all timing differences and ADIT balances, and does not result in any stranded cost. While under divestiture all ADITs would become due and owing, the utility and ratepayers would receive the full market value of existing generation assets. Q. WHERE WILL THE UTILITY OBTAIN THE FUNDS TO PAY THE IRS FOR THE RECAPTURED ACCELERATED BENEFITS? A. If such assets are sold for a gain, any recaptured deferred taxes would be recovered through the sales proceeds. This was the finding of the Vermont Public Service Commission in Vermont Telephone Company s Docket No. 0. If such assets are sold TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 for a loss, the tax deduction for the loss in net tax basis would be used to offset any recaptured amounts. Q. WHAT HAPPENS TO ADITs IF THE COMMISSION DOES NOT REQUIRE DIVESTITURE? A. For any such plant facilities that are not divested and will be used to provide service to future customers in a competitive restructured industry, the answer turns on whether the resulting restructured assets will still be considered utility property under the IRC. If they are, normalization will continue and the Commission must ensure that the benefits of ADIT s are passed on to customers upon reversal. However, because electric utilities will most likely enter an unregulated, competitive environment as a result of restructuring, ADIT balances should be returned to ratepayers as a refund, credit, or offset to any stranded cost amounts determined by the Commission. Without such treatment, ADIT balances will most likely inure to the benefit of shareholders upon deregulation. If the generation assets do not remain as utility property under the IRC, the IRS may require recapture as discussed above and no benefits from accelerated deductions will exist. Finally, if such assets are no longer useful to the utility upon restructuring, the Company will receive a tax writeoff or loss benefit for the net tax basis of the useless assets. This tax loss should be used to offset any recaptured deferred income taxes. Once again, after recapture no future tax liabilities related to these ADITs will remain. Q. IS THERE ANY JUSTIFICATION FOR TRANSFER OF ADITs TO SHAREHOLDERS UNDER ACCEPTED COST OF SERVICE REGULATORY PRINCIPLES? A. No. ADITs represent temporary tax benefits under normalization from expenses recovered from ratepayers in advance of payment to the IRS. These benefits are to be returned to ratepayers under general principles of rate regulation and equity over the remaining lives of the assets that gave rise to the ADITs. For the reasons set out above, fairness and equity demand that ratepayers who prepaid these deferred taxes continue to To the extent ratepayers have already prepaid the deferred taxes, such amounts should be funded from the cost-free funds previously provided by ratepayers. In other words, ratepayers should not be responsible for providing the utility with such recaptured amounts because they have already paid the deferred taxes to the utility when the timing differences originated. TESTIMONY OF RANDY M. ALLEN PAGE 0 OF 0

0 0 receive the related benefits over the remaining lives of the assets, and that utilities not be allowed to keep them because of restructuring. SFAS NO. 0 Q. WOULD YOU PLEASE DESCRIBE SFAS NO. 0? A. SFAS No. 0 is the accounting pronouncement that addresses Accounting for Income Taxes. This statement establishes financial accounting and reporting standards for the future effects of income taxes that result from an enterprise s activities during the current and preceding years. It requires an asset or liability approach for financial accounting and reporting for income taxes, and does not impact the income statement. SFAS No. 0 became effective for fiscal year s beginning after December,. Prior to SFAS No. 0, entities only recorded the historical effects of deferred taxes. SFAS No. 0 is effective for enterprises in general, not just regulated enterprises. The issue of SFAS No. 0 is, therefore, not unique to the regulated public utility industry. Q. REFERRING BACK TO YOUR EXAMPLE OF DEFERRED INCOME TAXES, WOULD YOU PLEASE ILLUSTRATE THE REQUIREMENTS OF SFAS NO. 0? A. For ease of reference, I will repeat below the example of deferred taxes from page of this testimony. Please note that the column entitled Ratemaking Depreciation in the page example, is labeled Book Depreciation in the example below. This is because prior to FAS No. 0, timing differences between tax and book depreciation were not afforded deferred tax treatment. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

USEFUL TAX TAX BOOK TAX DEFERRED DFIT LIFE DEPR EFFECT DEPR EFFECT TAX RESERVE 0 0 0 0 0 0 Year 0 0 0 0 0 0 Year 0 0 0 0 0 0 Year 0 0 0 0 0 0 Year 0 0 0 0 0 0 Year 0 0 $ (00) 0 Year 0 0 $ (00) 0 Year 0 0 $ (00) 0 0 Year 0 0 $ (00) 0 Year 0 0 $ (00) Year 0 $,000 $,000 $,000 $,000 Total 0 Prior to SFAS No. 0, an entity would be required to record its accumulated historical balance of deferred taxes as an asset or liability. As shown in the far right column, a $00 deferred tax liability (DFIT Reserve) would be reflected on the company s books of accounts at the end of year two of the life of the asset. Under SFAS No. 0, the determination of future tax consequences would result from a comparison of unrecovered tax basis and unrecovered book basis at the statutory tax rate. In this example, the unrecovered tax basis at the end of year two is $,00 ($,000 original basis less $00 tax depreciation in year one and $00 tax depreciation in year two), while the unrecovered book basis is $,00 ($,000 original basis less $00 book depreciation in year one and $00 book depreciation in year two). At the assumed 0% tax rate, the tax on the unrecovered tax basis would be $00 ($,00 X 0%), while the tax on the unrecovered book basis would be $00 ($,00 X 0%). As shown in the calculation below, a These future tax consequences on the unrecovered bases can also be derived by adding the tax effect for years through 0 for both the tax and book depreciation columns above. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 comparison of these two amounts would result in a net SFAS No. 0 asset of $00 at the end of year two. Unrecovered Tax Effect of Tax Basis $00 Unrecovered Tax Effect of Book Basis $00 SFAS No. 0 Net Asset $00 Pre-SFAS No. 0 Liability $00 Net Difference $00 This $00 SFAS No. 0 accounting asset would be shown on the company s balance sheets in its financial reports, but would not affect the company s income. Thus, the net impact of SFAS No. 0 is a $00 shift on the company s balance sheets from a $00 net liability to a $00 net asset. However, regardless of whether a net asset or net liability exists in any one year, over the life of the asset current tax expense will equal deferred tax expense and no asset or liability will remain. This is shown in the totals in the deferred tax example on the previous page. Also notice that under either prior accounting treatment or SFAS No. 0, deferred income taxes have a natural life cycle which lasts over the entire useful life of the plant investment that gives rise to the deferred tax treatment. Q. WHAT ARE THE OBJECTIVES OF ACCOUNTING FOR INCOME TAXES UNDER SFAS NO. 0? A. The objectives of accounting for income taxes under SFAS No. 0 are first to recognize the amount of taxes payable or refundable for the current year, and second to record deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized in an enterprise s financial statements or tax returns. The Financial Accounting Standards Board acknowledges the limitations of SFAS No. 0. According to the Board, the accuracy of SFAS No. 0 accounting is realistically constrained because the amount of tax at issue is the result of all past and future events that may affect the tax return, and because information about the future is inherently limited. Nevertheless, SFAS No. 0 is an attempt by the Board to require enterprises to fully disclose the likely future effects of taxes for financial reporting purposes. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 Q. HOW DOES SFAS NO. 0 TREAT TAX BENEFITS WHICH HAVE PREVIOUSLY BEEN FLOWED THROUGH BY REGULATORS? A. In effect, SFAS No. 0 requires deferred taxes to be recognized for financial reporting purposes based on the timing differences between tax and book treatment, rather than differences between tax and ratemaking treatment, as was the case prior to SFAS No. 0. As a result, SFAS No. 0 now recognizes deferred taxes for timing differences previously flowed-through by regulators. However, it is important to remember that these SFAS No. 0 deferred taxes on benefits previously flowed through are accounting assets, not regulatory assets. Q. WHAT ARE REGULATORY ASSETS AND LIABILITIES? A. Simply stated, regulatory assets are amounts which ratepayers are obligated to pay utilities in the future. Conversely, regulatory liabilities are amounts which utilities are obligated to pay ratepayers in the future. The creation and maintenance of regulatory assets and liabilities is governed by SFAS No., Accounting for the Effects of Certain Types of Regulation. SFAS No. states: Revenues intended to cover some costs are provided either before or after the costs are incurred. If regulation provides assurance that incurred costs will be recovered in the future, this Statement requires companies to capitalize those costs [i.e., create an asset]. If current recovery is provided for costs that are expected to be incurred in the future, this Statement requires companies to recognize those current receipts as liabilities. Examples of regulatory assets include storm damage reserves or delayed recoveries, amortization of rate case expenses, etc. Q. DO AMOUNTS RECORDED UNDER SFAS NO. 0 REPRESENT REGULATORY ASSETS OR LIABILITIES? Since ratemaking and book treatment are generally the same under SFAS No., some say that deferred income taxes have always been recognized on the timing difference between tax and book treatment. However, this is not accurate. For example, during flow-through years, no deferred taxes were recorded because tax and ratemaking both followed accelerated deductions, even though book treatment used straight-line deductions. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 A. No. SFAS No. 0 amounts simply represent accounting assets or liabilities for financial reporting purposes. Such amounts generally represent future liabilities to the IRS related to taxes the utility has not yet recovered - and may not necessarily recover - from ratepayers. Q. ARE SFAS NO. 0 AMOUNTS INCLUDED IN UTILITY RATES? A. No. Across the country, the effects of SFAS No. 0 have not been afforded any rate treatment because they only reflect an accounting requirement associated with reporting the future consequences of taxes. SFAS No. 0 amounts are not included in utility revenue requirements and no promise is made by regulators to turn the SFAS No. 0 asset into cash. Q. DOES THE REGULATORY LITERATURE CONFIRM YOUR CONCLUSION THAT SFAS NO. 0 ACCOUNTING ASSETS ARE NOT REGULATORY ASSETS? A. Yes. America s Electric Utilities: Past, Present and Future, Leonard S. Hyman, Fifth Edition, Public Utilities Reports, Inc., page, defines a regulatory asset as an entry on the books which regulators promise they will turn into cash by allowing the utility to charge customers an extra sum on every bill until the regulatory asset is written off the books. As already discussed, SFAS No. 0 amounts are not reflected in revenue requirements and no promise is made by regulators to turn the SFAS No. 0 asset into cash. Also, Electric Utility Restructuring: A Guide to the Competitive Era, Peter Fox- Penner, Public Utilities Reports, Inc.,, page, states that regulatory assets are an assortment of regulator-approved extended payment plans for certain large expenses. A regulatory asset allows a utility to count on its balance sheet a promissory note effectively promising that the utility s future revenues will be adequate for amortization of a specific liability. Q. DOES DEREGULATION OR RESTRUCTURING CHANGE THE NORMAL LIFE CYCLE FOR DEFERRED TAXES? A. No. Whether regulated or not, SFAS No. 0 requires asset or liability treatment for the future tax consequences of events that have been recognized in an enterprise s financial statements or tax returns. Upon deregulation or restructuring, the generating concern will TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 continue to record deferred income taxes throughout the various remaining life cycles of its plant investment. Deferred taxes under SFAS No. 0 do not represent stranded costs or investments. Just as SFAS No. 0 has not had an impact on ratemaking since, it should not have an impact under restructuring. Allowing the inclusion of deferred taxes under SFAS No. 0 as a stranded cost, effectively adjusts the book reserve for ratemaking purposes to reflect full normalization and makes ratepayers responsible for more than the tax due on full straight line depreciation for plant facilities already used in providing service to customers at the point of restructuring. The inclusion of the accounting asset or liability for SFAS No. 0 advances that position and makes current ratepayers at the point of restructuring responsible for the future use of generating facilities by competitive customers. For such plant that will survive and provide future service, the future competitive customers should be fully responsible for such deferred taxes. Such amounts simply become part of the costs and expenses of the going generation concern in the future. If the underlying assets are maintained, such amounts will be recovered through market rates. Q. IF THE COMMISSION ALLOWS INCLUSION OF SFAS NO. 0 AMOUNTS AS STRANDED COSTS, DO YOU HAVE ANY RECOMMENDATIONS ON HOW THESE AMOUNTS SHOULD BE TREATED? A. Yes. As previously stated, SFAS No. 0 amounts are not regulatory assets and should not be included as stranded costs related to restructuring. SFAS No. 0 assets and liabilities represent future tax accounting consequences that will be extinguished over the remaining service lives of the related facilities. However, if the Commission allows SFAS No. 0 amounts to be included as stranded costs and recovered over a relatively short period of time, the Commission should be aware that these SFAS No. 0 amounts are not discounted to present value. If recovery is allowed, SFAS No. 0 amounts should be discounted to their net present value using a reasonable rate of return. To allow recovery of SFAS No. 0 amounts without discounting would place the companies in a better position then they would have been absent restructuring. Discounting was required by the Pennsylvania Public Utilities Commission in the PECO Energy stranded cost proceeding. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 EXCESS DEFERRED INCOME TAXES Q. DESCRIBE THE NATURE AND ORIGIN OF EXCESS DEFERRED INCOME TAXES? A. Excess Deferred Income Taxes represent the difference between deferred taxes collected from ratepayers at % and those same deferred taxes recalculated at the current % statutory tax rate resulting from the Tax Reform Act of. They arise from the requirements under Sections and of the Internal Revenue Code (IRC) that public utilities normalize method and life timing differences prior to when the corporate tax rate was %. With the Tax Reform Act of 's reduction in the corporate income tax rate from % to %, regulated utilities found themselves maintaining ADIT reserves in excess of the deferred taxes which would become due and payable upon reversal of normalized method and life timing differences. While the utility industry acknowledged that they had an obligation to repay these EDITs to ratepayers, they successfully lobbied Congress for the enactment of Section 0(e) of the Tax Reform Act of, which requires the repayment of excess protected method and life timing differences over the remaining regulatory service lives of the investments which had originally given rise to these deferred taxes. Q. HOW SHOULD EDITs BE TREATED UNDER RESTRUCTURING? A. Because electric utilities will most likely enter an unregulated, competitive environment as a result of restructuring, EDIT balances should be returned to ratepayers as a refund, credit, or offset to any stranded cost amounts. Without such treatment, EDIT balances will inure to the benefit of shareholders upon deregulation. Q. IS THERE ANY JUSTIFICATION FOR TRANSFER OF EDITs TO SHAREHOLDERS UNDER ACCEPTED COST OF SERVICE REGULATORY PRINCIPLES? A. No. EDITs represent past utility over-recoveries of income tax expenses due to normalization which will never become due and payable to the IRS. This is evidenced in the utility industry s own lobbying efforts discussed above, that conceded that the benefits of these EDITs should be returned to ratepayers under general principles of rate regulation and equity over the remaining lives of the assets that gave rise to the EDITs. Because the remaining regulated lives of these assets will cease upon deregulation, these properties TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 should no longer be subject to IRC Sections and requirements to continue amortizing them to ratepayers over the remaining lives. Even if these code sections still relate, fairness and equity demand that ratepayers who overpaid these deferred taxes receive them, and that the utilities not be allowed to keep them because of restructuring. Q. WOULD IT BE FAIR TO RETURN EDITs TO RATEPAYERS IF SFAS NO. 0 AMOUNTS ARE NOT INCLUDED AS A STRANDED COST? A. Yes. EDITs represent prior ratepayer over-payments, and exist independent of SFAS No. 0. EDITs and SFAS No. 0 amounts are different items that should be given separate consideration. UNAMORTIZED INVESTMENT TAX CREDITS Q. PLEASE DISCUSS THE NATURE AND ORIGIN OF UNAMORTIZED INVESTMENT TAX CREDITS. A. Unamortized Investment Tax Credits represent the balance of investment related tax credits (ITCs) used to directly reduce a given year s tax liability to the IRS under the requirements of IRC (f), but which have not yet been provided or passed through to ratepayers under normalization. These credits instead benefit ratepayers over the remaining regulatory lives of the underlying assets which gave rise to the ITCs. For regulatory purposes, ITCs have been disregarded in calculating the utility's recoverable tax expense during the year the ITC was claimed for tax purposes. Instead, the utility has two alternative ways to pass the associated benefits of the credits on to ratepayers. These include: ) a dollar-for-dollar reduction to the rate base value of the underlying assets (IRC (f)()); or ) reductions to the recoverable amounts of future tax expenses equal to the amount of unamortized credits, spread out ratably over the service lives of the underlying assets (IRC (f)()). The vast majority of regulated electric utilities opted for IRC (f)() treatment as that has been the prevalent general practice. Ongoing allowance of ITCs was largely eliminated by the Tax Reform Act of, but UITCs recognized for tax purposes prior to have not yet been fully returned to ratepayers. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

Q. PLEASE GIVE A SIMPLIFIED EXAMPLE OF HOW THE NORMALIZATION OF ITC UNDER IRC (F)() WORKS. TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 0 0 A. Assume a 0% ITC, and a $00,000,000 investment in generating plant (Asset A) with a thirty year regulatory service life. The utility would have currently received a 0% ITC on Asset A, that would have reduced year one income taxes payable by $0,000,000. For regulatory purposes, this $0,000,000 ITC reduction to taxes payable was not reflected as a reduction in the calculation of recoverable tax expense from ratepayers for year one. Instead, recoverable tax expenses were reduced by $,000,000 annually for years one through thirty, thus amortizing the UITC ratably over Asset A's regulatory service life. However, restructuring of the electric industry interrupts this process by effectively eliminating the remaining regulatory service life of generation assets by ending traditional regulatory rate setting in favor of competition. Lets assume that in year 0 Asset A is deregulated. At that time, only.% of UITCs will have been passed on to ratepayers, and the remaining $,, of UITCs will reside with the utility with no enforceable mechanism to ensure that ratepayers get their full $0,000,000 value of the ITC previously realized by the utility. Q. HOW SHOULD UITCs BE TREATED UNDER RESTRUCTURING? A. Because electric utilities will most likely enter an unregulated, competitive environment as a result of restructuring, UITC balances should be returned to ratepayers as a refund, credit, or offset to any stranded cost amounts. Without such treatment, UITC balances will inure to the benefit of shareholders upon deregulation. Q. IS THERE ANY JUSTIFICATION FOR TRANSFER OF UITCs TO SHAREHOLDERS UNDER ACCEPTED COST OF SERVICE REGULATORY PRINCIPLES? A. No. UITCs represent past utility over-recoveries of income tax expenses due to normalization which will never become due and payable to the IRS. This is very much like EDITs previously addressed. Because the remaining regulated lives of these assets will cease upon deregulation, these properties should no longer be subject to IRC Sections and normalization requirements to continue amortizing them to ratepayers over the remaining lives. Even if these code sections still relate, fairness and equity demand that ratepayers who overpaid these taxes receive them, and that the utilities not be allowed to keep them because of restructuring. TESTIMONY OF RANDY M. ALLEN PAGE 0 OF 0

0 0 0 OVER-FUNDED PENSION PLANS Q. HOW DO OVER-FUNDED PENSION PLANS RELATE TO STRANDED COSTS AND RESTRUCTURING? A. When a pension plan is over-funded, the actuarial value of the plan is exceeded by the value of the plan assets. This over-funding can be caused by a number of different reasons, including, but not limited to, higher than expected plan earnings, changes in plan assumptions and funding in excess of minimum cash requirements. Because such overfunding happens on a historical basis, the value of the excess funding is usually returned to ratepayers via amortization or self-correcting funding over a number of years. However, because electric utilities will most likely enter an unregulated, competitive environment as a result of restructuring, over-funded amounts should be returned to ratepayers as a refund, credit, or offset to any stranded cost amounts. Without such treatment, overfunded balances will inure to the benefit of shareholders upon deregulation. OTHER UNAMORTIZED BALANCES Q. WOULD YOU PLEASE ADDRESS OTHER UNAMORTIZED BALANCES? A. Because I have not performed specific analyses of the accounting books and records and prior rate orders for the electric utilities involved in this case, I do not have any specific other unamortized balances to evaluate. However, based on the same principles discussed above, any other such unamortized balances should also be afforded appropriate treatment as stranded costs or mitigation of stranded costs to prevent such amounts from inappropriately inuring to the benefit of shareholders or ratepayers upon deregulation. Such other items could include unrecovered storm damages, rate case expenses, and postretirement transition obligations, or unamortized gains on reacquired debt, sale of property, plant, and equipment, and negative plant acquisitions. This list is not meant to be all inclusive, but points out the variety of issues that need to be considered under the principles addressed above. OTHER MITIGATING CIRCUMSTANCES Q. ARE THERE OTHER ISSUES THAT THE COMMISSION SHOULD CONSIDER? A. Yes. Improper reallocation to generating functions of common costs, such as land and general properties, and accrued amounts, such as post-retirement benefits expense, should TESTIMONY OF RANDY M. ALLEN PAGE OF 0

0 be reviewed. For example, the allocation of the post-retirement transition obligation to generating functions should be performed based on the number of employees at January, when the transition obligation was created and subjected to amortization, not based on the current number of employees. In this manner, the allocation will be based on the structure that existed at the time, unchanged due to today s structure after downsizing and a different proportion of generating employees. In addition, any surplus Sulfur Dioxide Emission Allowances held by the utilities should also be used as an offset to stranded costs as these items can be sold by the utilities after restructuring with the proceeds inuring to the shareholders. Q. DOES THIS CONCLUDE YOUR TESTIMONY? A. Yes, it does. TESTIMONY OF RANDY M. ALLEN PAGE OF 0