before the public utility commission of ......2020/06/25 · pac/2200 bulkley/2 reply testimony of...

Docket No. UE 374 Exhibit PAC/2200 Witness: Ann E. Bulkley

BEFORE THE PUBLIC UTILITY COMMISSION

OF OREGON

PACIFICORP ___________________________________________________________

Reply Testimony of Ann E. Bulkley

June 2020

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TABLE OF CONTENTS I. PURPOSE .......................................................................................................................... 1 II. SUMMARY AND OVERVIEW .................................................................................... 3 III. SUMMARY OF ANALYTICAL RESULTS ................................................................. 7 IV. UPDATED ROE ANALYSES ..................................................................................... 13 V. CAPITAL MARKET CONDITIONS AND THE IMPLICATIONS FOR THE COST OF

EQUITY .................................................................................................................................. 17 VI. RESPONSE TO STAFF WITNESSES MR. MULDOON AND MS. ENRIGHT ...... 37

Proxy Group Composition ................................................................................................. 39 Multi-Stage DCF Results .................................................................................................. 48 Assumptions in Multi-Stage DCF Model and Relevance of Results ................................ 51 Reliance on Multi-Stage DCF Model ................................................................................ 58 Alternative ROE Methodologies ....................................................................................... 59 Authorized Returns in Other Jurisdictions ........................................................................ 67 Business Risks ................................................................................................................... 69 Capital Structure ................................................................................................................ 70

VII. RESPONSE TO AWEC WITNESS MR. GORMAN .................................................. 71 DCF Analyses .................................................................................................................... 72

ATTACHED EXHIBITS

Exhibit PAC/2201 - Updated Summary of Results

Exhibit PAC/2202 - Updated Constant Growth DCF Model

Exhibit PAC/2203 - Updated Multi-Stage DCF Model

Exhibit PAC/2204 - Updated GDP Growth

Exhibit PAC/2205 - Updated Capital Asset Pricing Model

Exhibit PAC/2206 - Updated Risk Premium Approach

Exhibit PAC/2207 - Updated Expected Earnings Analysis

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Exhibit PAC/2208 - Adjustment to Staff’s Constant Growth DCF Model; Adjustment to Staff’s Hamada Equation; Adjustment to Staff’s Multi-Stage DCF Model Y; Adjustment to Staff’s CAPM Analysis; Adjustment to Staff’s ROE Analysis

Exhibit PAC/2209 - Adjustments to Gorman’s DCF Analysis

Exhibit PAC/2210 - Adjustments to Gorman’s CAPM Analysis

Exhibit PAC/2211 - Adjustments to Gorman’s Risk Premium Analysis

Exhibit PAC/2212 - Walmart Response to PacifiCorp Data Request 013

Exhibit PAC/2213 - Walmart Response to PacifiCorp Data Request 007

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Q. Are you the same Ann E. Bulkley who previously submitted direct testimony in 1

this proceeding on behalf of PacifiCorp d/b/a Pacific Power? 2

A. Yes. 3

I. PURPOSE 4

Q. What is the purpose of your reply testimony? 5

A. The purpose of my reply testimony is to respond to the opening testimony of 6

Mr. Matt Muldoon and Ms. Moya Enright on behalf of the Staff of the Public Utility 7

Commission of Oregon (Staff), Mr. Michael P. Gorman on behalf of the Alliance of 8

Western Energy Consumers (AWEC), Mr. David B. Posner on behalf of the Sierra 9

Club, Mr. Steve W. Chriss on behalf of Walmart, Inc. (Walmart), and 10

Mr. Lloyd C. Reed on behalf of the Klamath Water User’s Association (KWUA), as 11

it relates to the just and reasonable return on equity (ROE) and the appropriate capital 12

structure for PacifiCorp in Oregon. I also respond briefly to the opening testimony of 13

Mr. Bob Jenks on behalf of the Oregon Citizens’ Utility Board (CUB) with respect to 14

the Power Cost Adjustment Mechanism (PCAM). 15

Q. Are you sponsoring any exhibits as part of your reply testimony? 16

A. Yes. I am sponsoring Exhibits PAC/2201 through PAC/2211, which have been 17

prepared by me or under my direct supervision. ‘ 18

Q. How is the remainder of your reply testimony organized? 19

A. The remainder of my reply testimony is organized as follows: 20

• In Section II, I provide a summary and overview of my reply testimony and 21

the important factors to be considered in establishing the authorized ROE for 22

PacifiCorp; 23

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• In Section III, I compare the other ROE witnesses’ recommendations in this 1

proceeding to the returns for comparable vertically integrated electric utilities 2

nationwide; 3

• In Section IV, I present my updated ROE analyses based on market data 4

through May 29, 2020, which continue to support the 10.20 percent ROE and 5

capital structure consisting of 53.52 percent equity and 46.48 percent long-6

term debt recommended in my direct testimony; 7

• In Section V, I discuss the changes in capital market conditions since my 8

direct testimony was filed and respond to the other ROE witnesses’ testimony 9

regarding the effect of economic and capital market conditions on the cost of 10

equity and the implications for the financial models used to estimate the 11

authorized ROE in this proceeding; 12

• In Section VI, I respond to Staff witnesses Mr. Muldoon’s and Ms. Enright’s 13

ROE and capital structure analyses and recommendations; 14

• In Section VII, I respond to AWEC witness Mr. Gorman’s ROE analyses and 15

recommendation; 16

• In Section VIII, I respond to Sierra Club witness Mr. Posner’s testimony as it 17

relates to ROE; 18

• In Section IX, I respond to Walmart witness Mr. Chriss’ testimony as it relates 19

to ROE; 20

• In Section X, I respond to KWUA witness Mr. Reed’s testimony as it relates 21

to ROE; 22

• In Section XI, I respond to CUB witness Mr. Jenks’ testimony as it relates to 23

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the PCAM; and 1

• Finally, in Section XII, I summarize my conclusions and recommendations. 2

II. SUMMARY AND OVERVIEW 3

Q. What are your key conclusions and recommendations regarding the appropriate 4

ROE and capital structure for PacifiCorp? 5

A. My key conclusions are as follows: 6

1) Capital market conditions have changed dramatically since my direct 7

testimony was filed in February 2020. Government bond yields have 8

decreased substantially due to actions of the Federal Reserve and the U.S. 9

Congress to provide unprecedented support for the U.S. economy during 10

the COVID-19 pandemic. However, these lower yields on U.S. Treasury 11

bonds are not the sole determining factor in setting the authorized ROE for 12

PacifiCorp in this proceeding. Other market indicators suggest that the 13

cost of equity has risen. These include: heightened volatility in equity 14

and bond markets, much wider credit spreads between government and 15

utility bonds, and significantly higher Beta coefficients (the measure of 16

risk in the Capital Asset Pricing Model (CAPM)) from both Bloomberg 17

and Value Line. 18

2) Both the Discounted Cash Flow (DCF) model and the CAPM are 19

producing higher return estimates based on market data as of 20

May 29, 2020, than at the time the analysis in my direct testimony was 21

conducted (based on market data as of November 29, 2019). These higher 22

results are consistent with other market indicators suggesting that the cost 23

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of equity has increased since my direct testimony was filed. 1

3) An authorized ROE of 9.00 percent (as recommended by Staff witnesses 2

Mr. Muldoon and Ms. Enright) or 9.20 percent (as recommended by 3

AWEC witness Mr. Gorman) would place the return for PacifiCorp in the 4

bottom quartile of authorized returns for vertically-integrated electric 5

utility companies in the U.S. This is not reasonable, especially given the 6

evidence regarding PacifiCorp’s business and financial risks in Oregon. 7

PacifiCorp has above average risk relative to the proxy group companies, 8

as discussed in my direct testimony, and investors should be compensated 9

for that risk through a higher than average return. 10

4) The adjustments that the other ROE witnesses in this proceeding make to 11

my ROE analysis also do not support their recommended ROEs. 12

5) While other witnesses in this case recognize that market conditions have 13

affected the assumptions used in the ROE estimation models, they have 14

not accurately reflected how these conditions have affected the DCF and 15

CAPM methods. By relying too heavily on the DCF model results, and by 16

failing to use forward-looking assumptions in the CAPM, the other 17

witnesses fail to account for current market conditions and understate the 18

forward-looking cost of equity. 19

a) Mr. Gorman relies on a historical Beta that he believes more 20

appropriately reflects the relative risk of utility stocks and the 21

market, citing to high utility stock prices as the basis for the low 22

Beta coefficients. The very issue that Mr. Gorman notes has 23

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created a lower than historical average Beta, the artificially high 1

demand for utility stocks, translates into artificially high share 2

prices, which have resulted in historically low dividend yields in 3

the DCF model. This has been confirmed by the recent volatility 4

in equity markets, with utility stock prices declining significantly 5

and utilities facing significant volatility, which has caused 6

dividends yields and Betas for utilities to increase. It would be 7

irrational to argue that these market conditions have rendered 8

current Betas unreliable without also acknowledging the effect on 9

the dividend yield in the DCF model. 10

6) Utility commissions across the nation are looking beyond the results of the 11

traditional ROE estimation models to establish returns that are reasonable 12

under current market conditions. 13

a) Even though several of the ROE estimation models are producing 14

return estimates between 6.00 percent and 8.50 percent, utility 15

regulators recognize that such low returns are not compensatory 16

for investors. The first and third quartiles of authorized ROEs for 17

integrated electric utility companies since 2018 have been within a 18

range from 9.50 percent to 9.99 percent, which suggests that 19

regulators are relying on more than just the results of the 20

traditional models. As shown in Figure 2 of my reply testimony, 21

the majority of authorized ROEs for integrated electric utilities 22

since 2018 have been within the range of results established in my 23

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direct testimony. 1

7) The investor required return is not established with respect to any 2

individual model. Rather than endorsing the results of an individual 3

methodology, the Commission should consider how current market 4

conditions affect the risk profile for equity investors as well as the results 5

of a broader range of ROE estimation methodologies. Finally, the 6

Commission’s adherence to the Hope and Bluefield decisions suggests that 7

the methodology is not what is to be determined, but rather a “just and 8

reasonable” return that is comparable to the return available on 9

investments of similar risk. 10

8) The other ROE witnesses’ recommendations fail to consider the overall 11

risk related to the Tax Cuts and Jobs Act (TCJA) for utilities in general 12

and how their recommended ROE and capital structure could affect the 13

financial risk of PacifiCorp. Contrary to Mr. Gorman’s suggestion that the 14

TCJA is already reflected in the market data considered by investors: 15

i. Moody’s Investors Service (Moody’s) has continued to downgrade 16

utilities throughout 2019 and 2020 related to the negative cash 17

flow implications of tax reform. 18

ii. The other ROE witnesses’ recommended ROEs ignore this risk 19

and the potential remedies that have been offered by the rating 20

agencies to mitigate that risk, such as approving higher authorized 21

returns and equity ratios to improve cash flow metrics. 22

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Q. Have you updated your ROE analyses in your reply testimony? 1

A. Yes. As discussed in Section IV of my reply testimony, I have updated my analytical 2

results based on market data as of May 29, 2020. These results demonstrate that the 3

cost of equity for PacifiCorp has increased since the filing of my direct testimony. In 4

particular, the results of both the DCF and CAPM methods have increased. These 5

results provide additional support for my ROE recommendation of 10.20 percent. In 6

addition, while the analytical results of ROE estimation models provide a starting 7

point, my recommendation continues to appropriately consider the results of multiple 8

methodologies as well as other factors, including company-specific risks, flotation 9

costs, capital market conditions, and the capital attraction and comparable return 10

standards. Further, I support PacifiCorp’s proposed capital structure consisting of 11

53.52 percent equity and 46.48 percent long-term debt as reasonable relative to the 12

operating utility companies held by the proxy group. 13

III. SUMMARY OF ANALYTICAL RESULTS 14

Q. Please summarize the ROE recommendations of the other ROE witnesses in this 15

proceeding. 16

A. The other ROE witnesses in this proceeding recommend an authorized ROE for 17

PacifiCorp between 9.00 percent and 9.80 percent. In order to arrive at their ROE 18

recommendation, Staff has relied exclusively on the results of the Multi-Stage DCF 19

model, while Mr. Gorman has developed multiple ROE estimation models, many of 20

which do not support his final recommendation, as shown in Figure 1. Ultimately, 21

Mr. Gorman relied primarily on the results of his Constant Growth DCF model using 22

analysts’ earnings per share (EPS) growth rates and his Risk Premium results, while 23

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placing more limited weight on the results of other models. 1

Figure 1: Summary of Other ROE Witnesses’ Model Results1,2 2

Mr. Muldoon/Ms. Enright (Staff)

Mr. Gorman (AWEC)

Constant Growth DCF 8.80%-8.90% 9.18%-9.19% Sustainable Growth N/A 8.20%-8.53% Multi-Stage DCF 8.52%-9.39% 8.23%-8.28% Recommended DCF Results 9.20% CAPM 7.70%-8.0% 5.95%-8.24% Empirical CAPM ("ECAPM") N/A N/A Recommended CAPM Results 8.20% Risk Premium N/A 8.80%-9.50% Recommended Risk Premium

9.20% Expected Earnings N/A N/A Returns in other jurisdictions N/A N/A ROE Recommendation 9.00% 9.20%

Q. Do the other witnesses in this proceeding address the current market conditions? 3

A. Yes. AWEC witness Mr. Gorman’s testimony on this issue is somewhat inconsistent. 4

Mr. Gorman disputes my conclusion regarding the effect of market conditions on the 5

ROE estimation models, asserting that the DCF models are producing reliable and 6

accurate estimates of the current market cost of equity for utility companies.3 Despite 7

this view, Mr. Gorman acknowledges that market conditions have reduced the Beta 8

estimates for his proxy companies and therefore relies on a long-term historical 9

average Beta in his CAPM analysis. In addition, Mr. Gorman ultimately recognizes 10

that models that produce returns in the range of 6.00 percent to 8.50 percent are 11

simply not reasonable, and do not meet the fair return standards of Hope and 12

1 Walmart witness Mr. Chriss and Sierra Club witness Mr. Posner did not perform their own ROE analysis, and Mr. Chriss did not provide his own specific ROE recommendation. Therefore, they are not included in this summary table. 2 Staff does not rely on the results of the Constant Growth DCF model or the CAPM, but rather uses these as a check on the Multi-Stage DCF results. 3 AWEC/200, Gorman/73.

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Bluefield. Therefore, while Mr. Gorman suggests that market conditions have not 1

affected the model results, in the development of his analyses and his review of the 2

results of his models, he recognizes that there are many model results that cannot be 3

relied upon. 4

Q. Are authorized returns in other jurisdictions a relevant benchmark that 5

investors consider? 6

A. Yes. The regulatory decisions of other Commissions provide a basic test of 7

reasonableness and a benchmark that investors consider in assessing the authorized 8

ROE against the returns available from other regulated utilities with comparable risk. 9

Staff witness Mr. Muldoon, AWEC witness Mr. Gorman and Walmart witness 10

Mr. Chriss all present evidence regarding authorized returns for electric utilities in 11

other jurisdictions, suggesting that these returns are relevant for purposes of 12

establishing the authorized ROE for PacifiCorp in this proceeding. It is a legal 13

requirement that authorized ROEs must be comparable to other investments of 14

commensurate risk. 15

Figure 2 shows the distribution of authorized returns for integrated electric 16

utilities from January 2018 through May 2020. The range of authorized ROEs has 17

been from 8.75 percent to 10.50 percent over this period, with an average authorized 18

ROE of 9.70 percent and a median of 9.73 percent. 19

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Figure 2: Authorized ROEs 2018-Present4 1

As shown in Figure 2 above, the majority of authorized returns for integrated 2

electric utilities (44 out of 58 decisions) from 2018 through May 2020 have been 3

between 9.50 percent and 10.50 percent. As shown in Figure 2, with the exception of 4

Mr. Posner’s recommendation at 9.80 percent, the other ROE witnesses in this 5

proceeding have recommended a range of 9.00 percent to 9.20 percent, which is well 6

below the majority of the authorized ROEs over this time period. I am 7

recommending an ROE of 10.20 percent, which is within the range established by 8

recently authorized ROEs. 9

Q. Have you analyzed how authorized returns on equity in Oregon have compared 10

with national averages over time? 11

A. Yes. I analyzed authorized ROEs from 2006-2020 and evaluated how authorized 12

4 Source: Regulatory Research Associates.

8.50%

9.00%

9.50%

10.00%

10.50%

11.00%

1/1/2018 4/1/2018 6/30/2018 9/28/2018 12/27/2018 3/27/2019 6/25/2019 9/23/2019 12/22/2019 3/21/2020

Aut

hori

zed

RO

E (%

)Vertically Integrated Electric Company Decisions

Bulkley Recommendation (10.20%)

Staff Recommendation (9.00%)

Gorman Recommendation (9.20%)

Posner Recommendation (9.80%)

PAC/2200 Bulkley/11


ROEs in Oregon have compared with the national averages for electric utilities and 1

gas distribution companies. The results are presented in Figure 3. 2

Figure 3: Oregon Authorized ROEs vs National Average 3

2006-2020 4

As shown in the Figure, the authorized returns for regulated electric and gas 5

utilities in Oregon from 2006-2019 have been consistently below the national average 6

in most years. I attribute this, in large part, to the Commission’s primary reliance on 7

the results of the Multi-Stage DCF model to establish a utility’s authorized ROE. 8

While the Commission has considered whether the results of the Multi-Stage DCF 9

model are reasonable by reference to other models such as the Constant Growth DCF 10

model, the CAPM and the Risk Premium model, the Commission has not placed 11

8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

14.00%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Aut

hori

zed

RO

E (%

)

Min/Max Authorized ROE

Oregon Average ROE

Average Authorized ROE

PAC/2200 Bulkley/12


weight on those other models.5 1

It is important for the Commission to consider, and when appropriate place 2

weight on, the results of multiple methodologies to ensure that the authorized return is 3

just and reasonable. PacifiCorp must compete for capital within the overall holding 4

company structure, which must in turn compete for capital with other businesses 5

across the country. If the authorized ROE for PacifiCorp is set at a level consistent 6

with authorized ROEs outside Oregon, this will support PacifiCorp’s access to capital 7

and financial integrity over the longer-term. 8

Q. What factors should be considered in evaluating the results of ROE models and 9

establishing the authorized ROE? 10

A. The primary factors that should be considered are: (i) the importance of investors’ 11

actual return requirements and the critical role of judgment in selecting the 12

appropriate ROE; (ii) the importance of providing a return that is comparable to 13

returns on alternative investments with commensurate risk;6 (iii) the need for a return 14

that supports a utility’s ability to attract needed capital at reasonable terms;7 and (iv) 15

the effect of current and expected capital market conditions. 16

Q. What factors support your recommended ROE for PacifiCorp in this case? 17

A. Based on my updated analyses, I conclude that my ROE recommendation of 10.20 18

percent remains reasonable for PacifiCorp in Oregon. A return at this level is: 19

1. Supported by the analyses contained in my direct testimony and updated in 20

5 See, e.g., In the Matter of PacifiCorp’s Proposal to Restructure and Reprice Its Services In Accordance with Senate Bill 1149, Docket No. UE 116, Order No. 01-787 (Sept. 7, 2001). 6 Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591 (1944); Bluefield Waterworks & Improvement Co. v. Public Service Commission of West Virginia, 262 U.S. 679 (1923). 7 Ibid.

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my reply testimony; 1

2. Consistent with current and prospective financial market conditions; 2

3. Supported by the methodologies considered by other regulatory jurisdictions; 3

4. Consistent with the range of ROEs awards for integrated electric utilities in 4

other state jurisdictions; 5

5. Considers the unique business and operating risks of PacifiCorp in Oregon; 6

and 7

6. Will support PacifiCorp’s ability to attract capital to finance investments at 8

reasonable rates, which will provide long-term benefits to ratepayers by 9

limiting the long-term cost of capital. 10

IV. UPDATED ROE ANALYSES 11

Q. Have you updated your ROE analyses? 12

A. Yes. As shown in Exhibits PAC/2201 through PAC/2207, I have updated the ROE 13

analyses in my direct testimony using market data through May 29, 2020. All of the 14

methodologies in my updated analysis have been developed in a manner that is 15

consistent with the approach taken in my direct testimony. I have excluded 16

CenterPoint Energy from my updated analyses because the company no longer meets 17

my proxy group screening criteria after its recent dividend cut. I have continued to 18

exclude results below 7.0 percent because such returns do not provide a sufficient risk 19

premium above the long-term debt cost to compensate equity investors for the risks 20

associated with ownership. Figure 4 summarizes the results of my updated analyses. 21

As shown in Figure 4, the results of the ROE estimation models generally 22

have increased since the analysis in my direct testimony was performed (i.e., 23

PAC/2200 Bulkley/14


November 30, 2019). In particular, the mean results of the Constant Growth DCF 1

model have increased by 24 basis points, while the Multi-Stage DCF results have 2

increased by 70 basis points.8 This is due primarily to higher dividend yields for the 3

proxy group companies, as utility stock prices have declined. However, despite the 4

recent decline, dividend yields remain below the historical average dividend yields 5

for the proxy group, suggesting that the results of the DCF model may still understate 6

the investor-required return on equity. Likewise, the CAPM results have increased by 7

96 basis points, and the ECAPM results have increased by 76 basis points.9 Increases 8

in the CAPM and ECAPM model results are primarily due to higher Beta coefficients 9

reported by both Bloomberg and Value Line, as the correlation between utility returns 10

and returns for the broader market has increased substantially. Higher Betas more 11

than offset the decline in government bond yields. The Risk Premium results have 12

declined by 28 basis points as current and projected Treasury bond yields have fallen 13

more than the equity risk premium has risen. Finally, the mean results of the 14

Expected Earnings approach have decreased by 9 basis points. 15

Q. Do the Beta coefficients used in your updated CAPM and ECAPM results reflect 16

the recent market volatility for all of your proxy companies? 17

A. No. It is important to note that Value Line reports on the Electric Utility industry in 18

three segments (i.e., East, Central and West) on different time schedules. My updated 19

CAPM analysis uses market data as of May 29, 2020, which includes Value Line’s 20

upward revisions to the Beta coefficients for the East region. In June 2020, Value 21

8 Based on 30-day average stock prices. 9 Based on near-term projected Treasury bond yields, using average results for both Value Line and Bloomberg Betas.

PAC/2200 Bulkley/15


Line published upward revisions to the Beta coefficients of the Central region 1

Electric Utilities. Based on communications with Value Line, it is my understanding 2

that the Betas for the entire industry have been affected by recent market conditions 3

and as a result expect that the West region report will also result in higher Betas when 4

those reports are published in July. Based on the fact that only one-third of the 5

upward revision in electric utility Betas is reflected in my analyses, it is likely that my 6

CAPM results are a conservative estimate of the investor-required return on equity. 7

PAC/2200 Bulkley/16


Figure 4: Updated ROE Analyses 1

Mean Low Mean Mean High30-Day Average 8.91% 9.28% 10.06%90-Day Average 8.75% 9.04% 9.72%180-Day Average 8.74% 8.99% 9.57%

Constant Growth Average 8.80% 9.11% 9.78%

First-Stage Growth Mean Low Mean Mean High30-Day Average 9.43% 9.63% 9.84%90-Day Average 9.09% 9.28% 9.47%180-Day Average 8.94% 9.13% 9.31%

Multi-Stage Average 9.15% 9.35% 9.54%

Current 30-day Average Treasury

Bond Yield

Near-Term Blue Chip Forecast

Yield

Long-Term Blue Chip Forecast

Yield

Value Line Beta 8.96% 9.09% 9.56%

Bloomberg Beta 11.04% 11.10% 11.35%

Value Line Beta 8.90% 9.03% 9.50%Bloomberg Beta 10.96% 11.03% 11.28%



Current 30-day Average Treasury

Bond Yield

Near-Term Blue Chip Forecast

Yield

Long-Term Blue Chip Forecast

YieldRisk Premium Analysis 9.24% 9.39% 9.96%

Risk Premium Mean Result

MedianExpected Earnings Result 10.81%

Treasury Yield Plus Risk Premium

9.53%

Constant Growth DCF

CAPM

Expected Earnings AnalysisMean

11.01%

Calculated Return on the S&P 500 Companies

S&P Implied Return on the S&P 500

ECAPM Calculated Return on the S&P 500 Companies

S&P Implied Return on the S&P 500

Multi-Stage DCF

PAC/2200 Bulkley/17


V. CAPITAL MARKET CONDITIONS AND THE IMPLICATIONS FOR THE 1

COST OF EQUITY 2

Q. Several of the other ROE witnesses in this proceeding contend that the low 3

interest rate environment supports a substantial reduction in the authorized 4

ROE for PacifiCorp.10 Do you agree? 5

A. No, I do not agree. While I acknowledge that Treasury bonds yields have declined 6

since the analysis in my direct testimony was performed, government bond yields are 7

only one of many factors that equity investors consider in determining their return 8

requirements. It is important to view current Treasury bond yields in the context of 9

conditions in the economy and capital markets. It would not be reasonable for the 10

Commission to consider only the decline in 30-year Treasury bond yields, without 11

also considering the recent market conditions that have contributed to that decline. 12

Further, there are reasons to believe that the recent declines in Treasury bond yields 13

are not representative of the longer-term trend in government and corporate bond 14

yields. Rather, those lower interest rates are directly attributable to the COVID-19 15

pandemic, the economic effects of which occurred after the filing of direct testimony. 16

The economic effects of the measures used to contain COVID-19 have caused the 17

Federal Reserve to reduce the federal funds rates and take additional measures to 18

support the U.S. economy and provide liquidity and stability in financial markets. 19

These are short-term events that have little to do with the longer-term trend in bond 20

yields or equity costs. 21

10 See, for example, Staff/200, Muldoon-Enright/43-46,48; AWEC/200, Gorman/12-17.

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Q. Please discuss how capital market conditions have changed since your direct 1

testimony was filed in February 2020. 2

A. Capital market conditions have been extremely volatile in 2020. In January and early 3

February 2020, major market indices were generally increasing, with many reaching 4

new threshold levels. By mid-February, shortly after the filing of my direct 5

testimony, as the global health crisis became more apparent, market conditions 6

became increasingly more volatile. In mid-February utility stock prices reached an 7

all-time high, followed by a significant decline in the overall market and utility 8

stocks. Market conditions in March 2020 were more volatile than the last half of 9

February. As shown in Figure 5, the Standard & Poor’s (S&P) 500 Index swung by 10

more than 3 percent on 16 of the 22 trading days in March. As discussed in more 11

detail later in my reply testimony, on March 23, 2020, the Federal Reserve 12

implemented unprecedented monetary policy measures with the goal of providing 13

liquidity and stabilizing market conditions. The magnitude of these Federal Reserve 14

policies highlights the level of risk in the marketplace; however, the result has been 15

that equity prices in April and May were less volatile than in March. 16

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Figure 5: S&P 500 Index – Daily Price Change – January - May 202011 1

Q. Staff observes that there has been increased volatility in the equity markets in 2

recent months, but that measures of volatility are receding.12 Have you reviewed 3

any indicators that measure volatility in the financial markets? 4

A. Yes. I reviewed two measures of volatility in financial markets: 1) the Chicago 5

Board Options Exchange (CBOE) Volatility Index (VIX), and 2) the U.S. Treasury 6

Note Volatility Index (TYVIX). The VIX measures investors’ expectation of 7

volatility in the S&P 500 Index over the next 30 days. The TYVIX, also published by 8

CBOE, measures investors’ expectation of volatility in the 10-year Treasury Bond 9

over the next 30 days. The VIX and TYVIX have recently reached levels not seen 10

since the Great Recession of 2008/09. For example, the VIX closed at 82.69 on 11

March 16, 2020. The VIX has not reached 80.00 since November 2008; further, it is 12

11 Source: Bloomberg Professional. 12 Staff/200, Muldoon-Enright/53-54.

1/2/2020 1/22/2020 2/11/2020 3/2/2020 3/22/2020 4/11/2020 5/1/2020 5/21/2020

-15%

-10%

-5%

0%

5%

10%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

Bulkley DT Filed -February 14, 2020

PAC/2200 Bulkley/20


important to note that the highest level reached during the Great Recession of 1

2008/09 was 80.86.13 Similarly, the TYVIX was 16.39 on March 19, 2020. Since at 2

least January 2003, the TYVIX has never exceeded 15.00, including during the Great 3

Recession of 2008/09.14 4

Furthermore, as shown in Figure 6, while the VIX has declined in April and 5

May, this measure of volatility still remains well above levels seen prior to COVID-6

19 in January and February. It is important to view the declines in the VIX in the 7

context of the unprecedented response by the Federal Reserve and Congress. As 8

discussed in more detail below, the Federal Reserve’s corporate bond buying 9

programs are providing liquidity to bond markets and therefore reducing some of the 10

uncertainty that was driving the volatility seen in March. However, there is still much 11

uncertainty regarding the near-term effect of COVID-19 on the economy and the 12

financial markets, which is why the VIX is still above its long-term average. 13

13 Source: Bloomberg Professional. 14 Source: Bloomberg Professional.

PAC/2200 Bulkley/21


Figure 6: CBOE VIX and TYVIX – January 2003 – May 202015 1

Q. What steps have the Federal Reserve and the U.S. Congress taken to stabilize 2

financial markets and support the economy? 3

A. On March 23, 2020, the Federal Reserve began expansive programs to support credit 4

to large employers: the Primary Market Corporate Credit Facility (PMCCF) to 5

provide liquidity for new issuances of corporate bonds, and the Secondary Market 6

Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate 7

debt issuances. Further, the Federal Reserve supported the flow of credit to 8

consumers and businesses through the Term Asset-Backed Securities Loan Facility.16 9

Additionally, on March 27, 2020, the Coronavirus Aid, Relief, and Economic 10

Security Act was signed into law, which is a large fiscal stimulus package aimed at 11

15 Source: Bloomberg Professional. 16 Federal Reserve Board Press Release, “Federal Reserve announces extensive new measures to support the economy”, March 23, 2020.

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PAC/2200 Bulkley/22


also mitigating the economic effects of the coronavirus. While these expansive 1

programs have provided for greater price stability, as shown in Figure 6 above, both 2

the VIX and the TYVIX remain well above long-term historical average levels. 3

Q. Are there indicators that measure the uncertainty in the global economy related 4

to COVID-19? 5

A. Yes. Similar to the U.S. trade policy uncertainty index that I reviewed in my direct 6

testimony,17 economists Scott Baker, Nicholas Bloom and Steven Davis have also 7

developed a global economic policy uncertainty index. This index is a Gross 8

Domestic Product (GDP)-weighted average of the economic policy uncertainty index 9

of 21 countries. The economic policy uncertainty index measures the frequency that 10

articles in publications of a country discuss economic policy uncertainty.18 Figure 7 11

shows that uncertainty regarding global economic policy is at its highest level since at 12

least 1997, with the largest increase occurring in the last two years as a result of the 13

trade dispute between the U.S. and China and the spread of COVID-19. 14

17 PAC/400, Bulkley/20. 18 Source: Economic Policy Uncertainty: https://www.policyuncertainty.com/index.html.

https://www.policyuncertainty.com/index.html

PAC/2200 Bulkley/23


Figure 7: Global Economic Policy Uncertainty Index 1

Q. How has the market responded to the unprecedented intervention by the Federal 2

Reserve? 3

A. The uncertainty surrounding the economic effects of the spread of COVID-19 4

resulted in a flight-to-quality in February and March as investors purchased safer 5

assets such as U.S. Treasuries and many investors believed the U.S. economy would 6

enter a recession. This can be seen in Figure 8 below, which shows that U.S. 7

Treasury Bond yields declined precipitously as investors reacted to the economic 8

effects of the policies enacted to contain COVID-19. However, as discussed above, 9

in late March, the Federal Reserve began expansive programs with the purpose of 10

maintaining access to capital markets for corporate borrowers. These unprecedented 11

programs resulted in lower borrowing costs for corporate firms and thus continued 12

access to the capital needed to offset the economic effects of COVID-19. As a result, 13

interest rates have remained low and stability has been restored in the corporate bond 14

PAC/2200 Bulkley/24


market. For investors, this led to allocating more funds to equities. As shown in 1

Figure 8, while the yield on the 10-year Treasury Bond has remained relatively stable 2

and in the range of 0.58 percent to 0.88 percent between March 23, 2019 and May 31, 3

2019, the S&P Utilities Index increased drastically following the Federal Reserve’s 4

announcement on March 23, 2020. 5

Figure 8: 10-year U.S. Treasury Yield and S&P Utilities Index 6

Q. Have rating agencies commented on the effects of current market conditions on 7

regulated utilities? 8

A. Yes. In April 2020, S&P downgraded the outlook on the entire North American 9

utilities sector indicating that 25 percent of the industry was previously on a negative 10

outlook or CreditWatch with negative implications and that S&P expected that 11

COVID-19 would create incremental pressure and that a recession would lead to an 12

increasing number of downgrades and negative outlooks for utilities.19 13

19 Standard & Poor’s Ratings Direct, “COVID-19: The Outlook for North American Regulated Utilities Turns Negative,” April 2, 2020.

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PAC/2200 Bulkley/25


Q. What are your conclusions regarding the recent market volatility and its effect 1

on the cost of equity for PacifiCorp? 2

A. As discussed above, investors responded to the economic effects of COVID-19 by 3

divesting higher-risk assets such as equities and purchasing lower-risk assets such as 4

U.S. Treasury bonds. Furthermore, the constant news regarding the spread of 5

COVID-19 and its economic effects have resulted in an abundance of information for 6

investors to consider. While the policies of the Federal Reserve have stabilized the 7

corporate bond market, the result has been an increase in equity prices, as investors 8

have had to move along the risk spectrum in search of returns. This has resulted in 9

unprecedented volatility in financial markets as investors have rotated in and out of 10

various assets classes responding to both positive and negative developments. 11

Therefore, ROE estimation models that rely on recent market data must be 12

interpreted with extreme caution. For example, the Constant Growth DCF model 13

relies on the average share prices for the proxy companies, which have been 14

extremely volatile in the last several months and are likely currently influenced by the 15

policies of the Federal Reserve; these prices are not likely representative of what 16

should be expected during the period that PacifiCorp’s rates will be in effect. This 17

highlights two key factors that must be considered when determining the ROE for 18

PacifiCorp: 1) current and prospective market conditions should be considered when 19

determining where, within the range of results, PacifiCorp’s authorized ROE should 20

be set, and 2) where possible, it is necessary to consider projected market data in each 21

of the models, which reflect economists’ expectations for the market conditions that 22

will prevail during the period that PacifiCorp’s rates will be in effect. 23

PAC/2200 Bulkley/26


Q. Several of the other ROE witnesses have focused on the decline in government 1

bond yields as evidence that the cost of capital has fallen for PacifiCorp. Please 2

put this situation in context for the Commission? 3

A. A brief summary of the monetary policy actions of the Federal Reserve that occurred 4

after the filing of my direct testimony will help to put these lower interest rates in 5

context. The Federal Reserve met on March 15, 2020, and acknowledged that the 6

spread of COVID-19 posed increased risks to economic activity in the U.S. In 7

response, the Federal Reserve reduced the federal funds rate by 100 basis points, 8

resulting in a target range of 0.00 percent to 0.25 percent.20 This was the second 9

unscheduled meeting in March 2020, with the first occurring on March 3rd when the 10

Federal Reserve reduced the federal funds rate by 50 basis points. In addition to the 11

reduction in the federal funds rate, the Federal Reserve also announced plans to 12

increase its holdings of both Treasury and mortgage-backed securities.21 As 13

discussed previously, on March 23, 2020, the Federal Reserve implemented an 14

expansive credit program designed to provide liquidity to corporations, large 15

employers, consumers, businesses and municipalities.22 This program initially 16

targeted investment grade corporations, but in April 2020 was expanded to include 17

corporations that were investment grade rated as of March 22, 2020, even if they had 18

been subsequently downgraded. The PMCCF and SMCCF programs were initially 19

funded at $75 billion, but the combined size of these programs, including the addition 20

20 Federal Open Market Committee, Federal Reserve Board Press Release, March 15, 2020, at 1. 21 Id. at 2. 22 Federal Reserve Board Press Release, “Federal Reserve announces extensive new measures to support the economy,” March 23, 2020.

PAC/2200 Bulkley/27


of below investment grade corporate debt is proposed to be up to $750 billion.23 1

It is important to view the recent Federal Reserve policy decisions in the 2

context of the reactions to global exogenous events, in particular COVID-19. The 3

recent spread of COVID-19 has affected the global economy and caused a rise in 4

volatility in the financial markets; thus, the Federal Reserve reacted by reducing the 5

federal funds rate to minimize the effect of COVID-19 on the U.S. economy. 6

Q. Do you agree with the other ROE witnesses that the lower yields on government 7

bonds are evidence that the long-term cost of capital for PacifiCorp has declined 8

substantially? 9

A. No, I do not. The reason is that the events that contributed to the sharp decline in 10

government bond yields are considered by most experts to be temporary in nature, not 11

permanent. For example, according to the Blue Chip Financial Forecasts report for 12

June 2020, economists are projecting real GDP growth of 15.2 percent in third quarter 13

of 2020 and 8.2 percent in the fourth quarter of 2020.24 Therefore, a number of 14

prominent economists surveyed by Blue Chip are expecting a strong rebound in 15

economic growth in the second half of 2020. 16

Q. What has happened to spreads between government and utility bond yields in 17

recent months? 18

A. Both Staff and AWEC acknowledge that credit spreads have increased between 19

government and utility bond yields.25 However, neither Staff nor AWEC adequately 20

reflect this elevated risk in their ROE recommendations. The credit spreads between 21

23 FOMC Term Sheet, Primary and Secondary Corporate Credit Facilities, April 9, 2020. 24 Blue Chip Financial Forecasts, Vol. 40, No. 6, June 1, 2020, at 2. 25 Staff/200, Muldoon-Enright/47, AWEC/200, Gorman/49-51.

PAC/2200 Bulkley/28


government and utility bond yields, both in the primary and secondary markets, have 1

increased since the filing of my direct testimony. For example, as of 2

November 29, 2019, the 30-day average spread between 30-year Treasury bonds and 3

Moody’s Baa-rated utility bond index was 1.49 percent. As of May 31, 2020, the 30-4

day average credit spread between these same instruments was 2.27 percent. 5

Similarly, the spreads in the new issuance market have also increased as compared to 6

2019. For example, Figure 9 presents the spreads for two 30-year unsecured bond 7

issuances by BHE. As shown in the Figure, the spread over Treasuries on March 27, 8

2020 was 2.96 percent compared with 1.39 percent on January 14, 2019. These 9

higher credit spreads are another indication of elevated risk in capital markets, as 10

investors require higher compensation for the potential default risk associated with 11

utility bonds. 12

Figure 9: Berkshire Hathaway Energy Senior Unsecured 30-year Debt Issuances26 13

Issue Date Amount (millions)

Coupon Corresponding Treasury Yield

Spread over

Treasuries 3/27/20 $900 4.25% 1.29% 2.96% 1/14/19 $1,000 4.45% 3.06% 1.39%

Q. Mr. Gorman comments on the high valuations in the utilities sector,27 and notes 14

the current Value Line Betas for utilities have declined well below historical 15

levels due to these high valuations.28 What is your response? 16

A. As discussed in my direct testimony, I agree with Mr. Gorman that the valuations of 17

public utilities have increased well above historical average levels in recent years, as 18

26 Source: S&P Global Market Intelligence. 27 AWEC/200, Gorman/7-8. 28 Id. at 55.

PAC/2200 Bulkley/29


demonstrated by their elevated Price-to-Earnings (P/E) ratios.29 Mr. Gorman has 1

made an adjustment to the Value Line Beta in his CAPM analysis to reflect these high 2

valuations; however, he has not made a similar adjustment to his DCF results. 3

The DCF model generally produces reasonable and reliable estimates of the 4

cost of equity for companies in stable, mature industries, such as regulated utilities; 5

however, the results of the DCF model are being distorted by the high valuations and 6

low dividend yields of utilities. Even though utility share prices have declined in 7

recent weeks, the P/E ratios remain higher than historical average levels over the past 8

decade, while dividend yields remain lower than historical average levels. Equity 9

analysts have commented on the unusually high valuations of utility shares compared 10

to historical levels, and as discussed in my direct testimony, several utility regulators 11

have recognized that the DCF model is not producing reliable results under current 12

market conditions.30 13

Q. How have recent market conditions affected the valuations and dividend yields 14

of utility shares? 15

A. To examine the effect of recent market conditions on the dividend yields of utilities, I 16

updated Figure 2 of my direct testimony, which shows the average annual dividend 17

yield for electric utilities from 2009 through 2019. The update is contained in 18

Figure 10 below, which now includes data through May 29, 2020. As shown in 19

Figure 10, while investors have responded to the economic effects of COVID-19, 20

resulting in heightened volatility and a recent decline in the market, it is important to 21

highlight the relative performance of the proxy group companies during this period. 22

29 PAC/400, Bulkley/16-17. 30 Id. at 40-42.

PAC/2200 Bulkley/30


Figure 10 shows that, while the stock prices of the proxy group companies have 1

declined, resulting in an increase in dividend yields, the average dividend yield for 2

the proxy group over the period from February 19, 2020 through May 29, 2020, was 3

3.69 percent, which is still low when compared to the historical dividend yields. 4

Moreover, this dividend yield shows that the use of average stock prices over an 5

earlier period, such as Staff’s use of average stock prices from the first trading day of 6

January, February and March, clearly depresses the dividend yield in the DCF model. 7

Figure 10: Average Dividend Yields for Proxy Group31 8

Q. What have equity analysts said about the valuations of utility stocks since you 9

filed your direct testimony? 10

A. Several equity analysts have recognized that utility stock valuations remain very high 11

relative to historical levels even after the decline in share prices that occurred as a 12

31 Source: Bloomberg Professional. Includes 2020 data through May 29, 2020.

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PAC/2200 Bulkley/31


result of the economic effects of COVID-19. For example, Barron’s recently noted: 1

Charles Fishman, a utility analyst at Morningstar, points out that 2 “utility valuations in February were at record highs,” and that 3 “commercial and industrial electricity demand reductions and 4 delay in investment due to the pandemic” have weighed on these 5 stocks as well. 6 In May, power demand in the U.S. was down 8% year over year, 7 according to Morgan Stanley. That follows a 5% drop in April. 8 But even after lackluster performance recently, utility shares still 9 aren’t cheap. The stocks in the Utilities Select Sector SPDR ETF 10 trade at about 19 times their current fiscal year profit estimates, 11 according to FactSet. That’s above their five-year average of a 12 little below 18 times.32 13 This is also supported by an updated version of the Edward Jones report on 14

the utility sector that I referenced in my direct testimony: 15

Utility valuations have become more attractive as shares have 16 fallen from recent highs. On a price-to-earnings basis, shares are 17 now trading closer to their historical averages, after trading near 18 all-time highs. Until early this year, we have seen utility valuations 19 moving with interest rate movements, although there have been 20 exceptions to this. Overall, however, we believe the low-interest-21 rate environment has been the biggest factor in pushing utilities 22 higher since many investors buy them for their dividend yield.33 23 Therefore, while equity analysts have acknowledged that utility stock prices 24

have declined as a result of the economic effects of COVID-19, they have also noted 25

that utility stocks are still trading at valuations that are above historical averages. 26

This implies that even after the economic effects of COVID-19 are considered, the 27

ROE calculated using historical market data in the DCF model is still understating the 28

forward-looking cost of equity. 29

32 Strauss, Lawrence C. “Utility Stocks Aren’t Acting Like The Havens They’re Supposed Be. Here’s Why.” Utility Stocks Aren’t Acting Like The Havens They’re Supposed Be - Barron’s, 12 June 2020, www.barrons.com/articles/utility-stocks-arent-acting-like-the-havens-theyre-supposed-be-51591979393. 33 Andy Smith. Edward Jones, Utilities Sector Outlook (March 24, 2020), at 2.

PAC/2200 Bulkley/32


Q. Utilities traditionally have been a safe-haven for investors during periods of 1

market volatility. Has this been true during the recent period of volatility? 2

A. No, it has not. Contrary to the testimony of Sierra Club witness Mr. Posner, “equities 3

with stable yields” have not been “a desirable haven for investors seeking yields.”34 4

To this point, Charles Schwab recently noted: 5

Amid the sharp drop in stocks in February and March, however, 6 the historically low-equity-beta Utilities sector simply didn’t play 7 its traditional relative safe-haven role. The drop in interest rates 8 could be expected to provide relative support to these sectors, 9 which rely on high levels of debt and pay relatively high 10 dividends. However, there were unique circumstances that 11 overwhelmed their historical relationships. Due to the strong reach 12 for yield that had been prevalent prior to the crisis, the high-13 dividend-paying Utilities sector had been bid up to record high 14 valuations. Even the recent market volatility hasn’t fully reversed 15 that situation, so we’re not confident the sector will return to its 16 defensive roots if the markets sell off again. This is one 17 consideration in maintaining a marketperform rating, despite 18 heightened risk of a market pullback.35 19

Q. What are your conclusions regarding the recent valuations of utilities and the 20

effect on the cost of equity for PacifiCorp in this proceeding? 21

A. As discussed above, the economic effects of the COVID-19 pandemic have resulted 22

in a recent decline in the share prices of utilities; however, the share prices and thus 23

the valuations of utilities are still well above historical levels. In addition, the 24

economic effects associated with COVID-19 are expected to be short-term in nature 25

and are not expected to persist over the long-term. As the economy recovers from 26

these external events and the Federal Reserve is able to withdraw its extraordinary 27

monetary policy accommodation, investors will rotate out of safer assets such as U.S. 28

34 Sierra Club/200, Posner/2. 35 Charles Schwab, Utilities Sector Rating: Marketperform, May 21, 2020.

PAC/2200 Bulkley/33


government bonds and defensive sector equities such as utilities and into riskier 1

cyclical sector equities. In addition, those investors who purchased utilities as an 2

alternative to low yields on government bonds will likely rotate back to government 3

bonds as those yields increase. Thus, the cost of equity for the proxy companies 4

using the DCF model is likely to be an overly-conservative estimate of investors’ 5

required returns because the proxy group average dividend yield reflects the increase 6

in stock prices that resulted from substantially lower interest rates. Alternatively, my 7

CAPM and Bond Yield Plus Risk Premium analyses include estimated returns based 8

on near-term and longer-term projected interest rates, reflecting investors’ 9

expectations of market conditions over the period that the rates established in this 10

proceeding will be in effect. 11

Q. Mr. Gorman asserts that any effect on utility risk or share prices related to the 12

TCJA has already been internalized by the market.36 Do you agree? 13

A. Not entirely. As discussed in my direct testimony, it is reasonable to expect that 14

investors have reviewed the reports published by the credit rating agencies such as 15

Moody’s, S&P and FitchRatings (Fitch) and are therefore considering the effects of 16

the TCJA.37 However, utilities are still working with regulators to determine 17

appropriate solutions to mitigate the effect of the TCJA on cash flows. In fact, in 18

addition to the Commission, two other commissions, the Wyoming Public Service 19

36 AWEC/200, Gorman/5. 37 PAC/400, Bulkley/30.

PAC/2200 Bulkley/34


Commission38 and the Utah Public Service Commission39 where PacifiCorp operates 1

have recently acknowledged the negative effect of the TCJA on the cash flow of 2

utilities. Moreover, since the filing of my direct testimony, Moody’s has continued to 3

downgrade utilities as a result of tax reform. As shown in Figure 11, which is an 4

update to Figure 7 in my direct testimony, there have been five rating downgrades in 5

2020, which suggests that Moody’s is continuing to evaluate the effect of the TCJA 6

on the cash flows of individual utilities. 7

38 In the Matter of Questar Gas Company dba Dominion Energy Wyoming’s Application for Approval of Amended Stipulation Previously Approved in Docket No. 30010-150-GA-16, Docket No. 30010-180-GA-18 (Record No. 15138), Order, at 1-2 (Aug. 20, 2019). 39 Application of Dominion Energy Utah to Increase Distribution Rates and Charges and Make Tariff Modifications, Docket No. 19-057-02, Report and Order, at 6 (February 25, 2020).

PAC/2200 Bulkley/35


Figure 11: Credit Rating Downgrades Resulting from TCJA 1

Utility Rating

Credit

Credit

Downgrade

New Jersey Natural Gas Company Moody’s Aa3 A1 3/18/2020 Consolidated Edison Company of New York Moody’s A3 Baa1 3/17/2020 Consolidated Edison, Inc. Moody’s Baa1 Baa2 3/17/2020 Washington Gas Light Company Moody’s A2 A3 1/30/2020 Public Service Co. of North Carolina, Inc. Moody’s A3 Baa1 1/30/2020 Wisconsin Power and Light Company Moody’s A2 A3 12/11/2019 Wisconsin Gas LLC Moody’s A2 A3 11/20/2019 Vectren Utility Holdings Moody’s A2 A3 10/25/2019 Southern Indiana Gas & Electric Company Moody’s A2 A3 10/25/2019 Indiana Gas Company Moody’s A2 A3 10/25/2019 El Paso Electric Company Moody’s Baa1 Baa2 9/17/2019 Questar Gas Company Moody’s A2 A3 8/15/2019 DTE Gas Company Moody’s A2 A3 7/22/2019 South Jersey Gas Company Moody’s A2 A3 7/17/2019 Central Hudson Gas & Electric Moody’s A2 A3 7/12/2019 Oklahoma Gas & Electric Company Moody’s A2 A3 5/31/2019 American Water Works Moody’s A3 Baa1 4/1/2019 Niagara Mohawk Power Corporation Moody’s A2 A3 3/29/2019 KeySpan Gas East Corporation Moody’s A2 A3 3/29/2019 Xcel Energy Moody’s A3 Baa1 3/28/2019 ALLETE, Inc. Moody’s A3 Baa1 3/26/2019 Brooklyn Union Gas Company Moody’s A2 A3 2/22/2019 Avista Corp. Moody’s Baa1 Baa2 12/30/2018 Consolidated Edison Company of New York Moody’s A2 A3 10/30/2018 Consolidated Edison, Inc. Moody’s A3 Baa1 10/30/2018 Orange and Rockland Utilities Moody’s A3 Baa1 10/30/2018 Southwestern Public Service Company Moody’s Baa1 Baa2 10/19/2018 Dominion Energy Gas Holdings Moody’s A2 A3 9/20/2018 Piedmont Natural Gas Company, Inc. Moody’s A2 A3 8/1/2018 WEC Energy Group, Inc. Moody’s A3 Baa1 7/12/2018 Wisconsin Energy Capital Moody’s A3 Baa1 7/12/2018 Integrys Holdings Inc. Moody’s A3 Baa1 7/12/2018 OGE Energy Corp. Moody’s A3 Baa1 7/5/2018 Oklahoma Gas & Electric Company Moody’s A1 A2 7/5/2018

PAC/2200 Bulkley/36


Q. What are your conclusions regarding the effect of capital market conditions on 1

the cost of equity for PacifiCorp in this proceeding? 2

A. My primary conclusion is that recent market conditions have affected the assumptions 3

used in the ROE estimation models. I believe it is important to rely on multiple 4

models to estimate the cost of equity; this is especially important under current 5

market conditions when the DCF model results, which are so commonly presented to 6

regulators, are being distorted by conditions in capital markets. As discussed in my 7

direct testimony, other state utility regulators have recognized that the DCF results 8

are not providing investors with a compensatory return and therefore have looked to 9

the results of alternative methodologies to test the reasonableness of the DCF results 10

and as the basis for selecting an authorized ROE toward the upper end of the DCF 11

range.40 In addition, on May 21, 2020, the Federal Energy Regulatory Commission 12

(FERC) issued Opinion No. 569-A in which FERC determined that it would place 13

equal weighting on the results of the DCF, CAPM and Risk Premium methodologies 14

for electric transmission companies.41 15

Furthermore, while the ROE estimation models use some historical data (i.e., 16

stock prices and dividends in the DCF model, and bond yields in the CAPM, based on 17

the expected change in market conditions), I believe it is also appropriate to consider 18

near-term projections. 19

For all of these reasons, I recommend an authorized ROE for PacifiCorp that 20

takes into consideration the results of multiple methodologies to estimate the cost of 21

40 PAC/400, Bulkley/40-42. 41 Federal Energy Regulatory Commission, Opinion No. 569-A, May 21, 2020, at para 2.

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equity. 1

VI. RESPONSE TO STAFF WITNESSES MR. MULDOON AND MS. ENRIGHT 2

Q. Please summarize Staff’s ROE analyses and recommendation. 3

A. Mr. Muldoon and Ms. Enright develop a range of results of 8.52 percent to 9.39 4

percent, based on the results of their Multi-Stage DCF model.42 Staff’s ROE 5

recommendation is based solely on the results of the Multi-Stage DCF model, from 6

which Staff selects the approximate midpoint return of 9.00 percent. Staff also 7

consider a Constant Growth DCF analysis and a CAPM analysis to test the 8

reasonableness of their Multi-Stage DCF results, but does not give those models any 9

weight in establishing the recommended ROE for PacifiCorp.43 Further, Staff 10

recommends a capital structure comprised of 52.00 percent common equity and 11

48.00 percent long-term debt.44 12

Q. How does Staff’s ROE recommendation compare to authorized returns for 13

integrated electric utilities in other jurisdictions? 14

A. Even though Staff cites the Hope decision, which requires that the return for a 15

regulated utility be comparable to returns available to investors in other investments 16

with comparable risk, Staff’s ROE recommendation is substantially below the 17

average authorized return for integrated electric utilities since 2018 of 9.70 percent. 18

Staff has not provided any evidence or supporting documentation that demonstrates 19

why the authorized ROE for PacifiCorp should be set 70 basis points below the 20

average return for integrated electric utilities and 80 basis points below PacifiCorp’s 21

42 Staff/200, Muldoon-Enright/9. 43 Id. at 11-12. 44 Id. at 8.

PAC/2200 Bulkley/38


currently authorized ROE of 9.80 percent. 1

Q. What is your response to Staff’s approach to establishing the range and 2

recommended ROE in this case? 3

A. Staff’s ROE recommendation of 9.00 percent is based entirely on the results of its 4

Multi-Stage DCF model. Staff contends that the results of its Multi-Stage DCF 5

model are reasonable as compared with the ROE estimates produced by the Constant 6

Growth DCF and CAPM methodologies. However, as explained later in my reply 7

testimony, Staff’s application of those models are based on flawed inputs and 8

assumptions. In addition, as noted above, Staff fails to consider how its 9

recommended ROE for PacifiCorp compares to authorized ROEs for integrated 10

electric utilities in other jurisdictions. Lastly, Staff does not consider the incremental 11

business risks of PacifiCorp relative to the proxy group in establishing their ROE 12

recommendation. In doing so, Staff effectively ignores the Hope decision to which 13

they refer where the U.S. Supreme Court stated that “the return to the equity owner 14

should be commensurate with returns on investments in other enterprises having 15

corresponding risks.”45 16

Q. What are your principal areas of disagreement with Staff’s analyses and 17

recommendation? 18

A. While I have many areas of disagreement with the technical aspects of Staff’s 19

analyses, as a practical matter, the most important area of disagreement is that Staff’s 20

ROE recommendation of 9.00 percent would place PacifiCorp’s authorized return at 21

the low end of the range of returns for integrated electric utilities and 80 basis points 22

45 Federal Power Comm’n v. Hope Nat. Gas Co., 320 U.S. 591, 603 (1944).

PAC/2200 Bulkley/39


lower than the 9.80 percent return the Commission established for PacifiCorp in 1

2013. Staff and I disagree on the following aspects of the ROE estimation models 2

and considerations in developing a recommended ROE: (1) the composition of the 3

proxy group; (2) the relevance of the Multi-Stage DCF results and the time period 4

over which those results should be calculated; (3) the application of the Multi-Stage 5

DCF model, particularly the long-term growth rate assumption; (4) the importance of 6

considering the results of multiple models, including the Constant Growth DCF, 7

CAPM, Risk Premium and Expected Earnings analyses to check the reasonableness 8

of the DCF results and to inform the ultimate ROE recommendation; (5) other factors 9

that support a cost of equity above the proxy group mean, including elevated capital 10

spending levels and above average business risks relative to the proxy group; and (6) 11

the appropriate capital structure for PacifiCorp. 12

Proxy Group Composition 13

Q. Please explain the differences between Staff’s proxy group and yours. 14

A. As shown in Table 5 of Staff witnesses Mr. Muldoon and Ms. Enright’s opening 15

testimony, Staff relies on a proxy group comprised of six integrated electric utility 16

companies and two transmission and distribution (T&D) only companies.46 The 17

differences between my proxy group and Staff’s group are largely attributable to 18

differences in our respective screening criteria. Five of the eight companies in Staff’s 19

proxy group are also in my proxy group. 20

The following summarizes Staff’s screening criteria that are applied to the 21

Value Line universe of Electric Utilities. From that group, Staff has applied screens 22

46 Staff/200, Muldoon-Enright/15, Table 5. Also see Exhibit Staff/204 for the complete peer group screening analysis conducted by Staff.

PAC/2200 Bulkley/40


to include companies in the proxy group that: 1

1) have not cut their dividends in the last five years according to Value Line; 2

2) have credit ratings within two notches above or below the current ratings 3

for PacifiCorp (A from S&P and A3 from Moody’s); 4

3) were not involved in a significant merger or acquisition during the past five 5

years, and are not planning significant merger and acquisition activity; 6

4) have heavily regulated revenues (per U.S. Securities and Exchange 7

Commission form 10-K filings) and assets (per Edison Electric Institute data); and 8

5) whose capital structure has between 45 and 55 percent long-term debt 9

according to Value Line. 10

Finally, Staff has not included a screen for ownership of regulated generation 11

assets, and as such Staff’s proxy group includes companies that do not own regulated 12

generation (i.e., T&D utilities). 13

Q. Do you have any concerns with the screening criteria Staff has used to select its 14

proxy group? 15

A. Yes, I do. I will address each of my concerns in this section, starting with the 16

dividend payment screen. I disagree with Staff’s dividend screen because it 17

eliminates companies without five years of dividend history even if there is no 18

concern among investors that the dividend has been cut or omitted during that period. 19

Q. Is it important to include a dividend screen in establishing the proxy group? 20

A. Yes. From an investor’s standpoint, the dividend screen is important because it 21

indicates whether a company is consistently paying quarterly dividends or whether 22

those dividends have been reduced or omitted due to the need to preserve cash. 23

PAC/2200 Bulkley/41


Furthermore, it is necessary that a company pay a dividend to estimate an individual 1

company ROE using the market data for that company. 2

Q. How does Staff’s use of a five-year historical dividend screen affect the potential 3

proxy group? 4

A. By applying the screening criterion to changes in dividends over the last five years, 5

Staff unnecessarily excludes companies that do not have five years of dividend 6

history in Value Line. Over the last several years, there have been many mergers and 7

acquisitions that result in a new entity that does not meet Staff’s dividend screen, 8

because the resulting merged company does not have five years of dividend history. 9

For example, Evergy, Inc. is excluded from Staff’s proxy group on this basis even 10

though Evergy was formed in June 2017 through the merger of Great Plains Energy 11

and Westar Energy, both of which had a long history of paying dividends, and Evergy 12

itself has consistently paid quarterly dividends for the past three years. 13

Q. Have you used a dividend screen in your proxy group selection? 14

A. Yes. I applied a dividend screen which requires that the company consistently pay 15

quarterly dividends, excluding only those companies that have recently reduced or 16

omitted their dividend. By applying the screen in this manner, I am not reducing the 17

proxy group unnecessarily for mergers and acquisitions because these transactions are 18

not interrupting the dividend payments of the companies. Therefore, the dividend 19

screen that I have relied on is more appropriate than the screen Staff has used because 20

I am excluding only companies that have cut dividends without unnecessarily 21

reducing the size of the proxy group for the creation of new companies as a result of 22

transactional activity. 23

PAC/2200 Bulkley/42


Q. Do you agree with the use of a credit rating screen in selecting the proxy group 1

companies? 2

A. Yes. I selected companies that had an investment grade long-term issuer rating from 3

S&P and/or Moody’s. While Staff also applies a credit rating screen, their criterion is 4

very narrow, eliminating companies that do not have credit ratings within plus or 5

minus two notches of PacifiCorp’s A rating from S&P and A3 rating from Moody’s. 6

Q. What is the effect of Staff’s narrowly defined credit rating criterion? 7

A. Staff excludes companies from the proxy group if their credit rating is lower than 8

BBB+ from S&P or Baa2 from Moody’s. This criterion results in the elimination of 9

15 of companies from Staff’s group. The development of the screening criteria is 10

intended to establish a proxy group that is reasonably comparable to the subject 11

company, yet not unnecessarily restrictive such that one individual estimated result 12

can bias the analysis. In order to balance these interests, it is reasonable to include all 13

companies with an investment grade rating in the proxy group because investors 14

generally differentiate between investment grade and non-investment grade 15

companies. Staff’s credit rating screen is too narrow and excludes companies that are 16

reasonably comparable to PacifiCorp in terms of business and financial risk. 17

Q. Do you agree with Staff’s merger screening criterion? 18

A. No, I do not. Similar to Staff’s approach in developing the dividend yield screening 19

criterion, the time period over which Staff applies this criterion unnecessarily limits 20

the proxy group companies. Staff’s merger screening criterion excludes companies 21

that have been involved in significant M&A activity at any time during the past five 22

years, as well as companies that are planning future M&A activity. 23

PAC/2200 Bulkley/43


Q. Is it appropriate to exclude companies that are involved in transformative 1

transactions from the proxy group? 2

A. Yes. The reason to exclude companies that have announced a merger is that the 3

merger announcement often affects the stock price of one or both companies, which 4

can cause concerns that the market data used in the DCF and CAPM methods are not 5

representative of the companies on a going-forward basis. Once the merger is 6

completed or terminated, there is no reasonable basis to exclude companies due to the 7

merger/acquisition. Applying a criterion that companies cannot have been involved 8

in a transaction for five years is unnecessary because the data that is being relied on in 9

the development of the ROE estimation models typically does not extend far back 10

enough historically to affect the current estimate of the ROE. It is more appropriate 11

to eliminate companies from the proxy group if the merger has occurred at some point 12

during the analytical period that is being used in the ROE estimation models. This is 13

consistent with the approach I have relied on in applying a merger screen in the 14

development of my proxy group. 15

Q. Is it practical to apply a criterion that excludes companies for future merger 16

activity? 17

A. No, it is not. It is not clear how Staff would apply this criterion because typically that 18

information would not be publicly available prior to the merger announcement date. 19

Therefore, Staff would not have the necessary information to apply such a screen. 20

Q. How has Staff’s merger screening criterion affected the proxy group? 21

A. As shown in Staff’s Exhibit 204, Staff identified eight companies that would be 22

excluded from the proxy group based on the merger screen. It is important to note 23

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that some of the transactions that Staff uses to exclude the companies from the proxy 1

group are from 2014 and 2015. Figure 12 below summarizes the companies that were 2

included in my proxy group that Staff excluded due to merger activity. Staff relied on 3

stock price data as of the first trading day of January, February, and March 2020. As 4

shown in this table, the merger activity that was used for elimination of these 5

companies was outside of the historical data set used by Staff in its analysis. 6

Therefore, since these merger activities could not reasonably be expected to influence 7

the stock prices used in Staff’s analysis, there is no basis for excluding these 8

companies from the proxy group. 9

Figure 12: Merger Screen Exclusions 10

Company Merger Date Merger Activity CenterPoint 2019 Acquired Vectren Dominion 2019 Acquired SCANA Entergy 2015 Acquisition of Union Gas plant Evergy 2017 Combination of Great Plains and Westar NextEra 2017 Attempted acquisition of HECO

Northwestern Energy 2014 Acquired 633 MW of hydroelectric

Q. Do you agree with Staff’s application of a revenue screen to identify proxy 11

companies that are primarily engaged in electric utility operations like 12

PacifiCorp is in Oregon? 13

A. No. Staff has selected companies for its proxy group that are “heavily regulated”. 14

While this is not quantified in the testimony, in Exhibit 204, it appears that Staff is 15

applying revenue and asset screens that exclude companies with 80 percent or less of 16

revenues from regulated operations and less than 80 percent of their assets dedicated 17

to regulated electric operations. While I recognize that these percentages are the 18

judgment of the analyst, I note that the screening is intended to develop a comparable 19

PAC/2200 Bulkley/45


group of companies that is of sufficient size to avoid biasing the results. Therefore, I 1

have chosen companies that derive greater than 60 percent of their total operating 2

income from regulated operations and companies that receive more than 60 percent of 3

their regulated operating income from regulated electric utility operations. 4

Q. Please explain why you have used regulated operating income rather than 5

regulated revenues or assets to screen your proxy group. 6

A. In establishing my proxy group, I relied on the percentage of net operating income 7

derived from regulated operations instead of the percentage of total revenue from 8

regulated operations because net operating income is more representative of the 9

contribution of that business segment to earnings and the corporation’s overall 10

financial position. Specifically, a significant portion of electric utility company 11

revenue is derived from the costs of purchased fuel and purchased power, which, in 12

most cases, are recoverable through tracking mechanisms and do not, therefore, 13

contribute to earnings. Furthermore, this portion of total revenue can fluctuate 14

considerably based on the cost of fuel and purchased power. Therefore, relying 15

exclusively on a revenue screen does not provide a clear or necessarily consistent 16

indication of the contribution of the regulated utility operations to a company’s 17

earnings. Net operating income excludes the cost of purchased commodity and 18

therefore more closely represents the contribution of the business segment to a 19

company’s earnings. 20

Q. Please describe the screen Staff has applied based on the capital structure of the 21

potential proxy group company. 22

A. Staff includes companies in the proxy group if their capital structure has between 45 23

PAC/2200 Bulkley/46


and 55 percent long-term debt according to Value Line. Staff provides no support for 1

why this range is appropriate for PacifiCorp. 2

Q. Do you believe this screen is appropriate? 3

A. No, I do not. First, Staff’s range is heavily weighted to include companies with less 4

equity in the capital structure than is proposed by PacifiCorp. PacifiCorp’s proposed 5

equity ratio is 53.52 percent. Therefore, relying on a proxy group with a range of 6

equity from 45 to 55 percent biases the proxy group to a lower equity ratio than 7

PacifiCorp’s current capitalization ratio. Also, Staff’s use of a credit rating screen, a 8

capital structure screen and the Hamada equation adjust the proxy group multiple 9

times for differences in capital structure that are not necessary. Credit rating agencies 10

consider multiple leverage ratios when determining the appropriate credit rating for a 11

company. Therefore, the application of a separate capitalization screening criterion is 12

not necessary, as it is already captured in the credit ratings. Furthermore, the capital 13

structure data reported by Value Line, which Staff uses to screen its proxy group, are 14

at the holding company level. The use of the capital structure as a screening criterion 15

narrows the proxy group to some range of capitalization that is determined by the 16

analyst to be comparable to the subject company. Applying the Hamada adjustment 17

is a second unnecessary adjustment if the screening criteria have been effective at 18

developing a proxy group that is comparable on the basis of capitalization. The 19

application of these two screens and the Hamada equation unnecessarily adjusts for 20

capitalization three times in the Staff’s analysis. 21

Q. Please explain your generation ownership screens. 22

A. I have selected companies that own regulated generation assets because they have a 23

PAC/2200 Bulkley/47


different risk profile than companies that do not own generation (i.e., T&D only 1

utilities). Furthermore, in order to increase the risk comparability to PacifiCorp in 2

Oregon, I have applied an additional screen based on the percentage of coal-fired 3

generation. Staff, on the other hand, has not applied a generation screen, and has 4

therefore included companies that do not own regulated generation. In particular, 5

Staff’s proxy group includes Consolidated Edison, Inc. and Eversource Energy, both 6

of which own very limited regulated generation assets and therefore do not have risk 7

comparable to PacifiCorp. 8

Q. What evidence is there that investors consider companies that own generation 9

facilities to have higher risk than T&D utilities? 10

A. The generation function is generally regarded by investors as being higher risk than 11

electric transmission or distribution. As stated by Moody’s in its 2017 ratings 12

methodology for regulated electric and gas utilities: 13

Generation utilities and vertically integrated utilities generally 14 have a higher level of business risk because they are engaged in 15 power generation, so we apply the Standard Grid. We view power 16 generation as the highest-risk component of the electric utility 17 business, as generation plants are typically the most expensive part 18 of a utility’s infrastructure (representing asset concentration risk) 19 and are subject to the greatest risks in both construction and 20 operation, including the risk

before the public utility commission of ......2020/06/25 · pac/2200 bulkley/2 reply testimony of...

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