Download q. are you the same charles e. olson whose direct testimony

EXHIBIT WG (2B)
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WASHINGTON GAS LIGHT COMPANY
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REBUTTAL TESTIMONY OF CHARLES E. OLSON
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4
Q.
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A.
6
Q.
My name is Charles E. Olson.
ARE YOU THE SAME CHARLES E. OLSON WHOSE DIRECT TESTIMONY
WAS FILED EARLIER IN THIS CASE?
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PLEASE STATE YOUR NAME.
A.
Yes, I am.
I.
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10
Q.
PURPOSE OF TESTIMONY
HAVE YOU REVIEWED THE TESTIMONY AND EXHIBITS OF OPC
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WITNESS STEPHEN G. HILL, STAFF WITNESSES GUNTER J. ELERT AND
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RANDY M. ALLEN, AOBA WITNESS BRUCE OLIVER AND DOD/FEA
13
WITNESS ANDREA C. CRANE THAT WERE FILED IN THIS CASE IN JUNE?
14
A.
Yes, I have. I disagree with the conclusions of these witnesses on return
on common equity and with three of them on capital structure.
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II.
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17
Q.
A.
Q.
REBUTTAL TO OPC WITNESS HILL’S TESTIMONY
BEGIN PLEASE WITH OPC WITNESS STEPHEN G. HILL. WHAT RETURN
ON COMMON EQUITY RATIO DOES HE RECOMMEND?
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Yes, Exhibit WG (2B-1) was prepared by me.
III.
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DID YOU PREPARE AN EXHIBIT FOR USE WITH YOUR REBUTTAL
TESTIMONY?
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IDENTIFICATION OF EXHIBITS
A.
Mr. Hill recommends a return on common equity of 10.0 percent in
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combination with a common equity ratio of 52.85 percent. I do not agree with
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his recommendations.
WITNESS OLSON
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2
Q.
THE COMPANY’S PROPOSED COMMON EQUITY RATIO IS 53.4 PERCENT.
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WHY DO YOU DISAGREE WITH MR. HILL’S RECOMMENDATION OF 52.85
4
PERCENT?
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A.
Quite clearly there is not a great deal of difference between 53.4 percent
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and 52.85 percent. What I find troubling is the logic Mr. Hill used to support his
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adjustment.
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historical capital structure has been 49.6 percent. But this statement is based
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on data for seven quarters and surely is too short a period to represent the
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financial history of Washington Gas, even the recent history. Not only that, Mr.
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Hill ignores the fact that Washington Gas issued some $50 million in common
12
equity in June 2001, right in the middle of his measurement period.
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issuance was a significant effort to increase the common equity ratio on a going
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forward basis. In my view the common stock offering renders his historical
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comparison meaningless.
He begins with a statement at page 20 that the Company’s
That
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Mr. Hill continues at pages 21-23 of his testimony with a discussion of
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how Washington Gas’ common equity ratio compares to that of other
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companies in the so-called gas industry. His comparison includes companies
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with significant diversification, low bond ratings and telecom investments.
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Some of the companies are in low growth areas and do not have to invest
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significant amounts in new plant and equipment. The implicit suggestion here
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is that all Washington Gas really needs in the way of common equity capital is
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the industry average.
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Finally, at pages 24-26 and at his Exhibit (SGH-1), Schedule 2, page 3,
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Mr. Hill explains his upward adjustment to short-term debt and the
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WITNESS OLSON
1
corresponding reduction to the common equity ratio. He bases his adjustment
2
on the historical use of short-term debt relative to the current projection. But as
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shown on his Schedule 2, page 1, the use of short-term debt for the quarters
4
ended September 2001, December 2001 and March 2002
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significantly.
6
Q.
declined
IN ADDITION TO REDUCING THE COMMON EQUITY RATIO FOR
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WASHINGTON GAS, DID MR. HILL ALSO REDUCE THE COST OF
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COMMON EQUITY AS A RESULT OF HIS OPINION THAT THE COMMON
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EQUITY RATIO IS TOO HIGH?
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A.
11
Q.
WHAT COST OF COMMON EQUITY CAPITAL DID MR. HILL DERIVE USING
DCF ANALYSIS?
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Yes, he did. I will discuss that point later in my testimony.
A.
As reported at the bottom of page 40 of his testimony as well as at his
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Schedule 6, he found the DCF cost of equity to be 10.51 percent. He reached
15
his conclusion using the concept of sustainable growth to estimate the growth
16
rate component in his DCF approach.
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Q.
PLEASE EXPLAIN WHY YOU BELIEVE THAT IT IS INAPPROPRIATE FOR
18
MR. HILL TO PLACE SUBSTANTIAL RELIANCE ON THE SUSTAINABLE
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GROWTH RATE APPROACH IN HIS DCF ANALYSIS.
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A.
Of course. Mr. Hill has incorrectly developed a line of reasoning that
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supports the use of the sustainable growth rate approach in estimating the cost
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of common equity to public utilities. He begins at page 33 of his testimony with
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a statement that the “g” in the DCF model is “the expected sustainable growth
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rate.” His statement is not correct. The cost of common equity capital is an
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expectational concept. What this means is that the growth rate used in the
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WITNESS OLSON
1
DCF formula to determine the allowable rate of return is the growth rate that is
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expected by the investor. The growth rate expected by the investor is not the
3
same thing as the expected sustainable growth rate. The expected sustainable
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growth is defined at Appendix B, page ii, and is equal to growth from retained
5
earnings plus financing growth. This concept of growth is not necessarily in the
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minds of investors; indeed no one has ever proved that it is. It would have
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been fine for Mr. Hill to say that the investors would be unwise to expect more
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than sustainable growth, but that is not what he did.
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Mr. Hill also claims that Professor Myron Gordon has determined that
10
sustainable growth embodies the underlying fundamentals of growth and is
11
therefore a primary measure of growth to be used in the DCF model (Appendix
12
B, pages i to ii). He supports his position by the claim that Gordon developed
13
the DCF model and first introduced it into the regulatory arena. Again, Mr. Hill
14
is incorrect. He is first incorrect in his claim that Myron Gordon developed the
15
DCF technique and first introduced it into the regulatory arena. Second, he
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clings to the expected sustainable growth approach in spite of more recent
17
work that refutes it. Effectively, he refuses to admit that finance theory has
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moved beyond the work that Myron Gordon did as a consultant more than 25
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years ago.
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Q.
ABOUT THE DCF APPROACH MORE THAN 25 YEARS AGO?
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WHY DOES IT MATTER WHAT SOMEONE LIKE MYRON GORDON SAID
A.
The function of the Maryland PSC in this proceeding is to determine a
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reasonable rate of return on common equity for Washington Gas.
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appropriate approach to estimating rates of return for regulated companies has
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changed significantly over the past 25 years the change should be reflected in
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If the
WITNESS OLSON
1
the ratemaking process. Therefore, the opinions of Myron Gordon from an
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earlier era are not relevant to this function.
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regulatory circles believe what Mr. Hill has stated is true, i.e., that Myron
4
Gordon developed the DCF technique and first introduced it into the regulatory
5
arena. People reason that if Gordon said it, it must be true. Mr. Hill is using
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this common belief to support an approach to estimating the return on equity
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that is outdated, biased and produces low results.
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Q.
DID MR. HILL OFFER ANY SUPPORT FOR HIS BELIEF THAT MYRON
GORDON DEVELOPED THE DCF TECHNIQUE AND FIRST INTRODUCED
9
IT INTO THE REGULATORY ARENA?
10
11
Nevertheless, some people in
A.
No. He simply makes reference to a 1974 book on cost of capital as the
12
basis for his claim that Myron Gordon developed the DCF technique and first
13
introduced it into the regulatory arena.
14
Q.
IF MYRON GORDON DID NOT DEVELOP THE DCF APPROACH, WHO DID?
15
A.
I am not sure. In an important article, titled “The Application of Finance
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Theory to Public Utility Rate Cases” (Bell Journal, 1972), Stewart C. Myers
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discusses the method. For early examples of the use of the DCF method, he
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cites Brigham, Kosh, Myers and Roseman. The years mentioned are 1969 and
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1971. I also used the DCF approach in testimony in several cases in 1971 and
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1972.
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remember that DCF as a method of estimating cost of equity was discussed in
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the basic course in public utilities at the University of Wisconsin in 1962. Thus,
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there is little doubt that DCF was around and being used long before 1974
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when Myron Gordon addressed the topic in his book.
Interestingly, Myers doesn’t mention Gordon as a DCF pioneer.
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I
WITNESS OLSON
1
Q.
WHAT IS WRONG WITH THE EXPECTED SUSTAINABLE GROWTH
2
CONCEPT OR RETENTION GROWTH APPROACH AS IT IS SOMETIMES
3
REFERED TO?
4
A.
There is nothing wrong with the notion that, on a very long-term basis,
5
the value of a stock cannot grow more rapidly than the underlying fundamentals
6
permit. In effect, the concept of expected sustainable growth tells us something
7
about how investors ought to behave. However, when making DCF estimates
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of the cost of common equity capital, we are not interested in how investors
9
ought to behave. Instead, we are interested in how they are behaving. What is
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essentially wrong with Mr. Hill’s approach to return on common equity is that he
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purports to determine what return investors expect based on how he believes
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they ought to behave. What he should have done is to attempt to capture their
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actual growth rate expectations.
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The sustainable growth theory is based on the premise that utility stocks
15
will always trade at a price that is somewhere around book value. Under this
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theory of cost of capital, investors know that rates will be set in a way that
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brings the price of a utility stock back to near book value whenever it strays too
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far away.
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Currently, market prices for many electric and gas utility common stocks,
20
including that of Washington Gas, trade at prices that are well in excess of book
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value. Not only that, they have traded at prices in excess of book value for the
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last 15 or more years. This raises an interesting and fundamental question
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relative to rate of return regulation.
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estimates on growth rates that are sustainable, why have they bid utility stocks
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prices to levels that are 50 or more percent above book value?
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If investors base their DCF growth
WITNESS OLSON
1
Quite obviously, investors are not assumed to be irrational; if they were,
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there would be no conceptual basis for the DCF model. However, it is equally
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clear that investors do not believe that utility stocks will trade around book value
4
either. Additionally, it is apparent that regulatory bodies do not believe share
5
prices should trade at prices near book; if they did, market-to-book ratios would
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be far lower than they are today.
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I addressed the question of high market-to-book ratios in my direct
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testimony. The point of that testimony was that investors clearly do not believe
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that Commissions will base rates of return on concepts such as sustainable
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growth and then apply those returns to book value type rate bases. If they did
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that or it was believed that they would do that, utility stock prices would have to
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come down. My purpose in restating this is to question why Mr. Hill did not
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rebut this testimony; clearly he had the opportunity. In all probability, he had no
14
answer because he knows that the DCF as he applies it is conceptually
15
incorrect.
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expectations on sustainable growth.
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Q.
WHAT DO INVESTORS IN PUBLIC UTILITY STOCKS DO WHEN IT COMES
TO ESTIMATING GROWTH?
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Investors, contrary to his claim, do not base their growth
A.
Quite clearly if gas and other traditional public utility common stocks are
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trading well in excess of book value investors expect them to continue to trade
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at these levels.
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expectation that they are going down.
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understand regulation well enough to understand that public utility commissions
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use the DCF method and apply it to original cost rate base cannot be true.
Rational investors would not buy these stocks with the
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-7-
Further, the notion that investors
WITNESS OLSON
1
As a group, investors have earned high returns on most common stocks
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in recent years and have come to expect returns of 15 or more percent on a
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going forward basis. In spite of the stock market declines of the recent past,
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price-earnings ratios and expected growth rates are still high; this means that
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investors are still optimistic and paying attention to analyst forecasts. None of
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this should be taken to mean that regulatory bodies such as the Maryland PSC
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have to authorize returns on equity of 15 or more percent. But at the same
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time, no one should believe that the average utility investor is seriously basing
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her cost of capital determination on the sustainable growth approach as it is set
forth by Mr. Hill. In my opinion that is simply unrealistic.
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11
Q.
IS THERE A RECENT EXAMPLE OF THE FINANCIAL PRESS STATING
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THAT INVESTORS STILL EXPECT TO EARN ANNUAL RETURNS OF 15 OR
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MORE PERCENT PER YEAR?
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A.
Yes. The feature article in the Barron’s dated July 1, 2002 and titled
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After the Bubble says that most investors, according to recent polling, “expect
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annual stock-market returns to resume their recent 15-20% pace momentarily.”
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The article goes on to note that history, regulatory backlash, misunderstood
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market fundamentals and continuing stock-market overvaluation all argue that
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such investor expectations will be brutally dashed.
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Q.
ASSUMING WHAT YOU SAY IS CORRECT, DR. OLSON, DOESN’T THAT
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SUGGEST THAT THE MORE FUNDAMENTAL APPROACH SUGGESTED BY
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MR. HILL IS APPROPRIATE?
23
A.
An approach of the type recommended
by Mr. Hill is certainly
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appropriate for any investor who wants to exercise careful judgment toward the
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fundamentals. However, in the context of a public utility rate case his obligation
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WITNESS OLSON
1
is to estimate the growth rate that investors expect, not the one that they ought
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to be estimating from a textbook perspective. If utility stocks traded at prices
3
near book value it would clearly be appropriate to utilize the sustainable growth
4
approach for estimating DCF returns.
5
Q.
DOES MYRON J. GORDON, THE FINANCE PROFESSOR, CITED BY
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MR. HILL AS THE PERSON WHO INTRODUCED THE DCF APPROACH TO
7
THE REGULATORY AREA, STILL CLAIM THE SUSTAINABLE GROWTH
8
APPROACH IS THE BEST APPROACH?
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A.
I do not believe so.
In an article titled “Choice Among Methods of
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Estimating Share Yield: The Search for the Growth Component in the DCF
11
Model” (Journal of Portfolio Management, Spring 1989, p.50), Professor
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Gordon found that analyst estimates of the type I relied on provide more
13
accurate estimates than retention or sustainable growth methods. I believe that
14
Mr. Hill is aware of this but he continues to make the claim that Gordon’s former
15
approach is still correct.
16
Q.
WHAT WOULD HAPPEN IF THE 10.0 PERCENT RETURN ON COMMON
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EQUITY THAT MR. HILL RECOMMENDS AS THE COST OF EQUITY FOR
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HIS COMPARABLE COMPANIES WAS ACTUALLY EARNED BY EACH OF
19
THE COMPANIES IN HIS GROUP?
20
A.
They would on average, have to reduce their payout ratios.
Their
21
earned returns would be lower and this would cause some of them to make
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dividend cuts. I am not suggesting that the return on equity must be set at a
23
high level to maintain the dividend levels of the comparable companies or WGL
24
Holdings.
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investors are doing DCF analysis using the traditional method advocated by Mr.
Rather, what I am saying is that it is unrealistic to believe that
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WITNESS OLSON
1
Hill. Investors are not paying prices above book value with the expectation of
2
flat dividends or dividend cuts. Instead, they are acting as if they believe that
3
current market-to-book ratios will be maintained or increased. Their view is that
4
enough will be earned on book value to do just that.
5
Q.
RATE ANALYSIS IS ILLOGICAL?
6
7
ARE YOU SAYING THAT MR. HILL’S EXPECTED SUSTAINABLE GROWTH
A.
Yes.
His approach is premised on the notion of investors and
8
commissions focusing on book values and authorized returns. But this can not
9
be the case, given actual market-to-book ratios. Quite obviously, investors just
10
don’t see it this way. They don’t expect dividends to be cut; instead they expect
11
them to go up. This means that they are not doing the type of DCF analysis
12
that Mr. Hill says they are.
13
Q.
AT PAGES 48-51 OF HIS TESTIMONY, MR. HILL PRESENTS WHAT HE
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CALLS A MODIFIED EARNINGS-PRICE RATIO APPROACH TO THE COST
15
OF COMMON EQUITY CAPITAL. IS HIS USE OF THIS APPROACH USEFUL
16
IN A CORROBORATIVE SENSE AS HE CLAIMS AT PAGE 48?
17
A.
18
Q.
19
A.
No.
WOULD YOU PLEASE EXPLAIN WHY NOT?
Yes. What Mr. Hill has done is to go back in history and dredge up an
20
old approach to rate of return that was used more than 30 years ago by the
21
Federal Power Commission (“FPC”). He then renamed it and made a false
22
claim that FERC has recently found this technique useful.
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claim, this approach to rate of return that has not been considered credible for
24
years.
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Contrary to his
WITNESS OLSON
1
The modified earnings-price ratio approach that Mr. Hill sets forth is
2
really the Midpoint Theory that was developed at the FPC decades ago. More
3
than 30 years ago in Opinion No. 609, the FPC made these observations at 47
4
FPC 157:
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Opinions of this Commission, from El Paso Natural Gas
Company, 28 FPC 688, 701, in 1962 forward, indicate that we
have found the Midpoint Theory attractive. We have done so
in part because it has tended to provide further support for our
rate of return conclusions reached by other means. We have
done so also because the theory appears to provide a test that
is relatively simple to apply. Rate of return determinations are
difficult, and they necessarily involve considerable subjectivity,
and it is thus tempting to embrace techniques which appear to
simplify their disposition.
We are now convinced, however, that the Midpoint Theory
must be viewed with considerable skepticism.
See
Commissioner Carver's' concurring opinion in United Gas Pipe
Line Company, Docket No. RP70-13, Opinion No. 589,
December 9, 1970, 44 FPC 1556 at 1570. Not only does it
provide so wide a range as to be entitled to little weight, as is
the case in this proceeding, but we are persuaded that to the
extent it may be based upon circular reasoning, it should be
tested in its end result by the application of other evidence of
comparable earnings. In determining just and reasonable
rates of return, we must consider all relevant evidence and not
rely solely upon the Midpoint Theory or any other theory.
Earnings-price ratios and earnings-book ratios, are in large
measure, a function of the regulatory process. A utility's
earnings-book ratio is determined, in effect, when this
Commission, and others, establish allowances on equity. If
the earnings-book ratio is above a fair and reasonable
earnings level, the allowed rate of return is excessive; if the
earnings-book ratio is below a fair equity return, the allowance
should be increased.
Since allowances are based on
previously experienced test-year conditions, earnings-book
ratios may be either too high or too low depending on whether
variables affecting profitability improve or worsen in periods
following the test year. As such, the earnings-book ratio may
serve to indicate whether past regulation was either
excessively tight or loose, but to say that the earnings-book
25
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WITNESS OLSON
ratio is, in some sense, an independent measure of a firm's
demand for equity capital is illogical.
1
2
In my view, the Commission was expressing a very critical view of the
3
Midpoint Theory in Opinion No. 609. Moreover, the FERC does not currently
4
rely on the Midpoint Theory to determine allowable rates of return.
5
6
Q.
AT PAGE 50, IN REFERRING TO HIS MODIFIED EARNINGS-PRICE RATIO
7
ANALYSIS, MR. HILL MADE THE FOLLOWING STATEMENT: “THE
8
FEDERAL ENERGY REGULATORY COMMISSION, IN ITS GENERIC RATE
9
OF RETURN HEARINGS FOUND THIS TECHNIQUE USEFUL AND HELD
10
THAT UNDER THE CIRCUMSTANCES OF MARKET-TO-BOOK RATIOS
11
EXCEEDING UNITY, THE COST OF EQUITY IS BOUNDED ABOVE BY THE
12
EXPECTED EQUITY RETURN AND BELOW BY THE EARNINGS-PRICE
13
RATIO.” IS THIS CORRECT?
14
A.
No.
In Order No. 469, to which Mr. Hill referred, the Commission
15
referred back to an earlier Order (No. 442) and said that the shortcomings of
16
the E/P (“earnings-price ratio”) corroborative test remain. There is no reference
17
to the technique being useful. More important, in Order No. 489, issued about
18
a year after the Order referred to by Mr. Hill, the Commission made the
19
following comment relative to market-to-book and earnings-price ratio evidence:
20
21
22
23
24
25
FA Staff's presentation in this proceeding is substantially
similar to those filed in the three earlier annual proceedings.
Its analysis is not entitled to great weight because of its lack of
precision. If one were to accept FA Staff's presentations at
face value, they would appear to support nearly any cost of
common equity estimate in the range of 9.38 to 13.70 percent.
And, the 11.21 percent cost of common equity found
reasonable by the Commission is certainly within that range.
Cooperatives claim that an adjusted E/P ratio analysis
corroborates its cost of capital estimate of 10.87 percent.
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WITNESS OLSON
However, the Commission notes that Cooperatives' adjusted
E/P ratio is merely a derivative of the discounted cash flow
model which uses book value growth, i.e., the "k = D/P+br+sv"
model. The presentation is a tautology in that a minor
reformulation of the primary model has been used to
demonstrate the validity of the model itself. Therefore,
Cooperatives' adjusted E/P analysis is not useful as
corroborative evidence in this proceeding. See 51 Fed. Reg.,
31,795, Footnote reference omitted.
1
2
3
4
5
6
After Order No. 489, the Commission issued Order Nos. 510 and 517
7
relative to generic rate of return. Neither one mentioned earnings-price ratios.
8
Apparently, the parties that had advocated their use in earlier dockets got the
9
message that the Commission did not consider earnings-price ratios, earnings-
10
book ratios and similar considerations to be valid in determining an appropriate
11
12
return on equity.
Q.
13
14
PAGES 52-53 A CHECK OF HIS DCF ANALYSIS?
A.
15
What he has done, in the words of FERC, “is a tautology.”
Q.
18
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20
21
22
23
24
No. All Mr. Hill has done is to apply his DCF in a slightly different way.
His equation at page 53 is no more than dividend yield plus retention growth.
16
17
IS THE MARKET-TO-BOOK ANALYSIS PRESENTED BY MR. HILL AT
IS MR. HILL’S CAPM ANALYSIS VALID AS AN ESTIMATE OF THE COST OF
COMMON EQUITY?
A.
No, but it is not necessary to explain why in any detail. Mr. Hill
does a very good job of explaining why beta is not a good measure of risk.
This testimony, which is contained in his Appendix D, clearly demonstrates the
weakness of beta as a measure of risk and therefore, the CAPM. Based on
this testimony, Mr. Hill should have concluded that the CAPM is not a suitable
means of estimating the cost of common equity capital.
25
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WITNESS OLSON
1
Q.
MR. HILL RECOMMENDS A RETURN ON COMMON EQUITY OF 10.00
2
PERCENT EVEN THOUGH HIS DCF RESULT (WHICH HE SAYS IS HIS
3
PRIMARY INDICATOR) IS 10.51 PERCENT. WHY DID HE REDUCE HIS
4
RECOMMENDED RETURN BY 51 BASIS POINTS FROM HIS DCF BASED
5
RESULTS?
6
A.
This is discussed at pages 54-61 and seems to involve a number of unrelated
7
reasons. For the most part, the reduction seems to be based on his claim that
8
Washington Gas has less financial risk than the comparables. He also reduced
9
his number because his non-DCF based methodologies produce a lower result
10
than his DCF study. Additionally, he suggests that his recommended return on
11
common equity was not reduced because of the weather related insurance plan
12
that Washington Gas has in place.
13
Q.
MAKE GIVEN THE FACTORS HE DISCUSSED?
14
15
WAS HIS REDUCTION FROM 10.51 TO 10.00 A REASONABLE ONE TO
A.
No. A more balanced analysis should have led him to the conclusion
16
that his return should have been adjusted upward, probably to a range of 11.5
17
to 12.0 percent.
18
Q.
19
A.
PLEASE EXPLAIN THE BASIS FOR THIS CONCLUSION.
Certainly. To begin, there is no basis for a conclusion that Washington
20
Gas has less financial risk than a reasonable group of comparable companies.
21
Mr. Hill’s conclusion that Washington Gas has less financial leverage is largely
22
based on his Schedule 2, Page 2 of 4. There, using data from C.A. Turner and
23
Edward Jones, Mr. Hill purports to show that other gas companies have more
24
financial leverage that Washington Gas.
25
misleading for a number of reasons.
- 14 -
However, this comparison is
WITNESS OLSON
1
First, many of the companies on that list are not gas distribution
2
companies or are highly diversified. Second, some of the companies have
3
pipeline or telecom operations. Third, as is made clear in the testimony of Ms.
4
Jennings, the snapshot style comparisons that Mr. Hill makes are of limited
5
value for ratemaking purposes. Fourth, some of the short-term debt being held
6
by the companies on Mr. Hill’s list is properly attributed to Construction Work in
7
Progress and not rate base. Fifth, some of the companies on the list are able
8
to finance with tax exempt debt and therefore carry more debt than Washington
9
Gas. Sixth, some of the companies are in low growth areas and don’t have to
10
be in the debt market as often as Washington Gas.
11
companies have recently made significant acquisitions that were financed at
12
least in part with short-term debt.
13
Q.
WHAT DOES VALUE LINE ESTIMATE THE COMMON EQUITY RATIOS WILL
BE FOR MR. HILL’S COMPARABLES IN THE 2005-07 PERIOD?
14
15
Finally, some of the
A.
Value Line projects that the average common equity ratio for Mr. Hill’s
16
group will be 54.6 percent in 2005-07. Washington Gas is estimated to be in
17
the middle of the distribution with a 55 percent equity ratio. In my opinion there
18
should be no capital structure penalty.
19
Q.
IF MR. HILL’S 10.51 PERCENT DCF RESULT SHOULD NOT BE ADJUSTED
20
DOWN TO 10.00 PERCENT, WHY DO YOU THINK IT SHOULD BE
21
ADJUSTED UPWARD TO A RANGE OF 11.5 TO 12.0 PERCENT?
22
A.
I base this conclusion on three considerations. First, at page 44, Mr. Hill
23
says that the Ibbotson risk premium over U.S. Treasuries is 5.4 to 7.0 percent.
24
Given current long-term interest rates this suggests a cost of equity range of 11
25
to 12 percent. Second, Mr. Hill recognizes that many of the gas distributors in
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WITNESS OLSON
1
his sample group have weather normalization clauses. Because Washington
2
Gas does not have such a clause its cost of equity should be higher than the
3
group average.
4
breaks or market pressure included in Mr. Hill’s recommendations.
5
should be an allowance of 50-75 basis points for these items in the cost of
6
capital. Based on the analyses done by Mr. Hill, his 10.51 percent DCF result
7
should be increased by 50 to 150 basis points.
8
Q.
There
AT PAGES 72-76 OF HIS DIRECT TESTIMONY, MR. HILL IS CRITICAL OF
THE RISK PREMIUM ANALYSIS THAT YOU DID. DO YOU AGREE WITH
9
HIS TESTIMONY OF THAT POINT?
10
11
Finally, there is no allowance for financing costs, market
A.
No, I do not. As a general matter, it would seem fair to say that Mr. Hill’s
12
testimony on this point is directed more at the risk premium method than at my
13
testimony. His first criticism of the method is that the method looks backward
14
and thereby assumes that “past is prologue.” While this is clearly true, it is
15
reasonable to believe that this is exactly what investors do. They look at the
16
long history of stock returns exceeding bond returns by 7 or so percent and
17
generalize that will continue. They also know that during the last 15 or so years
18
stock returns have been in the 18 percent range and expect this to continue. I
19
do not know why Mr. Hill finds this to be so inappropriate when he relies on a
20
DCF approach that is essentially grounded in the use of past data.
21
Mr. Hill’s second criticism of the risk premium methodology is that
22
returns vary greatly from period to period.
23
returns will vary year to year, but they buy stocks anyway. What is critical is
24
that the Ibbotson study has shown that the long-term stock returns are well
25
- 16 -
So what?
Investors know that
WITNESS OLSON
1
above the long-term bond returns. This is why many investors buy stocks and
2
why some buy index funds such as the S&P 500.
3
Q.
4
A.
Yes.
REBUTTAL TO DOD/FEA WITNESS CRANE’S TESTIMONY
IV.
5
6
ARE YOU FINISHED WITH YOUR REBUTTAL OF MR. HILL?
Q.
PLEASE TURN NOW TO THE TESTIMONY OF ANDREA C. CRANE THAT
7
WAS FILED ON BEHALF OF THE UNITED STATES DEPARTMENT OF
8
DEFENSE AND OTHER FEDERAL EXECUTIVE AGENCIES (“DOD/FEA”).
9
WHAT CAPITAL STRUCTURE DOES MS. CRANE RECOMMEND IN THIS
CASE?
10
11
A.
Ms. Crane recommends a capital structure with 51.04 percent common
12
equity, 6.66 percent short-term debt, 1.82 percent preferred stock and 40.48
13
percent common equity. In my view her capital structure includes too little
14
equity and too much debt capital.
15
Q.
EQUITY RATIO FROM 53.4 PERCENT TO 51.04 PERCENT?
16
17
WHAT IS THE BASIS FOR MS. CRANE’S REDUCTION IN THE COMMON
A.
There are two reasons she offers to justify her downward adjustment.
18
First, at page 9 she says the use of a capital structure at April 30, 2003 is too
19
speculative for ratemaking purposes. Second, at page 11 she states that her
20
recommended common equity ratio of 51.04 percent is considerably above the
21
typical equity ratio of the gas companies followed by the publication, C.A.
22
Turner Utility Reports.
23
Regarding her first reason for a lower common equity ratio, namely that an
24
April 30, 2003 capital structure is too speculative, I respectfully disagree. The
25
middle of the first year of the rate effective period is a standard regulatory
- 17 -
WITNESS OLSON
1
concept and regulatory agencies have been using such forecasts for years.
2
There is little that is speculative about April 30, 2003 relative to November
3
2002. Normal weather revenues are relatively predictable as are expenses and
4
dividends. It is also important to note that November is near the annual low
5
point for common equity because of the seasonal flow of revenues. Overall, a
6
more forward basis for ratemaking is to be preferred to a more historical basis.
7
Ms. Crane’s second reason for her common equity ratio of 51.04 percent
8
is that this number is above the typical equity ratio for a gas utility. At page 11
9
she refers to the C.A. Turner average of 40 percent.
Her statement is
10
misleading. The companies that make up this group are not all “typical” gas
11
distribution utilities. Some are pipelines and a number have significant non-
12
utility diversification. UGI, for example, with its 17 percent equity ratio has very
13
high cash flow and a 22 percent return on equity. It is a 51 percent owner of
14
the largest U.S. propane marketer. SEMCO with its 17 percent equity ratio is
15
also highly diversified. The bottom line here is that just because a financial
16
service such as C.A. Turner or Edward Jones classifies a company as a gas
17
utility, it does not mean that it meets comparability standards for rate case
18
purposes. Ms. Crane’s comparison is inappropriate and should not be relied
19
upon.
20
Q.
IN THIS CASE?
21
22
A.
25
She recommends a return on common equity of 10.13 percent. In my
view that is too low a return to permit capital attraction on reasonable terms.
23
24
WHAT RETURN ON COMMON EQUITY DOES MS. CRANE RECOMMEND
Q.
HOW DID MS. CRANE ARRIVE AT HER RECOMMENDED RETURN ON
EQUITY OF 10.13 PERCENT?
- 18 -
WITNESS OLSON
1
A.
Her analysis appears to be cursory. She took my six companies and
2
updated the dividend yield, using the six-month period from December 12, 2001
3
through June 11, 2002. She derived a dividend yield of 5.08 percent for the
4
comparable group and 5.02 percent including Washington Gas.
5
rounded these results down to 5.0 percent. She says she checked this yield
6
against the one reported in the June C.A. Turner Report; that yield is reported
7
as being 3.9 percent. She then concluded that her dividend yield appears to be
8
generous to Washington Gas.
9
She then
In my view, her comparison step was unnecessary and her conclusion
10
unwarranted.
To my knowledge, rate of return experts do not check their
11
dividend yields using benchmark groups. The reason is straightforward; if you
12
change the group, the growth rate and the dividend yield both change. I am not
13
surprised that the group yield was lower for the broader based C.A. Turner
14
companies; some of those companies have experienced and forecasted growth
15
rates in excess of 10 percent.
16
Ms. Crane’s next step was to determine an expected growth rate. She
17
began, at page 14, by being critical of the forecasted consensus growth rate
18
that I utilized. Her testimony states that I should have used other growth rates
19
such as historical growth rates in earnings, dividends and book value. I can
20
only respond by stating that she does not understand my testimony and the
21
derivation of the growth rates that I utilized.
22
I use analysts’ forecasts because the finance literature is clear that such
23
forecasts better explain stock prices than historical results. The Gordon article I
24
referred to in my rebuttal of Mr. Hill is an example of that type of analysis. A
25
part of the process that analysts use in developing their growth estimates is to
- 19 -
WITNESS OLSON
1
review, analyze and take into account the historical growth rates in earnings,
2
dividends and book value per share. Therefore, it is apparent that the historical
3
growth rates are already reflected in the analyst growth rates I used and do not
4
have to be taken into account again.
5
counting.
Indeed, to do so would be double
6
Interestingly, while Ms. Crane says that I should have used the historical
7
growth rates, she did not. If she had, her DCF result would have been well
8
under 10 percent.
9
Q.
AT PAGES 16-17 MS. CRANE IS CRITICAL OF YOU BECAUSE OF THE
10
MARKET-TO-BOOK ADJUSTMENT THAT YOU MADE.
11
RESPONSE?
12
A.
WHAT IS YOUR
At page 16 she says that a rationale (sic) investor should not expect to
13
pay more than book value for a utility’s stock if it is regulated on a rate
14
base/rate of return methodology. She offers several real world reasons as to
15
why this could happen but her explanations are not very convincing. First, she
16
says that commissions could be setting rates of return that exceed the cost of
17
capital for the utilities they regulate. Could be? If what she says is true, it
18
appears to be happening in about every state. I doubt that a good case could
19
be made that all regulatory agencies are allowing returns in excess of the cost
20
of capital.
21
Second, she states that investors could have expectations of future returns that
22
exceed their required returns. If this is true, it is properly built into a DCF
23
analysis. What is happening is that investors expect prices to remain above
24
book value; in turn that means they expect a market-to-book adjustment of the
25
type I recommend to be made as an implicit part of the rate of return
She certainly does not offer any evidence to prove her point.
- 20 -
WITNESS OLSON
1
determination process. Third, she mentions diversification. While that can be a
2
factor in some cases, it is clearly not true for my comparables that have
3
relatively little diversification. All of them have limited diversification and could
4
not have market-to-book ratios in excess of 1.75 times that are driven by a few
5
non-gas distribution investments.
6
Q.
RESULT. IS THAT TRUE?
7
8
AT PAGE 17 MS. CRANE SAYS THAT YOU HAVE REJECTED YOUR DCF
A.
Of course not. I have been using the DCF approach longer than any
9
active rate of return witness. There is a long history of adjustments to market
10
base cost of capital methods when circumstances call for it. Ms. Crane is
11
simply coming on strong with an unsupported assertion.
12
Q.
REJECT YOUR RISK PREMIUM APPROACH. IS SHE CORRECT?
13
14
AT PAGES 17-18 MS. CRANE MAKES THE CLAIM THAT YOU ALSO
A.
No. She says that when I found my initial result of 14 percent I should
15
have questioned my assumptions rather than simply lowering my result to 12.5
16
to 13.0 percent. She is incorrect. What I did was question the assumption that
17
Washington Gas was as risky as the S & P 500. My judgment was that it was
18
less risky and I, therefore, lowered my estimate accordingly.
19
Q.
MS. CRANE ALSO SAYS THAT YOUR RISK PREMIUM STUDY COVERED
20
TOO LONG A PERIOD BECAUSE IT WENT BACK TO THE MID-1920’S.
21
DOES SHE SUPPORT HER VIEW?
22
A.
No, her analysis is very cursory. All she can say is that communications
23
have changed since then and investors have become better informed. She
24
offers no support for this position. Indeed, it would be just as logical to say that
25
- 21 -
WITNESS OLSON
1
better communications result in a greater ability to sell investors a bill of goods.
2
Witness the Enron and WorldCom debacles.
3
Q.
MS. CRANE PRESENTS REBUTTAL TESTIMONY RELATIVE TO THE
4
INCENTIVE RATE PLAN PRESENTED BY WGL. DO YOU AGREE WITH
5
HER CRITICISM OF THE PLAN?
6
A.
No. It is quite clear from her testimony, at pages 19-25, that she is
7
strongly against the incentive plan. But rather than do a point by point rebuttal
8
of her testimony, I will simply make several observations based on my 40 or so
9
years of knowledge relative to such plans. First, these plans generally lengthen
10
the time between rate cases. This is a highly desirable outcome because no
11
one benefits from rate cases other than contractors who work on them. While it
12
is true that in theory the incentive should not be necessary, in practice it is.
13
Second, incentives are the order of the day in modern ratemaking. Simple cost
14
based regulation is just not as good an alternative. Third, it is clear that there is
15
little to no risk reduction with the Company’s proposed plan. The rewards and
16
penalties are symmetric. Finally, there is no need to protect the interruptible
17
customers.
18
alternatives.
They already receive discounts and have market based
19
If the Commission has misgivings about the plan, it should set a five year
20
duration for the plan with a mandatory rate case at the end of that period. Quite
21
obviously, four, six or seven years would work just as well.
22
Q.
23
A.
DOES THIS COMPLETE YOUR REBUTTAL OF MS. CRANE?
Yes. I would now like to turn to my rebuttal of Staff Witness Elert.
24
25
- 22 -
WITNESS OLSON
1
2
V.
Q.
REBUTTAL TO STAFF WITNESS ELERT’S TESTIMONY
TURN NOW TO THE TESTIMONY AND EXHIBITS OF STAFF WITNESS
3
GUNTER J. ELERT.
4
RECOMMEND AND HOW DID HE ARRIVE AT THAT RECOMMENDATION?
5
A.
WHAT RETURN ON COMMON EQUITY DOES HE
As indicated at page 2, lines 9-10 of his testimony, he recommends a
6
return on common equity of 10.10 percent. He arrived at his recommended
7
return by doing two DCF analyses, a risk premium study and a CAPM analysis.
8
Q.
PLEASE BEGIN WITH MR. ELERT’S FIRST DCF STUDY WHICH HE
9
REFERS TO AS AN INTERNAL RATE OF RETURN/DISCOUNTED CASH
10
FLOW ANALYSIS. HOW DID HE DO THAT ANALYSIS AND WHAT WAS
11
THE RESULT?
12
A.
The first DCF analysis began with the market price at December 31,
13
2001 for the group of gas distribution companies that he used in his analysis.
14
Mr. Elert used this data point and the forecasted annual dividends for each of
15
the years 2002 through 2006. He then assumed that the stock would be sold at
16
December 31, 2006 at the price Value Line is projecting as of 2004 – 06. The
17
annual return that would be earned under those assumptions, taking into
18
account the time value of money is the DCF estimate of the cost of common
19
equity and averages 10.19 percent for the 7 company group.
20
Q.
VALID WAY TO ESTIMATE THE COST OF COMMON EQUITY CAPITAL?
21
22
IS THE INTERNAL RATE OF RETURN APPROACH USED BY MR. ELERT A
A.
The concept is valid but Mr. Elert made an error in applying it. Value
23
Line’s analysts provide estimates of the total return that investors can expect to
24
make over a 4 to 5 year investment horizon. The data they rely on are the
25
same data Mr. Elert relied on; they consider the current stock price, expected
- 23 -
WITNESS OLSON
1
dividends and a projected sales price. If investors believe that Value Line is
2
accurate as an investment advisory service and rely on the forecasts they make
3
this approach is valid.
4
The problem is that Mr. Elert made an error by using a five-year
5
discounting period instead of a four-year period. Value Line’s price estimate is
6
correctly centered on 2005, the middle of the terminal period rather than the
7
end. This can be verified by using the total return estimates made by Value
8
Line which are as follows:
Annual Total
9
Company
Return Estimate
Midpoint
Witness Elert
12
AGL Resources
9 – 17%
13 %
9.18%
13
ATMOS Energy
15 - 23
19
15.40
14
Laclede Group
8 - 12
10
8.09
15
NICOR
13 – 19
16
12.25
16
Peoples Energy
10 – 17
13.5
11.10
17
Piedmont Natural
9 – 15
12
9.03
18
WGL Holdings
7 – 10
8.5
6.29
19
AVERAGE
13.14%
10.19%
10
11
20
In the case of both NICOR and WGL, Witness Elert's estimates based
21
on a 2006 terminal value are below the lowest Value Line estimates. Clearly
22
his 2006 terminal value is incorrect. Quite clearly the 13.14 percent estimate of
23
the cost of equity is above that made by Mr. Elert but it is the correct number.
24
Q.
PLEASE EXPLAIN MR. ELERT’S SECOND DCF STUDY.
25
- 24 -
WITNESS OLSON
1
A.
Certainly.
Mr. Elert also relied on Value Line for the inputs for his
2
second DCF study. As explained at pages 6 and 7 of his testimony and shown
3
at his Exhibits GJE – 3 and 4, he used forecasted growth rates in revenues,
4
cash flow, dividends and earnings for the period 2002-06. In combination with
5
his dividend forecast for 2002, the resulting return requirement is 9.92 percent.
6
I find several problems with this approach.
7
First, earnings growth rates are believed to be better drivers of stock
8
prices than other variables. Yet he rejected a growth rate based on earnings
9
alone because it would result in too high a value.
This means that his
10
recommended return was predetermined to be a number that was below the
11
11.25 percent his earnings growth numbers produced. This is odd, given that
12
many commissions find returns at this level to be just and reasonable. Second,
13
it is simply not accepted practice to use revenue and cash flow as growth rate
14
estimators when doing public utility rate of return.
15
weaker as proxies than earnings, dividends and book values.
They are simply much
16
Third, and most important, Mr. Elert made a mistake in the derivation of
17
his numbers. When using the forecasted data he used a 2004-06 estimate for
18
2006 rather than 2005, the midpoint of his measurement period. Schedule No.
19
1 of Exhibit WG (2B-1) presents the corrected data. The average growth rate is
20
6.29 percent, not the 4.67 percent estimated by Mr. Elert. When this is added
21
to his average dividend yield of 5.02 percent the resulting cost of equity is 11.31
22
percent.
23
24
Q.
MR. ELERT AVERAGED HIS TWO DCF ESTIMATES TO DERIVE HIS
RECOMMENDED RETURN ON COMMON EQUITY OF 10.10 PERCENT.
25
- 25 -
WITNESS OLSON
1
WHAT IS THE RESULT WHEN THE CORRECTED ESTIMATES ARE
2
AVERAGED?
3
A.
Averaging the 13.14 percent internal rate of return/DCF study with the
4
average growth rate DCF result of 11.31 percent results in a common equity
5
return of approximately 12.25 percent.
6
Q.
RESULT OF 10.55 PERCENT.
7
8
PLEASE EXPLAIN HOW MR. ELERT DERIVED HIS RISK-PREMIUM
A.
This information is presented at pages 7-11 and the result is shown at
9
Exhibit GJE – 5. Essentially, Mr. Elert uses a risk-premium of 4 percent; this is
10
based on a series of articles and books that are referenced in Footnote 7 at
11
pages 9 and 10. His “belief value” is 3 percent with a range of 1 to 5 percent;
12
he adds one percent to compensate for any 9/11 effects of the cost of capital.
13
He adds this 4 percent risk-premium to the forecasted cost rate for AAA
14
corporate debt to derive a cost of equity of 10.55 percent.
15
Q.
UTILIZED BY MR. ELERT?
16
17
WHAT IS WRONG WITH THE RISK-PREMIUM OF 4 PERCENT THAT IS
A.
There is a fundamental problem with his estimate. The problem is that
18
he is telling us what he believes and not estimating the risk-premium that the
19
typical investor has in mind. Mr. Elert may well be right about the risk-premium
20
but if it isn’t what investors believe is irrelevant. What the Commission needs to
21
know is the market consensus, not the personal opinions of the witnesses in
22
this case. Investors are firm in their collective belief that the historical risk-
23
premium of 7.5 or so percent is the correct number. This is why they believe
24
that they will earn 15 or more percent on most stocks and only slightly less on
25
utilities.
The Ibbotson data that I base this conclusion on have been the
- 26 -
WITNESS OLSON
1
benchmark for the risk-premium number for 25 years and they are embedded in
2
investor behavior. It is investor belief that drives the cost of capital, not what
3
Mr. Elert believes.
4
Q.
DERIVE AND WHY DO YOU DISAGREE WITH IT?
5
6
TURN NOW TO MR. ELERT’S CAPM ANALYSIS. WHAT RESULT DOES HE
Mr. Elert’s CAPM analysis is discussed at pages 11 – 14 and is
A.
7
presented at Exhibit GJE- 6. The return it produces is 8.30 percent. Mr. Elert
8
does not rely on this methodology so I will keep my reply comments limited to
9
two points. First, Mr. Hill does a very good job of explaining why the CAPM is a
10
poor estimator of the cost of common equity in his Appendix D. Second, Mr.
11
Elert’s choice not to use his 8.30 percent risk-premium result should not be
12
taken to mean that his recommended return of 10.10 percent for Washington
13
Gas is in any way “generous.”
14
indefensible, both conceptually and numerically.
15
Q.
16
A.
18
DOES THIS CONCLUDE YOUR REBUTTAL OF MR. ELERT?
Yes, it does.
VI.
17
Q.
All it means is that the CAPM result is
REBUTTAL TO STAFF WITNESS ALLEN’S TESTIMONY
PLEASE REFER TO THE DIRECT TESTIMONY OF STAFF WITNESS
19
RANDY M. ALLEN AT PAGE 9, LINES 10-14.
20
TESTIMONY MR. ALLEN NOTES THAT MR. KLINE EXPLAINS THAT
21
REVENUES SHOULD BE NORMALIZED BUT THAT HE FAILS TO MENTION
22
THE WEATHER INSURANCE POLICY THAT THE COMPANY PURCHASED
23
IN OCTOBER 2000. HE FURTHER NOTES THAT THIS POLICY COVERS
24
ONE-HALF OF THE UTILITY SALES NET REVENUE EXPOSURE TO
25
HEATING DEGREE DAYS. IS THIS CORRECT?
- 27 -
AT THAT POINT IN HIS
WITNESS OLSON
1
A.
2
Q.
Yes. That is my understanding of what Mr. Allen says.
IN RESPONSE TO WGL STAFF DATA REQUEST NO. 1, QUESTION NO. 15,
3
MR. ALLEN INDICATES THAT THE EXISTENCE OF SUCH AN INSURANCE
4
POLICY REDUCES THE RISK TO SHAREHOLDERS AND IS IMPORTANT
5
INFORMATION FOR THE COMMISSION TO KNOW.
6
NOTE THAT THIS INFORMATION WILL PROVIDE A COMPLETE AND
7
ACCURATE PICTURE OF THE COMPANY’S FINANCIAL CONDITION
8
WHICH WAS ONLY PARTIALLY PRESENTED IN THE RATE FILING
9
APPLICATION.
10
STATEMENT?
11
A.
WHAT
IS
YOUR
RESPONSE
HE GOES ON TO
TO
MR.
ALLEN’S
First, there is no support provided by Mr. Allen for the claim that the
12
Company’s financial position is only partially presented. Second, it is true that
13
the insurance policy does reduce risk to the shareholders, but only weather
14
related risk.
15
existence of this policy should not be taken to mean that Washington Gas is a
16
low risk distribution company. Third, this policy has a term of five years and it
17
will expire in October 2005. There is no guarantee that it can be renewed at
18
that date, or if it can, what the premium will be. In a DCF context this means
19
that investors will not see this policy as having a significant impact on the
20
volatility of the cash flow they will experience.
There are many other risks that are not covered.
Thus, the
21
Finally, I believe that it is essential to recognize that the shareholders are
22
the ones who have paid for a risk reduction related to weather based sales
23
volatility and not the ratepayers. It follows that the rate of return should not be
24
reduced because of any risk reduction related to this policy.
25
suggestion to the contrary should be ignored.
- 28 -
Mr. Allen’s
WITNESS OLSON
1
2
VII.
Q.
REBUTTAL TO AOBA WITNESS OLIVER’S TESTIMONY
AT THIS POINT I WOULD LIKE YOU TO ADDRESS THE TESTIMONY OF
3
MR. BRUCE R. OLIVER FOR AOBA.
4
DOES HE RECOMMEND AND WHAT RETURN ON EQUITY DOES HE
5
INDICATE IS APPROPRIATE?
6
A.
Q.
WHAT IS THE BASIS FOR MR. OLIVER’S RECOMMENDED COMMON
EQUITY RATIO OF 45 PERCENT?
9
10
Mr. Oliver recommends a 45 percent common equity ratio and a 10.75
percent return on common equity.
7
8
WHAT COMMON EQUITY RATIO
A.
I don’t know because it is not articulated in the testimony. There are no
11
exhibits or text tables that make reference to any analysis that he used to
12
derive this conclusion.
13
Q.
IS THERE SUPPORT IN HIS TESTIMONY FOR THE RECOMMENDED
RETURN ON COMMON EQUITY OF 10.75 PERCENT?
14
15
A.
16
Q.
No.
WHAT IS MR. OLIVER'S POSITION WITH RESPECT TO THE PROPOSED
INCENTIVE PLAN?
17
18
A.
19
Q.
20
A.
21
Q.
22
A.
At page 24 of his testimony he says that it should not be approved.
DO YOU AGREE WITH HIS POSITION ON THIS ISSUE?
No, I don’t. My rebuttal of Ms. Crane is also applicable to Mr. Oliver.
DOES THIS CONCLUDE YOUR REBUTTAL TESTIMONY?
Yes, it does.
23
24
25
- 29 -