Download q. please state your name, profession, and occupation.

Before the
Public Service Commission of Maryland
Case No. 8725
Prepared Rejoinder Testimony
of
Dennis R. Bolster
on Behalf of
Baltimore Gas and Electric Company
and
Potomac Electric Power Company
November 14, 1996
REJOINDER TESTIMONY OF DENNIS R. BOLSTER
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Q.
PLEASE STATE YOUR NAME, PROFESSION, AND OCCUPATION.
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A.
My name is Dennis R. Bolster. My address is 1015 Fifteenth Street, Northwest,
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Washington, D.C. 20005. I am an economist and a senior consultant with Foster
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Associates, Inc.
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qualifications is attached to my rebuttal testimony.
A statement of my occupational and educational history and
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Q.
PLEASE DESCRIBE THE PURPOSE OF YOUR REJOINDER TESTIMONY.
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A.
Baltimore Gas and Electric Company (BGE) and Potomac Electric Power Company
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(Pepco) have asked that I comment briefly on the surrebuttal testimony of the other
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cost of capital witnesses in this proceeding.
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Q.
TAKE STRONG EXCEPTION TO YOUR
PROPOSED ADJUSTMENT TO THE DCF. PLEASE COMMENT.
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THE OTHER WITNESSES
A.
As stated in my rebuttal testimony, it is my position that currently the arithmetic sum
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of growth plus dividend yield -- which produces a value of about 10% to 10.5% for
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any sample of electric utilities -- is an unreasonable, if not confiscatory, measure of a
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fair rate of return on common equity. The reason is that the electrics’ market-to-
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book ratios have risen to levels where strict application of the DCF formula does not
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produce reasonable results. This defect with the DCF is well known; for example,
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Roger Morin discusses it in PUR’s manual on regulatory finance:
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Application of the DCF model produces estimates of common equity
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cost that are consistent with investors’ expected return only when
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stock price and book value are reasonably similar, that is, then the
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M/B is close to unity. As shown below (table omitted), application of
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the standard DCF model to utility stocks understates the investors’
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expected return when the market to book ratio of a given stock
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exceeds unity. This is particularly relevant in the capital market
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environment of the 1990’s where utility stocks are trading at M/B
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ratios well above unity.
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Utilities’ Cost of Capital, Morin, Roger A., Public Utilities Reports,
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1994, p. 236.)
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In recognition of this deficiency, I proposed that the dividend yield be
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adjusted, by 30%. Only in this way can application of the DCF formula result in a
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reasonable rate of return. I continue, therefore, to urge the Commission either to
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incorporate an adjustment like I propose in its cost of capital findings, or to rely on a
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method other than the DCF. 1
[Emphasis added] (Regulatory Finance:
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I contend that the 175% to 184% average market to book ratio for my
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reference group of high-grade, low risk electrics has been higher in recent years due
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to the bull market for industrial stocks; my hypothesis is that the electrics’ stock
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prices are about 30% higher than they would be under “normal” stock market
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conditions.
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In an attempt to illustrate how the unprecedented stock market conditions
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have affected the price of electrics’ stock, I compared, over the period 1978 to 1995,
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Witness Bolster
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AA/A rated electrics’ average market-to-book ratio to three independent variables: a)
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the AA/A electrics’ average rate of return on average common equity capital; b) the
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average yield on 30 year Treasury bonds; and c) the average market to book ratio of
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the S & P 400 industrials. I find that the level of the electrics’ market-to-book is
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highly correlated to the level of these three variables. As is shown on page 1 of
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BGE/PEPCO Exhibit___(DRB-2), when I solve the resulting equation for the
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market-to book that the electrics would have were the S & P 400 market-to-book
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ratio alternatively 370% (the 1992-1995 average), and 182% (the 1978-1991
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average), assuming the other two variables were kept constant: an expected rate of
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earnings of 12.5%, and an expected yield on 30 year Treasury bonds of 7.25%, I find
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that the change in the S & P 400 industrials’ market-to-book ratio from 370% to
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182% would have the effect of reducing the electrics’ market-to-book ratio by 26%.
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This study generally confirms my proposed adjustment which hypothesizes that
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absent the prolonged heated bull market, the electrics’ market-prices would be about
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30% lower.
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Q.
AT PAGES 10 AND 11, MR. HILL QUESTIONS THE AUTHORIZED RATE OF
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RETURN DATA YOU REFERENCED IN YOUR DIRECT TESTIMONY.
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PLEASE COMMENT.
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A.
On page 2 of BGE/PEPCO Exhibit___(DRB-2), I summarize the rates of return
authorized for electric utilities, by quarter, over the period 1992-1996, as reported by
1
In my rebuttal, I compared the situation of the DCF today to that of the E/P method in the
1960’s. Mr. Hill takes exception to my allegation that the E/P is a special case of the DCF. I
find his position ironic for when “r” (the expected rate of earnings) and “k” (the market
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Regulatory Research Associates, Inc., which reflects 144 distinct decisions,
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including every major electric case,. and a representative cross section of the
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industry. 2
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As shown on the table, over the period 1992-1996 (which tends to mirror
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current and projected economic and capital market conditions), the average
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authorized rate of return to electric utilities was 11.6%. It was also 11.6% in 1995,
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and somewhat lower (11.3%) in the first half of 1996 (when interest rates were about
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60 basis points lower than I currently project for the future).
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The table also sets forth the indicated quarterly authorized ROE risk
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premium. As shown, the average risk premium over the 1992-1996 period is 4.6%,
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similar to that which I proposed using the CAPM method. Moreover, when a simple
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regression is performed comparing interest rates to the authorized risk premium, the
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slope is generally the same as was indicated in my risk premium regression study, a
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negative .50. Were the authorized risk premium regression solved for a projected
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7.25% long-term rate, a risk premium of 4.47% and a cost of equity of 11.7% are
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indicated.
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Q.
MR. HILL ALLEGES THAT YOUR TESTIMONY USES “CONFUSING TERMINOLOGY” WHICH HE CLAIMS IS AN INTEGRAL PART OF THE COM-
capitalization rate) are the same (as he is proposing), the DCF reduces to the E/P. The methods
are different only when “r” and “k” are not equal.
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RRA defines a rate case as major if the requested rate increase is at least $5 million, or
the rate change granted is at least $3 million. In 1994, the 31 reported decisions included a
representative cross section of the industry operating in 21 states, including for example among
others, the following AA rated companies: Tampa Electric, Oklahoma G & E, Iowa-Illinois G &
E, Wisconsin P & L, Madison G & E, and Wisconsin Public Service.
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Witness Bolster
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PANY’S MARKET-TO-BOOK/FAULTY DCF POSITION IN THIS PROCEED-
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ING. (HILL, P. 11). PLEASE COMMENT.
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A.
The allegedly confusing terminology is my use of “expected rate of earnings” to
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depict the rate of earnings used by the analysts to estimate investor’s growth
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expectations, and “projected rate of earnings” to depict the much lower rate of
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earnings produced by the DCF calculation which the witnesses would apply to book
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value. Mr. Hill prefers to call this latter value, the “required return” He goes on to
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say that “In today’s market, market price exceeds book value per share and the return
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investors require in the market is lower than the return on book value (the expected
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return.) (Hill, p 12).
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contradiction of using one value (the higher expected return on book) to compute
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another value (the lower required return on market) which is used to replace the first
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value.
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That, of course, is precisely the problem: the inherent
Dr. Morin also discusses this inherent problem with the DCF in the PUR
manual:
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To estimate what ROE resides in the minds of investors is equivalent
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to estimating the market’s assessment of the outcome of the
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regulatory hearings. Expected ROE is exactly what regulatory com-
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missions set in determining an allowed rate of return. If the ROE
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input required by the model differs from the recommended return on
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equity, a fundamental contradiction in logic follows. In other words
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the method requires an estimate of return on equity before it can even
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be implemented. Common sense would dictate the inconsistency of a
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return on equity recommendation that is different than the expected
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ROE that the method assumes the utility will earn forever.
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assuming in effect that the company will earn at a return rate
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exceeding the recommended cost of equity forever, but then one is
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recommending that a different rate be granted by the regulator.
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[Emphasis added] (Ibid., p. 236)
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The confusion Mr. Hill complains about is not due to my terminology, but
follows necessarily from the undeniable contradiction in the method.3
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10
Q.
THE OTHER WITNESSES DISPUTE YOUR PROJECTED 7.25% YIELD ON
LONG-TERM U.S. TREASURY BONDS. PLEASE COMMENT.
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One is
A.
In brief, the witnesses dispute my use of a projected long-term interest rate different
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from the Blue Chip consensus. As I stated in my testimony, my projection was
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based on the Blue Chip forecasts (including the projections of the “top 20%”) and
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The Bank Credit Analyst Interest Rate Forecast, a highly regarded international
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publication which Foster Associates, Inc. has relied on for interest rate forecasts in
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numerous rate cases.
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The difference between the Blue Chip consensus forecast, and the Blue Chip
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“top 20%” and BCA forecasts is explained by expected inflation. BCA is projecting
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Mr. Hill criticizes me for not understanding that the expected rate of return applies to a
book value per share whereas the required return applies to a market value per share. What I find
interesting is that Mr. Hill can make this statement while at the same time recommending that the
required return be applied to book value. If he and the other witnesses were proposing to apply
their recommended costs of equity to the market value of BGE/PEPCO’s common equity, we
would not be exchanging surrebuttal and rejoining testimony.
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a rise in inflation in 1997 to 4%, which they believe will result in a rise in the
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Federal Funds rate to above 6%, and an increase in long-term U.S. Treasury bonds to
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above 7.5%:
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We believe the Fed missed an ideal opportunity to raise rates in
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September. The market was positioned for a rate hike which might
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have helped take some heat out of the stock market, while implying
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only marginal risk to the expansion. However, the more important
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issue from our investment strategy perspective, is that our own
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economic forecast implies the need for a significant tightening in Fed
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policy during the coming months. If we are proven right, then short-
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term rates are headed much higher than is currently discounted [6%]
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and long-term yields are headed well into their undervaluation zone
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[7.5%]. (The BCA Interest Rate Forecast, October 1996 edition, p.
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16).
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This reflects my view also.
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Q.
THE OTHER WITNESSES DISMISS YOUR COMPARABLE EARNINGS
FOR EXAMPLE, MR. HILL STATES “IT IS CLEAR WHICH
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ANALYSIS.
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EQUITY COST ESTIMATION METHODOLOGY REGULATORS BELIEVE
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PERFORMED BEST -- THE DCF, NOT COMPARABLE EARNINGS (HILL,
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APPENDIX A, P. III). PLEASE COMMENT.
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A.
I cannot deny that what Mr. Hill says is correct in terms of the past twenty-five
years. But I am asking this Commission to reconsider this belief, and ask itself the
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question: Does the DCF in fact “perform best” today? I contend that it does not, and
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therefore some substitute must be found.
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With its “long and rich history in regulatory proceedings” and “origins in the
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fair return doctrine enunciated by the U.S. Supreme Court in the landmark Hope
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case,” 4 comparable earnings is one possible substitute for, or supplement to the
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DCF. “Wall Street” (at least the First Vice President of Merrill Lynch, John Olson)
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agrees. In a 1994 speech to the natural gas industry, Mr. Olson argued vigorously
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that utilities commence to file rate applications based on comparable earnings. He
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claims that Wall Street wants competitive levels of return, and if nothing is done to
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reform ROE regulation, Wall Street’s investing interest in utility stocks will slowly
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and steadily evaporate.: “It makes no sense to buy a low growth, regulated utility
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with an 11% ROE when you can buy corporate America with a 17% ROE, a better
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balance sheer, and with much better growth”. 5 Mr. Olson’s specific proposal was
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to use the five year moving average S & P 500 ROE to estimate the cost of equity to
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utilities. At the time he presented his talk, the S & P 500 five-year average ROE was
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13.5%; today, it is 17.5%.
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In the language of regulation, Mr. Olson is arguing for recognition of
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opportunity cost: capital should not, and will not be committed to any venture
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unless it can earn a return commensurate with that prospectively available in
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alternative investments of similar risk. I do not propose that the Commission look
4Op. cit., Morin, p. 393.
5”The Case for ROE Reform”, Speech of John E. Olson to the September 14, 1994 meeting of
the Pacific Coast Gas Association.
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exclusively to opportunity cost, but I do recommend that the Commission give it
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weight as measured by comparable earnings.
3
Q.
DO YOU HAVE ANY FINAL COMMENTS?
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A.
Yes. The ultimate response -- in defense of the proposed reduction in the allowed
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rate of return -- is that the regulator has no obligation to the investor. Whether the
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investor’s expected growth will be sustained, or whether the investor will be given
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an opportunity to actually earn his required return on his actual investment, or
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whether the investor’s current expectations as to the future rate of earnings on book
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common equity will be achieved are of no consequence to the regulator. Rather, in
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this world view, the DCF cost of equity represents merely a term of reference
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supplied by capital markets, totally disembodied from the investor who supplied the
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term of reference, or the expectations upon which it was derived. If the application
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of that term of reference (say, 10.5%) to the utility’s book value were to result in a
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30 to 40% reduction in those investors’ savings, or were to result in a sharp
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reduction in the expected sustained growth which the analyst projected in
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formulating that term of reference, or were to result in a sharp reduction in the
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dividend rate upon which investors formulated the price they were willing to pay,
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that is simply of no concern to the regulator. The regulator has no obligation to the
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investor.
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As I have stated on numerous other occasions, I do not subscribe to this
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“blind disregard to the investor” role of the regulator. Rather I see the regulator’s
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role to be fair to all stakeholders: to the customers; to the Company and its
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employees; but also to the shareholders who assume the risk, provide the capital and
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who are entitled to a fair shake. If over a sustained period of time when economic
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and capital market conditions were generally similar to those prevailing currently,
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investors reasonably have come to expect that electric utilities will be allowed to
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earn about 12% on common equity, and if investors see, over that same period of
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time, that on average, the electrics have been able to achieve, sometimes exceed that
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12% rate of earnings, then surely regulation must assume responsibility for these
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investors expectations, and would be doing them a grave injustice if it suddenly
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changed the rules of the game by reducing the allowed rate of earnings to 10.5%.