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Suez Water Rhode Island, Inc. V/Akefield, Rhode Island

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Suez Water Rhode Island, Inc. V/Akefield, Rhode Island Exhibit Docket No._ SUEZ WATER RHODE ISLAND, INC. V/AKEFIELD, RHODE ISLAND RATE OF RETURN DIRECT TESTIMONY OF HAROLD V/ALKER, III DECEMBER 2017 Prepared by: GANNETT FLEMING VALUATION AND RATE CONSULTANTS, LLC -s*lz- E] Valley Forge, Pennsylvania TABLE OF CONTENTS INTRODUCTION 1 SUMMARY OF RECOMMENDATION ....... I PRINCIPLES OF RATE REGULATION AND FAIR RATE OF RETURN ... J INVESTMENT RISK.... 4 DESCRIPTION OF SUEZ WATER RHODE ISLAND, INC. 5 THE INDUSTRY.. 6 COMPARABLE GROUP 9 CAPITAL STRUCTURE ....... t2 EMBEDDED COST RATE t6 FINANCIAL ANALYSIS T7 RISK ANALYSIS.. 20 CAPITAL COST RATES COMMON EQUITY COST RATE ESTIMATE ....... 33 DISCOUNTED CASH FLOW .34 CAPITAL ASSET PRICING MODEL... .44 RISK PREMIUM .48 SUMMARY OF COMMON EQUITY COST RATE..... .53 OVERALL RATE OF RETURN RECOMMENDATION .55 APPENDIX A. ............1 TERMS, ABBREVIATIONS AND ACRONYMS Terms, Abbreviations and Acronyms Deftred CAPM Capital Asset Pricing Model Conmrission Rhode Island Public Utility Conrnission Corpany Suez Water Rhode Island, Inc. Conparable Conpanies Water Group Followed by Anaþts Corrparable Group Water Followed byAnaþts Cost ofCapital Investor-required cost rate DCF Discounted Cash Flow DPS Dividend per share EPA U. S. Environmental Protection Agency' s EPS Eamings per share Financial Risk L,everage GICS Global Industry Classification System GO General Obligation Bonds IOU lnvestor Owned Utilitres [æverage Fixed cost capital Long- term U. S. Treasury Secr¡rities Base Risk-Free Rate M/B Market-to-Book Ratios Moody's Moody's Investors Service National Association of Regulatory Utility NARUC Con¡rnissioners Non-Systematic Risk Conpany-Specific Risk PUC Rhode Island Public Utitty Conrnission ROE Return on Equity RP Risk Premilnn S&P Standard & Poor's SIC Standard Industrial Classification SWR SUEZ Water Resornces Inc. SWRI Suez'Water Rhode Island, lnc. Systematic Risk Non-Diversifiable Risk Value Line Value Line Investment Swvey 'Water Water Group Group Followed byAnaþts 11 1 INTRODUCTION 2 a. PLEASE STATE YOUR NAME AND BUSINESS ADDRESS. A. My name is Harold'Walker, III. My business mailing address is P. O. Box 80794, Valley 4 Forge, Pennsylvania 19484. 5 a. BY WHOM ARE YOU EMPLOYED AND IN WHAT CAPACITY? 6 A. I am employed by Gannett Fleming Valuation and Rate Consultants, LLC as Manager, 7 Financial Studies. 8 a. WHAT IS YOUR EDUCATIONAL BACKGROUND AND EMPLOYMENT 9 EXPERIENCE? 10 A. My educational background, business experience and qualifications are provided in 11 Appendix A. t2 SCOPE OF TIMONY 13 a. WHAT IS THE PURPOSE OF YOUR TESTIMONY? t4 A. The purpose of my testimony is to recommend an appropriate overall rate of return that 15 Suez Water Rhode Island, Inc. ("SWRI" or the "Company") should be afforded an T6 opportunity to eam on its water utility service rate base. My testimony is supported by T7 Exhibit HW-1, which is composed of 19 Schedules. l8 SUMMARY OF RECOMMENDATION t9 a. WHAT IS YOUR RECOMMENDED COST OF EQUITY? 20 A. My recommendation is that the SWRI be permitted an overall rate of retum of 7.82o/o, 2t including al0.5o/o cost of common equity, based upon the Company's capital structure at 22 December 31,2017. My recommended cost of common equity reflects SWRI's unique 23 risk characteristics. I 1Q. HOW DID YOU DETERMINE YOUR RECOMMENDED COMMON EQUITY 2 COST RATE? 34. I used several models to help me in formulating my recommended coÍlmon equity cost 4 rate including Discounted Cash Flow ("DCF"), Capital Asset Pricing Model ("CAPM") 5 and Risk Premium ("RP"). 6Q. IS IT IMPORTANT TO USE MORE THAN ONE MARKET MODEL? lA. Yes. It is necessary to estimate common equity cost rates using a number of different 8 models. At any given time, a particular model may understate or overstate the cost of 9 equity. While any single investor may rely solely upon one model, different investors rely l0 on different models and many investors use multiple models. Therefore, because the price 11 of common stock reflects a number of valuation models, it is appropriate to estimate the t2 market-required common equity cost rate by applying a broad raîge of analytical models' 13 a. PLEASE SUMMARIZE YOUR COMMON EQUITY COST RATE t4 RECOMMENDATION. 15 A. There is no market data concerning the SWRI's shares of common stock because SWRI 16 shares of common stock are not publicly traded. Accordingly, due to the lack of market l7 data conceming the SV/RI's equity, I used a comparable group of publicly traded 18 companies to estimate the common equity cost rate. Based upon the results of my entire t9 analysis, I conclude the SWRI's current coÍrmon equity cost rate is at least 10.5%. The 20 current range of common equity cost for the SWRI is 10.35% (DCF), 10.05% (CAPM), 2l and 10.95% (RP). Value Line Investment Survey ("Value Line") is relied upon by many 22 investors and is the only investment advisory service of which I am aware that projects 23 earned return on equity. As a check on the reasonableness of my common equity cost rate 2 1 reconìmendation, I reviewed Value Line's projected returns on conìmon equity for 2 comparable utilities. Value Line's projected earned returns on common equity for my J comparable utilities range from 10.5% to l4.0Yo. The range of the projected returns 4 suggests that my recommendation that SWRI be permitted an opportunity to earn 10.5% is 5 reasonable, if not conservative. 6 PRINCIPLES OF ATF], REGULATION AND FAIR TE OF'RETIIRN l a WHAT ARE THE PRINCIPLES GUIDING FAIR RATES OF RETURN IN THE 8 CONTEXT OF RATE REGULATION? 9 A. In a capitalistic or free market system, competition determines the price for all goods and 10 services. Utilities are permitted to operate as monopolies or near monopolies as a tradeoff 11 for a ceiling on the price of service because: (1) the services provided by utilities are I2 considered necessities by society; and (2) capital-intensive and long-lived facilities are 13 necessary to provide utility service. Generally, utilities are required to serve all customers T4 in their service territory at reasonable rates determined by regulators. As a result, 15 regulators act as a substitute for a competitive-free market system when they authorize I6 prices for utility service. t7 Although utilities operate in varying degrees as regulated monopolies, they must compete 18 with governmental bodies, non-regulated industries, and other utilities for labor, materials, t9 and capital. Capital is provided by investors who seek the highest return commensurate 20 with the perceived level of risk; the greater the perceived risk, the higher the required return 2l rate. In order for utilities to attract the capital required to provide service, a fair rate of 22 return should equal an investor-required, market-determined rate of return. Ja 1Q. WHAT CONSTITUTES A FAIR RATE OF RETURN? 24. Two noted Supreme Court cases define the benchmarks of a fair rate of return. In J Bluefi.eldt, afair rate of return is defined as: (1) equal to the retum on investments in other 4 business undertakings with the same level of risks (the comparable earnings standard); 5 (2) sufficient to assure confidence in the financial soundness of a utility (the financial 6 integrity standard); (3) adequate to permit a public utility to maintain and support its credit, 7 enabling the utility to raise or attract additional capital necessary to provide reliable service 8 (the capital attraction standard). The second case, Hope2, determined a fair rate of return 9 to be based upon guidelines found in Bluefield as well as stating that: (l ) allowed rovenues 10 must cover capital costs including service on debt and dividends on stock; and (2) the 1l Commission was not bound to use any single formula or combination of formulae in l2 determining rates. Utilities are not entitled to a guaranteed retum. However, the 13 regulatory-determined price for service must allow the utility a fair opportunity to recover 14 all costs associated with providing the service, including afair rate of return. 15 INVESTMENT RISK t6 a. PREVIOUSLY, YOU REFERRED TO RISK. PLEASE DEFINE TIIE TERM T7 RISK. 18 A. Risk is the uncertainty associated with a particular action; the greater the uncertainty of a I9 particular outcome, the greater the risk. Investors who invest in risky assets expose 20 themselves to investment risk particular to that investment. Investment risk is the sum of 2l business risk and financial risk. Business risk is the risk inherent in the operations of a lBluefield Water Works & Improvement Company v. P.S.C. of West Virsinia,262IJ.S.679 (1923) 2Federal Power Commission v. Hope Natural Gas Company, 320 U.S. 591 (1944). 4 1 business. Assuming thataCompanyis financed with 100% common equity, business risk 2 includes all operating factors that affect the probability of receiving expected future income J such as: sales volatility, managemont actions, availability of product substitutes, 4 technological obsolescence, regulation, raw materials,labor, size and growth of the market 5 served, diversity of the customer base, economic activity of the area served, and other 6 similar factors. 7 A. WHAT IS FINANCIAL RISK? 8 A. Financial risk reflects the manner in which an enterprise is financed. Financial risk arises 9 from the use offixed cost capital (leverage) such as debt and/or preferred stock, because 10 of the contractual obligations associated with the use of such capital. Because the fixed 11 contractual obligations must be serviced before earnings are available for common t2 stockholders, the introduction of leverage increases the potential volatility of the eamings 13 available for common shareholders and therefore increases common shareholder risks. T4 Although financial risk and business risk are separate and distinct, they are interrelated.
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