BEFORE THE PUBLIC SERVICE COMMISSION OF SOUTH CAROLINA REBUTTAL TESTIMONY OF ROBERT B. HEVERT ON BEHALF OF SOUTH CAROLINA ELECTRIC & GAS COMPANY DOCKET NO. 2009-489-E TABLE OF CONTENTS I. INTRODUCTION........................................................................................................1 II. PURPOSE AND OVERVIEW OF TESTIMONY....................................................1 III. ROE RECOMMENDATION SUMMARY AND OVERVIEW..............................5 IV. RESPONSE TO THE DIRECT TESTIMONY OF MR. O’DONNELL AS IT RELATES TO THE COMPANY’S COST OF EQUITY ......................................12 Proxy Group Selection Criteria and Comparison Companies ..................................15 DCF Model Growth Rate Estimates ...........................................................................21 Relevance of Pension Funding Assumptions in Establishing the Company’s Return on Equity .....................................................................................................................35 Relevance and Application of the CAPM...................................................................46 Flotation Cost Adjustment ..........................................................................................49 V. RESPONSE TO DIRECT TESTIMONY OF MR. O’DONNELL AS IT RELATES TO THE COMPANY’S CAPITAL STRUCTURE ............................50 VI. UPDATED AND REVISED COST OF EQUITY ANALYSES ............................60 VII. CONCLUSION ..........................................................................................................61 DOCKET NO. 2009-489-E ROBERT B. HEVERT PAGE i I. INTRODUCTION 1 Q. PLEASE STATE YOUR NAME, AFFILIATION AND BUSINESS ADDRESS. 2 A. My name is Robert B. Hevert. I am President of Concentric Energy Advisors, Inc. 3 (“Concentric”), located at 293 Boston Post Road West, Suite 500, Marlborough, 4 Massachusetts 01752. 5 6 Q. ON WHOSE BEHALF ARE YOU SUBMITTING THIS REBUTTAL 7 TESTIMONY? 8 A. I am submitting this testimony on behalf of South Carolina Electric & Gas Company, 9 referred to throughout my testimony as “SCE&G”, or the “Company”. 10 11 Q. ARE YOU THE SAME ROBERT B. HEVERT THAT PROVIDED DIRECT 12 TESTIMONY IN THIS PROCEEDING? 13 A. Yes, I am. I provided Direct Testimony regarding the Return on Equity (“ROE”) and 14 proposed capital structure for SCE&G.1 15 II. PURPOSE AND OVERVIEW OF TESTIMONY 16 Q. WHAT IS THE PURPOSE OF YOUR REBUTTAL TESTIMONY? 17 A. The purpose of my Rebuttal Testimony is to respond to the direct testimony of Mr. 18 Kevin W. O’Donnell on behalf of the South Carolina Energy Users Committee, as 19 that testimony relates to the Company’s cost of equity and capital structure. My 20 Rebuttal Testimony also provides an updated set of calculations regarding the 1 As in my Direct Testimony, I interchangeably use the terms “ROE” and “Cost of Equity” throughout my Rebuttal Testimony. DOCKET NO. 2009-489-E ROBERT B. HEVERT PAGE 1 OF 63 1 Company’s cost of equity in this proceeding, and includes my assessment of the ROE 2 contained in the May 3, 2010 Stipulation on Certain Matters (the “Stipulation”) 3 between the South Carolina Office of Regulatory Staff (“ORS”) and the Company, in 4 which the parties agreed to an ROE of 10.70 percent.2 5 6 Q. IS THE STIPULATED ROE OF 10.70 PERCENT REASONABLE? 7 A. Yes, it is. As discussed throughout the balance of my Rebuttal Testimony, the 8 stipulated ROE falls within the range of reasonable results. The stipulated ROE of 9 10.70 percent reduces the Company’s rate request by $36.7 million.3 10 11 Q. HAS MR. O’DONNELL’S TESTIMONY CAUSED YOU TO CHANGE YOUR 12 CONCLUSIONS REGARDING THE APPROPRIATE RETURN ON EQUITY 13 IN THIS PROCEEDING? 14 A. No, it has not. There are several important aspects of Mr. O’Donnell’s testimony 15 with which I strongly disagree, including the composition of his proxy group, his 16 application of the Constant Growth Discounted Cash Flow (“DCF”) model, his 17 summary dismissal of the Capital Asset Pricing Model (“CAPM”), and his assertion 18 that certain pension funding assumptions provide a meaningful benchmark for 19 assessing the Company’s cost of equity. The result of Mr. O’Donnell’s positions with 20 respect to those issues is an ROE recommendation that is unduly low. As opposed to 21 Mr. O’Donnell’s analyses and recommendation, the updated analyses discussed in 22 Section VI of my Rebuttal Testimony, which include a series of analyses based on 2 See, Stipulation on Certain Matters, Docket No. 2009-489-E, May 3, 2010. 3 $36.7 million represents the total revenue requirement difference between the 11.60 percent ROE recommended in my Direct Testimony and the 10.70 percent ROE agreed to in the Stipulation. DOCKET NO. 2009-489-E ROBERT B. HEVERT PAGE 2 OF 63 1 Mr. O’Donnell’s proxy group, indicate that the 10.70 percent to 11.90 percent range 2 indicated in my Direct Testimony remains valid. 3 4 Q. DO YOUR ANALYSES SUPPORT THE STIPULATED ROE OF 10.70 5 PERCENT? 6 A. Yes, they do. In that regard, it is important to note that I have performed the analyses 7 discussed throughout my Rebuttal Testimony independently of the Company’s 8 settlement discussions. As such, my analyses are unbiased by the Stipulation. As 9 noted above, my recommended range includes 10.70 percent. In contrast, Mr. 10 O’Donnell’s 9.50 percent recommendation appears to be based on a range of 8.75 11 percent to 10.50 percent, the lower end having been established by reference to his 12 DCF results for SCANA (i.e., not based on a proxy group of comparable companies), 13 and the upper end corresponding to his comparable earnings method.4 14 15 Q. PLEASE PROVIDE AN OVERVIEW OF YOUR REBUTTAL TESTIMONY. 16 A. For reasons developed more fully in the balance of my Rebuttal Testimony, my 17 general conclusions regarding the Company’s ROE are as follows: 18 • My updated ROE analyses, which include certain adjustments made in 19 response to Mr. O’Donnell’s Direct Testimony, continue to suggest a range of 20 results of 10.70 percent to 11.90 percent for the Company’s ROE. My 21 updated range of results and recommendation are supported by several 22 analyses, including updated DCF and CAPM analyses applied to three proxy 23 groups, and are further supported by an updated Risk Premium analysis. 4 Direct Testimony and Exhibits of Kevin W. O’Donnell, at 16. DOCKET NO. 2009-489-E ROBERT B. HEVERT PAGE 3 OF 63 1 • Mr. O’Donnell’s recommended ROE is unreasonably low, and is dependent 2 upon certain unreasonable assumptions. In fact, when adjusted to remove the 3 effect of those assumptions, Mr. O’Donnell’s analyses yield ROE results that 4 support the ROE in the Stipulation and are within the range of my 5 recommendation. 6 • Mr. O’Donnell’s assertion that my testimony conflicts with SCE&G’s 7 “investment consultants” is fundamentally misplaced. As discussed in Section 8 IV, Mr. O’Donnell has mistaken expected returns for required returns; 9 expected returns are not relevant to the determination of the proper required 10 cost of equity for a regulated utility. Moreover, Mr. O’Donnell’s position has 11 been rejected by regulatory commissions, is not supported in finance texts and 12 literature, and is inconsistent with the Commission’s recent decision in Order 13 No. 2010-79 (Docket No. 2009-226-E). 14 • Mr. O’Donnell’s recommended capital structure, and his assertion that the 15 Company’s proposed capital structure is “hypothetical” in nature and reflects 16 the effects of “double leverage,” are premised on key assumptions for which 17 he has provided no support, are inconsistent with the practical credit 18 implications associated with SCE&G’s capital investment program, ignore the 19 incremental effect of comparatively high levels of leverage (such as that 20 proposed by Mr. O’Donnell) on the cost of capital, and are inconsistent with 21 prior Commission orders. Consequently, I believe that Mr. O’Donnell’s 22 capital structure recommendation should be given no weight by the 23 Commission in this proceeding. DOCKET NO. 2009-489-E ROBERT B. HEVERT PAGE 4 OF 63 1 2 Q. HOW IS THE BALANCE OF YOUR REBUTTAL TESTIMONY 3 ORGANIZED? 4 A. My remaining testimony is organized as follows: Section III provides an overview of 5 my ROE Rebuttal Testimony, including a summary of my updated and revised ROE 6 calculations. Sections IV and V contain my response to Mr. O’Donnell’s testimony, 7 as it relates to the Company’s ROE and proposed capital structure, respectively. 8 Section VI provides my updated and revised ROE analyses, and Section VII provides 9 my conclusion. 10 III. ROE RECOMMENDATION SUMMARY AND OVERVIEW 11 Q. PLEASE PROVIDE AN OVERVIEW OF MR. O’DONNELL’S ROE 12 RECOMMENDATIONS IN THIS PROCEEDING. 13 A. Mr. O’Donnell has recommended an ROE of 9.50 percent based on analytical results 14 that range from 8.75 percent to 10.50 percent. As discussed throughout my Rebuttal 15 Testimony, that recommendation is unreasonably low relative to very observable and 16 relevant benchmarks. One such benchmark is the range of recently authorized ROEs 17 for vertically integrated electric utility companies. While the stipulated ROE of 10.70 18 percent is within the range of recent authorizations, Mr. O’Donnell’s 9.50 percent 19 recommendation is well below prevailing levels. In fact, in the past three years, there 20 have been no awards for vertically integrated electric utilities that were at or below 21 the return recommended by Mr. O’Donnell. DOCKET NO. 2009-489-E ROBERT B. HEVERT PAGE 5 OF 63 1 While I recognize that the Commission should not be bound by the decisions of other 2 regulatory jurisdictions, I believe this data (i.e., recent authorized ROEs for vertically 3 integrated utilities) provides a useful benchmark against which Mr. O’Donnell’s ROE 4 recommendation may be compared. 5 6 Considered from a slightly different perspective, Mr. O’Donnell’s 9.50 percent 7 recommendation represents an equity premium of approximately 481 basis points to 8 the 30-day average yield on 30-year Treasury securities.5 In contrast, the 10.70 9 percent return authorized by the South Carolina Public Service Commission (the 10 “Commission”) in Docket No.