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Before the Public Service Commission of South Carolina

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Before the Public Service Commission of South Carolina BEFORE THE PUBLIC SERVICE COMMISSION OF SOUTH CAROLINA DOCKET NO. 2009-226-E In the Matter of: ) ) Application of Duke Energy Carolinas, ) DIRECT TESTIMONY OF LLC for Authority to Adjust and Increase ) JAMES H. VANDER WEIDE FOR Its Electric Rates and Charges ) DUKE ENERGY CAROLINAS, LLC ) ) 1 I. INTRODUCTION AND PURPOSE 2 Q. PLEASE STATE YOUR NAME, TITLE, AND BUSINESS ADDRESS. 3 A. My name is James H. Vander Weide. I am Research Professor of Finance and 4 Economics at the Fuqua School of Business of Duke University. I am also 5 President of Financial Strategy Associates, a firm that provides strategic and 6 financial consulting services to business clients. My business address is 7 3606 Stoneybrook Drive, Durham, North Carolina 27705. 8 Q. PLEASE DESCRIBE YOUR EDUCATIONAL BACKGROUND AND 9 PRIOR ACADEMIC EXPERIENCE. 10 A. I graduated from Cornell University with a Bachelor’s Degree in Economics and 11 from Northwestern University with a Ph.D. in Finance. After joining the faculty 12 of the School of Business at Duke University, I was named Assistant Professor, 13 Associate Professor, and then Professor. 14 Since joining the faculty I have taught courses in corporate finance, 15 investment management, and management of financial institutions. I have taught 16 a graduate seminar on the theory of public utility pricing and lectured in executive 17 development seminars on the cost of capital, financial analysis, capital budgeting, 18 mergers and acquisitions, cash management, short-run financial planning, and 19 competitive strategy. I have served as Academic Program Director of executive 20 education programs at the Fuqua School of Business, including the Duke 21 Advanced Management Program, the Duke Executive Program in 22 Telecommunications, the Duke Competitive Strategies in Telecommunications 23 Program, and the Duke Program for Manager Development for managers from the 24 former Soviet Union. I have conducted seminars and training sessions on _______________________________________________________________________________________________ DIRECT TESTIMONY OF JAMES H. VANDER WEIDE Page 2 DUKE ENERGY CAROLINAS, LLC DOCKET NO. 2009-226-E 1 financial analysis, financial strategy, cost of capital, cash management, 2 depreciation policies, and short-run financial planning for a wide variety of U.S. 3 and international companies. 4 In addition to my teaching and executive education activities, I have 5 written research papers on such topics as portfolio management, the cost of 6 capital, capital budgeting, the effect of regulation on the performance of public 7 utilities, the economics of universal service requirements, and cash management. 8 My research papers have been published in American Economic Review, Financial 9 Management, International Journal of Industrial Organization, Journal of Finance, 10 Journal of Financial and Quantitative Analysis, Journal of Bank Research, Journal of 11 Portfolio Management, Journal of Accounting Research, Journal of Cash Management, 12 Management Science, Atlantic Economic Journal, Journal of Economics and Business, 13 and Computers and Operations Research. 14 Q. HAVE YOU PREVIOUSLY TESTIFIED ON FINANCIAL OR 15 ECONOMIC ISSUES? 16 A. Yes. As an expert on financial and economic theory, I have testified on the cost 17 of capital, competition, risk, incentive regulation, forward-looking economic cost, 18 economic pricing guidelines, depreciation, accounting, valuation, and other 19 financial and economic issues in approximately 400 cases before numerous 20 federal, state, and international regulatory and judicial bodies. My resume is 21 attached as Appendix 1. ________________________________________________________________________________________________ DIRECT TESTIMONY OF JAMES H. VANDER WEIDE Page 3 DUKE ENERGY CAROLINAS, LLC DOCKET NO. 2009-226-E 1 Q. WHAT IS THE PURPOSE OF YOUR TESTIMONY? 2 A. I have been asked by Duke Energy Carolinas, LLC (“Duke Energy Carolinas” or 3 “the Company”) to prepare an independent appraisal of Duke Energy Carolinas’ 4 cost of equity, and to recommend to the Public Service Commission of South 5 Carolina (“the Commission”) a rate of return on equity that is fair, that allows 6 Duke Energy Carolinas to attract capital on reasonable terms, and that allows 7 Duke Energy Carolinas to maintain its financial integrity. 8 II. SUMMARY OF TESTIMONY 9 Q. HOW DO YOU ESTIMATE DUKE ENERGY CAROLINAS’ COST OF 10 EQUITY? 11 A. I estimate the cost of equity for Duke Energy Carolinas in two steps. First, I 12 apply several standard cost of equity methods to market data for a large group of 13 utility companies of comparable risk. Second, I adjust the average cost of equity 14 for my comparable companies for the difference between the financial risk of 15 those companies in the marketplace and the financial risk implied by the rate- 16 making capital structure for Duke Energy Carolinas. 17 Q. WHY DO YOU APPLY YOUR COST OF EQUITY METHODS TO A 18 LARGE GROUP OF COMPARABLE RISK COMPANIES RATHER 19 THAN SOLELY TO DUKE ENERGY CAROLINAS? 20 A. I apply my cost of equity method to a large group of comparable risk companies 21 because standard cost of equity methodologies such as the discounted cash flow 22 (“DCF”), risk premium, and capital asset pricing model (“CAPM”) require inputs _______________________________________________________________________________________________ DIRECT TESTIMONY OF JAMES H. VANDER WEIDE Page 4 DUKE ENERGY CAROLINAS, LLC DOCKET NO. 2009-226-E 1 of quantities that are not easily measured.1 Since these inputs can only be 2 estimated, there is naturally some degree of uncertainty surrounding the estimate 3 of the cost of equity for each company. However, the uncertainty in the estimate 4 of the cost of equity for an individual company can be greatly reduced by 5 applying cost of equity methodologies to a large sample of comparable 6 companies. Intuitively, unusually high estimates for some individual companies 7 are offset by unusually low estimates for other individual companies. Thus, 8 financial economists invariably apply cost of equity methodologies to a group of 9 comparable companies. In utility regulation, the practice of using a group of 10 comparable companies, called the comparable company approach, is further 11 supported by the United States Supreme Court standard that the utility should be 12 allowed to earn a return on its investment that is commensurate with returns being 13 earned on other investments of the same risk.2 14 Q. WHAT COST OF EQUITY DO YOU FIND FOR YOUR COMPARABLE 15 COMPANIES IN THIS PROCEEDING? 16 A. On the basis of my studies, and as summarized in the table below, I find that the 17 cost of equity for my comparable companies is equal to 11.1 percent. This 18 conclusion is based on my application of standard cost of equity estimation 19 techniques–the DCF model, the ex ante risk premium approach, the ex post risk 20 premium approach, and the CAPM–to a broad group of companies of comparable 21 risk. As noted below, the cost of equity for these comparable companies must be 22 adjusted to reflect the higher financial risk associated with Duke Energy 1 The problem of difficult-to-measure inputs is especially acute for Duke Energy Carolinas because, as a subsidiary of Duke Energy Corporation (“Duke Energy”), its stock is not publicly traded. 2 See Bluefield Water Works and Improvement Co. v. Public Service Comm’n. 262 U.S. 679, 692 (1923) and Hope Natural Gas Co., 320 U.S. at 603. ________________________________________________________________________________________________ DIRECT TESTIMONY OF JAMES H. VANDER WEIDE Page 5 DUKE ENERGY CAROLINAS, LLC DOCKET NO. 2009-226-E 1 Carolinas’ rate-making capital structure, which produces a cost of equity equal to 2 12.3 percent for Duke Energy Carolinas. 3 TABLE 1 4 COST OF EQUITY MODEL RESULTS COST OF METHOD EQUITY Discounted Cash Flow 12.4% Ex Ante Risk Premium 11.4% Ex Post Risk Premium 10.9% Historical CAPM 9.8% DCF-based CAPM 11.1% Average 11.1% Cost of Equity Reflecting Higher Financial Risk of 12.3% Duke Energy Carolinas’ Rate-Making Capital Structure 5 Q. YOU NOTE THAT THE COST OF EQUITY OF YOUR COMPARABLE 6 COMPANIES SHOULD BE ADJUSTED FOR FINANCIAL RISK. WHY 7 IS THAT ADJUSTMENT NEEDED? 8 A. The cost of equity for my comparable companies depends on their financial risk, 9 which is measured by the market values of debt and equity in their capital 10 structures. The financial risk of my comparable companies differs from the 11 financial risk associated with Duke Energy Carolinas’ rate-making capital 12 structure. It is both logically and economically inconsistent to apply a cost of 13 equity developed for a sample of companies with a specific degree of financial 14 risk to a capital structure with a different financial risk. One must adjust the cost 15 of equity for my comparable companies upward in order for investors in Duke 16 Energy Carolinas to have an opportunity to earn a return on their investment in 17 Duke Energy Carolinas that is commensurate with returns they could earn on 18 other investments of comparable risk. ________________________________________________________________________________________________ DIRECT TESTIMONY OF JAMES H. VANDER WEIDE Page 6 DUKE ENERGY CAROLINAS, LLC DOCKET NO. 2009-226-E 1 Q. HOW DOES DUKE ENERGY CAROLINAS’ FINANCIAL RISK, AS 2 REFLECTED IN ITS RATE-MAKING CAPITAL STRUCTURE, 3 COMPARE TO THE FINANCIAL RISK OF YOUR COMPARABLE 4 COMPANIES? 5 A. Duke Energy Carolinas’ rate-making capital structure in this proceeding contains 6 47.0 percent debt and 53.0 percent equity. The average market value capital 7 structure for my comparable group of companies contains 37.54 percent debt, 8 0.72 percent preferred, and 61.74 percent equity. Thus, the financial risk of Duke 9 Energy Carolinas as reflected in its rate-making capital structure is greater than 10 the financial risk embodied in the cost of equity estimates for my comparable 11 companies. 12 Q. WHAT IS THE FAIR RATE OF RETURN ON EQUITY FOR DUKE 13 ENERGY CAROLINAS INDICATED BY YOUR COST OF EQUITY 14 ANALYSIS? 15 A.
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