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Volume 21 Pennsylvania-American Water Company 2020 General Base Rate Case R-2020-3019369 (Water) R-2020-3019371 (Wastewater)

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Volume 21 Pennsylvania-American Water Company 2020 General Base Rate Case R-2020-3019369 (Water) R-2020-3019371 (Wastewater) VOLUME 21 PENNSYLVANIA-AMERICAN WATER COMPANY 2020 GENERAL BASE RATE CASE R-2020-3019369 (WATER) R-2020-3019371 (WASTEWATER) DIRECT TESTIMONY AND EXHIBIT OF ANN E. BULKLEY STATEMENT NO. 13 EXHIBIT NO. 13-A PAWC Statement No. 13 PENNSYLVANIA-AMERICAN WATER COMPANY Direct Testimony of Ann E. Bulkley, Senior Vice President Concentric Energy Advisors, Inc. Concerning Fair Rate of Return and Capital Structure Docket Nos. R-2020-3019369 (Water) R-2020-3019371 (Wastewater) Date April 29, 2020 Direct Testimony of Ann E. Bulkley Table of Contents Page No. I. WITNESS IDENTIFICATION AND QUALIFICATIONS ...................................................... 1 II. PURPOSE AND OVERVIEW OF TESTIMONY ................................................................. 2 III. REGULATORY PRINCIPLES ............................................................................................. 7 IV. CAPITAL MARKET CONDITIONS ................................................................................... 10 A. CURRENT MARKET CONDITIONS ...................................................................................... 11 B. THE EFFECT OF MARKET CONDITIONS ON VALUATIONS .............................................. 18 C. EFFECT OF TAX REFORM ON THE ROE AND CAPITAL STRUCTURE ............................ 29 V. PROXY GROUP SELECTION .......................................................................................... 37 VI. COST OF EQUITY ESTIMATION ..................................................................................... 44 A. IMPORTANCE OF MULTIPLE ANALYTICAL APPROACHES .............................................. 45 B. CONSTANT GROWTH DCF MODEL .................................................................................... 48 C. CAPM ANALYSIS .................................................................................................................. 54 D. EXPECTED EARNINGS ANALYSIS ..................................................................................... 60 VII. BUSINESS RISKS AND MANAGEMENT PERFORMANCE ........................................... 64 A. RISKS ASSOCIATED WITH CAPITAL EXPENDITURE PROGRAM .................................... 64 B. RISKS ASSOCIATED WITH ENVIRONMENTAL AND WATER QUALITY REGULATION ... 68 C. MANAGEMENT PERFORMANCE AND RECOGNITION ...................................................... 73 VIII. CAPITAL STRUCTURE AND COST OF DEBT ............................................................... 76 IX. MULTI-YEAR RATE PLAN ............................................................................................... 81 X. CONCLUSIONS AND RECOMMENDATION ................................................................... 83 VERIFICATION .............................................................................................................................. 86 i DIRECT TESTIMONY OF ANN E. BULKLEY 1 I. WITNESS IDENTIFICATION AND QUALIFICATIONS 2 Q. Please state your name, occupation and business address. 3 A. My name is Ann E. Bulkley. I am employed by Concentric Energy Advisors, Inc. 4 (“Concentric”) as a Senior Vice President. My business address is 293 Boston 5 Post Road West, Suite 500, Marlborough, Massachusetts 01752. 6 Q. On whose behalf are you submitting this testimony? 7 A. I am submitting this testimony on behalf of Pennsylvania-American Water 8 Company (“PAWC” or the “Company”), a wholly-owned subsidiary of American 9 Water Works Company, Inc. (“AWK”). 10 Q. Please describe your background and professional experience in the energy 11 and utility industries. 12 A. I hold a Bachelor’s degree in Economics and Finance from Simmons College and 13 a Master’s degree in Economics from Boston University, with more than 20 years 14 of experience consulting to the energy industry. I have advised numerous energy 15 and utility clients on a wide range of financial and economic issues with primary 16 concentrations in valuation and utility rate matters. Many of these assignments 17 have included the determination of the cost of capital for valuation and ratemaking 18 purposes. My qualifications and testimony listing are presented in more detail in 19 Attachment A. 20 Q. Please describe Concentric’s activities in energy and utility engagements. 21 A. Concentric provides financial and economic advisory services to many and various 22 energy and utility clients across North America. Our regulatory, economic, and 1 DIRECT TESTIMONY OF ANN E. BULKLEY 1 market analysis services include utility ratemaking and regulatory advisory 2 services; energy market assessments; market entry and exit analysis; corporate 3 and business unit strategy development; demand forecasting; resource planning; 4 and energy contract negotiations. Our financial advisory activities include buy- and 5 sell-side merger, acquisition, and divestiture assignments; due diligence and 6 valuation assignments; project and corporate finance services; and transaction 7 support services. In addition, we provide litigation support services on a wide 8 range of financial and economic issues on behalf of clients throughout North 9 America. 10 II. PURPOSE AND OVERVIEW OF TESTIMONY 11 Q. What is the purpose of your Direct Testimony? 12 A. The purpose of my Direct Testimony is to present evidence and provide a 13 recommendation regarding PAWC’s authorized return on equity (“ROE” or “cost of 14 equity”) and to assess the reasonableness of its proposed capital structure for 15 ratemaking purposes. 16 Q. Are you sponsoring any exhibits in support of your Direct Testimony? 17 A. Yes. My analyses and recommendations are supported by the data presented in 18 Schedules-1 through 19 of Exhibit 13-A. 19 Q. Please provide a brief overview of the analysis that led to your ROE 20 recommendation. 21 A. As discussed in more detail below, it is important to consider the results of several 22 analytical approaches in determining a reasonable recommendation for the 2 DIRECT TESTIMONY OF ANN E. BULKLEY 1 Company’s ROE. To develop my ROE recommendation, I first developed a proxy 2 group that consists of water and natural gas utility companies that face risks 3 generally comparable to those faced by PAWC. I included both water and natural 4 gas utilities in the proxy group because a proxy group composed only of water 5 utilities would have resulted in an unreliably small group of only five companies. 6 To that proxy group, I applied the Constant Growth form of the Discounted Cash 7 Flow (“DCF”) model, the Capital Asset Pricing Model (“CAPM”), the Empirical 8 Capital Asset Pricing Model (“ECAPM”), and the Expected Earnings Analysis. As 9 discussed in more detail in Section IV of my Direct Testimony, it is appropriate to 10 rely on several ROE analyses because there are concerns among investors and 11 regulators that the DCF model is not producing reasonable results at this time due 12 to current conditions in capital markets. For example, Schedule-3 of Exhibit 13-A 13 demonstrates that the DCF model is producing individual company results as low 14 as 4.34 percent; a result that is only slightly higher than PAWC’s cost of long-term 15 debt of 4.40 percent for the first year of the Rate Plan (ending December 31, 2021) 16 and 4.29 percent for the second year of the Rate Plan (ending December 31, 17 2022), which are not reasonable estimates of the cost of equity.1 18 My recommendation also takes into consideration the following business risk 19 factors as compared with the proxy group: (1) the Company’s capital expenditure 1 Source: Company provided data. Shareholders are the residual claimants on the firm’s earnings and assets, therefore, the return to equity holders must be sufficiently higher than the return to bond holders. The very low DCF results do not provide a sufficient risk premium to compensate investors for the additional risk of an equity investment. As discussed in more detail in Section VI of my Direct Testimony, I applied a minimum threshold of 7.00 percent to the DCF results. The results summarized in Figure 1 reflect this lower bound. 3 DIRECT TESTIMONY OF ANN E. BULKLEY 1 requirements; (2) the effect of environmental regulations on water and wastewater 2 utilities and the costs associated with compliance; and (3) the superior 3 management performance of PAWC. Although I did not make any specific 4 adjustments to my ROE estimates for the foregoing factors, I considered each of 5 them when determining where the Company’s ROE should fall within the range of 6 analytical results. Finally, I compared PAWC’s proposed capital structure to the 7 actual capital structures of the proxy group companies to evaluate the 8 reasonableness of the Company’s proposed capital structure and I found that the 9 Company’s proposed capital structure was reasonable, appropriate and consistent 10 with the financial risk faced by PAWC’s peers. 11 Q. Please summarize your analytical results. 12 A. My analytical results are summarized in Figure 1. 13 4 DIRECT TESTIMONY OF ANN E. BULKLEY 1 Figure 1: Summary of Cost of Equity Results2 Constant Growth DCF Median Low Median Median High Including AWK 30-Day Average Price 9.34% 9.82% 11.15% 90-Day Average Price 9.12% 9.76% 11.15% 180-Day Average Price 8.98% 9.74% 11.02% Excluding AWK 30-Day Average Price 9.29% 9.39% 10.48% 90-Day Average Price 9.07% 9.28% 10.34% 180-Day Average Price 8.79% 9.27% 10.24% Capital Asset Pricing Model Q3 2020 – Q3 2021-2025 Current Risk- 2021 Projected Projected Risk- Free Rate Risk-Free Rate Free Rate (1.56%) (1.80%) (3.20%) Including AWK Value Line Beta 9.58% 9.67% 10.17% Bloomberg
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