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DOCKET NO. 46416
APPLICATION OF ENTERGY TEXAS, INC. FOR A CERTIFICATE OF PUBLIC UTILITY COMMISSION OF CONVENIENCE AND NECESSITY TO CONSTRUCT MONTGOMERY TEXAS COUNTY POWER STATION
DIRECT TESTIMONY
OF
ELLEN LAPSON
ON BEHALF OF
ENTtRGY TEXAS, INC.
OCTOBER 2016
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Entergy Texas, Inc. Direct Testimony of Ellen Lapson PUCT Docket No. 46416
TABLE OF COITENTS
Page
I. Introduction 1
11. Purpose of Testimony 3
III. Overview of Report 4
IV. Recommendations and Conclusions 9
EXEIIBITS
Exhibit EL-1 Professional Qualifications of Ellen Lapson, CFA
Exhibit EL-2 Evaluating the Balance Sheet Impact of Entergy Texas, Inc. 2015 RFP PPA Proposals, July 27, 2016
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Entergy Texas, Inc. Direct Testimony of Ellen Lapson PUCT Docket No. 46416
1 I. INTRODUCTION
2 Ql. PLEASE STATE YOUR NAME A_ND BUSINESS ADDRESS.
3 A. My name is Ellen Lapson, and my business address is 370 Riverside Drive,
4 New York, New York 10025.
5
6 Q2. BY WHOM ARE YOU EMPLOYED AND IN WHAT CAPACITY
7 A. I am the founder and lead consultant of Lapson Advisory, a division of Trade
8 Resources Analytics LLC, of which I am a member. Lapson Advisory provides
9 independent consulting and training services relating to the valuation and financial
10 analysis of utilities and infrastructure companies.
11
12 Q3.. PLEASE BRIEFLY DESCRIBE YOUR EDUCATIONAL AND PkOFESSIONAL
13 QUALIFICATIONS.
14 A. I earned a Bachelors of Arts degree from Barnard College in 1969 and a Masters in
15 Business Administration with a concentration in Accounting from New York
16 University's Stem School of Business in 1975.
17 Since 1969, I have worked in finance with special focus On the financial
18 analysis of utility debt and equity securities. Prior to founding Lipson Advisory,
19 from 1994 through December 2011, I was a Managing Director of the utilities, power
20 and gas analytical team at Fitch Ratings, one of the three prominent credit rating
21 agencies in the U.S. market. During my seventeen years at Fitch, I evaluated, or
22 supervised other analysts evaluating the credit of hundreds of electriC, gas and water
23 utilities, primarily in the United States. From 2004 through 2011, I also supervised
1
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Entergy Texas, Inc. Direct Testimony of Ellen Lapson PUCT Docket No. 46416
1 and wrote the credit rating criteria applied in the electric, gas, and water sector. My
2 responsibilities included keeping in contact with portfolio managers and debt and
3 equity securities analysts who followed the utility sector.
4 My prior position for 20 years from 1974 to 1994 was in commercial banking
5 and investment banking at a predecessor of J.P. Morgan, Inc. (Chemical Bank and
6 Chemical Securities, Inc.). For 15 years there I arranged funding and advised
7 companies in the utility sector and related sectors such as power generation and fuels.
8 For five years, I was a divisional controller and managed internal accounting and
9 financial controllership.
10 I started my career in the investment community as an equity,analyst at Argus
11 Research Corporation for six years, specializing in utilities.
12 A detailed listing of my professional qualifications, consulting assignments,
13 and expert testimony I have performed on behalf of Lapson Advisory is provided in
14 Exhibit EL-1.
15
16 Q4. PLEASE DESCRIBE THE DUTIES OF YOUR PRESENT POSITION.
17 A. My duties at Lapson Advisory include managing consulting assignments and advising
18 companies on how to improve their access to capital and debt markets. I develop and
19 conduct executive training programs for financial analysts- in corporate finance and
20 credit analysis for the electric and gas sector. I have frequently testified as an expert
21 witness on matters relating to utility finance and utility capital market matters.
2
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Entergy Texas. Inc. Direct Testimony of Ellen Lapson PUCT Docket No. 46416
1 Q5. ON WHOSE BEHALF ARE YOU FILING THIS DIRECT TESTIMONY?
2 A. Irf this proceeding, I am an expert financial witness on behalf of Entergy Texas, Inc.
3 (ETI" or the "Company").
4
5 II. PURPOSE OF TESTIMONY
6 Q6. WHAT IS THE PURPOSE OF YOUR TESTIMONY?
7 A. The purpose of my testimony is to provide my recommendations regarding the
8 appropriate methods to model the financial cost of capacity purchase agreements and
9 tolling contracts (collectively, the "RFP PPM") submitted in responše to ETI' s 2015
10 Request for Proposal s.1
11 Lapson Advisory was engaged in January 2016 to provide consulting advice
12 to personnel of ETI and Entergy Services, Inc. (Esr) (the administrator of the 2015
13 ETI RFP) for the purpose of assisting their evaluation of the expected effects of the
14 RFP PPAs, if selected by ETI, upon ETI's capital structure, future access to capital,
15 and cost of capital. Lapson Advisory studied the effects of such contracts upon ETI' s
16 future access to capital in the context of current and future financial reporting
17 standards and prudent accounting practices. My recommendations to ETI were
18 conveyed in an initial Summary Report dated February 21, 2.016 (attached to my
19 Exhibit EL-2) and explained in greater detail in a report dated July 27, 2016 entitled
20 "Evaluating the Balance Sheet Impact of Entergy Texas, Inc. 2015 ETI RFP PPA
21 ProposalS" (hereinafter, the "Report," Exhibit EL-2).
2015 Request for Proposals for Long-Term Combined Cycle Gas Turbine Capacity and Energy Resources and Limited-Term Capacity and Energy Resources for Entergy Texas, Inc." (the "2015 ETI RFP").
3
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Entergy Texas, Inc. Direct Testimony of Ellen Lapson PUCT Docket No. 46416
1 Q7. DO YOU SpONSOR ANY EXHIBITS?
2 A. I sponsor the exhibits listed in the Table of Contents to my testimony.
3
4 III. OVERVIEW OF REPORT
5 Q8. WHAT WAS THE NATURE OF YOUR ENGAGEMENT?
6 A. The 2015 ETI RFP solicited proposals for power purchase contr'acts and tolling
7 agreements and proposals from vendors to sell a pow-er 'unit or portion of a unit to
8 ETI. In addition to such proposals, ETI evaluated a self-build option. Lapson
9 Advisory researched the issues involved in measuring and comparing the financial
10 costs of RFP PPAs versus the financial costs of asset acquisition by ETI via either ihe
11 purchase of a unit from a third-party or self-build. Lapson Advisory prepared a
12 Summary Report in February 2016 providing its recommendations regarding how to
13 reflect the financial costs of RFP PPAs in the 2015 ETI RFP economic evaluation, in
14 order to support timely completion of that evaluation. The Summary Report is
15 included as an attachment to our final Report, Exhibit EL-2, which provides a
16 detailed discussion of the basis for the recommendations included in the Summary
17 Report.
4
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Entergy Texas, Inc. Direct Testimony of Ellen Lapson PUCT Docket No. 46416
1 Q9. IN RESEARCHING YOUR REPORT, WHAT DID YOU DE LERMINE
2 REGARDING THE COMPARABILITY OF THE FiNANCIAL COSTS
3 ASSOCIATED WITH THE VARIOUS RESOURCE OPTIONS CONTEMPLATED
4 BY THE RFP?, 5 A. A comprehensive comparison of options that entail asset ownership by ETI (either via
6 the purchase of a plant from a developer or by means of self-build) to those involving
7 a PPA must account for differences in the form of resource acquisition that would
8 affect ETI' s balance sheet, capital structure and cost of capital. If ETI were to
9 acquire outright ownership of a power facility by means of either self-build or asset
10 purchase, it is reasonable to assume that the utility will fund the asšet with a mix of
11 equity and debt funding that preserves a prudent capital structure.
12 On the other hand, if ETI satisfies its capacity and energy,needs by entering
13 into a long-term PPA requiring fixed payments over a period of twenty years or
14 longer, for example, there would be long-term impacts upon the utility's capital
15 structure and its cost of capital that can impose additional costs on utility operations.
16 PPAs that entail fixed periodic payments (capacity charges") oblige a utility (the
17 purchaser) to pay these charges, even if power from the contract is not needed or not
18 of economic benefit in future periods. Failure to make the contractual payments
19 would be a corporate default, similar to defaulting on a bond or a loan. Therefore, the
20 financial community views contracts with recurring commitments to make fixed
21 payments as debt-like obligations.
22 Securities analysts and creditors view capacity payment obligations under
23 PPAs as a form of financial leverage similar to a loan or a bond liability and give
5
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Entergy Texas, Inc. Direct Testimony of Ellen Lapson PUCT Docket No. 46416
1 such obligations consideration in the measurement of the financial hexibility of the
2 utility. Taking into consideration this additional debt-like leverage, the utility would
3 have to increase its equity balance and reduce or replace some other corporate
4 borrowing in order to maintain the target ratio of debt to total capital or debt to
5 equity.
6 Thus, to fairly compare the costs of RFP PPA proposals relative to asset
7 ownership alternatives, the analysis should incorporate a proxy value for the increase
8 in debt-like obligations related to entering into the RFP PPA and the equity required
9 to rebalance the capital structure to mitigate risk consistent with the asset acquisition
10 alternatives. This will ensure that a consistent financial analysis is used for both RFP
11 PPAs and asset acquisition alternatives. The Report explains Upson Advisory's
12 recommended method to quantify the debt equivalence and capital costs of the RFP
13 PPAs submitted in response to the 2015 ETI RFP and meet the goals of consistent
14 evaluation and preservation of ETI' s financial integrity.
15
16 Q10. DOES THE REPORT ACCOUNT FOR RECENT CHANGES IN GENERALLY
17 ACCEPTED ACCOUNTING PRINCIPLES REGARDING LEASES AND THEIR
18 EFFECT ON THE EVALUATION OF THE RFP PPAS?
19 A. Yes. The Report draws donclusions about the likely financial reporting treatment of
20 the RFP PPAs, both as to the situation under currently prevailing accounting
21 standards and as to their treatment under revised lease accounting standards •
22 promulgated by the Financial Accounting Standards Board (FASB") in February
23 2016.
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Eniergy Texas, Inc. Direct Testimony of Ellen Lapson PUCT Docket No. 46416
1 Our research as set forth in the Report indicates that some capacity purchase
2 agreements or tolling agreements proposed in response to the 2015 ETI RFP are
3 likely to be subject to reporting as leases with explicit recognition of a long-term
4 debt-like liability on the balance sheet of ETI pursuant to the FASB's February 25,
5 2016 guidelines for leases that will become effective for ETI's financial reporting
6 starting in 2019,2 as discussed by Company witness Mr. Thomas C. Kidd. Under
7 current accounting rules, few if any PPAs are reflected as assets and liabilities 6n the
8 balance sheet of utilities.3 However, as explained in the Report, financial analysts
9 who specialize in fixed income investments and credit analysts already attribute debt
10 imputation to capacity contracts, even those that are not explicitly recognized
11 currently in the power purchaser's balance sheet.
12 The revised rules in Leases, Topic 842, further discussed by Mr. Kidd, will
13 require some PPAs with specific characteristics to be classified as lease obligations of
14 the utility purchaser, with financial statement recognition of an asset ,representing the
15 rights conveyed by the lease and a liability (debt) in an equal amount! Under the new
16 lease accounting rules, long-term contracts deemed to be leases are likely to appear
17 on the utility's balance sheet. Some of' the RFP PPAs are likely to contain the
18 characteristics. of leases, and these contracts would likely have a greater apparent
2 Financial Accounting Standards Board (FASB), Accounting Standards Update No. 2016-2, Leases, Topic 842, February, 2016 (henceforth, "Leases, Topic 842." 3 The exceptions are those contracts identified as capital leases (also called financing leas'es) pursuant to FAS No. 13, Accounting for Leases, now reclassified as Accounting Standards Codifications Topic 840, or ASC 840. Contracts identified as operating leases under FAS No.,, 13 /ASC 840 are reported in footnote disclosures, but not in financial statements.
7
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Entergy Texas, Inc. Direct Testimony of Ellen Lapson- PUCT Docket No. 46416
1 impact on the financial condition of ETI as perceived by bankers, lenders, and bond
2 investors than other PPAs not classified as leases.
3
4 Q11. DOES THE REPORT, DISCUSS HOW THE INVESTMENT COMMUNITY
.5 CURRENTLY APPROACHES DEBT EQUIVALENCE FOR CAPACITY
6 CONTRACTS?
7 A. Yes, it does. The Report discusses the methods that major credit rating agencies use
8 fo assess the financial impact of long-term PPAs requiring capacity payments. The
9 approaches used by the major credit rating agencies are extremely influential among
10 fixed income. analysts, and the Report describes the methodology used by Standard
11 Poor's (S&P”) and Moody's Investors Services (Moody's"). The Report concludes
12 that S&P's methodology for attributing debt equivalence to PPAs iš more
13 quantitative, consistent, and replicable than the approach used by Moody's (and Fitch
14 Ratings, whose method is generally similar to Moody's). Consequently, the Report
15 adopts a methodology that is based on the S&P model.
16
17 Q12. WHAT ARE THE MAJOR TOPICS COVERED 11.1- LAPSON ADVISORY'S
18 REPORT?
19 A. First, the Report explains the equivalence of PPAs to debt.. Second, the Report
20 reviews the major methods used by the investment community for computing debt
21 equivalence and the cost of 'equity relating to PPA debt equivalence, and recommends
22 a quantitative methodology to account for these effects. This section of the Report
23 also addresses why debt equivalence should be calculated at the time of resource
8
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Entergy Texas, Inc. Direct Testimony of Ellen Lapson PUCT Docket No. 46416
1 evaluation and selection. Another section of the Report addresses special concerns
2 regarding any PPAs that are likely to be identified as leases under the guidance of
3 Leases, Topic 842. Based upon the results of the research on these topics, the Report
4 provides recommendations about how ETI should measure the financial costs of RFP
5 PPAs in its evaluation process. Finally, the Report includes numerical tables, exhibits
6 and work papers supporting the research ana recommendations.
7
8 IV. RECOMMENDATIONS AND CONCLUSIONS
9 013. WHAT ARE THE CONCLUSIONS AND RECOMMENDATIONSyROVIDED IN
10 THE REPORT REGARDING THE EVALUATION OF THE RFP PPAS?
11 A. Based upon the detailed study reported in Exhibit EL-2, Lapson Advisory made the
12 following recommendations to ETI and ESI regarding the evaluation of the RFP
13 PPAs:
14 1. Principles of prudent management require that ETI evaluate all the costs including
15 capital costs of implied debt and equity requirements and impacts upon ETF s
16 future.financial strength that would result from entering into long-term PPAs.
17 2. Determining the amount of imputed debt associated with entering into a PPA
18 permits the computation of estimated capital costs derived from the amount of
19 equity that would be needed to rebalance the capital structure to the tdrget debt to
20 equity ratio and the cost of this rebalancing.
21 3. The appropriate time to assess the capital costs of PPA contracts'is at the time of
22 the evaluation of the proposals and prior to selection.
9
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Entergy Texas, Inc. Direct Testimony Of Ellen Lapson PUCT Docket No. 46416
1 4. Lapson Advisory recommends that the base case should evaluate all RFP PPAs
2 using 25% debt equivalence. This base case represents the lower' end of the range
3 of debt equivalence.
4 5. As an additional sensitivity case, all RFP PPAs should also be evaluated using
5 50% debt equivalence. This represents an estimate of the upper range of debt
6 equivalence for those PPAs that do not have the characteristics of leases pursuant
7 to updated FASB lease accounting standard Leases, Topic 842.
8 6. Proposed RFP PPAs that have .the characteristics of leases as defined under
9 Leases, Topic 842 should be rejected. If such contracts are not rejected outright,
10 then such PPAs should be evaluated using a sensitivity case of 100% debt
11 equivalence, which will match the actual financial recording of long-term lease
12 liability on ETI' s audited financial statements in 2019 and beyond.
13
14 Q14. DO YOU HAVE ANY CONCLUDING COMMENTS?
15 A. Yes. The recommendations contained in the Report and summarized above are
16 consistent with the, interests of. utility customers and the public interest in having
17 reliable service from a financially sound utility and in receiving the benefits of
18 prudent decisions about future cost-efficient resources. The needs of customers are
19 aligned with the interest of the utility in this regard (that is, to maintain its financial
20 soundness and to make cost-effective purchase decisions that reduce long-term risk.)
21
22 Q15. DOES THIS CONCLUDE YOUR DIRECT TESTIMONY?
23 A. Yes.
10
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Exhibit EL-1 P1JCT Docket No. 46416 Page 1 of 5
EPERIENCE AND QUALIFICATIONS ELLEN LAPSON, CFA
LAPSON ADVISORY 370 Riverside Dr., 9D Financial Consulting, New York, NY 10025 Expert Testimony, +1-212-866-1040 Financial Training www.lansonadvisorv. com .
SUMMARY OF QUALIFICATIONS
Industry expert on financing utilities and similar types of infrastructure. Over 40 years of professional experience in commercial and investment banking, securities analysis, and credit ratings. Focus on utilities, power generation and alternative energy sources; natural gas and fuels, corporate and project finance. 'Provides executive training in utility financial analysis and credit analysis. Consult and provide expert witness testimony in matters involving capital access for infrastructure, energy and utilities. MBA in accounting and finance; Chartered Financial Analyst (CFA).
EMPLOYMENT
Lapson Advisory Financial consulting services to utilities and developers Principal of infrastructure projects. Financial strategy and credit Dec. 2011 - present advisory for power, energy, infrastructure companies, and utilities. Expert witness testimony on financial and regulatory topics relating to utilities and infrastructure finance. Design and conduct financial and credit training.
Fitch Ratings Chair of Fitch's global Corporate Finance Criteria Utilities, Power & Gas Committee overseeing criteria for rating corporations, Managing Director financial institutions, insurers, REITs, and project 1999-2011 finance transactions (2010-2011). Senior Director Manager or primary analyst on credit ratings of over 200 1994-1999 utility, pipeline, power generation companies. Utility tariff monetization. Senior member of rating committees for utilities and energy and power-related projects. Liaison with utility sector fixed income investors, focusing on 50 largest institutional investors holding utility and power bonds, buy-side and sell-side analysts, and utility bankers.
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Exhibit EL-1 PUCT Docket No. 46416 Page 2 of 5
JP Morgan Chase Managed financial advisory transactions, structured debt (formerly Chemical NY Corp.) private placements, syndicated credit facilities for Vice President utilities, mining and metals, project finance. Structured 1975-94 financing for utility regulatory assets (first of its kind Asst. Vice President "stranded cost" securitization transaction) for Puget 1974-1975 Energy, 1992-94. Led financing for bankrupt utility as debtor-in- possession; prepared financing plans for distressed utilities; structured exit financing for reorganization of two utilities emerging from Chapter 11. Divisional Controller - 1981-1986
Argus Research Corp. Equity analysis of U.S. electric and gas' utilities, natural Equity Security Analyst — gas pipelines, and telecommunications companies. Utilities Modeling and projecting corporate financial statements. 1969-1974 Research coverage and reports.
EDUCATION & CHARTER.
Stern School of Business, New York University, MBA, 1975 Major concentration: Accounting Master's Thesis: Cash Flow vs. Accrual Accounting Data in Utility Equity Valuation Chartered Financial Analyst (CFA) since 1978 Barnard College, Columbia University, BA, 1969
PROFESSIONAL ASSOCIATIONS
Institute of Chartered Financial Analysts, 1978 - present Wall Street Utility Group, 1996 — present
ADVISORY COUNCILS AND BOARD SERVICE
Rocky Mountain Institute, Sustainable Finance Advisory Board, July 1, 2016 to present.
Represented U.S. investment community in advisory panel on International Accounting Standard Board proposals for financial reporting for rate-regulated activities, sponsored by Edison Electric Institute and American Gas Association, Dec. 2014
National Academy of Sciences/ National Research Council, Resilient America Forum, July 2014.
MIT Energy Institute, External Advisory Council, The Future of Solar Energy, 2012-2014.
Electric Power Research Institute, Advisory Council, 2004-2011; Chair, 2009 and 2010.
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Exhibit EL-1 PUCT Docket No. 46416 Page 3 of 5
EXPERT WITNESS TESTIMONY
Jurisdiction Proceeding Topic U.S. Federal Energy Dockets No. EL16-29 and EL16-30, Capital market Regulatory NCEMC, et al. vs Duke Energy Carolinas environment affecting the Commission and Duke Energy Progress, on behalf of the determination of the cost Respondents (2016) of equity capital Hawaii Public Utilities Docket No. 2015-0022, Merger Ring:fencing and Commission Application on behalf of NextEra Energy financial strength and Hawaiian Electric Inc. (2015) U.S. Federal Energy Dockets EL13-48 and EL15-27, Delaware Capital market Regulatory Div. of the Public Advocate vs. Baltimore environment affecting the Commission Gas and Electric Company and PEPCO determinafion of the cost Holdings et al., for Respondents (2015) of eqiiity capital Arkansas Public Docket No. 15-015-U, Entergy Arkansas, Effect of ROE and other Service Commission Inc. Application for Change of Rates, on rate Matters on cash flow behalf of Entergy Arkansas, Inc. (2015) and credit ratings. U.S. Federal Energy Dockets No. EL14-12 and EL15-45, Capital market Regulatory ABATE, et al. vs MISO, Inc. et al., on environment; capital Commission behalf of the MISO Transmission Owners spending and risk (2015) U.S. Federal Energy Dockets No. EL12-59 and 13-78, Golden Capifal market Regulatory Spread Electric Coop., on behalf of South- environment; capital Commission western Public Service Co. (2015) spending and risk U.S. Federal Energy Dockets No. EL13-33 and EL14-86, ENE Capital market Regulatory et al. vs. Bangor Hydro-Electric Co. et al., environment 'affecting the Commission on behalf of New England Transmission measurement of the Cost Owners. (2015) of equity capital U.S. Federal Energy Dockets No. ER13-1508 et alia, Entergy Capital market Regulatory Arkansas, Inc. and other Entergy utility environment affecting the Commission subsidiaries, on behalf of Entergy Services measurement of the cost Inc. (2014) of equity capital Delaware Public DE Case 14-193,,Merger of Exelon Corp. Ring-fencing for utility Service Commission and Pepco Holdings, Inc. on behalf of the merger; avoidance of Joint Applicants (2015) financial harm Maryland Public Case No. 9361, Merger of Exelon Corp. Ring-fencing for utility Service Commission and Pepco Holdings, Inc. on behalf of the merger; avoidance of Joint Applicants (2015) financial harm. New Jersey Board of BPU Docket No. EM 14060581, Merger of Ring-fencing for Utility Public Utilities Exelon Corp. and Pepco Holdings, Inc., on merger; avoidance of behalf of the Joint Applicants (2015) financial harm U.S. Federal Energy Docket ER15=572. Application of New Incentive compensation Regulatory York Transco, LLC, on behalf of NY for electric transmission; Commission Transco, LLC. (2015) capital market and financial strength
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Exhibit EL-1 PUCT Docket No. 46416 Page 4 of 5
U.S. Federal Energy Docket EL 14-90-000 Seminole Electric Capital market Regulatory Cooperative, Inc. and Florida Municipal environment affecting the Commission Power Agency vs. Duke Energy FL on determinatiOn of the cost behalf of Duke Energy (2014) of equity capital DC Public Service Formal Case No. 1119 Merger of Exelon Ring-fencing for utility Commission Corp. and Pepco Holdings Inc., on behalf merger; avoidance of of the Joint Applicants (2014-2015) financial harm U.S. Federal Energy Docket EL14-86-000 Attorney General of Return on Equity; capital Regulatory Massachusetts et. al. vs. Bangor Hydro- market environment Commission Electric Company, et. al on behalf of New England Transmission Owners (2014) Arkansas Public Docket No. 13-028-U. Rehearing direct Invetor and rating Service Commission testimony on behalf of Entergy Arkansas. agency reactions to ROE (2014) set by Order. Illinois Commerce Docket No. 12-0560 Rock Island Clean Access to capital for a Commission Line LLC, on behalf of Commonwealth merchant electric Edison Company, an intervenor (2013) transmission line; finan,cial capability U.S. Federal Energy Docket EL13-48-000 Delaware Division Return on Equity; capital Regulatory of the Public Advocate, et. al. vs. Baltimore' market view of Commission Gas and Electric Company and PEPCO transinission investment Holdings et al., on behalf of (i)Baltimore Gas and Electric and (ii) PEPCO and subsidiaries (2013) U.S. Federal Energy Docket EL11-66-000 Martha Coakley et. Return on Equity; capital Regulatory al. vs. Bangor Hydro-Electric Company, et. market view of Commission al on behalf of a group of New England transmission investment Transmission Owners (2012-13) New York Public Cases 13-E-6030; 13-G-0031; and 13-S- Cash:flow and financial, Service Commission 0032 on behalf of Consolidated Edison strength; regulatory Company of New York. (2013) mechanisms Public Service Case. 9214 "In The Matter Of Whether Effect of certain power Commission of New Generating Facilities Are Needed To contracts on the credit and Maryland Meet Long-Term Demand For Standard financial strength of MD Offer Service, on behalf of Baltimore Gas util4 counterparties and Electric Co., Potomac Electric Power Co., and Delmarva Power & Light (2012)
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PUBLICATIONS BOOK CHAPTERS
"Managing Credit Risk in the Electricity Marker, Ellen Lapson and Denise Furey, chapter 21 in Managing Energy Price Risk, 4th Edition, Vincent Kaminski ed., Risk Publications, London, 2016.
"Standard Market Design: Credit of Some Sectors Will Be Affected by SMD", Ellen Lapson. Chapter in: Electric & Natural Gas Business: Understanding It, 2003 and Beyond, Robert E. Willett ed:, Financial Communications Company, Houston, TX, 2003.
Energy Modeling and the Management of Uncertainty, Robert Janieson ed., Risk Publications, London, 1999. "Managing Risks Through Contract Technology: Know Your Counterparty", Ellen Lapson, pp 154-155.
"Managing Credit Risk in the Electricity Marker, Ellen Lapson (pp 281.-294 Chapter in: The US Power Market: Restructuring and Risk Management, Robert Jameson ed., Risk Publications, London, 1997.
Deregulation of the Electric Utility Industry — Proceedings of the AIMR Setninar; ed. AIMR (CFA Institute), Charlottesville, VA, 1997. Speaker 3: E. Lapson.
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Exhibit EL-2 PUCT Docket No. 46416 Page 1 of 32
Evaluating the Balance Sheet impact of Entergy Texas, inc. 2015 RFP PPA Proposals
Prepared by Lapson Advisory
Summary Recommendations, February 21, 2016,
and Final Report, July 27, 2016
1
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Exhibit EL-2 PUCT Docket No. 46416 Page 2 of 32
Table of Contents I. Introduction, Nature of the Assignment and Scope of Work 3 1.1 Professional Qualifications 4 II. Debt-like Nature of PPAs 8 11.1 Nature of PPAs 8 II. 2 Key Differences Between PPAs and Utility-owned Plants 9 11.3 Current Rating Agency Treatment of PPAs 11 III. Evaluating PPA Debt Equivalence and Cost of Capital Implications 48 IIL 1 Methodology . f 19 111.2 Selection of the Discount Rate and Risk-weighting Factor • 21 111.3 The Cost of Rebalancing the Capital Structure 22 111.4 Applying Debt and Equity Adjustments in the Project Evaluation Process 25 111.5 Conclusions 26 IV. New Lease Accounting Standards 27 IV.1 Impact of Topic 842 on Financial Statement Presentation of PPAs 27 IV.2 Implications For Future Access To Capital, Credit Ratings, and Cost Of Capital 28 V. Recommendations 30
Tables Table 1: Comparing PPA Valuation Approaches 17 Table 2: Rebalancing the Capital Structure 23 Table 3: Impact of PPA on the Cost of Capital 23 Table 4: Impact of PPA on Corporate Debt Leverage 25
Attachments Att. No. 1 Professional Qualifications of Project Team Att No. 2 Summary Report , February 21, 2016 Att No. 3 Financial Accounting Standards (FAS) No. 13, now identified as Accounting Standards Codification Topic 840 (ASC 840), Accounting for Leases . Att. No. 4 Accounting Standards Update 2016-2, Topic 842, Leases' * Att. No. 5 Standard & Poor's Corp., Credit Direct, "Key Credit Factors for the Regulated Utilities Industry", Nov. 19. 2013 Att. No. 6 Moody's Investors Service, "Rating Methodology: Regulated Electric and Gas Utilities", December 23, 2013 Att. No. 7 Applying S&P Debt Imputation to a PPA : Att. No. 8 S&P RatingsDirect Research Update, June 2016, "Entergy Texas Inc. Ratings Affirmed, Outlook Still Positive; Stand-Alone Credit Profile Score Weakens to bbb-"
Work Papers WP No. 1 PPAs Deemed to be Finance or Operating Leases: Summary of Financial Statement Effects WP No. 2 Lease Accounting Standard Applied to a PPA: Sched. A. Finance Lease; Sched. B. Operating Lease i WP No. 3 Back-Up to Tables and Exhibits in Electronic Format
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I. Introduction, Nature of the Assignment and Scope of Work
Lapson Advisory was engaged by the law firm of Duggins Wren Mann & Romero LLP (DWMR), on behalf of Entergy Texas, Inc. (ETI), on January '4, 2016. Lapson Advisory's assignment is to provide expert consulting services in connection with energy and capacity purchase agreements and tolling contracts (collectively, the RFP PPAs) that.may be submitted and evaluated in response to ETI's 2015 Request for Proposals (ETI 2015 RFP or the Solicitation). 1
Lapson Advisorys role is to advise personnel of ETI and Entergy Services Inc. (the administrator of the 2015 RFP) on the expected effects of the RFP PPAs, if selected by ETI, upon ETI's capital structure, future access to capital, and cost of capital. Lapson Advisory was directed to consider the effects of such contracts Upon ETI in the context of current and future financial reporting standards and prudent accounting practices.
The issue of future financial reporting standards affecting the PPAs bid into the 2015 solicitation took on added importance as a result of a major change in the accounting guidelines for leases and similar contracts first announced by the Financial Accounting Standards Board (FASB) in November 2015. The FASB published its formal updated lease accounting standards on February 25, 2016. 2 Pursuant to the new financial reporting standard, some purchase power and energy contracts (PPAs) will be identified as leases and will become subject to new financial reporting rules in the year 2019 and beyond. That time frame will geneeally coincide with the contract lives of the proposed RFP PPAs.
On February 21, 2016, Lapson Advisory submitted to ETI a sumniary report containing its essential evaluation and recommendation, in order to sul5port timely completion of the ETI 2015 RFP economic evaluation. Lapson Advisory also made a presentation to the ETI Operating Committee regarding the conclusions in the summary report on April 26, 2016. This final report affirms the conclusions and accompanying rationale underlying the summafy report, and contains a more detailed elaboration of the matters addressed in the summary report. The summary report is included as Attachment 2 to this report.
To carry out its work, Lapson Advisory conducted research and analysis on the following topics:
2015 Request for Proposals for Long-Term Combined Cycle Gas Turbine Capacity and Energy Resources and Limited-Tenn Capacity and Energy Resources for Entergy Texas, Inc." (henceforth, the ETI 2015 RFP.) 2 FASB, Accounting Standards Update No. 2016-2, Leases, Topic 842, February, 2016 (Attachment No. 4). Prior to the effectiveness of Accounting Standards Update No. 2016-2 for financial statements in 2019 andffiereafter, Financial Accounting Standard No. 13, Accounting for Leases (Attachment No. 3) remains in effect.
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00457 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 22 of 50 H.O. Davey
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1. Current Generally Acceptable Accounting Principles (GAAP) of the Financial Accounting Standards Board (FASB) affecting financial reporting of PPA obligations and leases; 2. New GAAP accounting standard update for leases published by FASB on February 25, 2016 (Accounting Standards Update No. 2016-2, Topic 842) to become mandatory for 2019 and thereafter, pursuant to which certain PPAs will be deemed to be leases; 3. Current policies and practices of major credit rating agencies for evaluating the financial impact of PPAs upon the credit worthiness of electric utilities; 4. Potential policies of credit rating agencies for their rating evaluations of PPAs that are deemed to be leases and rePorted with full financial statement recognition under Accounting Standards Update No. 2016-2, Topic 842; Leases; 5. Other current and future financial impacts of PPAs on utility financial risk and access to capital, including risks associated with the reporting of leases (including certain PPAs) on published financial statements of ETI; 6. Relevant regulatory practices of the Public Utility Commission of Texas (PUCT) for recovery of ETI's PPA energy and capacity charges; / 7. Verification of the framework and decision tree developed by the Entergy Services accounting staff to identify which proposals are highly likely to be deemed to be leases under Accounting Standards Update No. 2016-2, Topic 842, Leases; 8. Financial and regulatory mechanisms that may be employed to mitigate the adverse effects of debt imputation upon the financial condition of a utility power purchaser; 9. Methodologies to appropriately reflect the financial impact and risk of the proposed PPAs in ETI's evaluation of the proposals.
The final stage of this phase of work is to document the key findings' of Lapson Advisory's research and formulate the recommendations contained in this report
1.1. Professional Qualifications
The members of Lapson Advisory's staff carrying out this project are Ellen Lapson, CFA and John Perkins.
Ms. Lapson's professional career in finance for over 45 years has been focused on financial analysis of the utility industry, utility sector capital market access, and credit ratings. From 1994-2011, Ms. Lapson was a leader of utility sector credit ratings at Fitch Ratings. Since 2012, Ms. Lapson has performed consulting projects and conducted professional training courses relating to utility and energy sector financial analysis, cash flow, and access to capital markets and has testified in regulatory proceedings involving utility financial viability and capital market access.
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Mr. Perkins has served as the Director of Corporate Finance for Consolidated Edison Co. of New York and Treasurer of Orange and Rockland Utilities. His responsibilities included financial forecasting, interaction with bankers and credit rating agencies, raising capital for the utilities, and testifying regarding the cost of capital in regulatory proceedings. Mr. Perkins has also taught university courses in economics and transportation regulation and planning.
For more detail on the professional qualifications of Ms. Lapson and Mr. Perkins, please refer to Attachment 1.
1.2 Summary & Recommendations
The ETI 2015 RFP solicits proposals for power purchase contracts and tilling agreements and proposals from vendors to sell a power unit or portion of a unit to ETI. In addition to such proposals, a self-build option will be evaluated. 3
The costs of the RFP PPAs are not directly comparable with options that' entail asset ownership by ETI (either via asset acquisition or self-build) without accounting for differences in the form of resource acquisition that would affect ETI's balance, sheet, capital structure and cost of capital.
a. Asset Ownership Options To compute the capital costs when ETI acquires outright ownership of a power facility by means of either self-build or asset acquisition, it is typically assumed that the utility will fund the asset with a mix of equity and debt funding that preserves a prudent capital structure. This is a reasonable assumption regarding ETI in this Solicitation.
b. PPAs There are impacts upon a utility's capital structure and its cost of capital if the utility enters into a PPA requiring fixed payments over a long time period. PPAs that entail fixed periodic payments (capacity charges)4 oblige a utility (the purchaser) to pay these charges, whether or not power from the contract is needed and economical in future periods. Failure to make the contractual payments would be a corporate default, similar to defaulting on a bond or a loan. Therefore, the financial community views contracts with recurring commitment to make fixed payments as debt-like obligations.
3 ETI 2015 RFP, Sec. 2.2.1. In the RFP, proposals by vendors to sell a power unit or portion of a unit to ETI are called "acquisitions" or "asset acquisitions". 4 Throughout this report, the terms "capacity payments" and "fixed charges" are used interchangeably to denote any cash charges that the purchaser must pay even if no power is taken in the period.
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00459 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 24 of 50 H.O. Davey
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In the financial analysis of a utility with capacity payment obligations under PPAs, those obligations are viewed as a form of financial leverage similar to a loan or a bond liability and given consideration in the measuremeht of the financial flexibility of the utility. Taking into consideration this additional leverage, the utility would have to increase its equity balance arid reduce or replace some other corporate borrowing in order to maintain the target ratio of debt to total capital (or debt to equity).
Thus, to fairly compare the costs of RFP PPA proposals relative to asset ownership alternatives, the analysis should incorporate a proxy value for the increase in debt- like obligations related to entering into the RFP PPA and the equitÿ required to rebalance the capital structure to mitigate risk consistent with the asset acquisition alternatives. This will insure that a consistent analysis is used-for both RFP PPAs and asset acquisition alternatives. It will also support customers interests in having service from a financially sound and reliable utility. This report describes Lapson Advisory's recommended method to quantify the debt equivalence and capital costs of the RFP PPAs submitted iri response to ETI 2015 RFP and meet the goals of consistent evaluation and preservation of ETI's financial integrity.
Lapson Advisory has reviewed the financial reporting treatment of the RFP PPAs, both as to the situation under currently prevailing accounting standards and as to their treatment under the revised lease accounting standard.
Under current accounting rules, few if any PPAs are reflected as assets and liabilities on the balance sheet of utilitiess. The new lease accounting standards6 will require some PPAs with specific characteristics to be clasgified as lease obligations of the utility purchaser, with financial statement recognition of an asset representing the rights conveyed by the lease and a liability (debt) in an equal amount. Under the new lease accounting rules, long-term contracts deemed to be leases will affect the utilitys balance sheet. Some of the RFP PPAs are likely to contain the characteristics of leases, and these contracts would likely have a greater apparent impact on the financial condition of ETI as perceived by bankers, lenders, and bond investors than other PPAs not classified as leases.
The balance of this report is structured as follows: • Section II explains the equivalence of PPAs to debt. • Section III reviews current methods for computing debt equivalence and the cost of equity relating to PPA debt equivalence. This se-ction also addresses why debt equivalence should be calculated at the time of contract evaluation and selection.
5 The exceptions are those contracts identified as capital leases (also called financing leases) pursuant to FAS No. 13, Accounting for Leases, now reclassified as Accounting Standards Codifications Topic 840, or ASC 840. Contracts identified as operating leases under FAS No. 13 /ASC 840 are reported in footnote disclosure, but not in financial statements. 6 Acbounting Standards Update No. 2016-2, Leases, Topic 842, op. cit.
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• Section IV addresses special concerns regarding PPAs that will be identified as leases under the guidance of the Accounting Standards Update No. 2016-2, Topic 842, Leases. • Section V contains Lapson Advisorys recommendations.
Lapson Advisory's conclpsions and recommendations, which appear in full in Section V, are summarized below:
1. Prudent management requires ETI to evaluate all the costs including capital costs (implied debt and equity requirements) and impacts upon 'ETI's future financial strength that will result from the debt-like nature of long-term PPAs. Only by considering those effects on capital structure can ETI make comparisons on a reasonable and fair basis among different types, of PPAs (including those that will be deemed to be leases for financial reporting) and between PPAs and ownership alternatives.
2. Determination of imputed debt related to entering into a PPA will result in the computation of estimated capital cost derived from the amount of equity that would be needed to rebalance the capital structure to the target debt to equity ratio and the cost of this rebalancing. 1 3. The appropriate time to assess the capital costs of PPA contracts is at the time of the evaluation of the proposals and prior to selection.
4. The base case should evaluate all PPAs using 25% debt equivalence.
5. As a sensitivity case, all PPAs should also be evaluated using 50% debt equivalence.
6. PPAs structured with the characteristics of leases as defined under the updated FASB lease accounting standard should be rejected. If such contracts are not rejected outright, then such leases should be evaluated using a sensitivity case of 100% debt equivalence, which will match the actual financial recording of long-term lease liability on ETI's audifed financial statements in 2019 and beyond.
7. The interests of utility customers in having reliable service from a financially sound utility and in receiving the benefits of cost-efficient decisions about future sources of energy are aligned with the interest of the Utility in this matter (that is, to maintain its financial soundness and to make cost-effective purchase decisions that reduce long-term risk.)
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00461 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 26 of 50 H.O. Davey
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11. Debt-like Nature of PPAs
In the ETI 2015 RFP, ETI will evaluate third-party PPAs and ETI assef ownership proposals (potential asset acquisitions and an ETI self-build alternative).. Long-term PPAs are a potential substitute for asset ownership alternatives; they are designed to meet the same need, but they have different financial and accounting characteristics.
Any type of fixed asset ownership by ETI would be partially funded by debt, requiring fixed, unavoidable payments of interest and principal; the balance of the acquisition costs wafuld be funded with common equity. If circumstances change, making the capacity provided by the power plant less necessary or less economically attractive, the debt obligation continues, but the substantial .proportion of equity funding reduces the amount of debt employed. This is a well- accepted financial strategy that transfers financial risk from utility customers to equity investors.
11.1 Nature of PPAs
The RFP '13PAs may include contracts for fixed capacity for a long-term period, approximately 10-20 years. If the contract requires fixed capacity payments over the life of the contract, such paymentš are due regardless of changed circumstances that may decrease or even eliminate ,the original need. For example, customers' demand for power that motivated the RFP may decline over time due to conservation efforts or substitution by other sources, leading to a mismatch between the fixed, unavoidable contract payments and the revenue needed to pay them. Just as for debt, the obligation to make fixed capacity payments on the PPA is firm, and it does not change if the revenue that pays for that obligation falls short. A utilitys failure to make the payments on a contract (in the absence of breach of any terms of the contract by the supplier) would constitute a financial default by the utility, and could lead to cross defaults on debt obligations. This is the reason that financial institutions and investors view contracts with fixed capacity payments as similar to debt.
Uncertain Regulatory Expense Recovery
The nature of the regulatory process that produces the revenue could' be another source of revenue shortfall. If the recovery of the capacity payment depends upon regulatory approval in periodic base rate cases, it is possible that some fixdd' capacity payments will not be recovered in customer rates due to the timing of rate cases. Also, expense recovery may not be complete if demand falls and rates are not readjusted to compensate or if there is a delay in the readjustment.
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00462 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 27 of 50 H.O. Davey
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Long-Term PPA Obligations
Some of the RFP PPAs ma3i have terms of up to twenty years. The long-term nature of the PPAs compounds the potential problems of changing demand and uncertain regulatory expense recovery. This makes long-term PPAs more uncertain or risky for the utility than those with very short terms. Over time, the factors that could reduce customer demand for the resource committed to the contract are more likely to change and the magnitude of the change can be greater over a longer span. Twenty-year contracts expose the demand to greater potential yariation in demographics and the economic condition of the region. Recent experience has shown that technology is rapidly evolving, and the economics of the energy market may undergo several cycles over two decades, which could make the source of power under tbe contract less economically attractive. Regulatory polthies and procedures are also less certain or predictable over a very long term.
An additional issue with lofig-term PPAs is that they will extend across several financial cycles. A contract with an apfroximately twenty-year term assumed to begin in 2019 will persist through multiple economic cycles7. Curreht financial market conditions in the extended recovery phase after a reCession are accommodative to borrowers, but at the trough of each such cycle, financial conditions are likely to be less accommodating than they are at present. Besides exacerbating concerns about customer usage, low points in cycles bring additional financial stresses. At such times of stress in the banking and financial markets, the additional leverage implicit in a PPA will add to concern by both rating agencies and the capital market. Access to capital may suffer and cost may increase due to this leverage.
Lenders, bondholders, and financial counterparties view the fixed contractual payments of long-term PPAs as additional financial leverage for the power purchaser.
11. 2 Key Differences Between PPAs and Utility-owned Plants
There are some key differences in the financial support of PPAs and utility ownership options.
When a utility builds or purchases an asset, it finances ownership of the asset with actual debt and equity to fund the investment and to maintain a capital structure that will continue to give assurance to investors, rating agencies, regulators, and customers that the utility will maintain its financial integrity. The specific fufiding combination chosen will maintain key balance sheet, income statement, and cash flow ratios that are necessary to maintain the utilitys credit ratings. The decision to
7 In the past five decades, at least six US recessions have been identified with an average interval of eight years, suggesting approximately three market cycles from 2016 through 2038.
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00463 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 28 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 10 of 32 enter into a long-term asset ownership investment considers not only the costs of that investment, but also the impact the funding will have on future capital costs for the company. While this is a concern for the utilitys management, the utilitys customers and regulators also have an interest in the continuing financial health of , the utility so that it can provide reliable service and make needed investments in the future.
From the point of view of the utility, the ability to earn a "reasonable" return ori prudent investments generates earnings and, in particular, cash flóws, that enhance the utility's credit measures while compensating for the risk of asset ownership in regard to potential technological or demand changes and uncertainties about the assurance or timeliness of regulatory recovery.
At the same time, these earnings and cash flows related to the equity investment in rate base assets protect the customers interest in the financial integrity of the utility, not just in current economic circumstances but under less favorable circumstances (as discussed above), which may develop over the long asset life.
On the other hand, in financial terms a PPA is purely a long-term- series of cash outflows. From the viewpoint of the utility, its shareholders and its creditors, the best case is that the contract's cash outflows will be recovered fully from customers, generating no net earnings or cash flows. Absent a special regulatory mechanism, ,the PPA offers no opportunity for return to compensate for the risk undertaken by the utility as a committed purchaser. Nor does it generate net cash flows or returns which help maintain or improve the financial ratios for the utility and support its ability to access capital markets at reasonable rates under all conditions.
In summary, PPAs are appropriately viewed as a substitute for direct investment, with a corresponding burden of debt equivalence. Adding a PPA that is equivalent to debt will increase ETI's perceived financial leverage and will require an offsetting equity increase to maintain the prior capital structure of the utility at a prudent debt and equity balance. Absent specific efforts to ensure comparability, choosing a PPA resource does not provide the deliberate protection of financial integrity that occurs when a utility finances energy resources procured through asset acquisition or self- build.
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00464 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 29 of 50 H.O. Davey
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11.3 Current Rating Agency Treatment of PPAs
Fixed assets (and leases identified under GAAP standards currently in effect as "capital leases", alternately called "financing leases") are reflected on the balance sheet of the utility as both an asset and a liability (a debt-like obligation) and on the income statement with charges for amortization and interest expense.8
Under current GAAP, PPAs and operating leases do not appear on the balance sheet of the purchaser as asset or liability. They are reflected in the income statement as periodic capacity payments or lease rental expenses, unlike the entries on the income statement for= utility-owned resources. Thus, PPAs affect key published financial ratios of a utility differently than ownership af fixed assets.
Because financial ratios calculated with values derived directly from the audited financial statements in accordance with GAAP do not reflect the debt-like nature of the PPAs (unless the PPA is deemed to be a FAS 13 capital lease), rating agencies and credit analysts may adjust values from the audited GAAP accounting statements to reflect all or a portion of the value of the PPA contract as an imputed debt and the right to take power under the contract as an asset.
11.3 (a)Standard and Poor's Quantitative Analysis
In its rating criteria applied to utilities, Standard & Poor's (S&P) states the case for considering PPAs as financial obligations akin to debt:
We view long-term purchased power agreements (PPA) as creating fixed, debt-like financial obligations that represent substitutes for debt-financed capital investments in generation capacity. By adjusting financial measures to incorporate PPA fixed obligations, we achieve greater comparability of utilities that finance and build generation capacity and those that purchase capacity to satisfy new load. 9
Although S&P's statement is focused on making credit rating comparisons among companies with different proportions of owned assets or PPA obligations, the same logic applies to comparing competing proposals bid into this RFP.
In FAS No. 13/ ASC 840, the terms "capital lease" and "financing lease" are synonymous. Pursuant to FAS No. 13/ ASC 840, such leases give rise to full recognition of asset and liability and the asset balance is amortized on the income statement in a manner comparable to an owned asset. (Attachment No. 3). For a review of updated GAAP reporting standards that will alter the financial reporting of some PPAs deemed to be leases, see Section IV of this report,
9 S&P Credit Direct, "Key Credit Factors for the Regulated Utilities Industry", Nov. 19. 2013, paragraph 57. (Attachment No. 5)
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S&P applies its quantitative valuation of contracts consistently to all ublity sector companies with PPAs that involve identifiable capacity payments for the use of assets. The valuation method is summarized briefly below, and it is explained at greater length in Section III of this report.
In brief, S&P's analysts compute the present value of all fixed payments (capacity payments) over the life of the contract at a specified discount rate. S&P then applies a risk-weighting factor assigned by the rating committee to the present,value of the contractual payments. The risk factors vary from 0% to 100%, depeinding upon S&Pš confidence in the likelihood of full and timely recovery of the capacity charges from customers through a reliable regulatory mechanism. For example, ifthe power purchaser has no way to recover the contractual payments other than through the market price of energy sales, the risk weighting factor would be 100%,1 and the full present value of the contractual capacity payments would be deemed to be an addition to the company's debt. On the other hand, S&P assigns a risk factor of 0% for companies for which complete and timely recovery of the payments is assured by a legislated mandate and a reliable regulatory mechanism; typically, those utilities that were required by state statutes to divest all generation fall into this category. We observe that integrated utilities PPAs that do not have such strong regulatory assurance are assigned risk-weighting factors of 25% to 50% by S&P, depending on S&P's assessment of the opportunity for full and timely recovery of the capacity payments from customer billings.
If S&P's analysts assign a risk-weighting factor of 0%, 25% or 50% to a contract, the value of the additional debt recognized because of the PPA is 0, or 25% or 50% of the present value of capacity payments over the remaining life of the contract. An identical amount is assumed to be the value of the Right-of-Use (ROU) asset created by the PPA contract. When it determines an amount of additional debt related to a PPA; S&P characterizes portions of the capacity payments under the PPA as implied interest payments and implied charges for depreciation and amortization. These adjustments to the data from the audited financial statements affect the financial ratios that S&P uses in its credit rating process in various ways, as explained ins Section III. If the audited financial statements of a utility classify a PPA as a capital lease on the utilitys balance sheet with amortization reflected in the income statement, the S&P methodology would replace the capital lease reported in the financial stateinents to reflect the valuation of the contract at 0%, 25%, 50%, or ose and the 100% weighting, consistent with the other non-lease PPAs. The purpt effect of S&P's adjustments is to increase the comparability of the credit rating ratios of utilities using PPAs or leases to procure resources in relation to the ratios of utilities using owned resources.
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11.3 (b) Moody's Qualitative / Quantitative Akproach
The approach Moody's applies to contracts and leases of rate-regulated utilities is explained in a report on methodology published in 2013 and included in this report as Attachment 6.10 Moody's approach is sometimes qualitative and sometimes quantitative, rather than the more structured quantitative method applied by S&P. Unlike S&P, Moody's treatment differs if a PPA is deemed in GAAP financial statements as a capital lease, an operating lease, or a non-lease PPA.
Moodys always incorporates a debt-like equivalent for PPAs whenever, the PPA has the characteristics of either a capital lease or an operating lease (a's,k:letermined pursuant to GAAP accounting standards). When Moody's includes the lease-like PPAs as debt equivalents in credit rating ratios, Moodys does not apPly any risk- weighting discount, unlike S&P's practice of applying a risk-weighting factor that may reduce the debt equivalence. If a PPA is not deemed a lease for GAAP reporting, and Moody's analysts consider that there is no assurance of regulatory or contractual expense recovery, Moody's may accord the PPA full debt equivalence in their credit ratio calculations. In essence, whenever Moody's does reflect the PPA as a debt-equivalent, the effect is the same as S&P's 100% risk-weighting factor. Like S&P, Moody's views the cost recovery of PPA charges to be a source of potential risk that must be considered in its rating process.
When utilities have effective regulatory mechanisms or wholesale contracts that provide 'for the recovery of PPA costs, Moodys is not likely to give explicit debt equivalence to the PPA in their financial credit ratios. However, even so, Moodys analysts apply a qualitative assessment of the likelihood of full and timely recovery of the costs of the contract to their rating decision through channels of the rating process other than adjusted financial ratios. Moody's states in its report on rating criteria for rate-regulated electric and gas utilities:
In addition, we may consider that factors not incorporated into the accounting treatment may be relevant (which may include the scale of PPA payments, their regulatory treatment including cost recovery mechanisms, or other factors that create financial or operational risk for the' Utility that is greater, in our estimation, than the benefits received). When the accounting treatment of a PPA is a debt or lease equivalent (such that it is reported on the balance sheet. or disclosed as an operating lease and thus included in our adjusted debt calculation). we generally do not make adjustments to remove the PPA from the balance sheet. However. in relevant circumstances we consider making adjustments that impute a debt equivalent to PPAs that are
10 Moody's Investors Service, "Rating Methbdology: Regulated Electric and Gas Utilities", December 23, 2013. (Attachment No. 6)
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off-balance sheet for accounting purposes. Regardless of whether we consider that a PPA warrants or does not warrant treatment as a debt obligation, we assess the totality of the impact of the PPA 'on the issuer's probability of default. Costs of a PPA that cannot be recovered in retail rates creates material risk, especially if they also cannot be recovered through market sales of power.11 (Emphasis added.)
Moody's states that it considers several elements in its decision on the treatment of PPAs, including regulatory and price factors, as a qualitative influence in its rating reviews, as follows:
Moody's will examine on a case-by-case basis the relative credit risk associated with PPAs in comparison to plant ownership.12
In the same report, Moody's refers to several potential methods it blay use to quantify the debt characteristics of a PPA if those characteristics are not quantified and incorporated in the audited financial statements, ihcluding treatment as an operating expense, as debt based on a multiple of the required annual payment, or as debt calculated as the present value of future payments (not discounted by any specified risk factor). These options may give Moodys ratings analysts a degree of freedom that allows for differentiation of individual cases, but they do not lend themselves to a replicable evaluation of non-lease PPAs versus asset ownership, alternatives. .
In summary, Moody's analysis of the debt-like nature of purchased power contracts is both quantitative and qualitative with regard to PPAs that are identified in GAAP financial statements as capital leases or in the footnotes to financial statements as operating leases and those whose costs are not recoverable from customers by means of regulatory mechanisms or wholesale contracts. On the other hand, their analysis is qualitative and not quantitative with regard to other PPAs. The absence of a clear quantitative translation of the qualitative rating factors applied by Moodys makes Moodys approach difficult if not impossible to replicate for comparing PPAs with different characteristics. Therefore we deemed it not suitable for using in evaluating competing proposals in response to this ETI 2015 RFP.13
11 Ibid., p 58
12 Ibid., p. 59. " A third rating agency, Fitch Ratings, does not rate ETI or other Entergy affiliates. Fitch uses a mixed qualitative and sometimes quantitative approach, similar to Moody's. Like Moody's, Fitch treats PPAs that are recognized as capital leases or operating leases in GAAP financial statements as an equivalent to debt at their full value, not subject to• a weighting factor. Also, Fitch's rating criteria for operating leases state that PPAs with capacity payments may be deemed to be leases, in which case the full value of the PPA's debt equivalence would be added to the financial statements. Fitch indicates two ways to determine the equivalent debt amount: a multiple such as seven or eight times the required
14
00468 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 33 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 15 of 32
11.3 (c ) Other Means to Evaluate Debt Equivalence
A method that iš widely known and used in the financial markets is the approach used in GAAP financial statements to value certain types of leases known a's capital leases or financing leases pursuant to FAS No. 13 /ASC 840.14 In brief, under FAS No. 13, for any contracts that are defined as capital leases (including certain PPAs), the present value of contractually committed payments over the life of the contract is reported in audited financial statements as a lease-related debt and the identical amount is added to assets as a right-of-use (ROU) Asset. Unlike the S&P methodology:the FASB approach recognizes 100% of the present value of fixed payments as a debt and an asset and does not reduce that amount by applying a risk factor. There are some differences between the FASB approach I and S&P's methodology in the timing of the recognition of expenses over the term' of the lease or the contract. Like the S&P methodology for valuing PPAs, the FASB approach to leases is quantitative and systematic. Furthermore, it is quite authoritative. However, it does not apply to all PPAs, and is more narrowly focused on those contracts that effectively tie up the ownership benefits of a specific and„identifiable asset for all or nearly all of the economic life of the asset. Nonetheless, FASB's lease accounting standards provide a theoretical endorsement for the use of a present - value calculation that could be applied to all PPAs, including non-lease PPAs, based upon committed payments as the appropriate means to measure debt equivalence. Please refer to Section IV for a full discussion of FASB's lease accounting rules and the Accounting Standards Update No. 20162, Leases, Topic 842.
In a search of financial literature and in informal contacts with financial analysts, the authors did not learn of any other methods currently in use other than the quantitative PPA valuation approach used by S&P (present value of fixed payments reduced by a "risk factor"), the quantitative lease valuation approach in FASB lease accounting standards (full present value of fixed payments), and the mixture of qualitative and quantitative approaches employed by Moody's and Fitch Ratings. Many financial ahalysts in the debt capital markets and at banks are familiar with the S&P approach and use data and/or credit ratios supplied by S&P. Anecdotally, we understand that some fixed income and credit analysts simulate the S&P adjustments in their in-house financial models when reviewing utility financial annual payment or the present value of all future required capacity payments. In the case of non-lease PPAs, Fitch criteria state that their analysts apply qualitative judgment§ about the likelihood of full and timely recovery. We view Fitch as offering an approach similar to Moodys. Fitch Ratings, Special Report, Rating U.S. Utilities, Power and Gas Companies, March 11, 2014, and Special Report, Operating Leases, Aug. 5, 2011.
14 Similar to FAS No. 13 / ASC 840 currently in effect, FAS Accounting Standar& Update No. 16-2, Leases, Topic 842 effective in financial reports in 2019, will require ihe use of the present value of all future fixed payments to determine the initial value of a leak liability and asset, as explained more fully in Section IV.
15
00469 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 34 of 50 H.O. Davey
Exhibit EL-2 PUCT Do6ket No. 46416 Page 16 of 32 statements.
11.4 Conclusions
A method is needed to put PPA proposals and asset ownership alternatives on a more comparable basis when evaluating the available alternatives for supplying the future resource requirements under the 2015 RFP. Financial statements prepared in conformity with current GAAP accounting standards quantify clearly and consistently the debt-like character of a sub-set of contracts deemed to be*capital leases using a presenrvalue approach, but generally do not evaluate the debt-like quality of non-lease PPAs and do not help establish coMparability between the wide array of PPAs and asset ownership alternatives.15
For both theoretical and practical reasons suminarized in the following text and in Table 1 below, we recommend the use of a quantitative system that employs the present value of future fixed capacity payments to value the additional debt-like financial burden imposed by a PPA. We considered two alternative methods that are based on a present value approach and one alternative that mixes quantitative and qualitative methods. These are the alternatives considered:
A. The first alternative is to adopt, the present value techniques used by accountants and auditors to value capital leases for financial reporting and apply it to quantify the value of non-lease PPAs. All PPAs, Whether leases or non-lease contracts, would be initially valued with debt equivalence of 100% of the present value of all future fixed payments for capacity. This method will in fact .replicate the way that PPAs that are deemed to bd leases will actually be reported in ETI's audited,balance sheet beginning in 2019, which is likely to coincide with the operating lives of the contracts to be evaluated. It would also give a very large debt-like effect to non-lease PPAs.
B. The second alternative we considered is to adopt the S&P approach and apply that to all PPAs evaluated in the ETI 2015 RFP. This alternative imposes a lesser capital burden upon PPAs than the first option described above, because the present value of future capacity payments may be reduced by the application of a risk factor that is less than 100%. In the case of PPAs that are deemed to be leases, however, this approach t is likely to understate the amount of debt that would be reported on ETI's balance sheet if the contract is selected.
C. The Moody's/Fitch mixed qualitative and, quantitative approach is not
15 But see Section IV in this report regarding new GAAP lease accounting standards that 'Will' recognize debt and asset values for some but not all PPAs in audited financial statements.
16
0'0470 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 35 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 17 of 32
recommended for use in evaluating the results of the ETI 2015 RFP, because the qualitative aspects cannot be applied to the RFP PPAs in a manner that is systematic, transparent, and easily replicable.
Table 1 below summarizes these points regarding the comparison of the three methOdologies.
Table 1: Comparing PPA Valuation Approaches
A. Applying B. S&P FASB Lease PPA C. Moody's & Fitch Valuation to Valuation PPA Approaches all PPAs Approach Mixture of quantitative Quantitative Ye§ Yes and qualitative
PV times Mixed: Financial Present QuantitatiVe method used Weighting Value (PV) statement values; PV; Factor multiple of payments
Systemaiic and transparent Yes Yes No
Easily replicable Yes Yes No
Can be adapted to evaluate both PPAs yes Yes Not clear and leases
I Consistently applicable in future years Yes Yes Not clear
Applying the FASB lease valuation method to PPAs in general (Column A in Table 1) or adopting the S&P PPA valuation approach (Column B in Table 1) is based upon using the present value of future capacity payment obligations to represent the value of an asset and a liability. Both of these methodologies are systematic, transparent and easily calculable, and can be applied to any form or number of PPAs. Each of these methods represents and reflects a PPA as if it were an asset acquisition, permitting the comparison of asset ownership and PPA alternatives in a rational way. It can be applied subsequent to the selection of a PPA at any point during the lifespan of the confract, and it would render consistent result's. from year. . to year. 6ne difference between the two approaches is that applying the FASB lease valuation method would transform 100% of the prešent value of all PPAs into a debt
17
00471 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 36 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 18 of 32 equivalent value, and thus wOuld call for a very large equity infusion to rebalance the capital structure for that added debt.16 On the other hand, the S&P method would reduce the present value of capacity payments by a risk factor and thus reduce the amount of added debt and additional equity related to the PPA.
Some advantages of adopting the S&P approach are the following: • It is well-known and accepted by lenders and bondholders and within the financial community; • It is the methodology that will in all probability be applied by S&P in its future ratings of ETI. • S&P is an influential participant in the credit and bond market and in the investment markets in general. • This method 'represents and reflects a PPA as if it were an asset acquisition and has the benefit of replicating the impact of the PPA on all financial ratios of importance to the investors and rating agencies, including: cash flow to debt and earnings before interest and taxes (EBIT) to debt, cash flow coverage of interest as well as debt to equity or debt to total caOit:31.
After consideration of the alternatives, we recommend employing the general approach used by S&P to quantify the cost of a PPNs impact on ETI's capital structure and provide a framework for systematic .and consistent comparison among asset ownership and PPA alternatives. In addition, we recommend that a supplemental case be performed in which any PPAs that are likely to be classified as leases should be evaluated with a risk-weighting factor of 100%. Implementation of the recommended approach will be discussed in the following Section III.
llI Evaluating PPA Debt Equivalence and Cost of Capital implicatiOns
As is discussed in the prior section, ownership options such as utility self-build and asset acquisition from third parties will be analyzed with the assumption that the asset investment is funded using a mix of debt and equity financing that maintains a balanced and prudent capital structure. Entering into a PPA with debt-like characteristics will affect the financial risks of ETI as perceived by lenders, investors, and credit rating agencies, but it will only be quantified in financial statements prepared pursuant to GAAP accounting rules if the PPA meets the definition of a lease pursuant to the accounting standards update Leases, Topic 842. To compare the financial costs of the various options to be evaluated in the 2015 RFP, ETI will need to employ a consistent method for assessing the implicit capital it
16 For a discussion of the process of rebalancing the capital structure with additional equity and the corresponding reduction of other corporate debt, see Section 111.3.
18
00472 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 37 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 19 of 32 costs of PPAs in comparison with the more explicit capital costs of the ownership alternatives.
The prior section concluded with the recommendation to apply a method similar to that used by S&P to evaluate the debt equivalence and financial ratio impact of PPAs. This section provides a more detailed explanation of the implementation of that procedure.
HU Methodology S&P employs the following process to determine the equivalent amount of additional debt relating to a PPA with identifiable capacity payments. (A detailed numerical example is shown in Attachment 7):17
1. All forecasted future cash outflows for the capacity payment obligation of the PPA are determined for the expected term of the contract.
2. The cash outflows are discounted by a standard interest iate that S&P periodically revises based on market conditions. This produces the net present value of the expected future cash outflows.
3. For utilities regulated under cost-of-service regulation, a factor related to the risk of recovery of charges from customers is applied to the resultant net present value of these cash flows. The risk factor ranges from 0% to 100%.
a) A 0% factor is generally reserved for companies for which complete and timely recovery of the payments is assured by a legislated mandate and a reliable regulatory mechanism. Many companies falling in this group were required by their states to divest all generation.
b) For most utilities the adjustment factor ranges from 25% to 50%, based on the degree of assurance of complete recovery of all charges through the regulatory mechanisms employed. Generally, the risk adjustment factor is 50% for utilities dependent upon recovery through base rates and 25% for utilities whose cost recovery occurs through a separate regulatory adjustment clause with a reasonably high likelihood of recovery of all prudent PPA costs.
17 Attachment No. 5, S&P Credit Direct, "Key Credit Factors for the Regulated Utilities Industry", 2013, op. cit., paragraph 66. S&P has additional procedures for assessing debt equivalence to PPAs in which capacity charges are not explicit, but the 2015 RFP requires bidders to provide explicit capacity charges.
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00472 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 38 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 20 of 32
c) If there is no mechanism that assures recovery of the capacity payment from customer revenues and recovery is entirely dependent upon market conditions (for example, in wholesale polnier sales or a merchant power business), the risk factor would be 100% (no discount.)
4. S&P calculates the equivalent debt relating to the PPA as an increment of the net present value of cash outflows for capacity charges for the full life of the contract determined in step 2 above times the risk factor determined in step 3 above. The result is an equivalent debt balance relating to the PPA.
S. To balance liabilities with assets on the balance sheet the same discounted present value amount determined in step 4 is added to the asset side of the balance sheet as the value of contracted services.
6. Equity is not adjusted. The PPA is viewed as being debt-like, and does not bring along with it any intrinsic equity component.
7. S&P calculates an implied interest expense relating to the implied debt by multiplying the discount rate used in step 2 by the amount of implied debt (or average PPA imputed debt, if there is fluctuation of the level over the course of the year). This implied interest expense is added to the reported interest expense for the period.
8. S&P attributes an implied depreciation expense to the PPA. The implied depreciation component is determined as follows: multiply the relevant period's capacity payment by the risk factor and then subtract the implied PPA-related interest for that period.
9. The cost amount classified as implied depreciation is removed from operating cash flow and reclassified as capital spending cash flow, thereby increasing operating cash flow and funds from operations (FFO) for the purpose of S&P's credit ratios. As a result, the impact of PPAs on ratios based on operating cash flow and FFO measures is tempered.
10. A like amount of cash PPA capacity charges are removed, equal to the amount of the implied PPA interest expense and implied PPA depreciation. The sum of the implied interest expense and implied depreciation expense equals the entire amount of capacity payments on the PPA as reduced if a risk factor of less than 100% was applied in steps 3 and 4.
20
00474 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 39 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 21 of 32
S&P applies its approach consistently to PPAs in excess of one year, regardless of the contract duration. This makes sense to us because the method is transparent and consistent, and also because the present value of committed future capacity payments naturally assigns a lower value to those contracts with shorter duration than to contracts with a longer duration. For a contract with a shorter term (e.g., three years), the amount of imputed debt will be modest in relation to a contract with a term of twenty years.
The effect of S&P's adjustments is to add debt to the power purchaser's balance sheet and associated imputed interest and depreciation to the income statement, while removing the PPA capacity payment operating expense from 'the income statement This results in enhancing the operating cash flow relative to the operating cash flow reported in GAAP financial statements, because a portion of the capacity payment -has been reclassified as depreciation and amortization. The implied PPA debt amount is revalued quarterly or annually over the iterm of the PPA. The debt principal reduces over time as the present value of the remaining capacity payments decreases, becoming zero when the final contract payment is made. In S&P's credit analysis, these adjustments make the PPA look more like a utility-owned power plant, funded with debt only. With these adjustments, a utility will show a higher ratio of debt to equity and of debt to total capital than the ratio calculated based on values from the GAAP balance sheet, and its interest expense is increased.
111.2 Selection of the Discount Rate and Risk-weighting Factor
To implement this method for PPA evaluation, three inputs are needed: The cash Capacity payments or fixed payments required under the contract • i for all periods in the contract's term, derived by ETI from the proposals; • A disdount rate to perforrn the present value computation; • A risk-weighting factor.
For the discount rate, S&P uses a rate representing a c(3& of incremental long-term debt financing. In numerical exhibits in this report, we have used 5% as a very rough and simple approximation, for illustration.
To select a risk-weighting factor, we considered the criteria that S&P applies in its evaluations of utility PPAs, which is based on an interpretation of the applicable regulatory jurisdiction. According to S&P, it is their normal practice to assign a risk-weighting factor of either 25% or 50% to integrated utilities, depending upon the degree of assurance of complete recovery of all charges through the regulatory mechanisms employed in the jurisdiction. Generally, the risk adjustment factor is 50% for utilities dependent upon recovery through base rates, and 25% for utilities whose cost recovery occurs through a separate regulatory adjustment clause with a reasonably high likelihood of recovery of all prudent PPA costs.
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00475 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 40 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 22 of 32
We observe that ETI has several different recovery mechanisms in Texas. The energy charges relating to a PPA are likely to be recovered through a well- established energy and fuel cost recovery mechanism, with a degree of reliability and predictability that accords with S&P's 25% risk-weighting factor. However, the recovery of ETI's PPA capacity payments are not similarly asšured. ETI could avail itself of base rate recovery for the charges, or it could avail itself of a capacity charge recovery mechanism. Either of these methods, however, falls short of the assurance provided by the energy and fuel cost recovery mechanism, and could result in unrecoverable capacity payments. Therefore, Lapson Advisory concludes that the recovery of capacity charges under an RFP PPA may be represented by the 50% risk-weighting factor.
In the past several years, S&P has not provided any disclosure to the public nor to ETI regarding whether it currently applies a risk-weighting of.,25% or 50% for the evaluation of ETI's existing PPAs, and it is also possible that S&P analysts use a number between 25% and 50% to represent the dichotomy between 'the relative assurance of the recovery of contractual energy payments and the lack of assurance of recovering capacity payments. Lapson Advisory considers a 50% risk-weighting factor to be the most conservative choice from the viewpoint of capital markets investors with regard to safeguarding the financial condition of ETI. Running a sensitivity case that reflects a 50% risk-weighting factor as a back-up to the base case of 25% gives a sense of both the upper and lower bounds on the range of S&P's possible debt equivalence for the RFP PPAs. 111.3 The Cost of Rebalancing the Capital Structure
In order to place a PPA proposal on a comparable basis with non-PPA proposals during the evaluation, an adjustment should be made to the PPA proposal that captures the costs that would result if the utility took steps to restore the utility's original capital structure to the balance that existed prior to entering into the PPA. Absent such an adjustment, the evaluation would not reflect the full cost of the PPA.
The adjustment is an added cost to the PPA that is based on the implied increase in equity and a similar reduction of debt to rebalance the additional debt related to the PPA in the utilitys total capital structure. Every dollar of equity added in the rebalancing transaction provides cash that can be used `to displace a dollar of debt elsewhere in the capital structure. For example, let's assume that a utility whose authorized and actual capital structure is 50% equity and 50% debt enters into a PPA with a $20 million implied equivalent debt level (after apPlying any relevant risk-weighting factor). To offset this $20 million increase in debt, the utility must reduce other corporate debt by $10 million and increase equity by $10 Million, thus reducing a portion of the additional $20 million of implied PPA debt and restoring the originally desired capital structure (see table 2 below.). The cost of this added $10 million of equity minus the cost of the displaced debt is the additional c4ital cost imposed by the PPA.
22
00476 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 41 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 23 of 32
Table 2: Rebalancing the Capital Structure
Utility ABC, before PPA Liabilities & Assets Equity Various assets 400 Debt 200 50% Equity 200 50% Total Assets 400 Total Capital 400 100%
Utility ABC, after adding PPA at present value of $10 Various assets 400 Debt plus PPA 220 52.4% PPA Contract ROU* 20 Equity 200 47.6% Total Assets 420 Total Capital 420 100.0%
Utility ABC, after rebalancing capital structure Various assets 400 Debt plus PPA , 220 Less: debt PPA Contract* 20 -10 reduced 210 Total debt 5b%
Original Equity 200 Plus: added 10 equity Total Equity 210 50% Total Assets 420 Total Capital 420 100%
* Present value of capacity payments of $80 x risk-weighting fa' dor of 25%.
It has already been noted that the self-build or asset purchase options are analyzed based on an assumption that the acquisition will be funded with a mix of debt and equity that retain a reasonable and prudent capital structure. Thus, the cost of capital is built into their evaluation. Evaluating the debt equivalence of a PPA and calculating the adjustments to reduce debt and increase equity needed to rebalance the capital structure as illustrated in this section will put the PPA alternatives and asset ownership alternatives on a more comparable footing as to true costs. The example in Table 3 below shows the effect of the capital rebalancing adjustments on the cost of capital and utility revenue requirements attributable to the hypothetical case shown in Table 2.
Table 3: impact of PPA on the Cost of Capital
impact of PPA on Cost of Capital PPA Capacity Payments, 20 years present value $80 Times risk-weighting factor 25% $20
23
00477 Eversource Energy, D.P.U. 20-16 National Grid, D.P.U. 20-17 Unitil, D.P.U. 20-18 Exhibit Att. AG 2-25(b) May 18, 2020 Page 42 of 50 H.O. Davey
Exhibit EL-2 PUCT Docket No. 46416 Page 24 of 32
Restore Capital Structure: Equity 50% $10 Debt 50yo ($10) After-tax cost of equity 9.80%
Tax Rate 35% 1-tax rate 65% Pre-tax Revenue effect of equity 15.08% Pre-tax impact debt eliminated -5.0% Impact on Revenue Requirement: Added equity $1.51 Debt eliminated (displaced) -$0.50 Net Impact on Revenue Requirement $1.01
Attachment 7, Schedule 7.1A demonstrates in greater detail the application of this approach to determine the debt equivalence of a PPA at a 25% risk weighting factor, and Schedule 7.1B compares the results for three risk weighting factors of 25%, 50%, and 100%. Schedule 7.2A demonstrates the process of calculating the amount of the theoretical equity requirement to rebalance the capital structure when a risk weighting factor of 25% is applied to the PPA and the cost of capital associated with rebalancing, and Schedule 7.2B compares the results for risk weighting factors of 25%, 50%, and 100%. The 25% or 50% weighting factors shown in Schedules 7.1B and 7.2B are presented because they are indicative of the upper and lower debt equivalence boundaries for proposals deemed to be PPAs but not leases: The 100% weighting factor is shown because it is comparable to the recognition of an explicit balance sheet liability for a PPA identified as a lease, whether a finance or operating lease, that will be required for financial reporting beginning in 2019, as explained in Section IV.
Table 4 analyzes data from Attachment 7 and illustrates the actual scale of the equivalent debt leverage that could he added to a utility conwarable, to ETI as a consequence of a PPA resulting from the 2015 RFP. The table shows the computed debt to total capital and equity to total capital before entering into a PPA (Year 0) and then on a pro forma basis immediately after entering into a contract with a term of 20 years and assumed annual capacity payments of $100 million per annum. The effects are shown at weighting factors of 25%, 50%, and 100%. Prior to the PPA commitment, the utility's total corporate debt to total capital is 50%; upon entering into the PPA, the ratio of corporate debt plus PPA liability to total capital would range from 57% at a 25% risk weighting of the PPA commitment, to 70% at a risk weighting of 100%. 18
18 Using the S&P methodology, debt leverage relating to any PPA is at its maximum in Year 1 of the contract and generally diminishes slightly with the payment of eachcapaCity payment over the term of the contract However, for a PPA deemed to be a finance lease, the
24
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Exhibit EL-2 PUCT Docket No. 46416 Page 25 of 32
Table 4: Impact of PPA on Corporate Debt Leverage
Pro Forma Debt Leverage with Recognition of PPA Liability ($ Millions) Prior to PPA, Pro Forma, at Enfry into PPA (a)
Year 0 At risk weightings of: 25% 50% 100% Equity 960 960 960 960 Debt (b) & PPA Liability 960 1272 1583. 2206 Total Capital 1920 2232 2543 3166 Equity to Total Capital 50% 43% 38% 30% Debt & PPA to Total Capital 50% 57% 62% 70% Increment +7% +12% +20%
Notes:
(a) Present Value PPA Liability at risk weightings of 25%, 50% and 100% derived from Attichment 7, Schedule 7.1B. (b) Based on Attachment 7, Schedule 7.2A. Initial equity and corporate debt in Year 0 roughly approximate that of Entergy Texas, Inc. at Dec. 31, 2015, excludink special tariff-backed obligations of a special purpose entity ($500 million).
111.4 Applying Debt and Equity Adjustments in the Project Evaluation Process
Analysis of debt equivalence of PPAs and quantitative comparison of asset ownership alternatives and PPAs should be applied at the time of bid evaluation and selection. Selecting PPAs without regard to potential future capital or financial costs, based on the assumption that those irnplications would only be considered much later, after project selection and completion, possibly in the context of a future rate case, would likely result in the selection of a resource that is ultimately more costly to customers. ,
Although the effects On capital costs can only be estimated or -projected in an approximate manner in advance, it would be a serious mistake to avoid making any estirnates of such capital costs because the costs are not "known and peasurable" for historical test periods.
Failing to estirnate such capital costs and capital structure effects would deprive
required accounting treatment under the revised FASB lease accounting standards Leases, Topic 842 results in the progressive reduction of shareholders equity in the first half of the lease term, as illustrated in the Work Paper WP No. 2.
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Exhibit EL-2 PUCT Docket No. 46416 Page 26 of 32 decision makers of important information relevant to future costs that are likely to affect customers and the utility. A more costly alternative may be chosen due to the imbalance in the data provided. Most of the inputs (costs or volumes) used to calculate the estimated future impacts of competing proposals over future years are forecasted values; there is no reason to make estimates and forecasts of all types of operational factors and fail to make any forecasts regarding capital costs and impacts upon the utility's financial condition. Making forecasts is essential to all planning processes, including project selection. •
Applying forecasted capital costs of PPA's or leases at the time of the evaluation and selection of energy resources is a vital step in prudent utility management
111.5 Conclusions Applying an adjustment for the cost of implied debt and equity in the process of PPA contract evaluation is a proxy for future impacts of individual contracts on utility capital costs that is both necessary and prudent. The numerical examples provided in Table 4 in this Section III illustrate that when credit analysts and a credit rating agency such as Standard & Poors apply debt equivalence to PPAs, it is likely to result in a material deterioration of the company's equity to capital ratio and an expansion of the perceived debt leverage. Implementing the recommended methodology for valuing the debt equivalence of the RFP PPAs and thus determining the related cost of rebalancing the capital structure to compensate for the debt-like character of individual PPAs in their evaluation is a reasonable and practical approach and a necessary part of the evaluation process. Applying a valuation of the implied additional debt and the resulting amount of equity needed to rebalance the capital structure does not prejudge decisions that the PUC Texas will make in the context of rate proceedings if one of the RFP PPAs is selected through the selection process.
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Exhibit EL-2 PUCT Docket No. 46416 Page 27 of 32 iv. New Lease Accounting Standards
Rid Impact of Topic 842 on Financial Statement Presentation of PPAs
FASB published its new leasing guidelines (Leases, Topic 842) on February 25, 2016 to take effect for financial reporting starting in 2019. The new standards will require recognition on the purchaser'S balance sheet of the cothmitments under PPAs that are, or contain, a lease. This will result in balance sheet reCognition for many PPA arrangements that would be off-balance sheet under the current financial reporting guidelines (formerly identified as FAS No. 13, now ASC 840). All leases (with minor exceptions), including those that were, or would have been,:classified as operating leases under the standards of FAS No.13 / ASC 840, will in the future be - reported and included on the balance sheet 19
Also, the definition of which PPAs are or contain a lease will change: The Accounting Stahdards Update report states:
Topic 842 [the updated leasing standard] defines a lease as a 'contract or part of a contract, that conveys the right to control the use ?if identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. Control over the use of the identified asset means that the customer has both (1) the right to obtain substantially all of the economic benefits from the use of the asset and (2) thb right to direct the use of the asset.20
Leases, Topic.842 gives examples of what types of PPAs will be considered leases (see Attachment 3, Leases, Topic 842, pages 57-60, Sections 842-10-55408 to 123).
Under the revised standards, contracts with terms of greater than twelve months that meet the conditions that define a lease will be capitalized on the balance sheet by recognizing a ROU asset and a lease liability. The entire present value of the portion of PPA payments determined to be minimum lease payments is recorded as lease liability without any adjustment for a risk-weighting factor. Accordingly, for all power purchasers with a risk-weighting factor less than 100% (such as ETI),_a- contract that is deemed to be a lease will result in higher reported debt-like obligations on the balance sheet in each period than would be the case with the imputed debt using S&P's adjustment.
Leases, Topic 842 makes a distinction between "operating leases" and "finance leases." Both operating leases and finance leases must be reported on'the balance
19 Leases, Topic 842 contains detailed transition rules regarding whether and how a pre-2019 contract would be subject to the new rules. 20 FASB Accounting Standards Update No. 2016-02, February 2016, Leases, Topic 842, page 30.
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sheet by the capitalization of an ROU asset and recognition of a lease liability. However, the effects upon the timing of recognition of lease expenses and the presentation of cash flows for operating leases and finance leases will differ.
. For the purpose of Lapson Advisory's recommendations on debt equivalence levels, these distinctions between finance and operating leases regarding expense and cash flow reporting are not relevant.21 While the balance sheet impacts of any PPA that qualifies as a lease under Topic 842 are sufficient in and of themselves to support the recognition of debt equivalence in evaludting PPAs, the additional effects on cash flow and expense reporting if a PPA is identified as a finance lease could result in additional negative consequences in the investment market.. In summary, classification of a PPA as either an operating lease or a finance lease will result in the recognition of a lease liability on the balance sheet of the purchaser/lessee, which šupports the condition in the ETI RFP (Sec. 6.1.5) that proposed PPAs that result in balance sheet recognition of a long-term lease liability are not acceptable to ETI. The PPA condition is a' reasonable and prudent way to protect ETI's financial strength and future access to credit and debt markets on favorable Willis, for the benefit of customers.
1V.2 lrnplications For Future Access To Capital, Credit Ratings, and Cost Of Capital
Investors future reactions to the appearance of PPAs that are deemed to be leases as long-term liabilities on the balance sheet of the purchaser are unclear at the present time, and possibly will not be known until late 2019 or 2020 (when investor's will have seen financial statements reflecting the effects of the new rule), or even later. Although Moodys has stated that it will not change any 'ratings as a reSidt of this acCounting change, it is not clear if Moodys decision will persist over time or instead applies only to the initial adoption of the accounting change.
While the new lease standard has been under discussion for some years, there was continuing uncertainty concerning the final rules, and the fact that theSe rules will not take effect until 2019 has allowed market participants to put off decisions on how they will respond to the new disclosure. One indicative precedent is that investors currently accept at face value the transactions determined to be finance leases (capital leases) pursuant to the existing lease accounting standard ASC 840, formerly FAS No. 13; the financial statement presentation of such arrangements on a lessee's balance sheet, income statement, and statement of cash flows are accepted as reported in audited financial statements (consistent with the methods of Moodys, Fitch, and reporting models supplied to banks and investors by financial information services, for example). If investors and financial analysts apply a similar acceptance of the audited financial data for arrangements identified as leases
21 Additional information regarding the potential financial reporting impacts of a PPA deeined to be either an operating lease or finance lease pursuant to the new accounting standards is provided in accompanying work papers WP No. 1 and WP No. 2.
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pursuant to the new accounting standard, then utilities with significant PPA obligations reported on-balance sheet as leases are likely to be viewed as having more financial leverage and thus more risky.
Lapson Advisory expects that credit rating agencies will publish guidance on the impact on their rating methodology in the near future. The initial publications by the rating agencies are likely to reassure investors that regardless of the changes in financial reporting, the agencies will not make any ratings changes '(unless new information emerges as a result of increased disclosure), since the economic essence of a transaction will not be altered by a change in financial reporting disclosure. However, even after the initial publication of rating agency reactions, the rating agencies treatment may well evolve over a number of years, given the long terms of the PPAs that will be deemed to be finance leases.
Whatever the treatment initially adopted by the credit rating agencies, it is unknown to what extent existing and potential equity and bond inVetors, banks, and other lenders will give weight to the recognition in audited financial statements of the PPAs deemed to be finance leases, following the accounting, rather than calculating adjustments to remove the on-balance "sheet debt and 'convert the associated implied interest and amortization back into the form' of a more traditional PPA.
For PPAs with a life as long as twenty years, the contracts will extend over several credit market cycles, and it is unknown what adverse impacts will result from the appearance of the lease liability (and in the case of finance leases, interest expense) in the reported financial statements during any future period of stress in the credit markets.
ETI's financial condition, while certainly adequate, is not unassailably strong. For example, on June 6, 2016, S&P announced that it lowered ETI's Stand-Alone Credit Profile score from bbb' to bbb-', in consideration of weak financial measures and the expectation that the credit ratios would remain'depressed for the next several years. At the same time, S&P affirmed ETI's issuer credit rating of 'BBB: and ratings outlook, which are based upon the credit strength of the Entergy parent "and affiliates. In contrast, the Stand-Alone Credit Profile score represents S&P's assessment of ETI's individual financial condition, absent parental support. (See Attachment No. 8, S&P RatingsDirect Research Update,, "Entergy Texas Inc. Ratings Affirmed, Outlook Still Positive; Stand-Alone Credit Profile Score Weakens to bbb-".) In the light of the concern about ETI's stand-alone credit profile, ETI should not ignore the potential adverse impact of additional debt leverage that 'could result from the recognition of lease obligations in ETI's future financial statements.
Given the uncertainties discussed in this section, ETI prudently specified in its 2015 RFP that contracts that would result in the recognition of a long-term liability due to lease accounting would not be acceptable; emphasizing the importance of that condition, ETI asked bidders to attest that their proposals would not result in
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Exhibit EL-2 PUCT Docket No. 46416 Page 30 of 32 recognition of a long-term liability associated with the contract. Lapson Advisory recommends that ETI reject any PPA submissions in response to the RFP that would cause the PPA to be recognized as a lease under the new accounting standards, or would otherwise result in recognition of a long-term liability, in consideration of the uncertainty regarding the potential adverse long-term effect of additional perceived debt lèverage in audited financial statethents.
In the event that ETI decides to include any such lease in its contract evaluation process, Lapson Advisory recommends that an additional sensitivity case be performed using 100% debt equivalence for the contract. This scenario will be a reasonably accurate forecast of the expected balance sheet presentation of the transaction. The effect of the new accounting treatment on the views of rating agencies, investors, and lenders over the life of the lease cannot be fully anticipated at present and cannot be mitigated, and the 100% sensitivity case represents the reality of how such contracts will affect debt and debt-like obligations on the company's published financial statements for 2019 and thereafter.
V. Recommendations
ETI must evaluate and compare the economic features of PPAs bid into the ETI 2015 RFP versus asset ownership options. That is only possible if the PPAs and asset ownership alternatives are put into a comparable framework. We recommended in our summary report and continue to recommend making adjustments to the RFP PPA bid evaluations to estimate the RFP PPAs debt equivalence and the capital costs of rebalancing ETI's capital structure. Section III of this report sets forth a recommended methodology to adjust the RFP PPAs that are evaluated.
Principle's of prudent utility management require ETI to evaluate all the costs including capital costs (implied debt and equity requirements) and impacts upon ET1's future financial strength that will result from the debt-like nature of long-term PPA contracts. Only by considering those effects on capital structure can ETI fairly and reasonably make comparisons on an equivalent basis among different types of RFP PPAs (including those that will be deemed to be leases for financial reporting) and between PPAs and ownership alternatives.
V.1 Base Case: 25% Debt Equivalence
As a base case, and consistent with our earlier summary report, Lapson Advisory recommends that ETI calculate the debt equivalence of RFP PPAs by determining the present value of fixed payments under the contract and applying a risk- weighting factor of 25%.
The explanation for the 25% risk-weighting factor is presented in Section 111.2. In Lapson Advisory's view, the 25% risk-weighting is near the lower end of the range
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of debt equivalence relating to the PPA contracts to be evaluated. This risk- weighting is one that S&P has applied in regulatory jurisdictions where there is not a strong legislative mandate for cost recovery of contract 'costs, but there are reasonably good regulatory cost recovery mechanisms. This is generally the case for ETI's energy commodity charges under PPA contracts, although ETI's opportunity to recover the capacity payments under PPA contracts does not provide comparable assurance as to the full recovery of all charges.
The recommended methodology is consistent with S&P's approach, which is well known and well regarded in the financial community.
Lapson Advisory recommends that this base case debt equivalence should be applied to all RFP PPAs evaluated, regardless of their duration, including any that may require,financial statement recognition as leases and are addressed in section V.3 below and in Section IV of this report.
V.2 Sensitivity Case: 50% Debt Equivalence
Consistent with our earlier summary report we recommend applying•a 50% debt equivalent sensitivity case. The reason for applying a sensitivity case with 50% debt equivalence to all PPAs is that the Public Utility Commission of Texas's methods for the recovery of capacity charges related to the PPAs is less assured than that of other states that S&P typically accords a 25% risk-weighting factor, and considerably less assured as to amount and timeliness than the recover-3i mechanism the PUCT applies to energy payments under the PPAs.
This sensitivity c.ase should be applied to all long-term capacity purchase or lease contracts that are evaluated, including any that require financial statement recognition as leases and are addressed in item 3 below and in Section IV. Lapson Advisory views the 50% risk-weighting factor as the upper bound of the range of debt eqaivalence for all PPAs except those that are deemed to be leases.
V.3 Sensitivity Case: Leases
For the reasons explained in Section IV, and consistent with the recommendations in our previous summary report, Lapson Advisory recommends that ETI should not enter into contracts that are structured in a way that is likely to result in the application of lease accounting under the new financial accounting standards Update 2016-2 (Leases, Topic 842). This recommendation is consistent with the terms of ETI's 2015 RFP solicitation. Application of a sensitivity case of 100% debt equivalence will replicate the treatment of the PPA in ETI's balance sheet reporting in the years 2019 and beyond. It is an appropriate way to reflect future financial reporting in audited financial statements and the uncertainty about any future adverse impact that such reported debt exposure may exert on ETI's access to
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Exhibit EL-2 PUCT Docket No. 46416 Page 32 of 32 capital and cost of capital in the future over the maximum term of 20 years.
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