OTS Statement No. 1 Witness: Kevan L. Deardorff Date: June 29, 2004 PENNSYLVANIA PUBLIC UTILITY COMMISSION v. PPL ELECTRIC UTILITIES CORPORATION Docket No. R-00049255 Direct Testimony of CO m o rn 33> Kevan L. Deardorff •—i I—\ m > - CD O m Office of Trial Staff CO CD x» < cr up m m o > cn cr Concerning: Rate of Return 1 Q. PLEASE STATE YOUR NAME AND BUSINESS ADDRESS. 2 A. My name is Kevan L. Deardorff. My business address is P.O. Box 3265, 3 Harrisburg, Pa. 17105-3265. 4 5 Q. BY WHOM ARE YOU EMPLOYED AND IN WHAT CAPACITY? 6 A. I am currently employed by the Pennsylvania Public Utility Commission as a 7 Fixed Utility Financial Analyst. I am assigned to the Office of Trial Staff (OTS) 8 as an expert witness. 9 10 Q. WHAT IS YOUR EDUCATIONAL AND PROFESSIONAL 11 BACKGROUND? 12 A. I have prepared this information in Appendix A supplementing my direct 13 testimony. 14 15 I. Subject of Testimony 16 Q. PLEASE IDENTIFY THE ISSUES THAT ARE ADDRESSED IN YOUR 17 TESTIMONY. 18 A. The issues addressed in my direct testimony concern rate of return, including the 19 cost of common equity, and the overall fair rate of return for the PPL Electric 20 Corporation ("PPL" or "Company"). 1 Q. DOES YOUR DIRECT TESTIMONY INCLUDE AN EXHIBIT THAT 2 SUPPORTS YOUR RECOMMENDATIONS WITH RESPECT TO A FAIR 3 RATE OF RETURN? 4 A. Yes. OTS Exhibit No. 1 presents the analyses that I have conducted regarding rate 5 of return. 6 7 II. Background Discussion 8 Q. HOW DOES THE RATE OF RETURN COMPONENT FIT WITHIN THE 9 REVENUE REQUIREMENT FORMULA? 10 A. The revenue requirement formula is as follows: 11 RR = E + D+T + (V-d)xR 12 Where: 13 RR = Revenue Requirement 14 E Operating Expense 15 D Depreciation Expense 16 T Taxes 17 V Gross Rate Base 18 d Accrued Depreciation 19 R Overall Rate of Return 20 In the above formula, the rate of return is expressed as a percentage. The 21 calculation of that rate is independent of the determination ofthe appropriate rate 22 base value for ratemaking purposes. As such, the appropriate total dollar return is 1 dependent upon the proper computation of the rate of return and the proper 2 valuation ofthe Company's rate base. 3 4 Q. WHAT CONSTITUTES A FAIR AND REASONABLE OVERALL RATE 5 OF RETURN? 6 A. A fair and reasonable overall rate of return is one which will allow the utility the 7 opportunity to recover those costs prudently incurred by all classes ofcapital used 8 to finance the rate base during the prospective period its rates will be in effect. 9 The Bluefield Water Works and Hope Natural Gas cases of 1923 and 1944, 10 respectively (cited below), set forth the principles that are generally accepted by 11 regulators throughout the country as the appropriate criteria for measuring a fair 12 rate of return: 13 A public utility is entitled to such rates as will pennit it to earn a 14 return on the value ofthe property which it employs for the 15 convenience ofthe public equal to that generally being made at the 16 same time and in the same general part ofthe country on 17 investments in other business undertakings which are attended by 18 corresponding risks and uncertainties; but it has no constitutional 19 right to profits such as are realized or anticipated in highly profitable 20 enterprises or speculative ventures. The return should be reasonably 21 sufficient to assure confidence in the financial soundness of the 22 utility and should be adequate, under efficient and economical 23 management, to maintain and support its credit and enable it to raise 24 the money necessary for the proper discharge of its public duties. A 25 rate of return may be reasonable at one time and become too high or 26 too low by changes affecting opportunities for investment, the 27 money market and business conditions generally. 1 Bluefield Water Works & Improvements Co. v. Public Service Comm. ofWest Virginia, 2 262 U.S. 679, 692-93 (1923). 3 4 It is important that there be enough revenue not only for 5 operating expenses but also for the capital costs ofthe 6 business. These include service on the debt and dividends on 7 the stock. By that standard the return to the equity owner 8 should be commensurate with risks on investments in other 9 enterprises having corresponding risks. That return, 10 moreover, should be sufficient to assure confidence in the 11 financial integrity ofthe enterprise, so as to maintain its credit 12 and to attract capital. 13 14 FPC v. Hope Natural Gas Co.. 320 U.S. 591, 603 (1944). 15 While interpretations of these excerpted citations may vary somewhat, they 16 provide general guidelines for the regulator to determine a fair rate of return. 17 18 Q. WOULD YOU PLEASE EXPLAIN HOW YOU CALCULATED YOUR 19 OVERALL RATE OF RETURN? 20 A. Yes. The overall rate of return in this rate proceeding is calculated using the 21 weighted average cost of capital method, which is the interaction of the following 22 components: the percentage of long-term debt; the percentage of common equity; 23 the cost of long-term debt and the cost rate of common equity. First, it is 24 necessary to determine the proportion of each type of capital (referred to as the 25 capital structure) which has financed the rate base and assign the appropriate cost 26 rate to each. The cost rate of debt is fixed and can be computed accurately. The 27 cost rate of common equity is not fixed and is much more difficult to measure. 1 The overall rate of return is then calculated using the proportions of capital 2 and cost rates for each type ofcapital. OTS Exhibit No. 1, Schedule 1, demon- 3 strates the interaction of the capital structure and the cost rates of each type of 4 capital. By multiplying each capital component's capital ratio by its associated 5 cost rate, a weighted cost rate is derived for each capital component. The overall 6 rate of return is the sum of weighted cost rates. 7 8 IIL Company Position 9 A. Summary 10 Q. WHAT IS THE COMPANY'S RATE OF RETURN CLAIM IN THIS 11 CASE? 12 A. Mr. Paul R. Moul, the Company's cost ofcapital witness, recommended the 13 following rate of return for PPL: 14 15 Weighted 16 Capital Cost Cost 17 Structure Rate Rate 18 (%) (%) (%) 19 Long-Term Debt 51.30 6.43 3.30 20 Preferred Stock 1.83 6.19 0.11 21 Common Equity 46.87 11.50 5.39 22 Total 100.00 8.80 23 24 Source: PPL Exhibit PRM-1, Page 1, Schedule 1. 1 B. Basis 2 Q. WHAT IS THE BASIS FOR PPL'S CLAIMED CAPITAL STRUCTURE? 3 A. At Page 19 of PPL Statement No. 9, Mr. Moul states that it is appropriate to use 4 the capital structure of the Company for rate making purposes since the Company 5 raises its own debt and preferred stock directly in the capital markets. The 6 Company's estimated capital structure at December 31, 2004, consists of 51.30 7 percent long-term debt, 1.83 percent preferred stock, and 46.87 percent common 8 equity. Mr. Moul also believes that this prospective capital structure reflects all 9 know changes that will occur during the course of the future test year and 10 considers conditions that will exist during the period of time the proposed rate will 11 be effective. 12 13 Q. WHAT IS THE BASIS FOR PPL'S COST OF DEBT CLAIM? 14 A. The calculation of PPL's cost rate of long-term debt is shown on Mr. Moul's 15 Schedule 7, Page 13. The long-term debt cost rate of 6.43 percent is a weighted 16 cost rate based on PPL's debt issues expected to be outstanding at December 31, 17 2004. This estimated cost rate includes the maturity and early redemption of a 18 total of 130.6 million of long term debt and the recognition of the call premiums 19 on the early redemption of the high cost debt. 1 Q. WHAT IS THE BASIS FOR PPL'S COST OF PREFERRED STOCK 2 CLAIM? 3 A. The calculation of PPL's cost rate of preferred stock is shown on Mr. Moul's 4 Schedule 8, Page 16. The preferred stock cost rate of 6.19 percent is a weighted 5 cost rate based on PPL's preferred stock issues expected to be outstanding at 6 December 31,2004. 7 8 Q. WHAT IS THE BASIS FOR PPL'S COST OF EQUITY CLAIM? 9 A. Mr. Moul summarizes his cost of equity analysis on Pages 3 through 5 of PPL 10 Statement No. 9, wherein he recommends that an 11.50 percent common equity 11 cost rate be used in this proceeding. To determine his cost of common equity, Mr. 12 Moul states that he relied upon four well-recognized measures: the Discounted 13 Cash Flow (DCF), the Risk Premium (RP), the Capital Asset Pricing Model 14 (CAPM), and the Comparable Earnings (CE) approach. He applied the DCF and 15 the CAPM methods to a group of nine electric companies referred to as the 16 "Electric Group" and a group of eight natural gas companies referred to as the 17 "Gas Group". The RP results were derived from common equity returns for the 18 S&P Public Utility Index and long-term debt returns for the Public Utility Bond 19 Index.