ML19308A393

Testimony in Response to Tx Utils Generating Co & Houston Lighting & Power First Set of Interrogatories

ML19308A393
Person / Time
Site:	South Texas, Comanche Peak
Issue date:	06/30/1978
From:	Solomon J CAROLINA POWER & LIGHT CO.
To:
Shared Package
ML19208C305	List: ML19208C304 ML19208C306 ML19208C308 ML19208C310 ML19208C312 ML19208C314 ML19208C315 ML19208C322 ML19308A389 ML19308A390 ML19308A391 ML19308A392 ML19308A393 ML19308A398 ML19308A399 ML19308A400 ML19308A401 ML19308A402 ML19308A403 ML19308A404 ML19308A405 ML19308A406 ML19308A407 ML19308A409 ML19308A410 ML19308A412 ML19308A413 ML19308A414 ML19308A415 ML19308A416 ML19308A417 ML19308A418 ML19308A419 ML19308A420 ML19308A421 ML19308A422 ML19308A423 ML19308A424 ML19308A425 ML19308A426 ML19308A427 ML19308A428 ML19308A429
References
ER77-485, NUDOCS 7909260097
Download: ML19308A393 (10)

Text

CAROLINA POWER & LIGHT COMPANY c-ve~m '-

, FERC DOCKET NO. ER77-485

. PREPARED TESTIMONY OF J. BERTRAM SOLOMON

( 1Q PLEASE STATE YOUR NlL2!E AND ADDRESS.

2 3A My name is J. Bertram Solomon. My business address is 1000 Crescent 4 Avenue, N.E. , Atlanta, Georgia 30309.

5 6Q PLEASE OUTLINE YOUR FORMAL EDUCATION.

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' 8A I received the degree of Master of Business Ad=inistration from Georgia 9 State University in 1973. My area of concentration was Finance. I 10 also received the degree of Bachelor of Science in Industrial Manage-11 ment from the Georgia Institute of Technology in 1972, 12

( 13 Q PLEASE STATE YOUR PROFESSIONAL ENPERIDiCE.

14 15 A As a Cooperative student at Georgia Tech, I gained approximately two 16 years' work experience as an assistant engineer in an industrial 17 production setting. After my graduation from Georgia Tech in 1972, 18 I worked approximately one and one-half years as a program manager for

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19 a management consulting firm and for another one and one-half years 20 as a project analyst for a resort development firm. I was employed 21 by the Southern Engineering Company of Georgia, my present ecployer, 22 in January 1975. Since that time, I have had assign =ents in both the 23 retail and wholesale rate departments of my Company, primarily in 24 the area of electric utility rates. In the retail area I have partici-25 pated in the preparation of rate increase filings for both G & T and

( 26 27 distribution rural electric membership cooperatives as well as the determination of revenue requirements and the proper rate design for 28 unregulated rural electric membership cooperatives. My. primary activi-29 ties, however, have been in the wholesale area where I have partici-20 pated in the analysis of approximately one and one-half dozen Federal 31 Energy Regulatory Co- 4 ssion filings of private utilities operating in 32 cight different states. I also participated in the preparation of 33 testimony and exhibits for several of these rate filings. Additionally, 34 I have participated in the preparation of retail and wholesale allo-35 cated cost of service studies and power cost projections.

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( 37 Q HAVE YOU EVER TESTIFIED IN OTHER C0511SSION PROCEEDINGS?

38 39 A I have testified before the Federal Energy Regulatory Co= mission in 40 proceedings involving the Public Service Cocoany of Indiana, Docket 41 No. "R76-149; Georgin Power Company, Docket Nos. E-9091, E-9521 and 42 ER76-587; and Carolina Power & Light Company, Docket No. ER76-495.

43 I have also testified before the Public Service Co==ission of Kentucky 44 and the Texas Public Utility Co==ission in both wholesale and retail 45 rate proceedings.

46 47 Q BY WHOM IS SOUTHERN ENGINEERING COMPANY OF GEORGIA RETAINED IN THIS 48 PROCEEDING?

49 50 A Southern Engineering is retained by North Carolina Electric Membership k

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k Corporation and Four County Electric Meet .rship Corporation (Coopera-( l 2 tive Intervenors). Witness Gross and I will be the Cooperrtive Inter-3 venors' Witnesses in this proceeding.

4 5 Q Wi!AT WAS YOUR ACSIGNMENT IN THIS PROCEEDING 7 6

7 A My assignment was twofold: First, I was to review the direc: testi-

8 mony and exhibits and other available information of the Carolina

! 9 Power & Light Company (CP&L) concerning the cost to serve CT&L's 10 wholesale Cooperative customers. Specifically, I was to consider 11 whether the methods employed by CP&L for Period II to develop the 12 rate base and operating expsnses shown in the Cocpany's cost of service ,

13 study were proper and in accord with Commission precedent and sound 14 ratecaking procedures and whether the requested rate of return is f air 15 and meets the standards established by the Supreme Court in its deci-16 sions in the Bluefield and Hope cases. Secondly, I was to prepare an 17 allocated cost of service study which includes the adjustments to 18 the Company's cost of service found to be necessary by Mr. Gross and 19 I and which accurately reflects the rates of return which would be 20 carned under the Company's wholesale electric tariff RS-ll during the 21 Pc_.iod II test period.

22 23 Q WOULD YOU PLEASE SUINARIZE THE TESTIMONY THAT WILL BE GIVEN BY TE 24 OTHER COOPERATIVE INTERVENOR WITNESS IN THIS PROCEEDING?

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26 A Mr. Gross is providing testimony on corrections to CP&L's Period II 27 estimated CP demands, the correct treatment of the SEPA wheeling loads 28 in calculating the demand allocation factors and on the appropriate 29 rate design.

30 31 Q DOES CP&L CURRENTLY HAVE ANY OTHER RATE INCREASE REQUESTS PE'iDING 32 BEFORE THIS C012ilSSION?

33 34 A 35 Yes, Docket an requesting No.increase ER76-495ininannual which the Compsy's pronosed rate RS-llom its Cooperative customers revenues 36 of 34% was filed in January,1975 and is currently pending before 37 this Commission. The Administrative Law Judge (ALJ) rendered his initial decision in that docket September 7, 1977.

38 39 40 In settlement discussions in the instant docket, the parties were able 41 to agree on a stipulation covering a few issues which are coccon to both 42 proceedings. In the stipulation dated March 16, 1978, the parties agreed 43 that, for purposes of this docket they will accept the Co==ission's 44 final decision in Docket No. ER76-495 with respect to the following 45 issues as governing the disposition of those issues in this docket:

46 47 a) demand allocation f actor method (i.e., whether domand-48 related costs should be allocated on the basis of four 49 coincident peaks, twelve coincident peaks, or on alterna-50 tive method chosen by the Commission) l

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( l b) fuel stock allocation method 2 -

3 c) interest expense syncronization 4

5 d) depreciation rates and 6

7 c) comprehensive interperiod tax allocation.

8 The parties also stipulated that Plant in Service should be calculared

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9 10 on the basis of the average of the 13 monthly balances as was done by 11 the Company in this proceeding.

12 13 Q WOULD YOU BRIEFLY SUSDIARIZE THE CONCLUSIONS WHICH YOU AND MR. GROSS 14 HAVE REACHED AS A RESULT OF STUDYlNG CP&L'S COST OF SERVING ITS WHOLE-15 SALE CUSTOMERS?

16 17 A The cost of service study presented by the Company in this proceeding 18 significantly overstates the cost of providing service to the Coopera-19 tive customers. The following major errors have been made by CP&L 20 in its Period II cost of service study, necessitating adjustments 21 (this list excludes the issues which were included in the stipulation 22 discussed above):

23 24 Witness Gross 25 26 1. CP&L has improperly estimated the monthly coincident k 27 peak demands in Period II for the Cooperatives.

28 29 2. CF&L has erred in its treatment of its SEPA wheeling 30 load in the calculation of demand allocation factors.

31 32 3. CP&L has improperly designed its rates in that:

4 33

, 34 a) it has failed to recognize the different character-35 istics of its Cooperative and Municipal customers 36 by providing only one rate for wholesale service, 37 i 38 b) it has failed to recognize the differential in the 39 cost of serving loads from its transaission system 40 versus serving loads at the distribution level by 41 providing the same charges for service at both the 42 transmission and distribution level, 43 44 c) it has included a 95% demand ratchet which is 45 totally unjustified by record evidence and completely 46 inconsistent with the use of the twelve-conth average 47 demand allocation method decided to be just and 48 reasonable by the Administrative Law Judge in Docket 49 No. ER76-495, and 50 t

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d) it has unjustly and unreasonably restricted its provision

( 1 2 for totalized billing.

3 4 Witness Solomon 5

6 1. CP&L has failed to match the Period II test year revenues 7 and expenses. ,

8 9 2. The Company has proposed improper base rate and fuel adjust-10 cent charges based upon an unjust amortization for the pre-11 viously capitalized value of the uranium and plutonium material 12 contained in spent nuclear fuel assemblics, for the disposal 13 cost of these spent fuel assechlies and for estinated future costs of disposal of nuclear fuel currently in its reactors.

14 15 16 3. In calculating its cash working capital allowance, CP&L 17 used the 45-day formula of 12.5% of total 0 6 M expenses 18 less purchase power in lieu of presentation of evidence 19 on the actual amount cash working capital required. I 20 have conducted a lead-lag study of the Company's cash working 21 capital requirements and have found that the receipt of 22 revenues for service rendered actually leads rather than 23 lags the payment by the Company for the goods and services 24 it requires to provide that service. Thus, the Company

- 25 has no requirement for its customers to provide addi-tional cash working capital.

{ 26 27 The Company has unjustly inflated its Period II rate 28 4.

29 base by using unreasonably excessive rates for capital-30 izing Allowance for Funds Used During Construction.

31 32 5. CP&L has requested an unfair rate of return by reason 33 of its use of a cocmon equity return on the customer 34 contributed unamortized investment tax credit and an 35 excessive return on co= mon equity.

36 37 Q HOW WERE THE ISSUES SUBJECT TO THE MARCH 16, 1978 STIPULATION 38 TREATED IN YOUR COST OF SERVICE STUDY?

39 40 A For purposes of this filing, I have followed the ruling of the Adminis-41 trative Law Judge on each of these issues.

42 43 I used the demand allocation factors calculated by Mr. Gross based 44 upon the average of the twelve monthly coincident peaks method. In applying this method, Mr. Gross used his own estimate of the twelve 45 1 46 monthly coincident peak demands for the wholesale customers and he

! 47 corrected the Company's treatment of its SEPA wheeling load. This 48 correction also called for the removal of the revenue credit for wheeling 49 revenues shown on Cooperative Intervenor Exhibit No. (JBS-1), page 5.

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The fuel stock was allocated by the production level de=and allocation factor.

3 4 The interest expense was syncroniced by applying the return ce=ponent 5 for long term debt shown on Cooperative Intervenor Exhibit No.

6 (JBS-8), page 8 to the total rate base as adjusted.

7 8 The depreciation rates of the Co=pany were adjusted by correcting 9 the net salvage ratios, the service life of certain steam production 10 plants and certain nuclear salvage factors used in the Company's 11 Exhibit No. JB-1 to reflect the Judge's decision in Docket 12 No. ER76-495. A su= mary of the calculation of the revised depre-13 ciation expense and accumulated provision for depreciation is shown 14 on Cooperative Intervenor Exhibit No. (JBS-3).

15 16 The Company's use of comprehensive interperiod income tax allocation 17 was left unadjusted.

18 19 The Plant in Service used by the Company was also 1cf t unadjusted.

20 21 Q HOW WERE THE OTHER ISSUES LISTED ABOVE TREATED IN YOUR COST OF SERVICE 22 STUDY?

23 24 A The Power Supply Production (PSP) and Power Supply Transmission (PST) 25 demand allocation factors as co=puted by Mr. Gross were substituted (x 26 for the Cocpany's four-month average PSP and PST.

I' 27 28 My reco== ended adjustments to revenues, expenses and rate base were 29 made at the appropriate places in my cost of service study and were 30 c1carly narked as adjustments.

31 32 My reco== ended overall rate of return on rate base was used in the 33 determination of the allowable increase (decrease) shown on Coopera-34 tive Intervenor Exhibit No. (JBS-1), page 2.

35 l 36 Q WHAT WAS THE EFFECT ON THE COOPERATIVE INTERVENORS OF MAKING THESE 37 CHANGES TO THE COMPANY'S COST OF SERVICE?

38 39 A As can be seen on page 2 of Cooperative Intervenor Exhibit No.

40 (JBS-1), the adjusted rate of return under the present rates (RS-ll) 41 during Period II would be 10.897%. Before the corrections reco= mended 42 by Mr. Gross and I, the Company showed a rate of return of 8.873%.

43 Using my reco=cended rate of return, my adjusted cost of service 44 shows that revenues should be decreased by $4,053,979 (7.42%) for 45 the Cooperatives below the level of the RS-ll rates as opposed to 46 the Company's requested increase of $4,084,941 or 7.48%

47 48 Q. PLEASE EXPLAIN HOW CP&L HAS FAILED TO PROPERLY MATCH PERIOD II TEST YEAR 49 REVENUES AND EXPENSES.

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I 1A The Company made two errors which result in this mismatch of revenues 2 and expenses. One of them, discussed by staff witness Shulcan, is the 3 mismatch of fuel revenues and fuel expenses resulting from the Company's 4 method of booking fuel revenues and expenses. I agree in principle with 5 this adjustment; however, as a result of the second mismatch discussed 6 below it is necessary to recalculate the required adjustment.

7 8 The second mismatch results from the Company's practice of booking 9 revenues during the month bills are rendered as opposed to during the 10 month for which service is rendered. For instance, the Company may 11 render its bill for service rendered during the month of January on the 12 5th of February; the costs of providing service are incurred during 13 the month of January, but the revenues are booked as February revenues.

14 The result of this procedure is that the Period II expenses are for 15 the months of January through December, 1977, while the revenues are 16 f or the period December,1976 through November, 1977. I have corrected 17 this mismatch in revenues and expenses by elitinating the revenues 18 included for December, 1976 and adding the revenues for December, 1977 ,

19 (which were reported in CP&L's filing as January, 1977 and January, 1978, 20 respectively). The co=putation of this adjustment is shown on Coopera-21 tive Intervenor Exhibit No. (JBS-4) .

22 23 Q WHY IS IT NECESSARY TO RECALCULATE STAFF'S FUEL REVENUE /EYPENSE SYNCRONI-24 ZATION ADJUSTMENT?

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26 A Mr. Shulman assumed that the fuel adjustment factor (FAF) was calculated

( 27 on the basis of fuel expenses incurred in the second month preceding

28. the month when service was rendered. However, the FAF is actually 29 calculated on the basis of fuel expenses incurred in the second month 30 preceding the month when the bill is rendered which is the first month 31 before the month when service is rendered.

32 33 I have recalculated this syncronization and the results are shown on 34 Cooperative Intervenor Exhibit No. (JBS-4) .

35 36 Q WHAT IS THE NET RESULT OF MAKING E0Td SYNCRONIZATION ADJUSTMEICS YOU 37 DESCRIBED ABOVE?

38 39 A Total wholesale revenue should be increased by $43,172 co= posed of a

40 decrease in Cooperative revenue of $46,578 and an increase in Municipal 41 revenue of $89,750.

42 43 Q WHY DO YOU FIND THE COMPANY'S PROPOSED AMORTIZATION FOR PREVIOUSLY 44 CAPITALIZED SPENT NUCLEAR FUEL ASSEMBLIES, THE ESTIMATED COSTS OF THEIR 45 DISPOSAL, AND THE ESTIMATED FUTURE COSTS OF DISPOSAL OF NUCLEAR FUEL 46 IN THE REACTORS TO BE UNREASONABLE AS THE BASIS OF SETTING RATES IN THIS 47 PROCEEDING?

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49 A There are two major reasons. First, the decision to charge this amortization 50 and estimated costs seems to have been founded upon the assumption that r

( 1 there will never be reprocessing of spent nuclear fuel for use in com-

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2 cercial nuclear generating f acilities in the United States. As shown by 3 the testimony of intervenor witness Dr. Thc=as S. Elle=an, this is an 4 erroneous assumption. At most, there is a temporary caratorium on such 5 reprocessing, and it appears logical from the testimony of Dr. E11etan 6 that this coratoriu will be short lived. To collect these amounts based 7 upon esticates of costs which may or may not be incurred over a large 8 number of years in the future would be highly unreasonable.

9 10 The second major reason for rejecting the Company's inclusion of these 11 costs is that a major portion of the costs are based upon estimates of 12 cost to be incurred in the future which have not been supported as being 13 reasonable by CP&L in this proceeding. These future costs, if indeed 14 they are ever incurred, are more properly collected af ter their occurance 15 at some future date when their magnitudes are more reasonably known.

16 17 Q UPAT IS YOUR RECOMMENDATION FOR THE TREATENT TO BE GIVEN THESE ITEMS 18 IN THE PERIOD II COST OF SERVICE IN THIS PROCEEDING?

19 20 A It is my recommendation that the $1,007,630 for the amortization of the 21 spent nuclear fuel assemblies and the $1,319,156 for the amortization 22 of the disposal cost of those assemblies or a total of $2,326,786 be 23 removed from the Period II cost of service. It is totally unreasonable 24 to charge the customers an additional $1,007,630 per year on the basis 25 of such an abrupt change in long-standing government policy which flys 26 directly in the face of logic. This is especially unreasonable in N 27 light of the fact the Company is currently being compensated by its 28 customers for carrying as an asset the $5,038,150 value which is the 29 basis for this charge. Additionally, in the highly unlikely event that 30 the Company's assumption is correct and it becomes clear that spent 31 nuclear fuel will never be reprocessed in this country for use in nuclear 32 generating units, the Company can be compensated then for writing off 33 the value of the uranium and plutoniu= material contained in the spent 34 nuclear fuel assemblies.

35 36 The $1,319,156 per year additional charge should certainly not be allowed 37 since as discussed above this figure is based upon estimated future costs 38 for which the Company can be co=pensated af ter they are incurred.

39 40 Likewise the estiented long run cost of $14,627,607 for permanent dis-41 posal of nuclear fuel now in the reactors should be removed from the 42 test year expenses and, thus, should not be allowed to flow through the 43 fuel clause.

44 45 The expens.e, rate base and revenue adjustments for these items are shown 46 on Cooperative Intervenor Exhibit No. (JES-7).

47 48 Q WILL YOU PLEASE EXPLAIN WHY YOU USED A LEAD-LAG STUDY TO CALCULATE CP&L'S 49 CASH WORKING CAPITAL INSTEAD OF THE 45-DAY F0FJRTLA USED BY CP&L?

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( 1A In the past, the Cocmission has allowed companies to use 45 days opera-2 tion and maintenance expense less purchased power for cash working capital 3 allowance. As cited by Staff, however, opinion as to the current value 4 of this formula is changing. In particular, the Administrative Law 5 Judge for the previous CP&L case, ER76-495, found that use of the 45-day 6 allowance would cause an unjust result. }breover, the ALJ relied on a 7 lead-lag study to show that the lag between CP&L's payment of expenses I and receipt of revenues was not 45 days but only 2 daya! It is patently 8

9 unjust and unreasonable to allow the use of 45 days working capital 10 when no such lag exists. Therefore I have conducted a lead-lag study to 11 determine the cash working capital actually needed by CP&L.

12 13 Q PLEASE EXPLAIN THE CONCEPT OF ALLOWING A CASH WOPXING CAPITAL COMPONENT 14 IN THE RATE BASE.

15 16 A The Company is required to render service to its customers on a continuous '

17 basis and in so doing must employ the use of goods and services on a 18 continuous basis. Meters are normally read at the end of the month (t) 19 and it then requires time to prepare the bills for that month (t), send 20 them out and then receive cash payment for the metered service. Thus,

! 21 the Company does not normally receive payment for service rendered during 22 one month (t) until the middle or latter part of the next month (t + 1).

23 To the extent that the Company must pay for the goods and services 24 consumed in providing service during that month (t) prior to receiving 25 payment from customers there is a requirement for a short-term invest-26 ment to be made in carrying these costs.

i .' 27 28 As an example, let us assume a 30-day month wherein service is rendered, 29 that the Company is required to make daily payments as goods ard services 30 are consumed in providing the electric service and that it te! cs a total 31 of 30 days af ter the end of the month to prepare and mail the bills and 32 then receive the money in hand to cover the cost of providing that elec-33 tric service. On average the cost of providing the service was paid by 34 the Company at the mid-point of the service period (15 days), but the

, 35 customer's payment was not received for 30 days af ter the end of the 36 service period. In this scenario, the Company's net lag would be a g 37 total of 45 days. This is the same net lag reficcted in the standard 38 45-day formula relied upon by many companies as an approximation of 39 their cash working capital requirement. Obviously, all the costs upon

40 which rates are established and the customer's bill is computed are not i

41 paid on the exact day the ciectric service' is rendered. Thus the 45-day 42 f ormula must be viewed as an estimate of the net of the leads and lags 43 of all these cost items.

44 45 As pointed out by the Staff and as I discussed above, one of the basic 46 precepts of ratemaking in this country and, indeed, of this Commission f

47 is that rates must be based on a matching of the revenues and the costs 48 incurred in the rendition of service. The costs included by this Commis-49 sion in establishing these rates are basically: operation and maintenance expenses, depreciation, taxes and the cost of capital. These items are 1

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all a part of the rates paid by the customer for the current costs to the Company of providing service and, except to the extent there are 3 non-cash items included or items the carrying costs of which have already 4 been provided for through rate base additions or deductions, since they 5 are converted to cash by the customer, they should all be included in 6 a lead-lag study to deterrine the actual working captial requirement 7 of a Company. I have therefore reflected all of these items in my study 8 shown in Cooperative Intervenor Exhibit No. (JBS-5).

9 10 Q WHAT ARE THE RESULTS OF YOUR LEAD-LAG STUDY?

11 12 A As shown on page 1 of Cooperative Intervenor Exhibit No. (JBS-5) ,

. 13 CP&L actually experiences a net lead in receipt of revenues to cover 14 current cash expenditures rather than a lag. Therefore any allowance of 15 cash working capital would be unjust and unreasonable.

16 17 Q BRIEFLY DTLAIN THE RATIONALE USED IN DEVELOPING THE LEADS AhT LAGS IN 18 YOUR STUDY.

, 19 20 A In conducting my lead-lag study, I used the same basic methodology 21 as utilized by the ALJ in ER76-495 and by Staff in the instant case.

22 Based on data supplied by the Company, I determined for each expense 23 the number of days from the time the expense was incurred in providing 24 electric service until the payment for that expense was made. I then 25 determined the number of days f rom the time service was rendered until 26 payment for that was received. The difference between these two numbers k 27 produced the overall net lead or lag experienced by the Company.

28 29 I have divided my study into three areas - 0 & M expenses, taxes, and 30 cost of capital. I have also shown a subtotal for O & M expenses and 31 taxes and then a total including the cost of capital items. For each 32 area I assumed that the expense or liability is incurred continuously 33 during the entire period in question or on the average at the midpoint 34 of the period; i.e., on the 180th day of the year if the period is a 35 year.

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, 37 For example, let us consider the lag for Federal income tax. CP&L pays 38 Federal income tax on a quarterly basis. The first quarter payment is 39 due on April 15 which allows for a lag of 60 days, 45 days f rom the 40 average date on which the tax was incurred plus the 15 days remaining 41 af ter the end of the quarter before pay =ent is due. The three other 42 quarterly payments are due June 15, September 15, and December 15, 43 respectively. Each of these dates produce a lag of 30 days, 45 days 44 f rom mid-quarter to the end of the quarter less 15 days for payment 45 prior to the end of the quarter. The weighted average lag that results 46 is 37.5 days making the conservative assumption that one-fourth of the 47 annual tax liability will be paid each quarter.

48 49 In deterning the lag for f uel expense I first grouped the suppliers 50 according to the terms of the four types of payments as provided by k

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CP&L in response to Cooperative Data Request Item No. 1-1. For fuel received from suppliers in Group A, the terms call for payment on the 3 10th of the following month for fuel received the 1st through the 15th 4 or payment on the 25th of the following month for fuel received the 5 16th through the end of the month. Thus the lag in both instances is 6 32.5 days, 7.5 days from the midpoint of the fif teen days during which

- 7 the fuel is received plus 25 days remaining until payment is due.

8 Including the lag for the other three groups and freight charges produces 9 a weighted-average lag of 24 days for fuel expense.

10 11 I have followed this basic methodology for determining the lag for each 12 cost shown in my study.

, 13 14 I have also determined that CP&L experiences a 35-day lag in receiving 15 payment from its customers. This revenue lag is based on 15 days from 16 rendition of the service until the end of the month, 5 days to render 17 the bill and 15 days for payment.

18 19 Q IN YOUR EXHIBIT NO. (JBS-5) YOU HAVE INCLUDED FEDERAL TAXES, 20 INTEREST ON LONG TERM DEBT, PREFERRED STOCK DIVIDENDS AND COSDiON STOCK 21 DIVIDENDS, NONE OF WHICH THE ALJ ALLOWED IN HIS INITIAL DECISION IUR 22 ER76-495. PLEASE EXPLAIN WHY YOU INCLUDED THESE ITEMS.

23 24 A As I explained above, each of these items represents a cost that the 25 Company must pay and that is therefore included in the revenues collected g 26 f rom the customers just as any other cost to the Company. The collec-( 27 tion of the dollars associated with these items represent, therefore, 28 cash which the Company has on hand contributed by the customers to meet 29 its cash needs. These funds must be used in this manner since they are 30 not capital contributions for which there would have to be a rate base 31 reduction nor investments in short-term interest-bearing instruments 32 f or which there would have to be an interest income credit to the cost 33 of service.

34 35 Finally, I want to reiterate that these items represent costs which have 36 been used in matching the revenues to be paid on an annual basis with j( 37 the costs incurred in rendering service during the same period and, as 1 38 such, none of them are contributions of capital, but rather are payments 39 for the cost of capital. In the past these items have many times been i 40 reviewed in the context of making offsets or additions to the allowance

! 41 under the 45-day formula rather than in the context of a full, detailed 42 study of the actual cash working capital requirements of a Company.

43 As shown above, when reviewed in the context of a comprehensive lead-44 lag study, it is necessary to include the payments and receipt of revenues 45 f or each of these cost items.

46 47 Q MR. SOLOMON, WHY ARE YOU RAISING AS AN ISSUE IN THE INSTANT DOCKET, 48 WITH A PERIOD II TEST YEAR OF 1977, THE METHOD OF CALCULATING THE 49 PROPER AEUDC RATES FOR CAPITALIZING AFUDC DURING PREVIOUS YEARS 50 GOING BACK AS FAR AS 1969?

( l A The rates used to capitalize AFUDC in prior years vitally affects 2 the current test period cost of serving the wholesale customers since 3 the current rate base includes AFUDC capitalized in prior years.

4 5 Q HAVEN'T THE AMOUNTS OF AFUDC CAPITALIZED IN PRIOR YEARS BEEN REVIEED 6 AND APPROVED BY THE AUDITING STAFF OF FERC?

4 7 i 8A Prior to January 1,1977 when Order No. 561, issued in Docket No.

9 RM 75-27 became effective, there were no detailed guidelines for the 10 determination of AFUDC capitalization rates. During that time, the 11 audits by the Staff reserved approval of all amotmts capitalized from 12 use of an AFUDC rate in excess of 6.5% pending a rulemaking on the 13 subj ect.

14 15 Q HAS THIS ISSUE BEEN RAISED BY THE WHOLESALE INTERVENORS IN OTHER 16 PROCEEDINGS INVOLVING CP&L?

17 18 A Yes, Dr. J. Leslie Livingstone filed testimony in Docket Nos. E-8884 19 and ER76-495 on behalf of both Cooperative and Municipal intervenors 20 setting forth a more appropriate method of calculating AFUDC rates 21 prior to the issuance of Order No. 561. Subsequent to the issuance 22 of Order No. 561, this issue was severed from both the Dochets and 23 was consolidated for purposes of a separate hearing on this single 24 issue. Dr. Livingstone will be working out of the country during 25 the su=mer, thtts, I will be filing testimony on this issue on behalf g 26 of the Cooperative intervenors and Mr. Keith Wilkins is providing testi-l 27 mony on behalf of the Municipal intervenors.

28 29 Q WHAT IS THE CURPINT STATUS OF THAT CONSOLIDATED PROCEEDING?

30 31 A Judge Lewnes rendered his initial decision on January 9,1978. This 32 decision and the exceptions of the parties are now before the Co= mis-33 sion. In his decision Judge Lewnes concluded "...had Order No. 561 34 been in eff ect during the historic period involved, the cost for '

35 service rendered to CP&L's customers would be greater than now pre-36 vails. Wherefore, it is held that the amounts of capitalized AFUDC '

37 claimed by CP&L in Docket No. ER76-495 are deemed to be reasonable and 38 as a consequence no adjustments are wacranted." It is my contention 39 that Judge Lewnes erred in his determination primarily because the 40 criteria he used in making this determination was inappropriate and 41 secondarily because of a lack of understanding of the complexity and 42 subtle nuances of the detailed issues involved.

43 44 Q WHAT CRITERIA SHOULD BE USED FOR EVALUATING THE PAST CAPITALIZATION 45 0F AWDC7 46 47 A In answering this question I must first reiterate the fact that this 48 issue originated from a dispute over the appropriate method of calcu-49 lating the rate at which AFUDC would be capatilized during a period 50 prior to the issuance of Order No. 561 and when the Commission's Uniform 1

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System of Accounts read in pertinent part defining AFUDC as follows:

3 "... includes the net cost for the period of construction 4 of borrowed funds used for such purposes and a reasonable 5 rate on other funds when so used."

6 7 Thus, the lack of any specific guidelines for the calculation of the l- 8 " net cost" of construction funds led to disputes over the appropriate 9 method of calculating this cost. The calculation of this cost was, l 10 however, the only aspect of the calculation of AFUDC to be capitalized 11 which was in doubt. The policy of the Comission was clearly that the 12 rates obtained were not to be applied in a manner which would result

, 13 in the compounding of AFUDC. Since the Co=ission has issued specific 14 guidelines in the for: of Order No. 561 for the co=putation of the 15 AFUDC rate, it seets appropriate to utilize these guidelines in 16 measuring the appropriateness of the rates used by CP&L prior to 17 issuance. In closing, I would like to emphasize that it was the 18 determination of this rate not the application of the rate which was

, 19 subj ect to achiguities in the Coc=ission's prior policies.

20 21 Q HOW DID THE COMPANY CALCULATE THE RATE AT WHICH AFUDC WOULD BE CAPITA-22 LIZED PRIOR TO ORDER No. 561?

23 24 A There was no actual calculation but rather a judgment as to the approxi-25 mate cost of the funds used for construction purposes. The rate was 7%

26 in 1969 and then remained at a level 8% from 1970 through 1976. This

(

27 method of adducing the cost of construction funds is clearly unreasonable 28 as a . basis for establishing rates.

29 30 Q PLEASE SUMMARIZE THE RESULTS OF YOUR APPLICATION OF THE CRITERIA

4. 31 DESCRIBED PREVIOUSLY FOR THE YEARS 1969 THROUGH 1977.

I 32 33 A The calculations shown in Cooperative Intervenor Exhibit No.

34 (JBS-6) show that the Company over-capitalized AFUDC in the at ount 35 of $38,530,000. The rate base and cost of service adjustments recuired 36 to correct the effect of this over-capitalization in CP&L's Period II 37 cost of service are shown on Cooperative Intervenor Exhibit No.

38 (JBS-6), page 8.

39 40 Q PLEASE DESCRIBE THE PROCESS YOU USED IN COMPUTING THE COMPANY'S OVER-41 CAPITALIZATION.

42 43 A To establish the appropriate capitalization rates, I used the net rate 44 as calculated by the Company's witness Paul S. Bradshaw in Docket 45 Nos. E-8884 (Phase I) and ER76-495, Exhibit No. 153 (PSB-101), page 2, 46 line 25 which were calculated in accordance with Order No. 561, for 47 the years 1969 through 1974. Since Mr. Bradshaw used the incorrect 48 cost of com=on ' equity in his computation for 1975 and 1976 rates, I l 49 recalculated those using the appropriate common equity rate. I also l 50 calculated the appropriate rate for 1977 based upon data supplied by i

I i

. , _ . _ . _ , . - ~ . _ _ _ . _ . . . . _ . . _ _ _ . _

i i

l I

( 1 CPEL in response to data requests and data in the CP&L Form 1 for 1977.

2 I then cenpared these capitalization rates with those actually applied 3 by the Company during each of those years. I then used the percentage 4 by which the Company's rates were in excess to determine the excessive 5 AFUDC recorded assuring that the AFUDC first capitalized during construc-6 tion was first to be transferred to plant in service.

7 8Q PLEASE EXPL/IN WHY YOU USE MR. BRADSHAW'S NET RATES INSTEAD OF GROSS 9 PATES FOR THE YEARS 1969 THROUGH 1974.

10 11 A In addressing the question of whether a net or gross rate should be 12 used, the Coemission in order No. 561 quoted from Order No. 530 .A in 13 pertinent part as follows:

14 15 ". .. If a net of tax allowance for funds rate is pre-16 acribed by a regulatory body in setting the rate levels 17 of utilities, we consider that such treatment is consistent 18 with the intent of Order No. 530 and it is not necessary 19 for utilities to set aside deferred income taxes related 20 to the interest co=ponent of the allowance for funds rate.

21 In light of this, we do not believe that it is necessary 22 to take provision in the Uniform System of Accounts to cover 23 this catter."

24 25 In other words, it is not necessary for a company to provide a deferred

( 26 tax account and "nor= alice" the taxes related to interest during con-( 27 struction. They nay simply use a net of tax rate and allocate the 28 interest expense related to construction to non utility operations or 29 "other income and deductions" for purposes of calculating inco=e taxes.

30 This is exactly what was done by CP&L in Docket Nos. E-8884 and ER76-495 31 in prior years. This was illustrated by intervenor witness Livingstone 32 on page 3 of his direct testimony in Docket No. E-8884 and confirmed 33 by Company witness Utley on page 6 of his rebuttal testimony in the 34 same Docket. Dr. Livingstone's explanation reads as follows:

35 36 "I refer to Exhibit SB-4, Statement B, page 1, which 37 is Carolina's projected statement of income for Period II --

38 1974. In this statement under "other income and deductions" 39 there appears the item " income taxes -- credit" for $12,818,000.

40 The acount of this item also has been added in with "inco=e 41 taxes" under the heading of operating expenses. . . . . .This item 42 arises from Carolina's tax worksheet for Period II at page 71 43 of the operating expenses section, where Carolina has assigned 44 interest expense of $26,705,000 to other (i.e. , non-utility) 45 expense for inec=e tax calculation purposes. The amount of 46 $12,818,000 is 48% of the assigned interest expense of 47 $26,705,000."

48 49 In discussing the two general nethods used for capitalizing AFUDC and 50 the treatment of interest during construction for income tax purposes 1 on page 6 of his rebuttal testimony in Docket No. E-884, Mr. Utley says:

2 3 "One method of capitalizing AFC is to use a capitalization 4 rate without any tax effect on the debt portion (this is 5 referred to as a gross rate) and simultaneously pernitting 6 the tax effect of the interest attributable to CUIP to be 7 used to reduce income taxes "above the line." This proce-8 dure, which is used by many utilities, passes the tax benefit 9 through to consumers immediately.

10 11 An alternative form of interest capitalization is to use 12 a net after-tax rate for capitalization purposes and asso-13 ciate the interest deduction as a component of other income.

14 This procedure has great merit bacause it isolates the income 15 statement from the effect of CWIP. I an attaching an 16 exhibit (Exhibit _ (JFU-1)) which demonstrates by hypothe-17 tical illustration the effect of the use of this procedure.

, 18 l 19 Either one or other of these procedures may be used.

20 The latter precedure is preferrable, as evidenced by the 21 results shown by my exhibit."

22 -

23 Obviously the latter method discussed by Mr. Utley was used by CP&L 24 to remove the interest associated with construction completely from 1 25 the calculation of income taxes used for ratemaking purposes in the

, 26 Company's cost of service study, thus necessitating the use of a net

( 27 after-tax rate.

28 29 The Company, in its brief, further explained its treatment of AFUDC 30 and the tax benefits associated with interest during construction on j 31 page 33 of its initial brief in that same Docket (E-8884):

32 33 "CP&L properly allocates benefits arising from allow-34 ance for funds used during construction (AFUDC) between

. 35 current and future rate payers and shareholders. The 36 Company accocplishes this allocation first by employing a 37 net after-tax rate for charging AFUDC to construction work in 38 progress (CWIP) and second by assigning to non-operating 39 income the interest expense deduction and resultant tax benefits 40 associated with the borrowed portion of construction 41 funds (T.646) ."

42 43 Then on page 35 of this same brief, the Company shows that it has been 44 using this same treatment at least since 1970:

45 l 46 "CP&L has been using the allocation method emple/ed in this

! 47 case without complaint since 1970. During this time, the l 48 Company underwent a five year compliance audit by the l 49 Com=1ssion staff; and although there was some preliminary 50 dicussion about the method, the final audit report did not take exception to it (T. 638)."

- ~ >. ~ - - . n.

( 1 2

It is cicar f rom this the Cocpany's treatment of the income tax effect of interest during construction is consistent with the above quota-3 tion of Order No. 530 as quoted in Order No. 561 and requires the use 4 of a net of tax rate.

5 6 0 WHY DID YOU FIND IT NECESSARY TO RECOMPUTE THE RATE FOR 1975 AND 1976?

7 8 A In his computation, Mr. Bradshaw used the wrong rate of return on 9 equity for each of those years. Mr. Bradshaw erred in his interpretation 10 of the return allowed on original cost cocmon equity by the North 11 Carolina Utilities Co= mission (NCUC). For the 1975 return on original 12 cost common equity Mr. Bradshaw relied upon the order of the state 13 co=nission issued January 6,1975. The test period in that proceed-14 ing, Docket No. E-2, Sub 229, was the twelve months ending Dece=ber 15 31, 1973. However, the state coccission, just as does this Co==is-16 sion, stated that it considered the fact "that the records of the 17 Co==ission clearly reflect that additional financings in the interin 18 and those anticipated in the near term future as well as additional 19 plant co=ing on line in the near future will have the natural effect of 20 reducing the rate of return on actual equity to socewhere in the range 21 of 12.5%." Thus, even though the return allowed by the Co= mission 22 produced a 14.6% return on cocoon equity for the test period ending 23 December 31, 1973, the Cocsission rendered its decision in January, 24 1975 and found that 12.5% was a fair return on actual co==on equity and 25 that the rates allowed would produce that result on data updated to 26 more accurately reflect the time the rates would be effective. The

(~ 27 Company also made it clear in its FERC Form 1 for 1977 that its own 28 interpretation of the UCUC order was that the Co==1ssion actually 29 allowed a 12.5% rate of return on coc=on equity. This is shown on page 30 428 of the 1977 For: 1. For the year 1976, the Co=pany used the NCUC 31 order in Docket No. E-2, sub 264 icened February 20, 1976 to derive the 32 return on original cost co==on equity allowed by the state com:ission.

33 In this order, the Comrission provided only its rate of return on fair 34 value co= mon equity thus requiring a co=putation of the return on 35 original cost co==on equity which resulted. The Company erred in naking 36 this calculation when it derived the 11.83% used. The correct calcu-37 1ation is shown below to be 11.28%:

38 39 Capital Cost Cost Rate 40 (000's) (000's) 1 41 I 42 Long-tern Debt 557,406 43,349 7.78% ,

43 Preferred Stock 161,624 12,951 8.01 l 44 Common Equity 352,173 39,739 11.28 i 45 Cost Free 32,789 )

46 TOTAL 1,103,992 96,039 1 47 1 48 I have substituted these common equity returns for those used by Mr. I 49 Bradshaw in my calculation of the appropriate AFUDC rates for 1975 l 50 and 1976. These calculations are shown on Cooperative Intervenor

(

(JBS-6) , page 2.

7

' ( l 2

Exhibit No.

3Q HAVE YOU PREPARED AN EXHIBIT SHOWING idE ADJUSTMENTS PIQUIPID TO BE 4 MADE TO THE COST OF SERVICE STUDY FOR PERIOD II?

5 6A Yes. this is shown on Cooperative Intervenor Exhibit No. (JBS-6),

7 page 8.

8 9Q HOW SHOULD THE RATE OF RETURN WHICH SHOULD BE ALLOWED ON CP&L'S RATE 10 BASE BE DETERMINED?

11 12 A The allowed rate of return on rate base should be equal to the Co=pany's 13 weighted cost of the capital used to finance such rate base. This 14 weighted cost is determined by measyring the cost of each type of capital 15 employed, long-term debt, preferred stock and com=on equity, multiplying 16 this cost by the relative portion of the total capital made up by the 17 respective type of capital and se= ing the results.

18

, 19 Q WHAT CAPITAL STRUCTURE AND COST OF LONG-TERM DEBT AND PREFEPSID STOCK 20 DID YOU USE?

21 22 A As shown on Cooperative Intervenor Exhibit No. (JBS-8), pages 6, 7 23 and 8, I used the December 31, 1977 actual capital structure and embedded 24 costs of long-term debt and preferred stock as reported in CPLL's 1977 25 FERC Fo rm 1.

26

( 27 Q WFY DO YOU THINK IT APPROPRIATE TO DENY THE COMPNn*'S PROPOSAL TO INCLUDE 28 THE UNM10RTIZED INVESTMENT TAX CREDIT BALANCE IN THE DETERMINATION OF 29 THE COST OF CAPITAL AT THE RAZE OF RETURN ON COMMON EQUITY?

30 31 A First, all parties in this proceeding agree that these scounts are customer 32 contributed capital which is collected through rates under the auspicies 33 of charges for taxes which are not paid by the Company. As such, these 34 funds have no cost to the Company and logically should be deducted from 35 the rate base or included in the capital structure at zero cost. However, 36 the Congress in revising the Internal Revenue Code in 1971 decided this

, 37 should not be done in the interests of " sharing" the benefits of this 38 income tax reduction between the investors of the Company and its customers.

39 Thus, it provided that these amounts should not be deducted from rate 40 base nor treated as zero cost capital. Which brings ne to my second 41 reason. It is'inconceivabic to me that this so-called " sharing" provision 42 could ever be interpreted as requiring that the Company not only charge 43 its custo=ers for taxes not paid, but that its stockholders would also 44 be allowed to collect from consuoers an equity return on the capital 45 the customera contributed. A third reason logically follows in that 46 this Commission hca not been allowing an equity return on this balance, 47 as also is the case in many state jurisdictions, yet the electric utility 48 companies have not been losing this investment tax credit. Thus, not 49 only does the Company's position fly directly in the face of logic, it 50 has not been borne out by past experience.

1 Q WiiAT IS THE EFFECT OF NOT DEDUCTU'G THESE AMOUNTS FROM RATE BASE NOR 2 INCLUDING THDi IN THE CAPITAL STRUCTURE AS ZERO COST FUNDS 7 3

4 A The effect is to allow the Company to earn its overall cost of capital 5 on this amount. This overall cost of capital or rate of return is, 6 of course, cade up of the cost of long-term debt, preferred stock and 7 a return on common equity and, in my opinion, certainly sufficient to 8 meet the requirements of the IRS.

9 10 Q SINCE THE COST OF COS'ON EQUITY CAPITAL IS NOT SURIECT TO PRECISE 11 MATHDIATICAL MEASURDIENT, WHAT CRITERIA DID YOU USE IN DETEpJIINING 12 THE FAIR COST OF COE!ON EQUITY CAPITAL AND WHAT APPROACH DID YOU USE 13 TO DERIVE THIS COST?

14 15 A I used the criteria set forth in Bluefield Water Works and Imorovecent 16 Co=oany versus Public Service Co==ission, 262 U.S. 679 (1923) and 17 Federal Power Com:ission versus Hope Natural Gas Cocoanv, 320 U.S.

18 591 (1944). In these landmark decisions the Supreme Court established 19 as standards for reasuring the cost of capital that the return to the 20 equity owner should be co=censurate with the returns on invest =ents in 21 other enterprises having corresponding risks and, moreover, should be 22 sufficient to assure confidence in the financial integrity of the 23 enterprise so as to maintain its credit and to attract capital.

24 25 In determining a f air rate of return on common equity which would meet g 26 these two criteria, I have utilized an approach consistently employed

( 27 by this Commission. I have reviewed the presentations of Co=pany 28 witness Langum and Staff witness Hutt, I have cade an independent 29 review of the carnings record of the major electric utility ec=panies 30 in the country, I have reviewed the past financial performance of CP&L 31 and its current financial condition, I have reviewed the decision of 32 the Administrative Law Judge in the preceding Carolina Power & Light 33 Company rate case issued in September,1977, I have reviewed the rates 34 of return allowed on common equity by this Commission in other recent 35 cases, and I have evaluated the commonly used financial ratios produced 36 under my recommended rate of return to be sure CP&L would be able to t 37 maintain its financial integrity, to maintain its credit and to attract 38 capital.

39 40 Q PLEASE DISCUSS YOUR REVIEW OF COMPANY WITNESS LANGUM'S PRESENTATION.

41 42 A In his "co==ensurate return or comparabic earnings" study, Dr. Langum 43 introduced studies of the rate of return on com:on equity allowed by 44 state regulatory commissions, the earnings experience on coc=on equity 45 of High Grade industrial companies anc' the carned rate of return on 46 equity and equity ratios of 39 electric companies during the period 47 1963-1976. He first concluded that since the average rate of returr on 48 co==on equity derived from operating income allowed utilities by state 49 regulatory commissions in original cost jurisdictions during 1975, 50 1976, and part of 1977 was 13.5%, CP&L should be allowed a 13.5% rate l 1 of return on common equity by the Federal Energy Regulatory Commission.

2 Even though Dr. Langum was careful to use only those rate orders by 3 state co= missions in original cost jurisdictions, it is obvious that 4 this Commission should not rely upon such an analysis since there are 5 cany differences in ratetaking philosophy between the FERC and many 6 state commissions such as the use of a projected test year as 7 opposed to an historic test year, and since the Commission has stated 8 on previous occasions that to allow state commission decisions to 9 dictate ratecaking on the federal level would be to relinquish the 10 responsibility and authority conferred upon it by the Congress.

11 12 On pages 16 through 19 of his Exhibit, Dr. Langum presents the rate of 13 return on co==on equity cnd common equity ratio of operating electric 14 utilities in original cost jurisdictions without flow-through, including 15 companies with publicly-held cocoon stock and subsidiaries of holding 16 companies. A su==ary of the results for these 39 companics and for 17 CP6L is shown on Dr. Langun's Exhibit, pages 8 and 19 for the periods 18 1968 through 1976 and 1963 through 1976, respectively. The following 19 average returns on equity and equity ratios were derived from those 20 pages:

21 22 CP&L 1963-1976 1968-1976 1976 23 24 Return on Equity - 11.05% 11.91%

25 Equity Ratio -

32.16% 34.38%

, 26

\ 27 39 Companies 28 29 Return on Equity 12.46% 12.10% 11.69%

30 Equity Ratio 36.31% 34.71% 33.93%

31 32 These figures show that CP&L's rate of return on equity and equity ratio 33 has icproved relative te the group as of 1976, and that using the 34 cxperience of the 39 companies yields a zone of reasonableness for 35 rate of return on equity of between 11.69% and 12.46%. Ignoring the 36 actual rates of return carned by these 39 coupanics during this 14-37 year period as a determinant of the fair rate of return on common 38 equity for CP&L, Dr. Langum used these cata in connection with data 39 on the rate of return on coc=on equity and the co==on equity ratio of 40 industrial companics with a quality ranking of High Grade by Moody's on 41 pages 22 through 27 of his Exhibit to determine whether or not his -

42 recommended rate of return on co= mon equity is "in line" with ~the 43 historical relationships of corporate profitability in the unregulated 44 part of the American economy. Not only has Dr. Langum chosen for 45 cocparison unregulated companics not operating in monopolistic situa-46 tions and thus with attendant higher risks (as shown by the fact that 47 f or the 1973 through 1976 period the average rate of return on common 48 equity of the 41 industrial companies excluding oil companies was 17.50%

49 and the average common equity ratio vns 82.8%), he chose companies with 50 the highest possibic common stock rating awarded by Moody's. Even

\

- .._. __ . _ _ . - . _ - _ . .., _ .. _ . _. . , . . ., m , . .m

1 assuming, for the sake of argument, using Dr. Langum's " relativity

(

2 approach" of comparing the component for co==on equity of electric 3 utilities to the co=ponent for co==on equity of unregulated industries 4 is an acceptable approach to the determination of the fair rate of 5 return on the co= ton equity of CP&L, the unreasoned selectivity he 6 employed in applying this approach renders a rate of return recom-7 mendation which is extremely unjust and unreasonable as I will snow.

8 Dr. Langum has summariced the results of his application of this 9 approach on page 27 of his Exhibit. The logic u 9d is that the compo-10 neat for common equity reco== ended by Dr. Langus (shown in the last two 11 columns on the third line of nu=bers on page 27) divided by the appropriate 12 component for co= mon equity of the 41 industrial companies should 13 produce a reasonable percentage as co= pared to those percentages shown 14 on the bottom line of that exhibit. At first blush, the results seem 15 to do exactly that; however, it doesn't require a great deal of inspec-16 tion to discover a serious flaw in Dr. Langua's application of this 17 methodology as shown on that page. Instead of using the average of the 18 entire period shown or a reasonabic average of some subset of this data 19 such as the average of the highest and lowest years, Dr. Langum chose 20 as his comparison industrial component for co= mon equity that produced 21 in 1976 by the highest rate of return on co==on equity earned by the 22 industrial companies in the entire 1963 through 1976 period. It was 23 this type of scif-serving selectivity which was cited by the Adminis-24 trative Law Judge in his decision in Docket No. ER76-495 in rejecting 25 CP&L's presentation in support of its requested return on equity.

26

( 27 I have prepared Cooperative Intervenor Exhibit No. (JBS-8), page 28 1, to show the resulting rate of return on equity produced when the 29 comparison cocponent for common equity af the 41 industrials used is

?O the average of the entire 1963 through 1976 period and when the average 31 of the two years producing the highest and lowest ratio of component 32 for common equity for the electric ut'.11 ties to the ccmponent for coc=on 33 equity of the industrials is used. The result is a high of 12.56% and a 34 low of 10.39% or an average of 11.47% rate of return on co= mon equity.

35 36 Dr. Langum also used as justification for his recommendation of 13.5%

37 the fact that, in his judgment, this would produce a level of carnings 38 sufficient to bring Moody's ratings of CP&L's bonds to A and maintain 39 them at that level. In fact, subsequent to the filing of Dr. Langum's 40 testimony in this proceeding and subsequent to the issuance of the 41 Administrative Law Judge's decision in the predecessor case, Docket No.

42 ER76-495 (finding a rate of return of 12.00% to be a f air rate of return 43 on equity for CP&L), Moody's upgraded its rating of CP&L's first mortgage 44 bonds from Baa to A. Moody's had downgraded CP&L bonds to Baa in 1975.

45 Since that time, however, CP&L's financial condition has improved each 46 year. This can be seen fro = the times charges carned and earnings per 47 common share reported in Moody's Public Utility Manual and Moody's 48 Public Utility News Reports for 1975, 1976 and 1977:

49 50

__ .- - _ - _ - _ .--~

1 1 1977 1976 1975

(

2 3 Times Charges Earned 4 Before Income Tax 3.36 3.17 2.50 5 After Income Tax 2.31 2.24 2.06 6 Earnings Per Common Share $2.61 $2.52 $2.47 7

8 As pointed out by Dr. Langum, Standard & Poor's has maintained CP&L's 9 bond rating at A throughout this period.

j 10 j 11 Additionally, by reducing his reco= mended rate of return on co= mon 12 equity of 13.75% in Docket No. ER 76-495 to 13.5% in the instant Docket, 13 Dr. Langum has shown that he feels CP&L should be awarded a lower rate 14 of return in this case than in the preceeding case.

15 16 Q FROM TIIIS ANALYSIS, WHAT DO YOU CONCLUDE TIIE ZONE OF REASONABLI2ESS

. 17 FOR CP&L'S ALLOWED RATE OF RETURN 05 EQUITY SHOULD BE?

! 18 19 A It is my conclusion f rom the foregoing that the appropriate zone 20 of reasonableness for CP&L's allowed rate of return on equity should 21 be between 10.4% and 12.6%.

22 1

23 Q IIOW DOES Tl!IS ZONE OF REASONABLEUESS CO'SSRE WITIl THAT ESTABLISHED BY 24 THE ADMINISTRATIVE LAW JUDGE IN HIS INITIAL DECISION IN DOCRET NO.

25 ER76-495?

26

( 27 A It compares very favorably since the Judge in that Docket found the 28 cone of reasonableness to be from 11.0% to 12.5%.

29 30 Q WOULD YOU NOW PLEASE SHARE THE RESULTS OF YOUR REVIEW OF STAFF WITNESS 31 IIL"IT'S TESTIMONY?

32 33 A Yes, Witness Hutt also used as his primary measurement tool a "compara-34 tive study" of Carolina Power & Light and seven " comparable" electric 35 utilities supplemented by a number of other considerations such as the 36 recent performance of CP&L, its construction plans, and the effect of h 37 environmental standards. Mr. Hutt used the six-year period 1972 through 38 1977 for his study of CP&L and his seven selected companies. IIis Exhibit 39 on page 27 shows that the average carned rate of return on common equity 40 f or these seven utilities ranged from a low of 10.66% in 1974 to a high 41 of 12.36% in 1977. After reviewing this and the other data for these 42 companics, he concluded that a fair rate of return on common equity for 43 Carolina Power & Light should be 12.8%, which is outside the range 44 established by the seven companies, because it is his opinion that CP&L 45 is a riskier company than the seven as a group.

46 t 47 There are several basic problems with this analysis, not the least of 48 which is the fact that the Bluefield and llope decisions call for a rate 49 of return commensurate with the returns on investments in other enterprises 50 having corresponding risks. Mr. Hutt's group of seven utilities failed

(

('

1 to meet this test of comparability by definition since he finds CP&L to 2 be riskier than the group and finds it necessary to allow a rate of 3 return to CP&L outside the range of returns earned by his comparison 4 group during his study period. Additionally, even though his four 5 selection criteria were objective, his study contains too few companies 6 and too few years to yield meaningful results. The number of years is 7 especially short for purposes of indexing such as Mr. Hutt has done to 8 compare the results of the group of cocpanies with that of CP&L. If 9 the year chosen as the base,for the index is abnormal, the short five-10 year period which follows does not allow time for this distortion to be 11 ridden out. Also, some of the f actors listed by Mr. Hutt as repre-12 senting increased rish to CP&L relative to the seven " comparable" 13 utilitics appear to be either incorrect or inconsistent with other 14 statements in his testimony, data contained on other pages of his 15 exhibit and/or comparable data shown on CP&L witness Langum's exhibit.

16 For instance, Mr. Hutt's first factor is " slower rate of growth in 17 total kWh sales (page 22)." Page 22 actually shows that CP&L's total 18 kWh sales have grcwn more rapidly than those of the comparison group.

19 The rate of growth over the period shown is 20% for the group and 24%

20 f or CP&L. The annual compound rate of growth over that period is 3.67%

21 for the group and 4.33% for CP&L. The index shown for 1977 is 119.77 22 for the group and 123.6 for CP&L.

23 24 Another factor listed is, " return on average com=on equity has been 25 declining since 1975 while that of the seven co=parabic utilities has 26 been rising since 1974 (page 27)." While page 27 does in fact show

( 27 CP&L's return on average common equity declining from 1975 to 1976 and 28 then agafn f rom 1976 to 1977, this contradicts the results shown on 29 page 8 of the same exhibit where the return on common equity is shown 30 to increase f rom 1975 to 1976 and remain relatively stable from 1976 to 31 1977. This latter performance is confirme'd by witnes,s Langu='s exhibit, 32 page 8 where he also shows the rate of return on common equity increasing 33 from 1975 to 1976. Another such contradiction is attendant to the 34 f actor listed as " earnings per share have been erratic and generally 35 declining since 1972 while the seven comparable companies have had a 36 steady rise since 1974 (page 29)." The CP&L earnings per share reported by 37 lbody's Public Utility Manual and News Reports as well as the Company's 38 prospectus dated October 4,1977 show a steady rise in earnings per share 39 since 1974 In f act, page 29 shows that the earnings per share of both 40 the group and CP&L declined frem 1972 to 1974 and then both increased 41- 18% from 1974 to 1977. The footnote at the bottom of that same page 42 also indicates that CP&L restated its carnings per share for 1975 and 43 1976 to reflect a settlement agreement with its wholesale customers and 44 the effect of the Ad=inistrative Law Judge's decision in Docket No. ER76-495 45 which then illustrates the same steady increase in earnings per share for 46 CP&L during the period 1974 through 1977. Finally, in my opinion, an 47 isolated review of Mr. Ilutt's factor number 7, " average number of shares 48 outstanding are up substantially since 1972 relative to the growth experi-49 enced by the seven comparable companies (page 30)" could lead to an erroneous 50 conclusion. In fact, it is possible that this factor could be contributory

j j i to lowering the risk of CP&L relative to the seven companies rather than increasing it. The increase in average number of shares of common 2

3 stock outstanding in and of itself does not necessarily provide an 4 indication of the risk of a utility either standing alone or relative 5 to other utilities. Additionally, this Co= mission has often noted the 6 f act that the risk of a company is generally decreased as its equity 7 ratio is increased, and that is shown to be the result of this increase

, 8 in average number of shares outstanding of CP&L by Mr. Hutt himself 1 9 when on the same page he says, " Carolina Power has had a thicker equity 10 in both 1976 and 1977 than the seven comparabic electric utilities."

11 12 Q IF TIIE DATA USED IN MR. IlUTT'S COMPARATIVE STUDY WERE RELIED UPON IN 13 MARING A DErERMINATION OF THE APPROPRIATE RATE OF RETURN ON CO'LMON 14 EQUITY FOR CP&L, WOULD YOU CONCLUDE THAT CP&L'S RISK MAS AT LEAST 15 COMPARABLE EN0 UGH TO TIIAT OF THE GROUP OF SEVE UTILITIES TO WARRANT 16 ASSIGNING IT A RATE OF RETURN WITHIN THE RANGE OF 10.66% TO 12.36%

17 FOUND TO BE EARNED BY THE GROUP DURING TIIE PERIOD 1972 THROUGH 1977?

18 19 A Yes, pages 24 and 29 of Mr. Hutt's Exhibit show that CP&L's after-tax 20 total charges coverage and earnings per share have been increasing just 21 as have those of the group. Also, in 1977 the after-tax total charges 22 coverage and earnings per share for the group and for CP&L are very 23 close together. In fact, these statistics for CP&L are closer to the 24 average for the group in 1977 than any of the seven companies within l 25 the group with the one exception of the af ter-tax total charges coverage 26 of Pennsylvania Power and Light which is 0.01 closer to the average than

( 27 is that of CP&L. Another major factor is that the equity ratio of CP&L 28 is over two percentage points higher than the average of the group and, 29 as shown on page 8 of Exhibit No. (WEH-1), Value Line projects CP&L's 30 equity ratio to increase to almost 40% in 1978.

31 32 Additional factors to consider are that coal and nuclear f acil'Mes 33 comprisc 95% of CP&L's generating capacity compared with the national 34 average of 56% (in 1976) as shown in the Electric Utilities Basic Analysis i 35 of Standard & Poor's Industry Surveys dated February 23, 1978 (section 36 2) and that 28% of its revenue comes from industrial sales which is the 37 same as the national average shown for 1976 in the same publication.

58 39 Q PLEASE DISCUSS YOUR REVIEW OF THE INITLib DECISION OF THE ADMINISTRATIVE 40 LAW JUDGE ISSUED SEPTI 21BER 7,1977 IN CAROLINA POWER & LIGHT COMPANY, 41 DOCRET NO. ER76-495 (PHASE II) AND THE APPIICABILITY OF HIS FINDINGS TO 42 THIS PROCEEDING.

43

44 A In his decision, the Adninistrative Law Judge devoted 11 pages to a

45 thorough analysis of the record evidence on the subject of determining 46 a fair rate of return on equity. He concluded that the credible evidence 47 of record established a range within the zone of reasonableness of 11.0%

i 48 to 12.5% as a f air rate of return on common equity for CP&L and that a 49 12.0% rate of return should be adopted as being at the upper band of I 50 reasonableness.

l 1

('

l As previously noted, CP&L's financial condition has been steadily improving i

2 since 1975 as indicated by the najor financial indicators of coverage 3 ratios, earnings per share and equity ratio. Given CP&L's improved 4 financial condition, the zone of reasonableness established by the 5 review of data filed by Dr. Langum of 10.4% to 12.6%, the zone of reason-6 ableness established by the review of Witness Ilutt's comparative study

7 of 10.7 to 12.4 and the zone established by the Administrative Law 8 Judge recently of 11.0% to 12.5% it is my conclusion that the 12.0%

9 allowed by the Administrative Law Judge in Docket No. ER76-495 should 10 be used as the fair rate of return on co=non equity of C"6L in the 11 instant docket.

12 13 Q M!AT ADDITIONAL ANALYSES DID YOU MAKE IN 0?IER TO CONFIRM TilAT 12.0%

14 WAS A FAIR RATE OF RETURN ON COSMON EQUITY FOR CP&L?

15 .

16 A As a check on the reasonableness of my rate of return on com=on equity 17 recommendation of 12.0%, I have conducted two additional analyses. First, 18 I have cade a review of the rates of return on co= mon equity allowed by 19 this Co= mission and its predecessor, FPC, in recent opinions. I have also l

i 20 analyzed the results of several Discounted Cash Flow (DCT) calculations 21 under various conditions.

22 23 Q PLEASE DISCUSS Tile RESULTS OF YOUR ANALYSIS OF RECE';T CO> MISSION RETUPJ' 24 ON EQUITY CAPITAL ALLOWANCES.

25 26 A The rates of return on co= mon equity allowed in these ten recent electric

\ 27 utility cases are shown on Cooperative Intervenor Exhibit No. (JBS-8) ,

28 page 5. The allowed rates of return range from 12.0% to 13.5% on equity 29 ratios of 37.48% and 29.03%. The average of the returns on equity 30 allowed is 12.'83% and the average of the equity ratios is 35.07%. Of 31 course, a review of returns allowed by the Co=nission over such a short 32 period of ti=e, with so few compar.ies in various states of financial 33 condition involves circularity and suffers seriously as the sole method 34 for determination of the f air rate of return on co= mon equity for a 35 particular company. However, it is useful in assuring that the zone of 36 reasonableness established by the evidence of record falls generally 37 within the range of equity returns actually allowed by the Coanission 38 in recent Opinions. The zone of reasonableness determined earlier in 39 ny testimony overlaps only the lower end of the range of returns recently 40 allowed by this Cocaission; however, that zone is compatible with this 41 range since it is based upon tne evidence in the instant docket upon 42 which the Administrative Law Judge and the Commission will rely in 43 making its decision in this docket.

44 45 Q UllY ARE YOU USING A DISCOUNTED CASH FLOW A'iALYSIS AS A C11ECK ON TIIE 46 REASONABLENESS OF YOUR REC 0! MENDED RATE OF RETURN ON EQUITY?

47 48 A The DCF nethodology allows the develop =ent of a reasonable assessment

49 of the expectations of the market place in terms of the return on commea 50 equity stock. I say expectation not si= ply because a computation can

. l r

1 be made based upon projected data as well as histerical data, but

( 2 because projections of expected earnings and dividends can only be 3 rationally made on the basis of past experience. Thus, if properly 4 employed, the investor's expected rate of return can be determined.

5 6 The Discounted Cash Flow method assumes that the investor's capitali-

, 7 zation rate or required rate of return on cc mon equity is equal to the 8 current yield of the security plus the expected price appreciation.

9 It is generally assumed that this price appreciation results from a 10 growing stream of future returns and thus the formula is expressed as 11 follows: D 12 r = fr+ g 13 The D divided by P is the current dividend yield and the g may be the 14 expected growth rate of dividends or carnings.

15 16 The DCF method is very appealing in theory, however, its major strength 17 also becomes its major weakness when applied in a regulatory setting in 18 that the determination of the expected growth in dividends and/or earnings 19 per share must be based on individual judgment and thus subject to 20 considerable controversy. Obviously, a wide range of common equity 21 returns could be justified by picking t'.te appropriace estimated growth 22 factor.

23 24 in addition, it could be reasoned that, since the formula shown above 25 is based upon a long run outlook in that it assumes a constant growth 26 rate (g) to infinity, investors may expect the future yield (D/P) to

( 27 be something other than that currently experienced. This is logical 28 in light of the f act that the price of a given con =on stock is subject 29 to substantini volitility in the short run depending on a number of 30 f actors varying from the fundamental financial condition of the company 31 to the psychological mood of the marketplace. Thus, judgment must be 32 exercised not only in chosing the appropriate growth rate (g), based 33 upon a decision as to whether dividend growth or earnings growth is 34 .more appropriate, but also in chosing the dividend yield to be employed.

35 36 Still, the DCF method can be used as a valuable check on the co= mon

( 37 equiry return developed in other ways as the Commission has recently 38 indicated.

39 40 Q llGW HAVE YOU EMPLOYED THE DCF METHOD AS A CHECK IN YOUR ANALYSIS?

41 42 A Considering the factors discussed above, I have relied upon four calcu-43 1ations using this method -- three based upon expected growth in divi-44 dends since dividends provide the most stable stream of returns and 45 another using the dividend y1cid and average annual increase in carnings 46 per share over nine five-year periods as reported in Public Utilities 47 Fortnight 1v. The results of these calculations are shown on Coopera-l 48 tive Intervenor Exhibit No. (JBS-8), pages 2, 3 and 4 These j 49 calculations produce a relatively wide range of possible returns, but 50 the average confirms that my recom= ended 12.0% is a generous rate of return on common equity.

s 1 For the first calculation I have used the current annual dividend and

( 2 current stock price as reported in the Wall Street Journal for June 2, 3 1978. Based upon the current annual dividend of $1.84 per share and 4 the June 2,1978 market price of $22.50 per share the current yield is 5 8.18%. To determine the appropriate expected rate of growth in divi-6 dends I have used the dividends declared per share reported by Value 7 Line as shown on Staff Witness Hutt's Exhibit, page 8 for the years 8 1963 through 1977. As shown on Cooperative Intervenor Exhibit No.

9 (JBS-8), page 2, I have calculated the annual conpound rate of growth 10 in dividends for fourteen differcht periods beginning with the one-year 11 period 1976 through 1977 and one-year increments ending with the 12 fourteen-year period 1963 through 1977. The high and low growth rates 13 for these periods are 4.70 and 2.56, respectively and the average of 14 these growth rates is 3.26. Adding this 3.26% growth rate with the 15 8.18% dividend yield produces an expected rate of return of 11.44%.

16 17 For my next calculation I determined the average dividend yicid for the 18 period 1963 through 1977 to be 5.77%. I then added the previously 19 determined average annual dividend growth rate of 3.26% and obtained a 20 required rate of return on equity of 9.03".

21 22 The third calculation, using the growth in dividends, is based upon the 23 Value Line projections (shown on Staff witness Hutt's Exhibit, page 8) 24 of the average annual dividend yield in the 1980-82 period and the 25 average annual increase in dividends during the period 1975-77 to 26 1980-82. These figures are 5.6% and 8.5%, respectively, and their sum

( 27 is 14.10%.

28 29 Averaging the lowest result and the highest result from the three calcu-30 lations I obcain 11.57% as a reasonable rate of return on equity expec-31 tation by the market place.

32 33 The fourth calculation, shown on Cooperative Intervenor Exhibit No.

34 (JBS-8), page 4, utilizes the dividend yield and average annual increase 35 in carnings reported by Public Utilities Fortnight 1v for nine five-year 36 periods for 110 electric utilities. The indicated required rates of 37 return on common equity resulting from the addition of the two figures 38 for each time period ranged from a low of 9.2% to a high of 12.5% with 39 an average of 10.94%. The average was ce= posed of a 7.16% dividend 40 yield and a 3.78% annual increase in earnings per share. The results 41 of this calculation for the 110 co=panies are comparable to those 42 obtained in the three DCF calculations above for CP&L, and they all 43 support my earlier conclusion that ny reco= mended rate of return on 44 common equity is well within the zone of reasonableness. In fact, 45 these calculations show my reco= endations to be well in the upper 46 portion of the zone.

47 48 Q ARE THERE An* OTHER REASONS WY CP&L SHOULD NOT BE ALLOWED A RATE OF RETURN 49 ON COMMON EQUITY IN EXCESS OF 12.0%? l 50 1 l

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r 1A Yes, CPLL is experiencing tremendous annual, cost-free capital contri-2 butions by its rate payers currently for huge amounts of taxes which it 3 will not pay until many years later or not at all. This has been cited

, 4 by the Cocnission as a rencon for granting a retunT on cocmon equity 5 lower thar. night otherwise be appropriate.

6 7 Also, as shown by Staff witness Hutt and as I stated above, CPLL is in 8 a very favorabic fuel situation with approximately 95% of its energy 9 generated with coal and nuclear fuel.

10 11 Q DOES YOUR RECOMMENDED RATE OF RETURN PROVIDE IPTEREST COVERAGE RATIOS 12 WHICH ARE ADEQUATE FOR THE COP?ANY TO MAINTAIN ITS FI'UdiCIAL INTEGRITY 13 AND ATTRACT CAPITAL?

14 15 A Yes, as shown below my reco== ended rate of return should assure the 16 Company's ability to maintain its financial integrity and attract 17 capital.

18 19 In Standard and Poor's The Fixed Income Investor, January 3,1976, 20 pages 987 and 988, in discussing bond ratings, Standard and Poor's 21 says that the primary earnings tests remain those centering on fixed 22 charge coverage and that the most important of the coverage tests for 23 rating purposes are the pre-tax and pre-tax excluding AFDC coverage 24 tests. The minimum coverages given for AA and A ratings were 3.0 and 25 2.5, respectively. The pre-tax coverage calculation can be expressed 26 as folleus: ~

( 27 28 """* " * **

• Times Covered = Interest Requirements 29 30 31 + Preferred Dividends Common Return or 32 Times Covered =

nterest (1 - Tax Rate) (1 - Tax Rate) 33 Interest Requirements 34 35 This calculation, using my recommended return, yicids a coverage ratio 36 of 3.83 as follows:

37 -

38 (14.07%)(8.01%) + (35.61%) (12.00%)

39 (50.32%)(7.77%) + (1 .5112) (1 .5112) 40 (50.32%)(7.77%)

41 42 14.96 = 3.83 43 3.91 44 45 This is the coverage ratio CP L would achieve if its capital structure 46 were equal to its rate base. However, the capital structure I used 47 in my rate of return determination is not the same as the rate base 48 used in my cost of service study. The primary reason for this is 49 because construction work in progress (except for pollution control 50 f acilities) and nuclear fuel in process is not included in the rate i '

l .

1 base so I will make two additional corputations below showing the effect 3

( 2 on coverage of this difference with and without AFUDC.

3 4 Coverage With AFUDC:

5 6 (Eefore Tax Cost of Capital)(Rate Base) + (Before Tax AFUDC Rate)(CWIP) 7 (Debt Component) (Capital Structure) 8 9 (14.96)(1,772,562,808) + (8.87)*(703,343,916)**= 3.51 .

10 (3.91)(2,387,754,757) 11 l 12 *From Cooperative Intervenor Exhibit No. (JBS-6), page 2.

13 ** Average CWIP + NFIP from 1977 Form 1 less CWIP included in rate base.

14 15 Coverage Without AFUDC:

16 17 (Before Tax Cost of Capital)(Rate Base) i 18 (Debt Component)(Capital Structure) 19 20 (14.96)(1,772,562,808) 21 (3.91) (2,387,754,757) = 2.84 22 j 23 Thus, comparing these coverages with the mini =ums listed above for 24 AA and A coverage, enc can see that my reco= mended return should allow

. 25 CP&L to comfortably maintain its A ratings. This should be especially

{ .

26 true given CP&L's favorable fuel situation, customer breakdown and cash

( 27 flow from customer contributed capital in the form of deferred taxes, 28 investment tax credits and income taxes allocated to other income,

, 29 1 30 Q DOES *" SIS CONCLUDE YOUR TESTIMONY AT THIS TIME?

! 31 j 32 A Yes, it does.

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34 35 i 36 1

37 i 38 l 39 40 j 41 j 42

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44 45 46 47 i 48 i 49 I 50 i

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