'" TGI 2005 ROE, Exhibit B-3, Response to BCUC IR 74.1, Appendix 74.1

APPENDIX 74.1

{6- ZOB-20

TGI 2005 ROE, Exhibit B-3, Response to BCUC IR 74.1, Appendix 74.1

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First, the definition of efficiency iselusive. It is difficult for regulators, con-sultanrs, accountants, and sometimesthe company irself, co distinguish effi~cient behavior from inefficient. Whilemeasures of utility efficiency have beendeveloped (e.g., labor productivity, roralfuctor productivity, number of com-plaines, etc.), there always will be a largecomponent of utility performance thatfulls outside of what can be objectivelyanalyzed and measured.

This inability to effectively monitorperformance means that hands-on reg-ularors are doomed to steer a coursebetween dangerous rocks and a power-ful whirlpool. By steering away fromthe pure cost~plus contract, whereratepayers fuce runaway coses, regula-tors risk being drawn into periodic andsometimes large disallowances that -threaten utility financial integrity andratepayer security.

Second, this Failure to have objectivestandards for efficiency is compoundedby "information" and/or "agency"problems. It is difficult for oursiders orthose without years of experience toevaluate the decisions of utility man-agers (or to even know what thosemanagers do). Utility manager.; arelikely always to be more informed thanregulators or their sraffi regarding thecompany they manage. It is terribly dif-ficult to monitor utility decisions whenthe information How is so incompleteor when regulators must rely on urilitymanagers to volunteer information onpoor decisions.

Third, and most pertinent to rate ofrerum, objective confirmable standardsmay never exisr to confirm estimatesof COSts.In the case of rate of return,there is no way of knowing what meuue Fair rate of rerum is (or was), evenin hindsight. All we ever have is for-ward-looking race of rerum estimatesand hisroncal earned recums. This isnot so for any other COStcategory. »

Incentives for Efficiency

The current regulatory framework setsefficient utility behavior as its goal buralways seems to Fail to reach it. Why?

The Current State of theRatemaking ProcessThe current raternaking process is tor-ruous and ofren unpleasant, for com-missions, utilities and ratepayer.>. AMississippi Supreme Court Judge cap-tured a quintessential aspect of theprocess when he said:

"Utility rate litigation has becomesporr, a vent for passions. Each COntestsatiates for the moment, then fuels theappetite for further fight. We shrinkfrom the thought of the season ending."1

That was uue when this quote waswritten(l989), and it's uue today. It isnor, however, the direct consequence ofthe actions of attorneys, consultants,intervenors, commissioners, or scaffthat cre-.ltes this problem. It is the regu-latory process chat makes it almostinevitable that rate case issues are sub-ject to repeated, increasingly detailed,and costly inquiry. This regularoryframework nor only provides a ques-tionable incentive for efficient opera-tion for utilities, it also is expensive.Both of these forures crote an envi-ronment for contentiousness over theissue of rate of return.

Inthe Feb. 15,2003, edition ofPubLic UtiLiti~s

FortnightLy. JonathanLesser says tharregu1acors need rorethink the tradi-tional discowued

cash flow (DCF) method for findingthe cost of capiral, or "at the very least,regulacor.; should no longer rely solelyon the DCF co set allowed rerurns."

This is an old issue. Lesser may (ormay not) be aware chat commissions inthe United Srates have been searchingfor a way ro streamline urilities' rate ofrerum investigations for decades, andyet they still generally rely on the DCFmethod. For practical purposes, this isunlikely to change in the United Scates,despite the recommendations of thoselike Dr. Lesser and those before him whohave recommended a different path.

The topic of the f.Ur rate of rerumcontinues to be a vexing part of utilityregulation. No one, anywhere, has yetdevised a way co make the processagreeable. Why has the process been sodifficult?

It is not possible co assess the ade-quacy of particular rate of rerum tech-niques without looking more broadlyat how those techniques fit intO thelarger regulatory process.

It is hard to foresee abandoning the discounted cashflow method relied upon so heavily for the pastcouple of decades.By JEFF D. MAKHOLM, PH.D.

In Defense of the'Gold Standard'

TGI 2005 ROE, Exhibit B-3, Response to BCUC IR 74.1, Appendix 74.1

For example, estimates of depreciablelives can always be updated by experi-ence with actual capital assets. Thesame is true with estimates of marginalcost-aperience will tend to confirmbetter estimates in the fucure. Butthe "true" rate of return is alwaysunverifiable.

Cost of the Process

The second major problem with thecurrent ratemaking process is its COSt.Not only does the process serve uspoorly, it is very expensive. There havebeen attempts by the Federal EnergyRegulatory Commission (FERq andthe New York Public Service Commis-sion to regularize the rate of rerumcomponent of rate cases. Both havefuiled to do so. The Generic FinancingProceeding in New York. conducted inthe early 1990s, despite its staggeringprice tag in professional fees and theloss of productive time for utility andcommission employees, fuiled, asFERC's did before it. to streamlinethe process.

The Evolution of Rateof Return Analysis

The fair rate of rerurn became a hotlyCOntested issue in the early 1970s,when the electric utility business wasundergoing the "triple rh.reat" ofunprecedented inflation, rapid fuelprice increases, and the end of decadesof impressive technical advances inlower-<:ost generating technoIogy. TheDCF and capiral asset pricing model(CAPM) methods gOt their start at thisrime and have survived nearlyunchanged as the primary rate ofreturn methods, with the DCF the vir-tual default method in practically allU.S. regulatory jurisdictions.

Improvements in the theoreticalaccuracy, objectivity, and reliability ofthese methods have come at a snail'space and generally address only minor

14 PuBUC UnUTlES FORTNIGHTU' MAy 15, 2003

issues, For example, more than 20 yearsago, arguments raged in race of returnproceedings over whether to use for-ward-looking, rather than historical,information in the financial modelsused co calculate the rate of rerurn.1

A dozen years ago, the argumenthad progressed to smaller issues (interms of the potential effect on rate ofreturn) such as the ex-dividend dateadjustments and the inclusion into the

Most rate case issues,with the exception of majorcost items, are capable ofbeing settled in relativelyshort orde~

sustainable growth model of anallowance for the selling of stock at

prices above book value.Meanwhile, every seeming advance

in rate of return analysis is foUowed bya retreat. Historically based "compara-ble ~" analyses, preswned deadafter the advent of the well-groundedfinancial theories like DCF andCAPM, have risen from the ashes ofpast regulation to be considered a gen-uine rate of return technique. Further-more, sound theoretical models areoften sacrificed on the alw of ati hocadjustments, when staff or companyanalysts scr:unble to move a model'sresults down or up for a ncver-endingvariety of reasons thac are impossible toverify empirically or theoretically.

It remains crue today that most ratecase issues, with the exception of majorcost items, are capable of being settledin relatively shorr order except for rateof return, where the old issues are con-tinually batded our. So, what are the

options co reduce the scope of the inter-minable fighting over rate of rerum?

Previous Attempts to Standard-

ize Rate of Return Analysis

Rate of return techniques abound, butvery little time and attention is paid todetermining which have practical use-fulness. The theories that underlie theempirical determination of the cost ofcapiral have become increasingly arcaneand irrelevant to the practical racemak-ing world, where common sense,believability, and simplicity determinewhich techniques an adminiscrative lawjudge or commissioner will use co setthe allowed rerum. At times it seemsthat the goals of theoretical accuracyand usefulness are murually exclusiveattributes in rate of rerum models usedin utility rate cases.

Although much time is spent dis-cussing the technical aspects of rate-of-return techniques, we never get aroundto establishing criteria for determiningwhether they are any good in real ratecases.

Both FERC and the New York Pub-lic Scrvice Commission tried to regular-ize rate of return investigations byconcencrating on the method (or meth-ods) involved. FERC's generic rare-of-return process, begun in 1986, endedin a fog of adjustments for a seeminglyendless procession of "special cases."The 1991-1993 Generic FinancingProceeding in New York. which wasdesigned to produce an objective stan-dard for setting the fair rate of return,

has not srreamlined the process. On thecontrary, the outcome of that genericproceeding (which was never adoptedby the commission in New York) con-tinues to haunt New York rate cases likea dusty book of alchemy from ancientcimes-undemandable only to thosewho wimessed its creation.

The methods adopted in New York.for example, were overly complex, ))

www.fortnightly.com

TGI 2005 ROE, Exhibit B-3, Response to BCUC IR 74.1, Appendix 74.1.Iii

III!IIII:

ad hoc, and led inevitably to funherexpensive fights and litigation when thefinancial winds shifted. Boch proceed-ings consumed a gre:l.t amount of time.efforr, and expense in an attempt toestablish generic rules in the first place.In a larger sense, there was so muchground co make up chat the ptoceed-ings could not be said to have beenworthwhile-even if durable ruleshad come Out of thern.

Why the Appeal of the DCF?The DCF method has endured formost of the past twO decades for threebasic reasons:

• It rests on a solid, straightforwardcheoretical base; ,

• It capiralizes on the depth of U.S.capiral markers-meaning analy-sis can use "proxy groups" ofpublicly traded companies in thesame industry co manage thevariability of individual companyDCF calculations; and

• It makes use of company growthprojections from disinterestedindustry analysrs-a key attributefor a method co gauge the oppor-tunity COStof capiral in the mindof investors.3

It is difficult co overstate the practi-cal importance of these three aruibutesof the DCF mechod. The CAPM, bycomparison, is absrruse as a piece ofcheory. Further, because most of thecomponents of the calculation are

common co all companies (i.e., therisk-free rate and the market risk pre-mium), the CAPM cannoc make use ofthe law of large numbers. That is to

say, che problems associated with whichrisk-free rate co pick, or which marketrisk premium to adopt, hinder theresult. no matter how many companiesthe calculations are performed upon.Finally, che CAPM has no tie co disin-terested company analysts that nor onlyreflect, but also shape. the opinions of

16 P~BUC UnunEs FORTIlIGIffi.Y MAy 15, 2003

investors. It is thus no surprise chat cheCAPM is vastly less popular amongU.S. regulatory commissionsas a rate of rerum method.

The other methods mentioned byLesser have more debilitating aruibutesstill. The comparable earnings methodis generally irrelevanc co investor expec-tations, to the extent that is uses histor-ical earnings dara. Risk premiumanalyses rake the COStof debc as given(easy to do. as debt costs are observ-able), but suuggle perperually withhow co calculate the equity risk pre-mium. To the extent chat the equityrisk premium uses historical data. it isagain generally irrelevant ro investorexpectations. If it derives the premiumby reference to a prospective cost ofcapiral rnethod (like the DCF orCAPM), then it is simply not an inde-pendent method at all.

In the COntext of U.S. rate cases, theDCF method's attributes are magni-fied, as are the drawbacks of the othermethods. The nature of the methods coresolve disputes in U.S. utility ratecases is at least as important as the the-oretical attributes of the particularmethods employed. "Informationallydemanding" methods, like the CAPM,do not stand a chance as a method forresolving conflict between contendingparties cornpared to the "information-ally simple" methods, with tangibleparameters, like the DCF.

As a result, Lesser's "more methods"recommendation is a dead end. He iscorrect co point out the greater vari-ability in estimates now than in yearspast. Mergers, the advent of holdingcompanies. and deregulation all haveserved co shrink the numhc:r of compa-nies to which the DCF analysis can beapplied. Nevertheless, the marginalreduction in proxy group size or stabil-iry in the past decade does not counter-vail the three underlying reasons whythe DCF IS so popular.

Perhaps the best way to deal withthe perperual contention surroundingthe rate of rerurn is not to repudiatethe overwhelmingly preferred DCFmethod or pretend that more methodsand more investigation might work,but rather to shrink. the scope for con-tention surrounding the issue.

Reducing Rate of ReturnConflictsOne cried and tested method to reducerate of rerum contention is to turn to

alternative regulatory frameworks chateither eliminate the need to set the fairrate of rerum or thac lengthen the rimebetween rate cases. There are at leastthree pocencial ways to reduce rate ofreturn contention.

Unbundling and deregulation Theairline industry, uucking industry, gasproduction and cransporr, and electric-ity generation capacity once fell undercornprehensive rate of return regulationbut were subsequently deregulatedeither partially or fully.

Unbundling and deregulationreduces rate of rerum barues becausethey reduce the size of the asset basesubject to rate regulation. In ocherwords, with a smaller pie, there shouldbe less incentive co fight. For example,in what I called the "contraerualization"of the U.S. interstate gas transpOrtindustry, the determination of the fairrace of rerum has become increasinglyless important as conuaerual obliga-tions between gas rransporrers and dis-uiburors replace traditionally regulacedraces. And if rate regulation ends com-pletely, then the reason for the fighcover race of rerum vanishes.

Reduce the number of contestedissues. Permitting cost pass-throughslike fuel adjustment clauses, weacheradjustments, revenue decouplingmechanisms, and other techniquesthat remove attrition: reduces theneed for filing frequent rate»

www.foftl1lghtty.com

TGI 2005 ROE, Exhibit B-3, Response to BCUC IR 74.1, Appendix 74.1

cases because it eliminates f.u:rorsoutside of management's control.

Institutionalized price cap regula-tion. Price cap regulation, or perform-ance-based regulation (PBR), allowsprices to be indexed to both the gen-eral price level and durable industry-wide productivity trends. As such, ithas reduced the frequency of contestedprice-setting cases where rate of retumis an issue. However, PBR regulationdoes not prevent rate of rerum fromarising as an issue when it does appear.

In conclusion, contention over thefair rate of rerum is an unavoidablecomponent of utility regulatory over-sight, even under alternative frame-works. Efforrs to make the processobjective and mechanical are futile asan adminismtive and practical marter.

The only realistic way to reduce rate ofrerum contention over the long term isto unbundle and deregulate utilityfunctions (like gas rransmission), andlengthen the time between rate cases byinstituting PBR or other progressiveregulatory programs.

For the rare of rerum contention thatdoes exist, it is hard co foresee abandon-ing the DCF as the gold standard reliedupon so heavilyby U.S. commissions andutilities for the past couple of decades.From the perspective of dispute-resolu-tion techniques and simple efficiency,the DCF-despite its difficulties-retains attributes char other rate ofrerum methods just cannot match. ~

Jeff Maitbolm is a senior vial presidenJ aJ NaJian-aJ Eamamic Research AsrociaIes Inc. (NEIU)

rmd CIJ-cbair of NEIU iEnergy Pradic8.

Endnotes1.Justice Robettson, MiWsippi Supreme Courl,

Slate ofMiWsippi el al, II. Misrissippi PubHc Ser-

vice CommissIOn and Mississippi Pow6r Com-

pany, Jan. 4, 1989.

2. In reality, this issue has, alas, never gone

away enlire1y.

3. Regulatory commissions OUl.5ide the United

Slates do no! have the luxury of either such

deep capital markea (with many publicly tr.ldedcompanies in the same indusay) or the ass0ci-

ated vast array 01 SlOCk analysts. As a resu1l. theyuse Olher medlods. bur with less robust resulls

and often more extensive c:ontentioo.

4. Aarition OCCUIS when earnings are depressed

over time because the marginal C05t 01 new

plant and equipment exceeds average oosts

and average prices.

I"

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~18 PUBUC UnllTIES FoRTHIGIITU MAy 15, 2003 www.fortmghttv·com