1. Utility Finance: A View from the Trenches Brad Jackson Foley & Lardner, LLP

2. Summary of Issues The Regulatory Compact Capital structure issues Measuring the unmeasurable: the investor’s required return on equity Financing new infrastructure

3. The Regulatory Compact Natural monopolies Utility agrees to make required investments and provide adequate (safety and reliability) service at regulated prices Government agrees to protect firm against competition and authorize just and reasonable rates that include a return on the utility’s investment

4. Capital Structure Issues The utility’s cost of capital is its weighted average cost of debt and equity PSC establishes long term equity % range (i.e., 54-58%) Typically tied to desired credit rating –If % of equity in utility’s capital structure is below range, may need to infuse equity

5. Capital Structure Issues The balance –Cost of equity is higher than cost of debt, so higher equity ratio results in higher rates –But lower equity ratio creates more risk and result in higher cost of capital

6. Capital Structure Issues Impact of long-term PPAs –Portion treated as “debt equivalent” –Increases debt % in capital structure –Requires equity infusion to maintain d/e ratio –Makes it more difficult to justify economically long-term purchases from non-utility facilities vs. self-building

7. Investor’s Required Return Bluefield and Hope Natural Gas: Utility is entitled to earn a return on its investment commensurate with the return earned by other businesses with similar risks. The return should be sufficient to assure confidence in utility’s financial integrity, to maintain the utility’s credit, and allow the utility to attract capital at reasonable cost.

8. Investor’s Required Return The Models, or full employment for analysts Comparable earnings – 14.5-15% –Determine return earned by companies with similar risk –Earned return = expected return? –Include non-regulated firms in sample? –Reliance on analyst risk factors

9. Investor’s Required Return Capital asset pricing model – 11.5-12% –Measure risk of an investment as part of a diverse portfolio; look at only effect of economy-wide forces –Market risk premium: are historic premiums valid basis for expected premium? –PSC staff: shareholders have been earning higher returns than they required

10. Investor’s Required Return Risk premium analysis – 11.4% –Apply historic spread between utility stocks and bonds to projected utility bond yields –Simple, easy to understand and apply –Mechanistic Discounted cash flow model – 9.2-11.0% –Analyst projections of growth biased upward? –Large variability in results (7.17-12.18% in recent PSC staff analysis)

11. Investor’s Required Return Practical and policy considerations for the rate of return –Energy industry restructuring and uncertainty = risk? –Regulatory uncertainty increases cost of capital? PSC staff white paper

12. Investor’s Required Return –Holding company dynamics Which securities are we valuing? How to consider holding company’s non-utility investments and risk –Divestiture of formerly integrated functions (transmission, generation dispatch) Thinner rate bases More variable expenses

13. Investor’s Required Return –Carrots and sticks Encourage infrastructure investment Reward prudent activity and penalize imprudent activity Lower returns to lower rates vs. higher returns for having lower rates

14. Financing New Infrastructure Traditional rate basing –Cost pass through at authorized returns (risk of changing returns) –Direct regulation of operational efficiency Modified rate basing –Investment is added to rate base with long- term fixed return

15. Financing New Infrastructure Leased generation –Investment financed and owned by non-utility affiliate and leased to utility with fixed lease payments including fixed (and enhanced) return –Financed with more debt than utility investment –Higher cost to customers, but infrastructure may not be built otherwise