STATE OF ALASKA BEFORE THE REGULATORY COMMISSION OF ALASKA Before ...

101 Pages·2014·1.2 MB·English

STATE OF ALASKA

BEFORE THE REGULATORY COMMISSION OF ALASKA

Before Commissioners:Robert M. Pickett, Chairman
Paul F. Lisankie
T.W. Patch
Norman Rokeberg
Janis W. Wilson

In the Matter of the Consideration of the Revenue )
Requirement Designated as TA 262-4 Filed by )
ENSTAR NATURAL GAS COMPANY, A ) Docket No. U-14-____
DIVISION OF SEMCO ENERGY, INC. )
)

PREFILED DIRECT TESTIMONY
OF
ROBERT B. HEVERT

1 INTRODUCTION
2 Q. Please state your name, affiliation and business address.
3 A. My name is Robert B. Hevert. I am Managing Partner of Sussex Economic Advisors,
4 LLC (“Sussex”). My business address is 161 Worcester Road, Suite 503, Framingham,
5 Massachusetts 01701.
6 Q. On whose behalf are you submitting this testimony?
7 A. I am submitting this direct testimony (“Direct Testimony”) on behalf of ENSTAR
8 Natural Gas Company and Alaska Pipeline Company (to which I will refer to
9 collectively as “ENSTAR” or the “Company”), a division of SEMCO Energy Inc.,
10 which is a subsidiary of AltaGas Ltd.
11 Q. Please describe your educational background.
12 A. I hold a Bachelor’s degree in Business and Economics from the University of Delaware,
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1 and an MBA with a concentration in Finance from the University of Massachusetts. I
2 also hold the Chartered Financial Analyst designation.
3 Q. Please describe your experience in the energy and utility industries.
4 A. I have worked in or with regulated industries for over twenty-five years, having served
5 as an executive and manager with consulting firms, a financial officer of a publicly-
6 traded natural gas utility (at the time, Bay State Gas Company), and an analyst at a
7 telecommunications utility. In my role as a consultant, I have advised numerous energy
8 and utility clients on a wide range of financial and economic issues, including corporate
9 and asset-based transactions, asset and enterprise valuation, transaction due diligence,
10 and strategic matters. As an expert witness, I have provided testimony in approximately
11 100 proceedings regarding various financial and regulatory matters before numerous
12 state utility regulatory agencies and the Federal Energy Regulatory Commission. A
13 summary of my professional and educational background, including a list of my
14 testimony in prior proceedings, is included in Attachment A.
15 EXECUTIVE SUMMARY
16 Q. Please provide a summary of your Direct Testimony.
17 A. Based on my analysis, I believe a return on equity (“ROE”) of 13.75 percent is
18 reasonable and appropriate for ENSTAR.1 In today’s capital markets, the range of rates
19 of return on investors’ common equity for natural gas companies with similar business
20 lines, structure, and operations to ENSTAR is 12.50 percent to 14.00 percent. Once
21 ENSTAR’s specific risk profile is taken into account, including its upcoming capital
22 investment requirements, its need to operate and maintain transportation and
23 distribution assets, its lack of geographic diversity in gas supply, and its relatively small

1 Throughout my Direct Testimony, I interchangeably use the terms “ROE” and “Cost of Equity.”
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1 operations in a geographically isolated environment, I believe that a 13.75 percent rate
2 of return on investor’s common equity rate reasonably reflects the current market for
3 ENSTAR.
4 My recommendation, and the analytical results on which it is based, considers a
5 variety of factors including prevailing capital market conditions and the specific risks
6 faced by ENSTAR. Because the application of financial models and interpretation of
7 their results often is the subject of differences among analysts in regulatory
8 proceedings, I believe that it is important to review and consider a variety of data
9 points; doing so puts in context both quantitative analyses and the associated
10 recommendations.
11 In this proceeding, there is the highly relevant benchmark of the 12.55 percent
12 ROE currently authorized for the Company in its last rate case in 2010. In that
13 proceeding, the authorized ROE appropriately reflected the incremental risk associated
14 with ENSTAR’s operations relative to other natural gas utility operations elsewhere in
15 the United States. In fact, the average authorized ROEs in 2010 for natural gas utilities
16 (excluding ENSTAR) ranged from 9.19 percent to 11.00 percent and an average 10.08
17 percent. Those returns suggest a premium of 155 to 336 basis points to account for the
18 incremental risk associated with ENSTAR’s unique operations.
19 At issue then, is whether there is any reasonable basis to conclude that the Company’s
20 relative risk has changed such that the return required by equity investors has changed
21 since the Commission authorized the Company’s current ROE in August 2010. As
22 discussed throughout my Direct Testimony, the Company’s risk profile remains
23 substantially the same but for increased capital investments in its pipeline system. In
24 addition, significant recent changes in the Company’s rate base are likewise attributable
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1 to its need to operate and maintain its pipeline system. Consistent with those factors,
2 my recommended range coincides with the Company’s currently authorized return, and
3 my recommended ROE, 13.75 percent, is toward the upper end of the range. As
4 discussed throughout the balance of my Direct Testimony, a departure from my
5 recommended range, which includes the Company’s currently authorized ROE, would
6 not be supported by the objective evidence and would be incompatible with the
7 principles of regulatory consistency.
8 PURPOSE AND OVERVIEW OF TESTIMONY
9 Q. What is the purpose of your Direct Testimony?
10 A. The purpose of my Direct Testimony is to present evidence and provide ENSTAR’s
11 recommendation regarding the Company’s ROE and capital structure. My analyses and
12 conclusions are supported by the data presented in Exhibit RBH-1 through Exhibit
13 RBH-11, which have been prepared by me or under my direction.
14 Q. What are your conclusions regarding the appropriate Cost of Equity, capital
15 structure and cost of debt for the Company?
16 A. My analyses indicate that the Company’s Cost of Equity currently is in the range of
17 12.50 percent to 14.00 percent. Based on the quantitative and qualitative analyses
18 discussed throughout my Direct Testimony, I recommend that the Commission
19 authorize the Company the opportunity to earn an ROE of 13.75 percent.
20 The Company’s capital structure, which includes 52.25 percent common equity
21 and 47.75 percent long-term debt, is consistent with those in place at comparable
22 companies. I conclude that the Company’s capital structure is consistent with industry
23 practice and, therefore, reasonable and appropriate. Lastly, I note that the Company’s
24 5.04 percent cost of debt is consistent with the prevailing yields at the times of issuance
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1 and, therefore, is reasonable.
2 Q. Please provide a brief overview of the analyses that led to your ROE
3 recommendation.
4 A. Because all models are subject to various assumptions and constraints, equity analysts
5 and investors tend to use multiple methods to develop their return requirements. I relied
6 on three widely-accepted approaches to develop my ROE recommendation: (1) the
7 Discounted Cash Flow (“DCF”) model, including Quarterly Growth and Constant
8 Growth; (2) the Capital Asset Pricing Model (“CAPM”); and (3) the Bond Yield Plus
9 Risk Premium approach.2
10 My recommendation is consistent with the Company’s currently authorized
11 ROE and the fact that its risk profile remains substantially the same, but for increased
12 capital investment in its pipeline system. My recommendation also takes into
13 consideration the Company’s unique risk profile, in particular the natural gas supply
14 risk arising from its geographic isolation, its need to operate and maintain natural gas
15 transportation and distribution assets, its relatively small operations in a geographically
16 isolated environment, its regulatory framework and lack of revenue stabilization
17 mechanisms, and the direct costs associated with equity issuances. Although I did not
18 make explicit adjustments to my ROE estimates for those factors, I did take them into
19 consideration in determining the range in which the Company’s Cost of Equity likely
20 falls.
21 Q. How is the remainder of your Direct Testimony organized?
22 A. The remainder of my Direct Testimony is organized as follows:

2 See Exhibit RBH-1 through Exhibit RBH-6
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1 Section IV – Discusses the regulatory guidelines and financial considerations
2 pertinent to the development of the cost of capital;
3 Section V – Provides a discussion of the Company’s currently authorized ROE and
4 the specific business risks to consider when developing Cost of Equity analyses;
5 Section VI – Explains my selection of the proxy group used to develop my
6 analytical results;
7 Section VII – Explains my analyses and the analytical bases for my ROE
8 recommendation;
9 Section VIII – Provides a discussion of other considerations that have a direct
10 bearing on the Company’s Cost of Equity;
11 Section IX – Highlights the current capital market conditions and their effect on the
12 Company’s Cost of Equity;
13 Section X – Addresses the reasonableness of the Company’s capital structure;
14 Section XI – Briefly discusses the Company’s cost of debt; and
15 Section XII – Summarizes my conclusions and recommendations.
16 REGULATORY GUIDELINES AND FINANCIAL CONSIDERATIONS
17 Q. Please provide a brief summary of the guidelines established by the United States
18 Supreme Court (the “Court”) for the purpose of determining ROE.
19 A. The Supreme Court established the guiding principles for establishing a fair return for
20 capital in two cases: (1) Bluefield Water Works and Improvement Co. v. Public Service
21 Comm’n of West Virginia (Bluefield); and (2) Federal Power Comm’n v. Hope Natural
22 Gas Co. (Hope). In those cases, the Court recognized that the fair rate of return on
23 equity should be: (1) comparable to returns investors expect to earn on other
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1 investments of similar risk; (2) sufficient to assure confidence in the company’s
2 financial integrity; and (3) adequate to maintain and support the company’s credit and
3 to attract capital.
4 Q. Does Alaska precedent provide similar guidance?
5 A. Yes, the Commission cited the Hope and Bluefield decisions in its determination of the
6 Cost of Equity in prior cases.3 Based on those standards, the authorized ROE should
7 provide the Company with the opportunity to earn a fair and reasonable return and
8 should enable efficient access to external capital under a variety of market conditions.
9 Q. Why is it important for a utility to be allowed the opportunity to earn a return
10 adequate to attract equity capital at reasonable terms?
11 A. A return that is adequate to attract capital at reasonable terms enables the utility to
12 provide safe and reliable service while maintaining its financial integrity. In keeping
13 with the Hope and Bluefield standards, that return should be commensurate with the
14 returns expected elsewhere in the market for investments of equivalent risk. The
15 intended consequence of the Commission’s order in this case, therefore, should be to
16 provide ENSTAR with the opportunity to earn a return on equity that is: (1) adequate to
17 attract capital at reasonable terms; (2) sufficient to ensure its financial integrity; and (3)
18 commensurate with returns on investments in enterprises having corresponding risks.
19 To the extent ENSTAR is provided a reasonable opportunity to earn its market-based
20 Cost of Equity, neither customers nor shareholders should be disadvantaged. In fact, a
21 return that is adequate to attract capital at reasonable terms enables ENSTAR to provide
22 safe, reliable natural gas utility service while maintaining its financial integrity.

3 See, for example, “In the Matter of the Tariff Revision Designated as TA28-358 Filed by Potter Creek Water
Company for an Increase in Rates for Its Water Service,” Docket No. U-08-63, Order No. 6, July 14, 2009, at 20.
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1 BUSINESS RISKS
2 Q. What risk factors did you consider when selecting your proxy group and
3 performing your Cost of Equity analyses?
4 A. Because the Company faces risks that natural gas utilities elsewhere in the United States
5 do not, I considered these factors in assessing the risk profile of the Company. Those
6 factors include: (1) natural gas supply risk due to the Company’s geographic isolation;
7 (2) weather variability; (3) its relatively small operations in a geographically isolated
8 environment.
9 Natural Gas Supply Risk
10 Q. Please describe the risk when all natural gas is sourced from a single geographic
11 production area with no connections to an interstate pipeline system or other
12 natural gas sources.
13 A. Unlike natural gas companies in other states, ENSTAR’s natural gas supply is entirely
14 dependent on producers in a single supply region: the Cook Inlet. This geographic
15 isolation is a particular concern because, to the extent that the Company’s supply needs
16 are not met, ENSTAR must seek alternative supply options such as importing natural
17 gas or constructing a pipeline to a new supply source.
18 Natural gas producers have recognized that gas supply has changed in the Cook
19 Inlet region. One major producer, Hilcorp, acknowledged a change in the industry such
20 that “we’re going to have a just-in-time inventory for natural gas.”4 Further, “…
21 Hilcorp doesn’t plan to go back to the way things were in Cook Inlet when there was an
22 abundance of natural gas found while looking for oil, which produced numbers like 20
23 to 1 reserves to production ratios, held prices down and required industrial facilities like

4 Petroleum News, “Hilcorp Says There’s Gas in Cook Inlet, Will Develop It to Meet Contracts,” June 9, 2013.
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1 the LNG export plant and the fertilizer plant.”5 The Cook Inlet Long Term Gas Supply
2 Group (of which ENSTAR is a member) has identified the potential for disruption in
3 supply from the Cook Inlet producers to meet the utilities’ needs. If such a risk is
4 imminent, and there is no pipeline transporting gas from the Alaska North Slope, it will
5 prioritize firm arrangements such as the import of Liquefied Natural Gas (“LNG”).6
6 Natural gas supply risks become more pronounced when customer requirements
7 change. For example, in 2006, Fairbanks Natural Gas (“FNG”) filed an Emergency
8 Complaint for Service to request ENSTAR to provide natural gas service to FNG.7 In
9 the event that ENSTAR must meet the needs of unanticipated service requests, gas
10 supplied in such situations will be unavailable to other ENSTAR customers unless the
11 Company is able procure additional supplies. Given the limited supply sources in the
12 region, meeting emergency supply requests in the future could have adverse effects on
13 ENSTAR customers.
14 Q. What are the risks associated with the lack of geographic diversity in a utility’s
15 supply portfolio.
16 A. Geographic diversity in gas supply portfolios reduces the risk of gas supply interruption
17 and reduces the potential adverse effects of swings in prices due to regional events.
18 Since the Company’s gas supply is dependent on a single region, the stand-alone risk of
19 each gas supply contract is virtually identical. Because the Company cannot access
20 other supply regions, its entire supply source is subject to the same risks and

5 Id.
6 See, Cook Inlet Long Term Gas Supply Group, “Cook Inlet Natural Gas Supply December 2013 Update Long
Term Gas Supply Group” (included as Attachment B).
7 See, “In the Matter of the Emergency Complaint for Service by Fairbanks Natural Gas, LLC, Against ENSTAR
Natural Gas Company, a Division of Semco Energy Inc.,” Docket No. U-06-105, Emergency Complaint for
Service, September 19, 2006.
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1 constraints; there is no diversification of risks over a variety of supply sources.
2 While natural gas utilities in the “Lower 48” are able to access natural gas
3 supplies from various regions through liquid markets and an extensive pipeline network,
4 ENSTAR’s supply portfolio is dependent on a single production region and contracts
5 with natural gas producers. Since the Company operates in a location that is
6 geographically isolated, it does not have access to the diversification benefits associated
7 with access to a variety of sources of gas. The supply risk is greater given that natural
8 gas discoveries in Cook Inlet in recent years have not outpaced the declining reserves.8
9 Without a geographically diversified gas supply portfolio, the Company is dependent on
10 increased investment from Cook Inlet natural gas producers. Absent increased
11 production from these producers or a North Slope pipeline, the Company must seek
12 alternative supply options such as importing LNG, or investing in gas transportation
13 infrastructure to another supply region, which would represent a significant increase in
14 the cost of gas. Increases to the cost of gas will increase the likelihood of the Company
15 under-recovering its fixed distribution costs due to decreased sales. As such, this
16 represents a substantial risk to ENSTAR relative to other natural gas utilities.
17 Weather Risk
18 Q. Please summarize the risk posed by yearly weather variations.
19 A. Weather risk leads to cash flow and earnings variability from season to season and year
20 to year due to variability in temperatures. Since the demand for natural gas is strongly
21 correlated to heating degree days (i.e., colder temperatures result in greater demand),
22 gas utility revenues and cash flows are highly dependent on weather.

8 Peter J. Stokes, PE of Petrotechnical Resources of Alaska, “Cook Inlet Gas Study -2012 Update,” at page i.
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