PUBLIC UTILITY COMMISSION Case No. 17-3112-INV

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 8 of 481234567891011121312-month basis is expected to remain somewhat below 2 percent inthe near term but to stabilize around the Committee’s 2 percentobjective over the medium term. Near-term risks to the economicoutlook appear roughly balanced, but the Committee is monitoringinflation developments closely.141516171819202122232425262728In determining the timing and size of future adjustments to the targetrange for the federal funds rate, the Committee will assess realizedand expected economic conditions relative to its objectives ofmaximum employment and 2 percent inflation. This assessment willtake into account a wide range of information, including measuresof labor market conditions, indicators of inflation pressures andinflation expectations, and readings on financial and internationaldevelopments. The Committee will carefully monitor actual andexpected inflation developments relative to its symmetric inflationgoal. The Committee expects that economic conditions will evolvein a manner that will warrant gradual increases in the federal fundsrate; the federal funds rate is likely to remain, for some time, belowlevels that are expected to prevail in the longer run. However, theactual path of the federal funds rate will depend on the economicoutlook as informed by incoming data.”4In view of realized and expected labor market conditions andinflation, the Committee decided to raise the target range for thefederal funds rate to 1 to 1-1/4 percent. The stance of monetarypolicy remains accommodative, thereby supporting some furtherstrengthening in labor market conditions and a sustained return to 2percent inflation.2930Q10. Mr. Baudino, why is it important to understand the Fed's actions since 2008?31A10.The Fed's monetary policy actions since 2008 were deliberately undertaken to lower32interest rates and support economic recovery. The Fed's actions have been quite33successful in lowering interest rates given that the 20-year Treasury Bond yield in June342007 was 5.29% and the public utility bond yield was 6.34%. The U.S. economy iles/monetary20170614a1.pdf

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 9 of 481currently in a low interest rate environment. As I will demonstrate later in my2testimony, low interest rates have also significantly lowered investors' required return3on equity for the stocks of regulated utilities.45Q11. Are current interest rates indicative of investor expectations regarding the future67direction of interest rates?A11.Yes. Securities markets are efficient and most likely reflect investors' expectations about8future interest rates. As Dr. Roger Morin pointed out in New Regulatory Finance:9101112"A considerable body of empirical evidence indicates that U.S.capital markets are efficient with respect to a broad set ofinformation, including historical and publicly availableinformation."513Despite recent increases in the general level of interest rates since the second half of142016, the U.S. economy continues to operate in a low interest rate environment. It is15important to realize that investor expectations of higher future interest rates, if any, are16already embodied in current securities prices, which include debt securities and stock17prices.1819Moreover, the current low interest rate environment favors lower risk regulated utilities.20It would not be advisable for utility regulators to raise ROEs in anticipation of higher21interest rates that may or may not occur.225Morin, Roger A., New Regulatory Finance, Public Utilities Reports, Inc. (2006) at 279.

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 10 of 481Q12. How has the increase in interest rates last year affected utility stocks in terms of23bond yields and stock prices?A12.Table 1 below tracks movements in the 20-year Treasury bond yield, the Mergent4average utility bond yield, and the Dow Jones Utilities Average (“DJUA”) from5January 2016 through June 2017.TABLE 1Bond Yields and DJUA20-YearTreasury %Avg. UtilityBond .28704.35726.62706.9167Table 1 shows that the 20-year Treasury bond yield was slightly higher in June 20178than it was in January 2016 before the Fed began raising short-term interest rates.9However, the yield on the Mergent average public utility bond was substantially lower

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 11 of 481in June 2017 than in January 2016. Similarly, the DJUA was substantially higher in2June 2017 than it was in January 2016.34My conclusion from this data is that even though the Federal Reserve raised short-term5interest rates since March 2016, utility bond yields are still lower and the DJUA is6higher than they were at the beginning of 2016.7Q13. How does the investment community regard the electric utility industry currently?8A13.9The Value Line Investment Survey noted the following in its June 16, 2017 report onthe Electric Utility (Central) ��Most electric utility stocks have fared well in the first half of 2017.The prices of most issues have risen at a high single-digit or lowdouble-digit percentage. (The exceptions can be attributed tocompany-specific reasons.)Value Line’s remarks with respect to the electric utility industry indicate that despite30the recent increase in interest rates, utility stocks continue to be highly valued31investments in today’s marketplace. The safety and relatively high dividend yields for32regulated utilities are attractive to investors.Investors are still reaching for yield, and are not fearful of theexpectation that the Federal Reserve will raise interest rates. Thehigh valuation of stocks in the Electric Utility Industry is evident bya few ways of measuring this. The group’s average dividend yield,at 3.3%, is comfortably above the median of all stocks under ourcoverage. However, this yield is low, by historical standards. Inaddition, for many years electric utility equities had a price-earningsratio well below that of the market. Thus, the relative price-earningsratio shown on our pages was below 1.00. Last year, this figure wasright around 1.00 for many electric utility stocks. Today, manyissues have a price-earnings ratio above 20. We also note that themajority of electric utility equities are trading within their 3- to 5year Target Price Range.”

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 12 of 4812Q14. In 2017, the Edison Electric Institute (“EEI”) published its 2016 Financial Review3of the investor-owned electric utility industry. Please summarize EEI’s4conclusions with respect to credit ratings for the electric utility industry.5A14.EEI’s report noted the following with respect to the industry’s credit 2930“The industry’s average credit rating was BBB in 2016, remaining for athird straight year above the BBB average that has held since 2004.Ratings activity, at 67 changes, was in line with the industry’s annualaverage of 70 changes per year since 2008. Upgrades were 73.1% of totalactions, the third-highest annual figure for upgrades in our dataset. In fact,the last four years have produced the four highest annual upgradepercentages in our historical data. EEI captures upgrades and downgradesat the subsidiary level; multiple actions within a parent holding companyare included in the upgrade/downgrade totals. The industry’s averagecredit rating and outlook are based on the unweighted averages of allStandard & Poor’s (S&P) parent company ratings and outlooks.31EEI’s analysis shows that the investor-owned electric utility industry had strong, stable,32and slightly improving credit metrics in 2016.333435While the industry’s average rating was unchanged at BBB , theunderlying data show a modest strengthening. Six companies receivedupgrades at the parent level while only two were downgraded. Ouruniverse of U.S. “parent” company electric utilities includes a few thatare either a subsidiary of an independent power producer, a subsidiary ofa foreign-owned company, or that have been acquired by an investmentfirm; three of the year’s upgrades focused on a relationship with thatultimate parent company. Two other upgrades cited a reduced focus onmerchant generation and an improved business risk profile. At January 1,2017, 74.0% of ratings outlooks were “stable”, 18.0% were “negative” or“watch-negative”, 6.0% were “positive” or “watch-positive”, and 2.0%were “developing”.

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 13 of 481Q15. What are the current credit ratings and bond ratings for GMP?2A15.GMP currently carries a strong, investment grade A- issuer credit rating and an A3senior secured debt rating from Standard and Poor’s (“S&P”). S&P reaffirmed these4ratings in an action issued on December 14, 2016. S&P noted the following in its5report:66 “We have revised our designation of the relationship between U.S.7regulated utility Green Mountain Power Corp. (GMP) and its parent,8Gaz Metro Inc. (GMI), to reflect our view of a higher level of9commitment from the parent. 10We are affirming our 'A-' issuer credit rating on GMP which is based on11the company’s low-risk regulated utility strategy, constructive12regulation in Vermont, small scale and limited diversity, and FFO/debt13in the 16-18% range. The outlook is stable. 14The stable outlook reflects our expectation that the company will15continue to limit its business risk by focusing on low-risk utility16operations while maintaining credit protection metrics that are17commensurate with its current ratings.”186The S&P report was provided by GMP in response to PSD1.Q2.

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 14 of 4812III. DETERMINATION OF FAIR RATE OF RETURNQ16. Please describe the methods you employed in estimating a fair rate of return for34GMP.A16.I employed a Discounted Cash Flow (“DCF”) analysis using the group of 12 regulated5electric utilities used by Mr. Coyne in the ROE analysis he submitted on behalf of the6Company. My DCF analysis is the standard constant growth form of the model that7employs four different growth rate forecasts from the Value Line Investment Survey,8First Call/IBES, and Zacks. I also employed Capital Asset Pricing Model (“CAPM”)9analyses using both historical and forward-looking data. Although I did not rely on the10CAPM for my recommended ROE for GMP, the results from the CAPM tend to11support the reasonableness of my recommendation.1213Q17. What are the main guidelines to which you adhere in estimating the cost of equity1415for a firm?A17.The estimated cost of equity should be comparable to the returns of other firms with16similar risk structures and should be sufficient for the firm to attract capital. These are17the basic standards set out by the United States Supreme Court in Federal Power18Comm'n v. Hope Natural Gas Co., 320 U.S. 591 (1944) and Bluefield W.W. & Improv.19Co. v. Public Service Comm'n, 262 U.S. 679 (1922).2021From an economist’s perspective, the notion of “opportunity cost” plays a vital role in22estimating the return on equity. One measures the opportunity cost of an investment23equal to what one would have obtained in the next best alternative. For example, let us

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 15 of 481suppose that an investor decides to purchase the stock of a publicly traded electric2utility. That investor made the decision based on the expectation of dividend payments3and perhaps some appreciation in the stock’s value over time; however, that investor’s4opportunity cost is measured by what she or he could have invested in as the next best5alternative. That alternative could have been another utility stock, a utility bond, a6mutual fund, a money market fund, or any other number of investment vehicles.78The key determinant in deciding whether to invest, however, is based on comparative9levels of risk. Our hypothetical investor would not invest in a particular electric10company stock if it offered a return lower than other investments of similar risk. The11opportunity cost simply would not justify such an investment. Thus, the task for the12rate of return analyst is to estimate a return that is equal to the return being offered by13other risk-comparable firms.1415Q18. What are the major types of risk faced by utility companies?16A18.In general, risk associated with the holding of common stock can be separated into17three major categories: business risk, financial risk, and liquidity risk. Business risk18refers to risks inherent in the operation of the business. Volatility of the firm’s sales,19long-term demand for its product(s), the amount of operating leverage, and quality of20management are all factors that affect business risk. The quality of regulation at the21state and federal levels also plays an important role in business risk for regulated utility22companies.23

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 16 of 481Financial risk refers to the impact on a firm's future cash flows from the use of debt in2the capital structure. Interest payments to bondholders represent a prior call on the3firm’s cash flows and must be met before income is available to the common4shareholders. Additional debt means additional variability in the firm’s earnings,5leading to additional risk.67Liquidity risk refers to the ability of an investor to quickly sell an investment without a8substantial price concession. The easier it is for an investor to sell an investment for9cash, the lower the liquidity risk will be. Stock markets, such as the New York and10American Stock Exchanges, help ease liquidity risk substantially. Investors who own11stocks that are traded in these markets know on a daily basis what the market prices of12their investments are and that they can sell these investments fairly quickly. Many13electric utility stocks are traded on the New York Stock Exchange and are considered14liquid investments.1516Q19. Are there any sources available to investors that quantify the total risk of a1718company?A19.Bond and credit ratings are tools that investors use to assess the risk comparability of19firms. Bond rating agencies such as Moody’s and Standard and Poor’s perform detailed20analyses of factors that contribute to the risk of an investment. The result of their21analyses is a bond and/or credit rating that reflect these risks.22

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 17 of 481Discounted Cash Flow (“DCF”) Model2Q20. Please describe the basic DCF approach.3A20.The basic DCF approach is rooted in valuation theory. It is based on the premise that4the value of a financial asset is determined by its ability to generate future net cash5flows. In the case of a common stock, those future cash flows generally take the form6of dividends and appreciation in stock price. The value of the stock to investors is the7discounted present value of future cash flows. The general equation then is:891011𝑉 Where:𝑅𝑅𝑅𝑅 (1 𝑟) (1 𝑟)2 (1 𝑟)3(1 𝑟)𝑛V asset valueR yearly cash flowsr discount rate12This is no different from determining the value of any asset from an economic point of13view; however, the commonly employed DCF model makes certain simplifying14assumptions. One is that the stream of income from the equity share is assumed to be15perpetual; that is, there is no salvage or residual value at the end of some maturity date16(as is the case with a bond). Another important assumption is that financial markets are17reasonably efficient; that is, they correctly evaluate the cash flows relative to the18appropriate discount rate, thus rendering the stock price efficient relative to other19alternatives. Finally, the model I typically employ also assumes a constant growth rate20in dividends. The fundamental relationship employed in the DCF method is described21by the formula:𝑘 222324Where:𝐷1 𝑃 𝑔0D1 the next period dividendP0 current stock price

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 18 of 4812g expected growth ratek investor-required return3Under the formula, it is apparent that “k” must reflect the investors’ expected return.4Use of the DCF method to determine an investor-required return is complicated by the5need to express investors’ expectations relative to dividends, earnings, and book value6over an infinite time horizon. Financial theory suggests that stockholders purchase7common stock on the assumption that there will be some change in the rate of dividend8payments over time. We assume that the rate of growth in dividends is constant over9the assumed time horizon, but the model could easily handle varying growth rates if we10knew what they were. Finally, the relevant time frame is prospective rather than11retrospective.1213Q21. What was your first step in conducting your DCF analysis for GMP?14A21.My first step was to choose a proxy group of companies with a risk profile that is15reasonably similar to GMP. In this case, I chose to use the same group of companies16used by Company witness Coyne. Mr. Coyne described his selection criteria on pages1721 through 22 of his Direct Testimony. Although my typical selection criteria are18somewhat different from Mr. Coyne's, his proxy group contains many electric utilities19that I have included in my comparison groups in other recent cases. For purposes of20this case, it is reasonable to proceed with the proxy group of 12 companies shown by21Mr. Coyne in Figure 4, page 22, of his Prefiled Testimony.2223

Case No. 17-3112-InvGMP Rate CasePSD Direct Testimony of Richard BaudinoAugust 14, 2017Page 19 of 481Q22.

Exhibit PSD-RAB-1: Resume/CV Exhibit PSD-RAB-2: Depiction of Interest Rate Trends Exhibit PSD-RAB-3: Calculation of Average Dividend Yield Exhibit PSD-RAB-4: Proxy Group – Growth Rate & DCF Return on Equity Exhibit PSD-RAB-5: Proxy Group – Capital Asset Pricing Model Analysis Exhibit PSD-RAB-6: Proxy Group – Calculation of Market Returns