Direct Testimony and Schedules Patrick L. Cutshall Before the Minnesota Public Utilities Commission State of Minnesota In the Matter of the Application of Minnesota Power for Authority to Increase Rates for Electric Utility Service in Minnesota Docket No. E015/GR-16-664 Exhibit __________ CAPITAL STRUCTURE, COST OF CAPITAL, AND RETIREMENT PLAN ACCOUNTING November 2, 2016
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Direct Testimony and Schedules Patrick L. Cutshall
Before the Minnesota Public Utilities Commission
State of Minnesota
In the Matter of the Application of Minnesota Power for Authority to Increase Rates for Electric Utility
Service in Minnesota
Docket No. E015/GR-16-664
Exhibit __________
CAPITAL STRUCTURE, COST OF CAPITAL, AND RETIREMENT PLAN ACCOUNTING
November 2, 2016
Table of Contents
I. INTRODUCTION AND QUALIFICATIONS ..................................................... 1
II. ALLETE CORPORATE STRUCTURE ............................................................... 5
III. RISKS FACING MINNESOTA POWER ............................................................. 8
A. Customer Base ......................................................................................... 10
B. Minnesota Power’s Recent Financial Performance ................................. 11
C. Credit Ratings .......................................................................................... 14
IV. RECOMMENDED TEST YEAR CAPITAL STRUCTURE .............................. 29
A. Debt .......................................................................................................... 30
B. Common Equity ....................................................................................... 34
V. RETIREMENT PLAN ACCOUNTING ............................................................. 39
A. Pension Expense ...................................................................................... 40
B. Other Post-Employment Benefit Expense ............................................... 54
C. Prepaid Pension Asset .............................................................................. 61
D. Prepaid OPEB Asset ................................................................................ 73
VI. CONCLUSION .................................................................................................... 76
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I. INTRODUCTION AND QUALIFICATIONS 1
Q. Please state your name and business address. 2
A. I am Patrick L. Cutshall, and my business address is 30 West Superior Street, 3
Duluth, Minnesota 55802. 4
5
Q. What is your present position with ALLETE, Inc.? 6
A. I am the Treasurer of ALLETE, Inc., doing business as Minnesota Power 7
(“Minnesota Power” or “the Company”). 8
9
Q. Please describe your educational background and work experience with 10
ALLETE, Inc. and Minnesota Power. 11
A. I have 29 years of experience in Finance. I earned a bachelor’s degree in 12
accounting from the University of Minnesota Duluth in 1987 and have the 13
professional designations of a CPA (Certified Public Accountant), which is 14
currently inactive, and a CFA (Chartered Financial Analyst). I began my career at 15
ALLETE in 1989 as an Accounting Analyst and became an Investment Analyst in 16
my first year. I was promoted to the Retirement Fund Manager in 2003, to 17
Director of Investments and Tax in 2014, and most recently to Treasurer. Prior to 18
my employment at ALLETE, I worked as a CPA for Ernst & Whinney, a 19
predecessor to Ernst & Young LLP. 20
21
Q. What are your present duties as Treasurer of ALLETE? 22
A. As Treasurer, I am responsible for raising capital, including both debt and equity, 23
banking and bank relationships, credit rating relationships, investor relations and 24
Exhibit__ (PLC), Schedule 6: Customer Benefits from Prepaid Pension 26
Assets. 27
28
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II. ALLETE CORPORATE STRUCTURE 1
Q. Please explain the significance of Minnesota Power to ALLETE. 2
A. Minnesota Power is ALLETE's dominant business by a significant margin, 3
representing approximately 77 percent of ALLETE's capital. 4
5
Q. What are ALLETE’s other investments? 6
A. ALLETE's other investments are organized into two types of businesses: (1) other 7
regulated utility businesses; and (2) energy infrastructure and related services. 8
ALLETE's regulated utility investments include two investments in addition to 9
Minnesota Power: (1) American Transmission Company (“ATC”) (approximately 10
8 percent ownership), an independent transmission company in Wisconsin; and 11
(2) Superior Water Light & Power (“SWL&P”), an electric, water, and gas utility 12
in Wisconsin. ALLETE’s energy infrastructure and related services include three 13
investments: (1) ALLETE Clean Energy (“ACE”), a company that develops, 14
acquires, and manages clean and renewable energy projects; (2) U.S. Water, 15
which provides sustainable solutions for industrial customers to use water more 16
efficiently; and (3) BNI Energy, whose primary business is a lignite coal mining 17
operation in North Dakota that serves the Milton R. Young generating plant 18
located at the mine site. ALLETE also has some minor additional non-regulated 19
investments, the largest being ALLETE Properties, our legacy Florida real estate 20
investment. 21
22
Q. How does Minnesota Power's capital structure relate to that of ALLETE? 23
A. As an operating division of ALLETE, Minnesota Power has a capital structure 24
that is derived from ALLETE's consolidated capital structure.1 The ALLETE 25
consolidated capital structure includes common equity and debt that finances all 26
of ALLETE's business activities, including those of its subsidiary operations. The 27
Minnesota Power capital structure, which is the capital structure used for 28
1 ALLETE's capital structure is reflected in its 2015 ALLETE's Form 10-K filed with the U.S. Securities and Exchange Commission and included in this filing as Schedule F in Volume IV.
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ratemaking purposes, is calculated by starting with ALLETE's capital structure 1
and then extracting the debt of ALLETE's subsidiaries and ALLETE's equity and 2
debt investments in those subsidiaries. 3
4
Q. Please give a brief history of ALLETE’s non-Minnesota Power investments. 5
A. The Company initiated a diversification strategy in the early 1980s in order to 6
reduce its dependence on revenues from a concentrated industrial base of taconite 7
and paper customers in northeastern Minnesota. Over the past 30 years, this 8
strategy has contributed significantly to the Company’s financial strength during a 9
period of substantial restructuring in the taconite and paper industries. Today, the 10
Company’s diversification investments consist primarily of regulated electric, 11
water, and gas services; coal mining; an investment in an independent 12
transmission company; a small portfolio of real estate holdings; and investments 13
aimed at creating energy solutions. Although individually and collectively 14
modest in size, these investments strengthen the Company by broadening the base 15
of customers, geographies, and products and services. 16
17
Q. Is the diversification beneficial to Minnesota Power? 18
A. Yes. Over the years, the Company’s efforts to diversify its revenue base have 19
resulted in a stronger company with broader capabilities and enhanced long-term 20
earnings and cash flow stability. As of December 31, 2015, approximately 10 21
percent of ALLETE’s assets were invested in ACE ($494 million), 5 percent of 22
ALLETE’s assets were at U.S. Water ($255 million), 3 percent of ALLETE’s 23
assets were at ATC ($124 million), 2 percent were at BNI Energy ($109 million), 24
2 percent were at SWL&P ($106 million), and 1 percent were at ALLETE 25
Properties ($56 million). Combined, these investments accounted for about 23 26
percent of ALLETE’s total assets. From 2010 through 2015, ALLETE’s 27
subsidiaries have averaged 14 percent of ALLETE’s total assets and contributed 28
to an average of 17 percent of ALLETE’s net income as illustrated in Figure 1 29
below. ALLETE’s diversified investments are expected to broaden the 30
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Company’s revenue base and help mitigate business risks facing Minnesota 1
Power utility operations. 2
3
Figure 1. 4
ALLETE Subsidiaries Percent of Assets and Earnings 5
6
7
Q. Has ALLETE experienced change in its capital structure since the 8
Company’s last rate case? 9
A. Yes. In prior rate cases, there was no subsidiary debt held at the ALLETE level, 10
so only equity was removed to get the Minnesota Power capital structure. 11
ALLETE now has debt that supports the subsidiaries, which must be removed for 12
ratemaking purposes. This change comes from our diversification efforts and the 13
related growth at non-regulated subsidiaries since our last rate case. However, the 14
Minnesota Power capital structure determination is the same as in previous rate 15
cases. The Commission approved this approach in the Company's 1987, 1994, 16
2008, and 2009 rate filings (Docket Nos. E015/GR-87-223, E015/GR-94-001, 17
E015/GR-08-415, and E015/GR-09-1151). 18
19
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III. RISKS FACING MINNESOTA POWER 1
Q. What unique risks affect Minnesota Power? 2
A. Minnesota Power’s significant industrial customer concentration makes it unique 3
compared to other utilities. Minnesota Power’s revenue from industrial customers 4
was approximately 63 percent and 64 percent of retail revenue in 2015 and 2014, 5
respectively. This compares to an industry average of 17 percent in 2015, making 6
Minnesota Power’s revenue as a percentage of industrial sales the highest 7
amongst investor-owned utilities.2 8
9
In addition, Minnesota Power’s retail customer mix is unique in that energy sales 10
to large industrial customers make up approximately 72 percent of the Company’s 11
total retail energy sales. Taconite processing, our largest industrial customer 12
group, had another economic downturn in 2015 and 2016, producing 13
approximately 80 percent of the average tons of taconite in 2015 compared to the 14
previous five years. 15
16
This industrial concentration is a factor that subjects Minnesota Power to 17
substantial earnings volatility risk relative to its peers. Minnesota Power operates 18
in a natural resource-based service territory with economic prospects closely 19
linked to the fortunes of a few large customers that operate in highly cyclical 20
industries: taconite processing, paper and wood products manufacturing, and oil 21
pipelines. This is unlike the typical utility with a stable base comprised mostly of 22
residential and commercial customers. 23
24
Q. Does this customer concentration specifically distinguish Minnesota Power 25
from other Minnesota investor-owned electric utilities? 26
A. Yes. Minnesota Power’s industrial customer concentration is significantly higher 27
than other Minnesota investor-owned electric utilities. As mentioned above, 28
2 Based on Form EIA-826 Monthly Electric Utility Sales and Revenue Report with State Distribution by EEI (2015).
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Minnesota Power’s percentage of retail revenue from its industrial customers was 1
63 percent in 2015. Otter Tail Power Company and Northern States Power 2
Company’s (Minnesota) percentage of retail revenue from its industrial customers 3
was 14 percent and 20 percent in 2015.3 4
5
Q. Do the rating agencies recognize Minnesota Power's customer concentration 6
as a risk? 7
A. Yes. In the most recent credit reports from both Standard & Poor’s Corporation 8
(“S&P”) and Moody’s Investors Service, Inc. (“Moody’s”), the rating agencies 9
cite Minnesota Power’s customer concentration as a risk factor for ALLETE. 10
S&P’s business risk position for ALLETE reflects the “company’s small size, 11
limited geographic diversity, and significant exposure to a cyclical industrial 12
customer base that includes taconite mining, iron concentrate, paper, pulp, and 13
pipeline customers.”4 14
15
Moody’s also explains that “[m]aterial industrial customer exposure adds 16
volatility to the company’s business risk profile.”5 Moody's continues with, 17
ALLETE's exposure to industrial customers is significant, 18 representing roughly 50 percent of annual sales volume in 19 most years, among the highest of the Moody’s US 20 regulated utility universe. The make-up of its industrial 21 customers consist of iron pellet and taconite producers (26 22 percent of regulated operating revenue in 2015), paper, 23 pulp and wood products (9 percent), and oil pipelines (8 24 percent). All three industries are currently facing 25 challenging market environments that translated into 26 weaker industrial sales in two of the three sectors in 2015.6 27
28
3 Based on Form EIA-826 Monthly Electric Utility Sales and Revenue Report with State Distribution by EEI (2015). 4 S&P credit report on ALLETE, Inc. (May 6, 2016). 5 Moody’s credit report on ALLETE, Inc. (Mar. 3, 2016). 6 Moody’s credit report on ALLETE, Inc. (Mar. 3, 2016).
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Due to the industrial customer concentration risk, S&P rates ALLETE’s business 1
risk profile among the riskiest in the utility industry. 2
3
A. Customer Base 4
Q. Do the large industrial customer contracts provide protection to the 5
Company during a business cycle downturn? 6
A. Minnesota Power’s nine Large Power customers have long-term Electric Service 7
Agreements with two- to four-year cancellation notice provisions. These 8
contracts, however, also contain operating flexibility provisions that allow the 9
customers to reduce their demand commitments significantly with minimal notice. 10
If all Large Power customers were to nominate their Minimum Service 11
Requirement, as stated in their Electric Service Agreements, Minnesota Power's 12
Large Power firm demand revenues could decline substantially – by 13
approximately 75 percent, which equates to $125 million annually. If select 14
Large Power customers were to shut down, and after proper notification is given, 15
in two years the impact would increase to a 94 percent revenue reduction or $159 16
million annually. 17
18
Q. Has the recent economic downturn affected sales to Minnesota Power's 19
industrial customers? 20
A. Yes. As noted in Company witness Mr. David McMillan’s testimony, the 21
economic downturn in 2015 affected the industrial customers. The downturn 22
resulted in shutdowns and layoffs at U.S. Steel’s Keewatin Taconite and Minntac 23
facilities, Cliffs Natural Resources’ North Shore Mine facility and United 24
Taconite plants, and Magnetation. 25
26
Q. Have sales in the Midcontinent Independent System Operator (“MISO”) 27
wholesale market offset the losses the Company experienced in 2016 when its 28
industrial customers' sales declined? 29
A. Only partially. 30
31
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Q. Please explain. 1
A. While the MISO market gives the Company a market into which power can be 2
sold, the margins in this market are based on day-ahead or spot prices and not the 3
Company’s cost of service. MISO prices have continued to remain low and 4
Minnesota Power expects to recover about 56 percent of the lost large industrial 5
customer retail margins in 2016. As explained in the Direct Testimony of 6
Company witness Ms. Julie Pierce, recovering approximately 56 percent was 7
possible only because Minnesota Power executed contracts for both bilateral and 8
spot market sales. 9
10
B. Minnesota Power’s Recent Financial Performance 11
Q. Please summarize Minnesota Power's present authorized capital structure 12
and rate of return. 13
A. In Minnesota Power’s 2009 general rate filing, the Commission found that an 14
equity ratio of 54.29 percent and a 10.38 percent ROE were appropriate, resulting 15
in an overall rate of return of 8.18 percent. 16
17
Q. Has Minnesota Power earned its allowed rate of return since its last rate 18
Q. When establishing a credit rating, what factors do the rating agencies 22
consider? 23
A. According to S&P’s November 19, 2013, Corporate Methodology, credit ratings 24
are a blend of qualitative assessments and quantitative information. S&P’s 25
analysis starts with an assessment of the (1) business risk profile and (2) financial 26
risk profile of the company to create an anchor rating. It then uses additional 27
rating factors which modify the anchor rating. 28
7 S&P’s Ratings Direct Summary: ALLETE Inc. (May 6, 2016). 8 S&P’s Assessing U.S. Investor-Owned Utility Regulatory Environments (Aug. 10, 2016).
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1
S&P has historically provided the most specific guidelines regarding the financial 2
metrics expected for a particular rating, and the Company looks to these 3
guidelines when making capital structure decisions. While Moody’s analysis has 4
historically been more qualitative than S&P’s analysis, it also assesses the 5
business risk of a company by evaluating its regulatory framework, ability to 6
recover costs, diversification, and ability to earn reasonable returns. 7
8
Q. How do Minnesota Power’s utility operations affect ALLETE's credit 9
ratings? 10
A. As a division of ALLETE, Minnesota Power does not carry separate ratings. 11
Rather, Minnesota Power is ALLETE’s dominant business, representing 12
approximately 77 percent of ALLETE’s capital. Consequently, Minnesota 13
Power’s capital structure and financial performance substantially dictate 14
ALLETE’s credit ratings and financial integrity. 15
16
Q. What is the difference between business risk and financial risk? 17
A. In S&P’s Corporate Methodology, S&P describes the business risk profile as “the 18
risk and return potential for a company in the market in which it participates, the 19
country risk within those markets, the competitive climate, and competitive 20
advantages and disadvantages the company has.” S&P later describes the 21
financial risk profile as: 22
The outcome of decisions that management makes in the 23 context of its business risk profile and its financial risk 24 tolerances. This includes decisions about the manner in 25 which management seeks funding for the company and 26 how it constructs its balance sheet. It also reflects the 27 relationship of the cash flows the organization can achieve, 28 given its business risk profile, to its financial obligations. 29 The criteria use cash flow/leverage analysis to determine a 30 corporate issuer's financial risk profile assessment. 31 32
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Q. What are ALLETE’s credit ratings? 1
A. Table 3 below depicts the investment grade credit rating scales (described above) 2
used by S&P and Moody’s. ALLETE is currently rated BBB+ by S&P and A3 by 3
Moody’s. These ratings are only two and three notches above the lowest 4
investment grade rating by each respective agency. 5
6
Table 3. 7
Investment Grade Credit Ratings ALLETE’s ratings are circled in red
S&P Moody’s
AAA Aaa
AA+ / AA / AA- Aa1 / Aa2 / Aa3
A+ /A / A- A1 / A2 / A3
BBB+ / BBB / BBB- Baa1 / Baa2 / Baa3
Anything below these ratings is considered non-investment grade
8
Currently, ALLETE’s business risk profile is “strong” on a scale of: excellent, 9
strong, satisfactory, fair, weak, and vulnerable; and ALLETE’s financial risk 10
profile is “significant” on a scale of: minimal, modest, intermediate, significant, 11
aggressive, and highly leveraged. These profile rankings result in the Company 12
receiving an anchor rating of “BBB.” Minnesota Power’s regulatory framework 13
is instrumental in ALLETE receiving an adjusted rating of BBB+, one notch 14
above a BBB rating. 15
16
Q. Please provide additional information about ALLETE’s business risk profile 17
and how it compares to other utilities. 18
A. To put ALLETE’s “strong” business risk profile into perspective, of the 227 19
utilities rated in S&P’s most recent “U.S. Regulated Utilities Strongest to 20
Weakest” publication, 91 percent have “excellent” business risk profiles, and only 21
Higher
Lower
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9 percent have “strong” profiles.9 ALLETE’s business risk rating is worse than 1
other utilities’ ratings because of Minnesota Power’s high concentration of 2
cyclical industrial customers compared to its overall customer base, as discussed 3
previously. Consequently, with a higher (i.e., worse) business risk profile relative 4
to other rated utilities, ALLETE must sustain stronger financial metrics in order to 5
Table 4 below summarizes the business risk of investor-owned neighboring 8
electric utilities. 9
10
Table 4. 11
Investor-Owned Neighboring Electric Utilities10
Business Risk
Madison Gas & Electric Excellent Interstate Power & Light Excellent Wisconsin Power & Light Excellent NSP – MN Excellent Wisconsin Electric Power Co Excellent MidAmerican Energy Co Excellent Wisconsin Public Service Co Excellent NSP – WI Excellent
Minnesota Power/ALLETE Strong
12
13
Q. Does ALLETE’s business risk profile reflect unique characteristics of 14
Minnesota Power’s operations? 15
A. Yes. According to S&P, credit ratings incorporate many subjective judgments. 16
To determine a utility’s business risk profile, S&P explains, “[w]e combine our 17
assessments of industry risk, country risk, and competitive position to determine 18
the assessment for a corporation’s business risk profile.” 11 ALLETE’s industry 19
risk and country risk components are highly rated, but its competitive position is 20
9 S&P’s Issuer Ranking: U.S. Regulated Utilities, Strongest to Weakest (July 30, 2013). 10 Table 4 is consistent with neighboring electric utilities on Table 7. 11 S&P’s Corporate Methodology, at ¶ 4 (Nov. 19, 2013).
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the reason ALLETE is only rated “strong.” The competitive position consists of 1
the company’s: (1) regulatory advantage, (2) scale, scope, and diversity, (3) 2
operating efficiency, and (4) profitability. The rationale for the “strong” rating as 3
stated in S&P’s April 14, 2014, rating of ALLETE is “the company’s risk profile 4
also reflects its high concentration of industrial customers (accounting for half of 5
all electric sales).”12 6
7
Q. What does the financial risk profile address? 8
A. Financial risk addresses the ability of a company to make scheduled payments of 9
principal and interest on its financial obligations. To assess a company’s ability 10
to make these payments, for a level of cash flow that is different from its business 11
risk, the credit agencies evaluate certain financial ratios to determine whether the 12
company will have sufficient levels of cash flow to cover its interest expense and 13
repay the principal amount of its debt. The credit rating agencies also evaluate 14
the relative amounts of debt and equity in the company’s capital structure to 15
determine whether the company is appropriately capitalized given its business 16
risk. 17
18
Q. What is ALLETE’s financial risk profile? 19
A. S&P considers ALLETE’s financial risk profile to be “significant” on a scale of 20
minimal, modest, intermediate, significant, aggressive, and highly leveraged: 21
Table 5. 22
23 12 S&P’s Ratings Direct Summary: ALLETE Inc. (Apr. 14, 2014).
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1
Q. What factors do the rating agencies consider to establish a company's 2
financial risk profile? 3
A. Among the rating agencies, S&P has historically provided the most specific 4
guidelines regarding financial metrics, and ALLETE looks to these guidelines 5
when making financing decisions. S&P looks at two core ratios to determine a 6
company’s financial risk profile: 7
(1) Funds From Operations to Debt, or FFO/Debt; and 8
(2) Debt to EBITDA or Debt/ EBITDA (EBITDA being a proxy for cash 9
flow). 10
As previously noted, S&P expects ALLETE’s core ratios to remain near 20 11
percent to 22 percent for FFO/Debt and less than 4.5x for Debt/EBITDA13 over 12
the next few years. However, Minnesota Power’s FFO/Debt ratio in 2015 was 13
17.4 percent – well below S&P expectations for ALLETE. 14
15
Q. How are ALLETE’s business and financial risk profiles used to identify 16
ALLETE’s anchor rating? 17
A. After determining ALLETE’s business risk profile and financial risk profile, S&P 18
combines the profiles to create ALLETE’s anchor rating of BBB, as shown in 19
13 S&P Global Ratings, RatingDirect, Summary: ALLETE Inc. (May 6, 2016).
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Q. What additional factors affect a company’s anchor rating to arrive at its 1
overall credit rating? 2
A. Once the anchor rating is established, S&P then considers additional factors such 3
as diversification, capital structure, liquidity, financial policy, management and 4
governance, and comparable rating analysis. The majority of these factors are 5
directly or indirectly influenced by the regulatory framework and rate case 6
outcomes. As described above, these factors lead to a one notch increase of the 7
company’s credit rating to BBB+. 8
9
Q. Do ALLETE’s other subsidiaries (other than Minnesota Power as an 10
operating division) impact its credit metrics? 11
A. Yes, they help positively offset Minnesota Power's credit metrics. ALLETE’s 12
credit rating is determined by ALLETE’s financial risk, business risk, and 13
modifiers for S&P and Moody’s. Aside from SWL&P, S&P and Moody’s do not 14
assess a credit rating by individual subsidiaries under ALLETE because 15
Minnesota Power is ALLETE’s dominant business, representing approximately 16
77 percent of ALLETE’s capital. ALLETE appropriately capitalizes its 17
subsidiaries, and in 2015 other ALLETE subsidiaries in aggregate had an 18
FFO/Debt ratio of 31.8 percent, enhancing Minnesota Power’s FFO/Debt rating of 19
17.4 percent for an overall FFO/Debt ratio of 20.2 percent for ALLETE. 20
Therefore, ALLETE’s other subsidiaries enhanced ALLETE’s credit metrics in 21
2015 and are expected to continue to enhance ALLETE’s credit metrics in the 22
2017 test year. 23
24
Q. Is the FFO/Debt and Debt/EBITDA range suggested by S&P calculated on 25
the basis of a company's balance sheet capital structure? 26
A. No. A company’s balance sheet by itself does not provide the information 27
necessary to determine the appropriateness of a company’s capital structure. It is 28
important to understand that credit ratings do not reflect unadjusted balance sheet 29
capital structure ratios, but rather financial ratios that include off-balance sheet 30
debt obligations. Consequently, ALLETE's balance sheet ratios are adjusted to 31
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reflect off-balance sheet debt obligations. 1
2
For example, S&P adjusts purchased power agreements (“PPA”) in S&P’s Key 3
Credit Factors for the Regulated Utilities Industry (November 2013): “[W]e 4
view long-term purchased power agreements (PPA) as creating fixed, debt-like 5
financial obligations that represent substitutes for debt-financed capital 6
investment in generation capacity.” 7
8
Therefore, the balance sheet is only a starting point in determining the metrics 9
used in assessing a company’s credit quality. S&P’s key credit factors include 10
off-balance sheet debt equivalents to determine a company’s credit standing. The 11
materiality of these debt equivalents varies considerably from company to 12
company. 13
14
Q. What debt equivalents are included in Minnesota Power's capital structure 15
for credit rating purposes? 16
A. As of December 31, 2015, we estimated that S&P included $288 million of 17
Minnesota Power debt equivalents, comprised of $97 million from pension and 18
OPEB obligations, $90 million from PPAs, $73 million from asset retirement 19
obligations, $17 million from accrued interest, and $11 million from operating 20
leases. 21
22
Q. Should debt equivalents be considered in determining the reasonableness of 23
Minnesota Power’s test year capital structure? 24
A. Yes. Since credit ratings are driven by financial ratios that include debt 25
equivalents for off-balance sheet obligations, the Company must consider these 26
obligations in its capital structure decisions. Due to the debt equivalents 27
associated with Minnesota Power’s operations, in order to maintain its credit 28
metrics and investment grade credit ratings, the Company is required to carry a 29
higher level of common equity in its capital structure. 30
31
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The Commission has recognized the credit rating agencies’ methodology of 1
adding obligations regarded as debt equivalents, such as PPAs, to reported 2
balance sheet debt. The Commission’s Order in the Company’s 2008 rate case 3
noted that “a company’s S&P bond-rating depends as much on the company's 4
adjusted debt ratio as it does on its equity ratio.”14 5
6
Q. How do the debt equivalents for Minnesota Power compare to those of other 7
electric utilities? 8
A. It would be very unusual for a utility to have no debt equivalents in the capital 9
structure used in its credit rating determination. The most significant debt 10
equivalents for utilities are usually obligations related to asset retirement 11
obligations, PPAs, operating leases, and pension and OPEB obligations. These 12
are the same obligations affecting Minnesota Power’s capital structure decisions. 13
14
The relative magnitude of debt equivalents, however, is greater for Minnesota 15
Power than for most other neighboring utilities. Approximately a third of the debt 16
equivalents consist of PPAs, which is one of the more manageable debt 17
equivalents. These PPAs, however, are mainly for our contracted purchase from 18
the Oliver Wind facility, Square Butte PPA, and Manitoba Hydro. For Minnesota 19
Power, debt equivalents increase the challenge of maintaining the Company’s 20
credit rating and therefore must be viewed as debt and taken into consideration 21
when determining the allowed equity ratio for the Company. Table 7 below 22
shows the relative magnitude of the debt equivalent balance for Minnesota Power 23
as compared to amounts included in other neighboring utilities. It is noteworthy 24
that the Company’s business risk position is “Strong,” whereas the neighboring 25
utilities all carry the better business risk profile of “Excellent”. 26
27
14 In the Matter of the Application of Minn. Power for Auth. to Increase Elec. Serv. Rates in Minn., Docket No. E015/GR-08-415, FINDINGS OF FACT, CONCLUSIONS OF LAW, AND ORDER at 33 (May 4, 2009).
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Table 7. 1
Investor-Owned Neighboring Electric Utilities15
Debt Equivalents as % of Total Capitalization1
Minnesota Power2 11%
Wisconsin Power & Light 11% NSP – MN 9% Interstate Power & Light 9% Wisconsin Public Service Co 8% Wisconsin Electric Power Co 8% Madison Gas & Electric 6% MidAmerican Energy Co 4% NSP – WI 4% 1 Calculated from data provided in Select Stats & Ratios by S&P as of December 31, 2015.
2 Minnesota Power's debt equivalent as a percent of total capitalization as of December 31, 2015.
2
Q. Will Minnesota Power continue to have significant amounts of debt 3
equivalents? 4
A. Yes. As previously discussed, S&P imputes debt for PPAs and as we find 5
innovative ways to find low cost financing structures for energy (especially 6
renewable energy), Minnesota Power will have more PPAs in the future. In May 7
2011, Minnesota Power and Manitoba Hydro signed a PPA that requires 8
Minnesota Power to purchase 250 MW of capacity and energy from Manitoba 9
Hydro starting in 2020. In October 2015, Minnesota Power and Manitoba Hydro 10
signed a PPA that provides for Minnesota Power to purchase 50 MW of capacity 11
at fixed prices starting in 2017. Any additional Minnesota Power PPAs will 12
increase imputed debt, which will put downward pressure on ALLETE’s credit 13
metrics (if not offset by a higher allowed equity ratio). 14
15
15 Otter Tail Power Company is not included in neighboring electric utilities. S&P does not specifically breakdown credit metric details for Otter Tail Power Company.
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Q. How does a company's capital structure affect its credit ratings? 1
A. In the determination of a company’s credit rating, rating agencies consider the 2
amount of debt and debt-like instruments (debt equivalents) that a company 3
utilizes relative to the company’s cash flow and total capital employed. All else 4
equal, a company’s financial risk profile will increase – and its credit rating will 5
face downward pressure – as a company increases the amount of leverage (debt 6
and debt equivalents) used in its capitalization. 7
8
Q. How should the Commission take these debt equivalents into account when 9
reviewing the Company’s capital structure proposal? 10
A. Since credit rating agencies include debt equivalents in their determination of 11
debt-to-capital ratios for credit rating purposes even though they are not included 12
in Minnesota Power’s test year capital structure, Minnesota Power’s proposed 13
46.19 percent unadjusted debt-to-capital ratio translates to a higher S&P debt-to-14
capital ratio for credit ratings purposes. It is therefore important to set Minnesota 15
Power’s permitted common equity levels for regulatory purposes high enough to 16
ensure Minnesota Power’s adjusted debt-to-equity ratio falls within S&P’s 17
expectations for its current credit ratings. I discuss the specifics of this 18
adjustment in more detail in Section IV.B. of my Direct Testimony, below. 19
20
Q. Does the overall nature of the Minnesota regulatory environment also affect 21
ALLETE’s credit ratings? 22
A. Yes. Based on the S&P ratings methodology for financial risk and business risk, 23
ALLETE’s anchor rating is currently BBB. A favorable regulatory 24
framework/regime has been instrumental to ensure an overall credit rating of 25
BBB+. Unfavorable regulatory decisions can increase the utility’s business risk 26
and put downward pressure on credit ratings. S&P specifically references 27
assessing the regulatory framework/regime as a critical factor in determining the 28
credit risk of a utility because of the environment in which the utility operates and 29
the influence on its financial performance. S&P’s 2013 report, Key Credit 30
Factors for the Regulated Utilities Industry, explains: “We base our assessment of 31
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the regulatory framework’s relative credit supportiveness on our view of how 1
regulatory stability, efficiency or tariff setting procedures, financial stability, and 2
regulatory independence protect a utility’s credit quality and its ability to recover 3
its costs and earn a timely return.” 4
5
Moody’s also notes in its 2013 report Regulated Electric and Gas Utilities two 6
key factors that are important in the assessment for a utility are: (1) regulatory 7
framework; and (2) the ability to recover costs and earn returns. These reports 8
and other discussion with both S&P and Moody’s confirm that regulatory stability 9
is critical for ALLETE. If not for regulatory support, ALLETE’s credit ratings 10
would be jeopardized, resulting in higher costs for our customers. 11
12
Q. What is the estimated impact of a ratings decrease on the Company's cost of 13
debt? 14
A. It is difficult to quantify the impact because the premium charged by investors is 15
dynamic and fluctuates widely with market conditions. However, based on 16
Bloomberg data, the additional cost in terms of added credit spread paid by BBB- 17
credit companies compared to BBB+ rated companies averaged 0.52 percent for 18
the period December 2006 through December 2015. Credit spreads between 19
BBB- and BBB+ rated companies were as high as 1.75 percent at one point 20
during the 2008-2009 financial crisis. Ultimately, a downgrade will result in a 21
higher cost of debt for Minnesota Power’s ratepayers. 22
23
Q. Has Minnesota Power proposed any alternative rate mechanisms to reduce 24
risk? 25
A. Yes, as referenced in the testimony of Ms. Podratz and Mr. McMillan, Minnesota 26
Power has proposed an Annual Rate Review Mechanism. 27
28
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Q. If approved, how would the rate mechanism impact the Company’s 1
management of its capital structure? 2
A. If the ratings agencies recognize this mechanism to be strong enough to reduce 3
risk and improve our business and or financial risk profile, it would lead to lower 4
borrowing costs and better access to the capital markets. Mr. Hevert addresses 5
how this proposal is factored into the Company's requested ROE. 6
7
8
IV. RECOMMENDED TEST YEAR CAPITAL STRUCTURE 9
Q. Please describe the components of Minnesota Power's capital structure. 10
A. Minnesota Power recommends a capital structure consisting of 53.81 percent 11
common equity and 46.19 percent long-term debt. Minnesota Power's capital 12
structures for the calendar years 2015, projected 2016, and the 2017 test year, are 13
shown in Schedule D-1. For 2015, Minnesota Power’s 13-month average capital 14
structure consisted of 54.09 percent common equity and 45.91 percent long-term 15
debt. For 2016, the average capital structure is expected to consist of 54.52 16
percent common equity and 45.48 percent long-term debt. These ratios do not 17
reflect any off-balance sheet obligations that, for credit rating purposes, are 18
viewed as the equivalent of debt. 19
20
Table 8 below summarizes Minnesota Power’s capital structure, ROE, and overall 21
rate of return provided in our 2009 retail rate case, 2015 actuals, and as projected 22
Total $20.5 $39.1 $77.0 $98.2 $200.6 $161.2 $27.0 $623.6
3
Q. How much equity does ALLETE carry in its capitalization? 4
A. Minnesota Power is by far ALLETE’s dominant business. Consequently, 5
ALLETE’s equity ratios are driven by Minnesota Power’s capital structure. For 6
the test year, ALLETE is expected to be capitalized with a projected equity ratio 7
of 56.0 percent and Minnesota Power with a projected equity ratio of 53.8 percent 8
(precisely, 53.81 percent). 9
10
Q. Does ALLETE expect to issue common stock in 2017? 11
A. Yes. As previously indicated, Minnesota Power has a need for additional external 12
financing. To maintain a capital structure that will support adequate investment 13
grade credit ratings and allow the Company to access needed capital at reasonable 14
costs, ALLETE expects to issue both debt and equity capital. 15
16
Q. Please explain why the recommended test year capital structure for 17
Minnesota Power is reasonable and appropriate. 18
A. The Company’s objective is to maintain adequate investment grade credit ratings 19
in order to continue to access the capital it needs at reasonable terms and maintain 20
17 Equity Forward net of carrying costs associated with delayed draw. 18 Includes common stock issued through Invest Direct, Employee Stock Purchase Plan, and Retirement Savings and Stock Ownership Plan.
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its financial integrity. The ongoing capital expenditure requirements and debt 1
maturities facing Minnesota Power make this objective both more difficult and 2
more important. The Company’s recommended test year capital structure 3
produces an adjusted FFO/Debt and Debt/EBITDA ratio within the expected 4
range for ALLETE’s current S&P credit rating. ALLETE expects to issue 5
additional equity to fund Minnesota Power’s capital requirements. 6
7
Q. What do the credit rating benchmarks indicate regarding the 8
appropriateness of Minnesota Power’s test year capital structure? 9
A. Minnesota Power’s test year capital structure includes a 46.19 percent unadjusted 10
debt-to-capital ratio. After applying S&P’s adjustments for debt equivalents, 11
Minnesota Power’s test year debt-to-capital ratio for credit rating purposes 12
increases to 51.46 percent. With the S&P adjustments for debt, Minnesota 13
Power’s FFO/Debt is at 20.1 percent and debt to EBITDA at 4.0x. As I 14
mentioned earlier, S&P expects ALLETE to remain near 20 percent to 22 percent 15
for FFO/Debt and debt to EBITDA less than 4.5x. 16
17
Q. Please explain why a capital structure that produces an adjusted debt-to-18
capital ratio of 51.46 percent is acceptable. 19
A. As discussed above, the adjusted debt-to-capital ratio of 51.46 percent produces 20
an FFO/Debt ratio that is within the acceptable range for S&P. If the Company’s 21
metrics would move below the standard for ALLETE’s current rating. A decline 23
in credit quality would increase Minnesota Power’s cost of capital at a time when 24
the Company continues to have substantial external financing needs. 25
26
Q. Do you support the analysis and the rate of return on common equity of 27
10.25 percent presented by Mr. Hevert? 28
A. Yes. Mr. Hevert's result of 10.25 percent is reasonable in today’s economic 29
environment, including the risks that are unique to Minnesota Power, and is 30
representative of the range of equity investors’ required rate of return for 31
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investment in integrated electric utilities in today’s capital markets. The 1
significance of the ROE increases in volatile markets because the level of 2
earnings authorized by the Commission directly impacts the Company’s ability to 3
fund capital investment with internally generated funds. 4
5
Mr. Hevert’s recommended ROE considers the Company’s unique risk profile, 6
including its customer concentration, capital expenditure program, and debt 7
maturities. With the Company required to access debt and equity markets for a 8
substantial amount of capital, our ability to attract capital at reasonable returns to 9
ensure continued safe and reliable electric service while maintaining the 10
Company’s financial integrity is crucial. Potential investors will evaluate the 11
Company’s ability to meet its fixed obligations and provide an acceptable return 12
before committing their capital to the Company. 13
14
V. RETIREMENT PLAN ACCOUNTING 15
Q. What is the purpose of this section of your Direct Testimony? 16
A. In this section of my testimony, I explain how the Company’s pension and OPEB 17
expense amounts for the 2017 test year were derived. I note that Company 18
witness Ms. Nicole Johnson’s Direct Testimony provides background information 19
on overall compensation, including how retirement plans fit into our 20
compensation planning. Therefore, this section focuses just on pension and 21
OPEB expense accounting and the resulting accumulated contributions in excess 22
of net periodic benefit costs. Note that because the pension and OPEB plans are 23
managed at the total Minnesota Power level, which includes non-regulated 24
operations as well as regulated operations, many costs included in the testimony 25
are at the total Minnesota Power level. In most cases, the Minnesota 26
jurisdictional numbers (MN) are also included. 27
28
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A. Pension Expense 1
Q. What amount of pension expense is included in Minnesota Power’s 2017 test 2
year budget? 3
A. The 2017 pension expense is projected to be $7,730,200 total Minnesota Power 4
($5,719,569 MN). 5
6
Q. How many pension plans does ALLETE have? 7
A. Company witness Ms. Johnson discusses the Company’s pension plans and plan 8
components in her Direct Testimony. In summary, for purposes of my testimony, 9
ALLETE has three qualified pension plans, collectively referred to as the 10
Company’s pension or pension plan: 11
12
Plan A – “non-bargaining plan,” for active non-bargaining unit employees as 13
of January 1, 2016, 14
Plan B – “bargaining plan,” for active bargaining unit employees as of 15
January 1, 2016, and 16
Plan C – “inactive plan,” for participants with a deferred vested benefit, 17
retired participants, or surviving spouse status as of December 31, 2015, 18
including former non-bargaining unit and bargaining unit participants which 19
are no longer represented by the union contract. 20
21
Q. How are ALLETE’s pension plan contributions and pension expense 22
determined? 23
A. The amounts of the Company’s (1) contributions to its pension plan and (2) its 24
annual pension expense are different because they are governed by two different 25
authorities. Contributions to the pension plan are made to comply with the 26
funding requirements of the Employee Retirement Income Security Act of 1974 27
(“ERISA”) and the Internal Revenue Code (“IRC”), including the provisions of 28
the Pension Protection Act of 2006. 29
30
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The pension expense is determined by Generally Accepted Accounting Principles 1
(“GAAP”) determined by the Financial Accounting Standards Board (“FASB”) 2
and accepted by the U.S. Securities and Exchange Commission (“SEC”). 3
4
Q. Can you provide more detail explaining how the Company’s annual pension 5
expense is derived? 6
A. Yes. Minnesota Power’s actuary, Mercer (US) Inc. (“Mercer”), calculates the 7
Company’s pension expense using actuarial analyses, which are performed in 8
accordance with Financial Accounting Standards Codification 715-30 Defined 9
Benefit Plans – Pension (now “ASC 715-30”). 10
11
ASC 715-30 requires the pension expense for a given year to be determined 12
annually, which is calculated by Mercer. In addition, the Company’s independent 13
auditor, PricewaterhouseCoopers, LLP, audits the actuarial assumptions used to 14
ensure compliance with GAAP. 15
16
Q. Has the Company taken steps in recent years to reduce its pension expense? 17
A. Yes. Below is a summary of these changes. Company witness Ms. Johnson 18
provides more detail regarding several of these changes in her Direct Testimony. 19
20
Closed Plan B to new entrants – February 1, 2011 21
Determined discount rate using Mercer Bond Model to support a higher 22
discount rate, lowering liabilities and overall expense – 2014 23
Created Plan C – January 1, 2016. The purpose of creating Plan C was to 24
restructure Plan A and Plan B into a third plan (Plan C) for inactive 25
participants to deliver benefits in a more cost-effective method. Plan C was 26
established to place all participants not accruing benefits in one plan with the 27
assets and liabilities associated with those accrued benefits and take advantage 28
of accounting rules that allow longer amortization period for unrealized losses 29
within the pension calculation for plans covering inactive participants only. 30
Accordingly, assets and liabilities were transferred from Plans A and B to 31
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Plan C with this change. As explained in Ms. Johnson’s testimony, because 1
no new Minnesota Power employees are eligible for pension benefits, this is 2
just a shifting of participants from one plan to another plan. The estimated 3
expense savings when we decided to adopt Plan C was $4.7 million total 4
Minnesota Power ($3.4 million MN) and $4.6 million total Minnesota Power 5
($3.4 million MN) for 2016 and 2017 respectively. 6
Q. What are the components of the 2017 pension expense calculation? 7
A. ALLETE’s pension expense is determined by calculating and aggregating five 8
components: 9
10
1. Service Cost – The present value (using the Discount Rate as described below) 11
of the projected retirement benefits earned by each employee in the current 12
year. 13
2. Interest Cost – The amount the present value (using the Discount Rate as 14
described below) of future benefit payments is expected to increase during the 15
year due to one year’s interest accrual. In other words, this is the expense 16
incurred because the employees are one year closer to receiving their benefit. 17
3. Expected Return on Plan Assets – The amount expected to be earned on the 18
plan’s assets. It is estimated by multiplying the Expected Return on Assets 19
(“EROA”) to the five-year smoothed pension asset balance. 20
4. Amortization of Prior Service Cost – The cost of increased/(decreased) 21
benefits, amortized over the remaining service life of the affected participants. 22
5. Amortization of Net Gain or Loss – Gains or losses accumulate when the 23
annual change in the benefit obligation or the plan assets deviate from 24
expectations, i.e. the difference between the prior years’ actual return on plan 25
assets vs. the prior years’ Expected Return on Plan Assets. If these 26
accumulated gains or losses exceed 10 percent of the greater of the benefit 27
obligation or plan assets, the excess is amortized over a period of time based on 28
participant demographics. 29
30
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Q. What information does the actuary utilize to calculate the annual pension 1
expense? 2
A. The primary pension assumptions used to estimate the Company’s 2017 pension 3
expense are listed below: 4
5
Discount Rate of 4.25 percent: The discount rate is computed using the 6
Mercer Bond Model, which creates a hypothetical portfolio of AA or 7
better rated corporate bonds such that bond yields and principal payments 8
would fully match the projected benefit payments from the pension plan. 9
The discount rate is set equal to the yield on this hypothetical portfolio. 10
This methodology is the most precise and yields the highest discount rate 11
(lowest expense) that we are allowed to use per the SEC. 12
EROA of 7.50 percent: The 7.50 percent rate compares to average rates of 13
7.10 percent from the EEI Pension and OPEB Survey 2015-2016 14
(Exhibit__ (PLC), Schedule 1), and 7.30 percent as determined in 15
ALLETE’s internally calculated survey of EEI member companies’ 2015 16
annual reports (Exhibit__ (PLC), Schedule 2). As shown, ALLETE’s 17
EROA is higher than average (which produces a lower expense). 18
2017 contributions of $18,006,400 total Minnesota Power. 19
20
Q. Did the Commission establish the Company’s 2010 test year pension expense 21
on the basis of the Company’s forecasted or actual 2010 test year costs in 22
Minnesota Power’s last rate case? 23
A. No. In our last rate case, Department of Commerce, Division of Energy 24
Resources (formerly the Office of Energy Resources) (“Department”) observed 25
that Minnesota Power’s pension expense at that time had been volatile, and 26
recommended that “the most effective means of neutralizing this volatility and 27
arriving at a reasonable estimate of the Company’s annual costs over the next few 28
years – when the rates set in this case will be in effect – was to use the Company’s 29
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five-year historical-average pension expense.”19 However, the Administrative 1
Law Judge “found that the Company’s methodology for forecasting pension 2
expense was reasonable and consistent with generally accepted accounting 3
principles all publicly traded companies must use.”20 Ultimately, the Commission 4
concluded that the Company’s pension expense should not be based on the 5
pension discount rate in effect at one point in time.21 Rather, the Commission 6
applied a five-year average, establishing the 2010 test year pension expense on 7
the basis of the Company’s average annual pension costs for calendar years 2006 8
through 2010.22 9
10
Q. Did the Company consider applying a five-year average of pension expense 11
for purposes of establishing the 2017 test year expense? 12
A. Yes. We considered utilizing the five-year average pension expense for the years 13
2013 through 2017. However, as shown in Table 11 below, this five-year average 14
results in 2017 test year pension expense that would be much higher than 15
Minnesota Power’s forecasted pension expense of $7,730,200 total Minnesota 16
Power ($5,719,569 MN) for 2017: 17
18
Table 11. 19
5-year Pension Expense 20
Year
Total Minnesota Power
Pension Expense
Minnesota
Jurisdictional
2013 19,141,329 14,793,063
2014 11,587,063 8,852,034
2015 13,741,693 10,357,502
Est 2016 5,019,858 3,701,178
Est 2017 7,730,200 5,719,569
Average 11,444,029 8,684,669 21
19 In the Matter of the Application of Minn. Power for Auth. to Increase Rates for Elec. Serv. in Minn., Docket No. E015/GR-09-1151, FINDINGS OF FACT, CONCLUSIONS, AND ORDER at 24 (Nov. 2, 2010). 20 Id. at 25. 21 Id. at 26. 22 Id.
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1
Q. Why is the five-year average pension expense higher than the Company’s 2
actuarially-determined forecasted pension expense for 2017? 3
A. There are two main reasons the five-year pension expense is higher than the 4
actuarially determined forecasted 2017 pension expense. The first reason is the 5
creation of Plan C. As described above, the creation of Plan C significantly 6
reduced pension expense starting in 2016. The second reason is the Company has 7
contributed a total of $35 million total Minnesota Power to the pension plans 8
during the five-year period, which has increased plan assets and lowered the 9
pension expense. 10
11
Q. Did the Company also consider utilizing a five-year average of pension 12
expense assuming Plan C was implemented as the basis for 2017 test year 13
pension expense? 14
A. Yes. However, the actuarially-determined 2017 pension expense, based on the 15
actuarial analysis, is still substantially lower than the five-year average assuming 16
Plan C for all five years, as illustrated in Table 12 below: 17
18
Table 12. 19
Year
Total
Minnesota Power MN Jurisdictional
2013 14,593,976 11,278,715
2014 8,288,214 6,331,851
2015 9,464,956 7,134,005
est 2016 5,019,858 3,701,178
est 2017 7,730,200 5,719,569
Average 9,019,441 6,833,064 20
21
Q. Why is the five-year average with the Plan C adjustment still higher than 22
anticipated 2017 pension expense? 23
A. As stated previously, the Company has contributed $35 million total Minnesota 24
Power to the pension plans during the five-year period. Contributions increase 25
plan assets and lower pension expense. These contributions and associated 26
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returns were made throughout the five-year period, and the full effect is realized 1
in 2017. 2
3
Q. Does averaging of historic pension expense have predictive attributes for 4
future pension expenses? 5
No. The correlation between the historical five-year average pension expense 6
(current year plus four historical years) to the actual year pension expense or even 7
the actual average three-year pension expense (current year plus two future years) 8
is low. The correlation coefficient or r-squared values are very low at .50 and .30 9
respectively. The r-squared value is a statistical measurement which measures 10
how the proportion of the variance of one number is attributable to another 11
number. An r-squared value of 1 is perfectly correlated, 0 is uncorrelated, and -1 12
is perfectly negatively correlated. The uncorrelated association of the average 13
five-year pension expense can also be seen visually in Figure 2 below, where the 14
two lines appear to move in different or almost random directions and therefore 15
visually are not correlated. One would expect if these numbers were more 16
correlated they would move in the same direction in a given year. The graph also 17
shows, as was discussed above, on average the five-year average methodology 18
was significantly below the actual pension expense since our last rate case. 19
20
Figure 2. 21
22
23
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Q. Did you examine the correlation between other averaging methods to arrive 1
at a test year pension expense and actual pension expenses? 2
A. Yes. We also examined the correlation between determining pension expense 3
based on a five-year average of actual discount rates and actual pension expense. 4
This averaging method has a higher correlation than the five-year average 5
expense with respect to its prediction of the next year’s pension expense, but does 6
not accurately predict pension expense beyond that. The correlation coefficient is 7
.90 to the actual current year’s pension expense and .55 to the actual average 8
three-year’s pension expense (current year plus two future years), respectively. 9
Due to its inability to predict pension expense into the future, this methodology is 10
not consistent with a representative test year construct. 11
12
Figure 3. 13
14
15
Q. Have you evaluated another way pension expense can be projected? 16
A. Yes. We evaluated the correlation between the prior year’s actual expense and 17
current year’s expense. The correlation was better with an r-squared of .69 and .38 18
to the actual current year’s pension expense and the actual average three-year’s 19
pension expense (current year plus two future years). The improved correlation 20
over the averaging methods can be seen in Figure 4 below, where the lines appear 21
to move in tandem with one another. 22
23
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Figure 4. 1
2
3
Q. Have you evaluated additional other ways pension expense can be projected? 4
A. Yes, the final way we evaluated projected pension expense was with our annual 5
autumn forecast of pension expense, which has been done every year since 2007 6
by Mercer. Prior to 2008, GAAP allowed September pension numbers to be used 7
for calendar year-end financial statements, so no estimates were needed because 8
we knew what the pension expense would be before the end of the year and the 9
budget was due. This method was the best method evaluated with an r-squared of 10
.99 and .76 to the actual current year’s pension expense and the actual average 11
three-year’s pension expense (current year plus two future years). Visually, in 12
Figure 5 below, the high correlation between the estimate and actual pension 13
expense can be seen. 14
Figure 5. 15
16
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Q. Can you summarize the correlation results for the different methods you 1
evaluated? 2
A. Yes, of the four methods used to project the next year’s expense or three-year 3
average expense, Mercer’s actuarially determined estimated pension expense was 4
far superior to any other method. This can be seen in Table 13 below which 5
shows the correlation coefficient of the four methods. 6
7
Table 13. 8
Correlation Coefficient (R-Squared) To Current Year ExpenseTo Next 3-year actual average
(current + 2 future years)Estimated Pension Expense .99 .765-Year Historic Average Discount Rate Pension Expense .90 .55Actual Previous Year Pension Expense .69 .385-Year Historic Average Pension Expense .50 .30 9
10
Q. What does this comparison of five-year averages to current pension expense 11
illustrate? 12
A. This comparison illustrates three important points that contribute to the reason 13
Minnesota Power proposes to utilize its 2017 pension expense (not an averaging 14
method of past expense or discount rates) to set 2017 test year rates. 15
16
First, past average pension expense or average past discount rates are not a 17
reliable indicator of future pension expense due to the unpredictability of 18
investment returns, discount rates, plan benefit changes, and other pension plan 19
assumption changes resulting from the current and projected economic 20
environment. This is why GAAP requires pension expenses to be re-determined 21
annually on the basis of updated information, and why the Company establishes a 22
forecasted pension expense for budgeting purposes that is then updated on 23
December 31 of the year to determine actual expense for the following year. 24
25
Second, averaging of past discount rates or past pension expense can have 26
unintended effects on customers. Utilizing a five-year average of pension 27
expense reduced the test year expense in our 2009 rate case filing, but utilizing a 28
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five-year average in the current rate case would increase the test year pension 1
expense – and by far more than the averaging in 2009 reduced test year costs. 2
3
Third, switching to a different smoothing mechanism would unfairly punish the 4
utility investors because, over the long run, the utility investors would never 5
recover the long-term pension expense average. This is why we believe the 6
current estimated 2017 test year pension expense is the appropriate expense for 7
determining rates. 8
9
As Company witness Mr. McMillan describes in his Direct Testimony, Minnesota 10
Power’s rate case filing is intended to provide an accurate and transparent picture 11
of the Company’s reasonable costs of providing electric service to customers. 12
Utilizing an average of discount rates or actual historical expense obscures that 13
goal, as it bases pension expense included in rates on past numbers rather than on 14
the financial circumstances in effect during the test year and beyond. Further, 15
applying an averaging method over time may actually increase customer costs in 16
the long run. 17
18
Q. But isn't a purpose of averaging to “normalize” test year pension expense, 19
especially in a volatile market, rather than utilizing a potentially aberrant 20
discount rate or expense estimate? 21
A. That is my understanding of the goal of averaging, but it can undermine the 22
concept of a representative test year. “Normalizing” one potentially changing 23
cost but not others interferes with the idea that all or most costs will change in the 24
course of a year, but that the test year is reasonably representative of the utility’s 25
overall cost of service. Further, in the case of pension expense, GAAP 26
incorporates a different form of smoothing into the annual forecasted and actual 27
expense, thereby already “normalizing” without additional ratemaking 28
adjustments. 29
30
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Q. How does the 2017 forecasted and actual pension expense already 1
incorporate a “smoothing” mechanism to moderate the volatility of discount 2
rates and other factors? 3
A. For purposes of calculating pension expense, the Company already utilizes all 4
smoothing methods allowed under pension accounting rules (ASC 715-30) that 5
are designed to reduce pension expense volatility. Under these methods: 6
7
ALLETE uses a market-related value of assets in calculating expense. 8
The market-related value of assets phases in gains or losses over a five-9
year period. This reduces volatility by using a more stable asset value to 10
determine the expected return on plan assets component of expense. The 11
market-related value of assets also reduces volatility in the amortization of 12
gains and losses, described below, because recent gains and losses are 13
excluded from the amortization calculation to the extent they are not 14
phased in. 15
ALLETE amortizes accumulated gains and losses, excluding gains and 16
losses not yet phased into the market-related value of assets, in the pension 17
expense. 18
o ALLETE uses a corridor to determine if gains and losses will be 19
amortized in expense. The corridor is the greater of 10 percent of 20
the plan’s obligation or 10 percent of the plan’s market-related 21
value of assets. 22
If accumulated gains and losses fall within the corridor, no 23
gains and losses are amortized in expense. 24
If accumulated gains and losses exceed the corridor, the 25
excess is amortized over the average working lifetime of 26
active participants, or the average lifetime of inactive 27
participants if there are no active participants in the plan. 28
Increases or decreases in plan liabilities resulting from plan amendments 29
are amortized over the average working lifetime of the active participants 30
affected by the plan amendment. 31
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1
Q. What are the effects of the smoothing on previous years? 2
A. Without the current smoothing mechanisms in place, the pension expense would 3
have varied much more. For the last five years, the standard deviation of the 4
unsmoothed pension expenses is $49.2 million total Minnesota Power, while our 5
GAAP pension expense’s (which is smoothed) standard deviation is $3.4 million 6
total Minnesota Power. This volatility can also be seen in Table 14 below when 7
comparing the expense not smoothed with the GAAP smoothed expense: 8
9
Table 14. 10
Total Minnesota Power Pension Expense 12/31/2011 12/31/2012 12/31/2013 12/31/2014 12/31/2015
Pension Expense without Smoothing 47,163,800 30,074,052 (64,759,889) 61,088,931 17,087,748
Q. How does this smoothing principle compare to the averaging that has been 13
applied to utility pension expense in past Minnesota rate cases? 14
A. These smoothing approaches reduce volatility over time, and therefore differ from 15
the averaging approach in several ways. First, the smoothing methods are 16
consistent with GAAP, thereby aligning ratemaking with financial accounting. 17
Second, the smoothing approaches, unlike averaging, do not reduce the utility’s 18
recovery of actually incurred costs to serve customers, but rather change the 19
timing of cost recognition under GAAP accounting. This is because the 20
smoothing incorporates actual costs on an annual rolling basis, as opposed to an 21
average of costs using an expense amount or discount rate that may not reflect 22
actual conditions. Third, averaging the smoothing already implemented under 23
GAAP and then averaging (or smoothing again) is not necessary. Fourth, the 24
averaging (unlike GAAP smoothing methods) does not always reduce volatility. 25
For example, as stated above, the five-year GAAP expense has a standard 26
deviation of $3.4 million total Minnesota Power but the standard deviation of the 27
five-year average expense is $4.5 million total Minnesota Power; this outcome 28
illustrates that averaging does not always reduce volatility. 29
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1
Q. Is there an alternative way to recover pension expense? 2
A. Yes. As illustrated above, pension expense varies considerably and averaging 3
methods are not reasonably representative of actual pension expense for a test 4
year or for multiple years into the future. An alternative approach would be to 5
institute a mechanism that adjusts rates annually for pension expense and the 6
associated contributions. An annual true-up would sync with the Company’s 7
annual incentive plan filing and would be consistent with the Commission’s past 8
approval of true-ups related to other volatile costs, such as property taxes. This 9
would be the most accurate, timely, and direct recovery mechanism supporting 10
true cost of service. 11
12
Q. What do you conclude regarding the Company’s pension expense included in 13
Minnesota Power’s 2017 test year? 14
A. Minnesota Power supports recovery of the Company’s forecasted 2017 pension 15
expense as determined by Mercer or an annual adjustment mechanism as 16
described previously if the Annual Rate Review Mechanism is not approved. 17
Throughout the years, the Company has been consistent in supporting the 18
determination of pension expense based on the Company’s GAAP pension 19
expense as determined by our actuary, including the current year’s assumptions. 20
Using another method to determine rates, such as an historic average, has the 21
strong potential to distort the forecasting methodology mandated by the SEC and 22
GAAP to measure the cost of the plan, thereby precluding the Company from 23
recovering its costs of providing retirement benefits to Company employees. 24
Further, historic averages do not incorporate changes in the economic 25
environment or plan and assumption changes implemented by the Company to 26
help control the cost of the pension plans. Finally, as demonstrated, GAAP 27
already uses a very effective smoothing approach to account for various gains, 28
losses, and other changes, and therefore further averaging is not necessary. 29
30
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B. Other Post-Employment Benefit Expense 1
Q. What Post-Employment Benefit Expenses are included in the OPEB? 2
A. ALLETE’s OPEB expense reflects post-employment medical, dental, and life 3
benefits. Please see Ms. Johnson’s testimony for more details regarding these 4
benefits for employees. 5
6
Q. What amount of OPEB expense is included in Minnesota Power's 2017 test 7
year budget? 8
A. The 2017 OPEB expense is projected to be a negative expense of $829,460 total 9
Minnesota Power (negative expense $613,717 MN). This negative expense has 10
the customer benefit of reducing Minnesota Power’s overall revenue requirement. 11
This expense, however, may not stay negative in the future for a variety of 12
reasons, including asset returns, discount rate changes, etc. Another reason is 13
GAAP only requires Minnesota Power to accrue expenses for eligible employees 14
that are 45 years of age or older. Although we have closed our OPEB plans to 15
new employees (as explained in Ms. Johnson’s testimony), some of our current 16
eligible employees are younger than 45. Therefore, when they attain this age, we 17
will begin to accrue for their benefits and this will increase future OPEB expense. 18
19
Q. How do utilities fund OPEB plans and calculate OPEB expense? 20
A. There is no legal mandate to fund OPEB plans as there is for pension plans; 21
however, utilities have typically funded their OPEB plans as mandated or agreed 22
upon by their governing commissions. ALLETE’s OPEB funding policy is to 23
fund, at a minimum, its OPEB expense. The OPEB expense is determined by 24
GAAP mandated by Financial Accounting Standards and accepted by the SEC, 25
which is similar to pension expense. 26
27
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Q. Why does the Company have the policy to fund OPEB expense? 1
A. On September 22, 1992, the Commission adopted “SFAS 106 accrual accounting 2
for Minnesota utility recordkeeping and ratemaking purposes.”23 The Order 3
stated, “SFAS 106 does not require funding for OPEB obligations.”24 The 4
Department, however, “recommended that external funding be required, in order 5
to provide assurance of future payment of these obligations.”25 In 1992, “the 6
Commission required Xcel to establish an external funding mechanism by its next 7
general rate case for FAS 106.”26 Later, Minnesota Power filed its 1994 rate case, 8
in which Company witness Bruce E. Gagnon testified, based largely on the Xcel 9
Energy precedent, that “[t]he Company intends to fund the SFAS 106 liabilities as 10
the funds are collected.”27 Since then, Minnesota Power has not only funded its 11
expense, it has funded more than its expense. 12
13
On June 27, 2012, the Company requested the ability to determine on an annual 14
basis whether to fund its post-employment benefit trust obligations; 28 however, 15
the Commission denied this request.29 One of the reasons for the denial was that 16
23 In the Matter of the Accounting and Ratemaking Effects of the Statement of Fin. Accounting Standards, Docket U999/CI-92-96, ORDER ADOPTING ACCOUNTING STANDARD AND ALLOWING
DEFERRED ACCOUNTING at 7 (Sept. 22, 1992). 24 Id. at 4. 25 Id. 26 In the Matter of Xcel’s Petition for Approval to Discontinue Funding of Tax Advantaged Extern Fund (VEBA Fund) for Retiree Medical Costs and the Withdrawal of the Accumulated VEBA Fund Balance over a Five-Year Period, Docket No. E,G002/M-02-2188, ORDER APPROVING
PETITION WITH MODIFICATION AND REQUIRING COMPLIANCE FILING at 1 (Oct. 17, 2003) (citing the Commission’s Order in Docket No. U999/CI-92-96). 27 In the Matter of the Application of Minn. Power for Auth. to Change its Schedule of Rates for Retail Elec. Serv. in the State of Minn., Docket No. E-015/GR-94-001, DIRECT TESTIMONY OF
BRUCE E. GAGNON at 8 (Jan. 3, 1994). 28 In the Matter of Minn. Power’s Petition for Approval of Deferred Accounting Related to Pension Plan Contributions and Expenses, Docket No. E015/M-11-1264, REPLY COMMENTS
(June 27, 2012). 29 In the Matter of Minn. Power’s Petition for Approval of Deferred Accounting Related to Pension Plan Contributions and Expenses, Docket No. E015/M-11-1264, ORDER DENYING
PETITION (Mar. 11, 2013).
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the “request would appear to defeat the trust account’s purpose, which is to ensure 1
that funds are available to pay benefits when they are due.”30 2
3
Q. What is the benefit of the policy to fund, at a minimum, the OPEB expense? 4
A. As with pension funding, by funding expense we are providing an assurance of 5
future payments of these obligations and reducing annual expense amounts. For 6
test year 2017, Mercer projected the earnings on these funds will reduce our 7
OPEB expense by total Minnesota Power $9.4 million ($7.0 million MN). 8
9
Q. Can you provide more detail explaining how the Company’s annual OPEB 10
expense is derived? 11
A. Yes. Minnesota Power had the OPEB expense calculated by Mercer using 12
actuarial analyses, which are performed in accordance with Accounting Standards 13
Codification 715-60 Defined Benefit Plans – Other Post-Employment (“ASC 715-14
60”). Consistent with GAAP, ASC 715-60 sets forth the methodologies and 15
assumptions used to calculate OPEB expense. 16
17
ASC 715-60 requires the OPEB expense for a given year to be determined 18
annually, which is calculated by Mercer. In addition, the Company’s independent 19
auditor, PricewaterhouseCoopers, LLP, audits the actuarial assumptions used to 20
ensure compliance with GAAP. 21
22
Q. Has the Company taken steps to reduce/control OPEB costs in recent years? 23
A. Yes. We have made five recent major changes, which are explained in more 24
detail in Ms. Johnson’s Direct Testimony: 25
26
1. Beginning on February 1, 2011, new employees were no longer eligible for 27
OPEB health benefits; 28
30 Id. at 2.
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2. Effective January 1, 2012, the age requirement for retiree health eligibility 1
was increased to age 55, up from age 50; 2
3. In 2013, retiree health cost sharing was changed from 75 percent Company/25 3
percent retiree to 70 percent Company/30 percent retiree for post-65 retirees; 4
4. Post-employment life insurance for non-bargaining unit participants was 5
eliminated unless the employee retired prior to January 1, 2016; and 6
5. Minnesota Power added a high deductible consumer directed health plan 7
option in 2014, and a second high deductible consumer directed health plan 8
option in 2017. 9
10
Q. What are the components of the 2017 OPEB calculation? 11
A. ALLETE’s OPEB expense is determined in largely the same manner as pension 12
expense – that is, by calculating and aggregating five components: 13
14
1. Service Cost – The present value (using the Discount Rate as described below) 15
of the projected post-employment benefits earned by each employee in the 16
current year. 17
2. Interest Cost – The amount the present value (using the Discount Rate as 18
described below) of future benefit payments is expected to increase during the 19
year due to one year’s interest accrual. In other words, this is the expense 20
incurred because the employees are one year closer to receiving their benefits. 21
3. Expected Return on Plan Assets – The amount expected to be earned on the 22
plan’s assets. It is estimated by multiplying the EROA by the five-year 23
smoothed OPEB asset balance. 24
4. Amortization of Prior Service Cost – The amortization of the cost of increased/ 25
(decreased) benefits, amortized over the remaining service life of the affected 26
participants. 27
5. Amortization of Net Gain or Loss – Gains or losses accumulate when the 28
annual change in the benefit obligation or the plan assets deviate from 29
expectations, i.e. the difference between the prior years’ actual return on plan 30
assets vs. the prior years’ Expected Return on Plan Assets. If these 31
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accumulated gains or losses exceed 10 percent of the greater of the benefit 1
obligation or plan assets, the excess is amortized over a period of time based on 2
participant demographics. 3
4
Q. What information does the actuary utilize to calculate the annual OPEB 5
expense? 6
A. The primary OPEB assumptions used to estimate the Company’s 2017 OPEB 7
expense are listed below: 8
9
Discount Rate of 4.25 percent: The discount rate is computed using the 10
Mercer Bond Model, which creates a hypothetical portfolio of AA or 11
better rated corporate bonds such that bond yields and principal payments 12
would fully match the projected benefit payments from the pension plan. 13
The discount rate is set equal to the yield on this hypothetical portfolio. 14
This methodology is the most precise and yields the highest discount rate 15
(lowest expense) which we are allowed to use per the SEC. 16
EROA of 7.50 percent for non-taxable plans and 6.0 percent for taxable 17
plans: These rates compared to the Pension and OPEB Survey 2015-2016 18
average of 7.10 percent (Exhibit__ (PLC), Schedule 1) and OPEB EROA 19
rates of 6.57 percent as determined in ALLETE’s internally calculated 20
survey of EEI member companies 2015 annual reports (Exhibit__ (PLC), 21
Schedule 2). As shown, ALLETE EROA is higher than average (which 22
produces a lower expense). 23
Health care trend rates: Initial trend rate of 6.25 percent with ultimate 24
trend rate of 5.0 percent. This is in comparison to the EEI Pension and 25
OPEB Survey 2015-2016 average of Initial Trend Rate of 6.84 percent and 26
ultimate average trend rate of 4.81 percent (Exhibit__ (PLC), Schedule 1). 27
28
29
30
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Q. Were test year OPEB costs, like pension costs, determined in the Company’s 1
last Minnesota rate case by averaging five years of actual expense? 2
A. No. OPEB costs for the 2010 test year were based on the Company’s forecasted 3
expense solely for the 2010 test year. While the Commission noted that the 4
dependence of these costs on a single, potentially volatile discount rate could call 5
into question the reasonableness of those costs, the issue had not been addressed 6
in the record and, therefore, was not decided by the Commission.31 7
8
Q. Does the OPEB expense calculation, like the pension expense calculation, 9
incorporate a smoothing mechanism? 10
A. Yes, the OPEB expense calculation incorporates the same smoothing mechanisms 11
as the pension expense, including use of the market-related value of assets, 12
amortizations of prior service costs/(credits), amortizations of (gains)/losses, and 13
the application of the corridor, described below, for determining if (gains)/losses 14
need to be amortized. 15
16
For purposes of calculating OPEB expense, the Company already utilizes all 17
smoothing methods allowed under OPEB accounting rules (ASC 715-60) that are 18
designed to reduce OPEB expense volatility. Under these methods: 19
20
ALLETE uses a market-related value of assets in calculating expense. 21
The market-related value of assets phases in gains or losses over a five-22
year period. This reduces volatility by using a more stable asset value to 23
determine the expected return on plan assets component of expense. The 24
market-related value of assets also reduces volatility in the amortization of 25
gains and losses, described below, because recent gains and losses are 26
excluded from the amortization calculation to the extent they are not 27
phased in. 28
31 In the Matter of the Application of Minn. Power for Auth. to Increase Rates for Elec. Serv. in Minn., Docket No. E015/GR-09-1151, FINDINGS OF FACT, CONCLUSIONS, AND ORDER at 27 (Nov. 2, 2010).
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ALLETE amortizes accumulated gains and losses, excluding gains and 1
losses not yet phased into the market-related value of assets, in the OPEB 2
expense. 3
o ALLETE uses a corridor to determine if gains and losses will be 4
amortized in expense. The corridor is the greater of 10 percent of 5
the plan’s obligation or 10 percent of the plan’s market-related 6
value of assets. 7
If accumulated gains and losses fall within the corridor, no 8
gains and losses are amortized in expense. 9
If accumulated gains and losses exceed the corridor, the 10
excess is amortized over the average working lifetime of 11
active participants, or the average lifetime of inactive 12
participants if there are no active participants in the plan. 13
Increases or decreases in plan liabilities resulting from plan amendments 14
are amortized over the average working lifetime of the active participants 15
affected by the plan amendment. 16
17
Q. Is there an alternative way to recover OPEB expense? 18
A. Yes, as with the pension expense discussed previously, we could institute a 19
mechanism that adjusts rates annually for pension expense, and the associated 20
contributions. This would be the most accurate and direct recovery mechanism. 21
22
Q. What do you recommend with respect to including OPEB costs in Minnesota 23
Power’s 2017 test year? 24
A. Similar to the pension expense, the Company supports recovery of the Company’s 25
forecasted 2017 OPEB expense as determined by the actuaries, including the 26
current year’s assumptions or an annual adjustment mechanism as described 27
previously if the Annual Rate Review Mechanism is not approved. We believe 28
this is the most accurate and consistent method for determining OPEB expense, 29
and was approved in our prior rate case. Using another method, such as an 30
historic average, has the strong potential to distort the forecasting methodology 31
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required by the SEC and GAAP to measure the cost of the plan, thereby 1
precluding the Company from recovering its actual costs of providing these 2
benefits to utility employees. Further, historic averages do not incorporate 3
changes in the economic environment, or plan and assumption changes 4
implemented by the Company, to help control the cost of the OPEB plans. 5
6
C. Prepaid Pension Asset 7
1. Background 8
Q. Please describe how the Company funds its pension plans. 9
A. Most years, the Company makes contributions to its pension plan to ensure 10
adequate funding to cover future benefit obligations to employees. As the 11
Internal Revenue Service describes, “[c]ontributions to a defined benefit plan are 12
based on what is needed to provide definitely determinable benefits to plan 13
participants. Actuarial assumptions and computations are required to figure these 14
contributions.”32 15
16
More specifically, the Pension Protection Act of 2006 (“Pension Protection Act”) 17
established certain minimum funding requirements for plan years beginning in 18
2008 and through the present. Prior to enactment of the Pension Protection Act, 19
pension contributions and pension expense were largely equal or in balance. 20
However, the Pension Protection Act established new requirements for calculating 21
the necessary levels of pension plan contributions, which resulted in significant 22
increases in the contributions employers must make to the pension plan in any 23
given year. 24
25
When an employer contributes more to the pension plan than it has expensed, the 26
result is a prepaid pension asset. Conversely, contributing less than expensed will 27
result in a liability. 28
32 IRS Retirement Topics - Defined Benefit Plan Benefit Limits, available at https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-defined-benefit-plan-benefit-limits (last visited Sept. 20, 2016).
62 Docket No. E015/GR-16-664
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1
Q. Why are the Company’s pension expenses and contributions different? 2
A. The pension expense and contributions represent different aspects of the pension 3
plan and are governed by two different authorities. The pension expense 4
represents the Company’s annual pension plan costs on the income statement, and 5
is determined by GAAP as set forth by the FASB and accepted by the SEC. 6
Contributions to the pension plan are made by the Company to satisfy the funding 7
requirements of the Employee Retirement Income Security Act of 1974 8
(“ERISA”) and the IRC, including the provisions of the Pension Protection Act 9
for contributions to pension plans. 10
11
Q. What is the level of Minnesota Power’s pension contributions since the 12
Pension Protection Act took effect? 13
A. As illustrated in Exhibit__ (PLC), Schedule 3 and in Figure 6 below, Minnesota 14
Power’s pension contributions from 2008 through 2016 have totaled $119.2 15
million total Minnesota Power ($91.2 million MN). In addition, Minnesota Power 16
has incurred pension expense totaling $78.4 million total Minnesota Power ($59.9 17
million MN), of which it has only collected approximately $7.0 million MN 18
through rates since 2008. 19
20
Figure 6. 21
MN Jurisdictional Historical Pension Contributions, Expense, and Recovery 22
A. Minnesota Power’s prepaid pension asset arises from the fact the Company has 2
contributed more to the pension plan than it has expensed since 1952, the 3
inception year of the plan. Increased contributions to the pension plan 4
substantially increase the prepaid pension asset balance, which in turn reduces 5
pension expenses. 6
7
Q. What is the amount of ALLETE’s prepaid pension asset? 8
A. The amount of ALLETE’s estimated 2017 test year 13-month average prepaid 9
pension asset is $80,685,986 total Minnesota Power ($59,707,183 MN). 10
11
Q. Are there other naming conventions for prepaid pension assets? 12
A. Yes. Historically, when a Company contributed more to its pension plan than it 13
expensed, this has been called a “prepaid pension expense” or a “prepaid pension 14
asset.” More recently this has been called “accumulated contributions in excess 15
of net periodic benefit cost.” Due to the familiarity with the naming, we will use 16
the “prepaid pension asset” convention. 17
18
Q. What is the status of Minnesota Power’s current cost recovery for pension 19
contributions and pension expense? 20
A. As previously noted, Minnesota Power proposes to recover its actual 2017 21
pension expense through rates. Currently, the Company is recovering through 22
rates an amount of pension expense based on a five-year average as calculated in 23
our 2009 rate case. Minnesota Power also makes contributions to its pension plan 24
on behalf of its employees, which is necessary to comply with federal law and to 25
provide employees with job benefits appropriate to their work delivering utility 26
service to Minnesota Power customers. Although these contributions result in a 27
utility net asset that has the effect of reducing the pension expense, this asset is 28
not presently in rate base and therefore is not earning a return. 29
30
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Q. Has Minnesota Power ever earned a return on its prepaid pension assets? 1
A. No. Minnesota Power requested recognition of the prepaid asset in our Petition 2
for Approval of Deferred Accounting Related to Pension Plan (Docket No. 3
E015/M-11-1264) filed on December 22, 2011. Minnesota Power’s request for 4
deferred accounting treatment was denied in part because the cost was not 5
considered “unusual, unforeseeable, and large enough to have a significant impact 6
on the utility’s financial condition,” which are the traditional Commission criteria 7
for deferred accounting.33 8
9
Q. What is Minnesota Power proposing with respect to its prepaid pension asset 10
in this proceeding? 11
A. Minnesota Power is proposing to include the MN Jurisdictional portion of the 12
prepaid pension asset, which exists as a balance sheet asset, as a component of 13
Minnesota Power’s working capital section of its rate base and be entitled to a 14
return. 15
16
Q. Why is it appropriate to include Minnesota Power’s prepaid pension asset in 17
rate base? 18
A. Minnesota Power believes strongly that recognition of pension funding as a 19
component of rate base is appropriate for several reasons: (1) they are a necessary 20
cost of providing electric service; (2) a certain level of pension contribution is 21
required by law to fund pension plans; (3) contributions to the pension plan are 22
made by the Company’s shareholders and benefit customers; and (4) other 23
utilities are permitted to include an asset in rate base, consistent with standard 24
ratemaking treatment when contributions and expenses differ significantly for an 25
expenditure. Given that the Company is entitled to a fair return on costs incurred 26
by shareholders as necessary to provide utility service, these costs should be 27
included in rate base. 28
33 In the Matter of Minn. Power’s Petition for Approval of Deferred Accounting Related to Pension Plan Contributions and Expenses, Docket No. E015/M-11-1264, ORDER DENYING
PETITION at 2 (Mar. 11, 2013).
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1
2. Legal Requirements 2
Q. How has Minnesota Power determined what level of contributions to make to 3
the pension plan each year? 4
A. On an annual basis, the Company has contributed at least the IRC minimum 5
statutory required contribution to the pension plans. The Company has made 6
additional contributions to the pension plans to the level at which they will not be 7
subject to benefit restrictions as described in IRC Section 436 of the Pension 8
Protection Act, and at which they will not be considered “at-risk” status as 9
defined in IRC Section 412 of the Pension Protection Act. Periodically, the 10
timing of contributions was accelerated typically just to the preceding year for a 11
variety of reasons, including the availability of funds and to reduce the implied 12
debt rating agencies compute for debt equivalents related to pension obligations.34 13
However, we are given credit for this contribution in the following years. For 14
more information regarding debt equivalents, see Section III(C)(2), of my 15
testimony. 16
17
Q. What if the Company does not make the minimum contributions and only 18
contributes expense? 19
A. We would be in violation of federal laws. ERISA and the IRC establish minimum 20
funding requirements for defined benefit pension plans. Although there is no 21
requirement that a defined benefit pension plan be 100 percent funded (except 22
upon plan termination), the Company, as plan sponsor, must make minimum 23
annual contributions to the plan equal to the cost of annual benefit accruals plus a 24
seven-year amortization of the unfunded liability. In addition to interest on 25
underpayments, an initial excise tax of 10 percent is levied upon an unpaid 26
funding deficiency, which may increase to 100 percent of the liability if the 27
34 Standard & Poor’s Rating Services, RatingsDirect, Corporate Methodology: Ratios and Adjustments at 25 (Nov. 19, 2013).
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deficiency is not promptly corrected after notice from the IRS. The penalties are 1
imposed each year that the deficiency is not paid. 2
3
Q. Why is it reasonable for the Company to make contributions above the 4
minimum? 5
A. The Company has a written policy of funding the plan to keep the plan at least 80 6
percent funded on an actuarial basis in order to avoid certain financial and 7
administrative penalties. We have contributed to this 80 percent level. If a plan 8
falls below 80 percent funded, it is considered “at-risk,” no amendment can be 9
made that has the effect of increasing plan liabilities, and certain payments from 10
the plan are prohibited. If the funding goes below 60 percent, all benefit accruals 11
must cease. In addition, the 80 percent funding level is a term negotiated with the 12
International Brotherhood of Electrical Workers (“IBEW”) Local 31. We agreed 13
to this term, which allowed the creation of Plan C. As stated previously, the 14
adoption of Plan C created an expense decrease of $4.7 million total Minnesota 15
Power ($3.4 million MN) and $4.6 million total Minnesota Power ($3.4 million 16
MN) for 2016 and 2017 respectively. 17
18
As will be shown later in my testimony, contributions decrease expense because 19
earnings on these contributions decrease pension expense more than they increase 20
the cost of capital. 21
22
Q. What is the likely effect if the Company’s pension contribution were equal 23
only to the pension expense? 24
A. It would increase expenses dramatically and violate pension terms negotiated with 25
our union. There would be four major issues: 26
27
1. As stated previously, a tax of 100 percent would be applied on the amount 28
of the IRC established minimum contribution not funded which is above the 29
pension expense; 30
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2. For every $10 million not funded, the pension expense would increase by 1
$750,000 ($10 million x EROA of 7.5 percent); 2
3. Compounded earnings on the contributions would not be available to 3
reduce pension expense; and 4
4. We would need to renegotiate, when appropriate, contract terms negotiated 5
with the IBEW if we prefer not to fund pension Plan B and Plan C at 80 6
percent or higher (based on the adjusted funding target attainment percentage 7
(“AFTAP”)). 8
9
Q. Is it possible for the Company to have a prepaid pension asset and also have 10
a currently underfunded pension plan? 11
A. Yes. A plan can be underfunded at the same time it has a prepaid pension asset 12
because they measure different things. The prepaid pension asset is the amount 13
by which cumulative contributions exceed cumulative recognized pension 14
expense. A pension plan is underfunded when its pension benefit obligations 15
exceed the value of its assets. However, without the prepaid asset, the plan would 16
be more underfunded because the value of the assets would be lower, and 17
therefore even less than the Company’s pension benefit obligations. As I discuss 18
above, this would be to the detriment of pension expense and could put the 19
Company in violation of federal law. 20
21
Q. Can the Company withdraw assets from the pension plan other than to pay 22
benefits or plan expenses? 23
A. No, federal law prohibits the Company from withdrawing any assets from the 24
pension other than to pay employee benefits and plan expenses. 25
26
3. Cost of Fairly Compensating Employees 27
Q. Can you expand on your comment that pension contributions should be 28
included in rate base because they are a necessary cost of providing electric 29
service? 30
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A. Yes. Pension costs – like other employee compensation expenses – are a 1
necessary cost of fairly compensating employees, as described by Company 2
witness Ms. Johnson. Skilled, reliable employees are critical to providing safe, 3
reliable electric service; therefore, the cost of compensating those employees at 4
market-competitive levels, including retirement benefits, is likewise appropriately 5
included in electric service rates. It is a long-standing principle in Minnesota rate 6
regulation that a utility’s reasonable and prudent employee retirement plans are 7
necessary to fairly compensate employees for their work in providing electric 8
service to customers. As such, Minnesota Power customers currently receive the 9
benefit of employee service without fully contributing to the cost of compensating 10
these employees, as the amount of pension expense recovered does not adequately 11
account for the full cost of pensions. 12
13
4. Uncompensated Shareholder Investment that Benefits Customers 14
Q. Why is it relevant that pension contributions are made by the Company 15
rather than by customers? 16
A. Pension contributions are made by the Company, rather than by customers. 17
However, these contributions have benefited customers as the earnings on these 18
funds have significantly reduced the Company’s annual pension expense under 19
ASC 715-30, yet the Company has not earned any return on these funds. The 20
customer benefits by having a lower pension expense, which is included in base 21
electric rates. More specifically, the prepaid pension asset can provide benefits to 22
the customer in at least three ways: 23
24
1. Customers benefit from a reduction in the unfunded balance of the pension 25
obligation because the risk of being required to fund more in future years is 26
also reduced. 27
2. The earnings applied to this balance reduces the current year pension expense 28
through the workings of the EROA on this balance and ASC 715-30. 29
3. Customers benefit from applying the EROA to the accumulated earnings on 30
the prepaid pension asset (the compounding of earnings). 31
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1
It is a long-standing ratemaking principle that utilities are entitled to and need a 2
reasonable return on investments made for the benefit of customers.35 Here, 3
customers benefit from the federally-mandated contributions made to fund 4
pension benefits available to utility employees. 5
6
Q. Does the prepaid pension asset include any accumulated earnings on the 7
prepaid pension asset? 8
A. No. The prepaid asset is only the excess of the Company’s accumulated 9
contributions over its accumulated expense. Exhibit__ (PLC), Schedule 4 10
illustrates how the prepaid pension balance was created by adding each year’s 11
contributions and subtracting each year’s pension expense since 1987. 12
13
Q. Please explain how applying the EROA reduces 2017 test year pension 14
expense and revenue requirement. 15
A. Minnesota Power’s annual pension expense is determined under ASC 715-30. 16
ASC 715-30 instructs that pension expense be reduced by the expected earnings 17
on the assets in the pension trust. That reduction in pension expense is 18
determined by multiplying the 7.50 percent EROA to the five-year smoothed 19
pension asset balance. The result is then subtracted from the Company’s annual 20
pension cost. This means the earnings that are available to reduce pension 21
expense are greater as a result of the prepaid pension asset. 22
23
Q. Have you determined the expense reduction that results from applying the 24
EROA to the prepaid pension asset? 25
A. Yes. As shown in Exhibit__ (PLC), Schedule 5, the 2017 Minnesota Power 26
prepaid pension asset will reduce the 2017 test year pension expense by 27
$5,479,280 total Minnesota Power ($4,054,115 MN). Note this expense reduction 28
35 See Bluefield Waterworks & Improvement Co. v. Pub. Serv. Comm’n of W. Va., 262 U.S. 679, 692 (1923) (stating that a “public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public.”).
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example does not reflect the savings that would have been generated in prior 1
years if the EROA had been applied to the accumulated earnings on the prepaid 2
pension asset in those years. 3
4
Q. Can you calculate the added benefit of applying the EROA to the 5
accumulated earnings on the prepaid pension asset? 6
A. Yes. The estimated 2017 test year benefit of applying the EROA on the 7
accumulated earnings on the prepaid balance is shown in Exhibit__ (PLC), 8
Schedule 5. This will reduce 2017 test year pension expense by $7,843,211 total 9
Minnesota Power ($5,803,186 MN). 10
11
Q. Why is including the prepaid pension asset in rate base consistent with 12
standard ratemaking? 13
A. Including the prepaid pension asset in rate base is consistent with standard 14
ratemaking treatment when contributions and expenses differ significantly for an 15
expenditure. These include adjustments in working capital included in rate base 16
for prepaid assets or expenses and deferred tax assets and tax liabilities, both of 17
which investor provided/received funds in excess/under expense are included in 18
rate base. This is further exemplified by the fact many U.S. utilities currently 19
recover, in some manner, contributions to their pensions which include allowing 20
prepaid pension assets in their rate base.36 This includes at least one Minnesota 21
utility that has been allowed to include the prepaid pension asset in its rate base.37 22
23
Q. Is Minnesota Power seeking recovery of actual contributions minus expense? 24
A. Yes, we are seeking recovery of our prepaid asset, which consists of the 25
cumulative contributions minus cumulative expense. This can be seen in 26
36 Oregon Public Utility Commission Pension Survey, Pension Treatment in Rate Making Survey, Summary Report, (Mar. 28, 2013). 37 In the Matter of the Application of N. States Power Co. for Auth. to Increase Rates for Elec. Serv. in the State of Minn., Docket No. E002/GR-13-868, FINDINGS OF FACT, CONCLUSIONS, AND ORDER at 20 (May 8, 2015).
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Exhibit__ (PLC), Schedule 4 by year since 1987, when the prepaid pension 1
balance materially began. This is consistent with the Commission's May 8, 2015, 2
Findings of Fact, Conclusions, and Order in Docket No. E015/GR-13-868, Xcel 3
Energy's most recent past rate case. 38 4
5
Q. Are there offsets to the Company’s proposal to include the full amount of the 6
Jurisdictional prepaid pension asset in rate base? 7
A. Yes. The full MN Jurisdictional amount in rate base will be reduced by the 8
corresponding accumulated deferred income tax (“ADIT”). Like other prepaid 9
assets where book and tax expense are different, the prepaid pension asset is 10
reduced by the ADIT related to it. The ADIT related to the MN Jurisdictional 11
prepaid asset of $59,707,183 is $31,890,236 MN Jurisdictional. Included in the 12
ADIT is the advanced contribution deduction, which is created when the 13
Company elects to take an advanced tax deduction of contributions made by 14
September 15, 2018, on our 2017 tax return; therefore, the net rate base increase 15
will be $27,816,947 MN. Company witness Ms. Jamie Jago describes the overall 16
ADIT in more detail in her Direct Testimony. 17
18
Q. How is the ADIT created in regards to the prepaid pension asset? 19
A. The Company’s contribution to the pension plan is tax deductible up to the IRS 20
limit. When this contribution exceeds the expense in any given year it creates a 21
Since the plan’s inception, the accumulation of these annual deferred tax 23
liabilities/assets creates the ADIT related to the prepaid pension asset. The ADIT 24
liability is subtracted from the rate base (or, for example, netted with the prepaid) 25
38 While we understand Minnesota Energy Resources Corporation’s (“MERC”) recent request to include the prepaid pension asset in rate base was denied, MERC’s primary position appears to be that the full pension funded status should be included in rate base. Minnesota Power’s proposal is more in line with the Xcel Energy precedent. Further, we understand that Otter Tail Power Company is also seeking to include its prepaid pension asset in rate base. Clearly this is an important issue for Minnesota utilities seeking to recover their costs of providing utility service.
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because the company receives a tax deduction for the prepaid amount plus the 1
advanced deduction (because the contributions are greater than the expense). 2
Thus, this lowers the taxes we pay compared to our GAAP expense. We therefore 3
need to decrease rate base for this ADIT related to the prepaid pension asset, 4
consistent with how we treat all other ADIT in rate base. 5
6
Q. Have you calculated the net customer benefit resulting from applying the 7
EROA and other expense reductions and revenue requirement from the 8
prepaid pension asset? 9
A. Yes. There is a net benefit to customers for the 2017 test year as summarized in 10
Table 15 below and detailed in Exhibit__ (PLC), Schedule 6. This benefit does 11
not include any of the advanced deduction tax deduction benefit as described 12
previously. 13
14
Table 15. 15
All numbers in table are MN Jurisdictional 16
Customer benefits from prepaid pension asset: $4,054,115
Revenue requirement for financing prepaid pension asset: $3,643,079
Estimated 2017 net benefit prepaid benefit to customer $411,036
17
Q. Why doesn’t recovery of pension expense adequately compensate the 18
Company for its pension investments? 19
A. By recovering only the pension expense, the Company is not recovering all of its 20
pension cost if the prepaid is not included in rate base. This is because the 21
Company is not recovering the cost of its capital that it is mandated to contribute 22
which is in excess of the recovered pension expense. This amount is easily 23
calculated as the weighted average cost of capital multiplied by the Company’s 24
prepaid pension asset, which is the mechanism that would be used if the prepaid 25
asset were to be included in rate base. This cost of capital is the true cost of 26
shareholders funding the pension in excess of what the Company is recovering. 27
28
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Q. Please summarize the Company’s request with respect to the prepaid pension 1
asset. 2
A. The Company requests the prepaid pension asset of $59,707,183 (MN) be 3
included in the working capital section of rate base and that it be allowed to earn a 4
return on these assets, the same as any other working capital prepayments and 5
other Minnesota and U.S. utilities. 6
7
Because the prepaid pension asset represents contributions in excess of expense, 8
investor capital is required to fund the prepaid pension asset balance and investors 9
are entitled to a return on their capital. Further, the Company is required to fund 10
the pension plan. Customers also benefit from these contributions because 11
earnings on these contributions directly reduce pension expense. Accordingly, it 12
is necessary to include the prepaid pension asset in rate base to fully reimburse the 13
Company for its reasonable costs of service. 14
15
D. Prepaid OPEB Asset 16
Q. What is ALLETE proposing with respect to its prepaid OPEB asset? 17
A. Minnesota Power is providing information regarding its prepaid OPEB asset. We 18
are not asking to include the prepaid asset in rate base at this time, as I explain 19
later in my testimony. 20
21
Q. Are there other naming conventions for Prepaid OPEB Assets? 22
A. Yes. Historically, when a Company contributed more to its OPEB plan than 23
expense, this has been called a “prepaid OPEB expense” or a “prepaid OPEB 24
asset.” More recently this has been called “accumulated contributions in excess 25
of net periodic benefit cost.” Due to the familiarity with the naming, we use the 26
“prepaid OPEB asset” convention. 27
28
Q. Why does the Company have a prepaid OPEB asset? 29
A. The prepaid OPEB asset arises from the fact the Company has contributed more 30
to the OPEB plans than it has expensed since the inception of the plans. 31
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1
Q. Are the Company’s OPEB plans currently fully funded? 2
A. Yes. 3
4
Q. What is the amount of ALLETE’s prepaid OPEB asset? 5
A. The amount of ALLETE’s estimated 2017 test year end prepaid OPEB asset is 6
$3,326,430 total Minnesota Power ($2,461,223 MN). 7
8
Q. Is there a legal requirement regarding OPEB funding? 9
A. No. 10
11
Q. What is the Company’s OPEB funding policy? 12
A. ALLETE’s OPEB funding policy is to fund, at a minimum, its OPEB expense. 13
As previously noted, the Company has been funding OPEB based on Commission 14
precedent and past Department recommendations. The Company sought to 15
discontinue funding in 2013, but the request was denied at that time. The 16
Company is not making a separate request to end funding of the OPEB at this 17
time. 18
19
Q. What is the benefit of at least funding the expense? 20
A. By funding expense, we are providing an assurance of future payments of these 21
obligations and for 2017 test year, we project the earnings on these funds will 22
reduce our OPEB expense by total Minnesota Power $9.4 million ($7.0 million 23
MN). 24
25
Q. Can the Company withdraw assets from the OPEB plans other than to pay 26
benefits or plan expenses? 27
A. Doing so is technically possible, but ill-advised, because the funds are held in a 28
Voluntary Employees Beneficiary Association (“VEBA”) trust. The Company 29
would pay a federal excise tax of 50 percent in addition to the Company’s 30
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statutory tax rate on the withdrawn amount. Consequently, we cannot realistically 1
use these funds for any purpose but covering employee benefits. 2
3
Q. If the Company has generally matched OPEB funding to the level of expense, 4
why is there a prepaid OPEB asset? 5
A. Prepaid assets are created when cumulative contributions exceed expense. Due to 6
the Company’s policy of funding OPEB expenses and changes in OPEB benefits 7
as discussed previously and in more detail in Company witness Ms. Johnson’s 8
testimony, the Company’s OPEB expenses have been negative since 2013 and are 9
projected to be negative in the Company’s 2017 test year. If the Company funds 10
expense and expense is negative, the Company would need to withdraw funds 11
from the OPEB or VEBA trust to avoid a prepaid asset39; however, as described 12
above, it would be ill-advised for the Company to withdraw funds due to tax 13
penalties. Consequently, we will continue to have a prepaid OPEB asset. 14
15
Q. Why do other utilities in Minnesota have unfunded accrued benefit liabilities 16
instead of a prepaid asset for their OPEB plans? 17
A. As previously discussed in the early 1990’s, when FAS 106 was adopted, other 18
utilities were required to fund their expenses; however, they later requested and 19
received approval to discontinue funding their VEBAs.40 Therefore, because their 20
contributions were no longer at least equal to their expense, they now have 21
unfunded accrued benefit liabilities for their OPEB plans. 22
23
39 A prepaid asset is created when contributions exceed expense. The math holds true when a prepaid asset is created even when expense is negative. For example, if the contribution is 0 and the expense is negative the prepaid will increase because the contribution is greater than the expense. 40 In the Matter of Xcel’s Petition for Approval to Discontinue Funding of Tax Advantaged External Fund (VEBA Fund) for Retiree Medical Costs and the Withdrawal of the Accumulated VEBA Fund balance over a Five-Year Period, Docket No. E,G002/M-02-2188, ORDER
APPROVING PETITION WITH MODIFICATION AND REQUIRING COMPLIANCE FILING (Oct. 17, 2003).
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Q. Why isn't the Company asking to include its prepaid OPEB asset in rate 1
base? 2
A. Because there is no legal mandate to fund the OPEB, as there is for the pension, 3
the prepaid OPEB asset should not grow significantly over time or become a 4
liability and will likely shrink. In addition, since the Company has a long-5
standing policy and agreement with the Commission to fund, at a minimum, the 6
Company’s OPEB expense, we will not have an unfunded accrued benefit liability 7
as other utilities have. Therefore, we are not seeking to include the prepaid OPEB 8
assets in rate base, as we have for the prepaid pension asset. 9
2014 Median 4.11% 7.25% 7.50%2013 Median 4.94% 7.25% 9.88%2012 Median 4.10% 7.50% 12.30%2011 Median 4.82% 7.75% 3.50%2010 Median 5.40% 7.88% 8.75%2009 Median 5.75% 8.44% 17.00%
For more information, please contact:Bill Pfister Richard McMahonManager, Financial Analysis Vice President, Finance and Energy Supply202.508.5531 [email protected][email protected] Page 1 of 2
EEI Pension and OPEB Survey 2015-16
CompanyExpected
Discount RateYield Curve / Model (Firm) Yield Curve / Model (Specific)