Entergy Texas, Inc. v. Public Utility Commission of Texas, Office of Public Utility Counsel, and State of Texas Agencies and Institutions of Higher Education

ACCEPTED

03-14-00706-CV

5038192

THIRD COURT OF APPEALS

AUSTIN, TEXAS

4/27/2015 10:27:46 AM

JEFFREY D. KYLE

CLERK

No. 03-14-00706-CV

IN THE FILED IN

3rd COURT OF APPEALS

THIRD DISTRICT COURT OF APPEALS AUSTIN, TEXAS

AT AUSTIN, TEXAS 4/27/2015 10:27:46 AM

JEFFREY D. KYLE

ENTERGY TEXAS, INC., Clerk

Appellant,

v.

PUBLIC UTILITY COMMISSION OF TEXAS, ET AL.,

Appellees.

Appeal from the 345th Judicial District Court, Travis County, Texas

The Honorable Amy Clark Meachum, Judge Presiding

________________________________________________________________

APPELLANT’S REPLY BRIEF

_________________________________________________________________

John F. Williams

State Bar No. 21554100

jwilliams@dwmrlaw.com

Marnie A. McCormick

State Bar No. 00794264

mmccormick@dwmrlaw.com

DUGGINS WREN MANN & ROMERO, LLP

600 Congress Ave., Ste. 1900 (78701)

P. O. Box 1149

Austin, Texas 78767-1149

(512) 744-9300

(512) 744-9399 fax

ATTORNEYS FOR APPELLANT

ENTERGY TEXAS, INC.

ORAL ARGUMENT REQUESTED

April 2015

TABLE OF CONTENTS

TABLE OF CONTENTS ........................................................................................... i

INDEX OF AUTHORITIES.................................................................................... iii

STATEMENT OF FACTS ........................................................................................1

SUMMARY OF ARGUMENT .................................................................................1

ARGUMENT AND AUTHORITIES ........................................................................3

I.  Discretion alone does not justify the Commission’s decision.........................3

II.  The Court may not sustain the Commission’s decision upon the theory

that ETI’s total rate case expenses were “too high” or that ETI

wantonly incurred expenses.............................................................................6

A.  The Commission did not find that ETI’s expenses were

excessive or that ETI files rate cases too frequently. ............................6

B.  The Court cannot sustain the Commission’s decision upon an

unarticulated factual theory. ................................................................10

III.  The Commission’s disallowance of ETI’s costs of litigating the

incentive compensation issue is arbitrary and capricious and an abuse

of discretion. ..................................................................................................12

A.  The Commission’s finding that ETI made an unreasonable

argument in the underlying rate case is arbitrary and capricious........12

B.  Regardless, the Commission’s decision is reversibly wrong on

procedural grounds. .............................................................................16

1.  The Commission changed its past practice without

explanation or advance notice...................................................16

2.  Additionally, the Commission effectively and improperly

adopted a new rule in this contested case. ................................21

IV.  The Commission further erred in quantifying its disallowance of

ETI’s expenses of seeking to include financially-based incentive

compensation in rates. ...................................................................................24

i

V.  The Commission’s disallowance of depreciation expense associated

with ESI’s efforts in the rate case is not supported by any evidence

and is arbitrary and capricious. ......................................................................27

CONCLUSION AND PRAYER .............................................................................31

CERTIFICATE OF COMPLIANCE .......................................................................32

CERTIFICATE OF SERVICE ................................................................................33

APPENDICES .........................................................................................................34

ii

INDEX OF AUTHORITIES

Cases

Bowman Transportation, Inc. v. Arkansas-Best Freight System, Inc.,

419 U.S. 281, 95 S.Ct. 438, 42 L.Ed.2d 447 (1974) ............................................15

CenterPoint Energy Entex v. Railroad Comm’n of Tex.,

213 S.W.3d 364 (Tex. App. – Austin 2006, no pet.)...........................................27

Citizens to Preserve Overton Park v. Volpe,

401 U.S. 402, 91 S.Ct. 814, 28 L.Ed.2d 136 (1971) ............................................14

City of El Paso v. El Paso Elec. Co.,

851 S.W.2d 896 (Tex. App. – Austin 1993, writ denied) ............................. 11, 28

City of El Paso v. Public Util. Comm’n of Tex.,

883 S.W.2d 179 (Tex. 1994) ..................................................................................4

City of El Paso v. Public Util. Comm’n of Tex.,

916 SW.2d 515 (Tex. App. – Austin 1995, writ dism’d by agr.)...........................5

City of Port Neches v. Railroad Comm’n of Tex.,

212 S.W.3d 565 (Tex. App. – Austin 2006, no pet.) .............................................5

Continental Imports, Ltd. v. Brunke,

No. 03-10-00719-CV, 2011 WL 6938489 *5

(Tex. App. – Austin Dec. 30, 2011, pet. denied) .......................................... 11, 28

Downer v. Aquamarine Operators, Inc.,

701 S.W.2d 238 (Tex. 1985) ..................................................................................3

Entergy Gulf States, Inc. v. Public Util. Comm’n of Tex.,

173 S.W.3d 199 (Tex. App. – Austin 2005, pet. denied) ............................. 23, 24

Flores v. Employees Ret. Sys.,

74 S.W.3d 532 (Tex. App. – Austin 2002, pet. denied) .........................................4

Goeke v. Houston Lighting & Power Co.,

797 S.W.2d 12 (Tex. 1990) ..................................................................................11

Hendee v. Dewhurst,

228 S.W.3d 354 (Tex. App. -- Austin 2007, pet. denied) ....................................17

Industrial Utils. Serv. Co. v. Texas Natural Resources Conservation

Comm’n,

947 S.W.2d 712 (Tex. App. – Austin 1997, no writ) .................................... 20, 21

Lewis v. Metropolitan Savings & Loan Association,

550 S.W.2d 11 (Tex. 1977) ..................................................................................14

iii

McHaney v. Texas Comm’n on Environmental Quality,

No. 03-13-00280-CV, 2015 WL 869197 at *8 (Tex. App. – Austin

Feb. 27, 2015, no pet. h.) ......................................................................................22

Morgan Drive Away, Inc. v. Railroad Comm'n of Tex.,

498 S.W.2d 147 (Tex. 1973) ......................................................................... 11, 28

Office of Pub. Util. Counsel v. Public Util. Comm'n,

878 S.W.2d 598 (Tex. 1994) ................................................................................17

Oncor Elec. Delivery Co. v. Public Util. Comm’n of Tex.,

406 S.W.3d 253 (Tex. App. – Austin 2013, no pet.)................................ 4, 17, 19

Pioneer Natural Resources USA, Inc. v. Public Util. Comm’n of Tex.,

303 S.W.3d 363 (Tex. App. – Austin 2009, no pet.) ...................................... 5, 26

Professional Mobile Home Transport v. Railroad Comm’n,

733 S.W.2d 892 (Tex. App. – Austin 1987, writ ref’d n.r.e.) ....................... 12, 28

Railroad Commission of Texas v. Lone Star Gas Co.,

611 S.W.2d 908 (Tex. Civ. App. – Austin 1981, writ ref’d n.r.e.) ......................15

Starr County v. Starr Indus. Services, Inc.,

584 S.W.2d 352 (Tex. App. -- Austin 1979, writ ref’d n.r.e.) ...................... 14, 15

State of Texas’ Agencies & Institutions of Higher Learning v. Public Util.

Comm’n of Tex.,

450 S.W.3d 615 (Tex. App. – Austin 2014, pet. filed) ........................................13

Suburban Util. Corp. v. Public Util. Comm'n,

652 S.W.2d 358 (Tex.1983) ...................................................................................5

Texas Bd. of Pharmacy v. Witcher,

447 S.W.3d 520 (Tex. App. – Austin 2014, pet. requested) ..................................4

Texas Health Facilities Comm’n v. Charter Medical-Dallas, Inc.,

665 S.W.2d 446 (Tex. 1984) ........................................................................... 4, 10

Texas Medical Association v. Mathews,

408 F.Supp. 303 (W.D. Tex. 1976) ......................................................................15

Vista Medical Center Hosp. v. Texas Mut. Ins. Co.,

416 S.W.3d 11 (Tex. App. – Austin 2013, no pet.)....................................... 10, 27

Statutes

Tex. Gov’t Code Ann. § 2001.141 .................................................................... 10, 27

Tex. Gov’t Code Ann. § 2001.174.............................................................................3

iv

Tex. Util. Code Ann. § 36.051 ........................................................................ 5, 9, 27

Tex. Util. Code Ann. § 36.058 .................................................................................30

Tex. Util. Code Ann. § 36.061 .................................................................... 3, 5, 6, 27

Tex. Util. Code Ann. § 36.203 ...................................................................................9

Other Authorities

5 B. Mezines, J. Stein and J. Gruff, Administrative Law § 51.03 (1979) ...............15

Rules

Tex. R. Civ. Evid. 201 .............................................................................................17

Administrative Cases

Application of AEP Texas Central Co. for Authority to Change Rates,

Docket No. 28840 .................................................................................... 17, 25, 26

Application of AEP Texas Central Co. for Authority to Change Rates,

Docket No. 33309 .................................................................................................17

Application of CenterPoint Energy Houston Electric, LLC for Authority

Change Rates, Docket No. 38339 ........................................................................18

Application of Entergy Gulf States, Inc. for Authority to Change Rates and

to Reconcile Fuel Costs, Docket No. 34800 ....................................... 9, 10, 16, 18

Application of Entergy Texas, Inc. for Authority to Change Rates and

Reconcile Fuel Costs, Docket No. 37744 ........................................... 9, 10, 16, 18

Application of Entergy Texas, Inc. for Authority to Change Rates, Reconcile

Fuel Costs, and Obtain Deferred Accounting Treatment,

Docket No. 39896 ......................................................................................... passim

Application of Oncor Electric Delivery Co. LLC for Authority to Change

Rates, Docket No. 35717 ......................................................................................18

Application of Southwestern Electric Power Co. for Authority to Change

Rates and Reconcile Fuel Costs, Docket No. 40443............................................18

Proceeding to Consider Rate Case Expenses Severed from Docket No.

28840 (Application of AEP Texas Central Company for Authority to

Change Rates), Docket No. 31433 .......................................................................25

v

STATEMENT OF FACTS

Entergy Texas, Inc. (“ETI”) does not dispute the statements of fact

submitted by the Public Utility Commission of Texas (“PUCT” or “Commission”),

Office of Public Utility Counsel (“OPUC”), and State Agencies, save in a few

respects. Specifically, ETI disputes the Attorney General’s argumentative

characterization of ETI’s request concerning financially-based incentive

compensation in the underlying rate case, and of the way financially-based

incentive compensation has been treated in past PUCT dockets. ETI also disputes

the suggestion of OPUC and the Attorney General that the Commission found

ETI’s rate case expenses to be “excessive.” ETI discusses these factual

inaccuracies more fully below.

SUMMARY OF ARGUMENT

The Commission’s disallowance of over $522,000 for ETI’s effort to recover

incentive compensation expense is arbitrary and capricious for several reasons.

The contours of the incentive compensation issue have never been defined, ETI’s

argument in the rate case was not materially different from what ETI and other

utilities have argued in the past, and ETI actually prevailed on the issue in part. In

light of these facts, the Commission’s characterization of ETI’s advocacy as

unreasonable is itself unreasonable.

1

More important, the Commission has consistently allowed utilities,

including ETI, to recover the expenses of seeking incentive compensation, even

when the utilities have been unsuccessful. The Commission has never before said

it is unreasonable to incur expense to litigate the incentive compensation issue or

any other “long shot” issue. The Commission’s abrupt policy change, without

even an acknowledgement of its historical treatment of advocacy costs, at the end

of this case, after ETI had already incurred its costs, is arbitrary and capricious and

an abuse of discretion.

This abuse is further manifest in the Commission’s quantification of the

disallowance. The Commission employed a “proxy” for the amount of expense

ETI incurred to litigate the incentive compensation issue, faulting ETI for failing to

track all of its expenses by issue. But again, the Commission has never before

disallowed the entire expense of litigating a single issue in a rate case, certainly not

the incentive compensation issue. That is why utilities have not recorded their

expenses by issue. If the Commission wanted to impose these new standards, it

could and should have done so on a prospective basis. The Commission’s decision

to impose the new standards at the end of this case, contrary to the way the agency

has historically handled the issue, should be reversed.

So should the Commission’s disallowance of over $207,000 in depreciation

expense associated with ESI’s efforts on the rate case. The Commission said only

2

that this expense was “unreasonable,” without identifying any fact underlying that

ultimate finding. Moreover, there is abundant and undisputed record evidence that

ESI’s costs were reasonable, necessary, and fairly charged to ETI and its other

affiliates. None of the Attorney General’s arguments presents a legitimate basis

upon which to affirm the Commission’s decision, and it should be reversed.

ARGUMENT AND AUTHORITIES

Two themes run throughout appellees’ briefs. ETI will address those first,

and then turn to specific issues.

I. Discretion alone does not justify the Commission’s decision.

Appellees attempt to justify the Commission’s decision principally by

asserting that the Commission has discretion in awarding rate case expenses under

Public Utility Regulatory Act (“PURA”) section 36.061(b)(2). See Tex. Util. Code

Ann. § 36.061(b)(2). The Commission does have some measure of discretion, but

that alone cannot justify its decision here. The Commission must adhere to

applicable “guiding” principles in exercising its discretion. Tex. Gov’t Code Ann.

§ 2001.174(2)(F); Downer v. Aquamarine Operators, Inc., 701 S.W.2d 238, 241-

42 (Tex. 1985).

One of the fundamental principles of administrative law is that an agency is

bound to make decisions based upon a full consideration of the evidence and a

serious appraisal of the facts. E.g., Texas Health Facilities Comm’n v. Charter

3

Medical-Dallas, Inc., 665 S.W.2d 446, 452 (Tex. 1984). Another is that an agency

is not absolutely bound to follow its decisions in previous cases in the same way a

court must follow controlling precedent. E.g., Oncor Elec. Delivery Co. v. Public

Util. Comm’n of Tex., 406 S.W.3d 253, 267 (Tex. App. – Austin 2013, no pet.)

(citing Flores v. Employees Ret. Sys., 74 S.W.3d 532, 544-45 (Tex. App. – Austin

2002, pet. denied)). Another guiding principle is that parties to contested cases are

entitled to advance notice of what is expected of them in the administrative

process. E.g., Oncor Elec. Delivery Co., 406 S.W.3d at 268-69; Flores, 74 S.W.3d

at 545. A related rule is that an agency is bound to impose a new policy upon

regulated entities via the formal rulemaking process unless the issue is of first

impression, flows from an amended statute or rule, or cannot be adequately

captured within the bounds of a general rule because the problem is so specialized

in nature. E.g., City of El Paso v. Public Util. Comm’n of Tex., 883 S.W.2d 179,

188-89 (Tex. 1994); Texas Bd. of Pharmacy v. Witcher, 447 S.W.3d 520, 534 (Tex.

App. – Austin 2014, pet. requested).

In addition to these basic principles applicable to all administrative cases,

PURA includes principles that specifically pertain to the Commission’s decisions

on rate case expense recovery. Appellees cite cases that correctly observe that

4

PURA section 36.061(b)(2) affords the agency some discretion in determining

what expenses should be allowed.1 However, as this Court recently noted:

Although section 36.061(b)(2) gives the Commission the discretion to

disallow improper expenses, this discretion is tempered by section

36.051’s mandate that the utility must be allowed to recover its

operating expenses and a reasonable return on invested capital ... If

the expense can be shown to be actual, necessary and reasonable it

should be allowed.

Oncor Elec. Delivery Co., 406 S.W.3d at 264 (citing Suburban Util. Corp. v.

Public Util. Comm'n, 652 S.W.2d 358, 362–63 (Tex.1983)). In other words, the

Commission does not have the discretion to disallow rate case expenses that are

reasonably incurred.2 Appellees’ repeated suggestion that the Commission’s

discretion effectively insulates its decision from meaningful review is flat wrong.

1

See Tex. Util. Code Ann. § 36.061(b)(2), cited in City of El Paso v. Public Util. Comm’n of

Tex., 916 SW.2d 515, 522 (Tex. App. – Austin 1995, writ dism’d by agr.), Pioneer Natural

Resources USA, Inc. v. Public Util. Comm’n of Tex., 303 S.W.3d 363, 377 (Tex. App. – Austin

2009, no pet.), & Oncor Elec. Delivery Co. LLC v. Public Util. Comm’n, 406 S.W.3d 253, 264

(Tex. App. – Austin 2013, no pet.).

2

The testimony of OPUC’s witness Nathan Benedict ignores the impact of PURA section 36.051

on rate case expense recovery. See AR Part II, Binder 3, OPUC Exh. 1 (Direct Testimony of N.

Benedict at 4). So do appellee’s briefs. OPUC cites City of Port Neches v. Railroad Comm’n of

Tex., 212 S.W.3d 565 (Tex. App. – Austin 2006, no pet.) for the proposition that the agency may

disallow reasonable expenses. See OPUC’s Brief at 16. That case, discussing rate case expense

recovery under the Gas Utilities Regulatory Act, does not say reasonable rate case expenses may

be disallowed. It says even though a particular underlying cost of service is determined to be

reasonable, the utility’s expense of seeking recovery of that cost is not “automatically” or “as a

matter of law” deemed reasonable. City of Port Neches, 212 S.W.3d at 581. In other words, the

reasonableness of a utility’s rate case expenses is a fact question separate from the

reasonableness of a utility’s underlying cost of service. City of Port Neches undermines the

Commission’s decision here, where the Commission made the “impermissible leap” that the

reasonableness of an underlying cost of service automatically controls the reasonableness of

related rate case expenses.

5

This case implicates all of the principles set forth above. The Commission

does not avoid their application simply because it has some discretion in applying

PURA section 36.061(b)(2).

II. The Court may not sustain the Commission’s decision upon the theory

that ETI’s total rate case expenses were “too high” or that ETI

wantonly incurred expenses.

Appellees also contend that the Commission’s decision was based upon a

finding that ETI’s total expense for prosecuting Docket No. 39896 was “excessive”

or “unusually high.” The Commission’s order, though, confirms that this was not

the basis of the disallowance ETI challenges here.

A. The Commission did not find that ETI’s expenses were

excessive or that ETI files rate cases too frequently.

The Administrative Law Judge (“ALJ”), in the proposal for decision

(“PFD”) that was adopted by the Commission, recognized that Docket No. 39896

was complex and labor intensive. He noted that ETI presented 39 witnesses, who

discussed hundreds of categories of costs, and that while ETI used the services of

12 attorneys, the other parties and Staff were represented by a total of 15

attorneys.3

3

AR Part I, Binder 2, Item 32 (PFD at 17); AR Part I, Binder 2, Item 55 (Final Order at 1)

(adopting PFD).

6

Though the ALJ and Commission found that the expenses of the case were

“high,” they did not find that the expenses were too high.4 Nor did they reduce

ETI’s expense recovery based upon any finding or conclusion that the total was

unreasonable. Rather, the ALJ and Commission expressly rejected OPUC’s and

State Agencies’ theories that ETI’s expenses should be reduced on bases other than

an “issue-specific” approach.5

In support of their arguments that ETI’s total expenses were unreasonable,

State Agencies and OPUC criticized many categories of ETI’s costs. The ALJ

discussed and expressly rejected most of those criticisms, finding that:

 State Agencies’ challenge to ETI witness Gerald Tucker’s testimony

was “overly simplistic”;6

 State Agencies’ proposal to disallow the expenses of a “lessons

learned” memo would encourage inefficiency;7

 State Agencies’ challenge of miscellaneous internal rate case expenses

should be rejected because ETI proved “in great detail” that they were

reasonable;8

 ETI had “the better argument” on OPUC’s challenge to expenses

associated with the Calpine-Carville purchased power agreement;9

4

AR Part I, Binder 2, Item 32 (PFD at FOF 17); AR Part I, Binder 2, Item 55 (Final Order at

FOF 17).

5

AR Part I, Binder 2, Item 32 (PFD at 31-32); AR Part I, Binder 2, Item 55 (Final Order at 2).

6

AR Part I, Binder 2, Item 32 (PFD at 9).

7

Id. at 10-11.

8

Id. at 13.

9

Id. at 14-15.

7

 he was “unswayed” by State Agencies’ criticism of ETI’s expert’s

review of outside legal fees; the external “legal costs involved do not

appear to be inordinate”;10

 meal, courier, and taxi expenses were a reasonable part of prosecuting

the laborious rate case;11

 State Agencies’ identification of “relatively few errors” in

categorizing meal expenses does not lead to doubt about the overall

accuracy of ETI’s accounting;12 and

 State Agencies’ challenge to airfare and lodging expense was “vague”

and “unproven”.13

The Commission adopted the ALJ’s resolution of all these issues.14 The

Commission also refused to accept the ALJ’s recommendation that another

category of expense, associated with ETI’s advocacy concerning transmission

equalization costs, should be disallowed.15

The Commission ultimately disallowed only a few discrete categories of

expense, for reasons specific to those categories.16 Regarding the category at issue

here, the Commission gave only one reason for the disallowance: “for Entergy

attempting to recover financially-based incentive compensation in base rates.”17 It

10

Id. at 17.

11

Id. at 18-19.

12

Id. at 19.

13

Id. at 21.

14

AR Part I, Binder 2, Item 55 (Final Order at 1).

15

Id. at 3.

16

Id. at 2-3 & FOF 18.

17

Id. at 2.

8

is incorrect to suggest in this appeal that the Commission disallowed any expenses

on the basis that the grand total was unreasonably high.

It is also incorrect to suggest that the Commission disallowed any expenses

based on the purported “frequency” of ETI’s recent rate cases. There is no legal or

factual support for the parties’ intimation that ETI files rate cases with

unreasonable frequency. The frequency of rate cases is cost-driven.18 PURA

guarantees an electric utility rates that afford it a reasonable opportunity to recover

a reasonable return on its investment, and to recover its reasonable and necessary

expenses. Tex. Util. Code Ann. § 36.051. Expenses, which change over time, are

largely recovered through base rates.19 The only Commission-approved way for an

electric utility to capture changes in its overall level of base-rate expense is to file a

rate case.

In the previous ETI rate cases mentioned in appellees’ briefs, the

Commission granted ETI substantial base-rate increases and expressly found that

the increases were just and reasonable. See Application of Entergy Gulf States,

Inc. for Authority to Change Rates and to Reconcile Fuel Costs, Docket No. 34800

(Mar. 16, 2009, Order at FOFs 24 & 45 & COL 7); Application of Entergy Texas,

Inc. for Authority to Change Rates and Reconcile Fuel Costs, Docket No. 37744

18

AR Part II, Binder 3, ETI Exh. 7 (Considine Rebuttal at 5).

19

Some categories of expense, like fuel expenses, are recovered through other methods. Tex.

Util. Code Ann. § 36.203. Those categories of expense are not at issue in this case.

9

(Dec. 13, 2010, Order at FOFs 16 & 35 & COL 7). Any suggestion that ETI was

unjustified in pursuing those increases is, therefore, unfounded. So is any

suggestion that it was unfair for ratepayers to pay the expenses of pursuing those

cost increases. The Commission expressly found that the expenses of pursuing

those rate cases were just and reasonable. See Docket No. 34800, supra (Feb. 5,

2009, Order at FOF 27 & 45 & COL 7); Docket No. 37744, supra (Dec. 13, 2010,

Order at FOFs 18 & 43 & COL 7). In any event, ETI’s pursuit of its statutorily-

guaranteed opportunity to recover its costs in the past has no bearing on this case.

The Commission did not make any finding that it does.

Simply put, the parties invite the Court to affirm the Commission’s

disallowance of expenses by relying on contested factual theories that the

Commission did not accept or rely on. The Court should not accept the invitation.

B. The Court cannot sustain the Commission’s decision upon

an unarticulated factual theory.

An agency is required to make findings on any factual theory underlying its

decision. Tex. Gov’t Code Ann. § 2001.141(b) & (d). Those findings must

provide a logical link between the facts and the agency’s application of a statutory

standard. E.g., Vista Medical Center Hosp. v. Texas Mut. Ins. Co., 416 S.W.3d 11,

26 (Tex. App. – Austin 2013, no pet.) (citing Texas Health Facilities Comm'n v.

Charter Med.-Dallas, Inc., 665 S.W.2d 446, 453 (Tex.1984)). The purpose of this

requirement is to inform the parties and the courts of the basis for the agency's

10

decision so that the parties may intelligently prepare an appeal and so that the

courts may properly exercise their function of review. E.g., Goeke v. Houston

Lighting & Power Co., 797 S.W.2d 12, 15 (Tex. 1990). It is ironic, then, that

OPUC faults ETI for failing to challenge the Commission’s observation that ETI’s

expenses were “high.”20 ETI did not challenge that finding because there is no

indication in the Commission’s order that the observation was a basis for any

disallowance.

Because the Commission did not articulate that the two disallowances at

issue here were based upon a conclusion that ETI’s expenses were “excessive,” the

Commission’s order cannot be sustained on this theory. The Court is precluded

from affirming the Commission’s order on a factual theory that the Commission

did not rely upon in the order itself. E.g., Morgan Drive Away, Inc. v. Railroad

Comm'n of Tex., 498 S.W.2d 147, 152 (Tex. 1973) (“We may consider only what

was written by the [agency] in its order, and we must measure its statutory

sufficiency by what it says,” and “findings of basic [underlying] facts cannot be

presumed from findings of a conclusional nature.”); Continental Imports, Ltd. v.

Brunke, No. 03-10-00719-CV, 2011 WL 6938489 *5 (Tex. App. – Austin Dec. 30,

2011, pet. denied) (not designated for publication) (citing City of El Paso v. El

Paso Elec. Co., 851 S.W.2d 896, 899–900 (Tex. App. – Austin 1993, writ denied);

20

See OPUC’s Brief at 16.

11

Professional Mobile Home Transport v. Railroad Comm’n, 733 S.W.2d 892, 903–

04 (Tex. App. – Austin 1987, writ ref’d n.r.e.)).

III. The Commission’s disallowance of ETI’s costs of litigating the incentive

compensation issue is arbitrary and capricious and an abuse of

discretion.

A. The Commission’s finding that ETI made an unreasonable

argument in the underlying rate case is arbitrary and

capricious.

In its order, the Commission said it was unreasonable for ETI to advocate

recovery of financially-based incentive compensation in rates because, “[t]he

Commission has repeatedly ruled that a utility cannot recover the cost of

financially-based incentive compensation because financial measures are of more

immediate benefit to shareholders and financial measures are not necessary or

reasonable to provide utility services.”21 As ETI acknowledged in its initial brief,

it is true that the Commission has in the past referred to a perceived dichotomy

between “financial” and “operational” measures as a basis for incentive

compensation. But the Commission has not clearly or consistently explained how

to determine whether a given incentive program benefits customers versus

shareholders such that it is or is not recoverable. The Commission concedes, and

this Court has observed, that whether a particular incentive program benefits

customers enough to be recoverable in rates is a fact issue to be determined on a

21

AR Part I, Binder 2, Item 55 (Final Order at 2).

12

case-by-case basis.22 See State of Texas’ Agencies & Institutions of Higher

Learning v. Public Util. Comm’n of Tex., 450 S.W.3d 615, 660-61 (Tex. App. –

Austin 2014, pet. filed). And as evidenced in Appendix C to ETI’s initial brief, the

Commission has not treated materially-similar incentive programs consistently

over time. In fact, the Commission was persuaded in part by some of ETI’s

testimony in this case, and allowed ETI to recover some $1 million in cost-control

incentives that another utility was unable to recover in the past.23 Contrary to

appellees’ rhetoric, ETI’s advocacy in this case was not “futile,” “fruitless,” or

“unsuccessful.” In light of these circumstances, it makes no sense to characterize

ETI’s advocacy as “overly-aggressive” or “unreasonable.”

In an attempt to avoid this conclusion, the Attorney General sets up a straw

man. The Attorney General contends that the Commission did not fault ETI for

arguing about which incentives should be considered recoverable under what it

terms the “two bucket” policy. According to the Attorney General, the

Commission faulted ETI for something else -- arguing to eliminate the distinction

between the “buckets.” First, and most important, the Commission did not say

anything like that. Second, the two “arguments” the Attorney General attempts to

distinguish are shades of the same thing. Whether a particular incentive program

22

E.g., PUCT’s Brief at 5.

23

Application of Entergy Texas, Inc. for Authority to Change Rates, Reconcile Fuel Costs, and

Obtain Deferred Accounting Treatment, Docket No. 39896 (Final Order at 4-5) (allowing

recovery of incentive compensation programs tied to “cost control” measures).

13

falls in one bucket or another is not just a matter of superficial labeling. It requires

the fact-finder to decide whether a given program “more immediately” benefits

shareholders or ratepayers. ETI’s position was that its incentive compensation

programs at issue in this case benefit customers substantially and meaningfully and

should be recovered.24 That is the same thing as arguing that ETI’s programs fall

in the bucket that is recoverable from customers. The Attorney General’s “bucket”

argument does not hold water.

OPUC suggests this case presents a simple question of evidentiary

sufficiency. It does not. An agency decision may pass the “substantial evidence”

test and still be invalid for arbitrariness. Starr County v. Starr Indus. Services,

Inc., 584 S.W.2d 352, 355 (Tex. App. -- Austin 1979, writ ref’d n.r.e.) (citing

Lewis v. Metropolitan Savings & Loan Association, 550 S.W.2d 11, 13-14 & 16

(Tex. 1977)). In determining whether an agency has acted arbitrarily or

capriciously, a court must decide whether the agency order was based on a

consideration of all relevant factors. Starr County, 584 S.W.2d at 355-56 (citing

Citizens to Preserve Overton Park v. Volpe, 401 U.S. 402, 91 S.Ct. 814, 28

L.Ed.2d 136 (1971)). There must appear a rational connection between the facts

and the decision of the agency. Starr County, 584 S.W.2d at 356 (citing Bowman

24

Id., ETI Exh. 36 (Gardner Direct at 29-33 of 77); ETI Exh. 50 (Gardner Rebuttal at 2-10 of

18); ETI Exh. 15 (Hartzell Direct at 3-31 of 31); ETI Exh. 53 (Hartzell Rebuttal at 2-15 of 15);

PFD at 166-176.

14

Transportation, Inc. v. Arkansas-Best Freight System, Inc., 419 U.S. 281, 95 S.Ct.

438, 42 L.Ed.2d 447 (1974); 5 B. Mezines, J. Stein and J. Gruff, Administrative

Law § 51.03, at 51-33 (1979)). Stated differently, the reviewing court must

remand “. . . if it concludes that the agency has not actually taken a hard look at the

salient problems and has not genuinely engaged in reasoned decision-making.”

Starr County, 584 S.W.2d at 356 (citing Texas Medical Association v. Mathews,

408 F.Supp. 303, 305 (W.D. Tex. 1976)).

The testimony of OPUC’s witness Nathan Benedict does not reasonably

support the Commission’s decision in this case. Mr. Benedict generally testified

that the Commission excluded financially-based incentive compensation from

ETI’s rates set in Docket No. 39896.25 But he did not acknowledge that, in the

same docket, the Commission allowed recovery of costs it had previously

disallowed because they were supposedly “financially-based” incentives. And

contrary to OPUC’s suggestion,26 the Commission may not use its own

“experience” to fill in evidentiary gaps. Railroad Commission of Texas v. Lone

Star Gas Co., 611 S.W.2d 908, 911 (Tex. Civ. App. – Austin 1981, writ ref’d

n.r.e.). The Commission’s characterization of ETI’s argument in the rate case is

not reasonable in light of the record or its past decisions.

25

AR Part II, Binder 3, OPUC Exh. 1 (Benedict Direct at 8).

26

OPUC’s Brief at 14.

15

B. Regardless, the Commission’s decision is reversibly wrong

on procedural grounds.

Even if the appellees’ characterization of ETI’s advocacy on this issue were

in line with the facts, the Commission’s decision to disallow the expenses of the

advocacy was arbitrary and an abuse of discretion.

1. The Commission changed its past practice without

explanation or advance notice.

As ETI explained in its initial brief, though many utilities have sought to

include incentive compensation in rates, the Commission has never before

disallowed the cost of making unsuccessful incentive compensation arguments. In

fact, the Commission has expressly determined that other utilities’ rate case

expenses were reasonable, necessary, and recoverable from ratepayers, even in

cases where the utilities made unsuccessful arguments on incentive compensation.

See Appendix D to ETI’s Appellant’s Brief. The Commission has also allowed

ETI and its predecessor to recover rate case expenses in dockets where ETI made

similarly unsuccessful requests in the past. See Docket No. 34800, supra (Mar. 16,

2009, Order at FOF 27); Docket No. 37744, supra (Dec. 13, 2010, Order at FOF

18). The Commission cannot point to any case where it has disallowed the

16

expenses of making unsuccessful arguments about incentive compensation, or for

making some other argument the Commission deems a “long shot.”27

The Commission contends its decision in this case is not a departure from its

earlier decisions because ETI’s request in this case was different from requests in

previous cases. That is not so. In every one of these past cases, a utility proposed

to recover incentive costs that were “financially based.” For example:

 In Docket No. 28840, AEP sought to recover its entire test-year

level of incentive compensation expense, even though only

34% of it was set through “operational” measures. Application

of AEP Texas Central Co. for Authority to Change Rates,

Docket No. 28840 (Aug. 15, 2005, Final Order at FOFs 165-

67);

 In Docket No. 33309, part of the incentive compensation AEP

sought to include in rates was “related to financial incentives.”

Application of AEP Texas Central Co. for Authority to Change

Rates, Docket No. 33309 (Mar. 4, 2008, Order on Rehearing at

FOF 82);

 In Docket No. 34800, ETI’s predecessor unsuccessfully sought

to include in rates its incentive compensation costs that were

“financially-related,” arguing even those costs meaningfully

27

OPUC argues that this Court may not consider orders from previous Commission dockets

because they are not part of the administrative record in this case. See OPUC’s Brief at 19. This

Court rejected that same argument in Oncor. See Oncor Elec. Delivery Co. LLC v. Public Util.

Comm’n of Tex., 406 S.W.3d 253, 267 (Tex. App. – Austin 2013, no pet.). This Court

specifically acknowledged it may consider how the Commission has treated other utilities to

determine whether a particular policy is new in a given case. Id. at 267. The Court can take

judicial notice of agency decisions like these, which are publicly available and the authenticity of

which is readily verifiable. See Office of Pub. Util. Counsel v. Public Util. Comm'n, 878 S.W.2d

598, 600 (Tex. 1994) (holding that court of appeals must take judicial notice of agency's

published order if asked to do so) (citing Tex. R. Civ. Evid. 201(b)(2)); Hendee v. Dewhurst, 228

S.W.3d 354, 377 n.30 (Tex. App. -- Austin 2007, pet. denied) (likening agency decisions to court

decisions with regard to judicial notice).

17

benefited customers. See Application of Entergy Gulf States,

Inc. for Authority to Change Rates and to Reconcile Fuel Costs,

Docket No. 34800, ETI Exh. 72 (Direct Testimony of J.

Hartzell, PhD, on Remand);28

 In Docket No. 35717, Oncor sought to recover its entire test-

year level of incentive compensation expense, even though

about 25% of it was “related to financial measures.” See

Application of Oncor Electric Delivery Co. LLC for Authority

to Change Rates, Docket No. 35717 (Nov. 30, 2009, Order on

Rehearing at FOFs 91-93);

 In Docket No. 37744, ETI sought to include in rates its

incentive compensation costs that were “financially-based,”

arguing even those costs meaningfully benefited customers.

See Application of Entergy Texas, Inc. for Authority to Change

Rates and Reconcile Fuel Costs, Docket No. 37744, ETI Exh.

14 (Direct Testimony of J. Hartzell, PhD);29

 In Docket No. 38339, CenterPoint sought to include in rates

both its short-term and long-term incentive compensation plans,

but the Commission included only the former in rates, finding it

was “directly tied to metrics such as customer service and

safety.” See Application of CenterPoint Energy Houston

Electric, LLC for Authority Change Rates, Docket No. 38339

(Jun. 23, 2011, Order on Rehearing at FOFs 81-83); and

 In Docket No. 40443, Southwestern Electric Power Company

sought to recover its roughly $10.7 million test-year level of

incentive compensation, even though roughly half of it was tied

to “financial measures.” See Application of Southwestern

Electric Power Co. for Authority to Change Rates and

Reconcile Fuel Costs, Docket No. 40443 (Mar. 6, 2014, Order

on Rehearing at 13 & FOFs 214-220).

28

See Appendix A.

29

See Appendix B.

18

There is no material distinction between ETI’s request in this case and the utility

proposals made in previous cases.

OPUC argues that the Commission’s past decisions did not establish

“policy” because they were “not contested.”30 But again, the Commission

expressly found in each of these past cases that it was reasonable for the utility to

recover its expenses, and never carved out costs of making unsuccessful arguments

about incentive compensation. The fact that parties may have agreed with these

decisions does not undermine them. If anything, it bolsters them.

To be clear, ETI does not contend that the Commission can never change its

policy on a given issue. But when it does, the Commission must give advance

notice that it is considering a policy change, and articulate a reason if a change is

made. The Attorney General does not even suggest that the Commission met these

requirements in this case.31 The Commission’s failure in each of these respects is

reversible error, just like it was in Oncor Elec. Delivery Co., 406 S.W.3d 253.

Appellees’ attempts to distinguish Oncor are not persuasive. First, this

Court in Oncor reversed the Commission’s decision because the Commission did

not explain its departure from a past practice. The same thing happened in this

case – the Commission had always acted one way under a given set of facts, and

then took the opposite path on the same set of facts. Second, another basis for this

30

OPUC’s Brief at 20.

31

See PUCT’s Brief at 33.

19

Court’s reversal of the Commission’s decision in Oncor was that the Commission

departed from its past practice when it was too late for the utility to do anything

about it. The same thing happened in this case. The administrative process at

issue began when Docket No. 39896 was filed. At that time, the Commission had

given no indication whatsoever that it would not continue to allow recovery of

otherwise reasonable expenses related to litigating incentive compensation. The

opportunity to file rebuttal testimony in the severed expense docket did not

adequately protect ETI’s interests. By the time the new standard was proposed and

vetted in the severed expense docket, ETI had already incurred the very costs

proposed to be disallowed. The fact that ETI had the opportunity to file rebuttal

testimony in the expense docket does not mean ETI had proper notice of the

Commission’s new policy at the critical time, before ETI incurred the costs at

issue.

All the appellees cite Industrial Utils. Serv. Co. v. Texas Natural Resources

Conservation Comm’n, 947 S.W.2d 712, 718 (Tex. App. – Austin 1997, no writ) as

support for the Commission’s decision. But that case proves ETI’s point. In

Industrial Utils. Serv. Co., the utility sought a rate increase, asked the agency to

deny it, and then sought to recover its expenses of prosecuting the rate case. This

Court upheld the agency’s denial of the expenses. This case is quite different.

Here, ETI sought and received a rate increase, based in part upon ETI’s successful

20

request to recover what have historically been deemed to be financially-based

incentive compensation. It is not, therefore, unreasonable for ETI to seek the

expenses of making that request. Moreover, the agency in Industrial Utils. Serv.

Co. did not have a historical practice of allowing recovery of expenses for making

unwanted rate proposals. Here, in contrast, the Commission has consistently

allowed recovery of expenses for making even unsuccessful incentive

compensation arguments. The Commission has never disallowed the expenses of

seeking to include financially-based incentive compensation in rates. Industrial

Utils. Serv. Co. is simply inapposite to this case.

2. Additionally, the Commission effectively and

improperly adopted a new rule in this contested case.

The Commission’s imposition of a new policy in this case also constitutes

improper ad hoc adjudication. Appellees contend the agency did not craft a “rule”

of general applicability in this case, but only applied the statutory principle that a

utility may not recover “unreasonable” expenses.32 State Agencies also contend

the scope of the Commission’s decision is not clear, so it cannot be a “rule.”33 But

regardless of whether the Commission meant it is unreasonable to take any “long

shot” position or just to seek recovery of financially-based incentive compensation,

it is clear the Commission intended to apply its new allocation of risk to the

32

E.g., PUCT’s Brief at 35; OPUC’s Brief at 25-26; State Agencies’ Brief at 17 & 19.

33

State Agencies’ Brief at 17.

21

industry going forward. The Commission did not in its order identify any facts

peculiar to this case that suggest the new policy applies only to this case. The

Commission broadly declared that it is “unreasonable” to incur expense to litigate

the recoverability of financially-based incentive compensation. And the

Commission based its conclusion solely upon something the Commission

characterized as “well-established policy” – not facts.34

Again, Chairman Nelson confirmed at an open meeting that the Commission

was in this case setting a “new policy.”35 She even observed, on the record, that

the subject is more properly addressed in a rulemaking.36 Appellees contend this

statement somehow implies the opposite. They cite this Court’s recent decision in

McHaney v. Texas Comm’n on Environmental Quality, No. 03-13-00280-CV, 2015

WL 869197 at *8 (Tex. App. – Austin Feb. 27, 2015, no pet. h.). In McHaney, this

Court considered a TCEQ Commissioner’s statement that “if there is a need for

clarity in our rules, I would encourage our staff to look at that and see if we need to

go through the rulemaking or provide some other guidance.” McHaney, 2015 WL

869197 at *8 (emphasis in original). The Court viewed that statement as support

for the conclusion that the agency did not intend to impose a “rule” in the contested

case at issue. Chairman Nelson, however, did not suggest that the Commission

34

AR Part I, Binder 2, Item 55 (Final Order at 2).

35

See April 11, 2013 Transcript at 7:25-8:14.

36

Id.

22

was following established policy or merely question whether the Commission’s

rules reflect the policy clearly enough. Chairman Nelson unequivocally

acknowledged that the PUCT was adopting a “new policy” in this case, and

recognized that new agency policy should be adopted through the formal

rulemaking process.

The Attorney General and State Agencies also argue that the agency’s

formal adoption of a rule after this case indicates that the Commission was not

adopting a rule in this case.37 That is a non-sequitur. The fact that the agency

ultimately followed the formal rulemaking process does not shed any light on what

the agency intended earlier, in this case. The Commission declared for the first

time in this case that it is “unreasonable” to propose to recover what in the past has

been deemed “financially-based” incentive compensation, and that it is

“unreasonable” to incur expenses for such a proposal. It was improper to impose

these new policies outside the context of a formal rulemaking because none of the

justifications for ad hoc adjudication apply.

State Agencies cite Entergy Gulf States, Inc. v. Public Util. Comm’n of Tex.,

173 S.W.3d 199, 212 (Tex. App. – Austin 2005, pet. denied) as support for the

Commission’s action. That case recognizes that an agency may engage in ad hoc

adjudication when it “may not have had sufficient experience with a particular

37

See PUCT’s Brief at 38; State Agencies’ Brief at 23.

23

problem to warrant rigidifying its tentative judgment into a hard and fast rule.”

Entergy Gulf States, 173 S.W.3d at 212. But the Commission has had plenty of

experience considering the expenses of advocacy related to incentive compensation

issues, as discussed above. If the Commission wanted to change its policy going

forward, it was bound to do so in the context of a formal rulemaking.

IV. The Commission further erred in quantifying its disallowance of ETI’s

expenses of seeking to include financially-based incentive compensation

in rates.

The Commission used a “proxy” to measure the disallowance discussed

above. Specifically, the Commission determined the percentage of ETI’s

requested rate increase that was attributable to its unsuccessful incentive

compensation argument, and then disallowed that same percentage of ETI’s rate

case expenses.

The Commission has never done that before. The Commission’s sole

justification for using a proxy is that ETI did not track all of its expenses by issue

over the life of the rate case. But utilities have not tracked their rate case expenses

by issue because the Commission has never before imposed a disallowance for

litigating an issue. Indeed, the Commission has repeatedly allowed utilities to

recover the expense of making the very same argument ETI made here. It is the

Commission’s after-the-fact change in policy, not a failing of ETI’s, that caused

24

the difficulty in measuring the actual expenses of litigating a particular issue in this

case.

The problem with the Commission’s “proxy” approach is that it does not

logically approximate the actual amount of costs ETI incurred to litigate the

incentive compensation issue. Instead, the Commission’s proxy method is keyed

to the value of the litigated issue. State Agencies argue that there is a logical

correlation between the value of a litigated issue and the amount of money a utility

spends to litigate it. There is not. It is true that the raw, maximum value of a

litigation position might represent an upper limit on the expenses that may

reasonably be incurred to pursue it. But that is where any correlation stops. It may

cost relatively little to pursue even a high-dollar-value litigation position. The

value of the position simply does not inform what it actually costs to litigate.

Contrary to the Commission’s argument, the agency’s use of a proxy in this

case does not resemble the way the agency quantified a disallowance in Docket

No. 28840. There, the Commission disallowed half of the expenses associated

with a witness’s testimony — specifically, the expenses of Dr. Goodfriend’s

testimony on quality-of-service issues.38 Dr. Goodfriend’s testimony was 117

38

See Application of AEP Texas Central Co. for Authority to Change Rates, Docket No. 28840

(Jul. 2, 2004, PFD at 125); Proceeding to Consider Rate Case Expenses Severed from Docket

No. 28840 (Application of AEP Texas Central Company for Authority to Change Rates), Docket

No. 31433 (Mar. 3, 2006, Final Order at FOF 29).

25

pages long. Roughly 60 pages of it concerned the quality-of-service issue.39 The

disallowance of half the cost of the testimony almost exactly correlates with the

portion of the testimony the Commission found was flawed. That is, the

Commission disallowed the actual expenses of unreasonable testimony in Docket

No. 28840, not some unrelated amount of money based upon the value of the

position the witness was advocating.

State Agencies and OPUC point to the Pioneer Natural Resources case as

support for the Commission’s use of a proxy to measure a disallowance.40 The

Commission did not use a proxy, or “infer” anything, to quantify the disallowance

in that case. In Pioneer, the Commission limited the utility to recovering only 35%

of the cost of a computer system because only 70% of the system served the utility,

and because only half the system was operational in the test year. The 35%

multiplier was, as this Court noted, simply the mathematical product of the 70%

and 50% components (i.e., 70% x 50% = 35%). Pioneer Natural Resources, 303

S.W.3d at 369. The Commission’s quantification of the expense it deemed

unreasonable in Pioneer contrasts sharply with what the Commission did here.

Here, the Commission did not quantify the actual expenses of making an argument.

The Commission quantified something else, based upon the value of the argument.

The Commission imposed its new policy at the end of the case, after the expenses

39

Id. (Direct Testimony of S. Goodfriend at 11-71 of 117).

40

See State Agencies’ Brief at 27 (citing Pioneer Natural Res., 303 S.W.3d at 369).

26

had already been incurred and tracked according to historically accepted practices,

when it was too late for ETI to do anything about it.

V. The Commission’s disallowance of depreciation expense associated with

ESI’s efforts in the rate case is not supported by any evidence and is

arbitrary and capricious.

As ETI explained in its initial brief, the Commission disallowed over

$207,000 of depreciation expense associated with assets ESI employees used in

their work on the rate case. The Commission in its order said only that this

expense was “not reasonable.”41 That is an “ultimate” finding of fact, stated in

statutory language. See Tex. Util. Code Ann. §§ 36.051(rates must permit utility to

recover “reasonable” and necessary operating expenses) & 36.061(b)(2)

(contemplating recovery of “reasonable” rate case expenses). The Commission

was bound to, but did not, make any underlying finding of fact supporting this

ultimate finding. See Tex. Gov’t Code Ann. § 2001.141(d). The Court may not

presume findings of underlying facts. E.g., Vista Medical Center Hosp., 416

S.W.3d at 26. The Commission’s decision is reversible for this reason alone.

CenterPoint Energy Entex v. Railroad Comm’n of Tex., 213 S.W.3d 364, 373 (Tex.

App. – Austin 2006, no pet.) (reversing agency’s disallowance of expense as

“unreasonable” because agency failed to make underlying findings permitting

court to review reasonableness of its decision).

41

AR Part 1, Binder 2, Item 55 (Final Order at FOF 18(a)).

27

Assuming arguendo the Commission could escape that flaw in its decision,

the only basis the ALJ articulated for his decision on this issue was rank

speculation that ETI might not incur depreciation expense if it had hired an

unaffiliated company to do the same work.42 This speculation is not supported by

any evidence in the record, and it is directly contrary to the Commission’s

treatment of test-year ESI depreciation expense in the underlying rate case.

In response, the Attorney General now says Entergy did not explain what

assets were being depreciated. This was not a stated reason for the disallowance in

the Commission’s order or the ALJ’s PFD. The order cannot be sustained on this

basis. Morgan Drive Away, Inc., 498 S.W.2d at 152; Continental Imports, Ltd.,

2011 WL 6938489 *5 (citing City of El Paso, 851 S.W.2d at 899–900);

Professional Mobile Home Transport, 733 S.W.2d at 903–04.

More important, this detail is in the record. As noted by ETI’s witness

Michael Considine in this case, Company witness Stephanie Tumminello

explained (in the rate case) the process by which depreciation costs were billed to

ETI.43 Ms. Tumminello explained what ESI assets were being depreciated.44 Her

testimony was part of the record officially noticed in this case.45

42

AR Part I, Binder 2, item 32 (PFD at 12); AR Part I, Binder 2, Item 55 (Final Order at 1).

43

AR Part II, Binder 3, ETI Exh. 6 (Oct. 25, 2012, Considine Supp. Direct at 4).

44

See Docket No. 39896, supra, ETI Exh. 41 (Tumminello Direct at 79).

45

AR Part III, Vol. A (Transcript of Hearing on Merits at 16).

28

The Attorney General argues that Ms. Tumminello’s testimony pertained

only to test-year expenses and not expense incurred while ESI was working on the

rate case. The Attorney General ignores that Ms. Tumminello’s testimony was

filed with ETI’s application in Docket No. 39896, which included both requests for

a base-rate increase and recovery of rate case expenses.46 Ms. Tumminello did

sponsor schedules and testify about test-year ESI depreciation expense. But her

testimony was not limited to test-year processes or expenses. Her explanation of

what assets ESI depreciates, how the expense is recorded by project, why the

expense is necessary, and how it is billed and allocated to operating companies like

ETI addresses the company’s practices generally.47 And Ms. Tumminello

confirmed, based upon a survey she conducted, that ESI’s costs are in line with

those of peer service companies and do not include any profit or markup.48 Ms.

Tumminello’s testimony that control processes ensure depreciation costs billed to

ETI are no higher than the costs billed to other affiliates is equally unqualified.49 A

PricewaterhouseCoopers opinion letter further confirms that ESI has established

processes generally to ensure that it bills only actual costs, and that its charges to

46

See Docket No. 39896, supra, (Application) & ETI Exh. 8_ (Considine Direct at 18).

47

See Docket No. 39896, supra, ETI Exh. 41 (Tumminello Direct at 79-86 & SBT-26 (list of

depreciable assets by account number)).

48

Id. at 82-84.

49

Id. at 84-85 & Tumminello Direct Exh. SBT-15 (Attachment 8, “Affiliate Billing Process

Controls”).

29

ETI are no higher than costs billed to other affiliates.50 Mr. Considine’s testimony

in the severed expense docket echoes these conclusions multiple times.51

The Attorney General further muses that the depreciation expense for ESI’s

work in the rate case might contain depreciation on aircraft. But again, Ms.

Tumminello testified generally that ESI aircraft depreciation expense is “included

as a component of total flight costs of ESI aircraft” and not included in general

depreciation.52 The spreadsheet Mr. Considine sponsored in the expense docket,

showing expenses charged to ETI for ESI’s services in the rate case, does not

include any “flight” or “aircraft” costs.53 This argument is specious.

The Attorney General now contends ETI’s evidence does not meet the

standards for affiliate expenses set out in Docket No. 16705 and PURA section

36.058. See Tex. Util. Code Ann. § 36.058(c). This argument is incredible, given

that the Commission expressly found in this case that “Entergy met the

requirements in PURA § 36.058 regarding payments to its affiliates for its rate-

case expenses.”54 Clearly, the “heightened affiliate standard” was not the basis for

the Commission’s disallowance of ESI depreciation expense.

50

Id. at Tumminello Direct Exh. WP SBT-4.

51

AR Part II, Binder 3, ETI Exh. 4 (Considine Supp. Direct at 3-4 of 5); AR Part II, Binder 3,

ETI Exh. 5 (Considine Supp. Direct at 3-5 of 6); AR Part II, Binder 3, ETI Exh. 6 (Considine

Supp. Direct at 3-5 of 5); AR Part II, Binder 3, ETI Exh. 7 (Considine Rebuttal at 9-11 of 11).

52

See Docket No. 39896, supra, ETI Exh. 41 (Tumminello Direct at 83-84).

53

AR Part II, Binder 3, ETI Exh. 7 (Considine Rebuttal at Exh. MPC-R-1).

54

Order at 3, FOF 19, & COL 11.

30

Because the Commission’s disallowance of this expense is not supported by

any evidence in the record, and because it cannot reasonably be reconciled with its

treatment of analogous expense in the rate case, the decision must be reversed.

CONCLUSION AND PRAYER

For the foregoing reasons, Entergy Texas, Inc. respectfully requests the

relief it requested in its appellant’s brief.

Respectfully submitted,

DUGGINS WREN MANN & ROMERO, LLP

By: /s/ Marnie A. McCormick

John F. Williams

State Bar No. 21554100

jwilliams@dwmrlaw.com

Marnie A. McCormick

State Bar No. 00794264

mmccormick@dwmrlaw.com

P. O. Box 1149

Austin, Texas 78767-1149

(512) 744-9300

(512) 744-9399 fax

ATTORNEYS FOR APPELLANT

ENTERGY TEXAS, INC.

31

CERTIFICATE OF COMPLIANCE

I certify that this document contains 7,474 words in the portions of the

document that are subject to the word limits of Texas Rule of Appellate Procedure

9.4(i), as measured by the undersigned’s word-processing software.

/s/ Marnie A. McCormick

Marnie A. McCormick

32

CERTIFICATE OF SERVICE

As required by Texas Rule of Appellate Procedure 9.5, I certify that on the

27th day of April, 2015, the foregoing document was electronically filed with the

Clerk of the Court using the electronic case filing system of the Court, and that a

true and correct copy was served on the following lead counsel for all parties listed

below via electronic service:

Elizabeth R. B. Sterling

Environmental Protection Division

Office of the Attorney General

P. O. Box 12548 (MC 066)

Austin TX 78711-2548

Counsel for Appellee Public Utility Commission of Texas

Rex D. VanMiddlesworth

Benjamin Hallmark

Thompson Knight LLP

98 San Jacinto Blvd., Ste. 1900

Austin TX 78701

Counsel for Appellee Texas Industrial Energy Consumers

Katherine H. Farrell

Administrative Law Division

Office of the Attorney General

P. O. Box 12548 (MC018-12)

Austin TX 78711-2548

Counsel for Appellee State Agencies

Ross Henderson

Office of Public Utility Counsel

1701 N. Congress Ave., Ste. 9-180

P. O. Box 12397

Austin TX 78711-2397

Counsel for Appellee Office of Public Utility Counsel

/s/ Marnie A. McCormick

Marnie A. McCormick

33

APPENDICES

A. Direct Testimony of Dr. J. Hartzell on Remand in PUCT Docket No. 34800

B. Direct Testimony of Dr. J. Hartzell in PUCT Docket No. 37744

34

APPENDIX A

Direct Testimony of Dr. J. Hartzell on Remand

in PUCT Docket No. 34800

SOAR Docket No. XXX-XX-XXXX

PUC Docket No. 34800

EGSI - 2007 Rate Case

EGSI Remand Ex. No. 72

DOCKET NO. ~

APPLICATION OF ENTERGY § PUBLIC UTILITY COMMISSION

GULF STATES, INC. FOR §

AUTHORITY TO CHANGE RATES §

AND TO RECONCILE FUEL COSTS . § OF TEXAS

DIRECT TESTIMONY

OF

JAY C. HARTZELL

ON BEHALF OF

ENTERGY GULF STATES, INC.

SEPTEMBER 2007

2007 Texas Rate Case 10. I

DOCKET N O . - - - -

ENTERGY GULF STATES. INC.

DIRECT TESTIMONY OF JAY C. HARTZELL

2007 TEXAS RATE CASE -

TABLE OF CONTENTS

Page

I. Witness Identification and Qualifications 1

II. Purpose and Organization of Testimony 2

Ill. Financlal·Based Incentive Compensation as a Tool for Improving

Consumer Welfare 4

A. The Positive Effect of Incentive Compensation on Utility

Customer Weffare 4

B. The Reasons for Providing Financial·Based Incentive

Compensation 10

EXHIBIT

Exhibit JCH· 1 Resume

2007 Texas Rate Case J().2

Entergy Gulf States, Inc. Page1of19

Direct Testimony of Jay C. Hartzea

2JXJ7 Texas Rate Case

1 I. WITNESS IDENTIFICATION AND QUALIFICATIONS

2 Q. PLEASE STATE YOUR NAME, OCCUPATION, AND BUSINESS

3 ADDRESS.

4 A. I am Jay C. Hartzell. I am an Associate Professor of Finance at the

5 Mccombs School of Business at the University of Texas at Austin. My

6 work address is Department of Finance, T:he University of Texas at Austin,

7 1 University Station B6600, Austin, Texas, 78712.

8

9 Q. FOR WHOM ARE YOU TESTIFYING?

10 A. I am testifying on behalf of Entergy Gulf States, Inc. ("£GSI").

11

( 12 Q. PLEASE DESCRIBE YOUR EDUCATIONAL BACKGROUND AND

13 PROFESSIONAL EXPERIENCE.

14 A. I provide my complete resume in my Exhibit JCH-1. In brief, I obtained a

15 Bachelor of Science degree (cum laude) from Trinity University in May

16 1991, with majors in Business Administration and Economics. After

17 graduating, I went to work as a consuhant for Hewitt Associates, in The

16 Woodlands, Texas. Hewitt is a -consulting firm that specializes in benefits

19 and compensation. While there, I specialized in the area of defined

20 contribution plans. I left Hewitt lo go to graduate school at the University

21 of Texas at Austin in 1993. I completed my PhD in finance there in May

22 1998. Upon graduating, I took a job as an Assistant Professor of Finance

23 at New York University's Stem School of Business, where I worked

2.007 Texas Rate Case W.-3

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Direct Testimony of Jay C. Hartzell

2007 Texas Rate Case

1 until 2001. At that time, the University of Texas at Austin hired me as an

2 Assistant Professor at the McCombs School of Business .("McCombs

3 Schooi-), where I have work~ since. I was promoted to the rank of

4 Associate Professor (with tenure), effective in the fall 2006. I also now

5 serve as the Director of the Real Estate Finance and Investment Center at

6 the McCombs School.

7

8 a. WHAT ARE YOUR MAIN AREAS OF RESEARCH?

9 A. My primary research interest is in the area of corporate governance. This

10 area encompasses several topics, including executive compensation, the

11 role of institutional investors, mergers and acquisitions, and boards of

12 directors. I have also written papers in the area of real estate finance, with

13 many of these also focusing on the areas of corporate governance, using

14 data from that industry.

15

16 II. PURPOSE ANO ORGANIZATION OF TESTIMONY

17 Q. WHAT IS THE PURPOSE OF YOUR TESTIMONY?

18 A. EGSI has asked me to comment on the use of financial-based goals in a

19 company's incentive compensation plans, and how those goals affect

20 consumer welfare. I first address the factors specific to the utility industry

21 that support the conclusion that the presence of financial-based goals in

22 an incentive compensation plan is consistent with consumers' interssts. I

23 then tum to the broader topic of how an incentive <:e>mpensation plan

2007 Texas Rate Case J()..4

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Direct Testimony of Jay C. Hartzell

2001 Texas Rate-case

1 including financial measures provides incentives to a firm's employees to

2 take actions that improve customer welfare.

3

4 a. WHY ARE YOU OUALlflED TO ADDRESS THESE SUBJECTS AND TO

5 PROVIDE THIS TESTIMONY?

6 A. In addition to my formal training as a student, I have studied and

7 conducted research on corporate governance, including executive

8 compensation, for more than 10 years, starting with work in graduate

9 school, including my dissertation. Since that time, I have written nine

1O papers on corporate governance topics, plus my dissertation. Six of those

11 have been published in peer-reviewed academic journals, including the

( 12 top such journals in the field of finance. I have presented and discussed

13 papers on corporate governance (including compensation) at the major

14 conferences in the field. I have also taught related topics to PhD students,

15 as part of a PhD class in empirical corporate finance.

16

17 Q. DO YOU SPONSOR ANY EXHIBIT?

18 A. Yes. My exhibit is listed in the table of contents to this testimony.

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Direct Testimony Qf Jay C. Hartzell

2007 Texas Rate Case

1 Ill. FINANCIAL-BASED INCENTIVE COMPENSATION AS A TOOL FOR

2 IMPROVING CONSUMER WELFARE

3 Q. WHAT IS YOUR UNDERSTANDING OF THE COMMISSION'S

4 RATEMAKING TREATMENT OF A UTILITY'S INCENTIVE

5 COMPENSATION EXPENSES?

6 A. It is my understanding that in recent cases, the Public Utility Commission

7 has had a policy of excluding from base rates compensation that is based

8 on the firm's financial measures, but has allowed compensation that is

9 based on operational measures such as quality of service, reliability,

10 public safety, cost control, power plant performance, reduction of

11 absenteeism, and cost containment.

12

13 Q. WHAT ISSUES REGARDING INCENTIVE COMPENSATION WILL YOU

14 ADDRESS?

15 A. I will comment on the coexistence of these two types of incentives

16 (financial-based and operational-based), and the role of financial-based

17 incentives in ultimately contributing to customer welfare.

18

19 A. The Positive Effect of Incentive Comoensation on

20 Utility Customer Welfare

21 a. IS THERE A LINK BETWEEN CUSTOMER WELFARE AND A FIRM'S

22 FINANCIAL PERFORMANCE?

23 A. Yes. Satisfied customers clear1y experience greater customer welfare, all

24 else equal, as they are happy with the products they consume. This is

2007 Texas Rate Case 10-6

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Direct Testimony of Jaye. Hartzell

2007 Texas Rate Case

1 true not only for customers in unregulated industries, but also for

2 customers in regulated industrieS. For example, customers who

3 experience fewer power outages will suffer less disutility from being

4 without power, but will also spend less time and expend fewer resources

5 compensating for outages, or complaining about the service they have

6 received.

7 In addition to benefiting eustomers, greater satisfaction tends to

8 benefrt the firm, as well. Satisfied customers are likely to buy more of the

9 firm's products, which leads to higher revenues and profits, and a higher

10 stock price, all else equal. Satisfied customers are also more likely to be

11 retained as customers, and customer retention helps the firm's profitability

( 12 via higher net revenues than they would have .experienced without such

13 satisfaction. Companies with better reputations for customer satisfaction

14 are also more likely to attract new customers who can leam of firms'

15 reputations prior to making their purchasing decisions. At the same time,

16 because improved customer satisfaction tends to lead to improved

17 financial performance, the prospect for improved financial results can play

18 a positive role in motivating mana~rs to improve customer welfare.

19 Although regulated utility -companies do not deal with the same type

20 of competitive dynamics faced by unregulated companies, the general

21 concepts r~ated to customer satisfaction still apply. For example,

22 potential industrial customers and other large users face choices when

23 they decide where to locate a new facility (a factory, a campus, etc.) or

2007 Texas Rate Case

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Oirec:t T eslimony of Jay C. HartzeU

2007 Texas Rate Case

1 whether to expand a current facility or instead build a new one, or whether

2 to produce their own power rather than rely on the local utility company.

3 Holding the rates they are offered constant, if the customer has a facility in

4 a location with an electricity provider who provides good service, then the

5 customer's satisfaction with that service would make the customer more

6 likely to expand that facility, and would make the customer less likely to

7 look for alternative locations or to self-generate, all else equal. A

8 customer that is more likely to expand in the current location rathe~ than

9 l~k elsewhere would in tum benefit -the financial performance of the

10 customer's current utility company. -

11 This conceptual link between customer welfare and financial

12 performance also applies to residential utilify customers. Residential

13 customers can choose, for example, between gas (including propane)

14 appliances and electrical appliances. The more satisfied they are with

15 their electrical service provider, the more likely they are to ~oose

16 electrical appliances (all else equal). This customer behavior in response

17 . to good service again leads to better financial performance for the electric

18 utility.

19

20 Q. WHY WOULD TODAY'S FINANCIAL HEALTH OF THE FIRM

21 POSITIVELY AFFECT FUTURE CUSTOMER WELFARE?

2007 Texas Rate Case 10-8

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Direct Testimony of Jay C. Hartzell

2007 Texas Rate Case

1 A. I can see at least five channels through which a more financially

2 successful company will be associated with greater customer welfare both

3 now, and in the future.

4 First, companies that are financially healthy will be able to raise

5 capital at lower cost. Put another way, companies that are less healthy

6 financially and therefore are more likely to enter into financial distress

7 (including bankruptcy) will face higher costs of capital. These higher costs

8 of capital will in tum lead to higher rates for customers and lower customer

9 welfare. This channel is straightforward: as a .company gets closer to

10 distress, the expected costs of distress increase, and lenders (including

11 bondholders) charge more for their loans to the firm. Because the cost of

12 debt is one of the key components of the cost of capital, these higher

13 borrowing costs lead to a higher oven1ll cost of capital. In addition, if 1he

14 higher costs of capital are large enough, this effectively limits the less

15 healthy finn's acce5s to funds, implying that financially healthy firms have

16 broader access to capital than their less healthy oountefparts. This cost of

17 capital effect is especially relevant to the utility industry given the

18 industry's reliance on large capital spending projeGts and use of debt

19 capital.

20 Second, in an industry where prices that finns can chatge are

21 regulated, if managers have incentives to increase fmancial performance,

22 then this will lead them to focus on cutting oosts. By linking managers'

23 pay to stock price, for example, managers will, among other goals, attempt

2007 Texas Rare Case J().9

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Direct Testimony of Jay C. HartzeQ

2001 Texas Rate case

1 to increase stock price by operating mere efficiently. This improved

2 efficiency will lead to a lower cost basis in the future than what one would

3 have observed without such incentives, which will in tum lead to lower

4 future prices for customers (compared to .what would likely have been

5 charged otherwise) and increased customer welfare.

6 Third, the utility industry is characterized by high fixed costs of

7 production and economies of scale. This cost structure implies that larger

8 firms can operate at lower marginal costs (all else equal). Thus, as higher

9 customer service or satisfaction leads to greater customer attraction and

1O retention, these in tum lead to growth in the customer base and revenues.

11 The magnitude of these effects may be smaller for a regulated utility than

12 for a firm in an ~nregulated industry, but I see no reason why the effects

13 would not still be present and go in the same direction. Such growth in

14 reven.ues is associated with greater financial perfonnance, but the

15 Increase in size allows the firm to produce more cheaply due to the large

16 fixed costs in the industry and economies of scale. These cost savings

17 again materialize in lower future rates for customers (compared to what

18 they would have been without the growth in the1irtn's operations).

19 Fourth, managers who care about the financial performance of the

20 company are more likely to make better investment decisions. The stock

21 market, via analysts who follow the firm's behavior and traders who act

22 based on their beliefs about the firm's prospects, acts as a monitor of a

23 wide range of managerial actions, including investment decisions. Stock-

2007 Texas Rate Case 10-10

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Direct Testimony of Jay~. Hartz.en

2007 Texas Rate'Case

1 price based incentives can help discipline managers, and constrain ihem

2 from investing in ways that might not benefit the finn.

3 Fifth, companies that are less healthy financially - or, to put it

4 another way, closer to financial distress - will likely experience greater

5 costs, which will in tum be passed on to customers. This is because

6 stakeholders who have relationships with the company will demand more

7 favorable terms from the firm in order to compensate them for the greater

8 risk of dealing with a less healthy a>mpany. For example, consider a

9 supplier who sells machinery to a utility company that is not financialty

10 healthy (or is believed to be near distress). Such a supplier will likely

11 demand higher prices from the utility before committing to any sort of

( 12 investment in a relationship with the utility, In order to oompensate for the

13 risk that the revenues from the relationship may cease to exist before the

14 supplier can recoup its costs. These effects are predicted to be stronger

15 where firm-specific investments are required - such as customized

16 machinery - or, the relationship is expected to nave a longer tenn. In

17 addition, suppliers to less healthy finns (firms that are nearer distress) are

18 likely to provide less attractive terms of trade --for example, requiring <:ash

19 payment rather than accepting trade credit. 8oth of these - higher prices

20 or worse trade and mK:lit terms - wHI materialize as higher costs for the

21 utility, which will in turn likely be passed on to customers via higher .priGes

22 for energy. SimUar arguments can be made for other stakeholders <>f the

23 firm, such as employees of the firm. Employees of firms that a~ mor-e

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Direct Testimony of Jay C. Hartzell

2007 Texas Rate Case ·

1 likely to become financially distressed will likely demand higher wages in

2 order to compensate them for the risks they face in working for such a

3 company. Absent a StJfftcient wage differential, financially distressed firms

4 are likely to lose skilled and talented employees and to find it difftcUlt to

5 attract good new ones, further exacerbating these firms' situations.

6 In summary, by providing managers with incentive compensation

7 that is based in part on the financial performance of the firm, managers

8 have incentives to keep the firm financially healthy. A utility's financial

9 health is very likely to benefit customers via lower oosts than otherwise

10 would be experienced, which in tum lead to lower rates than otherwise

11 would be the case. These lower costs occur because of (I) a lower cost of

12 capital; (ii) more efficient operations; (iii) greater scale of production;

13 (iv) better investment decisions by managers; and {v) better prices and/or

14 terms from stakeholders, such as suppliers and employees.

15

16 B. The Reasons for Providing Financial-Based Incentive Compensation

17 Q. WHAT TOPICS DO YOU DISCUSS IN THIS SUBSECTION OF YOUR

18 TESTIMONY?

19 A. I explain how incentive compensation is used as an effective tool in

20 aligning the interests of a firm's employees and its stakeholders, including

21 the firm's customers and shareholders. I also discuss how this improved

22 incentive alignment motivates a firm's employees to take actions that tend

23 to ultimately benefit the firm-including customers and shareholders.

2007 Texas Rate Case 10~12

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Direct Testimony of Jay C. Hartzel

2007 Texas Rate C8se

1 a. WHAT IS THE BASIC UNDERLYING THEORY OF INCENTIVE

2 COMPENSATION AS IT APPLIES TO A PUBLICLY·TRADED

3 COMPANY?

4 A. The traditional paradigm of incentive-based compensation centers around

5 the role of incentive pay in solving a •moral hazard• problem, where the

6 principals involved cannot observe the actions of an agent who acts on

7 their behalf. This agent is expected to act in a way that maximizes his or

8 her personal welfare, which is not necessarily the same set of actions that

9 would maximize the welfare of the principals. This potential conflict of

10 interest, tenned an agency problem, gives rise to a role for incentive

11 compensation. Because the principats cannot observe or write eontraots

12 based on the ager.it's actions (because it is assumed that those actions

13 cannot be observed or legally verified), incentives are put in place such

14 that the agent is more likely to benefit when they take the oourse of action

15 that is desired by the principals. SpecificaUy, the agent receives higher

16 pay when he or she takes actions that benefit the principals.

17 Understanding this, the agent is mor.e likely to take those actions desired

18 by the principal - put forth more effort, -pick better projects, or shirk less,

19 tor example.

20 The typical view in finance is from the .perspective of the

21 sharehotders: shareholders are the principals and owners of the finn, and

22 they hire managers to act as agents on their behalf. Incentive pay has a

23 role in tt)at it provides for greater compensation to managers when there

2007 Texas Rate Case 10-13

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Direct Testlmony of Jay C. Hartzetl

2007 Texas Rate Case

1 are indications that they took actions that benefited shareholders. One of

2 the most fundamental and accepted theoretical results from the principal-

3 agent academic literature is that an agenfs pay should be linked to a

4 particular performance measure (such as stock price, accounting profits.

5 or a score based on customer satisfaction) if that measure provides an

6 additional informative signal of the manager's actions.

7 If a principal (such as the Commission) has a goal of maximizing

8 customer welfare. then the same principal·agent theory still applies. In

9 this context, pay should optimally be related to any performance measure

10 that contains marginally useful information about whether managers acted

11 in a way that Is consistent with maximizing customer welfare. In other

12 words. even if the goal is to maximize customer welfare, pay should also

13 be related to financial performance so long as the financial perfonnance

14 measures contain some additional information about customer welfare.

15

16 Q. HOW CAN INCENTIVES BASED ON FINANCIAL MEASURES IMPROVE

17 MANAGERS' FOCUS ON CURRENT AND FUTURE CUSTOMER

18 SERVICE?

19 A In the extreme, this most basic principal-agent theory is developed in a

20 one-period setting, without regard to future periods. In this set.up, the

21 manager acts, outcomes are realized at the end of the period (depending

22 in part on those actions). and the manager receives his or her pay.

2007 Texas Rate Case 10-14

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Direct Tatimony of Jfl'f C. Hartzell

2007 Texas Rate Case

1 A more realistic setting would allow for multiple periods, where both

2 managers and principals would have to consider not only their immediate

3 actions, but also their expected Mure actions, and trade-offs between

4 what they choose to do today versus what they may receive in the future.

5 This more realistic setting leads to another common problem or incentive

6 conflict between managers and principals: these parties having differing

7 time horizons. Typically, managers are expected to have a shorter..term

8 focus than otherwise would be optimal. As a result of their possibly

9 shorter time horizons, managers may make decisions that focus solely on

10 the short term at the expense of the long-term. Incentive compensation

11 tied to measures that look both to the short-tenn (such as the current

12 year's earnings) and long-term {such as stock price) is an accepted

13 solution to extend the managers' time horizons. and to balance short-term

14 and long-tenn perspectives, in decision-making and execution.

15

16 a. DOES EXTENDING THE MANAGERS' TIME HORIZONS HAVE A

17 POSITIVE EFFECT ON EXPECTED CONSUMER WELFARE?

18 A. Yes. In the context of maximizing -customer welfare. the horizon of the

19 manager is an important issue. To the extent the Commission wishes to

20 maintain and .enhaooe -customer welfare not only in the short-run, but also

21 in the future, financial measures like stock price performance play a useful

22 role in an incentive oompensation structure in order to aocomplish this

23 objective.

'2007 T-exas Rate Case 10-15

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Direct Testimony of Jay C. Hartzell

2007 Texas Rate Case

1 In addition to providing incentives for managers to optimize their

2 decisions in the current year. a financial-based incentive plan can provide

3 this perspective by capitalizing the long-term benefits of managers'

4 decisions. In other words, via incentives based .on financial perfonnance

5 measures such as stock Priee. the expected long-term impact of

6 managers' decisions has immediate impad on financial perfonnance

7 measures, thereby affecting managers' pay and incentives. Stock prices

8 are based on the present value of the firm's expected future cash flows.

9 So, by making a manager's compensation depend on stock price. one ties

10 the manager's wealth to expected future cash flows. This makes him ~

11 her more willing to make decisions that produce long-term benefits for the

12 firm, even if it is at the cost of short.term cash flows or profits.

13

14 a. HOW DO FINANCIAL-BASED INCENTIVES EXTEND THE MANAGERS'

15 TIME HORIZONS TO THE BENEFIT OF CONSUMER WELFARE?

16 A. To see how incentive pay affects customer welfare over multiple years,

17 first take an extreme hypothetical example where managers are only

18 compensated based on this year's customer welfare. This could create an

19 incentive for the manager to make deeisions that would sacrifice the future

20 of the finn (and its customers) for the benefit of the Immediate welfare of

21 customers. The manager might •over·lnvest" in immediate customer

22 service, weakening the finn's future financial position and its ability to

23 provide high-quality. low cost service in the future. With limited resources,

2007 Texas Rate Case 10~16

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Direct T.estimony of Jay C. HartzeM

2007 Texas Ratecase

1 the firm might decide to pay for this •over-investmenr In immediate

2 customer service by taking money from long-tenn maintenance spending

3 or capital investment that would produce long-term efficiency or

4 productivity gains.

5 But, by linking a manager's pay at least in part to the financial

6 health of the firm, one forces the manager to think about more than just

7 the short term, and to consider future years and the future performance of

8 the firm when they decide on a course of action. If the manager over-

9 invested in immediate customer welfare, then it would weaken the firm's

10 financial position and potentially, consumers' future welfare. Conversely,

11 by weighing not only immediate customer welfare, but also financial

( 12 measures like stock price that are related to the firm's short- and long.term

13 viability, the manager has the incentive to position the firm to provide

14 higher levels of customer welfare in the future.

15

16 a. WHY SHOULD THERE BE A POSITIVE RELATION BETWEEN

17 CUSTOMER WELFARE AND FINANCIAL PERFORMANCE?

18 A. Back to the basic theory, then, financial measures should be part of the

19 manager's a>mpensation structure if one wants to maximize customer

20 welfare so long as those financial measures are related to {or are signals

21 of) customer welfare. This is plausible and r.easonable for several

22 reasons. First, customer welfare is difflcult to measure oompletely, so it is

23 unlikely that objective customer-based measures that one <:an use in a

2007 T-exas Rate Case 10-17

Entergy Gulf States, Inc. Page16of19

Direct Testimony of Jay C. Hartzell

2001 Texas Rate case

1 compensation structure will fully capture what is trying to be measured.

2 Then, so long as the firm's f11ancial performance is poaitively correlated

3 with customer welfare, in this period or in the future, financial performance

4 should optimally enter the compensation structure with positive weight

5 (meaning that the manager receives greater compensation when the

6 financial performance of the firm is greater). The accepted literature on

7 compensation theory Is clear that less-noisy (I.e ., more accurate) signals

8 of managers' actions are preferred over noisier (less accurate) signals, but

9 even noisy signals of managers' actions should be included in the optimal

10 compensation contract. Thus, so long as a financial measure such as

11 stock price is correlated with customer welfare (beyond what the

12 operational measures can explain), then it should enter the compensation

13 structure of the manager. The more accurate it is as a signal, the greater

14 weight (or bigger role) it should receive.

15

16 a. ARE THESE FINANCIAL THEORIES SUPPORTED BY EMPIRICAL

17 EVIDENCE?

18 A. Yes. There are multiple empirical studies published in peer-reviewed

19 academic joumals that report evidence consistent with these hypotheses.

20

21 a. HOW DO THESE EMPIRICAL STUDIES SUPPORT THESE

22 HYPOTHESES?

2007 Texas Rate Case 10-18

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Direct T.estlmony of Jay C. Hartzell

2007 Texas 'Rate·Case

1 A. There is a wealth of existing empirical evidence that is supportive of these

2 theories. First, published papers have shown that customer satisfaction

3 measures are positively correlated with firms' financial perfonnance. In

4 other woros, firms with higher customer satisfaction scores tend to have

5 better financial performance, not worse. This fact from the -data is

6 consistent with the arguments above that more-satisfied customers are

7 expected to result in higher profits and belier overall financial

8 performance. This finding also suggests that financial measures -can play

9 a positive role in motivating managers to improve customer welfare. This

10 result of a positive relation between financial performance and customer

11 satisfaction is inconsistent with the idea that managers tend to maximize

( 12 financial performance to the detriment of customers, which should help

13 alleviate some fears that contracts incorporating financial-performance

14 incentives will lead managers to diminish their customers' welfar:e for the

15 sake of greater financial performance and higher compensation. In the

16 data, financial success tends to be associated with gr.eater wstomer

17 satisfaction, not iess.

16 There is also evidence that higher wstOmer satisfaction scores are

19 associated with higher market values across firms. This empirical result is

20 consistent with the widely-held notion that the s1ock market is a

21 mechanism by which the long-term benefits of customer welfare are

22 capitalized into a present value measure. This 1esult that higher customer

23 satisfaction scores are associated with higher market values has been

2007 Texas Rate Case 10-19

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Direct Testlmony of Jay C. Hartzell

2007 Texas Rate Case

1 shown for a broad set of companies in general. and also for the utility

2 industry in particular.

3 Empirical evidence also suggests that these relations between

4 customer satisfaction and financial petformance change as customer

5 satisfaction becomes very high. This change is consistent with the idea

6 that there are diminishing (financial) returns to improving customer

7 satisfaction. implying that it becomes more and more expensive to keep

8 improving customer satisfaction. Such an increasing cost of customer

9 satisfaction is consistent with the notion discussed earlier that providing

1O managers with incentive compensation that is only based on this pe~'s

11 customer welfare measures might lead managers to over-invest in current

12 customer welfare to the detriment of the long-tenn financial health of the

13 firm, potentially endangering future customer welfare, as well. As also

14 discussed earlier, including measures such as stock price in the

15 compensation structure of managers can help provide incentives for

16 managers to not only consider the immediate welfare of customers, but to

17 also weigh future years' customer welfare and the fenancial health of the

18 company when they make decisions while running the firm.

19 The evidence on firms in or near financial distress is also consistent

20 with the opinions presented earlier that firms that are more likely to enter

21 into financial distress are more likely to encounter significant costs of

22 distress, which could materialize in the form of higher future costs for

23 customers and lower future customer welfare {compared to the <:0sts that

2007 Texas Rale Case 10-20

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Direct Testimony of Jay C. Hartz.eH

2007 Texas Rate Case

1 would have been realized without the firm in distress). There is evidence

2 that finns with more debt (relative to their equity) suffer more when their

3 industries do not do well. Heavily indebted firms tend to invest less and

4 lose more sales in industry downturns when compafed to their less-

5 indebted industry counterparts, which would be expected to lead to higher

6 average costs in industries with economies of scale, such as the utility

7 industry. In addition, it has been shown that these finns with more debt

8 tend to be penalized by customers and suppliers, again leading to greater

9 costs than what one would have experienced without such distress.

10 .

11 Q. CAN YOU DRAW ANY CONCLUSIONS BASED UPON THESE

( 12 COMMONLY ACCEPTED ECONOMIC AND FINANCIAL PRINCIPLES?

13 A. Yes. These theoretical arguments are intuitive and based on sound,

14 commonly accepted economic and financial principals Thus, it is possible

15 to draw conclusions based upon the ·application of logic to fundamental

16 finance principles. In my opinion, the existing empirical evidence is

17 supportive of the conclusion that incentive compensation siructures that

18 include financial-based performance measures-tend to benefit oonsumers.

19

20 Q. DOES THIS CONCLUDE YOUR PREFILED DIRECT TESTIMONY?

21 A. Yes.

UIJ7 Texas Rate Case 10-21

APPENDIX B

Direct Testimony of Dr. J. Hartzell

in PUCT Docket No. 37744

SOAH Docket No. 473~10-1962

PUC Docket No. 37744

ETI Exhibit No. 14

DOCKET NO. - - -

(

APPLICATION OF ENTERGY § PUBLIC UTILITY COMMISSION

TEXAS, INC. FOR AUTHORITY §

TO CHANGE RATES AND § OF TEXAS

RECONCILE FUEL COSTS §

DIRECT TESTIMONY

OF

JAY C. HARTZELL, PHO.

ON BEHALF OF

ENTERGY TEXAS, INC.

DECEMBER 2009

2009 ETI Rate Case 4-357

ENTERGY TEXAS, INC.

(

DIRECT TESTIMONY OF JAY C. HARTZELL, PHO.

2009 RATE CASE

TABLE OF CONTENTS

I. Background and Introduction 1

II. Overview of the Issues Surrounding Incentive Compensation 3

Ill. The False Dichotomy Between Compensation Tied to "Financial"

Measures and Compensation Tied to "Operational" Measures; and

the Benefits of Cost Control, Profitability, and Stock Price Measures 8

IV. Costs to Customers of Discouraging the Use of Incentive

Compensation That is Linked to Cost Control, Profitability and

Stock Prices 18

V. Response to Common Arguments Against Incentive Compensation

Linked to Cost Control, Profitability and Stock Prices from the

Customers' Perspective 23

VI. Empirical Evidence Supporting Testimony 25

VI I. Conclusion 28

EXHIBITS

EXHIBIT JCH-1 Curriculum Vitae of Jay C. Hartzell

2009 ETI Rate Case 4-358

Entergy Texas, Inc. Page 1 of 28

Direct Testimony of Jay C. Hartzell, PhD.

2009 Rate Case

1 I. BACKGROUND AND INTRODUCTION

2 Q. PLEASE STATE YOUR NAME, TITLE, AND BUSINESS ADDRESS.

3 A. My name is Jay C. Hartzell. I am an Associate Professor of Finance at the

4 Mccombs School of Business at the University of Texas at Austin. My

5 business address is Department of Finance, The University of Texas at

6 Austin, 1 University Station 86600, Austin, Texas 78712.

7

8 Q. ON WHOSE BEHALF ARE YOU TESTIFYING?

9 A. I am testifying on behalf of Entergy Texas, Inc. ("ETI" or the "Company"}.

10

11 Q. PLEASE STATE YOUR EDUCATION, PROFESSIONAL AND WORK

12 EXPERIENCE.

13 A. I obtained a Bachelor of Science degree (cum laude) from Trinity

14 University in May 1991, with majors in Business Administration and

15 Economics. After graduating, I went to work as a consultant for Hewitt

16 Associates, in The Woodlands, Texas. Hewitt is a consulting firm that

17 specializes in benefits and compensation. While there, I specialized in the

18 area of defined contribution plans. I left Hewitt to go to graduate school at

19 the University of Texas at Austin in 1993. l completed my PhD in finance

20 there in May 1998. Upon graduating, I took a job as an Assistant

21 Professor of Finance at New York University's Stern School of Business,

22 where I worked until 2001. At that time, the University of Texas at Austin

I

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23 hired me as an Assistant Professor at the Mccombs School of Business

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11 '

1 ("Mccombs School ), where I have worked since. I was promoted to the

2 rank of Associate Professor (with tenure), effective in the fall 2006.

3 Beginning in the fall of 2008, I was given the title of Allied Bancshares

4 Centennial Fellow. I also now serve as the Executive Director of the Real

5 Estate Finance and Investment Center at the Mccombs School. My

6 current curriculum vitae is attached as Exhibit JCH-1.

7

8 Q. HAVE YOU PREVIOUSLY TESTIFIED BEFORE A REGULATORY

9 COMMISSION?

10 A. Yes. I have submitted written testimony on incentive compensation issues

11 and testified on behalf of the Company before the Public Utility

12 Commission of Texas ("Commission" or "PUCT") in PUCT Docket No.

13 34800, and on behalf of Entergy Louisiana, LLC before the Louisiana

14 Public Service Commission on incentive compensation issues in Docket

15 No. U-20925. I have also submitted written testimony on behalf of Entergy

16 Arkansas, Inc. before the Arkansas Public Service Commission on

17 incentive compensation issues in Docket No. 09-084-U.

18

19 Q. WHAT IS THE PURPOSE OF YOUR TESTIMONY?

20 A. The purpose of my testimony is to discuss the extent to which incentive

21 compensation - including compensation based on dollar-based measures

22 such as cost control, profitability, and stock prices - is linked to and

23 benefits customers' interests for companies such as ETI.

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1 11. OVERVIEW OF THE ISSUES SURROUNDING INCENTIVE

2 COMPENSATION

3 Q. WHAT FORMS OF INCENTIVE COMPENSATION DO YOU FOCUS ON

4 IN YOUR TESTIMONY?

5 A. The focus of my testimony is on incentive compensation that is linked to

6 cost control measures (for operating costs and capital expenditures),

7 profitability measures (including earnings and operating cash flow), and

8 stock prices. Compensation that is linked to these sorts of measures - for

9 companies generally and for ETI in particular - include annual incentive

10 plans, long-term incentive plans, restricted stock grants, and stock option

11 grants. The compensation could come in the form of cash (as in annual

12 incentive plans), stock or stock-based units (as in ETl's long-term

13 incentive plan, or "L TIP"), or options.

14

15 Q. WHAT IS YOUR UNDERSTANDING OF HOW COMPENSATION BASED

16 ON COST CONTROLS, PROFITABILITY AND STOCK PRICES HAS

17 BEEN CHARACTERIZED IN RECENT PUCT RATE DECISIONS?

18 A. In such cases, compensation that is linked to cost controls, profitability

19 and stock prices as discussed in the previous question has commonly

20 been referred to as incentive compensation that is based on "financial

21 measures." This category of incentives has been distinguished from

22 incentive compensation that is based on measures that are not

23 denominated in dollars, such as customer satisfaction, reliability, and

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1 safety metrics, which has commonly been categorized as incentive

2 compensation based on "operational measures." As I discuss later in my

3 testimony, I view this as a false dichotomy for the purposes of assessing

4 whether customers benefit from a particular form of incentive

5 compensation.

6

7 Q WHY DO FIRMS USE INCENTIVE COMPENSATION IN GENERAL, AND

8 COMPENSATION BASED ON COST CONTROLS, PROFITABILITY AND

9 STOCK PRICES MORE SPECIFICALLY?

10 A. Incentive compensation is a prevalent tool used to attract, motivate, and

11 retain the .qualified and talented employees needed to ensure that a

12 business can continue to operate successfully. To understand why it is so

13 widely used, it is first useful to draw a distinction between the level and

14 form of compensation. The level of compensation can be thought of as

15 the total dollar value of compensation received by an employee from all

16 sources, including salary, cash incentive-based pay, the value of

17 long-term incentives such as stock performance units and options granted

18 (albeit typically applicable to a much smaller group of employees), and the

19 value of benefits. In order to attract and retain employees, this level

20 needs to be in line with the labor market for a particular type of employee,

21 whether it is an engineer, a maintenance worker, or a chief executive

22 officer. Otherwise, all things equal, that same employee will take a job

23 with a company that is offering the more attractive level of pay and

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1 benefits. Company witness Kevin G. Gardner discusses the overall

2 reasonableness of ETl's level of compensation in his direct testimony.

3

4 Q. HOW DOES THE FORM OF COMPENSATION DIFFER FROM THE

5 LEVEL OF COMPENSATION?

6 A. The form of compensation can be thought of as the split of total

7 compensation across these components - for example, how much is paid

8 via salary versus annual incentive-based compensation. Holding the total

9 level of compensation fixed at the proper market level, the form of

10 compensation is important because it can help motivate employees to

11 engage in behaviors that positively impact the operational efficiency of the

12 firm, or positively affect its cost structure. At the same time, the form of

13 compensation is important to attract and retain certain types of employees

14 that offer a skill set or a particular talent that is important to the company's

15 operations. For example, if a compensation plan provides for incentive

16 payments if goals are met - such as controlling costs at some level - then

17 according to basic economic theory, employees will be motivated to work

18 harder toward those goals. More subtly, such incentive pay will tend to

19 attract and retain employees who believe that they are especially good at

20 controlling costs because they will expect higher compensation under

21 such a plan. This implies that a firm seeking to manage costs will find it

22 valuable to institute such an incentive compensation plan as part of the

(

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1 design of the form of compensation, while keeping the level of

2 compensation at a competitive market-based amount.

3

4 Q. WHAT IS YOUR UNDERSTANDING OF THE COMMISSION'S

5 PREVIOUS VIEW ON ALLOWING THE RECOVERY OF INCENTIVE

6 COMPENSATION EXPENSE THROUGH RATES?

7 A. My understanding of the Commission's recent rulings on this issue is that

8 the Commission has distinguished between compensation tied to what it

9 has termed operational measures and compensation tied to what it has

10 termed financial measures. Generally, the Commission has not allowed

11 for the recovery of incentive compensation tied to financial measures

12 through rates, but has allowed for the recovery of incentive compensation

13 tied to operational measures. The core rationale for this distinction has

14 been that it has not been sufficiently demonstrated that incentive

15 compensation linked to financial measures is in the public interest or of

16 direct benefit to customers. The decisions in those previous cases,

17 however, do not reflect a review or consideration of the relevant literature

18 or other matters I discuss below, all of which support a conclusion that

19 allowing utilities to use incentive pay based on cost control, profitability,

20 and stock prices is properly viewed as in the public interest and is

21 expected to be of direct benefit to customers.

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1 Q. HOW WOULD YOU SUMMARIZE YOUR OPINION ON THE ISSUE OF

2 WHETHER INCENTIVE COMPENSATION BASED ON COST

3 CONTROLS, PROFITABILITY, AND STOCK PRICES BENEFITS

4 CUSTOMERS?

5 A. In my opinion, a well-designed compensation plan that includes incentive

6 compensation tied to cost controls, profitability, and stock prices would

7 tend to provide greater benefit to customers than an otherwise similar

8 compensation plan that did not include any such incentive compensation.

9 I discuss the details below, but the overarching basis for my opinion is as

10 stated above: incentive compensation based on cost control, profitability,

11 and stock prices helps companies attract, motivate, and retain talented

12 employees, and by doing so, both customers and shareholders directly

13 benefit. Moreover, if ETl's inc~ntive compensation were only based on

14 non-dollar-based measures such as safety and reliability, customers

15 would tend to be worse off, because such a plan would not provide

16 employees with incentives to look after the financial health of the

17 Company. The important point is that customers and shareholders both

18 benefit from well-designed, balanced compensation plans that provide

19 employees with the appropriate level of compensation and that include

20 incentives based on cost control, profitability, stock prices, and

21 non-dollar-based measures such as reliability, safety and customer

22 satisfaction.

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1 111. THE FALSE DICHOTOMY BETWEEN COMPENSATION TIED TO

2 "FINANCIAL" MEASURES AND COMPENSATION TIED TO

3 "OPERATIONAL" MEASURES; AND THE BENEFITS OF COST

4 CONTROL. PROFITABILITY, AND STOCK PRICE MEASURES

5 Q. DO YOU AGREE WITH THE OPINION THAT INCENTIVE

6 COMPENSATION LINKED TO WHAT THE COMMISSION HAS TERMED

7 "FINANCIAL MEASURES" DOES NOT PROVIDE DIRECT BENEFITS TO

8 CUSTOMERS?

9 A. No. Based on its previous rulings, the Commission appears to be

10 categorizing as "financial" all incentive performance measures that have

11 been labeled as such by the utility and that are based on dollar amounts.

12 These include not only measures such as earnings per share, but also

13 measures designed to promote cost containment. 1 In reading these

14 decisions and the debates among the parties discussed therein, much of

15 the discussion seems to take it as given that incentives linked to financial

16 (or dollar-based) measures, regardless of their specific characteristics, do

17 not benefit customers. As a result, the competing viewpoints reflected in

18 these decisions seem to address mainly whether to label particular

19 measures as operational or financial. 2

20 Instead of focusing on whether a particular measure is dollar-based

21 or not - and therefore, whether incentives linked to that measure are

22 "financial" or "operational" based on the above dichotomy - I think it is

For example, see PUC Docket No. 28840, PFD at 78.

2

For example, see PUC Docket No. 35717, PFD at 98.

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1 more worthwhile to return to the primary question: whether specific

2 incentives linked to dollar-based measures (including cost control,

3 profitability, and stock prices) are of benefit to customers.

4

5 Q. WHY WOULD INCENTIVE COMPENSATION LINKED TO COST

6 CONTROL, PROFITABILITY, AND STOCK PRICE MEASURES BE OF

7 DIRECT BENEFIT TO CUSTOMERS?

8 A. This is the case because these measures provide a necessary and

9 important incentive to managers to improve service and control costs.

10 Perhaps the easiest example of a dollar-based measure that could be

11 used in an incentive compensation plan that would benefit customers

12 directly is cost containment. As an example, consider an incentive

13 compensation plan that pays corporate managers an incentive award if

14 costs are suitably contained. On the one hand, such an incentive is likely

15 to benefit shareholders to some extent - managers who work under such

16 a compensation plan will work to control costs in order to achieve their

17 incentive compensation, and to the extent that they are successful, the

18 company will generate greater profits, benefiting shareholders. But

19 customers also directly benefit, because the company has lower costs,

20 and through the regulatory process, customers will ultimately pay lower

21 rates than they otherwise would have paid in the absence of such cost

22 controls.

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1 Q. WHAT IS THE ROLE OF THE REGULATORY PROCESS IN ENSURING

2 THAT INCENTIVES LINKED TO COST CONTROL BENEFIT

3 CUSTOMERS?

4 A. To understand the role of the regulatory process in linking cost control to

5 customer benefit, first consider an extreme example where there is no

6 regulatory lag and rates adjust instantaneously so that any change in a

7 utility's costs is immediately passed through to customers. In this case, a

8 cost-containment incentive clearly directly benefits customers and does

9 not benefit shareholders at all because customers reap the entire benefit

10 of any cost-saving innovations. In the other extreme, if rates never adjust

11 to changes in costs, then a cost-containment incentive benefits

12 shareholders but not customers. Thus, the regulatory process plays the

13 critical role of sharing the gairis from cost controls brought about by

14 managerial incentive compensation between customers and shareholders.

15

16 Q. IS THIS POINT THAT CUSTOMERS BENEFIT FROM MANAGERIAL

17 EFFICIENCY A COMMONLY ACCEPTED TENANT OF UTILITY RATE

18 ECONOMICS?

19 A. Yes. This idea of a win-win scenario, where both shareholders and

20 customers benefit from managerial efficiency, is not new and is a core

21 idea at the heart of well-established principles of regulatory economics.

22 For example, James C. Bonbright discusses it in his seminal 1961 treatise

23 on utility economics, Principles of Public Utility Rates. He notes that a

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1 potential drawback to regulated rates based on cost-plus-return pricing is

2 that it could discourage managerial efficiency because the firm would earn

3 little to no greater return after an efficiency gain because of a resultant

4 change in rates. He goes on to say that regulatory lag can help resolve

5 this problem, for the reasons discussed above. From his discussion, it

6 follows naturally that incentive compensation that links managerial

7 compensation to cost savings would likely be of benefit to customers.

8

9 Q. DO THESE PRINCIPLES APPLY TO OTHER FORMS OF INCENTIVE

10 COMPENSATION THAT ARE LINKED TO PROFITABILITY AND STOCK

11 PRICE MEASURES?

12 A. Yes. While I think that cost containment measures are the most obvious

13 example of incentives that have in some past PUCT cases been

14 categorized as "financial" and yet directly benefit customers, these

15 principles apply to other dollar-based or financial measures as well, such

16 as incentive awards tied to corporate profitability and stock prices.

17

18 Q. CAN YOU PLEASE FURTHER ELABORATE ON WHY CUSTOMERS

19 ARE LIKELY TO BENEFIT FROM COMPENSATION THAT IS LINKED

20 TO PROFITABILITY?

21 A. Yes. There is a direct link between cost containment and company

22 earnings, especially for a regulated utility. Managers with an incentive to

23 increase earnings will focus on controlling or cutting costs in a regulated

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1 industry because it is more difficult to grow revenues. Additionally, the

2 same type of reasoning that supports a linkage between cost containment

3 and customer benefit also applies to incentive measures that focus on

4 containing capital expenditures. If managers can offer the same service

5 while cutting back on capital expenditures by investing more efficiently,

6 then shareholders benefit due to greater short-run cash flows for the

7 company, and customers benefit through the regulatory process through

8 lower recovery for the cost of capital due to a lower capital base.

9

10 Q. WHAT TYPE OF INCENTIVE COMPENSATION DO YOU INCLUDE

11 WITHIN THE CATEGORY OF COMPENSATION THAT IS LINKED TO

12 STOCK PRICES?

13 A. This category would include most long-term incentive plans (including

14 ETl's) that use performance units that are based on stock prices, as well

15 as stock options.

16

17 Q. CAN YOU BRIEFLY SUMMARIZE WHY YOU BELIEVE THAT

18 COMPENSATION THAT IS LINKED TO STOCK PRICES BENEFITS

19 CUSTOMERS?

20 A. Compensation that is linked to stock prices has several advantages for

21 customers as long as it is part of a reasonable, well-designed

22 compensation plan - in other words, as long as the total level of

23 compensation is reasonable compared to the market for similar positions

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1 and the form of compensation is well balanced across dollar-based and

2 non-dollar-based measures. First, compensation that is linked to stock

3 prices helps ensure that managers will consider the financial health of the

4 company when they make decisions, and it is in customers' interests to

5 have the company continue to be financially healthy. Second,

6 stock-based compensation provides an incentive for managers and

7 employees to ensure that the company operates efficiently, and via the

8 regulatory process, lower costs result in lower rates than would otherwise

9 occur. Third, stock-based compensation provides a monitoring

10 mechanism for managerial decision making and the overall quality of

11 management. Fourth, there is an interaction between these effects, as the

12 capital markets will tend to reward efficient long-term investments or

13 capital expenditures that will also lead to lower costs for customers.

14

15 Q. DO THESE REASONS THAT COMPENSATION THAT IS LINKED TO

16 STOCK PRICES BENEFITS CUSTOMERS ALSO APPLY TO

17 COMPENSATION THAT IS LINKED TO COST CONTROL AND

18 PROFITABILITY?

19 A. In general, yes. Stock prices are driven in part by cost control and

20 profitability, so to the extent that managers have an incentive to increase

21 the stock price, they will also have an incentive to control costs and

22 increase profits and cash flows, and vice versa. Of the reasons listed in

23 the previous answer, the first two reasons - incentives to ensure that the

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1 company is financially healthy and that it operates efficiently - are the

2 ones that are most closely shared by compensation based on cost control

3 and profitability.

4

5 Q. STARTING WITH THE FIRST REASON YOU MENTIONED, WHY DOES

6 COMPENSATION THAT IS LINKED TO PROFITABILITY AND STOCK

7 PRICES BENEFIT CUSTOMERS BY IMPROVING A COMPANY'S

8 FINANCIAL HEALTH?

9 A. If compensation that is linked to profitability and stock prices gives

10 managers an incentive to increase their company's earnings, cash flows,

11 and stock price, then this will also provide them with an incentive to

12 ensure that the company remains financially healthy. Stock prices of firms

13 that are in poor financial condition - for example, that have high debt

14 relative to the value of their assets - tend to be lower, all else being equal.

15 Similarly, firms in poor financial condition tend to have lower earnings and

16 operating cash flows. A stronger financial condition will also benefit

17 customers. If a company maintains a financially healthy position, it will

18 tend to have a lower cost of capital that will in turn benefit customers

19 through lower rates. For a discussion of this effect, see Chapter 15 of

20 Investment Valuation, by Aswath Damodaran. 3 In addition, the costs of

21 doing business with suppliers (of both goods and services, including labor)

3

ASWATH DAMODARAN, INVESTMENT VALUATION (John Wiley & Sons, 2d ed. 2002).

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1 will remain lower. For example, if a company was not in a financially

2 stable condition, suppliers would tend to demand higher prices or more

3 onerous credit terms, resulting in higher costs that would lead to higher

4 rates than would otherwise occur. These are often termed "indirect costs

5 of financial distress," and are a commonly accepted concept in finance

6 that is supported by empirical evidence as I discuss further below.

7

8 Q. CAN YOU FURTHER EXPLAIN HOW INCENTIVE COMPENSATION

9 THAT IS LINKED TO PROFITABILITY AND STOCK PRICES CAN TEND

10 TO LEAD TO LOWER COSTS FOR CUSTOMERS?

11 A. The first step is to understand that compensation linked to profitability and

12 stock prices will provide managers with an incentive to operate efficiently

13 because, by doing so, a company's profitability (including earnings and

14 cash flow) and stock price will be higher than it would otherwise be. To

15 increase stock price, management tries to maximize the present value of a

16 company's expected cash flows by minimizing expenses and the cost of

17 capital. The role of incentive compensation in motivating managers to

18 minimize the cost of capital component and the associated benefits to

19 customers were discussed earlier. A second channel provided by

20 incentive compensation that can benefit customers is the incentive to

21 maximize the company's cash flows. In a regulated environment,

22 particularly one in which promotion of sales growth is discouraged, it is

(

\ 23 likely to be more difficult to increase cash flows or profits by growing

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1 revenues, so management will tend to focus on efficient operations and

2 investment.

3 These lower costs will benefit shareholders in the short run, but

4 customers over the long run. This is due to the regulatory process that

5 directly links operating costs to rates. In fact, it is my understanding that

6 the Formula Rate Plan proposed in this case provides for an even more

7 direct link between cost savings and rates due to the frequency of reviews

8 and reflection of any identified cost savings in customer rates. This

9 channel is similar to the discussion earlier as to why incentive

10 compensation that is based on cost controls will tend to benefit customers.

11

12 Q. HOW DOES COMPENSATION THAT IS LINKED TO STOCK PRICES

13 BENEFIT CUSTOMERS VIA THE MONITORING OF MANAGERIAL

14 DECISIONS?

15 A. One of the functions of the stock market and its various participants is to

16 monitor companies' management. In their efforts to properly value stocks,

17 analysts, portfolio managers, and traders follow companies and

18 continually assess the various decisions, announcements, and pieces of

19 information they produce. In doing so, they act as a monitoring device,

20 ensuring that poor decisions would be punished by a falling stock price, so

21 managers have incentives to invest the shareholders' financial resources

22 efficiently. In this manner, managers help keep customers' costs lower

23 than they might otherwise be in the absence of such monitoring, and

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1 improve the overall quality of service. An example of such evidence, cited

2 in one study, shows that institutional investors can help ensure that

3 management does not act myopically to cut research and development

4 expenditures in order to meet short-term earnings targets. 4

5

6 Q. HOW DO THESE INVESTMENT AND COST EFFECTS INTERACT DUE

7 TO THE STOCK MARKET?

8 A. An important role for stock-based compensation is to encourage

9 managers to refrain from sacrificing long-run success in pursuit of

10 short-term profit. 5 Stock prices are based not just on a company's

11 performance in the current year, but also on the market's expectations

12 about a company's future performance over many years. This ensures

13 that good investments tend to increase stock prices, even though those

14 investments use cash today in order to produce greater cash flows in the

15 future. This is a critical advantage of stock-based compensation over

16 annual incentive plans that are based on a particular year's (or a few

17 years') performance. Stock-based .compensation can help overcome

18 managerial myopia and provide managers with an incentive to make

19 efficient, long-term investments that benefit both customers (due to

4

Brian J. Bushee, The Influence of Institutional Investors on Myopic R&D Investment Behavior,

73 THE ACCOUNTING REVIEW, 3 at 305-333 (July 1998).

5

For example, see M.P. Narayanan, Form of Compensation and Managerial Decision Horizon,

31 JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS, 4 at 467-491 (1996).

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1 efficient investments that lead to lower costs) and shareholders (due to

2 higher cash flows). In this case, the testimony of Company witnesses

3 Joseph F. Domino and Chris E. Barrilleaux addressing the Company's

4 expected future capital investments, and that of Company witness Robert

5 R. Cooper regarding long-term resource planning, provide examples of

6 such consideration.

7

8 IV. COSTS TO CUSTOMERS OF DISCOURAGING THE USE OF

9 INCENTIVE COMPENSATION THAT IS LINKED TO COST CONTROL,

10 PROFITABILITY AND STOCK PRICES

11 Q. WHILE YOUR EARLIER TESTIMONY DISCUSSED THE BENEFITS TO

12 CUSTOMERS OF USING INCENTIVE COMPENSATION THAT IS

13 LINKED TO COST CONTROL, PROFITABILITY AND STOCK PRICES,

14 ARE THERE ALSO NEGATIVE IMPACTS TO CUSTOMERS OF NOT

15 USING STOCK-BASED COMPENSATION?

16 A. Yes. In my opinion customers would be adversely affected if ETI did not

17 include such incentive compensation. in its overall compensation policy.

18

19 Q. STARTING WITH AN EXTREME EXAMPLE OF A COMPENSATION

20 POLICY WHERE ALL EMPLOYEES WERE ONLY PAID WITH

21 SALARIES, CAN YOU HIGHLIGHT THE IMPACT TO CUSTOMERS OF

22 SUCH A POLICY?

23 A. Yes. First, it is useful to note that if employees did not receive any

24 incentive compensation, salaries would have to be much higher in order to

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attract and retain the same quality of talent. Second, costs would likely

rise and employee performance would likely suffer, as it would be difficult

to effectively and efficiently motivate employees to take actions that would

benefit shareholders and customers. In my opinion, customers would be

worse off under such a policy. This is supported by the principle that

individuals respond to incentives (a basic tenet of economics), and by

empirical work that shows workers' output responds to the institution of an

incentive plan.6

WOULD CUSTOMER INTERESTS BE ADVERSELY AFFECTED IF A

COMPANY USED SALARY AND INCENTIVES LINKED TO MEASURES

THAT HAVE BEEN TERMED "OPERATIONAL" ONLY? IN OTHER

WORDS, IF THEY PROVIDED. SALARY AND INCENTIVES BASED ON

MEASURES LIKE RELIABILITY AND SAFETY, BUT NO INCENTIVES

BASED ON COST CONTROL, PROFITABILITY AND STOCK PRICES?

Yes. I believe customers would be worse off under such a compensation

policy. On the one hand, incentives linked to what have beP.n termed

"operational" measures can improve customer welfare because the

company can better attract, motivate and reta in talented employees.

Compared to the hypothetical case where a company compensates its

employees with salary only, by using salary and incentives linked to, for

6

( Edward P. Lazear, Performance Pay and Productivity, 90 THE AMERICAN ECONOMIC REVIEW,

at 1346-1361 (December 2000 ).

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1 example, safety or reliability, the company can pay less in salary and use

2 the associated savings to contribute to the annual incentive plans. On the

3 other hand, such a compensation plan still has substantial problems in the

4 context of customer benefits.

5 First, there is still no free lunch - employees' salaries and incentive

6 payments linked to operational incentives would have to be larger than

7 they otherwise would be if the firm also offered incentive compensation

8 linked to cost control, profitability and stock prices in order for the firm to

9 compete in the market for labor. Second, such a compensation plan

1O would not provide any incentives for employees and managers to control

11 costs. If employees only had incentives to improve non-cash measures of

12 performance, such as safety and reliability, then they would likely

13 over-invest in these measures relative to what customers might prefer, at

14 the expense of alternative investments that would produce lower costs for

15 customers. For example, if management only had incentives based on

16 wait times when customers called with questions or complaints (plus a

17 base salary), then they would have an incentive to hire enough staff such

18 that customers never had to wait if they called to ask a question.

19 However, if you left it up to customers , they would likely view it as

20 worthwhile to run the risk of having to wait for a little while on rare

21 occasions if it meant that their service was provided at a lower cost and

22 those cost savings were passed along to customers through the regulatory

23 process.

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1 Third, a compensation plan consisting of salary and incentives

2 based solely on annual measures of operational performance could likely

3 lead to "horizon problems." By horizon problems, I mean that managers

4 tend to have a natural tendency, absent incentives, to focus on the short

5 run at the expense of the long run. Stock prices by their nature are

6 forward looking. Taken together, a compensation plan that included

7 incentives based on annual measures such as reliability and customer

8 satisfaction, but not incentives based on cost controls, profitability and

9 especially stock prices, could provide incentives for managers to maximize

10 their immediate compensation at the expense of longer-run benefits that

11 the customer could have enjoyed. 7

12 For example, consider a manager facing a decision whether to hire

13 additional staff to answer phones in a call center (and bring down phone

14 wait times) or to invest the same amount in a capital investment to put in

15 place a new, more centralized call center that would produce significantly

16 lower costs several years in the future. If the manager is paid purely in

17 cash compensation including an incentive payment based on current-year

18 customer satisfaction surveys (that would include phone wait times), then

19 the manager would be more likely to forgo the long-term investment

20 project and increase payroll by hiring additional employees in order to

21 maximize his or her incentive pay by implementing the short-term solution

7

See M.P. Narayanan, Form of Compensation and Managerial Decision Horizon, 31 JOURNAL

(, ' OF FINANCIAL AND QUANTITATIVE ANALYSIS, 4 at 467-491 (1996).

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2009 Rate Case

1 today. But, at some point, customers are better off by having slightly

2 longer waits on the phone now but reaping the benefits of lower overall

3 costs in the future. A well-designed compensation plan that includes

4 incentives linked to both customer satisfaction (in this example) and cost

5 control, profitability and stock prices would provide incentives for the

6 manager in this example to properly consider the benefits of such a long-

7 term investment without sacrificing current customer satisfaction.

8

9 Q. HOW DOES THE INCLUSION OF INCENTIVE COMPENSATION THAT

10 IS LINKED TO COST CONTROLS, PROFITABILITY AND STOCK

11 PRICES HELP AVOID THESE NEGATIVE OUTCOMES FOR

12 CUSTOMERS?

13 A. If a company adds compensation that is linked to cost controls,

14 profitability, and stock prices to a compensation plan that includes base

15 salary and incentives based on non-cash based measures in a reasonable

16 way, customers are likely to be better off. Such incentive compensation

17 helps a company attract, motivate, and retain talented employees and

18 gives managers a reason to focus on the long run in addition to the current

19 year's performance, costs, customer service, and the like.

20 This focus on the longer run is evident in the design of ETl's LTIP

21 and stock option plan. For example, ETl's LTIP bases its payments in a

22 particular year on the achievement of goals over the previous three years,

23 encouraging managers to consider consistent and long-term success as

2009 ETI Rate Case 4-380

Entergy Texas, Inc. Page 23 of 28

Direct Testimony of Jay C. Hartzell, PhD.

2009 Rate Case

(

1 key objectives. Plus, options granted vest over a three-year period,

2 forcing managers to think about future years and how the firm will be

3 viewed several years into the future. The stock options also have a life of

4 ten years, which provides an additional incentive to focus on the long

5 term. Such a focus on maximizing stock price over a ten-year period is

6 beneficial for all stakeholders. As stock options may be awarded annually,

7 option grants present a rolling ten-year window for those employees who

8 receive them, reinforcing that long-term view. Finally, the provision that

9 requires senior managers to continue to hold stock received via exercising

10 option grants up to a multiple of their salary further encourages longer-run

11 thinking and incentive alignment, as managers cannot exercise all their

12 options for cash and be immune to declines in the firm's financial health.

13

14 V. RESPONSE TO COMMON ARGUMENTS AGAINST INCENTIVE

15 COMPENSATION LINKED TO COST CONTROL. PROFITABILITY AND

16 STOCK PRICES FROM THE CUSTOMERS' PERSPECTIVE

17 Q. HOW DO YOU RESPOND TO THE ARGUMENT THAT INCENTIVE

18 COMPENSATION THAT IS LINKED TO COST CONTROL,

19 PROFITABILITY, AND STOCK PRICES WILL BE DETRIMENTAL TO

20 CUSTOMERS BECAUSE IT WILL CAUSE MANAGERS TO CUT

21 CUSTOMER SERVICE-RELATED EXPENSES TO INCREASE

22 PROFITS?

23 A. This argument underscores the importance of a well-balanced

24 compensation plan. By including b

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