The opinion
ACCEPTED
03-14-00706-CV
5234415
THIRD COURT OF APPEALS
AUSTIN, TEXAS
5/11/2015 3:11:14 PM
JEFFREY D. KYLE
CLERK
NO. 03-14-00706-CV
IN THE THIRD COURT OF APPEALS FILED IN
3rd COURT OF APPEALS
AUSTIN, TEXAS AUSTIN, TEXAS
5/11/2015 3:11:14 PM
ENTERGY TEXAS, INC., JEFFREY D. KYLE
Appellant Clerk
v.
PUBLIC UTILITY COMMISSION OF TEXAS,
Appellee
APPELLANT ENTERGY TEXAS, INC.’S
MOTION FOR THE COURT TO TAKE JUDICIAL NOTICE
AND RESPONSE TO STATE AGENCIES’ MOTION TO STRIKE
TO THE HONORABLE THIRD COURT OF APPEALS:
Appellant Entergy Texas, Inc. (“ETI”) files this motion for the Court to take
judicial notice and response to Appellee State Agencies’ Motion to Strike Portions
of ETI’s Reply Brief. In support of its own motion, and in opposition to State
Agencies’ motion, ETI shows this Court as follows.
This is a suit for judicial review of the final order of the Public Utility
Commission of Texas in its rate case expense Docket No. 40295. ETI challenges
the Commission’s decision principally because it is an unexplained, after-the-fact
departure from prior Commission practice in two different respects. First, ETI
pointed out that the Commission has never before disallowed the rate case
expenses associated with making unsuccessful arguments about financially-based
incentive compensation. See ETI’s Appellant’s Brief at 17-18. Second, ETI
pointed out that the Commission has never before used a “proxy” to quantify a
disallowance for rate case expenses. See id. at 27-28. In support of both these
arguments, ETI cited several prior Commission decisions to show what the
Commission’s prior practice has been. See id. at 17-18, 27-28, & Appendix D.
This Court has specifically acknowledged it may consider how the Commission
has treated other utilities in past dockets to determine whether a particular policy is
new in a given case. The Court so ruled even though the Commission’s decisions
in the past dockets were not part of the administrative record in the contested case
under review. 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.).
In its Appellee’s Brief, the Commission argued its allowance of rate case
expenses in previous dockets is distinguishable because the utilities’ arguments in
those cases were different from ETI’s argument in this case. See Commission’s
Appellee’s Brief at 33. The Commission said ETI “shows no examples” of
previous cases analogous to this one. Id.
The Commission also argued that its use of a proxy in this case was
consistent with the way it quantified a disallowance in another docket. See id. at
44. Specifically, the Commission argued that it disallowed fifty percent of the
expenses associated with the testimony of Cities’ witness Dr. Goodfriend in
2
Docket No. 28840. The Commission suggested that the percentage disallowed did
not reflect the actual expenses associated with the witness’s flawed testimony. Id.
at 45-46. State Agencies made the same argument in their Appellee’s Brief. See
State Agencies’ Appellee’s Brief at 26.1
To correct Appellees’ assertions about these matters (which are outside the
administrative record), ETI provided more detail about the previous Commission
dockets at issue. ETI appended to its Reply Brief copies of its witness’s testimony
about financially-based incentive compensation in two previous dockets. These
documents show that ETI made the same arguments about incentive compensation
in those two dockets as it did in this case. See ETI’s Reply Brief at Appendices A
& B. These documents were presented to directly refute the Commission’s
characterization of the arguments made in previous dockets.
ETI also provided a link in its Reply Brief to the testimony of Dr.
Goodfriend in Docket No. 28840. This document shows that the Commission’s
disallowance of fifty percent of the expenses of this testimony correlates almost
exactly to the portion of the witness’s testimony that the Commission determined
was “flawed.” This document, too, was presented to directly refute the arguments
1
Docket No. 31433, cited by State Agencies, is the rate case expense docket severed from rate
case Docket No. 28840. See 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. As both the Commission and ETI have pointed out in briefing, most public filings at
the Commission are available on the Commission’s interchange at:
http://interchange.puc.texas.gov/WebApp/Interchange/application/dbapps/filings/pgSearch.asp .
The “Control Number” is the Docket Number for each proceeding.
3
that the Commission and State Agencies made about the basis for the disallowance
in that previous case.
Nevertheless, State Agencies have moved to strike not only these
documents, but the portions of ETI’s brief that mention them. This Court should
deny State Agencies’ motion and take judicial notice of the documents at issue.
ETI has not presented these documents in support of the truth of their
content. ETI has presented the documents only to establish that they were filed,
and the nature of the matters the witnesses discussed, in prior dockets. These
documents were filed with the Commission, a state agency. They are publicly
available, and their authenticity is readily verifiable. This Court can, therefore,
take judicial notice of these documents for the limited purposes ETI presents them.
Tex. R. Evid. 201(b); Freedom Communications, Inc. v. Coronado, 372 S.W.3d
621, 623 (Tex. 2012); Office of Pub. Util. Counsel v. Public Util. Comm'n, 878
S.W.2d 598, 600 (Tex. 1994); Vickers v. State, No. 06-14-00072-CR, 2015 WL
1882910, *6 n.11 (Tex. App. – Texarkana Apr. 27, 2015, no pet. h.); Katy Intern.,
Inc. v. Jinchun Jiang, 451 S.W.3d 74, 94 n.20 (Tex. App. – Houston [14th Dist.]
2014, no pet. h.); Hendee v. Dewhurst, 228 S.W.3d 354, 377 n.30 (Tex. App. --
Austin 2007, pet. denied).
State Agencies also curiously complain that ETI has not provided “specific
citations” for these documents. The existence and location of these documents in
4
the Commission’s files are clear from ETI’s Reply Brief, as the documents
themselves are attached to the brief. However, to dispel any concern that the
documents attached to ETI’s Reply Brief are not authentic, readily-verifiable
public documents, ETI attaches certified copies of the documents to this motion. A
certified copy of the document that appears as Appendix A to ETI’s Reply Brief
(Dr. Hartzell’s Direct Testimony in Docket No. 34800) is attached to this motion
as Appendix A.2 A certified copy of the document that appears as Appendix B to
ETI’s Reply Brief (Dr. Hartzell’s Direct Testimony in Docket No. 37744) is
attached to this motion as Appendix B. A certified copy of Dr. Goodfriend’s
testimony in Docket No. 28840, to which ETI linked in its Reply Brief, is attached
to this motion as Appendix C.3
ETI respectfully requests the Court take judicial notice of the nature of the
content of the following documents, and the fact they were filed in the following
Commission dockets:
Direct Testimony of Jay C. Hartzell, Ph.D., EGSI Remand
Exhibit No. 72, in Public Utility Commission Docket No.
34800;
2
This testimony was first filed as part of Entergy Gulf States, Inc.’s application in Docket No.
34800 and is also available on the Commission’s interchange, Application of Entergy Gulf
States, Inc. for Authority to Change Rates and to Reconcile Fuel Costs, Docket No. 34800, Item
1, Bates No. 5531, at:
http://interchange.puc.state.tx.us/WebApp/Interchange/Documents/34800_1_563631.PDF .
3
This testimony is also available on the Commission’s interchange, Application of AEP Texas
Central Company for Authority to Change Rates, Docket No. 28840, Item 338, at:
http://interchange.puc.state.tx.us/WebApp/Interchange/Documents/28840_338_425996.PDF .
5
Direct Testimony of Jay C. Hartzell, Ph.D., ETI Exhibit No. 14,
in Public Utility Commission Docket No. 37744; and
Redacted Direct Testimony of Sarah J. Goodfriend, Ph.D., filed
February 9, 2004, on behalf of Cities Served by AEP Texas
Central Company, in Public Utility Commission Docket No.
28840.
ETI also respectfully requests this Court overrule State Agencies’ motion to strike
these documents and the sentences of ETI’s reply brief that discuss them. ETI
further requests any other relief to which it may show itself justly entitled.
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.
6
CERTIFICATE OF CONFERENCE
I certify that I have conferred with counsel representing the Public Utility
Commission of Texas, State Agencies, and the Office of Public Utility Counsel,
and they oppose this motion. Counsel for Texas Industrial Energy Consumers, an
intervenor in the district-court proceeding, does not agree to or oppose this motion.
/s/ Marnie A. McCormick
Marnie A. McCormick
7
CERTIFICATE OF SERVICE
The undersigned counsel certifies that 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 via electronic service on the 11th day of May, 2015:
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 Intervenor Texas Industrial Energy Consumers
Katherine H. Farrell
Sara R. Hammond
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 Intervenor Office of Public Utility Counsel
/s/ Marnie A. McCormick
Marnie A. McCormick
8
APPENDIX A
Direct Testimony of Jay C. Hartzell, Ph.D
PUC Docket No. 34800
SOAH Docket No. XXX-XX-XXXX
PUC Docket No. 34800
EGSI - 2007 Rate Case
· EGSI Exhibit No,; 721 11 ,: •
DOCKET NO. 3L/l:300 . ;>.·.. ,•)"',, rJ
HH.l 3
APPLICATION OF ENTERGY § PUBLIC UTILITY COMMISSION .·
GULF STATES, INC. FOR §
AUTHQRITY 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 10-1
DOCKET N O . - - - -
ENTERGY GULFSTATES, 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. Financial-Based Incentive Compensation as a Tool for Improving
Consumer Welfare 4
A. The Positive Effect of Incentive Compensation on Utility
Customer Welfare 4
B. The ReasC?ns for Providing Financial-Based Incentive
Compensation 10
EXHIBIT
Exhibit JCH-1 Resume
2007 Texas Rate Case 10-2
Entergy Gulf States, Inc. Page 1of19
Direct Testimony of Jay C. Hartzell
2007.Texas Rate Case
1 I. WITNESS IDENTIFICATION AND QUALIFICATIONS
2 Q. PLEASE STATE YOUR NAME, OCCUPATION, AND BUSINESS
3 ADDRESS.
4 A. I cim 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 86600, Austin, Texas, 78712.
8
9 Q. FOR WHOM ARE YOU TESTIFYING?
1.0 A. I am testifying on behalf of Entergy Gulf States, Inc. ("EGSI").
11
12 Q. PLEASE DESCRIBE YOUR EDUCATIONAL BACKGROUND AND ·
13 PROFESSIONAL EXPER1ENCE.
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 consultant for Hewitt Associates, in The
16 Woodlands, Texas .. Hewitt is a «>nsulting firm that specializes in benefits
19 and compensation. While there, I specialized in the area of defined
20 contribution plans. I left Hewitt to go to graduate school at the University
21 of Texas at Austin in 1993. I compfeted 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
2007 T-exas Rate Case 10-3
Entergy Gulf States, Inc. Page2of 19
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 School"), where I have worked 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 Q. 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 AND 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 ronsumers' interests. I
23 then turn to the broader topic of how an incentive -compensation plan
2007 Texas Rate Case 10-4
Entergy Gulf States, Inc. Page3of 19
Direct Testimony of Jay C. Hartzell
2007 Texas Rate<;ase
1 including financial measures provides incentives to a firm's employees to
2 take actions that improve customer welfare.
3
4 Q. WHY ARE YOU QUALIFIED 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
10 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.
2007 Texas Rate Case 10-5
Entergy Gulf States, Inc. Page4of 19
Direct Testimony qf Jay C. Hartzell
2007 Texas Rate Case
1 Ill. FINANCIAL-BASED INCENTIVE COMPENSATION ASA 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 Compensation on
20 Utility Customer Welfare
21 Q. IS THERE A LINK BETWEEN CUSTOMER WELFARE AND A FIRM'S
22 FINANCIAL PERFORMANCE?
23 A. Yes. Satisfied customers clearly experience greater customer welfare, all
24 else equal, as they are happy with the pr-0ducts they consume. This is
. 2007 Texas Rate Case 10-6
:Entergy Gulf States, Inc. Page5of 19
Direct Testimony of Jay C. 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 iess time and expend· fewer ·resources
5 compensating for outages, or complaining about the service they have
6 received.
7 In addition to benefiting -customers, greater satisfaction tends to
8 benefit 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 satisfact.ion
14 are also more likely to attract new customers who can learn 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 manag~rs to improve customer welfare.
19 Although regulated utilitfcompanies do not deal with the same type
20 of competitive dynamics faced by unregulated companies, the general
21 concepts related 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 :eampus, etc.) or
2007 Texas Rate Case 1-0-7
Entergy Gulf States, Inc. Page6of19
Direct Testimony of Jay C. Hartzell
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 locaJ 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 c·ustomer'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 <;ilternative locations or to self-generate, all else equal. · A
8 customer that is more likely to expand in the current location rather than .
9 look 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 utility customers. Residential
13 customers. can choose, for example, between gas (including propane)
14 appiiances and electrical appliances. The more· satisfied they are with
15 their electrical service provider, the more likely they are to choose
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
Entergy Gulf States, Inc. Page7of 19
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 !ass 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 loWBr .customer
9 welfare. This channel is straightforward: as a .company gets closer to
10 distress, the expected costs of distress increase, and· 1en6ers (including
11 bondholders) char.ge 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 overall cost of <:apital. In addition; if ·the
14 higher costs of capital are large. enough, this .effectively limits the less
15 healthy firm's access to funds, implying that financially healthy. firms have
16 broader access to capital than their less healthy counterparts. This rost of
17 capital effect is especially .relevant to the utility industry given the
18 industry's reliance on large capital spending projeots and use of debt
19 capital.
20 · Second, in an industry where prices that firms can charge 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 Rate Case l0-9
Entergy Gulf States, Inc. Page8of 19
Direct Testimony of Jay C. Hartzell
2007 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 turn 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 unregulated 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~es is associated with greater financial performance, 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 sayings
17 again materialize in lower future rates for customers (compared to what
18 they would have been without the growth in the firm'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
Entergy Gulf States, Inc. , Page9of 19
Direct Testimony of Jay-C. Hartzell
2007 Texas Rate -Case
1 price based incentives can help discipline managers, and constrain ·them
2 from investing in ways that might not benefit the firm.
3 Fifth, companies that are less healthy financially - or, to put it
4 · another w~y, closer to financial distress - will likely experience greater
5 costs, which will in turn 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 company. For example, consider a
9 supplier who sells machinery to a utility company that is not financially
10 healthy (or is believed to be near distr-ess). Such a supplier will likely
11 demand higher prices from the utmty before. committing to any sort .of
12 investment in a relationship with the utility, in order to compensate 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-sp.eciftc investments are required - such as customized
· 16 machinery - or, the relationship is expected to have a longer term. In
17 addition, suppliers to less healthy firms (ftrms that are nearer-distress) are
18 likely to pr-ovide less attractive terms of trade - for example, r..equiring~h
19 payment rather than accepting tracle credit. Both of these - higher prices
20 or worse trade and -credit terms - will materialize as higher -costs for the
21 · utility, which will in turn likely be passed on to customers via higherpriGes
22 for €nergy. · Similar arguments can be made for other stakeholders-Of the
23 firm, such as employees of the firm. Employ.0es of firms that are more
2007 T~xas Rate Case 1-0-11
Entergy Gulf States, Inc. Page 10of 19
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 s1:1fficient wage differential, financially distressed firms.
4 are likely to lqse skilled and talented employees and to find it difficult 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 costs 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
Entergy-Gulf States, Inc. Page 11of19
Direct Testimony of Jay C. Hartzell
2007 Texas Rate Case
1 Q. 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, wher.e the
6 principals involved cannot observe the actions of an agent who acts on
7 their behalf. This ag~nt 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 inter.est, termed an agency problem, gives rise to a role for incentive
11 compensation. Because the principals cannot observe or write contracts
12 based on the agent'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 tak.e the-course of action
15 that is desired by the principals. Specifically, 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 desir.ed
18 by the principal - put forth more effort, -pick better projects, or shirk less,
19 for example.
2-0 The typical view in finance is from the -perspective of the
21 shareholders: shar.eholders ar.e the principals and owners of the firm, and
. 22 they hire managers to act as agents on their behalf, Incentive pay has a
23 role in that it provides for greater compensation to managers when there
2007 Texas Rate.Case 10-13
Entergy Gulf States, Inc. Page 12of 19
Direct Testimony of Jay C. Hartzell
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 agent's 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 informatiori 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 perfonTiance
14 measures contain some additional information about custor:ner welfare.
15
16 a. HOW CAN INCENTIVES BASED ON FINANCIAL MEASURES IMPROVE
17 MANAGER.S' FOCUS. ON CURRENT AND FUTURE C.USTOMER
18 ·SERVICE?
19 A. lri 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 manaQer receives his or her pay.
. 2007 Texas Rate Case J0-14
Entergy Gulf States, ~nc, Page 13of19
Direct Testimony of Jay C. Hartzell
2007 Texas Rate-Case
1 A more realistic setting would allow for multiple periods, where both
2 managers arid principals would have to consider not only their immediate
3 actions, but· also their ·expected future 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 manager8 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. A'S a result of their .possibly
9 shorter time horiwns, 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-term (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-term perspectives, in decision-making and execution.
15
16 Q. 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 ..enhance >Customer w.elfar..e 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 compensation structure in -0rc:ler to accomplish this
23 obj0ctive.
'2007 T-exas Rate Case 1-0-15
Entergy Gulf States, Inc. Page 14of 19
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 performance
5 measures such as stock p~ce, the expected long-term impact of
6 managers' decisions has immediate impact on financial performance
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 o~
11 her more willing to make decisions that produce long-term b~nefits for the
12 firm, even if it is at the cost of short-term cash flows or profits.
13
14 Q. 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 decisions that would sacrifice the future
20 of the firm (and its customers) for the benefit of the immediate welfare of
21 customers. The manager might "over-invest" in immediate customer
22 service, weakening the firm's future financial position and its ability to
23 provide high-qu~lity, low cost service in the future; With limited resources,
2007 Texas Rate Case 10-16
Entergy Gulf State;s, Inc. Page 15of 19
Direct Testimony of Jay C. Hartzell.
2-007 Texas Rate-Case
1 the firm might· decide to pay for this "-over-investment" in immediate
2 customer service by taking money from long-term 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 yea.rs and the future performance of
8 the firm when. tliey decide on a course of action. If the manager over-
9 invested in immediate customer welfare, then it w0uld 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-tenn
13 viability, the manager has the incentive to position the firm to provide
14 higher levels of customer welfare in the future.
15
16 Q. WHY SHOULD · THERE BE A POSITIVE RELATION BETWEEN
17 CUSTOMER WELFARE A.ND FINANCIAL PERFORMANCE?
18 A. Back to the basic theory, then, financial measures should be part of the
19 manager's compensation 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 reasonable for several
22 reasons. First, customer welfare is difficult to measure"Completely, so it is·
23 unlikely that objective customer-based measures that one -can use in a ·
2007 T-exas Rate Case l0-17
Entergy Gulf States, Inc. Page16of 19
Direct Testimony of Jay C. Hartzell
r
2007 exas Rate Case
1 compensation structure will fully capture _what is trying to be measured.
2 Then, so long as the firm's financial performance is positively 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 Q. ARE THESE FINANCIAL THEORIES SUPPORTED BY EMPIRICAL
17 EVIDENCE?
18 A. Yes. There are multiple empirical studies published in peer-reviewed
19 academic journals that report evidence consistent with these hypotheses.
20
21 Q. HOW DO THESE EMPIRICAL STUDIES SUPPORT THESE·
22 HYPOTHESES?
2007 Texas Rate Case 10-18
Entergy Gulf States, Inc. Page 17of19
Direct Testimony of Jay C. Hartz-ell
2007 Texas-Rate·-case
1 A. There is a we.alth 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 perf.ormance. In
4 other wor-ds, firms with higher customer satisfaction seer.es tend to have
5 better financial performance, not worse. This fact from the .data is
6 consistent with the arguments. above that mor.e satisfied customers are
7 expected to result in higher profits and better overall fmancial
8 performance. This finding also suggests that financial measures--can play
9 a positive role in motivating managers to improv.e 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 maximiz.e
12 financial perforinance to the detriment of customers, which should help
13 alleviate some fears that contracts incorporating financial-performance
14 incentiv.es will lead managers to diminish their customers' welfar.e for the
15 sake of greater financial performance and higher compensation. Jn the
16 data, financial success tends to -be associated. with greater -customer
17 satisfaction, not iess.
18 There is also evidence that higher .customer satisfaction scores ar.e
19 associated with higher market values acroos firms. This empirical r.esult is
20 consistent with the widely-held notion that -the stock market is a
21 mechanism by which the long-term benefrts of customer welfare are
22 capitalized into a present value measure. This result that higher customer
23 satisfaction scores are associated with higher market values has been
2007 Texas Rate -Case W-19
Entergy Gulf States, Inc. Page 18 of.19
Direct Testimony 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 performance 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 exp~nsive 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 compen.sation that is only based on this peri9d's
11 customer welfare measures might lead managers to over-invest in current
12 customer welfare to the detriment of the long-term 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 notonly·consider the immediate welfare of customers, but to
17 also weigh future years' customer welfare and the financial 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 <;osts that
7JJ07 Texas Rate Case 10-20
Entergy Gulf States, Inc. Page 19of19
Direct Testimony of Jay C. Hartzell
2007 Texas Rate Case
1 would have been realized without the firm in distress). There is evidence
2 that firms 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 compared 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 firms wlth 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 structures that
H3 include financial-based performance measures tend to benefit oonsumers.
19
20 Q. DOES THIS CONCLUDE YOUR PREHLi:D DIRECT TESTIMONY?
21 A. Yes.
2JXJ7 Texas Rate Case 10-21
This page has been intentionally left blank.
2007 Texas Rate Case 10-22
APPENDIX B
Direct Testimony of Jay C. Hartzell, Ph.D
PUC Docket No. 37744
SOAH Docket No. XXX-XX-XXXX
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.
B ...-.....,~~~~::::..::::....::::
DATE:_...._-"--'-____;:::_.::_.::::::::.
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
Vii. Conclusion 28
EXHIBITS
EXHIBIT JCH-1 Curriculum Vitae of Jay C. Hartzell
700Q If.TI Rate Case 4-358
Entergy Texas, Inc. Page 1of28
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 B6600, 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. I 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
23 hired me as an Assistant Professor at the Mccombs School of Business
2009 ETI Rate Case 4-359
Entergy Texas, Inc. Page 2 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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.
2009 F.Tl Rate Case 4-360
Entergy Texas, Inc. Page 3 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
1 II. 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
2009 ETI Rate Case 4-361
Entergy Texas, Inc. Page 4 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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
4-362
Entergy Texas, Inc. Page 5 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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 motivate.,d 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
2009 ETI Rate Case 4-363
Entergy Texas, Inc. Page 6 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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.
2009 ETI Rate Case 4-364
Entergy Texas, Inc. Page 7 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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 incentive 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 im!)ortant 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.
2009 ETI Rate Case 4-365
Entergy Texas, Inc. Page 8 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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.
2009 ETI Rate Case 4-366
Entergy Texas, Inc. Page 9 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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.
2009 ETI Rate Case 4-367
Entergy Texas, Inc. Page 10 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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 gains 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
2009 ETI Rate Case 4-368
Entergy Texas, Inc. Page 11of28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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
2009 ETI Rate Case 4-369
Entergy Texas, Inc. Page 12 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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 ~ost 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 8RIEFL Y 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
2009 ETI Rate Case 4-370
Entergy Texas, Inc. Page 13 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
1 and the form of compensation is well qalanced 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
2009 ETI Rate Case 4-371
Entergy Texas, Inc. Page 14 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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).
2009 ETI Rate Case 4-372
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Direct Testimony of Jay C. Hartzell, PhD.
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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
2009 ETI Rate Case 4-373
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Direct Testimony of Jay C. Hartzell, PhD.
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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
2009 ETI Rate Case 4-374
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Direct Testimony of Jay C. Hartzell, PhD.
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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).
2009 ETI Rate Case 4-375
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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
2009 ETI Rate Case 4-376
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Direct Testimony of Jay C. Hartzell, PhD.
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1 attract and retain the same quality of talent. Second, costs would likely
2 rise and employee performance would likely suffer, as it would be difficult
3 to effectively and efficiently motivate employees to take actions that would
4 benefit shareholders and customers. In my opinion, customers would be
5 worse off under such a policy. This is supported by the principle that
6 individuals respond to incentives (a basic tenet of economics), and by
7 empirical work that shows workers' output responds to the institution of an
8 incentive plan. 6
9
10 Q. WOULD CUSTOMER INTERESTS BE ADVERSELY AFFECTED IF A
11 COMPANY USED SALARY AND INCENTIVES LINKED TO MEASURES
12 THAT HAVE BEEN TERMED "OPERATIONAL" ONLY? IN OTHER
13 WORDS, IF THEY PROVIDED SALARY AND INCENTIVES BASED ON
14 MEASURES LIKE RELIABILITY AND SAFETY, BUT NO INCENTIVES
15 BASED ON COST CONTROL, PROFITABILITY AND STOCK PRICES?
16 A. Yes. I believe customers would be worse off under such a compensation
17 policy. On the one hand, incentives linked to what have been termed
18 "operational" measures can improve customer welfare because the
19 company can better attract, motivate and retain talented employees.
20 Compared to the hypothetical case where a company compensates its
21 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).
2009 ETI Rate Case 4-377
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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
10 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.
2009 ETI Rate Case 4-378
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Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
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).
2009 ETI Rate Case 4-379
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Direct Testimony of Jay C. Hartzell, PhD.
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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 compe11sation 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
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Direct Testimony of Jay C. Hartzell, PhD.
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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
1O 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 both incentives based on non-dollar
2009 ETI Rate Case 4-381
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Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
1 based measures such as customer service, reliability and safety, and
2 incentives based on cost control, profitability and stock price, as does ETI,
3 management will not want to cut one in order to increase the other, but will
4 instead look for balanced decisions that help both.
5
6 Q. IS THERE REASON TO BE CONCERNED FROM THE CUSTOMERS'
7 PERSPECTIVE BECAUSE STOCK PRICES AND PROFITS ARE
8 DRIVEN BY MANY OTHER FACTORS IN ADDITION TO
9 CONTROLLING COSTS, OR HAVING A LOW COST OF CAPITAL?
10 A. No. Avoiding this concern is why firms generally do not use compensation
11 plans that consist solely of stock- or profit-based incentive pay - to do so
12 would be too risky for the employees and would lead to larger overall
13 compensation expense because risk-averse individuals would demand
14 higher compensation levels in order to compensate them for bearing the
15 risk of such a hypothetical plan. This is also why stock- and profit-based
16 incentive compensation is more important at the top of the organization.
17 Senior management can more clearly see (and anticipate) the impact of
18 their actions on the firm's stock price, so stock-based compensation is a
19 more efficient compensation tool for this level of management.
1JIOQ F.Tl Rate Case 4-382
Entergy Texas, Inc. Page 25 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
1 VI. EMPIRICAL EVIDENCE SUPPORTING TESTIMONY
2 Q. ARE THE CONCEPTS IN SUPPORT OF THE CUSTOMER BENEFITS
3 OF INCENTIVE COMPENSATION SUPPORTED BY EMPIRICAL
4 EVIDENCE?
5 A. Yes. As I discuss below, there are multiple studies published in
6 peer-reviewed journals that report evidence that is consistent with my
7 testimony.
8
9 Q. IS THERE EMPIRICAL EVIDENCE THAT THE ADOPTION OF
10 INCENTIVE TARGETS BASED ON STOCK OR EARNINGS
11 PERFORMANCE BENEFITS CUSTOMERS?
12 A. Yes. There is a published study that examines the adoption of long-term
13 incentive plans that reward managers with stock or stock-based
14 compensation, where the stock grants are based on long-run profitability. 8
15 The study finds that after the adoption of such plans, managerial
16 compensation is more closely linked to the interests of managers and
17 stakeholders, including customers. This is also consistent with the studies
18 I discuss below, such as one that links market value with customer
19 satisfaction.
8
Alka Arora and Pervaiz Alam, CEO Compensation and Stakeholders' Claims,
22 CONTEMPORARY ACCOUNTING RESEARCH, 3 at 519-547 (Fall 2005).
2009 ETI Rate Case 4-383
Entergy Texas, Inc. Page 26 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
1 Q. HOW DO OTHER EMPIRICAL STUDIES SUPPORT THE OPINION
2 THAT INCENTIVE COMPENSATION TIED TO STOCK OR
3 PROFITABILITY BENEFITS CUSTOMERS?
4 A. Earlier, I mentioned two empirical studies that provide support for my
5 opinion that stock-based incentive compensation provides benefits to
6 customers. The first study provides evidence of how the oversight of
7 companies' performance by stock-market participants can affect those
8 firms' investment behavior and curtail managerial myopia. 9 This is one of
9 the channels I discussed earlier by which the presence of stock-based
10 incentive compensation can benefit customers by encouraging managers
11 to focus beyond the short term and think about long-term efficient
12 investments. The second study shows that workers do respond to
13 incentive plans in a manner consistent with the intent behind the plans'
14 design. 10 Thus, if a company adopts a compensation plan that includes
15 incentives based on customer welfare and stock price, one can expect
16 managers to take actions to improve customer welfare and maximize
17 stock price (holding all else equal).
18 In addition, there is empirical evidence in the literature that firms
19 with higher market values tend to also have higher customer satisfaction,
20 supporting the conclusion that the goals of financial success and customer
9
Brian J. Bushee, The Influence of Institutional Investors on Myopic R&D Investment Behavior,
73 THE ACCOUNTING REVIEW, 3 at 305-333 (July 1998).
10
Edward P. Lazear, Performance Pay and Productivity, 90 THE AMERICAN ECONOMIC REVIEW,
at 1346-1361 (December 2000).
2009 ETI Rate Case 4-384
Entergy Texas, Inc. Page 27 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
1 satisfaction are interrelated. 11 This result has been shown for a broad
2 sample of firms, but also for utilities in particular. This empirical finding is
3 inconsistent with the idea that the most profitable or valuable firms
4 become that way by cutting customer service, and instead suggests that
5 there exists positive feedback between a firm's financial performance
6 (stock price) and customers' welfare, even in the utility industry.
7 Empirical evidence also exists that some firms hurt their financial
8 performance (stock price) by overinvesting in customer service. 12 This
9 result suggests that including stock price in the compensation plan will
10 help ensure against myopic investments in short-term service that would
11 come at the expense of investments that would produce greater long-term
12 benefits to customers. It also points toward the conclusion that basing
13 incentive compensation for purposes of setting rates solely on operational
14 goals could well be harmful to customers' interests in the long run.
15 Finally, there is empirical evidence that firms with lower stock prices
16 (or that are less financially healthy) face higher costs and greater risks.
17 For example, some researchers have shown how less financially healthy
18 companies have trouble responding to external shocks, and face higher
19 costs of doing business (through higher wages or worse terms from
11
Christopher D. Ittner and David F. Larcker, Are Nonfinancial Measures Leading Indicators of
Financial Performance? An Analysis of Customer Satisfaction, 36 JOURNAL OF ACCOUNTING
RESEARCH, Supplement 1998 at 1 - 35.
12 Id.
2009 ETI Rate Case 4-385
Entergy Texas, Inc. Page 28 of 28
Direct Testimony of Jay C. Hartzell, PhD.
2009 Rate Case
1 suppliers, for example ). 13 These results support yet another channel by
2 which stock-based incentive compensation should provide direct benefits
3 to customers. Stock-based incentive compensation encourages
4 managers to maintain a company's financial health, thus leading to more
5 efficient operations and greater cost control than would otherwise occur.
6
7 VII. CONCLUSION
8 Q. DOES THIS CONCLUDE YOUR DIRECT TESTIMONY?
9 A. Yes, at this time.
13
Chris Parsons and Sheridan Titman, Capital Structure and Corporate Strategy (January
2007). The article is available at titto://ssrn.com/abstract=983553.
2009 ETI Rate Case 4-386
APPENDIX C
Redacted Direct Testimony of Sarah J. Goodfriend, Ph.D
PUC Docket No. 28840
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SOAH DOCKET NO. XXX-XX-XXXX zao~ FEB -9 PH 2: 21
PUC DOCKET NO. 28840 PUBLIC UTfLIT y COMMISSION
FILING CLERK
APPLICATION OF AEP TEXAS § BEFORE THE STATE OFFICE
CENTRAL COMPANY FOR § OF
AUTHORITY TO CHANGE RATES § ADMINISTRATIVE HEARINGS
REDACTED
DIRECT TESTIMONY
OF
SARAH J. GOODFRIEND, PH.D.
ON BEHALF OF
CITIES SERVED BY AEP TEXAS CENTRAL COMPANY
CERI'IFIED TO B£ A 'T'RUE AND CORRECT
COPY OF THE ORIGINAL ON FILE WITH THE
PUBLIC lfl'ILITY COMMISSION OF TEXAS
CENTRAL RECO · DIVISION
BY:':.....liµ.u..::e:::it'...4,L...t:::;.~:C:::!!::"'(
DATE:_........_..'-..L.:...-A~I=::'
FEBRUARY 9, 2004
1 I. INTRODUCTION AND ORGANIZATION OF TESTIMONY
2
3 Q. PLEASE STATE YOUR NAME AND BUSINESS ADDRESS.
4 A. My name is Sarah Goodfriend and my business address is 1500 West 24th Street,
5 Austin, Texas 78703.
6 Q. BRIEFLY DESCRIBE YOUR EXPERIENCE AND QUALIFICATIONS
7 RELEVANT TO THIS PROCEEDING.
8 A. As an economic consultant specializing in competition and regulatory policy issues, I
9 have twenty-five years of experience in the regulated electric utility and
10 telecommunications industries. Prior to entering graduate school, I was employed as
11 an economist by the Public Utility Commission of Texas ("PUCT"). In 1983, I
12 worked for Carolina Power And Light Company, receiving a Ph.D. in economics
13 from the University of North Carolina at Chapel Hill in 1985. Since that time, I have
14 worked and testified on behalf of the Economic Policy Office of the Federal Energy
15 Regulatory Commission and the Bureau of Economics of the Federal Trade
16 Commission. I returned to the PUCT in 1992 to create an Office of Economic Policy
17 and was appointed a PUC Commissioner in 1993, serving until 1995. Before starting
18 my consulting practice, I joined the Washington D.C. office of MCI
19 Telecommunications Corporation where I was responsible for policy development
20 and providing expert witness testimony. I have been an independent consultant since
21 1997.
22 As an independent consultant, I provided expert testimony on behalf of South
23 Texas Electric Cooperative and a Central Power and Light Wholesale Customer
24 group in the AEP-CSW merger proceedings. Since then, as my resume shows, I have
DIRECT TESTIMONY 6 GOODFRIEND
remained active as an advisor or testifying witness on behalf of various market
2 participants in the electric utility and telecommunications industries. Most recently, I
3 have worked as an advisor to a group of Retail Electric Providers ("REPs") pursuant
4 to their participation in the Texas Nodal Team stakeholder meetings. Some of these
5 REPs are active in the TCC service tenitory.
6 Q. ON WHOSE BEHALF ARE YOU PROVIDING THIS TESTIMONY?
7 A. I have been retained by Cities served by AEP Texas Central Company ("Cities").
8 AEP Texas Central Company ("TCC") is the monopoly TDSP for these Cities in their
9 role as market participants, end-use customers and ratepayers.
10 Q. WHAT IS THE PURPOSE OF YOUR TESTIMONY?
11 A. Cities desire that the rates and operations of TCC not hinder the development of a
12 competitive market. Cities' experience with the deregulated market has not been
13 good. I have been asked to identify cross-subsidies, anti-competitive behavior and
14 areas where improvements to quality of service can be made. My testimony evaluates
15 TCC's (1) quality of service to retail customers, (2) request for good cause exception
16 Subst. R. §25.342(f)(D), (3) proposed discretionary service fees and (4) request for
17 pre-approval for recovery of REP bad debt expense.
18 A. PRINCIPAL FINDINGS AND RECOMMENDATIONS
19 Q. WHAT ARE YOUR PRINCIPAL FINDINGS?
20 A. My testimony reaches these principal findings:
21 1. The quality of service that TCC is providing to REPs, end-use customers and
22 the market is unacceptable and contrary to provisions of the Public Utility Regulatory
23 Act ("PURA").
DIRECT TESTIMONY 7 GOODFRIEND
1 2. The structure of TCC costs supports difficult to detect cross-subsidy of
2 wholesale operations by using and placing retail ratepayer dollars at risk.
3 3. TCC's request for a good cause exception to the PUCT's Electric Business
4 Separation Subst. R. § 25 .342(f)(D) Other Service would permit greater
5 circumvention of the PUCT's Unbundling Rules than now exists.
6 4. Transmission Construction Services and Associated Business Development
7 ("ABD") Operation and Maintenance ("O&M") Services are the two categories of
8 service that TCC offers pursuant to the Other Service exception. Neither class of
9 service complies with the requirements of Subst. R. § 25.342(f)(D)(i).
10 5. TCC's Transmission Construction Service is principally supplied using
11 personnel non-essential to T&D system operations. To avoid future cross-subsidies,
12 TCC's best course of action is to create a stand-alone Constrnction Services operation
13 separate from the regulated utility business.
14 6. TCC's non-compliance with requirements of Subst. R. § 25.342(f)(D) Other
15 service is consistent with evidence of high Administrative and General expense but
16 declining staffing/resources for retail operations that Dr. Patton finds and is also a
17 likely reason for the poor service quality for regulated retail operations that Dr. Patton
18 and I find.
19 7. Various changes need to be made to TCC's proposed Discretionary Service
20 Tariff fees, terms and conditions to improve service quality and better align TCC's
21 tariff offerings with market needs.
22 8. TCC's request for pre-approval for deferral and inclusion of any REP bad debt
23 expense is premature and contrary to policy.
DIRECT TESTIMONY 8 GOODFRIEND
Q. WHAT ARE YOUR PRINCIPAL RECOMMENDATIONS?
2 A. I recommend the Commission:
3 1. Adopt a rate of return recommendation consistent with the requirements of
4 PURA Sec.36.052 to recognize the poor quality of services TCC now provides.
5 2. Direct TCC to return to the lower level of estimated meter readings it reported
6 for each customer class prior to the inception of the retail Choice Pilot project.
7 3. Deny TCC's request for a good cause waiver of Subst. R.
8 § 25.342(f)(D)(ii)(III) Other services. Thus, The Commission should direct TCC to
9 apply the $2,542,584.341 profit TCC has failed to record as a revenue credit in this
10 proceeding to reduce the total revenue requirement in this case. 2
11 4. Immediately place a moratorium on TCC's acceptance of new Transmission
12 Construction contracts. The moratorium should not be lifted until (a) TCC
13 demonstrates compliance with Subst. R. §25.342(f)(D) Other service, or, as a
14 preferred alternative, (b) separates Transmission Construction Services completely
15 from unregulated utility operations in ERCOT.
16 5. Immediately place a moratorium on TCC's acceptance of new ABD O&M
17 contracts until (a) TCC demonstrates compliance with Subst. R§ 25.342(f)(D) Other
18 Service and (b) TCC implements the REP-survey recommendations listed below.
19 6. Direct TCC to implement the following changes to its Discretionary Service
20 tariff fees, terms and conditions:
I Profit from Updated Response to Cities 17-14, provided in Workpapers.
2 Response to Staff BA 1-5. Margins received from third-party contracts for transmission services were booked
to FERC Account No. 417-Revenues from Non-utility operations.
DIRECT TESTIMONY 9 GOODFRIEND
1 a) 6.1.2.1.8 Inaccessible Meter Fee should remain a Denial of Access to
2 Meter Fee. TCC should retain responsibility to document, upon request,
3 customer denial of access.
4 b) 6.1.2.1.6 Special Meter Reading Fee should not be charged when a REP
5 requests an actual meter re~d on an outstanding bill with estimated usage.
6 c) An Account History Fee should not be charged to end-users, REPs or
7 aggregators of record. 3
8 d) 6.1.2.1.13 Copying Fee, 6.1.2.15 Special Products/Service Fee or other fee
9 may not be charged as a substitute for the Account History Fee.
10 e) 6.1.2.1.16 Special Billing Services Fee, 6.1.2.1.13 Copy Fee or 6.1.2.15
11 Special Products/Service Fee shall not be charged to REPs or aggregators
12 requesting a Detailed Billing and Invoicing Analysis.
13 f) TCC's terms and conditions are not in compliance with Consumer
14 Protection Rules as proposed. TCC should be directed to conform its tariff
15 to the rule adopted in Docket No. 27084.
16 7. Deny TCC's request to defer any bad debt expense incurred in providing
17 service to REPs and deny TCC's request for grant of authority in this rate proceeding
18 to include such costs in TCC's next base rate case.
19 8. Direct TCC to file as non-confidential the "B Report" portion of TCC's
20 Quarterly Performance Report that ERCOT now files confidentially on behalf of
21 TCC.
3 The Account History Fee does not appear in the tariff as a proposed or existing discretionary service and so
has no tariff reference number.
DIRECT TESTIMONY 10 GOODFRIEND
Q. PLEASE PROVIDE THE LIST OF REP-SURVEY RECOMMENDATIONS
2 YOU REFER TO IN YOUR FIFTH RECOMMENDATION ABOVE.
3 A. The list is:
4 • Increase dedicated resources and reorganize job responsibilities so each REP has
5 a dedicated REP relations person. (Now there is one person "dedicated" to all
6 REPs).
7 • Create and apply job performance metrics to reward job performance relating to
8 REP satisfaction.
9 • At no charge, prepare a Detailed Billing and Invoicing Analysis for different
10 classes of meters and services for each REP or aggregator that requests it.4
11 • Schedule and offer at least one face-to-face meeting between REPs and their
12 customer service representatives annually.
13 • Provide current usage information to aggregators upon request for all active
14 premise locations ("ESI-IDs") that have provided a letter of authorization for their
15 usage information to be released to the aggregator.
16 • Annually perform an anonymous Customer Satisfaction Survey for REPs and
17 aggregators.5
18 • Provide Commission staff with a software and staffing improvement plan
19 identifying timetables, targets and budgets for Customer Service business and
4 Alternatively, TCC should produce a manual of information necessary for the REP/aggregator to perform
detailed analysis. A Detailed Billing and Invoicing Analysis includes the breakout and definition of each
charge type which underlies any composite charge provided, so that the bill or invoice may be readily
understood and interpreted.
5 The survey should be modeled on the anonymous telephone survey now being performed by CenterPoint
TDSP for REPs. Perform this survey until granted waiver of this requirement by the Commission. File the
results publicly with the Commission.
DIRECT TESTIMONY 11 GOODFRIEND
1 related Information Technology operations to improve TCC's performance with
2 protocols and other measures of quality of service discussed here.
3 Q. HOW ARE YOUR RECOMMENDATIONS RELATED TO YOUR
4 FINDINGS?
5 A. My recommendations lay out what is necessary for the PUCT to do in this proceeding
6 to (1) gain control over the unnecessary costs that TCC is imposing on the ERCOT
7 market by providing poor service quality at retail and (2) eliminate the cross-subsidies
8 of wholesale operations that TCC is providing from retail ratepayers.
9 B. ORGANIZATION OF TESTIMONY
10 Q. HOW IS YOUR TESTIMONY ORGANIZED?
11 A. This concludes Section I, Principal Findings and Recommendations. In Section II, I
12 evaluate the Customer Service TCC provides to the retail market. Section III
13 addresses TCC's request for good cause exception to §25.342(f)(D)(ii)(III) and
14 includes compliance issues related to TCC's provision of unregulated wholesale
15 service. Section IV addresses TCC's proposed discretionary service fees and Section
16 V addresses TCC's request for certain treatment of REP bad debt expense. The
17 testimony concludes with support for rate case expenses in Section VI.
18 II. CUSTOMER SERVICE PROVIDED BY TCC TO THE RETAIL MARKET
19 Q. WHAT ARE YOUR FINDINGS?
20 A. (1) AEP has unnecessarily imposed significant costs on the market, on market
21 participants, and thereby, on the quality of service the market delivers to end use
22 customers.
DIRECT TESTIMONY 12 GOODFRIEND
1 (2) AEP lacks concern for TCC's retail customers. This lack of concern results in
2 missed opportunities to improve market performance at little or no cost to TCC.
3 (3) AEP management understaffs and undersupports TCC customer service functions
4 necessary for market development and for the delivery of acceptable service quality
5 to end users.
6 ( 4) Without regulatory action in this proceeding, TCC will continue to provide a case
7 study in how TDSP interests fail to align with market needs.
8 A. STANDARDOFEVALUATION
9 1. DESCRIPTION OF UNNECESSARY COSTS
10 Q. WHAT DO YOU MEAN BY "UNNECESSARY COSTS"?
11 A. Unnecessary costs are costs imposed when a TDSP fails to perform acceptably in all
12 dimensions of service: (1) quality and timeliness of communication, (2) speed of
13 response, (3) pro-active problem solving, (4) dedication of resources and (5) accuracy
14 of response. When any one of these dimensions of service deteriorates, the customer
15 begins to experience unnecessary costs of doing business. Said differently, a TDSP
16 that is able to excel in these performance areas is contributing to minimizing the costs
17 of doing business in the market, and probably minimizing its own long-term costs of
18 providing customer service as well. End-use customers are the ultimate beneficiaries
19 when a TDSP is performing acceptably in all dimensions of service, thereby avoiding
20 unnecessary costs to market participants and consumers.
DIRECT TESTIMONY 13 GOODFRIEND
1 Q. HOW ARE END-USE CUSTOMERS HARMED BY UNNECESSARY COSTS?
2 A. Customers are harmed in three ways:
3 First, a customer suffers directly from unnecessary delay and inaccuracy. A delayed
4 bill means the customer cannot budget or exercise control over electricity costs.
5 Second, customers are harmed by prices higher than they need to be. And, third,
6 customers are harmed because it is not rational for REPs to market, develop a
7 reputation or differentiate their products on the basis of service quality.
8 Q. WHY ARE PRICES HIGHER THAN THEY NEED TO BE?
9 A. There are two paths by which prices to end-use customers increase. Economists
10 understand that in competitive markets, any increase in a suppliers' cost of doing
11 business must ultimately lead to a price increase. Unnecessary costs increase the
12 REP's cost of doing business. Because REPs must ultimately pass along service costs
13 imposed by an inefficient TDSP to end use customers, these unnecessary costs can be
14 thought of as an implicit or hidden tax on REPs, and ultimately on end-use customers.
15 Q. WHAT IS THE SECOND PATH TO HIGHER PRICES?
16 A. By raising all REPs' cost structures, unnecessary costs operate as an implicit
17 reduction in headroom. This understanding is why the Commission has been
18 concerned since before the onset of Customer Choice with "headroom". The
19 reduction in headroom is the second path whereby unnecessary costs result in a price
20 increase to end users. A reduction in headroom can limit entry or force market exit of
21 otherwise worthy suppliers. In tum, this tends to raise prices to end-users by limiting
22 the size, number or extent of diversity among suppliers.
DIRECT TESTIMONY 14 GOODFRIEND
1 Q. WHAT IS THE PROBLEM CREATED FOR RETAIL SERVICE QUALITY?
2 A. With Customer Choice, REPs have become the closest link to customers for
3 enrollment, billing, and customer care services. Yet, the quality of service the REP
4 can provide can be no better than what the REP receives upstream from ERCOT or
5 the monopoly TDSPs. Thus, it makes no sense for REPs interested in differentiating
6 their service from their peers on the basis of superior service quality to invest in
7 resources that would allow them to do so, until risks associated with TDSP service
8 quality are controllable. This important dimension of REP competition cannot take
9 root without reliably acceptable upstream service quality from TDSPs and ERCOT.
10 2. PURA STANDARDS: WHEN UNNECESSARY COSTS
11 BECOME UNACCEPTABLE COSTS
12
13 Q. WHAT PURA STANDARDS ARE INSTRUCTIVE FOR AN ASSESSMENT
14 OF RETAIL SERVICE QUALITY?
15 A. First, PURA provides some qualitative standards for assessing service quality. For
16 example, Sec. 38.022 recognizes that an electric utility may not engage in a practice
17 that tends to restrict or impair competition. As just discussed, poor TDSP service
18 quality is such a practice in the context of an emerging competitive market.
19 Second, within the Customer Safeguards for Retail Competition section,
20 (PURA Sec. 39.101), the Commission must establish customer protection standards
21 that entitle customers to, among other things, bills presented in a clear format and in
22 language understandable by customers; accuracy of metering and billing; and other
23 information or protections necessary to ensure high-quality service to customers. The
24 customer is also entitled to prompt resolution of disputes with its chosen REP and
25 TDSP.
DIRECT TESTIMONY 15 GOODFRIEND
PURA recognizes the tendency of suppliers to deteriorate service quality as a
2 method of cost-cutting and so provides for the assessment of civil and administrative
3 penalties to enforce customer safeguards.
4 Q. DOES PURA PROVIDE OTHER STANDARDS?
5 A. Yes, PURA prohibits service from deteriorating relative to standards established
6 under integrated utility operation. PURA directs the PUCT to modify its current
7 customer protection rules on or before June 30, 2001 "to ensure at least the same level
8 of customer protection against potential abuses and the same quality of service that
9 exists on December 31, 1999 is maintained in a restructured electric industry."
10 (PURA Sec. 39.lOl(f)).
11 Finally, PURA provides for a timely enforcement action and the exercise of
12 some "incentive regulation," in that PURA requires the PUCT to consider quality of
13 service when setting the rate ofreturn. (PURA Sec. 36.052).
14 3. PURA/ECONOMIC FRAMEWORK: THE ALIGNMENT
15 STANDARD
16
17 Q. ARE YOU OFFERING AN ECONOMIC FRAMEWORK FOR ANALYSIS
18 THAT YOU DERIVE FROM PURA'S STATUTORY STANDARDS?
19 A. Yes, I am. There is a simple way to understand how service quality provided by
20 TDSPs can deteriorate relative to the integrated utility world of December 1999.
21 Q. PLEASE EXPLAIN.
22 A. In the integrated utility/captive customer model, "the market" consisted of captive
23 customers, and captive customers or their representatives accessed the regulatory
24 process to provide effective feedback on utility operations. This regulatory model
25 encouraged the private incentives of utility management concerning quality of service
DIRECT TESTIMONY 16 GOODFRIEND
to be, depending on specifics of management and regulation, more or less aligned
2 with the interests of end-use customers (or at least aligned with regulatory perceptions
3 of end-user requirements).
4 Q. HOW SO?
5 A. Regulation could create incentives for the utility to align its expenditure pattern with
6 customer service requirements. In rate proceedings, regulators set prices and imposed
7 service standards. This kind of regulation provided readily available ways for end-
8 use customers or their representatives to access the regulatory process and express
9 dissatisfaction with rates, services, service offerings (rate design) and service quality.
10 Considering the total dollars at risk in generation, transmission and distribution
11 combined, utility efforts to respond to customers and manage customer relations were
12 a necessary asset-preservation investment strategy. Absent effective regulation, there
13 was no need to consider regulatory feedback effects on its balance sheet when making
14 cost/quality decisions.
15 Q. HOW HAVE THINGS CHANGED?
16 A. A new problem introduced by Customer Choice is one of "incentive alignment" for
17 the remaining regulated utility, the TDSP. One of the purposes of regulation is to
18 create incentives for a utility to "internalize" important externalities, in other words,
19 to create incentives for the utility to take into account the effects of its decisions and
20 actions on costs borne by others when this "internalization" is in the public interest.
DIRECT TESTIMONY 17 GOODFRIEND
1 Q. ARE YOU SAYING THAT AEP ISN'T PROVIDING TCC WITH ENOUGH
2 RESOURCES DEDICATED TO RETAIL CUSTOMER SERVICE QUALITY?
3 A. Yes, and I am saying more. Although a misallocation of resources is a part of the
4 answer, it is not the full answer.
5 Q. PLEASE EXPLAIN.
6 A. One can explain the poor quality of customer service at TCC as a consequence of
7 cost-cutting by AEP management in response to financial pressures (such as those
8 created by recent failed investments in unregulated businesses).6 To manage needed
9 cash flow, AEP allows the service quality offered by the regulated business to
10 deteriorate in order to compensate for cash flow lost by unregulated operations. This
11 describes a situation of unacceptable and impermissible cross-subsidy of the
12 unregulated operations by misallocation of resources from the regulated business.
13 Although the evidence is consistent with this view, I believe this unacceptable
14 cross-subsidy is a symptom as well as a contributing factor to problems with
15 customer service at TCC. Said differently, even if AEP were not cross-subsidizing
16 losses, due to the incentive alignment problem I describe, we would still find TCC's
17 service quality to deteriorate with the arrival ofretail choice in ERCOT.
18 Q. WHY AREN'T AEP-TCC'S INCENTIVES TO PROVIDE QUALITY
19 SERVICE PROPERLY ALIGNED NOW?
20 A. Incentives have changed because the odds have changed. Especially in the case of
21 AEP, significant assets are no longer at risk in this regulatory proceeding. AEP has
6 See for example, the $5.8 million in trading losses that appears against Miscellaneous Income in TCC's Rate
Filing Package, WP II-E-5. See also AEP's Annual Report for 2002.
DIRECT TESTIMONY 18 GOODFRIEND
1 sold or will sell ERCOT assets upstream and downstream of its TDSPs. Unlike the
2 other TDSPs in ERCOT, AEP no longer has significant investment in affiliated REP
3 operations whose service quality depends, at least in part, on the service quality it
4 receives from the TDSP. Moreover, AEP is prohibited under its agreement with
5 Centrica from entering the ERCOT market as a residential and small commercial REP
6 until 2006.7
7 From a utility management perspective, generation is no longer subject to
8 rate-of-return regulation by Texas regulators. In ERCOT, the individual utility
9 transmission investment decision is now subjected to an ERCOT-wide priority
10 planning process and then annual costs are socialized. In subjecting major
11 transmission projects to ERCOT staff and stakeholder review, the ERCOT planning
12 process tends to operate like a pre-investment prudence review, reducing
13 disallowance risks (except perhaps for cost overruns) for larger transmission
14 investments. Thus, compared to the old world, the dollars at risk or exposure from
15 poor service quality are significantly reduced. End-use customers' dissatisfaction
16 with service from the distribution utility no longer poses the potential threat to
17 revenues or profits that it once did.
18 From an end-user perspective, finding the responsible party has become more
19 difficult and once found, the payoffs for effort are simply lower. With socialized
20 transmission costs, end-use customers of the TDSP are no longer directly responsible
21 for paying the costs of their TDSP's transmission investments. Thus, the payoff to
7 Notice and Request for Approval of Changes in Ownership and Affiliation of Mutual Energy CPL, LP and
Mutual Energy WTU, LP, May 22,2002 Docket No. 25957, Attachments.
DIRECT TESTIMONY 19 GOODFRIEND
1 end~use customers in terms of cost/bill reductions from using the regulatory process
2 to address concerns with service quality has declined.
3 Moreover, the complexity and interdependence of market transactions
4 necessary in order to provide end-user services has increased, requiring the
5 coordinated efforts ofTDSPs, ERCOT and REPs. Not surprisingly, Customer Choice
6 engendered unprecedented levels of electricity customer complaints. 8 If customers
7 are unsure where responsibility lies, this complexity further reduces the pay-off to
8 end use customers or their representatives of holding a TDSP accountable for its
9 contribution (or lack thereof) in setting the level of service quality the market is
10 capable of providing.
11 Q. WHAT KIND OF STANDARDS HAS THE COMMISSION SET FOR TDSPS,
12 ERCOT AND REPS ?
13 A. The Commission has set quantitative standards for certain electronic transactions and
14 numerical and qualitative standards throughout its Customer Protection Rules.
15 Q. WHY HAS THE COMMISSION SET QUANTITATIVE STANDARDS FOR
16 CERTAIN ELECTRONIC TRANSACTIONS?
17 A. Essentially, the Commission has set quantitative standards for certain electronic
18 transactions in order to create accountability among parties for the success of highly
19 interdependent transactions.
8 See Report to the 78th Texas Legislature, Scope of Competition in Electric Markets in Texas, Public Utility
Commission of Texas, January 2003, page 106
DIRECT TESTIMONY 20 GOODFRIEND
Q. PLEASE EXPLAIN.
2 A. ERCOT is the central registration agent for retail premises and the electronic hub for
3 all retail electronic "enrollment" transactions. Electronic transactions are necessary
4 for customers to change REPs, change premises, receive electric service, etc. At the
5 beginning of the market, technical problems were affecting the ability of parties to
6 timely "turnaround" the necessary transactions.
7 Q. WHAT KIND OF STANDARDS APPLY TO TDSPS?
8 A. Standards are established for ce11ain transactions by ERCOT Protocols. Some
9 standards also appear in TDSP tariffs. For example, when ERCOT sends a TDSP a
10 notice of a switch request, the ERCOT Protocol requires the TDSP to send an
11 electronic acknowledgement of the request back to ERCOT within two business days
12 ofreceipt. TDSPs are also required to send their invoicing out to REPs within tariff-
13 established time frames.
14 Q. WHAT ARE THE QUARTERLY PERFORMANCE REPORTS?
15 A. Among other things, Quarterly Performance Reports provide technical information
16 about several electronic transactions. To identify how successful ERCOT, TDSPs
17 and REPs are in moving electronic transactions over their interconnected networks
18 and in completing the necessary electronic lifecycles in a timely and accurate fashion,
19 the technical report examines some of the 47 standard electronic transactions in the
20 Texas market (Texas SET) that can occur.9
9 Developed in response to early problems in turning around electronic transactions, the Performance Measure
Reports require that ERCOT report transaction volumes and "success rates" in completing electronic
transactions within established Protocols. The Commission established a benchmark for success rates equal to
98%. In other words, ERCOT, the TDSPs and REPs should strive to complete the electronic transactions that
are their portion of the turnarounds within Protocol, 98% of the time.
DIRECT TESTIMONY 21 GOODFRIEND
1 Q. DO THE QUARTERLY PERFORMANCE REPORTS PROVIDE OTHER
2 TECHNICAL INFORMATION?
3 A. Yes. Due to early market problems, a shadow system of "workarounds" or "safety
4 net" transactions came into being bypassing ERCOT and requiring the direct
5 coordination of TDSPs and REPs. The Quarterly Report requires some limited
6 reporting by TDSPs and REPs on these manual/electronic transactions and on inter-
7 company invoicing. I will be referencing some of this data later in my testimony.
8 Q. WHAT OTHER STANDARDS WILL YOU BE REFERENCING?
9 A. The PUCT has promulgated specific standards within its Consumer Protection rules.
10 A reading of these rules suggests that the qualitative standards I have suggested above
11 describe the essential elements that together can make or break service quality. IO
12 Q. HOW DO THESE FIVE DIMENSIONS OF SERVICE QUALITY RELATE
13 TO THE ALIGNMENT STANDARD FROM ECONOMIC THEORY?
14 A. Deficiencies in any one of these will impose unnecessary costs on the market.
15 Q. HOW DID YOU DECIDE TO PROCEED?
16 A. In order to investigate the quality of service provided to REPs, I decided to survey
17 REPs active in the TCC service area regarding service quality.
IO These are: (1) Quality and Timeliness of Communication, (2) Speed of Response, (3) Pro-active Problem
solving, (4) Dedication of Resources and (5) Accuracy of Response.
DIRECT TESTIMONY 22 GOODFRIEND
1 B. SURVEY DESCRIPTION AND RESULTS
2 1. INTRODUCTION AND ORGANIZATION
3 Q. HAS AEP-TCC SURVEYED REPS REGARDING THEIR EVALUATION OF
4 TCC SERVICE QUALITY?
5 A. No.
6 Q. HAVE OTHER AEP TDSPS IN STATES WITH RETAIL CHOICE
7 SURVEYED REPS REGARDING THEIR EVALUATION OF TDSP SERVICE
8 QUALITY?
9 A. No. There has been no survey. I I Moreover, there is no incentive structure in place at
10 AEP or TCC to reward employees according to REP perceptions of service quality.12
11 Q. HA VE ANY OTHER ERCOT TDSPS SURVEYED SERVICE QUALITY?
12 A. Within the last month, I understand that an anonymous telephone survey by a market
13 research firm is being conducted on behalf of CenterPoint, the TDSP in the Reliant
14 service te1Titory. To my knowledge this is CenterPoint's first formal survey of its
15 REP customers. ERCOT also has announced plans for its first customer survey.13
16 Q. HOW DID YOU PROCEED?
17 A. To investigate TCC service quality, I created and sent a REP Customer Satisfaction
18 Survey to all REPs active in the TCC service territory. I surveyed four areas of
19 importance to REP service quality: (1) Responsiveness to REP inquiries, (2)
20 Educational programming and outreach to REPs, (3) Responsiveness in resolving
11 Response to Cities 2-97.
12 Response to Cities 2-96.
13 Ercot Report to RMS, 1/14/04.
DIRECT TESTIMONY 23 GOODFRIEND
1 market problems generally, and (4) specifically, with respect to FasTrak issues. The
2 survey and cover letter is provided as Exhibit SJG-1.
3 Q. HOW IS THIS SECTION OF YOUR SERVICE QUALITY TESTIMONY
4 ORGANIZED?
5 A. First, I will introduce the survey. Second, I will report the numerical results of
6 responses on relative and absolute rankings of TCC. Third, I will review each of the
7 four topic areas for which I solicited comments. For ease of exposition, I will not be
8 discussing all the survey responses. However, I have included them all in matrix
9 form within the body of my testimony. I will be discussing some representative
10 responses that appear in the matrix.
11 Q. DID YOU EVALU ATE THE RESPONSES YOU RECEIVED'?
12 A. Yes. Research and discovery permitted me to directly evaluate some of the REP
13 responses to the Customer Satisfaction Survey. I have supplemented the REP
14 responses with additional examples or illustrations related to assessing unnecessary
15 costs imposed on the market by TCC's service quality failures.
16 Q. WHY WAS THERE A NEED FOR AN ANONYMOUS SURVEY?
17 A. Because of the day-to-day working relationship with TCC, and fear of possible
18 retaliation, REPs suggested the need for anonymous survey response. Even so,
19 several REPs I contacted indicated that they would not be responding due to
20 confidentiality concerns.
21 Q. DO YOU BELIEVE FEAR OF RETALIATION rs RATIONAL?
22 A. Yes. REPs depend upon the cooperation of TDSP personnel. It is rational to fear
23 forms of retaliation such as assigning a new employee to work an critical issue for a
DIRECT TESTIMONY 24 GOODFRIEND
particular REP, working orders from one REP before another, responding to emails or
2 phone calls more promptly, etc. that discriminate but are difficult to detect.
3 Q. ARE THERE SOME OTHER REPS YOU DID NOT EXPECT TO
4 PARTICIPATE?
5 A. Yes, based on economic self-interest it seemed less likely that I would receive
6 responses from REPs affiliated with AEP or REPs affiliated with other TDSPs.
7 Q. HOW LARGE THEN WAS YOUR POTENTIAL POOL OF RESPONDENTS?
8 A. These considerations leave 26 or 27 REPs as potential respondents. Roughly l/3 of
9 these potential respondents completed and returned the survey. The respondent group
10 of REPs included those who had been in the market from the beginning and those
11 entered later; REPs serving Residential, Commercial and Industrial customers (or
12 some combination thereof), and REPs with different market shares and distributions
13 of overall market share in AEP.
14 2. NUMERICAL RESULTS
15 Q. YOU SAID EARLIER THAT YOU WOULD BE PROVIDING DIRECT
16 QUOTES FROM THE SURVEY IN ITALICS AS REPRESENTATIVE OF
17 YOUR FINDINGS FOR EACH AREA. DO YOU HAVE A
18 REPRESENTATIVE RESPONSE FOR THIS SECTION?
19 A. Yes. It all comes down to communication and responsiveness. Resource constraints
20 may play a role but CenterPoint and Oncor find themselves well in front of AEP and
21 TNMP. The relative ranking of AEP-TCC is consistent with the individual
22 respondent's statement .
DIRECT TESTIMONY 25 GOODFRIEND
Q. HOW DID YOU PROCEED IN THIS AREA?
2 A. For each of the four survey areas (responsiveness to inquiries, education and
3 outreach, resolving market problems and FasTrak), I requested that respondents
4 provide a relative ranking of the four ERCOT TDSPs, from 1 (best) to 4 (worst). For
5 the four survey areas combined, respondents provided 30 relative rankings for AEP-
6 TCC.
7 The distribution of these ranks is represented by the following chart.
8
Figure 1: Relative Rank of TCC
Among ERCOT TDSPs
8
•Inquiries 7 7
Q)
(/) 7 mResolve Fas Trak
c: ~ Educ & Outreach
0 6
c.
(/)
D Resolve Problems
Q)
a:: 5
.._
0 4
>i
(J
cQ) 3
::s
CT 2
Q)
.... 1
u. 1
0 0 0
0
Best 2nd 3rd Worst
9
10 Q. PLEASE DESCRIBE THE CHART.
11 A. The relative rankings are clustered at number 3, with a few outliers. The chart may
12 be read as indicating that for the Inquiries responses, indicated by solid black, 7
13 respondents gave TCC a 3rd, while 1 respondent gave AEP a 2nd and the other gave
14 AEP a 4th or Worst. For Education and Outreach, indicated by the diagonal stripe, 7
DIRECT TESTIMONY 26 GOODFRIEND
1 respondents gave AEP a 3rd and 1 respondent gave TCC a 4th. That one respondent
2 did not rank TCC on the question is indicated by a "O." (The "O"s indicate non-
3 responses). While AEP does best on FasTrak, notice that there were only 6 responses
4 indicated by the hatch marks of 4 giving AEP a 3rd, 1 giving TCC a 2nd and 1 giving
5 TCC a 1. Some respondents indicated that they had not initiated FasTrak issues with
6 TCC. Others indicated they had little experience with TCC in this area. TCC fairs
7 worst on resolving market problems. While it is tempting to discuss the outliers, it
8 would be a mistake to give them too much attention, since some variation in opinion
9 is to be expected and the sample is small.
10 Q. DID YOU ALSO PROVIDE RESPONDENTS AN OPPORTUNITY TO
11 GRADETCC?
12 A. Yes. For each survey area, I requested that respondents provide a grade with
13 A=excellent, B==good, C=fair, D=poor, and F=fail. The resulting frequency
14 distribution shows more variation in this small sample than the one above. This
15 results express differences in the graders' standards as well as differences of opinion.
16 Q. DO YOU HAVE A REPRESENTATIVE RESPONSE FOR THIS RANKING?
17 A. Yes. Management needs to make customer service a priority.
18 Q. DO REP RESPONSES SHOW A DIVERSITY IN STANDARDS?
19 A. Yes. Those REPs that want to use service quality as a competitive distinction will be
20 sensitive to TDSP service quality, since their ability to distinguish themselves
21 depends upon the TDSP's service quality. REPs competing on the basis of price are
22 less sensitive to service quality issues (as long as other REPs are getting the same
DIRECT TESTIMONY 27 GOODFRIEND
1 level of service quality that they do). The distribution of REP grades is provided in
2 the following chart:
3
4
Figure 2: TCC Grade Distribution
from REP Survey
12-r-~-;::================================:::::-~-,
•Inquiries &'1 Educ & Outreach EiiJ Resolve Problems D Resolve Fas Trak
~
Ill
c: 6
0
Q.
Ill
Q) 4
a::
0 2 -
'ft
0 ......___ _ _ __
A Excellent BGood C Fair D Poor F Fail
Grades for Performance
5 Q. WHAT IS TCC'S GRADE POINT AVERAGE?
6 A. Using 4.0 for A, 1.0 for D and 0 for F, TCC's overall grade point is 1.834.
7 Q. WHAT ARE YOUR COMMENTS ON THIS CHART?
8 A. Although the numerical results are interesting, they lack the consistency that appears
9 across the repeated written responses. The frequency distributions that result visually
1O from the ranking exercises provide infonnation about where most responses lie
11 (central tendency) but also report some inconsistencies that exist in the responses.
12 The qualitative responses are much more uniform.
DIRECT TESTIMONY 28 GOODFRIEND
Q. HOW IS THE PUCT STANDARD THAT YOU RECOMMEND RELATED TO
2 THESE REP STANDARDS?
3 A. The PUCT standard is more stringent because the PUCT has the responsibility of
4 evaluating service quality in light of all market costs, costs to REPs, to the market, to
5 the competitive process and to end-users.
6 Q. IF YOU WERE GRADING TCC, WHAT GRADE WOULD YOU GIVE TCC?
7 A. Applying the standard I urge the Commission to adopt, and based on the evidence I
8 will present, I would give TCC a grade of unacceptable, a Dor an F.
9 3. QUALITATIVE RESULTS
10 Q. HOW WILL YOU PROCEED IN THIS SECTION?
11 A. This section is divided into four subsections fo
This text is long and has been trimmed here. Open the source document for the complete record.