Q. please state your name and business address

A. My name is Austin Joseph Slater, Jr. My business address is 4301 Wilson Boulevard, Arlington, Virginia, 22203.

A. I am a Vice President with the National Rural Electric Cooperative Association ("NRECA") and have been asked to provide testimony regarding the investment and diversification activities of rural electric cooperatives and the justifications for these activities generally. I have also taken the opportunity to correct some of the inaccuracies proffered by the Complainants, Mid-Atlantic Petroleum Distributors Association (“MAPDA”) and the Mid-Atlantic Propane Gas Association (“MAPGA”), in their Complaint. I will also respond to the Direct Testimony of Burnice C. Dooley, filed on behalf of MAPDA and MAPGA. Choptank Electric Cooperative ("Choptank Electric") and Southern Maryland Electric Cooperative ("SMECO") are members of the NRECA. NRECA is the national trade association representing 870 distribution cooperatives, 60 generation and transmission cooperatives, and 38 statewide associations; collectively, NRECA represents over 35 million consumer-members (13 million electric services) in 46 states. NRECA services to its members include conferences and training, legislative and regulatory advocacy, and employee retirement and health benefit plans.

A. I received a Bachelor of Science degree in Business Administration and Economics from Shepherd College in 1976. Subsequently I graduated from the George Washington University in 1983 with a Masters of Business Administration degree in finance and investments.

A. Yes, I have represented SMECO before the Public Service Commission of Maryland ("PSC" or "Commission") in its continuing wholesale purchased power cost adjustment Case Nos. 7122, Phases VI through XVI, and 8504, Phases (a) through (n). I also represented SMECO in retail rate cases numbers 7724, 7853 and 8314. Finally, I have represented Choptank Electric and SMECO in PSC Case No. 8678, the Commission’s initial inquiry into electric industry restructuring.

A. I reviewed the complaint of MAPDA/MAPGA, the filed testimony of Mr. Burnice Dooley, and the answers of Choptank Electric, Choptank Home and Business Services, and SMECO. I have also reviewed the discovery requests and responses propounded by the parties to this proceeding.

A. Electric cooperatives are consumer-owned corporations, governed by an elected board of directors. They were initially formed to provide central station electric service to areas of the nation that investor-owned and/or municipal electric utilities were unwilling to serve. Electric cooperatives operate “at cost” and are formed on the basis that all operating revenues paid by their members, less operating costs, shall ultimately be returned to the members; it is a zero sum game as regards profit. Consequently, as recognized in the Internal Revenue Code, Section 501(c)(12), most electric cooperatives are exempt from income taxation. To the extent the cooperative receives operating revenues in excess of its operating costs, the excess funds are provided, on an interim basis, to the board and management as equity capital. These contributions by the cooperative's members are frequently called capital credits, patronage dividends, patronage capital, equity capital, or member-equity.

Cooperatives use this financial resource for electric plant addition, replacement and renewal, investments in associated organizations, research and development, survey and investigations, member communication and education, and other similar proper and useful purposes all to the benefit of the consumer-members, prior to “rotating” the funds back to the members in proportion to the value or quantity of business done by each member with the cooperative.

The cooperative’s board of directors is elected from, and by, the members of the cooperative. In addition to serving as stewards for their constituents’ financial and service interest, they articulate, through policy-governance, the satisfaction of their members’ needs, and advocate for their welfare. The will and preference of the membership is ensured through the democratic processes of director election, annual meetings (a forum for members to discuss cooperative policy and suggest action), and direct one-on-one access to members of the board.

A. Electric cooperatives are not unlike their investor-owned counterparts in that they too are confronting the very difficult and uncertain dynamics of the following four forces:

A. Most significant, and most germane to this proceeding, has been the remarkably effective effort by electric cooperatives to diversify their product and service portfolio to simultaneously address all four of the challenges identified above. Diversified products and services have been a favorable development for many cooperatives because they provide the twin benefits of meeting member needs by giving members additional options from an already reliable and trusted service provider and of giving the cooperative the added business stability realized by a balanced portfolio, a proven business strategy.  Some products, most notably fuels, offer a singularly winning solution by responding to the forces identified above. For example, multi-fuel capability offers the future benefit of allowing the cooperatives to follow the rapid advancements in fuel-cell technology by supplying the fuel for this alternative electricity resource. Similarly, diversification of products and services offers today's cooperatives relevance and strength in the evolving marketplace, as their founding members, who witnessed the cooperative illuminate their homes and farms for the first time, are rapidly replaced by a new generation of customers with much higher and more sophisticated expectations. 

Just last week, the Public Utilities Subcommittee of the Environmental Committee of the Maryland House of Delegates held a briefing related to SMECO's and Choptank Electric's activities pertaining to MACS. Dr. Kenneth Gordon, an economist and former Chairman of the Maine and Massachusetts commissions, testified on affiliate issues relating to the Cooperatives' participation in non-core markets, including the sufficiency of the Commission's Order No. 76292 standards of conduct in protecting the competitive process in Maryland. Among other things, he testified to the need for companies like SMECO and Choptank Electric to operate in whatever markets they judge most likely to be beneficial, a belief that I share. I have attached his testimony as Attachment 1.

In short, diversification by cooperatives is beneficial. It meets member needs by allowing the boards and managers of cooperatives to build on and leverage the existing skills and resources of the cooperative while staying close to their service focus and traditional mission.

A. Cooperatives sometimes work independently and sometimes in alliance with other cooperatives and organizations. NRECA is frequently asked to provide consultation on this decision. Going it alone and/or starting-up a venture may represent significant end gains, but usually with greater risk. Partnering with other cooperatives and service providers generally reduces the return, but also may significantly reduce the risk while allowing the cooperative to achieve member service objectives. The creation of Mid-Atlantic Cooperative Services ("MACS") demonstrates an excellent example of diversifying risk through partnering. For example, 17 North Carolina cooperatives have pooled their resources to form Diversified Services, Inc., a propane sales and service, transportation, and facilities fabrication provider.

A. First, let me note that both Congress and the Rural Utilities Service have encouraged electric cooperatives to invest in the economic development of rural areas¹. Likewise, Congress has encouraged electric cooperatives to develop their resources and ability to achieve the financial strength needed to enable them to satisfy their credit needs². In surveys taken since 1996, cooperative managers and board members have indicated the following four reasons for diversification (in descending order of frequency):

A. No. Product and service diversification by electric cooperatives is nothing new and, generally speaking, cooperatives have always been in some form of diversification. Traditional examples include: in-store kitchens and home appliances, development of telephone cooperatives, electrical wiring services, financing programs, and satellite TV. It is important to note that cooperatives didn’t decide one day that diversification was important to their future; rather, electric cooperatives have long approached diversification as consistent with and vital to fulfilling their objective of service to their member owners and communities.

A. We now have good data to demonstrate this phenomenon, as gathered from the voluntary responses of 577 electric cooperatives to a survey³ on diversification. The table below presents, for the 2001 survey, the five most frequent responses to diversification service and product offerings, segregated into two separate streams, core and non-core (the number of respondents are indicated in brackets following each business):

Top Core Diversified Businesses	Top Non-Core Diversified Businesses
1. Home Surge Protection (387)	1. Financing Programs (133)
2. Power Quality Devices/AMR (173)	2. Internet Service, dial-up (128)
3. Green Power (82)	3. Propane Gas (105)
4. Stand-by Generation (68)	4. Satellite TV (96)
5. Automatic power outage notification (48)	5. Telephone, long-distance (84)

It should be noted here that when I refer to “core” services and product offerings as listed above, I am not necessarily using the word “core” as the Commission defined it in Order No. 76292 in Case No. 8820. I am using “core” here more broadly; that is, I am using “core” to signify that the new service is either the provision of electric energy itself or the provision of a technology service exclusively and directly driven by the usage of electricity.

Significant other non-core responses included a wide and interesting range of activities: appliance sales and service (69), HVAC (51), cellular telephone service (37), water (35), natural gas (30), waste water (23), fuel oil (16), and several others.
Clearly, the majority of our nation’s electric cooperatives have elected to diversify into other businesses, and over 100 are selling and servicing in the propane market. In the year 2001 alone, 37 cooperatives entered the propane business. The complaint of MAPDA and MAPGA is clearly out of step with actual practice across the country.
Q. WITH REGARD TO THE PROPANE GAS INVESTMENTS, DO YOU SEE ANY SIMILARITY BETWEEN THOSE INVESTMENTS BY COOPERATIVES AND NATURAL GAS INVESTMENTS BY INVESTOR-OWNED UTILITIES?

A. Yes, propane sales and service by an electric cooperative is comparable to the operation of a natural gas subsidiary by an investor owned utility, and for many of the same reasons cited earlier (e.g. multi-fuel strategy, evolving energy technology, consumer expectations). In fact, natural gas operations frequently sponsor propane operations on the periphery of their service area to establish a market presence and recruit customers in anticipation of the extension of their pipelines. The only ostensible but subtle difference is the gas orifice used in the appliance or burner. Another factor lending to this sense of comparability is that many cooperatives are metering propane sales (traditionally natural gas sales are metered and billed after consumption, whereas propane is delivered to a large tank and billed at delivery). The advent of metered propane by cooperatives has been a highly popular feature with their customers, and furthers the comparability to metered natural gas. The sizeable customer advantage provided by cooperatives offering metered propane is a likely reason why the conventional market is adverse to the entry of electric cooperatives into the propane business.

A. No. Electric cooperatives should not be unfairly singled-out for the unique and specialized restrictions proposed by the Complainants. The cooperative members’ interests are best served by relying on the democratic processes currently in place that allow an elected board of directors, and their delegated management team, to make such determinations as guided by the welfare and advancement of their stated mission. Placing any restriction on the cooperatives would represent the usurpation of member control of a vital asset at a time when it is vitally needed for the success and survival of their organizations. The MAPDA/MAPGA proposal ignores the rapidly evolving energy marketplace and the unfettered resources available to competitors vying for the cooperative’s customers, most notably other regulated utilities and energy marketers. The survey also revealed that approximately 80% of the cooperatives that are diversifying rely on internally generated financing to fund all or a part of the service(s). Restriction on these funds would literally place the Maryland cooperatives in handcuffs as they form a response to these new and dynamic forces and endeavor to meet their members’ expectations.

A. Yes, restrictions are already in place by cooperative financial lenders, as checks on the security of their debt. The Rural Utilities Service ("RUS"), an agency of the Department of Agriculture, which serves as the principal lender to electric cooperatives, has placed a restriction of 15% of total utility plant on cooperative investments without RUS approval⁴. If a RUS borrower meets other stringent financial criteria, then it may have increased investment flexibility⁵ MACS is a good example of the type of investment contemplated by the RUS. Examples of such investments include, without limitation, water and waste water systems, telecommunications, and natural gas distribution systems. Alternately, for those cooperatives who have “bought-out” of the RUS lending program and have elected to borrow all long-term debt from the National Rural Utilities Cooperative Finance Corporation ("CFC"), they must observe a restriction of 10% of total utility plant, or 50% of equity, whichever is greater. Choptank Electric borrows all long-term debt from CFC, whereas SMECO is an RUS borrower, and supplemental CFC borrower; therefore, Choptank Electric’s limitation is about $32 million and SMECO’s is about $58.7 million, utilizing year-end 2001 financial reports. If the principal lenders to these two cooperatives (which owe them literally hundreds of millions of dollars) find comfort and security in providing these investment parameters, such existing restrictions should be acceptable to the Maryland PSC as prudent and reasonable safeguards. The self-serving limitations proposed by MAPDA and MAPGA are not necessary.

A. Choptank Electric, through Choptank Home and Business Services, and SMECO have taken a reasonable and measured financial position in MACS, which offers significant strategic and market potential. This step represents prudent and thoughtful action by the cooperatives in response to industry restructuring, competitive market forces, evolving technology, and changing demographics and expectations of their membership. Each cooperative, either indirectly in the case of Choptank Electric or directly in the case of SMECO, has invested $2.65 million in MACS, representing a very modest allocation (4.5% and 2.3% respectively) of member equity. In my observation, this level of investment in a non-core activity is relatively low in comparison to other cooperatives in the country.

Finally, to the credit of both of the cooperatives' boards and management, the risk associated with their investment has been further tempered by the existence of three investing members, and further enhanced by the selection of a pre-existing, going-concern operation. Consequently, in my opinion, the boards and management of the cooperatives have made a sound decision in their investment in MACS.
Q. When WOULD a cooperative typically EXPECT to realize a financial benefit from a diversification investment?

A. That is difficult to answer with precision. It would be dependent on the type of diversification investment, the market, and certainly the economy generally, to name just a few variables. A profit would not be expected in many cases for three to five years.

A. No. Mr. Dooley is misinformed. My investigation indicates there were several meetings of each subsidiary board in 1998.

17. 
    DO THE CHOPTANK ELECTRIC AND SMECO INVESTMENTS IN MACS UNDULY RISK THE RETURN OF PATRONAGE DIVIDENDS TO THE MEMBERS OF CHOPTANK ELECTRIC AND SMECO?
    

1. 
   In my opinion, the investment in MACS will not adversely impact the return of patronage dividends to the cooperative members. It may in fact enhance the intermediate term potential for capital credits and ensure the long-term success of the cooperatives, thereby augmenting the return of capital to the members. There is a misconception among some people that a cooperative's investment like the ones that Choptank Electric indirectly and SMECO directly made in MACS would reduce the return of patronage capital to members. As I explain below, this is not the case. In fact, prudent diversification investments may actually pose less of a risk to returning capital credits than plant investments. Finally, the low magnitude of this investment constitutes minimal financial exposure.
   

A. Certainly. A basic understanding of accounting is all that is required to see why return of patronage capital is not impacted by virtue of making an investment. One must first understand the balance sheet-- it is a snapshot in time of a company's financial position. It lists the assets of the company on its left side and the liabilities of the company and owners' equity on its right side. In the world of electric cooperatives, "owners' equity" is referred to as "patronage capital."

A. At the end of each year, a cooperative's board of directors determines the amount of that year's net operating margins, which are then allocated to, or "earmarked" for, members. It is important to note that this allocation, or earmarking, is not a distribution or return of margins to members. It is earmarked, ultimately to be returned to members, perhaps many years later. The time of the return of capital to members varies from cooperative to cooperative and is based upon the policy adopted by the cooperative's board of directors, as well as other financial requirements imposed by lenders and other financial considerations. In this regard, allocating net operating margins is much like issuing an "IOU" to each member. In the meanwhile, the cooperative uses those margins for other purposes, such as to build substations, erect poles and wires, pay employees, and make investments.

A. In the cases of Choptank Electric and SMECO, neither of their investments in MACS impacted either cooperative's income statement. Therefore the MACS investments did not affect net margins in that year. Both cooperatives (SMECO directly and Choptank Electric indirectly through Choptank Home) made their investments using a balance sheet transaction. That is, they exchanged one asset, cash, for another asset, an investment. By doing so, each cooperative maintained the same level of assets immediately after the investment as they had just prior to the investment. Their equity, or patronage capital, was unaffected. Moreover, because net margins (again, an income statement item) were also unaffected by the balance sheet transaction, the return of patronage capital was unaffected as well.

A. Yes, I do. First, though, I would like to explain what “capital credits” are. Capital credits to an electric cooperative member are akin to dividends to an investor-owned utility shareholder. There is one distinction, however. Capital credits are a return of capital to an electric cooperative member; dividends are a return on capital to an investor-owned utility shareholder. The return of allocated net margins as I described earlier is done through capital credits.

A. This statements are inaccurate and unsupported. As noted earlier in my testimony, diversification of products and services is a time-tested strategy for electric cooperatives. Today, hundreds of electric cooperatives are leveraging the strength of this business model by providing an array of vital services to their members. The mission of electric cooperatives is, and always has been, to meet member needs and expectations. That does not mean, however, that member needs and expectations remain the same. Not only has the mission of electric cooperatives remained unchanged, the very survival and success of the cooperatives may be dependent on this very attribute in an era of restructuring, customer choice, and rapid technological change.

A. Many cooperatives across the country own or are investors in “for profit” businesses. The fact that they have invested in these businesses in no way changes or jeopardizes the existence of the utilities as electric cooperatives. They still operate on a cooperative basis and still are governed by cooperative principles. Similar to MACS, for-profit companies in which electric cooperatives invest lawfully and fairly provide goods and services, earn a return on their investment, pay income taxes and return the net to the owners of the cooperative. I see nothing wrong with this extensively utilized business model, and note no arguments in the Complainants' case that support their objection. Creating and owning a for profit business is no more at odds with being a cooperative than is depositing money in an interest-bearing bank account.

A. The statement is without grounds, wholly inaccurate and serves as testament to the overall tenor of strained arguments by the Complainants or, perhaps, the fundamental lack of understanding of electric cooperatives. I personally have provided professional consulting services to cooperatives wishing to merge or consolidate in Colorado, Kentucky, North Carolina, Ohio, Pennsylvania, Tennessee, Texas, and Washington. MACS is a modest pooling of financial resources, in tandem, to fund a joint venture offering significant strategic and financial potential to the cooperatives. It was not a merger or consolidation by any definition of these terms. A merger or consolidation represents the complete combination of two organizations into one, with liquidation of the original corporation(s) and the survival of one of the parties or creation of a new corporation. Under a comprehensive Agreement of Merger/Consolidation, all debts, assets, and properties are transferred. Articles of Incorporation, by-laws, policies, contracts and other instruments are amended or redrafted. A newly constituted board of directors, officers, and management team is selected. Mergers or consolidations require enormous legal, regulatory, operational and governance processes involving considerable time, effort and investment. MACS is a newly formed investment entity and cannot possibly be confused with a consolidation or merger. The MAPDA/MAPGA argument suggests, for comparison, that the proposed merger of the Potomac Electric Power Company and Baltimore Gas and Electric Company in the 1995 –1997 timeframe is analogous to the three party investment in MACS. It is not.

A. Yes, it does.