7. Proxy Groups for Modeling

7.1. Prior Commission Decisions on Proxy Groups

The Commission has been more than reluctant to apply a natural gas proxy group to water utilities citing a belief that the industries are sufficiently different to distinguish the returns in one from the other. A proxy is a substitute. Companies selected as a proxy for a particular utility (or group of utilities) should have characteristics similar to the targeted utilities that the proxy companies are selected to represent. In order to assess comparability and reasonableness of financial model results, there should be no deviation from financial model to financial model of the companies selected for a proxy group. For each model, Applicants and DRA used data from the particular proxy groups they rely on as input to the model to derive their proposed return on equity.

In this proceeding, we had a mix of proxy groups and, as we discuss here, still find significant problems with the use of gas distribution companies as a proxy for water utilities-consistent with our very recent concerns for the three large multi-district water companies. (D.09-05-019 at 15.) In that proceeding, we rejected the attempt in the absence of any new arguments or demonstration of any change of fact or condition: "Accordingly, we assigned no weight to the testimony that relies on the natural gas distribution companies as a proxy." (D.09-05-019 at 16.)

In this proceeding, Applicants and DRA heeded our admonition in D.09-05-019¹⁰ and attempted to provide new arguments that would warrant our re-examining natural gas distribution companies as a reasonable proxy for water companies. Our concern here is that these Class A companies, except for San Jose, are significantly smaller than the three applicants in A.08-05-002 et al. Therefore, although we will review the arguments for natural gas proxy, we do so with great caution, because we believe the comparison likely has a greater size disparity (the size of the gas distribution companies) between the applicants here and the applicants in A.08-05-002 et al., and our habitual conclusion that water and gas utilities are not directly comparable.

7.2. Proxy Groups

DRA used the return requirements of investors in the common stock of two proxy groups: a group of water utilities and a group of publicly-held gas distribution companies. (Exhibit DRA-1, Page 1 of Attachment JRW-4.)

DRA's Water Proxy Group includes the following utilities:

American States Water Company (NYSE-AWR)¹¹

Aqua America, Inc. (NYSE-WTR)

Artesian Resources Corporation (NDQ-ARTNA)

California Water Service Group (NYSE-CWT)

Connecticut Water Service, Inc. (NDQ-CTWS)

Middlesex Water Company (NDQ-MSEX)

Pennichuck Corporation (NDQ-PNNW)

SJW Corporation (NYSE-SJW)

York Water Company (NYSE-SJW)

DRA's Gas Proxy Group includes the following companies:

AGL Resources, Inc. (NYSE-ATG)

Atmos Energy Corporation (NYSE-ATO)

Laclede Group, Inc. (NYSE-LG)

NICOR Inc. (NYSE-GAS)

Northwest Natural Gas Company (NYSE-NWN)

Piedmont Natural Gas Company, Inc. (NYSE-PNY)

South Jersey Industries, Inc. (NYSE-SJI)

Southwest Gas Corporation (NYSE-SWX)

WGL Holdings, Inc. (NYSE-WGL)

DRA included an analysis for the Gas Proxy Group in estimating an equity cost rate for the water companies for two reasons. First, it believes the financial data needed to perform a Discounted Cash Flow analysis for the Water Proxy Group is limited. For example, the Value Line Investment Survey provides projections for only three companies in the Water Proxy Group.¹² In addition, DRA believes that financial analysts' coverage of the water companies is also limited. In contrast, DRA argues that "better data" is available for the Gas Proxy Group to perform a Discounted Cash Flow equity cost rate study. Second, DRA believes the return requirements for investors in gas companies should be similar to the requirements of water company investors. DRA notes that both industries are capital intensive and heavily regulated, are characterized by a lack of competition, and provide distribution and delivery of an essential commodity where both retail rates and return on equity are set by state regulatory commissions.

DRA assessed risk of the two groups using six different risk measures published by Value Line. These measures include Beta, Safety, Financial Strength, Stock Price Stability, Price Growth Persistence, and Earnings Predictability. According to DRA, the two groups have similar risks as indicated by comparing their respective Price Growth Persistence and Earnings Predictability. However, Beta, Safety, Financial Strength, and Stock Price Stability measures indicate the Gas Proxy Group is slightly less risky than the Water Proxy Group. Overall, DRA believes the Gas Proxy Group is less risky than the Water Proxy Group based on the Value Line risk metrics.

7.3. Discussion

We discount DRA's first reason to use gas utilities as irrelevant: the availability of "better data" does not matter when that better data is for a different industry. Because the fact that there is better data for natural gas utilities is irrelevant, the conclusion that the Value Line risk measures show the water companies (using presumably bad data) are more risky than the gas utilities is irrelevant as well. Therefore, as in the past, we must remain highly skeptical of any direct risk comparison of water and natural gas distribution companies.

7.4. San Jose

San Jose used two proxy groups, water utilities and natural gas utilities. It applied seven criteria for its selection: (1) the companies were included in the AUS Utility Reports; (2) there were five-year earnings per share growth rate projections; (3) they had a positive five-year dividends per share growth projection; (4) Value Line determined an adjusted beta for them; (5) there was no cut or omission of dividends in common dividends for the five years ending in 2008; (6) the companies derived 60% or more income from, and 60% or more assets were devoted to, water service; and (7) the companies were not involved publicly in any merger or acquisition. We note that these criteria would have an upward bias in the modeling results by excluding less successful companies from the group.¹³ San Jose applied the same criteria to select nine successful natural gas utilities.¹⁴ We similarly reject San Jose's use of gas proxies.

7.5. Valencia

Valencia's sample group was: American States Water Company, Aqua America, Inc., California Water Service Group, Connecticut Water Services, Inc., Middlesex Water Company, and SJW Corporation. (Exhibit VWC-1 at 18-20.) Thus, its proxy group differed slightly from San Jose's and its financial modeling results varied because of the different proxy-related input data and other modeling inputs.

7.6. Park/Apple

Park/Apple argues that DRA should not include Pennichuck Corporation, arguing that although DRA's witness now believes the company's condemnation was not active, it should be excluded. Park/Apple argues that DRA is systematically trying to bias downward the results of its analysis. (Park Opening Brief at 7.) Park/Apple has concerns about including York Water Company and Artesian Resources Corporation in Capital Asset Pricing Model estimates arguing the "beta" is biased for York Water Company and unavailable for Artesian Resources Corporation. (Park Opening Brief at 7.) Park/Apple further argues that if gas utilities are used at all, there should be an upward adjustment because gas companies are less risky. The company argues that DRA is off by "no less than 74 basis points" (Park Opening Brief at 8) in its misuse of gas utilities.

7.7. San Gabriel

San Gabriel's witness Zepp used a proxy group composed of American States Water Company, American Water Works, Aqua America, Inc., California Water Service Group, Connecticut Water Service, Inc., Middlesex Water Company, and SJW Corporation. Again Pennichuck Corporation was excluded because of ongoing eminent domain litigation. (San Gabriel Opening Brief at 5-7 and citing Ex. SG-5 at 3-4.) San Gabriel and others argue DRA's proxy group, including Pennichuck Corporation, "skews" the modeling results downward.

7.8. Suburban

Suburban's proxy group was similar to the others, including DRA, but did not include Artesian Resources Corporation and Pennichuck Corporation which were included in DRA's proxy group. These companies' inclusion has been problematic in other proceedings. (Suburban Opening Brief at 3-4.)

Suburban is very opposed to DRA's use of the gas proxy group, arguing DRA's inclusion of a gas proxy group is inappropriate:

In many ways, the water industry is significantly more risky than the gas industry. For example, because water is the only utility service that customers ingest, water utilities face unique health concerns. Also, the water utility industry is significantly more capital intensive than the gas distribution industry, and each new customer requires significant new investment, unlike the gas distribution industry, which can obtain additional load with minimal, if any, investment. Finally, unlike the gas distributors that have an abundance of supply, source of supply issues for water utilities are a significant concern, especially in California. (Suburban Opening Brief at 4, citing to Ex. SUB-3 at 10.)

We find these arguments are not supported by any analysis. For example, while it is true people drink water and there is an associated health risk, natural gas is extremely explosive and can also suffocate people. So there are other "unique" concerns with gas where we would have to analytically determine which risk is greater-death by water or death by gas. We also note that Suburban does not prove its assertion that water is more capital intensive or requires more new investment per customer.

¹⁰ Although D.09-05-019 was not adopted until May 7, 2009 (published May 8, 2009), the proposed decision was first served on December 19, 2008. Thus we presume parties, DRA in particular, were aware of the proposed decision and the continuation of the policy to exclude natural gas proxies for water companies.

¹¹ NYSE is the New York Stock Exchange; NDQ is the NASDAQ Stock Market. The three to four-letter acronyms are the company's stock identification or "ticker symbol" used by the exchanges.

¹² Value Line is a stock analysis service with various publications. http://www.valueline.com/.

¹³ The water companies in this group were: American States Water Company, Aqua America, Inc., California Water Service Group, Middlesex Water Company, SJW Corporation, and York Water Company.

¹⁴ The natural gas companies in this group were: AGL Resources, Inc., Atmos Energy Corporation, Chesapeake Utilities, Delta Natural Gas Company, Laclede Group, Inc., Northwest Natural Gas Company, Piedmont Natural Gas Company, Inc., Southwest Gas Corporation, and WGL Holdings, Inc.