9. The Cost of Equity

In competitive markets for goods, the return on common equity is determined by the relative risks of alternative investments and the willingness of individual investors to accept varying degrees of risk. In a closely regulated market, regulation substitutes for competition and the regulator, acting as a substitute for the market, provides investors an opportunity to earn a fair and reasonable return for accepting the degree of risk presented by the regulated business.

Because DRA essentially responded to the five separate analyses for cost of equity, we tend to use DRA's analysis and critique of Applicants as an outline of our review of the whole record. This decision does, however, rely on the entire record (all served and filed documents and pleadings, all exhibits and testimony) but it is not necessary for us to spend hundreds of pages to review and critique every statement, figure, or calculation in the body of this decision.

9.1. Caution When Using Financial Models

The parties have shown that the seemingly academic and rigorous financial models for deriving cost of capital can be "played like a fiddle," producing significantly different tunes depending on whose fingers are on the strings and bow. Thus, the Commission must, as always, exercise extreme caution and critically review the wide range of results seemingly rendered from the same models held in different hands. Recently for San Gabriel, one of the current applicants, we noted:

What stands out in a comparison of the testimony of the experts is the inevitable and pervasive use of [their] judgment, which colors all results. (D.07-04-046 at 58.)

We also noted at that time:

Although the parties agree that the models are objective, the results are dependent on subjective inputs. For example, each party used different proxy groups, growth rates, and calculations of market returns. (Id. at 57.)

The financial models commonly used in water utility cost of capital proceedings²¹ are the usual suspects: Discounted Cash Flow Analysis and Capital Asset Pricing Model, both of which are highly susceptible to subjective inputs. Various other models and measures of risk premium analysis have also been proposed by the parties. None of the models are independently reliable-in terms of measuring return without subjective input and interpretation²²-or persuasive on their own. Therefore, the Commission has historically reviewed an array of models with varied assumptions before exercising its judgment in adopting a return on equity.

Even though the parties argue that the result from their particular use of the financial models is objective, the results for every party are actually completely dependent on the subjective selection of inputs. From the financial models' varying results, the parties advance arguments in support of their respective analyses and criticize the input assumptions used by the opposing parties. It should be noted here that none of the parties agreed with the financial model results of the others. For example, using a seemingly academic and rigorous financial model for Discounted Cash Flow, we are offered the following recommendations for a return on equity depending on who plays the fiddle:
San Jose's model derives 11.87%,²³ Valencia derives 12.0%,²⁴ Park/Apple derives 13.7%,²⁵ San Gabriel derives 12.8%,²⁶ Suburban derives 11.15%,²⁷ and DRA derives a very different result of 9.81%.²⁸

In the final analysis, it is the application of informed judgment by the Commission, not the so-called precision of financial models, which is the key to adopting a fair return on equity and overall cost of capital. We affirmed this view in D.89-10-031, noting that all models have flaws and, as we have routinely stated in past decisions, the models should not be used rigidly or as definitive proxies for the determination of the investor-required return on equity. Consistent with that skepticism, we find no reason to adopt or endorse the financial modeling of any single party. The models are only helpful as rough gauges of the range of reasonable outcomes.

9.2. Legal Standard

The legal standard for setting the fair rate of return has been established by the United States Supreme Court in the Bluefield and Hope cases.²⁹ The Bluefield decision states that a public utility is entitled to earn a return upon the value of its property employed for the convenience of the public, and sets forth parameters to assess a reasonable return. Such return should be equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings attended by corresponding risks and uncertainties. That return should also be reasonably sufficient to ensure confidence in the financial soundness of the utility, and adequate, under efficient management, to maintain and support its credit and to enable it to raise the money necessary for the proper discharge of its public duties.

Hope held that the value of a utility's property could be calculated based on the amount of prudent investment minus depreciation, which we call rate base. Hope reinforces the Bluefield decision and emphasizes that the returns should be sufficient to cover operating expenses and capital costs of the business. The capital cost of business includes debt service and stock dividends. The return should also be commensurate with returns available on alternative investments of comparable risks. However, in applying these parameters, we must not lose sight of our duty to utility ratepayers to protect them from unreasonable risks including risks of imprudent management.

We attempt to set the return on equity at a level of return commensurate with market returns on investments having corresponding risks, and adequate to enable a utility to attract investors to finance the replacement and expansion of a utility's facilities to fulfill its public utility service obligation. To accomplish this objective, we have consistently evaluated analytical financial models as a starting point to arrive at a fair return on equity.

²¹ And previously as a part of general rate cases.

²² For example, proxy groups, growth rate, or earnings assumptions.

²³ Exhibit DRA-1 at Appendix B-51.

²⁴ Exhibit DRA-1 at Appendix B-55.

²⁵ Exhibit DRA-1 at Appendix B-53.

²⁶ Exhibit DRA-1 at Appendix B-53.

²⁷ Exhibit DRA-1 at Appendix B-50.

²⁸ Exhibit DRA-1 at 34.

²⁹ Federal Power Commission v. Hope Natural Gas Company, 320 U.S. 591 (1944) and Bluefield Water Works & Improvement Company v. Public Service Commission of the State of Virginia, 262 U.S. 679 (1923).