16. Relative Risks and Company Specific Risks
16.1. Overview
The Commission is always wary of adopting risk premiums added beyond the results derived from the financial models. Even when we adopt a premium, we do so cautiously, as we did for Apple Valley:
We stress that the inclusion of a risk premium is not automatic, and in Apple Valley's next general rate case, it must continue to meet its full burden of proof for its proposed return on equity and any request for a risk premium addition. (D.05-12-020 at 20.)
DRA makes several adjustments to its base return on equity recommendation-25 basis points upwards for Valencia, and 25 basis points downwards for Suburban. DRA also proposes a 25 basis point adjustment upward for risk to Park/Apple but then offsets it with a further 25 basis point adjustment due to an adopted Water Revenue Adjustment Mechanism.
16.2. DRA's Relative Risk Analysis
Exhibit DRA-1, Page 2 of Attachment JRW-13 shows the operating revenues, net plant, pre-tax interest coverage, common equity ratio, and return on equity for the Water Proxy Group and the California water companies. On average, the California water companies are smaller in terms of operating revenues and net plant and have higher pre-tax interest coverage, common equity ratio, and return on equity. These indicators suggest to DRA that whereas size may indicate the California water companies are riskier than the Water Proxy Group, the other indicators-especially the much higher pre-tax interest coverage and common equity ratios-suggest they are less risky than the Water Proxy Group.
DRA argues the companies' assertions of risk are "overblown" and that:
None of the applicants performed [a] systematic risk study, but rather emphasized such subjective factors as alleged threats to their water supply and alleged regulatory risk. Thus, the Applicants' claims of peril as justification for a substantial risk premium should be dismissed as little more than rhetoric. Moreover, what is notably lacking in the record of this case is any concrete evidence that any of the Applicants have experienced challenges in obtaining financing in recent years, despite the fact that all of them have existing authorized [returns on equity] that are far below what they are seeking in this proceeding. (DRA Reply Brief at 5.)
To gauge the relative riskiness of the California water companies, DRA performed a study of the authorized versus earned return on equity for the five California water companies and its Water Proxy Group. DRA performed two risk assessments. First, DRA compared the earned versus the authorized return on equity over the past five years. In this test, under-earning an authorized return on equity indicates higher risk. Second, DRA computed the Coefficient of Variation48 (coefficient) of the earned return on equity over the past five years. As such, it allows for comparison between observations. In this test, a higher coefficient indicates higher risk.
DRA used the median as a measure of central tendency because it argues that the California water companies are significantly affected by Suburban's current high return on equity. Over the past five years, Applicants under-earned their authorized return on equity, with a median level of underperformance of -0.67%. The range is from +8.35% for Suburban to -1.25% for Valencia.
By comparison, the median level of underperformance for the Water Proxy Group is -1.70%. The range for the Water Proxy Group is from +2.07% for
SJW Corporation to -5.03% for Southwest Water Company.49 As such, the level of underperformance is greater for the Water Proxy Group than for Applicants. In the second test, the average coefficient for the five California water companies is 0.17, with a range from 0.06 (Suburban) to 0.30 (Park /Apple). The average coefficient for the Water Proxy Group is 0.28, with a range from 0.08 (Aqua America, Inc.) to 0.67 (Pennichuck Corporation). The coefficient test also indicates greater riskiness for the Water Proxy Group than Applicants.
DRA argues its results indicate that, on average, Applicants are less risky than the Water Proxy Group. As such, the equity cost rate results for the Water Proxy Group are applicable to Applicants. DRA argues the Commission has traditionally provided for a premium for smaller water companies. DRA's relative risk studies indicate that no such premium is needed.
DRA averaged the results of its two risk studies to assess the relative risk of Applicants. (Exhibit DRA-1, Panel A, Page 5 of Attachment JRW-13.) According to DRA, Suburban (the middle-sized of the five50) is the least risky of the five companies. San Jose and San Gabriel are in the middle in terms of risk, whereas Park/Apple and Valencia (the two smallest) are the riskiest of the five.
DRA believes Applicants are, overall, a little less risky than its Water Proxy Group, and could argue that no risk adjustment is necessary. However, the range of the risk premium study results indicates that some of the Applicants are somewhat riskier than the average of the Water Proxy Group, and some are somewhat less riskier than the average of the Water Proxy Group. Therefore, DRA believes some adjustment may be necessary.
According to DRA, Park/Apple and Valencia are rated the riskiest based on the average relative risk ranking. (Exhibit DRA-1, Panel B, Page 5 of Attachment JRW-13.) DRA recommends a 25 basis point risk premium for these companies. However, because Park/Apple has a risk-reducing decoupling mechanism-a Water Revenue Adjustment Mechanism, the 25 basis point risk adjustment for Park/Apple is unnecessary. DRA argues that a full decoupling reduces significantly the water utilities risk by protecting them from the downside of loss sales. (Tr.Vol. 3, Sanchez/ll. 19-23.)
The average relative risk ranking results place San Jose and San Gabriel in the middle, therefore DRA did not recommend a return on equity adjustment for those two companies.
Finally, Suburban's average relative risk ranking demonstrates a low risk profile. Therefore, DRA recommended a 25 basis point reduction to the benchmark return on equity to reflect the low level of risk for Suburban.
Thus, in summary, DRA's recommended returns on equity are: Suburban-9.50%; San Jose-9.75%; San Gabriel-9.75%; Park/Apple-9.75%; and Valencia-10.00%.
16.3. The Relevance of Size
Applicants' witnesses provide risk adjustments intended to account for differences in size or unique risks of the individual water companies. DRA disagreed entirely arguing size does not matter and is not a quantifiable risk for Applicants. DRA also argues that none of the Applicants performs any type of company-specific quantitative risk analysis. Each applicant primarily quantifies its recommended firm-specific risk premiums by citing the study by Ibbotson Associates (now Morningstar) which indicates that the stock returns provided by small firms are higher than the returns of large firms.
DRA opposed this justification for a firm-specific risk premium for several reasons. First, for the Ibbotson study of historical stock returns of small firms, one-half of the historical return premium is not properly computed.51 Second, DRA argues the Ibbotson study's size premium is based on the companies' stock returns with betas which are much higher than those of water utilities. Thus, DRA argues this use of a size premium is incorrect because the included premium is for industries that are much riskier (i.e., with higher betas) than the water utility industry. Third, DRA argues that utility stocks do not exhibit a significant size premium.52
A number of factors, according to DRA, account for this phenomenon. Utilities are regulated closely by state and federal agencies and commissions and hence their financial performance is monitored on an ongoing basis by both the state and federal governments. In addition, public utilities must gain approval by government entities for common financial transactions, such as the sale of securities. Also, unlike other industries, public utilities' accounting standards and reporting are standardized. Finally, a utility's earnings are determined through the ratemaking process where regulators review performance.
DRA objects to Dr. Zepp's study on risk. First, the method to estimate Discounted Cash Flow growth and equity cost rates is not consistent with the Discounted Cash Flow approach he used in this proceeding. Second, Dr. Zepp has made no separate assessment of the riskiness of the large and small water companies and so he cannot conclude that size alone-relative to other risk factors such as weather, economy, water source, etc.-is the determining risk factor.
Third, DRA argues Zepp relies on two large and two small water companies and thus the study is statistically unreliable.
Lastly, DRA argues that smaller water utilities are not necessarily more risky than larger water utilities, citing a recent Standard & Poor's article:53
Our criteria revision reflects our view that for general obligation ratings, a small and/or rural issuer does not necessarily have what we consider weaker credit quality than a larger or more-urban issuer. Although we assess these factors in our credit analysis for some revenue bond ratings, we believe many municipal systems still exhibit, in our view, strong and stable credit quality despite size or location constraints.
16.4. Park/Apple's Firm Specific Risk Adjustment
Park/Apple argues it should have a risk adjustment of 90 basis points and it cites to a study comparing Park's last eight bond issues and a hypothetical rate for its proxy group's credit rating. (Park Opening Brief at 22 et seq.) The company argues it also faces increased risk attributed to the newest rate case plan and its relatively small size compared to other larger water companies that are publicly traded. (Park Opening Brief at 25 and 28.) Park/Apple claims it would be a "micro-cap" company at 8% the size of the average proxy group company. But Park/Apple is not publicly traded on a major exchange and thus attracts different investors. The studies cited support size risk premium of 127-135 basis points. (Park Opening Brief at 29.)
Park/Apple alleges that its Water Revenue Adjustment Mechanism and Modified Cost Balancing Account mechanism provide only a minimal risk reduction.54
DRA does not propose making a specific risk factor adjustment for the Water Revenue Adjustment Mechanism and Modified Cost Balancing Account. DRA argues the record here provides no basis for continuing to add a risk premium to Park/Apple's adopted return on equity. Thus, DRA argues that Park/Apple failed to meet its burden of proof that the Commission should authorize a risk premium. DRA argues that the existing Water Revenue Adjustment Mechanism and Modified Cost Balancing Account reduce Park/Apple's business risk. (Exhibit DRA-1 at 61-62.)
16.5. Discussion
In fact, the Commission has found that the Water Revenue Adjustment Mechanism and Modified Cost Balancing Account are too new and therefore are not reflected in the market data and thus provide some un-captured risk reduction.55 We believe that, other things being equal, the Water Revenue Adjustment Mechanism makes a water utility's future earnings more predictable with lower risk because of the assured revenue stream when coupled with a Modified Cost Balancing Account which provides an assurance of recovering reasonable includable costs. Another applicant, Suburban, contradicts Park/Apple and acknowledges that a Water Revenue Adjustment Mechanism substantially reduces financial risk and assures recovery of revenues.56
These mechanisms tend to shift Park/Apple's risk (and the other applicants' with these mechanisms) in the variability of its revenues and production expenses from shareholders to ratepayers, nor does Park/Apple acknowledge that its Water Revenue Adjustment Mechanism and Modified Cost Balancing Account protect from more than just reductions in sales due to water conservation. Park/Apple's Water Revenue Adjustment Mechanism protects Park/Apple from all variations in revenues regardless of what causes a drop in sales. Additionally, the Modified Cost Balancing Account ensures predictable cost recovery, even when quantities fluctuate for key includable expense items, such as purchased water, pump tax, and purchase power.
In a recent water cost of capital proceeding, the Commission did not make a specific return on equity adjustment for the Water Revenue Adjustment Mechanism and Modified Cost Balancing Account, but it did recognize these mechanisms reduce utility risk.57 Prior to the adoption of the Water Revenue Adjustment Mechanism and Modified Cost Balancing Account for Park/Apple, the Commission included a 30 basis point adder to its authorized return on equity. The Commission noted in the last litigated return on equity proceeding for Apple Valley (separate from Park) that the allowed 30 basis point risk premium was not guaranteed and that in a future proceeding, the company would have to justify any request for a risk premium.
It is clear that with Park/Apple's Water Revenue Adjustment Mechanism and Modified Cost Balancing Account decoupling mechanism in place, the Commission has decreased Park/Apple's business risk and we need not continue the 30 basis point risk premium.
16.6. Suburban's Risk Premium
Suburban presents its results of three analyses: its Risk Premium analysis results in an 11.97% return, its Capital Asset Pricing Model suggests 13.30%, and a Comparable Earnings Average results in 13.95% return on equity. When considered with its Discounted Cash Flow result of 11.15%, Suburban argues that its request of 11.75% is reasonable. It argues too that it does not have a Water Revenue Adjustment Mechanism (thus implicitly acknowledging that the mechanism would otherwise reduce its risk by some factor) and that it is a relatively small company (San Jose and San Gabriel are bigger and Valencia and Park/Apple are smaller). (Suburban Opening Brief at 10.)
16.7. Regulatory Risk
Although mentioned in other sections (see, for example, Section 3: Regulatory Environment), we reject all of the Applicants' arguments that California utilities face an extra or high level of risk due to regulation.
San Gabriel incorrectly argues, for example, that the rate case plan with regular general rate cases harms the company by precluding a filing "when [San Gabriel] determine(s) such filings are required and seriously restricts San Gabriel from presenting the best available evidence" by using an attrition mechanism rather than serial rate cases. (San Gabriel Opening Brief at 23-24.) In fact, one of the benefits of a regular rate case cycle is that companies can (and are expected to) have a substantial business plan and forecast construction and operations in a thorough and competent fashion. The regulatory process is not an open wallet. San Gabriel ignores on the other hand the protections of balancing and memorandum accounts which facilitate the full recovery of prudently incurred costs without forecast risk or timing risks.
16.8. Contamination Risk
Applicants, San Gabriel in particular, argue that they face "unique" operating risks for contamination. (San Gabriel Opening Brief at 24.) They failed to offer any evidence either that their water sources are uniquely more contaminated (or at greater risk) than the proxy group used by DRA (or themselves) that would justify an enhanced return, or that another similarly highly contaminated (or at great risk) proxy group is authorized an enhanced return on equity due to contamination. San Gabriel does show that it has contamination problems, but does not show that these problems uniquely affect its cost of capital. We therefore accord no weight to the unsupported rhetoric. In contradistinction, the Commission specifically allows the jurisdictional water utilities to make appropriate rate filings and recover prudently incurred costs when addressing specific water contamination in addition to the ongoing costs of mandated water treatment generally.58 San Gabriel argues any proceeding for contamination cost recovery raises its cost due to delay-but does not show that its cost of debt (or equity) is uniquely high because of contamination issues.
We therefore find that there is no evidence to support any specific enhancement to the return on equity for any identifiably unique risks of water contamination.
16.9. Summary of Risk Premium
We find that the risks which allegedly warrant a premium over the results of any of the models, Discounted Cash Flow or Capital Asset Pricing Model, are very much risks in the eyes of the individual companies and thus elude verifiable and accurate measurement. We therefore do not have a record which would permit us to adopt any individual adjustments for risk.
48 The coefficient, computed as the standard deviation return on equity/mean return on equity, is a standardized measure of volatility.
49 Exhibit DRA-1, Page 4 of Attachment JRW-13, which includes a ninth proxy company, Southwest Water Company.
50 San Jose has the highest operating revenues (over $200 million), roughly twice those of San Gabriel (over $100 million), with Suburban only half as big as San Gabriel (about $50 million) trailed by Park/Apple and Valencia (about $20 million each).
51 DRA cites to Richard Roll, "On Computing Mean Returns and the Small Firm Premium," Journal of Financial Economics (1983) at 371-86.
52 DRA cites to Annie Wong, "Utility Stocks and the Size Effect: An Empirical Analysis," Journal of the Midwest Finance Association, 1993 at 95-101.
53 Standard & Poor's, "26 Western Water and Sewer Issuers are Upgraded on Revised Criteria," January 12, 2009.
54 Exhibit PWAV-1 at 27-35.
55 D.09-05-019, mimeo. at 35.
56 Exhibit SUB-1 at 4.
57 D.09-05-019, mimeo. at 34-35.
58 For example, after dealing with contamination issues piecemeal, Rulemaking 09-03-014 is our current effort to bring some systematic process to bear on water contamination issues.
