18. Water Cost of Capital Adjustment Mechanism

18.1. Summary

We will adopt the same cost of capital adjustment mechanism adopted in D.09-07-051 with two modifications: we increase both boundaries of the dead band to 200 basis points to reduce the potential for a large adjustments to the authorized return on equity caused by the economic recovery which may significantly change the Moody's bond indices. Secondly, we will make the base period October 1, 2009 to September 31, 2010.

18.2. DRA

DRA recommends that the same water cost of capital adjustment mechanism be adopted here as was adopted in D.09-07-051 for the three
multi-district companies. (Tr. Vol. 3 at 143, Sanchez/DRA.) DRA also recommends that the appropriate benchmark/index that should be applied to the various utilities' water cost of capital adjustment mechanism in this proceeding should be based on the Moody's Aa and Baa utility bonds.⁶¹ (Exhibit DRA-2 at 2.) If the utility's rating was AA, A or higher, the Moody's Aa bond index would apply; if the utility bonds are rated BBB+ or lower, the utility would apply Moody's Baa.

DRA recognizes that Applicants do not have their bond issues rated by Moody's or other rating agencies. Thus, an approximation must be made as to which of the Moody's bond ratings would be applicable to Applicants as an index and for setting the benchmark. According to San Jose, the closest bond rating to the company's debt profile is a Moody's A public utility bond yield. Therefore, for setting up the water cost of capital adjustment mechanism for
San Jose, the appropriate index for establishing the benchmark is Moody's Aa utility bond yield. Park/Apple's position is that the most comparable credit rating proxy for the company would be BBB, which in this case should be set using Moody's Baa utility bonds. DRA believes that the remaining utilities have similar pricing structures to Park/Apple's long-term bond yields. Thus, DRA recommends that Moody's Baa utility bond yield index be applied to Suburban, San Gabriel, and Valencia.

On February 27, 2009, DRA reached a settlement agreement with Golden State Water Company, California-American Water Company, and California Water Service Company on a water cost of capital adjustment mechanism. DRA proposes that this mechanism be used to adjust the return on equity and update long-term debt and preferred stock costs in the years between filings. DRA proposes the same adjustment trigger when the average 12-month index exceeds the established benchmark. DRA testified to how the mechanics will operate and apply to Applicants during cross-examination. (Tr. Vol. 3 at 144-145.) DRA noted that there is no major difference on how the adjustment would be applied to the various water utilities, except for the utility bond index rating to be used to set the benchmark.

18.3. San Gabriel

San Gabriel argues that the upheaval in the financial markets adversely affects where the benchmark should be set, and that the Commission should not deviate from its long-standing approach in forecasting cost of capital. (Transcript at 137.) It argues instead to use the forecasts for 2011 and 2012 included in its May 2009 application and testimony.

18.4. Suburban

Suburban raises an important problem: that the mechanism, with a base year using the 2009 impacts of the financial crisis, could result in an unintended adjustment.

Suburban is more concerned, however, with the impact of the changes in the financial markets on the assumptions contained in the cost of capital adjustment mechanism that the Commission approved in D.09-07-051. The Commission must ensure that the water utilities in this proceeding are not unfairly subjected to downward adjustments to its returns as the markets recover from the period of poor performance during which the adjustment mechanism was developed. (Suburban Opening Brief at 18.)

DRA also notes that the Commission has already determined that the water utilities generally have not been significantly harmed during the financial crisis. (D.09-07-051 at 10.) DRA also argues (Exhibit PWAV-8) the yields for AA and Baa utility bonds have dropped significantly from the highs at the peak of the financial crises, and DRA expects that they will continue to drop back to normal historical levels since the financial markets have begun to stabilize.

18.5. Discussion

We find San Gabriel's proposal to use its out-of-date forecasts for 2011 and 2012 to be unreasonable-a forecast made in 2009 is clearly stale and does not reflect the real market condition changes by 2011 and 2012. We do agree, however, that the mechanism for the current applicants may have a likely bias towards a reduction in 2011. We believe this to be the case because, as we hope to see a continuing economic recovery in 2010 and later, we expect the Moody's index to fall as market interest rates fall from the unusual highs included in the base year. San Gabriel notes that the index is likely to trigger increases for the three multi-district companies in 2010 based on the 2009-2010 market conditions. This is based on the projected impacts for BBB-rated companies in 2010 when adjusting their 2009 base year. Thus, if the economy improves, this could likely result in a decrease which would likely trigger a decrease in 2011 for San Gabriel and the other applicants assigned a BBB rating.

We believe the adjustment mechanism, in principle, is superior to stale forecasts. Therefore, we propose to modify the trigger this one time. Currently the trigger mechanism has a 100 basis point dead band, plus and minus, before an adjustment occurs. We do not want an anomaly of the 2009-2010 index to likely result in a decrease simply because the economy returns to a more stable condition. Therefore, we will double the boundaries of the mechanism to
200 basis points. We will also use the base period October 1, 2009 through September 31, 2010 as the base period for these companies to offset prior market anomalies.

Moody's Bond Rating Proxy

	Applicant	DRA	Adopted
San Jose	A	A	A
Valencia		Baa	Baa
Park/Apple	BBB62	Baa	Baa
San Gabriel	No	Baa	Baa
Suburban		Baa	Baa

⁶¹ Moody's is one of several independent, unaffiliated research companies that rate fixed income securities. Moody's assigns ratings on the basis of risk and the borrower's ability to make interest payments. Moody's ratings are ranked as follows: Aaa = highest grade, best quality issuer, lowest risk. This is followed progressively lower in grade, quality and risk with ratings of Aa, A, Baa (which reflects medium grade, moderate risk) and then Ba, B, Caa (which reflects poor grade, high risk), Ca, and C.

⁶² A rating of BBB by Standard & Poor's is approximately the same as a Moody's rating of Baa, a lower-medium investment grade rating.