10. Cost of Capital

As discussed below, we adopt a capital structure for Alco which is 70% long term debt and 30% equity. Alco has no preferred stock, but it does have long term debt and common stock and therefore we do not impute a capital structure. As noted in briefs, Alco and DRA agree to a 70/30 ratio.41 We therefore adopt, as discussed below, the following cost of capital:

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.42 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.

Ratemaking capital structure is long-term debt, preferred stock, and common equity.43 Because the level of financial risk that a utility faces is determined in part by the proportion of its debt to equity capital, or the degree of financial leverage, we must generally ensure that the utility's adopted equity ratio is sufficient to maintain a reasonable credit rating and to attract capital without incurring unnecessary costs for an excessive amount of expensive equity.

Generally, long-term debt is the least expensive form of capital but the utility must ensure that it timely meets every interest payment and maintains any required terms or conditions of the loan agreements or mortgage indentures, and that it can refinance or refund the debt when it matures. Preferred stock is generally more expensive than debt (at the time it is originally issued) and may or may not have a maturity or refund provision. Interest may usually be deferred but it then accumulates and takes preference over payment of dividends to common equity owners. Thus, equity owners assume more risk than either debt holders or preferred stock owners, including the risk of losing their entire investment, and therefore equity investors require the highest return over the long run.

We believe that the company does have a significant control over the mix of debt and equity and thus ratepayers should not bear unnecessary costs as a result of management discretion-the equity return is a market return for the assumption of like-risk in comparable investment choices. Thus, even if, for the sake of argument, a smaller water company as a matter of course has a higher transaction cost and even a higher interest cost for debt, debt is almost always cheaper than equity and does not carry the added loading of an income tax allowance in rates. Therefore, if a company carries a high equity ratio, for ratemaking purposes we should necessarily consider adjusting either the return on equity or the capital structure.

The company and DRA agree upon a 70% debt and 30% equity ratio and we will adopt this ratio for all 2010--2012 cost of capital calculations.

Long-term debt costs are almost always based on actual, or embedded, costs. Future interest rates must be anticipated to reflect projected changes in a utility's cost caused by the issuance and retirement of long-term debt during the year. This is because the rate of return is established on a forecast basis.

We recognize that actual interest rates do vary and that our task is to determine "reasonable" debt cost rather than actual cost based on an arbitrary selection of a past figure.44 In this regard, we conclude that the latest available interest rate forecast should be used to determine the forecast of additional debt included in the embedded debt for the forecast period. (See recently, D.07-12-049, and 38 CPUC2d 233, where 18 years ago, the Commission definitively discussed the need for, and use of, a reliable forecast of future interest costs.)

The company and DRA disagree significantly on the cost and availability of debt. DRA further expresses a concern that Alco should not issue debt in excess of the amounts recently authorized in D. 08-11-035. We can address this briefly: Alco cannot issue long-term debt without specific authority by the Commission pursuant to Pub. Util. Code §§ 816-830. Should Alco choose or need to issue debt in excess of its current authority it must first obtain authority to do so.

Alco assumes that, based on the current market conditions and other factors specific to Alco, its future cost of debt will be approximately 9.5% to 10.0% (Ex.A-5, at 93). Alco argues that (1) its last cost in 2007 was 7.85% and (2) there has been a 200 basis point increase in the market "spread" between 2007 and 2010 for 20-Year - BB rated bonds, and that Alco on this alone should be allowed a debt cost of 9.85% (7.85% + 2.00%). (Alco Opening Brief at 33-34.)

DRA disagrees with Alco's forecast of new long term debt costs, and argues instead that the Commission should adopt a cost which is 400 basis points above the 10-Year U.S. Treasury note. This results in a recommended cost of 7.85%, and the general belief that Alco can borrow at less than 8%. (Ex. D-1 at 13-11 through 13-14.) DRA also argues that Alco has made expensive choices or recommendations, for example, by using capital leases with 4M Development Corporation, and should instead deal with banks and insurance companies as it did in prior loans with Allstate. DRA is also concerned that the leases contain hidden interest costs which significantly drive-up the actual cost to ratepayers. (DRA Opening Brief at 39 - 42.)

If we look at current 10-Year Treasury Note yields for November 2010, we find that rates are around 2.60%.45 If we refer back to July (when we held evidentiary hearings) rates were slightly higher at 2.90% to 3.0%. (Id.) Thus, DRA's 400 point premium, above, would result in a forecast rate of between 6.60% to 7.00%. By comparison, the Federal Reserve's Statistical Release H.15 reports that corporate bonds (rated at Baa) yielded approximately 6.0% in July 2010 and 5.70% to 5.80% for November 2010. Thus Alco's 200 point premium would result in a forecast of between 7.70% and 8.0% before considering any further differential between Alco's proposed - BB benchmark rating and the Baa reported by the Federal Reserve. Essentially, a rating at Baa is considered to be an adequate lower-grade investment grading whereas a rating of - BB (more commonly BB-) is a tier lower and generally considered less than investment grade or somewhat speculative. (There is a slight difference too in that Baa is a term generally used by Moody's Investor Service, whereas BB- is a term used by Standard and Poor's.)

The use of "investment grade" versus "speculative" is problematic when dealing with small investor-owned, regulated public utilities. First, the existence of rate regulation specifically because the company provides a monopoly service, significantly alters the dynamics when assessing the likelihood of a company having the cash flow and continuity of business necessary to assure repayment of principal and timely debt service. In a far-less regulated environment, i.e., a company not subject to rate regulation by any agency such as this Commission, investors would be more likely to find a family-owned company the size of Alco to be risky and perhaps a "speculative" investment and not likely an investment grade opportunity.

We believe utility rate regulation substantially alters the risk profile of a public utility because it provides substantial assurances or enhancements that make debt service and repayment far more likely. The one problem that even regulation doesn't address is finding corporate or institutional lenders interested in the relatively small size of the principal amounts borrowed by companies like Alco. For example, D.08-11-035 granted Alco authority to borrow $8 million. We routinely authorize the large gas and electric utilities authority in the many-hundreds of millions of dollars where debt is issued to a national or world-wide market of investors.

Although DRA objects to the inclusion of certain costs added into the 4M Development Corporation loan we do not have in the record the detailed breakdown of the embedded costs of debt (with or without these additional costs). We therefore adopt a market forecast which subsumes any underlying embedded costs.

Based upon all of the above considerations of market yields, risk and regulation, and size of the company, we find that a long term debt cost of 8.00% is a reasonable forecast for the rate case cycle 2010 - 2012.

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.

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 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.)

Alco proposes a return on equity of 13.20% based upon a comparison of itself with the California large multi-district Class A water companies. (Alco Opening Brief at 30 citing to Ex. A-5, at 84-92.) Essentially Alco begins with the recently authorized 10.20% return on equity adopted in D.09-05-019 and derives an additional risk premium of 300 basis points (100 basis points = 1.0%) for a 13.20% requested return on equity.

Rate of return for Class B water companies is not as rigorously reviewed and tested as is the return for a Class A company. For example, Resolution W-4760, dated July 9, 2009, for Del Oro Water Company, adopted an overall rate of return of 10.80%. No further detail or analysis was provided to explain or distinguish this adopted return. (Resolution W-4760 at 4.) DRA asserts that this included a return on equity of 10.96%. (Ex. D-1 at 13-7.) DRA provides very little other analysis and we necessarily accord DRA's recommendation little weight.

Alco derives its 300 basis point adder to the 10.2% return on equity recently adopted for the large Class-A companies in two parts: 200 points from a bond yield curve differential for BBB and BB- publicly traded utility bonds (Ex. A-5 at 87-88) and another 50-100 points to compensate for Alco's "limited financial flexibility" due essentially to its smaller size when compared to the Class-A companies. (Id. at 89 - 90.) Neither argument is rigorous, precise or particularly apposite.

The comparison of BB bonds, (at the low-end of speculative in Standard and Poor's lexicon) and BBB- (at its low-end of investment grade) is problematic as presented by Alco. First, the company presents a one-time snapshot without context or continuity. Secondly, the comparison is at most relevant to measuring a point-in-time interest rate differential for debt and is not indicative of investor risk perceptions for an equity investment. We therefore accord no weight to Alco's 200-point proposal.

We are again very concerned that the second component, a small-size adjustment factor that is based on a long-term debt cost comparison is imprecise for adjusting equity returns. The typical cost of equity models measure, or at least forecast, a differential for the risk assumed by an equity holder above a risk-free alternative. (D.09-05-019 at 17 and footnote 22 at 19.)46 So the question we decide in adopting a return on equity is what reward is required for the ownership risk of the utility compared to a risk-free investment such as a government bond.

We are not convinced that Alco has demonstrated with any precision that a small-size adder of 50-100 basis points is warranted. We do not like the exercise of judgment to be confused with or tainted by seemingly arbitrary choices. But we agree at a fundamental level that Class B companies are smaller than Class A companies; they have a less-rigorous regulatory oversight (which could be seen as a two-edged sword of risk and opportunity); and small fluctuations in operations can have a disproportionate impact on financial results. We therefore will exercise our judgment and provide a 50 basis point adder to the 10.20% return we have so recently found to be applicable to the Class A water companies. We therefore adopt a return on equity of 10.70% for 2010 - 2012.

41 Alco Opening Brief at 26 and DRA Opening Brief at 38 - 39: "DRA uses a 69.38% debt and 30.62% equity breakdown in deriving its recommended [rate of return]."

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

43 Short-term debt due within one year is excluded.

44 38 CPUC2d 233 at 242 and 243 (1990).

45 http://www.federalreserve.gov/releases/h15/Current/.

46 A risk premium is a return in excess of the risk-free rate of return that an investment is expected to yield. An asset's risk premium is a form of compensation for investors to tolerate the extra risk compared to that of a risk-free asset. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

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