5. Discussion
The authority requested by Alco is subject to § 816 et seq. and § 851 which state, in relevant part, as follows:
§ 816: The power of public utilities to issue [debt and equity] and to create liens on their property... is a special privilege, the right of supervision, regulation, restriction, and control of which is vested in the State, and such power shall be exercised...under such rules as the commission prescribes.
§ 817: A public utility may issue [long-term debt and equity] for any of the following purposes and no others:
(a) Acquisition of property.
(b) Construction, completion, extension, or improvement of its facilities.
(c) Improvement or maintenance of its service.
(d) Discharge or lawful refunding of its obligations.
. . .
(g) Retirement of or in exchange for...outstanding [debt or equity]..., with or without the payment of cash.
(h) For the reimbursement of moneys actually expended from income or from any other money in the treasury of the public utility ... for any of the aforesaid purposes except maintenance of service and replacements, in cases where the applicant has kept its accounts and vouchers for such expenditures in such manner as to enable the commission to ascertain the amount of money so expended and the purposes for which such expenditure was made.
§ 818: No public utility may issue [debt or equity]...unless...it shall first have secured from the commission an order authorizing the issue, stating the amount thereof and the purposes to which the...proceeds thereof are to be applied, and that, in the opinion of the commission, the money, property, or labor to be procured or paid for by the issue is reasonably required for the purposes specified in the order, and that...such purposes are not, in whole or in part, reasonably chargeable to operating expenses or to income.
§ 819: The commission may by its order grant permission for the issue of such stocks...or other evidence of interest or ownership, or bonds, notes, or other evidences of indebtedness in the amount applied for, or in a lesser amount, or refuse such permission, or grant it subject to such conditions as it deems reasonable and necessary. The commission may authorize issues of bonds, notes, or other evidences of indebtedness, less than, equivalent to or greater than the...capital stock of a public utility corporation.
§ 823(a): No public utility shall, without the consent of the commission, apply any...of the [proceeds from debt and equity] to any purpose not specified in the commission's order, or to any purpose specified in the order in excess of the amount authorized for such purpose.
§ 823(d): No note payable at a period of not more than 12 months after the date of issuance of such note shall, in whole or in part, be refunded by any issue of stocks or stock certificates or other evidence of interest or ownership, or of bonds, notes of any term or character, or any other evidence of indebtedness, without the consent of the commission.
§ 825: All [debt and equity] of a public utility, issued without an order of the commission...is void. No failure in any other respect to comply with...the order of authorization of the commission shall render void any [debt or equity], except as to a corporation or person taking it otherwise than in good faith and for value and without actual notice.
§ 851: No [utility]...shall...encumber...any part of its...property necessary or useful in the performance of its duties to the public, or any franchise or permit or right thereunder...without first having secured from the commission an order authorizing it to do so. Every such...encumbrance...made other than in accordance with the order authorizing it is void.
The Commission has broad discretion under § 816 et seq., and § 851 to determine if a utility should be authorized to issue secured debt and equity. The primary standards used by the Commission are whether a utility has demonstrated a need to issue debt and equity for utility-related purposes, and whether the utility has the ability to pay for the requested debt and equity. The Commission may also use its authority under § 819 to attach conditions to the issuance of debt and equity in order to protect and promote the public interest.
There are three main issues associated with A.07-10-012. These are:
1. Whether Alco should be granted prospective authority to issue $8.33 million of debt and equity for the purposes identified above in Table 1.
2. Whether Alco should be required to reduce its debt-to-equity ratio and, if so, over what period of time.
3. Whether Alco should be required to file a GRC application.
We address each of these issues below.
5.1. Authority to Issue Debt and Equity
We first consider Alco's request for authority under § 816 et seq., to issue long-term debt and equity. As shown in Table 1 above, Alco has identified $8.0 million of proposed uses for the requested debt and equity. These purposes are: (1) repay capital leases executed in 2005 and 2006 for utility vehicles and equipment; (2) repay short-term notes executed in 2006 and 2007 to finance new water plant; (3) reimburse treasury funds expended in 2005 and 2006 to finance new water plant; (4) install water mains pursuant to a federal court order; (5) install an AMR system; and (6) pay for debt issuance costs and establish a contingency reserve for the above projects. These purposes are authorized by §§ 817 and 823(d). As required by § 818, these purposes are not reasonably chargeable to current operating expense or income.
To support its request, Alco provided a summary of unreimbursed construction expenditures for 2005 and 2006, forecasts of cash flow (including constructions costs) and external financing for 2007 and 2008, and forecasts of annual revenues, expenses, debt, and equity for 2007 through 2011. Based on this information, we find that Alco has a reasonable need to issue $8.0 million of debt and equity for the previously stated purposes, and that Alco has the ability to pay for the cost of the requested debt and equity capital.6
For the preceding reasons, we will grant Alco prospective authority under § 816 et seq., to issue $8.0 million of debt and equity. Although today's Decision authorizes $8.0 million of debt and equity, Alco requested authority to issue $8.33 million. Alco intends to issue an additional $0.33 million of common equity, if necessary, to lower its debt-to-equity ratio to 3-to-1. Utilities are not authorized by § 817 to issue equity for this purpose. Accordingly, we decline to grant Alco's request to do so. However, in light of Alco's excessively high debt-to-equity ratio, we will authorize Alco to issue $0.33 million of common equity instead of additional debt. Thus, the amount of debt and equity authorized by today's Decision is $5.67 million of long-term debt, $2 million of preferred stock, and $0.33 million of common equity, for a total of $8.0 million.
We next consider Alco's request for authority under § 851 to issue debt secured by utility assets. Public utilities routinely issue secured debt because such debt is usually cheaper than non-secured debt. Therefore, we find Alco's request to be reasonable, and we will grant it. However, if a default occurs and title to any property, franchise, permit, or right that is necessary or useful in the performance of Alco's duties to the public is transferred pursuant to the terms of the secured debt, the thing transferred shall not be removed from utility service without prior authorization from the Commission.
The debt and equity authorized by today's Decision is subject to the following conditions:
1. Consistent with § 823(a) and § 823(d), Alco shall use the proceeds of the debt and equity authorized by today's Decision for only those purposes identified in Table 1 above. Today's Decision does not authorize the use of these proceeds to finance plant and equipment needed to serve new customers in the service territory that is the subject of Investigation (I.) 07-06-020 and Resolution W-4630.
2. Consistent with § 823(d), Alco may use the debt and equity authorized by this Decision to repay treasury funds and short-term debt only to the extent the treasury funds and short-term debt were used to finance the acquisition of utility plant and equipment.
3. To provide Alco with financial flexibility, Alco may allocate the proceeds from the authorized debt and equity among the purposes authorized by today's Decision as Alco deems necessary.
4. Alco shall not issue debt or equity to finance an AMR system until after Alco has received Commission authorization to install an AMR system.
5. Alco's authorized use of proceeds includes $1,118,260 to repay capital leases executed in 2005 and 2006. Because the lease balances should decline over time as lease payments are made, the total amount of debt and equity that Alco is authorized to issue by today's Decision shall be reduced by an amount equal to the difference between $1,118,260 and the actual lease balances that are paid off.
6. Alco shall not issue common equity to the extent that doing so results in a transfer of control of Alco.
7. The preferred stock dividends shall not exceed 8.5%. The owner(s) of the preferred stock shall not have voting rights at stockholder meetings or any rights to participate in earnings.
Consistent with § 824, Alco shall maintain records to (1) identify the specific long-term debt and equity issued pursuant to today's Decision, and (2) demonstrate that proceeds from such debt and equity has been used only for the purposes authorized by today's Decision.
5.2. Authorized Capital Structure
At the end of 2007, Alco's capital structure consisted of 91% long-term debt and 9% equity,7 a ratio of more than 10-to-1. While debt is usually a cheaper source of capital than equity, debt is also a riskier source. In general, the more debt a utility has, the higher the financial risks for both creditors and stockholders. This, in turn, increases the cost of both debt and equity capital.
A highly leveraged capital structure like Alco's increases financial risk because of the demands it places on a utility's cash flow. The required payments of debt principal and interest can consume a significant portion of the cash generated by the utility. An unexpected shortfall in cash flow may leave the utility with insufficient cash to simultaneously meet its scheduled debt payments, fund needed capital expenditures, and pay for operating expenses.
Alco's current debt-to-equity ratio in excess of 10-to-1 creates a level of financial risk that is inappropriate for a public utility water company. Therefore, we approve Alco and DRA's agreement to reduce Alco's debt-to-equity ratio to 3-to-1. Alco shall achieve the required debt-to-equity ratio by December 31, 2011. Beginning in 2012, Alco shall not exceed a debt-to-equity ratio of 3-to-1 without Commission authorization.
To ensure that Alco makes steady progress in reducing its excessive level of debt, we will require Alco to reach a debt-to-equity ratio of 5-to-1 by the later of December 31, 2009, or 180 days after Alco issues any of the debt authorized by today's Decision. Alco shall then reach a debt-to-equity ratio of 4-to-1 by the end of 2010, and 3-to-1 by the end of 2011. Alco may issue more preferred stock and common equity than authorized by today's Decision in order to meet these deadlines, provided there is a corresponding reduction to the amount of long-term debt issued pursuant to today's Decision, so that the total debt and equity issued pursuant to today's Decision does not exceed $8.0 million. If Alco needs to issue more equity than authorized by today's Decision in order to meet the targeted debt-to-equity ratios, Alco may file an application to request the necessary authority to issue the additional equity.
In its comments on the proposed decision, Alco states that it may have difficulty issuing the debt authorized by today's Decision due to extraordinary turmoil in the financial markets. If this problem materializes, Alco may seek to postpone the deadlines established by today's Decision for achieving the prescribed debt-to-equity ratios by filing a petition to modify today's Decision.
To ensure that the preferred stock issued by Alco is equity, and not another form of debt, the preferred stock issued pursuant to today's Decision shall possess the following characteristics:
· The preferred-stock dividends shall be paid quarterly and shall be non-cumulative. Those dividends that are not paid in a quarter shall be canceled and not carried into a future quarter.
· The preferred stock shall be a permanent part of Alco's capital structure. The owner(s) of the preferred stock shall not have the right to sell the stock back to Alco, and Alco may not redeem the preferred stock without prior Commission authorization. Any redemption will be at the original cost of the preferred stock.
· To ensure that Alco has sufficient cash to fund utility operations and make scheduled debt payments, preferred-stock dividends shall be paid only when cash flow from operations as defined by Generally Accepted Accounting Principles exceeds the sum of (1) capital lease payments, plus (2) dividends on the preferred stock, plus (3) debt principal payments, plus (4) interest payments to the extent interest is not subtracted from cash flow from operations, plus (5) 10% of the sum or the previous four items.
· The capital, financial, and operating needs of the utility shall have priority over the payment of preferred-stock dividends and the redemption of preferred stock. Alco shall not pay preferred-stock dividends or buy back preferred stock if doing so jeopardizes Alco's ability to pay debt principal and interest, fund utility operations, or provide public utility services.
5.3. General Rate Case
We conclude that Alco should file a GRC application by June 1, 2009, with a 2010 test year. A GRC proceeding is necessary given that DRA and Alco have separately projected that Alco's cost of capital in 2009 will be less than Alco's currently authorized rate of return of 9.86%.8 A GRC proceeding will provide an appropriate forum for determining Alco's actual cost of capital and adjusting its authorized rate of return, as necessary.9 More importantly, the $8 million of debt and equity authorized by today's Decision is equal to 140% of Alco's revenues in 2007 and 84% of Alco's rate base in 2007.10 We believe that a transaction of this magnitude calls for an in-depth Commission review of Alco's operations via a formal GRC proceeding in order to ensure the public's continued confidence in the reasonableness of Alco's rates and service.
A GRC proceeding will also provide an opportunity to verify that Alco has used the proceeds of the debt and equity authorized by today's Decision for proper purposes. To this end, we will require Alco to attach to its GRC application a report that shows how much debt and equity it has issued pursuant to today's Decision; identifies the specific bank account(s) that Alco has established pursuant to General Order 24-B, Section C, to receive and disburse these funds; lists the disbursements of these funds; and describes how these disbursements are only for uses that comply with today's Decision.
We will likewise direct DRA to audit Alco's use of the proceeds of the debt and equity authorized by today's Decision to verify that such uses comply with today's Decision. DRA shall submit an audit report during the GRC at a time to be determined by the scoping memo. The scope of DRA's audit shall include an examination of whether the treasury funds that are refunded and short-term debt that is retired by the debt and equity proceeds were actually used to acquire utility plant and equipment in 2005, 2006, and 2007.
In its comments on the proposed decision, Alco asks for permission to use the advice letter process for the GRC, stating that a formal application process could be very expensive. Alco estimates that a formal GRC proceeding will require at least 600 attorney hours at an average cost of $550 per hour, plus additional costs for temporary accounting help, lodging in San Francisco while the GRC is underway, and other GRC-related expenses.
We appreciate Alco's concerns about the costs of a formal GRC proceeding. Nonetheless, we conclude that a formal GRC proceeding is warranted for the previously stated reasons. Alco may recover the reasonable costs that it incurs for a formal GRC proceeding. As always, Alco will have the burden of demonstrating the reasonableness of its GRC costs. We caution Alco that it should use expensive attorneys only when absolutely necessary. Work performed by attorneys at a cost of $550 per hour may be disallowed if the work can be accomplished through less expensive means.
Alco also states in its comments on the proposed decision that it does not know when it will be able to issue the debt authorized by today's Decision due to the current worldwide financial crisis. Because of this, Alco recommends that the requirement to file a formal GRC application be modified to require Alco to file the application no later than 180 days after Alco obtains the debt proceeds.
We decline to adopt Alco's recommendation. However, if Alco is delayed in the issuance of the debt authorized by today's Decision due to ongoing turmoil in the financial markets such that Alco cannot provide in a GRC application filed on June 1, 2009, the information required with respect to the debt authorized by today's Decision, then Alco may request, pursuant to Rule 16.6 of the Commission's Rules of Practice and Procedure (Rule), an extension of up to 6 months to file a formal GRC application with a 2010 test year. Any such request should explain why Alco cannot file by June 1, 2009, the GRC application contemplated by today's Decision. Any further extension of time should be sought through a petition to modify today's Decision.
6 The financial information appended to A.07-10-012 and Alco Hearing Exhibits 1 and 3 show that Alco will have sufficient revenues to pay for debt and equity authorized by today's Decision, provided that Alco receives future rate increases to recover the cost of utility assets financed by the debt and equity authorized by today's Decision.
7 Alco Exhibit 1, Attachment A.
8 DRA projects that Alco's weighted cost of capital will be 8.46% in 2009, and Alco projects that it will be 9.22%.
9 Today's Decision does not make any findings regarding Alco's projected cost of capital for 2009, other than to note that both DRA and Alco project that Alco's cost of capital in 2009 will be less than its authorized rate of return.
10 Alco's revenues and rate base for 2007 were $5.7 million and $9.56 million, respectively (Resolution W-4645, Appendix B). $8 million is 139.7% of Alco's revenues in 2007 ($8,000,000/$5,724,415) and 83.7% of Alco's 2007 rate base in 2007 ($8,000,000/$9,558,547).
