7. Rate Base

7.1. Distribution Plant-Pipeline Replacement
Project

Almost all of the differences⁵³ between Southwest, ORA, and San Bernardino with respect to gas distribution plant-in-service, are attributable to different recommendations regarding the rate at which PVC mains and services should be replaced in the Southern and Northern California Divisions. All PVC services have all been replaced in Northern California. Thus, the replacement program includes mains in Northern California, and PVC services and mains in Southern California.

Southwest, ORA, and San Bernardino agree that eventually all existing PVC pipe mains and services must be replaced. However, parties disagree over the period necessary for pipe replacement, and amounts proposed for test year 2003, and the attrition years. ORA proposes to replace the pipe uniformly over a 20-year period; the County recommends a 25-year replacement period, while Southwest proposes to replace PVC pipe on an accelerated basis during the test year, and attrition years, and then scale back replacement over an additional 15-years.⁵⁴

7.2. Background

Southwest installed PVC pipe in the late-1950s, 1960s, and 1970s. Beginning in 1997, Southwest embarked on an accelerated PVC pipe replacement program for its PVC mains and services, using polyethylene (PE) pipe not subject to the problems encountered with PVC. Southwest conducted a Pipeline Integrity Assessment (PIA) to determine the factors that might cause mains and services to fail, and planned a process to address these factors. As a result of the PIA, Southwest spent $19.2 million on pipeline replacement between 1998 and 2001. Southwest estimates it will spend an additional $23.6 million in 2002 and 2003, and $36.6 million between 2004 and 2007.

ORA and San Bernardino contend there is little justification for the proposed increased rate of PVC pipe replacement. ORA and San Bernardino assert that a 1993-97 study of leak rates, measured in leaks-per-mile, indicate that there is no upward trend in leak rates, and that a review by a Commission certified pipeline safety inspector confirms leaks are negligible. ORA adds that PG&E has a greater leak rate than Southwest, nevertheless, PG&E has operated under a 25-year pipeline replacement program, and that a PVC laboratory analysis confirms that piping materials have generally retained their design integrity.

San Bernardino argues that under Southwest's "scoring" system, that awards scores to particular pipelines using the PIA, a score of 77 constitutes a need for replacement in Northern California, while only a 65 is needed to justify replacement in Southern California. San Bernardino contends that applying a score of 77 to Southern California would result in reducing the amount of replacement piping to about 36% of the amount requested by Southwest.

Both ORA and San Bernardino contend that a longer replacement period will mitigate the rate impact of the PVC pipe replacement and allow for better coordination of joint trenching operations for main replacements. ORA and San Bernardino believe their recommendations will still provide sufficient revenues for Southwest to focus on the most problematic portions of its system. ORA, also recommends that Southwest be required to file an annual progress report on its PVC replacement operations.

Southwest argues that the positions of ORA and San Bernardino are quite limited in scope, and therefore their conclusions are faulty. Southwest states that many factors, other than leak rates, determine the need for PVC pipe replacement.⁵⁵ Southwest points to later information on leak rates between 1997 and 2001, and the types of leaks,⁵⁶ that support an aggressive replacement program. Finally, Southwest argues that its PVC pipe replacement program is not comparable to PG&E's program. Southwest states PG&E's program replaces steel and cast iron pipe, and not PVC pipe, and that steel and cast iron pipe tend to suffer from pinhole leaks, not the type of major breaks at joints found in PVC pipes.

7.3. Discussion

In other proceedings, we are often asked to encourage utilities to maintain, repair or replace existing plant. In the instant proceeding, it is not a matter of encouraging or directing Southwest to maintain its system, or whether the aging PVC pipe must be replaced. Parties agree that the PVC pipe, portions of which are over 40-years old, must eventually be replaced. The question before us is how quickly the PVC pipe should be replaced.

In weighing the testimony and evidence presented by parties, and potential safety concerns, we conclude that an accelerated replacement program for Southwest's PVC mains and services is reasonable. However, in order to mitigate the rate impact, we will spread the accelerated replacement program over an additional two years. In its next GRC, we expect Southwest to justify the remainder of the PVC pipeline replacement program, and any proposed modifications. Otherwise, we expect that Southwest will proceed to replace PVC pipe at an equal rate for the next 15 years.

Although Southwest is under no regulatory requirement to replace its PVC pipe, it undertook a reasonable approach to potential problems and safety issues through initiating the PIA. The PIA is an example of the prudent analysis that we expect from utilities under our authority. As Southwest points out, although leak rates and leak types are one PIA factor, the PIA program considers many other factors in determining whether PVC mains and services should be replaced. Our consideration of leak rates, and safety is one of the factors motivating our decision. The most recent Southern California Division information on leak rates indicates an increase in leaks per mile, and more importantly, an increase in the most serious type of leaks (Type 1) for services in 2000 and 2001.⁵⁷ Southwest points out that there is no current industry standard, or regulatory federal or state standard for acceptable leak levels, and that ultimately there should be zero leaks. We agree that reducing leak rates to zero is a laudable goal, or alternatively, leak rates should be minimized. Thus, we acknowledge the importance of reducing leaks in PVC mains and services in order to avoid accidents and improve safety provided by an accelerated replacement program.

Our adoption of an accelerated replacement program also weighs other facts brought forth during testimony. First, Southwest notes that current leak rates decline in those areas where PVC pipe has been replaced; thus, we expect the replacement program will reduce maintenance expenses as it progresses. Our adopted maintenance expenses reflect this expectation. Secondly, Southwest did not wait until this GRC to begin its program, or to delay major portions of work. Southwest has already embarked on its program and replaced substantial PVC pipeline footage. As shown in Appendix B below, Southwest's replacement footage increased for each successive year after 1998. In 2001 replacement footage exceeds proposed test year replacement footage by 16%, and estimated 2002 replacement footage exceeds Southwest's 2003 test year replacement footage by almost 100%.⁵⁸ We view this level of replacement activity as an indication that Southwest determined this is an important program, and has proactively taken action without encouragement from this Commission.

As shown in Appendix B, we have modified Southwest's requested replacement program, and adopted a level of replacement footage we believe adequate to meet the need for replacing PVC pipe mains and services consistent with our primary goal of maintaining safety. Our adopted pipeline replacement footage is based on an average of Southwest's proposed pipeline replacement footages for test year 2003, attrition years 2004, 2005, 2006, and proposed test year 2007. The adopted levels of replacement footage are approximately 22% less than the replacement footage requested by Southwest, but exceed the recommended replacement footages under ORA's and San Bernardino's proposals. Our lower levels of pipeline replacement reflect ORA's contention that Southwest should investigate joint trenching opportunities, and, the concerns of ORA and San Bernardino to decrease the rate shock for customers.

As we are adopting an accelerated pipeline replacement program, we will use Southwest's estimated 2002 plant, that also reflects an accelerated pipeline replacement program, to estimate 2003 rate base.

7.4. Pipeline Replacement Program (Northern
California)

Although the majority of the PVC pipeline replacement is in Southern California, differences also exist between ORA and Southwest over the replacement schedule for PVC mains in Northern California. Most of the services installed in Northern California are non-PVC pipe, and therefore do not require replacement. Southwest proposes a 15-year replacement schedule for PVC mains that would replace about 30,000 feet per year. ORA proposes a 20-year replacement schedule that would replace about 21,000 feet per year of mains.

In adopting a replacement program for Northern California, unlike Southern California, there is little information on leak rates. Since Northern California services have already been upgraded, it appears that the overall problem is less severe. However, we are concerned over the safety of Northern California mains, and therefore we will adopt a pipe replacement program that provides adequate replacement in consideration of these factors. Our adopted Southern California PVC replacement program is accelerated during the first five years, and then equally applied during the remaining 13-years. For Northern California, we will adopt a similar program to replace PVC mains at a rate of 25,000 feet per year for the test year, the three attrition years and 2007. This rate exceeds ORA's recommended rate by approximately 19%, although it is less than Southwest's requested rate by 20%. We expect Southwest to replace the remaining PVC mains at an equal amount annually for the next 14-years beginning in 2008. In the next GRC, we expect that Southwest to replace the remaining PVC mains at an equal amount annually for the next 14-years beginning in 2008. In the next GRC, we expect that Southwest will provide further information on the leak rates experienced in Northern California mains, and make recommendations on further PVC replacement, including changes in the proposed rate, as necessary.

We also adopt a reporting requirement similar to PG&E's reporting requirement for its gas pipe replacement program. We direct Southwest to provide an annual progress report to the Commission regarding the pipeline replacement program as shown in Exhibit 103. The report should include, among other items, the footage of mains and services replaced, costs, and information on leak rates.

7.5. Working Capital

7.5.1. Materials and Supplies

Southwest calculated materials and supplies (M&S) utilizing a five-year average of 13-month inventory balances divided by gas plant in-service. This ratio is then multiplied times plant-in-service balances to estimate M&S. ORA used different estimating methods for M&S including a four-year average and an adjustment for reduced PVC pipeline replacement. Southwest disputes the M&S reduction in Southern California and contends that a reduced pipe replacement program will actually increase M&S balances as a result of increased need for repairs.

Our adopted pipe replacement program is close to the program requested by Southwest. Therefore, we will adopt Southwest's estimate of M&S for Southern California decreased by 15% consistent with our adopted pipeline replacement program. Southwest did not dispute ORA's M&S adjustment for Northern California; thus we will adopt ORA's Northern California M&S estimate.

7.5.2. Working Cash

Southwest and ORA developed working cash estimates using the lead-lag methodology in Commission General Order U-16. However, ORA estimated revenue lag at 40-days, while Southwest used 44-days. ORA argues that its 40-day estimate is reasonable since it is based on historic lead-lag days. ORA also asserts, that due to expiration of high gas cost contracts, it is expected that customers will pay their bills more quickly, thus reducing revenue lag. Southwest, however, points out that during an ORA on-site audit in March 2002, ORA was informed revenue lag had actually increased to 46.7 days. We note that although gas costs may have decreased, and higher priced gas contracts expired, given the current economic climate it is unlikely that customers will pay their bills any more quickly. Thus, we will use Southwest's 44-day revenue lag in our calculation of working cash that is also more reflective of current information.

Southwest and ORA also differ in estimates for income tax payments' lag days used in the working cash calculation. Southwest based its estimates on statutorily mandated filing dates. ORA based its income tax lag days on a proxy reflecting income tax payments for Edison and PG&E. ORA alleges that in Southwest's last GRC, Southwest made an incorrect assumption on the payment of income taxes, and therefore a proxy is appropriate. Southwest states it provided the actual timing of income tax payments to ORA in response to a data request, and in response to questions from the ALJ.⁵⁹ Southwest's response states that actual federal income tax lag days were a negative 224 days for 2001, while state income tax lag days were a positive 39 days. We will not adopt these
actual income tax lag days as they are an apparent anomaly resulting from unusual gas prices. We will not adopt ORA's proxy based on the tax payments for other utilities, as there is not evidence that this proxy should apply to Southwest's tax payments. Instead, we will adopt Southwest's initial estimate of tax lag days based on the statutorily mandated tax payment filing dates.

7.6. General Plant

Southwest and ORA initially disagreed over two general plant issues, Miscellaneous Intangible Plant (Intangible Plant), and 2001 Construction Work in Progress (CWIP) balances; however they have agreed to defer the 2001 CWIP balances until the next GRC.

Regarding Intangible Plant, ORA made a 40% reduction to reflect questionable costs for a Southwest affiliate, Utility Partners (UP). ORA's analysis and recommended disallowance are included in its Audit Review, Exhibit 122. As discussed in Exhibit 122, UP⁶⁰ developed software for use by Southwest and other utilities. Although ORA initially found that Southwest violated affiliate transaction rules, ORA now acknowledges that an exemption for affiliate transaction rules applies to Southwest's relationship to UP. ORA explains that its 40% reduction reflects Southwest's equity share in UP, and is based on the reasonableness of UP project costs charged to Southwest already included in plant in service.⁶¹

Southwest in its rebuttal provides extensive insight into the relationship between Southwest and UP, UP's software projects, and how these projects are useful for improving Southwest operations.⁶² Southwest states its investment in UP involved only shareholder earnings and no ratepayer funds. Southwest also explains that although it had a preferred customer agreement with UP that began in 1999, that agreement provided third-party oversight for costs charged from UP to Southwest. Finally, Southwest asserts that ORA's calculations are in error, as certain UP projects are amortized, or not included at their full value in rate base for the test year, and that deferred income taxes cause additional changes. Southwest calculates that including these adjustments results in a reduction in ORA's proposed disallowance from approximately $8.5 million to $3.3 million.

7.7. Discussion

We will not further address the $30 million in software projects currently in CWIP, except to remind Southwest of its commitment to demonstrate in its next GRC that these project costs are reasonable before any of these dollars may be included in plant-in-service. As stated previously, Southwest bears the burden of proof that such costs are reasonable, and not ORA. Southwest argues that it has not been required in prior proceedings before this Commission or in any other regulatory jurisdictions to provide independent proof.⁶³ Each proceeding before us has its own unique circumstances, with findings determined on the facts applicable to the specific proceeding; thus, we will not excuse Southwest on the basis that a specific showing has not been previously required.

We will not adopt ORA's recommended disallowance regarding the remaining UP project costs. Southwest provided substantial information regarding the usefulness of each of these projects to the company's operations and as improvements to efficiencies. ORA concluded that the project costs were unreasonable because these costs exceeded budgeted amounts. However, many projects, especially those involving complex projects, such as information technology, may exceed their budgets. Thus, a final cost that exceeds a budget is not of itself a measure of unreasonableness. Furthermore, this measure of cost unreasonableness would have to be significantly reduced by the various credits for both fully and partially amortized projects, and deferred income taxes in weighing the value of a project against its cost.

7.8. Contract Escalation

Southwest agrees with ORA's allocation of capital expenditures to labor, non-labor and contactor services, but argues that the contractor services component should also be escalated by 1.75%, or 3% for the test year. We have reviewed Southwest's calculations and agree with a 3% increase in the contractor component.

7.9. Truckee Operations Center

ORA excluded the building and furniture costs of the Truckee Operations Center from its estimates of plant arguing that Southwest had failed to provide a definite plan to construct the operations center, obtaining a building permit, or selection of an architect. Initially, Southwest included the operations center in its 2002 plant in service, although it now expects to finish construction by the end of 2003. Southwest contends it has committed to build the operations center, and through its witness provided an update of the status of design and permit process.

As a result of the Truckee expansion project, and the need to have an operations center in the Truckee area, it is not a matter of whether Southwest will have an operations center, but a question of when. We have already included, with ORA's agreement, expenses for a new Truckee district manger, who will eventually require an office. Our review of the record indicates that although design and construction of the operations center has been delayed in the past, it appears that construction is likely during 2003. Therefore, although we will not include the costs for the Truckee Operations Center in the test year estimates, we will include these costs in plant for attrition year 2004.