15. Rate of Return

For a regulated utility, rate of return on rate base is the ratio of earnings to total rate base. Essentially, rate of return is the compensation paid to investors for the capital they have provided for public utility service. A fair rate of return is acknowledged to be no less than the company's cost of capital (so that the utility can maintain its credit rating and attract additional investment). Cost of capital is determined as a weighed average of the cost of debt, the cost of preferred stock, and the cost of common stock. The cost of each capital component is weighted on the basis of the company's capital structure (that is, the relative amounts of equity and long-term debt that constitute the company's long-term financing).

Suburban and ORA agree on most of the elements of Suburban's capital structure. For test year 2003, capital structure consists of long-term debt, 37.90%; preferred equity, 6.50%, and common equity, 55.60%. For test year 2004, the respective ratios are 38.30%; 6.00%, and 55.70%. For 2005, the respective ratios are 38.90%; 5.70% and 55.40%. Suburban adopted ORA's more current projections of common equity ratios. The parties have slight differences on their estimates of embedded costs of long-term debt. Suburban relied on historical data, while ORA relied on a forecasted interest rate. The latter approach is more appropriate in determining the future cost of long-term debt. We will accept ORA's calculations of 8.83% for 2003; 8.45% for 2004, and 8.23% for 2005.

Cost of equity is typically the most contested component of rate of return in water general rate cases. It is a direct measure of the company's after-tax return on equity (ROE) investment, and its determination is by necessity somewhat subjective and not susceptible to direct measurement in the same way as capital structure and embedded cost of debt.

Both Suburban and ORA acknowledge the established legal standard for determining a fair ROE, and we have many times cited that same legal standard. In the Bluefield Water Works case,⁴ the Supreme Court stated that a public utility is entitled to earn a return on the value of its property employed for the convenience of the public, and set forth parameters to assess a reasonable return. That return should be "...reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economic management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties."

As the Supreme Court also noted in that case, a utility has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. In 1944, the Court again considered the rate of return issue in the Hope Natural Gas Company case,⁵ stating, "[T]he return to the equity owner should be commensurate with returns on investments in other enterprises sharing corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital." The Court went on to affirm the general principle that, in establishing a just and reasonable rate of return, consideration must be given to the interests of both consumers and investors.

With these principles in mind, we examine ORA's recommended rate of return and return on equity, and then Suburban's.

15.1 ORA's Recommended Return on Equity

To determine the appropriate return on equity for Suburban, ORA performed a quantitative analysis and then assessed the level of business and financial risk Suburban faced. In its quantitative analysis, ORA used two financial models, DCF (discounted cash flow) and RP (risk premium), to estimate investors' expected return on equity.⁶ ORA applied both models to a group of comparable water utilities selected based on two criteria: (1) water operations account for at least 70% of the utilities' revenues, and (2) the utilities' stocks are publicly traded. The comparable group was comprised of seven companies: American States Water, American Water Works, California Water Service, Connecticut Water Service, Middlesex Water, Philadelphia Suburban, and San Jose Water.⁷ ORA used this comparable group for both its DCF and RP analyses.

ORA's DCF analysis yielded an average expected ROE of 7.87%. Its RP analysis produced an initial result of 10.21%. It averaged the two results to produce a composite model return of 9.04%.

In addition to its DCF and RP quantitative analyses, ORA assessed the level of financial and business risk Suburban faces. In concluding that Suburban's business risk is low, ORA cited the Commission's many risk-reducing mechanisms available to water utilities, including balancing accounts for purchased water, purchased power, and pump taxes, memorandum accounts for Safe Drinking Water Act compliance, 50% fixed cost recovery, and Construction Work in Progress in rate base.

15.2 Suburban's Recommended Return on Equity

Suburban used five market-oriented methods, including the DCF and RP models,⁸ to arrive at a market cost rate of common equity of 10.82%, and three conversion methods to arrive at its recommended 12% return on equity. Suburban's financial consultant, Henry G. Mülle, stated that his 12% ROE recommendation includes a 25 basis-point (1/4 of 1%) allowance for increased risk.

Suburban's DCF calculation, including a growth rate calculated from various market indices, was 10.46%. Suburban's RP calculation, including a beta-adjusted risk premium, showed a market cost of common equity for an A rated water utility of 11.08%.

Mülle said that he tested his findings by comparing them to the Value Line quarterly estimates of prospective ROEs to be achieved by the water utility industry. Value Line looks at four of the industry's largest water utilities and, as of November 2002, projected what Mülle interpolated as an average 10.60% ROE for 2003; 11.10% ROE for 2004, and 11.60% ROE for 2007.

In contrast to ORA's assessment of risk, Suburban regards its risk as high because of the contamination in much of its source of water supply. To maintain its bond quality rating between A and AA, Suburban cites one of the Standard & Poor's interest coverage benchmarks as requiring an ROE of between 11.5% and 12%.

15.3 Return on Equity Discussion

ORA and Suburban each attack perceived shortcomings in the other's ROE showing. Suburban argues that ORA's use of only two market-oriented methods results in widely divergent results of 7.87% and 10.21% that are too far apart to be averaged in arriving at a recommended ROE of 9.04%. Moreover, according to Suburban, ORA's market-oriented methods estimate investors' expected market return on their market-valued investments (ROM), rather than expected return on book value common equity (ROE) for Suburban. Suburban argues that ORA should have used conversion methods to translate ROM into ROE.

ORA argues that Suburban's analyses are contrary to Commission policy in that its CAPM, as well as its small co-premium adjustment, consider non-regulated and non-water company market factors in arriving at an ROE. ORA states that the Commission discourages comparisons to non-regulated companies because the non-regulated companies do not benefit from such regulatory tools as fixed cost recovery, balancing accounts and memorandum accounts.⁹ ORA also rejects Suburban's analysis of market value and book value of stock prices for water utilities, arguing that the authority upon which the analysis is based¹⁰ does not recommend any one method of utilizing the DCF model.

Ultimately, the choice of factors used to measure an appropriate return on investors' equity is a matter of judgment. Both parties rely on DCF and RP analyses that we have consistently accepted in the past for water companies. In ORA's analysis, however, we are troubled by the unusually large disparity (234 basis points) between the DCF and RP results. ORA has not adequately explained the reasons for the disparity, nor the logic of averaging two such differing results to arrive at an ROE of 9.04%. This is significantly lower than ROE results either endorsed by ORA or adopted by this Commission in recent water company cases.¹¹ Results of a third ROE model, even one with acknowledged shortcomings, would have been useful in weighing ORA's recommendations.

By the same token, Suburban's use of data including non-regulated and non-water companies affects the results of some of its data since, as ORA notes, the Commission has consistently resisted using non-utility data to gauge a water company's risk analysis or ROE. Suburban's use of regulatory mechanisms available in Pennsylvania and Florida to deal with utility risk is meaningless without a thorough review of programs already in place in each state to deal with risk. When asked to explain how Suburban would justify a 12% ROE in the face of the lower returns anticipated for other California water companies, Suburban's witness pointed to his five market-oriented analyses and emphasized the utility's risk. While we agree that sitting atop a Superfund Site is risk enough for any water company, the evidence also shows that Suburban has in fact alleviated its risk through the CR reimbursements and contributions of the BPOU Project Agreement.

Suburban points out that what it calls the inconsistency between ORA's DCF model (7.87% ROE) and its RP model (10.21% ROE) can be alleviated by taking a more traditional approach in the model. In its DCF model, ORA included a comparable company (American Water Works) for yield purposes but excluded that company for growth purposes. When asked on cross-examination about the exclusion of American Water Works for earnings growth rate purposes, ORA's witness explained that she felt at the time that an acquisition announcement involving the company was likely to have influenced its earnings growth rates. In fact, recent Standard & Poor's Earnings Guide data show post-announcement earnings growth expectations ranged from a low of 6% to a high of 9.5%, while pre-announcement earnings growth expectations ranged from 6% to 9%. Since the acquisition announcement in fact appears to have had little effect on forecasts of earnings growth rate, the American Water Works data could have been used in ORA's model for both yield and growth purposes, as would normally be the practice. By doing so, ORA's DCF model would have shown an ROE range of between 9.21% and 9.72%. When averaged with the RP method, a more plausible average return on equity between 9.71% and 9.97% would have been obtained, and criticism of the diverse results in the two approaches would have been eliminated.

In the absence of more compelling alternatives, we will adopt an ROE of 9.84% for Years 2003, 2004 and 2005. We choose the midpoint of the adjusted averages because we believe that this strikes a reasonable balance of the data that ORA and Suburban have presented to us.

15.4 Rate of Return

With the capital structure, cost of debt, and cost of equity components determined, the calculation in Table 3 derives the rate of return on rate base:

Table 3

Cost of Capital

	Adopted
	Capital Structure	Cost	Rate of Return
Test Year 2003
Long-Term Debt	37.90 %	8.83 %	3.35 %
Preferred Equity	6.50%	4.25 %	0.28 %
Common Equity	55.60%	9.84%	5.47%
Total 100.00% 9.10%
Test Year 2004
Long-Term Debt	38.30 %	8.45%	3.24%
Preferred Equity	6.00%	4.25%	0.26%
Common Equity	55.70%	9.84%	5.48%
Total 100.00% 8.98%
Attrition Year 2005
Long-Term Debt	38.90%	8.23%	3.20%
Preferred Equity	5.70%	4.25%	0.24%
Common Equity	55.40%	9.84%	5.45%
Total 100.00% 8.89%