13. Lease of Water Rights to the City of Folsom

In November 1994, SCWC signed a contract to lease, to the City of Folsom, 5,000 acre-feet per year (AFY) of water rights to the American River and has included all associated revenues in a non-operating revenue account. Staff asserts that SCWC was imprudent in signing the lease and was negligent in not filing an application under § 851 for Commission approval of the lease. Staff recommends the lease be voided, SCWC be fined $180,000, SCWC's rate of return be reduced by 50 basis points, lease proceeds be booked to an operating revenue account, all recorded lease proceeds from 1996 - 2003, plus interest, be credited to ratepayers and SCWC be ordered to file certain water supply and demand information. This decision assigns all lease proceeds from the year 2003 forward to an operating revenue account, which will be used in the determination of the revenue requirement for the Arden-Cordova CSA. The other ORA recommendations are not adopted.

13.1. Procedural Background

Issues related to the 1994 lease were raised by ORA in the test year 2001 GRC (A.00-03-064) for SCWC's Region I, which includes the Arden-Cordova CSA. In that proceeding, the Ratepayer Representation Branch (RRB) contended that SCWC violated § 851 when it entered into its 1994 agreement with the City of Folsom. Staff recommended that the Commission order SCWC to return all revenue collected from the leasing of water rights since 1994 to the customers and order SCWC to file an application requesting Commission authorization of the contract.¹⁹ Subsequently, SCWC issued rebuttal testimony on this issue. RRB and SCWC eventually settled the GRC; and, as part of the settlement, the parties agreed to defer the lease issue to a proceeding in early 2001.²⁰ That proceeding was to be the GRC for Region II. The Region II GRC was not filed as anticipated at the time of the settlement. Instead, the next GRC filed by SCWC is the current Region III GRC. Therefore, ORA, the staff advocacy successor to RRB, has raised the lease issue in this proceeding, and SCWC has again rebutted the related staff testimony.

13.2. Factual Background

The facts contained in the following background discussion are not in dispute.

In June 1964, SCWC purchased the Natomas Water Company. With the purchase, SCWC obtained 32,000 acre-feet per year (AFY) of water rights to the American River. Subsequently, by D.71889 issued January 24, 1967, the Commission authorized SCWC to transfer the Folsom water system and 22,000 AFY to the City of Folsom

From 1966 to 1970, SCWC used approximately 500 AFY of raw, untreated water from the American River for irrigation customers in Rancho Cordova. SCWC had no facility to treat surface water after the City of Folsom acquired the Folsom Treatment Plant.

SCWC constructed the Coloma Treatment Plant (operational in 1973) to treat surface water. The plant and system that was recorded in SCWC's rate base could treat and distribute only 5,000 AFY of SCWC's entitlement to American River water. Attached as Exhibit B to Exhibit 38 is a chart detailing SCWC's actual surface water production from the American River from 1973 through 2002. The chart shows that SCWC's use of surface water from the American River was as low as 678 AF in 1973, gradually increasing to 3,451 AFY by 1990.

In November 1994 SCWC signed the lease with the City of Folsom. At that time, SCWC had never used more than 3,451 AFY of surface water from the American River to serve its customers. Lease revenues received by SCWC have been booked in PUC Account 526, Miscellaneous Non-Operating Revenues. Since this is a below-the-line account, all revenues have benefited shareholders.

In 1994, groundwater was plentiful and it was cheaper for customers to be supplied by groundwater than by American River surface water, which had to be treated at the Coloma Treatment Plant before it could be delivered to customers. At that time, it cost approximately $56.73 per acre-foot to deliver potable water from the Coloma Treatment Plant (American River surface water), compared to only $37.10 per acre-foot to deliver potable water from SCWC's groundwater wells in its Cordova system. The total power and chemical cost for the two sources of water is virtually identical, but the labor cost associated with operating the Coloma Treatment Plant made using surface water more expensive.

Also in the 1994 timeframe, while a few wells had begun to show traces of TCE²¹ contamination, SCWC had successfully installed granulated activated carbon filters on the wells to remove TCEs. SCWC did not discover that there were detectable levels of perchlorate in its groundwater wells until 1997, and did not discover the presence of NDMA in its wells until 1998. All of SCWC's groundwater wells were fully operational until 1997, when the utility discovered the perchlorate contamination. Since 1997, SCWC has taken out of service 11 wells due to the contamination.

To address water supply problems, SCWC has placed into operation several new groundwater wells that were drilled in locations away from the contamination and has constructed new treatment capacity at its Coloma Treatment Plant. In the short term, SCWC plans on using 10,000 AFY of untreated water obtained in a "take or pay", five-year contract with the Sacramento Municipal Utilities District (SMUD). The contract became effective July 29, 2002.

13.3. Discussion

There are three principal issues related to the lease. The first is the prudence of SCWC's decision to lease 5,000 AFY of water rights to the City of Folsom, beginning in 1995. The second is whether SCWC should have filed an application, under § 851, to request Commission authorization to effectuate the lease. The third concerns the proper ratemaking treatment for revenues received from the lease of the water rights.

In general, for cases related to the transfer or encumbrance of utility property, where there are potential issues such as management reasonableness, the useful and necessary criteria and allocation of the benefits, it would be preferable for the utility to file a § 851 application for our determination, even if a strict interpretation of § 851 indicates that a filing is not necessary. Absent such a filing, the utility puts itself at risk for the transaction being voided, penalties being imposed, and refunds or other ratemaking adjustments being ordered. In this particular proceeding, ORA has raised significant, relevant issues related to the lease of SCWC's water rights to the City of Folsom and the company's decision not to seek Commission authorization for the transaction. The fact that we are addressing these concerns now rather than in 1994 when the transaction was contemplated is due to the actions of SCWC.

Regarding the prudence of the lease, our standard is that the determination of prudence or imprudence should be based on what was known or should have been known at the time the decision to act was made. That standard is also fair and appropriate in this case where we are evaluating specific actions of SCWC's management and considering sanctions related to those actions.

Unfortunately, much of what ORA argues in this case appears to be based on hindsight, not conditions as they existed at the time SCWC entered into the 1994 lease. For instance, ORA points to the need now for the water rights since groundwater contamination has reduced the availability of pumped water. For a prudence review, information that was known, or should been known, in 1994 regarding such factors as the existing contamination, the potential for treating that contamination, the potential for finding other contaminants and the potential for stricter regulations should be analyzed to determine whether SCWC could have and should have anticipated the magnitude of the present contamination problem and the need for the water rights. Similarly, regarding growth of the system, the ORA assertion that water leased to the City of Folsom is now needed to serve the Arden-Cordova CSA is based on information much of which is subsequent to the signing of the 1994 lease. The more compelling evidence as to the prudence of the company's actions would include information related to long term water demand forecasts conducted in the 1994 timeframe and the supply mix options, considered in that same timeframe, that would satisfy the long term water demand. Considering the weight of the evidence in the record, we cannot conclude that SCWC management acted imprudently when it signed the 1994 lease, and we will not impose a rate of return penalty as requested by ORA.

While we do not find that SCWC acted imprudently, the responsibility for signing the discretionary lease falls on the utility; and, as such, the responsibility for effectively addressing any adverse consequences of that discretionary action also falls on the utility. It is therefore appropriate to explore all options to alleviate any negative effects of that transaction. Also, the resolution of the prudence issue is independent of the resolution of the issues concerning whether SCWC should have filed a § 851 application, to which we now turn, and the proper ratemaking treatment for lease revenues.

The issue of whether SCWC should have secured authorization from the Commission, under the provisions of § 851, before leasing the water rights to the City of Folsom, depends on whether these water rights were "useful or necessary in the performance of its duties to the public." SCWC makes the point that up to 3,451 AF per year of the available 10,000 AF per year of water rights had been used to the point in time when the lease was signed, so the 5,000 AF leased to the City of Folsom had never been used. Those are established facts in this case. ORA has also established that SCWC now needs more water rights, in fact its entire allocation of 10,000 AFY to replace capacity of the to shut-down wells. In this instance, the American River water rights, in part and ultimately as a whole, are useful and necessary to provide service to the Arden-Cordova customers. However, for determining the necessity, in 1994, for SCWC to file an application under the requirements of Section 851, the positions of the parties indicate we need to clarify whether water rights can be viewed in pieces in the "necessary and useful" analysis and clarify what "necessary and useful" means for the purposes of § 851.

As to whether water rights can be viewed in pieces, we agree with SCWC, based on the facts in this case. The original 32,000 AFY in water rights obtained by SCWC from the Natomas Water Company in 1964 were separable in that 22,000 AFY were subsequently included in the sale of SCWC's Folsom System to the City of Folsom in 1967. We see no reason why portions of the remaining 10,000 AFY should not also be considered separable for purposes such as sale or lease. Also, the record shows that at least 5,000 AFY were not being used and were not necessary in 1994. Therefore, we conclude that, in 1994, 5,000 AFY were not necessary or being used in the operation of the Arden-Cordova CSA.

There is precedent for a utility not being required to file an application under § 851 when transferring utility property. ²² The criterion was whether the property was presently necessary or useful at the time of the transfer. ORA did not cite any Commission decisions that contradict this criterion. However, we note that it is common for utilities to file § 851 applications when selling land and buildings that are no longer useful or necessary. Whether the property is, or is not, useful or necessary can be confirmed and the disposition of any gains or benefits can be determined by the resulting decision. As indicated previously, our preference would be for SCWC to have filed a § 851 application in 1994 and we would encourage utilities to do so in the future. However, a strict reading of § 851 favors the position of SCWC, and we conclude that SCWC was not required to file an application pursuant to § 851 when it leased the water rights to the City of Folsom. We will therefore not penalize the company or void the lease as recommended by ORA.

We now turn to the ratemaking issue. In the past we have allocated net benefits from the transfer or encumbrance of utility property to ratepayers, to shareholders or to both based on circumstances and assessments of risk. Also as we indicated earlier in determining that while SCWC did not act imprudently when entering into the lease agreement, the utility is still ultimately responsible for the decision to do so. To the extent possible, the associated risks should not fall on the ratepayers. In this case, due to the length of time that has passed since November 1994, when the lease was signed, we have substantial knowledge related to the effect of the lease historically as well as prospectively. It was not until 2002 that SCWC required more than 5,000 AF of surface water, as evidenced by the SMUD agreement. Up until this time, ratepayers were apparently not harmed by SCWC's decision to lease the water rights. However, it is from this point forward that the Arden-Cordova CSA need for the water rights leased to Folsom becomes apparent. By the five-year water transfer agreement with SMUD, SCWC has annual access to as much as 10,000 AF of water for the time period July 2, 2002 through July 29, 2007. Costs related to the SMUD agreement will be borne by ratepayers. Beyond that time period, it is not certain or clear how SCWC will obtain its water supply for the Arden-Cordova CSA. In whatever manner it is accomplished, ratepayers will again, in all likelihood, be expected to shoulder the related costs. It is from this point, sometime in late 2002, that ratepayers are substantially exposed to the negative effects of the lease. The first full-year of these effects would be 2003.

SCWC argues that the water rights were never in rate base, are non-utility/non-regulated property of SCWC and therefore the lease proceeds should accrue only to shareholders. We do not accept that proposition. When SCWC purchased the Natomas Water Company in 1964, the transfer of water rights was included in the transaction. As even SCWC admits, certain amounts of those rights were exercised previously by the Natomas Water Company and subsequently by SCWC. The fact that certain amounts of the water rights were not necessary or useful at a certain point in time may be relevant in determining whether or not a § 851 application is necessary when selling or leasing those rights. However, that fact is not relevant in determining whether those rights are, or are not, utility property. In fact, evidence in this proceeding shows that the leased water rights are now necessary and would be useful to the ratepayers, were they not already encumbered by the lease.

In this case, the entire cost the Natomas Water Company purchase, which included 32,000 AFY was borne by the ratepayers. Shareholders were not separately responsible for recovery of any of the costs. We see no reason to assign the benefit of the water rights to shareholders merely due to the fact that as SCWC states, "At that time - 1963 - it was common practice to attach no monetary value to water rights and therefore SCWC acquired these water rights for free."²³ That is insufficient reason to make such an assignment. We determine that the entire amount of water rights was utility property at the time of the purchase and the entire, currently remaining, 10,000 AFY, which includes the 5,000 AFY being leased to the City of Folsom, continues to be utility property.

Based on this risk assessment, it is reasonable to allocate the benefits of the lease to shareholders from inception until the end of 2002 and allocate the benefits to the ratepayers beginning in 2003, for the duration of the lease. Lease revenues should substantially offset the negative short and long term effects of the lease in the same timeframe that those negative effects will occur. Therefore, beginning in 2003, revenues derived from the 1994 lease of water rights to the City of Folsom should be booked to an operating revenue account.²⁴ Those revenues should be used to offset water production costs for the Arden-Cordova CSA. Based on the circumstances of this case, we feel these actions fairly address the concerns that have been raised. The result is preferable to either the company or ORA proposals where either shareholders or ratepayers would receive the entire lease benefit.

Since this decision allocates pre-2003 lease revenues to shareholders, we will not adopt ORA's recommendations to fine SCWC $20,000 for each year it failed to record the revenues from the lease of the water rights in PUC account 607, and to order SCWC to return all revenues collected from the lease of water rights contract with the City of Folsom since 1994, plus 7 % interest, to the Arden-Cordova CSA's customers.

Also, at this time, we do not feel it is necessary to order SCWC to provide the supply, demand, and cost studies recommended by ORA. These considerations, to insure adequate water supply for the Arden-Cordova water system, can be addressed in the next Region I GRC, at which time SCWC will have the burden of proof to justify its expenses and capital expenditures related to water supply and production.

COST OF SERVICE ISSUES