VI. Rate of Return

The rate of return (ROR) is the amount earned, or allowed to be earned, by a utility, expressed as a percentage of the utility's rate base. In our proceedings, it is calculated as weighted average of the utility's cost of capital: the cost of long-term debt, the cost of preferred stock, and the return on common stock equity (ROE). In this proceeding, there is little dispute over the debt and preferred stock portions of the cost of capital.⁵ It is the ROE that is at issue. While SJWC requests 11.75%, RRB recommends 8.40% for ROE.

A. Position of SJWC

SJWC contends that: (1) the economic models, fairly applied, fully justify an ROE in excess of 11.75%; (2) interest rates have risen steadily over the past two years and dramatically over the last six months; (3) the marketplace now views water utilities' risks as being comparable to those of other major utilities; and (4) SJWC's operating risks require that there be a compensating upward ROE adjustment.

According to SJWC, the relevant risks to investors are: (a) SJWC's small market capitalization; (b) its single geographic location; (c) its growing capital intensity from escalating capital additions and its infrastructure replacement program, exacerbated by the growing infrastructure demands of the Safe Drinking Water Act regulations and increasing operating leverage; and (d) the resulting need to maintain an equivalent AA/A bond credit rating and associated pre-tax interest coverages.

SJWC argues that RRB's 8.40% ROE recommendation is the simple average of two financial model runs which does not look to the market place for validation. According to SJWC, the "application of judgment" standard required by the Commission should consider the following:

First, an investor would plainly be better off investing in no risk debt securities than an equity earning only the 8.4% recommended by RRB.

Second, RRB ignores the fact that interest rates have been on a steady climb the past two years and particularly this past year. Between May 1999 and May 2000, there was a 46 basis point increase in T-Bond yields and a 123 basis point increase in A-rated utility bond yields. According to SJWC, that translates to a 7.6% one-year increase in T-Bond yields and a 16.5% one-year increase in A-rated utility bonds or a combined 12% increase over that 12-month period.

Third, RRB ignores the professional advisors such as Value Line which, for example, has projected an 11% ROE for 2000 and a 12% ROE for 2003-2005 for the investor-owned water utility industry.

Fourth, Standard & Poors has recognized that the investor-owned water utilities have the same risk profile as investor-owned electric and natural gas utilities.

Fifth, the Commission has previously acknowledged the fact that SJWC being a single-district water company has increased business risk (D.96-07-036, Finding of Fact 17).

Sixth, SJWC's small size in the marketplace, stiff investment needs and higher percentages of non-residential customers are additional risk elements that should be recognized in its ROE.

Finally, SJWC points out that the Commission has recognized as reasonable a 62 point upward change in Pacific Gas and Electric Company's ROE to reflect the upward change in the marketplace over the past year alone, specifically excluding any change in risks (D.00-06-040, mimeo., pp. 18-19).

B. Position of RRB

The starting point in RRB's analysis was to select a group of 10 water companies, including SJWC, of comparable characteristics. Next, RRB used the Discounted Cashflow Model to calculate the present value of their future dividends and the Risk Premium Model to determine the greater return required for stocks relative to risk free investment. Based on this analysis, RRB concluded that investors presently expect these companies to earn a return on equity of 7.61% under the Discounted Cashflow Model and 9.14% under the Risk Premium Model, for an overall average of 8.37%.

RRB than examined the risks facing SJWC to determine whether investors would reasonably require it to earn more or less than the average expected return. According to RRB, pertinent here is that the price at which SJWC's corporate parent trades is higher than its book value per share (thus indicating that SJWC's return is greater than that required by investors); that the regulatory environment in California is very supportive of water companies (thus providing SJWC a good opportunity to earn its authorized return); and that SJWC's ratio of common equity to total capital is greater than the average of the comparable group (thus establishing that SJWC has low financial risk). Accordingly, RRB recommended, given its relatively low overall risk, that SJWC be authorized a return on equity of 8.40%, or approximately the average investors would expect to earn from the companies of the comparable group of water companies selected by RRB.

RRB argues that SJWC is no riskier than the average water company. With regard to the various "business and financial risk concerns" cited by SJWC, as listed below:

(1) "[SJWC's] small market capitalization." RRB contends that the Commission has consistently determined that water companies are less risky than the more highly capitalized electric utilities. (See, e.g., Re San Jose Water Co., 67 CPUC2d 6, 17 (1996).) And any comparison between water companies and nonregulated industries is far more attenuated. Even among Class A water companies, size is not a factor: without exception, all are financially sound and should be treated the same. (Re Financial and Operational Risks of Commission-regulated Water Utilities. D.94-06-033, 55 CPUC2d 158.)

(2) "[SJWC's] single geographic location." RRB contends SJWC's location in economically strong Santa Clara County reduces risk by increasing the predictability of revenues.

(3) "[SJWC's] growing capital intensity from escalating capital additions and its infrastructure replacement program, exacerbated by the growing infrastructure demands of the Safe Drinking Water Act regulations and increasing operating leverage." RRB contends that construction proposed under this program is far from extraordinary. Rather, it is perfectly inline with the trend of what SJWC has spent during the past three years.

(4) "[T]he resulting need to maintain an equivalent AA/A bond credit rating and associated pre-tax interest coverages and times-fixed charges earned coverages." RRB contends that given its strong financial position, SJWC would need only achieve Pretax Interest Coverage of 3.40, the midpoint between the minimum for AA and A, to maintain its credit. This closely corresponds to the return on equity of 8.40% recommended by RRB. By contrast, with its requested return on equity of 11.75%, SJWC would achieve Pretax Interest Coverage of 3.96 - an amount far more than needed to maintain a rating of AA/A.

Regarding SJWC's criticism that possibly the most significant deficiency with RRB's analysis is RRB's use of only two analytical methods, RRB argues that the Commission's consistent practice has been to use as the basis for its determination of the appropriate return on equity the exact methodology followed by RRB in the present proceeding. (See Re San Jose Water Co., supra, 67 CPUC2d at 17.) Further, RRB argues that SJWC's use of the Comparative Earnings Method is directly contrary to the Commission's admonition that water companies should not be compared with companies in other industries. (Id.) Also, according to RRB, just as problematic is SJWC's use of the Capital Asset Pricing Model, which shows very little correlation here between risk and reward.

Lastly, with regard to SJWC's arguments that "interest rates are trending distinctly upwards" and the 62 basis points increase in ROE granted to PG&E by D.00-06-040, RRB responds that a more pertinent comparison here is between interest rates at the time the Commission last reviewed SJWC's cost of capital and interest rates. RRB points out that in fact, on July 17, 1996, when the Commission issued D.96-07-036, authorizing a return on equity of 10.20% for SJWC, the rate on bonds issued by the United States Treasury for a duration of 30 years was 7.06%. By contrast, on April 30, 2000, the date used by RRB in preparing its testimony in the present proceeding, the rate for Treasuries was 5.85%. RRB points out that this represents a decline of some 121 basis points, and indicates, if anything, that a return on equity of 8.40%, as recommended by RRB, is more in keeping with changes in the financial markets than SJWC's recommendation of 11.75%. Further, RRB argues that the direction of interest rates has no direct bearing on the cost of capital. According to RRB, the return on equity should be determined comprehensively through the use of financial models and not on the basis of transitory changes in interest rates.

C. Discussion

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.⁶ 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 assure 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.

The Hope decision reinforces the Bluefield decision and emphasizes that such 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 risk. 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.

Forecasting the prospective cost of common equity for a utility whose stock is not publicly traded is a relatively complex undertaking. It involves consideration of such matters as business and financial risks, investor expectations and capital ratios. It commonly involves the use and application of recognized financial models as proxies to provide a range of ROE appropriate to the specific applicant. But it also involves testing the results from those mathematical models against common sense, all of it informed by the exercise of sound judgment and an understanding of business and investment risks peculiar to the specific applicant. Stated otherwise, the traditional models (discussed above) create a range against which to measure one's conclusions; they are, however, only a part of the forecasting process and are themselves subject to material disagreements as to their inputs and assumptions and to wide interpretation in their use and application. As stated by the Commission: "We believe that results of various financial models are good starting points as well as analytical guides for establishing ROE. However, the actual determination of a reasonable ROE is a matter of judgment." (D.96-07-036, 67 CPUC2d 6, 17 (1996) (San Jose Water Company GRC; emphasis added.)

Turning to the testimony before us in this proceeding, we find that SJWC continues to labor under the misconception that investor-owned water utilities face risk factors comparable to electric utilities. The Commission has historically not authorized the same returns for water utilities as it does for electric utilities. And the Commission has consistently determined that no connection exists between returns authorized water companies and electric utilities. For example, as the Commission stated in D.96-07-036:

"[T]here is no constant spread between ROEs authorized for energy utilities and water utilities. There is no reason that ROEs for energy and water utilities should move in lock-step, because to do so ignores not only the underlying financial criteria (e.g., debt-equity ratios, interest coverage, etc.) but also the relative financial business risks faced by each utility sector. In the past, we have considered water utilities to be lower risk investments than energy utilities. With the imminent restructuring of the electric industry, the difference in business risk between water utility sector and the electric utility sector may become even more significant from an investor's point of view. Also, business risks of water utilities are minimized because a variety of mechanisms exist through the general rate case process to address any increased risks resulting from the costs of water shortage or water-quality problems. These mechanisms include revising sales forecasts, inclusion of needed capital improvement in forecasted plant addition, and pass-through (through balancing account treatment) of any increase in cost of purchased water or power." (67 CPUC2d at 17.)

The current woes facing the electric utilities following deregulation of generation are fully discussed in the news media and need not be repeated here. However, one may readily conclude from these news articles that the California investor-owned water utilities do not have comparable risk factors to the electric utilities. For example, this summer's electricity crisis forced the state's investor-owned utilities to purchase wholesale electricity costing $4 billion more than what they charge customers under existing rates. Southern California Edison Company and PG&E have filed petitions to modify the post-transition electricity rate decisions⁷ which specify that liabilities remaining in a transition recovery account after the rate freeze ends cannot be collected by the utility. Responsibility for these shortfalls is a large risk, and the risk factors facing water utilities pale in comparison. Thus, we reject SJWC's comparable risk factor argument.

We now turn to the financial models used by the parties. The financial models are used only to establish a range from which the parties apply their individual judgment to determine a fair ROE. Although the parties agree that the models are objective, the results are dependent on the subjective inputs. From these subjective inputs the parties advance arguments in support of their respective analyses and in criticism of the input assumptions used by other parties. These arguments will not be addressed extensively in this opinion, since they do not alter the model results. In the final analysis, it is the application of judgment, not the precision of these models, which is the key to selecting a specific ROE estimate within the range predicted by analysis.

We view the output of the financial models provided by the parties with some skepticism. We give little weight to the outputs of SJWC's Comparable Earnings Model, and Capital Asset Pricing Model, in this instance, because these models yield implausible results. The table below compares the output of the other two models used by the parties.

	SJWC November 1999	RRB May 2000
Risk Premium	12.08%	9.14%
Discounted Cash Flow	11.85	7.61
Recommended ROE	11.75%	8.40%

These results provide a range for establishing ROE. As we stated, the actual determination of a reasonable ROE is a matter of judgment.

First, we are not persuaded by SJWC's argument that its requested 11.75% ROE is reasonable in light of Value Line's projection of a 11% ROE for 2000 and a 12% ROE for 2003-2005 for the investor-owned water utility industry. Value Line's recommendation is not California specific. For example, it may not sufficiently recognize the reduced risk to SJWC's investors because of the availability of various balancing accounts which shift much of the business risk to ratepayers. SJWC has balancing accounts for purchased water, purchased power and pump tax. Also, the Commission has on occasion authorized Catastrophic Event Memorandum Accounts, Water Quality Memorandum Accounts, and Drought and Water Conservation Expense Memorandum Accounts for water utilities in specific situations. These balancing accounts underscore the fact that water utilities enjoy a relatively protected regulatory environment in California.

Next, we will discuss the financial, business, and regulatory risk expected during the year 2001-2003 period to arrive at our adopted ROE.

Financial risk is tied to the utility's capital structure. The proportion of its debt to permanent capital determines the level of financial risk that a utility faces. In general, the lower the proportion of a utility's total capitalization consisting of common equity, the higher the financial risk. Therefore, as a utility's debt ratio increases, a higher ROE may be needed to compensate for that increased risk. With regard to SJWC, since the Commission reviewed SJWC's capital structure for 1996 and 1997 in D.96-07-036, there is a slight decrease in the debt ratio proposed for 2001 and 2002. However, the change is not significant enough to warrant a downward adjustment of ROE from the 10.20% last found reasonable.

Business risk is defined to be the degree of variability in operating results. That is, a company that has the most variability in operating results has the most business risk. An increase in business risk for utilities can be caused by a variety of events, for example: deregulation, or greater fixed costs in relationship to sales volume. Because no measurable change in risk through years 2001-2003 is anticipated for SJWC, there is no basis to reflect an upward or downward adjustment to SJWC's cost of equity, previously found reasonable, to reflect a change in business risk.

Regulatory risk pertains to new risks that may result from future regulatory action that this and other regulatory agencies might take. It also includes the potential disallowance of operating expenses and rate base additions.

Aside from infrastructure construction to meet the demand of pending Drinking Water Act regulations, SJWC has not cited any new risks that would require upward adjustment of ROE. Construction capital requirements are following the trend compared to past years (Exhibit 10). Even with regard to pending Safe Drinking Water Act regulations, SJWC has the option to file an application with the Commission seeking recovery of these costs. On balance, we conclude that there has been little, if any, change in the risk factors that would require upward or downward adjustment of the ROE last found reasonable by the Commission.

After considering the evidence on the market conditions, trends, interest rate forecasts, quantitative financial models, risk factors, and interest coverage presented by the parties and applying our informed judgment, we conclude that a constant ROE of 10.20% for the years 2001-2003 would be just and reasonable. This represents no change from the ROE previously found reasonable for the prior test years. Pre-tax interest coverage for SJWC based on the agreed-upon capital structure would be 3.47 times and 3.44 times for the years 2001 and 2002, respectively. This coverage is more than adequate and should not negatively affect the utility's bond ratings. The adopted ROE will produce rates of return on rate base of 9.23% and 9.25% for 2001 and 2002, respectively.⁸