2. Background

Current Water Utility Rules

Currently, six of the nine Class A water utilities have authorized affiliate transaction rules in place, and each utility's set of rules is unique. Over the past 25 years, the Commission has adopted affiliate transaction rules for the following Class A water utilities:

Affiliate transaction rules adopted in holding company decisions over time are currently in effect. Of the nine Class A water utilities, five utilities (all the above except for Park Water Company (Park Water)) have operated under holding company decision affiliate transaction rules for a number of years. Adopted separately and at different times, the rules are consistent on some points, but diverge in other areas. Park Water has affiliate transaction rules adopted in Decision (D.) 04-06-018 and D.06-01-019. The other three Class A water utilities in the State of California are currently operating without any formal affiliate transaction rules. These are: San Gabriel Valley Water Company (San Gabriel), Suburban Water Systems (Suburban), and Great Oaks Water Company (Great Oaks). All of the Class B, C, and D water and all of the sewer utilities do not have authorized affiliate transaction rules in place.

Suburban has been operating under a parent company structure since 1975. Suburban's parent has a number of affiliate operations that are larger than its regulated operations, yet Suburban does not follow any formal affiliate transaction rules.² San Gabriel operates under a parent/holding company structure, without any formal affiliate transaction rules. D.93-09-036, which approved a direct billing method for charging San Gabriel executives' salaries to its affiliates, does not constitute formal affiliate transaction rules. In addition to D.04-06-018, Park Water also operates under D.06-01-019, which established limited rules to ensure ratepayers are protected against cross-subsidization and financial risk that may occur as the result of Park Water's financing transactions with affiliates. The Commission did not establish any specific annual reporting standards for Park Water for its affiliate transactions.

The size and scale of water utility affiliates is significant. The table below shows the number of affiliates of the nine Class A water utilities, as reported in response to a question in the Rulemaking, and in their 2008 Annual Reports. The table potentially understates the number of affiliates, because the utilities included only those affiliates with which they had transactions in 2008. The total number of affiliates remains unclear.

A few examples of known affiliate relationships may be helpful. California-American Water Company's (Cal-Am) parent, American Water Works Company, Inc., is the largest investor-owned water and wastewater utility company in the United States, and is the parent company of nineteen state subsidiaries and numerous other companies.⁷ As another example, California Water Service Company (Cal Water) is part of Cal Water Group which has six subsidiaries that provide regulated and non-regulated water and wastewater utility services in four western states.⁸ Suburban is part of Southwest Water Company (Southwest), which, through its operating subsidiaries, owns 132 water and wastewater systems, and operates others under contracts to cities, utility districts and private companies.⁹

The Commission has also adopted rules that govern the water utilities' ability to provide non-tariffed products and services through the use of regulated assets and personnel (formerly called excess capacity rules). The primary decision on non-tariffed utility services is D.00-07-018, adopted in Rulemaking (R.) 97-10-049.¹⁰ These rules distinguish the types of non-tariffed utility offerings as either active or passive,¹¹ require water utilities to file advice letters for the provision of certain types of active services, and require that the utilities provide certain information regarding each active service and each passive service in their annual reports. The rules also include a methodology for water utilities to allocate revenue from non-tariffed utility services between ratepayers and shareholders depending upon whether the service is active or passive. These rules adopted in R.97-10-049 regarding non-tariffed utility services do not apply to sewer utilities.

Energy Utility Holding Company and Affiliate Transaction Rules Adopted Prior to Electric Restructuring

For energy companies, the Commission issued a series of decisions starting in the mid-1980s which allowed the energy utilities to form holding companies and unregulated affiliates. Affiliate rules were imposed by this Commission on the energy companies first when San Diego Gas & Electric Company (SDG&E) filed for permission to form a holding company pursuant to Public Utilities Code Section 854.¹² The Commission approved this restructuring of the utility in D.86-03-090. Among other requirements, the decision contained several conditions to govern the manner in which SDG&E and its parent and affiliated companies were to conduct their respective transactions with one another and with this Commission. Energy utilities forming holding companies were required to keep track of the transactions they had with these affiliates, keep separate books, use transfer pricing rules imposed by the Federal Energy Regulatory Commission, and report these transactions yearly to the Commission.

Rather than impose and enforce rules that separate the operations of the utility from those of its affiliates, the Commission found that the parent ...

... and its subsidiaries may receive a number of potential benefits from their affiliation with SDG&E. Some benefits may give SDG&E affiliates an initial advantage over competitors. SDG&E has name recognition; it is a large, well-established utility which has gained the confidence of the business community. This may provide affiliates with improved access to financing. Other potential benefits may involve access to and use of utility expertise and resources. These assets, some of them intangible, were developed with ratepayers' support. If the utility is not compensated, these benefits to affiliates represent a cross-subsidy from utility ratepayers. We believe there will exist, in spite of all preventive measures, certain cross-subsidies that are not identified or adequately measured. (D.86-03-090 at 684.)

The Commission also found that this new holding company structure posed a risk of a "brain drain" and diversion of management attention from utility to affiliates. And although finding that the holding company structure in part shields the utility from the effects of affiliate riskiness, the additional risk posed by these affiliates' ventures was of concern to the Commission:

Because of these benefits, costs, and unidentified cross subsidies, we believe SDG&E's ratepayers should be compensated by way of a payment from [the parent company] and its subsidiaries to the utility. (Id.)

The Commission listed several factors as important to consider in the process of measuring the appropriate compensation to be made to ratepayers, including how management attention will be affected; how the name and reputation of the utility will help the affiliate; the likelihood of cross-subsidy and beneficial personnel transfers for different types of affiliate businesses; the ability of the affiliate to utilize proprietary information, utility assets and expertise; and how to use market measures of value for utility/affiliate transactions.

In D.88-01-063, Southern California Edison Company (SCE) was granted approval to form a holding company. The Commission adopted conditions similar to those adopted in the SDG&E holding company decision.

In 1993, the Commission issued D.93-02-019, "In re Reporting Requirements for Electric, Gas, and Telephone Utilities Regarding Their Affiliate Transactions." This decision requires a comprehensive report of transactions between utility and its affiliates to be submitted each May, covering transactions for the previous year. The following topics are covered in this report:

· Complete organizational structure and organizational detail.

· Officer listings for affiliates,

· Utility manual listing procedural and accounting safeguards,

· Contracts with the affiliates,

· Verbal agreements involving expenditures greater than $100,000,

· List of internal audits of affiliate transactions,

· Provisions of goods and services - from utility to affiliates and from affiliates to utility,

· Transfers of assets - both tangible and intangible/intellectual property,

· All financial transactions, Securities and Exchange Commission (SEC) reports, and all financial statements,

· All nonclerical employee movements between utility and affiliates, by employee and position, and

· Any fees required and paid associated with these movements.

Energy Utility Affiliate Transaction Rules in the Electric Restructuring Period

During the mid-1990s period of restructuring of the energy industry, many unregulated parties expressed concerns that they would be put at a competitive disadvantage if the utilities were allowed to use their market power to benefit their affiliates. In addition to financial separation and ratepayer cross-subsidy concerns, they mentioned the sharing of proprietary information and the combining of activities (like joint marketing; joint purchases; and sharing of officers, technical expertise, and employees) that would lead to an advantage enjoyed by utility affiliates over their competitors. Such advantages were argued to be distortionary as they represented cost advantages not engendered by the internal efficiencies of the firm.

R.97-04-011/Investigation (I.) 97-04-012 initiated a proceeding to design rules to govern transactions between the utility and its affiliates, resulting in D.97-12-088, modified by D.98-08-035. In summary these rules are comprised of the following:

· Applicability rules (the affiliate must be involved in the energy industry in some way for these rules to apply),

· Non-discriminatory standards (i.e., no preferential treatment or discounts, no tying or assignment of customers, and no steering of customers to affiliates),

· Non-discriminatory disclosure of information and other record keeping rules,

· Separation standards (i.e., no joint purchases or marketing, no joint use of assets or officers, rules restricting sharing of employees, restricted corporate support, restricted sharing of name and logo of utility, and transfer pricing rules), and

· Oversight and audit rules.

Each energy utility has a unit tasked with making sure the utility follows these rules, and must file a compliance plan each year to explain how the utility is in compliance. Further, the utility must notify the Commission through advice letter whenever a new affiliate is created, and whether this affiliate is covered by the application rules.

An issue transferred to the proceeding from the Southern California Gas Company (SoCal Gas) General Rate Case (GRC) proceeding in 1997 added one additional rule regulating the provision of non-tariffed products and services by the utilities. This rule was designed to encourage the utilities to make use of the scope economies available in certain fixed utility assets, and to share the proceeds with the ratepayers who paid for the assets. An example of such a scope economy (sometimes referred to as "excess capacity") is the land available under transmission towers built by the utility which can be leased to tree growers or storage facilities. While the Commission stated that it preferred new products to be generated and sold by affiliates, it allowed utilities to exploit such scope economies if the utilities followed other affiliate transaction rules. Several ongoing programs were grandfathered at the time the rules were created, but new categories can be offered through advice letter showing how the new product or service satisfies the rule. Fewer than ten new categories have been approved by the Commission over the years following the creation of the rules.

These rules have worked for the most part, although auditors have found violations of varying degrees of severity over the years. The most serious violations have been through the sharing of confidential information by SoCal Gas and SDG&E with their affiliate Sempra Energy Trading. This led to a Commission investigation and audit in I.03-02-033, with the result that the holding company (Sempra Energy) no longer allows its head of risk management to provide guidance to SET. No fines or other sanctions were imposed, and the proceeding was closed in D.06-12-034.

The energy utility affiliate transaction rules were revised in D.06-12-029 for California's four largest energy utilities to require more complete reporting to the Commission of utility-affiliate and utility-holding company communications, prohibit problematic shared services, and ensure a utility's financial integrity is protected from the riskier market ventures of its unregulated affiliates and holding company parent. D.06-12-029 adopted revisions to the affiliate transaction rules for the four largest energy utilities, which are contained in Appendix A-3 to that decision.¹³ Section VII of the energy utility affiliate transaction rules addresses utility products and services, including non-tariffed utility services. That decision also revised General Order 77 which governs the reporting of executive compensation. The major revisions to the rules were designed to:

· Ensure that key utility and holding company officers understand the rules and their obligations under them;

· Provide greater security against the sharing within the corporate family, through improper conduits, of competitively-significant, confidential information; and

· Ensure a utility's financial integrity is protected from the riskier market ventures of its unregulated affiliates and holding company parent through new financial protection provisions known as ring-fencing.

Water Industry Affiliate Transactions Rulemaking

R.09-04-012 was opened on April 16, 2009 to develop consistent rules governing affiliate transactions and non-tariffed utility products and services for all water and sewer utilities. The OIR stated that the purpose of the rules was to " ...provide appropriate Commission oversight and protect ratepayers. Moreover, regulatory consistency would be improved by adopting standard affiliate transaction and non-tariffed utility service rules in a single rulemaking, as has been done for the energy utilities." The OIR also stated that "(b)ecause most Class A water utilities are now owned by holding companies that in most cases have both regulated and non-regulated subsidiaries, it is essential that this Commission develop rules which address the relationship between the regulated water utility and its parent and affiliates."

² Suburban filed a holding company application, Application (A.) 09-07-015, and sought to consolidate that application with this proceeding. Suburban's request was denied in the Scoping Ruling. Subsequently, D.10-05-001 dismissed A.09-07-051 without prejudice.

³ This table only includes Class A water utilities. Class B utilities are not required to submit a report of their transactions with their affiliates in their Annual Report to the Commission, and no Class B utility responded to Question #7 in the Order Instituting Rulemaking (OIR).

⁴ Park Water is the parent of Apple Valley Ranchos Water Company.

5 In its 2008 Annual Report submission Golden State Water Company (Golden State Water) listed Bear Valley Electric Services, which is a division of GSWC and not an affiliate.

⁶ Transactions for sections (a), (b), (c), and (f) of Schedule E-4 were reported by Valencia Water Company (Valencia Water) in its 2008 Annual Report with no clear indication of the names or number of affiliates involved in these transactions. The information contained in this schedule, however, is consistent with the five "associated companies" listed in the Annual Report's General Information chart.

⁷ The subsidiaries include American Water Capital Corp., American Water Works Service Company, American Water Operations and Maintenance, Inc., Philip Automated Management Controls, and Utility Management and Engineering, Inc.

⁸ The other subsidiaries are CWS Utility Services, New Mexico Water Service Company, Washington Water Service Company, Hawaii Water Service Company, and HWS Utility Services LLC.

⁹ Suburban states that it does not provide any services to its affiliates, but that Southwest, as a parent company, provides certain services to Suburban, the costs of which the Commission allocates using its longstanding four-factor methodology. In addition, Suburban states that it benefits from and is charged for information technology shared services.

¹⁰ Two subsequent decisions in that proceeding made corrections, and a third approved in part a petition to modify D.00-07-018. The later decisions are D.01-01-026, D.03-04-028, and D.04-12-023.

¹¹ D.00-07-018 adopted an Appendix A, which designated many potential non-tariffed offerings as either active or passive, and stated that any non-tariffed utility offerings not present on the list would be designated as active if the shareholders incurred incremental investments costs of $125,000 or more. D.01-01-026 published that Appendix A.

¹² All statutory references herein are to the Public Utilities Code.

¹³ The affiliate transaction rules for large energy utilities in Appendix A-3 to D.06-12-029 are available at http://docs.cpuc.ca.gov/published/Graphics/63089.PDF, which contains all of the attachments to D.06-12-029. D.07-03-049 corrected clerical omissions in D.06-12-029, Appendix B.