6. Settlement

The "Joint Settlement of the Office of Ratepayer Advocates and San Jose Water Company" (Settlement) is attached as Appendix A to this decision. The Settlement addresses all issues in dispute between SJWC and ORA. In accordance with the terms of the Settlement, SJWC rates charged for water service will be increased so as to increase revenues by $11,773,000, or 8.00%, in 2004; $4,283,000, or 2.69%, in 2005; and $4,245,000, or 2.59%, in 2006. The positions of SJWC and ORA prior to and after settlement are summarized below and are detailed in the Settlement's reconciliation tables.

	SJWC	Settlement	ORA
		Position
2004 Revenues At Present Rates	$ 147,231,000	$ 147,231,000	$147,231,000
Proposed 2004 Revenues	$ 170,273,200	$ 159,004,200	$152,198,300
Proposed 2005 Revenues	$ 180,631,200	$ 163,608,200	$154,958,300
2006 Attrition Increase	$ 5,210,000	$ 4,245,000	$1,382,200

The Settlement reflects a substantial reduction from SJWC's pre-settlement request. It is also closer to the pre-settlement position of ORA. As discussed below, based on the direct testimonies of SJWC and ORA and the rebuttal

testimony of SJWC, we find the outcomes and terms of the various Settlement elements to be reasonable. The Settlement is also consistent with applicable law and in the public interest, and will be adopted by this decision.

a. Customers and Consumption

The only pre-settlement issue related to customers and consumption is unaccounted-for water. SJWC's estimate of 7.2% was based on a five-year average (1998 - 2002), while ORA's estimate of 6.5% was based on a three-year (2000 - 2002) average to better reflect recent leak detection improvements. The Settlement position of 6.8%, based on the most recent three-year (2001 - 2003) average is reasonable.

b. Operation and Maintenance Expenses

1. Escalation

Based on the December 18, 2003 and January 1, 2004 ratified union contracts and the assertion that non-union labor escalation mirrors that of the unions, the Settlement agrees to use labor escalation rates of 4% for 2004 and 3.5% for 2005 for all payroll costs except that related to SJWC's ten executive salaries. For ratemaking purposes, the ten executive salaries will be maintained at the 2003 level for 2004 and 2005, as recommended by ORA. This agreement is reasonable.

For historic labor escalation and historic and forecasted non-labor escalation, the Settlement's use of ORA's recommended values, which are based

on September 2003 economic data as opposed to SJWC's use of May 2003 data, is also reasonable.

2. Operations - Source of Supply

The settlement incorporates ORA's methodologies for estimating purchased water and pump taxes. The use of current purchased water and pump tax rates, rather than estimated test year rates, is reasonable and consistent with current Commission procedures whereby SJWC will be able to file rate offset advice letters for purchased power and pump tax rate increases or decreases.

The Settlement incorporates ORA's use of a six-year averaging methodology for transportation and other categories. Except where noted below, the consistent use of the six-year average was employed by the Settlement for operation and maintenance (O&M) and administrative and general expenses, and results in reasonable test year estimates.

3. Operation - Pumping

The Settlement reasonably includes estimates of purchased power, which are based on the Settlement quantities of water pumped in 2004 and 2005.

The Settlement position to adjust purchased services to reflect the allocation of additional security costs and postal software licensing costs is reasonable. SJWC and ORA agree that the programs are necessary and, due to recent implementation, are not reflected in the historic averages used for the test year estimates. The same adjustment is also appropriately reflected in the allocated purchased service costs for source of supply maintenance, pumping maintenance, transmission and distribution O&M expenses and customer accounts expenses.

4. Operation - Water Treatment

The Settlement's use of ORA's estimates for chemicals is reasonable, since ORA's calculation is based on a more recent review of 2003 actual usage and actual chemical unit cost.

5. Operation - Customer Accounts

For the uncollectible rate, ORA's estimate of 0.1652% is based on a six-year (1997 - 2002) average, while SJWC used the 2002 recorded rate of 0.2846 as its estimate. The Settlement agreement to use of a three-year (2001 - 2003) average to estimate an uncollectible rate of 0.1770 is reasonable, in that it incorporates the use of a number of historic rates to account for fluctuations while still reflecting recent economic conditions.

The Settlement's use of current postage rates, as recommended by ORA, is reasonable for calculating postage expense, since postal rates are not expected to increase in the near future.

The Settlement's use of ORA's estimate of conservation costs is reasonable. In addition to the six-year average amount, an additional cost for revising the water management plan is amortized over five years, the interval between plan revisions.

The Settlement's use of ORA's $0 estimate for the other category of customer accounts expenses is also reasonable, since the minimal historic data is distorted by prior year accounting adjustments.

6. Maintenance - Pumping

The Settlement reasonably includes an additional $120,000 for each of the test years to fund the rehabilitative maintenance of two wells per year. These expenses to restore lost capacity and extend well life are incremental to historically averaged amounts, since the program is new.

7. Maintenance - Transmission and Distribution

The Settlement includes an additional $318,000 in 2004 and $324,678 in 2005 to fund the maintenance of 11,721 fire hydrants that until January 1, 2003, were the responsibility of the City of San Jose. Increased rates related to the transfer of responsibility to SJWC were previously authorized in
Resolution W-4374, dated February 27, 2003. For test year estimating purposes, these expenses are incremental to historically averaged amounts and are reasonable.

8. Other

The agreement that SJWC should be allowed to recover $145,997 in 2004 and $262,168 in 2005 in operating costs associated with security enhancements identified and recommended in SJWC's security vulnerability assessment (VA) is reasonable. The VA was required pursuant to the Public Health Security and Bioterrorism Preparedness and Response Act (HR 3448), and it has been certified by the United States Environmental Protection Agency.

The agreement that SJWC should be allowed to recover $17,458 in 2004 and $17,825 in 2005 for postal verification software licensing, maintenance and subscription fee is reasonable. The resultant presorting allows SJWC to mail customer statements at a rate of $0.278, instead of the standard first class postage rate of $0.37.

c. Administrative and General Expenses

For estimating test year property insurance expense, the Settlement's use of ORA's methodology, which trends recorded data for the period 1997 - 2003, is reasonable.

Based on a review of additional invoices for 2003 as well as review of estimates provided by SJWC's insurance broker, the Settlement estimates for workers' compensation insurance (WCI), public liability insurance (PLI) and directors and officers insurance (DOI) are reasonable. In aggregate, the Settlement amounts of $2,690,600 for 2004 and $3,552,887 for 2005 are much closer to SJWC's respective estimates of $2,714,300 and $3,588,200 than to ORA's respective estimates of $1,817,000 and $1,994,000. However, the recorded 2003

WCI premium and 8/1/03 to 8/1/04 premiums for PLI and DOI amount to $2,445,597, which supports the reasonableness of the Settlement amount for 2004. The substantial increase from the recorded 2002 level of $1,354,600 also supports the significant estimated increase in premiums for 2005.

For regulatory expense, the Settlement's use of ORA's recommended $50,000 per year, without adjustment for inflation, is reasonable.

The Settlement includes an additional $141,000 for 2004 and $143,000 for 2005 for expenses related to compliance with the Sarbanes-Oxley Act of 2002, which requires the establishment and certification of internal financial controls and imposes increased audit fees. Since the requirements are new, the associated costs are incremental to historically averaged amounts and are reasonable.

The Settlement's use of ORA's estimate for rents, which is based on the recent recorded 2002 amounts, escalated to test year dollars, is also reasonable.

d. Balancing and Memorandum Accounts

As part of the Settlement, SJWC withdraws its request for (1) a full cost balancing account for water production expenses and (2) a water quality memorandum account for anticipated future water quality expenses. ORA opposed the establishment of both accounts and the exclusion for consideration in this proceeding is reasonable.

e. Plant

The Settlement's use of beginning of year plant balances for 2004 is reasonable, since this information provides a more recent and reliable starting point for determining test year plant balances, when compared to the beginning of year 2003 balance used by SJWC.

The Settlement resolves the status of 14 specific plant projects. For two of the projects involving approximately $4 million, ORA and SJWC agree that the

projects are prudent, necessary and in the public interest but have removed the costs from the GRC, because SJWC has sought Safe Drinking Water State Revolving Fund (SRF) loans to finance the projects. The parties agree that if the SRF loans are denied, SJWC should be allowed to recover the costs through an advice letter filing. This agreement is reasonable.

For six other projects totaling approximately $12 million, SJWC and ORA agree that the projects are prudent, necessary and in the public interest, but due to the uncertain timing of the projects, the parties agree to remove the costs at this time and subject the projects to advice letter filings when the projects are actually completed. Use of capital project advice letters is reasonable for these six projects. They are relatively large, non-recurring projects where the timing is uncertain, but where the need, scope and costs have been defined. We will allow SJWC to begin rate recovery for each of the projects, if and when they are completed, by filing an advice letter as proposed. SJWC will combine its requests for recovery to file once in 2004, once in 2005 and once in 2006, to minimize the number of advice letters. The request for each project should be based on the recorded cost, capped at the estimated cost as detailed in the Settlement.

While approving the proposed advice letter procedures for use here, we note that this type of filing tends to mask the true magnitude of the GRC rate increases. While the stated total increase granted by this decision is approximately $20 million over the three-year rate case period, capital project advice letter filings could increase that amount by another $2 million to $3 million.

For the remaining six specified projects, the parties reasonably agreed to the disposition of approximately $7 million in project costs. Delays, evaluation of ORA's analysis and uncertainty related to health regulations resulted in SJWC agreeing to reduce costs related to five projects by approximately $5 million. On the other hand, ORA agreed that SJWC provided enough additional information to justify a $2 million project.

f. Depreciation

As part of the Settlement, SJWC withdraws its request to convert to a computerized straight-line depreciation methodology. ORA opposed the new methodology, and the Settlement agreement that SJWC will continue to follow the Commission's Standard Practice U-4 to calculate straight-line remaining life depreciation is reasonable.

g. Rate Base

The Settlement rate base incorporates the effects of the settled items above and, as such, is reasonable.

h. Rate of Return

The only pre-Settlement rate of return dispute was the return on equity (ROE). SJWC requested an ROE of 11.50% on rate base for each of the years 2004 and 2005, while ORA recommended an ROE of 9.18%. The parties settled on an ROE of 9.90%, which is within the range of returns currently authorized by the Commission for California Class A water utilities. There is no persuasive evidence that SJWC's ROE should be significantly higher or lower than that of other Class A water utilities. Therefore, we find that the 9.90% ROE for SJWC is reasonable for test years 2004 and 2005. The adopted rate of return on rate base is 8.86% for both 2004 and 2005, as shown below.

i. Attrition

The Settlement's calculated attrition allowance for 2006 is reasonable. The calculation is based on the traditional procedure of applying the operational attrition from 2004 to 2005 to the test year 2005 rate base and grossing that net amount to the revenue increase amount. In this case, there is no financial attrition.

j. Design of Rates

1. Rate Assistance for Low-Income Customers

For the Water Rate Assistance Program (WRAP), the Settlement incorporates ORA's modifications to SJWC's proposal. A 15% discount, rather than the $5.00 discount proposed by SJWC, will provide larger benefits for larger qualifying households. Customers in master metered residences will be able to receive assistance. Eligibility will be extended to customers who may not have qualified for PG&E's CARE program (because they do not have PG&E service in their own name) but who are otherwise eligible, as established through income verification. SJWC will implement the program through an advice letter filing and will maintain a separate balancing account to which all revenue and expenses associated with the program will be booked for later recovery or refund. The WRAP adopted in the Settlement is reasonable.

2. Resale Service

The parties' agreement to eliminate the existing discount for Resale Service Schedule No. 6 is reasonable, since the rate differential has not been substantiated by any study showing lower cost of resale service.

3. Private Fire Service

The parties agreement to increase Private Fire Service rates by 30.72% plus the system-wide increases is reasonable, since a study prepared by SJWC shows revenues from current rates are 30.72% below the cost of service provided.

4. Residential Fire Sprinkler Service

Since there is no evidentiary basis for exempting Schedule No. 1B, General Metered Service with Automatic Fire Sprinkler Systems, from the GRC increase adopted in this proceeding, the Settlement's use of a system-wide increase for 2004 and 2005 is reasonable.