VI. Allocation Dependent on Risk
A. OIR Proposals - Risk
The OIR stated the Commission's tentative conclusion that ratepayers bear most of the risks associated with property that is depreciable (buildings and other utility assets) and non-depreciable (land and water rights). The OIR therefore proposed to allocate most of the gain from sale of depreciable assets to ratepayers to compensate them for bearing this risk:
A return to the prominent use of the incidence of risk should be the primary standard for the efficient allocation of the gain. It is clear to us that the assumption of risk is an integral part of the regulatory compact, and that the incidence of this risk should be a major consideration when allocating any gain realized at the sale of a utility asset. . . . It is clear that by most measures, and under most circumstances, this risk is primarily borne by the ratepayer under utility regulation.7
Regarding non-depreciable assets, such as land, we explained that while land is not depreciated, "the entire acquisition cost of the land is put into rate base and the shareholder receives a return on that amount for as long as that land is in rate base. Ratepayers still pay for carrying costs such as maintenance, taxes, insurance, and interest expense for the land."
We explained in the OIR that in this proceeding, we are generally concerned with the following types of risk:
(a) The risk of not recovering the acquisition cost of the asset.
(b) The risk of not recovering the asset's maintenance and other carrying charges.
(c) The risk of not being compensated for the asset's opportunity cost.
(d) The risk of incorrect valuation of the asset.
(e) Inaccurate estimate of the useful life of the asset.
(f) The risk of disallowance by the Commission.
We tentatively concluded in the OIR that, "almost all of the financial risks are borne by the owners in the competitive market, but they are generally borne by ratepayers under utility regulation. Only the risk of the Commission's disallowance of a utility's asset purchase can be said to be borne by shareholders."
The OIR also suggested that in focusing its gain on sale analysis on risk, we should discard tests on which we have relied in the past, such as "ratepayer harm"8 or "ratepayer indifference."
We developed the "ratepayer harm" standard in our Redding II decision.9 In that decision, we found that where (1) a public utility sells a distribution system to a governmental entity, (2) the distribution system consists of part or all of the utility operating system located within a geographically defined area, (3) the components of the system are or have been included in the rate base of the utility, and (4) the sale of the system is concurrent with the utility being relieved of, and the governmental entity assuming, the public utility obligations to the customers within the area served by the system, then the gains or losses from the sale of the system should be allocated to utility shareholders, provided that the ratepayers have not contributed capital to the distribution system and remaining ratepayers are not adversely affected by the transfer of the system.
The OIR proposed that the decision issued here supersede all previous decisions, including Redding II and its ratepayer harm standard.10
b) Southern California Gas Headquarters Sale - Ratepayer Indifference Test
In the OIR, we also cautioned against a test such as the "ratepayer indifference" standard we initially adopted - and soon thereafter rejected - when considering Southern California Gas Company's (SoCalGas) sale of its headquarters.11 In D.90-04-028, the Commission adopted the ratepayer indifference test in order to "discourage poor sales and maintain ratepayer indifference by allocating to ratepayers that portion of the gain that reflects the remaining value the asset would have had in utility service."12 The basic principle the Commission developed was that, "To keep ratepayers indifferent to the transaction, we need to allocate to them enough of the gain on sale to compensate for the difference between what the old building would have cost had it continued in rate base, and what the new asset will actually cost."13 The difference between replacement value and actual market value would go to "shareholders as a reward and incentive for seeing that its (sic) [asset] was put to the highest and best use in the economy."14
On rehearing, the Commission rejected the ratepayer indifference test in favor of a more traditional risk/reward analysis.15 While the Commission found that shareholders had borne some risks and allocated shareholders approximately half the gain, it took great pains to limit the scope of its decision to the case at hand.
SoCalGas' headquarters posed health and safety risks from asbestos, seismic vulnerability and lack of adequate fire protection. The Commission therefore found it was appropriate to allocate approximately half the gain to shareholders as an incentive to the utility to sell the building: "It is a reasonable incentive, where a utility's principal headquarters poses health and safety risks and is no longer suitable for long-term use and should be sold, to provide shareholders with a share of the benefits realized from the sale to encourage management to seek a more suitable new headquarters." However, we cautioned against general application of the decision: "Such incentives are not appropriate unless the principal headquarters should be disposed of for reasons of sound utility planning. Otherwise, there would be a perverse incentive to replace depreciated assets, or assets with a low historical cost, with more expensive, newly-purchased assets, imposing higher costs on ratepayers without corresponding accompanying benefits."16
B. Comments - Risk as Primary Determinant of Gain/Loss Allocation
The parties' comments are divided on the OIR's assumption that risk should drive the outcome of gain on sale decisions, and that we should cease relying on ratepayer harm or indifference to allocate the gain.
The consumer advocates (ORA/TURN and Aglet) agree with the risk premise. ORA/TURN's joint comments conclude that, "Based on the risk allocation theory, the OIR correctly finds that ratepayers should be rewarded most of the gain from sales of utility assets because the regulated utility's financial risk is primarily borne by the ratepayers."17
Similarly, "Aglet agrees with the Commission's policy statement on gain on sale, `A return to the prominent use of the incidence of risk should be the primary standard for the efficient allocation of the gain.'" Aglet notes that "Ratepayer risks are asymmetrical . . . . If things go bad, ratepayers are most often left on the hook for losses. The outcome of the utility financial crisis of 2000-2001 is a notorious example of protecting shareholders at ratepayer cost."18 Aglet therefore supports using risk as the primary test for allocating capital gains.
Aglet cites many instances in which ratepayers have borne extraordinary utility losses:
Aglet does not suggest that shareholders bear no risk of utility investments, but assignment of ownership risks to ratepayers has a long history. Examples abound: special ratemaking provisions for contamination by hazardous materials; similar protections for catastrophic losses; opportunity to seek replacement cost recovery for assets that are retired prematurely; for example, steam generators at PG&E's Diablo Canyon Power Plant; recovery of uneconomic power plant costs through headroom during the early years of electric industry restructuring; recovery of the costs of undepreciated, abandoned plant that is not used and useful; and balancing accounts that assign to ratepayers the risks of inaccurate sales and fuel cost forecasts. . . . The Commission will not allow California utilities to fail, and ratepayers are the ultimate insurers against the largest investment risks.19
In contrast, the electric and water utilities point to risks they contend the OIR did not consider, and disagree with the OIR's conclusions about the risks it did mention. SCE observes that the OIR's risk calculus does not acknowledge anomalies such as the California energy crisis, stating that the crisis "has left doubts in the minds of utility stakeholders as to California regulators' ongoing commitment to the regulatory compact."
SCE states that the OIR understates shareholder risks, alleging that there is no guarantee the utility will receive a rate of return that is compensatory under test-year ratemaking because forecasts of costs are not perfect. SCE notes that regulated utilities receive a cost of capital lower than unregulated businesses; hold assets longer than typical businesses and therefore recover investments more slowly; and have an obligation to serve that unregulated businesses do not bear. SCE claims the OIR ignores these shareholder risks, and reaches conclusions about the level of ratepayer risk in holding property that the facts do not justify. PacifiCorp also claims shareholders bear "less quantifiable risks associated with municipalization20 and changes in regulatory regimes."21
Similarly, the water utilities raise concerns about various risks the OIR does not consider, including possible inaccuracy of forecast estimates,22 Commission cost disallowances, and the Commission practice of giving utilities a rate of return on the original cost of an asset, rather than on the appreciated worth of the asset as it grows in value over time.23
Several utilities analogize ratepayers' relationship to utility property to the role of a renter occupying private rental property. For example, SDG&E/SoCalGas assert that renters do not obtain any interest in the building simply because they pay rent. SDG&E/SoCalGas conclude that ratepayers should not recover profits from the sale of utility assets for the same reason that renters do not profit when a landlord sells his building.
In reply to the renter analogy, Aglet acknowledges that ratepayers do not own utility property, but argues that they nonetheless "bear risks associated with the value of the property. Tenants do not pay landlords for vacancies, fire damage or repair of hazardous circumstances . . . ." Aglet concludes that "fairness to shareholders and ratepayers regarding gains on sale depends on assessment of risks and rewards, not legal theories about property ownership."24
California Water Service Company suggests that to allow ratepayers to receive a portion of the gain from the sale of utility property effects an unconstitutional taking of property. It cites Pacific Gas & Electric Co. v. Public Util. Comm'n of California, 475 U.S. 1 (1986), for the proposition that "utilities own their property and . . . ratepayers do not acquire an interest in such property by virtue of paying rates for utility service."25
The small LECs make the same argument, stating that in relying on Democratic Central Committee Washington Metropolitan Area Transit Commission, 485 F.2d 786 (D.C. Cir. 1973) in support of our risk allocation theory, we ignore "the most important historical authority on the subject, Board of Public Utility Comm'r v. New York Telephone Co., 271 U.S. 23, 32 (1926), in which the Supreme Court held that utility customers pay for service, not for a property interest in any of the facilities used to provide service to them." If ratepayers do not own utility property, the small LECs assert, they may not recover any gains from the sale of that property.
SCE asserts that Democratic Central Committee is not controlling precedent and must be distinguished on its facts. It states that because the case was decided by the D.C. Circuit Court of Appeals, and not the 9th Circuit, where California is located, it is not controlling precedent.
The utilities urge us not to abandon the "ratepayer harm" standard we developed in Redding II. They note that Redding II is one of the few Commission decisions that set generic policy on gain on sale allocation in any context. PG&E notes that the Commission has applied the Redding II standard guidelines to at least 16 PG&E operating system sales in the past seven years. PG&E asserts that "there is no valid policy reason for departing from what the Commission has recognized as `established Commission precedent . . . .'"26 California Water Association states that the OIR "gives rather short shift to the one subset of such sales for which the Commission has adopted a clear and concise set of guidelines . . . ."27 The small LECs ask that we retain the Redding II standard for sales of an entire utility.28
Further, the utilities assert that the Redding customers (the departing customers) paid in rates their portion of the system sold to Redding. They question why the ratepayers left after sale of the distribution system should receive the gain on sale, since they may not have been responsible for the costs of the assets that are left.
Aglet, in contrast, states that the "logic behind Redding II is faulty." It argues that the distribution facility sales to which we have applied Redding II always result in a gain: "Aglet is unaware of a single sale that resulted in a loss to the utility. It is no surprise that utilities support the Redding II doctrine because it gives shareholders consistent gains without any real risk of loss."29 Aglet asserts that our Redding II analysis "is a matter of policy, not law, and there is good cause for reassessment of prior Commission policies."30
The Modesto Irrigation District also criticizes the Redding II process: "Despite the fact that the rules established in [the Redding II] rulemaking were intended to address gain-on-sale issues arising out of those situations identified in that decision, there has been a sufficient level of dissatisfaction with the Redding II principles that, as the instant OIR notes, gain-on-sale issues are often addressed on a case-by-case basis."31
The parties do not specifically comment on the continued viability of the ratepayer indifference test.
C. Discussion - Risk Analysis
We conclude that incidence of risk is the best determinant of how to allocate gains and losses on sale. We find that the question before us is based more in economic theory and policy than on strict legal principles. We have discretion to adopt a gain or loss allocation methodology that reflects the regulatory compact into which utilities enter. Because ratepayers fully compensate utilities for costs related to land, improvements and other tangible and intangible assets dedicated to utility use, ratepayers should in most cases receive an equal share of the gain (and the loss) in most routine asset sales. While finding a perfect spot on the continuum involves an exercise of discretion, we hold that in routine sales of utility assets, the allocation should be as follows:
· Depreciable assets: 100% to ratepayers
· Non-depreciable assets: 50% to ratepayers and 50% to shareholders
Our conclusion that in many cases ratepayers and shareholders share the risks of loss associated with utility assets is not new. The D.C. Circuit Court of Appeals so found in the Democratic Central Committee case. There, the court concluded after a lengthy analysis of precedent around the country that,
In sum, the decisions outside the District [of Columbia Circuit] have not viewed capital gains on in-service non-depreciable utility assets as inevitably belonging to investors to the exclusion of consumers. Rather, in each of the cases -- although they are few -- the allocation has depended upon location of the risk of loss. These holdings, then, may be accepted as applications of the broader principle that the benefit of a capital gain follows the risk of capital loss.32
The court further held that "[t]he ratemaking process involves fundamentally `a balancing of the investor and the consumer interest.'"33 The court found that "[t]he proposition that capital gain rightly inures to the benefit of him who bore the risk of capital loss has been accepted in ratemaking law.34
The OIR's risk analysis and our finding here are based on the economics of utility regulation. To ensure efficiency, rewards should go to those who bear the actual costs and burdens of the risks engendered by particular economic actions, such as the purchase of assets. We reassert this fundamental finding here. To award a significant gain to a party who bore no or little risk would tend to distort the capital markets.
However, the utilities in their comments raise some risks accruing to the purchase of non-depreciable property. A consideration of these risks leads us to alter the tentative conclusion, reached by the OIR, that ratepayers clearly and regularly bear the major portion of the risks associated with utility property. Further efforts to quantify the level of risks would provide a false precision.
3. The Energy Crisis, Natural Disasters and Other Extraordinary Losses
The gain on sale calculus should not take into account extraordinary risks such as the recent California energy crisis or Hurricane Katrina. Whatever the reasons for the energy crisis - an imperfect market structure, market manipulation, regulatory and competitive failures - it is clear that the crisis did not arise because of electric utilities' ownership of land, buildings or other assets. Thus, the fact that the energy crisis occurred should not change our decision on how to allocate routine capital gains. The general, ordinary risks utilities and their ratepayers face (what SDG&E/SoCalGas term the "everyday, more mundane risk - independent of major industry restructuring events or major market changes - that utilities face all the time"35) should determine the gains allocation outcome.
The utilities also cite general regulatory risk and the potential for bankruptcy as risks borne by shareholders. These generalized risks, not specific to any particular asset purchase, are resolved in two areas: in the market value of the utility's stock, and the allowable rate of return assigned by the Commission in the utilities' cost of capital proceedings. This proceeding is not the appropriate forum to address overall risks, which are often borne by shareholder and ratepayer alike.
We do not believe we should set gain on sale rules to anticipate extraordinary losses having nothing to do with the risks related to holding land and other tangible assets. Such a practice could over- or under-compensate ratepayers, by basing rules on non-recurring and unusual events. Our preference is to set gain on sale rules based on the ordinary risks utilities face, so that unique gains or losses do not skew our economic allocation of benefits. 36
While it is true that forecasts may understate true costs in a given year, in the long run these forecasts of utility costs and earnings necessary to cover those costs will ensure that utilities are adequately compensated. Moreover, ratepayers bear the equivalent risk that forecasts will overstate needed utility rates of return in a given year, yet the utilities do not contend we should give ratepayers extra gains based on inherent unreliability in forecasting. Further, the Commission often allows utilities to true up their forecasts with their actual costs, thus mitigating any risk borne by shareholders. Finally, the risks that forecasts will understate true costs are negligible compared with the risks borne in the private sector that revenues will be inadequate and the firm will need to go out of business. Thus, we do not find that we should alter our risk-based calculus based on forecast risk.
The utilities assert that we should treat ratepayers just as landlords treat renters. Under this reasoning, if property values rise, the utility, as owner, should recover all of the gain. Ratepayers, by analogy to renters, should not be entitled to share in the owners' profits.
There are several problems with this analogy. Key among them is the distinction between operating in a regulated market and an unregulated one. Utilities acquire land, improvements and other assets to serve their utility customers with the understanding that they will place the assets in rate base and be compensated with a reasonable rate of return. Ratepayers will cover the utilities' operational costs (maintenance, repairs, depreciation if applicable, taxes and other carrying costs). The utilities are guaranteed customers and a revenue stream in the form of rates.
Landlords, by contrast, operate in a competitive market. In such markets, customers are not captive to the monopoly and may move away. The market, not the regulator, determines rental prices. The apartment owner is at risk of losing his investment, or at least not covering his full costs, due to loss of customers or falling rental prices, which are both beyond his control. A landlord's property may remain vacant in times of slack demand, so the property owner has no guaranteed stream of revenue. The whims of the market control the value of a landlord's investment.
Thus, the terms under which utilities and private property owners operate are somewhat different. A utility acquires property dedicated to public use, and receives a rate of return and payment for maintenance and repair, with the understanding that it will return gains to ratepayers when the property is no longer necessary for utility operations. Once the utility sells the property, the ratepayers have a right to some of the gain, in compensation for bearing the risks associated with the property.
We are not holding, as the IOUs claim we cannot do, that ratepayers hold legal title to utility property by virtue of bearing the foregoing costs. Rather, we find that ratepayers should receive capital gains from the property's sale because they bear the burden of the financial risk of the investment. The regulatory compact requires that if ratepayers bear such costs, they must be compensated for such burdens once the utility sells the property.
The D.C. Circuit explained utility shareholders' rights in the Democratic Central Committee case: "what has . . . prevailed is the central idea that the investor's legally protected interest resides in the capital he invests in the utility rather than in the items of property which that capital purchases for provision of utility service." 485 F.2d at 801, citing Supreme Court Justice Brandeis' "celebrated separate opinion" in Missouri ex rel. Southwestern Bell Telephone Company v. Public Serv. Comm'n, 262 U.S. 276, 290 (1923), which maintained that,
The thing devoted by the investor to the public use is not specific property, tangible or intangible, but capital embarked in the enterprise. Upon the capital so invested the Federal Constitution guarantees to the utility the opportunity to earn a fair return.
Thus, utility shareholders receive compensation to which they are entitled in rates. They are not also entitled to retain all of the proceeds received after their assets are sold.
We will continue to apply the Redding II principles in the narrow circumstances to which they were designed to apply. Thus, where (1) a public utility sells a distribution system to a governmental entity, (2) the distribution system consists of part or all of the utility operating system located within a geographically defined area, (3) the components of the system are or have been included in the rate base of the utility, and (4) the sale of the system is concurrent with the utility being relieved of, and the governmental entity assuming, the public utility obligations to the customers within the area served by the system, then the gains or losses from the sale of the system should be allocated to utility shareholders, provided that the ratepayers have not contributed capital to the distribution system and remaining ratepayers are not adversely affected by the transfer of the system. We have not been presented with an adequate record to justify broadening or narrowing Redding II's scope.
We have no basis to return to the ratepayer indifference test we adopted in D.90-04-028 - and promptly rejected within the year in D.90-11-031. No party urges that we adopt the test as a standard. The standard involved overly complicated calculations to derive the capital gain applicable to ratepayers and shareholders in any event. We thus reject the ratepayer indifference test as a means of allocating gains on sale going forward.
7 OIR at 35.
8 We cited the decision colloquially known as Redding I, D.85-11-018, 19 CPUC 2d 161 (1985), and Democratic Central Committee v. Washington Metropolitan Area Transit Comm., 485 F.2d 785 (D.C. Cir. 1973).
9 D.89-01-016, 32 CPUC 2d 233 (1989).
10 OIR at 23.
11 D.90-04-028, 1990 Cal. PUC LEXIS 200, 36 CPUC 2d 235 (1990), 112 PUR 4th 26.
12 1990 Cal. PUC LEXIS 200, at *43.
13 Id. at *44.
14 Id. at *45.
15 SDG&E and SoCalGas claim the OIR shows bias against utility shareholders in how it discusses D.90-04-028. We fail to see how citing prior Commission decisions is evidence of bias, and reject the claim.
16 1990 Cal. PUC LEXIS 1015, findings of fact 42-43, at *114-15.
17 ORA/TURN Comments at 8.
18 Aglet Comments at 2.
19 Aglet Reply Comments at 2.
20 The risk of municipalization is the risk that a portion of a utility distribution system will be condemned by a municipality's exercise of the power of eminent domain.
21 PacifiCorp Comments at 4.
22 The small local exchange carriers (LECs) also assert that potential errors in an annual forecast are risks utility shareholders alone face.
23 See, e.g., Park Water Comments at 12-20, San Gabriel Valley Water Comments at 2-3.
24 Aglet Reply Comments at 2-3.
25 California Water Service Company Comments at 5.
26 PG&E Comments at 13 & 15, citing D.03-04-032, 2003 Cal. PUC LEXIS 234, at *3 ("We allocate PG&E's gain resulting from the sale of its distribution assets to [Turlock Irrigation District] to PG&E shareholders, pursuant to established Commission precedent, Redding II."). See also California Water Association Comments at 10-11.
27 Comments of California Water Association at 10.
28 Comments of Small LECs at 3.
29 Aglet Reply Comments at 6.
30 Id.
31 Modesto Irrigation District Comments at 1.
32 485 F.2d at 798.
33 485 F2d at 806.
34 485 F2d at 807-808.
35 Comments of SDG&E and SoCalGas at 17.
36 We recognize that the energy crisis caused the bankruptcy of one major energy utility and the failure of another to provide dividends which resulted in real and sometimes large losses to investors.
