IX. Allocation as Incentive for Prudent Asset Management

In the OIR, we tentatively concluded that, "[t]he allocation of the gain on sale standards should provide an incentive to encourage prudent management of utility assets." We explained that, "if shareholders receive a portion of the gain on sale that is too large, they have an incentive to add properties that are not really needed for service to customers but have the potential to bring them high profit at some later date when sold." On the other hand, we noted, "it may be necessary to provide shareholders with enough of the gain to encourage the utilities to sell properties that are no longer needed."⁶²

A. Comments - Incentives

ORA/TURN assert that we should only allocate a small fraction of the gains to shareholders. They reason that, "assigning most of the gains to ratepayers will minimize the likelihood of adverse incentives to the utility management to hedge unnecessarily in the property market." ORA/TURN believes the primary business of utilities should be utility service and not real estate investment or speculation. They conclude by stating that over-allocation of gains to shareholders "may tempt management to sell useful and economic utility assets prematurely based solely on a sudden opportunity from a spasm in the market."⁶³

SCE believes that existing regulatory and ratemaking practices already provide appropriate and adequate incentives for prudent management of utility assets. Although SCE does not disagree per se that an appropriate allocation mechanism should not create perverse incentives, SCE does not believe that a fixed allocation ratio is necessary or appropriate.

PacifiCorp asserts that sales of utility assets carry elements of risk and require substantial management attention, and urges that shareholders be compensated for these risks. It cites its sale of its Centralia coal-fired generating plant to a Canadian company as an example. Despite the fact, according to PacifiCorp, that several regulatory commissions granted its shareholders the right to a portion of the gain, "in total, more than 100% of the gain was allocated to customers even though each state recognized that shareholders should receive a portion . . . . Pacific is less likely now to seek such opportunities."⁶⁴

Park asserts that it is not credible to assert that the utilities will have an incentive to add properties that are not really needed for service to customers. Park reasons that the inclusion of these properties in rate base must pass muster at the Commission, which would not happen if property lay idle. Park also delivers a warning: "There is no reason to think that any utility would come forward to sell property if 80 percent of the gain or more were to go somewhere else. Better to hold onto the property." Park notes that "the strongest incentive to take care of ... property is to allow the shareholders 100 percent of the revenue."⁶⁵

Aglet reacts to several utility assertions with the question "incentives or threats? Aglet is very concerned about the tenor of utility arguments that allocating gains to ratepayers will lead to higher costs and stagnation or decline of service quality." Noting that, "public utilities are in the business of providing safe, reliable service," Aglet concludes: "Bullying the Commission for risk-free rewards is offensive."⁶⁶

B. Discussion - Incentives

We do not believe law or good regulatory policy require that we set the shareholder portion of gain on sale at a high level in order to achieve prudent property management. Nor do we believe utilities are threatening to deliberately manage their property irresponsibly if we do not set shareholder gain at a high level.

Nonetheless, we believe the motive for high profits - especially in a real estate market as volatile as California's - may unduly skew management decisions regarding valuable real property holdings. As we stated in D.03-09-021, "the result of allocating all net proceeds to shareholders creates a powerful financial incentive for water utilities to sell real property . . . without regard to long-term customer service needs, and may even lead to real property speculation by water utilities."

Nothing in the comments changes our tentative conclusion, set forth in the OIR, that shareholders should receive a portion of the gain ("between 5% and 50% of the gain on sale under normal circumstances") but not a majority of it. We settle on 50% on non-depreciable assets in the exercise of our discretion. We adopt the percentages (100%-0%) the IOUs agreed were appropriate in their original comments for depreciable property. The 50%-50% split ensures mitigation of the minor risks we acknowledge shareholders face in holding property and divides the gains equally between the shareholders and ratepayers.

We noted in the OIR that it was our goal to encourage prudent investment in and continued ownership of property that is necessary for utility service, to ensure that utilities dispose of properties that have been rendered unnecessary by change of circumstances, and to encourage utility management to negotiate a reasonably high sale price for their property. We cannot quantify an allocation with exact precision, but given the record, a 50%-50% allocation is a fair and reasonable outcome for shareholders, partly to compensate for the financial risk borne by the utility, and partly as an incentive to utility management to manage its assets wisely.

If we were convinced that many of the extraordinary risks the utilities cite (see "Discussion - Risk Analysis," above) were germane to the gain on sale allocation question, we might grant shareholders a greater portion of the gain. However, as our earlier discussion reveals, most of the risks to which utilities point - the energy crisis, Hurricane Katrina, utility bankruptcy, municipalization, inadequate rate of return - are either so extraordinary that no gain on sale policy could compensate shareholders, or are so ordinary that our normal ratemaking processes make shareholders whole.

Nor should - or can - our gain on sale policy compensate ratepayers for extraordinary risks they bear that are unrelated to property ownership. The Commission raised rates significantly during the energy crisis, but appropriately made no adjustment to its gain on sale policy to accommodate that emergency.