XIII. Water Specific Issues - Water Utility
Infrastructure Improvement Act of 1995,
Public Utilities Code § 789 et seq.
A. OIR Questions - Water
Water utility regulation is unique because there is a specific statute governing gain on sale allocation, the Water Utility Infrastructure Improvement Act of 1995, Pub. Util. Code § 789 et seq. (Infrastructure Act). The statute provides, in pertinent part, that a water corporation shall invest the "net proceeds" of the sale of "real property" in water system infrastructure that is necessary or useful for utility service. The statute gives a utility a period of eight years from the end of the calendar year in which the water corporation receives the net proceeds to invest them in facilities necessary or useful to the performance of duties to the public. Any proceeds the utility does not so invest in the eight-year period shall be allocated solely to ratepayers.
The OIR poses several questions specific to the statute:
May water utility shareholders enjoy a return on assets that the utility's shareholders did not purchase? Examples:
(1) facilities paid for by company ratepayers,
(2) facilities constructed in the 1980s and 1990s with state-provided low interest loans under the SDWBA and the State Revolving Fund,
(3) water assets developers or other entities pay for as contributions in aid of construction, and
(4) state grant funds from Proposition 50 proceeds to construct water utility infrastructure in low-income areas.
If according to § 790, the full gain is included as rate base, should there be any safeguards against "churning" of assets by utility management in order to increase rate base? What should these safeguards be?
In order to reconcile § 790 and § 851, at what point do we require the utility to file an application? If the utility files a § 851 application at the time of the sale and the Commission approves the sale, what must the utility file at the end of the eight years, if anything, to reconcile the net proceeds?
We address each of these questions below.
B. General Interpretation of Infrastructure Act, Pub. Util. Code § 789 et seq.
According to the California Water Association (CWA), § 790's requirement that water utilities invest net sales proceeds in utility plant means that all such investment should be included in the utility's rate base with the opportunity to earn a reasonable return. CWA believes the Legislature in passing the statute recognized a pressing and continuing need for substantial investment by water utilities in new infrastructure, plant and facilities, and looked to real property no longer needed for utility service as a source of capital to fund that investment. The statute offers rate base inclusion for the reinvested proceeds "as an inducement to utilities to dispose of such property and to make such needed reinvestments."81
2. Discussion - General Interpretation of Infrastructure Act
We interpret the Infrastructure Act to limit Commission discretion in how it allocates gains on sale of real property, provided that water companies shall use the proceeds from sales of formerly used and useful utility real property to invest in new water infrastructure.82 Such proceeds may not be used to reduce rates or otherwise be returned to ratepayers unless the water companies fail to reinvest the proceeds within the eight-year period contained in § 790(c).83
No party cites the legislative history of the Infrastructure Act in its comments. Nonetheless, we have examined the committee reports submitted at the Legislature when it was considering the Act, and find them quite definitive on how to interpret the statute. The California Supreme Court has stated: "To interpret statutory language, the courts must ascertain the intent of the legislature so as to effectuate the purpose of the law."84 While the first (and often last) step in interpreting a statute is always the statutory language itself, the parties' differing interpretations of the Act's language suggest that it is appropriate to examine the legislative analysis to determine what the Legislature intended in enacting the statute.
The April 5, 1995, analysis provided for the California Senate floor when it was considering the legislation85 explained that the statute was designed to ensure uniform allocation of gains on sale and to limit Commission discretion in allocating such gains:
The PUC, which is charged with the regulation of the water companies, has issued several decisions in the area of gain on sale (the disposition of the proceeds) from a sale of non used and useful property. In some instances, the PUC has allowed a water company to allow the gains to revert to shareholders. In other instances, the PUC has required the company to flow all or part of the gains to ratepayers often in the form of lower rates.
This bill attempts to create a uniform standard that would accrue all gains on the sale of property back to the owners for the specified use of improvements in infrastructure and then after a period of ten years,86 the proceeds will be allocated to ratepayers.
All other reports on the legislation say essentially the same thing.87 These reports evince a legislative intent to give water companies certainty on how to allocate their gains from the sale of real property. Recognizing the need for infrastructure investment, the difficulty for water companies of acquiring capital in the market, and the varying approaches the Commission has taken on the subject, the Legislature created a bright-line rule. Thus, water utilities must invest net proceeds from the sale of formerly used and useful real property in new water infrastructure. They need not refund such proceeds to ratepayers, but they may not pay the funds out to shareholders in the form of dividends or other earnings either.
We discussed the legislative intent behind the Infrastructure Act at length in D.03-09-021. In keeping with the foregoing analysis, we found that,
In summary, § 790 requires water utilities to sell no longer needed property and to invest the net proceeds in needed infrastructure. These net proceeds are to be the utility's primary source of capital for infrastructure, and the utility must track the investment of the proceeds. The utility has eight years to re-invest the funds, and must include the property among its other utility property.
We also voiced a word of caution: "the result of allocating all net proceeds to shareholders creates a powerful financial incentive for water utilities to sell real property . . . . Such a right could encourage 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, relying on rate base treatment to protect shareholders from losses but using § 790 to reap all gains."88
We therefore concluded in D.03-09-021 that water companies must carefully track real property sales proceeds, and must be able to link funds received from such sales to their investments in new infrastructure. We also concluded that, "[t]he Commission has exclusive authority to determine the used, useful, or necessary status of any and all infrastructure improvements and investments." Therefore, we adopted several tracking and application requirements under the Act, which we applied to the party to the proceeding and reaffirm below.
Nothing in the Infrastructure Act or its legislative history precludes us from adopting tracking requirements to ensure that water companies actually comply with the statute. We believe tracking is appropriate given the risks we acknowledged in D.03-09-021.
C. Shareholder-Purchased Assets vs. Other Assets
As noted above, the OIR asks several questions about how water companies should treat sales proceeds from property not purchased with shareholder funds. We address each type of property in turn.
Park believes that any gains from sale of assets funded by non-shareholder investment, if in the form of government-financed funding, should be returned to the funding agency. It states that § 790 should be revised to conform to that position.
With regard to Proposition 50, ORA/TURN assert that water companies should return net proceeds from the sale of Proposition 50-financed property to the granting public agency. "ORA and TURN believe that the Commission should uphold its longstanding policy of forbidding utilities to earn on the investment of others."89
We will take up claims regarding Proposition 50 funds, including how to allocate gains on sale, in our Proposition 50 proceeding, R.04-09-002. Thus, we do not act on the parties' comments on Proposition 50 here.90
With regard to other water utility investments made with government funds, we lack a record to determine whether the funding agencies are in a position to receive reimbursement for sales proceeds traceable to property purchased with government funding.
2. Developer Contributions in Aid of Construction
a) Comments - Developer Contributions in Aid of Construction
ORA/TURN claim that advances for construction and contributions in aid of construction comprise as much as 30% to 40% of plant investments for some water utilities. They claim that such funds do not belong to the shareholders, who bear none of the financial risks related to the funds, and that the Commission has long prohibited utilities from earning a rate of return on investments that do not belong to the shareholders. They cite D.03-09-021, in which the Commission rejected an interpretation that the Infrastructure Act requires all net proceeds from a § 790 sale to be allocated to the shareholders. Thus, ORA/TURN ask the Commission to declare that the Act requires § 790 net proceeds allocable to advances for construction and contributions in aid of construction be assigned to ratepayers.
Developer contributions in aid of construction are not generally in rate base, according to Park. Thus, ratepayers have no claim to the gain on sale since they have not paid for the property, a rate of return, or maintenance costs. Since, according to Park, ratepayers have not borne risks related to such assets, returns from such assets, once reinvested, should be in rate base.
CWA contends that the Infrastructure Act does not contemplate a "second `rate base' on which a different (i.e., lesser) rate of return would be allowed."91 According to CWA, the statute makes no distinction between real property financed by shareholders' equity, by debt, by developers' contributions, or otherwise. The utility should be allowed a return on all such property.
b) Discussion - Developer Contributions in Aid of Construction
Section 790 does not limit the definition of "net proceeds" to proceeds attributable to shareholder investment. The clear intent of the Infrastructure Act, as we discuss above, is to ensure that water companies invest proceeds from sales of no longer used and useful utility real property in water infrastructure. If such property was once used and useful, but not in rate base (as Park Water says is the case with most developer contributions in aid of construction), § 790 nonetheless governs such assets. We find that water companies should re-invest gains from the sale of assets recorded under Contributions in Aid of Construction (CIAC) in new water infrastructure, and that the water companies may earn a reasonable rate of return on that reinvested gain. The gain must result from a sale of formerly used and useful real property, as we discuss above, because the statute only applies to such property.
The Commission leaves open for further consideration the issue of whether a "reasonable rate of return," on reinvested gain from the sale of CIAC property ought to be the same as (or different from) the rate of return the utility earns on other property.
Only if the water company fails to make such investment within the statutory eight-year period should the proceeds revert to ratepayers. At the same time, the companies may not pay out the sales proceeds in dividends or other profit to shareholders. Rather, they must place the proceeds in a memorandum account approved by the Commission and meet the other tracking requirements we imposed in D.03-09-021 and reiterate here.
A related issue on which several parties commented relates to proceeds a water company recovers from a polluter for contaminating water supply. These are essentially litigation proceeds that water companies receive from third parties who contaminate water supplies.
We evaluated water utility treatment of contamination proceeds in D.04-07-031.92 There, the Southern California Water Company had received a monetary settlement for pollution of groundwater from MTBE, a gasoline additive and known carcinogen. We concluded that the settlement proceeds should pass to ratepayers to compensate them for the higher water rates they had paid in the past and would pay in the future due to contaminated groundwater. We rejected the water company's assertion that the proceeds should not be refunded to ratepayers.
Contamination proceeds do not involve sales of real property, so the Infrastructure Act does not apply, nor are such proceeds gains on sale. Thus, such proceeds are outside the scope of this proceeding.
D. Churning
The OIR asked parties to comment on the following question related to "churning" of assets:
If according to § 790, the full gain is included as rate base, should there be any safeguards against "churning" of assets by utility management in order to increase rate base? What should these safeguards be?
Park Water Company states that there is little risk that utilities would churn their assets to increase rate base. Any such risk "could be eliminated if the rates at each period were set to compensate the owner for the use value of the asset during the regulated period, whether that be higher or lower than cost."93
CWA agrees that it is a "valid concern" that "water utilities will improperly characterize real property with little or no rate base value as no longer necessary or useful for public utility service just in order to sell such property and reinvest the net proceeds in new plant that will qualify for rate base treatment."
However, CWA believes the Commission can address the concern without creating cumbersome new regulatory procedures. It believes water utilities' triennial general rate case reviews and filing of § 851 applications to sell or otherwise dispose of property will safeguard against churning. The requirement that utilities file reports pursuant to Pub. Util. Code § 455.2 will keep the Commission informed on a timely basis of any water utility sales of real property and subsequent reinvestment of the proceeds. The new water rate case plan in D.04-06-018 will also ensure detailed reporting of all dispositions of real property.94 That decision provides as follows:
To the extent not included in a previous GRC [General Rate Case] application, include a detailed, complete description accounting for all real property that, since January 1, 1996, was at any time, but is no longer, necessary or useful in the performance of the water corporation's duties to the public and explain what, if any, disposition or use has been made of said property since it was determined to no longer by used or useful in the performance of utility duties. The disposition of any proceeds shall also be explained.
CWA contends that § 851 does not require utilities to seek Commission permission to sell property that is not necessary or useful for utility service. Thus, CWA contends, there is no justification to require such advance permission as a safeguard against churning. The foregoing reporting requirements should give the Commission adequate opportunity to investigate utility determinations that particular sales of real property need not have been submitted for § 851 authorization, and to evaluate whether the proceeds were in fact reinvested in utility plant that is necessary and useful in providing utility service.
D.03-09-021 gives us a good look at how the Infrastructure Act might prompt a water company to sell property without Commission approval in an attempt to enhance shareholder profits rather than improving infrastructure. In that case, a water company had built a new customer service center using proceeds from the sale of its old customer center. We found that the "customer center replacement project [did] not comport with the statutory provisions [in § 790] . . . for regulatory scrutiny and ratemaking treatment . . . . [T]he project is remarkably vague and the need for the project has not been demonstrated. Cal Water has not presented any objective fact, such as customer growth rates, that would justify this project."
Moreover, we rejected the water company's claim that,
[t]o meet the reinvestment requirement of § 790, . . . reinvestment of the actual sale proceeds is not necessary so long as the utility invests at least that amount in needed facilities during the same year. Under this reasoning, Cal Water conclude[d] that the actual sale proceeds should be available for immediate distribution to shareholders. Cal Water's statutory interpretation allowing this substitution process results in real property sales proceeds, such as the sale of the old Chico customer center, being allocated exclusively and immediately to shareholders.
We therefore required the water company to make a detailed filing demonstrating that it was acting in the ratepayers' interest:
We, therefore, order Cal Water to submit an application fully explaining in detail its real estate program from its beginning to current plans. All properties included in the program shall be specifically identified and the use and regulatory history of each property set out. Cal Water shall state its rationale for removing any property from rate base and provide supporting documentation. Cal Water shall include the accounting history of each property, including original cost and amount realized, for each property as well as the disposition of all proceeds. The Commission staff, after careful review of the proposed transactions for compliance with all applicable statutes and rules, will file and serve a detailed report on its review.95
In view of the situation in D.03-09-021, we agree that safeguards against churning are appropriate. The reporting requirements D.03-09-021 imposed on Cal Water are sufficient for that purpose, and we will require regulated water companies to do the following:
1. Track all utility property that was at any time included in rate base and maintain sales records for each property that was at any time in rate base but which was subsequently sold to any party, including a corporate affiliate.
2. Obtain Commission authorization to establish a memorandum account in which to record the net proceeds from all sales of no longer needed utility property.
3. Use the memorandum account fund as the utility's primary source of capital for investment in utility infrastructure.
4. Invest all amounts recorded in the memorandum account within eight years of the calendar year in which the net proceeds were realized.96
E. Reconciliation of § 851 and § 790
The OIR asked, with regard to the interplay between § 851 and § 790, at what point we should require the utility to file an application and how we should track the proceeds of a sale, consistent with those statutes.
ORA/TURN recommend that in order to ensure a water utility complies with both § 851 and the Infrastructure Act, we should require the utility to file a pre-sale § 851 application and keep detailed records matching net sales proceeds with reinvestment.
Park observes that there is nothing to reconcile between § 851 and § 790, since the former deals with sale of necessary or useful utility property and the latter deals with property that was at one time but is no longer necessary or useful in the performance of the water corporation's duties to the public. CWA similarly contends that there is no need to reconcile the two statutes.
Nonetheless, Park acknowledges recent Commission positions that a utility cannot rely on its own determination of whether the plant is necessary or useful, or may be considered so in the future. Park states that it "may behoove utilities to file a § 851 application at the time of the sale." Since § 790(a) requires that the water utility maintain records necessary to document the investment of the net proceeds pursuant to the statute, at the end of the eight years, Park states that the utility should file these records with the Commission. Park suggests that this be done as a compliance filing with the Commission's Water Division.
CWA reiterates its position that utilities need not file for § 851 approval to sell property that is not necessary and useful. Nonetheless, states CWA, the Commission may wish to authorize water utilities to establish memorandum accounts to track the net proceeds of utility sales and "net proceeds" investments. CWA suggests that the Commission review these memorandum accounts when it conducts the water companies' general rate cases. "If memorandum account records eventually reveal that a utility has not reinvested all the net proceeds of a sale of real property and accrued interest within the eight-year period prescribed by the Infrastructure Act, then a timely general rate case decision can ensure that the remaining balance `shall be allocated solely to ratepayers.'"97
As noted previously, § 851's general requirements are beyond the scope of this proceeding. However, in the context of the Infrastructure Act, we agree with ORA/TURN (and have already decided in D.03-09-021) that we should impose certain reporting and application requirements to ensure that water companies act in compliance with § 790 and invest sales proceeds from formerly used and useful utility property into new infrastructure.
Because § 790 may create incentives for water companies to sell property that is still useful for utility service, water companies must notify the Commission before they propose to sell real property covered by § 790 notwithstanding participation in the pilot program authorized in Resolution ALJ-186. We will require that water companies provide the Director of the Water Division of the Division of Ratepayer Advocates 30 days' advance written notice whenever they plan to sell land, buildings, water rights, or all or part of a water system. This notice requirement applies to water company assets that the company believes are no longer used and useful. The 30 days' advance notice will give the Commission an opportunity to assess whether companies are selling off key portions of their asset base. Notice will not preclude later review of such sales in a water company's GRC or a later proceeding.
The notice shall include the following heading in at least 16 point bold type: "Notice under Rulemaking 05-06-040. Commission staff must respond within 30 days." The notice must include the name, address, phone and email address of the potential purchaser(s). If the Commission staff objects to the proposed sale, it may send an objection in any form to the seller and proposed purchaser(s). Mailing of such an objection shall prevent the proposed purchaser from claiming it is a bona fide purchaser of the property at issue until the issues raised in the objection are resolved.
F. Condemnations/Involuntary Conversions
San Gabriel points to two types of condemnation for which it contends the utility should receive the proceeds. First, utilities routinely sell property as a result of condemnation or under the threat or imminence of condemnation by a city or other governmental agency. The condemnations occur so the government agencies can complete public works projects such as street widening.
Second, water utilities may also receive proceeds from "inverse condemnation" under the "Service Duplication Law," Pub. Util. Code § 1501 et seq. Such condemnations occur when the government constructs water facilities that duplicate the facilities of a private water utility. Under § 1503, the private utility is entitled to compensation for the reduction in value of its property even where the government does not physically acquire the utility property.
In both cases, San Gabriel contends the proceeds should be treated as sales proceeds, and the gain or loss passed to utility shareholders. San Gabriel claims such treatment is consistent with the USOA, Generally Accepted Accounting Principles (GAAP) and federal and California income tax rules.
Confusingly, the CWA states that "any rules adopted in this proceeding should apply only to gains from the voluntary sale of utility property," while asserting that its position is consistent with San Gabriel's.98
ORA/TURN oppose San Gabriel's recommendations. They state a condemnation is not a "sale" contemplated by § 790, and therefore that monies received in compensation for condemnation do not constitute "net proceeds" under the Infrastructure Act. They note that some condemnations involve non-real property assets, while the Infrastructure Act applies only to real property. They claim the common law definition of the term "sale" requires a willingness to sell, while condemnation involves an involuntary transfer of property rights or value. Thus, the Commission should exclude condemnations from the ambit of § 790.
We received a great deal of comment on the condemnation (including sale under threat of condemnation) issue after the draft decision issued. We find the issue requires further consideration and, perhaps, briefing. We therefore defer consideration of this issue to a second, narrowly focused phase of this proceeding. We will decide this issue concurrently with the § 455.5 issue discussed earlier in this decision.
G. Small Water Companies (Class B, C and D)
Aglet opposes application of the rules we develop here to Class B, C or D water companies, and suggests we apply the rules only to the Class A companies, the largest type of water utility we regulate. Aglet states that regulatory treatment of small water companies differs significantly from that for large utilities. Many small water utilities have little or no rate base, rarely if ever issue dividends, and do not have the resources to litigate complicated ratemaking issues before the Commission. Aglet suggests that we consider issues pertinent to Class B, C and D utilities in the OIR on water contamination issues we alluded to in the OIR.99
We disagree that the rules we develop here should apply only to Class A water companies. The statute applies on its face to all "water corporations" without limitation. Moreover, the smaller water companies may need the infrastructure investment § 790 facilitates as much or more than larger companies, and have less access to the capital markets than their larger brethren. Thus, we see no basis to make the requested distinction among water companies. The rules we apply here shall apply to all water companies we regulate.
81 CWA Comments at 20.
82 The § 790 portion of this decision relates only to reinvestment of gains or losses from sales of water utility assets.
83 "This article shall apply to the investment of the net proceeds referred to in subdivision (a) for a period of 8 years from the end of the calendar year in which the water corporation receives the net proceeds. The balance of any net proceeds and interest thereon that is not invested after the eight-year period shall be allocated solely to ratepayers."
84 California Teachers' Ass'n v. Governing Board of Rialto Unified School Dist., 14 Cal. 4th 627, 632 (1997).
85 The April 5, 1995 Senate Floor Analysis of SB 1025, the legislation that became the Infrastructure Act, is available on the Internet at http://www.leginfo.ca.gov/pub/95-96/bill/sen/sb_1001-1050/sb_1025_cfa_950405_165744_sen_floor.html.
86 The term was later amended to eight years.
87 See July 11, 1995 Assembly Committee Analysis of SB 1025, at http://www.leginfo.ca.gov/pub/95-96/bill/sen/sb_1001-1050/sb_1025_cfa_950711_103355_asm_comm.html; July 6, 1995 Senate Floor Analysis, at http://www.leginfo.ca.gov/pub/95-96/bill/sen/sb_1001-1050/sb_1025_cfa_950706_122701_sen_floor.html; June 9, 1995 Assembly Committee Analysis, at http://www.leginfo.ca.gov/pub/95-96/bill/sen/sb_1001-1050/sb_1025_cfa_950609_124807_asm_comm.html, and February 24, 1995 Senate Committee Analysis, at http://www.leginfo.ca.gov/pub/95-96/bill/sen/sb_1001-1050/sb_1025_cfa_950224_160520_sen_comm.html.
88 D.03-09-021, 228 PUR 4th 204 (2003), 2003 Cal. PUC LEXIS 1249, at *104.
89 ORA/TURN Comments at 51.
90 The Assigned Commissioner in R.04-09-002 recently proposed expanding the scope of that proceeding to cover all government bond funds.
91 CWA Comments at 22.
92 2004 Cal. PUC LEXIS 368.
93 Park Water Comments at 18.
94 Re General Rate Case Plan for Class A Water Companies, D.04-06-018, App. A, at 10, 2004 Cal. PUC LEXIS 018, at *62-63.
95 The full discussion of this issue appears at 2001 Cal. PUC LEXIS 1249, at *91-109.
96 We denied rehearing of D.03-09-021's interpretation of § 790 in D.04-01-052, 2004 Cal. PUC LEXIS 1.
97 CWA Comments at 26-27.
98 CWA Reply Comments at 10.
99 "Due to the complexities of water contamination issues, these issues will be considered in a separate OIR." (OIR at 28.)
