5. Return on Equity Adjustment

The scope of the proceeding was designed to resolve whether or not an adjustment to the ROE of a water utility is required as a result of the adoption of a WRAM.

While evidence was introduced at length on the general subject of risk mitigation, the record in this proceeding does not provide a reasonable basis to establish whether to make such an adjustment or provide sufficient precision to determine a range within which such an adjustment could be made to an ROE based on a change in a single risk factor in isolation. No party presented statistical analysis that would support a unique basis point adjustment. However, providing clarity on the ROE issue is beneficial for those companies that have adopted decoupling WRAM's and for those companies considering the adoption of a WRAM.

In summary, the arguments explaining why the adoption of the WRAM should be considered outside of a generic cost of capital proceedings are not persuasive. As stated by Dr. Vilbert, "The adoption of a RAM, if it is well designed, would simply offset the additional risk created by pursuit of the conservation policy.^39." Therefore, we do not adopt DRA's proposals on an ROE adjustment.

5.1. Impact of WRAMs

The Commission's WAP concluded that water utilities had a financial disincentive to conserve water. Therefore, to advance the goals of conservation, the Commission would need to remove that disincentive. To begin the effort of changing the usage patterns and valuation of water, the first steps must address the linkage between utility profitability and the growth of water sales. At a minimum, the adoption of decoupling mechanisms for the water utilities was necessary. The question then becomes, has adoption of that one mechanism, in isolation, caused a change in risk that is sufficiently clear and precise so as to warrant an adjustment to the cost of capital.

Dr. Vilbert's testimony raised the most persuasive arguments to address this question. He argues that a well-designed revenue adjustment mechanism should merely remove the increased risk that resulted from the adoption of policies that promote conservation. He cited the Commission's previous actions with regard to ERAM's and DRAM's to substantiate this conclusion. To further buttress his position he also raises a series of questions and concerns regarding the adoption of an adjustment to the ROE. He posits that the resultant risk change is not one that warrants a change in the cost of capital. Moreover, even if it could be determined that the WRAM affected the systematic risks of a utility, it is simply not possible to estimate the isolated changes to the cost of capital with sufficient precision to justify a change in an established ROE.

Furthermore, the effort to do so invites an even larger debate on how one would characterize the differences in regulatory environment, and business and financial risk. Is the isolation of one policy provision and its effects reasonable? Could there be the unintended consequence of diluting the meaningfulness of generic cost of capital proceedings that more holistically review a company's risks? Could other policies from the past that hadn't been given this same isolated review become suspect? As a result, would the regulatory environment be negatively affected? And are we further skewing the regulatory environment in California with regard to a water company's ability to earn its allowed rate of return at a time when we want to see more investment and more efficient use of resources?

Testimony from Susan Abbott also raises arguments against making an adjustment. In discussing the process of rating agencies' evaluation, she notes that any uncertainty of the regulatory environment at a time when attracting capital investment is critical, is viewed as a negative by investors. She argues that "any diminution of California's water utilities' allowed returns on equity as a result of implementing WRAM's would be incompatible with equal treatment within the regulated monopoly segment of the economy of the State of California.⁴⁰" In her testimony, she informs us that neither the financial community nor the rating agencies have specifically addressed the issue of diminution in business risk resulting from implementing a WRAM. She argues that while WRAM's are innocuous, ROE adjustments are not. She concludes that "The financial damage that arbitrary reductions in authorized returns would cause has the potential to seriously impede the water utilities in their efforts to maintain their financial integrity through the extremely challenging period of capital-raising and expenditures they currently face."⁴¹ She concludes her testimony with a cautionary note about the need to recognize the extraordinary challenges⁴² facing the water utilities and the resultant effect of reducing even further a water utility's ability to generate cash flow to cover its fixed obligations.

While DRA argues that the WRAMs eliminate almost all variations in earnings due to sales fluctuations,⁴³ there are other risks⁴⁴ to consider before assessing an ROE adjustment. They are best reviewed comprehensively in a cost of capital proceeding.

The utilities argue that the desired outcome and purpose of the WRAMs and MCBAs is to ensure that the utility and ratepayers are proportionally affected when conservation rates are implemented.⁴⁵

The Commission has previously found that balancing accounts that relieve a company of additional variability in its revenues and/or expenses do so by shifting that risk to ratepayers, but it doesn't necessarily result in an adjustment to the ROE in the authorizing decision.⁴⁶

We conclude that the adoption of WRAMs cannot be used, in isolation, to adjust a previously authorized ROE. Rather, we conclude that the WRAM mechanism, as designed, will stabilize revenues.

5.2. DRA's Proposed ROE Adjustment

DRA's methodology looks at changes in earnings volatility as the key indicator of how adoption of a WRAM affects water utility risk and the required ROE. (Exhibit 39.) DRA asserts increasing the percentage of fixed cost recovery guaranteed through a WRAM increases justification for an ROE adjustment. DRA recommends relying on the change in earnings volatility, as applied in the context of the Capital Asset Pricing Model (CAPM) to determine the magnitude of the appropriate ROE adjustment before the adoption of a WRAM as well as after. Because it is not possible to observe the change in earnings volatility before adoption of the WRAM, DRA recommends the Commission use its informed judgment to determine the expected change in earnings volatility.

The Class A water utilities state DRA's recommendation is without foundation. The utilities assert adoption of a WRAM will have no impact on a utility's nondiversifiable risk. Instead, they assert that the only impact will be on diversifiable risk.

Therefore, the parties disagree on whether the WRAMs and MCBAs impact nondiversifiable risk and should result in a lower cost of capital. The utilities assert most differences between actual and forecasted sales are due to weather conditions. Since weather is a diversifiable risk, there should be no impact on the cost of capital. (Testimony of Dr. Michael Vilbert, Exhibit 33, p. 26; see also Testimony of Dr. Thomas Zepp, Exhibit 26, pp. 4-5.) DRA states weather is not entirely diversifiable and is not the only factor that results in a difference between actual and forecasted sales. CalWater testified that weather, economics and demographics all influence actual sales. (Testimony of Dave Morse, Exhibit 4, p. 14.) CalAm notes other components affecting sales-unexpected changes in demand, unanticipated conservation from another source, and unanticipated changes in recreation habits. (Exhibit 35, Answer 2.) DRA states the impact of climate change on weather is not a diversifiable risk and notes that CalAm's witness Dr. Vilbert is in accord. (DRA's reply brief, p. 13.) DRA states the Commission can determine that the WRAMs and MCBAs affect both diversifiable and nondiversifiable risk.

We have not previously concluded that decoupling mechanisms exclusively impact diversifiable risk. In setting ROE for energy utilities, we have not quantified the impact of decoupling mechanisms but have noted those mechanisms reduce risk. (D.93887, 7 CPUC2d 349, 357; D.82-12-055, 10 CPUC2d 155, 162.)

The utilities find no support for the methodology used by DRA in the articles relied on by DRA. They fault DRA's methodology for assuming that the WRAM reduces all risks by the same factor, whether they are diversifiable or nondiversifiable. In rebuttal, witness Vilbert points out that the underlying paper⁴⁷ upon which DRA witness Murray relies, uses three accounting variables to forecast the systematic risk: earnings variability, payout ratio, and average asset growth. An appropriate implementation of this theory, he argues, would involve forecasting the effect of the WRAM on all accounting variables used in the prediction, not just one.

Utilities note that analysts rely on stock returns to estimate nondiversifiable risk and not on accounting variables. (Exhibit 34, p. 7.) DRA states the articles provide sufficient support for its conclusion that there is a correlation between accounting earnings volatility and nondiversifiable risk. Dr. Vilbert challenges the notion of a "correlation" relationship as a substitute for a causal relationship. In summary, the utilities' witnesses offered testimony that supports their conclusion that accounting variables are not the best measure of the change in risks due to the WRAM.

CalWater and GSWC's witness analyzed market reaction to recently approved decoupling mechanisms for eleven gas utilities. He found no significant change in share price at one, seven, or 90 days from the date of approval of the decoupling mechanism. (Testimony of Walter S. Hulse III, Exhibit 45, p. 6.) He also focused on two gas utilities that operate exclusively in the same state from the public announcements of requests for decoupling mechanisms and found no sustained increase in share price. (Exhibit 45, p. 10.) Regardless of whether or not the gas industry experiences are representative of the water industry in this regard, CWA's witness examined credit rating agencies' perceptions of adoption of electric revenue adjustment mechanisms for California energy utilities and found the agencies did not heavily weight these mechanisms in their rating deliberations. (Testimony of Susan Abbott, Exhibit 43, p. 2.) This raises the point of whether or not it is rational to make an adjustment when financial market participants wouldn't.

Witness Abbott stresses greater concern with the regulatory action to arbitrarily reduce the ROE. Negatively impacting cash flow at a time when the water industry is facing environmental requirements, aging infrastructure and the challenges of being a capital intensive industry speaks to the soundness of overall regulatory policy. Such an adjustment, on an industry that is already a net negative cash flow business, has the potential to impede their ability to raise capital. Park also raises the cash flow issue. The transition to conservation rates and a WRAM can result in under-collection and lost cash flow until the WRAM is amortized. The impact on small companies, such as Park, is greater than on large ones. On an industry that is already hugely fragmented, we cannot ignore the additional burdens on companies that are smaller. As Abbott points out, large electric utilities, with large debt offerings, have the ability to attract CalPERS dollars whereas, NO California water utilities have successfully done so (even with more attractive returns than other CalPERS investments).

We have only one methodology before us to examine the reduction of risk on the utilities' ROE following the removal of sales related risk by the WRAM, DRA's proposal to measure earnings volatility. DRA asks us to do that in the absence of relevant financial models.⁴⁸ Buried within DRA's methodology of estimating volatility and multiplying it by the difference between authorized ROE and the value of a government bond, is the recommendation for the Commission to exercise considerable judgment without sufficient supporting analysis in estimating a reduction in earnings volatility and possible impact on required ROE. It has been shown, through cross-examination and rebuttal testimony, to be a unique methodology. The DRA proposal is loosely based upon the precedent from a previous drought OII when the Conservation Memorandum Accounts were adopted. At that time, there was no requirement for water companies to file a GRC every three years, unless the Commission opened an OII requiring such a filing. Given the lack of any filing requirement and the short-term nature of the drought, it would have made sense for the Commission to reason that consideration of the ROE impact could not be deferred to the next normally scheduled ROE determination because there would be no certainty as to when that might occur. While we commend DRA for its creativity and attempt to quantify an isolated change in ROE due to the adoption of a WRAM, we will not adopt this methodology.

5.3. Future Determination of Impact on Risk

To obtain a more accurate estimate of the impact of a WRAM on the required ROE, we would need more data, collected subsequent to implementation of the ROE adjustment. Ideally these data would include ROE estimates at a minimum using Discounted Cash Flow (DCF), Risk Premium (RP), and CAPM models. These ROE models should be applied to the company in question (if publically-traded) and other (publically-traded) companies of comparable business, financial, and regulatory risk, and other relevant risk factors. Preferably, there would be an analysis of regulated utilities with comparable risk factors, and which have been authorized a revenue adjustment mechanism similar to the WRAM we are considering, but we realize this will be a very limited sample. Ideally, we would also prefer that there be at least 30 months of data with the RAM in effect, either for comparable companies or for the water utilities authorized in this proceeding to implement a WRAM.

The Commission's determination of the required ROE would benefit from a multiple regression analysis which has the required ROE (estimated by the ROE models identified above) as a dependent variable impacted by various independent variables, including but not limited to: business risk, financial risk, regulatory risk, WRAM, other adjustment mechanisms, balancing accounts, customer income, GNP, taxes and fees paid by the utility, population, inflation, unemployment rate, time-of-year, weather, water rates, variability in water supply, and risk of inadequate water quality .

In summary, the Cost of Capital proceeding is the most appropriate venue to explore these relationships. In this context, one can adequately consider the interconnectedness of all policies and risks, the cumulative effect of risks from all new and ongoing policies, and the resultant impact of the cumulative effects of policies. In the water arena, where the conflicting policy goals of low rates and reliable water supply are becoming harder and harder to balance, it is imperative to refrain from isolated decision making with regard to the financial earnings of a diversely-challenged industry based upon one policy.

³⁹ See Direct Testimony of Dr. Michael J. Vilbert on Behalf of CalAm, Oct. 19, 2007, Exhibit 33, p. 3, lines 20-21.

⁴⁰ Direct Testimony of Susan D. Abbott for CWA, Exhibit 43, p. 11.

⁴¹ Id., p. 12.

⁴² Those challenges include financial integrity, high levels of capital expenditures, a crucial need to promote conservation, the fragmented nature of the industry, contamination risks, security and transportation risks, unexpected condemnations, and the high levels of awareness about product quality which relate to the unique health and welfare risks of the water supply business.

⁴³ Testimony of Terry Murray, Exhibit 40, pp. 7-8.)

⁴⁴ Those risks include financial risk, operating/business risk, weather, variations in water supply, local and general economic conditions, systematic risk as measured by beta, unsystematic risk, implementation of the water action plan, etc.

⁴⁵ The proportional impact is defined as resulting in neither harm nor benefit to the utility or ratepayers from changes in consumption over the forecast level in the context of the settlement agreement.

⁴⁶ "Consequently, we expect that in future proceedings all of these existing and adopted protections against erosion of future earnings will be given their proper weight in the determination of risk and consequently return on equity." (D.05-07-022, Section VII.G.)

⁴⁷ Beaver, Wiliam, Kettler, Paul, and Scholes, Myron, "The Association Between Market Determined and Accounting Determined Risk Measures," The Accounting Review, October 1970.

⁴⁸ DRA witness Murray uses the Risk Premium model (and indirectly, CAPM), by referring to the risk-free rate plus the difference between the ROE and the Risk Free rate. She uses accounting variables for earning volatility correlated with systematic risk. The witness did not use, or at least did not mention using, the DCF model.