Discussion

We deny the proposed merger because the burdens imposed significantly outweigh the benefits gained. We base this conclusion on our analysis of the facts under criteria applicable to settlements and mergers.

The proposed settlement is opposed by three parties; as a practical matter, therefore, this is a hotly contested proceeding in which some of the parties (the applicants and ORA) ultimately presented a joint position. Our standard for review of settlements is in Rule 51.1 of the Commission's Rules of Practice and Procedure. This rule requires that a settlement be reasonable in light of the entire record, serve the public interest and not contrary to applicable law. Regarding the public interest aspects of a merger, our test for approval is that the merger is not adverse or injurious to ratepayers. (Re Merger of California Water Service, Dominguez, Kern Valley and Antelope Water Companies, D.00-05-027, affirmed on application for rehearing in D.00-09-042, p. 5.)

Furthermore, whether or not a proposed merger is embodied in a settlement, the operator of the combined utility system must have the technical, managerial, and financial capability to run the system. Finally, specific criteria for a water utility merger have evolved in our interpreting the Public Water Systems Investment and Consolidation Act of 1997. The stated purpose of the statute is to provide incentives for acquisition of water systems where the acquisition would help the system to replace or upgrade its infrastructure to meet increasingly stringent state and federal safe drinking water laws and fire flow standards. (See Pub. Util. Code § 2719.) The means by which the statute would accomplish this purpose is to allow into rate base the full "fair market value" of utility property, when "fair market value" is paid as the purchase price. In effect, an amount in excess of the book value of the purchased plant may be used as rate base for ratesetting purposes as an incentive for taking on the responsibility of upgrading an inadequate, troubled water system. (See Pub. Util. Code § 2720.) However, we have noted a limit to the reasonableness of this type of incentive. In Pine Flat and Pine Mountain Water Companies, D.00-01-018, we concluded that when a new rate base amount is unreasonable and unfair as a result of applying the new "fair market value" standard considering the future benefits received, we retain authority to deny a merger.

In the motion to approve the settlement, applicants and ORA contend the settlement meets all required criteria. In responses opposing approval, the cities contend the settlement would result in unreasonable rates and unnecessary improvements, contrary to the public economic interest and to various statutes, such as CEQA. They also contend that the acquiring company often does not respond to customer complaints, and therefore fails the criterion of managerial competence. Thus, the cities are saying the merger meets none of the criteria, i.e., that it is not reasonable, lawful, or in the public interest. We agree with the cities that the sale of Peerless to SCWC is not in the public interest and thus should be denied. We address each of these criteria below.

Reasonableness

Peerless' current total rate base is $422,119. Adjusting the rate base to reflect almost the entire purchase price (about $4 million), per the settlement, results in a net increase in rates of $119,163, or 15.4%, solely attributable to the merger. This 857% increase in rate base raises a serious question over whether the effect of the merger on Peerless' existing customers is fair and reasonable. (See Pub. Util. Code § 2720(b).) As Bellflower's witness Faal notes, the highest recent increase in rate base as a result of a merger is 81.8%. Customers would have to pay the pay the authorized return on this increase. We have previously concluded that where rate base "write-ups" lead to unreasonable rate increases without commensurate benefits, we have the authority to deny the merger. (Re Merger of California Water Service, Dominguez, Kern Valley and Antelope Water Companies, D.99-09-030, p. 5, Conclusions of Law 4 and 5.)

We consider these purchase price-related and Merger Plan increases to be unreasonable. Moreover, when coupled with the potential further increase of 16-28% when Peerless is merged with SCWC's Metropolitan District, the cumulative increase in rates is extraordinarily onerous.

The appraised value of the water rights in December 1996 was $2,700 per AF. (Exh. 2, Tab G-Perry Appraisal, p. 1.) More recent water transaction have ranged as high as $3500 per AF (Exhibit 2, p. 3 and Exhibit 2, Tab E.) These transactions indicate that a valuation of $3000 per AF is reasonable.

SCWC indicated that it will use the excess water rights belonging to Peerless to serve Metropolitan District customers, since once the merger is approved these water rights belong to all SCWC customers. If roughly half of the water rights are used for Metropolitan District customers at no cost, this is not a benefit for Peerless customers but rather a burden. It effectively places the 2,000 Peerless customers in the position of subsidizing the water supply of 98,000 Metropolitan District customers before the districts are consolidated. This is unreasonable.

SCWC contends the merger would provide important non-quantifiable benefits, such as the ability to finance needed improvements. SCWC proposes to finance $ 2.64 million in improvements within 5 years and $11.5 million in improvements eventually. With only 2000 current connections, this improvement plan would result in stunningly high per-connection investments. However, the cities provide persuasive evidence that the Peerless system is mostly in satisfactory condition. While it is true that five operating wells are inactive due to contamination, there are five operating wells and others used for emergencies. No party presented evidence that current water quality is in violation of DHS primary standards or threatens to be so in the future. Complaints regarding secondary standards, coloration, leaks and low pressure, were investigated and traced to customer plumbing, not Peerless' pipes. Moreover, in the last 6-7 years, DHS has inspected the entire system and declared it to meet all existing standards. DHS reports of the Peerless system show that it has few leaks or customer complaints, and has adequate capacity to meet customer demand. In 1994 and 1999, DHS reported that Peerless was meeting all obligations to provide safe, potable water. (Exh. 4 and 5.) This is persuasive evidence that this system is not in such poor condition that we need be concerned with immediate financing for major improvements. Thus, Peerless is not the type of utility contemplated by § 2719 as needing timely merger strategies in order to provide safe, adequate service. Moreover, Zastrow is selling the company because he is retiring, not because he is unable to run and maintain it.

City engineers provided persuasive evidence that some of the proposed improvements are not needed, or are significantly inflated. In fact, all of the cities believe the needed improvements in their respective cities could be paid within their existing budgets, each of roughly $500,000 per year.

We also find the need for new wells to replace contaminated wells could be eliminated by connecting Peerless to the cities' systems, which due to their deeper wells are not experiencing contamination. Moreover, if the problems of discoloration and low pressure are attributable to old customer pipes, as Peerless complaint investigations and DHS reports indicate, spending $11 million on improvements to Peerless' system will not alleviate these problems. Thus, the record shows that SCWC's proposed improvements are unnecessary, and rate increases to support those improvements are unreasonable.

In summary, the proposed rate base increases, need for improvements and estimate for improvements are unreasonable. Peerless is not a troubled water system in need of rescue, and the large rate increase due to the merger and capital improvement plan dwarfs any economies that the merger might provide. In particular, the capital improvement plan, inseparable from this proposed merger, would lead to extremely high per customer investment levels. Even though SCWC would eventually average these new investments and resulting revenue requirements into its larger Metropolitan District, this serves only to hide the economic impracticality of the merger and investment plan proposed by SCWC and Peerless. Moreover, as we discuss later, economies of scale may be realized by alternative means, without the large rate increase due to the merger.

Consistency with Applicable Law

SCWC contends that the well construction it proposes will have no significant impact on the environment because it already has numerous existing wells, implying an exemption from the requirements of CEQA because it will build near these facilities, or on the same sites. However, Bellflower contends there is no assurance that sites near present wells can or will be obtained. We need not address or resolve these environmental issues at this time since we conclude the proposed merger must be denied.

What we do resolve now is that the proposed merger and capital improvement plan would lead to a per customer rate base attributable to former Peerless' customers that greatly exceeds any previously found reasonable for a water company. It will greatly increase rates without adequate benefits to offset the increases. Consequently, we cannot find the resulting rates to be just and reasonable, as § 451 requires, nor can we find the proposed merger meets the criteria set forth in § 2720(b). We conclude the merger is inconsistent with applicable law.

Public Interest

Public policy, as set forth in statute and Commission decisions, favors acquisition of technically or financially challenged water utilities by other providers with adequate resources and the potential to realize economics of scale. We have already found that Peerless is not a troubled water system, but to the extent that transfer of ownership is desirable, other suitable providers appear ready, able, and willing to acquire Peerless.

Three cities in Peerless' service territory request to acquire the Peerless facilities in their respective cities. Negotiations between one city, Bellflower, and Peerless failed because the owner of Peerless was not motivated to sell to this city. These cities request an opportunity to connect to Peerless and provide service at cheaper rates immediately upon acquisition.

Each city has existing physical connections to Peerless for emergency purposes. Lakewood and Paramount already operate water systems with few customer complaints, and have city engineers with the technical expertise to successfully operate Peerless. The same can be said of the mutual water company in Bellflower. These water providers also have the financial means to acquire and maintain Peerless. (Exh. 27, 31, and 32.) Connecting with any one or all of these three cities will immediately result in lower rates to the Peerless' customers.

Zastrow's concern that the acquisition of Peerless by Bellflower Somerset would require customers to purchase shares in the mutual was adequately addressed. As Koops testified (Exh. 21), this requirement may be met by charging each customer as little as $1, and may be collected in the regular customer bill. Therefore, any requirement to purchase shares in a mutual water company is not a deterrent for low-income or fixed-income customers.

Bellflower also indicated that capital improvements are not financed by a mutual water company through special assessments, which increases rates, as Zastrow presumed. Such improvements are financed from city budgets, retained earnings and city loans. Therefore, they do not affect rates.

The advantages of connecting with one or all of these cities are obvious, especially when considered in light of the proposed merger and investment plan. Under this plan, rate base will immediately increase from approximately $420,000 to $4 million. Over the next five years, a capital improvement plan will lead to another $2.64 million in investments. This will eventually rise to $11.5 million, an enormously costly investment program to provide water service to approximately 2000 customers. We find that it is wasteful for numerous purveyors to construct duplicate facilities and connections throughout these cities. It is clear that operating the water system as proposed by SCWC is extremely costly. In counterpoint, we note that Bellflower has successfully reduced this number of purveyors from twenty to six in its city within recent years. To grant SCWC's acquisition of Peerless does nothing to reduce the number of purveyors. However, since we have no authority to force Peerless to sell to one or all of these cities, we only note that such a sale would greatly benefit the Peerless customers and lead to a rationalization of water service.

Accordingly, we find the merger is not in the public interest. If the current ownership of Peerless wishes to transfer the utility, it must do so under terms and conditions that better fit the public interest as set forth in this decision.