7. Cost of Capital Methodology
7.1. Positions of the Parties
Great Oaks did not request a conventional cost of capital for a Class A water company - it instead seeks a return based on its interpretation and application of Commission practices similar to the allowances for smaller water utilities often referred to as a rate of margin return:
The rate of margin that we asked for in our rate case was basically a rate of margin number that we understood was -- that the PUC had found appropriate for Class B companies and we -- that's where that number came from. ...Great Oaks has annual expenses exceeding what its rate base is currently. Great Oaks anticipates that its rate base will continue going down. (Transcript at 161-162.)
Great Oaks argues that it has a declining rate base and faces increasing expenses which it believes would support the rate of margin (operating margin) analysis, which it believes has been traditionally applied to Class B water companies. Great Oaks asserts it more closely resembles a Class B water utility on all relevant cost of capital, operating and financial characteristics than it does any of the other Class A water companies, with only the number of customers placing Great Oaks in the Class A category.
Great Oaks proposed a rate of return of 17.58% on its operating expenses using a rate of margin analysis. Great Oaks effectively seeks a return on equity of 18.70% based on a 100% equity capital structure.11 In fact, Great Oaks has an actual capital structure which is 3% preferred stock and 97% equity.
DRA opposes Great Oaks' approach and, as addressed below, supports the use of an imputed capital structure to obtain a regulatory cost of capital for Great Oaks.
7.2. Discussion - Methodology
Upon meeting the Class A size requirement, all water companies generally assume the same responsibilities and obligations to customers and generally must comply with the same regulatory processes and policies. Great Oaks argues, however, that under Pub. Util. Code § 727.5(e)12 the Commission is free to chose any method to determine a reasonable cost of capital for a water utility, and therefore, it may depart from the typical method relied upon for Class A companies and adopt the method proposed by Great Oaks. (Great Oaks Opening Brief at 9-10.) We do not disagree with the premise that we have authority to report from the current method where it could be shown to be more reasonable, however, as explained by more of the circumstances cited by 6.0 and materially different.
Great Oaks argues that it has risks which are uniquely different from the risks faced by the other Class A companies and that the only similarity it shares with the other Class A companies is that it has more than the minimum 10,000 connections (Id. at 12). Great Oaks is the smallest of the Class A water companies but, with a forecast of approximately 24,000 connections, it is nevertheless twice the minimum size of 10,000 connections for the classification. It is much bigger than the largest Class B company, which is Alisal Water Corporation dba Alco Water Service, with fewer than 9,000 customers. Thus, Great Oaks is 2.7 times the size of the largest Class B.
Great Oaks argues it has a diminishing rate base. (Id. at 15.) That alone is not a risk which warrants any adjustment to return: investors are entitled to earn a reasonable return on the necessary investment to provide service. Ratepayers are not obliged to maintain investors' income level in total number of dollars, but only an opportunity to a return, as a percentage, on the necessary investment. If the utility does not need new investment it can pay dividends or reacquire stock to adjust the amount of outstanding equity to equal the level necessary for investment in rate base. We would agree that, while at some point a de minimus rate base value would provide no return on investment cushion to absorb the variations between forecast and actual expense, Great Oaks has not shown it to have such a small rate base that it faces a significant risk of an operating loss if there is a minor adverse variation in forecast expenses.13
Great Oaks argues that its expenses are expected to increase annually. (Id. at 16.) Revenue requirement is adjusted to account for the forecast costs of operations in general rate cases, the adopted attrition allowances, authorized balancing and memorandum accounts, and by other specific applications for rate recovery, all of which are appropriate mechanisms to offset and recoup rising expense. We should not artificially increase the cost of capital or the return on equity to offset legitimate expenses; we should set appropriate utility rates to recover either forecast costs (in rate case and attrition adjustments) or specific actual costs (in balancing and memorandum accounts). When we adopt a cost of capital or return on equity, it is not intended to offset foreseeable annual increases in expense; it is to attract and retain capital by offering a market return to investors.
Finally, we note that the Commission has not applied the rate of margin method to Class B water utilities, contrary to Great Oaks' apparent belief. Pursuant to D.92-03-093 (Ordering Paragraph 8), the rate of margin (operating margin) method may be used for Class C and Class D water companies. While Class B water companies utilize simpler advice letters rather than applications for their general rate cases, the Commission establishes a cost of capital and return on equity for Class B utilities, based on their rate bases, not a rate of margin as requested by Great Oaks.
For these reasons, we do not accept Great Oaks' proposal that we deviate from the traditional cost of capital approach for Class A water companies contemplated in the rate case plan.
11 ". . . under the model used in this rate case, the return on rate base would be 18.78 [percent]. And since the equity is 100 percent, the return on equity would, therefore, also be 18.7 [percent]." (Transcript at 163.) Also, Ex. GO-3 at A-18.
12 (e) In establishing rates for recovery of the costs of used and useful water plant, the commission may utilize a capital structure and payback methodology that shall maintain the reliability of water service, shall minimize the long-term cost to ratepayers, shall provide equity between present and future ratepayers, and shall afford the utility an opportunity to earn a reasonable return on its used and useful investment, to attract capital for investment on reasonable terms and to ensure the financial integrity of the utility. (Emphasis by Great Oaks in its Opening Brief at 10.)
13 We note that in A.09-09-001, Great Oaks' pending general rate case, it indicates that its last test year rate base was $9,648,723, its rate base on a recorded basis for the calendar year 2008 was $11,888,532, and it requests a test year 2010-2011 rate base of $11,202,434. Thus, Great Oaks' rate base has both risen and fallen since its last date proceeding and its forecast through 2011.
