8. Capital Structure
Great Oaks has a 97% equity and 3% preferred stock capital structure. However, DRA imputed a capital structure of 34% debt and 66% common equity. DRA argues that an imputed capital structure is reasonable, and is fair to ratepayers who would otherwise bear the cost of an equity return and the related income tax allowance for an all-equity structure. DRA argues that this is consistent with Commission precedent for setting rates of return for utilities such as Great Oaks that have an "atypical" capital structure. DRA points out that the Commission has previously adopted an imputed structure of 34% debt and 66% equity in recent rate cases. (DRA Opening Brief, at 15-16.)
Ratemaking capital structure is long term debt, preferred stock, and common equity.14 Because the level of financial risk that a utility faces is determined in part by the proportion of its debt to equity capital, or the degree of financial leverage, we must ensure that the utility's adopted equity ratio is sufficient to maintain a reasonable credit rating and to attract capital without incurring unnecessary costs for an excessive amount of expensive equity.
Generally, long term debt is the least expensive form of capital but the utility must ensure that it timely meets every interest payment and maintains any required terms or conditions of the loan agreements or mortgage indentures, and that it can refinance or refund the debt when it matures. Preferred stock is generally more expensive than debt (at the time it is originally issued) and may or may not have a maturity or refund provision. Interest may usually be deferred but it then accumulates and takes preference over payment of dividends to common equity owners. Thus, equity owners assume more risk than either debt holders or preferred stock owners, including the risk of losing their entire investment, and therefore equity investors require the highest return over the long run.
We believe that the company has a significant control over the mix of debt and equity and thus ratepayers should not bear unnecessary costs as a result of management discretion. Thus, even if, for the sake of argument, a smaller water company as a matter of course has a higher transaction cost and even a higher interest cost for debt, debt is almost always cheaper than equity and does not carry the added loading of an income tax allowance in rates. Therefore, if a company carries a high equity ratio, for ratemaking purposes we should necessarily consider adjusting either the return on equity or the capital structure.
DRA relies on a venerable decision:
[W]e have generally deemed a high equity capital structure, like that of Great Oaks, less than desirable for Class A water companies, as well as for other public utilities. This is because a high equity structure is generally inefficient in that it causes the public to be burdened with the higher costs of obtaining capital. We have previously discussed the rationale for this policy:
Debt financing is less expensive than equity financing because interest payments on debt are generally less than returns paid to common stockholders and because interest payments are tax deductible while returns on common equity are not. The tax savings generated by interest expense directly benefits ratepayers through a proportional reduction of revenue requirement needs. (DRA Opening Brief at 17 citing to D.93-10-046, at 3 (citing Re San Gabriel Valley Water Co. (1989) 32 Cal.P.U.C. 2d 423, 439).)
We continue to espouse this policy preference for using or imputing cost-effective debt into the capital structure of Class A utilities. In D.09-05-019, we discusssed the cost advantage to ratepayers of including debt in the capital structure and required other Class A companies to fully justify their equity ratios in a subsequent cost of capital proceeding.
Great Oaks' prior cost of capital, including capital structure, was adopted by resolution, and a settlement. Although our rules clearly denote settlements are not precedential (Rule 12.5), and we cannot unravel the give and take involved in a settlement, we can take notice of our prior adoption of imputed capital structures because our same rules require that any settlement must be based on the evidence, consistent with the law, and in the public interest. (Rule 12.1(c).)
As noted above, Great Oaks' application was not consolidated with the other single-district Class A water companies in A.09-05-001 et al., but we can and do consider our decision D.10-10-036 in that proceeding. In D.10-10-036, we declined to use DRA's generic capital structure for the various applicants, and we adopted instead their actual capital structures which varied in their debt to equity ratios. We noted in that decision our strong preference for a reasonable amount of debt which reduces the overall cost of capital recovered from ratepayers.
Great Oaks, unlike the other Class A water companies, has no long term debt in its capital structure. In this proceeding the company proposed that ratepayers pay the higher return on equity (a premium above the cost of debt) on the significant proportion of the company's total capital that for all other Class A water companies is funded by long term debt. If we adopted Great Oaks' proposal, ratepayers would also needlessly pay a much higher income tax allowance as well. Great Oaks does not have the discretion to simply chose the most expensive capital structure and ignore the benefits to ratepayers of using tax-deductible lower cost debt. We therefore impute a debt component in these specific circumstances for Great Oaks to reduce the costs otherwise imposed on ratepayers.
Valencia and Park/Apple are the two smallest Class A water companies other than Great Oaks, and they have 2010 equity ratios of 75% and 57%, respectively (see, D.10-10-036 at 3), significantly lower than Great Oak's 97%.15 These lower equity ratios allow the use of tax-deductible debt, which when coupled with the normally lower cost of debt provides a significant cost savings to ratepayers. Thus the use or imputation of debt can be in the public interest because it lowers costs to ratepayers. An appropriate amount of debt, assuming the utility has sufficient cash flow and is otherwise financially sound, does not adversely impact the cost of equity allowing the investors an opportunity to earn a reasonable return on equity.
We have previously used an imputed debt allowance for Great Oaks and find DRA persuasive that we should impute a suitable capital structure rather than Great Oaks' excess reliance on equity. We therefore adopt a 30% debt structure, and allocate the remaining 70% to reflect the existing 3% preferred stock and impute a residual allowance of 67% equity. Preferred stock dividends, like common stock dividends, are not tax deductible. Thus the tax effect of this structure (30-3-67) mimics a 70% equity structure and is closer to DRA's 66% equity structure than it is to Great Oaks' 100% equity structure. This adopted capital structure is consistent with the range of the next smallest Class A companies and with our regulatory objective to set rates at the lowest reasonable level, while still leaving Great Oaks with a relatively high equity ratio for ratemaking purposes compared to other Class A companies. Using imputed debt substitutes for Great Oaks' excessive and more expensive reliance on equity and lessens the cost burden on its customers.
14 Short-term debt due within one year is excluded.
15 Valencia has subsequently reduced its equity ratio, as noted in D.10-10-036.
