10. The Cost of Equity
10.1. Positions of the Parties
Great Oaks argues, if its rate of margin proposal is not adopted, that it should receive 192 basis points above the otherwise applicable return (Great Oaks Opening Brief at 4-5.) For comparison, the Commission adopted a 10.20% return on equity for the three large multi-district Class A water companies in D.09-05-019. We also recently adopted 10.20% return on equity for the single-district Class A water utilities (excluding Great Oaks) in D.10-10-036 issued in A.09-05-001 et al. Thus, Great Oaks seeks, as an alternative, approximately a 12.12% return on equity.19
DRA recommends a return on equity of 9.75%, which it states is consistent with its recommended return on equity for other Class A water companies in California.20
DRA argues that the Commission has consistently used a market analysis to determine Great Oaks' return on equity and rate of return on rate base. In D.93-04-061, the Commission adopted a capital structure that resulted in a return on equity of 11.5% and a rate of return of 10.56% for the test year 1993.21 Again, in D.03-12-039, the Commission adopted a return on equity of 9.78% and a rate of return of 8.9% for test year 2003.22 In both instances, DRA argues that it and Great Oaks relied on market analysis models, such as the Discounted Cash Flow model and the Capital Asset Pricing Model, to arrive at their separate recommended return on equity.23
In this proceeding, DRA presented a market analysis built on its showing in A.09-05-001 et al. and updated for Great Oaks. DRA updated the analysis performed by Dr. J. Randall Woolridge, who was DRA's witness in A.09-05-001 et al.24 DRA's witness in this proceeding revised that analysis to provide specific recommendations for Great Oaks. This application was supposed to be consolidated with the other applications in A.09-05-001 et al. but, at the specific request of Great Oaks, we delayed litigating the cost of capital to coincide with litigating the general rate case A.09-09-001. DRA argues (DRA Opening Brief at 19) that its intention was to apply the same cost of capital analysis to all Class A water companies that filed in May 2009, and that Great Oaks is the only remaining Class A water company that has not completed its cost of capital proceeding. Therefore, DRA used the same proxy groups that it used in A.09-05-001 et al. and updated its Discounted Cash Flow model and Capital Asset Pricing Model analyses to determine a fair and reasonable return on equity for Great Oaks.25
DRA evaluated the equity return requirements of investors on the common stock of two proxy groups: first, a proxy group of water utility companies (Water Proxy Group) and second, a proxy group of publicly-held gas distribution companies (Gas Proxy Group). (Ex. DRA-1 at 4.) DRA argues that:
The relative size of Class A water companies is irrelevant to a market-based analysis in this context because generally all Class A water companies face similar business and regulatory risks. ... Using this proxy group is reasonable because the earnings of these water companies are pre-determined to a certain degree through the ratemaking process and because their respective financial performance is monitored on an ongoing basis by [their respective] State and Federal Agencies and Commissions.
(DRA Opening Brief at 21.)
DRA's Discounted Cash Flow analysis alone would result in a recommended return on equity of 9.7%. (Ex. DRA-1 Attachment JRW-10, at 1 (Panel A).) Similarly, its Capital Asset Pricing Model analysis alone would result in a recommended 7.9% return on equity including a 4.37% risk allowance (beta). (DRA Opening Brief at 24 summarizing Ex. DRA-1.) DRA's final recommendation is a return of 9.75%, which is the high-end of the results of its two models.
DRA does not agree with any of Great Oaks' arguments that the company faces greater risks than the other Class A water companies because of its size as the smallest Class A company. (DRA Opening Brief at 25-27.)
10.2. Effect of Water Revenue Adjustment Mechanism (WRAM) on Market Return
The Commission has adopted two variations of a WRAM: a "Full WRAM" which ensures the actual collection of the adopted revenue requirement regardless of variations in sales or revenues for any reason; and a "Monterey-Style WRAM" which only adjusts for the difference in revenues from actual sales caused by adopting a conservation-focused rate design. In this latter WRAM, the revenues for actual sales are re-computed using non-conservation rates and compared to the revenues resulting from conservation rates with the resulting difference attributed entirely to the effect of the conservation rate design. This difference is subsequently collected or refunded in rates. At issue in the separate general rate case, A.09-09-001, is whether Great Oaks should have either WRAM.
Great Oaks argues that it faces greater risks because of mandatory conservation orders by the Santa Clara Valley Water District and "DRA's steadfast refusal to address lower water sales." (Great Oaks Opening Brief at 22.) There is no further elaboration on this assertion, but it appears that Great Oaks considers the purported difference in the sales forecasts between itself and DRA (in the general rate case) to be a "refusal" rather than a difference in opinion.
In the separate general rate case (A.09-09-001) the Commission must and will adopt what it believes to be just and reasonable rates relying upon the most persuasive arguments and supporting evidence including what the Commission considers to be the most likely sales forecast for the test year. For cost of capital we cannot assume there is an unjust or an unreasonable forecast skewing the required return. Therefore, we will not adjust the return for any risk perceived by Great Oaks that the adopted sales forecast may be unreasonable or that it fails to consider the effects of conservation. Additionally, the Commission has found that there has not been enough experience with WRAM to determine the likely impact on the required rate of return, except to determine that we believe a WRAM would reduce risk because otherwise it would be foolish to adopt a mechanism for Great Oaks or the other Class A water companies which knowingly increases risk. Thus, if or whenever we can reasonably quantify the impact of any WRAM, we expect the impact to be a reduction in the required return compared to the return required in the water industry generally and that of a company without a WRAM. We would not adopt a WRAM to increase a company's risk.
10.3. Discussion-- Cost of Equity
In competitive markets for goods, the return on common equity is determined by the relative risks of alternative investments and the willingness of individual investors to accept varying degrees of risk. In a closely regulated market, regulation substitutes for competition and the regulator, acting as a substitute for the market, provides investors an opportunity to earn a fair and reasonable return for accepting the degree of risk presented by the regulated business.
We take note of the financial markets' dislocation and therefore consider whether there are any extenuating circumstances of sufficient importance to warrant a departure from our normal procedures. The Commission must, as always, exercise extreme caution and critically review the wide range of results seemingly rendered from the same models held in different hands. Recently we noted:
What stands out in a comparison of the testimony of the experts is the inevitable and pervasive use of [their] judgment, which colors all results. (D.07-04-046 at 58.)
We also noted at that time:
Although the parties agree that the models are objective, the results are dependent on subjective inputs. For example, each party used different proxy groups, growth rates, and calculations of market returns. (Id. at 57.)
Great Oaks argues that unlike the proxy groups used by DRA (or by inference, the larger Class A companies) it is not publicly traded. Several Class A companies are not publicly traded and are closely held. In setting a return on equity our objective is to identify the return any investor would require to invest in a California Class A company. The Commission has never quantified a return differential for the marketability of widely traded (generally larger) companies and narrowly traded or closely held (usually smaller) companies. We see no basis for such a distinction for Great Oaks.
We therefore conclude that the current return of 10.20% on equity for Class A water utilities adopted in D.09-05-019 for the three large multi-district Class A water companies and in D.10-10-036 for the other single-district Class A companies is a just and reasonable return on equity for Great Oaks at this time. This authorized return reflects the risk reductions inherent in all of the outstanding balancing accounts or memorandum accounts available to the company, as well as the relatively high imputed equity ratio.
19 A basis point is one-one-hundredth of a percent, i.e., there are 100 basis points in 1.0% and thus 192 basis points is also either 1.92% or 0.0192, as a decimal.
(10.20% + 1.92% = 12.12%.)
20 DRA Opening Brief at 6, Footnote 16, citing Exhibit DRA-1, Testimony of Raymond Charvez on behalf of DRA on cost of capital for Great Oaks Water Company, A.09-05-007, December 9, 2009, at Updated Attachment JRW-1, Panel A.
21 Citing to DRA Opening Brief at Footnote 21 - See D.93-04-061, Re Application of Great Oaks Water Company for Authority to Increase Rates for Water Service . . . , A.92-01-001, April 21, 1993, 1993 Cal. PUC LEXIS 238, at 39-45.
22 Citing to DRA Opening Brief at Footnote 22 - See D.03-12-039, Re Application of Great Oaks Water Company for an Order authorizing it to increase rates for water service . . . , A.02-11-048, December 18, 2003, 2002 Cal. PUC LEXIS 1063, at 34-36.
23 Citing to DRA Opening Brief at Footnote 23 - See D.93-04-061, at 9; and D.03-12-039, at 26.
24 Ex. DRA-1, at 3.
25 Id.
