4. Discussion
In general, it is good policy to authorize a return on equity for a water utility that is the lowest rate sufficient to permit the company to raise enough capital to provide reliable service at reasonable rates. In seeking equity, utilities compete with other sellers of common stock. The average non-utility stock is riskier than an average utility stock,57 and subject to greater price fluctuations, and a non-utility is more likely to reduce or eliminate annual dividend payments when its profits are down. For these reasons, utility stocks are generally regarded as relatively safe havens for an investor's money, especially in times of economic uncertainty. On the other hand, the upside potential of utility stocks is also limited by the regulatory ceiling on allowed returns. Thus, a typical investor in utility stocks is buying a low risk of loss coupled with a steady stream of dividends.
When the Commission engages in setting the authorized cost of capital for a water utility, it considers various metrics, including the returns allowed by this Commission in the past, the returns allowed by other commissions for similar companies, and general economic conditions, including short- and long-term interest rates, the company's bond rating, and the willingness or ability of banks and other financial intermediaries to lend. The determination of the authorized return on equity may consider two numbers: the forecasted risk-free rate of interest,58 and the "equity risk premium," the amount of additional return required to produce a return on equity high enough to attract the necessary capital. In this case, expert testimony establishes the equity risk premium as historically ranging from 600 to 1,000 basis points. The applicants' experts and DRA's expert differ on the size of the equity risk premium in the 9.99 percent return specified in the agreement, but it appears to be in the range of 550 to 700 basis points.
In the Ruling, the ALJ took note of the fact that interest rates and inflation rates have been and are forecasted to remain at historically low levels. Given this trend, in evaluating the agreement, we must ask if the historical rate-setting procedure described above is appropriate in the current circumstances. Applicants' experts contend that the low interest rates on US Treasury obligations reflect investors' "flight to quality" because they seek safety in a time of economic uncertainty. Extending the same rationale, water utility stocks also benefit from the same "flight to quality." We do not address in this proceeding the extent to which investors have bypassed utility stocks in favor of government-guaranteed debt or, in the alternative, have moved from riskier stock investments to the relative safety of utility stocks. The record is devoid of evidence on this point and in considering whether to accept the settlement we are bound by the record as it stands.
We are similarly bound by the record in considering whether the appropriate proxy for the risk-free rate of return is the next six quarters' forecasted yields on the 30-year Treasury bond.59 While applicants' expert Vilbert conceded in response to a question from the ALJ that use of the forecasted yields on the 10-year Treasury bond is now the most widely accepted measure of the risk-free rate,60 the rate used by the applicants' experts for their return on equity analyses was the rate on the 30-year bond. This probably raises the proposed return on equity by between 25 and 50 basis points compared to using the 10-year Treasury bond rate.61
The supplemental questions proposed by the assigned Commissioner include:
1. What is the effect on the utility bill of the average customer of a 100-basis-point change in the return on equity?
2. What is the effect on the operations of the company of such a change?
3. How does the authorized return on equity compare with the earned return? and
4. What is the historical relationship between the cost of equity and the authorized return on equity for each company?
The parties' answers to these supplemental questions, briefly summarized, are as follows.
Answer to supplemental question 1: The parties separately calculate the effects of the hypothetical 100 basis point reduction on their individual customers. According to their calculations, the average residential customer bill for each Applicant will be impacted as follows:
a. For Cal Water, the weighted average decrease in an average residential customer's bill is $0.91 per month.
b. For California-American Water, the weighted average decrease in the average residential customer's bill is
$1.06 per month.c. For Golden State, the weighted average decrease in the average residential customer's bill is $1.24 per month.
d. For San Jose, the decrease in the average residential customer's bill is $0.99 per month.
Answer to supplemental question 2: The parties list multiple adverse effects on operations, ability to raise capital, and plant maintenance, which they assert would follow from such a reduction in return on equity. The answers assume that allowed equity returns that are not competitive with the allowed equity returns of competing water companies would lead investors to seek those higher returns rather than invest in any of these companies. The parties summarize their answer this way: With a 100 basis point reduction from a 9.99 percent return on equity, the minimal short-term reduction in an average customer's water bill will likely be offset by increased long-term costs. Those costs will take the form of higher capital costs, less cost-effective investment in infrastructure for long-term reliability, and a weakened utility sector. The combination of these factors is likely to cost consumers more in the long term than they save in the short term.
Answer to supplemental questions 3 and 4: The companies in this group have both over- and under-earned their allowed returns in years past. However, as shown on Attachment 4 to Exhibit JT2, periods of under-earning have been far more frequent than periods of over-earning. Attachment 4 also contrasts the recent performance of Applicants with that of California's energy utilities to show that even while these water companies were under-earning over the past five years, California's large energy utilities were over-earning during that same period.
Overall, we find that the record to support the Agreement is thinner than we would like. However, the record is not insufficient enough to warrant re-opening the proceeding or to reject the Agreement. In future cost of capital proceedings, parties should be prepared to address the concerns we raise in this discussion.
57 The Greek letter Beta stands for an accepted measure of stock price volatility. The average Beta of the broad market is around 1.00. Stocks with Betas less than 1.00 are less volatile; conversely, stocks with Betas much above 1.00 display extreme price volatility. In general, utility stocks have Betas between 0.50 and 0.65, roughly
one-half to two-thirds the volatility of the average traded non-utility security.
58 The so-called "risk free rate" is generally defined as the forecasted yield on the 10-year or 30-year Treasury bond over the next several quarters.
59 Remarks of Michael Vilbert at Evidentiary Hearing Transcript at 20.
60 Ibid. at 35.
61 Ibid. at 36.
