Discussion - Investigatory Phase

Responsiveness to Customer Complaints and Inquiries

The OII provides a statement of the problem:

The Commission has received numerous complaints from Arrowhead's customers over the years regarding water quality, services, and billing problems. Most customers have attempted to contact the company to resolve their problems directly, but have failed to resolve them because of various reasons, including difficulty in reaching company personnel, no response from the company after leaving messages, delay or no action by the company after contacts were made to fix the problems. Thirty-six informal inquiries or complaints were received by the Commission's Consumer Affairs Branch during the period between June 6, 1998 and March 9, 2000. Apparently, the company has failed to develop effective methods for handling and resolving customers' concerns.

According to the Water Division analyst's declaration attached to the OII, 15 of those 36 Consumer Affairs Branch contacts were service-related, 13 concerned billing, and the remainder were classified as rates and rules, safety, or miscellaneous. At the evidentiary hearings, the analyst testified that the company's position was sustained in six of those 36 cases.

Water Division also presented as witnesses the official responsible for the DHS Drinking Water Program for the central section of California and the DHS district engineer for the San Bernardino District, both of whom had oversight responsibilities for Arrowhead's system. DHS received 54 complaints from Arrowhead customers between 1990 and 1999, and 15 more since 1999. DHS's statistics show that annual complaint levels were relatively low in the early-1990's, climbed to a peak of 23 complaints in 1998, then declined to 14 in 1999 and dropped further in 2000. Approximately half of all Arrowhead customer complaints reaching DHS were for system leaks.

Arrowhead's own 2000 Annual Report to DHS bears out Consumer Affairs Branch's and DHS's figures: Arrowhead reported receiving 102 complaints in 2000. Of those, 59 were for leaks and another 39 related to water pressure or volume.

As troubling as these high complaint levels are, consistent reports of Arrowhead's non-responsiveness to those who complained are equally so. The record is replete with incidents and allegations of failure to return customer complaint calls, make repairs once a customer did reach the company, or respond to DHS calls and letters. William Peters appearing on behalf of himself and many other Arrowhead customers stressed local residents' frustration at their attempts over the years to get Arrowhead to respond to their water problems. Many, he observed, simply give up. This passage taken from a letter DHS wrote to Arrowhead in December 2000¹ illustrates the type of problem DHS has encountered, and is typical of other such DHS letters in the record:

After receiving the complaints we left messages for you at your phone voice mail and called your staff at your office. We regret we have not received any response to our messages either from you or from your staff. We request you to report back to this office with the findings of your investigation of complaints and appropriate actions you have taken to resolve the problems....

* * *

Please be advised that your continued unresponsiveness may result in potential health risks to your customers....

The Commission has itself experienced Arrowhead's non-responsiveness: In multiple instances, Arrowhead has failed to answer formal Commission complaints filed against it, failed to appear at formal hearings in those complaints, failed to respond to an ALJ's attempts to contact it, and so forth.² William Maple, who in D.99-09-056 prevailed in his complaint against Arrowhead, testified without opposition in this proceeding that he first called the company in May 1998 about a leak in front of his house, continued calling at least twice a week through June, and then filed an informal complaint in July 1998. He finally filed a formal complaint with the Commission in December 1998. Arrowhead did not file an answer to the complaint. When it did not respond to subsequent correspondence from the ALJ, the Commission found in Maple's favor by default. Maple testified that Arrowhead had never complied with the Commission's order to repair the leak and the damage it did to the street. He finally repaired the pipe leak himself, and the street was never repaired.

Arrowhead's response to these allegations is threefold. First, Arrowhead maintains the problem is overstated because the statistics its detractors cite include many complaints for which the company was eventually found not to have been at fault.

Second, Arrowhead maintains that, despite its opponents' characterization of the problem, their real complaint is not (or should not be) that it has an inadequate complaint handling system, but rather that it is overwhelmed by the number of complaints. Arrowhead's water system actually consists of two very different parts, one of which dates back to the 1930's and is in dire need of replacement, and the other a much newer system rebuilt with SDWBA funds in the early 1980's. Over the decades mains in the older section have deteriorated to the point where there are frequent leaks and breaks. Repairs have become extraordinarily difficult because system records are inadequate or nonexistent and valves are lost, buried, or frozen from age. Dirt roads above the lines are constantly being regraded, lessening the cover over mains and making them more susceptible to traffic loading and wintertime freezing. The great bulk of Arrowhead's complaints are caused by these problems in the old system, and it is simply overwhelmed to the point where it is not possible to keep up satisfactorily. As discussed later, Arrowhead accuses the Commission of having kept it in perpetual penury, unable to adequately maintain or upgrade its deteriorating plant.

Third, Arrowhead points to improvements it has made in repairing leaks and handling complaints since this proceeding began. By Resolution W-4167 and D.00-07-036, we granted Arrowhead a combined 87.6% interim rate increase.³ D.00-07-036 also ordered Arrowhead to establish memorandum accounts for contract repair work and for purchased water and to file advice letters twice a year to seek a billing surcharge or surcredit for the accumulated balances. With a mechanism in place to reimburse it, Arrowhead says, it was finally able to retain qualified contract help with sufficient labor and a backhoe on site to respond to leaks and other problems. Since mid-2000, this has helped it to reduce the number of complaints and respond to them more effectively.

In an effort to demonstrate that Arrowhead does have a well-defined, functional complaint handling system, one of its witnesses described in detail the methods Arrowhead uses to receive, record, dispatch and track complaints. The Water Division staff witness agreed that Arrowhead does have such a system; the problem as he saw it was the need to satisfy those complaints at the utility level so they don't escalate to the Commission (or DHS) level. He also agreed that an important cause of the high number of customer complaints reaching the Commission and DHS may be that many complaints were about things that Arrowhead found impossible to fix.

The evidence does support Arrowhead's contention that its response to leaks has improved since it retained a qualified contractor under the D.00-07-036 memorandum account procedure. For example, DHS noted in its Annual Inspection Report dated October 17, 2001 and accompanying Annual Inspection Letter some progress in repairing leaks and handling complaints, but at the same time DHS also stressed that many problems remain. From the Summary section of that 2001 Annual Inspection Letter:

During the inspection it was noted that since the last Annual Inspection of the Company in 1999, some operational improvements have been made in its water system, namely, the Company is almost up-to-date with the source water quality monitoring and tries to provide of late timely response to the customer complaints. We appreciate your efforts to improve the water system. However, there are still many deficiencies related to operation and maintenance of the system, which need to be addressed....

Peters also acknowledges Arrowhead's improvement in his brief: "It was not until July 2001, with the participation of an outside contractor, Darel Davis, that any real and effective leak repair program took place."

From the evidence, we draw the following conclusions. First, while Arrowhead may take issue with the specific complaint statistics DHS and our staff presented, it is clear that Arrowhead's complaint levels have been unacceptably high. Second, the most significant cause of Arrowhead's customer complaints has been its high incidence of leaks, which is in turn due to the deterioration of the older section of its system. Third, Arrowhead has failed to accept and acknowledge customer complaints, has failed to correct problems reported by customers, has failed to respond to DHS calls and letters, and has failed to cooperate with the Commission's process and orders involving customer formal complaints. Lastly, Arrowhead's performance has improved during the past year, due at least in part to relief granted in the interim decision in this proceeding.

We conclude that there is persuasive evidence in the record to sustain the charge set forth in the OII and quoted at the beginning of this discussion section.

Compliance with Health Requirements

The OII describes the Commission's concerns with Arrowhead's DHS citations:

G.O. [General Order] 103 requires Commission regulated water utilities to comply with the regulations and orders of DHS. Arrowhead has regularly violated DHS health and safety regulations and standards and DHS has cited the company for non-compliance over the years. Presently, DHS has two outstanding citations issued to Arrowhead denoting 35 separate, uncorrected health and safety deficiencies.

The staff declaration and attached DHS documentation presented in the OII were admitted into evidence with supporting testimony. The most recent DHS Annual Inspection Report and Deficiency List available at the time the OII was issued showed that as of June 1999 Arrowhead had approximately 36 uncorrected deficiencies. The OII in fact understated the extent of Arrowhead's citation problems. In February 2000 DHS supplied the following summary:

According to [DHS's] 1998 Annual Inspection Letter dated August 11, [1998,] since 1990 the Department has issued a total of 12 citations to the Company for failure to comply with various regulations and requirements. A review of the available records indicates that the Company has complied with some provisions of the citations, however, not with many others. In addition, the Company has also failed to pay penalties assessed in two citations, which amount to a total of $5,900 as of November 20, 1995.⁴

At the January 2002 evidentiary hearings, the DHS district engineer updated Arrowhead's compliance status to show that DHS had issued two additional citations, one in May 2001 and another in January 2002, and that Arrowhead had still not fully complied with requirements of four citations from 1998 and earlier. The most recent DHS Deficiency List from the October 2001 Annual Inspection listed approximately 30 current deficiencies. Arrowhead's response to the latest DHS Annual Inspection Letter addressed each deficiency, showing many as having been corrected recently and others to be corrected later this year, and acknowledged that some deficiencies cannot be addressed in the near term absent a large infusion of construction financing. Arrowhead's latest response letter was too recent for DHS to have received and evaluated it in the last evidentiary hearing.

The section chief responsible for DHS's Drinking Water Program for the central section of California described her view of Arrowhead at the July 2000 evidentiary hearing:

I would characterize the Department's dealings with Arrowhead Manor Water Company as one that does not typify our dealings with a public water system. Namely, the Department repeatedly had to request the completion of water quality monitoring, issued citations, issued follow-up citations in some cases with fines to get a suitable response. We have a number of deficiencies that continue to exist with regard to some of the operation and maintenance documents that we have on file for public water systems, and there are a number of outstanding reliability issues that the water company has not yet complied with. The distribution system, as I understand it, is the main problem. It's old. It's deteriorated. But there are just a number of monitoring water quality deficiencies that have just gone on for years and years before they were finally addressed.⁵

Quoting again from the district engineer's November 2001 letter to Arrowhead summarizing the results of DHS's 2001 Annual Inspection:

We appreciate your efforts to improve the water system. However, there are still many deficiencies related to operation and maintenance of the system, which need to be addressed. A commitment and a plan are required for the Company to be in compliance with the Waterworks Standards and regulations in view of monitoring delinquencies and other deficiencies, identified during the current and previous inspections, for which corrective action should be promptly taken.

In testimony in the January 2002 evidentiary hearings he gave a similarly mixed review:

Based on information available so far, the water currently being served by the Water Company to the public meets federal and State standards and the Water Company generally is up-to-date with monitoring frequency with one exception of lead and copper monitoring in the distribution system....

* * *

An evaluation of the current and past levels of maintenance and operation of the Water Company, and other circumstances and conditions, suggests that the Company's technical, managerial and financial capacity is seriously inadequate to ensure compliance with relevant federal and State regulations and provide a reliable and adequate supply of water at all times, and also to ensure the water supplied does not endanger the health of customers, because of potential risks arising from failure to take timely actions of monitoring and conducting repairs. The Water Company does not have a certified operator, has been seen as too slow to respond, with leaks large and small, going on for months and years without repairs, and thereby wasting precious water resources in the area.⁶

While not in agreement on many counts, Arrowhead does acknowledge its difficulties:

The status of the system and the deficiencies with regard to DHS requirements are clearly stated in the testimony. What's important is not what happened in 1990, but rather what's happened since the Memorandum Accounts were established in mid-2001.⁷

Arrowhead blames its DHS deficiencies on the same factors it cited for leaks and customer complaints: the deteriorating older section of its system, and extreme financial hardship due to lack of rate relief over the past decade. In January 2000 the district engineer summarized DHS's view of Arrowhead's responses to its 1999 Annual Inspection Letter:

[W]e would like to underline one more time that you need to make every possible effort to comply with existing regulations. We can consider a reasonable schedule to correct the deficiencies [and] prioritizing the activities, but non-availability of funds is not a defense of non-compliance. Otherwise you will continue to be in violation of California Safe Drinking Water Act and we will take all necessary enforcement actions to assure compliance with drinking water and water works standards.⁸

DHS does not consider financial hardship an acceptable reason for noncompliance, and neither do we.

The evidence proves that Arrowhead has not complied with DHS's regulations and orders. The Commission's G.O. 103, Section II.1.a. provides,

Any utility serving water for human consumption shall hold or make application for a permit as provided by the Health and Safety Code of the State of California, and shall comply with the laws and regulations of the state or local Department of Health Services.

Thus, failure to comply with DHS requirements also constitutes failure to comply with the orders of this Commission.

We therefore find that Arrowhead has not complied with applicable orders of the Commission and regulations and orders of the Department of Health Services.

Compliance with SDWBA Loan Requirements

As part of its evaluation of Arrowhead's GRC, the Commission staff conducted an audit of Arrowhead's SDWBA accounting practices and entries. That audit identified a number alleged discrepancies, which the OII summarized as:

1. Arrowhead opened a trust account at the beginning of the loan, subsequently abandoned its use and finally, in 1995, closed out the trust account.

2. Arrowhead failed to deposit fully its SDWBA surcharge collections into the trust account or to make the necessary semi-annual loan payments to DWR.

3. Arrowhead failed to account properly [for] the reduction of its tax liability by normalizing the investment tax credit earned on the plant financed by the SDWBA loan.

4. Arrowhead failed to maintain accurate accounting records in tracking its SDWBA loan activities.

5. Arrowhead applied the surcharge collections from customers to uses other than the intended repayment of loan principal and interest.

In this section, we review the record developed in the proceeding to answer the question posed in the OII: Has Arrowhead complied with Commission requirements in collecting, accounting for, preserving, and applying for the benefit of its customers the Safe Drinking Water Bond Act loan surcharges included in its rates?

Arrowhead's SDWBA Loan History

In 1980, the Commission authorized Arrowhead to enter into a $910,520 loan agreement with DWR under the Safe Drinking Water Bond Act of 1976. That loan provided funds to rebuild a portion of Arrowhead's water system.⁹ Arrowhead was authorized a $64,691 annual customer surcharge ($58,810 for payments to DWR, plus $5,881 additional to build a reserve) to accumulate funds to repay the loan principal and interest over 35 years. It was to track surcharge receipts, DWR repayments, and utilized ITC in a balancing account, with any surplus in the account to be refunded or applied on behalf of customers as directed by the Commission. In 1984 the Commission reduced the surcharge to $50,500 annually¹⁰ because the balancing account had built up a surplus greater than the required reserve fund. The Commission likely approved one or more subsequent surcharge adjustments, but the record here does not reliably reflect them.

In 1988, Lance Johnson and Sally Johnson Hollingsworth¹¹ purchased Arrowhead.¹² After this point, the record is incomplete and the parties differ on what happened. According to Arrowhead, the Johnsons were having cash flow problems and had to take out a loan on their home in 1991 and a Small Business Administration loan in 1993 to make ends meet. The record does show that revenues from the SDWBA surcharge were less than the DWR payment in every year from 1985 through 1992. According to Arrowhead's testimony here, it requested a surcharge increase in June 1990 that was not granted until October 1992. The staff auditor saw things differently: "Right after the [1988 transfer to the Johnsons], DWR raised the interest rate on the SDWBA loan but Mr. Johnson failed to increase his payments [presumably into the trust account] enough to cover the new semi-annual installments."

In either case, the parties agree that from 1995 on, with one exception, Arrowhead made no significant payments to the trust account or DWR, the trust account was closed in 1995, and the bank paid the $1,783 remaining balance to DWR. The single exception was a $50,000 lump sum payment Arrowhead made to DWR from company funds in 1998. Arrowhead and Water Division concur that Arrowhead's SDWBA surcharge continued to generate revenues for the company, an average of just over $60,000 annually between 1995 and 1999. By the time Arrowhead discontinued the surcharge in April 2000 at the Commission's direction in I.00-03-016, Arrowhead had collected $321,557 more in SDWBA surcharges (including interest) than it had paid out.

There have been several amendments to Arrowhead's SDWBA loan contract over the years, the most recent being Amendment A-4 executed on October 20, 2000. As a result of those amendments, the interest rate is now 7.4% per annum on the unpaid balance. DWR's Chief of the Safe Drinking Water Office testified to this summary of the loan status as of December 31, 2001:

Table 2

SDWBA Loan Status

Penalty interest, the term DWR uses for late payment penalties, is calculated at 1% monthly on all interest in arrears. Under Amendment A-4, Arrowhead was to have resumed semi-annual payments of $45,721.77 beginning July 1, 2000, but because the surcharge was discontinued effective April 15, 2000, it has made no additional payments to DWR. As a result, DWR's witness testified that the total amount due to bring the loan current as of January 1, 2002 was $232,236.92. ¹³

Compliance with I.00-03-016

Ordering Paragraphs 2 through 7 of the OII ordered Arrowhead to take a series of near-term actions to limit any additional harm Arrowhead's accounting practices might be causing. As detailed below, Arrowhead has substantially complied.

First, Arrowhead was to file the appropriate tariffs and discontinue billing customers for the SDWBA charge until further order. Arrowhead discontinued SDWBA billing effective April 15, 2000.

Second, Arrowhead was to provide to the Commission accounting documents showing SDWBA surcharge revenues billed, collected and disbursed during 1999. The intent of that order was satisfied by figures in the joint stipulation filed November 6, 2000 by Arrowhead and Water Division.

Third, Arrowhead was directed to "update its Deferred Investment Tax Credit [ITC] account." When Arrowhead borrowed SDWBA funds in 1981, the Commission by D.92178, Ordering Paragraph 4, required it to "establish and maintain a separate balancing account which shall include all billed surcharge revenue and the value of investment tax credits on the plant, as utilized" [emphasis added]. The decision discussion elaborated on the latter qualification: "a balancing account to be credited with revenue collected through the surcharge and with investment tax credits arising from the plant construction as they are utilized" [emphasis added]. D.92178 makes no mention of a "Deferred Investment Tax Credit Account," only this combined balancing account. The staff auditor's report cites D.92178, Ordering Paragraph 3,¹⁴ as the authority for requiring ITC to be normalized. Rather than normalizing ITC, Ordering Paragraphs 3 and 4 taken together require ITC to be flowed through to ratepayers as it is utilized. The audit report indicates that Arrowhead did not establish such an account.

Arrowhead argues that it had never had an opportunity to utilize the ITC that was generated because it consistently operated at a loss. Since losses for income tax purposes may be carried forward ("carry-forwards") as future year deductions and must be used before investment tax credits, any ITC generated would have expired before it could be used. The staff accountant acknowledged that those tax returns he examined showed losses, but he did not necessarily accept Arrowhead's tax return figures because the IRS had not audited them. Arrowhead's certified public accountant testified that its SDWBA investment tax credits expired in 1996, and because of its loss carry-forwards, it was exceedingly unlikely that the company had been able to utilize any tax benefit from ITC before then.

We believe that the record supports Arrowhead's position. While Arrowhead should have been maintaining a balancing account since approximately 1981 showing ITC utilized, it received no benefit from its ITC and ratepayers suffered no losses because of Arrowhead's failure to track ITC utilized after the present owner purchased the corporation in 1988. All investment tax credits have now expired. There is no longer any ratepayer advantage to reconstructing that account today, and Arrowhead's scarce financial resources would be better applied in other areas.

Fourth, Arrowhead was to provide a trust or fiscal services agreement acceptable to the Director of the Commission's Water Division, open a trust account, deposit all SDWBA funds in the company's possession, and thereafter provide a monthly status report identifying the source of future deposits. According to DWR, Arrowhead executed a new fiscal services agreement with California Bank and Trust Company, Inc., in Sacramento and filed it with DWR on October 24, 2000. DWR approved it on November 9, 2000. The agreement requires Arrowhead to deposit an average of $7,620.30 per month to meet the semi-annual principal and interest payments required under the SDWBA loan contract, and an average of $762.06 per month to create a reserve fund. As of the end of December 2001, the account had a balance of approximately $1,200. With the SDWBA surcharge having been discontinued, the only deposits being made were small amounts of surcharge funds collected from past due customers and interest on the account, and no payments were being made to DWR.

While its compliance was not in all cases timely, the record shows that Arrowhead has sufficiently complied with Ordering Paragraphs 2 through 7 of I.00-03-016.

SDWBA Fund Diversions

Arrowhead has acknowledged throughout this proceeding that it diverted SDWBA funds to other uses. From its opening statement in the investigatory phase hearing:

Arrowhead Manor Water Company has never hid nor denied that it was forced to use DWR surcharge funds to cover extraordinary purchased water expenses.... In addition, the company owners can demonstrate that they took extraordinary measures... to prevent having to access DWR surcharge monies to solve their cash flow problems. They tried every other source of funds before deciding to use DWR funds to cover purchased water expenses. Each time, it was truly a choice of last resort.

* * *

The Johnsons have co-mingled DWR surcharge funds with operations funds; however, the evidence shows that they did everything in their power to avoid doing so and, short of going bankrupt and/or closing down... there was no other way to keep the water flowing....

It denies, however, closing the trust account established pursuant to its DWR contract and D.92178:

It was at this time [1994-1995] that deposits to the DWR Fiscal Agent Account ended. However, AMWC did not close the Fiscal Agent account; in June 1995, the account was closed by the Bank of America and the last dollars in the Reserve Fund were sent to the DWR because the Bank of America went out of the Fiscal Services account business.... [From July 1995 on] there was no Fiscal Agent Account in which to deposit the DWR monies. Instead, they were deposited into a company savings account and accumulated until 1998, when $50,000 was paid to the DWR.¹⁵

The March 10, 1995 Bank of America form letter Arrowhead placed in evidence to support this contention indicates otherwise. In it, Bank of America informed its clients that it was pursuing the sale of the businesses in its Institutional Trust and Securities Services Division, and sought to retain its clients' business:

We want you to know that we are seeking experienced trust service providers and encourage you to remain with us until the transaction is complete. During this transition, you will continue to receive the same level of service that is currently being provided. You do not need to take any action. We understand the needs and concerns of our clients, and are dedicated to providing you with consistent and uninterrupted service.

At each step in this proceeding, Arrowhead has consistently attempted to place responsibility for its problems with others. In literally dozens of instances, staff auditors and their supervisors, Water Division managers and staff, the Commission, the company's previous owners and others have all been targets for its allegations of malfeasance, misfeasance or nonfeasance. Assembling the pieces from the proceeding record, however, provides a more likely explanation for Arrowhead's problems.

In 1988 Lance Johnson and Sally Johnson Hollingsworth purchased Arrowhead with a combination of cash, a promissory note, and long term utility debt. After the purchase, they had payments to the former owners to make and at best limited financial reserves to deal with any unexpected problems that might arise. Although Lance Johnson had management experience with large, municipal water departments, neither of the Johnsons had any experience owning or managing their own company or dealing with legal or regulatory issues. The larger part of Arrowhead's plant was already old and deteriorating when the system was hit with a series of damaging events between 1988 and 1992: several unusual freezes that severely damaged inadequately buried mains and caused hundreds of leaks; and drought conditions that reduced their water supplies and forced them to rely more heavily on purchased water.¹⁶ While they received some rate relief, they weren't sufficiently knowledgeable to pursue additional possibilities and instead went deeper into debt: a personal equity line of credit on their home in 1991 and a Small Business Administration loan in 1993. Arrowhead's representative described in her testimony what happened next:

The Johnsons separated in September, 1993, and Sally Johnson operated the water company office from her new home in San Bernardino from October, 1993, until May, 1995, when she remarried and moved to Colorado. Revenues dropped, mainly due to an enormous amount of accounts receivable as customers took advantage of the office move off the mountain, and expenses increased beyond the rate base in the GRC, approved in February, 1994. During this difficult transition period, the Johnsons both did their best to cope with company issues. However, both field and office efficiency was affected during 1994-5.

It was at this time that deposits to the DWR Fiscal Agent Account ended.¹⁷

Throughout this difficult period there was another, related factor at work stressing Arrowhead's finances: purchased water expense. In test year 1984, Arrowhead purchased 10 acre-feet of water from Crestline Lake Arrowhead Water Agency (CLAWA) for $4,800 ($480 per acre-foot). With leak problems on the old part of the system growing with every passing year, Arrowhead's use and cost of purchased water increased ever more rapidly: to 30 acre-feet and $19,950 ($665 per acre-foot) in 1990; to $33,685 in test year 1993; and most recently to $132,000 for 115 acre-feet ($1,150 per acre-foot) in the settlement the Commission approved in its interim D.00-07-036 in this proceeding. The Water Advisory Branch of Water Division has acknowledged the serious threat these rising purchased water costs have posed. In granting a 57.5% interim increase for purchased water, Resolution W-4167 states: "The Branch has reviewed AMWC's request and believes that the increase in purchased water costs the utility has experienced over the last 3 to 4 years [i.e., from 1995 or 1996 through 1999] is a serious threat to the utility's ability to `make ends meet' and stay in business."

The next section will explain the importance of Arrowhead's purchased water cost as a factor in this proceeding.

D.92178 authorized Arrowhead to enter into a specific contract with DWR to borrow SDWBA funds. Together, the decision and DWR contract required Arrowhead to establish and maintain a balancing account to track SDWBA surcharge revenues collected from customers and paid to DWR; to open an account with a financial institution that would serve as a fiscal agent to hold and disburse funds to DWR in repayment of the loan; and to make timely loan payments to DWR as called for in the contract. As a condition of establishing the SDWBA surcharge, the decision put Arrowhead on notice that it would be held responsible for refunding or applying on behalf of customers any surcharge revenues not applied to repaying the loan. Arrowhead acknowledges that it has co-mingled SDWBA surcharge collections with its regular operating revenues rather than depositing them in a trust account; that it has used SDWBA surcharge funds for purposes other than repaying the SDWBA loan; that it has failed to make timely loan payments to DWR as it is obligated to do under the contract; and that it is now unwilling and/or unable to refund to its customers or apply on their behalf those surcharge revenues which were not applied to repaying the loan. In addition, the record shows that Arrowhead caused or allowed its fiscal agent agreement and trust account to be terminated without timely replacement.

The Commission's statement in I.00-03-016 has been tested in this proceeding and found to be accurate; and its admonitions are appropriate to Arrowhead's situation:

Arrowhead apparently rationalizes its position with claims that it had to use surcharge revenues to offset operating losses over the years. This argument is directly contrary to the Commission's longstanding policy and judicial case law which prohibits this form of retroactive rate making. If operating revenues are insufficient to cover operating expenses, it is the utility's responsibility to request a rate increase to pay for the higher expenses. The diversion of funds from a specially created program for unauthorized purposes violates Commission decisions and mandates. Funds designated for special accounts must be used for the purpose for which they were created. In that way the program's operations and administration can be assessed accurately and the funds channeled properly for use consistent with the program's stated goals. In the present case, Arrowhead is merely a fiduciary conduit for the collection and disbursement of the surcharge revenues under the SDWBA loan contract. Regardless of the physical commingling of surcharge revenues and the utility's operating revenues, surcharge funds have, at no time, belonged to Arrowhead. Use of SDWBA money, other than in the manner prescribed in the loan contract, constitutes a misappropriation of funds.

In the July 2000 evidentiary hearings, ALJ McVicar directed Arrowhead and Water Division, and invited the other parties, to meet and attempt to arrive at a mutually-agreed upon set of figures for the amounts at issue in this proceeding. Arrowhead and Water Division did meet and were able to agree. On November 6, 2000 they filed their joint Motion for Adoption of Stipulation and attached Stipulation, Attachment A to this decision. We have examined their figures in light of the record developed in this proceeding and adopt them for purposes of moving forward. Briefly summarized, Attachment A shows:

Through the first quarter of 2000, Arrowhead had collected from its customers $321,557 in unremitted SDWBA surcharges, including interest. (Stipulation Appendix A).

Through June 2000, Arrowhead had paid to DWR either directly or through its SDWBA trust account $800,521. (Stipulation Appendix B).

As of July 1, 2000, Arrowhead owed DWR $1,114,919.62 in restated loan principal, and $34,574.01 in delinquent interest penalties. The restated principal has not changed since that time; the delinquent interest penalties are currently due and growing. Interest on the restated principal amount is 7.4% per annum, or $41,252.03 semi-annually. (Stipulation Appendix C).

As of August 31, 2000, Arrowhead had a positive purchased water balancing account balance of $342,812, including interest. (Stipulation Appendix D).

Purchased Water Balancing Account

The largest factor in Arrowhead's A.99-10-027 general rate increase request was its rising purchased water costs. As noted earlier, the Commission by Resolution W-4167 granted Arrowhead an interim $91,342 (57.5%) rate increase to cover the purchased water component of its overall increase request. That interim increase was made subject to refund depending on the outcome of the GRC in this proceeding, and eventually confirmed in the interim GRC decision (D.00-07-036).

In developing the record for D.00-07-036, it was learned that Arrowhead had received an offset increase for purchased water costs in 1990 and had at that time been ordered to establish a balancing account for purchased water¹⁸ as required by Public Utilities Code Section 792.5.¹⁹ Arrowhead did so, as shown by the fact that it filed an advice letter the following year requesting an additional offset of $900 annually for purchased water costs and $2,980 each year for 3 years "to recover an undercollection in the purchased water balancing account."²⁰ That increase was granted by Resolution W-3560 (May 8, 1991), which again ordered it to maintain a balancing account. Arrowhead apparently received two subsequent increases for purchased water costs²¹ with no further mention of the purchased water balancing account.

As described earlier, this was the same period during which Arrowhead's purchased water costs were spinning out of control due to the drought, CLAWA's rising purchased water rates, and Arrowhead's damaged and deteriorating system. Purchased water costs are, in fact, the factor Arrowhead cites for diverting SDWBA surcharge funds: "Arrowhead Manor Water Company has never hid nor denied that it was forced to use DWR surcharge funds to cover extraordinary purchased water expenses...."

In the preceding discussion section, we indicated that we would adopt the figures in the joint Arrowhead and Water Division Stipulation (Attachment A to this decision). We summarized the Stipulation as showing $321,557 in unremitted SDWBA surcharges, including interest, through the first quarter of 2000, and a positive purchased water balancing account balance of $342,812, including interest²² as of August 31, 2000. While coincidental, the near-equality of these figures is striking.²³

The parties took opposing positions on whether Arrowhead should receive credit for the undercollection in its purchased water balancing account. Arrowhead supports full recovery. Peters opposes any recovery. From Peters' brief: "[R]eplenishment of the Purchase Water Account should not fall to the customer base, but be the responsibility of the perpetrator of the loss of vast amounts of water: the company itself." Water Division supports recovery limited to three years:

The Commission should direct a court appointed receiver to collect the under-collection in the balancing account for Purchased Water. [Footnote omitted] The Water Division estimates that for the past three years, which is the period of time allowed under Section 737 of the Public Utilities Code for collecting previously unbilled charges from customers, the under-collection would be $187,106 as derived in Exhibit RRB-7.

The Commission should order restitution of the missing [SDWBA surcharge funds]. Part of the restitution can come from the surcharges authorized to recover this under-collection....²⁴

Water Division's reliance on Section 737 is misplaced.²⁵ Section 737 is the three-year statute of limitations for utilities to backbill "lawful tariff charges," but amounts accumulated in balancing accounts and awaiting Commission action are not lawful tariff charges and do not become lawful tariff charges unless and until the Commission authorizes their recovery in rates through inclusion in the utility's tariffs. The Commission has consistently distinguished rate adjustments associated with recovering or refunding balancing account balances from other backward-looking adjustments, ruling that: (a) balancing account related rate adjustments may look no further back than the date the balancing account was established; and (b) the Commission need not be constrained by the retroactive ratemaking provision of Section 728 in making such adjustments.

Under Section 792.5, not only must the Commission require the utility to establish a "reserve account reflecting the balance, whether positive or negative, between the related costs and revenues..." when it authorizes an offset, but the Commission also "shall take into account by appropriate adjustment or other action any positive or negative balance remaining in any such reserve account at the time of any subsequent rate adjustment." Thus, when a balancing account established pursuant to Section 792.5 is involved, the Commission is required to consider whether an adjustment or other action is appropriate with respect to the balance in the account when it sets rates. The Commission is not required to grant offset adjustments in every instance, rather only when it finds them appropriate.

In Arrowhead's case, the Commission has apparently not considered whether a purchased water balancing account adjustment or other action is appropriate since it granted Arrowhead an increase in Resolution W-3560 in May 1991. We will do so in a following section.