Conservation Expenses

As the last column of Table 2 shows, we will include $330,000 in rates for this activity in TY2003 (and the same in TY2004), less than CalAm requests but more than ORA recommends. In A.02-04-022, CalAm is proposing to increase Monterey customers' rates by more than 30% during this three-year GRC cycle. The application³⁸ shows administrative and general expenses, of which these special conservation expenses will become a part, of $1.609 million in 1996, increasing to $1.631 million in 2001, and $2.936 million in TY2003.³⁹ Promoting conservation is not a new and unfamiliar activity for CalAm and its customers; we authorized a special conservation rate design in its TY1997 GRC, and strengthened it in the form of the current per capita rate design in the test year 2000 GRC. As CalAm notes, "[R]egardless of what type of weather year it is, consumers on the Monterey Peninsula lead the nation in conservation, at about 7.5 units/month consumed for the average CalAm customer." While we understand the supply constraints CalAm is under, given the magnitude of the increase it seeks in this GRC, we are not convinced that granting it $450,000 under SRR#8 will be a cost-effective use of its customers' dollars. This is particularly so considering that they currently face exceptional incentives built into their rate design and already lead the nation in conservation.

Special Rate Request #4

In currently pending A.97-03-052, CalAm is seeking Commission authority to construct the Carmel River Dam and Reservoir Project. By D.98-08-036,⁴⁰ CalAm is required to prepare a long-term contingency plan ("Plan B") describing the program or combination of programs that the company would pursue if, for any reason, the project does not go forward. Assembly Bill 1182⁴¹ requires the Commission, in consultation with CalAm, the Department of Water Resources, and other affected interests, to prepare the long term contingency plan described in D.98-08-036, and to set forth the criteria that it uses to decide on the program or combination of programs to include in the plan.

CalAm has been and will continue to be required to fund Plan B studies. By SRR#4, CalAm seeks to establish an interest-bearing memorandum account to accumulate for later distribution to either ongoing expenses or capital all funds the Company is required to expend on Plan B. ORA and MPWMD oppose SRR#4. CalAm states in rebuttal testimony, "This request must be allowed in compliance with resolutions of the Commission." On brief, CalAm reiterates, "[T]hese Plan B expenses are mandated by the Legislature and by this Commission itself." Indeed, the Commission has twice required CalAm to provide funding for those Plan B expenditures the Commission and the Legislature have required of it. By Resolution W-4131, the Commission required CalAm to reimburse it for the costs of Plan B consulting services and environmental assessments, estimated to be $750,000, and authorized opening an interest-bearing memorandum account to track the payments for later recovery through rates. Again in Resolution W-4237, the Commission ordered up to an additional $500,000 in payments and authorized an interest-bearing balancing account for recovery through rates. Each time the Commission has required the funding CalAm anticipates in SRR#4, the Commission has authorized memorandum or balancing account treatment at the same time. If and when additional funding is ordered, we will consider the appropriate tracking treatment as we have in the past. CalAm's SRR#4 is unnecessary and will be denied.

Special Rate Request #5

As authorized by the Commission,⁴² CalAm has adopted MPWMD Ordinance 92 as its conservation and standby rationing plan. Under Ordinance 92, MPWMD bills CalAm for MPWMD's actual costs under the plan, whether for conservation or rationing, and CalAm requests those billings be afforded balancing account treatment. In the Commission-approved settlement in CalAm's last GRC, CalAm was authorized to establish a memorandum account to record actual MPWMD charges up to a limit of $100,000 annually.⁴³ ORA advocates allowing CalAm to establish a memorandum, not balancing, account in this proceeding, and does not state an annual limit. MPWMD makes supportive comments about CalAm's plan, but does not state a clear position on establishing a balancing or memorandum account. On brief, CalAm accepted ORA's memorandum account recommendation. We adopt ORA's recommendation.

Special Rate Request #6

In the Commission-approved settlement in CalAm's last GRC, CalAm was authorized to book in a conservation memorandum account up to $550,000 annually of its costs to comply with State Water Resources Control Board Order WR 95-10. ⁴⁴ CalAm now seeks recognition of its 2000 and 2001 actual and 2002 forecasted expenses, and a surcharge to recover those amounts over a three-year period. CalAm previously filed Advice Letter (AL) 556 seeking recovery of these expenses for year 2000. The Commission's Water Advisory Branch rejected AL556, saying "Since the establishment of the memorandum account does not guarantee full recovery of the expenses booked to that account, CalAm is required to justify the reasonableness of all expenses associated with the memorandum account," and, "[T]he staff will review the reasonableness of the conservation expenses during your next general rate case."⁴⁵ Despite CalAm's SRR#6, our staff did not conduct that review in this GRC; instead, ORA recommended SRR#6 be handled according to the procedures to be adopted in R.01-12-009, similar to its recommendation discussed in SRR#1 above. According to ORA's witness, ORA was concerned lest it make a recommendation in this GRC proceeding that might conflict with the eventual outcome in R.01-12-009, and particularly with the type of earnings test that should be applied.⁴⁶

We note that the amounts CalAm has asked to recover, $587,162 for 2000, $683,474 for 2001, and an estimated $550,000 for 2002, in two of the three years exceed the cap established in D.00-03-053. There is no support in the record for the nature or level of these figures other than CalAm's statement that they are amounts accumulated in the conservation memorandum account, and no other party has evaluated them. Lacking any evidence in the record that these are properly accounted for and reasonably incurred amounts, we arrive at the same conclusion for SRR#6 as for SRR#1: CalAm should await and follow the procedures that are established in R.01-12-009 to seek recovery.

Special Rate Request #7

In D.98-08-036, Ordering Paragraph #1, we ordered:

1. [CalAm] is authorized to establish a memorandum account that shall be used exclusively to record fines, if any, incurred for the water years ending September 30, 1998, or September 30, 1999, due to failure by Cal-Am to meet the requirements of Order WR 95-10 of the State Water Resources Control Board (SWRCB) relating to the annual limit on Cal-Am's diversions from the Carmel River. Recovery of any such fines may be allowed, subject to "just and reasonable" review of Cal-Am's management and operations. Whether to continue this memorandum account beyond the water year ending September 30, 1999, is an issue to be determined in Cal-Am's Test Year 2000 General Rate Case (GRC) for its Monterey Division.

CalAm characterizes this ordering paragraph as having authorized the Company to recover from its Monterey customers any fines imposed upon it for exceeding SWRCB Order WR 95-10. We approved a settlement including a similar outcome in D.00-03-053 in CalAm's last GRC:

12.10 Special Request #10 - State Water Resources Control Board Fines. CalAm and RRB [Revenue Requirements Branch] have agreed that CalAm should be allowed to recover any fines imposed by the SWRCB due to overpumping of the Carmel River Water Resources System, but only if the actions taken by CalAm that resulted in the fines were reasonable in light of CalAm's obligation to serve its customers. CalAm will be allowed to file for the memorandum account upon receipt of notice from the SWRCB of an impending fine.

In SRR#7, CalAm seeks a further extension to last until a permanent water supply solution is placed into service. ORA concurs. MPWMD "supports equitable treatment of any fine that may be imposed...."

All three parties agree in principle as to what relief should be ordered here. Our D.98-08-036 was carefully crafted, and we will once again authorize what we did there, but update it to apply to SWRCB fines incurred through the effective date of our order in CalAm's next GRC.

Special Rate Request #9

D.00-03-053 also approved the following settlement provision:

12.03 Special Request #3 - Memorandum Account for Endangered Species Act. Cal-Am and RRB agree that Cal-Am should be authorized to establish a memorandum account to track expenses incurred to comply with the Endangered Species Act. The memorandum account would become effective on the effective date of this Decision. Estimated expenses for Test Year 2000 are $125,000, and amounts in excess of $125,000 will be included Test Year 2001. Annual expenses could equal $25,000.

By SRR#9, CalAm seeks to recover through a balancing account surcharge over the next three years $292,214 in costs booked to this Endangered Species Act (ESA) memorandum account during 2000 and 2001, and another $100,000 estimated for 2002.

The efforts CalAm describes in SRR#9 are the same as, or a subset of, those further described in SRR#10 below. They involve activities to meet requirements imposed by the U.S. Fish and Wildlife Service, the National Marine Fisheries Service, and perhaps the California Department of Fish and Game. CalAm's preparation of a Habitat Conservation Plan is among those activities covered in both SRR's.

As in SRR#1 and SRR#6 above, ORA did not analyze CalAm's SRR#9 request because it recommended that it be handled according to the procedures to be adopted in R.01-12-009. And, as in SRR#6, the amounts CalAm has asked to recover may exceed the amounts anticipated in D.00-03-053. CalAm has provided effectively no support in the record for the nature or level of those amounts other than its statement that they were accumulated in the ESA memorandum account, and, because no other party has evaluated them, we lack any evidence in the record that they were properly accounted for and reasonably incurred. We once again conclude that CalAm should await and follow the procedures that are established in R.01-12-009 to seek recovery.

Because we grant CalAm's SRR#10 request to include its TY2003 and beyond ESA expenditures in CWIP, there should be no further entries in the ESA memorandum account for expenditures made after the beginning of TY2003.

Special Rate Request #10

CalAm estimates that it will spend $600,000 annually during TY2003, TY2004 and AY2005 in connection with its federal ESA efforts. In SRR#10, CalAm proposes to include those amounts in CWIP, and thus rate base, for each year.⁴⁷ ORA's corresponding figures for the three years are $550,000, $500,000, and $300,000. MPWMD took the position that CalAm's estimated ESA-related attorneys' fees were excessive and should be examined, and that any ESA expenditures that the Commission accepts for ratesetting should be expensed rather than capitalized.

ORA opposes including CalAm's ongoing ESA expenditures in CWIP. Citing the Commission's treatment of San Clemente dam retrofit and Carmel River dam project amounts in CalAm's last general rate case,⁴⁸ ORA would have CalAm apply AFUDC and carry them forward outside of rate base until the associated capital projects are completed and placed in service.

CalAm's ESA estimates are associated with three primary activities, and those activities are in turn associated with various capital projects including, most notably, the San Clemente dam retrofit and Carmel River dam. Some portion may also be associated with CalAm's operations separate from any capital project; if so, those activities have not been specifically identified or split out from the totals. For purposes of this GRC, we will treat the ESA expenditures in SRR#10 as being entirely capital-related. The three primary activities for which CalAm has estimated ESA costs are: a habitat conservation plan for the Carmel River; a habitat conservation plan for its entire system; and ESA-related attorneys' fees.

There is considerable material in the record introduced by CalAm to establish the amounts and timing of its ESA expenditures, while ORA's evidence was limited to analyzing CalAm's presentation. We will not detail here the methods either used because we did not find CalAm's estimates of its ESA amounts or their timing particularly reliable. CalAm's application estimate appears to have come through an impromptu response to an e-mail seeking quick input.⁴⁹ CalAm used the top of the range of each initial estimate and the most favorable interpretation of the timing. ORA's initial estimate used the middle or bottom of CalAm's ranges and its timing reflected later information. In the end, each made minor revisions to its figures and they moved closer together. On rebuttal, CalAm acknowledged that the first major activity for SRR#10, which had been dormant since summer, 2001, had still not begun by August 2002, "due to other more pressing ESA issues."

Regardless of our discomfort with CalAm's projections, the company clearly faces some very significant ESA-related costs in TY2003 and beyond. We will adopt ORA's figures for ratesetting because they are the more conservative. These are capital expenditures, so the accounting process will eventually reflect CalAm's actual ESA-related costs in the company's plant accounts for the next GRC cycle and beyond rather than our adopted estimates.

As we noted in our discussion of SRR#2 above, allowing CWIP in rate base rather than AFUDC has long been our policy for the regulated water utilities. The fact that we accepted a different treatment for the GRC cycle now ending when we approved the parties' settlement in D.00-03-053 need have no precedential value for our decision in this GRC. We grant CalAm's request to account for its ESA-related capital expenditures for TY2003 and beyond as CWIP, and set rates for the test years accordingly.

Special Rate Request #11

CalAm asks to recover the accumulated balance in its expense balancing account over a three-year period through a surcharge on all units of water sold. The total balance as of December 31, 2001 was $809,260, and was expected to grow through 2002. To allow Commission staff an opportunity to review the accumulated balance, CalAm requests that the recovery begin as of July 1, 2003, and be spread over a 30-month period.

As with the other balancing and memorandum account recovery requests, ORA deferred to R.01-12-009. CalAm provided no further description, breakdown or justification, and no other party examined the account. CalAm must await and follow the procedures that are established in R.01-12-009 to seek recovery.

Special Rate Request #12

In SRR#12, CalAm sought $518,532 over a three-year period for increased security between September 11, 2001 and December 31, 2002, plus an additional $231,800 annual allowance for increasing security during TY2003 and TY2004.

Earlier this year, CalAm filed A.02-03-019 seeking authorization to establish a company-wide security cost memorandum account to track for possible later recovery what it estimated at that time to be $821,000 in expenses and $1.247 million in capital expenditures for 2001 and 2002. By D.02-07-011, the Commission denied the application, citing the prohibition against retroactive ratemaking for amounts already expended and suggesting that to the extent CalAm wished to pursue recovery of additional security costs, the issue should be addressed in its future GRCs. CalAm subsequently determined not to pursue in this GRC the 2001 and 2002 retroactive amounts, but it still seeks $231,800 annually for TY2003 and TY2004. ORA has evaluated CalAm's line item budget for enhanced security and recommends eliminating the expense of a single private security guard at $183,800 annually, and two much smaller amounts for water sampling labor and miscellaneous labor and equipment, leaving a recommended allowance of $13,000 in each test year. All of the amounts at issue for security are said to be over and above what CalAm would normally spend absent post-September 11 concerns.

Contrary to CalAm's characterization of these as mandatory ongoing security costs, they are not mandated measures under any of the supporting documentation CalAm cited in its rebuttal testimony. When asked what was meant by "mandatory" in this context, CalAm's witness responded, "Our own company's internal policies in securing our water systems, as well as how we interpret some of the actions that... were taken and are being taken to secure water systems by others." CalAm's supporting statement that, "The company was implored to take special extra precautions..." indicated only that it was responding to, e.g., a series of national advisories directed at community water systems in general throughout the country in the post-September 11 time frame, and the federal Public Health Security and Bioterrorism Preparedness and Response Act (HR 3448), enacted in June 2002.

Under HR 3448, community water systems are required to conduct vulnerability assessments and submit them to the Environmental Protection Agency between March 31, 2003 and June 30, 2004, the date depending on system size. HR 3448 also calls for EPA to provide financial assistance through fiscal year 2005 to water systems to perform these vulnerability assessments and to prepare emergency response plans, and for the costs of security enhancements (but not including personnel costs). Funding levels and specific criteria to qualify are not yet available.

Among ORA's primary concerns is whether the specific measures CalAm proposes are the most effective at the least cost. When asked on cross examination whether the company had done any sort of evaluation of what would the be most cost effective way of providing security, CalAm's witness responded, "The only analysis I could say is that we solicited the costs from security firms as to what they would charge us to provide a security [guard]...."

We accept only ORA's recommended allowance of $13,000 in each test year. As ORA points out, if ratepayers are to be charged additional costs for security enhancements, then the Commission should be assured that the methods chosen are at least effective. We anticipate that in the course of preparing its vulnerability assessment due to EPA next year, CalAm will prepare a thorough evaluation of its requirements and costs and will know more about what HR 3448 reimbursements it may qualify for. In the meantime, CalAm's showing does not persuade us to add the full additional amounts that it requests into rates. That is not to say that we have determined that CalAm should or should not take additional security steps; rather, that CalAm must determine the most cost-effective means of meeting any needs it identifies and then give them whatever priority they are due among all of its other funding priorities. In denying CalAm's A.02-03-019 request for a security costs memorandum account, we pointed out, "There is no requirement of the utility to spend exactly, or only, the projected amount on each rate base or expenditure component used to set rates.... We leave fine-tuning of a utility's operation to the discretion of its management. Management discretion is exercised in allocating total dollars for capital and expense items to those areas where the capital and expense is most necessary, as dictated by constantly evolving priorities."

During the course of the proceeding, the ALJ agreed that certain materials relating to security of the company's water facilities are confidential and should be kept under seal: exhibit CA-15; pages 3A-1 and 3A-2 of exhibit ORA-1A; and a portion of the hearing transcript containing related testimony. ORA has filed a Motion to Submit Under Seal Section IV.K of its Concurrent Brief relating to the same topic. ORA's motion will be granted.

Cost of Capital

In order to determine a fair rate of return for a utility, we determine the proportion of long-term debt and equity in its capital structure, estimate what the effective cost of each will be, and then take a weighted average. The resulting rate of return is used to determine the revenue requirement in the summary of earnings for each test year.

ORA is recommending 2.50% be deducted from CalAm's rate of return for TY2003, TY2004 and AY2005 as a penalty for deteriorating customer service. Since we reject ORA's service penalty recommendation in a later section of this order, we deal here only with ORA's return figures before the 2.50% reduction.

Capital Structure

CalAm's application-proposed capital structure consisted of the following proportions of long-term debt and equity: for TY2003, 56.40% and 43.60%; for TY2004, 56.75% and 43.25%; and for AY2005, 56.99% and 43.01%. ORA concurred. That capital structure is reflected in our adopted rate of return, Table 3 below.

Cost of Debt

CalAm initially projected that its average embedded cost of long-term debt for TY2003, TY2004, and AY2005 would be 7.30%, 7.12% and 6.93% respectively. These figures were based on its existing debt issuances at known interest rates, and new debt issuances at coupon rates of 175 to 200 basis points above the forecasted 10-year Treasury bond rate.

ORA accepted CalAm's estimate of the amount of future long-term debt financing⁵⁰ and updated CalAm's new debt coupon rate estimates by adding 175 basis points⁵¹ to DRI's most recently forecasted 10-year Treasury bond rate. This resulted in ORA's initial projections of new long term debt costs of 7.88%, 8.47% and 8.49% over the three years.

At the evidentiary hearings, CalAm produced a new forecast of long term debt costs: "CalAm accesses the debt market through AWCC [American Water Capital Corporation]. Currently we anticipate that AWCC would be able to borrow in the capital markets at approximately 150 basis points above the 10-year Treasury bond rate. This would result in an estimated cost of new long-term debt of 7.30% in 2003, 7.40% in 2004 and 7.50% in 2005."⁵²

Applying CalAm's updated projected cost of new borrowing to CalAm's estimate of future long-term debt financing, embedded cost of outstanding debt, and retirements produces the adopted costs of long-term debt shown in Table 3 for TY2003, TY2004, and AY2005, respectively: 7.43%, 7.38%, and 7.28%.

Cost of Equity

Cost of equity is typically the most contested component of rate of return in water general rate cases. It is a direct measure of the company's after-tax return on equity (ROE) investment, and its determination is by necessity somewhat subjective and not susceptible to direct measurement in the same way capital structure and embedded cost of debt are.

Both CalAm and ORA acknowledge the well established legal standard for determining a fair ROE, and we have many times cited that same legal standard. In the Bluefield Water Works case,⁵³ the Supreme Court stated that a public utility is entitled to earn a return on the value of its property employed for the convenience of the public, and set forth parameters to assess a reasonable return. That return should be "...reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economic management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties."

As the Supreme Court also noted in that case, a utility has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. In 1944, the Court again considered the rate of return issue in the Hope Natural Gas Company case,⁵⁴ stating, "[T]he return to the equity owner should be commensurate with returns on investments in other enterprises sharing corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital."

The Court went on to affirm the general principle that, in establishing a just and reasonable rate of return, consideration must be given to the interests of both consumers and investors.

With these foundation principles in mind, we examine ORA's recommended ROE, and then CalAm's.

ORA's Recommended Return on Equity

To determine the appropriate ROE for CalAm, ORA performed a quantitative analysis and then assessed the level of business and financial risk CalAm faced. In its quantitative analysis, ORA used two financial models, DCF (discounted cash flow) and RP (risk premium), to estimate investors' expected ROE.⁵⁵ ORA applied both models to a group of comparable water utilities selected based on two criteria: (1) water operations account for at least 70% of the utilities' revenues, and (2) the utilities' stocks are publicly traded. The comparable group was comprised of seven companies: American States Water, American Water Works, California Water Service, Connecticut Water Service, Middlesex Water, Philadelphia Suburban, and San Jose Water. ORA used this comparable group for both its DCF and RP analyses.

American Water Works, CalAm's parent company, announced in September 2001 that it is being acquired by RWE Aktiengesellschaft, Thames Water Acqua Holdings GmbH (RWE). Because that pending acquisition had inflated American Water Works' stock price, ORA used stock price data from the period prior to September 2001.

ORA's DCF analysis yielded an average expected ROE of 8.19%. Its RP analysis produced an initial result of 11.31%, later corrected to 11.51%. It averaged the two results to produce a composite model return of 9.75%.⁵⁶ To this it added a 22-basis point ROE incentive to account for CalAm's practice of maintaining a higher ratio of long-term debt to total capital.⁵⁷ ORA's final recommended ROE for CalAm is 9.97% (excluding its recommended service penalty).

In addition to its DCF and RP quantitative analyses, ORA also assessed the level of financial and business risk CalAm faces. In concluding that CalAm's business risk, which ORA related primarily to regulatory risk, was low, ORA cited the Commission's many risk-reducing mechanisms available to water utilities, including balancing accounts for purchased water, purchased power, and pump taxes, memorandum accounts for Safe Drinking Water Act compliance, 50% fixed cost recovery, and CWIP in rate base.

CalAm's Recommended Return on Equity

CalAm used a variety of analytical techniques, including, as ORA did, DCF and RP models, but ran them on different, more varied sets of data. Using data available in January 2002, CalAm presented two DCF estimates (one based on water utilities and the other on gas utilities), three RP analyses (one on water utilities and two on gas utilities), and a capital asset pricing model (CAPM). In addition to using more, and more varied, data sets, CalAm also relied at several points on ROE adders and adjustments intended to conform the analyses more closely to CalAm's situation.⁵⁸ CalAm shows estimated equity costs ranging from 10.6% to 11.6% by the DCF method, and 10.9% to 11.6% for the RP method. In each case, the highest estimate in the range resulted from analyses using gas utility data. The CAPM method produced a cost of equity ranging from 10.6% to 12.0% using data from the Value Line Industrial Composite. CalAm concluded that its cost of equity is in the range of 10.9% to 11.8%,⁵⁹ and its final recommendation is an 11.0% ROE.

Return on Equity Discussion

ORA and CalAm each attack perceived shortcomings in the other's ROE showing. CalAm correctly pointed out the error that led ORA to increase its DCF result by 20 basis points. CalAm criticizes ORA's analysis as not reflecting in its DCF a difference between the recommended ROE and the average costs of Baa bonds, and the spread between its DCF and RP result as being too wide. CalAm believes ORA biased its results by being inconsistent across the two studies in choosing its sample companies. CalAm criticizes ORA's "blanket rejection of data on risk and required returns for companies not in the water industry." And CalAm sees increased regulatory risk for itself in California's regulatory climate, most particularly from the Commission's policy of capping step rates if a utility is over earning and the possible outcome of the Commission's R.01-12-009 water balancing account rulemaking. CalAm also sees additional risks that set it apart from other California Class A water utilities: its per-capita rate design in the Monterey Division; that not all construction projects are included in CWIP; and that when AFUDC is allowed, it is applied at the 90-day commercial paper rate.

ORA, in turn, charges that CalAm's ROE analyses are contrary to Commission policy in that its models use gas utilities and industrial companies as part of the comparable groups, whereas the Commission has refused repeatedly to use comparisons of energy utilities in its determination of cost of capital for water utilities, and has likewise rejected comparisons with businesses other than regulated utilities.⁶⁰ CalAm's reducing the results by 50 basis points when comparing itself with gas utilities is, in ORA's view, an unconvincing adjustment in light of the Commission's specific rejection of such comparisons. ORA also rejects CalAm's claim that the Commission's balancing account rulemaking proceeding significantly increases CalAm's risk, considering that it only covers one of many special recovery mechanisms available to water utilities. ORA views the Commission's step rate policy as fair because it always results in using the most current rate of return, and, in any case, if the utility earns more than its authorized rate of return, it is never required to refund its overearnings to ratepayers. And ORA attacks CalAm's characterization of weather-related risk as being accounted for in the market-based models and something an investor would consider as affecting all water utilities, not just California utilities. Lastly, ORA argues at length on brief that CalAm has been inconsistent in presenting its need for a higher ROE in this proceeding while it is at the same time presenting a much more favorable picture in its then-pending A.02-01-036 proceeding to merge with RWE.⁶¹

We find much to like in both parties' cost of equity analyses, and some we do not. First, both use as their bases the DCF and RP models that we have consistently accepted in the past for water companies. We are not impressed with CalAm's attempt to analyze water company costs of equity by using gas utility and other, non-utility companies' data; that approach, as ORA notes, we have consistently and unequivocally rejected in the past. CalAm makes a point, however, when it criticizes ORA's observation that no consistent relationship exists between interest rates and authorized ROEs. Unless by consistency ORA means lockstep adherence with a mathematical certainty, any competent analysis of authorized equity returns compared to interest rates must observe that, all else being equal, authorized ROEs tend to rise and fall with the rise and fall of interest rates, albeit more slowly in both directions. On the other side, CalAm's view notwithstanding, our R.01-12-009 balancing account rulemaking does not mean the elimination of all balancing and memorandum account protections that California's water utilities have come to rely so heavily on over the years. First, at the time of this writing the Commission had yet to issue its first interim order in that proceeding. Second, no water utility that is neither earning over its authorized return nor beyond its rate case cycle by its own choosing (frequently because it is over earning), would be affected by the policies proposed. Third, no rule or policy change proposed in that rulemaking would require any water utility to return any amount of overearnings to its ratepayers; only that a utility not be afforded rate increases when it is already at or above its authorized return. As for the extraordinary risks CalAm sees for its Monterey Division, we note that the longstanding WRAM account which we are extending by this decision is intended to mitigate CalAm's risk from the per-capita rate design; and that also by this decision we return CalAm to our standard water utility policy of including CWIP in rate base.⁶²

At the conclusion of its rate of return section on brief, CalAm provides one final statement. The minimum supportable ROE for CalAm in this case, it argues, would be based on the 8.55% cost of Baa rated bonds averaged with ORA's 11.51% corrected RP figure, or 10.03%. To that CalAm would add ORA's suggested 22-basis point capital structure incentive (i.e., a risk premium) to arrive at a 10.25% minimum supportable rate of return. In reviewing the parties' DCF and RP models, we have come to the conclusion that CalAm's analyses produce results that fail our reasonability test: investors in the economic climate of today and over the forthcoming rate case cycle will not require returns in the range of 10.9% to 11.8% to make equity investments in water utilities. Projecting an 8.55% Baa bond rate is also suspect when we compare that with CalAm's projection that it will be able to raise new long-term debt capital at 7.30% to 7.50% over the next three years. When we review the historical authorized returns on equity for California's Class A water companies,⁶³ we see that even CalAm's 10.25% lowest figure (which CalAm does not advocate) is well in excess of water company returns authorized during the past three years. The number of those returns is few, however, and at least some are based on settlements. Ultimately, the choice of a proper ROE must be a matter of judgment and the record. Subjective judgment alone would say that CalAm's equity return need not be as high as 10.25% in today's investment climate to attract capital, but no party has made a reasoned analysis on the record that would lead to a lower figure. Thus, on the basis of the record before us, we adopt a 10.25% ROE for TY2003, TY2004 and AY2005.

Rate of Return

With the capital structure, cost of debt, and cost of equity components determined above, the straightforward calculation in Table 3 derives the rate of return on rate base: