13. Settlement on Rate of Return

For a regulated utility, rate of return on rate base is the ratio of earnings to total rate base. Essentially, rate of return is the compensation paid to investors for the capital they have provided for public utility service. A fair rate of return is acknowledged to be no less than the company's cost of capital (so that the utility can maintain its credit rating and attract additional investment). For Park, cost of capital is determined as a weighed average of the cost of long-term debt and the cost of common equity. (Because Park is closely held and not publicly traded, preferred stock, a third element of the cost of capital, is not included.) The cost of each capital component is weighted on the basis of the company's capital structure (that is, the relative amounts of equity and long-term debt that constitute the company's long-term financing).

On August 28, 2003, Park and ORA jointly filed a motion for adoption of a settlement on cost of capital for the Central Basin Division. Following a series of settlement meetings, the two parties agreed on a return on rate base of 9.51% in test year 2004, 9.50% in test year 2005, and 9.49% in attrition year 2006. Park in its testimony had urged a return on equity (ROE) of 11%, while ORA submitted evidence supporting an ROE of 9.3%. The parties settled on an ROE of 10.15%.

The following table shows agreed-upon capital structure, cost of debt, and return on equity, and the resulting return on rate base for the test years.

	Cost of Capital Settlement Capital Structure Cost Rate of Return Test Year 2004 Long-Term Debt 40.02 % 8.55% 3.42% Common Equity 59.98% 10.15% 6.09% Total 100.00% 9.51% Test Year 2005 Long-Term Debt 40.02% 8.53% 3.41% Common Equity 59.98% 10.15% 6.09% Total 100.00% 9.50% Attrition Year 2006 Long-Term Debt 40.02% 8.51% 3.41% Common Equity 59.98% 10.15% 6.09% Total 100.00% 9.49

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 ROE investment, and its determination is by necessity somewhat subjective and not susceptible to direct measurement in the same way as capital structure and embedded cost of debt.

Both Park and ORA acknowledge the established legal standard for determining a fair ROE, and we have many times cited that same legal standard. In the Bluefield Water Works case,¹ 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,² 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 principles in mind, we examine the parties' proposed settlement of the rate of return issues.

13.1. Support for Settlement Proposal

Both Park and ORA submitted substantial testimony on cost of capital issues. To determine the appropriate return on equity for Park, both parties performed quantitative analyses and then assessed the level of business and financial risk Suburban faced. In its analysis, ORA used two financial models, DCF (discounted cash flow) and RP (risk premium), to estimate investors' expected return on equity.³

In addition to its DCF and RP quantitative analyses, ORA assessed the level of financial and business risk Park faces. In concluding that Park's business risk is low, ORA cited the Commission's many risk-reducing mechanisms available to water utilities, including memorandum-type balancing accounts for purchased water, purchased power and pump taxes, memorandum accounts for Safe Drinking Water Act compliance, 50% fixed cost recovery, and Construction Work in Progress in rate base. As to financial risk, ORA noted that Park's equity ratio of nearly 60% is larger than that of comparable water companies (approximately 50%), indicating that Park has lower financial risk than the comparable group.

Based upon its analyses and risk assessment, ORA recommended a return on equity of 9.3%.

Park also performed DCF and RP analyses, although, since Park's stock is not publicly traded, it questioned the comparison of Park with large publicly traded companies. Park stressed the risks the company faces because of its small size, limited financial flexibility and its demonstrated higher costs of borrowing. Park showed that it has net plant that is only 12.5% as large as net plant of the average larger water utility and operating revenues that are only 14.6% of the average for the larger water utilities.

Park notes that in the 1999 General Rate Case for the Central Basin Division, in which cost of capital was fully litigated, the Commission found that Park was viewed as a greater overall risk to investors. The Commission adopted a 30-basis point adder to ROE to recognize that risk. Based on what it perceives as greater risks since that time, Park in this case urged a 90-basis point adder. Park argued that its analyses support a return on equity of 11.75%, although it limited its request to 11% to minimize the impact on rates.

Park in its testimony was particularly critical of Commission Resolution W-4294 that in D.03-06-072 limits recovery of water supply expenses (power costs, purchased water costs and pump taxes) when a water utility earns more than its authorized rate of return for the period of time in question. Park's consultant did simulation analyses of three large California water companies, and presented evidence purporting to show that in each case the new balancing account rules reduce expected future ROE by no less than 75 basis points. ORA disputes that conclusion, noting that the newly adopted procedures for balancing account recovery are similar to those that already were being used by California-American Water Company and do not affect a utility's opportunity to earn its authorized return.

At hearing, rate-of-return witnesses for Park and for ORA took the stand together to respond to questions about the settlement. Leigh K. Jordan, Park's executive vice president, testified that the parties looked at the evidence that each had produced and at Commission actions in recent cases and concluded that a 10.15% ROE was "a reasonable ballpark approximation of what would have been the outcome if we had litigated the issue." (Transcript, at 408.) ORA financial analyst Cleason Willis testified that ORA regarded the settlement as a reasonable compromise between Park's recommendation of 11% and ORA's recommendation of 9.3%. He added that had the issue been litigated, his 9.3% estimate "was low enough to allow room for a risk premium adder." (Transcript, at 405.)

13.2. Discussion of Proposed Settlement

The Commission's Rules of Practice and Procedure address criteria for adoption of a settlement. Under Rule 51.1, the Commission must find that the settlement is reasonable in light of the whole record, consistent with the law, and in the public interest.

Ultimately, the choice of factors used to measure an appropriate return on investors' equity is a matter of judgment. Both parties rely on DCF and RP analyses that we have consistently accepted in the past for water companies. The 10.15% ROE is at midpoint between the 9.3% ROE recommended by ORA and the 11% ROE recommended by the company. While they disagree on the extent of the risk faced by Park, both parties acknowledge that risk is increased by the small size of the utility and its inability to borrow at rates available to larger Class A water companies. Indeed, ORA candidly acknowledges that its 9.3% recommendation could appropriately be increased by a risk adder, as was done in Park's 1999 general rate case. That would bring ORA's recommendation to within a few basis points of the ROE on which the parties settled.

Moreover, a 10.15% ROE is within a reasonable range of ROEs recently authorized other California Class A water utilities. It is approximately the same as the 10.10% ROE authorized for Park's subsidiary, Apple Valley Ranchos, in D.03-08-069 on August 21, 2003, and is only marginally greater than the 9.84% ROE granted the much larger Suburban Water Systems in D.03-05-078 on May 22, 2003. Based on the record as a whole, we conclude that the proposed settlement on rate of return is reasonable.

The settlement is consistent with the law and is in the public interest. Our assessment of whether the proposed rate of return is in the public interest must consider the future viability of the utility to provide service. At the same time, we must consider the customers' need for fair and reasonable rates. It is the Commission's obligation to balance these interests. We conclude that the settlement strikes such a balance. Accordingly, the settlement should be adopted.