III. DISCUSSION

A. D. 03-06-072's Revision Of Procedures For Recovery of Balancing Accounts Existing On Or After November 29, 2001, Is Not Unlawful Or Unconstitutional

Both California Water Association (CWA) and Southern California Water Company (SCWC) assert that the revised procedures for recovery of balancing accounts set forth in D.03-06-072 are unlawful and unconstitutional. (CWA Rhg. App., p. 5; SCWC Rhg. App., p. 1.) CWA points out that although public utilities are not guaranteed the right to earn their authorized rates of return, it is a basic tenet of public utility law that they must be afforded the opportunity to earn a fair rate of return (citing Bluefield Water Works & Improvement Co. v. Public Service Comm'n of West Virginia (1923) 262 U.S. 679, 692-693). CWA argues that by prohibiting a water utility from recovering accrued offset costs in a balancing account, which were reasonably and prudently incurred in the provision of public utility service in any year in which the water utility happens to be earning above its authorized rate of return, the Commission is denying that utility - over a period of time - the opportunity to earn its authorized rate of return. (CWA Rhg. App., p. 7).

We disagree. A correct interpretation of the revised balancing account procedures reveals the following:

(1) If a utility is either within or outside of its rate case cycle and is not over earning, the utility shall recover from the balancing account subject to reasonableness review.

(2) If a utility is either within or outside of its rate case cycle and is over earning, the over earnings will be used as a measure by which recovery of offset expenses in the balancing account will be reduced. For example, if the amount of the over earning is equal to or exceeds the amount of offset expenses to be recovered in the balancing account, those expenses shall be reduced to zero. Any offset expenses accumulated in the balancing account would be amortized below the line and any offset revenues collected in the balancing account would be returned to ratepayers.

(3) If a utility is within or outside of its rate case cycle and is over earning, but the over earnings are not equal to or greater than the offset expenses accumulated in the balancing account, the offset expenses in the balancing account will be reduced by the amount of the over earnings. If there are offset revenues in the balancing account, then these shall also be used to reduce the remaining offset expenses accumulated in the balancing account to zero. After the offset expenses in the balancing account are reduced to zero, if any offset revenues remain in the balancing account, such revenues shall be returned to ratepayers. If, conversely, after adjusting offset expenses in the balancing account by the amount of over earnings and offset revenues, offset expenses still remain in the balancing account, such expenses shall be amortized and recovered through a surcharge request in an Advice Letter or a GRC.

In light of these principles, CWA's arguments lack merit. The revised procedures set forth in D.03-06-072 neither disallow a water utility from recovering costs prudently and reasonably incurred in the provision of public utility service, nor deny a water utility the opportunity to earn its authorized rate of return over time. In fact, no matter how much a company has over earned, the over earnings are never used to reduce offset expenses below zero. In reality, the utility retains all of its over earnings. As the summation of the revised procedures set forth above indicates, such procedures simply require a utility to use over earnings as a measure by which the utility reduces offset expenses before being able to recover such expenses from the balancing account.

Both CWA and SCWC are well aware that the purpose of providing this rate adjustment mechanism is to protect utilities from unforeseen expenses of a significant nature over which the utility has no control. This purpose is stated in Reso. W-4294. In the situation where a utility is over earning, it clearly does not need this type of protection. D.03-06-072 finds that it is unreasonable and unnecessary to permit the utilities to pass through to ratepayers the dollar for dollar costs accumulated in their balancing accounts when these same utilities are earning more than their authorized rate of return. As the decision points out, to permit such recovery would be to grant the utilities an unanticipated windfall at ratepayer expense. (D.03-06-072, p. 15.) Conversely, if a utility is under earning, the utility may recover all of its offset expenses subject to reasonableness review. Thus, we find our rationale for revising the balancing account procedures to reasonably protect both shareholder and ratepayer interests.

We agree that the description of the revised procedures throughout the decision needs clarification. Therefore, we modify these parts of the decision to clarify the revised procedures as set forth below.

1. The Implementation Of The Revised Balancing Account Procedures Does Not Constitute Retroactive Ratemaking

CWA asserts that the decision's disallowance of costs reasonably and prudently incurred in the provision of public utility service when a water utility is over earning constitutes unlawful retroactive ratemaking as prohibited by and articulated in Pacific Telephone & Telegraph Co. v. Public Utilities Com. (1965) 62 Cal. 2d 634 (PacTel). (CWA Rhg. App., p. 9.) As a threshold matter, as explained above, we reject CWA's argument that the revised balancing account procedures result in disallowing reasonably incurred costs. We also disagree with CWA that the revised balancing account procedures constitute unlawful retroactive ratemaking.

In PacTel, supra, the California Supreme Court overturned a portion of a rate order on the grounds that it constituted impermissible retroactive ratemaking because if affected general rates. (Id. at 650.) In Southern California Edison Co. v. Public Utilities Commission (1978) 20 Cal.3d 813 (SoCal Edison) 20 Cal. 3d 813, the California Supreme Court distinguished between general ratemaking and rate adjustment mechanisms. In SoCal Edison, we replaced Edison's fuel clause, under which Edison had over collected tens of millions of dollars, with an "Energy Cost Adjustment Clause" (ECAC). Under the ECAC, Edison was required to record its actual fuel costs in a balancing account. Since both "over" and "under" collections in the balancing account are regularly amortized, we eliminated the possibility that Edison in the future would have such a large, long-term over collection as it had obtained under the fuel clause. We also ordered Edison to return to its ratepayers over a three year period the over collection generated under the prior fuel clause. Edison challenged this refund order as impermissible retroactive ratemaking.

The court rejected Edison's argument and distinguished between general ratemaking cases, in which many variables are taken into account and broad policies are formulated, and cases involving the narrowly restricted and semi-automatic functioning of an adjustment clause. The court found that we were correct in finding that the rates fixed by operation of the fuel cost adjustment clause were not "general rates" but "extraordinary rates not created by or in a general rate proceeding" and that "[t]he future reduction of fuel clause adjustment rates is not retroactive ratemaking," even though designed "to reflect past over or under collections." (Id. at 829-30 & fn. 21.) The court noted that the fuel clause was intended only to reimburse Edison for its increased fuel costs and not to contain any element of profit. This fact further supported the court's conclusion that Edison could be required to return the windfall of its past over collections to its ratepayers. (Id. at 818, 830-31.)

Although CWA acknowledges the holding in SoCal Edison, supra, CWA asserts that D.03-06-072 goes beyond the adjustment of rates by operation of the balancing accounts and "indirectly - though clearly - impacts general rates on a retroactive basis therefore representing unlawful retroactive ratemaking." (CWA Rhg. App., p. 9.) Specifically, CWA asserts that "a utility is denied the recovery of reasonably and prudently incurred costs accrued in a balancing account to the extent that it is over earning on its authorized rate of return, even though such over earning results from rates established in its prior general rate case. Thus, this procedure has the effect of adjusting past Commission-authorized general rates (through a current refund and below-the-line write-off of recoverable costs) based on a hindsight review of a utility's earnings. Such a result constitutes unlawful retroactive ratemaking." (CWA Rhg. App., pp. 9-10.)

CWA's argument is incorrect. The revised procedures for recovery of offset expenses from balancing accounts do not adjust general rates authorized by this Commission in the past based on a hindsight review of a utility's earnings. CWA is well aware of the fact that this rate adjustment mechanism is not part of a general ratemaking proceeding⁴, and has no direct or indirect effect on general rates. The revised balancing account procedures simply require the utility to use the over earnings as a measure by which it reduces offset expenses before being able to recover such expenses from the balancing account. Therefore, if the utility is over earning and such over earnings equal or exceed the amount of offset expenses in the balancing account, then the utility would not recover the offset expenses from offset revenues in the balancing account. Since the purpose of the balancing account is to protect utilities from unforeseen significant expenses that would adversely affect its rate of return, a utility that is over earning does not need the protection offered by this rate adjustment mechanism.

D.03-06-072 provides that "offset balancing account recovery should only occur when the utility fails to earn up to its authorized rate of return due to unanticipated expenses beyond its control and that are the subject of the balancing account." (D.03-06-072, p. 15.) SCWC asserts that the court in SoCal Edison, supra, rejected the notion that recovery of the fuel clause was in any way related to a utility's return on rate base (SCWC Rhg. App., p. 3.), and asserts that "there should be no link between the operation of the balancing account, on the one hand, and whether the utility earns its authorized rate of return, on the other hand." (Id. at 4.)

SCWC ignores the fact that the court in SoCal Edison, supra, noted that the fuel clause was intended only to reimburse Edison for its increased fuel costs and not to contain any element of profit. (Id., at 818, 830-831.) The court stated "no portion of such a rate increase may lawfully represent a profit to the utility." (Id. at 818-819.) The revised procedures address this very issue. Prior to D.03-06-072, recovery from the balancing account could result in a profit to the utility when the utility is over earning. To remedy this potential windfall, the revised procedures simply require a water utility, if over earning, to use its over earnings as a measure by which to reduce offset expenses because, in reality, the utility's rates generated enough revenue to pay for the increased expenses without the use of this rate adjustment mechanism. Therefore, we find that the revised procedures are consistent with the court's reasoning in SoCal Edison, supra, and do not result in retroactive ratemaking.

2. The Revised Procedures For Recovery Of Balancing Accounts Do Not Violate Due Process Guaranteed by the Constitution of the United States or California.

Both CWA and SCWC allege that the decision violates both substantive and procedural due process guaranteed by the U.S. and California Constitutions. (CWA Rhg. App., pp. 10, 13; SCWC Rhg. App., p. 6.) These arguments obfuscate their real complaint: that the Commission, after providing notice and the opportunity to be heard to affected parties, revised its procedures to correct an inequity to ratepayers. In any event, the revised procedures do not deny either substantive or procedural due process.

a) Substantive Due Process

The United States Supreme Court has interpreted the due process clause of the Fourteenth Amendment as providing two distinct guarantees: substantive due process and procedural due process. (Zinermon v. Burch (1990) 494 U.S. 113, 125.) CWA alleges that D.03-06-072 is arbitrary and capricious, therefore violating substantive due process, because there is no evidence upon which it bases its conclusion that balancing account procedures and cost offsets enhance a utility's earnings above the Commission's authorized rates of return. (CWA Rhg. App., p.13) SCWC alleges that the decision violates substantive due process by not setting forth evidence upon which it bases its conclusion that the existing procedures for maintaining balancing accounts produce "distorted results." (SCWC Rhg. App., p. 6.)

Substantive due process protects against "certain arbitrary, wrongful government actions" (Id. quoting from Daniels v. Williams (1986) 474 U.S. 327, 331.) "A substantive due process challenge to an economic regulation must satisfy a two-part test: (1) does the ordinance must serve a legitimate purpose, and (2) are the means employed rationally related to the legitimate purpose? (Citations omitted). The Ninth Circuit has articulated the test as one that requires that the plaintiff "prove that the government's action was clearly arbitrary and unreasonable, having no substantial relation to the public health, safety, morals, or general welfare." [Citations omitted.] (Adamson Companies v. City of Malibu (1994) 854 F. Supp. 1476, 1485.)

Applicants' objections are inaccurate and without merit. In a rulemaking to adopt policies and procedures, we are not required to rely on specific evidence in reaching our legal conclusions and findings. Because of the quasi-legislative nature of such proceedings, we are free to rely on a variety of materials in lieu of evidence to reach our legal conclusions and findings. Rule 14.1of the Commission's Rules of Practice and Procedure makes this clear: "Rulemaking is a formal Commission proceeding in which written proposals, comments, or exceptions are used instead of evidentiary hearings." Therefore, the assertion that we must rely on evidence in reaching our conclusions in a rulemaking is inaccurate and contrary to the rules defining this type of proceeding.

Nevertheless, there is ample evidence in the record of this proceeding upon which the Commission based its conclusion that the existing procedures become problematic when they have the effect of enhancing a utility's earnings above its authorized rate of return. (D.03-06-072, p. 15.) It is this record evidence (along with other materials, including matters presented in oral argument and in an all-party ex parte meeting with Commissioner Brown) that supports the conclusion at issue. Clearly, if these utilities are already over earning, then recovery of cost offsets from the balancing account will only enhance those over earnings, which have already provided the utilities with a revenue stream from which to recover offset expenses. In any case, the notion that D.03-06-072 violates substantive due process due to lack of evidence is erroneous and lacks merit.

CWA also states "there is no rational relation between the denial of recovery of under collections in water utility balancing accounts and the "valid state objective" in preventing a utility from over earning in any given year." In fact, CWA disputes that the prevention of over earning is a valid state objective at all. (CWA Rhg. App., p. 13.)

This objection is not only inaccurate, but also misleading. The decision does not deny recovery of under collections in a utility's balancing account. If a utility is not over earning, it is entitled to recover its offset expenses from the balancing account subject to reasonableness review. The revised procedures simply require a utility that is over earning to use such over earnings as a measure by which to reduce offset expenses prior to recovery from the balancing account. This does not constitute disallowance of those costs. The utility has, in fact, recovered those costs as a result of its over earning. We do not think that the utility should recover those same costs again from the balancing account. Moreover, the valid state objective we are pursuing by revising the procedures for recovery of balancing accounts is the protection of ratepayers - not the prevention of over earning by utilities. Our goal is to protect ratepayers from unnecessary rate increases, obtained through the use of an offset rate increase and balancing account, when a utility is over earning and does not need the protection offered by this rate adjustment mechanism. The means employed to protect ratepayers in this regard are the revised procedures for recovery of balancing accounts. Clearly, such revised procedures are rationally related to the legitimate purpose of protecting ratepayers. Hence, both CWA and SCWC have failed to meet their burden of proving that D.03-06-072 is in any way arbitrary, capricious, or unreasonable.

Both CWA and SCWC allege that we violated procedural due process by issuing D.03-06-072 without holding evidentiary hearings regarding whether the revised procedures deprive utilities of their property, that is the offset expenses accumulated in the balancing account. (CWA Rhg. App., pp. 13-14; SCWC Rhg. App., pp. 7-8.) CWA specifically asserted that issues of possible increased risk from the OIR's proposed changes, and how various risks affect a utility's rate of return, should be considered in evidentiary hearings.

Procedural due process requires that a person in jeopardy of being deprived of liberty or property be given notice of the pending action that could result in such a deprivation and "the opportunity to be heard at a meaningful time and in a meaningful manner." (Mathews v. Eldridge (1976) 424 U.S. 319, 333; internal quotation marks omitted).

As noted above, Rule 14.1, supra, does not require us to have an evidentiary hearing in a quasi-legislative proceeding. D.03-06-072 results from Rulemaking 01-12-009. The March 11, 2002 Scoping Memo, as amended, in this Rulemaking confirmed the categorization of this proceeding as quasi-legislative and determined that hearings were not necessary. The Scoping Memo rejected the need for hearings reasoning that "[r]eadjusting a utility's specific rate of return is not within the scope of this industry wide proceeding. The appropriate rate of return is an issue for the utilities' general rate cases. Furthermore, the question of how various risks affect a utility's rate of return involves an inquiry into all relevant circumstances, not just one specific factor. Again, the appropriate forum for such an inquiry is a utility's general rate case, or other appropriate proceeding the Commission may designate in the future." (March 11, 2002 Scoping Memo, pp. 5-6.)

According to Section 1701.1(a), our decision as to the nature of the proceeding shall be subject to a request for rehearing within 10 days of the date of that decision. Neither applicant objected to the categorization of this proceeding as quasi-legislative by filing for a rehearing, despite the fact that both had the opportunity to do so knowing that evidentiary hearings are not mandated in a quasi-legislative proceeding.

Thus, neither CWA nor SCWC has established legal error in its claim that we should have held evidentiary hearings. It was appropriate for us to revise our balancing account procedures by way of rulemaking. All affected parties had notice and ample opportunity to participate in the proceeding. Class A utilities were made respondents to the OIR. Applicants not only filed comments, but participated in oral argument on September 20, 2002, on all issues in this rulemaking. (D.03-06-072, pp. 4, 6.) Based on the above, it is evident that applicants were afforded procedural due process.

B. The Decision Does Not Result In An Unconstitutional Taking Of Property Without Due Process Of Law

Both CWA and SCWC assert that the revised procedures for recovery of balancing accounts result in an unconstitutional taking, or deprivation of property, without due process of law. (CWA Rhg. App., pp. 10-11; SCWC Rhg. App., p. 7.) Again, applicants' real challenge here appears to be to the Commission's ability to revise our procedures.

CWA argues that a public utility is entitled to recover the costs it reasonably and prudently incurs in providing utility service, and that those recoverable costs are the utility's property. Moreover, CWA asserts that the decision confirms this by acknowledging that, prior to November 29, 2001, utilities could legally book balancing account costs to a "deferred debit account" and, for accounting purposes, claim them as an asset on their balance sheets (Id. at 11, citing D.03-06-072, p.2, fn. 1). Therefore, CWA argues that the costs accrued in balancing accounts - just like any item that can be claimed as an asset on a balance sheet - are the property of a utility. CWA further argues that the decision deprives a utility of that property in circumstances where the utility is deemed to be earning above its authorized rate of return. (CWA Rhg. App., p. 11.)

CWA fails to acknowledge that the reason utilities could legally book balancing account costs to a deferred debit account and claim such costs as an asset on a balance sheet was because our balancing account procedures allowed them to do so. Pursuant to our authority to regulate water utilities,⁵ we may revise these procedures by requiring utilities that are over earning their authorized rate of return to use such over earnings as a measure by which to reduce offset expenses before being able to recover such expenses from the balancing account In the proper exercise of our authority over Class A Water Utilities, we have done so in D.03-06-072. Pursuant to this decision, we require a utility to use its over earnings as a measure by which the utility reduces offset expenses before being able to recover such expenses from the balancing account. When a utility is over earning such expenses can no longer be booked as an asset for accounting purposes and cannot be carried on the utility's books.

SCWC argues that "[b]ecause the costs booked into a supply cost balancing account are actually incurred expenses, a utility has a vested property right in the recovery of those expenses." (SCWC Rhg. App., p.7.) SCWC points out that public utilities have a legal right to recover all reasonable expenses incurred in the provision of utility service. (Id, citing SoCal Edison, supra, at 818.) However, SCWC fails to acknowledge that if a utility is over earning, it already has a revenue stream from which to recover not only all reasonable expenses but also all significant unforeseen expenses incurred in the provision of public utility service. In other words, the utility does not need to recover these expenses from the balancing account.

Moreover, a review of United States Supreme Court cases regarding when a ratemaking order results in an unconstitutional taking indicates that it is the effect of the rate order, not the methodology employed in its implementation, that determines whether a taking has occurred. "Rates which are not sufficient to yield a sufficient return on the value of the property used at the time it is being used to render the service are unjust, unreasonable and confiscatory, and their enforcement deprives the public utility company of its property in violation of the Fourteenth Amendment." (Bluefield Water Works and Improvement Company v. Public Utilities Commission of the State of West Virginia Et Al. (1923) 262 U.S. 679, 690.) "The Constitution does not bind rate-making bodies to the service of any single formula or combination of formulas. Agencies to whom this legislative power has been delegated are free, within the ambit of their statutory authority, to make the pragmatic adjustments which may be called for by particular circumstances. Once a fair hearing has been given, proper findings made and other statutory requirements satisfied, the courts cannot intervene in the absence of a clear showing that the limits of due process have been overstepped. If the Commission's order, as applied to the facts before it and viewed in its entirety, produces no arbitrary result, our inquiry is at an end." (Federal Power Commission et al. v. Natural Gas Pipeline Co. (1942) 315 U.S. 575, 586.) "[I]t is not theory but the impact of the rate order that counts. If the total effect of the rate order cannot be said to be unreasonable, judicial inquiry . . . is at an end. The fact that the method employed may contain infirmities is not then important." (FPC v. Hope Natural Gas Company (1944) 320 U.S. 591, 602.) "The Constitution protects the utility from the net effect of the rate order on its property. Inconsistencies in one aspect of the methodology have no constitutional effect on the utility's property if they are compensated by countervailing factors in some other aspect." (Duquesne Light Co. v. Barasch (1989) 488 U.S. 299, 314.)

In this case, revising such procedures does not amount to a rate order, and certainly doesn't rise to the level of an unconstitutional taking since the revised procedures have neither a confiscatory nor unreasonable effect on a utility's rates. To protect the interests of ratepayers, we have revised the procedures for recovery of offset expenses from balancing accounts. Such action does not result in a violation of either substantive or procedural due process, nor does it in any way result in an unconstitutional taking. Moreover, both CWA and SCWC fail to acknowledge that there is no taking of property if a party has no inherent right to the property in question. Since state law only affords utilities an opportunity to earn a fair rate of return (Bluefield Water Works & Improvement Co. v. Public Service Comm'n of West Virginia, supra, 262 U.S. 679, 692-693), neither CWA nor SCWC has a right to recovery of any offset expenses in a balancing account. Thus, no unconstitutional taking arises from our decision to adjust the procedures for recovery of offset expenses in balancing accounts when utilities are over earning.