Discussion

The Partial Settlement

The amended partial settlement between CalAm and ORA is Appendix F to this decision. A 120-page comparison exhibit detailing the initial and final positions of CalAm and ORA with respect to revenue requirements was submitted with the settlement.³ Those positions and the adopted results are summarized in today's decision (Appendix A, Adopted Summaries of Earnings, and Appendix D, Adopted Quantities and Calculations).

Settlement Terms

The settlement outlines and explains the areas where CalAm and ORA reached agreement through settlement; it does not address those accounts and issues for which there were no differences in CalAm's and ORA initial showings. The other parties did not advocate specific rate case numbers corresponding to those CalAm and ORA have settled. The comparison exhibit submitted at the same time as the settlement sets out an account by account analysis of CalAm's and ORA's initial and final positions, highlighting where differences remain. We address first the settlement, and then those remaining differences among CalAm, ORA and the other parties, in the sections to follow.

Settlement Discussion

CalAm and ORA have tendered an "uncontested settlement" as defined in Rule 51(f)(2), i.e., a "... settlement that ... is not contested by any party to the proceeding within the comment period after service of the ... settlement on all parties to the proceeding."

We reach this conclusion notwithstanding Santa Cruz's objection, stated on brief as, "The settlement between Cal-Am and ORA fails to meet this [Rule 51.1(e) approval] standard, particularly with respect to the recovery of the acquisition premium paid by [American Water Works] to acquire the Citizens facilities." First, Santa Cruz did not file and serve comments contesting the settlement as it was required to do by our Rules of Practice and Procedure, Rule 51.4, if it desired to contest the settlement.⁴ Under Rule 51.5, "Any failure by a party to file comments constitutes waiver by that party of all objections to the stipulation or settlement...." Second, the common CalAm and ORA position on the Citizens acquisition premium issue to which Santa Cruz objects on brief is not mentioned in, nor do we consider it part of, the settlement.⁵ ORA evaluated CalAm's acquisition premium figures in its pre-hearing investigation, concluded that CalAm had proven that total synergies exceed the annual acquisition premium amortization cost, and recommended in its direct showing that CalAm's acquisition premium amortization expense amounts be adopted.⁶ ORA went on to recommend that in future GRCs CalAm be allowed to recover its full acquisition premium amortization expense without having to demonstrate synergies savings, in exchange for all, rather than 90%, of any excess synergies going to customers. We discuss and decide both the synergies savings issue and the revised sharing proposal on their merits later in this decision.

Rule 51.1(e) requires that settlement agreements be reasonable in light of the whole record, consistent with law, and in the public interest. This settlement satisfies Rule 51.1(e), as discussed below.

This settlement represents a resolution of certain issues between CalAm and ORA, as specified. ORA's charge is to represent utility ratepayers, and it has earnestly upheld that purpose here. CalAm has vigorously pursued its interests and those of its stockholders. The settlement commands the sponsorship of both, thus indicating support from diverse interests.

CalAm's applications and supporting exhibits set out its initial position and its justification on the issues later settled. ORA in turn prepared direct evidentiary presentations that established and supported its position on the record, participated in evidentiary hearings, and filed briefs. The settlement defines the compromise the parties have reached on the settled issues. We have reviewed the outcomes the settling parties propose and agree that they have arrived at a reasonable agreement in light of the whole record. Where they were unable to reach agreement on other issues, they developed their positions in the evidentiary hearings, briefed them, and submitted those remaining issues to the Commission for determination.

Likewise, the record in this proceeding provides sufficient information to permit the Commission to discharge its future regulatory obligations with respect to the parties and their interests.

Pub. Util. Code § 454 provides that no public utility shall change any rate except upon a showing before the Commission and a finding by the Commission that the new rate is justified. In this case, the parties have explained their initial positions and what adjustments each has made to arrive at the figures in the settlement. Those settled figures, and our adjudication below of the issues not settled, will bring CalAm's revenues up to the levels necessary for TY2003 and thereafter. We have no hesitation in finding the resulting revenue requirements reasonable and the rates they support justified. No provision of the settlement is in violation of any statute or Commission decision or rule.

We thus conclude that the settlement meets the requirements of Rule 51.1(e) in that it is reasonable in light of the whole record, consistent with law, and in the public interest. We adopt the figures CalAm and ORA have settled on; we examine the issues that remain in the sections to follow.

Summary of Earnings

CalAm and ORA have set forth their initial and final positions in detail in the 120-page comparison exhibit submitted with the settlement. We discuss here their remaining differences, and the positions Santa Cruz has taken when relevant, and show the results in the adopted summaries of earnings, Appendix A to this decision.

Operating Revenues

CalAm and ORA agree on the production, sales, customers, and consumption figures underlying their estimates of operating revenues. Where their revenue estimates differ, it is because of differences in other areas.

Operation and Maintenance Expenses

The only contested operation and maintenance expense issues remaining are ORA-proposed disallowances for tank painting in both test years: In Sacramento, for Parkside Tanks #1 and #2 and Countryside Backwash Tank; in Larkfield, for Lower Wikiup Tanks #1 and #2. ⁷

In Sacramento, CalAm estimated Account 760, T&D Reservoirs and Tanks, for TY2003 and TY2004 at $53,300 and $70,300 respectively. ORA removed from CalAm's estimates the costs of painting the outside of Parkside Tanks #1 and #2 and Countryside Backwash Tank, yielding estimates of $36,108 and $45,268. ORA's witness visited each tank and determined that the outsides were not in need of painting, notwithstanding CalAm's stated practice of painting the outside of tanks when the insides are painted. CalAm's rebuttal witness, a licensed engineer with many years of experience, testified that these tanks have not been painted since their original construction 23, 15, and 20 years ago respectively, and failure to properly maintain a tank will substantially shorten its life and increase costs. Further, setup is a large part of painting costs, so it is typically cost-effective to paint the outside of a tank when the inside is painted. Both witnesses produced photographs that show the tanks in varied states of weathering, with areas of cracked or peeling coatings and surface corrosion. ORA on brief states, "[T]he fact that the tanks are in no structural danger shows that no additional revenue requirement should be granted at this time...," implying a maintenance standard we are loath to adopt. On balance, we find the company's presentation the more credible.⁸ We will allow the amounts CalAm requests. This determination also affects the parties' figures for operational working cash.

ORA took the same approach to two concrete tanks in the Larkfield district: Lower Wikiup Tanks #1 and #2. The arguments parallel those for the Sacramento district tanks, although ORA did not brief on this disallowance. Our determination is the same: We will allow the amounts CalAm requests.

Administrative and General Expenses

For administrative and general expenses, CalAm and ORA differ only in their in their estimates of payroll and related employee pensions and benefits in Sacramento district, and regulatory expense in all three districts.

Sacramento Payroll

For estimating purposes, CalAm and ORA showed payroll separately from the other expense accounts in the summary of earnings. CalAm's application proposed TY2003and TY2004 funding for three new positions: an operations manager to be hired in late-2002, a pump operator in 2003, and another pump operator in 2004. CalAm's direct presentation in the application noted the three new positions but gave neither details nor justification; ORA included funding only for the operations manager and likewise gave no reason in its direct presentation for excluding the two new pump operator positions. On rebuttal, CalAm provided its justification: 1500 added customers in Sacramento district since 1996 without adding operators; 1551 new connections anticipated through 2005 due to a new South Placer County development, growing to 14,000 new connections by 2012; 300 new connections annually from other, fill-in growth; heightened well-site security; wells located near potential contamination sources; and a new fluoride system required by the Department of Health services. ORA, in turn, presented on cross-examination and brief its reasons for excluding the two positions: virtually no customer growth in Sacramento district during the test years; ORA's observation that CalAm's South Placer County growth will take place beyond the test years, in 2005; ORA's disallowance of one of CalAm's proposed new wells; and operator time savings CalAm claims from its new Beloit Chlorine Depot. ORA also pointed out, and CalAm confirmed, that CalAm had kept an existing pump operator position vacant since the beginning of 2003, and it was in fact still vacant as of the mid-April 2003 evidentiary hearings.

CalAm does not present a persuasive position. It faults ORA for not explaining its disallowance in ORA's direct presentation, yet CalAm's direct showing was also a single sentence. CalAm cites figures for the customer growth it anticipates but fails to account for efficiencies that it acknowledges on cross-examination will reduce operator time; ORA acknowledges substantial growth but puts most of it beyond the test years. CalAm's claim that well-site security, potential contamination exposure and a new fluoridation system would increase operator needs was unhelpful absent some quantitative analysis. And most important, nowhere in the record do the parties put CalAm's proposed increase in perspective, e.g., would two new operators represent a 2% increase in the number of pump operators, or 50%? We adopt ORA's payroll figures, and its related employee pensions and benefits. CalAm's next GRC for Sacramento district is currently anticipated to be tendered in 2004 for TY2005. In the meantime, we suggest that it fill the vacant operator position before it seeks funding from customers for additional positions.

Regulatory Expense

CalAm's applications requested a Regulatory Commission Expense allowance for these three districts totaling $51,000 in each test year, describing these amounts as, "based on actual prior history and known occurrences that will take place in the current case - Full amount amortized over three years." ORA estimated $47,700 in TY2003 and $47,800 in TY2004. CalAm presented this historical and estimated data with its applications:

Table 2

Regulatory Commission Expense

Three-District Totals from Applications

1996 (actual)	$ 0
1997 (actual)	0
1998 (actual)	0
1999 (actual)	41,400
2000 (actual)	40,700
2001 (actual)	39,200
2002 (estimated)	51,100
TY2003 (requested)	51,100
TY2004 (requested)	51,100

In rebuttal testimony submitted shortly before evidentiary hearings began, CalAm more than tripled its Regulatory Commission Expense request, from $51,100 annually in TY2003 and TY2004 to $155,800 in each test year. CalAm bases its revised estimates on its GRC expenditures being higher than previously estimated through April 2003, and its projection of higher spending over the remainder of the proceeding. ORA stands by its estimate.⁹

CalAm attributes much of the increase to greater than expected legal and witness costs due to very active intervenor involvement in the proceeding and the many issues those intervenors raised.¹⁰ In fact, many, if not most, of those issues were generated by or closely related to CalAm's acquisition of the former Citizens districts, RWE's subsequent acquisition of AWW, and delays in the Commission-ordered Montara district divestiture to MSD. We do not expect these costs to recur in future years, so they should not be embedded in future rates. Even if our policy were to allow retroactive recovery of past costs in future rates, we would not be inclined to require CalAm's ratepayers to reimburse it for these double-acquisition and delayed divestiture-related costs.¹¹ But retroactive cost recovery is not our policy, CalAm's arguments on brief to the contrary notwithstanding. We explained this point recently in denying CalAm's appeal of its Monterey district TY2003 GRC Regulatory Commission Expense:

CalAm overlooks, however, that, absent a previously authorized memorandum or balancing account, the Commissions' longstanding, consistent practice is to set rates based on forecasted expenses. In this regard, although certainly not determinative, expenses incurred in the present proceeding may be considered in the setting of future rates, along with all pertinent evidence, especially including similar expenses from prior proceedings.¹²

We are also mindful that when a utility on its own initiative submits only one or a small number of accounts for updating late in a proceeding, those accounts may not be representative of expected changes in its expenses overall. In this case, CalAm acknowledges that it has chosen to update the Regulatory Commission Expense account figures (and only those figures) precisely because they have greatly increased. ORA and other intervenors will always be disadvantaged in cases such as this because they have very little opportunity to audit or test late-presented figures, and lack access to the most recent accounting data that may show offsetting decreases in other areas.¹³ Every utility has the ability and obligation to exercise reasonable restraint over its GRC spending; to the extent that CalAm claims to have spent more than it estimated, those are costs over which it had a large measure of discretion.

Here, CalAm's original estimates were, in its own words, "...based on actual prior history and known occurrences that will take place in the current case." We adopt those original Regulatory Commission Expense estimates as being much more consistent with the historical data, less affected by the recent flurry of acquisition and divestiture activity involving Citizens, RWE and AWW, and more representative of CalAm's forward-looking, normal Regulatory Commission Expense levels.

Rate Base - Plant in Service

CalAm and ORA agree on most components of utility plant. We address their remaining differences below.

Security-Related Plant Additions

CalAm has included in its plant additions budget $792,500 in TY2003 and $527,100 in TY2004 for security-related construction in all three districts. CalAm characterizes these as basic security measures that would be commonsense to take in normal times, and all the more advisable in times of heightened security-consciousness. ORA has deleted all of them from its estimates.

Under HR 3448, the federal Public Health Security and Bioterrorism Preparedness and Response Act enacted in June 2002, CalAm must conduct a vulnerability assessment for its water systems and submit it to the Environmental Protection Agency by June 30, 2004. The purpose of the vulnerability assessment is to assist the EPA, local regulatory bodies, and individual water companies to identify specific high priority facilities, security risks to those facilities, and potential improvements to lower those risks. ORA argues that the Commission should not approve recovery in rates of any security-related investments until the EPA has certified CalAm's vulnerability assessment. EPA may find that CalAm's security program is already adequate, or may recommend enhanced security for some areas but not others.

We have examined the security line items CalAm proposes for each district in TY2003.¹⁴ The largest component is fences and gates around water production, storage and treatment facilities. Lesser but still significant amounts would be spent on video surveillance and motion detection measures for those facilities, metal doors, re-keying locks, and other items. These appear to us to be reasonable and necessary measures under any security scenario, and even ORA's witness on cross-examination appeared to endorse adequate fencing as a minimum security need. And, as CalAm points out, these are capital investments similar to what we have previously accepted for CalAm and other Class A water utilities in their GRCs, not expense amounts of the type we have previously disallowed. We accept CalAm's estimates for security-related plant additions in TY2003 and TY2004.

Contamination-Related Projects

CalAm and ORA differ on the proper ratemaking treatment to be afforded to five Sacramento district capital projects undertaken to alleviate damage due to groundwater contamination caused by third parties. Those projects are: (1) Mather Booster Station; (2) Wilber Well; (3) New Suburban Service Area Well; (4) Water Treatment Improvements; and (5) Suburban Distribution System Improvements. The first, Mather Booster Station, is completed and in service while the others are planned for TY2003 and/or TY2004. ORA identifies a sixth project, Treatment for Entrained Gasses, as also being contamination-related and recommends the same ratemaking treatment for the same reasons. CalAm argues that this sixth project is not contamination-related, but also implicitly acknowledges that the gasses involved may not be naturally occurring. Accordingly we address ORA's ratemaking treatment for it here.¹⁵

CalAm believes that ORA has no dispute with either the prudence of these six projects or the amounts of the expenditures involved. We note that ORA's direct presentation does object that it was not provided with sufficient justification for several of them. Those objections were ill-defined and not pursued, however, so we consider ratemaking treatment of the projects, not their timing, cost or need, as the issue to be addressed.

ORA advocates placing the capital costs of these six projects into a deferred account for recovery from those parties eventually determined to be responsible for the groundwater contamination problems that necessitate them; ratepayers would bear none of the investment costs. CalAm would later be made whole through recovery of all or any portion of the costs from the contaminators, and its shareholders, not ratepayers, would suffer any recovery shortfalls. CalAm proposes the capital costs be included in rate base as any other plant investments would, and any later recoveries from third party contaminators would be treated as contributions used to reduce rate base.

ORA's arguments may be succinctly stated: Third-party contamination is a risk to be borne by shareholders, not ratepayers; contamination was a known issue when CalAm acquired the Sacramento district assets from Citizens, so it should have been reflected in the acquisition price; and, allowing CalAm to recover its costs from ratepayers would remove the company's incentive to seek recovery from those responsible. ORA rests its case on a statement of those principles and little further discussion.

CalAm criticizes ORA's recommendation:

That recommendation protects everyone except CalAm and its shareholders, who had nothing to do with creating the problem but who, under ORA's approach, would have to make the investment and bear all or at least a material portion of the carrying costs on that $4.25 million for an uncertain, indefinite time determined by CalAm's uncertain success in pursuing the wrongdoers. The ORA position is patently unfair to Applicant.¹⁶

However, CalAm's position is the mirror-image for ratepayers: Ratepayers would be totally unprotected and bear all the risk of non-recovery. Moreover, ratepayers would have to depend on CalAm to pursue any recovery, a CalAm with limited remaining incentive to do so. Under ORA's ratemaking proposal, at least the same party carrying the risk would have the responsibility and incentive to pursue the contaminators.

The prospects of recovery are unclear. On the one hand, CalAm on brief says it is pursuing the responsible parties, none of the charges are yet resolved, some are in negotiation, some are subject to tolling agreements to prevent running of the statute of limitations while negotiations continue, and some will probably have to be litigated. On the other hand, CalAm names three major contaminators¹⁷ but says it has yet to recover any monetary compensation and has no litigation currently underway.¹⁸ One CalAm witness' testimony was particularly pessimistic: "[P]enalizing CalAm... when a responsible party is not yet known, may not be found, may not be subject to prosecution or may have no means to pay for the contamination, is an extreme position. CalAm should not be held hostage... when a responsible party has not yet been determined."

Having described the issue, we turn to ORA's three main arguments stated earlier. First, contamination remediation is both a cost of business for water companies and one of those risks for which water utilities are compensated in their rates of return. That cost should be recovered from the contaminators whenever possible, and absent reasons to the contrary, any unrecovered amounts should be allocated between companies and their ratepayers considering the facts on a case-by-case basis. Second, there is insufficient evidence in the record to support a disallowance based on ORA's argument that the contamination problems were or should have been reflected in the Citizens acquisition price. Third, we are concerned about incentives. CalAm suggests it would be enough incentive for the Commission to order CalAm to file reports on a timely basis demonstrating what action it is taking against responsible parties, and then applying penalties or other measures if, after due process, those efforts are found deficient. We don't regard a simple reporting requirement as sufficient incentive considering that the amounts at stake are nearly 10% of rate base.

CalAm's proposal gives itself 100% protection and leaves ratepayers totally dependent on CalAm to pursue recovery. ORA's proposal leaves CalAm shareholders 100% at risk for all losses. There is no ideal ratemaking mechanism for this situation. The best we can do is keep CalAm whole while at the same time giving it a strong incentive to pursue the contaminators. To do that, we accept CalAm's estimated cost and timing for all six projects, and allow them in rate base accordingly.¹⁹ We announce our intention to order any eventual losses to be shared equally between shareholders and ratepayers by removing one-half of any remaining rate base value at the time new rates become effective in CalAm's next Sacramento district GRC, provided that CalAm may make an affirmative showing during the next Sacramento district GRC to demonstrate that reasonable progress has been made, and it has been and is continuing to make a good faith effort at recovery and should be allowed additional time before any final disallowance is made. CalAm shall bear the burden of proof if it chooses to make such a showing. CalAm and any other parties should at that time develop a record to define which projects and what amounts are involved. They may also present positions in support of a different outcome. When we believe the issue has matured sufficiently we will make a final determination.

Flat to Metered Conversion Project

CalAm plans to convert all 46,750 flat rate, unmetered residential connections in Sacramento district to metered service over a period of years. The application includes a $2,750,000 metering project in plant additions, but leaves all details to the company's extra-record workpapers. ORA reviewed those workpapers and summarized the plan as proposing $750,000 for the project in 2002, $500,000 in TY2003, and $500,000 in TY2004. Later information shows CalAm actually spent about $190,000 in 2002, and subsequently raised its meter conversion budget for the test years to $650,000 in TY2003 and $750,000 in 2004. ORA recommends the Commission not include the cost of CalAm's metering project in rates at this time.

ORA bases its disallowance entirely on CalAm's failure to address the standards set forth in Public Utilities Code § 781.²⁰ According to ORA, the Commission in D.90-06-030 ²¹ found that the standards of § 781 are appropriate to use as guidelines in considering utility requests for converting flat rate customers to metered service. Because CalAm did not do so, ORA recommends against including CalAm's meter conversion project in rates.

In the decision ORA relies on, Graeagle Water Company sought Commission authorization to mandatory convert all of its flat rate customers to meters and discontinue their flat rate service. The Commission in that case cited D.92489, Conclusion of Law #1: "The findings provided for in Section 781 of the Public Utilities Code need be made only when the Commission requires the installation of meters," to conclude that § 781 was not applicable to Graeagle's application. However, it also went on to conclude that it was appropriate to apply the standards set forth in § 781 as guidelines in considering Graeagle's request, and it proceeded to do so. This case is distinguishable from Graeagle by the fact that neither the Commission nor CalAm proposes through this GRC proceeding to require that unmetered customers generally, or any current unmetered customer, switch to metered service. Should CalAm later seek Commission authorization to impose metering on then-unmetered customers, we would consider the relevant facts and § 781 criteria at that time.

Having rejected ORA's reasoning, we turn to the plant additions amount CalAm is proposing for its metering conversion project. CalAm expected to spend $750,000 in 2002 on the project. It actually spent about $190,000. The overall program, and this project, are behind schedule. CalAm has provided ample justification for embarking on a meter conversion program, but other than the figures we have cited above, neither CalAm nor ORA has provided on the record any justification for the amounts or timing that CalAm seeks in the test years. According to CalAm, this is a 20 to 30-year program under current conditions. We will include it in rates with continued annual expenditures at the recorded 2002 level, with the knowledge that the Sacramento district's TY2005 GRC decision will automatically correct CalAm's going-forward rate base for expenditures above or below the amounts we project today.

Rate Base - Other Components

The differences in rate base components other than plant in service arise from differences in CalAm's and ORA's estimates in other areas.

Taxes

The differences in taxes arise from differences in CalAm's and ORA's estimates in other areas.

General Office

CalAm and ORA agree on the proper level of general office expenses to be allocated to each district. The general office figures set forth in the comparison tables accompanying the settlement are those for four districts, and are based on the allocations we adopted in CalAm's recent Monterey district GRC (D.03-02-030, as modified by D.03-06-043). CalAm's late-filed supplemental testimony of David P. Stephenson presented changes to the general office allocations for Sacramento, Larkfield and Felton districts necessitated by CalAm's post-hearing sale of Montara district.²² ORA has stated informally that it has no objection to receiving that testimony and no other party has objected, so we accept it as valid updating for the general office figures.²³

Acquisition Synergies

Citizens Synergies, and Future GRC Filings

CalAm and ORA agreed on the Citizens acquisition premium to be amortized in both test years in all three districts. Santa Cruz did not. CalAm on brief described the CalAm and ORA analysis as "a `simplified' approach to calculating the synergy savings from the Citizens' asset acquisition while remaining true to the Commission's guidelines in D.01-09-057." ORA evaluated CalAm's acquisition premium amortization figures in its pre-hearing investigation, concluded that CalAm was correct, and recommended in its direct showing that CalAm's position on that issue be adopted.²⁴ The comparison tables show unexplained differences between them in the acquisition premium amortization expense amount for Larkfield district in both test years, but those figures were superseded by the figures in CalAm's late-filed supplemental testimony of David P. Stephenson on behalf of CalAm noted in the General Office section above.

Santa Cruz expressed a host of objections to CalAm's synergies savings analysis and allocation. According to Santa Cruz, CalAm's synergies analysis is fundamentally flawed, in part because even if CalAm had not acquired Citizens' properties some other entity would have, and thus many of the benefits claimed would have been realized without CalAm's involvement. Some of the synergies savings, particularly those involving financing, were actually due to the RWE acquisition, and CalAm fails to distinguish between them. CalAm's claimed savings are based on excessively hypothetical circumstances, including an assumption that CalAm's cost of capital will be lower than Citizens' for the next 40 years. Some of the claimed synergies savings come from reductions in service. And, Santa Cruz argues, CalAm has not justified allocating any of the acquisition premium to either Montara or Felton.

We have examined each allegation in light of CalAm's showing and we do not agree with Santa Cruz. Most of the synergies savings accrue from cost of capital savings, cost of investment savings, and allocation of general office costs to Arizona; savings from other sources are small by comparison.²⁵ Cost of capital savings are a primary contributor, and those arise in large part from CalAm's much lower equity ratio (a topic we cover more fully in a later section).²⁶ We are convinced those savings do exist and came about due to CalAm's acquisition of the Citizens assets. In D.01-09-057, we approved allocating the Citizens asset purchase price among the six states involved on the basis of Citizens' gross plant. CalAm has extended that allocation method here down to the district level. Santa Cruz (and MSD with it earlier) argues that the share CalAm would allocate to Felton (and earlier, to Montara as well) is excessive, but it provides no better allocation proposal; its favored method is apparently to allocate none of the acquisition premium to Felton district, an outcome we reject as unsupported and unreasonable. We accept CalAm's acquisition premium amortization figures, as concurred in by ORA, for each district and test year.

We noted earlier Santa Cruz's objection to relieving CalAm from having to demonstrate synergies savings in future rate cases, in exchange for foregoing its opportunity to recover 10% of any excess proven synergies.²⁷ That objection is aimed at a two-part modification CalAm would have us order to the alternative sharing proposal adopted in D.01-09-057. The first change would be to eliminate the second synergies savings review in the 2004 Citizens Division GRC, and the second would be to eliminate CalAm's entitlement to a 10% share of any excess synergies savings.²⁸ These two changes have much to recommend them, and both are supported by ORA.²⁹ However, under Pub. Util. Code § 1708, when the Commission considers changing the outcome of a previous decision that was determined after hearings, absent justification to the contrary it must provide parties to that earlier proceeding both notice and an opportunity to be heard.³⁰ We have reviewed the various notices provided to the public and parties prior to the evidentiary hearings in this proceeding and find neither mention of these two proposals nor any indication that the parties in A.00-05-015 who are not parties to this proceeding were noticed of this GRC proceeding. We conclude that some parties to the proceeding that gave rise to D.01-09-057 have not been provided the notice and opportunity to be heard required by § 1708. We do not adopt CalAm's proposed modification to the alternative sharing proposal at this time, but we invite it to renew its request, with proper notice, in an appropriate future proceeding.

CalAm also seeks authorization to change the next GRC filing dates for Felton district to 2005 from 2004 (i.e., to request rates effective in January 2006 for TY2006). In R.03-09-005, our Rulemaking to evaluate existing practices and policies for processing GRCs and to revise the General Rate Case Plan for Class A water companies, we are currently reviewing the GRC filing requirements for all of CalAm's districts, including its former Citizens districts. Rather than decide CalAm's Felton district GRC filing schedule request here, we will consider it in the broader context of that rulemaking and coordinate it with the schedules for its other districts and those of the other Class A water utilities.

While we are willing to consider changing the Felton district GRC filing schedule in R.03-09-005, we must ensure that ratepayers fully realize the acquisition-related synergies due to them. Specifically, in D.01-09-057, we anticipated January 2004 GRC filings for rates effective in TY2005 in all of CalAm's former Citizens districts. Under the alternative rate sharing proposal we adopted in that decision, CalAm was to: recover in rates all proven synergies savings from the Citizens acquisition in 2002, 2003, and 2004; file TY2005 GRCs in January 2004; and through its TY2005 rates begin sharing with ratepayers the proven synergies savings in excess of those required to cover the acquisition premium amortization amounts. ³¹ Denying CalAm's request here and holding it to the D.01-09-057 filing schedule would be unrealistic in light of the timing of this decision, and unwise in the larger context of R.03-09-005. However, we still intend to ensure that ratepayers receive their share of the post-2004 Citizens acquisition synergies savings as D.01-09-057 anticipated, even if CalAm's request is granted and there is no TY2005 GRC for one or more of these districts. To accomplish that, for any Citizens districts for which there is no TY2005 GRC, revenues for service rendered on and after January 1, 2005 that are associated with the Citizens acquisition synergies savings in those districts will be made subject to refund pending a determination of what portion of the synergies savings are to be shared with customers.

RWE Synergies

By D.02-12-068 in A.02-01-036, the Commission authorized RWE and Thames Water Aqua U.S. Holdings, Inc. to acquire control of AWW, CalAm's parent. That acquisition closed on January 10, 2003. In approving the transaction, the Commission approved a settlement containing the following Condition #20:

20. For a period sufficient to cover a single full rate cycle for each of Cal-Am's four sets of filing districts, not to exceed four years from the date of closing, RWE, Thames, American and Cal-Am will implement a mechanism to track the savings and costs resulting from the proposed merger and a methodology to allocate all net savings and will submit to the Commission in writing a detailed description of that methodology in connection with future Cal-Am general rate case filings.

Commission Comment: We understand the use of the term "will" as if the parties had used the term "shall." The methodology to be developed shall allocate all net benefits to the ratepayers."

By Finding of Fact #19, the Commission interpreted Condition #20:

19. Through condition 20, the applicants are committed to pass through 100% of the future benefits of this transaction to CalAm's ratepayers.

Santa Cruz asserts that CalAm has failed to pass on in this proceeding those immediate and quantifiable benefits promised on the record in A.02-01-036 and required to be passed on by the Commission in D.02-12-068. On April 28, 2003, Santa Cruz (with MSD) filed a motion to suspend this proceeding until CalAm has identified and quantified all of the ratepayer savings achieved or achievable during TY2003 and TY2004, and to allow the opposing parties to conduct discovery on the topic. ORA supported Santa Cruz's motion.³²

CalAm's response to the motion acknowledged that there are immediate and quantifiable RWE-driven benefits that are not included in this proceeding, identified the sources of at least some of those benefits, and explained why Santa Cruz's motion should nonetheless be denied. CalAm's GRC applications were prepared during the first half of 2002 and the Notices of Intent filed on June 28, 2002, whereas D.02-12-068 was issued in December 2002 and the RWE acquisition closed in January 2003. Further, by settlement Condition #20 quoted above, and D.02-12-068, Ordering Paragraphs 12 and 13, CalAm will be tracking in a memorandum account the costs and savings resulting from the acquisition, must develop a methodology to allocate all net benefits to the ratepayers, and will carry the burden of proving that it has done so. CalAm anticipates it will make that showing with its next Citizens districts GRCs.

We agree with CalAm. Our D.02-12-068 and the RWE acquisition occurred too late to be properly reflected in this proceeding. Further, we made specific provisions in that decision to secure for CalAm's ratepayers the benefits from the transaction, including those immediate benefits which most concern Santa Cruz and ORA here, and ordered a deferral of certain attrition step increases to ensure ratepayers would receive them.³³ The ALJ's November 21, 2003 ruling denied Santa Cruz's motion to suspend and submitted the proceeding. For the reasons stated, we affirm the ruling.

Special Rate Requests

CalAm seeks approval of seven Special Rate Requests, each of which involves ratemaking treatment of some aspect of its operations. We deal with each here; the results are reflected in other areas of this decision where appropriate.

Special Rate Request #1

In 1995, Northridge Water District entered into a contract with Placer County Water Agency under which the District became entitled to receive up to 29,000 acre feet of water annually from the Agency. As a condition of receiving that water, Northridge was to petition the California Water Resources Control Board to change the authorized place of use to include Northridge's service area. In May 1996, Citizens Utilities Company of California entered into a cost-sharing agreement with Northridge to include Citizens' Sacramento district in the change of use petition. By Resolution W-4001, the Commission authorized Citizens "to establish a memorandum account to record the expenses associated with the start up costs for surface water procurement from Placer County Water Agency," i.e., the costs of joining with Northridge to include Citizens' service area as an authorized place of use. The petition was successful, and CalAm, Citizens' successor, now seeks to transfer the $192,179 memorandum account balance to plant in service and close the account.

ORA opposed CalAm's request, initially because CalAm had inadvertently misstated what the memorandum account funds were used for, and later because CalAm had not yet executed a contract with Sacramento Suburban Water District, Northridge's successor, to purchase part of the available water. Our review of the evidence confirms that the bulk of the funds were expended for the purposes anticipated in Resolution W-4001, although we cannot confirm the exact amounts. CalAm's witness provided a draft of the proposed water purchase contract and predicted it would be completed in about 90 days.

While CalAm would still prefer the Commission approve transferring the memorandum account balance into 2003 plant in service in this GRC, ORA's witness and CalAm also now agree that could be done through an advice letter filing once the Sacramento Suburban Water District contract has been executed and reviewed for need and reasonableness. ³⁴ We adopt that outcome.

Special Rate Request #2

On January 21, 1998, the Commission issued Resolution W-4089 authorizing three Class A water utilities to establish memorandum accounts for water contamination litigation expenses they expected to incur as a result of lawsuits then pending against them. On March 26, 1998, the Commission issued Resolution W-4094 extending memorandum account authorization to all water utilities under its jurisdiction. Resolution W-4094 explicitly noted that additional lawsuits had been filed against Citizens Utilities Company of California charging groundwater, soil and air contamination in the Sacramento Valley Basin. CalAm acquired Citizens' assets effective January 15, 2002, including, CalAm asserts, a deferred asset consisting of the right to recover $559,462 in Citizens' contamination litigation memorandum account. Further, although the suits against Citizens are still pending, CalAm says it bears none of the liability for the defense or possible outcome of those suits; that liability remained with Citizens following the acquisition. Thus, there were no more litigation costs to be entered into the memorandum account after the acquisition. Through SRR#2, CalAm seeks to: (a) recover the memorandum account balance in rates between now and December, 2007; (b) include the average annual remaining uncollected balance in rate base; and (c) close the account.

ORA opposes CalAm's request. First, ORA believes CalAm is premature in requesting recovery because Order Instituting Investigation (I.) 98-03-013 into water contamination is still open,³⁵ the Commission has yet to open the water quality investigation it anticipated in one of the decisions in that proceeding, and the contamination lawsuits against Citizens are still pending. Second, the contamination lawsuits are against Citizens, not CalAm, and the responsibility for them belongs to Citizens' shareholders, not CalAm's current ratepayers. Third, a memorandum account is not an entitlement to collect, and thus CalAm could not purchase it and classify it as a deferred asset. Fourth, the application does not present sufficient information to determine a reasonable level of expenses to be recovered from ratepayers.

We deny CalAm's request, primarily for ORA's fourth reason. CalAm introduced into evidence an April 10, 1998 letter from our Water Advisory Branch to all water utilities informing them that the Commission had authorized water contamination litigation memorandum accounts and attaching copies of Resolutions W-4089 and W-4094.³⁶ Inexplicably, CalAm included the letter's Resolution W-4094 attachment but not the Resolution W-4089 attachment. Resolution W-4094 incorporated the provisions of Resolution W-4089 by reference and is not meaningful without it, so we take official notice of Resolution W-4089.³⁷ Those incorporated provisions required, among other things, that when water utilities seek authorization to recover their contamination litigation memorandum account amounts, the Commission will consider: whether the utility has "use[d] every means possible to maximize its insurance proceeds" (i.e., proceeds related to both awards for liability and defense of the lawsuit) and "aggressively pursued legal action for recompense from the original polluters"; whether the litigation ended with a settlement; whether all of the costs claimed were from after the date the Commission authorized the memorandum account; whether the amounts claimed included other costs such as public relations fees, water quality testing costs, and/or other consulting fees; and whether any of the expenses claimed were already included in rates. The utility's filing must "include a thorough and detailed explanation of the costs incurred and a justification of their reasonableness for recovery."

CalAm's showing in this proceeding has been little more than an explanation of the background and a statement that it should be allowed to recover $559,462 because it "purchased all of the water utility assets of Citizens, including this deferred regulatory asset." CalAm's showing does not meet the standard we set forth in Resolutions W-4089 and W-4094. Our denial here is without prejudice; CalAm may renew its request in its next GRC.

One more aspect of this issue merits noting. Resolution W-4089 makes the following statements in reference to contamination litigation memorandum accounts:

A memorandum account is not a guarantee of eventual recovery of expenses, nor is it carried as a regular account under the uniform system of accounts for water utilities. It is carried `off the books,' as a memo account.

* * *

Our policy on memo account treatment has always been that the burden of proof of the reasonableness of expenses charged to the account is the responsibility of the utility requesting reimbursement of such expenses. We see no reason to deviate from this procedure in this instance. [Emphasis added].

These statements are consistent with our treatment of memorandum accounts in general. In light of this, we find CalAm's claim that the memorandum account balance is a "regulatory asset" troubling. ORA speaks disparagingly of that classification, but does not follow up to explain the accounting and ratemaking consequences. ³⁸ Our concern stems from the fact that in D.01-09-057 we defined the Citizens acquisition premium to be amortized in rates as the excess of purchase price over net book value of the California assets being purchased.³⁹ Simply stated, if the memorandum account balance is not properly accounted for as part of the net book value of the former Citizens assets, then it is part of the acquisition premium and thus the acquisition premium amortization expense already being recovered elsewhere in rates. The record in this proceeding does not allow us to make that determination. Should CalAm decide to renew its request in its next GRC, we expect it to carry the burden of proving that the amount it is claiming was part of the $93.957 million net book value of the California assets referred to in D.01-09-057 and not part of the $64.553 million acquisition premium already accounted for in rates.

Special Rate Request #3

CalAm seeks to recover through a rate surcharge the accumulated balances in its Sacramento district purchased power balancing and memorandum accounts as of December 31, 2002. ORA does not oppose the request, but believes CalAm should follow the procedures set forth in the Commission's Balancing Account Rulemaking Proceeding, Rulemaking (R.) 01-12-009. CalAm accepts ORA's recommendation.

The Commission issued D.02-12-055 defining the procedures for Class A water utilities to dispose of balancing account balances accrued before November 29, 2001. After the evidentiary hearings in this proceeding, it issued D.03-06-072 adopting procedures for Class A water utilities to dispose of balancing-type memorandum account balances accrued on or after November 29, 2001. We will require CalAm to file advice letters seeking Commission approval to recover its Sacramento district balances of both types through December 31, 2002 following the procedures adopted in those two decisions. In consideration of the timing of this GRC, any deadlines set forth in those decisions for such filings are waived for this Sacramento district filing. CalAm must file its advice letter(s) within 60 days of the effective date of this decision.

Special Rate Request #4

CalAm and ORA agree that Felton district Rate Schedule No. FE-6M should be eliminated. This schedule related to a former resale customer, has been inactive for an extended time, and serves no purpose. We concur.

Special Rate Request #5

CalAm proposes to increase its after-hours reconnection charges (Tariff Rule 11.C.1) in all three districts to $50 from $15. The current charge dates back to 1973 and, CalAm believes, falls far short of covering its related expenses, thus requiring the majority of its customers to support the few who are shut off for nonpayment. ORA recognizes that CalAm's proposal has merit but has not seen sufficient cost justification that it could endorse CalAm's request as reasonable.

CalAm claims its labor expenses are at least $70 (minimum two hours overtime plus 40% benefits) to reestablish service after hours. CalAm has provided on the record its average pay rate, payroll benefits, and minimum work time for after-hours reconnections, and the resulting calculations do support an expense of greater than $50 per reconnection.⁴⁰ Further, CalAm points out that the reconnection charges authorized for other Class A water utilities range up to $65, so CalAm's proposed charge appears supported and reasonable. CalAm notes that any additional revenue generated would be minor. We adopt CalAm's proposal.

Special Rate Requests #6 and #7

CalAm's applications propose to combine Larkfield district with Sacramento district, and Montara and Felton districts with Monterey district, for ratemaking purposes.⁴¹

CalAm would consolidate the Larkfield and Sacramento districts over time. Rates in Larkfield, excluding private fire protection service, would be held constant until the rates in Sacramento approximately equal (within 25%) those in Larkfield, plus a quantity rate differential in Larkfield to compensate for its higher per-unit purchased water cost. Sacramento customers' increased rates would provide the subsidy necessary to hold Larkfield customers' rates constant.⁴²

Felton and Montara districts would be consolidated with Monterey district by holding Montara's rates constant and increasing Felton's rates immediately to those of Monterey's standard rate design. The resulting revenue shortfall would accumulate in a new WRAM (Water Revenue Adjustment Mechanism) balancing account to be recovered from customers of all three districts in the next GRC.⁴³ CalAm proposes that this new WRAM bear interest and be exempt from any earnings tests or further Commission review beyond verification of the calculations in the account. Felton's current conservation discount and Safe Drinking Water Bond Act loan surcharge, and Montara's Master Plan investment surcharge, would be continued.

ORA and the other parties oppose both consolidation proposals. Jeff Almquist and Santa Cruz would instead have the Commission order CalAm to consolidate Larkfield, Montara, Felton and Sacramento by combining their revenue requirements and applying the Commission's standard rate design methodology to develop a single, uniform set of rates for the consolidated district. CalAm opposes the Almquist and Santa Cruz consolidation alternative.

ORA's opposition relies almost entirely on a set of policy guidelines developed jointly in 1992 by the Commission's Division of Ratepayer Advocates (ORA's predecessor) and the Class A water companies. Those guidelines established four criteria to be met in considering district consolidations:⁴⁴

1. Proximity: The districts must be within close proximity to each other. It would not be a requirement that the districts be contiguous as it is recognized that present rate-making districts consist of separate systems which are not connected. It was suggested that districts within 10 miles of each other would meet the location criteria.

2. Rate Comparability: Present and projected future rates should be relatively close with rates of one district no more than 25% greater than rates in the other district or districts. To lessen the rate impact of combining districts it may be necessary to phase in the new rates over several years.

3. Water Supply: Sources of supply should be similar. If one district is virtually dependent upon purchased water, while another district has its own source of supply, future costs could change by a greater percent for one district versus the other. This could result in significantly different rates in the future even if present rates were quite similar.

4. Operation: The districts should be operated in a similar manner. For example, if a single district manager presently operates two or more districts and the billing system is common to the same districts, such an operation would support the combination of the districts.

It was agreed that no districts would be combined for the express purpose of having one district subsidize another.

Although some of these factors remain relevant to our consideration, we note that we have previously stated in D.00-06-075:

[W]e believe that Branch's reliance on our Water Division's 1992 guidelines for combining water utility districts is misplaced. As the testimony at hearing showed, the guidelines were intended then, and continue today, to set criteria for single tariff pricing that, when met, establish prima facie reasonableness of the proposed consolidation. A number of rate consolidations have been approved pursuant to the guidelines without opposition by the Commission's advocacy staff. The guidelines, however, implicitly permit proposals for broader rate consolidations, with the understanding that such proposals are likely to be protested by the advocacy staff in order that a full record can be developed for Commission consideration.⁴⁵

For this reason, we cannot make a determination on the proposals' failure to meet some, or even most, of the four consolidation guidelines set forth above as ORA would have us do.

CalAm offered conflicting testimony as to whether its proposals meet the guidelines. On the one hand, "Applicant believes that this request [consolidating Montara/Felton/Monterey, and separately, Larkfield/Sacramento] satisfies the criteria set forth in the guidelines," while on the other, "[T]he Company presently meets certain of the criteria of the Guidelines for district consolidation, and will but does not currently meet others."

CalAm acknowledges that neither set of districts meets the proximity criterion.⁴⁶

With respect to the rate comparability criterion, CalAm states, "The standard rates for the Monterey district and Felton district are essentially the same." However, it also shows that applying those then-proposed Monterey standard rates to Felton district customers would generate $810,000 in revenues in TY2004 compared to $1,241,000 in revenues that its "essentially the same" proposed Felton stand-alone rates would generate.⁴⁷ And for Larkfield/Sacramento, "The current tariffs for these two districts do not meet that [rate comparability] criterion; the current rates in the Larkfield district exceed the rates in the Sacramento district by a little over 100% for residential metered customers consuming 10 units per month."⁴⁸

With respect to the water supply criterion, Felton relies on ample supplies from its creeks and springs, whereas CalAm's Monterey water supply is fraught with complication and subject to great uncertainty over the coming years.⁴⁹ It would be difficult to conclude that their source of supply situations are similar under the circumstances. Larkfield and Sacramento both rely largely on well production with lesser amounts of purchased water. To allow for their differences, CalAm would establish a quantity rate differential in Larkfield to compensate for its higher per-unit purchased water cost.

The former Citizens districts do appear to be operated in a similar manner. They share common upper management, sources of capital, and billing and accounting resources. Each uses local personnel for day-to-day operations on site and relies on out-of-state personnel for customer service functions.

CalAm describes four past Commission decisions as precedent for its proposed consolidations. Three of those decisions, however, were settlements which under the Commission's Rules of Practice and Procedure, Rule 51.8, cannot be considered precedential unless the Commission expressly provides otherwise.⁵⁰ It did not do so. The fourth was a Southern California Water Company proposal to introduce single tariff pricing for eight water districts comprising a single region in the Los Angeles area.⁵¹ There, in a single-issue proceeding, the Commission was able to examine the company's proposal and its short and long-range effects in great detail. Among other considerations, the company presented, and the decision lists, the average annual water bill at stand-alone rates and at the proposed regional rate for each the eight districts for every year from 1999 through 2015. Thus, the record made very clear how customers would be affected over a long period, and the Commission was able to conclude that the advantages of single tariff pricing in the region outweighed the disadvantages.

In this proceeding, no such clear picture has been presented for either CalAm's proposed consolidations or that of the intervenors. There has been no examination of the customer effects in coming years of the very significant capital projects CalAm anticipates in Sacramento district or Monterey district. What has been presented is now out of date in that it still includes the effects of a divested Montara district. The record is further complicated by the recent Citizens and RWE acquisitions, the costs and benefits of which will continue to be sorted out and reflected in district rate proceedings over the next several years. We are also troubled by CalAm's proposal to shunt very large amounts of current revenue requirement into a proposed WRAM to accumulate as an interest-bearing obligation against Felton and Monterey customers in future years.

For these reasons, the record in this proceeding does not allow us to find that the advantages of district consolidation outweigh the disadvantages. However, because of the size of the rate increases that our authorized revenue requirements would likely produce for Felton (which are discussed below), the public interest would be better served by a timely consideration by this Commission of rate consolidation proposals with an evidentiary showing that fully addresses the issues identified above. We will therefore order that CalAm make such an application within 90 days of the adoption of this order.

Cost of Capital

In order to determine a fair rate of return for a utility, we determine the proportions 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.

Capital Structure

CalAm's application-proposed capital structure consisted of the following proportions of long-term debt and equity: for TY2003, 63.99% and 36.01%; for TY2004, 63.73% and 36.27%; and for 2005, 63.63% and 36.37%. ORA concurred. That capital structure is reflected in our adopted rate of return for TY2003 and TY2004, Table 3 below.

Cost of Debt

American Water Works completed its $161 million acquisition of the Citizens assets in California on January 15, 2002. In connection with that acquisition, CalAm issued a five-year, 4.92% note with its affiliate, American Water Capital Corporation, for approximately $104 million, and is maintaining a separate ratemaking capital structure for these former Citizens districts to allow it to demonstrate to the Commission the cost of capital savings that help support amortizing the acquisition premium in rates. CalAm and ORA added to the capital structure approximately $2 million in additional long term debt issuances each year from 2002 through 2005. Both estimated their projected long-term interest rates for those new debt issues by adding 150 basis points to the forecasted 10-year Treasury bond rate. CalAm later accepted ORA's projections, and the results are shown in Table 3 below.⁵²

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 investment (ROE), 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.

We have many times over the years cited the well established legal standard for determining a fair ROE. 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.

CalAm, ORA and Santa Cruz each made a showing to support an ROE recommendation. With the principles above in mind, we first describe the methods each used, and then discuss our evaluation of them.

CalAm's Recommended Return on Equity

CalAm used a variety of analytical techniques, including DCF (discounted cash flow) and RP (risk premium) models, but ran them on different, more varied sets of data than did ORA.⁵⁵ Using data available in mid-2002, CalAm presented three DCF estimates (one said to be based on a sample of water utilities used by ORA in an earlier GRC proceeding, one based on its own sample of water utilities, and the third based on gas utilities), three RP analyses (one based on water utilities and two on gas utilities), and an internal rate of return analysis. CalAm shows estimated equity costs ranging from 10.6% to 11.8% by the DCF method, and 11.4% to 11.8% for the RP method. CalAm's equity cost estimates range up to 13.1%.⁵⁶ Only one is as low as 11%, and its witness recommends it be given little weight because it was based on ORA's sample of water utilities. In addition to using more, and more varied, data sets, CalAm also relied at several points on ROE adders and adjustments intended to conform its analyses more closely to CalAm's situation. CalAm concluded that its cost of equity is in the range of 10.6% to 11.8%, and its final recommendation was an ROE no less than 11.0%.

ORA's Recommended Return on Equity

To determine the appropriate ROE, ORA performed a quantitative analysis and then assessed the level of business and financial risk CalAm faced. In its quantitative analysis, ORA also used DCF and RP models to estimate investors' expected ROE, and applied both models to a group of comparable water utilities selected based on two criteria: (1) water operations account for at least 70% of their revenues, and (2) their stocks are publicly traded. The comparable group comprised six companies: American States Water, California Water Service, Connecticut Water Service, Middlesex Water, Philadelphia Suburban, and San Jose Water. ORA's DCF analysis yielded an average expected ROE of 8.00%. Its RP analysis produced 10.96%. It averaged the two results to produce its 9.48% final recommended ROE for CalAm.

ORA concluded that CalAm's business risk, which ORA related primarily to regulatory risk, was low, citing the Commission's many risk-reducing mechanisms available to water utilities. Those mechanisms include balancing accounts (now redesignated as balancing-type memorandum accounts) for purchased water, purchased power, and pump taxes, memorandum accounts for catastrophic events and for Safe Drinking Water Act compliance, 50% fixed cost recovery in the service charge, and construction work in progress in rate base. ORA also evaluated CalAm under a set of benchmark financial ratios used by Standard & Poor's to assess business risk and found CalAm would merit an A rating, within the range considered "investment grade." ORA judged this to be a clear indication of CalAm's ability to attract capital.

ORA also noted that CalAm's average equity ratio during the test years will be lower than the comparable group's average. While a low equity ratio can indicate increased financial risk, ORA stopped short of drawing that conclusion for CalAm.

Santa Cruz's Recommended Return on Equity

Santa Cruz's witness presented and defended the results of three different ROE models: a Value Line dividend-growth model yielding 9.02%, a retention-ratio (sustained earnings) DCF method producing 9.11%, and an earned-return RP method producing 9.47%. He initially recommended the Commission adopt the average of the three results, 9.2%, and later increased that figure to 9.3%.⁵⁷ Santa Cruz characterizes its analysis as more sophisticated than CalAm's, and being based on much later data that better reflects conditions at the time of the hearings.

Return on Equity Discussion

ORA and Santa Cruz attack perceived shortcomings in CalAm's ROE showing, and CalAm does likewise to ORA's and Santa Cruz's showings.⁵⁸

CalAm's primary cost of capital witness on rebuttal addressed five aspects of ORA's analysis. First, CalAm maintained that its lower than average equity ratio benefits ratepayers but also means more risk for its shareholders, and that ORA failed to impute an ROE adder to flow some of that leverage benefit back to shareholders.⁵⁹ Second, CalAm charges that ORA's DCF model produces an ROE that is less than the cost of Baa-rated investment grade bonds. Third, CalAm believes ORA's RP analysis provides a reasonable but conservative estimate for less leveraged water utilities, but CalAm merits an ROE adder (similar to the adder in the first point above). Fourth, CalAm argues that ORA should have given no weight to historical growth estimates because past growth in earnings per share, dividends per share, and retained earnings understate the growth investors currently expect. Fifth, CalAm showed that by, e.g., changing ORA's averaging method and excluding one or more of the water utilities in ORA's sample, it could greatly increase the resulting ROE from ORA's DCF analysis. Elsewhere, CalAm criticized the spread between ORA's DCF and RP result as being too wide and urged throwing out the lower DCF figure, and took issue with ORA's rejection of "v*s growth" in its DCF model.

CalAm was similarly critical of Santa Cruz's ROE showing for not imputing an ROE adder flowing back to shareholders some of the leverage benefits ratepayers may realize from CalAm's low equity ratio. Some of CalAm's other criticisms concerned Santa Cruz's use of growth forecasts of dividends per share rather than earnings per share in its DCF analysis; its initial omission of v*s growth in its estimate of sustainable growth in the DCF model, and the way Santa Cruz calculated v*s growth when it did later agree to include it; its use in the RP model of a 4.4% estimate for the average 10-year Treasury rate in 2003 rather than an average 5.62% Treasury rate reflecting 2003, 2004, and 2005;⁶⁰ and an alleged inability of Santa Cruz's three-stage growth DCF model to accommodate growth prospects that improve over time. CalAm also faulted the opposing parties for their use of market-oriented methods to estimate investors' expected market return on their market-valued investments, rather than expected return on book value common equity. Lastly, CalAm on brief called ORA to task for its too-low recommendation in light of these recent large water utility ROE awards which it notes: San Gabriel Valley Water Company, 9.83%; Apple Valley Water Company, 9.53%; Valencia Water Company, 9.72%; CalAm's Monterey district, 10.25%; and Suburban Water Company, 9.84%.⁶¹

ORA's direct testimony took issue with seven components of CalAm's ROE presentation. First, CalAm relied too heavily in its analysis on comparisons with gas utilities, a practice the Commission has repeatedly rejected in the past. Second, CalAm's call for an ROE adder to allow it to partake in savings generated by its lower than average equity ratio runs contrary to its representations in the RWE acquisition proceeding where it and the other applicants stated that CalAm's financing costs would go down due to that acquisition and ratepayers would receive the resulting benefits. Third, ORA believes CalAm should not cite uncertainty in the weather as anything but a normal risk of doing business as a water utility, already taken into consideration by the informed investor and accounted for in the market-based models. Fourth and fifth, ORA took issue with CalAm's characterization of the Commission's attrition step rate procedure and then-proposed new balancing account procedures as greatly increasing its risk by serving as de facto caps on its earnings. According to CalAm, "They create a one-way street where the earned ROE can be lower than is authorized, but not higher than authorized."⁶² Sixth, ORA performed a detailed analysis of authorized water returns and bond costs, and it showed, contrary to CalAm's assertions, that no consistent relationship exists between interest rates and authorized ROEs over the past eight years. And seventh, ORA rejected CalAm's use of a v*s growth factor in calculating sustainable growth, on the grounds that the v*s factor is associated with use of issuance cost in determining ROE, a concept ORA says the Commission has previously rejected.

Santa Cruz took issue with CalAm's use of a single-stage growth model; a leverage-based ROE adjustment; a 2003, 2004 and 2005 average of the projected 10-year Treasury rate rather than the TY2003 projection; and CalAm's reliance on unreasonably high earnings growth estimates and Value Line's Blume-method adjusted betas in capital asset pricing model work, both of which, Santa Cruz charges, improperly inflate the estimated ROE.

These charges and countercharges are too many and too technical to address here individually. In arriving at our conclusions, however, we have fully considered the parties' direct and rebuttal showings on each of them.

Commenting first on ORA's presentation, we remain concerned by the spread between its DCF and RP estimates. That is a concern we have also expressed in past GRC decisions. In this case, the initial spread narrowed with the updated DRI forecasts ORA later presented for Treasury's and Baa-rated bonds,⁶³ and ORA's methods and the resulting estimates seem otherwise technically correct, so we decline to reject them. CalAm would have us eliminate the spread by disregarding the lower, DCF result, but that change is no more supportable than throwing out the higher, RP result. We are impressed by ORA's straightforward, point-by-point rebuttal of this and CalAm's other criticisms.⁶⁴ ORA's resulting 9.48% ROE recommendation is lower than we will adopt here, but more realistic and closer to our final adopted ROE than is CalAm's.

Because a portion of its background material was stricken during hearings,⁶⁵ Santa Cruz lacked a good narrative explanation of its method in its direct showing. However, what we learned of its method through the remaining testimony and exhibits showed that Santa Cruz had taken a well thought out and balanced approach that produced results that, like ORA's, fell within a reasonable ROE range. In response to CalAm's criticisms on rebuttal, the Santa Cruz witness agreed to adjust his final estimate to include an additional 27 basis points of v*s growth in his retention-ratio DCF method ROE, producing a final 9.3% ROE recommendation.⁶⁶

All three parties' direct ROE witnesses seemed competent and well informed on the topic. CalAm's presentation was, in fact, a technical tour de force, nearly overwhelming in its detail and complexity. Whether it was persuasive was another matter. We find it disappointing that CalAm has relied so heavily in its analysis on comparisons with gas utilities, a practice the Commission has repeatedly rejected in the past because water utilities are less risky.⁶⁷ CalAm reduces the resulting ROE by 50 basis points when comparing water utilities with gas utilities, but that is an arbitrary and unconvincing adjustment considering that CalAm acknowledges it is based only on the witness' judgment, and in light of the Commission's specific rejection of such comparisons in the past.⁶⁸ In any case, he later adds back 60 basis points to each of his ROE results to adjust for his belief that CalAm is more risky than the average water utility in the samples, thus more than negating the earlier reduction and generating a higher ROE for CalAm than his analysis indicates would be warranted for gas utilities.

We are also unimpressed by some of the other contentions CalAm advances in support of its much higher ROE recommendations. First, according to its expert rebuttal witness, "Balancing accounts [in California] have been discontinued, yet the awarded costs of common equity have still been well below national norms."⁶⁹ In R.01-12-009, our Balancing Account Rulemaking, we redesignated as "balancing-type memorandum accounts" the type of balancing account to which the witness is likely referring. What has changed, besides the designation, is that these accounts may no longer be claimed as an asset on water utilities' balance sheets.⁷⁰ What has not changed is that they continue to provide water utilities valuable protection against underearnings caused by increased costs of the types they cover. Second, CalAm's primary ROE witness describes the attrition step rate procedure and the then-proposed balancing account procedures as "treating the [authorized] ROE as a ceiling rather than a target ROE." He goes on to characterize them as making the authorized ROE the maximum ROE that can be earned and thus denying the utility a fair opportunity to earn it.⁷¹ The Commission has long applied the earnings test to which he is referring, and it has not had the effect he claims, as demonstrated by CalAm's acknowledged long, consistent history of overearning its authorized ROE in California.⁷²

If one theme predominated in CalAm's ROE presentation, it was its consistent claim throughout to an ROE adder to reward shareholders for their low equity ratio. We do acknowledge that a low equity ratio is an important factor that lowers CalAm's cost of service.⁷³ In this case, however, CalAm's cost of capital is a primary contributor to the synergies savings resulting from CalAm's acquisition of the Citizens properties. The record clearly shows that CalAm's low equity ratio contributes directly to that cost of capital synergies savings.⁷⁴ To the extent those synergies savings exist, they go first to CalAm as compensation to amortize, and to pay a return on the unamortized balance of, its acquisition adjustment, and then to ratepayers.⁷⁵ Thus, the dollars associated with the ROE adder CalAm seeks as a reward for maintaining a low equity capital structure are already flowing to CalAm to amortize the premium it paid to acquire Citizens' assets.

After evaluating the parties' ROE models, we find that CalAm's analyses were less credible than those of the other parties, and produce results that fail a reasonability test. In addition to the infirmities we note above, investors in today's economic climate and over the forthcoming rate case cycle will not require CalAm to earn after-tax returns at or above 11% to make equity investments in it.⁷⁶

We turn to a combination of figures drawn from the parties' recommendations to establish an authorized ROE. First, when we set aside CalAm's results based on comparisons with gas utilities and those based on a low equity ratio adder, what remains is an ROE range of 10.0% to 11.2%.⁷⁷ The 10.6% midpoint of that range, combined with ORA's 9.48% and Santa Cruz's 9.3%, gives an overall average ROE of 9.79%. Next, CalAm on brief presents from data in the record an historical average 2.23% spread between Commission-authorized ROEs and each prior year's Baa bond interest rate, and produces an ROE for this proceeding by adding to it the 7.57% latest DRI projection of the average Baa bond rate for 2003, 2004 and 2005, and a low equity adder. ⁷⁸ No party endorses this method as a stand-alone ROE result, nor do we, but it does provide a reasonability check in combination with other methods. Without the low equity adder, it produces a 9.80% result.⁷⁹ And lastly, as another reasonability check, 9.80% is very close to the 9.83% average of the five recent large water utility ROE awards CalAm notes in its brief and we list above. We adopt an ROE for CalAm of 9.79% for TY2003 and TY2004.

Rate of Return on Rate Base

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

Table 3

Adopted Cost of Capital and Rate of Return

	Adopted
	Capital Structure	Cost	Weighted Cost
TY2003
Long-Term Debt	63.99%	4.97%	3.18%
Common Equity	36.01%	9.79%	3.53%
Total	100.00 %		6.71%
TY2004
Long-Term Debt	63.73%	5.00%	3.19%
Common Equity	36.27%	9.79%	3.55%
Total	100.00 %		6.74%

The extraordinarily low overall adopted rates of return on rate base, 6.71% for TY2003 and 6.74% for TY2004, are the direct result of weighting in the very large, $104 million, 4.92% interest rate note issued in connection with CalAm's purchase of the Citizens assets, as discussed in the Cost of Debt section above.

Step Rate Increase Filings

The parties raise two issues concerning the pro-forma earnings test to be applied to CalAm's 2004 step rate filing: the proper rate of return to use, and the proper sales figures to use. We previously considered both issues in CalAm's most recent GRC decision for Monterey district, D.03-02-030, and we reach the same outcomes here that we did there.

The rate of return in this proceeding is based on a different capital structure than would be used for CalAm's other, non-Citizens districts. CalAm points out that it would not be appropriate to apply the rate of return from any future GRC decision for its non-Citizens districts in the pro-forma earnings test for these Citizens districts. ORA's position is unclear because of clerical errors in that section of its exhibits. We addressed this issue in reverse in D.03-02-030 when we determined that the Monterey Division pro-forma earnings test should not use a rate of return ordered in a Citizens district GRC. We arrive at the same conclusion today: The Citizens districts' pro-forma earnings test should use only a Citizens district rate of return.

Second, ORA recommends that the recorded sales per customer for residential and commercial customers be used instead of the adopted sales per customer for revenue calculations in the pro-forma earnings test.⁸⁰ CalAm opposes ORA's recommendation as both unfair and a change from longstanding practice. Both sides make excellent arguments, but we reject ORA's recommendation today for the same reason we did in D.03-02-030: "The current procedure for processing rate increases, including step rates, may not be perfect, but it has proven effective for a number of years. Any change in the current procedures needs to be open to formal discussions with all water utilities and members of staff. Changes in these longstanding procedures should not be made in one company's rate case application."

In D.02-12-068 approving the RWE acquisition, we approved a settlement containing this provision as Condition #1: "Sacramento, Felton, Montara and Larkfield: Defer filing the authorized 2004 step rate increase that would have been filed in 2003. File a general rate case application in January 2004 for new rates effective January 2005." We have made a minor modification in our otherwise-standard step rate increase ordering paragraph to accommodate Condition #1 as D.02-12-068 required.

CalAm has also requested we establish a Felton district 2005 step rate increase, but, under the requirements of D.02-12-068, any 2005 step rates could not become effective until at least January 2006.⁸¹ We have not provided a 2005 step rate increase in this order because CalAm's next GRC for its Citizens districts will be for either TY2005 or TY2006, and 2006 should not be both an attrition year in this rate case cycle and a test year in its next rate case cycle.

Rate Design

In our discussion above of SRR#4, we agreed that Felton district Rate Schedule No. FE-6M should be eliminated, and in SRR#5 that the after-hours reconnection charges in all three districts should increase to $50 from $15. In SRR#6 and SRR#7, we determined not to allow district consolidations with their attendant subsidies and rate redesigns at this time. Those rate design issues having been decided, we follow ORA's otherwise-uncontested recommendation by applying the standards set forth in D.86-05-064 in I.84-11-041, the Commission's investigation into water rate design policy. Our policy calls for metered rates to be set to recover up to 50% of fixed costs in the service charge, and up to three quantity blocks (in this case, we use a single block). Residential flat rate service and private fire protection service are increased by approximately the overall percentage increase in each district, and the current conservation discount and Safe Drinking Water Bond Act loan surcharge are continued in the Felton district.

Appendix E provides a comparison of typical bills at present and authorized rates for residential metered customers in each district at various usage levels and the average usage levels.

Service Quality

ORA recommended the Commission find service to be satisfactory in all four districts. ORA tabulated the number of customer complaints received for each district between 1996 and 2001 and found that they had been resolved within a reasonable period after notification. There was no indication of what other considerations, if any, led ORA to make its recommendation.

Almquist's prepared direct testimony on behalf of Santa Cruz⁸² alleged that service in the Felton district had not been improved by the district's consolidation into CalAm's wider operations. According to Almquist,

Numerous residents [in the Felton public participation hearing] told of how they now had to call a customer service number in some other area of the country in order to communicate with the company regarding service requests and all other business. When residents have tried this number they end up in a voice mail system that tells them that the company is experiencing a high volume of calls and is unable to serve them. They are asked to call back later.⁸³

To verify this, he had an aide place three calls over a two-day period, and each time the aide was told by a machine that the company was experiencing long hold times and high call volumes and to try again later.

A review of the Felton district public participation hearing transcript confirms that one public speaker told of having made three unsuccessful attempts to reach the company's customer service number before giving up and going to the company's local office in person.⁸⁴ No other speakers related similar experiences.

To reach customer service, CalAm's California customers call a local number and are routed to service representatives in American Water Works' Alton, Illinois call center. CalAm's witness acknowledged that a number of customer calls were not resolved satisfactorily upon the first contact by a customer to the company, and in some cases, follow-up was too slow.⁸⁵ The witness described several measures taken recently to address those shortcomings: increased service representative authority to resolve concerns on the first call, including increased no-fault settlement limits; a modification to the system to provide better tracking of calls requiring investigation and follow-up; and revised billing system settings to more quickly identify anomalous meter readings before bills are mailed. Had these improvements been in place in 2002, CalAm believes, some 22 complaints would have been resolved on the first call instead of developing into informal Commission complaints.

In D.02-12-068 approving CalAm's acquisition by RWE, we stated,

In order to mitigate customer concerns about lack of responsiveness due to foreign ownership, we require Cal-Am's customer call center to meet the above targets for each of the categories listed above, averaged on a quarterly basis. We require that, for five full years following the effective date of this decision, Cal-Am shall make quarterly filings listing the above service quality targets, as well as the rates actually achieved. Cal-Am shall file these reports with the Director of the Water Division and ORA, on January 15, April 15, July 15, and October 15, commencing on the first quarter following the effective date of this decision. The reports shall be for the preceding three months (the January filing will be for October - December, etc.). The Commission may examine these reports in Cal-Am's general rate case or other appropriate proceeding.

No party introduced results from these reports; the first of them may or may not have been available at the time of the evidentiary hearings. Because we lack sufficient evidence, we make no finding on the quality of CalAm's service overall. We look forward to the parties' providing a more thorough evaluation in the next GRC for these districts.

Almquist's Issues

We summarize and address briefly here a number of points made by Almquist in his testimony.⁸⁶

First, Almquist charged that shareholders have profited handsomely from Felton district's transfer from Citizens to CalAm followed immediately by its transfer to RWE. Ratepayers, on the other hand, have seen little if any tangible benefit despite representations made when the parties sought Commission approval. CalAm has failed to identify and quantify the cost savings, efficiencies and other economies achieved through the Citizens acquisition or the RWE acquisition, or to distinguish one set of benefits from the other, and has not passed those benefits through to ratepayers. CalAm has provided no justification for allocating any of the Citizens acquisition adjustment to Felton district ratepayers. Further, CalAm's request for a rate increase is inconsistent with RWE's conduct in paying a $2.8 billion premium to acquire American Water Works, and its commitment not to recover any of that premium from ratepayers. In response, we note that we have discussed the Citizens and RWE transactions separately at length in two sections above. Where there are benefits that should be flowed to ratepayers in this GRC, that has been done.

Next, Almquist argues that the premium RWE paid to American Water Works shareholders has fully repaid American's shareholders for the acquisition premium they paid to Citizens when they purchased Citizens' water assets. Thus, the acquisition premium amortization the Commission authorized in D.01-09-057 is no longer justified. We previously considered and rejected this argument in the RWE acquisition proceeding.⁸⁷ We decline to reconsider it here.

Almquist charges that Felton district rates have increased greatly over the past 12 years, a period of low inflation, and are substantially higher than those of two adjacent water districts. In response, we note that individual water systems, including systems that adjoin one another, may face differing costs, and even if their costs were the same, rates charged by Felton's neighboring municipal and district-run systems are not necessarily reflective of the costs borne by those systems. As Almquist acknowledged, those districts are not Commission-regulated, have the authority to tax, and one of them may in fact be supported in part by real estate taxes. Nevertheless, Almquist's general rate comparisons with neighboring non-regulated systems do help us to determine the range of rates that that appear reasonable in the local context. The rate increases and rate levels that our adopted revenue requirement would produce for Felton may indeed produce "rate shock." For this reason, we will not raise Felton's rates to the levels set in Appendix B at this time. Instead, we will order CalAm to establish for the Felton district a balancing account to track the revenue shortfall that arises from the continuation of the current rate schedule. More specifically, CalAm shall record in the balancing account the difference between revenues generated by current rates ignoring any modifications to those rates from advice letter filings and those set in Appendix B. Such calculations shall also change consistent with the timing of changes in rates set forth in Appendix C. In addition, this balancing account will be exempt from the provisions of D.03-06-072, because the balance that arises from difference between the continuation of adopted rates that the revenues that would be generated by the rates in Appendix B are reasonable. The amortization of the balances accrued in the balancing account will be determined in conjunction with the application of CalAm is here directed to file regarding consolidation of districts for ratemaking purposes.

Almquist further believes that CalAm's parent corporation is doing exceedingly well financially and is able to pay its executives very high compensation. That should demonstrate to the Commission that CalAm is not in need of further rate increases. In response, CalAm points out that American Water Works is a holding company with many subsidiaries, both regulated and unregulated, and maintains that no part of the executives' salaries cited by Almquist is allocated to its regulated subsidiaries. Almquist has apparently done no evaluation and offers no recommendation of what alleged excessive amounts of executive compensation should be removed from CalAm's costs in this proceeding. Thus, we make no such adjustments.

Lastly, Almquist charges that CalAm has not explored the availability of low cost tax-exempt financing through a public agency. It should be ordered to do so, and its revenue requirement adjusted accordingly. We note that Felton district has in fact taken advantage of public financing in the past, in the form of Safe Drinking Water Bond Act loan funds obtained through the California Department of Water Resources. ORA's witness did a thorough analysis of CalAm's capital structure and sources of funds in this proceeding, and we have considered her recommendations in our Cost of Capital section above. No party, including ORA, Almquist or Santa Cruz, made a showing that CalAm has unreasonably foregone, or will forego during the test period, any opportunities to obtain lower cost, public-source capital. Thus no revenue requirement adjustments are justified, and no order to seek out low cost tax-exempt financing through a public agency is necessary.

(a) Metering will be cost effective within the service area of the corporation. (b) Metering will result in a significant reduction in water consumption within the service area of the corporation. (c) The costs of metering will not impose an unreasonable financial burden on customers within the service area of the corporation unless it is found to be necessary to assure continuation of an adequate water supply within the service area of the corporation.