V. Important Prior Commission Decisions

Energy: In D.85-11-018⁷, we approved the sale of a portion of PG&E's electric distribution system to the City of Redding. The sale of these assets resulted in a gain which we allocated to ratepayers. The Commission relied upon a "risk theory of allocations" for its decision, saying that whoever bears the financial risk of investment should receive the gain upon sale of the asset. The "risk of investment" was defined as the financial responsibility "for the write-off of a capital asset." (p. 168) We pointed to Democratic Central Committee etc. v. Washington Metropolitan Area Transit Commission, 485 F.2d 786 (D.C. Cir., 1973) as a leading case using the risk theory of allocations. We allocated the gain to ratepayers through a decrease in the revenue requirement.

We recognized that the use of risk analysis to determine the allocation of the gain "requires a case-by-case assessment" of who bore the risk and whether the risk was shared. (p. 172) The decision also recognized that the protean nature of the industries it regulated required flexibility in its ratemaking. Specifically, it said that these industries were "undergoing rapid and fundamental structural changes" which resulted in "a substantial shifting of costs," requiring that policymakers balance the interests of the parties involved. We said that our approach was not an "inflexible framework... especially where the equities of the situation require specific ratemaking innovations." (p. 172) We were convinced that an analysis of the differential burden of financial risk on ratepayers and shareholders should strongly influence our future decisions regarding the allocation of gains, while at the same time we recognized that the individual circumstances of each situation must be reviewed to ensure a reasonable outcome.

The result obtained in D.85-11-018 was essentially reversed in D.89-07-016.⁸ We used two standards to allocate the gain: 1) whether the ratepayers were harmed by the transaction leading to the gain, and 2) whether ratepayers had contributed capital to the acquisition of the asset. We stressed that these standards applied to the particular circumstances of this sale only.⁹ We concluded that, under these standards, the gain should be allocated to the shareholders. If either of these standards had not been met, the gain could have been used to mitigate the harm to ratepayers or repay their contributed capital. We did not reject risk as an important factor in the determination of the allocation of gain, and stated that the regulatory compact includes "assignment of investment rewards or losses to the party that takes the investment risk," (p. 239) However, we expanded our definition of risk and listed the following categories:

· The risk of poor service which is borne by ratepayers.

· Business risk which includes weak management, unmanageable business conditions, or inaccurate ratemaking forecasts. Both ratepayers and shareholders bear this risk.

· Financial risk is the short run variability in the price of the utility's stock. While in the long run the authorized rate of return should mitigate such variability, in the short run this risk is borne by shareholders

· The risk of specific investments "attaches to individual investments." The decision does not state how this particular risk is borne.

· Regulatory Risk includes decisions by the Commission and other regulatory bodies, such as the current decision regarding the allocation of gain.

Applying these risks to the case addressed in D.85-11-018, viz. the liquidation of a distribution system, we said that the major risks that applied were the risks of poor service, and "general financial risks that attach to any investment, which are assigned to shareholders, to the extent that they have contributed capital to the distribution system." (p. 239) We also said that the risk of an increased burden on the remaining ratepayers should also be considered. However, we did not specify how the relative assumption of these various risks by ratepayers and shareholders should affect our allocation decision, and reiterated that gain should be allocated solely on the basis of 1) whether ratepayers are harmed by the sale, and 2) if ratepayers have contributed capital to the investment.

In D.90-04-028 we approved the sale of SoCalGas's Los Angeles headquarters building, and split the gain on this sale between the ratepayers and shareholders. The major consideration in our allocation of the gain was a "ratepayer indifference" methodology, wherein ratepayers were compensated for the difference between what the headquarters would have cost had it remained in ratebase, and what a new headquarters would cost. This difference between book value and replacement cost would be given to ratepayers as it represented the implicit financial stake the ratepayers had in the continued use of that asset. The difference between replacement value and actual market value would go to "shareholders as a reward and incentive for seeing that its headquarters was put to the highest and best use in the economy." (p. 253)

This "ratepayer indifference" methodology was similar to the standard used in D.89-07-016, described above, wherein ratepayers were to be given a portion of the gain only to make them whole if they were harmed by the transaction, and to the extent that they contributed capital to the original purchase of the asset. ¹⁰

We reconsidered our decision in D.90-11-031 (38 CPUC 2d, pp. 166-209) and replaced the "ratepayer indifference" principle with the previous "traditional risk and incentive analysis" approach. We found that to give all gain to shareholders would establish a perverse incentive that would result in utility management purchasing new assets too often. However, we decided that shareholders should get some of the gain "as an incentive to management to maximize the proceeds" from the sale. (p. 187) The gain given to ratepayers was allocated over time to offset continuing headquarters costs. We rejected SoCalGas's claim that it is constitutionally entitled to retain all of the gain.

We pointed out that it is inconsistent for utility management to argue that there is a difference in the treatment of depreciable and nondepreciable property (i.e., land), and that their arguments regarding the allocation of gain for depreciable property apply equally to nondepreciable property. This is still a valid assessment. The purchase of land is not repaid to the shareholders through depreciation payments, as is the case for capital assets, but the ratepayers pay a reasonable rate of return on the original purchase price as long as the land is in ratebase, and the risk of the investment, if any, is borne by the ratepayers.

For the energy industry, we propose that decision(s) issued in this Rulemaking specifically supersede all previous Commission decisions relating to gain-on-sale, including D.85-11-018, D.89-07-016, D.90-04-028, and D.90-11-031.

Telecommunications: Before we adopted our New Regulatory Framework (NRF) price cap regulation for large telecommunications carriers, our policy for the treatment of gain on sale of land (non-depreciable property) under rate of return regulation had been to allocate the gain 100% to ratepayers, because they bear the risks of property acquisition and maintenance and fund the costs of ownership while the land's value appreciates. (D.86-01-026, 20 CPUC 2d 237 (1986), mimeo at 82-83; D.94-06-011, mimeo at 90.) The sale of utility property and any resulting gains were then reviewed in each carrier's general rate case.

Under NRF, the Commission adopted a new policy for treatment of the gain on sale of land that is reflected in two decisions: D.93-09-038 (GTEC/Verizon), and D.94-06-011 (Pacific Bell/SBC). The overall policy for each of the companies is similar, and is based on settlements reached between DRA and GTEC and DRA and Pacific Bell whereby the gain on sale of land was allocated between shareholders and ratepayers based on the time that the property was in utility ratebase pre-NRF (before 1990) and post-NRF (1990 and threrafter).

There were certain terms in the GTEC settlement that required specific treatment for the sale of land in specified periods. However, the basic principle for determining the gain on sale allocation was time in ratebase pre- and post-NRF. The Pacific Bell settlement provides a less complex illustration of the allocation principle. For sales of land that dated prior to the adoption of NRF in 1989, and the years 1990-1993, the Commission allocated 100 percent of the gain to ratepayers. For sales in the years 1994-1996, the gain allocated to ratepayers was based on a ratio of the time that the parcel was held in ratebase prior to NRF to the total operating service life. For sales in the years 1997 and beyond, the gain was split 50% to ratepayers and 50% to shareholders.

Regarding the sale of depreciable property (e.g., buildings), our policy has been to allow ratepayers to realize the gain by crediting the gain to salvage value that will then be reflected as an increase to the depreciation reserve. (See D.86-01-026, Section VII.F. mimeo., at 82.) This accounting policy has not changed under NRF. However, since the sharing mechanism was suspended in D.98-10-026 for SBC and Verizon, there is no mechanism in place for those two companies that provides ratepayers with any benefit resulting from the gain on the sale of depreciable property.

Another type of sale relates to lines-of-business. In 1996, Pacific Bell and the other six Regional Bell Operating Companies sold Bellcore, a commonly owned research and development company. In D.97-06-086, we approved Pacific Bell's and the Office of Ratepayer Advocate's agreement to allocate 50 percent of the after-tax intrastate portion of the gain to ratepayers. The decision was tailored to the specific circumstances of the case and we did not consider it to be a precedent.

For the telecommunications industry, we propose that decision(s) issued in this Rulemaking specifically supersede previous Commission decisions relating to gain-on-sale, including D.86-01-026, D.93-09-038 and D.94-06-011, but not D.97-06-086.

Water: Prior to 1995, we decided in D. 94-09-032 that it was inappropriate to allocate all of the gain on sale to shareholders. Rather, we allocated the gain 50% to shareholders and 50% to ratepayers. We reasoned that there should be some allocation to shareholders in order to meet the utilities' need to invest in new infrastructure. By the same token, we found ratepayers had borne costs associated with the property until its sale, and therefore should share in the gain on sale.¹¹

In 1995, the Legislature enacted the Water Utility Infrastructure Improvement Act of 1995, Public Utilities Code §§ 789 et seq. stating:

(d) Water corporations may, from time to time, own real property that once was, but is no longer, necessary or useful in the provision of water utility service and that now may be sold. It is the policy of the state that water corporations be encouraged to dispose of real property that once was, but is no longer, necessary or useful in the provision of water utility service and to invest the net proceeds therefrom in utility infrastructure, plant, facilities, and properties that are necessary or useful in the provision of water service to the public.

(e) It is the policy of the state that any net proceeds from the sale by a water corporation of real property that was at any time, but is no longer, necessary or useful in the provision of public utility service, shall be invested by a water corporation in infrastructure, plant, facilities, and properties that are necessary or useful in the performance of its duties to the public and that all of that investment in infrastructure, plant, facilities, and properties shall be included among the other utility property of the water corporation that is used and useful in providing water service and upon which the commission authorizes the water corporation the opportunity to earn a reasonable return.

Additionally, Public Utilities Code § 790 states:

(a) Whenever a water corporation sells any real property that was at any time, but is no longer, necessary or useful in the performance of the water corporation's duties to the public, the water corporation shall invest the net proceeds, if any, including interest at the rate that the commission prescribes for memorandum accounts, from the sale in water system infrastructure, plant, facilities, and properties that are necessary or useful in the performance of its duties to the public. For purposes of tracking the net proceeds and their investment, the water corporation shall maintain records necessary to document the investment of the net proceeds pursuant to this article. The amount of the net proceeds shall be a water corporation's primary source of capital for investment in utility infrastructure, plant, facilities, and properties that are necessary or useful in the performance of the water corporation's duties in providing water utility service to the public.

(b) All water utility infrastructure, plant, facilities, and properties constructed or acquired by, and used and useful to, a water corporation by investment pursuant to subdivision (a) shall be included among the water corporation's other utility property upon which the commission authorizes the water corporation the opportunity to earn a reasonable return.

(c) This article shall apply to the investment of the net proceeds referred to in subdivision (a) for a period of 8 years from the end of the calendar year in which the water corporation receives the net proceeds. The balance of any net proceeds and interest thereon that is not invested after the eight-year period shall be allocated solely to ratepayers.

(d) Upon application by a water corporation with 10,000 or fewer service connections, the commission may, after a hearing, by rule or order, exempt the water corporation from the requirements of this article.

(e) The commission retains continuing authority to determine the used, useful, or necessary status of any and all infrastructure improvements and investments.

In summary, § 790 enables water utilities that sell no longer needed property and invest the net proceeds in needed infrastructure to earn on these proceeds. These net proceeds are to be the utility's primary source of capital for infrastructure, and the utility must track the investment of the proceeds. The utility has eight years to re-invest the funds and must include the property among its other utility property. We have not previously had occasion to review the Water Utility Infrastructure Improvement Act with our statutory obligations pursuant to Public Utilities Code § 451 and 851.

We noted in D.03-09-021 that the result of allocating all net proceeds to shareholders creates a powerful financial incentive for water utilities to sell real property. Such an incentive could encourage water utilities to sell real property without regard to long-term customer service needs, and may even lead to real property speculation by water utilities, relying on rate base treatment to protect shareholders from losses but using § 790 to reap gains.

This is particularly troubling when a water utility decides to sell water rights which typically for accounting purposes have no monetary value, and then include these proceeds in rate base on which the utility may earn a return. We determined in D.04-07-031 that water in its natural state is a part of land and therefore constitutes real property.¹² As decided in D.04-03-039 pursuant to § 851, the Commission affirmed that water rights may not be leased or sold without Commission approval.

We also believe the statute may require further interpretation regarding water utility assets originally obtained from sources other than the utility shareholders. Water utilities commonly receive assets from sources other than the utility shareholders. Some water utilities acquire facilities that were paid 100% by company ratepayers. They may be facilities such as the one million dollar treatment plant that Nacimiento Water Company customers paid for rather than incur the cost of interest on a loan or the rate of return on a shareholder investment. Other such assets may include facilities constructed in the 1980s and 1990s with state-provided low interest loans under the Safe Drinking Water Bond Act (SDWB loans) and the State Revolving Fund (SRF loans). Unlike conventional loans for which ratepayer payments may be confined to loan interest, ratepayers bear responsibility to repay, through surcharges, principal and interest for loans. Other water utility assets are completely funded by forgivable loans, which, upon repayment-forgiveness, closely resemble grants. Such loans/grants include funding for infrastructure to replace or correct facilities damaged by MTBE contamination distributed by the State Department of Health Services (DHS) to utilities. DHS forgives the loans if the utility makes a good faith, even though unsuccessful, effort to find and sue the contaminator for damages. Though on some occasions, contamination litigations result in a monetary gain. Due to the complexities of water contamination issues, these issues will be considered in a separate OIR.

Finally, developers or other entities commonly pay for and provide water utility assets as contributions in aid of construction. There is reason to believe that the number of non-shareholder provided assets will escalate in the future.¹³

When these assets are no longer necessary or useful to the water utility, the utility sells them and uses the proceeds to purchase new infrastructure pursuant to §§ 789 et seq. As a result, this new infrastructure will become part of the water utility's ratebase, on which the utility earns a rate of return from ratepayers.

We will examine in this proceeding whether the statute requires such property to earn a full rate of return. We wish to determine in this proceeding whether §§ 789 applies to this real property or whether water utility shareholders can enjoy a return only on assets that were the product of shareholder investment.¹⁴

With respect to water utilities, here are some specific ratemaking issues that need to be addressed in this proceeding:

13. If according to § 790, the full gain is included as rate base, should there be any safeguards against "churning" of assets by utility management in order to increase rate base? What should these safeguards be?

14. In order to reconcile § 790 and 851, at what point do we require the utility to file an application? If the utility files a § 851 application at the time of the sale and the Commission approves the sale, what must the utility file at the end of the eight years, if anything, to reconcile the net proceeds?

15. What amount, if any, of the gains from non-shareholder investment (i.e. developer contributions in aid of construction) should be included in rate base?

VI. Risk under Various Scenarios

In this proceeding, we are generally concerned with the following types of risk:

(a) The risk of not recovering the acquisition cost of the asset;

(b) The risk of not recovering the asset's maintenance and other carrying charges;

(c) The risk of not being compensated for the asset's opportunity cost;

(d) The risk of incorrect valuation of the asset.

(e) Inaccurate estimate of the useful life of the asset.

(f) The risk of disallowance by the Commission.

Almost all of the financial risks are borne by the owners in the competitive market, but they are generally borne by ratepayers under utility regulation. Only the risk of the Commission's disallowance of a utility's asset purchase can be said to be borne by shareholders. As we have discussed above, under regulation, the risk of the asset's acquisition cost recovery is covered by ratepayers through the payment of depreciation expense; the risk of ensuring the asset's servicing is covered through operating and maintenance expenses in rates; the asset's recurring carrying charges, such as taxes, insurance, licenses, and fees, is also paid by rates; finally, the risk of not covering the opportunity cost of the investment is addressed by the allowance of a just and fair return on its equities and debt securities, once again as part of the calculation of rates.

We will discuss some of these risks here in more detail. First is the risk that an incorrect valuation is assigned to an asset when it is placed into ratebase. When an asset is placed into ratebase, it is assigned a specific value. That value is recoverable through depreciation, and there is a rate of return on the assigned value. The value is determined by the Commission. In the vast majority of cases, the Commission's assigned value is exactly the value proposed by the utility. If the Commission accepts the utility's valuation, there is virtually no risk for shareholders as the utility would not knowingly propose a valuation that is too low. However, the utility may propose too high a valuation. A valuation by the utility that is too high may occur due to purposeful overstatement of value (impermissible), purposeful erring on the side of a high valuation along a range of reasonable valuations (permissible, but subject to Commission adjustment within the reasonable range), or simple error.¹⁵ In this case, there is a risk to the ratepayer of overpaying capital costs, as well as excessive return. Shareholders bear the risk of the rare occasion that the Commission might adopt a valuation that is too low. However, given that the utility largely controls the information and the Commission almost always accepts utility proposals for valuation of assets, the ratepayer valuation risk far outweighs the shareholder valuation risk.

Except in the case of land, assets are assigned useful lives which are reflected in a depreciation schedule. An asset may in fact have a useful life which is shorter or longer than the assumed period. If the asset's useful life is shorter than the assumed period, the ratepayers continue to pay the depreciation, return on capital, and associated operation and maintenance costs for the asset unless it is removed from ratebase. There is an obligation under accounting rules and under the Public Utilities Code §455.5(b) to take such an asset out of ratebase, but this obligation is not always honored, in part because implementing rules have not been clear. This situation constitutes a risk for the ratepayer. The utility may need to prematurely replace the asset if its useful life is truncated. This constitutes a risk to the shareholders if the replacement costs are not accounted for in rates. However, this risk is mitigated because the utility will have the opportunity (in the next general rate case or elsewhere) to request revenues to cover the increased costs. If the asset's useful life exceeds the depreciation period, the utility and the ratepayer benefit from the ability to make use of the asset beyond its expected life without additional capital expense. However, if the utility chooses to propose replacement of the asset at the end of the assumed useful life, despite the fact that the asset is still useful, ratepayers bear the risk of overpayment for an unnecessary or premature replacement. Since this decision is within the utility's control, shareholders do not face an associated risk.

The Commission may decrease the upfront amount allowed into ratebase for an asset. This is the valuation risk faced by shareholders discussed above, which occurs infrequently. The Commission may also disallow recovery of all or part of an asset once it is in ratebase, if the Commission determines that the investment was imprudent. Generally, such a determination will stem from the standard that the investment must have been prudent based on information known or knowable by the utility at the time the investment was undertaken. Such after-the-fact disallowance constitutes a risk to shareholder. However, the Commission has rarely disallowed significant amounts in this manner. It can also be argued that ratepayers face the symmetric risk that assets that should not be allowed into ratebase may in fact pass prudency reviews. Finally, the Commission's ability to pursue after-the-fact prudency review for electric utility generation investments has been constrained by the Legislature.¹⁶

There may be various circumstances when an asset is sold. We summarize the risks at the time of sale (apart from the risks discussed above) under the following scenarios.

(1) The asset is fully depreciated and is always in ratebase. The asset is used and useful.

Under this scenario the ratepayers bear all the financial risk. The ratepayers pay back the utility for the entire cost of the asset over the estimated life of the asset through annual depreciation. The utility bears zero risk under this scenario, because each year the utility gets a portion of the investment back and a rate of return on the unrecouped investment.

Even when the fully depreciated asset remains in ratebase and may not be used and useful at some point, the ratepayers once again bear all financial risks and the utility bears none. Under this scenario, the ratepayers each year continue to pay the operations and maintenance, as other carrying charges. However, since the asset is fully depreciated, there will be no depreciation allowance or a return on the asset.

(2) The asset is not fully depreciated and is always in ratebase. The asset is used and useful.

Under this scenario the ratepayers bear all of the risks. Ratepayers bear operating expense allowances in rates. It is well settled under Commission ratemaking that if the asset is not fully depreciated, in most instances the ratepayers' financial obligation remains. Should the partially depreciated asset be retired early or sold at a loss, ratepayers bear the risk of that loss. Even when an asset becomes unsuitable by reason of obsolescence before investors have fully recouped their investment, the loss is passed on to the ratepayers. It would thus be logical to assign any gain, if any, to ratepayers as they bear the risks under this scenario.

(3) The asset is removed from the ratebase when it becomes no longer used or useful for utility service.

The ratepayers have paid depreciation, maintenance, other carrying charges, and a rate of return on the undepreciated amount of the asset, up to the time it is removed from the ratebase. Therefore, even though it is no longer being used for utility service, the risk of the investment has been borne by ratepayers. Once it is removed from ratebase, the ratepayers' obligation is over. At this point, the utility bears any further risk and cost associated with the asset. However, since the asset's cost has been returned through depreciation payments in rates, any further risk borne by shareholders may be small.

(4) Land

When land is in ratebase, the ratepayers bear the risks as above except that land is not depreciable. Shareholders are not given depreciation payments, but they will earn a return on the book value of the land in perpetuity. If the utility sells land that has been in ratebase, any loss is to be compensated by the ratepayers. Thus the treatment of gain or loss from the sale of land in ratebase should be no different than the sale of a depreciable asset; any gain or loss should flow to the ratepayers. If land is sold after it has been removed from ratebase, an allocation of the gain or loss from the sales should be made that reflects the risks shared by both the ratepayers and the utility.

¹¹ See D.94-09-032 (56 CPUC 2d 4-20).