VII. Discussion

Gain on sale as a regulatory concept is not well-discussed in regulatory literature or statute, with limited exceptions for the water industry. Most of the thinking on the topic has been developed through experience in regulatory proceedings here in California and in other states. A review of practices in other states reveals a wide range of outcomes related to differential emphasis on various aspects of the gain on sale question. A review of the history of CPUC decisions relating to gain on sale also reveals shifting and inconsistent policies. A primary goal of this Rulemaking is to articulate clear principles and standardize Commission practice in gain on sale proceedings, thus providing regulatory stability and predictability to the benefit of both shareholders and ratepayers. Exceptions to the rules that result from this Rulemaking should only occur in unusual cases.

A return to the prominent use of the incidence of risk should be the primary standard for the efficient allocation of the gain. It is clear to us that the assumption of risk is an integral part of the regulatory compact, and that the incidence of this risk should be a major consideration when allocating any gain realized at the sale of a utility asset. Further, the appropriate measure of risk for this purpose is the possibility of financial loss.¹⁷

It is clear that by most measures, and under most circumstances, this risk is primarily borne by the ratepayer under utility regulation, as we have explained above. In most cases, even though the initial capital investment is provided by shareholders, that capital is generally fully paid back by ratepayers through depreciation in rates. Further, usually all costs associated with the asset, such as maintenance, insurance, taxes, administrative costs, interest expense, and other carrying costs are paid by ratepayers. Shareholders also retain the proceeds from an asset sale up to the book value of the asset. Further, a rate of return on the undepreciated value of the asset is included in rates. In the case of land, shareholders earn a return on its initial cost for as long as it is in ratebase. In addition to the financial risk, under the regulatory compact, the regulated utility is generally protected from the risk of entry by competitors. Shareholder face a real, but relatively smaller, risk of disallowance.

The use of a "ratepayer indifference" standard, however defined, is necessary but not sufficient for a reasonable allocation standard for use by this Commission. Of course, if ratepayers are harmed by the sale of the asset, or by the transaction that engenders this sale, this harm must be mitigated in some way, either by voiding the sale or compensating the ratepayers.

It is apparent from the discussion in Section IV, above, that the usefulness of the Uniform System Of Accounts is limited only to the accounting and recordation of a transaction, but is not useful in the determination of how the gain is to be allocated.

We found in D.90-04-028 that it was desirable to provide SoCalGas shareholders a small portion of the gain as a "reward and incentive for seeing that its headquarters was put to the highest and best use in the economy." We agree and note that it is our goal to encourage prudent investment in and continued ownership of property that is necessary for utility service, to ensure that utilities dispose of properties that have been rendered unnecessary by change of circumstance, and to encourage utility management to negotiate a reasonably high sale price. This may require that shareholders be given an incentive of a percentage of the gain. We also recognize that shareholders bear some risk of disallowance by the Commission, as discussed above.

It is therefore correct to allocate a portion of the gain from sale to shareholders, partly to compensate for financial risk borne by the utility, and partly as an incentive to utility management to manage its assets wisely. An allocation of the gain to shareholders would promote efficiency to the extent it fairly compensates shareholders and presses utility management to further the above goals. However, an allocation to shareholders that is too great would lower efficiency, would not be necessary to achieve these goals, will transfer money needlessly from the ratepayers who bore the greater risk burden of the investment, and will encourage speculation by utility management. We tentatively conclude that a share as high as 50% of the gain may provide an incentive for management to speculate, especially given the variable nature of capital markets in California.¹⁸ On the other hand, if we choose a percentage as low as 5%, management may find that this would neither fairly compensate shareholders for their risks nor cover their costs sufficiently to act as an incentive. To compensate shareholders for risks and to provide a reasonable incentive without making an unfair and inefficient allocation, we seek comments on the appropriate level within the range of 5% and 50% of the gain allocated to shareholders, with the concomitant range of 50% to 95% of the gain allocated to ratepayers, in recognition of their respective risks. We intend as a result of this Rulemaking to adopt a specific allocation (e.g. 20/80) to shareholders and ratepayers, respectively, that would apply generally under normal circumstances.