IV. Infrastructure Act Memorandum Account

Section 790 requires that whenever a water utility sells any real property that was formerly necessary or useful in the performance of the utility's duties, the utility shall invest the net sale proceeds, if any (including interest at the rate that the Commission prescribes for memorandum accounts) in water system infrastructure, plant, facilities, and properties that are necessary or useful. For purposes of tracking the net proceeds and the required investments, the Commission has directed CWS to establish an IMA.

CWS now seeks authority to establish two IMAs. The first memorandum account is historical, the HIMA, which would record net sale proceeds of all real properties included in rate base at any time that was reclassified out of rate base and either sold outright or transferred to its affiliate, CWS Utility Services, prior to December 31, 2003. The other memorandum account is a prospective IMA, which would be applicable to such properties beginning January 1, 2004. The net sale proceeds of these real properties would be subject to Section 790.

As proposed, the HIMA would include approximately 60 real properties. Each of these real properties was at one time in rate base as either utility plant in service (UPIS) or plant held for future use (PHFU) and reclassified out of rate base to non utility property (NUP). The real properties included in the HIMA remained out of rate base an average of six years prior to either being sold outright or transferred at fair market value by CWS to CWS Utility Services.6 None of these real properties was disposed of by CWS while classified as UPIS or PHFU.7 The total net book value of these properties was approximately $776,000, and the net sale proceeds were approximately $19,268,000.8

A. Real Estate Program

Prior to 1997, the Engineering Department of CWS assessed the usefulness of its real properties 10 years or more into the future. Subsequent California Department of Health Services (DHS) establishment of more stringent water quality standards and availability of improved water testing instrumentation to detect groundwater constituents and contaminants at minute levels resulted in CWS reducing its long range assessment to five years.

This shorter assessment period increased the number of real properties perceived to have no likely future use for utility purposes. Some 36 of the real properties included in the HIMA were reclassified out of rate base prior to the establishment of CWS's real estate program; they remained on books of CWS as NUP until sold or transferred to CWS Utility Services. This large inventory of NUP was not providing CWS any return on its investment.

CWS established its real estate program in 1997 to realize value from its NUP inventory through reinvestment into its utility infrastructure, as detailed in Exhibit A.9 Also, some NUP consist of "nuisance" real property that is a liability to CWS due to trespassing, vandalism, and maintenance problems. In some instances, the cost to patrol the properties and to control vegetation exceeds their public utility usefulness.10

Under its real estate program, CWS periodically inventories its real properties to identify the properties or portions of properties no longer necessary or useful. These are reviewed individually by the Engineering Department and individual districts of CWS to determine if there is a continued present use for the property, and if not, whether there is a future use. The latter is determined by considering property size, location, elevation, and history of water and soil quality. Detailed requirements for potential future use as a storage tank, booster station, or well site are set forth in Exhibit A. If a site does not meet the requirements, CWS estimates the cost to rehabilitate the site for utility use.

CWS prepares a written memo for each site it determines no longer necessary or useful, explaining the basis of its determination.11 The real property is then decommissioned and transferred out of rate base to a non utility classification until sold or transferred, as described above.12 CWS discontinued the practice of transferring real property no longer necessary or useful to CWS Utilities Services in the spring of 2003.13 A detailed present and future use assessment of each real property included in the proposed HIMA of CWS is set forth in Exhibits A and D.

B. ORA's Analysis

ORA selected several of the higher valued properties included in the HIMA for inspection and field visits. ORA also reviewed the work papers and exhibits of CWS. From its inspection and review, ORA acknowledged merit of the reasons cited by CWS for taking real properties out of UPIS and PHFU. However, ORA believes that CWS could have rehabilitated some sites. ORA used as example the well sites reclassified out of UPIS and PHFU due to declining water production, sand, or high concentrations of contaminants (such as nitrates, arsenic and salt water intrusion). ORA believes that CWS could have blended the water with better quality water, treated the contaminants with chemicals, or deepened the wells.14

ORA concluded that CWS did not carry its burden of substantiating that the sites it sold were not necessary or useful prior to sale. ORA further concluded that CWS violated Sections 851 (because CWS either sold or assigned used or useful real property without first obtaining Commission authority) and violated Section 455.5 (because CWS did not notify the Commission within nine months that it had taken any production facilities out of service).

ORA recommends that the request of CWS for authority to apply Section 790 to the sale and transfer of real property under its real estate program be denied, and that CWS be fined $160,000 for its failure to comply with Section 851. ORA further recommends that the Commission ensure ratepayers receive the benefit from the net proceeds of sales and transfers listed in the HIMA. ORA would implement this recommendation by requiring CWS to reduce the cost of replacement real property within an eight year period subsequent to any such sale or transfer.15

To determine whether CWS properly included the approximately 60 real properties in its HIMA, We first review the difference between UPIS, PHFU, and NUP. These differences are identified in the Uniform System of Accounts (USOA), which was adopted by the Commission for Class A Water Utilities in D.50185, as modified by D.57578.

UPIS consists of real property owned and used by a utility to perform its public utility function. PHFU consists of real property held for future utility use under a definite plan. NUP property consists of property not currently being used for a utility purpose and having no definitive plan for a future utility purpose. UPIS and PHFU investments are components of rate base; these investments and associated expenses are recoverable through water rates. NUP investments and associated expenses are excluded from rate base and not recoverable through water rates.

Of some 60 real properties in CWS's HIMA, 47 are well sites. The majority of these sites were acquired more than 30 years ago, dating back as far as 1927 when land use requirements were minimal and acceptable contaminate levels were much less restrictive than they are now. CWS reclassifies a well site from UPIS to NUP if the site is no longer necessary or useful; it reclassifies a well site from UPIS to PHFU only if the individual site not currently necessary or useful has the potential to comply with local agencies' current permitting requirements and DHS requirements, including minimum square footage requirements for the construction of a well and related wellhead treatment facilities.16 The current minimum square footage required by CWS for a well site is 10,000 square feet. This requirement was recently increased from 6,000 square feet to allow space for treatment facilities to meet more stringent water-quality requirements.17

Of these 47 no longer necessary or useful well sites, 38 were not suitable for future use primarily because of the minimum square footage criterion; of these, 10 have even less than 6,000 square feet.18 As an example, retired BK Well Station #31 acquired in 1928 (inconsistently identified as reclassified to NUP in 1980 in Exhibit D and 1992 in Exhibit E) had not been in service since 1962 due to a drop in the water table. Although this UPIS well site was taken off line in 1962, CWS kept it in UPIS for backup supply and fire protection.

CWS, no longer needing the well for backup supply or fire protection, began decommissioning the well in 1977 pursuant to DHS requirements. CWS filled the well with concrete up to a depth of six feet underground, and completed the filling process with soil. All pipes and buildings were then removed. Upon completion of decommissioning and satisfying DHS requirements in 1980, the site was reclassified to PHFU.

In 1992, as part of its review of PHFU sites, CWS determined that the 3,801 square foot parcel was no longer potentially necessary or useful because the site was substantially below its current minimum 10,000 square foot requirement for a well site. 19 This site was reclassified to NUP from PHFU.

CWS explained that, over the years, it has consistently applied sound engineering principles to analyze potential future necessity or usefulness of its well sites. It also acknowledged that some of its records were lost over the years.20 There is no evidence to support the apparent inclusion of this Bk Wall Station #31 in rate base as PHFU from completion of the decommissioning process in 1980 to the date it was actually transferred to NUP in 1992. However, this site, having a book value of $434, did not materially impact ratepayers during the dozen years it was erroneously classified as PHFU. CWS should strengthen its record keeping process to avoid this type of error in the future and to ensure that its written assessments of UPIS and PHFU determinations are included in the original property records of each site. The IMA requirements we adopt today will complement this strengthened record keeping.

CWS did not dispute ORA's contention that CWS could have implemented measures to retain its BK Well Station #31 or its other real properties for utility use. However, CWS explained that the measures identified by ORA are not routine.21 CWS would have to determine for each property the extent and costs of measures needed to keep the property necessary and useful. There is no evidence on the cost of measures needed to retain these well sites in UPIS or PHFU. However, there is evidence that blending water or drilling deeper or new wells in locations contaminated with saltwater, as proposed by ORA, would not necessarily achieve compliance with water quality requirements.22 In any event, CWS would undertake only those measures that are cost effective.

The remaining real properties included in the HIMA consisted of tank, reservoir, booster pump, and operations center sites. CWS used the same necessity and usefulness criteria for these sites that it used to assess its well sites. For example, tank and operations center sites such as the Dominguez tank and operations center and the Hermosa-Redondo District operations center were classified no longer necessary or useful due to the Dominguez Water Company merger into CWS. This merger resulted in a water system interconnection and an operational and administrative consolidation of the two companies into a single district and new regional operations building.23

The criteria CWS used to reclassify its UPIS and PHFU properties to NUP are reasonable and consistent with the requirements set forth in the USOA for Class A Water Utilities, as adopted by this Commission. CWS followed these criteria in classifying its properties as NUP prior to being sold. We find that the properties CWS included in its HIMA are appropriately includable in its HIMA.

Section 851 precludes any public utility from selling real property that is necessary or useful in the performance of its public utility duties without first having secured Commission's authorization.

ORA does not object to CWS removing from rate base, without Commission approval, the real property CWS considers no longer necessary or useful.24 However, ORA does object to CWS selling the property prior to obtaining Section 851 approval from the Commission.25 Because CWS neither requested nor received Commission permission to sell any of the real properties included in its HIMA, ORA recommends a $160,000 fine (based on $20,000 per year from the beginning of the real estate program in 1997 to 2005) for Section 851 violations.26

In support of its position, ORA cites a Southern California Water Company (SCWC) decision in which the Commission fined SCWC for not seeking Section 851 approval to lease a portion of certain water rights.27 The Commission held that consideration of whether Section 851 approval is needed is made only after a utility files an application seeking Section 851 approval, and that the issue of necessity or usefulness is factual and subject to Commission review.28

The SCWC situation is different from the situation before us. SCWC acquired water rights as part of its acquisition of Natomas Water Company. Because it was common practice to not assign any monetary value to water rights at the time SCWC acquired the water rights, the value of those water rights was included in rate base as part of the overall purchase price paid by SCWC. Ratepayers were paying shareholders a rate of return on that investment, and shareholders were not responsible for recovery of any of the carrying costs.29 Therefore, at the time SCWC leased a portion of those water rights to the City of Folsom, the value of such water rights remained in rate base and never transferred into NUP.

In contrast, CWS transferred the entire value of each real property out of rate base to NUP from either UPIS or PHFU and kept them out of rate base an average of six years prior to selling.30 Irrespective of any differences between the SCWC decision and CWS's position, the key point in the SCWC decision to consider in this proceeding is that the issue of necessity or usefulness is a factual one that the Commission has the option to review.

ORA appears to interpret the SCWC holding to be that, without exception, a utility must obtain Section 851 approval prior to selling real property that was at any time in rate base. We note that, based on the CWS sale of real properties included in its HIMA, CWS would have averaged 7-8 (approximately 60 real properties over an eight year span from 1996 through 2003) Section 851 applications per year.

As an alternative to CWS filing individual Section 851 applications, ORA recommends that CWS seek, as part of its three-year GRC cycle, specific Section 851 approval for real properties it determines no longer necessary or useful. ORA already reviews the status of CWS's real property as part of ORA's Master Data Request and analysis of rate base. However, historically, CWS has not included Section 851 approval requests for the sale or transfer of property in its GRCs.

As discussed above, the Commission has discretion to review a utility's decision to sell real property that was formerly in rate base. We decline, however, to require CWS to seek specific Section 851 approval for each of its real properties determined by CWS to be no longer necessary or useful. We have already found CWS' UPIS and PHFU criteria to be reasonable and consistent with the USOA as adopted by this Commission. It is sufficient for purposes of regulatory oversight that we ensure CWS applies those criteria to its properties in a regular and consistent fashion.

The real properties included in the HIMA are not subject to Section 851 approval, and should not subject CWS to any penalty. In so holding, we retain our power to review the reasonableness of decisions by utility management, in particular, those decisions relating to continuing real or other property in rate base. Utility property is occasionally retired too early, and it is occasionally retained in rate base far too long. Both these management decisions can result in harm to ratepayers. Nothing in this decision limits our power to protect ratepayers in those circumstances.

Section 455.5 requires, among other things, that a water utility notify the Commission of water production facility which, after having been placed in service, remains out of service for nine or more consecutive months.

CWS did not dispute ORA's assertion that CWS did not notify the Commission when the real properties listed in its HIMA had been out of service for nine consecutive months. In its defense, CWS explained that the water facilities it routinely takes out of actual service for at least six months while remaining in rate base are exempt from being reported to the Commission because such water facilities are not "major facilities" critical for its public utility duties. Such properties have included water tanks taken out of service for maintenance and cleaning and wells placed on standby for only fire service due to taste, odor or coloration problems.31 Further, the properties included in its HIMA were no longer necessary or useful.

CWS considers whether an individual real property has a significant effect on providing water service as the criteria for determining whether the facility taken out of service is a major facility. For example, if a well taken out of service is in a district having only that one well, it meets CWS major facilities criterion and would be reported to the Commission. However, if the well taken out of service is in a district having 200 wells, like the Bakersfield District, that well would not be considered a major facility and the removal would not be reported to the Commission. This is because that one well would not have a material impact on CWS providing public water service.32

Subsection (f) of Section 455.5 is reasonably consistent with this position of CWS. The subsection limits the reporting requirement to those water production facilities that the Commission determines to be a "major facility" of the utility, and does not include any facility determined by the Commission to constitute PHFU. Although major facility is not defined in the code, the Commission has proposed in R.04-09-003 to define a major facility as it pertains to Section 455.5. For lack of a Commission definition of major facility at this time, we look to the evidentiary record to determine what impact, if any, these real properties taken out of service had on CWS providing public water service.

Consistent with the definition of CWS, ORA defined a major facility to be an item that would have a significant effect on the operation of a water system, with "significant" meaning to have some sort of impact on the water system.33

The record in this proceeding does not share any such impact. Notice of the applications to the customers of CWS did not result in the receipt of any customer complaints regarding CWS's water service. Further, no formal complaints were brought at the Commission that relate to production facilities taken off line during this time period.

Although Section 455.5(f) leaves the determination of major facilities up to the Commission, it is impracticable for this Commission to categorize each of the over 900 real properties owned by CWS. In so holding, similar to our Section 851 discussion, we retain our power to review the reasonableness of decisions by utility management. Until such time that the Commission clarifies the definition of major facilities, we concur with CWS's and ORA's assessment that the criterion for determining which real property is a major facility should be whether the property has a significant effect on providing water service.

We conclude from this major facility definition, and from the lack of any evidence that the real properties included in the HIMA had any impact on the ability of CWS to provide water service, that CWS has not violated Section 455.5.

There is no dispute that Section 790 requires CWS to establish an IMA and to include in the IMA sale proceeds of real property that was at any time, but is no longer, necessary or useful. However, ORA does oppose CWS including real property in the memorandum accounts prior to CWS obtaining Commission approval to sell the property. Once approval is obtained, ORA recommend that CWS include the sale proceeds in an IMA and track the sale proceeds for eight years. During this time period, the net sale proceeds would be "used to reduce the cost of any necessary replacement property." If no replacement property was necessary during that time period, the net proceeds would then be awarded to the shareholders. CWS would be allowed to earn a return on the net proceeds only to the extent that CWS invested an amount that is equal or greater than the net proceeds in its infrastructure.34

This ORA recommendation is not completely consistent with Section 790. Subsection (b) of this section specifically requires all utility infrastructure acquired by investments from an IMA to be included among its other utility property upon which the utility has an opportunity to earn a reasonable return. The code makes no distinction between replacement and other infrastructure property. Therefore, sale proceeds reinvested into CWS's infrastructure should be available to provide CWS an opportunity to earn a reasonable return.

CWS HIMA appears to be in compliance with Section 790. The net proceeds, along with debt financing during the same period of time, were exceeded by CWS investments in its utility infrastructure from 1997 to 2004.35 However, approval of the amount of sale proceeds included in the HIMA for reinvestment into the infrastructure of CWS should not be granted at this time. This is because the sale proceeds included in CWS HIMA is an issue in our R.04-09-003, regarding allocation of gains on sale, where we will create guidelines and a specific rule on allocation of the gain on sale between shareholders and ratepayers, so that allocation of the gain for a specific sale is easy and clear-cut.36 With respect to water utilities, gain on sale issues being addressed on a generic basis include whether the entire gain is included in rate base pursuant to Section 790, a reconciliation between Section 790 and Section 851, and the amount, if any, of gains from non-shareholder investments that should be included in rate base.37 Therefore, CWS should continue to track the sale proceeds in its HIMA and IMA pending a R.04-09-003 resolution of Section 790 gain on sales.

Regarding the Dominguez real property subject to a settlement agreement between CWS and ORA included in the HIMA, the parities shall abide by terms of that agreement and upon a R.04-09-003 gain on sale resolution. If CWS is ordered to share Section 790 gains with ratepayers, it shall, in its next GRC for that district, provide testimony on charging an equivalent rent to its ratepayers. However, if CWS is not required to share the gain on sale, ratepayers shall continue to pay the revenue requirement associated with the costs of owning and operating the pre-merger Dominquez District headquarters. If the Commission orders CWS to take action other than sharing or not sharing the gain with ratepayers, CWS and ORA agree not to be bound by the settlement agreement and may litigate the Dominguez real property issue in the next GRC.38

ORA also recommends that CWS file an annual IMA report that includes a description and status of all real properties approved by the Commission for sale and disposition of the net proceeds. We concur that there is a need for periodic reporting. However, we are reluctant to burden CWS and Commission staff with separate preparation and review, respectively, of an additional yearly filing. Instead, we will require CWS to report and ORA to review CWS's IMA as part of its ongoing GRC filings until the Commission establishes a reporting procedure for all water utilities.

CWS has complied with Ordering Paragraph 13 of D.03-09-021.

6 Exhibit F.

7 Reporter's Transcript Vol. 1, p. 57, lines 19 through 22.

8 Exhibit F.

9 Exhibit A, p. 3.

10 Reporter's Transcript Vol. 2, p. 158, lines 13 through 26.

11 Although this is a consistent company policy, CWS acknowledged that some of the memos declaring real property no longer useful prior to 1975 were not available and apparently lost. See Reporter's Transcript Vol. 2, line 16 through p. 161, p.13.

12 Real property transferred from CWS to CWS Utility Services was valued at the fair market value of the property at the date of transfer. Fair market value was determined from an appraisal, except for nominally valued property which was valued internally. See Reporter's Transcript Vol. 1, p. 25, lines 3 through 7.

13 Exhibit A, p. 7.

14 Exhibit G, p. 11.

15 Id.

16 Exhibit D, p. 3-5.

17 Reporter's Transcript Vol. 2, p. 156, lines 4 through 27.

18 Poor water quality caused by salt water intrusion was the other major reason well sites were no longer necessary or useful. For example, the Hermosa Redondo Well Site #13 with 40,266 square feet was reclassified no longer necessary or useful in 1988 due to salt water intrusion.

19 Reporter's Transcript Vol. 2, p. 156, lines 4 through 27.

20 Reporter's Transcript Vol. 2, p. 161.

21 Reporter's Transcript Vol. 1, p. 72 through p. 80.

22 Id.

23 D.00-05-047 mimeo., Ordering Paragraph 2.c. Subsequently, in Dominguez District's A.03-01-037 GRC, CWS and ORA entered into a settlement agreement on the sale and exchange of real properties used to acquire the new regional operations center. The agreement provided that CWS would report the sale of Dominguez District real properties in accordance with D.03-09-021, and that Dominguez District ratepayers would continue to pay the revenue requirement associated with operating Dominguez' pre-merged headquarters pending Commission resolution of the gain on sale of Dominguez' real property pertaining to the new regional operations building.

24 Reporter's Transcript Vol. 2, p. 244, line 24 through p. 245, line 2.

25 Id. p. 245, line 3 through 10.

26 Exhibit G, pp. 14 and 15.

27 D.04-03-009, as modified by D.04-04-069 and further modified by D.04-09-028, mimeo, p. 8, as part of an order denying rehearing.

28 D.04-09-028 (2004) mimeo. pp. 7 and 8.

29 Id. p. 20.

30 Exhibit F.

31 Id. p. 179, lines 14 through 28.

32 Id. p. 182, lines 4 through 13.

33 Id. p. 242, lines 7 through 13.

34 Exhibit G, p. 11.

35 Appendix A to A.03-12-008.

36 RE: Order Instituting Rulemaking Regarding Allocation of Gains On Sale By Energy Utilities, Incumbent Local Telecommunications Carriers and Water Companies. R.04-09-003 (September 2, 2004) mimeo., p. 3.

37 Id. mimeo., p. 31.

38 D.04-04-041 mimeo., Settlement Agreement, Section 2.2.

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