9. Cost of Capital

Under the rate case plan, this decision adopts a capital structure and a cost of capital, including the authorized return on equity, for the test year 2006 as well as the two attrition years 2007 and 2008. Apple Valley's capital structure, long term debt financing and equity investment are all provided by its sole shareholder, Park, but we adopt for ratemaking purposes the most appropriate capital structure and cost of capital for Apple Valley.

Apple Valley requests a capital structure of 42.33% debt and 57.67% equity for all three years, 2006 - 2008. Based on forecasts of its weighted average cost of borrowing it proposes debt costs of 8.49%, 8.41% and 8.35%, respectively, and a constant 11% return on equity for the three years. ORA accepted the capital structure and weighted cost for long-term debt for the three years,12 so the only disputed issue is the return on equity. We will adopt the agreed-upon capital structure and cost of debt because they reasonably reflect the actual capital structure and cost of debt for Park as applied to Apple Valley.

Apple Valley's consultants used the Discounted Cash Flow model to derive a water utility benchmark sample equity return of 10.4%. They also used three Risk Premium methodologies to derive a water utility benchmark sample equity return of 10.9% to 11.6%; and the CAPM model to derive a water utility benchmark sample equity return of 11.1%. Apple Valley also proposes that if it were to use gas utilities as a comparable basis it could justify a range of 10.3% to 11.2%.13 Additionally, Apple Valley proposes that there are specific high risks identifiable for water utilities generally and Park, and hence Apple Valley, that would support a range of return on equity of 11.3 to 12.5%. This includes a request for a 90 basis-point risk premium, despite the Commission's findings in D.03-08-069 that 30 basis points were sufficient. That decision was also "skeptical" of Apple Valley's analysis,14 which relied on the same models offered for us to consider again in this proceeding. In that decision, Apple Valley was authorized a 30 basis point risk premium on the "lower second quarter (or 9.80%) of the 9.21% to 11.22%" range for return on equity, resulting in an authorized 10.10% return.

We find that Apple Valley has again proposed an inflated range for equity returns and further that several of the asserted "risks" are in fact discretionary choices made by Park, the parent company that exercises complete control of Apple Valley. Apple Valley cites that Park does not publicly trade its stock, and this therefore limits its access to capital.15 Park was an "S" Corporation16 for about six years through 2003, a choice and subsequent change made by Park for the convenience of its limited investors. It is still a closely held company with a limited number of shareholders, and such a discretionary choice should not result in any increased costs to be borne by the ratepayers. We will not adopt a large risk premium caused by discretionary choices of closely held Park. The Commission found in 1999 that the cost for Park to be a public company was higher than being closely held17 - but we have no current detailed evidence on this point to compare to the cost of being a small private company.

We also find that natural gas rates of return are not relevant for Apple Valley. The cost recovery and market risks are totally dissimilar. Apple Valley failed to provide any convincing evidence to support the relevance of gas utility returns, and thus it failed to meet its burden of proof on this portion of its cost of capital showing. We therefore reject Apple Valley's presentation on the returns of equity applicable to gas utilities, while noting that Apple Valley does not base its request on this study.

The Commission has never endorsed a single method to forecast return on equity, preferring instead to consider the ranges provided by an array of methods. We will again consider Apple Valley's specific operations and risks, and an array of analyses, to find a just and reasonable return on equity for Apple Valley.

ORA did a limited analysis on the return on equity, acknowledging that it did not perform a separate study for Apple Valley.18 ORA reviewed the proposed capital structure and embedded cost of debt projected for 2006, 2007 and 2008, and accepted them as reasonable estimates.19 ORA looked at its three most recent recommendations for other Class-A water companies20 where, on average, ORA's studies recommended a return of 9.47%, about 2.08% less than the average requests of 11.55%. These cases all settled, but the average return included in the settlements was 10.02%. This was an average of 1.53% less than the rate proposed by the utilities.

ORA then focused on its most recent recommendation of 9.61% for California Water Service. It asserted the data underlying that recommendation are still current, and therefore recommended a rate of 9.61% (subsequently updated and corrected to 9.85%) plus a risk premium of 30 basis points (0.30%) for a final return on equity of 9.91% (updated and corrected to 10.15%). The proposed risk premium would continue the premium adopted in Apple Valley's last rate case in D.03-08-069, where the Commission adopted a return on equity of 10.10% including the risk premium. The unadjusted rate was therefore 9.80%.

Unlike the energy utilities that have annual cost of capital proceedings separate from their other ratemaking proceedings,21 the Class A water utilities have a review every three years as a component of the general rate case. One can argue whether there is more risk associated with a return subject to change annually (a volatility risk) or a return fixed for a longer period (an opportunity risk). But we do not see the same risks or degree of risk in water utilities that would warrant a more frequent review. The rate case plan for water utilities opted to review the equity return triennially.

Apple Valley has shown, with the limitations of their implied capital structure, that for 2001 through 2004, it earned a lower actual return on equity than was authorized, while its cost of debt and its equity ratio in the capital structure were (with one exception) lower than authorized.22 A lower cost of debt and lower equity ratio would tend to increase the actual return on equity, all other factors being constant.

Apple Valley introduced rebuttal testimony in Ex. 8 that was "an update and corrections to ORA's Cost of Capital Report presented in A.04-09-028 ... (and) an update of ORA's ROE [return on equity] estimate from A.04-04-040."23 ORA accepted this exhibit as providing an update and correction. Apple Valley and ORA then offered a written stipulation in Ex. 10 which indicated that the ORA recommendation changed from 9.61% to 9.85%, before consideration of a risk premium.

We will adopt the corrected ORA recommendation, inclusive of the risk premium, because the 10.15% return on equity (9.85% + 0.30%) most reasonably reflects the risks faced by Apple Valley.24 We stress that the inclusion of a risk premium is not automatic, and in Apple Valley's next general rate case, it must continue to meet its full burden of proof for its proposed return on equity and any request for a risk premium addition.