V. Ratesetting

The following discussion is organized around the three main components of cost-based ratemaking: net operating income, rate base, and rate of return. This is followed by a discussion of the utility's revenue requirement.

A. Net Operating Income

Net operating income is gross operating revenue less operating and maintenance expenses, depreciation, income taxes, and other operating taxes. The parties agree that an estimated 7 million gallons of water each year will be sold. Based on the rate design adopted herein, this volume will yield gross operating revenues of $120,121 (including $3,704 as the value of water delivered to Three Peaks Ranch pursuant to a separate agreement).

For test year 2004, Keene estimates that expenses total $101,220. The Water Division estimate is $88,478. The Stonybrook Corporation and Beard estimate certain expense items but did not provide an overall estimate of expenses. The agreed-upon expenses are discussed first, followed by the expense categories where the parties disagree.

1. Areas of Agreement

The parties agree on Keene's requests in certain categories: $1,500 for water testing, $3,900 for chlorination, and $6,100 for electricity and telephone. The Commission has reviewed these requests and finds them reasonable.

2. Labor Cost

Keene requests $50,526 for labor costs. The Water Division proposes $48,545. Stonybrook and Beard suggested that some work could be done at lower cost by contractors outside Union Pacific's collective bargaining units, but they offer no evidence on what savings such an arrangement would produce. The Commission adopts $50,526.

The applicant and the Water Division agree on the total estimated hours of labor (1,600 hours; equivalent to 75% of one employee) and the salary rate. The only disagreement between Keene and the Water Division concerning labor costs is the appropriate fringe benefit rate. The Water Division proposed 47% based on a 2002 estimate. Robinson testified that the current overhead rate is 52.43% for the bargaining unit covering the employee who performs most of the water system work. As Keene argues, the water system historically has been a union shop and cannot be changed into a non-union stop just because this might be more advantageous to ratepayers. RT at 246; 17-247:10 (Perez); Keene Reply Brief at 19. A fringe benefit rate of 53% is supported by the weight of the evidence, and that rate will be adopted here. The Commission also adopts the Water Division's position that Keene should read the individual water meters, and the labor necessary for this task is already included in the total estimated number of hours.

3. Vehicle Cost

Keene's amended request is that 75% of the costs (or $9,000) of the vehicle assigned to the employee who performs most of the work on the water system be recovered in rates. The Water Division proposes $6,850, allowing the recovery of 50% of costs based on 2001 information. Stonybrook proposes $1,000.

The employee needs to have a vehicle in order to travel to the water system, perform work at the water system, and respond to emergencies from his home. Applying the same percentage for vehicular costs as labor cost (75%) for the employee who uses the vehicle is a reasonable allocation method. Using the Water Division's own figures, a 75% allocation (even using 2001 figures) would exceed the $9,000 requested by Keene. The Commission adopts the $9,000 request.

4. Technical Advisor

In the past, Keene has contracted with a private consulting firm concerning operation of the water system and compliance with DHS's requirements. As Keene has now assumed these responsibilities, this expense has been reduced. Both Keene and the Water Division agree on $4,410 for the test year. Stonybrook proposes $2,000 but fails to support this figure. The Commission accepts the $4,410 request.

5. Permits and Monitoring

Keene requests $6,784 for permits and monitoring, based on an average of expenses between 2000 and 2003. The Water Division suggests that $1,443 should be recovered in rates and any additional expenses in this category be tracked in a memorandum account. The Water Division points out that the Commission's Resolution W-4327 allows Class B, C, and D water utilities to establish a memorandum account for these expenses and recover them on advice letters.

As discussed below, the system's water quality is of continuing concern to the Commission. More periodic testing may be required to ensure that the system is complying with GO 103 and applicable state and federal law. The memorandum account provides a practical means for tracking these monitoring expenses. The Commission allows $1,443 for license and permit expenses. For expenses beyond this amount, Keene should use the memorandum account to track these expenses and to seek recovery through advice letters.

6. Materials and Supplies

Keene and the Water Division agree on the estimate of $13,000. Stonybrook suggests half of this amount but does not provide any specific basis for its recommendation. The Commission accepts the $13,000 request.

7. Legal Fees

Keene estimates that it will incur $20,000 in legal costs for this ratemaking proceeding and proposes that this amount be amortized at $3,000 per year until fully recovered. The Water Division agrees that both the total fees and amortization proposal are reasonable. Stonybrook proposes that legal fees not be allowed.

Reasonable legal fees incurred in a rate proceeding are normally recovered in rates. Keene's attorneys have diligently litigated this proceeding, and Stonybrook has demonstrated no reason why Keene's legal fees should not be recovered here. The amortization proposal is a reasonable method of allocating the costs of a multi-year rate proceeding over multiple years. The Commission accepts the $20,000 request and instructs that this amount be amortized, without interest, at $3,000 per year until fully recovered. Any ratesetting-related legal fees beyond $20,000 should be booked to a memorandum account.

8. Expenses Not Requested

Keene has not requested recovery for property taxes, income taxes, insurance, or administrative/general expenses. This is because these expenses are integrated in overall Union Pacific expenses and the appropriate charges are not easily allocated to the Keene Water System. The Water Division suggests the recovery of $800 in anticipated income tax expenses; but if Keene does not want to claim this expense in rates, ratepayers will benefit. The Commission accepts Keene's preferences concerning these categories.

B. Rate Base

Rate base is one of the more contentious issues between the parties but the debate revolved around only one important item. As rate base, Keene claims the amount of $502,611, which represents the net plant cost of the 1997 pipeline replacement and relocation project undertaken before Keene was determined to be a public utility. To be clear, this is the distribution pipeline system within the Keene community (not including pipes "downstream" of master meters). This is not the 1993-94 project that resulted in the substitution of local wells for the water imported by pipeline from the City of Tehachapi. Keene does not seek rate recovery for the costs of the 1993-94 project; nor does it seek recovery for a well replacement project in 1997, a pump replacement project in 1999, or a line replacement for Three Peaks Ranch undertaken in 2000.

The original cost of the 1997 distribution pipeline project was $602,226. Keene estimates the useful life of this improvement to be 40 years. In determining net plant of $502,611, Keene has subtracted $106,000 in depreciation from 1997 to 2004.

The Water Division and other parties oppose the inclusion of any part of the 1997 pipeline project in rate base. The Water Division argues that Union Pacific has already expensed this project and that it would violate Generally Accepted Accounting Principles (GAAP) to capitalize this project retroactively. The Water Division also maintains that the 1997 project was an extension of the ill-conceived 1993-94 undertaking (see discussion, VII below), predominately advanced Union Pacific's interests, and only minimally benefited water users. Beard maintains that the 1997 project was undertaken principally to improve railroad operations by removing the pipeline from the railroad right of way where ongoing pipeline maintenance would interfere with train operations on this busy freight corridor.

No party contests the approximate 100-year age of the pre-1997 distribution pipeline and even Beard and Stonybrook tacitly admit that there were leaks in this system and health concerns. Michael Lyon indicated in prepared and oral testimony that DHS sought pipeline relocation and replacement, although Beard argues that DHS never directly ordered the replacement. The objectors argue that the replacement was primarily to remove the pipeline from the railroad right-of-way to the county road so that profitable rail freight operations would not be disrupted by maintenance of the water system.

Rather than a nefarious scheme, the evidence supports the conclusion that pipeline replacement and relocation was a prudent management decision. The distribution system was old and an increasing number of repairs on the busy railroad right-of-way, to repair leaks and otherwise meet DHS concerns, would increase the cost and danger of such maintenance.

The railroad may well have benefited from the relocation; but protestants' arguments on this point are general and they did not attempt to quantify this assumed benefit in a way that can be factored into ratebase determinations. The Water Division, for instance, argues that the railroad benefited by "unburdening" its right-of-way so that it can now be sold or leased to other parties. This is conjecture, as no evidence was produced indicating that the railroad has or intends to do so. Testimony as to the cost and danger of conducting non-railway operations within the rail corridor suggests that few if any sales or leases will occur. The Water Division also argues that the new pipes made the water system more marketable, potentially enabling the railroad to sell and end its responsibility for the system. Even if evidence existed to support this motive, the resulting benefit appears to have been nil since the railroad paid for the pipeline replacement but has been unable to sell the system. Finally, the Water Division argues that the pipeline benefited the company because it enabled the railroad to meet its water delivery obligation to Three Peaks Ranch. Since the Commission adopts the Water Division's earlier recommendation to charge the water company for water delivered without cost to Three Peaks Ranch, pursuant to this arrangement, any such benefit is essentially cancelled.

While the railroad benefits from the 1997 project are uncertain, there is no doubt that Keene water users benefited substantially by the replacement of a century-old leaking system with a new system. This project would have been necessary regardless of the fate of the Tehachapi-Keene pipeline. Without tangible and convincing evidence indicating that some of the pipeline cost should be allocated to the railroad, the Commission authorizes the inclusion of the net plant of $502,611 in rate base.

The Water Division's concerns that Union Pacific has already expensed the 1997 project are misplaced. Tax and utility accounting are generally separate regimes. For example, a regulated utility may be authorized by the Commission to charge for income tax on calculated revenues as if it were a stand alone water system, even though it is part of a holding company that has a totally different tax situation.

The evidence is sketchy at best has to how Union Pacific handled the 1997 pipeline costs for tax purposes. Even if expensed, the protestants have not demonstrated how ratepayers might be harmed. While the Water Division suggests that this violates GAPP, the Division offers no citations to GAPP provisions, Commission General Orders, or standard procedures that are violated. The decisions cited by the Water Division refer to attempts by utilities to both expense and depreciate assets in the ratesetting process. Such an error is not present here.

Based on the opinion evidence of its expert, the Water Division also argues that Keene was imprudent in "not replacing the line before it became 100 years old." RT 282 (Perez). If Keene had earlier replaced the pipeline, or had engaged in more active maintenance over the years, costs of the 1997 project may have been less than the amount Keene now seeks to add to rate base. However, the Water Division does not offer any financial or engineering evidence indicating what specific maintenance was imprudently postponed or, with proper ongoing maintenance, what savings might have resulted.

C. Rate of Return

At present rates, Keene would be receiving a negative 20.98% return on rate base (net operating loss of $105,450 ÷ average rate base of $502,611). Keene seeks a rate of return of 2.39% on rate base. Since the Water Division's position is that the water system should have zero rate base, it has not taken a position on Keene's request of 2.39%. The Water Division does indicate, however, that if the Commission allows the company's requested ratebase, the Division does not oppose a 2.39% rate of return. Stonybrook and Beard do not take a specific position on rate of return.

The Commission recently adopted Resolution W-4524, updating the method of calculating rate of return and, where applicable, rate of margin for Class C and D utilities. The resolution revised Standard Practice SP-U-3-SM, which includes guidance on how to calculate returns for these small water utilities. For 2005, the revised Standard Practice indicates an average rate of return of 12.90% for Class D utilities, such as Keene. If a Class D utility has little rate base (which would be the case here if Keene's 1997 improvements were not included in rate base), the utility would be entitled a rate of margin of 24.63%, on the average. (Res. W-4524 at Att. A, pp. 1, 5 (Mar. 17, 2005).)

Given an average rate of return of 12.90% for Class D water utilities, Keene's proposed 2.39% rate of return is fair and reasonable. The company has indicated that it seeks such a low rate because it recognizes that water users will pay much more for their water as a result of this proceeding.