VII. Comments on Proposed Decision
The proposed decision of the ALJ in this matter was mailed to the parties in accordance with Pub. Util. Code § 311 and Rule 14.2(a) of the Rules of Practice and Procedure. Comments were received on May 29, 2007, and reply comments were received on June 4, 2007. In its comments, the Division of Ratepayer Advocates raised a series of objections to the proposed decision. This decision has been modified in response to the DRA comments. We discuss the comments and modifications below.
A. Typographical Errors and Other Non-substantive Changes
Valencia and DRA pointed out certain typographical errors and unintentional omissions including an erroneous caption. Changes in response to these comments have been made throughout the document.
B. Base Revenue Memorandum Account
DRA objects to the inclusion in the decision of a provision for a base revenue memorandum account on the grounds that the issue was not included in the Scoping Memorandum as required by Commission rules and California law. See Southern California Edison Company v. Public Utilities Commission, (2006) 140 Cal App. 4th 1085. We believe this objection has merit and have removed the discussion of the Base Revenue Memorandum Account from this decision. We direct Valencia to file a separate application for approval of its proposed BRMA including an increasing block rate design.
C. Risk Premium Adjustment
DRA objects to inclusion of a risk premium adjustment on three grounds: Valencia is not a small company; there is no enhanced regulatory risk from operating in California; and Valencia should receive no risk premium enhancement for risks faced in common with all other water companies. We note that the second objection can be incorporated in the third since any California-specific risk is one faced by all California water utilities. We disagree with DRA regarding Valencia's size. While it is true that Valencia with approximately 28,000 customers is a Class A water company, it is not a large company and DRA admits as much.105 While Valencia is a subsidiary of Lennar, Inc., a large, publicly-traded real estate development company, its credit is not enhanced by its subsidiary status. As we noted in the draft decision, Lennar, as speculative real estate developer, is engaged in a volatile and risky business106 that carries a higher financial risk than operating a regulated water utility with a guaranteed rate of return. Even though Lennar was obligated, as a condition of acquiring Valencia, to ensure that Valencia has adequate capital to fulfill its public utility obligations, Lennar was not obligated to borrow money on its own credit to provide capital to Valencia nor would we want it to do so. With respect to the question of general vs. specific company risk, we are persuaded that DRA is correct and that risks Valencia faces operating in California are no different from those faced by other California water utilities and do not merit a separate premium adjustment.
D. Objections to Discounted Cash Flow and Risk Premium Analysis Methodology
As a preliminary matter, we note that there has been considerable confusion about numbers in this case in part because the original expert testimony offered on behalf of DRA was replete with arithmetic errors. These errors have largely been corrected in response to objections from the company but some additional corrections were required in order to obtain a consistent and coherent presentation of an alternate DCF analysis. Those additional corrections are reflected in the ROE approved in this decision and in the tables adopted in connection therewith. They added approximately 13 basis points to the ROE approved in this decision.
DRA makes six objections to Valencia's discounted cash flow (DCF) and risk premium (RP) methodology. We address only those objections that affect the ultimate ROE. (1) DRA alleges that Valencia improperly includes so-called "SV growth" in its DCF model. We concur with DRA that SV growth should be excluded. It is not an item recognized by Kolbe and Read, the authors of the authoritative textbook on public utility cost of capital estimates.107 Although Valencia's expert speculates on the reasons why Kolbe and Read do not factor SV growth into their DCF model, we need only note that they do not. (2) DRA objects to Valencia's exclusion of historical growth from its DCF model. DRA used an average of historical and forecasted growth rates in its DCF calculation while Valencia relied entirely on forecasted growth rates. Valencia's basis for excluding historical growth rates was the testimony of its cost of capital expert to the effect that the forecasted rates include a factor for historical growth. On balance, we believe that the combination of historical and forecasted earnings growth rates more accurately projects future earnings growth than forecasted growth alone. Inclusion of sustained historical growth rates in the DCF calculation sets a more reliable floor under future growth rates than use of projected growth alone. (3) For the same reason, we believe that inclusion of historic dividend growth rates provides a more reliable estimate of future dividend growth rates than reliance on forecasted earnings alone.
E. Comparison with Gas Utilities
Valencia uses a group composed of gas utilities, whose characteristics it claims are similar to the water utility industry in its DCF and RP analysis. The Commission has repeatedly stated that water utilities should not be compared to companies in other industries (D.04-05-023, D.03-05-078, p. 36; D.01-04-034, p. 11-14; D.90-02-042, p. 38). In D.92-01-025, p. 23, the Commission stated, "Due to the revenue recovery mechanisms in place for water utilities, we find that water utilities do not face the same overall risks as energy and telecommunications utilities." Therefore, the results of these models should not be considered in the determination of an ROE for Valencia.
F. Valencia's ROE Based on Corrected Data
As noted above, calculating an appropriate ROE for Valencia in this case was rendered more difficult than it should have been by the large number of arithmetic and methodological errors in the original DRA presentation, errors that continued, albeit in smaller numbers, through the filing of comments. Nonetheless, it has been possible to re-run DRA's DCF and RP models based on corrected input and reflecting the responses to comments outlined above. Doing so results in an unadjusted ROE of 9.59 to which we add a risk premium adjustment of 60 basis points for a final ROE of 10.19.
105 "...Valencia may be comparable in size to other small water companies like Park and Great Oak..." DRA Comments on Proposed Decision, p. 3.
106 We take judicial notice that Lennar, Inc. has lost almost $300 million in its last two quarters of reported operations.
107 The Cost of Capital - Estimating the Rate of Return for Public Utilities, by A. Lawrence Kolbe and James A. Read Jr., with George R. Hall, 1985.
