4. Issues Not Included in the Settlement
4.1. Cost of Capital
The United States Supreme Court established the standard for setting a fair rate of return in Bluefield, Hope and Duquesne.14 These decisions establish that a public utility is entitled to earn a fair return on the value of property invested to serve the public. The return should equal the return on investments in comparable companies and should be adequate to establish confidence in the financial stability of the company, maintain its credit standing, and attract necessary investment capital. Although these decisions establish the constitutional standard for a fair return, determining what ROE meets that standard requires the analysis of many factors.
Cal Am's requested ROE is based on the average of two market-based financial models yielding an ROE ranging from 9.1% without a risk adjustment, to 15.7% with a risk adjustment of 3.3%.
Because Cal Am is not a publicly traded company, both Cal Am and DRA applied market-based models to the stock of similar business risk companies to determine the cost of equity for those companies. The companies are: American States Water, California Water, Aqua America, Connecticut Water, Middlesex Water, and San Jose Water Corp. Cal Am included a seventh company, Southwest Water Corp., in the group it used. Cal Am also estimated the cost of equity for two additional groups of utilities. The two groups are seven regulated gas15 and seven regulated electric16 utilities. Cal Am states it used the gas and electric utility estimates strictly as a reasonableness check for its water utilities calculations. Cal Am's risk component was determined by examining the risk in the cost of equity estimates compared to the risk in Cal Am's capital structure. These models provide a range of ROE estimate results.
Cal Am used the Discounted Cash Flow (DCF) model and Capital Asset Pricing Model (CAPM) in its analysis. To determine the DCF based ROE, Cal Am used the Constant Growth DCF and the Multi-Stage DCF models. The Constant Growth model assumes the company has a constant payout ratio and earnings rate, and a Multi-Stage DCF model assumes investors expect near-term, non-constant growth and long-term constant growth.17 The two DCF models yielded 8.9% and 9.2% results for an average 9.1% DCF method cost of equity.
The CAPM model concludes that the expected return on a risky asset is equal to the sum of the prevailing risk-free interest rate and market risk premium adjusted for the riskiness of the investment relative to the market. It assumes all investors hold efficient portfolios moving in lock step with the market and the portfolios differ only in their sensitivity to the market.18 The CAPM analysis averages the results of the historical market risk premium (12.5%) and current market risk premium (12.2%) yielding an average 12.4% CAPM cost of equity. Both results shift upward when a capital structure risk adjustment is added.
DRA also used two market-based models, the DCF and Risk Premium (RP). The RP model used by DRA includes the risk investors associate with common stock and applied them to six of the comparable water utilities also used by Cal Am.19 DRA's DCF analysis yields an ROE of 9.41%, and its RP analysis yields an ROE of 10.51%. DRA averages these two percentages to arrive at a recommended ROE of 9.96%. DRA opposes a risk adjustment.
DRA provided a table comparing the recommended and adopted ROE's of Class A water companies in all GRC's since 2003.20 We include it here as Table 3.
Table 3: RECOMMENDED AND ADOPTED ROEs SINCE 2003
|
|
DRA Recommended ROE |
Company Recommended ROE |
Adopted ROE |
03-02-030 |
Cal Am |
9.97% |
11.00% |
10.25% |
03-05-078 |
Suburban |
9.04% |
12.00% |
9.84% |
03-08-069 |
Apple Valley Rancheros |
9.53% |
12.00% |
10.10% |
03-12-039 |
Great Oaks |
9.28% |
10.95% |
9.78% |
04-03-039 |
So Cal Water |
9.41% |
12.45% |
9.90% |
04-05-023 |
Cal Am |
9.48% |
11.20% |
9.79% |
04-07-034 |
San Gabriel |
9.43% |
12.25% |
10.10% |
05-12-020 |
Apple Valley Rancheros |
9.85% |
11.60% |
10.15% |
06-01-025 |
So Cal Water |
9.35% |
11.30% |
9.80% |
07-06-024 |
Valencia |
9.57% |
11.75% |
10.19% |
07-08-030 |
Cal Am |
9.69% |
11.60% |
10.00% |
Average |
9.51% |
11.65% |
9.99% | |
Current App. |
Cal Am |
9.96% |
11.50% |
The table indicates that for the past eleven GRCs, the adopted ROEs range from a low of 9.78% to a high of 10.25% with an average of 9.99%. DRA asserts its recommended ROE of 9.96% is consistent with the average Commission adopted ROE of 9.99% and urges the Commission to adopt it.
Cal Am includes VS growth (also call SV growth) in its calculations. VS growth represents the company's dividend growth rate through the sale of stock. Cal Am claims the VS growth rate is required when the company is not expected to issue new shares at prices equal to book value.21 DRA argues that the VS growth rate is unnecessary in calculating sustainable growth because DRA's results are the average of DCF and RP models. The DCF model uses both current and future stock prices and therefore captures the effects of the higher stock prices.22
Another factor considered in setting the ROE are interest rate trends. Cal Am estimated the risk-free interest rate to be 5.0%. This estimate is based upon an average of intermediate-term U.S. Treasury security constant maturity rates published by the Federal Reserve.23 DRA used Data Resources Inc. (DRI) forecasts for years 2008 - 2010, 10-year and 30-year Treasury bill rates of 5.28% and 5.53%, respectively.24 We have relied on DRI forecasts in the past, most recently in D.07-08-030 where DRI's forecast for 2007 - 2009 was 5.2% for 10-year Treasury bills and 5.41% for 30-year Treasury bills.
DRA provides an assessment of Cal Am's total risk by the Standard and Poors (S&P) rating agency.25 S&P evaluates a company's risk in order to assign a credit rating which is a direct measure of its ability to attract capital. Cal Am's parent company American Water Capital Company is rated A- by S&P. Ratings of AAA through BBB are considered investment grade.
As a result of our examination of the parties financial models, interest rates, authorized ROEs for other companies and credit worthiness of Cal Am, we find an ROE of 10.15% is fair and reasonable.
Cal Am is seeking a 3.3% leverage adjustment to account for increased risk. A company's total risk is a combination of the business and financial risk it faces. Business risk relates to the uncertainty in estimating a company's future operating income. Uncertainty regarding the weather and possible contamination that could affect water supply are business risks. Cal Water is a regulated utility and therefore part of its business risk is regulatory risk. The Commission has implemented a variety of measures to reduce the regulatory risk of water companies. Those measures include Balancing Accounts for purchased water and power, and pump taxes. Memorandum Accounts are another means used to reduce risk and protect earnings from regulatory lag. There are Memorandum Accounts for Safe Drinking Water Act compliance, catastrophic events, water quality, and Construction Work in Progress (CWIP).
The level of regulatory risk eliminated by Memorandum and Balancing Accounts was the subject of extensive Cal Am cross examination of DRA's witness Willis. The DRA testimony asserts that the Commission has virtually eliminated regulatory risk.26 Ultimately, the DRA witness allowed that some regulatory risk was beyond the Commission's power to eliminate.27
Financial risk is determined by the amount of debt in the capital structure. Usually, the bigger the debt in the capital structure, the more financial risk there is. Cal Am states that its capital structure has significantly more debt and therefore reflects greater financial risk than that of the sample water utilities. It asserts that any estimate of the cost of equity relying on market data for the sample water utilities must be adjusted to reflect the financial risk associated with Cal Am's capital structure if it is to constitute a fair rate of return in this proceeding.28 It requests an additional 3.3% to account for the company's financial risk in order to attract investors.
Although DRA agrees that water companies with highly leveraged capital structures are higher risk and in some circumstances a leverage adder may be reasonable, DRA asserts no adjustment is necessary here. DRA points out that Cal Am's parent company enjoys a credit rating of A- and issues Cal Am's debt securities.
We do not grant Cal Am's request for a leverage adjustment of 3.3%. The debt to equity ratio, although higher than the comparable water companies, does not adversely affect the S&P credit rating of its parent company. Further, since Cal Am's parent company issues its debt securities, its debt to equity ratio is something wholly within Cal Am's control. Finally, Cal Am has offered no evidence that its high debt to equity ratio has hindered its ability to attract investors. Similarly it has provided only one instance where the Commission has denied recovery of costs through Memorandum and Balancing Accounts.29
Finally, in D.06-11-050 we denied a leverage adjustment, finding that Cal Am was no riskier than comparable water companies and that Cal Am shareholders are rewarded for the lower equity ratio through the amortization of the Citizen's acquisition premium. Also, in the merger proceeding Cal Am claimed ratepayers would benefit from the savings on cost of capital, specifically from increased leverage. In D.07-08-030, we found the reasons for denying a leverage adjustment in D.06-11-050 still applicable and we continue to do so.
To summarize, we deny Cal Am's request for a leverage adjustment. We find its capital structure reasonable since its parent company still enjoys an A-minus rating and there is no evidence it has been unable to attract investors. We also find an ROE of 10.15% falls within the range of the financial models calculated by the parties, is consistent with the ROEs adopted in other proceedings, is comparable to the returns on investments of like companies, and comports with Cal Am's creditworthiness. The 10.15% ROE is fair and reasonable because it is adequate to assure confidence in the company's financial health, maintain its credit standing, and attract capital investment. This ROE will be effective for the term of this rate case, updated in the upcoming Cost of Capital proceeding and implemented under the existing rate making mechanisms.
4.2. Infrastructure Replacement System Surcharge
Cal Am seeks implementation of an ISRS. An ISRS produces revenue to offset costs associated with replacement or repair of non-revenue generating capital projects such as mains, pumping equipment, water treatment equipment, meters and hydrants as well as other fixed costs.30
Cal Am believes an ISRS will address regulatory lag which results in earnings attrition because the current rate case process only provides for annual rate adjustments, regardless of when the projects are completed. Cal Am contends the current use of balancing accounts to offset earnings attrition may not result in complete recovery.
The recovery mechanism Cal Am proposes is a surcharge, capped at 10% over three years, applied to the Commission authorized service and volume prices portion of customers' bills. It would be calculated quarterly utilizing actual costs for completed projects placed into operation. An advice letter detailing the calculations would be filed with a 15-day Water Division review period before the surcharge becomes effective. Cal Am claims the 15-day review period is adequate since the surcharge calculations will be based on a process to record capital expenditures that has been in place for many years and is familiar to staff.31
Cal Am discusses the 5%-capped surcharge mechanism utilized in Pennsylvania. It distinguishes the Pennsylvania example from the higher 10% sought in this case because Pennsylvania rate cases may occur with greater frequency and the surcharges are therefore rolled into rate base sooner. It asserts that in California, the Cal Am surcharge will be in effect for three years before being reset and therefore actually results in an annual surcharge only slightly higher than 3%.
Cal Am lists the customer safeguards of its proposal such as price caps, audits, resetting the price cap to zero, and customer notification processes.32 Cal Am asserts that a more predictable revenue stream will allow it to spread costs more evenly between GRCs and minimize some rate shock produced by the current GRC process.33 The company also lists the reasons alternative regulation such as an ISRS is vital to Cal Am's operation. The reasons include identifying a revenue stream for capital improvement, greater planning flexibility, providing specific customer information regarding capital expenditure funding, offsetting capital expenditure revenue loss due to conservation efforts, and improved offsetting of earning attrition over current processes.34
DRA opposes Cal Am's request for an ISRS. It asserts that Cal Am's application did not identify, inventory or quantify the age or condition of specific plant infrastructure warranting an ISRS.35 Without identifying the specific projects, DRA characterizes the ISRS as an "automatic rate adjustment" for capital investment and believes without specific project information, it is premature to consider such a funding mechanism.
DRA lists the steps it considers necessary to develop a sufficient plan, such as a multiple year forecast quantifying the number of wells, water treatment plants, distribution mains, services and other facilities that may fall under an ISRS; criteria used to determine when facilities will need replacement; estimates or forecasts identifying the level of capital investment planned; and the effect of national security or drinking water standards on infrastructure replacement.36
DRA describes the mechanism based on depreciation rates used by other utilities to replace infrastructure. That mechanism utilizes a straightforward calculation of the depreciation rate and a replacement rate that eventually replaces 100% of the system. Cal Am provided no system replacement rate for its ISRS proposal. Although DRA supports Cal Am's intent to develop a replacement plan, it believes adopting an alternative ratemaking mechanism prior to the development of a plan is unwise.
DRA questions Cal Am's claim of the benefits of a reliable revenue stream, believing it is no more accurate or predictable than traditional ratemaking. The current regulatory framework includes the ISRS-eligible project in rate base and the revenue stream is created there. In fact, DRA claims the current regulatory framework is more predictable since Cal Am will know what its base rates will be for three years, rather than having to wait until a project is completed to trigger a surcharge.
DRA dismisses Cal Am's claims that the ISRS reduces base rates or that an ISRS is needed to assure customers that a portion of their bill is being used for infrastructure replacement. DRA disagrees with Cal Am's claim of a rate base reduction. DRA asserts that although factually true in the short term, under Cal Am's proposal customers will start seeing the first of multiple and increasing surcharges as soon as the second quarter of a GRC cycle. DRA points out that only one customer voiced concern about system replacement and that concern highlighted Cal Am's lack of a replacement plan, not lack of identified funding.
DRA contends that Cal Am's ISRS proposal results in less regulatory oversight and therefore more risks than safeguards to ratepayers. First, DRA disputes Cal Am's claim that a 10% cap is less than other states' caps due to the longer GRC cycle in California. DRA counters that the Pennsylvania (PA) DSIC surcharge of 5% is actually less because PA utilities file rate cases every two years making the annual surcharge 2½% rather than 3.33% for a rate cap of 10% over three years. DRA further claims the 10% cap is based on a comfort level within the company rather than estimated capital project costs.
Similarly, DRA finds the 15-day review period problematic. DRA contends the 15-day review period is insufficient to ensure proper Water Division staff review of advice letters involving substantial sums.
Cal Am has argued that no regulatory oversight would be lost under its ISRS proposal; it would merely occur after project completion rather than prior to implementation. DRA maintains that after the fact disallowance is politically unpopular and once a project has been completed, there is no room for Cal Am to alter its position. DRA claims it becomes an "all or nothing" proposition eliminating the flexibility inherent in the current system. As an example, DRA cites the proposed settlement in this GRC which resulted in an overall 34% reduction in the revenue requirement sought by Cal Am.37
Both Cal Am and DRA cite portions of the National Association of Regulatory Utility Commissioners' (NARUC) February 25, 1999, resolution in support of their respective positions. Cal Am claims the resolution endorses the use of DSIC to tackle the job of replacing water system infrastructure. DRA quotes the NARUC resolution's many other "policies and mechanisms" to "help ensure sustainable practices in promoting needed capital investment and cost-effective rates."38 DRA points out that the Commission currently utilizes nearly all the policies or mechanisms identified by the NARUC Resolution.
The Commission adopted the Water Action Plan on December 15, 2005. The Plan includes six key principles: safe water; high quality water; highly reliable water supplies; efficient use of water; reasonable rates and viable utilities. One of the six objectives adopted to meet the principles was to promote water infrastructure investment. The Water Action Plan recognizes the need for a regulatory process that ensures companies develop long-term plans regarding aging infrastructure, includes plan review, and provides the necessary funding.
Cal Am's witness refers to the need for infrastructure replacement plans and the folly of waiting for all plant to fail or be near failure. The witness calls it "a disaster waiting to happen."39 We agree it is a prudent course of action, however, Cal Am has not provided an actual plan beyond seeking a 10% surcharge. Further, Cal Am has not provided any evidence that the Coronado or Village districts' infrastructure are currently at or near the failure point.
As envisioned by the Water Action Plan, an infrastructure replacement plan is inherently beneficial to both ratepayers and water utilities. It assures customers there is a plan for long-term, reliable delivery of high quality water for a known price and provides the water utilities with a clearly defined revenue stream for infrastructure replacement costs. Unfortunately, Cal Am's proposal consists mainly of establishing a revenue stream via a surcharge. Cal Am has not identified capital project costs or a long-term replacement strategy providing the essential link to the requested 10% surcharge. Cal Am believes the ISRS will allow it to determine the amount of funds available for capital projects and this will aid the company in determining what projects should be undertaken. Conversely, we believe a strong asset management strategy identifies needed capital improvements first, and then determines the revenue necessary to complete the projects. Therefore, we do not adopt Cal Am's ISRS proposal.
In D.07-08-030, we implemented a pilot DSIC program for Cal Am's Los Angeles District. The program provides Cal Am with the desired revenue stream, yet contains multiple safeguards to ensure the Commission retains regulatory oversight. This pilot program is intended to send a strong signal regarding our commitment to long-term capital asset management planning, including the development of infrastructure replacement strategies.
We will not implement the pilot DSIC program in the Coronado and Village districts at this time. We adopted the pilot program with the intention that if successful in meeting our Water Action Plan objectives, a similar surcharge mechanism could be considered for other Cal Am districts and other Class A water utilities. In the absence of evidence establishing urgency or financial need, we believe the current regulatory structure is sufficient. It will provide the necessary regulatory oversight and revenue for capital projects in the Coronado and Village districts until we can determine the success of our pilot DSIC program. The pilot program will be fully reviewed in the next Los Angeles District GRC.
We are committed to providing incentives for water utilities to more efficiently fund infrastructure investment. To that end, we encourage Cal Am to use the time until its next GRC to refine its asset management plan to include information such as:
· A multiple-year forecast indentifying the number, age and condition of wells, water treatment plants, distribution mains and other infrastructure components;
· Criteria for a long-range replacement strategy;
· Forecasts of the level of capital investment needed;
· Impacts of national security on drinking water standards and infrastructure, and;
· The necessary funding mechanism.
4.3. Administrative and General Expense
Cal Am and DRA reached agreement on all aspects of Administrative and General expense except those discussed below.
4.4. Employee Pensions and Benefits
The issue in dispute is health care premium costs. The primary difference between the parties' health care premium cost estimates is the use of different inflation factors. Cal Am estimated Group Health Insurance costs using an escalation factor of 8% for 2007 and an increase of 9% for 2008 based on historical trends in health care premiums.40 DRA calculated the health insurance costs using the CPI-U for group insurance, citing D.04-06-018 as the basis for that calculation. Cal Am contends that DRA has mistakenly concluded that health insurance premiums are categorized as insurance and therefore linked to the CPI-U, rather than as pension and benefits under the Commission's Uniform System of Accounts and linked to the Labor factor.41
Under cross-examination, DRA's witness Greene was asked to examine historical data based on the Coronado District's cost of health insurance. After examining the Coronado District's costs and percentage increases from 2002 through 2006, DRA's witness stated that he was "wrong in using the CPI-U numbers."42
We agree. The historical data more accurately reflects the actual costs the company has incurred for its employees' health insurance premiums and is the appropriate way to calculate future expenses for that item.
4.5. Regulatory Expense
DRA asserts that Cal Am's estimates for regulatory expense are excessive, although it acknowledges that considerable regulatory expense is involved in GRC proceedings. One of DRA's primary objections to the expense estimates involve the regulatory expense for 2008, a year it asserts Cal Am will not have any regulatory expenses.43
Cal Am contends that its costs are based on the actual expenses incurred in preparing for this rate case, as well as the costs for its most recent GRCs in other districts. Cal Am regulatory expense estimates used the actual prior costs for outside consultants, legal assistance, witness training, company labor and expenses and management level expenses. Cal Am goes on to point out that the new Rate Case Plan had not been issued at the time this application was filed and this proceeding has been bifurcated to address rate design in a second phase, two events that add significantly to its regulatory expense. Neither of these expenses was anticipated nor included in the original filing.44
While Cal Am's requested regulatory expenses are higher than previous years, there is some justification for the increases as actual historical expenses are the basis for the estimates. Also, at DRA's request, this proceeding was bifurcated, requiring additional time and attendant expense on Cal Am's part to prepare for a second phase of the proceeding that will extend into 2008.
We will adopt Cal Am's regulatory expense figures because they do not include the now-known 2008 expense associated with the bifurcation of this proceeding.
14 Bluefield Water Works & Improvement Company v. Public Service Commission of the State of Virginia (Bluefield) 262 U.S. 679, 692-693 (1923), Federal Power Commission v. Hope Natural Gas Company (Hope), 320 U.S. 591, 603, (1944), and Duquesne Light CO. v. Barasch (Duquesne) 488 U.S. 299, 310 (1989).
15 Cascade Natural Gas, Keyspan Corp., Northwest Natural Gas, Nicor Inc., Piedmont Natural Gas, South Jersey Industries, and Southwest Gas.
16 Central Vermont Public Service, Cleco Corporation, DPL Inc., Empire District Electric, Green Mountain Power, Hawaiian Electric, IDACORP, Inc., and Westar Energy.
17 The multi-stage DCF model uses near-term forecasts for the comparable companies and long-term forecasts of the gross domestic product from 1929 to 2005.
18 Exhibit 4, p. 23.
19 DRA does not include Southwest Water in its analysis.
20 DRA Reply Brief, p. 5.
21 Exhibit 4, Tab 11, p. 18.
22 Exhibit 29, Tables 2-2 & 2-5.
23 www.federalreserve.gov.
24 Exhibit 29, Table 2-6.
25 DRA Opening Brief, pp. 9-10.
26 Exhibit 29, pp. 3 -1.
27 RT pp. 262 - 74.
28 Exhibit 4, p. 31.
29 In D.03-09-022, the Commission denied Cal Am's request for Construction Work In Progress (CWIP) on its Coastal Water Project desalination plant.
30 Exhibit 3, p. 4.
31 Exhibit 3, Tab 4, p. 10.
32 Id., p. 15.
33 Id., p. 19.
34 Id., p. 16.
35 Exhibit 25, pp. 11-16.
36 Id.
37 The average is calculated using all four districts in the GRC. DRA Opening Brief, p. 23, Table 2.
38 Exhibit 43, p. 1.
39 Id., p. 20.
40 Sacramento District Exhibits A-D & F, Final Application, Ch. 6.
41 Cal Am Opening Brief, p. 44.
42 RT, p. 406: 24-25.
43 Exhibits 25, p. 4-5, Exhibit 26, p. 4-5, Exhibit 27, p. 4-4 & Exhibit 28, p. 4-4.
44 Cal Am Opening Brief, p. 46.
