IX. Cost of Capital

A. Capital Structure

San Gabriel projects common equity ratios averaging 67.3% for the years 2003-2006. ORA recommends a common equity ratio of 55% for all years. As discussed below, we conclude that for ratemaking purposes, a capital structure with an imputed common equity ratio of 60% is reasonable for San Gabriel.

San Gabriel argues that before adopting a hypothetical capital structure that contains less common equity than San Gabriel actually employs to provide service, there should be compelling evidence that San Gabriel's actual capital structure is inefficient, i.e., not least cost. According to San Gabriel, ratepayers have already received benefits from that actual capital structure in the form of lower costs of debt than otherwise could have been obtained - if debt could have been obtained at all - with the highly leveraged capital structure proposed by ORA for ratemaking purposes. San Gabriel contends that as a relatively small, privately held water utility facing substantial capital needs, it requires a strong equity position to be able to sell bonds on reasonable terms and to finance expected and unexpected investments in a timely manner.

ORA argues that the adopted common equity ratio in past San Gabriel rate cases has been 55%. ORA points out that in D.96-07-057, the Commission concluded that "Rather, we will adopt an imputed equity ratio of 55%, which we believe is a more reasonable and fair ratemaking approach that balances both shareholder and ratepayer interest." Further, ORA contends that a higher equity ratio is inefficient and burdensome to the ratepayers (51 CPUC2d at p. 625). ORA also refers to a decision regarding San Jose Water Company where the Commission stated: "Excess levels of common equity burden the ratepayer with excessive rates. Ratepayers do not receive a tax benefit for paying this revenue requirement on equity as they do from the tax deduction allowed for debt interest payments." (33 CPUC2d at p. 312.)

We believe that since San Gabriel is a relatively small Class A utility, an imputed equity ratio of 60% is reasonable for ratemaking purposes. A strong equity position allows San Gabriel to issue bonds when needed at reasonable terms, and ratepayers have benefited accordingly. Notwithstanding ORA's argument about the need for an efficient capital structure, there is also a tradeoff between high capital costs (high costs for both equity and debt) and tax benefits of debt. As the debt ratio is increased, both debt and equity costs increase and offset the tax benefits of debt. We also note that the Commission has found that an equity ratio of approximately 60% is reasonable and appropriate for small Class A water utilities.¹⁰ Accordingly, we adopt a common equity ratio of 60% for San Gabriel, for purposes of this proceeding.

B. Effective Cost of Long-Term Debt

ORA agreed with the timing and amount of long-term debt issues in San Gabriel's application. San Gabriel determined the interest rate for new long-term debt issues by adding 246 basis points to the 30-year Treasury bond rate forecast by Value Line. ORA independently verified and agreed with San Gabriel's 246 basis point figure. However, ORA used the forecasted 30-year Treasury Bond rate projected by Data Resource Inc. (DRI) for each year, plus the 246 basis points, to approximate San Gabriel's cost of new long-term debt. ORA's and San Gabriel's computation of the effective cost of long-term debt matched for years 2002 and 2003 while differing slightly in years 2004 through 2006.

Since the Commission regularly uses the DRI forecast, as opposed to Value Line, we will continue to use DRI. On this basis, the adopted costs of new long-term debt issues for San Gabriel are 8.04% for 2004 and 8.82% for 2006. Based on this, the adopted average embedded costs of debt are 8.38%, 8.36%, and 8.35% for 2003, 2004 and 2005, respectively.

C. Equity Cost

Equity cost is a direct measure of the utility's after-tax Return on Equity (ROE) investment. Its determination is based on subjective measurement, and not susceptible to direct measurement in the same way capital structure and embedded long-term debt costs are.

Both San Gabriel and ORA acknowledged the well-established legal standard for determining a fair ROE, and we have many times cited that same legal standard. In the Bluefield Water Works case, the Supreme Court stated that a public utility is entitled to earn a return on the value of its property employed for the convenience of the public, and set forth parameters to assess a reasonable return.¹¹ That return should be "...reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economic management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties."

As the Supreme Court also noted in that case, a utility has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. In 1944, the Court again considered the rate of return issue in the Hope Natural Gas Company case, stating, "[T]he return to the equity owner should be commensurate with returns on investments in other enterprises sharing corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital."¹²

Hence, we set the ROE at a level of return commensurate with market returns on investments having corresponding risks, and adequate to enable a utility to attract investors to finance the replacement and expansion of a utility's facilities to fulfill its public utility service obligation. To accomplish this objective, we have consistently evaluated quantitative financial models and risk factors prior to exercising informed judgment to arrive at a fair ROE.

1. Financial Models

The quantitative models commonly used in ROE proceedings as a starting point to estimate investors' expectations for ROE are the Discounted Cash Flow (DCF) and Risk Premium (RP). Although the parties agreed that the financial models are objective, the results are dependent on subjective inputs. Detailed description of the DCF and RP models are contained in the record and are not repeated here.

Although the parties agree that the models are objective, the results are dependent on subjective inputs. For example, each party used different proxy groups, betas, growth rates, and calculations of market returns. It is the application of these subjective inputs that resulted in a wide range of ROEs being recommended by the parties as shown by the results of their individual models. From these subjective inputs, the parties advance arguments in support of their respective analyses and in criticism of the input assumptions used by the other party. These arguments will not be addressed extensively in this opinion, since they do not materially alter the model results. In the final analysis, it is the application of judgment, not the precision of these models, which is the key to selecting a specific ROE estimate within the range predicted by analysis.

a) San Gabriel's Financial Models

San Gabriel estimated the ROE investors expected to earn by applying the DCF and the RP models to a selected group of three water utilities. The criteria it used to select this proxy group were that the water utilities have at least one bond rating of A or better from Moody or Standard & Poor (S&P); that are not being acquired and are not likely acquisition candidates; and that there be analyst's forecasts of future earnings, dividends and returns on equity.

San Gabriel supplemented its small sample of water utilities with a separate proxy group of eight gas distribution utilities to which it applied the DCF and RP models. The criteria used by San Gabriel to select this proxy group were that the gas utilities paid dividends; have at least one bond rating from Moody or S&P that is single A or higher; and, have at least 60% of revenues derived from gas distribution utilities.

San Gabriel derived an overall ROE range from the results of its DCF and RP models as summarized in the following table:

	San Gabriel's Estimated Ranges of Equity Costs
Discounted Cash Flow Estimates
Based on Water Utilities	12.2% to 12.3%
Based on Gas Utilities *	11.9% to 12.2%
Risk Premium Analyses Estimates
Based on Water Utilities	12.4% 12.4%
Based on Gas Utilities * Authorized ROEs	11.9% 12.0%
Based on Moody's Gas * Utilities Index	12.3% 12.4%
Estimated Equity Cost Range	11.9% 12.4%
San Gabriel requested ROE	12.25%

* San Gabriel reduced each of these gas proxy results by 50 basis points to make its gas proxy group comparable to water utilities.

b) ORA's Financial Models

ORA estimated the ROE that investors expect to earn from San Gabriel by applying a selected proxy group of six water utilities to the DCF and RP model. The criteria used by ORA to select this proxy group were that water operations accounted for at least 70% of the utility's revenues and that the utility's stock is publicly traded.

ORA applied three variations of the DCF model to mitigate period specific biases and to consider both current and long-term trends. It also applied two variations of the RP model to its same proxy group. ORA derived an overall simplified 8.61% to 10.24% average ROE range from the results of its DCF and RP models applied to its water utilities' proxy group, as summarized in the following table:

Model	Proxy
DCF Growth Rates 3-Month ROE 6-Month ROE 12-Month ROE DCF AVERAGE	8.63% 8.63% 8.56%		8.61%
RP Period 30-Year Treasury Bond 10-Year Treasury Bond RP AVERAGE	Five Year 10.49% 10.03%	10 Year 10.45% 9.99%	10.24%
ORA Recommended ROE			9.43%

2. Risk Factors

Risk factors consist of financial, business and regulatory risk. Financial risk is tied to the utility's capital structure. The proportion of its debt to permanent capital determinates the level of financial risk that a utility faces. As a utility's debt ratio increases, a higher return on equity may be needed to compensate for that increased risk.

Business risk pertains to uncertainties resulting from competition and the economy. That is, a utility that has the most variability in operating results has the most business risk. An increase in business risk can be caused by a variety of events that include poor management, and greater fixed costs in relationship to sales volume.

Regulatory risks pertain to the impact on risks that investors may face from future regulatory actions that we, and other regulatory agencies, might take. These risks are assessed to determine whether there is a need to increase or decrease a ROE to compensate investors for added or reduced risks.

San Gabriel witness Dr. Thomas M. Zepp testified that San Gabriel faces far greater operating and business risks than most other water companies. He concluded that just its smaller relative size justifies a 99 basis point risk premium for San Gabriel. Dr. Zepp further testified that other risk factors include the very substantial risk San Gabriel faces related to contamination of its water supplies, including uncertainty as to the availability of its wells, increased investment needs, ongoing and future costs of defending lawsuits alleging tort liability, and the risk of such liability, as well as further risks to San Gabriel's earnings due to the erratic availability of surface water supplies, the lack of financing flexibility for a closely held company like San Gabriel, and the asymmetric treatment of water supply costs under the new balancing account rules adopted by the Commission in D.03-06-072.

ORA's witness Seaneen M. Wilson disagrees with San Gabriel's risk assessment and concludes that no addition to the ROE is necessary. ORA responds that if new investment in water treatment facilities to treat groundwater contamination is required, and if investment in these facilities is determined to be reasonable, the capital projects will be included in rate base and San Gabriel will receive a return on its investment. ORA points out that if San Gabriel faces lawsuits regarding alleged contaminated water, a number of options are available to reduce risk, including a memorandum account to record costs associated with litigation, which will be allowed in rates if found reasonable. Further, ORA argues that San Gabriel's argument for a 99 basis points "small size" premium is based on a flawed analysis. According to ORA, other factors besides size, contribute to differences in earnings.

ORA also disputes San Gabriel's contention that the newly adopted procedures for balancing account recovery increases risk. According to ORA, the revised balancing account recovery mechanism authorized by the Commission in D.03-06-072 continues to allow the utility the opportunity to earn its authorized return, which is all that is required by the Supreme Court. ORA believes that since the risk faced by the water utilities is not increased, no addition to ROE is necessary.

3. Discussion

Ultimately, the choice of factors used to measure an appropriate return on investor's equity is a matter of judgment. Both parties rely on DCF and RP analyses that we have consistently accepted in the past for water companies. In ORA's analysis, we are troubled by the large disparity (163 basis points) between the DCF and RP results. ORA has not explained the reasons for the disparity, nor the logic of averaging two such different results to arrive at a recommended ROE of 9.43%.

By the same token, San Gabriel's use of data including use of a "comparable group" of gas utilities to perform its DCF analysis comparison is questionable. Further, with the availability of memorandum accounts and balancing accounts, we do not find San Gabriel's arguments for a special premium persuasive. In D.92-01-025, p. 23, the Commission stated "Due to the revenue recovery mechanisms for water utilities, we find that water utilities do not face the overall risks as energy and telecommunications utilities." Also, San Gabriel's use of three water utilities rather than the seven as used by ORA, tends to detract from the reliability of San Gabriel's sample. Accordingly, we find that San Gabriel's analysis produces a ROE higher than warranted (12.25%).

On balance, we conclude that an ROE at the upper end of ORA's range of 8.61% -- 10.24% is reasonable and appropriately recognize the business risk facing San Gabriel. Accordingly, we adopt a 10.10% ROE for the period 2003-2006. This constant ROE equates to returns of 9.41% on rate base for test year 2003, 9.40% for test year 2004, and 9.40% for attrition year 2005, as set forth below. We note that a 9.40% return on rate base was adopted by the Commission in D.02-10-058, in the last GRC proceeding for San Gabriel's Los Angeles Division.

	Capital Ratio	Cost Factor	Weighted Cost
TEST YEAR 2003 Long-Term Debt Common Equity Total	40% 60% 100%	8.38% 10.10%	3.35% 6.06% 9.41%
TEST YEAR 2004 Long-Term Debt Common Equity Total	40% 60% 100%	8.36% * 10.10%	3.34% 6.06% 9.40%
Attrition Year 2005 Long-Term Debt Common Equity Total	40% 60% 100%	8.35% * 10.10%	3.34% 6.06% 9.40%

* Updated DRI January 2004 forecast.