8. Cost of Capital

SoCalGas and SDG&E propose the continuation, with certain modifications, of the MICAM, which is described⁶⁵ as:

"a mechanism composed of three distinct components: a trigger that indicates when a change is necessary because market conditions for the cost of capital have changed significantly, a margin adjustment to reflect the change in the cost of capital, and a change to the authorized rate of return used in the earnings sharing calculation to reflect the change in the cost of capital."

In other words, the MICAM is a process to adjust rates in a predetermined fashion if or when certain conditions are met. By definition, the MICAM does not reflect the actual cost of capital for SoCalGas and SDG&E.

a. Traditional Cost of Capital

In a traditional ratesetting environment, the cost of capital would be determined by calculating and weighting the actual reasonable costs of existing long-term debt and preferred stock, the forecast cost of new securities expected to be issued in the forecast period, and a reasonable return on expected level equity (common stock and retained earnings).

Illustration of Traditional Cost of Capital
	Amount	Cost	Weight	Weighted Cost
Debt	$500,000,000	6%	50%	3.0%
Preferred	100,000,000	8%	10%	0.8%
Equity	400,000,000	12%	40%	4.8%
Total	$1,000,000,000		100%	8.6%

In the traditional cost of capital proceeding, as maturing debt is retired and refinanced, the embedded cost changes to reflect the impacts of the retirement and the forecast for new debt. The only other discretionary element is the Commission's judgment to adopt a fair and reasonable return on equity (which is also required to start the MICAM). Regardless of how current capital market prices vary, the debt and preferred cost components change in the traditional mechanism only because of new issues or retirements. If the above illustration were the applicants' forecast of capital structure and costs, then the adopted rate of return would be the weighted cost of 8.6% and the authorized return on equity would be 12%.

The traditional cost of capital mechanism recalibrates annually to reflect actual reasonable costs plus any forecast changes, and the Commission authorizes a reasonable return on equity. Both ratepayers and utilities are protected from long-term harm if actual costs are out of line with the forecast because the rate of return is adjusted annually.

b. Applicants' MICAM

As proposed by SoCalGas and SDG&E, the MICAM is a mechanism that, subject to triggering events, adjusts the cost of capital in post-test year rates. They further assert that this is essentially the same mechanism as last adopted for SDG&E. None of the trigger features described above are directly attributable to specific changes in the operating conditions, financial condition or operating risks of SoCalGas and SDG&E. The cost of outstanding debt issued by SoCalGas and SDG&E does not change regardless of how the market rates change for new debt.

SoCalGas and SDG&E argue that the capital expenditure-related cost index within the proposed Indices "implicitly adjust for changes in the cost of capital through the rental price of capital" feature of the index. We do not agree that the post-test year costs' escalation components must be linked and adopted as a package with a review of post-test year costs of capital. Instead, as described earlier, we adopt a specific escalation rate for capital expenditures based on a finding that the index is the most appropriate indicator of inflation (change) for that business activity. We will also adopt the most appropriate mechanism to reflect the change in the cost of capital in order to provide investors an opportunity to earn a reasonable return. SoCalGas and SDG&E have not convinced us that the MICAM is that mechanism.

Aglet identifies several defects in the MICAM.⁶⁶ First, Aglet argues that the MICAM relies on the published Moody's Aa Utility Bond rates⁶⁷ that may not reflect the risks actually experienced by SoCalGas and SDG&E.⁶⁸ SoCalGas had previously used 30-year U.S. Treasury bonds in its MICAM that were traditionally viewed as a long-term risk-free benchmark. The Treasury no longer issues 30-year bonds but does issue 10-year Treasury notes, which Aglet states are now viewed as the financial market standard benchmark for risk-free investments. Aglet argues for a return to the conventional cost of capital applications for SoCalGas and SDG&E but, as an alternate, would benchmark a MICAM to the 10-year notes instead of Aa utility bonds. According to Aglet, there is no reason to link the return of SoCalGas and SDG&E to the "investor perceptions of risks" indicated by the Aa bonds and the Commission should allow ORA and other intervenors to address the facts and present evidence on the costs of capital and diversification of risks as actually faced by the applicants.

SDG&E did participate in two recent cost of capital proceedings in 1999 and 2002 when the current MICAMs were supposed to be operative.⁶⁹ We see no merit to continue using a mechanism that does not reflect the specific risks (and opportunities) faced by SoCalGas and SDG&E. The adoption of post-test year rate adjustments should not become mechanically arbitrary and unrelated to the operational risks and service obligations faced by SoCalGas and SDG&E. We reject the proposed MICAM for SoCalGas and SDG&E and we will require both companies to file annual cost of capital applications in the next cycle, due May 8, 2005.

⁶⁵ Ex. 155, p. DTB-10 and Ex. 156, p. DTB-13, with identical language.

⁶⁶ See Ex. 800, pp. 11-13.

⁶⁷ Ex. 155, p. DTB-10 and Ex. 156, p. DTB-13.

⁶⁸ Ex. 800, p. 12.

⁶⁹ Transcript, p. 2,695.