2. Water Cost of Capital Adjustment
Mechanism Settlement
2.1. Summary
The applicants, California Water Service Company (California Water), California American Water Company (California American) and Golden State Water Company (Golden State), as well as the Division of Ratepayer Advocates (DRA), were advised in the scoping memo that any proposed adjustment mechanism for subsequent years to the base year's return on equity would be considered but that any proposal must be directly compared to the mechanism adopted for the major energy utilities in Decision (D.) 08-05-035.1 Parties settled before serving any testimony and therefore there is only one proposal before the Commission. Parties made the required comparison and the proposed mechanism here is consistent with the energy mechanism. We find, as discussed below, that the mechanism is reasonable in light of the whole record, consistent with law, and in the public interest.
2.2. Proposed Settlement
The parties provided the following summary2 describing the settlement (attached as Attachment A):
The proposed Water Cost of Capital Mechanism provides for an automatic adjustment, up or down as the case may be, to a water utility's adopted return on equity ... for 2009 (and thus, its overall rate of return on rate base for 2009) for years 2010 and 2011 only if there is a positive or negative difference of more than 100 basis points between the then current 12-month October 1 through September 30 average Moody's utility bond rates and a benchmark. For purposes of the Settlement Agreement, the initial benchmark is equal to the average interest rate of Moody's Aa utility bonds for AA or A credit-rated utilities or higher and Moody's Baa utility bonds for BBB+ credit rated utilities or lower for the period October 1, 2007 to September 30, 2008. The subsequent October 1 through September 30 average also would be based on the foregoing parameters. If the 100 basis point "deadband" is exceeded, a utility's [return on equity] will be adjusted by one-half of the difference between the benchmark and the October 1 to September 30 average. In any year where the 12-month October through September average of Moody's utility bond rates triggers an automatic [return on equity] adjustment, that average becomes the new benchmark. Appendix A to the Settlement Agreement provides three examples that illustrate how the Water Cost of Capital Mechanism would or would not change a utility's [return on equity] based on three different scenarios.
If the 100 basis point "deadband" is exceeded, an affected utility will be required to file a Tier 2 advice letter by October 15 that updates its [return on equity] and related rate adjustments to become effective on January 1 of the following year. The advice letter would also update the utility's long-term debt and preferred stock costs to reflect actual August month-end embedded costs in that year and forecasted interest rates for variable long-term debt and new long-term debt and preferred stock scheduled to be issued.3 However, a utility's capital structure, as adopted for base year 2009, shall not be adjusted. Workpapers outlining the calculations relating to the change in [return on equity], long-term debt costs, preferred stock costs and resulting changes in rates to become effective on the following January 1 are required to accompany the advice letter.
Finally, the Settling Parties have agreed that the Water Cost of Capital Mechanism shall be applicable to [California Water Service Company], California American Water and Golden State for the years 2010 and 2011. While the Settling Parties agree that the Settlement Agreement in these consolidated cost of capital proceedings does not bind the Commission in future cost of capital proceedings, they agree that in such future proceedings a similar adjustment to the cost of capital should be made for the two years following adoption of a base year cost of capital, assuming that the 100 basis point deadband is exceeded. The Settling Parties also agree that the concept of the Water Cost of Capital Mechanism provided for in the Settlement Agreement should be available to the four other Class A water utility members of [California Water Association] in their cost of capital proceedings commencing May 1, 2009.
The settling parties met the requirement to compare any proposal with the energy industry's mechanism and reported, in fact, that the two mechanisms, with some adaptation, do not materially differ:
The Settling Parties modeled the Water Cost of Capital Mechanism after the "Cost of Capital Mechanism" adopted by the Commission for the three large energy utilities (Pacific Gas and Electric Company, Southern California Edison Company, and San Diego Gas & Electric Company) in Decision No. 08-05-035. The energy utilities' Cost of Capital Mechanism provides for automatic adjustments to an energy utility's [return on equity] for the two years following adoption of a base year cost of capital. The adjustment is based on changes to the average Moody's Aa utility bonds over a specified 12-month period, and a deadband (a range of change in interest rates that may occur without triggering a change in [return on equity]) of 100 basis points applies. With minor changes to the energy utilities' Cost of Capital Mechanism - relating to the credit rating levels of the utilities whose bonds will be used as a benchmark - the Settling Parties agreed that the Water Cost of Capital Mechanism should mirror the energy utilities' Cost of Capital Mechanism. (Motion at 4 - 5.)
2.3. Settlement Rules
Rule 12.1,4 provides in pertinent part:
(Rule 12.1) Proposal of Settlement
(a) Parties may ... propose settlements on the resolution of any material issue of law or fact or on a mutually agreeable outcome to the proceeding. Settlements need not be joined by all parties; however, settlements in applications must be signed by the applicant. ...
The motion shall contain a statement of the factual and legal considerations adequate to advise the Commission of the scope of the settlement and of the grounds on which adoption is urged. Resolution shall be limited to the issues in that proceeding and shall not extend to substantive issues which may come before the Commission in other or future proceedings. ...
(b) Prior to signing any settlement, the settling parties shall convene at least one conference with notice and opportunity to participate provided to all parties for the purpose of discussing settlements in the proceeding. ...
(c) Settlements should ordinarily not include deadlines for Commission approval...
(d) The Commission will not approve settlements, whether contested or uncontested, unless the settlement is reasonable in light of the whole record, consistent with law, and in the public interest.
In short, we must find whether the settlement comports with Rule 12.1(d), which requires a settlement to be "reasonable in light of the whole record, consistent with law, and in the public interest." We address below whether the settlement meets these three requirements.
2.4. Satisfying the Settlement Rules
As interpreted below to be consistent with the law, we find the settlement to be reasonable in light of the whole record, consistent with law, and in the public interest
The record consists of the proposed settlement and the motion for its adoption. We find the proposed settlement and its hypothetical examples to be sufficiently detailed to clearly describe the mechanism and its ratesetting implications. The proposal clearly intends to adapt the energy utility mechanism to the water utilities by using appropriate indices to reflect the bond ratings of the individual water company or its parent company if the cost of borrowing relies on the parent's bond rating. Because it is a joint proposal where all parties attest by their signature that they developed and agreed to the proposal, we find it reasonable in light of the whole record.
The parties to the settlement are California Water, California American, Golden State, DRA and the California Water Association (Association). As noted in the motion, the Association's primary interest is that other Class A water companies may wish to have a similar mechanism when the Commission next determines their cost of capital. No settlement is binding on other parties or precedent for other proceedings (Rule 12.5), and we therefore leave to the subsequent proceeding for any other Class A companies the question of whether to adopt some form of this Water Cost of Capital Mechanism. The Association's support of the mechanism in this proceeding does mean that it is an unopposed all-party settlement. Our adoption of the Water Cost of Capital Mechanism in this decision no way presumes its adoption for any other company in a subsequent proceeding.
We note that the settlement states:
While this Settlement does not bind the Commission in future proceedings, the Parties agree that a similar adjustment to the cost of capital should be made following the adoption of a base year cost of capital in subsequent cost of capital proceedings ... (Settlement Agreement at 3, Emphasis added.)
We want to be clear and therefore we interpret this language as an agreement among the settling parties to propose a similar mechanism in subsequent cost of capital proceedings. It does not conflict with Rules 12.1 or 12.5 because it does not resolve the issue nor establish a precedent for future proceedings. With this interpretation, we find the proposed settlement is consistent with the law.
We find the settlement is in the public interest because it provides a synchronized means to adjust the return on equity to reflect significant changes in interest rates. This tends to preserve the marginal premium allowed on the return on equity (i.e., the extra amount of return) paid to equity investors compared to the interest paid to lenders as interest rates fluctuate up or down.
1 Scoping memo at 6-7.
2 February 27, 2009 Motion, at 3-4.
3 The proposed settlement does not specific a uniform and reliable source for interest rate forecasts. The Commission frequently relies on forecasts prepared and published by HIS Global Insight. We will therefore require the utilities to meet and confer with DRA and agree upon a standard forecast resource to be used by all companies in their filings.
4 All referenced Rules are the Commission's Rules of Practice and Procedure. ( http://docs.cpuc.ca.gov/published/RULES_PRAC_PROC/70731.htm)
