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1 BEFORE THE ARIZONA CORPORATION COMMISSION

2 COMMISSIONERS ArizonaCorporation Commission TOM FORESE, Chairman DOCKETED 3 BOB BURNS ANDY TOBIN 4 BOYD DUNN JUL 2 2018 JUSTIN OLSON DOCKBTED 5

6 IN THE MATTER OF THE APPLICATION OF Docket No. WS-01303A-17-0257 7 EPCOR WATER ARIZONA INC., FOR A DETERMINATION OF THE CURRENT FAIR 8 VALUE OF ITS UTILITY PLANT AND PROPERTY AND FOR 9 INCREASES/DECREASES IN ITS RATES l` » P AND CHARGES BASED THEREON FOR c a O n é' 10 UTILITY SERVICE BY ITS AGUA FRIA, o n ¢ . . n o c :<:o3° ANTHEM, CHAPARRAL, HAVASU, r " mw9 11 MOHAVE, NORTH MOHAVE, PARADISE l -lim N n o - VALLEY, SUN CITY, SUN CITY WEST, c z ; z 12 TUBAC, AND WILLOW VALLEY WATER '0 .-Q;ZCJ p p DISTRICTS AND FOR CONSIDERATION OF - av' * c 13 CONSOLIDATION PROPOSALS. N 2 : _J 14

15 RUCO'S APPLICATION FOR ISSUANCE OF SUBPEONEA TO REQUIRE THE ATTENDANCE OF PAUL WALKER FOR HEARING 16

17 The Residential Utility Consumer Office ("RUCO"), pursuant to Arizona Administrative

18 Code Rule 14-3-109 (O) and Rule 45 of the Arizona Rules of Civil Procedure respectfully

19 requests the issuance of a Subpoena in the form attached to require the attendance and

20 testimony of Paul Walker at hearing on July 17, 2018 at 10 A.M at the Arizona Corporation

21 Commission, 1300 West Washington, Phoenix Arizona, 85007. As good cause, RUCO states:

22 1. RUCO is currently a party in the rate case. The issue of rate consolidation is

23 perhaps the most contested issue in the subject case. Paul Walker is an expert on the issue of

-1- 1 rate consolidation. Mr. Walker was instrumental in the Commission's decision to approve a

2 policy regarding the consolidation in the Commission's inquiry to evaluate and potentially

3 encourage consolidation concerning Arizona's water and wastewater utilities industry. See

4 Docket WS-00000A-14-0198. Mr. Walker also co-authored with RUCO's former Director,

5 Patrick Quinn, a white paper on the issue of consolidations. Mr. Walker will add insight on the

6 issue of rate consolidation from both a technical and policy perspective. Mr. Walker will

7 discuss the white paper in detail and its application as well as Mr. Walkers views on the issue

8 in the subject case. Mr. Walker is well-known to the Arizona Corporation Commission as he

g has appeared in many cases on many issues over the years before the Arizona Corporation

10 Commission. Mr. Walker's testimony will undoubtedly benefit the record and provide additional

11 and relevant evidence for the Commission to consider in its deliberations on this very important

12 issue in this case.

13 2. Mr. Walker will testify on the issues associated with rate consolidation as well as

14 the facts and circumstances surrounding the white paper that he co-authored on the subject.

15 Attached as Exhibit 1 to this motion is a copy of the subject white paper.

16 3. Mr. Walker, among other things was the policy advisor to Former ACC Chairman

17 Marc Spitzer. Mr. Walker formerly worked in the administration of Governor Jane Dee Hull and

18 US Congressman John J. Rhodes, III. More recently, Mr. Walker was elected to the national

19 Board of Directors of ConservAmerica and served as the organizations Executive Director.

20 4. Mr. Walker does not work for RUCO nor is he being paid as a consultant for

21 RUCO in this case.

23 1 RUCO withdrew its support for the White Paper in the generic docket over its concern at the time of the Commission's ability to adhere to the underlying principles of the White Paper. RUCO does not share that 24 concern about the present Commission.

-2- 1 5. Mr. Walker will be out of the country through July 18, 2018 and will be available

2 to testify on July 19, 2018.

3 WHEREFORE, RUCO respectfully requests that the Commission issue a subpoena in

4 the form of the attached requiring the attendance of Paul Walker to testify at the hearing in this

5 matter scheduled to start on July 17, 2018.

7 RESPECTFULLY SUBMITTED this 2nd day of July, 2018.

10 ¢$ > Mel W. Pozefsky Chief Counsel 11

2 3

-3_ 1 On this 2nd day of July, 2018, and original and thirteen copies of the foregoing document were filed with Docket Control. Copies of the foregoing document were mailed by RUCO 2 to the following who have not consented to email service. On this date or as soon as possible thereafter, the Commission's e Docket program will automatically email a link to 3 the foregoing document to the following who have consented to email service.

4 Andy Kvesic Albert Gervenack Legal Division Bob Miller 5 Arizona Corporation Commission Property Owners and Residents 1200 w. Washington Street Association 6 Phoenix, AZ 85007 13815 Camino Del Sol LeqalDiv(d)azcc.qov Sun City West, AZ 85372 7 [email protected] Al.qervenack@_porascw.orq Consented to Service by Email [email protected] 8 Consented to Service by Email Thomas Campbell 9 Michael Hal lam Marshall Magruder Lewis Rosa Rothgerber Christie LLP P.O. Box 1267 10 201 E. Washington St. Tubac, AZ 85646-1267 Phoenix, AZ 85004 [email protected] 11 [email protected] Consented to Service by Email [email protected] 12 [email protected] Andrew Miller [email protected] Town of Paradise Valley 13 Consented to Service by Email 6401 E. Lincoln Drive Paradise Valley, AZ 85253 14 Douglas Edwards [email protected] 13517 W. Sola Drive Consented to Service by Email 15 Sun City West, AZ 85375 [email protected] Lawrence Robertson, Jr. 16 Consented to Service by Email Munger Chadwick, PLC 210 W. Continental Road, Suite 216A 17 Greg Eisert Green Valley, AZ 85622 Sun City Homeowners Association [email protected] 18 10401 W. Coggins Drive Attorneys for Santa Cruz Valley Citizens Sun City, AZ 85351 Council 19 re eisert mail.com Consented to Service by Email Consented to Service by Email 20 Regina Shan fey-Saborsky Corte Bella Country Club Homeowners 21 Association 22155 N. Mission Drive 22 Sun City West, AZ 85375 [email protected] 23 Consented to Service by Email

-4- l \ 1 Diane Terry Smith 13234 w. Cabrillo Drive 2 Sun City West, AZ 85375 Skylar [email protected] 3 Consented to Service by Email

4 Steve Wene Moyes Sellers Hendricks, LTC 5 1850 n. Central Ave., Suite 1100 Phoenix, AZ 85004 6 Attorneys for Bullhead City

7 Raymond Valle Verrado Utilities Council 8 20823 W. Canyon Dr. Buckeye, AZ 85396 9 [email protected] Consented to Service by Email 10 Roger Willis 11 Anthem Community Council 3701 W. Anthem Way, Suite 201 12 Anthem, AZ 85086 [email protected] 13 Consented to Service by Email

14 Michele Van Quathem Law Offices of Michelle Van Quathem, 15 PLLC 7600 n. 15th St., Suite 150-30 16 Phoenix, AZ 85020 Attorney for DMB White Tank, LLC, 17 DMB Verrado Golf I LLC, Verrado ARC LLC, and Verrado 18 Community Assoc., Inc. [email protected] 19 Consented to Service by Email

21 l l l 22 By 4 Cheryl Fraul 23

-5-

I 1 BEFORE THE ARIZONA CORPORATION COMMISSION

2 COMMISSIONERS TOM FORESE, Chairman 3 BOB BURNS ANDYTOBIN 4 BOYD DUNN JUSTIN OLSON 5 IN THE MATTER OF THE APPLICATION OF 6 EPCOR WATER ARIZONA INC., FOR A DETERMINATION OF THE CURRENT FAIR Docket No. WS-01303A-17-0257 7 VALUE OF ITS UTILITY PLANT AND PROPERTY AND FOR 8 INCREASES/DECREASES IN ITS RATES SUBPOENA DUCES TECUM AND CHARGES BASED THEREON FOR 9 UTILITY SERVICE BY ITS AGUA FRIA, ANTHEM, CHAPARRAL, HAVASU, 10 MOHAVE, NORTH MOHAVE, PARADISE VALLEY, SUN CITY, SUN CITY WEST 11 TUBAC, AND WILLOW VALLEY WATER DISTRICTS AND FOR CONSIDERATION OF 12 CONSOLIDATION PROPOSALS.

13 THE ARIZONA CORPORATION COMMISSION TO: 14 Paul Walker 15 209 E. Baseline Road, E-102 Tempe, Arizona 85283 16 PURSUANT to Ariz. Const. Art. 15 § 4, A.R. s. § § 40-105, 40-241, 40-242, 40-244, 17 A.A.C. R14-3-101 and R14-3-109, and 16 A.R.S. Rules of Civil Procedures, Rules 30 and 45, you are hereby commanded to appear and give your testimony at the time and place specified 18 below.

19 YOU ARE COMMANDED to appear at the hearing of this matter scheduled below and 20 produce any and all documents pertaining to this matter, including, but not limited to, books, papers, documents, tangible things, notes, correspondence, and drafts not provided in 21 previous discovery.

22 DATE AND TIME OF APPEARANCE July 19, 2018 AND PRODUCTION: 2 3 9:00 A.M.

-1- 1 PLACE OF APPEARANCE AND PRODUCTION: Arizona Corporation Commission, 2 1200 West Washington, Hearing Room, Phoenix, AZ 85007 3

4 You have been subpoenaed by: Residential Utility Consumer Office, whose attorney's name, address and telephone number is: 5

6 Daniel W. Pozefsky 1110 West Washington, Suite 220 7 Phoenix, AZ 85007 (602) 364-4839 8 Requests for reasonable accommodation for persons with disabilities must be made to 9 the division assigned to the case by parties at least 3 judicial days in advance of a scheduled court proceeding. 10 Your Duties In Responding To This Subpoena 11 You have the duty to produce the documents requested as they are kept by you in the 12 usual course of business, or you may organize the documents and label them to correspond with the categories set forth in this subpoena. See Rule 45(d)(1) of the Arizona Rules of civil 13 Procedure.

14 If this subpoena asks you to produce and permit inspection and copying of designated books, papers, documents, tangible things, or the inspection of premises, you need not appear 15 to produce the items unless the subpoena states that you must appear for a deposition, hearing or trial. See Rule 45(c)(2)(A) of the Arizona Rules of Civil Procedure. 16

17 Your Right To Object

18 The party or attorney serving the subpoena has a duty to take reasonable steps to avoid imposing an undue burden or expense on you. The Commission enforces this duty and may 19 impose sanctions upon the party or attorney serving the subpoena if this duty is breached. See Rule 45(c)(1) of the Arizona Rules of Civil Procedure. 20 You may object to this subpoena if you feel that you should not be required to respond 21 to the request(s) made. Any objection to this subpoena must be made within 14 days after it is served upon you, or before the time specified for compliance, by providing a written objection 22 to the party or attorney serving the subpoena. See Rule 45(c)(2)(B) of the Arizona Rules of Civil Procedure. 23 If you object because you claim the information requested is privileged or subject to 24 protection as trial preparation material, you must express the objection clearly, and support

_2_ 1 each objection with a description of the nature of the document, communication or item not produced so that the demanding party can contest the claim. See Rule 45(d)(2) of the 2 Arizona Rules of Civil Procedure.

3 If you object to the subpoena in writing you do not need to comply with the subpoena until a court orders you to do so. It will be up to the party or attorney sewing the subpoena to 4 seek an order from the court to compel you to provide the documents or inspection requested, after providing notice to you. See Rule 45(c)(2)(B) of the Arizona Rules of civil Procedure. 5 If you are not a party to the litigation, or an officer of a party, the court will issue an order 6 to protect you from any significant expense from the inspection and copying commanded. See Rule 45(c)(2)(B) of the Arizona Rules of civil Procedure.

7 l You may also file a motion with the Commission to quash or modify the subpoena if the 8 subpoena:

9 (i) does not provide a reasonable time for compliance, 10 (ii) requires a non-party or officer of a party to travel to a county different from the county where the person resides or does business in person, or to 11 travel to a county different from where the subpoena was served, or to travel to a place farther than 40 miles from the place of service, or to travel 12 to a place different from any other convenient place fixed by an order of a court, except that a subpoena for you to appear and testify at trial can 13 command you to travel from any place within the state,

14 (iii) requires the disclosure of privileged or protected information and no waiver of exception applies, or 15 (iv) subjects you to an undue burden. See Rule 45(c)(3)(A) of the Arizona 16 Rules of Civil Procedure. If this subpoena: 17 (i) requires disclosure of a trade secret or other confidential research, 18 development, or commercial trade information, or

19 (ii) requires disclosure of an unretained expert's opinion or information not describing specific event or occurrences in dispute and resulting from the 20 expert's study made not at the request of any party, or

21 (iii) requires a person who is not a party or an officer of a party to incur substantial travel expense. 22

-3- 1 The Commission may either quash or modify the subpoena, or the court may order to appear or produce documents only upon specified conditions, if the Commission who served l 2 the subpoena shows a substantial need for the testimony or material that cannot be otherwise i i met without undue hardship and assures that you will be reasonably compensated. See Rule 3 45(c)(3)(B) of the Arizona Rules of Civil Procedure.

6 SIGNED AND SEALED this date:

8 By: Executive Director 9

-4_ 1

EXHIBIT 1 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

May8, 2014

Commissioner Susan Bitter Smith Arizona Corporation Commission 1200 West Washington Street Phoenix, Arizona 85007

In Re: Acquisitions and Consolidations in Arizona's Water ac Wastewater Industry

Dear Commissioner Bitter Smith:

Thank you for asking us to begin evaluating the need to consolidate Arizona's water and wastewater industry; the Arizona Residential Consumer Office and Arizonans for Responsible Water Policy have begun a series of discussions on the issue and look forward to working with your office, and the Commission as a whole, on this issue.

The idea of incepting and encouraging consolidation in the Arizona private water and wastewater sector dates back to, at least, the late 1990s. On April 24, 1998 the Corporation Commission voted to establish "The Cornrnission's Water Task Force" vrdth the stated intent of "develop[ing] policies to address a wide variety of problems that private water companies and their customers face."' The Task Force conducted numerous meetings and issued a series of recommendations, including:

"Reduce the number of small, non-viable water systems through new Arles and pro<:edures."2

The Water Task Force wrote, as justification for its recommendation to begin consolidating the industry:

"Many of Arizona's water companies are quite small; the majority of them have less than $250,000 in annual revenues... many of these small companies are quite problematic. Most of the "problem" companies that the Commission must deal with are quite small Because of their small base of customers, even quality managers of small companies may find it difficult to raise sufficient revenues to make needed capital investments."

The Task Force concluded that "because of economies of scale, larger companies are likely to be more efficient. A larger company can consolidate the administrative aspects of many smaller "systems" thereby significantly reducing the overall cost of service. For these reasons, the Task Force agrees flat reducing the number of small non-viable water systems is a desirable god."4

The Water Task Force's report and recommendations were never acted upon by the Commission

1 n . of t h e n i n i ' W a r T a s k F e, October 28, 1999, Page 3 [Docket No. W-00000C98-0153] 2 Ibid, Page 3 3 Ibid, Page 4 4 Ibid, Page 4

1 RESPONSIBLE RESIDENTIAL UTILITY WATER CQNSUMER OFFICE

A decade later, in 2010, the Commission directed Commission Staff to open a "generic investigation which tools at how best to achieve the Commission's objectives with regard to encouraging the acquisition of troubled water companies".5 Throughout 2011, the Commission hosted water vvorlshops that explored the numerous issues facing Arizona's water industry: The 2011 vvorlshop process led to no find report, no find recommendations, and no find decision by die Commission

Which dl begs the question: If, for over a decade, every interested person has concluded that Arizona needs to incept "the acquisition of troubled water companies", why fas nothing been implemented?

The answer, we believe, is that no coalition has formed to evaluate, address, and mitigate the red and complex challenges that come with consolidating an industry Those challenges are complex, and must be understood before one sets out to "find the right path" toward consolidating an industry with over 300 ,` companies scattered throughout Arizona.

r ." " ~ We } e voe to do so in this paper. / K 'Q . .. \ .< . * Pat~Quinn lally \Y/alker Director, .C 0 nial Utilities Giairman, Arizonans for Responsible Water Cons . 4 rice

_p8211y81k3 served as advisor to Oiairman Marc Spitzer at the AOC; worked on Governor Jane Dee Hull's negotiating and lobbying teamduring the Indian Compacts; and was on the staff of U.S. Congressman John J. Rhodes, III. Paul specializes in regulatory analysis, lobbying, and consulting. In addition, Paul was elected to the national board of directors of ConservAmerica - a 6,000 renumber Republican organization to improve the environment through mar14:et~based policies at the national level He chairs Arizonans for Responsible Water Policy- atrade group comprised of large water companies advocating for longterm water changes; and serves on the Arizona Power Plant and Line Siting Committee, a statlnory board comprised of elected and appointed officials that determines the envinonrnental and economic compatibility of power plant and electric transmission line applications. He served as a in the Arizona Army National Guard and completed numerous militaryschools and courses; and he holds a Masters in Business Administration from Thunderbird - The American Graduate School of International Management.

at min spent over 30 years in the telecommunications industry before retiring as President of Qwest Arizona in 2008; prior to that position he had served as Vice President of Corporate Policy and I.aw, Director of Regional Regulatory Affairs, and Finance Director. Qwest was the regional operating company formed after the breakup of the AT8cT system in 1984 and provided telecommunication services to the vast majority of Arizona residents. Pat is a veteran who served in the U.S. Navy and has long been involved in a host of Arizona organizations, including: Greater Phoenix Leadership, the Homebuilders Association of Arizona; Arizona Town Hall; Tee AA and Phoenix Community Alliance. He earned his Master of Business Administration and Bachelor's degree in mathematics from the University of South Dakota. He was appointed as Director of the Arizona Residential Consumers Office injanuaryof 2013.

s Decision No. 71878, Finding of Fact 84, Page 84 [Docket No. SW-20445A09-0077, et.aL]

2 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

8bQ;gl3g§pQgiblg._\L/ate; Responsible Water is a trade group comprised of Arizona Water Company, Global Water, and Lrbeny Utilities. Together, our companies own and operate water and vvastevvater systems that serve over approximately500,000 people in communities across Arizona.

Responsible Water is committed to working to make Arizona's water future more secure and more sustainable by working cooperatively with Arizona policy leaders to identify and implement new practices and approaches th.at strengthen the water industry- and thus, Arizona's ability to manage its water resources. By conducting no-cost seminars for small water companies, developing white papers and studies that explore water management and innovative approaches to regulation, and by providing free technical assistance to troubled utilities, Responsible Water is committed to improving the entire water industry so that Arizona can continue to be a growing, vibrant, and sustainable home for generations. i n t i a l r Offi "R RUCO is a legislatively established governmental agency dedicated to representing the interests of residential utility ratepayers in matters before the Arizona Corporation Commission ("A@" or "Commission").

I Since establishment in 1983, RUCID has been actively involved in rate-related proceedings involving public service corporations providing electric, gas, telecommunications, slater and waste water services. As a matter of p01i¢>4 RUOO always intervenes and participates in rate cases involving Arizona's largest utilities. Intervention in the cases of smaller companies is decided on a case-bycase basis, with particular attention to the size of the increase sought, the rate history of the tnzilityg and the availability of resources at RUCID. In addition to RUOO staff, consultants may assist in analyzing anilities' requests for changes in rates arid preparing testimony In addition to specific rate proceedings, RUOO is also heavily involved in level policy decisions made at the ACII. RUCID approaches topics such as industry regulation, renewable energy and cost recovery mechanisms with a balanced view that weighs near terms considerations and longterm outcomes.RUOO prides itself on being a thoughtful stakeholder that can guide the development of smart policies in a way drat maximizes benefits to residential ratepayers and the utility system as a whole.

Definitions.

Atquifition Atyurtmenr An increase to utilityrate base which reflects the cost of die purchase of the utility or the asset.

Regional Conr0§dafion;The ability for the acquiring company to consolidate companies into regional or utility groups for purposes of having common rates, operations and management.

Integrated Confolidalion:The ability for the acquiring company to consolidate all of their companies into a parent company with common rates, operations arid management

ROE Premium: An. increase to the allowed return on equity as an incentive for certain investments. The theory is to provide a return above the market level in order to attract investment. AUTHORIZED ROE + ROE PREMIUM = mosT OF EQUITY

3 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

The Challenges of Consolidating an Industry Par BS, MS, Mathematics Paul Walker, BS, MBA, Business Administration

There are serious economic and regulatory issues that have to be addressed and evaluated before Arizona decides to move forward with consolidating its highly fragmented private water and wastewater industry We will discuss different apecrs of acquisition and consolidation later. The only way to address diesel issues is to go through them, one by one. This will require the Gommission to develop a holistic policy framework that transitions rate setting from a model just based on cost causation to onethat includes the enabling of I II consolidation. i

We apologize, in advance, for the fact that many of these issues are only fascinating to people like the authors - we will tryout best to avoid the economic theories too dull or esoteric, but we must emphasize than the reality of Arizona's challenge necessitates a comprehensive understanding of the difficulty of meeting that challenge. The reader should bear in mind that souse some of these issues axe dull,complex, and esoteric, Arizona has not acted to address this challenge; onlywith understanding can Arizona solve dies issue.

To begin the discussion we need to define the different types of consolidation Generally we are about consolidation as the acquisition of a smaller water or wastewater company by a larger water or wastewater company This implies the mere acquisition, but not necessarily the incorporation of the smaller company into the large company, Le., the smaller company still maintains much of its operational autonomy The other type of consolidation is what we call "integrated consolidation"; wider integrated consolidation, the smaller company is folly absorbed into the large company's operation This can be done at a regional or total company level. This will be discussed more later.

This paper is divided into five sections:

1. The Policy and Factual Landscape of Arizona Water, Page 5 2. A Clear and Compelling Public Interest, Page 14 3. Path to Consolidation, Page 16 4. Consolidation Opportunities, Page 24 5. Summary and Recommendations, Page 25

Additionally, there are four attachments to dis paper:

Attachment 1 - "Arizona's Next Century: A Strategic Vision for Water Supply Sustainability", Arizona Department of Water Resources, January2014, Page 26

Attachment 2 - Rate of Return and Operating Margin Policy, California Public Utility Commission, March 2013, Page 40

Attachment 3 - Pennsylvania Public Utility Commission Policy on Water Acquisitions, Page 43

Attachment 4 - "Water Utility Risk and Return", California Public Utilities Commission, 1990, Page 49

4 RESPDNSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

SECT1ONONE: THE poLlcy AND FACTUAL LANDSCAPE oF AR1ZONAWATER

There are three major forces one confronts in the Arizona water industry: • _

A k Regulato 41 Pron W u Economic facts must be clearly understood, regulatory principles must be adhered to, and policies must address the environmental reality of Arizona's water supply. The economic fact that Economies of Scale exist provides an opportunity to better control costs and incept investment. This fact is well explained in a 1990 publication of the California Public Utility Commission: "Water Utility Risk and Return."

"[S]mall water companies have special problems created by their lack of economies of scale and inaccessibility to external financing. The number of economic dichotomies between large and small water utilities warrant separate analyses and, ultimately, different ratemaking treatments."6

The economic fact that small companiesface greaterchallenges inattractingcapitalcreates achallenge for Arizona's water future; the fact is that most small Arizona water utilities rely on Contributions In Aid of Construction (Q[A<;l and Advances In Aid to Construction (AIAC) - and wind up with very little rate base, and very few options to access the investment market. As explained in Attachment 4, "Water and Return" :

"[T]he stability of the water utility business should provide comfort to creditors and equity investors seeking attractive investment opportunities with relatively low risk However the small size of water utility offerings, relative to other utilities, tend not to generate interest among investment bankers. Consequently, most water utilities remain unknown except to a subset of the financial community such as insurance companies. Virtually all external financing is accomplished durough private placement directly with investors, without use of an underwriter."7

The regulatory principles of "Cost Causation, Equity and Sustainability" can be adhered to in an acquisition and consolidation policy. This will require the Commission to modify the current policy to encourage smart consolidation. Finally, the "Environmental Reality" of Arizona's water situation today, and all water forecasts for Arizona, provide a clear and compelling public interest in strengthening and consolidating this industry. We shall explore each of those issues in this section.

6 "Water Utility Risk and Return", California Public Utilities Commission, April 1990, Page 1 7 Ibid, Page 3

5 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

Economic Facts

Cnc economic fact directly correlates to the question and benefits of consolidating the Arizona private mater and wastewater industry: Economies of Q 4 Scale. This term is fairly common, but it is important to ensure that it is understood at the outset. Env usnmanal lwlhuw lcllkv C rfulam

Economies of Scale: Economies of scale mean that a firm's average cost decreases as its output rises.

Example: The fixed costs of owning and operating a small water system include: the costs of the well and the pipes that deliver the water. Once those are in place, the costs are spread over the customer base. If the customer base grows, there are more people paying diode fixed costs and they will each pay less.

Example: The costs of a customer call center include the cost of the building, the telecommunications services, and the employees. Once those are in place, the costs are spread over the customer base. If one company owns and operates numerous utilities, it can use the same call center to support each utility- rather than building and financing a call center for each utility on its own.

Example: A utility requires not just the day=to-day operational staff; it also requires a management l team to oversee the accounting, capital improvement plans, financing, environmental compliance and l reporting, human resources, and investor relations. However, the management team that provides those services to a utility can provide those services to more than one tnility- when it does so, it takes advantage of economies of scale because the incremental costs of providing that management to a second, third, or tenth utility are less than the costs of having each of those other utilities having its own, independent management team.

Thus, economies of scale means that "large water utilities axe able to provide professional management and lower cost service because they spread the fixed costs of operations over more customers."** However, as we move forward in this paper the reader should bear in mind that the looming investments in water infrastructure, sustainability and increased water supplies will exert dramatic upward pressure on rates. Thus, vdiile economies of scale provide downward pressure on rates, Arizona's future is one of increasing investments, increasing costs, and thus, increasing rates for water customers.

Small Firm Capital Attraction Challenges: Smaller entities have fewer opportunities to access the investment market.

As CPUC explained, small firms "tend not to generate interest among investment bankers" therefore the majority of dieir financing comes from the owners and from any developers who build in the service area (through CIAC and AIAC) The resultant capital structure from such an approach winds up producing very

s Ibid, Page 19

I RESPONSIBLE RESIDENTLU. UTILITY WATER CQNSUMER OFFICE

little rate base - it is startlingly common in Arizona to find small vsater utilities with little to no rate base. That we have become accustomed to it is more than the very fact itself. Arizona needs to realize, literally right away, that: "The financial structure of the company to a great extent determines financial risk"'

Many companies with little to no rate base face extreme financial risk - they have no rate base to produce a return on equity and are simply operating margin entities in a business that faces significant environmental challenges and very high capital intensity. Capital intensity is the measure of: How much investment in plant is required to produce $1 in additional operating revenue.

AMERICMN WATER x . . .. _~?>;hit. . I Capital Intensity: Utility Plant / Operating Revenue zoos Ca Ital lntens s wo so 48 53.50 s3.oo so 60 av 63 5200 $1 50 s l.oo so so soon I squaw aeuwe scavane 4annu 5.1¢ CG!

nurse Au4 Min 91114 ~~- -nwatcr :a m I:

To summarize then, economies of scale can reduce the average cost per customer; but many small water utilities in Arizona have very challenging financial profiles dlat make them hard to invest in, and make it hard for their current owners to attract needed investment. Because of the latter challenge, owners rely on developers to fund their utility needs - thus further weakening their financial structure:

"Advances and contributions spread out the utilitys funding requirements for growth and development in the service ten-itory These sources of funds are not included in utility rate of return calculations because these sources of capital are not provided by company investors. Nonetheless, operational risks increase as the percentage of contribtnions increase for the For example, assuming a 10% return on rate base, a utility with $100,000 in plant, of which 40% is contributed, can only generate a return on investment of $6,000. If the utility had used debt and equity capital, it would be able to am $10,000. The operational risk is highlighted when revenues change due to voluntary conservation and/or mandatory rationing."10

In fact, in many cases in Arizona the CIAC (or the AIAC that revens to CIAC due to lack of growth) becomes so large Mat it subsumes the owners' investment. Building on Me CPUC example above, if the utility had received $40,000 in Advances, be the growth didn't occur as expected and thus only $10,000 of the AIAC was repaid, $30,000 in "CIAC" would be assigned to the rate base - cutting due rate base from $60,000 in the CPUC example, to $30,000; and cutting the return from $6,000 to $3,000. This example is not hypothetical, in fact it is commonplace among small Arizona water utilities - dais further worsening their capital structure, increasing their risk, and their acquisition more difficult for potential buyers.

9 Ibid, Page 2 10 Ibid, Page 13

7 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

Regulatory Principles

There are three key regulatory principles that must be stride adhered to should Arizona move forward with a policy and incentives to encourage consolidation of the Arizona water and wastewater industry Cost Causation, the Equity Principle, and Sustainability Cost Causation and the Equity

Econumk Principle will be the most complex issues to explain to customers. This is why F u n criteria for when and how to consolidate must be developed Q t

tn-ouvunua The readityis this: Consolidations and Acquisitions come with costs - and those India a costs must be recovered in a fair and manageable manner. However, there will be some cost savings drat come from economies of scale that may reduce or these increased costs. Investors and customers axe, quite literally, in the same position here: Both can benefit from a stronger, more consolidated industry, the kepis to understand how to balance the costs.

Principle 1: Cost Causation - the customer who causes a cost should pay the cost.

E . v . E f f i i n Cost causation involves one of the most complex issues in economics, what Arthur Okun called "the big tradeoff". Economic equality means drat no one gets an Lumfair advantage over another - which is obviouslysubjective because everyone has an opinion on what constitutes "fair and unfair." Economic efficiency means that connect pricing signals are sent, and those incentives correlate to desired outcomes.

Principle 2: Equity Principle - no customer should be forced to pay more than what is reasonable.

Rate Design: Cost allocation is the purpose of rate design - it is the process of determining how many dollars to collect from various customer classes for various utility services.

t and noble Rate :The rates set by the Commission must not be unduly discriminatory between customers or services. "Unduly discriminatory' means that the discrimination in pricing or I incentives is tied to and supports some public interest, e.g., tiered water rates charge exorbitantly rates for high use of water - much more than the incremental cost of providing amounts of water - but those high rates are justified because they support the public interest of conserving water.

Subsidies: Generally, Commissions avoid providing subsidies ("subsidies" are defined here as: charging less than due incremental cost of due service to one group of customers, while charging more than the stand done cost to another group of customers.)

Efficiency. Commission rates and incentives should give connect signals to customers and investors ("correct signals" are defined here as: promoting the efficient use of resources, and allowing customers and investors to manage and plan their budgets.)

Principle 3: Sustainability - the utility must receive enough money to staying business and continue providing safe, adequate, and reliable service.

8 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

Utility rates and incentives shoddy be sufficient to allow the utility to collect its legitimate costs. Ar the same time, decreases or increases in risk should be recognized and applied in a symmetric manner to the company's authorized rate of return in order to establish fair compensation to shareholders.

&4§p¢q Commission rates and incentives should be understandable to customers and the

Commission rates and incentives should avoid rate shock to customers, and should promote revenue stability to the Commission rates and decisions must provide price and investment signals and the Commission must recognize that those signals will affect behavior, but it maytake some time to do so.

If done correctly, establishing a consolidation enabling framework for Arizona water companies will integrate these three principles in a more holistic way. First, the true cost of one's water system may be hidden from customers if needed upgrades are not made or systems are neglected Second equity is a principle that is dependent on one's time horizon. In the medium to long run, the consolidation of two water systems may bring resiliencies and efficiencies that overcome shop run inequities. Third, sustainability comes when the true long run costs of operating a successful water system are recovered and allocated mthin a system that is resilient and efficient. Smart consolidation between companies should leverage all three of these principles in a way that delivers long-term net benefits to all ratepayers involved

Environmental Reality

All of the economic facts and regulatory principles must, in the end, dead wide and address reality. And Arizona's water readityis complicated Arizona water leaders have worked hard on water management since the 1922 Colorado River Compact. The Central Arizona Project, die 1980 Groundwater Management Act, the Central Arizona Groundwater Replenishment District, Commission- Nuns < u m sanctioned Tiered Rates, Water Banking, and more environmentally sound development have created a vast network of infrastructure and programs to better Q t manage Arizona's water supplies; but ongoing drought combined with population growth will continue to demand larger and larger investments and increasingly lquhlo q sophisticated water monitoring and management. I m-=1»~~=

Arizona has relied for decades on affordable CAP water - which provides water i i for agriculture and communities, and the Colorado River dams which provide affordable hydropower that both offsets CAP costs, and provides reliable and affordable power to rural Arizona. Bur Arizona remains i mired in drought, and the drought goes beyond the Colorado River - it covers nearly all of Arizona and l droughts are very hard on small water companies ._ pumping costs increase, CAGRD costs increase, development gets more costly and complex. Drought can be managed - but at a high cost financially, managerially, and technically

9 RESPQNSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

Arizona Remains in a statewide drought

U.S. Drought Monitor April 22. 2014 ¢=-u my-q kg n 814 A r i z o n a ws I I I EU' Wunalnm 'nun'-4 : : 1 : : : r : : : - i n l:.:l:l::Vu mol: 5 5 8 8 8 9 ::l=m:::l:ll::l 9941499 :::::l::l:=l:ll:l nanzranclnazl n u n ; - - v ~ a - u -~.»n4~ r¢»~¢~a-¢ _ s-vw .ma 3 u - u NB - r -¢ aaorWus br 3uI""'vnll~»~v ' s u r - v w hay: s a una - acoowou

l s ri Ra I ....\...... "L e

The drought affects not only Arizona - in fact, the entire vest is gripped in a historic drought. Today, four of the seven Colorado River states are covered 100°/o, in drought conditions, and Utah is almost entirely in drought. The Colorado River is in a historic drought and curtailment of the water deliveries that Arizona relies on for CAP, agriculture, and groundwater recharge seems likely to occur sooner, rather than later.

U.S. Drought Monitor April 22. 2014 nuuud0vnar/ Apr u :ow W e s t we Hun EDT :=>vaz»~ ihrawuvu zzczauzzx s o in - = U "|F* ll'J*'=§- nlmmnamu IL4v.§.*' 4143, 'g {¢'PiillI§" " : » _ 3 § ; Qmmmznnzn 8 ~ l~ . * xi*9334191 "~t1v; dvo III- 499998».- #:| "'%Tr'.ri¥i n I i s/. l 4. m::l::::l:n8l::l \1- u : zmuacnm8 _ ' l l L-4. 'gi:- \'' - l-¢ ;-»-. n~ . - 11gp 1 2712l - 5 O _:_ " 'e 1 %9 v i o n a 8299-- 5 - l9 l1|9r |bv-r1- "'v»~v» :'- i v uv'-uuurvn A-me-1 : h r R.»||\:!v- J I :I vco cucu _-:r.+\:F : Q i --i§§'_~g§-r ml l.\l> . i a - .. °E (3 e Mir Inmwghunanlar mau

10 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

Most experts agree that the [Colorado River] basin will get even drier

"Already, the drought is upending many of the assumptions on which water barons relied when they tamed the Colorado in the 1990s... Lake Mead currently stands about 1,106 feet above sea level, and is expected to drop 20 feet in 2014. A continued decline would introduce a new set of problems: At 1,075 feet, rationing begins; at 1,050 feet, a more drastic rationing regime kicks in.. Should Mead continue to fall, Arizona would lose more than half of its Colorado River water... That would have a ..*:. A g cascading effect. The Central *n i '. . .r . Arizona Project vvoudd lose u P ..$ .*. " .. The writlng°s on the wall. revenue it gets from selling water, '- which would raise die price of \ 4 . ` water to remaining customers, (1 i If .` 4 ; _.. leading fanners to return to .. /.. . Wu . "ac" 1 pumping groundwater for % 2.1 _ ~¢¢} . Liu J . . ~-»;». 1. ~§; . G art* i s W . . . . 74 C .* r s i" " \ " 1 . irrigation - exacdywhax the 7 ' r . _ . s. ? ¢ ~ _ . . 4 .3 8;- . A :a "*1 .~ Central Arizona Project was . ~v .3_ .fn .:, I 8* A? \ *@~ . supposed to prevent."" we 1 U: 9 f .1*" $1 ' -¢ »4 y r . v . v. a \ la - .\".. A _*L A I go i "an The Colorado Riverdrought . I":*x, - ~ ' '~ ... 1 also affects the Glen Canyon y and Hoover Dams ._ xv 4 l m 5 - v I .» . L - . l. Le x . - ~ `.~ .~ .. .. a- . v . .* .. ~49§!'.'="4"""" - s .~. Jr. ` .»~ 3° e ~ .. . L i _ $ ? $ ' i . t 4 . "At Glen Canyon Dam, the Bureau » r . -s . . . l.." 1.-..--._. & r .. . . .¢,.»..¢v:. -. of Reclamation plans to reduce .- ..._... » . . releases by750,000 acre-feet for Deaingwixhdmugvlmeanspraparingborecyde. the coming year, a historic low. l x \ q w o u . l » Y - iiIl- h u n OO w ¢ ¢»¢O¢n--nvnaalouv The iconic Hoover Dam is s q d l ¢ l ¢ l - 1 _ Fg yq experiencing a 14~year drought, the -b§uN.s¢10- - 5 4 8 5 h e " - - i n (T worst in the last 100 years... For . - m l - d - uq - .....-.._GLouAL\vA1¢n...... Western [Area Power ws-I--up-an-¢o¢iue f m - ¢ | - Administlation], insufficient water results in not having sufficient hydropower to meet its contractual obligations. Under many of [Wester's] contracts, [it] must purchase more expensive power on the market to meet [its] obliga1ions."'2

11 The New York Tunes, "Colorado River Drought Forces a Painful Reckoning for States", January5, 2014 12 EnergyBiz Magazine, "Powering a New Frontier", january/February2014

11 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

Arizona'$ " groth corridor" has an unmistakable corrdadqn to AxizQna'§ pprivate wager inigoby

The best estimates of Arizona's likely future growth are unmistakably correlated to the areas served by I°\1izona's private water industry- the reason is simple: Most private water companies exist outside of town and city limits, because towns and cities usually have their own, municipal water system. Many people choose to live outside of towns and cities, when growth moves beyond an existing town or citylirnit, it invariably runs into areas served by private water companies.

Arizona's Growth Corridor and Arizona's Private Water Utilities

z¢ by i 1 . \ i 4 *4 in . M i i I K g . 4%1. . . ' 4 HF .4 .:. V i . 'i .Q , ' 5 . I 9 " .g. r . 9 \ I l 1 . . " H .x ... I .L g . 1<. 1.4 . .. .4 I .in*' 4 4¢*, 1 s ~J 4 91 I .\ x i x. i i #". . 1, \ 8 h ,»\_& .»'\ :,\ . .J 1 8 x ` r 3 u go . " d \. ( . w. . , I go fu _ |f \ I, I .... $* | ?t< r " . F57..'g. . ` » : * ;)l 1§ .a;' ; . x I . f q r B e . x "1 'i j • IL g . 4 . \ i n <,~ *i I " i n " M \». v 4 4 A ' e . »; ,»r. a 4 1 *Y ; i. 1 » I .0.- * y 1 " > * , . 4 # 1 " j 0 2 1 ) ».¢. ~ * ,4 934 . . 4 A * : > HJ \ e 81 5 L T :. . 4 3 . . 4 f .311 an 'J .. 9 v f r 9%g _1 . A - 1 . r -,.;§ . " ... .. 41 QL R . ~=< " Q 4 .\. TY \ 1,..-.-- \ 4. ma; 4 .k ~@.. ,¢~., . -,-.¢~ * e " E- _1-aan ' ~ , . _.I.-n . 4 0 9 • 1-1-. _-um 1.1---" _Pu Qua 9 . 1 \. _ -1,...-¢- 4. - ...... * -.,--» ||...... - | 2-~" L_] Arizona Population c. 2000 Arizona Population c. 2050 Map of Axizzona's Private Water Estimated by Maricopa Association Companies of Governments

The Arizona Department ofWater Resources issued a milestone assessment of Alizona's water situation in January of 2014, "Arizona's Next Century: A Strategic Vision for Water Supply Sustainability." We are pleased that ADAR's Director, Michael Lacey, asked us to attach Arizona's Next Century to this white paper - Attachment 1 is that report's Executive Summary. The entire report, 60.58 INC, can be found on AD\WR's website at this URL:

https / \w\w.azvvater.<8ov/ MD\YWAri4um Stmtegnc >t>;L"~i< )cements/ ArizonaSu'ategicVisio;1l or\X'aterResourcesSustain.1bilitv.pdl

12 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

In Arizona's Next Centuryg ADWR several "strategic priorities" for Arizona:

1. Resolution of Indian and Non-Indian Water Rights Claims 2. Continued Commitment to Conservation and Expand Reuse of Reclaimed Water 3. Expanded Monitoring and Reporting of Water Use 4. Identifying the Role of InState Water Transfers 5. Supply lmponation - Desalination 6. Develop Financing Mechanism to Support Water Supply Resiliency

Clearly, a consolidated, strong water industryin Arizona would be able to address Points 2, 3, and 6. And a consolidated strong water industry coda play a key role in financing and supporting Points 4 and 5.

Because of Arizona's water challenge, ADWR states that: "The current challenge facing Arizona is that although the State has an easting solid water management foundation, slater demands driven by future economic development are anticipated to outstrip existing supplies. Additionally, the availability of surface water supplies have been reduced in recent years as drought conditions have been experienced locally and throughout the Colorado River Basin."

Emma

The growing, and worsening, drought in the U.S. west will require vast investments in Arizona's water infrastructure. It has been known for some time that the 1922 Colorado River Compact allocated the River's water supplies based on abnormally high River flows - there is not 15 million acre-feet per year in that River, it's more like 13 million but even that flow is highly volatile as the West is now, painfully, realizing.

ADAR's strategic priorities for the 21=* Century make it very clear that Arizona is facing a high-cost future: Desalination will be a multibillion dollar effort, and Arizona's private water industry will need to be large enough and strong enough to contribute hundreds of millions of dollars to that 21" Century effort.

ADAR's final strategic priority, "develop funding mechanisms to support water supply resiliency" is not only essen to desalination but also to ADAR's other strategic priorities. Expanding the use of reclaimed water, increasing water monitoring and conservation, and in~state water transfers all will come at great cost. Thus it is imperative for Arizona and all Arizona residents, that the Commission strengthen and consolidate the private water sector to meet the 21=X Century water challenges we face as a state.

While economies of scaled will provide downward pressure on prices and rates, it must be clearly understood that consolidating and strengthening Arizona's water infrastructure will be a massively expensive effort that will take decades. So, economies of scale arid consolidation will not result in decreasing rates in the near term - they will only provide downward pressure as Arizona deals with, and invests in, its 21" Century water challenge. Drought, volatile and diminished Colorado River supplies, desalination, reclaimed water and increased monitoring and conservation efforts are each costly, and all necessary and prudent to secure Alizona's water future.

13 RESPONSIBLE RESIDENTIAL UTILITY WATER Const'm;ER OFFICE

SECTIONTWO: A CLEAR AND CoMpEu.n~1G PUBLIC INTEREST

Because Arizona faces significant, increasing, and costly environmental challenges due to water scarcity it must evaluate the ability of the private water and wastewater industry to meet those challenges over the long term and to do so m an affordable way for utility customers. Arizona's private water industry lies in the path of Alizona's future growth, therefore the Commission must playa active role in planning for Arizona's water future.

Economies of scale and future water scarcity and increasingly strained sources are ended factors that support the consolidation of the highly fragmented Arizona water industry There are over 300 firms providing private water and wastewater services in Arizona - and as the environmental challenges and costs mount, more and more of those firms will become non-viable and more and more will descend into economic crisis. The Commission has, since 1998, been concerned with the viability of small water systems; and with the drought and the long-term change in Colorado River supplies, the time has come to address consolidation of the industry

At the outset, it is imperative to recognize that not all small systems have to be consolidated - the Cornrnission's interest is simply in ensuring that each water and wastewater system has adequate financiaL managerial, and technical ability to provide safe, adequate, and reliable service both today, and into the future. To that end the Commission should amend its Annual Report rule to also require water and wastewater systems to include the following data and any other information die Commission deems necessary:

Regulatory compliance currently (ADWR, ADEQ, AOC ADOR, and County and Gtycompliance). Regulatory issues the company foresees m the next five years. Basic Financial Ratios: DSC and TIER, which measure liquidity and viability

• One year Capital Improvement Plans that estimate: o the capital improvements (for repair and replacement of existing infrastructure), and o development that the utility believes will occur in that timeframe (with the utility's plan to cover those costs through MXAs, HUFs, and/or debt and equity financing.)

The Commission needs to also establish and levee sanctions and fines for willful failure to comply with regulatory requirements and standards. This will help encourage companies to establish adequate financial, managerial, and technical ability to meet the challenges of today and tomorrow.

However, simply relying on the "stick" of regulatory oversight is not likely to be sufficient. The Commission should focus on improving the regulatory and financial climate for small water companies to ensure dry are filing frequent rate cases, building their financial strength, and preparing for a more challenging water future.

Responsible Water has launched efforts to aid small, troubled water companies to assist them with regulatory compliance and financial challenges. Additionally, Responsible Water is launching a free water seminar series to provide small water companies with detailed briefings on regulatory issues, compliance, and financing. The Commission and the Department of Water Resources are also participating in the seminar series - dais tying outreach and information to die "carrot" and "stick" and increasing the ability of small water companies to meet Arizona's 21" Century water challenge.

14 RESPONSIBLE RESIDENTIAL UTILITY WATER CQNSUMER OFFICE

The public interest is well outlined in a memorandum provided to us from Steve Olea, Director of the Commission's Utility Division:

I "Unfortunately, it is not uncommon for small, troubled water systems to develop compliance issues with federal, state, or local requirements. Very often, these troubled systems lack the financial capacity or the technical expertise to correct these issues. When such a small, troubled system is acquired bye large, well operated, and well financed water system, the potential for significant benefits to ratepayers is obvious. This is the type of consolidation Mat should be encouraged and the Commission's acquisition policy should be tailored to these types of situations."

15 RESPONSIBLE RESIDENTIAL UTILITY \XG\TER CONSUMER OFFICE

SECTION THREE! PATH TO CONSOLIDATION

Consolidation is often used to define many different types of outcomes. To begin the discussion we need to define the different progressions of consolidation The first and most typical consolidation is a simple acquisition - where a larger company simply acquires a smaller company. This may bring some economies of scale to die acquired company." However, for the most pan the smaller company is still largely autonomous with its own rates and operations.

The next progression of consolidation occurs when the smaller acquired company is merged with other regional holdings of the large company. This "regional consolidation" can result in more economies of scale. This is accomplished dirough geographically combined rates, operations and management. The fined progression is when the larger companyis allowed to merge all of their holdings into one company and establish rates that apply to all dieir customers. This "integrated consolidation" allows for the greatest economies of scale (and scope.) To allow for this consolidation to progress in the public interest of ratepayers, a strong set of criteria needs to be developed to intelligently transition from small acquisitions to regional consolidation, and then, if justified full integrated consolidation

The process leading to full scale consolidation is a long one and it fundamentally stars with the basic acquisition. Therefore, the key to realizing the end goal of large scale integrated consolidation is to first encourage acquisitions.

There are four main enabling policies:

1. Rate base acquisition adjustments 2. Allowance of regional consolidations 3. Rate of return on equity (ROE) premiums 4. Cash flow/operating margin inducements

The first two policies are specific to the situation and company- therefore the scope and due ability no streamline their application. However, ROE premiums and cash flow inducements can be setup for statewide application through sliding scale mechanisms and/or qualifying criteria such as class of company being taken over, water loss thresholds, certain financial metrics, etc. The abilityto possess a regulatory toolkit that can be customized when need be or streamlined when the situation calls for it will enable more acquisitions and thus deliver integrated consolidation sooner.

Each policy tool will now be described in detail:

Acquisition Adjustment Strengthening Viability, Incepting Acquisitions

An "Acquisition Adjustment" is a decision by a public utility commission to include some or all of the acquisition cost of a company into the companys rate base. Most small water companies have very small (and in many cases, non-eidstent) rate bases.

This occurs because of several factors: First, oftentimes the original plant has simply been fully depreciated over time; Other times, these companies don't have the financial resources to build their infrastructure so

13 And perhaps also economies of scope if the acquirer is, for example, an integrated water and wastewater company and it acquires a strictly water company.

16 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

they rely on developers to build and finance the plant - it becomes GAC and is excluded from rate base; Finally, very frequently the company does invest in plant and repairs, but the developer GAC is so large that it simply negates the owners' investment. In each of those cases, the companys book value is virtually nothing; but its service area and operating revenues have financial values that support an acquisition price well above book value.

However, the buyer of the companyhas no may to recover the acquisition price if it is not included in rate base. Sometimes, that sunk cost is adequately compensated by the oppominityto grow the acquired entity or simply through the revenue stream from the acquired company An example of that son of acquisition is EP(I)R's acquisition of Oiapanal Water in Fountain Hills. EPCOR paid an acquisition cost approximately 30% higher than Oiaparral's book value, but the economics didn't necessitate an acquisition adjustment.

That example comes with a huge caveat - Chaparral Water was, ball accounts, a successful, capable, well- managed company with more than adequate financial, managerial, and technical ability. What Acquisition Adjustments arid a Consolidation policy must address is companies that alen't viable, or are in danger of falling into crisis because they lack the financial, managerial, arid technical ability to deal with current and looming issues (such as, e.g., Arizona's drought.)

There are two sources the Commission arid the Courts must consider when determining the justness of an acquisition adjustment - ]edge Leamed Hand, one of America's greatest jurists, in the 1943 Niagara Fa/lr Power Co. decision, and Professor James Bonbright, who wrote "Principles of Public UtilityRates".

]edge Learned Hand in Megara Falls Power Co. v. Federal Power Commission"

If the me base were to be set at the price paid by the new purchaser, then "the [company] who does not sell is confined for [its rate] base to [its] original cost; [the company] who sells can assure the buyer dirt [it] may use as a base whatever [the buyer] pays in good faith If the [seller] can persuade the buyer to pay more than the original cost the difference becomes a part of the [rate] base and the public must pay rates computed upon the excess. Surelydris is a most undesirable conclusion" - Niagara Falls Power Co. 1/. Federal Power Commission, 137 F (Zd) 787,793 (1943)

Thus, judge Learned Hand's view is: If the Commission simply allows any cost above original cost to be included in rate base, the seller will "assure the buyer that [it] may use as a base whatever [the buyer] pays in good faith." This will increase sales, but it will do so by changing the economics so that buyers become more indifferent to the purchase price, and sellers realize that the regulatory price constraint no longer exerts a downward force on the price they pk

Professor Bonbright, in "Principles of Public Utility Rates"

"[I]nvestors are not compensated for buying utility enterprises from their previous owners... Instead, they are compensated for devoting capital to the public service." - Chapter XII, "OnQgina/ C0.rz' venu.r Subrequenf Arquirition Cot!" retiion.

14 As cited in "Principles of Public Utility Rates" (Chapter XII, "Original Cost versus Subsequent Acquisition Cost" section.)

17 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

"The foregoing conclusion is subject to revision if the transfer of the properties to their present corporate owner ws an essential, or at least a desirable, pan of a program of integration, justified in die public interest for the purpose of securing operating efficiencies that would offset any unavoidable excess in acquisition costs over original costs. In such a situation... a claim by the [purchasing] company that its purchase of the acquired properties was, in effect, a devotion of capital to the public service, cannot be dismissed as without merit." - Ibid

[In such a situation, the purchasing] "company may properly receive an opportunity to prove its claims, although difficulties of proof are serious. Proof should be more readily adduced with respect to mergers and acquisitions, the terms of which have first been cleared with die regulating commission after a full public hearing and investigation." - Ibid

Thus, Bonbright's view is the acquisition cost is _not aper .re contribution to the public service a return - url : 1) The acquisition was justified in the public interest, and ! I 2) The acquisition costs allowed were set after a full public hearing and investigation. . I ! Therefore the Commission should not do what judge Hand warned about, it should not "simply allow any cost above original cost to be included in rate base" It should follow Professor Bonbright's pathway to consider vldiether "the transfer of the properties to their present corporate owner was an essential, or at least a desirable, part of a program of integration, justified in the public interest" by evaluating such claims through the hearing process.

This view is also reflected in Mr. Olea's recent memorandum on acquisitions:

"The Commission should not provide ratemaking incentives for consolidation for the sake of consolidation In order for an incentive to be appropriate, the water company seeking the incentive must show that the consolidation vdll provide clear and tangible benefits to ratepayers in an amount that is at least equal to the proposed incentive. Furthermore, an incentive should not be awarded unless die purchase price is die product of an arm's length negotiation. The fact that a consolidation may provide benefits to the respective systems' shareholders/owners is not a factor that should support aviary of an incentive." [Emphasis added]

While we wholeheartedly agree nth nearly everything Mr. Olea states in that paragraph, we caution the Commission on the high.lighted text: the benefits of consolidation to determine if they are "at least equal to the proposed incentive" is not possible, and wider all due respect to our friend and colleague, that effort does not address the real reasons for consolidation

The U.S. Drought Monitor shows the severity of the West's and Arizona's drought. It is now known, for certain, that the Colorado River was overallocated and that die River is more volatile than anyone anticipated. Arizona has been in persistent drought conditions for over a decade and it appears Mat rain and snowfall are now more volatile and will remain so, whatever the cause.

ADWR is connect in stating the need for significant increases in water monitoring, conservation, reclaimed water reuse, and the need to begin laying the groundwork for desalination. Those are vastly expensive

18 RESPONSIBLE RESIDENTIAL UTILITY \>0Q\TER CONSUMER 01=1=1cE

individual elements - and yet, Arizona needs to take all those steps and begin doing so today, Arizona is at the end of the "cheap vsater" era and at the forefront of a world in which water is more scarce, more valuable, and more expensive.

Consolidation and eronomief orca/e willnot continue the era ofcbeap wafer- //19' will ii/npfy fmootbthepath to tbejidure Ia/ue and co.rtof water inAn{0na.

Consolidations will be very unlikely to "pencil out" in the near term - because the cheapest course of action in the near term is always to do nothing. But over the longer tem within the next decade and cenaindy beyond that water is going to become expensive and will require highly sophisticated financially strong water management companies. That is the true benefit from consolidation - and that should be the test the Commission applies when considering consolidations and acquisition premiums.

The Commission should evaluate applications for acquisition adjustments on a casebyscase basis, but it would be well served by establishing that there is a compelling public interest in seeing the water industry l strengthened through a program of acquisitions that lead to consolidation. The Commission should adopt an acquisition policy similar to those of Pennsylvania's Public Utility CommissiorL15 Pennsylvania's policy lays out a few major poirlts:

The intent of the policy is to increase mergers and acquisitions to achieve regionalization. Each acquisition must serve the public interest. Acquired systems are below a certain size (3,300 connections), and the acquired systems was: o Not viable; o In violation of statutory or regulatory standards concerning the safety adequaqg efficiency or reasonableness of service and facilities; o Failing to comply, within a reasonable period of time, with any order of the Department of Environrnentd Protection or the Gornmission.

Here we must note that the above criteria from Pennsylvania shouldnot be construed as requiring each of those elements. To do so would be to instantly create an incredibly perverse and dangerous incentive for small systems to ignore statutes, regulations and orders. The Pennsylvania model simply lays out three criteria, any one of which (combined with the prerequisite limit on system size) Carl be evidence of "public interest" in the acquisition and thus the awarding of an acquisition adjustment.

Pennsylvania also allows as ROE premium to be combined with the acquisition to address arid incant "associated improvement costs." Meaning that, if tire acquired utility has significant investment needs, the Pennsylvania PUC can provide an ROE premium to make die acquisition of the troubled system even more attractive.

In an interview in Arizona Regulatory Reports, Pennsylvania PUC Chairman Robert Povvelson explained that Pennsylvania's "policy of encouraging regionalization arid consolidation via inter-agency cooperation and acquisition incentives has resulted in improved water quality and service reliability for many customers throughout our state". Such a result is by itself meaningful, but Mr. Powelson also explained that "customers

is Attachment 3

19 RESPONSIBLE RESIDENTIAL UTILITY \XQ\TER CONSUMER OFFICE

who were previously faced with chronically non-compliant service from small, marginally viable providers" were now seeing improved quality, reliability, and safety in their utility service.16

That same ele provided the following graph which demonstrates exactly how effective the Pennsylvania policyhas been in incepting consolidation:

Pennsylvania Policy Statement on Acquisition Incentives 52 P¢nnAdmin Code §§ 69.71169.721 cs I Water s. Wastewater parties to: T ...... sao

_g 272 as 184 9 : 130

o Pte 19956 1999-2000 .7009-2010 2011

Regional consolidations - authorizing the unification of geographically close systems

It is quite possible that a company could acquire a smaller company that is situated in close proximityto some other companies they own. These companies could for various reasons be consolidated into a regional entity with common rates, operations and management. This could occur if there were common facilities, shared water supply or potential economies of scale. For example, maybe the newly acquired company has a well that can pump more water than is needed and the neighboring company faced a shortage of water. It may be more cost effective to run pipe from the producing well to the other company's system than to drill new wells. There are many other examples of why regional consolidation makes good business sense, most of which are so obvious that they needn't be repeated here.

Rate of return on equity (ROE) premiums

To narrowly tailor the ratemaking incentive to the behavior that the Commission wants to encourage, the Commission could consider specific risk adjustments to the acquiring company's return on equity ("ROE"). The risk adjustment to the ROE could be limited to the system improvements (once completed) that are needed either to bring the acquired water system into compliance or to address quality of service issues, similar to Perlnsylvania's "associated improvement costs" reason for an enhanced ROE.

is Arizona Regulatory Reports, Issue 114, August 2011

20 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

Focusing on the ROE in this manner more narrowly tailors the ratemaking incentive to the behavior that the Commission would like to promote: the acquisition of smaller, troubled water companies by larger, well managed companies and the subsequent completion of system improvements.

Under this approach, the purchase price in the acquisition could be irrelevant; i.e., the ROE premium on its own could encourage and incept the acquisition without the need for an acquisition adjustment to rate base. The buyer would retain the incentive to negotiate die best possible purchase price (because he would know that the Commission woad not increase the rate base by the acquisition premium), arid the seller would have less reason to expect that an inflated purchase price could be simply passed on to ratepayers. At the same time, the buyer would have an incentive to purchase a troubled water company because he would know that the subsequent prudent investments that are necessary to improve the acquired system could be eligible for a higher ROE.

The precise adjustment to ROE would need to be determined in a rate case that is filed after the system improvements have been made. For example, if the ROE analysis in a rate case resulted in an ROE of 9 percent, and if the risk adjustment were 100 basis points, the ROE for the system improvements would be 10 percent, and the ROE for the remainder of the system would be 9 percent. The Commission may also want to consider whether the system improvements would continue to be eligible for an adjusted ROE in subsequent cases.

It is important to recognize that both of the ratemalting mechanisms discussed herein (the acquisition premium and the ROE adjustment) will result in higher rates.

Cash flow/operating margin inducements

The water and wastewater industry can only be consolidated by a) companies viable, and b) incepting the acquisition of non-viable or challenged utilities. This view was precisely espoused in the Commission's 1999 Water Task Force report, and it was repeatedly stated in the Commission's 2011 Water Worlshops. Very often in the review of acquisition policies the fanner point is forgotten,LC.that strengthening viability is an essential tool in consolidating the industry

"[S]mall water utilities are clearly more than large water utilities and theory would support the notion that the required return on investment shod be higher for small water than for large water compan1es."'7

By strengthening the viability of water and wastewater utilities, the companies become economically attractive without the need for an acquisition adjustment. Encouraging friendly mergers and acquisitions by ensuring financial viability is likely to be a lower cost path toward consolidating the industry and achieving economies of scope and scale.

The Commission's recent decision to consider adjusting utility classification revenue thresholds to account for inflation is likely to be useful in this regard because it is likely to make rate case filings less costly and simpler for small and medium-sized water and wastewater utilities. A second step the Commission should consider is increasing the operating margin dart is provided to utilities that lack Tate base, as is the case for most small systems. A range should be established by the Commission after careful consideration. Criteria

17 "Water Utility Risk and Return", Page 20

21 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

should be developed to allow the Commission to have the flexibility to set the percentage on a case by case basis. Currency, the Commission allows operating margins from 5 to 20% (although the authors' experience is that the margin is usually around 10°/o). By way of comparison, m California, the smallest water utilities there - the Oass C and D companies - receive operating margins of 20.73% and 22.08% respecdvelyls

The California position is supported baits determination that "a small water utilitys earned rate of return is significantly greater than that of a large water utility. Small water utilities also face greater operating risk and much greater regulatory risks than large water utilities."1'

The key consideration here is that are operating margin is not the same as a rate of return - indeed one look at the California Public Utility Commission's most recent order on rates of return and operating margins shows dirt the operating margin is about twice as large as the rate of return To many people that will be bewildering - but what one must remember is that an operating margin is not the "return" for die investors and owners of a utility, it is simply what they have left after paying their operating expenses. Their operating margin is what they have available to deal with any operational or financial challenge - the California PUC explicitly takes "into account the high operational risks faced by Class C and D water utilities" and grants them operating margins nearly twice the size of a traditional rate of return - the reason is that a key "factor contributing to small water utility operating risk is their very high operating expenses to operating revenue factor."2°

Again, bear in mind that a small system using an operating margin is, by definition, a system without significant rate base - it lacks financeable assets, thus it must operate on a cash flow basis. Any significant operational or financial challenge must be dealt with in cash, not financing. Therefore it is essential drat operating margins for small systems be increased to levels at least similar to those in California's regulated industry

Those first two steps, adjusting utility classifications to account for inflation (thus reducing the time and expense of rate case filings), and providing a healthy operating margin; will dramatically improve the ability of Arizona's small water and wastewater providers to dead with the environmental and regulatory challenges that lay in their near fmure.

Those steps will incept small water and wastewater utilities to file rate cases - allowing the Commission to begin getting a good look at the industry as it actually exists... Most of these systems haven't filed a rate case ! in decades, and the Commission frankly has no idea what their situation and strengths may be. By incepting the filing of rate cases, the Commission will get a read look at the small water situation in Arizona.

The effect of those two steps will be to make the industry healthier and more transparent. Both are essential to dealing with Alizona's water challenges, and to beginning to consolidate a highly fragmented industry.

Acquisitions are hampered not only by the lack of an acquisition adjustment incentive and the inability to consolidate rates (more on that later); they are also greatly hampered by the fact that many small systems are financially unhealthy and there is no real way to evaluate a company/s position before one makes an offer and gets access to its books and records. Rate cases solve both those challenges and will make it easier for

is See Attachment 2 19 "Water Utility Risk and Return", Page 1 20 Ibid, Page 16

22 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

consolidators to evaluate and identify good acquisition opponunides, and to use real information to evaluate and negotiate a fair price.

Before concluding this section, we must highlight the fact that in Arizona, many small water companies have demonstrated very significant challenges interpreting and navigating the Corporation Commission's rate case process. This is not an indictment of the Arizona Gommission it is a common problem: "Many small water utilities have little or no contact with the Commission until they experience major fiscal or operational difficulties." That quote describes Arizona and many other states, but it is from "Water Utility Risk and Return" published by the California PUC, describing California's regulatory clirnate.21

Therefore we urge the Commission to consider establishing an Ombudsman office - staffed with an accountant, an engineer, and an attorney. The Ombudsman office would have two missions: First, to assist small companies after they file a rate case or a financing application; and second, to conduct outreach to the small water industry and to customers of small water systems to explain the Commission and its processes. They would not be there to represent the company but to assist diem through the process. All too often, companies and customers are as confused as anyone bathe Commission's work Thai is m no one's interest.

Those steps, if combined with a Commission policy allowing rate consolidation, will lead to significant consolidation.

Should the Commission wlsh to further incept me case filings, it could consider an incentive along the lines of this, again from "Water Utility Risk and Return" :

"For whatever reason, many small utilities do not come in for needed rate increases. Allowing automatic rate adjustments which could be set to an index would allow the utility to recover those expenses that are out of the control of the Therefore, the recovery of lost or gained revenues are not adjusted when the utility saves or wastes money and the stockholders will bear diesel gains or costs. Indexing will also preserve the incentives found vwdl test year ratemal

An example of such as adjustment would be a power supply adjustor - allowing those, on a case by case basis, but only after the company files a rate case arid gets Commission approval, could provide an additional incentive to file rate cases, and could also reduce small water companies operating revenue risk

21 "Water Utility Risk and Recur", Page 12 2z Ibid, Page 23

23 RESPONSIBLE RESIDENTIAL UTILITY W-\TER CONSUMER OFFICE

SECTION FOUR: CONSOLIDATION OPPORTUNITIES

To achieve maximum economies of scale will require the Commission to begin consolidating rates within each utility, and consolidating the industry into larger more viable parent companies. These approaches will allow water systems to dead with unexpected costs and to attract capital on more reasonable terms. When one things about unexpected costs, most people think of well failures, but it also includes added and changed water quality regulations and standards, increasing costs for CAGRD and CAP water, and increasing power costs. Additionally, changes to water quality standards, as occurred in the case of Arsenic, have significant costs and effects on customer bills. Consolidation of rates among affiliated systems and consolidation of the industry itself can those

Rate Consolidation

The first component of consolidation deals with consolidating the rates of affiliated systems. The Commission has consolidated the rates of affiliated systems in the past - notably Liberty Water's McLain and Sunrise systems in Cochise County; and the Commission has also reconsolidated the rates of affiliated systems - notably Anthem and Agua Fria in Maricopa Count}n23 . In both cases, the Commission determination centered on customer rate impacts.

I The electric, gas and telecommunications industries have long recognized that under rate consolidation more people have better service at a reasonable price. Under rate consolidation the regulatory process is also less cumbersome and expensive to both the public and the company involved Consolidation avoids multiplicity of rate cases for each individual system, and simplifies Me handling of questions and complaints by the regulatory commissions. And it strengthens the ability of utilities to withstand regulatory changes, environmental challenges, and economic challenges by spreading those costs over a larger, common, group of customers, Le., betaking advantage of the economic fact that economies of scale exist.

One deference between the electric, gas and telecommunications industry and the water companies that must be addressed is that the other utilities customers all share common transmission systems. It would be necessary for the Commission to determine what factors are applicable in the water and wastewater consolidation decision. Factors may include but not be limited to common water resources, i.e., same aquifer, or common utility management, i.e., shared plant, shared services, common management, shared staff or future need for shared water sources, i.e. GAP or other surface water that requires large treatment systems.

As mentioned in the previous section, in order to achieve a wide spread significant consolidation of the industry rate base acquisition adjustments, allowance for regions consolidations, rate of return on equity premiums, cash flow and operating margin policies that strengthen small water companies must become tools that the Commission utilizes to encourage regional arid integrated consolidation This would allow Me Commission greater flexibility to pick the tool dirt best fits the situation.

23 We note that recently, another development, Cone Bella, has petitioned the Commission to reconsolidate themselves from Agua Fria, thus continuing to reconsolidate a once-regional operation.

24 RESPONSIBLE RESIDENTIAL UTILITY WATER ConsL'm18R 01=p1cE

SECTION FIVE! SUMMARY AND RECOMMENDATIONS

In the fined analysis, we believe that Arizona's environmental reality, and its expected population growth in areas served primarily by private water and wastewater utilities are sufficient justification for embarking on a Commission policy supporting and incepting consolidation of the private water industry Arizona's water situation is not "dire" but it is, as it always has been, complex, challenging, and ever-c . Knowing that the majority of small water systems lack financial and operational strength and knowing that Arizona's water situation is becoming more difficult is all the evidence the Commission needs to embark on a policy of consolidating and strengthening the industry before Arizona's population doubles in size.

But there are other benefits which we have also established in this paper: Customers will benefit from economies of scope and scale; the Commission will get a firmer grasp of the actual real-world financial and operational situation that small water companies face; the Commission will have greater oversight into the industry- and the industry itself will become much more transparent; and finally, Arizona residents will receive what Pennsylvania's PUC was able to attain for its residents: improved quality reliability and safety in dieir utility service.

Pad Walker Pat Grairman Director Arizonans for Responsible Arizona Residential Water Policy Consumers Office

25 RESPONSIBLE RESIDENTIAL UTILITY WATER CQNSUMER OFFICE

ATTACHMENT 1 Arizona Depamnent of Water Resources "Alizona's Next Century: A Strategic Vision for Water Supply Sustainability' Executive Summary January2014

26 RESPONSIBLE RESIDENTIAL UTILITY \*4Q\TER ConsL*m18R OFFICE

[ARIZONA'S NEXT CENTURY: A STRATEGIC VISION FOR WATER SUPPLY SUSTAINABILITYI

EXECUTIVE SUMMARY

The Challenge For over a century, Arizonans have faced challenges m ensuring that there are sufficient and sustainable water supplies and have successfully developed water supplies for agncurtural, industrial and domestic uses. Arizona has aggressively taken the actions necessary to ensure that sufticxent and dependable water supplies are.available for ms long'terrn economic stability. Whale diverse these actions have shared a common premise of being solution-oriented, meeting not only the immediate needs of the State but more importantly addressing the future challenges Arizonans would face Following In that tradition of strategic planning and action, Arizona now must face its next challenge in water supply security and management We are at the crossroads of having to decide what actions we will take to meet those challenges.

Over the last five years, the Arizona Department of Water Resources lADwnl, nm pannersrup with 14 | . M o . many in Arizonas water community has L r . s an pamcupated in the development of a » f r - i

comprehensive water supply and demand analysis I " 1 for Arizona through the work of the Water \¢~ Resources Development Commasszon (WRDC) At » - a v * '- <\ , » » » - Q I »: . i ' - v u - n I n the same time Arizona has also been acutely -¢. . . .3; I r

I | working with the U.S. Bureau of Reclamation O a t h - re . . s ("Reclamation") and the other six Colorado Rrver Y; Basin States (collectively, the 'Basin States') (sec Figure ES-1) to identify protected supply and 1 1~ ; demand Imbalances on the entire Colorado River a I i n system cufmnnating an the Colorado Rwcr Basin .- r 3 4- I . . Q.. \ f a. * . l . Water Supply and Demand Study {'Basin Study). 2 . *F f. . ; Through the work at the WRDC and the Basin 1 . .. i ii_ , f f n- I Study we have ldentifned a long-term imbalance .... .-» y . .... 6 *. .- s - between avallatale suopnes and protected water \ . \ . demands over the next 100 years of up to 3 million n k ¢ acre-feet. Our challenge is to explore viable 4 * - . 1 4 9 9 l.i"L\ 4~ v * : solutions to address thus projected imbalance and .__-._ -- L -4 - _ initiate the action necessary to develop those solutions Figure E5-1. Colorado Riwr8a5lhStudyArea {8edamorion, 2012)

The process to meet these dianenges has already begun on two fronts. lnrsx in cooperation was Reclamation and the other Basin States, ADWR (along with several Arizona stakeholders) Is actively aanlcipatlng in a process to identify multiple Basin»wide solutions including demand management reuse of reclaimed or recycled water, analyzing the viability of water transfers, analysis of alternate water management strategies Le g. Water Banking in the Upper Basin) watershed management and importation of water supplies from outside of the Colorado River Basin. Secondly at the request of Governor Jan Brewer, ADWR has Initiated a parallel process wrthln Arizona ro develop a Strategic Vision 17

9 RESPONSIBLE RESIDEnTs-Xl. UTILITY WATER CONSUMER OFFICE

lARIZONA'S NEXT CENTURY: A STRATEGIC VISION FOR WAT£R 1anuafy 2o14 SUPPLY SUSTAINABlLITYj that identifies possible strategies and projects to pursue to reduce these imbalances. Thus Strategic Vision creates the frafnewort for analvsis of potential strategies and provides context for maximizing them to address the needs of maNiple water uses across the State.

This Strategic Vision for Arizona is a necessary first step url this process. We have completed the initial analysis of the challenges faced by Arizonans and have organized the State into twenty-two solution oriented 'Planning Areas' (see Figure ES-2). The next logical step is to identify possible strategies to address pro}ected imbalances. while many of the mechanisms necessary to address our future imbalances are available today, there are null limited supplies. A comprehensive Strategic Wslon that identifies viable strategies will assist all water users in Arizona to come together to address our needs.

c I - n ~ \ - I 4 3i s 4 ~¢ 5 - - "Qt . ~~~ 9 a n \ -»¢- \

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"N r 1 I _ f L u g - Strategic Vision .., Planning Areas | | -..,..`. wr '.

Fguaz £5-2. Strategic Vsion Planning Aras

10 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

[ARlZONA'S NeXT CENTURY A STRATEGIC VISION FOR WATER SUPPLY SUSTAINABIUTY

History while we reside nm what some perceive as *. \. a harsh environment, those with great R' 'r '~"\, wsxon and leadership have harnessed the . 1 4 /NAGHAH natural resources needed to support a x" \ /" u ' . | nr wmnocn thrwing Arizona economy. This vision 4 \ "c \ £1 nm wnnnuo ume nu I a . stared well before statehood. First 1 \ ` I ' i f \,. . beginning with the passage of the 1902 -. 3 " 1 1"` . 4 Lcucannnn ~f r*~

National Reclamation Act and the efforts ..a.,~ I " r d the Salt River Valley Water User's \ , swgwlow J • 1 *A ~. `A_\"* l ~A M v\U* Association (SRP), over 200000 acres of onnnwm girl`*\ \ ( . \ /.- IAIIUTV DA! \ . . private ranching and farm lands an the | | I cum Mr an \ Phoenix area was pledged as collateral for \ v x; the construction of Roosevelt Dam in 1903, ' I r w o n l x \ . 'J Q with a reservoir storage capacity of nearly M v - " ' ` \ 1 qh\dAlll 1.4 million acre-feet* (MAF) (see Figure Es- LN- uamouruw\ - M bam i n M u 3). At the same time Central Arizona was Figure E5-3. cal! River Praia! Reservoir 5ynem and Servke harnessing the Salt River development of Area (Courtesy of sum) the waters of the Colorado River was also taxing shape, culmmanng over so years later, after a genes of legal and polmcal struggles, In the authonzatxon of the A __; _,4- . 4' / textual Arizona Protect (CAP) In 1968 (see N V $ - \ Figure 5.94). . y . 3 ; . * I . . I .Q . ¥0r decades Ar:zonas groundwater SO " ~~. .-_ . \ _»a . 5»uppIles were managed through the . " 1 . at L G 4 A * v N Court's until 1980 when the Anzcna 3 Legislature adcptea one of the man o - c9mprehemwe groundwater manage- 4- ...... __ '?-~..... ment strategies in the U.S. - the 1980 Groundwater Management As (GMA) g - ~ - Q - n u QS - n ¢ n Q E u The framework of the GMA us intended to .n4.¢...r. protect exrsung water users and serve Figure 5.94. CenuulAn}ona Project System(Courtesy of CAP) "ew uses with non-groundwater supplies preserving the groundwater supply as for future shortages The GMA established a trrnehne for reduction and elrmrnahon of groundwater pumping in caftan areas of the State, desrgnatmg Andre Management Areas (AMA) Ana lmgatnon Non-Expansion Areas IINAI to facilitate Ills process \see Flguf¢ £s-5).

J |*.\»H BMI: 1996 the can -as Mac Fed by !*¢USB.r¢au d Uedavanor in aeWrer wnsfgvv darn : »¢.¢n 77&4° in ein1co»\ we vwachazw rr~c..ned x:oa:xr..¢:a- ohne "cy: so*Mays garza Amos no' -.ea outs alls aid aowev Alan! :ac 'rumors wan: ng rt: ware' ¢z:':e'-a:an :savage oaantw in 2Dae'w-t 9 12 RESPONSIBLE RESIDENTIAL UTILITY WATER ConsL':~1ER OFFICE

lARIZONA'S NEXT CENTURY' A STRATEGIC VISION FOR WATER SUPPLY susTAlnABILrry;

Addressing the needs of Arizona's tribal communmes was also an important pan of Arizona's water management history The State of Arizona and non-lndlan water users have been working for decades to develop equitable distribution of Arizonas water supplies in cooperation with ms tribal communities through settlement of these claims.

" v 9u:..lu..l .

FIJI* .

U l l l 9. 49 ' 0 1 lj 4

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l l iv ¢ l l A s L Z ** £'!"'4 rw 1 » u . l - l av..4 Active Management Areas ' www aus 4 - Hun- 4 As u .». nu 51 nu u Sn and Irrigation Non-Expansion Aras 1.

Figure £55. Active Management Areos and litigation Nonfxponsion Areas water conservation and reuse of water supplies is the cornerstone of Arizona's water use hlstorv Arizona leads the nation m water ccnservanon and :he reuse of treated wastewater (reclaimed water). Water conservation continues to be the founaataon of Arizona's water management strategy. The State of Arizona and its cozens have achieved unparalleled water supply Improvements through implementation of conservation measures and vractrces that serve as a moxie for water managers throughout the world. Since the adoption of the GMA in 19B0 and subsequent refinements to its mandatory water conservation requirements Arizona has seen significant imorowernent in water use effnclencres as illustrated in Figure ES-6 below. 0

12 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

[ARlZONA'$ NEXT CENTURY: A STRATEGIC VISION FOR WATER hmnw2014 SUPPLY SUSTAINABILITYI

mandatory water conservation requirements Arizona has seen significant improvement in water use efficiencies as illustrated In Figure E5-6, below.

Arizona along was Cairlornia Florida.. and Texas also leads the nation in milizatlon of reclaimed water'. A significant ocmon of the reclaimed water produced m Arizona is reused for landscape irrigation agricultural irrigation. povvet generation, irrigation of parks and schools and amncially rediargeo into groundwater aquifers A pomona of the reclaimed water is also discharged into the beds of rivers OnO streams, benennng the environment by providing habitat for wilolrfe and adding aesthetic and economic value to Arizona's iandsape

Arizona Water Use, Population and Economic Growth (1957-2011)

220 1 0 5

200 9.5 180 8.5 160 7.5 140 .9B 5.5 ov S :to B .. s 55 o 3 100 5 BO 4 s § § 60 3 s

40 2.5

20 1.5 "I- o T _- 1 _ ' 0.5 1951 1973 sao 1990 zoom 2010 2011 M Adjusted GDI Population * Water Use (AF)

Figure ES-6. Alilwina Water Use, Wiparladon and Eeonomk Growth 1.957 2011 (ADWR, 2013)

As development expanded throughoxn Arizona Ana as the State moved closer to fun utilization of its diverse water ponfoiio, Arizonans adopted dynamic water management strategies to address the issues they encountered mdudmg Underground Storage and Recovery and Wat=r Banking of unused supplies, adcotion of 100-year Assured Water Supplv Rules for all new development and the creation of the Central Arizona Groundwater Replenishment District (CAGRDI to meet the needs of communities without direct access to renewable water supplies.

) Wars :vie Wazzsbgzst P WP "*w~ »~c*a: co-i.IPA#leea:¢:M:x:aecvemofo<3u»ce.r~¢:'orWatenleuseav1

1 4 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

[ARlZONA'S NEXT CENTURY: A STRATEGIC VISION FOR WATER SUPPLY susrAlnAaluTvl

The achievements or lined above serve as a guide for future planning as they are the result of strong commitments and significant investments m time and money to realize the benefits of the projects. Establishing and pursuing a vision for water secumy for fmure generations of Arizonans must begun well in advance of the need in order to ensure orderly development avoid economic disruption, and protect the unique and precious environment that we all enjoy. Many of the elements of Arizonas water development history were shaped by creative public/private pannershlps Such arrangements are likely to become more common and necessary as the federal government's role in water development projects continues to evolve.

Future Water Supplies & Demands The current challenge facing Arizona is that, although the State has an existing solid water management foundation, water demands driven by future economic development are anticipated to outstrip existing supplies. Additionally. the availability of surface water supplies have been reduced in recent years as drought conditions have been experienced locally and throughout the Colorado Reef Basin. Questions about future climate cpndmons add addmonal uncertainty to our ability to maintain an appropriate balance between demands and supply. Water resource planning efforts are instrumental in the identification and evaluation of these challenges. Arizona has been actively evaluating future water supply and demand conditions for decades.

Every ten years, consistent with State statue ADWR assesses water supply and demand conditions in each or the State's AMps. primarily to evaluate the ability to achieve the management goals identified by the Legislature for each AMA under the GMA. In 2009 and 201D, in anticipation of the next Management Plan, ADWR developed a demand and supply assessment for each of the five AMAs to (1) evaluate its cur-rent status and ability to achieve the statutory water management goals for these free areas and (2) to frame the discussions for alterative management strategies needed to meet and maintain those goals. Additionally ADWR also produced the Arizona Water Argos (Atlas) in 201o proinding water-related information on a local, regional and statewide level to frame and support water olanmng and development efforts. The development of the Atlas also spurred the development of a statewide water resources data repository housed at ADWR which is continuously updated as water use information us reported and collected. These are on-going efforts that allow both for focus on specrhc regions of are State and provide past and present water use information

Since 1980, Arizona has also developed or partnered nn, comprehensive Ana prospective statewide and multHtarte planing efforts {a list of these efforts as identified in Appendix HI of the Strategic Vision). More recently the WRDC was an Arizona-only effort identifying projected future statewide water demands and available water supplies for the next Eco years. Estimates for population growth an Arizona for the years 2035 2060 and 2110 are 10.5, 13.3 and 18.3 million people, respectlvely Annual water demand iS expected to grow from current levels of 6.9 MAF to between 8.2 and 8.6 MAF in 2035 between 6.6 and 9 1 MAF in 2060 and between 9.9 and 10.5 million acre~feet per year in 2110.

The Basin Study was developed to define current and fmure imbalances between protected demands and Colorado River water supply availability Zn the Colorado River Basin and the adjacent areas that receive water from the Colorado River, through 2050. This extensive study estimated that population within the study area ms projected to increase from about 40 million people an 2015 to between 49 4 million and 78.5 million people under the slow growth and a rapid growth scenario. respectively. As a 32

ld RESPONSIBLE RESIDENTIAL UTILITY \XG\TER CQNSUMER OFFICE l l

[ARlZONA'S NEXT CENTURY: A STRATEGIC VISION FOR WATER January 2014 SUPPLY SUSTAINABILITYI result of thos increased population, and factoring m Mexico's 1.5 MAF 1944 Treaty allotment and losses due to evapcrauon and system operations projected demands in the Basin are amiclpated xo range between 18.1 MAF (slow growth scenanol and 20.4 MAY (rapid growth scenario). Over the past 10 years, the Colorado Rner'syreld has averaged about 15.3 MAF annually. Comparing the median water demand projections to the median water supply prolecuons, Me long-term projected Basin~wlde imbalance ds estimated to be 3.2 MAF by 2060. The actual imbalance may be much larger, or could be sightly smaller depending on the avallabulizy of water and aaual ground experienced nm the region

Opportunities & Challenges Arizona is characterized by widely ¢- Aiuzcu s tractU IANAGEUENY 1:l»ous1u¢u7v diverse geographic zones, ranging ____.~ a _ ¢ -.- _ u - - .nunvons-u-u v _ a .--- .. . , _ . from forested mountains to arid LY r _ . I i deserts. These areas have ...w z /\ . 4 7' I dissimilar climates and / ?-4Jr<, m » 4* i 4 41 precipitation regimes resuitmg in ¢"'< | ` 4 I, 4 . > great vat bitty in and accessibility 4 a s 4 v g I . 8 | .1 a to, surface water supplies. Arizona . v . 4 | i *. . . 4 . * \ v 8'¢*1312 as also geologically complex which . i i i : r * g X 1 "w 4" 4* impacts the availability, Quality and - - . • r . x P \ x J accessibility of groundwater 2 4 8/i3» i 1 . ` r . 'I , » suvviies. Arizona is also unique in p q *ay 1 ms land ownership patters. Less \ ..0 . ¢ A than 18 percent of the land within . ~vi q . .,,14 . 4 . A 93:é the State is under private 4 2 ws* # \ ,..;,...\\ ownership. State Trust Land, Y) • Y administered by the Arizona State *r~ T 1. . ! 4 r Land Department (ASLD) comprises 844 ~ ! . L..~ r x 4 L almost 13 percent of the land with I 4 , : r ¢ "r-.J the remaining 69 percent in either . _Sn . # 1 I Federal or Indian ownership [see 44 \Ly? . N h Figure £$*7) This ownership is also » I I • often fragmented, with Federal -.-_... I _._...»-- q~~n ¢ ~ s - , -1 . i n,T L l State, and prate land holdings 9 1 - a - - l *° 3 o - . - . - --red t'-. s.. 9!* .4 4 assembled in a 'checkerboard' QQ . . .ll g*§~- \ -._ __. _ fashion that further complicates > Q... T: f 1 v ,__I the development and execution of comprehensive and cohesive land Figure ES-7 Arizona land Ownership (Courtesy ASLD) and water management strategies.

Another factor in the complexity of developing water supplies us the Arizona water law system a complex mixture of State and federal laws with groundwater and surface water largely regulated under separate statutes and rules. While the groundwater management system primarily applies inside designated AMAs and leAs the surface water system (except for Colorado River supplies) is administered statewide. Colorado River suppl l es are managed in cooperation with the State but contracts for Colorado River water are initiated through the US Secretary of the Interior and 3

15 RESPONSIBLE RESIDENTIAL UTILITY WATER CQNSUMER GFFICE

[ARlZONA'S NEXT CENTURY: A STRATEGIC VISION FOR WATER iawafv 2014 SUPPLY SUSTAINABILITYI administered by Reclamation Reclaimed water is managed under a completely different set of regulations and policies, and its management framework was significantly influenced by case law' This legal complexity adds to the challenge of ensuring that adequate supplies exist to meer the demands

across the state. i

Further adding to the legal complexities within the State are the on-going general stream adjudications of the Gila and Little Colorado Rivers. General stream adiudkatlons are indicial proceedings to determine or establish the extent and priority of water rights. The Gila River and the Little Colorado River adjudications were initiated in 1974 and induce water uses and claims by both state and federal entities. The State parties include municipalities mines uttlitv companies, private water providers water users' associations conservation districts, irrigation districts, state agencies and individual water users that rely on water diverted from streams, lakes, springs stored in reservoirs or stockponds and withdrawn from wells. Within these proceedings, water rights are also being adjudicated for water uses on Indian reservations and federal lands including military installations conservation areas, parks and forests, monuments, memorials and wilderness areas. These water uses may include both surface water (non-Colorado Rwer) and groundwater in certain instances. As of July 2013 there are 83,244 surface water claims in the Gala River Adjudication and 14,522 claims in the Little Colorado River Adjudication While progress on the adjudication process has been complicated by the diversity of water users and claimants the State has made significant progress in reducing uncertainty through execution of Indian Settlements resolving in whole or in part 13 of the 22 tribal claims through Court Decrees or negotiations culminating in Congressionally authorized settlements.

Over the next 25 to 1G0 years Arizona will need to identify and develop an additional 900,000 to 3.2 MAF of water supplies to meet the projected water demands. While there may be viable local water supplies that that have not yet been developed water supply acquisition and/or impanation will be required for some areas of the State to realize their growth potential. Examples of these potential supplies are

1) Non~lndian Agricultural Priority CAP water, 2) Reclaimed water/water reuse for which there is not yet delivery Cr storage infrastructure constructed to put N xo direct or indirect use 3) Groundwater in storage (both potable 8. bradxish supplies), 4) Water supplies developed from revised watershed management practkes, 5) Water $uppIles developed through weather modification 6) Water supplies developed from large-scale or macro rainwater harvesting/stormwater capture. and 7) Importation or exchange of new water supplies developed outside of Arizona (e.g, ocean desalination).

Strategic Vision Arizona could be facing a water supply imbalance between projected demands and water supply availability approaching 1 million acre-feet in the next 25 to 50 years In many portions of the State, this short term imbalance can lrkeiy be solved with enhanced management or locally available water supplies. However there is stiff a need to develop the financing to construct the infrastructure

4 » lnevno Fib~e.5¢wel (o v Inna

16 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

{ARlZONA'S NEXT CENTURY A STRATEGIC VISION FOR WAT£R January2014 SUPPLY SUSTAINABIUTYi necessary to accomplish this. The imbalance is projected to increase by an additional 23 MAF by the year 2110. The avallabilny of local water supples to meet these needs will vary based on the distribution and intensity of the demands throughout each region of the State. The stresses imposed by these imbalances would be experienced by all water using sectors in the State and would likely have undesirable environmental consequences.

Local water supplies may not be sufhdent to address these longer term needs and more options must be explored and evaluated including importation of new water supples from outside of Arizona. Pursuit of longterm options will require sustained investment and commitment by Arizona's policy and business leaders. In order to a v id economic disruption these efforts must begin immediately to ensure the long-term solutions are in place in advance or the need and the environment that makes Arizona unique is adequately and appropriately protected.

Regional Strategies No single strategy can address projected water supply imbalances across the State. Instead a portfolio of strategies needs to be amptemented dependent on the needs of each area of the State- lt is very important to recognize the uniqueness of the various regions throughout the State and the varying challenges f a n g those regions. A more thorough regional overview and evaluation of the water supply needs is required for each of the twenty~tvvo 'Planning Areas' within Arizona and is contained in Section ill of the Strategic Vision. These Planning Areas [see Figure ES -2) have been identified based on possible short-term and long-term strategies available to meet the protected water supply imbalances. Table ES- 1, below, highlights the portfolio of strategies that have been identified and the applicability to each of the Planning Areas. Many of the necessary planning efforts are well underway in some reglorls.

Statewide Strategic Priorities in analyzing all the strategies on a regional basis it became clear that there are specific measures that have widespread potential benefit to all Arizonans. Strategic priorities are identified below which ADWR believes will move Arizona forward through its next century. Addmonally, action items have been identified for the first 10 years following the submittal of this report including a requirement for the continued review and update of this report every 10 years.

The identified statewide strategic pnoritles are

1) Resolution of lndaan and Non-Indian Water R4qhf$ Goers Arizona has been successful in resolving either in whole or in pan 13 of 22 Indian water rights calms providing substantial benefits to both Indian and non-lndlan water users However the genera! stream adjudications, wmcn began in the 19705 remain incomplete. Completion of the general stream adjudication will result m the Suoenor Coup issuing a comprehensive final decree of water rights Until that process is complete uncertainty regarding the nature extent and priority of water rights will make rt drfflcun to identify al the strategies necessary for meeting protected water demands. ADWR believes that options need to be developed by the State to accelerate thus process. Creation of a Study Committee to develop options in a short tame frame could help provide guidance to ADWR so adequate funding an be rdentMed and obtained to complete the necessary technical wort to support completion of this process. Development or options could lnMally focus on conceptualization of water rights administration in a post-adyudlcated Arizona. This will streamline the Court and ADWR's effort to

17 RESPONSIBLE RESIDENTIAL UTILITY \XQ\TER CGNSUMER OFFICE

lARIZONA'S NEXT CENTURY: A STRATEGIC VISION FOR WATER January 2014 SUPPLY SUSTAINABILITY

ccllectrng and evaluating only mat information what wu assist in admmrstering the final water rights decrees.

2) Continued Commitment to Conservohon and Expand Reuse of Reclaimed Water Ccnservanon as the foundation of sustainable water management in our arid State. The continued commitment to using all water supples as efficiently as possible is necessary to stretch cur existing water supplies and has delayed the need to acquire other more expensive supplies. Additionally, many non-potable uses are currently being met Ov reclaimed water rndudmg: landscape imgatlon of parks and golf courses, agricultural irngatton and stream flow augmentation benefitting ecosystems. Reclaimed water as produced consistently throughout the year, with limned seasonal fluctuation. Using reclaimed water limns use of potable water for non-potable purposes and saves potable water for drinking water supplies. However as demands increase and water supplies become more stretched, the need to explore and invest in direct potable reuse for drinking water supplies will become necessary.

3) Expanded Monitorinq and Reportinq of Water Use Metering and repomng across the State would serve to support and enhance analysis of current hydrologic conditions.. However monitoring of water use outside of the AMAs and lAs is limited. Data collection is a crucial element of the development of groundwater models, which have proven to be invallJBbl¢ tools throughout the State in developing more thorough understanding of hydrologic systems and evaluating future conditions and potential impacts of new uses ardor alternative water management strategies.

4) Identifying the Role of In-State Water Transfers A source of significant controversy across the State, in-State water transfers have been the focus of much debate throughout Arizona's history. A comprehensive analysts or water transfer is needed in Arizona Evaluation of long-term versus shortterm transfers may actually provide insight into how water transfers can be developed to protect or even benefit local communities. Lessons from other western states that have adopted more market-based water right transfer models may be worthy of review as pan of this analysis.

I 5) Supply Importation - Desolino son I Importation of water from outside of Arizona will lilrely be required to allow the State to continue its | I economic development without water supply limitations. Supplies derived from ocean of sea water desalination can be imported directly into Arizona to meet the water needs of municipal and industrial water users, Wf\11¢ at the same time providing aesthetic, recreational and ecological benefits. Alternatively, desalination can be done in pannershio with Other Colorado River water users an exchange for water from Lake Mead. Potential partners for seawater desalination include higher priority Colorado River entitlement holders in Arizonan and California. the State of California or Mexico. Projects of this magnitude are expensive and energy intensive, although inn capital and operating costs have slgnrfrcantjy reduced as technology has improved and are comparable to water rates in other pans of the country. More importantly because of the need to identify partners and develop agreements such projects will require a sigmlicant investment of time - up to 20 years to bring to freemon. Because of the time n takes to develop these projects and the more pressing need for water supplies in certain parts of the State exploration of this strategy should begin immediately. 6

18 l

RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

[ARIZONA'S NEXT CENTURY: A STRATEGIC VISION FOR WATER n n wv 2 0 1 4 SUPPLY SUSTAINABILITYI

6) Develop Finonc/nq Mechanism to Support Water Supply Resiliency The strategies identified above Beth statewide and regional will refluire capital investment. Some areas of the State need immediate assistance in developing water projects specifically in portions of rural Arizona. Unfortunately these are areas where Iifnned populations cannot finance the required water infrastructure. The Water Resources Development Revolving Fund was created by the Arizona State Legislature to provide financial backing for these communities but has not been funded to date. Seed money for this revolving fund will be very important to meet the immediate needs of rural communities and provide long-term water supply security for many Arizonans.

Financing of large~scale projects is another issue. For many years, the water community has been attempting to develop options for funding water supply acquisition and infrastructure development. These conversations and analyses have largely been conducted in the absence of substantial financial expertise and have achieved limited success. It is time to elevate this conversation and address Arizona's future water supply needs and only Arizonas community, political, and business leaders are capable of garnering financial resources and mechanisms necessary to meet these needs. While the water supply needs may not be immediate, addressing the financing of future large~scale water projects needs to begin as soon as possible to ensure Arizona's industries and citizens have secure water supplies into the future.

10-Year Action Plan Outline Legislate Strategic vision update every 10 years (Year 1) Begun D\scusslons on Ocean Desalmatiora (Year 1) : Exchange Options I California I Mexico Direct Options | MCXICO • Resolve ADOT Right-of-Way Issues for utlIlt1e5 (Year 1) I I Establish Adjudacanon Study Committee (Year 1) • Begin Discussions on Water Development Financing (Year 2) : immediate Needs for Water Resources Development Revolving Fund for rural Arizona . Long-Term needs for Large-Scale water um potation pfolects • Remove current statutory limitation (AR S § 45-801.011221J on the ability to receive long-term storage credits for recharging reclaimed water beyond 2024 (Year 2) • Review Legal Ana Institutional Barriers to Direct Potabfe Reuse of Reclaimed water - develop and implement plan for resolution (Year 3) • Review and implementation of Adjudication Study Comm nee nnamgs (Year 3) •1 Develop and Begin implementation of Direct potable Reuse of Reclaimed Water Public Perception Campaign (Year 4) • Begin discussions with New Mexico on an interstate cooperative program for watershed management/weather modification in the Upper Gila watershed (Year 4) • Qesohfe Remaining Indian Settlements [Year 1 - lm

• Resole General stream Adjudication (Year S - 10} 7

19 RESPONSIBLE RESIDENTIAL UTILITY WATER CQNSUMER OFFICE

l "T l {AfllzonA5 NEXT CENTURY: A STRATEGIC VISION FOR WATER SUPPLY SUSTAINABIUTY 4

Table £5I. . Arm Strategies Apalkabk Supply l1ll\ih!i¢0 & ou¢n Tnnwlinc ' • _- Pia Al i s ' losulvc m ma wav ma: L I s C. 9 u. u. 17. no w - un In u u | & ¢ u - Clvuncn law n ea. no n UGU-8 .anno ¢- n m - a s pvunonih-44 l b p a u u n M L mu g u -1 n u -Q g n u q V!! 4- CII! KD :man u - 1 u i n 8 6 - 4 ' a n hunch-ww-»--w 9 4 c m -n u n l i i u o a n l u r - u . Wlu ¢NvuU-4l-Qu L x 5.9. ll. xo 17. as. - a n as a - n g uaggung l»u q l h ¢ a d l u r s ~ i 9 u w s :A » - u n n m 1 - 4 - W uufbz i u n q m v » \ M a n n ' w a l m a - u v m a u u m w u ~ v u » nlamu.uu.u ~.A Ann ' U n a W1wl¢uUuu&v U.l1.llU.U lus nlknfv m u - S n * i i * * ¢ : U U \ v~¢¢¢~1v a v : J V u IQQWHUQN I x.l.x.luu.sl.u In u - n m : : U n a Gfuweuauifsuuthduml u n i u u n » u Danvwl sw1li180-u1oI a n - u s o [email 1 ; Anna 9a"¢n A w e - n w LnualWnuiqaaylom- L!.lCl.il.$Lll nu i u u c l LlIu6lu\! 9 - 1 l d G:-nuawSgu- sLs1.u.u l s: wl \ l ¢| l - u ¢ Kala-wuabm *'°~1i1/**"¥ ¢»w4$~a1ics - n m ¢l4h¢~~us1¢ | l l l.aalwuvS~¢u~\-lgn-4-4 i n n m L i l u n - - n a w - 9 8 8 0 * a n Rvqdll~*v1vCsvlal~lv a v v c - 4 l - u v v o : i n 0 - : 1 n dwsmn 1 1 - - - w - v - Sa mi" N-suneuu-an »ua»*v-iran U u a m a w n n I W - 5 - U n l v-no-sw-I-uu~sw¢¢w A n n u - - n o M 1 I ulgs;»lru\,>glg; S u s a n P4SJMUUUI - n a n cu n u e a u *wm -Dul l l nc u l . u . u »~ n a o o ¢ ¢ ¥°'¥' 'V ;»¢ °»s¢hQu»l - : u s Hui;-vsuncw 7 - m n - I umm UUA hoe:-son-Dualb-nik: l . u u nmusnua Vu m1~ "W l a - - c s l r n 1 a lov¢sb¢l\vvqhva-l¢\D»vavsonvsuunnuvw-¢nuuv¢vu¢u¢ar1»auu-snvnf o. iv! 1r-uvarurq*¢

38 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

ARlZONA'S NEXT CENTURY: A STRATEGIC VISION FOR WATER l SUPPLY SUSTAINABILITY l January 2o14

Conclusion Just as many of Arizona's greatest historic accomplishments have been directly linked to water Arizona's future success is tethered to how effectively we continue to manage our water resources and develop new water supplies and infrastructure. Yet. our present success cannot sustain Arizonas economic development forever and we must continue to plan and invest in our water resources. The diversity, variably and complexity that are unique to Arizona make developing water supply strategies difficult. In some places, there may be local water supplies that that have not vet been developed. However it is now dear that water supply acquismon and/or importation will be required for some areas or the State to realize their growth potential While there are local areas that require more immediate action the State as a whole has the good fortune of not facing an immediate water crisis. Now is the time to begin addressing thos challenge by implementing this Strategic Vision for Arizonas water future. The lack or an immediate problem increases the potential lot inaction, running the risk of procrastination and not sufficiently motivating ourselves to plan and invest in our future. Governor Brewer's foresight ii calling for the development or a Strategic Vision for Water Supply Sustainability for Arizona is essential to guide and ensure our economic stability into the next century.

I I

39 RESPGNSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

ATTACHMENT 2 California Public Utility Commission Rate of Return and Operating Margin Policy

40 RESPONSIBLE RESIDENTIAL UTILITY WATER ConsuxmR OFFICE

smArt DF cAuFom\A EMraunC G Bour Jr M m PUBLIC UTILITIES COMMISSION $65 an ms; gnu.: s»:~vlAnosco u ac::xc in',*. _J March2l,20l4

RE: Raxcs of Recur and Rates of Margin for Class C and Class I) Water Ijnlities

.lo: (()MMISSI()N

By this memorandum, the Dtvisuon of Water and AWits (DWA) updates its rccomrncndcd Rates of Return ad Rates of Margin for C [us C and I) vnucr udlitiv:s.' lltcse updates have been calculated in accordance with Resolution W-45"4_ which revised the Standard Practice that Wdresses how the me of rectum and rate of margin arc calculated for Class (. and I) water utilttics.

UWA cnnsidertd a mumhvf Rf fvlalm\ in fldrnnining hr farm Rf mum UWA assessed the movement an actual and forecasted interest rates over the last ).ear's tlovscr actual ruts that are fonccast w recover lo near recent historical). In addition l ) w A look into account the high operational asks theed by Class C and Class D water utilities ad the constant level of authorized rates of rectum for Class A water ulihucs in 2014 over °0l3 (m eragc of 8 51% and 8.79%. rcspcctivdy).

In determining the rates of margin tr (l2L\-i (` and D water utilities. DWA considered the (lass H water militias most recent &Ulh4.lriLL'd average rates of rectum of 10. I (We, their most recent authorized equivalent average rate of margin of 19 38%. and the rcwmxncndcd rates of mum for (I.L~.~¢ (` and D water utilities as calculated.

For 20]4, UWA recommends that the following rates of return and ratots ml margin be used fur Class C and Class [J water utilities tn fonnal general rate cases (supporting documentation is attach )

Rates of Return (ROR) Rntcs of Margin (ROME Clan C l0.20% to ll.20% 2 0 . 5 4 % ... - ..- - . . Class n 10.80% Io ll.80% ...... _ _ _ . . - ...... -» -.-. .._.... 2 1 . 6 9 % If you have any questions regarding the Rates of Return nr Rexes of Margin wcummcndarions please contact Khan Duong of the Dzvislun of Wulcr and Audits ax 1415) 708-2799, or M u .11 \i'4\ <4 £\l\ Smcenzly .I ! 1 '; ; ,JO. i Kohl /n. Dircctnr Kavodr Kajupuii c. hxcf.» f . Davi9ion of Water and Audit lftihry Audry, I..i¢ance. & (`onlpBancc Brunch

Azuachm cm!

.\s r I>.9°-03-u=83. an Phase I 01 loot I .ma (Water Ri>L an J RESPONSIBLE RESIDENTIAL UTILITY WATER CONSL'MER OFFICE

(`AL(ll I ATION. OF CLASS c & D VVATER (()MPAN\2 RATES Cr \<£TuRx (ROR) & RATES OF MARGIN (ROME'

6 Rates are calculated using both return-nn-ratcbasc and rate of margin l'!l¢lltod$. 6 The method that produces the higher result is used. a ROR is set at a level above or how the recommended ranges. if warranted. 6 Where little or no rate base exists. the ROM is used 6 The ROM is applied to Operating, Expenses to determine the estimated dollar return, which is then compared with the average dollar ROR on rate base. 6 Calculations are caused on the assumption that there is a comparable relationship between authorized Class B ROR and ROM and Class (I and D ROR and ROM. 6 Class ( and D water opcnations. finances, and risks are more similar to those of the Class B water companies, than with Class A water utilities.

Dara Used in Determining the Rntcs of Return and Rates of Margin for Class ( and (lass D Water l tilitics l Actual Interest R114 fm the tedman ;-.-~ - Reserve -. Recammcndcd ROR Rrqe U .S. Ireasunca l " _._ a z I Ycxr (1ass(\Altcv CLn:D\\l1rr 3851 i Yet 5Y c u 3.J~\ ca MIN 1oJo°»su5a- 11*59~.-Iz1s~»~ 0 1795 0 N141 1 »- o396 4 . + 8315 ' o n !9395. \ I 309\* I l.D0%- 11004 0.av. 0 U r. Y ~-4 I pp,. 4 £;- 'I llI n m f Iv* `0141 10 II 3. uno.-..1l.lo°.-_.__ ; o n " , fl \ . v.I • " " | ! -.. r Forecast lnnezcsx Rates from ms Globes I l1 1811 _;_*1=se*;L'§!* (83.0102.2014» UMZ-_ ft f§;(1 . l 9|"\ 4155 1 ...- ..._._ ._..._-_ - - ..._.,ROM ...._....-.. , Cakulatiol of Rate d Ma'gll 1"R0)l] lnguls C2315 C I C l i p n Awngv: Clan B RM: of Margin (RoM"l _Iv.3s°. Avcrqge Clan B Ran: 9( Rnum ('ROR I 10 104. Awengr Flaw C ROR pa 71.111 K Awrlgr Class D RUR ll 50's Average !.`|as- C lu!m \vn4c L Use B RUM1 ' (Awruge (la" (` ROR Avaagc C an ll ROR) ' l\ ' J ' ., Average (Loa D RUM Average (l.a.¢s I! RUM ' (A scfzge ( lass I) '| (>9'°.1 ROB Average C ldwi B RQR) __ 1 l

' ( l.l» ( waler uulMca haw *Of to ".1:\(Jl) customers. (!ass D v.a1»:r ulilitics have 500 or Lem cuswnvzrm 1 Pursuant iv I) 91 W 091. Urda.ring Paragraph 8 and Resolution v. -4524 RESPONSIBLE~ RESIDENTIAL UTILITY WATER CONSUMER OFFICE

ATTACHMENT 3 Pennsylvania Public Utility Commission Policy on Water Acquisitions

43 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSL*MER OFFICE

SMALL NONVIABLE WATER AND WASTEWATER SYSTEMS-STATEMENT OF POLICY

§69.711. Acquisition incentives.

(a) GeneraLTo accomplish the goal of increasing the number of mergers and acquisitions to foster regionalization, the Commission will consider the acquisition incentives in subsection The following parameters shall first be met in order for Commission consideration of a utility's proposed acquisition incentive. It should be demonstrated that:

(1) The acquisition serves the general public interest.

(2) The acquiring utility meets the criteria of viability that will not be impaired by the acquisition; that it maintains the managerial, technical and financial capabilities to safely and adequately operate the acquired system, in compliance with 66 Pa.C.S. (relating to the Public Utility Code), the Pemylvania Safe Drinking Water Act (35 P. S. § § 721.1- 721.17) and other requisite regulatory requirements on a shop and long-term basis.

(3) The acquired system ha less than 3,300 customer connections; the acquired system is not viable; it is in violation of statutory or regulatory standards concerning the safety,adequacy, efficiency or reasonableness of service and facilities; and that it has failed to comply, within a reasonable period of time, with any order of the Department of Environmental Protection or the Commission.

(4) The acquired system's ratepayers shouLld be provided with improved service in the future, with the necessary plant improvements being completed within a reasonable period of e.

(5) The purchase price of the acquisition is fair and reasonable and the acquisition has been conducted through arm's length negotiations.

(6) The concept of single tariff pricing should be applied to the rates of the acquired system, to the extent that it is reasonable. Under certain circumstances of extreme differences in rates, or of affordability concerns, consideration should be given to a phase-in of the rate difference over a reasonable period of time.

(b) Acquisition incentives.In its efforts to foster acquisition of suitable water and wastewater systems by viable utilities when the acquisitions are in the public interest, the Commission seeks to assist these acquisitions by permitting the use of a number of regulatory incentives. Accordingly, the Gommission will consider the following acquisitions incentives:

(1) Rate ofretumpremiumr.Under 66 Pa.CS. § 523 (relating to performance factor considerations) , additional rate of return basis points may be awarded for certain acquisitions and for certain associated improvement costs, bed on sufficient supporting data submitted by the acquiring utility

44 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

within its rate case The rate of return premium as an acquisition incentive may be the most straightforward and its use is encouraged.

(2) Acquisition aiyiufment. When the acquiring utility's acquisition cost differs from the depreciated original cost of the water or wastewater facilities first devoted to public use, the difference may be treated as follows for ratemaking purposes:

(9 Credit acquisition aiyuftmenf.Under 66 Pa.C.S. § 1327(e) (relating to acquisition of water and sewer facilities), when a utility pays less than the depreciated original cost of the acquired system, the acquiring utility may book and include in rate base the depreciated original cost of the acquired system, provided that the difference between the acquisition cost and depreciated original cost should be amortized as an addition to income over a reasonable period of time or be passed through to ratepayers by another methodology that is determined by the Commission. The acquiring utility may argue that no amortization or pass through is appropriate when the acquisition involves a matter of substantial public interest.

Debit acquisition aa}u.ttf/rent. Under 66 Pa.c.s. § 1327(a), when a utility pays more than the depreciated original cost of the acquired system, the acquiring utility may book and include in rate base the excess of acquisition cost over depreciated original cost of the acquired system, provided that the utility can meet the requirements of 66 Pa.CS. § 1327(a). When the acquisition does not qualify under 66 Pa.C.S. § 1327(a), the debit acquisition adjustment should be treated in accordance with generally accepted accounting principles and not be amortized for ratemaldng purposes.

(3) Dgféfml ofarquirition improuemenf r0.rt.r.In cases when the plant improvements are of too great a magnitude to be absorbed by ratepayers at one time, rate recovery of the improvement costs may be recovered in phases. There may be a one time treatment- in the initial rate case-of the improvement costs but a phasing- in of the acquisition, improvements and associated carrying-costs may be allowed over a finite period.

(4) Plant improvement surcharge. Collection of a different rate from customers of the acquired system upon completion of the acquisition could be implemented to temporarily offset extraordinary improvement costs. In cases when the improvement benefits only those customers who are newly acquired, the added costs may be allocated on a greater than average level- but less than 100%- to the new customers for a redonable period of time, as determined by the Commission.

(Cl Pmredura/ iznp/ementation.

(1) An acquiring utility that has met the criteria set forth in 66 Pa.C.S. § 1327(a)(1)- (9) for inclusion of a debit acquisition adjustment in its rate base, may elect to have this acquisition adjustment considered on a case-by-cae basis as set forth in 66 Pa.C.S. § 1327(b), or as pan of its next rate case filing. The acquiring utility should file the supporting documentation outlined in subsection to support the requested acquisition adjustment.

45 l RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

(2) The appropriate implementation procedure to qualify for the other acquisition incentives in subsection would be to file the appropriate supporting documentation during the next filed rate case.

(3) In acquisition incentive filings, the burden of proof rests with the acquiring utility.

(d) Documentation to 51./PPc# inc/urion ofacquirilion a¢§u.¢tment. When an acquiring utility elects to have the acquisition adjustment to its rate base considered as a pan of its next rate case filing, the acquiring utility should file the following documentation to support the acquisition adjustment to its rate b8.S€I

(1) Statement of ft'/iance on existing record.r. An acquiring utility mayelect to rely in whole or in part upon the original cost records of the seller or Commission in determining the original cost of the used and useful assets of the acquired system

(2) Preparation of data to maps# acquisition arjjurlmenf.An acquiring utility upon its own election, may file an original cost plant-in-service study with the Commission to support its requested acquisition adjustment to its rate base. An original cost study is one method of determining the valuation costs of the property of a public utility. It requires the acquiring utility to develop realistic plant balances and accumulates the records and accounting details that support those balances. Disputes regarding

I the acquiring utilitys original cost valuation of the assets of the acquired system will be resolved in I the context of a late proceeding when interested parties will have an opportunity to be heard.

(i) Contents fan angina/ costp/ant-in.ren/ire stung/. When an acquiring utility elects to submit its own original cost of plant-in-service valuation, the acquiring utility is obligated to exercise due diligence and make reasonable attempts to obtain, from the seller, documents related to original cost. In particular, as pan of its exercise of due diligence, the acquiring utility should request from the seller, for purposes of determining the original cost plant-irr-service valuation, the original cost of the assets being acquired and records relating to contributions in aid of construction (CIAQ, such as the following:

(A) Accounting records and other relevant documentation and agreements of donations or contributions, services, or property from states, municipalities or other government agencies, individuals, and others for construction purposes.

(B) Records of unrefunded balances in customer advances for construction

(Q Records of customer tapir fees and hook-up fees.

(D) Prior original cost studies.

(E) Records of local, State and Federal grants used for construction of utility plant.

(F) Relevant PennVEST or Department of Environmental Protection records.

46 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSI_l1\IER OFFICE

(G) Any Cormnission records.

(H) Summary of the depreciation schedules from all filed Federal tax returns.

(I) Other accounting records supporting plant-in-service.

(h) Failure of.re//er to provide m.rt-re/ated doeumentr.The failure of a seller to provide cost-related documents, after reasonable attempts to obtain the data, will not be a bat for the Commission's denial of the inclusion of the value of the acquired system's assets in its proposed rate base. Because the documents obtained from the seller may be incomplete and may result in an inaccurate valuation, the acquiring utility will not be bound by the incomplete documents from the seller in the preparation of its original cost plant-in-service valuation.

Pmeedurefn booking CI/IC. The acquiring utility, at a minimum, should book as CIAC contributions that were properly recorded on the books of the system being acquired If evidence supports other CIAC that was not booked by the seller, the acquiring utility should make a documented effort to determine the actual CIAC and record the contributions for ratemaking purposes, such as lot sale agreements or capitalization vs. expense of plantin-service on tax returns .

(iv) Plant retired/ not booked/not used and u.r¢1LThe acquiring utility should identify all plant retirements and plant no longer used and useful, and complete the appropriate accounting entries.

(v) Ree0ncidadon with eommiuion reeordr.In the case of an acquisition of a water or wastewater system that is regulated by the Commission, the acquiring utility should reconcile and explain any discrepancies between the acquiring utility's original cost plant~in-service valuation and the Oommission's records, to the extent reasonably known and available to the acquiring utility, at the same time the supporting documentation for the study is filed.

(e) Time to .submit angina/ box! vo/ualion. When the acquiring utility elects to request an acquisition adjustment during its next rate filing, it should submit a copy of its newly prepared original cost plant-in-service valuation of the acquired system or a statement of reliance of the existing records of the Commission or the seller to the Commission's Secretary's Bureau, the Bureau of Audits, the Bureau of Fixed Utility Services, the Office of Trial Staff, the Office of Consumer Advocate, and the Office of Small Business Advocate at least 4 months prior to the date that the acquiring utility plans to make its next rate case filing with the Commission.

(1) The Commission staff may conduct an audit of the original cost valuation,but if no staff audit is completed and released at public meeting before the date of the rate case filing, the Commission's determination of the original cost valuation in the late case will be deemed final action on the original cost valuation and any associated acquisition adjustment, absent subsequently discovered fraud or misrepresentation. When staff completes an audit before the rate coe is filed, die results of the audit will not be binding on any party, but rather the audit report will be made available to the public and the report can be presented in the acquiring utility's next rate case, subject to applicable evidentiary rules .

I I I 47 RESPONSIBLE RESIDENTIAL UTILITY \56Q\TER CONSUMER OFFICE

(2) When the acquiring utility makes a rate case filing sooner than the 4-month window, the acquiring utility should not include any revenues or expenses related to the acquisition, including the requested acquisition adjustment in its proposed rate base unless it includes the original cost valuation with the rate filing and one of the following circumstances applies:

(i) A compelling reason exists for requesting the acquisition adjustment in the current rate

(ii) The acquisition was requested or otherwise directed by the Commission.

No statutory party objects to the inclusion of the acquisition adjustment to die proposed rate base of the acquiring utility.

(fl Purcbasepfire of the water and u/artewater garter.The factors relevant to the reasonableness of the purchase price of the acquired water and wastewater system include:

(1) Promotion of long-term viability.

(2) Promotion of regionalization.

(3) Usage per customer.

(4) Growth rates.

(5) Cost of improvements.

(6) Age of the infrastructure.

(7) Return on equity.

(8) Easting rates.

(9) Purchase price per customer.

Source

The provisions of this § 69.711 adopted March 29, 1996, effective March 30, 1996, 26 Pa.B. 1380; amended February 13, 1998, effective February 14, 1998, 28 Pa.B. 801; amended September 29, 2006, effective September 30, 2006, 36 Pa.B. 5991; corrected October 6, 2006, effective September 29, 2006, 36 Pa.B. 6107. Immediately preceding text appears at serial pages (255466) to (255468) .

Cross References

This section cited in 52 Pa. Gode § 69.721 (relating to water and wastewater acquisitions).

48 RESPONSIBLE RESIDENTIAL UTILITY WATER CONST*MiER OFFICE

ATTACHMENT 4 Water Utility Risk and Return California Public Utilities Commission April 1990

49 RESPONSIBLE RESIDENTLU. UTILITY WATER CONSUMER OFFICE

50 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSLMER QFPICE

EXECUTIVE sun~~ARY

large water utilities and small water utilities have very diff Ar¢nt operating profiles. while both have high cnpitah ro~ qui remants and must comply with mandated water quality standards, small water companies have spacial problems created by choir lack Cr economies or scale and lnaccnssibllity to external financing. The number at economic dichotonlos between Largo and small 1 water utllltaes warrant separate analyses and, ultiuatoly, d'tterenL ratenakinq treatments. In general, traditional rate regulation is still appropriately applied to this industry, which has not experienced the fundamental narkot changes Sean Zn energy and telecommunications. Authorized returns on cannon equity have been lower for ca l z tornla water utl 1iLIns than for California energy and Lolo- coumunicatlons utilities. An analysis of large water utility financial reports indicates that California water utilities earn al lqhtly lover returns on common oqulty than out at state water utilities, but their return cm total eapttol ms higher than cith6t the enarqy, telecommunications or the out-of-stata water utilities. This is probably bncnuse large California water uttlltlns are :era ettectlve in derlvxng revenues from ratebaso aasatn than out~of-state water companies. California water companies a'so have high pre-tax coverage for interest expenaos but their high operating ratios bring their profit margins below out-ut-state water coupanins. It appears that calitornlu water companies may be earning lower return: for their shareholders due to the companies' relative inability to control oparatinq expenses. The question also arises as to whether Cal itorn;a water conpanian could use financial leverage to better advantage. An analysis or small water company financial per rormanca indicates no discernible pattern. The only common denominators are (ll their classification as "small" water, (2} Lhnxr authorized rates of return and (3) their inability Lo onrn author z aea returns. Analysis inalcates that the sensitivity at a small water ut111ty's earned rate of return is algnlficantly greater than that or a large water utility. Small water utilities aieo face greater opnratlng risk and ouch greater raqulatory risks than large inter utilities.

1.:

5 1 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

C9anQn4b1e,stat;sLxs§4.£w9LnQ§a (1984-1988)

California Out~oI-Stats water Water Qgmnanina companies Return on Total Capital 1 1 3 8 \ 10.b8\ Return on common Equity 11.351 I J .' l O* Lnnq~Tern Debt Ratio IO.R4\ 5 6 . 8 6 % Operating Revenue no Plant 69.92\ 4 7 . 9 5 \ operating Ratio 83.53% T5.72\ net Profit Karqin 16.472 24.291 Pre-Tax Yntorest coverage 4.71x 2.95x ~_...-__.....--- -~ ......

azsgu~nnnaxxnn There appears to be no cuopellinq reason to chanqo the current ratemaXlnq mechanisms for large water compan1e$. However, the Commission could ccnnldcr holding en bane hearings or work- shops to permit utility representatives Te Ar tlculato their concerns and opinions. This would alloy the utllltlos to address the positions taken by staff in this report and may bring addi tonal issues to the coualsslon' s attention. This would also allow California water utilities an opportunity to present their particular concerns reqardlnq the threat of contamination at water supplies and the problems and coats associated with conp11~ once with sate drlnklnq water standards. Current ratomoking practices for small water operations should be further investigated and refined in an Order Institut- ing Investigation (OII) on small water company rulematlnq. In implementing a proceeding to address small water utility issues, the Commission is likely to encounter many of the problems that make the industry risky. For example, it is not clear that any of the owner~operators of small water companies would respond because *hey are unorganized, numerous and gnoqraphzcally dls~ perseid. In addition, they lack the expertise and sophistication ro advance their Lnterest in regulatory proceedings and they are I not active in wafer industry organizations, which generally concentrate on lore water company issues.

sons options towards developing ratenaking principles that are more beneficial to :mall vote: company operators are listed in this repot t in Suction v, 'Regulatory issues and Al tornat ivea."

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5 2 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

! 5 H 9 B b a p Q 4

This report was prepared by the Financial Branch and the water Utllltlus Branch of the commission Advlaory Ana Comp! Bianca

Division.

Phyllis White, Public Utilities Requlatary Proqrno special~ let I was responsible for the preparation of this report, under the general supnrvlslon at Cherrita Conner, Principal Financial

Examiner, and with the assistance of Holly Oswald, Financial

Exanlner III, and Jin Hernandez. Public Utllitlcs Raqulatory

Analyst II.

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53 RESPONSIBLE RESIDENTIAL UTILITY \X4\TER CONSUMER OFFICE

rAsLn OP cnsrtnrs

SubJect Free

Exnvutive Summary . . . » ....

Fecommendatton 1 I Memorandum ll!

Table of cnntentn n . ~| | 4 » . . . iv z. INTHUDUCTTON 4 » 4 ¢ » ...... 1 II. CIASSIYICATIOH 9 l l ¢ o .. . » I Ill LAHGZ WATER UTILITIES ¢ ¢ s - . . 2 A. Risk Overview 2

1 . Technological Risk l l l l l ¢ l l o 2

2. Financing Risk . . .. ¢ . ¢ n .. 3 3. Market Risk J 4. Water Quality Risk » ..;...» ...... 4 B. Analysis of Financial Performance 5 1. Standard and poor Bond Rating Benchmarks s 2. Ratio Analysis 6 ( Analysis of Qperational parforlnnce 6 1. Draught and mandatory Hationinq 6 2. Voluntary conservation .. 7

J. comparison of Water Rates a o. Current Ratenakinq Practices 8 1. Rates of Return q

Balanuinq Accounts . ~ » ...... 9

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54 RESPONSIBLE RESIDENTIAL UTILITY WXTER CONSUMER OFFICE

l ET u 1

WATER 1r7 r1.rTy Rxsx Ann Rf1!.?i!J

53 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

zxncuwrvx SUMMARY

Large water utilities and small water utllitLes have dl ffarnnt operating profiles. while both Nave high capitalvery re- quiremants and must comply with mandated water quai tty standards, anal 1 water companies have special problems created by their lack or ac¢n¢nies of arable and Inaccessibility to external financing. The number of acencmic dichotonles between Largo and small water utilities warrant separate analyses and, ultimately, different rntenaking trcatnents. In gansrol, tradltlanal rate regulation is still appropriately applied to this industry, which not experiuncad the fundamental market changes seen in has and talccommunicatlons. energy Authorized returns on common equity have been lower for California water utllitius than for California Ana tele- conmunlcatlons utilities. An analysis of largeenergy water utility financial reports indicator that cxllfornia water utilities corn al lightly lower roturna on common equity than out of state water utilities, but their return on total capital is higher than either the energy, telecommunications or the out-of-state water utilities. This is probably boon use large California water utilities are xoxo effective in deriving revenues from ratehase assets than out-of-state watt companies. California water companies also have high pre-tax coverage for interest expenses but their high operating ratios bring their profit margins below out-of~state water companies. It appear: that calltornla water companies may be earning lower returns for their shareholders due to the companies' relative inability to control opuratinq Qxpenses. The question also arises as fv whether California water compantea could use financial leverage to better advantuqa.

An analysis or small water company financial perrormancn indicates no discernible pattern. The only common denominators are (1) their classification as 'sna11" water, £21 their author ired rates cf return and (3) their inability to earn authorized returns. Analysis indicates that the sensitivity of a small water uti1ity°s earned rate of return is significantly greater than that of n large water utility. small wars: utilities also face greater operating risk and much greater rsqulatory risks than large water utilities,

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5 4 RESPONSIBLE RESIDENTIAL UTILITX7 WATER CONSUMER OFFICE

4 _ ~ * v ¢ D

(1994-l9ss1

California 0ut-of-state Water Water sszanannea Com an

Return on Total capital 11.334 1o.58% Return on Cum~ ~on Bquaty 13.35\ 13.448 Long-Term baht Ratio 40.s4§ se.ae% Gperating Revenue :Q Plant 69.92% 4?.95* Gperatlng Ratio 81.53% 75.724 Wet Profit Margin 16.47% 24.29% Pre-Tax Interest cwveragn 4.71x 2.95x _--.

R3QQ!§B£H8ILQ8 There appears to be no conpollino reason to change the current ratemaXlng mechnnisns for large water compantos. However, the Commission could consider holding en bane hearings or work- shops to permit utility reprnsontntives to artleulatn their concerns and opinions. This would allow the utilities to address the positions taken by staff in this report and may bring additional Issues to the eommloalcn°a attention. This would also allow callfornln water utilities an opportunity to present their particular concerns regarding the threat of contoninatlon of water supplies and the problems and coats associated with compliance with safe drinking water standards.

Current ratomoking practices for small water operations should be turthor znvestigatcd and ref zned in an Greer Institut- in Investigation 10111 on small inter company Rulemaking. IU Lmplementing a proceeding Ra address small water utility issues, the commission is likely to encounter many of the problems that make the industry risky. For example, it is not ¢isar that any of the owner-operat¢rs Rf small water companies would re9pona he~ cause they are unnrqanized, numerous and q4o9raphica11y dis- persed. in addition, they lack the expertise and sophistication to advance their interest in requlatary proceedings and they are not active in water industry organizations, which ganurally u4ncentrate an Large water company issues.

soma mptlons towards developing ratemaking principles that are more beneficial to small water company opnrntQr8 are listed in ants repot t Lm Section V, "Regulatory Issues and Alternatives."

..i 1..

5 5 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUM;ER OFFICE

n H u Q B a u E Q 5

This report was prepared by the Financial Branch and the wits! Utllitlns Branch at the cunmlssion Advisory and Compliance

Division,

Phyllis White, public Utilities Regulatory program spacinl- ist I vas responsible for the preparation of this report, under the general supervision or cherri Conner, principal Financial

Exnnlner, and with the assistahew of Holly Oswa14, Financial

Examiner Ill, and Jin Hernandez, Public Utilities R¢gu14tory

Analyst xx.

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5 6 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSL*MER OFFICE

Mann! or CONTENTS

5419192 ease

Executive Summary 5 Recommendation XE memorandum l l l i l l d é d o v l l ll!

Table of c¢ntents I ~ 1l a n .. 1 ¢ » ¢ .... iv

1. IrmiowcrIon b ' l llid l l I l 1

II. cLAssrrrcAIIos s 1 l » . 1 1 n 1 l » ~ u 1 III. Lnnsz wnr8n UTILITIES I BL l § 2 a. Risk Qvnrvieu ..... a vv » a ¢ u s 2 1. Tachnolagical Risk 1 4 1 0 ¢ 4 I 1 . 2 2. Financing Risk 1 ¢ .. 1 ¢ 1 . 3 3. Market Risk loc Q l l Ahb » 3 4. water Quality Risk - l l >»» y »¢ 4 B. Analysis of Financial Performance 5 1. standard and poor Band Rating Benchmarks 5 2. Ratio Analysis 81 14 V111 11 l 6 c . Analysis of Operational Plrtornance 6 1. Drought and Hamatnry Rationing 6 2. voluntary Conservgti¢n r l l l ls a A I 7 J. Comparison of Hater Rates 8 D current Patenakinq Practices u n » l 4 ~ 4 . e 1. Rates Rf R¢turn 9 z. Balancing Accounts g

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57 RESPONSIBLE RESIDENTIAL UTU_1T\7 WATER CONSUMER OFFICE

iuhdsnr 2335.

3. offset Filings 10

4. Construction work in Progress ...... xo IV. SHLL warns uTIL1rI¢s...... 1 2 A. Risk Overview 1 2 1. Financing Risk . ~ ¢ l ¢ - . ¢ 13 2. Hark rt Risk l I u l v 1 3 3. Water Quality Risk - u o v 1l 1 4 B. Analysis of Financial and operational Performance 1 5 1. Financial Analysis ...... 1 5 2. operational Analysis ...... 17 c . Current Ratcheting practlc¢s ...... 18 v . g5GuL*T0R1 ISSUES AND ALIERXNTIVBS i b I 19 i A. Rsclassiflcation ...... 19 B. Large water Ratclaking Altnrnativos ...... 19 c. Small water Ratamaking Alternatives ...... 20

1. Mergers and Acquisition: ...... 20 Financing Assistance ...... 2 . 2D 3. Rate Relief hbbbOQ 1 22 VI. rnnzx Q? TABLES 24

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5 8 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

wnrzn UTILITY ale: AID RETURN

1. lnwnnoucrroi

many at the traditional ratemaking mechanisms used in water regulation Moro established during a period when all utility markets were monopolies. In recent years, however conpetitlve pressures in energy and telecommunication utility markets have evolved as a result of federal legislative and regulatory actlnns and technological innovation. The Commission has revised its ratenaklng mechanisms in response to those new utility :ark et realitiaz. In implementing new regulatory frameworks, the cornis- sion has acted to maintain utility efficiency, productivity and financial strength, while ensuring that essential utility nerv- ices will continue to be provided at reasonable rates.

The Coonlssion continues to review regulatory policy and practices for all of the industries which it regulates. The following report la in response to the ¢unaission's request tor a rats at return and risk analysis of water utilities within its jurisdiction. Where refinement at water rateaaking policy and procedures is appropriate, the commission may wish to further explera ratamaking option: in an appropriate proceeding.

This report first review: the properties, concerns and ratemnklng treatment at Large water utilities. It than addresses corresponding issues from the perspaetivo of small inter utilities. some issues are cvnmon to both large and small utilities: however, as this paper will aevclop, large and small water ca~pani¢s represent very dl ffirent types The number of wcononlc dichotomies hotwaen larva andat small systems. water utilities warrant separate analyses and, ultimately, 4irt¢rent zatemaking treatment. re. emassrrxcnrrnu

In Declaicn 85-04-u7s, the Commission approved the ralloving unlrorn System of Accounts sub¢ivisi9ns for water utilities.

Class A: utilities having more than 10,060 service connactlons.

class B: utilities having between 2,000 and 1o,ooo service connections.

5 9 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

class oz Utilities having between son and 2,000 service mannactions.

Class D: Utilities having less than sao service connections. This classification, based upon service connections, is designed to reflect income tax regulations and the institution of the Safe Drinking Hater Bond Ast, as well as to reduce record keeping requirements fur utilities.

For purposes of this paper, we dnfinn large water utilities to be Class A and small water utilities to be classes B, c and D.

111. LABS: nmmzn UTILITIES

*_ nlsx OWRHVIHW

Risk has to do with perceptions of uncertainty and variabil- ity. utility risk can be divided into financial risk and operational risk. Financial risk is concerned with the possibility of bankruptcy and default due to the aonpany'a fixed debt chliqn- sons. The financial structure of the company to a great extant I deterzinas rlnancial risk. Dperatlonal or business risk encnn- paasas all of the factors which c¢11o¢:1va1y in¢rease the prmba- bility that expected earnings will not be realized or which eentribute to ¢arnin9s volatility. There is higher perception of risk in energy and telephone operaticna as a result of new competitive pressures in those industries. maw regulatory framawurks, lmplementnd in response to new realities, tend to c¢ntribute to perceptions at risk because they qansrally remove earnings proto¢tions, while they permit significantly higher 4arninqs opportunltics. For overall economic efficiency, market mechanisms are pre fnrrsd to regulation. None- the1¢aa, competition as a substitute for rate regulation trans- latns into greater earnings volatility, which translates into greater business risk. Some special areas of water utility operational and financial risk are discussed below:

(1) I!§hH1QA»9!9.1§nLJ3i§k Water companies are capital intensive and plant ass4:a have Ian lives. Pipelines can last for LUG years Ur Marc. Trnntment

60 RESPONSIBLE RESIDENTIAL UTILITX7 WATER CONSUMER OFFICE

raelllties. storage tanks and pump range in life span from 30 to 50 years. consequently, when :ac ltties ultimately wear the cost of replacement in relationship to original cost can out,Ba quits enormous. Because obso1esc¢nce is not a problem, technalaginal risk is snail . However, technology-basad productivity impr9va- merits are also rarer (or water utilities than some or the other utilities.

Technology Ls improving ac the cuatamer loyal, however ixprovad Irrigation methods, lcv water-use fixtures (toilets, shower heads) and changing social standards are making conservation morn acceptable and effective. This change in custnmar habits Dans not pose a direct risk to the utility, but it could present an indirect risk it these usngo reductions ar not recog- nlzed in the regulatory process.

( 2 ) Www financing: can from internal sources of funds--rntainnd earnings, depreciation, deferred taxis and from external financing--advances and uontributlonn from real estate developers, governasnt subsidies and issuance of debt and equity securities. Where water utilities compete with other public and private entitles for external financing capital, the stability of the water utility buslnaas should ptovido cnmrnrt to creditors and equity investors seeking attractlvu investment opportunities with relatively Lou risk. However the slali size at water utility offerings, relative to other utilities tend not to generate ihtnrost among inveatnent bankers. c¢nsequent1y, most water utilities remain unknown except to a subset of the financial community such as insurance eoupqnias. virtually all 4xterna1 financing is accomplished through privater placement directly with investors, without use of an underwrltcr.

Advances and contributions will be diacussnd on page 13 in the context of small water company issues Callfornia'e program far financial assistance for water cowpaniee, the Safe Drinking wat¢r Bond Act fsnweal , will be discussed to erne extant in the ! following water quality risk secxian and will be I dlscusse4 more I fully in the context cf small water company issnas on page 14.

( 3 ) Although the tun&amental market change: Sean in energy and re1ec4nmuni¢ntlons industry markets are not cvidnnt in the water industry, water companies arc not without competitive pressure. The primary source of canpetition for water utilities is Thu treat of customers drilling their own waki- This risk has always

61 RESPONSIBLE RESIDENTIAL UTILITY WATER CQNSUMER OFFICE

existed but the industry persevered because of the economies of scale avaliable to water suppliers. Nonetheless, industrial customers leaving the system :ay be a rail possibility for large uatcr companlas. If a rate design ineludos provisions such as lncrnaalng bloc! rates, the threat of nustonsr bypass is likely. Another form of competition cited by water companies is the potantlal at being condemned by local qovernsent and restructure into a local municipal water district. When a government entity exercises its right to entrant tonain, just conpensatinn must be paid for the taking ah measured by the property'l market value. Seldom are well canltructcd. well maintained and wall managed public utilities sold at rata base. Frequently water utility plant and facilities sell over rate base dun to the utility having relied heavily upon contributed capital rather than invea- tor money for extensions.

um !'L9MLS7Jli1-i.tJL..&1.§! water quality has been a ccncorn since 1974. The tedcral Safe Drinking Water Act (SDWAJ of 1574 authorized the Bnvlronman- tal protection Agency (EPA) to sot national drinking water standards and provided for protection of ground water sources ct drinking water. In respcnss tn the federal law, the California legislature enacted the Pure Drinking water Act of 1976 and the Dcpartnent of Health Services (OHS) established drinking wars: standards at least equal to EPA standards and required monitoring of community water supplies. Government mandates monitoring increases utility operating casts associated with water supply tasting, liability insurance premiums and construction of water quality impruvsment projects. The cost and rate impart of compliance with SWDA will vary with the size of the system and the complexity of the required i treatment. californla'a Safe Drinking Hater Bond Act (SUWEA) sos | created Te be a source of low cost financing for water utilities that must make system improvements but cannot obtain financing clseuhere. As part ct its review and funding process, DAS priori- tizes utilities based on the need for repairs and the ability to

finance the repair5 I Most Clan; A water utilities have to finan- eial strength to obtain external financing to make improvements to comply with DBS standards. Therefore, while class A water utilities may request sDwaA tunning tor water quality improve~ merits, they are unlikely to receive such tunes. Tahlo 1 shows typical costs for certain types of tests. Depending upon the Alan at the system, the cost of tasting and insurance may increase larqn water company rates 2-10 percent. most Class A ccmpamies, with systems requiring a significant

6 2 RESPONSIBLE RESIDENTIAL UTILITH7 VVATER CONSUMER OFFICE

nuubor or analyses, have found that it is economically feasible to perform the analysis in-hausu. Alternatively, a water utility may use a car ti f ied comnerclal labcrarory or a combination of in-house and commercial tacllltiea. U . in an outside laboratory can be expensive. In a generic sense, the costs will be determined by the size of the system, the aagrée of the contaminated water, the number of samples required, who does the sampling and other costs that can be associated with individual utilities. Water testing casts may be booked to a balancing account and entirely recovered in rates. The balancing account mechanism is aiscusssd on page 9.

The CACD ballsvas that the issue of water quality is the zest important and potentially the most costly issue facing the industry. Hater utilities are just new beginning to cwporience those problems and costs. As water quality standards and testing procedures evnlva ova: the next far years the industry and the Camnission will have to explore policies and alternatives which best ANdres: the concerns of all.

B. AnalysIs OF sznAxc1AL PIRFDRH~~RCE

Bvaluatinn of risk and return necessarily requires ccnsider- ation Rf subjective, non-quantitative criteria, as wall as objec- tive, quantltatlvs criteria. The following section is an analysis of selected financial criteria.

(1) aam@as m n&Mna.mwuurk= Bond ratings are measures of the credit risk inherent in a particular debt issue. Few voter utility bonds, however, are formally rated becauas must issues are relatively snail and :old to institutions that do their nun analyses. nhncthaluzn, Standard s Poor'a gav; benchmarks for invostaent grade bonds can sieve as independent market measures of utility financial integrity.

Tahln 3 illustrates saw investment grade ratings benchmarks for large water, energy and telecommunication utilities. The investment grade dlttinntinn indicates a strong capacity to pay interest and principal. Hot surprisingly, ratio criteria dotter among industries and within sogmnnts of the Sana industry. Compa- nies with more protecsad financial and operating positions have less strlnqant benchmark criteria. The tabla demonstrates that sep views water utility earnings to b¢ at lover risk relative Te other regulated industries.

63 RESPONSIBLE RESIDENTIAL UTILITY WATER Const;u:ER OFFICE

(2) unsunamynm This analysis was developed from financial data of large California water conpanlaa (class A) and a comparable group at other large water companies from all over the vnitea States. Where applicable, corresponding indicators for California tel¢- communications and energy utilities mis also shown. sources for the data were annual reports to shareholders, annual reports to the CPUC and value Line reports. Data tables AnN note cnmplote interprstatisns appear in the back of this paper. The fcllouing is a synopsis of the findings that appear in Tables 3 through 14. Authorized returns on cammi equity have been lower for California water companies than for other California utilities, however, the water utilities have tended to earn a hlqhnr par- cantaga of their authorized than have the energy and telecnmmuni- cation utilities. Authorized levels or earnings appear to be commensurate and appropriate for prevailing lovils of inflation and interest rates. California water utilities earned luwvr returns on common equity than out-o£"state water companies in three or the last five years. one poaslble enntrlbutor to lower earnlrga available to common shareholders may be the tendency of California water companies to avoid using debt leverage (and the attendant tax daauatiblllty of the coat of debt) to its optimal advantage because on average ctlifornia water utilities have earned higher returns ¢n total capital than have the other utilities in our samylu.

California water utilities are very c£¢¢ctive in deriving revenues from ratebase aasots. The greater rtvenua generating capacity is particularly significant in light of their higher use of advances Ana contributions and lawn: plant to custnaer ratio. California large vatcr companies, however, appear to have Marc dilticuity controlling their operating axpenssa. Ah a result, not profit margins for California water companies are lower than for cult-of-state u-ntszr companies . e. AuAL¥s1s or OPBNA:iONAL PERPQHHANCS

rt: £mnushm_4u4_!amxnzunLna;MQn;ng The iaaue of financial recovery tor 1st revenues dun to voluntary conservation or mandatory rationing is being addressed in Investigation $9-03-GGS. rhLs GI! is being kept open to ud- dross future uatnr company concerns with draught, zatinninq and

6 4 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

conservation impacts. In this procnsding, the utilities are claiming that conservation Ann mandatory rationing dccroaao the companies' revenues. commission staff agrees that the utility should he allowed tn uncover revenuers that were not attainable due to actions that were out of the control of the utility. The disagrncnnnt is with the percentage of recoverab1¢ lost revenues. The utilities want 100% and Commission staff is reccmaenNlng 95% of normal sales. Ir the utility is allowed to recover 100% of their normal revenues they will be kept financially whole. staff argues that this would guarantee revenues and eliminate any incentive to make prudent decisions in regards to expenses. staff is maintaining that, if draught can be considered a rink that water utilities must confront and it the Cnmmlsaion guarantees revenues lost dun Te the drought. then the utility should be given a lower rata at return to reflect the lower rist- The return on equity should be reducnd becauzc investors will hay# a more assured opportunity to earn their authorized return than the investors in the comparison inter companies on which the R98 com~ ~utation was based.

re the Commission adopts staff 's recommendation of a 951 recovery of normal sales, the utilities will cxperisnce a reduction in their return on equity ranging between so to 25%. The reduction would depend on the propcrtinn of revenues from water sales or snrvlce charges, the portion of water sales revanuc paying for production expenses, and how such of a utl 1ity's revenue pays for fixed caste and non-tex expenses.;/ A st raduc- tion in sales revenues would lover an authorized return an equity o f 121 to an actual return of 9% to 11.4a.

(2) 5Es2l911$irlL£Qn§9r!!sI&i9n Censarvation also prcvidea an alternative to manipulating return on equity. If the Ccnnlsslnn cr: to authorize the utilities to establish n revenue balancing account. similar to the :RAM account tor nlsctric compantms, than utilities' cnnservution incentives would increase and their operatlnq risk would substan- tially decrease. Return on equity should be invcsllgated at the

Q-u-4-..-__ If A Utility that has about 404 of its revenues from service charges, with relatively high Hater production expcnsms and about 53% fixed expenses auld son about a 6% ducraaaa equity. A utility with :no of its revenues (tom an charges, lower production axpensea and Ana fiend service could suffer a 25% decrease in return. expenses

..,'

65 RESPONSIBLE RESIDENTIAL UTILITY WATER Consum_18R OFFICE

sane time that the revenue balancing account is addressed to d¢termine any impact on risk perception.

(3) 9922421-EMl.9L1!a!&r_BlaN=§ Tabla 15 shows a rate co~ ~parilon, by Class size (A,B,c, and D) , at the monthly rates of the regulated and the unregulated water otllitios. The table shows that unregulated companies provide water at a lover average cost par month Ono at a lower consumption per month than rngulatei companies. For example, the customer of a class A water utility pays rates that average $28.97 a month, while using an average of 32.45 cot/no. The customer of an unregulated eonpany of a class A size pays rates avoraqing $16.95/n0. with a consumption of approximately 25.98 of per month. This translates into customers of rsqulated utlli- ties paying rates approximately 174% more per 1 onth while oonsun- ing approximately 120% morn core at water par month than custom- cra of unregulated water oampanlea.

The customers or the Class B, C and D utilities do not fare any better. Thu customers of a regulated utility have an average bill of $2074/m0- with an average consumption or 1?.n7 cc f/mo., while their unregulated counterparts pay rates on the average of $14.30 per month for an average cnnsu~ ~ption of 18.86 act n month. The customers of the small regulated water utilities are paying 145% more a month for their water while censuring 9.5% cafe a month less than the unregulated water companies. The classic explanation for the unregulated water utilities having an average lower monthly rate is throe-fold. Hunlclpal utilltlsa do not pay taxes; they charge substantial hook-up fans and, as public entities, the are able to issue tax exe»pt municipal bongs to finance new plant.

D. cuanauw nATznAx1n4 PEBMEICES

At the CommiasiGn, water mtillties have access to the same fnruns far r4t¢ relief as do energy and telccommunicatlons utilities. Many aapncts of water c¢sta of eervicc are reviewed only during formal general rate emcee proceedings which occur in thus year cycles, although water companl¢s are ollcweu to nffnst minor operating coats through informal advice letters and there is no restriction on how often aavicn letters may be filed. utilities are also permitted to offset certain fuel c¢stsEnergy but theo proceedings are for the 99 st part llmitcd to once a year. In addition, the capital costs Rf energy and mid-siz9 telecommu- n1mati9ns utilities are reviewed annually in industry gunnric

66 1

i RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

financial attrition proceedings.

(1) Bl§§2_9£.8li9ID Fur single-divtriot companies, return on common equity is fixed for the test period and remains eonatnnt until the company retllos. For water utilities with nu1ti~distrlct operations, returns authorized in any part1¢u1ar general rate casa will be applicable only for those districts tiling. In succsnding years, attrition adjustments are made tn reflect the rate of return found reasonable for the district in its lest decision or that found reasonable tar other districts in the com~ ~any's moat recent rate decision.

l When authorized returns are increasing single district water companies are eolavhat at a disaavantagu relative to mu1tl-distrlct water companies. Conversely, they have an advantage when l authorized returns are declining. when authorized rates of return l are increasing, zone portion of a multi-district water company ratebaae will cnntinav to earn at lower return levels. Helutlva to single district energy and telephcnn companies, multi-district water companies are at an advantage when authori1¢¢ rates are decreasing bccnusa at least sane of their rate base will remain eligible tor higher returns.

123 Ealan~~ini.&§§22n§§ The purpose at a balancing account is tn track the under- collacticn Ar owe:-collection assn¢lated with an incraaza or aearaase of an express item and the authorization or e corro- sponding revenue adjustment by the commission to offset that particular exp¢nsa charge.

pursuant to section ?92.5 of the California Public Utilities Cwae, whnnnver the cosuission authorizes any change in rates refluctitq and passing through 80 custannrs :p¢citic changes in eats, a balancing account4. is to be maintelnmi tyr that particular exp¢nss item, Thns¢ types of expanse tans are called off- senablo expenses and rslnte to costs over which the utility has no c¢ntrv1. Among ¢ttsetab1e expenses which require balancing accounts to Bo maintained are'

1. Purchase power ¢xpense 8_ purchased uatsr expense 3. pump Taxes 4. Franchise T4 x4s s. property Taxes 4. Postage

67 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSL'MER OFFICE

These balancing accounts enable a utility to recoup the additional expenalturas which may occur are to the Lag between the time an of tsetable expense change takes place and the time when the revenue increase to offset the expense change is authorized. prior to the balancing ucceunt requirement in the Code, utilities were not able tn recover the aaaltlonal expanses due to the time lag between expense change and revenue offset. Balancing accounts simplify the rata making process. Because balancing accounts recover potential losses during the lag Tina between expense increase and offset revenue increase (sen below), a utility no longer has to tile for an offset increase every time there's an increase in an cttsetahle expense. The balancing account accumulates over/under-collection until such time that l the utility is ready to :ala for an offset. \ W A properly maintained balancing account eliminates a utility°a risk Rf not belnq able to recover increases in expenses over which it has no control.

(3) .QH99§£L.ZL1i£!§§ Similar to other: utilities, vatcr utilities may offset unan- tinipatsd operating expenses at any tins during the year through an informal advice letter tiling. with the notable exception of qnnaral rate requests from small wnt¢r utilities, ncith¢r ROR nor ROE in exanln9d or aijustea in conjunction with advice letter filings. when water utllltins process an or fset request, the incrwaee must be, at least, enc percent of annual revenue. When an ortaet is approved, water utility balancing accounts are generally Amortized over a one year period. Although the dollar amounts at water utility rnvsnue under-col1ect1¢na are insignifi- cant relative to energy utilities, the result Le that water utility owners must cover under-collections more often than energy utility stockho1&era. One point of n@ta is that many of the Margy balancing account mechanism are currently being ¢on- sid9re8 tor elimination in light sf the evolving industry dynam- ice.

(4) Qnnax Un1 ik9 for energy and te1ec¢mmun1 cati¢ns utilities, the CPUC docs n¢t have certification authurlty over water plant Bdditions. For wnt9r utilltins, a certificate of Public convenience and Manessity (CPC$N) is issued only for service territory axpan- sions The canmissian stat! reviews utility plant addition f Ar reaennahlennss. however, and ¢n1y allows reeson¢b3n amounts for

I RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

plant additions to Bo included in rates. Water projects with significant construction period tall into five major catogorias: Ill miscellaneous structures. (2) tanks and reservoirs (3) transmission and distribution mains (4) treatment and (5) wells. Transmission and distribution Mainz represent the largest on-going construction projects. Trcatmont facilities are usually major projects but are infrequently constructed and as a result the dollar impact in any given year is ninlnal. The average construction Tina by catsgorios are:

Qstsa9zx 899.48323819111128 (Month) Treatment Facilities 8.3 Tanks and Reservoirs 6.2 Transmission and Distribution Hair: 3.9 Miscollnneous struoturss 3.1 wells 2.5 The evaraqe construction period for water projects is tour months. This is a considerably shorter period than is nxpsrienceé by energy utilities. Because of the short duration of construction fix# of pr@jecta, the Ccmnisaian, on May 11, 1982, on reena- uendatlon by the staff, established the policy of including construction Work in Progress (CHIP) in rata base for water utilities. However, this policy For water utilities did nut Lead the tomnission to endorse a similar policy for energy and tele- ccnmunicatlon utilities-*where construction time often exceeds one year and where Allowances for Funds Used During construction (AFUDCJ for Long turn construction projects are allowed to accu- nulate.

normally, a water utlllty'x plans tor constructing new facilities are reviewed in the Gnnoral Nate case. Tea utility is allowed to book cur? on the basis of that review. For nxanpln, it it is determined that the utility will be spending $160,000 per year average on new facllltlss, the utility will be nllvwed to boat $100,000 at the and of each year. Return on this investment is provided in the rate changes made for the following year. once a project in complete it moves into Plant in service, so Plant in service is also rsvlewea in the enc and allowed prespeutivaly.

sometinss a utility d¢ssn't have a firm plan fur adding a new facility, or has hewn that in the past it has added facilities in a slaw or erratic manner. In this case the commission has required the utility to tile for a rate base offset once the re¢l1ity is placed into service.

69 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

IV. SNALL WATER cunrnntns

A. RISK OVERVIEW

T h e r e a r e npproxlmatoly 190 small investor owner water utllitlos in California. The aajorlty are solo proprietorships, with the renaindsr being family-owned corporations and partner- chips. Their risks essentially parallel those of larger water utilities, hut their exposure is greater. Small system problnas can be generally characterlasd as insufficient lntraetructuru, too few resources, stagnant or declining customer growth and little or no capital. The coats aasoclatod with water contamination can be handled by a large company but can be a serious financial problem to a smaller water caupuny due to poor econo- nies al scale. The situation is lnnctioos exacerbated by a lack of business sophistication and understanding of regulatory proof cures.

Many anal water utllitias have little or no contact with tae Commission until they exporisnce major fiscal Ar operational difficulties. To assess the status of small water utilities inNer Commission rogulatinn, the Water Branch, In 1987 and 1988, sur- voyed a sampler of anal water conpanles. Gnu of the interesting findings was that at the utilities survcyod, one half nnadnd large plant improvements such as wells, water storage tanks, hydrants, chlorinators or other equipment. Although none wore found to be on the verge of collapse, many might he in that position if they continua to operate as is. other observations were:

(1) A small utility may operate at a loss or a break ann point until a large plant improvement is needed. At that time, a small utility with less than 159 connections will not be able to spend a large amount of money on a plant lmprovo- n e n t . The utility will continua to have a problem until ncncy is found far plant improvement.

¢2J owners do not want tn operate sub-standard utilities. of the system for which the owners wanted to sell or give away, nana had water quality that was above standard and est were below standard.

13) Many owners did not understand the adv1:¢ latter tiling process. Qr the utilities surveyed, 26¥ had not !i1e¢ for a n rate increase because the owners felt it was to¢ much trou- b l e

As a result at tan survey, the water Utilities Branch implemented an outreach program to small vntnr utility aanagcrsh a s

70 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

to instruct those that want to stay in the voter business how to apply for lntormal rats increases and how to apply for Sate Drinking Water BonO Act loans.

(1) 151!!9a§iNsx_.Bi.£ils Small water companies use advances and contributions more of ton than other utilities to fund construction of new f acili- ties. This torn of external tinanclnq is typically derived from real estate developers who deposit with the utility in advancer of constructlan the astloatad cost to build water Eacllitias needed tn serve the area to be developed. By contractual agreement, the utility will refund the advanced deposit over time based on either a multiple at revenues or cast per root of pipe. Cnntribu- tion deposits are not subj~ ~ct to refund.

Advances and contributions spread out the utility'a funding requlrcmsnts for growth and development in the service territory. Tresa sources or funds are not included in utility rate of return calculations because these sources of capital are not provided by company investors. Nonetheless , operational risks inurcasn as the percentage of contributions incrnasa for the utility. Par axanple, assuring a 1 ua return on ratobnse, a utility with s1no,nau in plant, of which to% is contributed, can only generate a return on investment of $6,000. If the utility had used debt and equity capital, it would be ably to earn $10,900. The cpara- tonal rest is hlghllghtad when revenues change dun to voluntary conservation and/or mandatory rationing.

The Tax Hefnrn Acc of 1986 ulTRA~ss) now requires that advances AnN contributions he treated as taxable income ruthnr than cvntrlhutions to capital. As a result, utilities are rcqulrod to pay federal taxes on the amount of advances and contributions received. Tris tax treatment will likely rcducn the appeal of these sources at funds. In Decision B?-09-026, the commission authorized nathan by which utilities may recover the federal taxes paid pursuant to THA-86.

?no Commission has ordered an investigation into the use or ccnnacticn fees to help to mitigate the financial problems stem- ning from 5 F all water otllitles inability to borrow nanny. If allowed, this change would put :Mn rsqulatsd utilities on a mnr¢ rem fcotinq with the unregulated municipal utilities, aid might make them muon viable.

(2) Hglk§*B1g§ some small water systems were not Ein4nci4.iy viable even

l 13 l l

l 71 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

when they were started. Inoxperienccd person or spcculntors sometimes acquire a system Bel sieving they can Improve it with Little capitol and sell at huge profits. Additionally, there may Bo non-financial rewards ouch as experlnnntatlcn by a r¢tlrea with snail business nr Br the buyers having 4 new role in the community. If the systun Ls in poor physical condition and service is Lnadequate, thereby requiring extensive maintenance and/or capital improvements fro; the beginning, new ounars are sometimes unwilling and often unahln to respond, allowing service to date- riorato further. problems like these may gr on for years. It angry customers are sufficiently organized, they may form a district Ar petition a local political subdivision to acquire the utility. If cuatoners are insufficiently organized to accou- plish a buy-out but canplain to the Canmiasion, the Commission nay enter lntn extenatva litlgatlnn in order to persuade the owner to effectively manage the system or to divest ownership. This strategy may have no effect or owners nay nuke nlnlmal improvements to avoid hearings and to justify eep£ta1~re1ated rate inerensas. In extroze cases, owners have abandoned their systems. where the commission will still have the responsibility or regulation after a sale, i.e. sales tn individuals versus sales to public entitles, current policy is to diecouraqu formation or unviable or marginal water utilities. The burden is placed on buyers to prove the financial soundness of the proposed a¢quisi~ sons, especially when buying abnvn book cost. However. a purchase price above the system's aeprnciated historical cast does not inherently mean the price is imprudent.

(3) Hs;nz_9uaL;s!_Bi:k The standards that a. ply to Class A utilltlea also apply to the Class B, C and D utilities. QW# real difference betuwen the class A utilities and the others is that there is 4 great limita- tick in the am@unts at capital that small utilities can raise. To alleviate the financial burden, the Safe Drinking Water 84nd Acts (SUWBAD at 1976, 198&, 1986, and 1988 were approved in the various state general elections. The legislative intent of the SDWBA was to assure that all domestic water supplies meet uininun standards established under Ca1 ifarnia's H¢a1th and Safety code. The snwaA directed that three state agenclas--the Department of Health Services runs; Department at Water Resource: (Duo) , and the CPUs--share the, adminietratlan of the pr¢grnn for investor-swned inter utilities. PHS is ahnrqed tilth the respQnsibi2 ity to rec¢nrend imprave-

7 2 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

rants and renabll station necessary to provide pure, wholesome, and potable vatcr available in adequate quantity or sufficient pressure for health, cleanliness and other domestic purposes.

DUR is the banker for the SDUBA program. Upon receipt of the approved project plans and new perot Fran DAS, a stalled financial analysis is Nada to determine that the loan would be adequately received and the water utility has the ability to repay the loan. Those utilities which meet DWT's financial re- qulrement: ors issued loan authorizations. Actual loans are made to a utility after (X) the croc approves the DWR lna5 contract and authorizes suffieitnt rates to repay the loan and (2) DAS approves the final SUWBA project plans and specifications. To obtain croc approval to borrow the SDWBA funds and increase rates to repay the loan, the water utility must tile an application vltb the CFUC. To provide the water utility's rata- payers with complots information on the anwaa project, the CPUC conducts a public meeting or evidentiary hearing in the water l utility service urea. The cnamission looks at the basic health l rsqulrenents Oni deficiencies, the required plant improvements, l size at the rote increase and the opinions of the ratepayers. The Commission doclsion is final.

In the fall of 1988, num mailed letters to all holders of loan contracts under the SDWBA of 1976 notifying them that the BDNBA of 1988 authorized the State to fix the interest rate at a.1a. a number of the larger wunicipol loan holders, upon receipt at this letter, contacted the Director of own and requested that the 1876 program be treated the sane as the 1984, 1986, and 1988 programs which allow the loan holdup to pay only ooh half of the interest rate paid by the state of California for the bonds which finance the SUWBA program. It is anticipated that in e prcposod 1990 sowed, a provision will in included tn sat the final rate of Interest for the 1975 program at one-Nal! the actual cost.

B. ANALYSIS or VIMANCIAL Ann upanmmlouam rsnronumucn

(1) zinan~~i4LJM3ua5ia This analysis is a snapehat or the financial position or the California small water utilities. The criteria was to s91 act smell water utilities that rocalved approval f Ar qnnnral rate increases by resolution in 1988 and 19 1 9. This :ample of tcurteen w¢tor utilities was analyzed by investigating cnrtuin financial indicators calculated Iris their 1988 annual r@p9rt@ to the CFUC {Table 169.

7 3 RESPONSIBLE RESIDENTIAL UTILITX7 WATER CONSUMER OFFICE

The tor non ground shared by the small water companies is their comparable authorized rate of return amu their inability to earn it. Ten companies out of the tour team sampled earned a negative rate of return. other than these items, staff fecund that the anally mater utilities hun no other financial aimllarltles.

The avurnqe capital structure for this sample of small water companies approximates that of the large water utilities--4u# long-term debt and soc common equity. However, six of the utilities were over to\ equity financed and at the uthsr extreme, two had negative common equity due to accumulated oparatlnq losses which vet: granter than accumulated equity investment.

A widely held belief is that small water companies rely heavily upon adman¢es and contributions. This analysis Shaved that there is a Vida range to the lavnls at advances and enntri- buttons held by the small water utilities. For example there were only three companies with a ratio higher than the 15% average. The rust had ratios below the av¢rag¢. Five eonpanies don't have any advances and contributions. Interestingly, there nay be a correlation between the use of contribute capital and the capital intensity or 4 system. For example, Barrow Hater, the moat capital intensive ¢nmpany with S 2,2a2 invested per custnmvr, has Qne cf the lowest enntributed plant ratio, 3.1o%, but 81k ¢rove water, the least capital intensive conway with $193 invested per cuatcmcr, has the highest percentage of contributed plant, s2.12%.

This sample dons not support the belief that utility reve- hues decrease with higher levels of contributed capital. The tour companies with revenue to not plant investment ratios greater than the avuraqe also hold more contributed capital than ume average. There la, hay.ivn r, nm dlscerniblc correlation b¢twcan contributed capital and ratebase earnings. Barrow Water earned 2.19% on ratebase in 1988 while Elk Grove earned 8.51% but Arm- sir¢nq Valley earned the highest return, 15.75% with only 1.194 contributed capital and $1,413 invested per customer. The company with the qr¢at¢st Insanes, Los Silicon at -50_3131 had zero contributed capital and S1,011 invested per customerr .

A factor ccntributlng to small water utility operating risk is their very high ¢perating expanses to 9peratinq avenue ratio. All or the cumpaniea in the sample had extremely high operating ratios, ranging from 64.96% to 230.94% and averaging 117.s1¢.

Eleven of the faurtcan ccupaniec. had apnratlng ratios a b b a Ana. not surprising, n¢t profit margins are slim, ranging from as.24% to -139.94&. Ten of the fourteen companies in this sample had net pr¢fit margins of 10% or below.

145

74 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

A basic regulatory goal is to es*ab1ish rates that are rea- 8onab1¢ t: ratepayers ad the: a"1ow uzllltics the opportunity to earn their authorized returns. It 1: arnremeiy dif'l:u1t me obtain that goal for enwall wacvr utilities.

[23 ? 39mL5M;3 §

The Earle and small water util'ties di'fcr greatly with l respect to changes in sales and revenues. The following chart shows that large wars: utility rates of return (ROR) are less l sensitive to changes in revenue than are small water companies. l Zh this example, cnanglng the expected revenues at a Class A water ucillzy (son Jas: water Company) - 103 varies the rata at return -+ 27%. Ir revenues of 4 class D wa t e r company (Central Valley Water Ccnpany] pro changed by Los the rata ¢f return will change 1 1128.

9A.E OF F:EtL;RN

- ..._ 553; a r . Sze:-.zu *avi . ; - 4- :as \ /" f am . . rems -» ' iv 1 - 4 v s I.. x ." .r : R 8 'sn __a l *. Jr"" u 10:~ 2 I 4 gr *- _,.» * J. ' I .

ISS'- =~ /I . I

4. - f *. f

-:Hz -19: Rahs #lox 928711 ¢4 as=€=.¢na5 =8vz'a.13 -n-¢-

Two actions could be taken to compensate Thu small water companions tar the high rlnancial risk :tata they fans. GnQ nathod cansidersd is to authorize a larqar RUN, but this increase just shafts the operating line upward wt&haut raducinq the level risk. at

-7

I I

75 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

An alt¢rnative method would be to grant c "management fee", to the small water campaniss, which would not be tied to the ratebasa, but tied to some other crltaria. The effect would tilt the RGR line so that kt would resemble the RUN line of the large water utilities (Management fees are discussed on page 21), that is, the operational risk racing Thu small water utilltlcs would be conpenmated.

c. cuonznv RRTBHAKIHG PRACTICES

Typically class B, c and D water utilities are per~ ~ittcd to file advice letter requvsta for timely rata :Eller without rand of a formal hearing. This neth4d elinlnatns the high coat of a rate case procaening. In establishing revenue requirements, current prattle is to par form individual company analyses of operating costs and to authorize ROR from within a standard narrow range. to a large extent, small water utilities are funded aolaly with equity capital. In the case at 100% equity financed ccnpanies, the ROR is the ROE.

The current standard RUN for 190% equity financed small water utilities, 10.75% plus or minus .25%, has been in street since April 20, lsaa. The aathod for deriving the standard range is rather subjunctive, with periodic revisions undo in response to changes in prevailing interest rates, inflation and general ecnnvmic candltiona. There is no standard basis paint spread, but consideration is given to recent returns authorized for the larger class A, ulxeU capltallzuU, water utilities. The range of authorized returns pravidns a degree al flexibility in setting revenue rnqulrements to allow tr perceived differences in water quality, service, management, etc. while still providing 4 ran- sonable return to owners. The axiatence or extraordinary circum- st4nces would dictate a man different Fran Thu standard rate.

For small water companies with net taxable income of less than $75,oOO, ratemaklng income tax e1l¢wonces are based on etrectlva tax rates of 15% or the first $so,uon and 25% of the next $25,900 compared to see for large Clara A water companies. These lower tax rates translate into lower net-to-gross multipli- ers ranging from 1.3 to 1.7 as appozsd to the 1.7 multiplier tar class A c¢npani¢s. These tax rate differentials nltigate the higher revenue raqulrements usually associated with utilities holding high amounts of equity capital. Table 17 shows the pretax uaiqhted cost of capital tar four of the largest Class A companies compared to the range available to snail warn companies.

76 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

v. nzcutambnr Issues Ann .nLmznnAr1vns

A. nscnassIrIcnrxos Current classifications subdivide the utilities by the number of service connections, the utilities, tor the mat part, arc still regulated by the traditional regulatory approach (rat¢base regulation) . This torn of regulation an the small wnt9r utilities (Classis B, c and D) seem to exacerbate the problem. A reclassification or the water utilities c4u1 d he designed In a way that allawa the Commiasian to identity the unique economic problems faced by the utilities within a glvnn class. For uxanple Chu root at the problem to anal! water utilities is economic in nature. small water utllitlos provide veter at higher par unit costs than large utilities. Large water utilities are nhle to provide professional xanagonont and lour cost aervico because they spread the fixed costs of operations over more customers. Becauco at the size and the nature of operations, it is of ten difficult for normal regulatory tools to provide the intended protection for both consumers and the swell water utilities serving them.

To alleviate many of the problems that are faced by the snail water utilities a new approach could he developed in clas- aificatlon and regulation. Una method la classification of run water utilities based on the percontuge or contributions. when a water utility has a large peroantage at contributions in their capital base, operational risk increases for the utility.

I B. LARGE wnwzn Rnrznaxxmc Ammzunawlvzs Largo water companies are capital intensive oporntlons that exhibit increasing returns to scale and enjoy wall defined service territories, in which troy are role suppliers to a captive customer market with few substitutes. Bypass Jan industrial customer drilling a well) could occur due to onecononic distor- tion created by inappropriate rate design. Frequent rate cases and balancing account treatment of uncontrollable operating expenses, insulate utility shareholders from extrema financial and operating risks. public utility rngulntion was dosiqned for monopoly industrious such as large lnvostor owned water companies.

The ratamaking procedures currently employed by the commission-°ovorsight of utility capitol bu3get8, Imputing prods:tlvlty incentives and controlling costs Rf service--continue to be appropriate tor this nectar of the water utility industry. Thorn

77 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

appears tn be no compelling reason to change. However, the Com- l mlss1¢n could consider pernlttlng utility representatives to articulate their concerns in a workshop listing options and alternatives to current regulation procadurns. W

c. SULL WATER RATEHAKING Amasnnarrvns

(1) B9!s£E£_41rLBQ4l\li£i&1nnsi A possible aolutlon to the myriad of problems besetting small water utilities is to more actively promote conmlasion Resolution Ho. M-4799 dar~d August 28, 1978 that supports convert Zion of unviable Ar marginal water utilities to public ownership or Thai: oargers with more viable Qatar cperaticne. The practi- cality and viability of such takeovers could be explored in detail in an order Instituting Investigation (OII) . Issues that should be investigate voulC lnc1uda°

O What incentives exist for larger ccnpaniea or nunicipqlitigs to tnkewwer Mae small companies. c Should the ¢omvisaion encourage such takeovers by creating aufficlent incentives. c what would be the likely impact on rates or both the acquiring company and the company aeqytred. c What practical problems should he considurnd, j.e. physical lucaticn and cnaractcristics, viability or interccnnnctinq aystens. o that are the possibilities of Large water utilities abzaining lu cost shawna funds for upgrading any small systems they may tnksavex.

42: !l1rans ._ilmLa:lsrai The problem of small water utilities is fundamentally duo to insufficient economies at Scala and n¢t just insufficient access to financlnq, Par that reason, the Ga~ ~mission as well as many other regulatory jurisdictions around the country have granted snail water companies lower equity returns than larger companies. Manutheless, small water utilities are clearly more risky than 'are water utilities and theory wcwld support the nation tint the required return on investucnt should be higher For small water than for large water companies,

:ac

7 8 RESPONSIBLE RESIDENTIAL UTILITY WLAJER CONSUMER OFFICE

The fo.1owinq are options towards improving the financial viability and flexibility of small water Ut1l 1£I¢$-

8935121281198

A fund could Bo created for the purpose of leading money to small uatnr companies, at reasonable rates Ana aver a long enauqh repaynnnt period to reduce rate shock. The program could he subsidized by general surcharge revenues or 4aneral obligation bands, permitting loans at vary low or n¢ intsr9st rates.

UP L41111 G : us 5.23 go JE• 9 A ay ; a s... when a company owner lends funds to the company which it would Ba unable to unsure on its own. or guarantors a loan on the company'a behalf, the commission c9u1d allow soma premium above the cost or the loan to coapensnte for the risk and the potential that the money could have bean investee in a venture that is more l profitable.

*..J*:>~.1*:» . " . . l l S t -

To attract qualified management and to maintain manage:mant's interest in the water Wyatan, salary compensation could be sot on an indivldmal basis rather than on a range of sa 1ari4s. In nddltlnn to salaries, o management tea could be considered. Hater utilities, large and snail. are allowed to expense :mnaq$m~rt salaries. Ten class A utilities and acne or the Class B utilities :Ana littler financial constraint in negotiating the amount that the Comnisslon will approve, besides, these classis pussssa such financial strength that management salable hay# a small effect an their rat¢ of return. It is the smaller classes, c and D, vhnre management snlarlea play a larger lmpcrtancc on the company's rate of return. The current process for snttinq management salaries is to project the oxpenae. The C¢nmission's Starr than evaluates the amount by comparing it to other utilities at similar size an¢ geography. what could Ba ¢onsidered is the individual nitrite of the company and its management. For example, a water utility whose uvner/epsrntor poaaean a Profes- sional Engineers Lieehsn, or a Plunbinq License or any Liconsv that allows the own¢r/operator to perform the work rather than having to contract the work out, could be allowed e salary that reflects the expertise and cenmitmnnt to the utility.

Although Class A water utilities serve the soma function as the Class B, c and D, they should be regulates diffcrsntly with

79 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

the issue of management salaries. Management tees could in granted to the class B, c and D water utilities. Although there is an argument that Class B, c and D water utilities require less dark than large utilities. an incentive is needed for the awnerfoparators or the :mall classes. especially Class D. In the class D utilities many are financially strapped and find it difficult to tend additional lending and/or addltienal investors. many resort to using their homes and/or personal property as collateral. A financial incentive, such as a management tee. vculd give reason to remain with the system rather than to aban- don it. 9 i l

. . ah* L Hz OI L N 4 in... s I ¥J'3~ Up LM] Current authorized raturna may not fully reflect the risks inherent LD small water company operations baeausa the current methodology for shall water companies concentrates heavily on their relative absence of financial risk {many are funded solely with equity capital.) There is no recognition of the relatively large operating uxpensos and high aarminqs volatility associated with snail water operntlnns. Establishing the generic ROR range for 1008 equity water Companies is quite subjective. Howavsr, attempting more preelslon Cr a strict quantification of a risk premium for operating risk could be oven more prob1en4t1¢. As risk inherent in small water company operations are not comparable to any water company for when market data is available, results Rf the other tinnnclal models would also Ba difficult to interpret. Honatholess, the cozmlsslon has the authority tn autharlze any rate of return within the range of fairness and reasanablonass. fn affirmation of its support of small water canary lnvastnrs. the commission may ad¢pt a policy of authorizing a number of percentage points above large water authorizations (for cxam9la) to determine the small water Ann.

(2) Ba$§_Rs1i§I The current pro¢¢ss in califarnia for sattinq rates for the small utilities is through the advice lcttur filing process. Tels cnthod ellminetns the high coat of a rate casa proceeding, while protecting the rights of both the consumer and the utility to participate in the process. Alternatives that could be ccnsiésred in setting rates are as tollowsz

80 RESPONSIBLE RESIDENTIAL UTILITY WATER CONSUMER OFFICE

L!§881H§ For whatever reason. many small uti11ti¢s do not cams in for needed rate increases. Allowing automatic rate adjustments which caulk be set to an index would allow the utility to recover those expenzus that are out at the control at the utility. TNerefere, the recovery of lost or gained revenues are not adjusted when the utility save: or wastes money and the stockholders will bear these gains Cr costs. Indexing will also preserve the incentives round with test year ratsuaking.

The Commission can wither construct a new index tor the water industry Er use an existing one, but one that does not contain variables that are controllable by It the utility is allowed to have some control overthe the utility. variable than the index may serve as a pass through mechanic. For example, the index may cover expenses brought on by drought conditions, such as mandatory rationing.

azzzans A commission approved referee could be designated by the commission with the role or settling disputes over exponsss batten the Commission stat! and ts utility. Many of the swall- Er water utilities would find TM!! advantageous. For example, smaller water utilities do not have the resource to file for a formal rata case hearing to dispute the expenses that commission stuff is disapproving.

81 RESPONSIBLE RESIDENTIAL UTILITY

l WATER CONSUMER OFFICE l

v i INDEX DF TABLZS l

The following tables illustrate sev¢ra1 topics discussed in l the text. For the mast part, they comparer the performance at cal irornla water cnnpanias with that of various other public ala private companies. The companies used in these analyses are listed in Tables 18 and 19.

129LQ 8C 1

1 water Quality Tasting s Associated Costs

2 Standard 5 Poor'a Rating Benchmark Definitions

3 California Water, Energy and Telecommunications companies, Allowed vs. Earned Return on Squlty

a In California Class A water utilities vs. A-Ratea Bands, Allnwea and Barned Returns, Yields, and spreads

5 Actual Return on Total capital

6 Actual Return on common Equity

7 Actual Long-Tern Debt RAt£¢ ! B Act4a1 Com~ ~on Equity Rntic

9 Pro-Tax Intarnst Coverage

10 Revenue to net Plant Investment

11 Advances & contributions to Het Utility plant

12 net plant Investment par Customer

13 Gpcrating Ratio

14 Het profit margin

£51 Rate comparisons et California Regulated and Unregulated Water Utilities

18. sample of Small water companies ?inunmial Statistics

17 Pre-Tax weighted Cast of Capital

l a List of companies Us¢d in the Nata IhLcs

19 List of companies fund for Rate & usage Comperisuns