2000816_sw.doc

MEMORANDUM

TO: COMMISSIONER HANSEN
COMMISSIONER SMITH
COMMISSIONER KJELLANDER

FROM: SCOTT WOODBURY

DATE: AUGUST 16, 2000

RE: CASE NO. UWI-W-00-1 (United Water)
GENERAL RATE CASE

On February 2, 2000, United Water filed an Application with the Commission for authority to increase its rates and charges for water service. At hearing, the Company reduced its requested revenue increase from $3,057,100 (11.57%) to $2,883,705 (10.99%). Staff in post-hearing exhibits recommends a $1,834,356 (6.91%) increase.
The Company in its post-hearing brief identifies the following issues that vis-a-vis the Company and Staff remain contested. Those issues can be summarized as follows:
Advances for Construction—Depreciation Expense Adjustment
Commission Staff proposed a $218,637 adjustment in revenue requirement related to depreciation expense on property advanced by developers. Staff’s proposal is a change in depreciation practice. The appropriateness of the practice has never heretofore been specifically addressed or challenged. Tr. p. 695. Staff contends that because the capital for these projects is not provided by investors and because advanced property is not included in rate base that depreciation is inappropriate. Exhibit 112; Tr. p. 683. Allowing depreciation on plant constructed with advances, Staff contends, places the risk of speculative development on current customers. Tr. p. 682. Advanced property does not qualify for rate base treatment until the advance is returned to the developer. Tr. p. 683. There is also a potential for unrefunded advances to roll-over to a contribution at the time the repayment period ends. Tr. p. 695.
United Water opposes the adjustment contending that the practice of charging depreciation on advances has been routinely followed and should not be changed in the context of a single utility’s rate case. Tr. p. 493. The Company notes that when a utility receives an advance, it also incurs a liability of repayment. It is the utility’s investors, the Company contends, who eventually supply the capital that funds the repayments, and depreciation, it argues, is obviously appropriate with respect to investor-supplied capital. Post-Hearing Brief p. 26. Finally, the Company contends that the recommended change in accounting policy, if accepted, would have adverse consequences, i.e, (1) diminished cash flow, (2) temporary mismatch between rate and book treatment and (3) would be time consuming and require significant administrative effort. Tr. pp. 494, 495.
As reflected in post-hearing Exhibit 2 and Staff Revised Exhibit 111 the Company and Staff agree that a more appropriate estimated figure for adjustment to depreciation expense, if accepted, would be $134,853 rather than $218,637. Tr. p. 496.
The NARUC Uniform System of Accounts for Class A water utilities while specifically addressing depreciation practice with regard to contributed property (Account 403, Depreciation Expense; Account 271, Contributions in Aid of Construction) provides no direct guidance on depreciation practices with regard to advanced property (Account 252, Advances for Construction). Tr. p. 497. Some states, the Company reports, permit depreciation expense on advanced property, others do not. Tr. p. 494. This adjustment would increase the Company’s rate base by $134,853 and decrease depreciation expense by the same amount.
Boise River Intake—AFUDC
In the Company’s last general rate case, Case No. UWI-W-97-6, Avista requested rate base treatment of $1,882,531 in capital expenditures for construction of river intake and installation of a transmission main. Tr. p. 165. The Commission disallowed the Company’s request stating:
Except upon on a finding of an extreme emergency, the Commission is prohibited under Idaho Code § 61-502(A) from setting rates for any utility that grants a return on construction work in progress or property held for future use which is not currently used and useful in providing utility service.

Order No. 27617; Tr. p. 234.
As reflected in the prior hearing, the river intake facilities consist of “a pipe that goes nowhere and is not hooked to anything.” The Company anticipates that the facilities will be utilized to divert surface water for a future water treatment plant in southeast Boise. Tr. p. 171. There is no projected need for the facilities until the year 2005. Tr. p. 235. The Commission is Case No. UWI-W-97-6 authorized recovery of amortization at the level of depreciation of the construction costs in the amount of $37,651 per year. Order No. 27617; Tr. p. 166.
In this case, the Company requests “post-closing AFUDC” for a present net investment of $2,555,658 in the river intake and pipeline and the deferral of the current amortization until the project goes into service. AFUDC, the Company states, is a recognition of the economic costs of unproductive capital, typically for construction expenditures not yet in service. Post-Hearing Brief p. 15. The AFUDC rate requested by the Company is the same rate as its requested cost of capital, i.e., 9.15%. Tr. p. 173. (Requested accounting treatment Tr. pp. 172, 173; Post-Hearing Brief p. 16.)
The Company admits that the underlying facts with respect to Boise River intake have not changed; nor have the statutory requirements of Idaho Code § 61-502A. Tr. p. 234. The Company maintains that application of the “used and useful” standard is unfair in instances (such as this) where the capital investment reduces future costs and/or maintains the Company’s ability to provide service in the future. (Citing Marden Treatment Plant as an example of how plant constructed in advance benefits customers.) Tr. pp. 166, 167.
Although previously authorized, it is noted that the Company in this case includes no amortization expense for river intake and pipeline in its revenue request, believing post-closing AFUDC is more equitable. Tr. pp. 170, 171. The Company maintains that the Commission authorized treatment deprives the Company of the opportunity to earn a return on its full investment by reducing the amount of investment that will be included in rate base. Allowing a level of depreciation expense does not relieve, the Company contends, but rather compounds the unfairness.
The Company’s proposal for AFUDC treatment of its Boise River intake expenditure is the same position as Staff supported in Case No. UWI-W-97-6. Tr. p. 647.
Investor Relations Expense
Staff’s proposed adjustment removes from United Water operating expense, the “investor relations” amount of $82,585 recorded as United Water’s allocated share of its (heretofore) publicly traded parent company’s (United Water Resources) expense of providing information to corporate shareholders, a Securities and Exchange Commission regulation and reporting requirement. Exhibit 11, p. 1, col. G; Tr. pp. 684, 685; Post-Hearing Brief p.27.
United Water Resources is now a wholly owned subsidiary of Suez Lyonnaise des Eaux. The merger agreement which was announced on August 23, 1999 was consummated on July 27, 2000, after receiving required regulatory approvals. Reference UWI letter filed with the Commission Secretary on August 2, 2000.
Suez Lyonnaise is now the sole shareholder of United Water Resources. Staff contends that with only one shareholder and because United Water Resources stock after the merger will no longer be publicly traded, United Water Resources will no longer incur the costs of providing shareholder information. Tr. p. 685.
The Company opposes this adjustment. Even though United Water Resources’ stock, it states, will no longer continue to be listed on the New York Stock Exchange and the Company will not be obligated to comply with associated SEC regulations, UWR is not being acquired by a private entity. The new parent is and will continue to be publicly traded and will incur investor relations expense and the Company states it will likely allocate a share of that expense to its subsidiaries. Tr. p. 491; Post-Hearing Brief pp. 27, 28. The Company contends that Staff’s proposed adjustment is speculative—a change in test year expense has not occurred and is therefore not “known and measurable.” Post-Hearing Brief p. 28. The Company recommends that the expense amount remain unchanged.
M&S Audit
Staff recommends that the Commission consider retaining a management and economics consulting firm to assist the Commission Staff in a study of the economic efficiencies or inefficiencies of the services provided to United Water Idaho by the Company’s affiliate, United Water Resources Management and Service Company (M&S). The main question to be answered by such a study, Staff contends, is not whether a charge is appropriate, but rather “can the tasks be accomplished locally (in Idaho) at a lower cost”—also is allocation of cost to Idaho fair and equitable? Tr. p. 673. The cost of such an audit is estimated by Staff to be approximately $200,000 to $250,000. Tr. p. 693.
The Company cites numerous management audits performed at various times over the last 22 years, all consistently coming to the same conclusion, i.e., “allocation methods are quite sophisticated, well documented, and services are provided at reasonable cost.” Tr. p. 27. The Company contends that no credible evidence has been presented in this case that an additional study is warranted. Tr. p. 29. Staff itself, the Company notes, proposes no adjustments to M&S charges or allocation procedures. Tr. p. 671. Obtaining the lowest price for functional area services may not be the critical decision factor, the Company contends. Rather, the total overall benefit must be considered (issues of quality, timeliness, experience, and professionalism). Tr. pp. 33, 54. The Company identifies the following as an example of benefits of being part of a larger corporation: (1) treasury functions (lower cost of debt); (2) lower insurance premiums; and (3) economies of scale—purchase contracts, etc. Tr. p. 32. Outside services, the Company speculates, would require careful oversight and related administrative expense. Tr. p. 33. The Company states that it has performed no cost analysis of performing M&S type services in-house. Tr. pp. 51, 54. Nor has the Company analyzed whether contracting with affiliates is the most cost effective method. Tr. pp. 67, 68.
Commissioner Hansen in cross-examination of Company witness Wyatt notes that the costs in 1998 of M&S for services was $1,306,824. For the 12-month period ending September 1999 the cost had increased to $1,409,948, an 8% increase (citing employee relations up 29%; customer and public relations up 59%; accounting/planning/taxes/audit up 24%). Tr. p. 70.
South County—Revenue Adjustment
Staff proposes to increase test year revenues by $136,118 to reflect projected South County revenues in the third year (70% of UWI rates) of the acquisition rate phase-in. Tr. p. 641. The Company has adjusted test year revenue for South County customers in this case to reflect the second year of the phase-in (60% of UWI rates—effective January 1, 2000). Tr. p. 35. Staff contends that the proposed third year rates (effective January 1, 2001) better reflect the known and measurable changes that will take effect during the first year of the general rate adjustment. Tr. p. 620.
The Company opposes the adjustment. Tr. pp. 35-40. Staff , it states, is proposing an out of test year adjustment, contrary to a long standing Commission preference for historical test periods. Citing In Re Utah Power, Case No. 1009-84, Order No. 13448 in which use of a future test year was rejected. Post-Hearing Brief p. 21. If 2001 rates go into effect now, the Company states it will for the balance of this year experience a related revenue deficiency.
The Company notes that the Commission in South County/UWI Order No. 27798 stated: The rate phase-in is designed to permit customers to “assess their water usage, to possibly adjust their water consumption habits and to connect (if available) to other irrigation sources.” Tr. p. 37. For background, the average annual water consumption of South County customers is 324 ccf. For United Water the average is 220 ccf. Tr. p. 61. Although the third phase rates may be known and measurable, the Company argues that the associated revenue is not. Higher rates may induce customers to reduce consumption. Imputing future South County revenues, the Company contends, is a mismatch of revenue and expense. Tr. pp. 35, 37, 62, 63.
Further, Staff’s proposed revenue adjustment, the Company contends, begs the following question: Should the Company be allowed to include known and measurable expense increases, e.g., contract labor, depreciation, capital investments, etc.? Tr. pp. 38, 39.
Spurwing
The Spurwing development was acquired by the Company under its non-contiguous tariff. Reference Case No. UWI-W-98-5. Staff proposes that $52,837 of capital investment associated with Spurwing development be excluded from rate base. Tr. pp. 619, 630. Staff also proposes eliminating associated depreciation expense in the amount of $2,723. Tr. pp. 630, 631. The Spurwing investments at issue (i.e, telemetry/chemical feed equipment (C98 C109); pump (C99 A106)), Staff contends, should be regarded as part of the underlying water system acquisition and as such should be nonrefundable developer contributed distribution plant or water supply plant advanced by the developer, and subject to refund. Tr. p. 630.
The Company opposes Staff’s adjustment. Spurwing, the Company maintains, is no longer a non-contiguous system but is now part of the Company’s integrated system. It was connected, the Company states, to take advantage of the Spurwing wells production capacity to supplement the Company’s west bench service level supply. Tr. p. 435. It is in connection with the integration and not the acquisition, that the Company on rebuttal states that it undertook the two capital projects that Staff challenges. The projects, the Company contends, were for the benefit of the system generally and not for the benefit of the Spurwing subdivision. Tr. pp. 434-435. Spurwing, it states, could have operated without this equipment. As such, the Company contends that the projects were not property that should have been either advanced or contributed by the developer. Post-Hearing Brief p. 11.
Redwood Creek
Redwood Creek was a discretionary purchase acquired in 1994 when the Company expanded its service territory into the Eagle area. Tr. p. 236. The Company’s growth projections for the Eagle area were challenged by Staff in the case as being unrealistic. In support of its proposed acquisition, the Company assured the Commission that other customers would never be required to subsidize its Eagle area investment. Reference Case No. EUW-W-94-1, Order No. _____.
In this case United Water seeks to rate base the balance of its remaining undepreciated capital investment in Redwood Creek, $573,906. Tr. p. 629. Staff points out that test year revenue generated from Redwood Creek customers ($57,741, see Tr. p. 239) does not fully support the overall investment. Staff contends that the Redwood Creek facilities are not needed to serve the needs of customers in the Company’s integrated system. Staff recommends that Redwood Creek facilities continue to be viewed on a stand alone basis and that Redwood Creek rate base be limited to $302,400, the amount of supported investment. Tr. p. 628. Staff recommends that $271,506 of the Redwood Creek facilities costs be excluded from rate base as unsupported investment. Staff further recommends that $7,371 of depreciation expense associated with the unsupported investment be eliminated. Tr. pp. 629, 630. Included in the unsupported Redwood Creek investment is a recent replacement pump designed specifically, the Company states, to deliver water to the Floating Feather booster pump which supplies the northwest pipeline. (Work Order No. C98 A105—$56,127). Tr. p. 175.
The Company objects to Staff’s proposed adjustment and contends that it is inappropriate to assess Redwood Creek on a stand alone basis. Post-Hearing Brief p. 13. The Company maintains that the pump investment was required to serve the needs of its integrated system and that it would be confiscatory to deny recovery of this investment. Tr. pp. 179, 180. Redwood Creek, the Company contends, is no longer a satellite system. Its facilities and well have been connected by the Northwest Pipeline to the Company’s integrated system. The Redwood Creek facilities, the Company states provide back up to the Company’s greater integrated system, necessary redundancy, system pressure stabilization, and fire protection. Because Redwood Creek facilities benefit the integrated system, the Company contends that all investment in the Redwood Creek facilities is now used and useful. Tr. pp. 156, 174, 180.
Should the Commission continue to find it reasonable, however, to view Redwood Creek on a stand alone basis, the Company maintains that it is appropriate to apply surplus revenues from Island Woods to the Redwood Creek deficiency. Island Woods was an Eagle area water system that was acquired at the same time as Redwood Creek, is with this case fully rate based and generates revenue greater than required to support the Island Woods investment. Tr. p. 179. The maximum investment that should be excluded from rate base, the Company contends should be no more than $53,800 to $77,900. See Exhibits 20, 21, 22; Tr. pp. 176-181. Staff disagrees with the Company contending that the Company’s other customers are entitled to realize the benefit and additional revenue from Island Woods and should not be required to subsidize Redwood Creek investment by giving up same. Tr. p. 630.
Cost of Equity
Undisputed
Capital Structure
56.81% debt
.12% minority interest or preferred equity
43.07 common equity
Exh. 108, Sch. 14; Exh. 18, Sch. 6, p.1.
Cost of Debt 7.52%
Cost of minority interest 5.0%
Exh. 18, Sch. 1, p. 1; Sch. 6, p. 2; Tr. p. 594.
Disputed
Staff
Cost of common equity 10.6%
Comparable earnings method 10.0%--11.0%
Discounted cash flow method 8.6%--9.6%
Recommended range 10.0%--11.0% w/point estimate of 10.6%
Tr. p. 594.
The 10.6% return on equity point estimate utilized is based on
1. A review of the market date and comparable shown on the schedules in Exh. 108
2. Use of the water utility group dividend yield in the United Water Resource DCF calculation in Exh. 108, Sch. 13.
3. Average risk characteristics for UWI.
4. Favorable customer relations
5. Capital structure
Overall weighted cost of capital
Recommends an overall weighted cost of capital in the range of 8.585%--9.0616%. Exh. 108, Sch. 14.
For use in calculating the revenue requirement, a point estimate consisting of a return on equity of 10.6% and a resulting overall return of 8.843% was utilized.
UWI
Common equity cost rate 11.30%
Based on the common equity cost rates of discounted cash flow method (DCF), risk premium model, capital asset pricing model (CAPM) and comparable earnings analysis applied to proxy groups of four (avg. cost rate 10.9%) and six (avg. cost rate 11.4%) Value Line water companies.
United Water contends that the Company is more risky than the average company in each proxy group. The Company’s unique business risks and small size, it argues, increase its common equity risk by a minimum of 17 basis points, or 0.17%. The recommended range of common equity cost rate, based on the two proxy groups relative to UWI is 11.07%--11.57%. The Company recommends the use of a range midpoint estimate of 11.32% rounded down to 11.30%. The resultant overall cost of capital is 9.15%. Exh. 18, Sch. 1, p. 1.
The Company contends on rebuttal that Staff’s technical analysis on cost of equity for the following reasons is flawed and create a bias toward the low end of reasonable costs:
1. Range of DCF common equity cost rates—grossly substantial and would not maintain the financial integrity of presently invested capital. Tr. pp. 399-400.
A DCF calculation is a dividend yield plus a growth rate to produce a discount rate or required return on equity. Staff selects a value of 5% for use as the dividend yield. This dividend yield, the Company maintains, is higher than the actual dividend yields of United Water Resource or the proxy groups of water companies (Exh. 18, Sch. 11, p. 1). Post-Hearing Brief p. 17.
2. Comparable earnings method approach grossly understates the appropriate indicated common equity cost rate.
3. Staff underestimates UWI’s relative business risk. The Company contends that lack of any sort of tracker mechanism makes the Company more risky. Cites 93 rate case. Tr. pp. 601, 602. The Company also contends that a company that must recover a portion of its fixed charge through its variable rates faces greater risk. Tr. p. 603.
Staff on additional direct and cross contends that the 10.6% recommended return on equity does meet debt coverage requirements and will not result in a bond downgrade. Staff on cross also states that an adder is not required above the 10.6% which is 10 basis points above the 10.5% midpoint of the Staff recommended range of 10-11%.
Raintree
On November 3, 1999, United Water (Ben Hepler, V.P.) purchased a domestic water distribution system from Raintree Mutual Water Company, Inc. (Raintree). Agreement for Purchase & Sale – Post-Hearing Exhibit 4. Raintree was a nonprofit company organized by a group of developers to provide water service to property they were developing. Tr. p. 158. The Raintree water system which serves multiple residential subdivisions has no independent source of domestic water supply. At the time of purchase there were 830 Raintree customers (total build-out is 1102 customers). Tr. p. 164. Prior to the purchase and pursuant to an Operations Agreement signed in September 1995, the Raintree system was operated by United Water Idaho Operations, Inc. (previously EM2), an unregulated affiliate of United Water. Tr. p. 158. Reference Exhibit 121—9/95 Raintree/EM2 (Ben Hepler V.P.) Water Service Contract (Operations Agreement); Raintree/United Water Supply Agreement—verbal 9/95—written 1/98 (Exhibit 24 Water Service Agreement). Water service and operations service began in early 1996. Tr. p. 158. United Water in this case seeks to rate base a net investment in Raintree of $828,942. Tr. p. 160.
In the rate case test year, United Water “on a wholesale basis” (four 6" meters) received revenues of $65,258 from Raintree. EM2, which was repricing water to Raintree customers at United Water residential metered rates, received revenues of $124,062, a net difference of $58,804. Exhibit 16, Sch. 3, p. 16; Tr. pp. 96, 97. The Company’s revenue requirement calculations are based on 783 Raintree customers (September 1999). Adjusting the test year revenue for the 783 customers number, the Company calculates a revenue adjustment of $89,008 ($58,804 + $30,204) for a total annualized revenue figure for Raintree of $154,266. The annual revenue for Raintree is $197/customer—compare average United Water revenue/customer $320. Tr. pp. 106, 752.
Staff opposes the Company’s attempt to rate base Raintree and questions the prudence of the Company’s purchase decision. Tr. pp. 611, 676, 677. The Company’s decision to purchase Raintree, Staff maintains and the Company admits, was discretionary. Tr. p. 746. Under a strict economic analysis, Staff contends that the incremental income that the Company will realize from the purchase ($58,783) does not support the investment requested; it will only support an incremental investment of $246,000. Exhibit 122. Additionally, Staff notes that before the purchase the Company’s costs were simply those of supplying water. With its purchase the Company has incurred significant expense obligations that it did not have prior to the purchase, i.e., billing and collection costs, meter reading costs (except four 6" meters), distribution costs, O&M on distribution facilities, and depreciation expense. Tr. p. 747. The Company’s existing customers after the purchase, Staff contends, are worse off. The Company before the purchase was already generating two-thirds of the total revenue that would be generated after the purchase, yet the Company now has investment and additional expense requirements. Tr. p. 616.
Staff also objects to the manner in which wholesale service was provided to Raintree, contending that Raintree was extended preferential treatment based on its relationship with EM2 and that the Company deviated from filed rates, line extension rules and regulations. Tr. pp. 619, 632, 634. This is the only instance, Staff states that it is aware of when United Water has allowed a new residential single family development to interconnect to its system and resell general water services—not a service option available under tariff or generally provided to other developers. Tr. p. 634. Staff contends that the availability of wholesale service that allows the bypassing of existing tariff rates and rules must be subject to Commission review and approval. Tr. pp. 634, 635.
The Company rejects Staff’s reasoning. Up to the time of purchase, it states, United Water customers were receiving a substantial benefit for which they had no investment—this situation, it hypothesizes, could not be expected to continue indefinitely. Tr. p. 732. To justify its rate base request, United Water evaluates the Raintree transaction as if it had entered into a main extension agreement with developers for a fully developed single project in 1995, with full build-out within five years. Tr. pp. 161, 728; Revised Exhibit 7. The 1995 extension rules, it maintains, were used as a benchmark in negotiating an arms length purchase. Tr. p. 191. Extension rules for United Water changed in May 1997 after which time contribution of distribution system facilities were required of developers. Tr. pp. 197, 726. The investment that the Company would have made under the 1995 rules and regulations (guaranteed revenue requirement method), the Company states, is greater than the amount eventually paid. Tr. pp. 130, 195, 265, 744.
The Company disputes Staff’s contention that its relationship with EM2 provided EM2 and Raintree with any preference or advantage. Tr. p. 256. Line extension rules in 1995 did not apply, the Company contends, because no extensions were made. The Company simply set meters on existing facilities. Tr. p. 261. From the outset of the organization of Raintree, the Company maintains that it was its intention that it would purchase the system. It is a cumbersome operating practice, it states, to have a separate company enclosed within its system. Tr. p. 265.
United Water states that it regarded Raintree developers as sophisticated and financially capable and a credible threat to create a separate water company within its service area. Tr. pp. 182-184, 191, 256. Water was sold to Raintree, the Company maintains, at metered tariff rates. The sale to Raintree it states, was no different than the sale of water to any other customer. Tr. pp. 184, 185. The Company further states that it was apprised by its attorney that based on a Commission Order in 1997, there was no reason to seek Commission approval of the 1995 agreement to wholesale water for resale. Basis of attorney opinion: 97-4 Eagle City Contract (Supplemental Water & Fire Service; Backup Water for Emergency Situations), Order No. 27121, 9/08/97 (Exhibit 23). Tr. pp. 185, 635, 636.
Staff seems to suggest, the Company states, that in circumstances when United Water’s customer intends to resell water purchased from United Water that there should either be a tariff or a Commission approved contract for wholesale service. This, the Company states, is the same argument that Staff made in the Eagle case—there is no such requirement. Tr. p. 189. There is wisdom, the Company contends, in a policy that simply says as long as the sale is at full tariff rates the Commission can be indifferent to the end use. Tr. pp. 190, 249, 250.

bls/M:uwiw001_sw2

MEMORANDUM 10