gnrw01.1res Direct.doc

Q. Please state your name and business address?
A. My name is Robert E. Smith. My business address is 472 West Washington Street, Boise, Idaho.
Q. By whom are you employed and in what capacity?
A. I am employed by the Idaho Public Utilities Commission. My title is Senior Auditor.
Q. Please describe your educational background and professional experience.
A. I received my BBA degree majoring in Accounting from Boise State College in 1972. Following graduation I was employed in the construction industry as Accountant/Office Manager until April 1975 when I accepted employment at the Idaho Public Utilities Commission. During the course of my employment at the Public Utilities Commission, I have attended numerous training schools, programs and seminars in the field of regulation.
Q. Have you previously appeared as a witness in regulatory proceedings?
A. Yes, many times.
Q. What subjects have you addressed in those previous appearances?
A. I have presented testimony and sponsored exhibits dealing with rate base, operating results, cost of capital, revenue requirement, rate design, corporate cost allocations, corporate affiliated transactions, jurisdictional cost allocations and class cost-of-service allocations. These appearances have included cases dealing with electric, gas, water, and telephone companies.
Q. What is the purpose of your testimony?
A. I will present the Idaho Public Utility Commission Staff’s (Staff) recommendations regarding the total revenue requirement for Ponderosa Terrace Estates Water Company. (Ponderosa or Company)
Q. Are you sponsoring exhibits in this case?
A. Yes. I am sponsoring Exhibits 101 through 106.
Q. Is Exhibit No. 101 Staff’s recommendation for the total revenue requirement of $26,992.29 for Ponderosa Terrace Estates Water Company?
A. Yes.
Q. Column (C) on Exhibit No. 101 is entitled “Per Company”. Did Mr. Cobott, the owner of Ponderosa Terrace Estates, provide these numbers to you?
A. Yes.
Q. Did you audit these numbers to determine their accuracy?
A. I have verified the accuracy of many of the numbers. However, some of these numbers do not represent actual expenditures verifiable by audit. Mr. Cobott has not drawn a salary for his labor to manage the system nor has he paid a salary to Mr. Fairfax to perform the daily maintenance and operation of the physical system.
Q. What was the basis for the labor items requested by the Company?
A. I don’t know. Mr. Cobott could not provide any time cards or other supporting documentation for the proposed amounts.
Q. Have you made adjustments to these expense items?
A. Yes. I have adjusted Mr. Cobott’s proposed management fee downward from $9,000 to $4,160. I have adjusted the daily water testing expense for Mr. Fairfax’s (maintenance worker) labor from $3,600 downward to $1,800.
Q. What was the basis of your adjustment to the management fee allowance?
A. First, I had lengthy discussions with Mr. Cobott on August 13 and 16, 2001, February 11, 2002 and on March 29, 2002. Based upon those discussions, I believe the time Mr. Cobott has personally devoted to this system averages no more than 4 hours per week. I have also reviewed the labor charges reported to this Commission by other small water companies in northern Idaho. The labor allowances proposed by Staff compare reasonably with labor charges reported by other small water companies.
Q. Have you prepared an exhibit that reflects how the Staff’s proposed Ponderosa labor allowances compare with other small water companies?
A. Yes. Exhibit No. 102 is such an exhibit.
Q. Looking at that exhibit, it appears that several companies have administrative costs higher than your proposed allowance and several are lower. Will you please address each of the comparable companies?
A. First, let me explain that small water companies, like Ponderosa, are generally part-time business activities of the owners. As a part-time business, many of the owners are not particularly careful with their bookkeeping practices and may not properly assign labor costs to the appropriate category. Rather than look at the separation of labor between administrative/management cost and maintenance costs, it is more appropriate to compare the total labor costs on this exhibit with the total labor costs included on Exhibit No. 101. Total labor costs proposed by Staff for Ponderosa Terrace include a $4,160 management fee, an $1,800 allowance for checking the wells and chlorination equipment, a $1,200 allowance for general system maintenance plus an additional $1,800 allowance representing the free electricity provided to Mr. Fairfax’s home through the water company electric meter. These proposed amounts result in a total labor allowance of $8,960.
When comparing this total with each of the other companies, note that this amount is much greater than Murray Water Works. The owners of Murray have not sought to increase rates in a number of years and have been required to make significant capital expenditures on their system. They have utilized revenue generated from customers to make the improvements necessary to their system.
McGuire Estates, on the other hand, has reported labor costs similar to the Staff-proposed allowances for Ponderosa. This is, however, a metered system requiring additional labor to read the meters and perform more complex bill preparation. Because this system was turned over to a homeowners association in 2000, this data is from the year 1998.
Happy Valley Water Company is also a metered system. The Company is owned by a couple that also owns a well drilling and pump company. The reported labor charges on this system represent approximately 46% of the allowance proposed by Staff for Ponderosa.
Bar Circle “S” Water Company is a metered system. This system reported total labor costs for the year 2001 that are comparable with the allowance proposed by Staff for Ponderosa. The owner is a builder and land developer who is in the process of preparing an application for a certificate to operate another water company on the Rathdrum Prairie.
Bitterroot Water Company is owned by absentee out-of-state owners. This metered system is managed, operated and maintained under contract with a lady in Rathdrum who owns a bookkeeping service. All the labor charges are for the services of the contract manager/operator or casual labor that she hires to help with repairs and meter reading.
Algoma Water Company in Sagle is probably the least comparable company on the list. The Company has been plagued with ownership issues since a corporation was dissolved and the individual who ended up with the system would do no maintenance. A new owner took possession of this system in early 2002. Significant repairs have been made to the system to bring it up to acceptable standards. All customer billing (flat rate design without meters) and bill paying have been performed by a Sandpoint CPA who has taken compensation of $200 per month for these services. Because the services performed are for both a water system and a sewer system, $100 per month has been charged to both the water system and the sewer system.
Spirit Lake East Water Company is a metered system that is owned and operated by a family corporation out of Spokane. Labor costs are allocated to the water company operation from the corporation based upon the owner’s estimates of time spent operating the water company.
A lawyer in Coeur d’Alene owns the Troy Hoffman Water Company. He contracts for administrative and maintenance services. This is a metered system.
Q. In his letter to the Commission dated May 27, 2002 (Exhibit No. 103), Mr. Cobott indicated that Mr. Fairfax, who had performed most of the daily maintenance and testing on the system, had quit working for the water company. Mr. Cobott stated, “With my 4 hours per week none of the above mentioned items will be taken care of because of my lack of salary.” Under Staff’s proposed revenue requirement, is Mr. Cobott limited to personal compensation from the water company of $80 per week?
A. No. The revenue requirement calculation is intended to represent reasonable expense items recoverable through rates charged customers. The separation between management and maintenance on the system was made to provide reasonable compensation for the services performed, not to identify or establish maximum rates of pay for individuals. The allowances provide higher hourly compensation for the management function as compared to the maintenance labor function.
In formulating its recommendations, Staff attempts to review the overall operating costs of a company for reasonableness and prudence of expenses. When auditable records are maintained by a company, this review can be a straightforward audit of prudence for each expenditure recorded. When a new company is created that lacks records for certain expense items (as in this case), Staff makes a diligent attempt to put together an estimated income statement to determine a revenue number that must be generated to support the operation. This estimated income statement is not a budget that the Company must follow by line item. Once a revenue requirement is established and rates are set for the Company, the owners use their own discretion regarding how the funds generated are used to meet expenses. The owners are expected to use due diligence to insure that expenditures are made only for appropriate water company activities. Only upon review by Staff for ratemaking purposes are adjustments made to the Company’s records. These reviews may be routine periodic audits to insure that expenditures are prudent for the water company, or they may be initiated by a company’s request for a change in rates. During these reviews, Staff will recommend disallowances of certain expenditures that are deemed to be inappropriate or excessive. All expenditures of a regulated utility must be determined prudent and in the best interest of the customers. However, in performing its review of a company, Staff must be fair to the company and its owners. The owners must be allowed to recover their prudent operating costs, be fairly compensated for their labor, and have the opportunity to earn a fair return on the capital they have invested in the water system.
Q. Do you believe the compensation you have recommended is fair, just and reasonable?
A. Yes. I believe the labor compensation allowance is reasonable for this part-time business, albeit on the generous side when compared to the labor cost comparisons on Exhibit No. 102 for other systems.
Q. You stated a moment ago that the owner of a water company is entitled to the opportunity to earn a fair return on the capital they have invested in the water system. Have you made a provision for a fair return?
A. Yes. Exhibit No. 101, at lines 3 and 36, includes $3,008.11 in the revenue requirement calculation. This represents a 12% return on the Company’s investment of $25,067.59 in its newest well. Line 35 reflects depreciation expense, or the return of the investment, of $963.87.
Q. Mr. Cobott in his letter of May 21, 2002 (Exhibit No. 103) indicates he has more than $200,000 invested and wants a 20% return on the investment. How does his request compare with your recommendation?
A. Mr. Cobott’s request for a return of 20% on his claimed $200,000 investment would produce a return requirement of $40,000. Although “return” and “profit” are synonymous terms, Mr. Cobott’s letter indicates he also wants a profit of $3,600 per year. His requests are duplicative. Mr. Cobott’s requested profit of $3,600 compares with the $3,008.11 calculated on Exhibit No. 101.
Q. Is the 12% return reasonable for a small water company?
A. Yes. The Idaho Public Utilities Commission determines the fair return for large publicly traded companies based upon detailed analysis of discounted cash flows including growth factors and analysis of returns realized by comparable risk companies in the markets. Such an analysis cannot be performed on a small non-public company. Traditionally, the Commission has recognized that these small companies are inherently more risky than the publicly traded utilities and has allowed a risk premium on the rate of return. For several years the Commission has used a 12% return on equity as a fair return for small water companies. In the last year and a half, interest rates have been declining. Therefore, I believe the 12% return is more than fair.
Q. Have you been able to verify Mr. Cobott’s claimed investment in this system of $200,000?
A. Exhibit No. 104 is a copy of the Real Estate Contract recorded in Bonner County in 1986 when Mr. Cobott purchased the water system. That Contract indicates a purchase price of $100,000. Exhibit No. 105 is a copy of the Sweetwater Drilling invoice for drilling the new well in 2000 and installing the pumping equipment at a total cost of $26,031.46. Other than these two documents, I have been unable to acquire any documented evidence of additional investment.
Q. If Mr. Cobott purchased the system for $100,000, and the new well cost $26,031.46, why is the net plant value used in your return calculation only $25,067.59?
A. Exhibit No. 106 is a copy of the depreciation schedule maintained by Mr. Cobott’s accountant. That depreciation schedule indicates that by the end of 2002, all the investment in the water system (line 6) and pump (line 10) will be fully depreciated. Therefore the only remaining depreciable water system asset is the new well installed in 2000, which does not appear on the depreciation schedule. The new well is now over a year old. Applying a 30-year depreciation life to the cost of the well ($20,262.02) and a 20-year life to the cost of the pumping equipment ($5,769.44) produces an annual depreciation expense of $963.87. This leaves a net book value of $25,067.59 at December 31, 2001.
Q. Have you recognized this annual depreciation expense of $963.87 in your calculation of the total revenue requirement of $26,706.21?
A. Yes. Depreciation expense is shown on line 35 of Exhibit No. 101.
Q. Mr. Cobott in his letter of May 21, 2002 (Exhibit No. 103) indicated that the land upon which the wells and well houses are located are owned by him personally, not by the water company. He asked that the water company pay rent on this property to him personally in the amount of $300 per month. Have you included a rental allowance for this land in your calculation of the revenue requirement?
A. No. Exhibit No. 104 (Real Estate Contract) indicates the property sold includes “ . . . a water system . . . along with all equipment, deeded well sites, water tank sites, pipe, hydrants, spigots, electrical components, pumps, water tanks, wells, easements & water rights.” It appears to Staff that the real estate Mr. Cobott is referring to is an integral part of the water system dedicated to public service since before its purchase. Moreover, the land appears to have been jointly conveyed with the water company rather than separately conveyed to Mr. Cobott.
Q. Mr. Cobott states in his letter (Exhibit No. 103) “I want the $5,520.00 mortgage expense. I had to mortgage my house to get the money to put in the second well.” Have you included this mortgage expense in the revenue requirement calculation?
A. Not directly. The 12% return of $3,008.11 on the new well investment together with the depreciation expense of $963.67 are provided in lieu of this request. Staff does not know how much money Mr. Cobott borrowed or for what purposes other than the investment in the new well. Disposition of borrowed funds for purposes of other than the water system are irrelevant to this case. Likewise, Staff does not know what the terms of Mr. Cobott’s personal home mortgage are. Staff has treated the water system investment as owner equity capital at a rate of return that is higher than the interest rate normally associated with debt. If indeed Mr. Cobott borrowed money from a bank, it undoubtedly was at a rate less than 12%. In effect, Staff’s approach provides a personal arbitrage benefit to Mr. Cobott where he collects more than his cost on the well investment.
Q. Have you recognized in Exhibit No. 101 any of the expenses requested by Ponderosa?
A. Yes. At line 31 I have added an equipment rental expense allowance of $1,200 per year, on line 32 I have added a property tax allowance of $286.08 and on line 37 I have added an item to recognize the effect of income taxes on the total revenue requirement. The income taxes effect increases the revenue requirement by $838.58 per year.
Q. Has Mr. Cobott, the owner of Ponderosa, indicated that he takes exception to some of the expense allowances reflected on Exhibit No. 101?
A. Yes. Mr. Cobott has on several occasions communicated by both letter and telephone with the Commission and the Commission Staff his disagreement with Staff’s proposed expense allowances. The Commission’s Order No. 29046 issued on May 6, 2002 beginning at page 6 discusses the items to which Mr. Cobott takes exception.
Q. Mr. Cobott also requested a $100 monthly rental allowance for an excavator he owns personally that is located in the service area and used exclusively for water company purposes. You indicated earlier that you included this item in your revenue requirement. Is that correct?
A. Yes, that allowance is shown on line 31 of Exhibit No. 101. Normally such equipment would be included as an investment subject to depreciation and earn a return on the undepreciated balance. Mr. Cobott is unable to provide documentation indicating either ownership or cost of this piece of equipment. Staff Engineer Michael Fuss has observed the equipment and is familiar with construction equipment rental prices. He has indicated this is a reasonable cost to include in the revenue requirement.
Q. Is the $2,400 “Maintenance Reserve” item on line 33 of Exhibit No. 101 a normal allowance approved by the Commission for a small water company?
A. No. Normally a company is expected to retain earnings from its operations to fund replacement costs on its system. Staff’s inclusion of this item for Ponderosa is a departure from the Commission’s normal revenue requirement allowances.
Q. Is this allowance a duplication of the maintenance labor allowances discussed earlier?
A. No.
Q. Why has Staff proposed this reserve?
A. Staff is concerned about the systems available water supply and age. Staff Witness Fuss discusses the water supply concern in his testimony. Staff is concerned that an additional water supply will be necessary in the future and will likely be a very expensive source. Staff is also concerned with the age of the system (approximately 30 years), which may begin to experience an increase in repair and replacement costs. Staff has proposed this reserve to build a fund to meet these costs. If the Commission accepts this proposal, the Company should be instructed to deposit these funds ($200 per month) in an interest bearing account. These funds should be used for no purpose other than to develop new water supplies or make essential repairs to the system. Staff recommends that the Commission designate these funds as contributions in aid of construction. Property added with contributions in aid of construction does not qualify as water company investment entitled to earn a return.
Q. Does this conclude your direct testimony in this proceeding?
A. Yes, it does.

GNR-W-01-1 SMITH (Di) 1
06/07/02 Staff

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