“No Conservation without Compensation”

1. “No Conservation without Compensation” Compensating Consumers for Assuming New Risks When Water Utilities Implement WRAMs Presentation by Terry L. Murray, independent consultant, to NASUCA, June 15, 2010

2. Outline of Presentation • Review how risk is reflected in cost of capital • Evaluate how WRAMs affect the allocation of risk between utilities and consumers • Discuss how the risk shift can be reflected in ratemaking to ensure that consumers are appropriately compensated for assuming new risks

3. The 3Rs: Risk, Reward and Ratemaking • Cost of capital 101: As risk increases, so does the cost of capital and therefore the reasonable rate of return allowed in ratemaking • The principle is enshrined in the Hope and Bluefield decisions that are the touchstone for assessing the reasonableness of cost of capital

4. Sauce for Geese and Ganders • Basic principle rewritten: As risk decreases, so does the utility’s cost of capital and reasonable return • Corollary: S/he who bears the risk should reap the return

5. WRAMs Are Risk-Shifting Mechanisms • The stated purpose of WRAMs is to remove disincentives to conservation by ensuring that utilities’ earnings are unaffected by conservation • Utilities claim WRAMs just offset their added risk due to conservation (e.g., lost sales) • Most WRAM proposals actually go further: they insulate utilities from non-conservation-related risks by, e.g., adjusting for all fluctuations from the rate-case revenue forecast, regardless of the cause.

6. The Bottom Line • Under most WRAMs, the risk of sales fluctuations (and, in some cases, cost variations) shifts from utility shareholders to consumers. • Therefore, shareholders actually bear less risk than they did before conservation measures and WRAMs were implemented and consumers bear more risk. • To restore the balance of risk and reward, the return on equity (i.e., the return to shareholders) must be reduced to compensate consumers.

7. Traditional ROE Methods Are of Little Use in Assessing the Risk Shift • Methods such as the Discounted Cash Flow (“DCF”) use data from publicly traded stocks to establish ROE based on the investor-required return for other companies of “comparable risk” • Few companies have WRAMs. Those that do are typically part of large holding companies where only a part of the company is affected by WRAM or are privately held.

8. Alternate Way of Understanding the ROE Impact of a WRAM • Break down ROE into two components: • “Risk-free” rate of return (which compensates shareholders for the time-value of their money and for interest-rate risk) and • Risk adder (which compensates shareholders for bearing risks above and beyond those associated with a “risk-free” asset such as a U.S. government Treasury bond) • WRAMs affect the second component

9. Quantifying the Pre-existing Risk Adder • The risk adder is simply the authorized ROE minus the return on a “risk-free” asset such as a 20-year Treasury bond • For example, if the authorized ROE is 9% prior to the adoption of the WRAM, the implied risk adder is about 5% (the 9% ROE minus the 20-year T-bond rate of roughly 4%).

10. Quantifying the Effect of Shifting Risk from Shareholders to Consumers • Technically, how much does earnings volatility (broadly, the ups and downs of the utility’s net revenues) change as a result of the WRAM and conservation mechanisms • Practically, how much more does an investment in the utility’s stock look like an investment in a risk-free asset such as a government bond

11. Limited Precedents for ROE Adjustments • No California adjustment yet for WRAM (due to difficulties in quantifying risk), but see D.08-08-030, Conclusion of Law 3 (“Implementation of WRAMs and MCBAs may result in a diminution of shareholder risk relative to ratepayers, other things being equal.”) and D.09-05-019 at 39 (“We find DRA persuasive that the results of the cost of capital models do not reflect the WRAM and MCBA …. It is likely there is some reduction to risk but we cannot rise to the precision of a specific measure of 15, or 25 or 50 basis points.”) • Some states have adopted ROE adjustments for similar energy decoupling mechanisms. Typical range of adjustment: 25-50 basis points (50 basis points each in 12/22/06 Vermont Green Mountain Power decision and 7/17/07 Maryland Order Nos. 81517 and 81518).

12. The Challenge for Consumer Advocates • Analyze and articulate the changes in risk allocation resulting from specific conservation/ WRAM proposals • Ensure that commissions understand the need to compensate consumers for bearing more of the risk of revenue (and possibly cost) fluctuations • Identify persuasive benchmarks (quantitative or qualitative) for the ROE adjustment