MOVING WATER FORWARD NATIONAL ASSOCIATION OF WATER COMPANIES. Water Policy Forum FOR STATE PUBLIC UTILITY COMMISSION STAFF

Transcription

1 MOVING WATER FORWARD NATIONAL ASSOCIATION OF WATER COMPANIES Water Policy Forum FOR STATE PUBLIC UTILITY COMMISSION STAFF Summary Report APRIL 2016

2 National Association of Water Companies 2016 Staff Water Policy Forum SUMMARY REPORT April 2016 National Association of Water Companies 2001 L Street NW Suite 850 Washington, DC Tel: Fax: Prepared by Lila A. Jaber, Shareholder Gunster, Yoakley & Stewart, P.A.

3 TABLE OF CONTENTS I. ACKNOWLEDGEMENTS... 3 II. PREFACE... 4 III. FORUM PARTICIPANTS... 5 IV. THE FUNDAMENTALS OF THE PRIVATE WATER INDUSTRY... 7 A. The Regulatory Compact... 7 B. The Industry is Fragmented... 8 C. Capital Intensive Industry... 8 D. Alternative Regulation E. The National Association of Regulatory Utility Commissioners (NARUC) s Best Practices Resolutions V. ADAPTING REGULATION TO CURRENT CHALLENGES: EMERGING ISSUES...12 A. Aging Infrastructure and Lack of Infrastructure Reliability Future Test Year Implementation of Infrastructure Surcharges B. System Fragmentation C. Water Efficiency and Fixed Cost Recovery Revenue Stabilization Mechanism D. Affordability VI. COMMUNICATING THE VALUE OF WATER...21 A. Customer Engagement Strategy B. Infographics C. Social Media D. Mobile Applications VII. COST OF COMPLIANCE AND STRATEGIES FOR NEW ENVIRONMENTAL REGULATIONS...25 A. Expected Research and Cost Impact of Regulation B. Example of Costs From Environmental Regulations VIII. RATE DESIGN CHALLENGES AND OPPORTUNITIES...29 A. Rate Design B. Alternative Ratemaking Approaches Revenue Stabilization C. Additional Ratemaking Mechanisms and Best Practices IX. Funding Future Investment and the Role of Regulation...34 A. Why Wall Street Likes Water Utilities B. Why Wall Street Fears Water Utilities C. A Balanced Approach is Necessary X. SMALL COMPANY REGULATION: IRON HAND OR KID GLOVES...37 A. Regulatory Challenges for Small Systems B. Best Practices for Small Systems: Recent Developments C. California Consolidation Policy XI. NARUC RESOLUTIONS...40 XII INDIANA LEGISLATION 48 Page 2

4 I. ACKNOWLEDGEMENTS The National Association of Water Companies (NAWC) extends its sincere appreciation to all of the participants and presenters at the NAWC 2016 Staff Water Policy Forum. NAWC wishes to thank National Association of Regulatory Utility Commissioners (NARUC) leadership for the ongoing support of these informative education forums, with special thanks to Chairwoman Karen Montoya (New Mexico) for her welcoming remarks during the Forum. Page 3

5 II. PREFACE The 2016 NAWC Staff Water Policy Forum was held March 30 through April 1, 2016, in Albuquerque, New Mexico. Participants in the Forum represented the water industry, consumer advocates, capital market analysts, and state economic regulators. The NAWC Water Policy Forums promote education and dialogue amongst the industry stakeholders. The Forum provides the industry participants an opportunity to gain perspective from regulators and consumer advocates about a number of issues including the role of consumer education, challenges in regulation, and potential for collaboration. The purpose of the Forum is not to reach consensus amongst the participants, but rather to inform about the challenges and opportunities of the water industry, sharing thoughts and ideas in the form of effective regulatory practices. The purpose is to encourage further best practices in adopting and implementing best practices to positively impact the water industry for the benefit of the consumers they serve. The ultimate goal is that each state adopts or promotes those effective regulatory practices. This report provides a summary of the topics discussed at the Water Policy Forum in hopes that it will facilitate additional discussion on these issues, a greater understanding of the importance of effective regulatory practices, and action by states to implement and apply effective regulatory practices. Page 4

6 III. FORUM PARTICIPANTS Mr. John Albert Subscriber Services Manager Water Research Foundation Mr. Braulio Baez Executive Director Florida Public Service Commission Ms. Nicole Belle Isle Utilities Engineer, Division of Water & Audits California Public Utilities Commission Ms. Tammy Benter Director, Water Utility Regulation Division Public Utility Commission of Texas Mr. Larry Blank Associate Director, Center for Public Utilities New Mexico State University Mr. Shawn Bradford Vice President, Corporate Services EPCOR U.S. Mr. Tom Broderick Director, Utilities Division Arizona Corporation Commission Mr. Bruno Carrara Utility Division Director New Mexico Public Regulation Commission Mr. Joe Gysel President EPCOR U.S. Mr. Jack Hawks Executive Director California Water Association Mr. Jay Hines-Shah General Counsel & Ethics Officer Illinois Commerce Commission Ms. Christine Hoover Senior Assistant Consumer Advocate Pennsylvania Office of Consumer Advocate Mr. Jim Jenkins Vice President, Regulatory & Public Policy American Water Ms. Kim Joyce Manager of Regulatory Affairs Aqua America Mr. Edward Kaufman Chief Technical Advisor Indiana Office of Utility Consumer Counselor Mr. Donald Lomoljo Chair, NARUC Staff Subcommittee on Water Utilities Hearing Officer Public Utilities Commission of Nevada Ms. Karen L. Montoya Vice-Chair New Mexico Public Regulation Commission Ms. Rochelle Phipps Rates Analyst Illinois Commerce Commission Ms. Krystle Sacavage Counsel to Commissioner Robert Powelson Pennsylvania Public Utility Commission Mr. David Springe Executive Director National Association of State Utility Consumer Advocates (NASUCA) Ms. Rebecca Stenholm Director, Public & Government Affairs EPCOR Water Mr. John Tang Vice President, Government Relations & Corp. Communication San Jose Water Company Ms. Cynthia Turiczek Staff Water Division Manager Public Utilities Commission of Nevada Page 5

7 Mr. Richard Verdi Vice President, Equity Research Ladenburg Thalmann & Co., Inc. Mr. Hampton Williams Assistant Staff Counsel Missouri Public Service Commission Ms. Jocelyn Wong Utilities Engineer, Division of Water & Audits California Public Utilities Commission NAWC Staff Mr. Michael Deane Executive Director Ms. Grace Soderberg Director of State Regulatory Relations Moderator Ms. Lila A. Jaber Practice Leader-Government Affairs Gunster Yoakley & Stewart, P.A. Ms. Nicki Garcia Office Manager & Assistant to Lila Jaber Gunster Yoakley & Stewart, P.A. Page 6

8 IV. THE FUNDAMENTALS OF THE PRIVATE WATER INDUSTRY A necessity of life, water is the only utility service that is physically ingested, making it unique from electric and natural gas, for example. There is no substitute for water. Therefore, regardless of cost, water service provided by a utility company must be safe to consume. Not only is the water subject to increasingly stringent standards of quality by regulators, but customers demand a high level of reliability. In this overview, Kimberly Joyce, with Aqua America, provides insight into the fundamentals of the private water industry. The essential nature of water service is intrinsically related to quality and reliability. As water plays a critical role in health, sanitation, and fire protection, the adequate delivery of water is a 24-hour, 7-days per week customer demand. The discussion that follows outlines the fundamentals of water from the importance of quality of service to the requirement of cost recovery. In that regard, this discussion must begin with the fundamentals of regulation still applicable and relevant today. A. The Regulatory Compact The need to reconcile or balance the competing interests of the consuming public and investor-owned utilities is known as The Regulatory Compact. Companies Deliver safe and reliable service Consumer Advocates Represent interests of the public for quality and cost Commissions Balance: Appropriate service quality Reasonable rates Financial health of the utility A fair return authorized and a fair opportunity to earn it A fair return authorized and a fair opportunity to earn it The Regulatory Compact is well-articulated in case law and state commission regulations. Utilities should be able to rely on consistent effective ratemaking to achieve adequate capital and consumers are protected by regulators who ensure utilities provide essential services at just, fair, and reasonable rates. This Regulatory Compact remains in place today. Simply stated by Forum Participant Joyce, a fair return should be allowed, as should the opportunity to earn it, so the industry has the ability to attract capital. By the same token, the industry should ensure a long-term quality water supply Page 7

9 to existing and new customers by maintaining and replacing aging infrastructure. The industry should also comply with quality water standards and extend water service to those who need it. 1 the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and attract capital. 2 B. The Industry is Fragmented The private water industry is a fragmented industry. With more than 52,000 community water systems in operation and 83% of the water systems serving less than 3,300 people, Forum Participant Joyce notes there are too many water systems, that they are too small, and too inefficient. Compare, for example, there are 1,200 and 3,000 natural gas and electric companies, respectively. As further demonstration of fragmentation, less than 1% of the water systems serve more than 100,000 people and over 80% of the market share is controlled by the government. Compared to some other utility industries, the water industry is the only utility that has not been deregulated. In fact, the water industry is heavily regulated by environmental and economic regulators. Contrary to the belief that water is free or not expensive to provide, the water industry is a rising cost industry with high capital needs, the longest capital recovery period, and declining per capita revenue. These factors contribute to the industry s negative cash flow making the industry less attractive to investors. C. Capital Intensive Industry According to the United States Environmental Protection Agency (EPA), it is now estimated that $384.2 billion are needed over the next 20 years for water infrastructurerelated expenses. 3 This cost does not include dollars associated with wastewater improvements. The cost drivers and risk considerations include: 8 1. Infrastructure replacement needs (supply, treatment, and distribution); 2. Increasingly stringent Safe Drinking Water Act (SDWA) requirements (e.g., the recent change in disinfection byproducts); 3. Increasing testing sensitivity; 4. Tort liability; 5. Rising costs of production; 1 See, Federal Power Commission et al v. Hope Natural Gas Co., 320 U.S. 591 (1944) and Bluefield Waterworks & Improvement Co. v. Public Service Commission of the State of West Virginia et al, 262 U.S. 679 (1923). 2 Hope at EPA Drinking Water Infrastructure Needs Survey and Assessment, Fifth Report to Congress, April Page 8

10 6. Declining per capita revenue partly because conservation efforts are working; 7. Growth-related needs; 8. Pressure on critical water supplies; 9. Rising security concerns (physical and cyber); and 10. Structural anomalies that cause regulatory lag. The chart below demonstrates the difference between the regulated industries as it relates to capital investment and recovery. As one can see, water utilities require more capital invested per dollar of revenue than any other regulated industry. To complicate the economics further, thus making it more difficult to attract capital, the water industry has the lowest depreciation rates. These characteristics negatively influence the industry s ability to attract capital, because low depreciation rates and long recovery periods are viewed negatively by capital market analysts. 9 Lowest Depreciation Rates Page 9

11 D. Alternative Regulation As noted by Forum Participant Joyce, many states have some form of alternative regulation for electric and/or gas. Alternative regulation mechanisms in those industries include cost trackers, multiyear plans, revenue decoupling, formula rates, and forward looking test years. By comparison, in water, only some state commissions have adopted forms of alternative regulation. Forum Participant Joyce and NAWC believe that state commissions should consider additional forms of alternative regulation. For example, the water industry has had some level of success with the distribution system infrastructure surcharge mechanisms or DSIC, yet it has not been implemented by all states. One or more states have implemented the other NARUC Best Practices. E. The National Association of Regulatory Utility Commissioners (NARUC) s Best Practices Resolutions As stated earlier, the purpose of the Water Policy Forum is to bring stakeholders together to share effective regulatory practices with one another. Indeed, it is the hope of NAWC and its member companies that the Forum discussion encourages state commissions to take action in implementing effective regulatory practices that enhance returns to promote and facilitate capital for necessary improvements. Several important regulatory tools are increasingly used by regulators to address the previously discussed unique needs of the regulated water industry. NARUC has long recognized a leadership role for it to promote regulatory practices and facilitate the use of effective regulatory practices. In July 27, 2005, the NARUC Board of Directors passed a Resolution, sponsored by the NARUC Water Committee, supporting consideration of those regulatory policies considered to be Best Practices. The Resolution identified many of the practices discussed in this Summary Report (DSIC, the use of future and/or hybrid test years, interim rates, pass through mechanisms, cost recovery clauses, and wise use water policies). In encouraging the implementation of effective regulatory practices, NARUC has adopted additional resolutions that address: effective practices for small systems and the widening gap between approved and actual returns on equity. 10 Copies of these resolutions are attached and are also available on the NAWC website: Some will be discussed in greater detail below. Participant Reaction As mentioned previously, the challenges of infrastructure replacement and compliance with both the Safe Drinking Water and Clean Water Acts are increasing. Forum Participant Joyce noted there are added challenges to the industry from: 1) increased tort liability with a growing number of class action suits; 2) rising costs of operation and production (labor, power, chemicals, and taxes); 3) declining per capita revenue because conservation efforts are working; 4) increased pressure on critical water Page 10

12 supplies; 5) rising security concerns with the addition of cybersecurity issues; and 6) increased regulatory lag. If these challenges are to be met in a cost effective manner, it is incumbent upon utilities and their regulators to identify and implement, as appropriate, regulatory practices designed to facilitate capital attraction, economies of scale, and efficient operations. Major capital investment and rising costs of water will lead to more rate cases and greater need for efficiency. Forum Participant Joyce noted that single tariff pricing is a best practice that allows costs to be spread among a larger group of customers recognizing the public interest of overall system improvements and efficiencies. One positive consequence is fewer rate cases mitigating costs to the consumer. Participants recognized that communicating the value of water will continue to be critical to resolve many of the issues discussed herein. As Forum Participant Joyce noted, many have reached the conclusion that regulatory and structural changes can help assure quality service at a reasonable price. Regulatory practices and policies, the regulatory compact, and a competitive capital market all influence the ability to attract capital on reasonable terms. 11 Page 11

13 V. ADAPTING REGULATION TO CURRENT CHALLENGES: EMERGING ISSUES As previously mentioned, the water industry faces challenges and opportunities associated with aging infrastructure, limited water supply, and the need to maintain water quality. Additionally, declining water usage and the interrelationship between energy-water needs create challenges to revenue growth. With that said industry participants believe opportunities exist to implement additional alternative rate mechanisms that allow the water systems to be maintained and further developed to meet these challenges. It is these pressures and opportunities creating recent trends in ratemaking. Forum Participant Jenkins began this discussion outlining some of the recent trends in ratemaking. Consumer Advocate Christine Hoover also provides insight into this conversation later in this section. Finally, Arizona Forum Participant Broderick provided an update to issues facing the Arizona industry and the regulators. A. Aging Infrastructure and Lack of Infrastructure Reliability The American Society of Civil Engineers gave a D grade to the water industry in their 2013 Report Card and estimates replacing infrastructure will cost $1 trillion over 25 years. The EPA estimated that $384 billion of new capital over the next 20 years will be needed just to keep the water systems operating. Therefore, there is a tremendous need for infrastructure investment. The chart below demonstrates only the anticipated cost for water main replacement, reflected by Mr. Jenkins as a national total by region. The needs are greater over the years as are the costs. With an industry focused on placing the customer at the center of everything it does, quoting Forum Participant Jenkins, cost recovery requires innovative alternative ratemaking to ensure all infrastructure needs can be met, allowing quality service to the consumer. 12 Page 12

14 For companies like American Water, the lack of regulatory mechanisms that provide timely cost recovery for infrastructure replacement can be a real issue in addressing infrastructure needs. Notably, states like Pennsylvania, with early adoption of DSIC, have afforded companies an opportunity to timely address infrastructure replacement. As the chart above reflects, American Water has shortened its pipe replacement life as a consequence of these policies. Current mechanisms have incentivized companies like American Water to get below the national average, but some companies are still replacing pipe over 150 years. This notwithstanding, there is more work to do. The chart below demonstrates the mechanisms that have been created and permitted in all industries. Compared to the electric and gas sectors, the water sector is far behind in terms of regulatory mechanisms Alternative Regulation and Ratemaking Approaches for Water Companies: Supporting the Capital Investment Needs of the 21 st Century, Prepared by the Brattle Group for the National Association of Water Companies. Page 13

15 Recognizing challenges faced by the water industry, NAWC has sought to close the Return on Equity (ROE) gap, reduce regulatory lag, and promote consistent cost recovery. In doing so, in some states, the industry proposed, and some regulators have implemented, alternative regulation methods to supplement traditional cost of service regulation. To capture as many of the alternative regulatory approaches as possible, NAWC requested The Brattle Group (Brattle) research that information and prepare a report of alternative regulation used across all industries. 5 As the map below indicates, 44 states have some form of regulation of private water companies. In the traditional regulatory approach for setting prices -- cost of service regulation -- rates are established by the regulatory commission generally in rate cases. Regulatory lag can occur between those rate cases unless rates are forward looking. Rate cases are detailed and time intensive, lasting between six to twelve months. Regulatory lag can be measured as the number of months between the last month of the test period for which the data used in the general rate case was collected, and the first month that the new rates actually go into effect. Consequently, if a utility investing substantially in new infrastructure has increasing 14 expenses, a longer regulatory lag makes it difficult to recover costs and earn the allowed rate of return. The ability of a utility to earn the allowed rate of return involves a balance between growth in billing units, cost inflation, and increase in productivity. The Brattle Report notes that today s traditional cost of service regulation is not well designed to meet the future needs of the water industry. 6 Alternative regulation comprises a variety of techniques for adjusting rates that: 1) support specific investment and depreciation expenses and costs; 2) reduce earnings volatility and attrition; and 3) supplement revenues lost to conservation and efficiency efforts. The principles of 5 Alternative Regulation and Ratemaking Approaches for Water Companies: Supporting the Capital Investment Needs of the 21 st Century, Prepared by the Brattle Group for the National Association of Water Companies. 6 Brattle Report at p. 1. Page 14

16 alternative regulation appropriately recognize that six to twelve-month long rate cases can lead to earning attrition and that some costs are outside the control of management. There are a variety of alternative regulatory policies that have been developed to phasein rate increases, assist utilities in meeting financial obligations, and reduce the regulatory burden. In its Report, Brattle addresses three classes of alternative mechanisms: 1. Revenue stabilization mechanisms; 2. Comprehensive regulatory approaches that establish rates outside the single general rate cases; and 3. Specific techniques for capital investment like the DSIC or Construction Work in Progress (CWIP) or riders. Forum Participant Jenkins addresses some of these alternative mechanisms (effective regulatory solutions) in greater detail below. 1. Future Test Year American Water implemented the future test year in a majority of the states in which it operates. Forum Participant Jenkins believes the use of a future test year more accurately estimates expenses, revenues, and capital additions to the 12-month period. His company is able to more appropriately address water usage, revenue and cost trends using a future test year, thereby resulting in less rate case filings. From a regulatory and public policy perspective, the selection of a test year should be determined by whether the test year will produce rates that are prospectively relevant; that is, the rates most accurately reflect the costs during the period the rates are most likely to be effective. In a rising cost industry with heavy capital investment requirements, the use of historic test years assures there will be no return on or recovery of capital that is invested during the test year and thereafter, until the utility files another rate case. 15 This practice discourages necessary investment during these periods and skews construction and investment timing based on artificial test year issues rather than system needs and efficient construction planning processes. Therefore, states like Pennsylvania and Florida have allowed the use of fully projected future test years. Proponents of fully projected future test years believe they ensure that a utility s rates and costs match the first year new rates in effect. Relying on fully projected future test years reduces regulatory lag and encourages fewer rate case filings, saving utilities and customers millions of dollars in rate case expense. As can be seen from the maps below, which are included in the Brattle Report, there are a considerable number of states that rely on a future test year. In addition, some states use a hybrid test year. 7 7 Arkansas, Colorado, Delaware, District of Columbia, Idaho, Illinois, Kentucky, Louisiana, Maryland, Mississippi, Missouri, New Jersey, New Mexico, North Dakota, Ohio, Pennsylvania, Utah, and Wyoming. Page 15

17 2. Implementation of Infrastructure Surcharges American Water s DSIC program has been implemented in multiple states and has wide-spread customer acceptance. The benefits have included economic growth (job creation), significant progress in replacing aging infrastructure, enhanced service quality, reduction of water lost through leaks, and avoidance of rate shock. American Water supports expansion of the DSIC into the wastewater sector as well. First implemented in 1996 in Pennsylvania, the DSIC, an infrastructure surcharge initially just used for water companies, is effective in promoting more timely recovery of capital; and therefore, facilitates capital attraction and investment in the industry. Eliminating the need for a full general rate proceeding and regulatory lag, utilities use these surcharges as programs to pass through to customers the revenue requirement associated with a return on (rate of return) and return of (depreciation expense) capital invested to replace water and wastewater infrastructure. DSIC programs differ from state to state. However, common elements include allowing the utility to begin earning a return on necessary infrastructure replacement outside of a general rate proceeding coupled with limits on the surcharges and some form of reconciliation procedures to protect ratepayers. Pennsylvania has extended the use of the DSIC mechanism to wastewater, gas, and electric companies. 16 B. System Fragmentation As stated in the previous section, the water industry reflects much fragmentation with many small systems and a growing need for infrastructure improvement. Not many of the small water companies can address the challenges of a rising cost industry in a way that meets the needs of the customers and yet results in a reasonable rate. As such, some states have adopted system consolidation policies to promote consolidation or acquisition by a larger water company. For example, a best practice state, Pennsylvania, adopted an acquisition adjustment policy that encourages acquisitions of small and/or troubled water facilities. Mr. Jenkins suggests an effective consolidation/acquisition policy will promote that the sale price be recongized in rate base and consider an acquisition incentive and/or ROE adder for the acquiring Page 16

18 company. These policies recognize the investment that must take place to make the necessary infrastrucuture upgrades to a troubled facility. C. Water Efficiency and Fixed Cost Recovery Among the greatest challenges facing the water industry today is the need to implement sustainable conservation programs without negatively impacting the financial viability of the utility. The water industry has been forced to make the shift towards promoting water use efficiency as population growth, drought, and environmental concerns impact water supply availability. Increased conservation efforts coupled with declining sales can lead to negative impacts on revenue. Revenue stability is a constant concern for water utilities, who must balance fair and equitable rate structures against the need to cover increasing infrastructure and supply costs. As demand lowers, the difficulty in covering fixed costs increases, and, short of innovative revenue recovery mechanisms, utilities may not meet their revenue requirement. 1. Revenue Stabilization Mechanism Between rate cases, revenue stabilization mechanisms can be used to adjust base revenues without addressing costs. Examples of revenue stabilization mechanisms include conservation adjustments or decoupling. Revenue decoupling is a rate adjustment mechanism that separates (or decouples ) a utility cost recovery from the amount of water it sells. Mr. Jenkins notes that customers should be rewarded for using water efficiently. This practice would establish a regulatory climate aligning the utility s interests with the State s interest in water efficiency it is a win/win in his opinion. Decoupling removes the utility s incentive to promote sales, allowing management to refocus on least-cost investment decisions. Other benefits of decoupling include: a better alignment between revenue recovery and corresponding costs, less frequent and less contentious rate cases, and better forecasting of revenues and declining consumption. D. Affordability 17 Mr. Jenkins notes that the price of water has increased by 6% in 30 major U.S. cities in For water, wastewater, and storm water combined, American Water notes a 41% increase since Even though water and wastewater bills have become an affordability issue for some customers, it is noteworthy that water remains about a penny per gallon, indicating that water remains underpriced and undervalued. The historic underpricing of water is largely due to a perception that water is free. Of course, the infrastructure required to treat and deliver clean water to the home is not free. The product of water costs less than other utility services and, for example, a consumer spends less per year on the service than for a soft drink. To fully analyze the affordability concern, we must fully appreciate that it costs significantly less to maintain and enhance an existing system than it does to build or replace one. Therefore, American Water encourages stakeholders to employ a total water management strategy Page 17

19 to better use resources in tightening economic conditions, population growth, aging infrastructure, and climate variability. To assist with concerns over the affordability of water, American Water has implemented affordability programs or Low Income Assistance Options. A Consumer Advocate s Perspective Forum Participant Christine Hoover provided insight into the positions and concerns of consumer advocates on a number of regulatory practices. Ultimately, Ms. Hoover s position is that traditional ratebase or rate of return regulation works sufficiently and serves as an appropriate balance of utility and consumer interests. She is a strong believer in rate cases, as she believes the regulator and the consumer advocate are afforded an opportunity to review all of the components of a company s rates and rate request. In her view, it is positive that utilities are afforded the opportunity to demonstrate that cost recovery is necessary and the hearing process allows for a testing of the evidence and participation by all stakeholders. She opined that departures from the traditional ratemaking process will disassemble the ratemaking process and result in ineffective, single issue ratemaking. In addition, she believes that because alternative ratemaking does not involve the same level of review, it could create less accountability for the utility and therefore, a greater risk for consumers. As it relates to consolidation, Forum Participant Hoover agrees that in some cases, consolidation can resolve problems with troubled systems. A new owner can address quality of service issues, managerial issues, and financial issues. Consolidated systems can lend themselves to the implementation of single tariff pricing as well. Forum Participant Hoover notes the use of single tariff pricing in Pennsylvania has allowed that state to address a number of troubled system issues. While it is not a view supported by all, there have been some clear benefits in that state from single tariff pricing and she cautions regulators must ensure appropriate consumer safeguards are in place. Forum Participant Hoover 18 raised concerns about the Pennsylvania Legislature s approval to combine water and wastewater revenues in order to calculate rates for those utilities that serve both water and wastewater customers. She believes the combination of these revenues could create a subsidy program whereby the water customers subsidize wastewater customers. While proponents believe this regulatory approach benefits all customers in the long-run, Ms. Hoover believes this practice is flawed on a number of levels. It will be confusing to the customer, and care needs to be given to what adequate notice looks like. Second, no one can deny there are subsidies between customers; and finally, no one can completely identify the primary driver of cost. As it relates to DSIC, consumer advocates generally believe infrastructure costs should be reviewed in a traditional full-blown rate case setting. Ms. Hoover does not necessarily believe the DSIC mechanism results in a reduction in the frequency of rate Page 18

20 cases. Moreover, she believes the DSIC does not result in adequate oversight of utility expenditures, but rather the review of expenditures is an after the fact single issue review. Additionally, she believes that the Commission should reduce ROE to reflect the reduced risk that comes along with the DSIC implementation. With regard to using a fully projected test year in the development of rates, Ms. Hoover believes additional regulations are needed to provide guidance and fully establish the information needed for implementation and a better understanding of how the information will be relied upon. She believes a fully projected future test year is too speculative and will not result in streamlining rate cases. A Regulator s Perspective Arizona Arizona has a long history of confronting its water supply challenges. The state has demonstrated its resolve to take actions needed to ensure long-term sufficient and dependable water supply. To address system sustainability and resource planning for long-term reliability, Arizona implemented a strategic vision to build on historic accomplishments. In past Forums, we learned that the Strategic Vision included: 1. The Salt River Project; 2. The Colorado River Compact and Law of the River; 3. The Central Arizona Project; 4. The Resolution of Tribal Water Rights Claims; 5. The 1980 Groundwater Management Act making Arizona a national leader in water conservation and water reuse programs within the five Active Management Areas; and 6. The creation of the Arizona Water Banking Authority with 8.5 million acre-feet in storage for future use. 19 From an economic regulation perspective, the Arizona Commission has a critical role to promote rate structures that facilitate conservation and to encourage best management practices. A system infrastructure benefit (SIB) mechanism that had been implemented to foster infrastructure replacement and development has recently been overturned by the appellate court. Other effective regulatory changes in Arizona include a reclassification of smaller water companies so more companies can take advantage for a streamlined rate application process. Now, for example, Class D and E companies can use a streamlined rate application filing that results in fewer schedules and no hearing. This process lends itself to a shorter timeframe for approval 120 days versus 270 days for a full rate case. Page 19

21 Participant Reaction In emphasizing many of the points made by the presenters, the Forum Participants noted the recent tragic issues in Flint, Michigan, and quality of water public health concerns raised there; and, while this was not an example of a privately held company, the Participants noted the importance of quality service, infrastructure investment, and effective communication. As it relates to the discussion on acquisition policies, Forum Participant Kaufman noted the recent legislation passed to create a utility acquisition program in Indiana to encourage the acquisition of distressed utilities. Act No. 257 was passed March 2016 by the General Assembly of the State of Indiana. The Legislation generally encourages the acquisition of troubled water companies by valuing all property actually used and useful at its fair value. To further the policy, regulators are given the authority to give weight and consideration to the reasonable cost of bringing the property into compliance. The Indiana legislation is attached to this Report. 20 Page 20

22 VI. COMMUNICATING THE VALUE OF WATER All Forum Participants note that effective communication with consumers, regulators, consumer advocates, and public officials, is a best practice. Two companies were asked to highlight best practices in this area: John Tang and Rebecca Stenholm with San Jose Water Company and EPCOR Water, respectively. Forum Participant Tang noted the shift from thinking about this issue as a need to educate the consumer. Instead, recognizing the customer is a stakeholder and partner critical to understanding the value of water. His company prefers to think about the communications strategy as a responsibility to engage and inform the customer and other stakeholders, viewing it from that perspective promotes collaboration and inclusiveness. For context, California-based San Jose has 230,000 connections, 90% residential and 10% commercial and industrial. With multiple sources of supply, San Jose has 113 production wells, 96 storage facilities, 2,400 miles of mains, 6,230 acres of watershed property, and 2 surface water treatment plants. In Arizona and New Mexico, EPCOR serves 350,000 people (203,000 connections) in 22 communities over 7 counties. With systems this size, both companies point to the challenges faced in the provision of service, necessitating a greater need to enhance communications strategy. For example, Forum Participant Tang notes three things in particular that drive the need to communicate effectively: 1) an aging infrastructure system with increasing need for investments; 2) higher percentage annual rate increases associated with increased water supply and compliance costs exacerbated by drought; and 3) customer pushback when rate recovery is sought. Forum Participant Stenholm agrees there is a large industry challenge associated with addressing infrastructure needs and the expectation to provide high quality low cost water. She adds that there are two additional challenges stemming from conservation and impacts from weather (climate change, severe long lasting droughts, and quality/quantity of aquifers. 21 With that said, both presenters discussed the opportunities that companies have found to communicate with the customer base and other stakeholders. For example, San Jose has leveraged technology and worked to build coalitions (ASCE, AWWA, and NAWC) to more effectively and proactively deliver a far reaching message promoting the value of water. In effect, they have worked together with the strategic allies to change the narrative. Both companies have multi-level approaches to engage the customer. EPCOR, for example, uses all of the strategies reflected in the diagram below. A couple of them are further highlighted in this section. Page 21

23 A. Customer Engagement Strategy B. Infographics Infographics can be used to communicate and inform consumers about all issues. Infographics that are colorful, bright, and eye-catching, can be effectively used to capture attention and maximize customer engagement. The example below used by Forum Participant Tang is just one infographic demonstrating the cost of water as it relates to other consumer items. 22 Page 22

24 This next infographic illustrates using a $1 bill, what portion is attributed to various costs. Both diagrams are examples of visual communication to further inform that water continues to be affordable compared to other industries, even though it is a rising cost industry. Forum Participants note the difficulty, yet the importance, of communicating the rate case process and the purpose of a rate case to consumers. It was generally noted that communicating this in the middle of the rate case is not the most effective. EPCOR has developed an infographic to assist in this effort. 23 In this one-page infographic, EPCOR explains how rates are set outlining the process and the timeframes. Forum Participants commented on the simplicity and effectiveness of this diagram. Forum Participant Stenholm noted that the company uses this on many levels to assist with its communication strategy. Page 23

25 C. Social Media With so many customers on social media, the industry has begun to use Facebook and Twitter, for example, as a mode of communication. Companies use social media to communicate outages and storm-related issues. Website and social media can also carry information videos to further inform the customer. Moreover, social media has assisted with establishing thought leadership amongst the industry and the consumer. D. Mobile Applications As seen on Ms. Stenholm s Customer Engagement Strategy chart above, companies are utilizing mobile applications to inform customers on a number of different issues. Another company, Aqua America, uses a mobile application to inform about ways to conserve water. Their WaterSmart mobile application also includes infographics that tell the story and educate the customer using easy to follow charts and pictures. Participant Reaction Effective customer communication is a best practice. The presenters emphasized the importance of providing useful information in a manner that is easy to understand and implement. Forum Participant Stenholm notes that communities are diverse and therefore how each company chooses to communicate may differ, but the commonality is that companies strive to have consistent, frequent communication such that the customer does not hear from the company for the first time when a rate increase is sought. Forum Participant and Consumer Advocate Kaufman expressed a concern that consumers might misunderstand and think that rates will be charged based upon some sort of finding of value as opposed to a rate process determining prudent costs. It was explained and further discussed that value of water has been used effectively, in recent years, as another way to explain the cost of service in terms relatable to other industries. Forum Participant 24 Deane noted NAWC and the industry have received positive results in industry-led value of water campaigns. Page 24

26 VII. COST OF COMPLIANCE AND STRATEGIES FOR NEW ENVIRONMENTAL REGULATIONS The Water Research Foundation is a cooperative that sponsors research and communicates its findings to over 1,000 subscribers. Incorporated in 1966, the Water Research Foundation was launched by leaders from the American Water Works Association. John Albert with the Water Research Foundation addressed the Forum. Regulatory History The 1974 Safe Drinking Water Act (SDWA) established the federal standard-setting process and in 1986, the EPA established a prescriptive rate schedule. The 1996 SDWA amendments require the EPA to publish a list of unregulated contaminants that may require regulation and are known or anticipated to occur in public water supplies. Nineteen (19) regulations for 91 contaminants have been put in place from Nine (9) were implemented prior to the 1996 SDWA amendments and ten (10) after the 1996 SDWA amendments. The chart below indicates the additional regulatory activity on EPA s horizon. 25 The complexity of this chart provides a small sense of what water utilities might have to address in the years ahead. The chart only highlights the SDWA implications and does not include Clean Water Act requirements and/or proceedings. Environmental regulations, which must be implemented by the industry, have a cost to the industry 8 According to the Water Research Foundation, the total national cost of the 19 regulations is $4.6 billion per year. Page 25

27 that is ultimately borne by the ratepayers. In that regard, state commissions have to take these considerations into account in establishing rates for utilities. A. Expected Research and Cost Impact of Regulation The Water Research Foundation has begun more extensive research on the costs of the existing environmental regulations. As discussed in greater detail below, Mr. Albert shared the cost information known to date with the Forum. The EPA does collect data and make a Regulatory Impact Assessments (RIAs) prior to its implementation of regulations. The EPA presents a detailed study of the quantified and unquantified benefits and costs of a national regulation at multiple maximum containment levels (MCLs), or regulatory alternatives. Information such as the occurrence, treatment options, and health risks are explained and used to estimate the number of systems out of compliance, population exposed, and number of cases or fatalities avoided. This document is then used to assist EPA in deciding on a final regulation to promulgate a Federal Register notice of final rules. The EPA uses occurrence data to determine the population exposed to a contaminant and the corresponding cases of illness and death, attributed to the exposure. The subsequent population with reduced exposure, and cases of illness and death avoided, as a result of water systems complying with a regulatory limit is also estimated. The USEPA valuates the cases of illness and deaths avoided as the quantified benefits of a regulation. B. Example of Costs From Environmental Regulations The cost to implement significant environmental regulations is always a concern and consideration for the industry and for regulators who have to approve these costs to be borne by the ratepayers. A significant regulatory action is considered a regulation that imposes an annual cost to the economy of $100 million or more at the time of promulgation. Forum Participant Albert shared what some of these costs can be. In 1991, one of the most expensive regulations, the Lead and Copper Rule (LCR), was promulgated. That regulation cost $19 billion to implement. It required an extensive new monitoring program for all systems and the installation of corrosion control treatment at 40,000 treatment plants. 26 Page 26

28 Forum Participant Albert noted that the Lead and Copper Rule Long-Term Revisions will likely address: 1. Partial Lead Service Line Replacement; 2. Optimized corrosion control and water quality parameters; 3. Changes in sample site selection criteria; 4. Changes in sampling protocol; and 5. Tap sampling and sampling protocol issues. The national cost implications are too difficult to assess due to the breadth and depth of the issues being discussed. No one is sure of the ultimate resolution(s) or what the proposed revisions will be. With all of the issues, EPA has organized a stakeholder approach to discuss the broad range of issues being addressed and the potential recommendations. The Surface Water Treatment Rule (SWTR), another expensive regulation, resulted in the construction of several hundred filtration plants for previously unfiltered surface water systems. Surface systems are generally larger than ground water systems, which lead to a high national compliance cost. The Disinfection ByProduct Rule (S1DBPR) simultaneously tightened the DBP standards, as well as required compliance for systems serving less than 10,000 people that were not previously covered by the 1989 Total Trihalomethane (TTHM) Rule. Eight (8) out of 19 regulations, encompassing approximately 88 percent of the total costs of all drinking water regulations, are due to economically significant regulations. 27 As the chart reflects below, three of the significant regulations alone (SWTR, LCR, and S1DBPR) account for 64 percent of the costs, all three of which were promulgated prior to the 1996 SDWA amendments. Page 27

29 EPA has additional proceedings on the horizon. C. Current Regulatory Schedule In 2016 and beyond, Mr. Albert notes that EPA will have the cyclical reviews again, the second round of LT2 monitoring, and the third six-year review. The chart below is a timeline of what can be expected. 28 Page 28

30 VIII. RATE DESIGN CHALLENGES AND OPPORTUNITIES Forum Participant Shawn Bradford introduced this discussion and presented best practices in rate design. As discussed previously, water is a rising cost industry. In addition, the challenges of infrastructure replacement and compliance with environmental-related mandates only add to the cost components. These circumstances require companies and regulators to consider and implement alternative ratemaking and innovative rate design mechanisms such that the ratepayer does not experience frequent rate cases and/or rate shock. EPCOR Water, as previously stated, operates in Arizona and New Mexico. EPCOR faces the additional challenge of drought conditions in those states as reflected in the U.S. Drought Monitor shown below. The question Forum Participant Bradford poses is: is this the new normal? From this perspective, EPCOR has to plan as if this is the new normal. Ongoing water shortages 29 indicate the trend will likely continue. The companies have entered into an era of declining demand (due in large part to successful conservation efforts and more efficient appliances) and rising costs. In spite of these conditions, the industry must move forward in replacing aging infrastructure and making further investment to meet the customer demands and ensure no disruption to source water supplies. Simply stated, revenue stability is critical. Recovery of costs must include operating, maintenance, and capital requirements not only for the day-to-day basis, but for situations of uncertainty or adversity. A. Rate Design Effective rate design reflects striking a balance. Companies and regulators have to prioritize and balance objectives. The utility, working in conjunction with its customers and regulators, must decide on objectives. They must design rate structure that reflects Page 29

31 those priorities. In this regard, Forum Participant Bradford believes the priorities should be to: 1. Recover the cost of service and ensure fairness; 2. Maintain a balanced structure; 3. Address affordability; 4. Address revenue stability and timely revenue recovery; 5. Capture fixed cost recovery; and 6. Promote efficient use of resources. In keeping with these priorities, Forum Participant Bradford outlines two scenarios below and illustrates that a more balanced pricing model is more effective. Today more often than not, a prevalent pricing model relies on: 1. Inclining block rates; 2. A modest base charge; and 3. A large variable charge. Recovery of fixed costs is only realized if projections are met or exceeded. Notably, a decline in sales (due to drought conditions or weather-related events) does not always mean a reduction in utility costs. There are challenges with this kind of pricing model. Utilities with a majority of revenue in variable charges struggle to recover costs. In reacting to the under recovery, companies may raise the variable component to meet a shortfall, but that increases the revenue vulnerability. Mr. Bradford calls this phenomenon the conservation conundrum. The graph below demonstrates what this looks like in a real-world scenario. 30 Page 30

32 Mr. Bradford notes this example demonstrates the lack of balance in the approved rate. There is a disproportionate amount of revenue placed in the upper tiers making the likelihood of under recovery high. He noted there are other more balanced approaches, which he outlines below in the comparison charts. Balanced Pricing Model In Forum Participant Bradford s examples above, the rate approved is balanced and reflects appropriate consideration of fixed and variable costs. There is a proportionate amount of revenue spread across all tiers. B. Alternative Ratemaking Approaches 1. Revenue Stabilization 31 As mentioned in a previous section of this Report, revenue stabilization mechanisms can be used to adjust base revenues without addressing costs (alternative ratemaking between rate cases and not as comprehensive as rate cases). Examples of revenue stabilization mechanisms include conservation adjustments or decoupling. Revenue decoupling is a rate adjustment mechanism that separates (or decouples ) a utility s revenue from the amount of water it sells. States that have implemented decoupling in water include California, New York, Maine, Connecticut, and Nevada. A Water Revenue Adjustment Mechanism or (WRAM) is designed to track the difference between authorized and actual revenue to ensure recovery of fixed costs. Page 31

33 Revenue Stabilization In these examples, the rates are set to recover all or a large proportion of fixed costs (70-90%) and the volumetric charges largely recover the variable costs. C. Additional Ratemaking Mechanisms and Best Practices Consistent with the discussion regarding best practices identified by NARUC and the industry, Forum Participant Bradford notes consistent implementation of a number of best practices will assist with timely cost recovery, infrastructure investment, and access to capital. Some of the best practices used in his region include: 1. Expense adjustor mechanisms or riders to pass through taxes, water resources, electricity costs, franchise fees, and healthcare expenses; 2. Defined timeframes for rate cases to reduce regulatory lag; DSIC (discussed in greater detail earlier); and 4. Implementation of a forward-looking test year to help mitigate impact on rate of return. In the area of customer assistance and price mitigation, best practices include affordability options via low income tariffs, single tariff pricing, and acquisition adjustment policies. Participant Reaction Forum Participant Bradford emphasizes rate design is not a one size fits all approach. In his opinion, rate levels matter more than the rate structure selected. Prices that are Page 32

34 artificially low or ignore key components of fixed cost send inaccurate signals. Correctly, different rate structures target specific types of water use and he notes that the overall price level is influential on customer demand. This makes informing consumers about the challenges in the industry and the value of water that much more important. Rate awareness is critical. The process and the outcome are better when customers and stakeholders have a better understanding of pricing levels and water use. Everyone benefits from a greater exchange of information and lessons learned. 33 Page 33

35 IX. Funding Future Investment and the Role of Regulation Richard Verdi with Ladenburg Thalmann presented to the Forum. According to the World Federation of Exchanges, the worldwide equity capitalization is approximately $70 trillion. The global utility sector is about $2.5 trillion. Therefore, utility stocks appeal to only certain investors. With that said, these investors have choices and therefore, utility stocks must compete for capital with other income generating equities, such as master limited partnerships, real estate investment trusts, and telecommunications. Certain developments and conditions in the water industry have resulted in some gravitation to the water industry by Wall Street. With 2.5 billion people at risk because of non-sustainable water use, Mr. Verdi believes demand for water will overshoot supply by 40% and half of the world s population will be living under conditions of water stress. These factors are triggering significant spending in the water space. Moreover, there are currently more than 50,000 municipal water systems and they have capital investment needs and/or are taking part in various consolidation efforts. Just these reasons alone explain some of Wall Street s attraction to water utilities. But there are additional reasons. A. Why Wall Street Likes Water Utilities Water utilities have a solid potential for growth. First, there are no substitute products. Second, as regulated monopolies, their investment is included into rate base and therefore, has an opportunity for cost recovery, thereby lowering the risk with that investment. Third, water companies are considering and making investment in other new projects: their contributions to shale gas development and military water operations, for example. Nevertheless, Wall Street also has certain fears as it relates to the water industry. B. Why Wall Street Fears Water Utilities 34 Regulation also means cost recovery is very dependent upon a constructive regulatory environment. By comparison, electric and gas utilities capture higher returns on equity. There is also a concern over the liquidity of water companies, with less than a dozen publicly-traded domestic water utilities, and low average daily trading volumes. Water companies have historically slower organic growth and water consumption continues to decline due to effective conservation efforts and efficiencies in system and technologies. Of course, lower usage translates into lower revenues. With an increasing capital intensive industry and declining revenues, regulatory lag becomes a major issue. The decision focal point for a utility then becomes a comparison of needs of the utility with the constructiveness of the public utility commission. Page 34

36 C. A Balanced Approach is Necessary Wall Street analysts know that different regulatory programs impact earned returns. Therefore, analysts look favorably upon effective practices in rate case procedure that reduces regulatory lag. For example, Wall Street analysts consider effective regulatory policies to include: mandatory rate case timelines for both historic and future test years, interim rate relief, step increases, and retroactive effective dates. Mechanisms, like decoupling and single tariff pricing, are also viewed favorably as effective practices in rate design. Cost recovery mechanisms that are used between rate cases are also viewed favorably by Wall Street analysts. Examples include the previously-mentioned DSIC mechanism, as well as the implementation of cost riders or surcharge mechanisms. Reducing regulatory lag is viewed favorably by Wall Street as infrastructure investment velocity increases, helping to enhance access to capital at a favorable cost keeping customer costs as low as possible. 35 Constructive regulatory commissions translate into a favorable earned return on equity (ROE) environment. Investors insist that the water utility captures a fair ROE. In Wall Street s analysis, the following can prevent the desired outcome: inflation, historic test years, capital markets issuances, and elevated capital budgets. These factors can contribute to regulatory lag. Instead, Wall Street prefers more easily understood programs, transparency and clarity, streamlined rate case approaches, and predictability. Forum Participant Verdi also makes the observation that large water companies will follow the money. In other words, geographically diverse water utilities will invest their money into states with favorable regulatory environments. From a smart business perspective, they have to avoid less constructive business footprints. Robust profile water utilities that generate higher multiples are primarily located in favorable business Page 35

37 footprints and lackluster water utilities that have lower multiples are primarily located in unfavorable business footprints. All stakeholders can come together to address these financial concerns. A balanced approach is vital to the water industry and it is what Wall Street expects. For their part, state commissions can implement alternative rate mechanisms like infrastructure surcharges, a repair tax, decoupling, and allow CWIP recovery. Working together with all stakeholders, water utilities have a role in ensuring a balanced approach. Water utilities should continue to concentrate on core utility operations and allocate capital along with making further investment into the core business. Forum Participant Verdi suggests the industry continue to foster strong relationships with regulators and the customers. Participant Reaction Forum Participant Verdi noted capital analyst s grade regulators using a perspective on recent decisions and whether those decisions have resulted in additional investment in the state. In that regard, Pennsylvania ranks the highest among analysts. In elaborating on that with the Forum Participants, Mr. Verdi noted substantially high returns are not always viewed favorably. Instead, regulatory focus should be on a fair rate. 36 Page 36

38 X. SMALL COMPANY REGULATION: IRON HAND OR KID GLOVES Forum Participant Jack Hawks, California Water Association (CWA), presented to the Forum. With 108 regulated investor-owned utilities as its members, CWA accounts for 1.5 million customers and $1.4 billion in annual revenues. Membership in CWA is voluntary. Through Executive Director Hawks, the responsibilities and activities of the CWA include: 1. Representing water companies before the California Public Utilities Commission, State Water Resources Control Board, the Department of Water Resources, and the California Water Commission; 2. Representing water companies before the State Legislature and Governor s office; 3. Representing water companies before NARUC, NAWC, AWWA, CUWCC, and CEC; 4. Serving as a media spokesperson; and 5. Providing small company regulatory assistance. In providing small water companies regulatory assistance, CWA provides assistance with rate case filings. The CWA is a contract consultant for small companies, but also offers assistance with annual report filings, grant and loan applications, as well as assistance in obtaining valuations and liability insurance. The CWA conducts how to seminars for small company providers related to regulatory and water quality compliance and customer communications issues. The challenges that small water systems have to address are not new; unfortunately, there is a repeating cycle. Additionally, small company providers have commonality in the issues they face. 37 More often than not, they are not solvent and use their own money to subsidize the systems. Many are reluctant to raise rates and they are uncomfortable or not knowledgeable in appearing before the state utility commissions. Moreover, most are not technology or communications savvy in regard to requirements for online filings and/or customer communications. Forum Participant Hawks noted that regulations can come in the form of an iron hand, as is the example of water quality compliance. But the regulation of small companies is more effective with the use of regulatory assistance and streamlined processes, a more kid glove approach. Solutions to small company viability issues are not new. 9 For example, in a report by NRRI, recommendations or solutions to address small water company challenges 9 NRRI (1984): Commission Regulation of Small Water Utilities: Outside Resources & Their Effective Uses. Page 37

39 include: the implementation of simplified rate procedures, modified rate designs, and consolidation and/or regionalization. A. Regulatory Challenges for Small Systems As stated earlier, regardless of size of facility or number of customers served, all water companies are held to the same standard for quality service. In addition, all companies need access to capital. Financing for small water companies may be different than that for large utilities, but nevertheless, it is obtainable. The difference is that some small companies might have to rely on owner financing or small bank loans for their capital. But like the larger companies, the likelihood of achieving affordable access to capital is greater with adequate rates and regulatory stability. Therefore, the use of effective regulatory practices in the regulation of small water companies is critical. Regulatory challenges do exist in this regard. Traditional rate applications are very expensive per customer, because they can be complicated and time-intensive. Some regulatory processes limit filings or have a lengthy process that creates regulatory lag. These regulatory hurdles prevent the company from obtaining timely revenue increases, and lack of revenue growth prevents necessary investment to address infrastructure-related issues. B. Best Practices for Small Systems: Recent Developments In the regulation of small water systems, some state commissions now recognize that rate application processes and mechanisms that reduce or remove the need for use of outside counsel or consulting services, thus reducing rate application duration and costs, should be encouraged. In addition, to meet the challenges of environmental compliance and continued capital investment required to deliver safe and reliable service to the customers served by regulated small water systems, some effective best practices have been identified as means to improve sustainable and continued investment in small water system infrastructure at cost-effective rates. To assist in the education effort and to ensure consistent application of effective regulatory practices on a larger scale, NARUC 38 has worked diligently to capture some of these regulatory practices in the form of a Resolution to be shared with all state commissions. Passed by NARUC in July 2013, the Resolution lists just some of the best practices recognized by state commissions: 1. Simplified rate applications using electronic filing; 2. Use of Annual Reports for cost recovery determination in lieu of lengthy rate cases; 3. Use of the Staff Assisted Rate Case Process; 4. Reliance on a simplified rate of return calculation; Page 38

40 5. Allowance of periodic cost of living adjustments; 6. Use of emergency fund mechanisms; and 7. Limitation of Contributions in Aid of Construction (CIAC) so rates are sustainable. The Small System NARUC Resolution, included at the end of this Forum Report, identifies ten core regulatory practices and three general management practices. All mechanisms and policies referenced in the resolution are in place in at least one state. The primary aim is to alter the ratemaking effort to match the scope of the impact. Mr. Hawks noted that California has adopted some of the best practices: 1) increasingly simplified rate applications for B, C, and D companies; 2) electronic filing; 3) use of the annual report for rate adjustments; 4) staff assisted support for rate cases; 5) cost of living annual increases; 6) simplified rate of return filings; 7) and a rate of margin option. C. California Consolidation Policy In promoting consolidation and acquisition of troubled or very small water companies, California implemented an acquisition policy that includes an incentive program for the acquiring utility. The California acquisition policy allows the company and staff to design rates to recover 100% of the fixed costs in the service charge. In addition, the CPUC allowed acquisition premiums in the formulaic manner described below: If purchase price < book value rate base amount = purchase price + 50% of the difference Amount > purchase price amortized over average remaining plant life Purchase price includes costs incurred to complete acquisition Senate Bill 88, enacted in June 2015, authorizes the state water board to order consolidation of a troubled 39 water system with appropriate notice and finding that the company is indeed a troubled utility (failing to provide adequate supply of water). The legislation also limited the liability of the acquiring utility. Participant Reaction Forum Participant Hawks notes the implementation of best practices in California has resulted in dramatic improvements in ensuring small system viability. For example, rate cases are complete in 4 to 6 months instead of the prior timeframe, 12 to 18 months. There are other notable differences: CWA s regulatory assistance program is strong and steady, small companies are filing more frequently for consistent regulatory relief, enabling them to make necessary improvements; and there have been 15 acquisitions by Class A and B companies in the past 18 months. Page 39

41 XI. NARUC RESOLUTIONS Resolution Supporting Consideration of Regulatory Policies Deemed as Best Practices WHEREAS, A number of innovative regulatory policies and mechanisms have been implemented by public utility commissions throughout the United States which have contributed to the ability of the water industry to effectively meet water quality and infrastructure challenges; and WHEREAS, The capacity of such policies and mechanism to facilitate resolution of these challenges in appropriate circumstances supports identification of such policies and mechanisms as best practices ; and WHEREAS, During a recent educational dialogue, the 2005 NAWC Water Policy Forum, held among representatives from the water industry, State economic regulators, and State and federal drinking water program administrators, participants discussed (consensus was not sought nor determined) and identified over 30 innovative policies and mechanisms that have been summarized in a report of the Forum to be available on the website of the Committee on Water at and WHEREAS, As public utility commissions continue to grapple with finding solutions to meet the myriad water and wastewater industry challenges, the Committee on Water hereby acknowledges the Forum s Summary Report as a starting point in a commission s review of available and proven regulatory mechanisms whenever additional regulatory policies and mechanisms are being considered; and WHEREAS, To meet the challenges of the water and wastewater industry which may face a combined capital investment requirement nearing one trillion dollars over a 20- year period, the following policies and mechanisms were identified to help ensure sustainable practices in promoting needed capital investment and cost-effective rates: a) the use of prospectively 40 relevant test years; b) the distribution system improvement charge; c) construction work in progress; d) pass-through adjustments; e) staff-assisted rate cases; f) consolidation to achieve economies of scale; g) acquisition adjustment policies to promote consolidation and elimination of non-viable systems; h) a streamlined rate case process; i) mediation and settlement procedures; j) defined timeframes for rate cases; k) integrated water resource management; l) a fair return on capital investment; and m) improved communications with ratepayers and stakeholders; and WHEREAS, Due to the massive capital investment required to meet current and future water quality and infrastructure requirements, adequately adjusting allowed equity returns to recognize industry risk in order to provide a fair return on invested capital was recognized as crucial; and Page 40

42 WHEREAS, In light of the possibility that rate increases necessary to remediate aging infrastructure to comply with increasing water quality standards could adversely affect the affordability of water service to some customers, the following were identified as best practices to address these concerns: a) rate case phase-ins; b) innovative payment arrangements; c) allowing the consolidation of rates ( Single Tariff Pricing ) of a multidivisional water utility to spread capital costs over a larger base of customers; and d) targeted customer assistance programs; and WHEREAS, Small water company viability issues continue to be a challenge for regulators, drinking water program administrators and the water industry; best practices identified by Forum participants include: a) stakeholder collaboration; b) a memoranda of understanding among relevant State agencies and health departments; c) condemnation and receivership authority; and d) capacity development planning; and WHEREAS, The U.S. Environmental Protection Agency s Four-Pillar Approach was discussed as yet another best practice essential for water and wastewater systems to sustain a robust and sustainable infrastructure to comprehensively ensure safe drinking water and clean wastewater, including: a) better management at the local or facility level; b) full-cost pricing; c) water efficiency or water conservation; and d) adopting the watershed approach, all of which economic regulators can help promote; and WHEREAS, State drinking water program administrators emphasized the following mechanisms which Forum participants identified as best practices: a) active and effective security programs; b) interagency coordination to assist with new water quality regulation development and implementation, such as a memorandum of understanding; c) expanded technical assistance for small water systems; d) data system modernization to improve data reliability; e) effective administration and oversight of the Drinking Water State Revolving Fund to maximize infrastructure remediation, along with permitting investor owned water companies access in all States; f) the move from source water assessment to actual protection; and g) providing State drinking water programs with adequate resources to carry out their mandates; now therefore be it RESOLVED, That the 41 National Association of Regulatory Utility Commissioners (NARUC), convened in its July 2005 Summer Meetings in Austin, Texas, conceptually supports review and consideration of the innovative regulatory policies and practices identified herein as best practices; and be it further RESOLVED, That NARUC recommends that economic regulators consider and adopt as many as appropriate of the regulatory mechanisms identified herein as best practices; and be it further RESOLVED, That the Committee on Water stands ready to assist economic regulators with implementation of any of the best practices set forth within this Resolution. Sponsored by the Committee on Water Adopted by the NARUC Board of Directors July 27, 2005 Page 41

43 WA-1 Resolution Endorsing Consideration of Alternative Regulation that Supports Capital Investment in the 21st Century for Water and Wastewater Utilities WHEREAS, Through the Resolution Supporting Consideration of Regulatory Policies Deemed as Best Practices (2005), the National Association of Regulatory Utility Commissioners (NARUC) has previously recognized the important role of innovative regulatory policies and mechanisms in facilitating the efforts of water and wastewater utilities to address their significant infrastructure investment challenges; and WHEREAS, Traditional cost of service ratemaking, which has worked reasonably well in the past for water and wastewater utilities, no longer adequately addresses the challenges of today and tomorrow. Revenue, driven by declining use per customer, is flat to decreasing, while the nature of investment (rate base) has shifted largely from plant needed for serving new customers to non-revenue producing infrastructure replacement and compliance with new drinking water standards; and WHEREAS, The traditional cost of service model is not well adapted to a no/low growth, high investment utility environment and is unlikely to encourage the necessary future investment in infrastructure replacement; and WHEREAS, Compared to the water and wastewater industry, the electric and natural gas delivery industries have in place a larger number and a greater variety of alternative regulation policies, such as multiyear rate plans and rate stabilization programs, and those set forth in the 2005 Resolution; and WHEREAS, The U.S. water industry is the most capital intensive sector of regulated utilities and faces critical investment needs that are expected to total $335 billion to $1 trillion over the next quarter century, as noted in the American Society of Civil Engineers 2013 Report Card for America s Infrastructure; and WHEREAS, Tap water is physically ingested and the quality of the service must be maintained to protect 42 the health and economic well-being of communities across our Nation and comply with current and future regulations covering the control of a number of contaminants from nitrosamines to chromium, at a cost estimated at $42 billion by the EPA as part of their April 2013 Report to Congress; and WHEREAS, Alternative regulatory mechanisms can enhance the efficiency and effectiveness of water and wastewater utility regulation by reducing regulatory costs, increasing rates for customers, when necessary, on a more gradual basis; and providing the predictability and regulatory certainty that supports the attraction of debt and equity capital at reasonable costs and maintains that access at all times; now, therefore be it RESOLVED, That the National Association of Regulatory Utility Commissioners, convened at its 125th Annual Meeting in Orlando, Florida, supports consideration of Page 42

44 alternative regulation plans and mechanisms along with and in addition to the policies and mechanisms outlined in the 22 Resolution Supporting Consideration of Regulatory Policies Deemed as Best Practices adopted by the NARUC Board of Directors on July 27, 2005; and be it further RESOLVED, That the Committee on Water stands ready to assist economic regulators with implementation of alternative regulatory approaches that support water companies capital investment needs of the 21st century. Sponsored by the Committee on Water Recommended by the NARUC Board of Directors November 19, 2013 Adopted by the NARUC Committee of the Whole November 20, Page 43

45 WA-2 Resolution Supporting the Consideration of Regulatory Mechanisms and Policies Deemed Best Practices for the Regulation of Small Water Systems WHEREAS, The United States Environmental Protection Agency estimates that more than eighty percent of the total water systems in the United States serve fewer than 3,300 people per system; and WHEREAS, The NARUC Water Committee recognized that small water company viability issues continue to be a challenge for regulators in the Resolution Supporting Consideration of Regulatory Best Policies Deemed as Best Practices (2005); and WHEREAS, It is acknowledged that the traditional cost-of-service regulatory model as applied to small water systems may result in regulatory costs that are disproportionately high on a per-customer basis, which ultimately impacts customers served by those systems; and WHEREAS, A number of regulatory policies and mechanisms have been implemented by public utility commissions throughout the United States to specifically address the challenges of regulating small water systems; and WHEREAS, In the regulation of small water systems, it is recognized that rate application processes and mechanisms that reduce or remove the need for use of outside counsel or consulting services, thus reducing rate application duration and costs, should be encouraged; and WHEREAS, To meet the challenges of environmental compliance and continued capital investment required to deliver safe and reliable service to the customers served by regulated small water systems, the following practices have been identified as means to improve sustainable and continued investment in small water system infrastructure at cost-effective rates: a) simplified rate applications for small water systems; b) electronic filing procedures; c) use of the annual report provided by the utility to the public utility commission to provide a significant portion of the rate application; d) commission staff assisted rate cases 44 including both direct commission staff involvement in the rate application process and site visits to reduce the need for formal discovery; f) simplified rate of return mechanisms that may include formulaic rate of return calculations or percentage increases in authorized returns indexed to recent water cases in the same jurisdiction; g) cost of living adjustments; h) rate mechanisms to facilitate emergency infrastructure funds; i) operating ratio rate mechanisms where there is very limited rate base; j) limiting the use of Contributions In Aid of Construction in situations where unsustainably low rates may be instituted as a result; and k) combining water and wastewater revenue requirements for purposes of rate cases, as appropriate, if the water and wastewater utilities are under the same ownership, which will reduce rate case expense and offer rate increase mitigation options driven by economies of scale that would be unavailable otherwise; and WHEREAS, It is further recognized that there are regulatory policies and mechanisms that address the viability of newly operating small water systems, including: a) enforcing Page 44

46 the technical, managerial, and financial requirements as defined by the United States Environmental Protection Agency; b) where applicable and beneficial to the customer, encouraging consolidation with a nearby water system; and c) in the case where the new system provides the 30 most benefit to the consumers, assuring adequate rates for infrastructure sustainability and emergency funding; and WHEREAS, It is recommended that jurisdictions periodically evaluate classification criteria for defining which water systems qualify as small water systems; now, therefore be it RESOLVED, That the National Association of Regulatory Utility Commissioners, convened in its 2013 Summer Meetings in Denver, Colorado, conceptually supports review and consideration of the innovative regulatory policies and practices identified herein as best practices in the regulation of small water systems; and be it further RESOLVED, That NARUC recommends that economic regulators consider and adopt as many as appropriate of the regulatory mechanisms identified herein as best practices; and be it further RESOLVED, That the Committee on Water stands ready to assist economic regulators with implementation of any of the best practices set forth within this Resolution. Sponsored by the Committee on Water Adopted by the NARUC Board of Directors, July 24, Page 45

47 WA-3 Resolution Addressing Gap Between Authorized Versus Actual Returns on Equity in Regulation of Water and Wastewater Utilities WHEREAS, There is both a constitutional basis and judicial precedent allowing investor owned public water and wastewater utilities the opportunity to earn a rate of return that is reasonably sufficient to assure confidence in the financial soundness of the utility and its ability to provide quality service; and WHEREAS, Through the Resolution Supporting Consideration of Regulatory Policies Deemed as Best Practices (2005), the National Association of Regulatory Utility Commissioners has previously recognized the role of innovative regulatory policies and mechanisms in the ability for public water and wastewater utilities to address significant infrastructure investment challenges facing water and wastewater system operators; and WHEREAS, Public utilities carry the responsibility to invest prudently, provide safe and reliable service, and take reasonable action to take precautionary measures to address business risk and economic forces, as necessary; and WHEREAS, Recent analysis shows that as compared to other regulated utility sectors, significant and widespread discrepancies continue to be observed between commission authorized returns on equity and observed actual returns on equity among regulated water and wastewater utilities; and WHEREAS, The extent of such discrepancies suggests the existence of challenges unique to the regulation of water and wastewater utilities; and WHEREAS, Ratemaking that has worked reasonably well in the past for water and wastewater utilities no longer addresses the challenges of today and tomorrow. Revenue, driven by declining use per customer, is flat to decreasing while the nature of investment (rate base) has shifted largely from plant needed to serve new customers to non-revenue producing infrastructure replacement; and 46 WHEREAS, Deficient returns present a clear challenge to the ability of the water and wastewater industry to attract the capital necessary to address future infrastructure investment requirements necessary to provide safe and reliable service, which could exceed one trillion dollars over a 20-year period; and WHEREAS, The NARUC Committee on Water recognizes the critical role of the implementation and the effective use of sound regulatory practice and the innovative regulatory policies identified in the Resolution Supporting Consideration of Regulatory Policies Deemed as Best Practices (2005); and WHEREAS, It is recognized that State legislative bodies play a significant and important role in considering and addressing the challenges present in the regulation of water and wastewater utilities; therefore, it is critical that economic regulators strive to continue to Page 46

48 foster an environment of cooperation and open communication between themselves, legislative bodies, 32 and other State agencies involved in the oversight of water and wastewater utilities such that implementation and effective use of sound regulatory practice and the innovative regulatory policies identified in the Resolution Supporting Consideration of Regulatory Policies Deemed as Best Practices (2005) is both possible and effective; and WHEREAS, A number of issues have been identified that if addressed may assist in lessening the discrepancy between authorized and actual returns, including: a) reducing, where appropriate, the length of time between rate cases and/or the length of time to process rate cases for regulated water and wastewater utilities; b) reducing rate case expense relative to requested revenue increases through the encouragement of mediation and settlement as appropriate; and c) examining the rate of infrastructure replacement and system improvements among regulated water and wastewater utilities; now, therefore be it RESOLVED, That the Board of Directors of the National Association of Regulatory Utility Commissioners, convened at its 2013 Summer Meeting in Denver, Colorado, identifies the implementation and effective use of sound regulatory practice and the innovative regulatory policies identified in the Resolution Supporting Consideration of Regulatory Policies Deemed as Best Practices (2005) as a critical component of a water and/or wastewater utility's reasonable ability to earn its authorized return; and be it further RESOLVED, That NARUC recommends that economic regulators carefully consider and implement appropriate ratemaking measures as needed so that water and wastewater utilities have a reasonable opportunity to earn their authorized returns within their jurisdictions; and be it further RESOLVED, That the Committee on Water stands ready to assist economic regulators with the execution of a sound regulatory environment for regulated water utilities, and will continue to monitor progress on this issue at future national committee meetings until satisfactorily improved. 47 Sponsored by the Committee on Water Adopted by the NARUC Board of Directors, July 24, 2013 Page 47

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