Discussion
of Issues
Issue 1:
Should the Commission propose the adoption of Rule 25-30.4575,
F.A.C., Operating Ratio Methodology?
Recommendation:
Yes, the Commission should propose the adoption of
Rule 25-30.4575, F.A.C., as set forth in Attachment A. The Commission should
certify Rule 25-30.4575, F.A.C., as a minor violation rule. (Harper, Galloway)
Staff Analysis:
In a staff-assisted rate
case (SARC), a calculation is made to determine the utility’s revenue
requirement. The revenue requirement reflects the monies a utility needs to
recover its operating expenses and provide it with an opportunity to earn a
fair rate of return on its investment.
The traditional calculation of
revenue requirement for smaller water and wastewater utilities is achieved by
adding the operation and maintenance (O&M) expenses to the net depreciation
expense, amortization expense, taxes other than income taxes, income taxes, and
a return on investment. The “return on investment” for SARCs is the overall
rate of return multiplied by the amount of rate base. All of these components
added together make up the revenue requirement in a SARC through traditional
ratemaking. However, in some SARCs, traditional ratemaking, also referred to as
the rate of return methodology, does not always provide sufficient revenue to
protect against potential variances in revenue and expenses. In these cases,
the utility may qualify for the operating ratio methodology.
When the operating ratio
methodology is applied, instead of calculating the revenue requirement by
including the return on investment (rate of return x rate base), the “return on
investment” has been replaced by an operating margin. The operating margin is
calculated by multiplying a defined percentage by the amount of O&M
expenses. As stated in the Lake Osborne Order, the operating ratio methodology
substitutes O&M expenses for rate base in calculating the amount of return
(or margin).
The table below shows the
difference between the two methodologies, the use of a rate of return times
rate base (traditional rate base methodology), as compared to the margin percentage
times operation and maintenance expenses (operating ratio methodology).
Table 1-1
Comparison of
Traditional and Operating Ratio Methodologies
|
Traditional Revenue
Requirement Calculation
|
Operating Ratio
Methodology
|
|
Operation and Maintenance
Expense
|
Same
|
|
Net Depreciation Expense
|
Same
|
|
Amortization
|
Same
|
|
Taxes Other than Income Taxes
(less RAFs)
|
Same
|
|
Income Taxes
|
Same
|
|
Rate of Return percent x
Rate Base
|
Margin percent x
O&M expense
|
|
= Revenue Requirement before
RAFs
|
= Revenue Requirement before RAFs
|
Many utilities that apply for a
SARC are financially troubled systems. Many times, these are not utilities that
are simply earning below the bottom of their authorized rate of return range;
these are utilities that are losing money. Often, these are utilities that have
been losing money on a consistent basis over a prolonged period of time. The
operating ratio methodology is intended to act as a bridge for these troubled
systems to become financially viable and return to the traditional revenue
requirement calculation. The operating ratio methodology also provides a
lifeline for them to stay in business and remain viable entities that can
provide safe and reliable water and wastewater services to their customers.
At the staff workshop and in its
post-workshop comments, OPC indicated its preference for the proposed Commission
rule to codify the operating ratio methodology set forth in the Lake Osborne
Order. OPC stated that because the proposed rule does not incorporate the exact
same criteria set forth in the Lake Osborne Order, it defies the purpose of
rulemaking and allows for the development of new policy based on non-existent
difficulties. OPC further stated that the Commission’s policy on the operating
ratio methodology had been clearly and consistently applied over 21 years.
The Lake Osborne Order recognized
that determining whether to utilize the operating ratio methodology required a
great deal of judgement. In keeping with the spirit of the Lake Osborne Order,
staff considered whether to include each of the five criteria from the Lake
Osborne Order in the proposed rule. However, because the Lake Osborne Order
states that the Commission “may” consider the factors listed in the order, this
would give the Commission too much discretion in the context of rulemaking
under Section 120.545(1), F.S. Therefore, staff began the process of
scrutinizing each criteria in hope of finding a way to enable the same
understanding that judgement is critical in determining which SARCs should
qualify for the operating ratio methodology.
For smaller water and wastewater
utilities whose resources are very limited, a SARC is a daunting process, even
though staff provides the expertise. Staff notes that some utilities that apply
for a SARC have never been before the Commission for a rate case or applied for
a rate increase, despite having been in existence for decades. Because many
SARCs are financially troubled systems, staff believes the suggestion that
there is no evidence of a need to make the proposed adjustments contained in
the proposed rule is misplaced.
Staff believes the attached
proposed rule is an opportunity to be proactive rather than reactive. Staff
disagrees with OPC’s assertion that provisions of the proposed rule address
“non-existent difficulties.” Instead, staff believes if the Commission codifies
the practice in a rule, the proposed rule should reflect the Commission
practice that has applied for over 20 years, the Commission’s experience gained
from implementing the operating ratio methodology, and the current economic and
operational conditions that small water and wastewater utilities face. Staff’s
analysis below discusses in more detail the areas where the Commission’s policy
on the operating ratio methodology should be refined from the Commission’s
policy set forth in the Lake Osborne Order.
Subsection (1) of the
Rule – How the Operating Ratio Methodology Should be Calculated
Subsection (1) of Rule
25-30.4575, F.A.C., provides that the operating ratio methodology will
calculate the water or wastewater utility’s revenue requirement based on the
utility’s operating expenses plus a margin of 15 percent of the utility’s
operation and maintenance expenses.
15 Percent Margin and No $10,000 Cap
OPC commented that the margin
percentage should be 10 percent with a $10,000 cap, consistent with the Lake
Osborne Order. OPC alleged there is no evidence that the Commission’s current
practice is ineffective or causing harm.
Again, staff disagrees with OPC’s
suggestion that there is no evidence to support an increase in the margin
percentage and the removal of $10,000 cap. While the Commission has never
applied a margin greater than 10 percent in any of the cases where operating
ratio has been approved, staff believes the rule should promote a policy that
allows utilities to provide the safest and most reliable service to customers.
Staff believes that changes in circumstances have occurred since the Lake Osborne
Order and the changes must be considered and evaluated. U.S. Water Services
stated in its comments that:
Many of the
utilities that I manage have little to no rate base through no fault of the
acquiring utility and are faced with financial difficulties meeting day-to-day
operations. Just as many of these utilities were financially non-viable,
distressed utilities that were acquired in order to turn them around and
provide safe and reliable service to customers. Without the operating margin,
several of these utilities would either not have been acquired and/or would
remain financially non-viable.
U.S. Water also stated that the
10 percent margin that was established more than 20 years ago in the Lake
Osborne Order should be further evaluated. Staff agrees, and believes that the
proposed rule’s 15 percent margin represents a natural evolution of the practice
addressed in the Lake Osborne Order.
Other states’ policies regarding
use of an operating ratio and the associated percentage applied to achieve a
margin were analyzed in the Lake Osborne Order. As part of this rule docket,
staff sent out a request through the National Association of Regulatory Utility
Commissioners (NARUC) to learn what other states have been doing since the
Commission’s initial decision in 1996. The specific states referenced in the
Lake Osborne Order included Kentucky, North Carolina, South Carolina,
California, and Michigan. With the exception of Michigan, which no longer
regulates water and wastewater utilities, and California, which did not respond
to the request, the states referenced in the Lake Osborne Order have not
changed from their 1995-1996 alternative rate setting policies. These states
are very interested in what the Florida Commission will decide. Below is a
synopsis of current policies for these states:
·
Kentucky
has been using a 12 percent margin since 1995-1996 and also allows a
dollar-for-dollar coverage for short-term interest expense.
·
North
Carolina continues to use a margin based on the yield on the 5 year U.S.
Treasury Bond plus 3 percent for risk.
·
South
Carolina sets operating margins for each water and wastewater utility
regardless of size and recent rulings have been above the 15 percent margin
level. However, the typical range is 10 – 15 percent. Two cases in 2018 were
settled with one margin of 12.32 percent and the other margin was 14.99
percent.
While it is important to be
informed about what other states are doing with regard to alternative rate
making, staff believes that Florida is in a unique situation with respect to
regulation of water and wastewater utilities. For example, water and wastewater
utilities operating in Florida must contend with a seasonal customer base, saltwater
intrusion, sinkholes, and hurricanes. Therefore, while consideration of other states’ policies is
informative, it is not necessarily conclusive for the Commission’s
determination of what is appropriate for this proposed rule.
OPC commented that the 10 percent
margin is not a fixed dollar amount, and that it increases as expenses
increase. OPC also asserts the proposed rule should include the same $10,000
cap that was in the Lake Osbourne Order. Staff disagrees. Docket No. 160176-WS,
Application for staff assisted rate case
in Polk County by Four Lakes Golf Club, Ltd., is a recent example of a
utility being negatively impacted by the limitation of the $10,000 cap.
Due to the cap, the utility’s allowed margin was reduced from 10 percent to
5.41 percent. Had the 10 percent margin been used, an operating margin of
$18,476 would have been included in the revenue requirement rather than only
$10,000. In this case, even if the full 10 percent margin had been used when
the operating ratio methodology was applied, the utility’s ability to provide
safe and reliable service was still compromised as evidenced by the $64,000 operating
loss it reported for the year.
Thus, contrary to OPC’s argument, to include a $10,000 cap and 10 percent
margin in the proposed rule would be harmful to the utilities and their ability
to provide safe and reliable service.
Docket No. 160165-WS, In re: Application for staff assisted rate case in
Gulf County by ESAD Enterprises, Inc. d/b/a Beaches Sewer Systems, Inc., is
another recent example of a utility being negatively impacted by the limitation
of the $10,000 cap. Due to the cap, the utility’s allowed margin was reduced
from 10 percent to 7.25 percent.
Had the 10 percent margin been used, an operating margin of $13,801 would have
been included in the revenue requirement rather than only $10,000.
The Lake Osborne Order stated
that it may be appropriate to apply a margin greater than 10 percent in the
case of a fully depreciated system where there would be an expectation of
greater than average volatility in operation and maintenance costs. However, of
the 23 cases where the operating ratio methodology was recommended, staff did
not pursue a margin greater than 10 percent in any of them. The caveat
contained in the Lake Osborne Order served to discourage application of a
higher margin by the instruction to prove “an expectation of greater than average
volatility in operation and maintenance costs.” Staff has found that it has
been a difficult task to prove “greater than average volatility” prior to the
volatility occurring.
Recently, in Order No.
PSC-2018-0327-PAA-WS, the Commission recognized that smaller water and
wastewater utilities are more risky than other utilities. In the order, the
Commission listed a variety of reasons that make smaller water and wastewater
utilities more risky in nature:
(1) WAW
utilities are more capital intensive than electric or natural gas utilities;
(2) WAW utilities experience lower relative depreciation rates than other
utilities, thereby providing less cash flow; (3) WAW utilities experience
consistently negative free cash flow, thereby increasing their financing
requirements; (4) WAW utilities’ credit metrics are inferior to those of
electric and natural gas utilities; (5) Florida WAW utilities are substantially
smaller than electric and natural gas utilities by virtually any measure
including total revenues, total assets, and market capitalization; (6) WAW
utilities’ earnings are much more volatile (uncertain) than electric and
natural gas utilities’ earnings; and (7) WAW utilities experience many more
business failures than electric and natural gas utilities.
Staff disagrees with OPC’s
opinion that the margin should remain unaffected by the Consumer Price Index
(CPI) or other inflationary factors. Staff believes that the percentage
increase from 10 percent to 15 percent reflects not only inflationary factors,
but also compensates for the riskier nature and true plight of smaller water
and wastewater utilities that qualify and apply for a SARC. Regarding any
underlying argument of potential overearnings, staff believes the Commission’s
annual in-house review of Annual Reports, which are required to be filed by all
regulated water and wastewater utilities, will alert the Commission of any
potential overearnings.
As discussed below, Subsection
(2) of the proposed rule includes limiting criteria. Subsection (2) would limit
the use of the operating ratio methodology to only those utilities that are
eligible for a SARC, and those utilities must continue to be eligible for a
SARC when the methodology is applied.
Water and Wastewater Utilities that
are Resellers
Subsection (1) of proposed Rule
25-30.4575, F.A.C., further provides that for water and wastewater utilities
that are resellers, purchased water and purchased wastewater expenses will be
removed from operation and maintenance expense before the 15 percent margin is
applied. As stated in the Lake Osborne Order, if a utility is a reseller, the
issue is whether or not purchased water and/or wastewater costs should be
excluded in the computation of the operating margin. Staff believes that this
qualification continues to remain valid, and thus, it is reflected in
Subsection (1) of proposed Rule 25-30.4575, F.A.C.
Subsection (2) of the Rule – Criteria
for Use of Operating Ratio Methodology
Subsection (2) of the proposed
rule addresses the criteria the Commission would use to determine whether to
use the operating ratio methodology.
125 Percent of O&M Expenses
Subsection (2)(a) of proposed Rule
25-30.4575, F.A.C., provides that the operating ratio methodology may only be
used for those utilities whose rate base is no greater that 125 percent of
operation and maintenance expenses. In its post-workshop comments, OPC takes
issue with this language in the proposed rule. While the Lake Osborne Order
limits eligibility to utilities with O&M expenses equal to or less than
rate base, the Commission also stated in the Order that the initial eligibility
criteria for the operating ratio methodology was purposely limited until more
experience was gained.
While this rule is designed for
small water and wastewater utilities, particularly those utilities where
investment in rate base is limited relative to the level of O&M expenses,
it is informative to compare what the typical relationship between rate base
and the level of O&M expenses is for larger, more financially viable
systems. For Class A water utilities in Florida, average rate base is three
times greater than the average level of O&M expenses. For Class A
wastewater systems, average rate base is five times greater than the average
level of O&M expenses. Staff believes that requiring the investment in rate
base to be less than the level of O&M expenses for purposes of this rule
appears overly restrictive when compared to the typical relationship between
rate base and the level of O&M expenses in this industry. Because the
exigent conditions that exist for water and wastewater utilities whose rate
base equals O&M expenses also exist for utilities with rate base marginally
greater than O&M expenses, staff recommends that the proposed rule should
modestly increase the threshold that was set forth in the Lake Osborne
Order.
Based on information from the
2017 Annual Reports, under the current practice, the operating ratio
methodology is available to 30 water and 29 wastewater systems. If the
threshold for rate base is increased to 125 percent of O&M expenses, an
additional 6 water and 8 wastewater systems will be eligible for the operating
ratio methodology. While this change represents a modest increase in the number
of eligible utilities, staff believes it is a reasonable evolution of the
eligibility criteria for use of the operating ratio methodology.
Limit on the Application of the
Operating Ratio Methodology to Only the Utilities that Qualify for a SARC
Subsection (2) of the proposed
rule provides that the operating ratio methodology may only be used for
utilities that qualify for a SARC under Rule 25-30.455, F.A.C. The current
threshold for SARC eligibility under Rule 25-30.455(1), F.A.C., applies to
water and wastewater utilities whose total gross annual operating revenues are
$300,000 or less per system, and $600,000 or less on a combined basis. At the
time of the Lake Osborne Order, the SARC threshold was for utilities with
revenue of $150,000 or less per system, which precluded any Class B utilities
from qualifying for a SARC.
OPC commented that the proposed
rule should remain consistent with the Lake Osborne Order and that only Class C
utilities should be eligible for the operating ratio methodology. However,
since the Lake Osborne Order, the Florida Legislature has amended Section
367.0814, F.S., to increase the SARC threshold and to add language providing
that the threshold for SARC eligibility must be adjusted on July 1, 2013, and
every five years thereafter. As a result, the SARC threshold increased to
$275,000 in July 2013 and then to $300,000 in July 2018. This means Section
367.0814, F.S., allows SARCs for utilities with revenue of $300,000 or less per
system, which may include some Class B utilities. Accordingly, staff believes
OPC’s position to exclude all Class B utilities for eligibility for the
operating ratio methodology is contrary to Section 367.0814, F.S. To be
consistent with the statute and because exigent conditions that exist for many
Class C utilities may also exist for smaller Class B utilities, staff believes
utilities with revenue of $300,000 or less per system that qualify for a SARC
should be eligible for the use of the operating ratio methodology.
Limit on the Use of the Operating
Ratio Methodology to Only Utilities that Continue to Qualify for a SARC
Subsection (2)(b) of the proposed
rule provides that if the application of the operating ratio methodology
changes the utilities' qualification for a SARC, the operating ratio
methodology may not be applied. Thus, this provision ensures that only
utilities that qualify for a SARC will benefit from the rule.
Quality of Service and Condition of
Plant
OPC also takes issue with the fact that the proposed rule
does not include the Lake Osborne Order’s considerations of the quality of
service and condition of the plant. OPC seems to suggest these considerations
should be included in the rule as a means to disqualify certain utilities from
the use of the operating ratio methodology. Staff disagrees. Staff believes
that the Lake Osborne Order recognized that quality of service or condition of
the plant are always considerations in a SARC and that, in fact, poor quality
of service or condition of the plant may be indicative of a utility that
would benefit from the use of the
operating ratio methodology. As stated in the Lake Osborne Order, “poor
condition of plant and/or unsatisfactory quality may be due to a variety of
factors such as age of the system, poor maintenance” and these factors may
“highlight the need for an adequate revenue stream to properly test and treat
the water and maintain/renovate the system.”
Because evaluation of the quality of service and condition
of the plant are standard considerations in every SARC, staff
believes it is unnecessary to include this criteria in the proposed rule.
Moreover, it stands to reason that unsatisfactory quality of service and
condition of the plant may be a result of insufficient revenues. To identify
poor quality of service or condition of the plant in the proposed rule may
cause a utility to be denied the opportunity to use the operating ratio
methodology, which would not be in the long-term interest of the utility or its
customers. If poor conditions are a direct result of the owner directly
contributing to the system’s decline, the Commission can pursue revocation of
the certificate and/or an escrow of operating ratio methodology funds when
improvements are needed to restore the utility system. Therefore, staff
believes that because quality of service and condition of the plant are
considered in every SARC, these factors do not need to be included and used as
disqualifying criteria in proposed Rule 25-30.4575, F.A.C.
Developer-Owned Utilities
OPC also took issue with the
proposed rule because it did not include the criteria from the Lake Osborne
Order regarding developer-owned water and wastewater utilities. In the Lake
Osborne Order, the Commission stated that being developer-owned should not
disqualify a utility from the operating ratio method. The Commission also
acknowledged in the Order that it may not be appropriate to use the operating
ratio if the development is in the early stages of growth. The Commission
stated:
Other factors that may be considered when determining
eligibility for the operating ratio method are customer growth, the developer’s
financial condition, the utility’s financial and operational condition,
government mandated improvements and/or other unanticipated expenses. The level
of CIAC collected by the utility may also be considered.
The points contemplated in this criteria are standard
considerations in every SARC. Therefore, staff believes it is duplicative and
unnecessary to include these criteria in the rule.
Summary
The proposed rule codifies the
Commission’s practice of applying the operating ratio methodology. As discussed
above, OPC expressed concerns about not seeing the long-standing Commission
practice of using the five criteria set forth in the Lake Osborne Order in the
attached proposed rule. However, staff believes the proposed rule sufficiently
and clearly addresses the necessary qualifications for implementing the
operating ratio methodology on a going forward basis. Simply restating the same
criteria and considerations of the Lake Osborne Order in the proposed rule as
OPC suggests ignores the discretionary nature of the Lake Osborne Order
criteria as well as the current requirements for rulemaking under Section
120.545(1), F.S., and the 20 years of Commission experience and practice in
implementing the operating ratio methodology. Simply put, shoehorning the same
discretionary criteria and considerations from the Lake Osborne Order into a
rule would be contrary to the rulemaking requirements. Moreover, the proposed
rule is not only well within the Commission’s delegated grant of legislative
authority but is also necessary to avoid violating the prohibition against
unadopted rules.
Even with the adoption of the
rule, staff will continue to present to the Commission both the option of the
traditional and the operating ratio methodologies and the potential effect on
the revenue requirement. The ultimate decision to use the operating ratio
methodology will remain with the Commission. Staff believes the proposed rule
captures the purpose and criteria necessary for the use of the operating ratio
methodology for determining the revenue requirement and recommends that that
the proposed rule as set forth in Attachment A should be approved.
Minor Violation Rules Certification
Pursuant to Section 120.695, F.S., beginning July 1, 2017,
for each rule filed for adoption the agency head shall certify whether any part
of the rule is designated as a rule the violation of which would be a minor
violation. Rule 25-30.4575, F.A.C., is a rule for which a violation would be
minor because violation of the rule would not result in economic or physical
harm to a person or an adverse effect on the public health, safety, or welfare
or create a significant threat of such harm.
Thus, staff recommends that the Commission certify Rule 25-30.4575,
F.A.C., as a minor violation rule.
Statement of Estimated Regulatory Costs
Pursuant to Section 120.54, F.S., agencies are encouraged
to prepare a statement of estimated regulatory costs (SERC) before the
adoption, amendment, or repeal of any rule. The SERC is appended as Attachment C
to this recommendation. The SERC analysis also includes whether the rule is
likely to have an adverse impact on growth, private sector job creation or
employment, or private sector investment in excess of $1 million in the
aggregate within five years of implementation.
The SERC concludes that the rule will not likely directly
or indirectly increase regulatory costs in excess of $200,000 in the aggregate
in Florida within one year after implementation. Further, the SERC concludes that the rule
will not likely have an adverse impact on economic growth, private sector job
creation or employment, private sector investment, business competitiveness,
productivity, or innovation in excess of $1 million in the aggregate within
five years of implementation. Thus, the rule does not require legislative
ratification pursuant to Section 120.541(3), F.S. In addition, the SERC states that the rule
will not have an adverse impact on small business and will have no impact on
small cities or counties. No regulatory alternatives were submitted pursuant to
paragraph 120.541(1)(a), F.S. None of
the impact/cost criteria established in paragraph 120.541(2)(a), F.S., will be
exceeded as a result of the recommended revision.
Conclusion
Based on the foregoing, staff recommends the Commission
propose the adoption of Rule 25-30.4575, F.A.C., as set forth in Attachment A. In
addition, staff recommends the Commission certify Rule 25-30.4575, F.A.C., as a
minor violation rule.
Issue 2:
Should this docket be closed?
Recommendation:
Yes. If no
requests for hearing or comments are filed, the rule may be filed with the
Department of State, and this docket should be closed. (Harper)
Staff Analysis:
If no requests for hearing or comments are filed,
the rule may be filed with the Department of State, and this docket should be
closed.
