Water

		Private water suppliers are required to meet increasingly stringent water quality standards and are expected to stretch existing supplies with efficiency technologies -- public policies that require additional investment and accommodating rate-setting regulations.
		Small water companies -- some of whom do not participate in PUC proceedings -- have a particularly difficult time raising the revenue to make needed investments and the State has not developed an adequate strategy for helping those captive customers.

Finding the Right Venue

Finding 11: While the rates charged by private monopoly water providers still need government scrutiny, the greater public interest lies in ensuring adequate and safe drinking water supplies -- challenges that fall outside the PUC's expertise of thwarting monopoly abuse.

Water companies in California face two increasing challenges: meeting stringent federal water quality standards that may require additional treatment devices to be installed and implementing water conservation improvements aimed at stretching water supplies.

The Public Utilities Commission, with its focus on protecting customers by keeping rates as low as possible, makes it difficult for companies to pay for conservation and water quality improvements, putting water suppliers in the middle of competing policy demands and potentially leaving some water customers without safe drinking water.

Water companies also complain that the PUC is too preoccupied with the evolving energy and telecommunications markets to deal effectively with the problems of the water industry, and that PUC filing requirements are too burdensome for small companies.

These issues -- along with the dramatic changes underway in other industries regulated by the PUC -- provides the opportunity to reconsider the State's choices for economic regulation of private water suppliers. That reassessment is essential to ensuring that all of the public's interests are adequately served.

The PUC's Regulation of the Water Industry

The PUC has jurisdiction over California's 195 investor-owned water companies, which together supply 20 percent of the State's domestic water customers. The Commission's oversight of these companies is confined to rate-setting.

Although the three largest companies under the PUC's jurisdiction serve a total of 780,000 customers, most of the companies are small. Only 13 serve more than 10,000 customers and 143 serve fewer than 500 customers each. The PUC has no authority over the State's several hundred municipal water companies, county water districts and special water districts.

The Commission acknowledges that many more small private water companies may be operating in the state, but says that it makes no effort to find them. Said one PUC official:

The only time we get involved with a company is when it wants to raise its rates or if a customer complains. We don't go out and inspect or go out looking for companies operating without our knowledge. If customers are happy, I'd rather not know about it.⁽¹⁰⁹⁾

Ironically, private water suppliers may be the last remaining monopoly utilities of the sort the PUC was set up to regulate. Unaffected by the kind of technological changes that have eroded the natural monopolies in electricity generation and telecommunications, domestic water providers are expected to remain monopolies for the foreseeable future.

The Public Utilities Commission establishes rates for water companies through its standard quasi-judicial proceedings as well as through administrative procedures.

Companies in the Class A category -- the 13 largest -- are required by the PUC to go through a general rate case proceeding to raise rates. Class A companies, which are organized into many water "districts" serving different geographical areas, can apply for a rate increase for each district once every three years. That means a company typically applies for rate increases every year for one-third of its districts. The PUC rules on the rate increase after examining the company's projected revenues, investments, expenditures and reasonable return on equity. At the PUC's urging, some large companies are combining districts to simplify record keeping and rate-making.

All of the 182 remaining companies (Classes B, C and D) are allowed to raise rates through a less formal process. Because these smaller companies have complained that the PUC's procedures impose a difficult burden on their limited resources, the PUC lets these companies raise rates using a simplified administrative process.

Class B companies -- those serving between 2,000 and 10,000 customers -- have the choice of asking for rate increases through a general rate case, a court-like proceeding, or through an administrative advice letter procedure. The smaller Class C and D companies can receive virtually automatic rate increases tied to the Consumer Price Index or can file requests for larger increases. The classifications and the related procedures are summarized in the following table:

Water Company Classifications
CLASS	NUMBER OF CUSTOMERS	NUMBER OF COMPANIES IN CLASS	RATE-MAKING PROCESS
Class A	More than 10,000	13	General rate case
Class B	2,000 - 10,000	7	Choice of general rate case or advice letter
Class C	500 - 2,000	32	Choice of automatic rate increase tied to Consumer Price Index or general rate case
Class D	fewer than 500	143	Choice of automatic rate increase tied to Consumer Price Index or general rate case

As the table shows, much of the rate setting for water companies accomplished administratively. In addition, rate setting for the water industry is far less complicated than for the large and rapidly changing energy and telecommunications industries. As a result, regulating water companies comprises a comparatively small part of the Commission's overall workload. One indicator of the proportion of PUC resources dedicated to water companies is the number of "hearing days" needed to resolve cases. In fiscal year 1994-95, out of a total of 574 hearing days, the Commission devoted 68 hearing days to water -- with 42 of those days spent on rate-making. During the same period the Commission spent 114 hearing days on telecommunications and 288 days on energy cases.⁽¹¹⁰⁾

Gauging how much time individual Commissioners spend on water matters is more difficult. One possible measure, however, is the comparative number of ex parte contacts -- private meetings with industry representatives outside hearing rooms. The ex parte records also show that water is a minor part of the Commission's agenda. In the first seven months of 1995, for example, Commissioners held 1,147 ex parte meetings on gas, electricity and telecommunications matters. During that period Commissioners met 13 times with interested parties to discuss water cases.⁽¹¹¹⁾

Regulations Affecting Water Companies

Private water companies, like their public-sector counterparts, are expected to ensure an adequate water supply for future customers and must meet stringent federal standards for drinking water. These standards can require companies to invest in water efficiency devices and programs for conserving water, and to monitor water quality and install treatment equipment where needed to protect human health.

Water conservation. The 30 largest investor-owned water systems under PUC authority -- those with 3,000 or more service connections, representing between 10 and 15 percent of the State's urban water use -- are all required by the Urban Water Management Planning Act of 1983 to submit conservation plans to the State Department of Water Resources (DWR).⁽¹¹²⁾

The purpose of the plans is to encourage water providers to consider conservation measures -- such as low-flow toilets and landscape irrigation timers -- in planning for future water supplies. While companies are not penalized for failing to conserve, companies that do not take measures to save water may be hard-pressed to supply future customers.⁽¹¹³⁾

With the State's population expected to surge from 33 million to 49 million in the next 25 years and with no new large dams expected, state water planners say California faces a projected annual water supply shortage of between 1 million and 3 million acre-feet of water by 2020 even if all reasonable conservation efforts are made.⁽¹¹⁴⁾ That gap is enough to furnish between 2 million and 6 million California households with water for one year. Reducing demand is one of the State's prime strategies for meeting long-term needs⁽¹¹⁵⁾ -- and in most cases is the cheapest way for individual companies to supply future customers.

In recognition of this fact, 150 water interests and agencies in the state, including the PUC and most of the largest water companies under PUC jurisdiction, in 1991 signed a memorandum of understanding on urban water conservation. The agreement spelled out 16 "best management practices," all of which by definition had been found to be cost-effective ways to make efficient use of available water supplies.

The agreement commits the signatories to phase-in the conservation measures through the year 2001.⁽¹¹⁶⁾ In projecting future water needs, state water planners are counting on annual urban water demand dropping by 1.3 million acre-feet per year by 2020 as a result of water providers following these best management practices.⁽¹¹⁷⁾

Water quality requirements. All domestic water systems -- including those regulated by the PUC -- must comply with federal Safe Drinking Water Act standards. First passed in 1974, the act was reauthorized in 1986 and again in 1996. The 1986 reauthorization required water system operators to check for many more contaminants and added requirements for treating surface water.

The standards require companies to monitor water quality and to install filtration and disinfection equipment where needed to reduce chemical contaminants and eliminate disease-causing micro-organisms. The expense of upgrading facilities to meet the standards means that many companies must raise rates.

When the act was reauthorized in 1996, Congress lessened the burden of compliance for small companies by including money for grants and loans. But that money may not become available in California until 1998.

In California the federal standards are enforced by the State Department of Health Services (DHS). The department is responsible for overseeing the State's 8,500 water systems, including those under PUC jurisdiction. DHS delegates oversight of the 4,940 smallest systems -- those serving fewer than 200 people -- to county health departments.

For those systems under its direct oversight, DHS conducts inspections, reviews monitoring reports, and issues orders or citations when systems are out of compliance. The Department helps systems correct problems by lining up funding, doing design work, setting up a schedule for work to be completed and tracking progress. The company can continue to supply water while it is out of compliance, but must notify customers that the water may not be safe, leaving customers with the choice of risking health by using the substandard water or turning to bottled water. A citation is issued if the company fails to comply.

In an average year, the Department of Health Services issues some 800 citations and compliance orders to water systems under its direct jurisdiction for failure to meet federal standards.

For the systems under county oversight, DHS provides engineering reports and other technical assistance and furnishes written evaluations of the county health department's work to the board of supervisors. Counties use less formal procedures to bring water systems up to standards, typically inviting company owners in for "office hearings" to work out solutions. As a result, statistics on the number of water systems under county jurisdiction that fail to meet federal standards at any given time are less reliable. These are precisely the small companies most likely to violate standards.

PUC Policies Hamper Water Companies

The PUC's heavy workload and its overriding interest in keeping down costs to customers create problems for the water companies, their customers and for the State as a whole. These problems are played out in four ways:

1. PUC rules discourage conservation. In looking at company expenditures to evaluate proposed rate increases, the PUC adheres to a traditional rate-of-return philosophy that encourages companies to sell as much water as possible. And in looking at proposed expenditures for conservation, the PUC is reluctant to allow companies to recover costs from ratepayers unless the program can be shown to be cost-effective within three years -- even though a 10- to 15-year horizon is needed to realize the benefits of water efficiency investment and to take into account the cost of future water supplies.

As a result, according to the director of the Department of Water Resources, privately owned water utilities are closed off from the water management tools available to publicly owned water suppliers:

Current CPUC policies and practices inhibit conservation-oriented pricing and investment among investor-owned utilities.... The traditional rate structures, which are the only ones acceptable to the CPUC, do not achieve the efficiencies required to meet the water demands of the next century.⁽¹¹⁸⁾

Ironically, PUC energy rate policies long ago were modified to reflect the diminishing nature of fossil fuels and the economic value of efficiently using resources. Asked why the Commission has not adopted demand-side management for water, the program manager for the PUC's Water Division explained "we haven't had pressure to do that like in energy." The reason, he said, is that "water is not a diminishing resource."⁽¹¹⁹⁾

2. The PUC does not cooperate with state conservation efforts at a policy level. Even though the PUC signed the urban water management agreement, PUC Commissioners now disagree among themselves about whether that signing means the PUC has agreed to automatically accept the best management practices as cost-effective when applied to individual companies.⁽¹²⁰⁾

The California Water Conservation Council, made up of more than 180 signatories to the urban water conservation agreement -- including 112 public and private water agencies, 17 public interest groups and 43 municipal utility districts, cities, counties, state agencies and other interested parties -- has been working hard since 1991 to implement the best management practices.⁽¹²¹⁾

Together, the urban water suppliers participating in the Council serve 90 percent of the State's urban population. The Council meets regularly to refine the best management practices and to design a conservation-based rate structure. The PUC is a member of the Council. But according to the Commission's Water Branch Chief, the PUC has limited its participation to sending a staff member to Council meetings as an observer.⁽¹²²⁾

The Department of Water Resources -- which is counting on conservation to help satisfy growing water needs -- has tried to get the PUC to actively participate in the California Water Conservation Council meetings and in other conservation endeavors. It has been largely frustrated in its efforts. In 1992 the PUC set up a water management committee with utility representatives and DWR staff to help utilities begin conservation efforts. But the committee fell apart because the Commission's staff was unwilling to consider a statewide conservation policy or to discuss issues involving specific companies outside of general rate case proceedings.⁽¹²³⁾ The director of DWR subsequently wrote two letters to the PUC president in 1994 urging cooperation in conservation matters. One of the letters read:

Being very candid, the department and local water utility staffs throughout urban California seem to have a fundamental difference of viewpoint with the CPUC staff concerning water conservation. It appears to many in the water industry that current CPUC practices inadvertently result in disincentives for water utilities to implement demand management programs.

... We have struggled to understand why it has been so difficult to find common ground with the CPUC staff on this issue. Certainly, some of the difficulty comes from the view of the CPUC staff that a very rigorous analysis must be made of any utility investment, including conservation, in order to protect the ratepayer. While this is a laudable goal in an abstract sense, we believe it does not give enough consideration to (the) realities of California's water situation.⁽¹²⁴⁾

According to DWR officials, the PUC did not respond to either letter.

The PUC maintains that it considers conservation measures in the context of specific rate cases. But water company representatives told the Little Hoover Commission that when they have asked the PUC to approve rate increases for conservation programs they nearly always have been turned down.

In what was widely regarded as a major coup for the industry, Southern California Water Company in 1995 persuaded the PUC to approve cost-recovery to replace a modest 1,000 toilets within its 250,000 customer service area, but such victories are rare. Indeed, when asked to give the best example of its support of conservation programs, the PUC pointed to this one case. A vice president of Southern California Water Company said the company was able to get approval for the low-flow toilets only by partnering with a water district outside PUC jurisdiction to share the cost and by appealing to a PUC Commissioner after the program was first turned down:

In past years, 1991, 1992, 1993, all water companies got nowhere with the PUC in getting cost recovery for any kind of conservation programs. In 1994 we proposed a partnership program with Metropolitan Water District, where our company would put up 25 cents and MWD and one of its subsidiaries would put up $1.00. We filed in January of 1994 and it took a year and a half for the PUC to approve it. The [PUC's] administrative law judge denied the program, so we frankly lobbied the assigned Commissioner. We said, "this is really dumb; if you can't approve this, what can you approve? We're getting $1.00 for every 25 cents we put in." In June of 1995 the Commissioner finally approved it.⁽¹²⁵⁾

Other companies, he said, had not been so fortunate:

We're very encouraged, but here's the downside: we're the only company they've allowed to do this. The PUC has implied that the payback period should be low and to do that you may need a partner. But it shouldn't take partnering. In some areas of the state, companies don't have agencies to partner with. Some of the companies just gave up, to be perfectly frank. How many times do you hear "No" before you quit?⁽¹²⁶⁾

A vice-president of Santa Clarita Water Company, which serves 19,500 customers, confirmed the industry's frustration with the PUC:

Because of all the problems other people were having, we haven't filed for cost recovery for any conservation programs. The PUC was denying a lot of the programs. People would propose conservation programs based on State Water Plan figures and the PUC would just disregard the figures. We have done things like conservation kits, sent out mailers on how to save water and hired a conservation coordinator, but we just never file for recovery.⁽¹²⁷⁾

One problem, according to the vice president of Southern California Water Company is that "The PUC doesn't do anything on a policy level. It's all ad hoc."⁽¹²⁸⁾

The PUC maintains, however, that it has done all it should do to advance water conservation. One PUC official said:

We work hand-in-glove with our sister agencies. But staff won't accept carte blanche what the utility may propose in conservation if it's not cost effective.⁽¹²⁹⁾

3. PUC policies are not aligned with water quality goals.To comply with federal drinking water standards, many water companies must upgrade facilities. It is particularly difficult for small companies to meet the standards. Some 143 of the water companies under PUC jurisdiction serve fewer than 500 customers each. Many of these are businesses operating the water service as a tangent to other activities or to supply a housing development far from existing municipal services.

These small companies are typically underfinanced, unable to pay for system upgrades and leery of participating in the PUC's complex proceedings to obtain rate increases. As a result, these companies -- particularly those in remote rural area -- account for many of the water systems that fail to comply with drinking water standards.

Of the 900 small surface water systems in the state under direct DHS jurisdiction -- all of them serving fewer than 1,000 customers -- some 150, or 16 percent, are out of compliance with safe drinking water standards at any given time. Often systems go in and out of compliance because deteriorating infrastructures lead to breaks in mains and subsequent contamination or because the company lacks the staff or the management inclination to monitor water quality.⁽¹³⁰⁾

Rectifying problems by disinfecting water or investing in filtration equipment and passing costs on to ratepayers is much more difficult for small systems than for large systems. The PUC allows companies to recover all "reasonable" expenses through rate increases and the Commission says it considers expenses necessary to comply with water quality mandates to automatically satisfy the "reasonable" test. That works fine for large companies that can afford to pay for needed improvements up front and recover costs up to a year later through a rate increase. But small companies often lack the money to invest in advance, and have a smaller customer base to absorb the cost over time. Meeting the standards also has a much great impact on rates for small companies than it does for large companies. While large companies typically need to increase rates only about 5 percent to comply with the federal standards, companies serving fewer than 1,000 customers may have to raise rates as much as 100 to 200 percent.⁽¹³¹⁾ As a result -- while the expense of complying with the federal standards costs the average household nationwide only $12 a year -- the average cost for customers of small companies comes to $145 a year.⁽¹³²⁾

The PUC has tried to address the problems of underfinanced companies by making it easier for companies with fewer than 10,000 service connections to file for rate increases to recover costs. But those procedures do not help companies that lack the funds to pay for upgrades in the first place. Nor do they solve the problem of companies that lack the management or the resources to properly monitor water quality.

Whether the improvements are funded with loans or through higher rates charged to water customers, resolving impediments to making upgrades requires the PUC and DHS to work together at a policy level. Recognizing the need for cooperation in water quality matters, the PUC in 1987 signed another memorandum of understanding -- this one with the Department of Health Services. That agreement spells out the intent of the two agencies to keep one another informed of actions involving water companies under their common jurisdiction and to meet at least semi-annually to review water quality efforts and resolve problems. But the two agencies have not met since the agreement was signed, and when the agreement was updated in 1996, the meeting requirement was dropped.⁽¹³³⁾

4. PUC does not devote adequate resources to water oversight. The private water companies complain that with all its other responsibilities, and with only 27 staff people to oversee more than 200 companies, the PUC does not give the water industry enough attention. The most recent accounting found that the PUC is collecting $8.3 million in fees each year from the private water companies under its authority, but spending only $6 million to regulate the industry.⁽¹³⁴⁾

The PUC's disinterest in locating water companies operating without its knowledge isolates these companies even more than others from possible financing mechanisms and leaves customers without a ready forum for resolving disputes.

The water companies say they want to remain under the purview of the PUC, preferring to "stay with the devil you know." But they have urged the PUC to speed up the rate-making process and to have at least one Commissioner present in contested proceedings.

They also want the PUC to set up a water policy board made up of health and water and PUC officials to ensure Commission decisions are consistent with the policies of the other regulating agencies. The PUC has had a water policy board in the past -- but the board has been made up solely of the PUC's own water and ratepayer advocacy staff.

What's Needed

To ensure that customers of private water systems are provided with safe and adequate water supplies, water companies need two ingredients: competent management and enough funds to keep infrastructure sound and to make any needed investments in treatment and conservation.

In the past DHS has been able to help small water companies upgrade systems with loans from a state revolving fund. The fund provided $425 million over 15 years and funded 533 such projects between 1976 and 1991. But the program ended when the last state bond measure authorizing water quality upgrade funds failed in 1992.⁽¹³⁵⁾

Some companies have tried turning to the private sector to finance system improvements. But PUC policies stand in the way. Water industry representatives told the Little Hoover Commission that the PUC's rigid rate-of-return policies and after-the-fact review of allowable expenses makes small companies unattractive to lenders. The director of the California Water Association, which represents investor-owned water companies, explained:

A lender looks at how stable a company is to see whether it can repay the loan. If the earnings are all over the place ... a lender won't look at them. The Commission allows a certain level of expenses, but if something comes up like having to do another set of testing for the Department of Health Services, it can double their expense budget in one year. A more consistent treatment of rate of return would allow lenders to have a little more confidence in the small companies.⁽¹³⁶⁾