Ruco v. Acc

IN THE
ARIZONA COURT OF APPEALS
DIVISION ONE

RESIDENTIAL UTILITY CONSUMER OFFICE, an agency of the State
of Arizona, Appellant,

v.

THE ARIZONA CORPORATION COMMISSION, Appellee.

ARIZONA WATER COMPANY, Intervenor.

No. 1 CA-CC 13-0002
1 CA-CC 14-0001
(Consolidated)
FILED 8-18-2015

Arizona Corporation Commission
No. W-01445A-11-0310
W-01445A-12-0348

AFFIRMED IN PART; VACATED IN PART

COUNSEL

Ridenour Hienton, P.L.L.C., Phoenix
By Scott S. Wakefield
Co-Counsel for Appellant

Residential Utility Consumer Office, Phoenix
By Daniel W. Pozefsky
Co-Counsel for Appellant
Arizona Corporation Commission, Legal Division, Phoenix
By Janice M. Alward, Wesley C. Van Cleve, Charles H. Hains, Bridget A.
Humphrey
Counsel for Appellee Arizona Corporation Commission

Bryan Cave, L.L.P., Phoenix
By Steven A. Hirsch, Rodney W. Ott
Counsel for Intervenor Arizona Water Company

OPINION

Presiding Judge Margaret H. Downie delivered the Opinion of the Court,
in which Judge Kenton D. Jones and Judge Jon W. Thompson joined.

D O W N I E, Judge:

¶1 The Residential Utility Consumer Office (“RUCO”) appeals
two decisions by the Arizona Corporation Commission (“Commission”)
that adopted a system improvement benefits (“SIB”) mechanism
permitting Arizona Water Company (“AWC”) to collect surcharges from
utility customers in between rate cases for defined capital expenditures.
Because we conclude the SIB mechanism does not comply with the
Arizona Constitution’s mandate that the Commission determine a public
service corporation’s fair value when setting rates, we vacate the approval
of that rate-making device. However, we affirm the Commission’s
determination of the appropriate return on equity.

FACTS AND PROCEDURAL HISTORY

I. The Parties

¶2 The Commission is a constitutionally created entity that,
among other things, regulates the rates charged by public service
corporations. See Ariz. Const. art. 15, §§ 2-3. AWC — a privately held for-
profit corporation — is a monopoly water utility whose rates are set by the
Commission; AWC provides water service to nineteen separate systems in
Arizona. RUCO is a state agency established to represent the interests of
residential utility consumers in Commission proceedings. See A.R.S. § 40-
462.

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II. Eastern Group Case

¶3 In August 2011, AWC filed an application with the
Commission to increase rates for its eastern group water systems
(“Eastern Group Case”). As relevant here, AWC requested: (1) a return on
equity (“ROE”) of 12.5%1 and (2) a distribution system improvements
charge (“DSIC”) that would permit AWC to recover, in between rate
cases, certain capital costs for improvement projects related to its
distribution system and aging infrastructure. RUCO intervened in the
Commission proceedings.

¶4 An administrative law judge (“ALJ”) held a multi-day
hearing on AWC’s application. Commission staff (“Staff”) and RUCO
both opposed the proposed DSIC. Staff expressed concern that it would
alter “the balance of ratemaking lag by reducing lag time for recovery of
depreciation and return on plant investments, to the benefit of AWC and
the detriment of its ratepayers,” and Staff also argued “that allowing
recovery of capital improvement costs between regular rate cases results
in less scrutiny of plant investments both as to prudency and the used and
usefulness of the plant.” In the alternative, Staff recommended several
conditions that should apply to any DSIC-type mechanism the
Commission might ultimately approve.

¶5 The ALJ recommended that the Commission set the ROE at
10.55% and that it deny the requested DSIC. After considering the ALJ’s
written opinion and recommendations, the Commission approved a rate
increase for AWC, setting the ROE at 10.55%. The Commission remanded
the DSIC issue “to allow the parties the opportunity to enter into
discussions regarding AWC’s DSIC proposal and other DSIC like
proposals.”

¶6 All parties except RUCO subsequently entered into a
settlement agreement in the Eastern Group Case (“Eastern Group
Settlement Agreement”). That agreement included a modified version of
the DSIC, now called a SIB.

¶7 An ALJ conducted a hearing regarding the Eastern Group
Settlement Agreement, with RUCO opposing its approval. With some

1 As we discuss infra, ¶ 53, the ROE is intended to provide AWC
with a fair rate of return on the value of property it employs for public
service.

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suggested modifications, the ALJ recommended that the Commission
approve the Eastern Group Settlement Agreement, including the SIB
mechanism, but also recommended that the ROE be reduced from 10.55%
to 10.00%.

¶8 The Commission adopted most of the ALJ’s
recommendations regarding the Eastern Group Settlement Agreement,
but, by majority vote, maintained the ROE at the previously approved
level of 10.55%.2 The Commission also required AWC to provide more
documentation with its surcharge applications than the settlement
agreement contemplated. RUCO filed an application for rehearing. After
further evidentiary proceedings, the ALJ again concluded the SIB was
appropriate and again recommended the Commission reduce the ROE to
10.00%.

¶9 In its final decision, by a 3-2 vote, the Commission approved
the SIB mechanism and maintained the ROE at 10.55%. RUCO filed a
timely notice of appeal.

III. Northern Group Case

¶10 In August 2012, AWC filed an application with the
Commission seeking rate increases for its northern group water systems
(“Northern Group Case”). AWC’s application included a DSIC proposal
similar to that requested in the Eastern Group Case. RUCO intervened in
the Northern Group Case as well.

¶11 All parties except RUCO entered into a settlement
agreement in April 2013 (“Northern Group Settlement Agreement”). The
agreement incorporated the SIB determination from the Eastern Group
Case. After an evidentiary hearing, an ALJ recommended that the
Commission approve the Northern Group Settlement Agreement.

¶12 The Commission adopted the ALJ’s proposed order.
However, it made the agreed-upon SIB mechanism “subject to additional
modifications that may be made by the Commission” in the Eastern
Group Case. RUCO filed an application for rehearing, but its request was
denied by operation of law pursuant to A.R.S. § 40-253(A) (“If the

2 Commissioner Brenda Burns dissented, stating that “AWC
ratepayers should not be asked to pay for an elevated ROE while also
being the test case for a newly approved SIB.”

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commission does not grant the application [for rehearing] within twenty
days, it is deemed denied.”).

¶13 RUCO filed a timely notice of appeal. By stipulation of the
parties, we consolidated the Eastern Group and Northern Group cases for
purposes of appeal. We also granted AWC’s motion to intervene. This
Court has jurisdiction over the consolidated appeals pursuant to A.R.S.
§ 40-254.01(A).

IV. The SIB Mechanism3

¶14 The SIB at issue in both the Eastern Group and Northern
Group cases is a form of tariff that permits AWC, with Commission
approval, to add surcharges to customers’ water bills for up to five years
to recoup certain capital costs (depreciation expenses and pre-tax return
on investment) of defined infrastructure replacement projects that AWC
completes prior to its next rate case. Capital expenditures subject to SIB-
based surcharges include:

 Transmission and Distribution Mains
 Fire Mains
 Services, including service connections
 Valves and valve structures
 Meters and meter installations
 Hydrants

¶15 AWC may request surcharges only for completed projects
that are “actually serving customers.” Before imposing a surcharge, AWC
must apply to the Commission and submit specified documentation. The
Commission is required to approve or disapprove each surcharge
application, and Staff and RUCO have 30 days from each application’s
filing to dispute a surcharge request. Each surcharge is “capped annually
at five percent of the revenue requirement authorized” in Commission
Decision No. 73736. AWC customers receive an “Efficiency Credit” of

3 The SIB mechanism is a type of DSIC. At times, we discuss
evidence and testimony regarding a DSIC that also applies to the SIB.
However, the SIB mechanism that the Commission ultimately approved
differs in some material respects from the DSIC that AWC initially
proposed. Our legal analysis is based on the SIB’s terms and
methodology.

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“five percent of the SIB revenue requirement.”4 The SIB mechanism
contemplates an annual “true-up,” or reconciliation, pursuant to which
any “under- or over-collected SIB revenues shall be recovered or
refunded” to customers “by means of a fixed monthly true-up surcharge
or credit.”

DISCUSSION

I. Constitutionality of SIB Mechanism

¶16 RUCO contends the SIB mechanism violates the Arizona
Constitution’s mandate that the Commission determine the fair value of a
public service corporation’s property when setting rates. According to
RUCO, allowing the SIB-based surcharges in between rate cases
circumvents this constitutional requirement.

¶17 Whether the SIB mechanism runs afoul of the constitution is
a question of law that we review de novo. See Sierra Club – Grand Canyon
Chapter v. Ariz. Corp. Comm’n, ___ Ariz. ___, ¶ 15, ___ P.3d ___ (App. July
23, 2015) (appellate courts are not bound by Commission’s legal
conclusions and must “determine independently whether the Commission
erred in its interpretation of the law”); Ariz. Water Co. v. Ariz. Corp.
Comm’n, 217 Ariz. 652, 656, ¶ 10, 177 P.3d 1224, 1228 (App. 2008) (in
reviewing Commission decisions, appellate courts review questions of law
de novo). RUCO bears the burden of persuasion. See A.R.S. § 40-254.01(E)
(litigant challenging Commission decision “must make a clear and
satisfactory showing that the order is unlawful”).

A. Fair Value Determination Requirement

¶18 “The Arizona Corporation Commission, unlike such bodies
in most states, is not a creature of the legislature, but is a constitutional
body which owes its existence to provisions in the organic law of this
state.” Ethington v. Wright, 66 Ariz. 382, 389, 189 P.2d 209 (1948). Under
the Arizona Constitution, the Commission has plenary power to set “just
and reasonable rates and charges” for public service corporations. Ariz.
Const. art. 15, § 3. Article 15, Section 3 provides, in pertinent part:

4 The two five-percent figures apply to different amounts. The cap
on each surcharge is five percent of the revenue requirement authorized
by the Commission in AWC’s most recent rate case, whereas the efficiency
credit is five percent of the SIB revenue requirement, as defined in the
settlement agreements.

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The corporation commission shall have full
power to, and shall, prescribe just and
reasonable classifications to be used and just
and reasonable rates and charges to be made
and collected, by public service corporations
within the state for service rendered
therein . . . .
Id.

¶19 The Commission’s plenary power over rate-making, though,
is not unfettered. Among other things, our constitution requires the
Commission to “ascertain the fair value of property” when it sets rates.
Ariz. Const. art. 15, § 14. Section 14’s mandate “is an imperative. The
commission is charged with an affirmative duty to act.” US West
Commc'ns, Inc. v. Ariz. Corp. Comm'n, 201 Ariz. 242, 245, ¶ 11, 34 P.3d 351,
354 (2001) (“US West”). “[A]scertaining the fair value of property of
public service corporations is a necessary step in prescribing just and
reasonable classifications, rates, and charges.” Ethington, 66 Ariz. at 392,
189 P.2d at 216; see also Ariz. Corp. Comm’n v. Ariz. Pub. Serv. Co., 113 Ariz.
368, 370, 555 P.2d 326, 328 (1976) (“[T]he Commission is required to find
the fair value of the company’s property and use such finding as a rate
base for the purpose of determining what are just and reasonable rates.”).

¶20 Surcharges trigger the constitutional requirement for a fair
value determination. See Residential Util. Consumer Office v. Ariz. Corp.
Comm’n, 199 Ariz. 588, 589, ¶ 1, 20 P.3d 1169, 1170 (App. 2001) (“RUCO”).
Indeed, the parties here acknowledge that “[t]he SIB mechanism is a
ratemaking device.”

B. Exceptions to Fair Value Determination Requirement

¶21 Arizona’s appellate courts have recognized two relatively
narrow exceptions to the constitutional requirement that the Commission
determine the fair value of a utility’s property when setting rates:
automatic adjustor clauses and interim rates. See id. at 591, ¶ 11, 20 P.3d at
1172. As we discuss infra, the SIB mechanism fits within neither
exception.

1. Automatic Adjustor Clauses

¶22 In approving the SIB mechanism, the Commission labeled it
an adjustor mechanism. We disagree. Cf. id. at 593, ¶ 21, 20 P.3d at 1174
(“If ever there was a situation ‘fraught with potential abuse,’ it occurs

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when the Commission of its own volition has the ability to declare any
rate increase an ‘automatic adjustment.’”).

¶23 An automatic adjustor mechanism permits “rates to adjust
automatically, either up or down, in relation to fluctuations in certain,
narrowly defined, operating expenses.” Scates v. Ariz. Corp. Comm’n, 118
Ariz. 531, 535, 578 P.2d 612, 616 (App. 1978). Adjustor mechanisms
“usually embody a formula established during a rate hearing to permit
adjustment of rates in the future to reflect changes in specific operating
costs, such as the wholesale of gas or electricity.” Id. The purpose of an
automatic adjustor mechanism is to pass on to customers certain naturally
fluctuating costs so that the utility neither benefits nor suffers a
diminished return from those costs. Id.

¶24 William Rigsby, Chief of Accounting and Rates for RUCO,
described the characteristics of a typical automatic adjustor clause as
follows:

When I think of an adjuster mechanism, I think of something
along the lines of like a purchased gas adjuster mechanism,
where the company has to . . . buy natural gas on the open
market, or an electric company . . . has to buy power . . . on
the grid in the wholesale market and so forth. And so the
cost of that either natural gas or electricity is passed on to the
ratepayer at no profit to the company, and that’s the reason
that it’s implemented, is because of the price fluctuations of
the commodity in the marketplace. It’s a two-way street. If
the prices go down, then consumers see a credit on the bill.
If prices go up, then, of course, they go ahead and they pay
that. Whereas in the case of . . . a DSIC, it’s not a two-way
street.

¶25 Rigsby’s testimony is consistent with our own jurisprudence
regarding automatic adjustor clauses. See, e.g., Mountain States Tel. & Tel.
Co. v. Ariz. Corp. Comm’n, 137 Ariz. 566, 569, 672 P.2d 495, 498 (App. 1983)
(An automatic adjustment clause is “a device that allows a rate to adjust
automatically, either up or down in relation to fluctuations in certain,
narrowly defined, operating expenses.”). RUCO’s view is also aligned
with the position Staff took at the outset of the Eastern Group Case. In
Phase I of that proceeding, Staff stated that adjustor mechanisms are used
to “allow utilities to pass on to customers changes in certain specific
volatile costs outside of the utility’s control, such as purchased power
costs.” Staff also correctly noted that “rate adjustors outside of a rate case

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are the exception rather than the rule and [are] very limited in what they
can do.”

¶26 Under the SIB mechanism, surcharges will not fluctuate in
amount within an annual cycle, and they will never decrease. Moreover,
AWC is being allowed to recoup capital expenditures, rather than
“narrowly defined operating expenses” that naturally fluctuate. As such,
the SIB mechanism lacks essential attributes of an automatic adjustor
clause and does not fall within that exception to the constitutional fair
value determination requirement.

2. Interim Rate

¶27 Interim rates assessed on a temporary basis in between rate
cases may also be exempt from the constitutional fair value determination
requirement. The interim rate exception, though, “is limited to
circumstances in which: (1) an emergency exists; (2) a bond is posted by
the utility guaranteeing a refund to customers if interim rates paid are
higher than the final rates determined by the Commission; and (3) the
Commission undertakes to determine final rates after a valuation of the
utility’s property.” RUCO, 199 Ariz. at 591, ¶ 12, 20 P.3d at 1172.

¶28 During the Commission proceedings, AWC did not assert
that emergency circumstances exist. It instead described its infrastructure
replacement needs as “extraordinary,” and on appeal, it characterizes
them as “exceptional.” AWC estimates the cost of needed improvements
in the Eastern Group systems alone at $67 million over a ten-year period.

¶29 In the first phase of the Eastern Group Case, Staff did not
quarrel with AWC’s cost estimates or dispute the notion that
infrastructure at the end of its useful life must be replaced. Staff, however,
did not consider AWC’s situation an emergency or even an “extraordinary
circumstance.” Jeffrey Michlik, Public Utilities Analyst for the
Commission, testified:

Q. Do you consider infrastructure replacement to be an
extraordinary circumstance?

A. No. . . . That’s something we expect of all the water
companies that are public service companies here. They
should . . . supply customers with safe and reliable drinking
water, with or without a DSIC.

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Q. Does the dollar amount of [the repairs] et cetera, drive
the determination of whether something is extraordinary or
not?

A. It could, I mean if it’s a huge amount.

Q. . . . In this case [AWC] has talked about a $67 million
expense that they anticipate in infrastructure replacement. . .
. Does Staff consider that . . . significantly high to . . . deem
that circumstance extraordinary?

A. No.

Staff contended AWC was proposing a DSIC-type mechanism “for routine
expenditures” that was “unjustified.” In a brief filed during Phase I of the
Eastern Group Case, Staff wrote:

[O]ther cost recovery mechanisms in use in Arizona all
address extraordinary circumstances outside the utility’s
control, such as the fluctuating cost of natural gas or a
federal mandate requiring the addition of massive amounts
of plant. This case seeks to recover the cost of replacing
aging infrastructure. The most basic laws of science and
nature are that materials have a limited life-span. They
deteriorate and must be replaced. [AWC] knew from the
time it entered the market that someday the infrastructure
would require replacement. [AWC] could and should have
anticipated this event and prepared for the same, but failed
to do so. [AWC] has some control over the rate of
deterioration, by performing routine repairs and
maintenance. By their own admission, they cut maintenance
expenses “to the bone” in 2008. Staff has expressed concern
that this has caused a more rapid deterioration of plant. To a
significant extent, the circumstances in which AWC now
finds itself are of its own making. The customer should not
be required to bear the burden of the Company’s decisions.

¶30 The ALJ’s Opinion and Order noted “plentiful evidence”
that certain AWC systems have degraded and that leaks and breaks are
“occurring at excessive rates,” requiring replacement of infrastructure “at
a much faster rate than [AWC] has historically done.” But the ALJ
concluded the situation was not “exceptional,” so as to warrant “the
creation of and authorization to use a nontraditional ratemaking device
such as the DSIC.” See RUCO, 199 Ariz. at 592, ¶ 18, 20 P.3d at 1173

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(“Nothing in the record indicates that the increase in CAP water expense
rose to the level of an emergency situation, thereby making [the utility]
eligible for an interim rate.”).

¶31 In considering the ALJ’s findings and recommendations, the
Commission similarly found no emergency and cited AWC’s
acknowledgement it had not been “’ambushed’ by the need to replace its
aging infrastructure.” The Commission further noted that, “[i]n spite of
AWC’s decision to cut operating costs, AWC has consistently continued to
pay its shareholders dividends, paying $4,287,600 in 2008, 2009, and 2010.
. . . AWC increased the amount of dividends in 2011, after having held
dividends steady for three years.”

¶32 The settlement agreements that were later negotiated also do
not state that an emergency exists or describe circumstances that would
ordinarily be considered an emergency. See, e.g., Garvey v. Trew, 64 Ariz.
342, 354, 170 P.2d 845, 853 (1946) (“The word ‘emergency’ has a well
understood meaning. It is defined and understood as: ‘An unforeseen
combination of circumstances which calls for immediate action.’”); see also
Hunt v. Norton, 68 Ariz. 1, 11, 198 P.2d 124, 130 (1948) (“’Emergency’ does
not mean expediency, convenience, or best interests.”). Instead, the
Eastern Group Settlement Agreement provides, in pertinent part:

It is necessary for AWC to undertake a variety of system
improvements in order to maintain adequate and reliable
service to existing customers. AWC is also required to
complete certain system improvements in order to comply
with requirements imposed by law. The Signatory Parties
acknowledge that these projects are necessary to provide
proper, adequate and reliable service to existing
customers . . . .

In its final approval of the settlement agreements, the Commission again
made no finding of emergency circumstances and noted AWC’s
concession “that its infrastructure replacement needs have been
developing for a long time.”

¶33 Because AWC neither claimed nor established the requisite
emergency circumstances, the interim rate exception to the constitutional
fair value determination requirement does not apply.

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C. Compliance with Fair Value Determination Requirement

¶34 Absent a valid automatic adjustor mechanism or interim
rate, the Commission “cannot impose a rate surcharge based on a specific
cost increase without first determining a utility’s fair value rate base.”
RUCO, 199 Ariz. at 589, ¶ 1, 20 P.3d at 1170. The question thus becomes
whether the SIB mechanism satisfies this constitutional mandate.

¶35 Arizona is a regulated monopoly state. Ariz. Corp. Comm’n v.
Ariz. Water Co., 111 Ariz. 74, 76, 523 P.2d 505, 507 (1974). “The monopoly
is tolerated only because it is to be subject to vigilant and continuous
regulation by the Corporation Commission.” Davis v. Corp. Comm’n, 96
Ariz. 215, 218, 393 P.2d 909, 911 (1964). One important component of the
Commission’s “vigilant and continuous” regulatory role is determining
and using fair value when setting a monopolistic utility’s rates. In
discussing the fair value determination requirement more than a century
ago, our supreme court stated:

In order that the Corporation Commission might act
intelligently, justly, and fairly between the public service
corporations doing business in the state and the general
public, section 14 was written into the Constitution . . . . The
“fair value of the property” of public service corporations is
the recognized basis upon which rates and charges for
services rendered should be made, and it is made the duty of
the Commission to ascertain such value, not for legislative
use, but for its own use, in arriving at just and reasonable
rates and charges . . . .

State v. Tucson Gas, Elec., Light & Power Co., 15 Ariz. 294, 303, 138 P. 781,
784-85 (1914); see also Simms v. Round Valley Light & Power Co., 80 Ariz. 145,
151, 294 P.2d 378, 382 (1956) (“It is clear . . . that under our constitution as
interpreted by this court, the commission is required to find the fair value
of the company’s property and use such finding as a rate base for the
purpose of calculating what are just and reasonable rates.”).

¶36 A fundamental underpinning of the fair value determination
requirement is the principle that the public has “the right to demand” that
a public utility operate “with reasonable efficiency and under proper
charges.” City of Phx. v. Kasun, 54 Ariz. 470, 475, 97 P.2d 210, 212 (1939);
see also Ariz. Corp. Comm’n v. State ex rel. Woods, 171 Ariz. 286, 292, 830 P.2d
807, 813 (1992) (The Commission must use its “powers to regulate public
service corporations in the public interest.”). Although our constitution

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“does not establish a formula for arriving at fair value, it does require such
value to be found and used as the base in fixing rates.” Simms, 80 Ariz. at
151, 294 P.2d at 382; see also Ariz. Corp. Comm’n v. Ariz. Water Co., 85 Ariz.
198, 202, 335 P.2d 412, 414 (1959) (“No formula is given for determining
fair value . . . but the Commission must establish the rate base on the basis
of fair value and that alone.”). The fair value determination is intended to
avoid “the harsh extremes of the rate spectrum” and to ensure that both
consumers and public service corporations are treated fairly. US West, 201
Ariz. at 246, ¶ 21, 34 P.3d at 355.

¶37 The Commission suggests the SIB mechanism is
constitutionally permissible because it is akin to step rate increases the
Arizona Supreme Court discussed in Arizona Community Action Ass’n v.
Arizona Corp. Commission, 123 Ariz. 228, 230, 599 P.2d 184, 186 (1979)
(“ACAA”). We conclude otherwise.

¶38 ACAA includes dicta stating that, in the context of a rate case,
the Commission may consider construction work in progress (“CWIP”) in
calculating a utility’s fair value and may approve prospective percentage
rate increases based on that fair value for a “limited period of time.” Id. at
230-31, 599 P.2d at 186-87. The court observed that “[t]he adjustments
ordered by the Commission in adding the CWIP to [the] determination of
fair value were adequate to maintain a reasonable compliance with the
constitutional requirements if used only for a limited period of time.” Id. at
231, 599 P.2d at 187 (emphasis added). But even accepting this language
as persuasive authority, as the Commission urges, the SIB mechanism at
issue here differs materially from the step rate increases discussed in
ACAA.

¶39 ACAA suggests that, with Commission authorization, a
utility may charge stepped-up rates for a limited period of time to account
for CWIP that was reviewed and approved by the Commission during a
rate case. Here, however, much of the work that will be subject to SIB-
based surcharges was not in progress when AWC’s rate case was
adjudicated. Under the settlement agreements, AWC may add
improvement projects that will be subject to the SIB mechanism. Cf.
Consol. Water Utils., Ltd. v. Ariz. Corp. Comm’n, 178 Ariz. 478, 482-83, 875
P.2d 137, 141-42 (App. 1993) (affirming non-inclusion of anticipated CWIP
in establishing fair value rate base because, among other things, “[t]he
amount of actual construction to be undertaken is not known and
measureable”). And even if the Commission’s review of new projects
were to approximate the evaluation occurring during a rate case, unlike
the two-year step increases in ACAA, the Commission here has authorized

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AWC to seek surcharges for five years – the entire time span between rate
cases.

¶40 Turning next to the question of whether the SIB
mechanism’s methodology satisfies the constitutional fair value
determination requirement, we note that the documentation AWC must
submit to obtain approval of surcharges is substantially less than what is
required in a rate case. See A.A.C. R14-2-103(A)(1) (delineating financial
and statistical information “required to be filed with a request by a public
service corporation doing business in Arizona for a determination of the
value of the property of the corporation and of the rate of return to be
earned thereon, with regard to proposed increased rates or charges”).
Moreover, it is undisputed that the Commission will not conduct a full
fair value determination when it evaluates AWC’s surcharge requests.

¶41 Rigsby testified that RUCO’s primary concern with a DSIC-
type mechanism is that the Commission will not “take into consideration
all of the various ratemaking elements that would be looked at and
scrutinized in a general rate case proceeding. That would include such
things as revenues, expenses, and, of course, capital expenditures and the
prudency considerations for each one of those ratemaking elements.” The
record supports this concern. As Rigsby observed, the Commission will
only be “looking at the capital costs and depreciation expense associated
with the plant additions under the SIB, as opposed to an actual test year,
where we’re looking at all of the ratemaking elements that would . . .
include not only plant and accumulated depreciation and such, but other
rate base items like accumulated deferred income taxes, customer
deposits, working capital.” In other words, the SIB mechanism focuses on
the marginal effect of the SIB on fair value — an important, but quite
limited assessment of fair value. Steve Olea, former Director of the
Utilities Division for the Commission, confirmed that “[t]he only thing
being considered in the SIB is the plant,” not current operating and
maintenance expenses, and he acknowledged that “the SIB application
doesn’t look at all the rate case elements that you would normally look at
in a rate case proceeding.”

¶42 To be sure, AWC must submit substantial information to the
Commission when it requests a surcharge, including project details, “a
calculation of the SIB revenue requirement and SIB efficiency credit,” a
true-up calculation for the prior surcharge period, an analysis of the
impact of the SIB Plant on the fair value rate base, revenue, and the fair
value rate of return, current balance sheets and income statements, and an
earnings test schedule. But although infrastructure costs will be current

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when the Commission considers surcharge requests, other critical
valuation factors will be premised on a past rate case that, at the outer
reaches of the SIB cycle, will be five years old. Such a process is
inconsistent with the mandate that the Commission perform a fair value
determination “at the time of inquiry.” See Ariz. Corp. Comm’n, 85 Ariz. at
201-02, 335 P.2d at 414-15 (“A reasonable judgment concerning all relevant
factors is required in determining the fair value of the properties at the
time of inquiry. If the Commission abuses its discretion in considering
these factors or if it refuses to consider all the relevant factors, the fair
value of the properties cannot have been determined under our
Constitution.”); Simms, 80 Ariz. at 151, 294 P.2d at 382 (“Fair value means
the value of properties at the time of inquiry.”).

¶43 The abbreviated review under the SIB mechanism is
particularly problematic given the five-year duration of the surcharges
and the compounding effect those surcharges will have on ratepayers over
that relatively lengthy period of time. Additionally, the Commission will
not be assessing savings or other efficiencies attributable to capital
improvements when it approves surcharges. See Kasun, 54 Ariz. at 475, 97
P.2d at 212 (public has right to demand that utilities operate with
reasonable efficiency); Scates, 118 Ariz. at 534, 578 P.2d at 615 (A noted
peril of a “piecemeal approach” to rate-making via tariff is that it serves
“both as an incentive for utilities to seek rate increases each time costs in a
particular area rise, and as a disincentive for achieving countervailing
economies in the same or other areas of their operations.”).

¶44 In defending its decisions, the Commission cites cases that
confirm its broad discretion in setting rates. See, e.g., Ariz. Corp. Comm’n v.
Ariz. Pub. Serv. Co., 113 Ariz. at 371, 555 P.2d at 329. The Commission,
however, lacks discretion to disregard or dilute state constitutional
requirements, including the mandate that it determine fair value in setting
rates.

¶45 Nor do we agree that Scates authorizes a rate increase
without a fair value determination based on “exceptional circumstances,”
as the Commission and AWC suggest. Scates reversed an order approving
increased telephone rates because the Commission “failed to make any
examination whatsoever of the company’s financial condition, and to
make any determination of whether the increase would affect the utility’s
rate of return.” 118 Ariz. at 537, 578 P.2d at 618. In language unnecessary
to its holding, Scates continued:

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There may well be exceptional situations in which the
Commission may authorize partial rate increases without
requiring entirely new submissions. We do not decide in
this case, for example, whether the Commission could have
referred to previous submissions without some updating or
whether it could have accepted summary financial
information. We do hold that the Commission was without
authority to increase the rate without any consideration of
the overall impact of that rate increase upon the return [of
the company], and without, as specifically required by our
law, a determination of [the company’s] rate base.

Id.

¶46 To the extent this dicta in Scates can be read as suggesting
that an “exceptional situation” may excuse the constitutional requirement
for a fair value determination, we disagree. No Arizona court has so held,
and since Scates, we have reaffirmed that, absent a valid interim rate or
automatic adjustor mechanism, the Commission may not impose rate
surcharges without first determining fair value. See RUCO, 199 Ariz. at
589, ¶ 1, 20 P.3d at 1171.

¶47 AWC’s reliance on US West is similarly unavailing. In a
fundamentally different context, our supreme court held in US West that
although a fair value determination is constitutionally mandated when
rates are set, in a competitive market, the Commission has “broad
discretion” to determine what weight to give that determination. US
West, 201 Ariz. at 246, ¶¶ 19-21, 34 P.3d at 355. We are not dealing here
with a competitive market. Nor is our focus on how the Commission may
weigh and apply fair value in approving surcharges. At issue is whether
the SIB mechanism provides the functional equivalent of a fair value
determination. See Ariz. Corp. Comm'n, 85 Ariz. at 202, 335 P.2d at 414
(The Commission abuses its discretion if “it refuses to consider all the
relevant factors” in determining fair value.). Moreover, US West confirms
that in the context of a regulated monopoly, the Commission must both
determine and use fair value:

[W]hile the constitution clearly requires the Arizona
Corporation Commission to perform a fair value
determination, only our jurisprudence dictates that this
finding be plugged into a rigid formula as part of the rate-
setting process. . . . As we have seen, a line of cases nearly as
old as the state itself has sustained the traditional formulaic

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approach. The commission . . . correctly points out,
however, that those decisions were rendered during a time
of monopolistic utility markets. In such a setting, where
rates were determined by giving the utility a reasonable
return on its Arizona property, the fair value requirement
was essential. We still believe that when a monopoly exists, the
rate-of-return method is proper.

201 Ariz. at 245-46, ¶¶ 17-19, 34 P.3d at 354-55 (emphasis added); see also
Phelps Dodge Corp. v. Ariz. Elec. Power Coop., Inc., 207 Ariz. 95, 105 n.8, ¶ 21,
83 P.3d 573, 583 n.8 (App. 2004) (“Although [US West] held that this rate-
of-return method for rate setting may be inappropriate in a competitive
environment, it affirmed the supreme court’s long-standing view that this
method is properly employed in traditional, non-competitive markets.”).

¶48 The Commission and AWC raise colorable policy arguments
in support of flexible rate-making tools like the SIB and stress that other
jurisdictions have approved similar devices.5 We recognize the
Commission’s legitimate desire to “initiate innovative procedures in an
attempt to deal promptly and equitably with increasingly complex
regulatory matters,” and its corresponding goal of avoiding “a constant
series of extended rate hearings [that] are not necessary to protect the
public interest.” ACAA, 123 Ariz. at 230-31, 599 P.2d at 186-87. But the
question before us is not whether the SIB mechanism represents prudent
public policy. Our focus is on the propriety of that mechanism given the
unique and express provisions of our state constitution.

¶49 The fair value determination requirement imposed by the
Arizona Constitution may be cumbersome, time-consuming, and
expensive, as the Commission asserts. The answer, though, is not to

5 Also in the record are materials describing potentially negative
policy implications of DSIC-type mechanisms, including circumvention of
regulatory review of rate base items for prudence and reasonableness,
elimination of incentive to control costs between rate cases, and rewarding
water companies that “imprudently fall behind in infrastructure
improvements.” Additionally, AWC’s reliance on “regulatory lag” as a
basis for implementing a DSIC-type mechanism caused Staff to note
during Phase I of the Eastern Group Case that “[w]hile utilities tend to
decry regulatory lag as causing them to have to wait too long to recover
costs, regulatory lag serves a useful purpose in incentivizing a utility to
operate efficiently and minimize costs.”

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ignore it or to circumvent the constitutional mandate by judicial fiat. See
Ariz. Const. art. 2, § 32 (“The provisions of this Constitution are
mandatory, unless by express words they are declared to be otherwise.”).
Although the Arizona electorate has refused to amend the constitutional
fair value requirement in recent years,6 “[s]hould they think it wise, our
citizens are free to amend the Arizona Constitution to reflect changed
circumstances.” US West, 201 Ariz. at 245, ¶ 12, 34 P.3d at 354.
Meanwhile, under appropriate circumstances, the Commission may
employ alternative rate-making devices approved by our appellate courts
if it complies with the well-established requirements for those
mechanisms.

¶50 Because the SIB mechanism does not comply with the
Arizona Constitution’s mandate that the Commission determine and use
fair value when setting a monopolistic utility’s rates, we vacate the
Commission’s approval of that rate-making device.

II. Return on Equity

¶51 RUCO also contends the adoption of a 10.55% ROE was
arbitrary given the Commission’s corresponding approval of the SIB
mechanism. To the extent this argument is not moot by virtue of our
disapproval of the SIB mechanism, we disagree.

¶52 “[T]he Commission is constitutionally mandated to set fair
rates of return on fair value base of public service utilities.” Ariz. Corp.
Comm’n v. Citizens Utils. Co., 120 Ariz. 184, 188, 584 P.2d 1175, 1179 (App.
1978). “This function cannot be performed by the judiciary and the
judicial role is limited . . . to determining whether the Commission’s
decision was supported by substantial evidence, was not arbitrary and
was not otherwise unlawful.” Id. The Commission exercises discretion in
setting an appropriate rate of return. Litchfield Park Serv. Co. v. Ariz. Corp.
Comm’n, 178 Ariz. 431, 434, 874 P.2d 988, 991 (App. 1994).

¶53 The Commission considered substantial evidence relevant to
the ROE determination. Some of that evidence, including expert opinions,
suggested that AWC required both a SIB-type mechanism and a higher

6 Arizona voters defeated proposed constitutional amendments to the
fair value determination requirement in 1984, 1988, and 2000. US West,
201 Ariz. at 245 n.2, ¶ 12, 34 P.3d at 354.

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ROE to complete necessary projects and obtain financing. See Bluefield
Waterworks & Improvement Co. v. Pub. Serv. Comm’n of W. Va., 262 U.S. 679,
693 (1923) (“The return should be reasonably sufficient to assure
confidence in the financial soundness of the utility and should be
adequate, under efficient and economical management, to maintain and
support its credit and enable it to raise the money necessary for the proper
discharge of its public duties.”). Other testimony posited that the
efficiency credit included in the settlement agreements effectively reduces
the ROE. Opinions about the appropriate ROE ranged from 8.5% to
12.5%. RUCO took the position that the ROE and SIB mechanism are, to
some degree, duplicative, and that the SIB reduces AWC’s risk “because it
improves cash flow and reduces regulatory lag related to cost recovery of
qualifying infrastructure investment.”

¶54 Faced with a conflict in the evidence, a majority of the
Commission opted to authorize the 10.55% ROE, even while approving
the SIB mechanism.7 There is support for that decision in the record, and
our role is not to reweigh the evidence to determine whether we would
reach the same conclusion. See DeGroot v. Ariz. Racing Comm’n, 141 Ariz.
331, 335-36, 686 P.2d 1301, 1305-06 (App. 1984) (appellate court does not
reweigh evidence to resolve perceived conflicts). We find no abuse of
discretion in setting the ROE at 10.55%.

7 Commissioners Brenda Burns and Robert Burns dissented. In his
written dissent, Commissioner R. Burns stated that the final decision
“allows for both a SIB mechanism and a higher return on equity . . . which
leads to duplicative recovery.” He concluded that permitting “both a SIB
and an elevated ROE is not in the best interest of the ratepayers.”

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CONCLUSION

¶55 For the reasons stated, we vacate the Commission’s approval
and adoption of the SIB mechanism but affirm its determination of the
appropriate ROE.

:ama

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