Attorneys Michael Colantuono, Kelly Salt, and John Bakker discuss the decision and its implication for water conservation pricing in California
With the recent 4th District Court of Appeals determination that San Juan Capistrano water rates do not meet Proposition 218 requirements, tiered rates have been under scrutiny. On May 12th, the California Urban Water Conservation Council held a webinar featuring attorneys Michael Colantuono, Kelly Salt, and John Bakker who discussed the decision in detail, and gave their thoughts on how the court decision will impact tiered water rates and water conservation pricing going forward.
Here’s what they had to say.
GREG WEBER, Executive Director of the California Urban Water Conservation Council
Greg Weber, Executive Director of the Council, began with an overview of the basics. He began by noting that Prop 218’s technical name is ‘The Right to Vote on Taxes Act.’ “I think that’s helpful for giving some context when we apply Prop 218 to the water world,” he said.
Prop 218, approved by voters in 1996, was pitched as a son of Prop 13, the measure enacted previously that limited ad valorem taxes and property taxes, and put in supermajority voting requirements for a number of tax measures, he explained. “If you read the legislative history to the extent that there is some of it, the main goal was to prevent what I call an end run around the Prop 13 limits,” he said. “It was to basically keep cities from using assessments, fees and charges to raise revenue for the general fund. I think it’s important to remember that while it gave people the opportunity to vote on taxes, the main goal was to avoid a subterfuge and a way of building up general funds by using utility revenues.”
Prop 218 enacted a number of procedural and substantive requirements; it addressed a wide variety of potential taxes or levies, Mr. Weber said, noting that today, this webinar would be focusing on the property-related services part of the proposition. “It wasn’t actually until 2006 that the California Supreme Court concluded that provision of water service is a property-related service, so for ten years, it wasn’t even entirely clear that Prop 218 applied to water service rates,” he pointed out.
The substantive requirements are well known to most of us, he said. “The revenue received for the property related service may not exceed the costs required; they may not be used for any other purpose other than the property-related service for which they are collected, and perhaps the one that’s caused the most consternation, that the amount of the fee charged may not exceed the proportional cost of providing the service to the parcel. We are now starting to get some case law on just exactly what that means.”
“Additional limits are that the service must be immediately available to the charged parcels,” Mr. Weber continued. “These charges also cannot pay for services that are generally available to the public. They must be specifically related to properties, so that’s a limitation whose ultimate limits have not even begun to be explored.”
Mr. Weber pointed out that in a lawsuit challenging the propriety of a rate structure or specific rates, the burden is on the water utility to prove that its rates are legal and that it’s consistent with 218. “This reversed a long standing tradition in which the challengers would have had to demonstrate that a rate structure was illegal and was not compliant with the applicable law,” he said.
He briefly noted that other Prop 218 procedural requirements include that rate changes must be noticed, a majority of landowners of 2/3rds of voters must approve, and a majority of property owners can block proposed rates by sending in written protests.
MICHAEL COLANTUONO, Colantuono, Highsmith, and Whatley PC
Michael Colantuono then discussed the details of the San Juan Capistrano case. He began by noting that the City of San Juan Capistrano established their allocation-based tiered rates in the early 1990s in response to the drought. “Every parcel in town has a budget for water use in each month that reflects the size of the parcel, the land use of the parcel, and the number of people who reside on the property,” he said. “So while an average single family residence with an average sized lot in town gets 17 hcf per month, the amount actually varies from parcel to parcel based on size.”
The rates have been updated every few years to reflect costs and the water allocations have been refined and brought down slightly. The rates at issue in this case were fashioned by a rate consultant in 2009, and adopted by the city council in February of 2010; the lawsuit was filed in 2012.
Mr. Colantuono said that the plaintiffs, the newly formed Capistrano Taxpayers Association, had four concerns about the water rates:
Groundwater project was a waste: “One is they felt the city’s reliance on its groundwater reclamation project that took the salty, briny groundwater that they were harvesting, treating and using was wasteful, and they brought an action under CCP Section 526A which is a statute which allows any taxpayer to challenge government ‘waste’. They felt that they should be relying solely on Metropolitan water which they felt was cheaper.”
“Phantom bond”: “They also objected to the fact that when the city did the Cost of Service Analysis, it estimated its cost to meet the capital needs of the wastewater utility by proposing a bond structure where they would issue bonds over the life of the five year rate program to acquire the capital they need to provide service to them,” he said. “After the rates were imposed, the city elected not to issue debt because it didn’t have creditworthiness enough in its water utility to get that at an affordable price. So instead, they used the same revenue coming in from these rates to accomplish their capital needs on pay as you go basis. One of the claims in the lawsuit was, “you said you were going to issue a bond and you didn’t issue the bond, you should reduce your rate to eliminate the cost of the bond.’ They were confusing an estimate of future costs with a straightjacket for how you operate the utility.”
Funding new purple pipe rates from domestic rates: “Their third complaint was that we were funding the development of a new purple pipe recycled water service that would serve some property owners with the proceeds of domestic water rates on all property owners, and they argued that violated article 13 d section 64, that says you can’t charge somebody for a future service that’s not available.”
Cost justification of tiers: “Lastly and most importantly, in hindsight, they claimed there was an inadequate cost justification of the breakpoints in the prices of the tiers.”
Mr. Colantuono noted that the groundwater charge was abandoned in trial court, and they lost the bond issue in the trial court and did not raise it on appeal. “So the only issues that were tried to the court of appeal were the question of whether or not the domestic rate can fund a recycled water service, and how much precision is required in the cost justification of the tiers,” he said.
“The court decided two things,” Mr. Colantuono said. “They ruled for the city on the recycled water issue, saying that a fee for water service is for water service broadly defined, which is all of the things we do to acquire, distribute, and maintain a water supply that’s safe and adequate over time. And that a recycled water program is effectively a water supply because it displaces demand for potable resources, making those resources available to others so that everybody could pay for the recycled water.”
“Then they said something a little confusing, and I think intellectually inconsistent,” he said. “They said that because the recycled water utility was necessary because of more use of our water supply then we had supply to meet, that only upper tier customers should pay for the recycled water, and that we should be required to prove on remand that we didn’t charge any of the cost of the recycled water utility to tier 1. That strikes me as illogical. Either the recycled water utility is a service that serves everybody as water supply and we can charge everybody, or it’s a supplemental water supply that only the upper tiers can pay for, but it’s not both, so I think there’s some illogic in the court’s decision there.”
“On the second issue, which is what cost justification is required for tiers, the court said, very fine,” he said. “What San Juan Capistrano actually did and what the court opinion says it did are not the same, and when lawyers evaluate the precedental effect of cited cases, we evaluate what the court said was true, what not was actually true.”
“What San Juan actually did is they distributed the cost of their water utility to the penny across their customer classes, single family residential, multi-family residential, commercial and industrial, recycled, fire flow, etc … to the penny,” he explained. “Within the residential class, they recovered their costs based on price tiers that were mathematically a smooth curve where the base rate was tier 2; tier 1 was a discounted rate that was about a third below; tier 3 which was up to double your allocation was 50% higher; and then tier 4 was five-sixths higher than that. A nice smooth geometric curve, so we distributed the costs of the residential class among the tiers in what I call a legislative way. We didn’t attempt to prove that tier 4 service was 5/6ths more expensive that the tier 3 service.”
“We felt that was appropriate for a couple reasons,” he said. “One is that there is no tier 4 customer class. Tier 4 is an observation of how much use a particular customer did in a particular month. We’re all tier 1, we all have the possibility of being tier 4, we could be tier 4 this month and tier 3 next month, so the relevant class to analyze as to cost in our view was the residential customer class. The court of appeal disagreed, and said that you should be able to calculate to the penny your cost of delivering each of those tiers. And because we didn’t have a cost justification to the penny for tiers 1,2,3, and 4, they invalidated our rates.”
“Now what the court said San Juan did and therefore what the case stands for is that we didn’t attempt to justify our costs at all; that we argued that because the water utility was recovering its costs and not subsidizing the general fund, that we didn’t’ have to explain how we were attributing costs between residential, commercial, etc,” he said. “So the opinion simply stands for the proposition that if you make no effort to divide your costs among customers in proportion to the costs of serving them, your rates don’t comply with 218.”
“I don’t think any of the lawyers in this webinar would have thought that was anything other than a true statement of the law, so as to its holding, San Juan Capistrano, doesn’t say all that much new,” he said. “The problem is a lot of dicta – meaning other things the court said along the way, that suggest that tiers have to be very tightly tied to costs. They suggest there is a knowable, calculable judicially measurable one right way to apportion costs, and they are going to be doing a very searching review of our cost allocation.”
The ‘proportional cost of service attributable to the parcel’ requires that ‘tiered prices be correlated with the actual cost of providing water at those tiered levels,’ the court’s decision says. “Actual costs – that means there is such a thing, that we know in some objective, scientific, non-debatable, non-judgmental way what the cost of delivering tier 4 water is,” he said. “I think that oversimplifies the world that we live in, but that’s the world that this court thinks we live in. It’s a very narrow reading of Article 10 Section 2 duty to conserve.”
The court rejected the argument that the upper tiers could be justified as fines and penalties, Mr. Colantuono said. “The language the court used is unfortunately broad and has raised some questions about our ability to use fines and penalties other than to justify pricing mechanisms, and it doesn’t even discuss our argument that Prop 218 only protects that level of water supply necessary to allow any reasonable use of property, meaning residential use.”
“There’s a lot of consternation about this decision, both at the state and local level, and the Governor immediately issued a press release at the very moment the case came down, disagreeing with it,” he said. “The State Water Resources Control Board is in active dialog looking for solutions to keep this tool of price signals to conserve during the worst drought that California has ever experienced.”
At the time of the webinar (May 12), the case was not yet final. The City of San Juan Capistrano filed a petition for rehearing and then withdrew it, announcing it would settle with the plaintiffs instead; the City has since agreed to refund customers.
Mr. Colantuono said he anticipated that the State Water Resources Control Board will ask the court to use its own power to rehear the case. “Rehearing can be sought by a party, and if a party doesn’t seek it, the court can rehear it too. I anticipate that the SWRCB and possibly ACWA, CSAC, and California cities will ask the court to use its own power to rehear the case.”
“Once the case is final as to the District Court of Appeal, then there will be requests by the SWRCB and the local government associations to ask the Supreme Court to depublish the case,” he said. “Depublish means eliminate it as precedent for future cases, so it would only be binding on San Juan Capistrano and the Capistrano Taxpayers Association; it would not bind anyone else. The problem with depublication is that it takes this authority off the books, but reraises the question as to how much precision is required in the cost justification of tiered rates, and it might take two years before the other cases that the lawyer behind this case has filed can percolate up to the court of appeal.” (Update: In June, the Attorney General’s office did ask the court to depublish the ruling. In July, that request was denied, leaving the ruling in place.)
Mr. Colantuono then posed the question, what if the case is not depublished, what other ways are there to restore the ability to use a pricing signal in a time of drought?
A constitutional amendment: Mr. Colantuono acknowledged this requires several hundred thousand signatures on an initiative petition, or it requires the legislature acting by a two-thirds vote of each house to put a measure before the voters. “This case and Prop 218 had libertarian sources. Anti-government/small government, keep the taxpayer resources with taxpayers kind of perspectives, so it’s ironic that the result will be to eliminate our ability to use capitalist market pricing signals and force us instead to use command and control techniques that tell people they can only water their lawn on alternate days. That irony may create sympathy in the Republican caucuses in the legislature for a constitutional amendment to restore price signals, and to eliminate the necessity of command and control. So a constitutional amendment is possible. It would likely be on the November 2016 ballot.”
Statutory fix to the Government Claims Act to eliminate class action lawsuits: “The Supreme Court interpreted the government claims act and a couple of cases in 2011 and 2013 to allow class action challenges to local government revenues,” he said. “We’ve already seen class action challenges to tiered rates being threatened in a number of places around the state since the April 20th decision in San Juan Capistrano. That problem can be fixed by the legislature and the legislature might be open to eliminating the class action remedy, which at least lower our risk of litigation and reduces the cost of litigation.”
Statutory affirmation that tiered rates can comply with 218: The legislature can reaffirm the water code 270 series expressing the legislature’s view that the tiered rates can be consistent with Prop 218. “The courts have been somewhat open to considering the legislature’s efforts to harmonize the competing sections of the constitution here, but it’s probably going to be less helpful than it might have been at another time because when the legislature tries to interpret the constitution after a court decision, courts are less likely to acknowledge.”
Validation of existing rate structures: Attorney John Bakker explained that the idea is that the legislature has the power it has and does validate various actions from time to time, although usually in a less controversial context. “I believe the legislature could validate existing rate structures that would not be cutting off the ability to challenge those rate structures that could have been challenged previously. I think there’s some case law support for that idea,” Mr. Bakker said. “It would be a very aggressive step and I’m not sure that the legislature would do it, but I just wanted to raise it as something that the legislature has the power to do or consider doing.”
Water rates litigation isn’t only the San Juan case, Mr. Colantuono said. “Before we got a decision in San Juan, the same lawyer who was challenging San Juan’s tiered rates who has since moved to a public law firm and has made it clear that this is a business that he intends to be active in, and he filed identical complaints against the city of Glendale and the Sweetwater Authority down in San Diego County. There is also a class action challenge to San Jose’s general fund transfer from its water utility. Those were all pending before April 20. After San Juan, I have seen public records requests and claims in a couple of cities already and a couple of water utilities already, and we should anticipate more. This is an invitation to a lawyer’s field day.”
Mr. Colantuono then reviewed the options for the water rate making community if San Juan is and stays the law:
Couple flat rates with fines for excessive use
Carefully cost-justify the tiers: “One is do what the court of appeal suggested in the San Juan case, which is identify particular costs that you can assign logically to the upper tiers like the cost of your water conservation staff, your public education efforts, and maybe the cost of your water police and put those on the upper tiers, calculate the volume of water you expect to sell in the upper tiers, and spread the cost across the volume to the penny. This can be done but that’s going to produce very flat rates that don’t send very much of a conservation signal.” He noted that there are there are good rate making lawyers and good rate making consultants have some other ideas they are working on.
Seek approval of tiered rates as a tax: “You need two-thirds voter approval for that, but I would imagine given the broad support for tiered rates that would be possible in some communities. It is pretty slow and pretty expensive.”
Investor owned utilities can impose tiered rates: “I also make the observation that Prop 218 only governs government,” Mr. Colantuono said. “It does not apply to investor owned utilities, so investor owned utilities can impose tiered rates, which means if you transfer your utility to an investor-owned utility, you can have tiered rates. Pretty dramatic solution for this problem, but it is one that’s out there.”
KELLY SALT, Best Best & Krieger
Kelly Salt began by noting that the court’s decision has left a lot of holes and little direction on how to justify tiers. She then gave some options for water agencies to ensure that their existing rates comply with Prop 218 as well as San Juan Capistrano court case.
Consider the marginal costs of water that justify tiers:
The need to develop additional supplies: “You’re going to obviously tie it directly to the additional water supply costs,” she said. “The courts have already recognized that as a true basis upon which to allocate different costs to different customers or among the customers in different tiers. So if you have higher supply costs associated with purchasing water, developing water, etc, than you can allocate a greater portion of those projects and costs to those who create greater demands on your system.” An agency could include their lowest priced water in tier 1, the second lowest cost in tier 2, and so on, she said.
An agency can also consider other differential costs and avoided costs associated with developing alternative water supplies, such as a desalination project, a recycled water project, or delivery system. “Those costs may be associated with the higher costs in your upper tiers, because those who create the greatest demand are requiring that you develop those alternative supplies in order to make sure that you have a potable supply system to serve all your customers.”
Water conservation and efficiency programs: Ms. Salt noted that it may be more appropriate to allocate a greater portion of the costs of water conservation programs and efficiency programs to those who create the need to meet that demand.
Consider avoided costs: “If you develop a recycled water cycle program, what other costs are you avoiding and is it appropriate to allocate those avoided costs to your higher tiers?”
Use unrestricted funds to justify the lower tiers: “That would be for example, your ad valorem property tax revenues that you receive, like the revenues associated with lease revenues, such as cell tower site leases on your property, or other revenues that you might take in that are unrestricted since its use of your other property.”
Supplement your existing administrative record and reenact your rates: “Obviously that might require that you go through another Prop 218 hearing; however you can certainly augment to your administrative record for any rates that you have already adopted through multi-year rate schedule as you go through the annual adoption or determination of whether or not to implement those annual rates.”
Prepare a new study or update your existing rate study and revise your rates
Ms. Salt pointed out that the San Juan Capistrano case is only one appellate court decision; at least two other courts have come to somewhat of a contrary conclusions on proportionality requirements of Prop 218 then that of the San Juan Capistrano case. She then discussed two of them: Griiffith versus Pajaro Management Agency, and Morgan versus Imperial Irrigation District.
Griiffith versus Pajaro Management Agency
The Pajaro Valley groundwater basin is subject to chronic overdraft. The agency adopted a program to deliver supplemental water to some coastal users and developed other supplemental water projects. The cost of the programs was to be shared by all properties served by a well within the boundaries of the agency. The agency adopted groundwater augmentation charges and essentially applied them to all customers.
“The court held that the groundwater augmentation charges do not differ materially from a charge on delivered water, and recognized that water service means more than just supplying water; it includes managing a groundwater basin and ensuring an ongoing potable supply of groundwater to the entire basin,” she said. “So this demonstrates that water is more than the just the cost of the supply you purchase; it’s all of your costs of managing and ensuring ongoing potable supply and therefore it might be appropriate to allocate a greater portion of the costs to those who use it.”
“Griffith also had an argument made by the plaintiff that the charge was disproportionate to the cost of service because they did not use any of the supplemental water; they were inland well users,” she said. “The court, however, found that the groundwater augmentation charges did not exceed the proportionate costs of service because all groundwater users benefit from the agencies groundwater management activities, not just the coastal users receiving supplemental water. The court’s ruling supports the practice of many public agencies that require all property owners who receive the benefits of a property-related service to share in a portion of the costs of that service. As the court recognized in the San Juan case, that would include recycled water, but it also includes all of your other costs associated with water conservation and water management costs.”
Ms. Salt noted that the court also rejected the plaintiff’s argument that the city of Palmdale versus Palmdale Water District case held that a parcel by parcel analysis is required in apportioning costs. “Palmdale held that the water district failed to carry its burden to justify disparate treatment of its customer classes; the court there had found that grouping similar users together and calculating fees on a class by class basis is a reasonable method of allocating costs of services,” she said. “The court indicated in the Griffith case that apportionment is not a determination that lends itself to precise calculation, given that Proposition 218 describes no particular method for apportion of fee or charge, other than the amount shall not exceed the proportional cost of service attributable to the parcel. The agency’s method of grouping similar users together for the same rate and charging users according to usage is a reasonable way to apportion the costs of service. That there may be other methods favored by the plaintiffs does not render the agency’s method unconstitutional.”
“Proposition 218 does not require more finely calibrated apportionment, so in other words, you can group similar users in calculating your fees on a class by class basis, rather than on a parcel by parcel basis,” she said. “It’s appropriate to have within your customer classes the ability to have more discretion in how you allocate your costs, so again apportionment is not a determination that lends itself to precise calculation, it justifies having some discretion in how you allocate those costs.”
Morgan versus Imperial Irrigation District
“One of the significant things that was at issue here was the court first acknowledged that the different services may cost more, and different users create special costs,” Ms. Salt said. “So in establishing your customer classes, it’s appropriate to use your customer classes to distribute different costs you incur, as well as within your customer classes, to allocate a greater portion to those who create or result in your customers creating different costs and creating special costs for you.”
“This recognition may have some relevance in arguing tiered rates and other conservation based rates are consistent with the proportionality requirements of Section 6b,” she said. “By analogy, it may be argued that high volume water users create special costs, and those costs may be allocated through a tiered or conservation based rate structure, and this is as the court found the rate consultant properly considered the cost differences in preparing the cost of service of study and allocating costs to different customer classes.”
“The court also found that in this instance, the rates that were structured, the staff had estimated the annual amount of water used by certain customers because they did not have proper metered rate measurement of the water use; instead they relied on data published by the AWWA and others,” she said. “The trial court found that the cost of service study was very thorough and not defective. And thus based in part on Imperial Irrigation District’s LANDSAT study, the trial court concluded that the IID staff satisfied the substantive requirements of Section 6b. So essentially court found that the data does not have to be perfect in justifying your rates, but there has to be a reasonable basis for it.”
JOHN BAKKER, Meyers Nave, PLC
John Bakker began by saying he wouldn’t be dwelling too much on risks and current rate structures. “This is really about agencies that have existing rates that are tiered basically; the risk is refund actions,” he said. “You can have an individual refund action from an individual customer, but you can also have a class action lawsuit seeking refunds. I think in most cases, you’re going to be able to make a case at best a litigant is only going to be able to get refund on the upper tier that they overpaid; in the lower tiers, you are paying less than the arguable actual costs, so it’s not going to be a catastrophic refund action. You’re not going to collect your full costs if a plaintiff prevails in a refund action, but you’re not going to lose everything.”
It’s possible the rate structure could be completely invalidated, Mr. Bakker said, noting that this is unlikely as agencies are entitled to be repaid for the services they are providing, and it doesn’t really make a lot of sense to entirely invalidate a rate structure that an agency is using to pay for services.
Mr. Bakker said there’s nothing that prevents an agency from not collecting at the higher rate if you’re concerned about it’s validity. “If you reduce the rate you are collecting at the higher tiers to the amount at the lower tiers, nobody’s being overcharged at that point and there’s nothing in 218 or any of the other taxpayer protection laws that prevent you from reducing rates.”
Some tiered rates are defensible, he said. “The best approach, the Cadillac approach is to have a both a lawyer and a fee consultant separately review your rate structures and get their views and then reconcile those views,” he said. “There’s a way lawyers look at things and there’s a way fee consultants and economists look at things, and sometimes they are not well reconciled, and so if you have those reviews done independently and then work after the fact on trying to reconcile those views, I think you’ll get to the best result.”
Mr. Bakker noted that there is a lot of debate among rate designers and fee consultants on how to allocate costs to customers. “So there’s a fair amount of room for rate design, despite what the San Juan court says,” he said.
It’s possible your rate structure has already been validated if you have issued debt based on it, Mr. Bakker said. “There’s a possibility that by operation of law, your rate structure has been validated under the validation statute which is under the code of civil procedure, section 860, so if you’ve issued debt after you’ve adopted your rates, you should have someone, a lawyer, take a look at whether there’s a possibility that your rate structure is validated.”
Mr. Bakker then turn to what the panel thinks the court got wrong in the San Juan decision.
“I think the biggest thing is the failure of the court to properly attempt to reconcile the water waste provision of the constitution with the other constitutional provision, Prop 218,” Mr. Bakker said. “The court has a duty to try to reconcile those two arguably inconsistent provisions and the court, to me I think, paid lip service to that. I also think there’s a lot of persuasive reasoning in Brydon versus Easy Bay MUD, which was a prop 13 case, granted, but I think there’s some good reasoning in there that the court just sort of ignored and swept aside on the view that was a Prop 13 case.”
“I think the reasoning with respect to the Brydon versus EBMUD still has tremendous utility in examining the question of tiered rates today, even with respect to the addition of the proportionality requirement of Proposition 218,” said Ms. Salt. “Because the court basically said in that case that shifting the cost of environmental degradation from the general public to those most responsible is consistent with the objectives of Prop 13, I would argue similarly you are proportionally allocating the greater costs of the impact of those who excessively use water away from those who conservatively use it, and that’s appropriate, particularly in light of Article 10, Section 2, and so I think you can reconcile the two very easily. The court chose, however, to take a very narrow reading of Article 10, Section 2 here, and in a sense, apply it, conclude that it’s not even applicable to the rates in question.”
Mr. Colantuono said that although there was a lot of briefing in this case, Article 10 Section 2 was not briefed very deeply. “We just observed that it stood for a statewide commitment to conservation. The court went and did its own research into Article 10, Section 2; it primarily looked at the historical resources from the 20s when that was added to our constitution, and without support of really good briefing, decided that what Article 10 Section 2 meant in 1928, it means in 2015 and ignored a century of case law development. I expect very good briefing on that issue to come out of the SWRCB as they try to get the courts to fix this case.”
Mr. Bakker said another thing is that they simplistically analyzed the proportionality requirements. “It’s a very simple view, it’s probably the narrowest view you could gloss on Prop 218, and I think it reflects a lack of understanding of the nuances of rate design. There’s a lot going on behind the scenes in rate design, and the court didn’t understand all that.”
“I think the final big thing that is wrong about the case is the discussion suggesting that excessive use penalties are generally inconsistent with Prop 218,” said Mr. Bakker.
Panel questions and answers
John Bakker then turned to questions, posing the first one to himself: Are penalties imposed for violating conservation standards permissible?
“If you look the end of the case, there’s a discussion basically rejecting the cities argument that the upper tiers were penalties and therefore not subject to Prop 218; I may be mischaracterizing the city’s arguments slightly,” said Mr. Bakker. “The court, and I would characterize this as dicta, went on to say, to basically reject the idea entirely of penalties for excessive use, arguing that it would violate Prop 218. The court said all the agency supplying any service would need to do to circumvent Prop 218 would be to establish a low legal base use for that service, declare by ordinance that any usage above that base use amount is illegal, and then decree that the penalty for such illegal usage equals incrementally increased rate for that service.”
“I think the court is confusing the city’s penalty rate argument with true penalties,” Mr. Bakker continued. “I think the court just missed this one, that language is dicta, I don’t think it would be very portable outside of that context. There’s a big distinction between true penalties for violating the law, and what one could refer to as penalty rates. In the rate context, the penalty rates are collecting revenues to pay for the service. In the true penalty context, the rates collect all the money for the service provision and the penalty is designed to control behavior, and any revenue arises from that comes to the agency’s general funds; there is some case law to that effect. In effect, Prop 26 distinguishes between levees and penalties and says that penalties are not subject to Prop 26. There’s this case, the California Taxpayers Assn versus Franchise Tax Board that makes a clear distinction between taxes and penalties, and I think I am of the firm belief that penalties for violating conservation standards are still permissible, notwithstanding what the court said in San Juan.”
“I think there are three positions we can take with respect to the fines argument,” said Mr. Colantuono. “One is that San Juan really just means you can’t use a fine argument to justify not having a cost justification for cost-justified fees -it certainly means that. It may mean that we can only use fines when we’re in a situation where we have sent somebody a notice, demanded they change their behavior, and fine them when they don’t. There’s a middle position which says we can build fines into our rate structure, provided we do it for water we don’t want to sell and that we don’t use it to meet any portion of our revenue requirement; that we treat these as supplemental revenues used for additional conservation or supply programs, so there’s three positions. It doesn’t mean very much, it means a whole lot, and something in the middle. For now, I think we ought to see if the case becomes final in its current form.”
Mr. Bakker asked Ms. Salt, “Why isn’t it appropriate to charge those who place greater demands on a water system and water supplies more for the cost of providing water? You’ll recall that San Juan found it was appropriate to allocate more costs of constructing a recycled water project to those who use more water.”
“I think this is where the court’s opinion was internally inconsistent,” Ms. Salt. “The court, with respect to recycled water, found that it was in fact appropriate not to charge those who used water in tier 1 because the recycled water project was there as an offset to potable water demand, and that those who did use the least amount of water shouldn’t have to pay for it. They are sending that back down to the trial court for further clarification or determination on that issue, so it seems internally inconsistent to me for the court to decide on the one hand that the tier one users shouldn’t have to pay for recycled water because they don’t create the need or demand for that, but then to say that it’s not appropriate to charge a higher rate simply because of the fact that those who place greater demands create additional costs to you, and having to specifically quantify to the penny what all of those costs are.”
Mr. Bakker then turned to Mr. Colantuono and noted that the San Juan case focused on water supply costs, but some fee consultants have been attributing other system costs to peak use. Is the cost of providing different sources of water the only justification for charging a higher rate?
“It was the most obvious justification, but there are some agencies that have a single source, and if you’re relying on a particular wholesaler for your entire water supply, the portfolio of supplies approach to cost justification of tiered rates was never going to work,” replied Mr. Colantuono. “So you might want to try to isolate particular costs within your utility, like your conservation coordinator, educational efforts, and enforcement efforts and attribute them to the upper tiers. There are also techniques related to the peaking characteristics of different customer classes that we use to spread rates across customer classes and it may be that something similar can be used to spread rates within a customer class.”
Mr. Bakker asks Ms. Salt under the San Juan reasoning, how are these tier heights to be determined and who triggers the need for what supply?
Ms. Salt said that she found the court didn’t give much direction at all in its decision on this particular question. “Ultimately if you were to look at the court’s reasoning, you could end up with as many as 20 different tiers if you have to justify each incremental cost associated with delivering more water, because their entire focus was on supply. The court didn’t even recognize in its hypothetical questions that it had for the supplemental briefing that there are other costs associated with delivering water … its entire focus was on source of supply, so at what point do you determine that there is an incremental cost to you to deliver 15 units, 16 units, 18 units of water. I think it’s an open question. I think the best we can do is continue to use the standards that have been universally or nationally applied and through the AWWA M1 manual in trying to determine tier widths in light of the guidance or lack thereof from the court in the San Juan case.”
“What we’re talking about here is how much water an agency allows in each tier,” said Mr. Colantuono. “In San Juan, it varies from parcel to parcel, but on average, it was 6 hcf in tier 1, which basically means no outdoor water use. 17 hcf in tier 2, and the tier 3 was up to double your allocation, which for an average customer would be 34, and tier 4 was above that. Nobody questioned at any point in this litigation that we had drawn those in appropriate places, therefore this case cannot be authority for any judicial limit on our ability to set those tier widths or tier heights. My view is that there isn’t any law that can be applied to answer that question. It is the kind of pure policy-driven legislative action that local governments engage in all the time. I would say that you should have a rational basis for your tiers, and you should articulate that rational basis in the record of your rate making, so you can explain yourself.”
“In San Juan’s case, I think they did a pretty good job of it,” continued Mr. Colantuono. “They showed that the 6 hcf was based on world health organization standard, adapted upwards a bit for our higher standard of living in the US, they showed that the 17 hcf was based on the shape of the bell curve of their customers actual use of water, showing that it was fairly typical, and then the double and above double was just a policy justification, so I don’t think the law controls this. There is loose language in the San Juan Capistrano decision which some of our opponents will read to say that it does.”
“So you’re saying the idea of establishing tiers for policy reasons to encourage conservation is fine,” Mr. Bakker said. “You then have to take another step to demonstrate the cost within those tiers, and if you do that, that you can make a case that’s permissible under Prop 218.”
Mr. Colantuono agreed. “One way to think about it is that before the tiers set in February 2010, San Juan Capistrano had three tiers: 17, 34, and above. They introduced the 6 hcf sort of super-saver tier in response to the water code which allows but does not require it. I think that was a legislative decision that the city council was elected to make, and that courts are not in a position to judge. Another way to put it is we get to decide what products we are selling; courts don’t tell us whether to have purple pipe service or not, whether to have flat rates or not, but once we choose a service and establish a price, courts will supervise how we do the cost accounting to set a price for that product or service.”
“That goes back to the fact that there are other court decisions that we can look to for guidance in terms of determining that issue,” added Ms. Salt. “How you allocate the costs I do believe should be a legislative discretion decision with policy considerations in mind for conservation and otherwise, so ultimately, while this case is persuasive authority, we hope we can look to the other court decisions until there is further guidance by the Supreme Court or other legislative or constitutional amendments which determine those issues for us.”
“Michael, the court says there really is an ascertainable cost of service that can be attributed to a specific parcel,” said John Bakker, reading from the decision. “If that’s the case, what legislative discretion remains for agencies in structuring their rates?”
“I think the statement is nuts,” responded Mr. Colantuono. “With all due respect to the court of appeal, I think it fundamentally misunderstands what ratemaking is about. Putting it most charitably to the court, I think what the court is trying to tell us is that San Juan had a particular strategy for justifying its tiers, and that strategy was to allocate it’s cheapest water to cheapest sources and its most expensive water to its most expensive sources, and it was all about supply costs and not about anything else. Well, once we’ve made that strategic choice, I think courts can evaluate fairly precisely how persuasively and how well we demonstrated that we did what we said we were trying to do … To say that there’s one true price for service is nuts.”
“The judge asked for a supplemental briefing on 10 questions, and the questions were all premised on this notion that we can ascertain costs, and so I gave the judge a 46 page brief, 23 pages answering his questions, and 23 pages explaining why his questions were fundamentally the wrong questions to be asking,” continued Mr. Colantuono. “One of the things I did was I identified 5 costs from San Juan Capistrano’s budget, things like liability insurance, workers comp insurance, a variety of indirect costs, and said to the court, how should we spread these? Should we put them all on tier 1 because to have a utility at all, we have to have these costs? Should we spread them flat volumetrically across all tiers? And for each of these costs, I put out three plausible distinct ways of allocating the costs, so on five cost centers I had 16 choices, and I said to the court, what law gives you the ability to tell my legislative body how each of those five choices be made? There isn’t any. It is a legislative process of judgments. Sure we have to be reviewed independently by judges and we have to have a persuasive case and we have to do our own math, but at its basics, there are many more ways than one to distribute the costs of a complicated water utility.”
“What water budget rates are possible if as San Juan says, budgets may not be used to establish tiers?,” asked Mr. Bakker.
“Budget-based rate is just another form of tiered rate structure, and so to the extent that tier 1 is your indoor use and tier 2 is your outdoor use, as long as you can provide a cost justification and a rationale behind it, I think you can proceed to use budget based rates,” said Ms. Salt. “Obviously it’s going to be a little more difficult to do that in light of the way the court approached the decision here, but as I said earlier, there are other bases on which you can establish cost allocation within your tier 1 and tier 2 for establishing your budgets, so I think they are still viable.”
Mr. Bakker then posed the question, are tiered rates even the most effective tool for encouraging conservation or are there other techniques that are more effective, noting that he’s talked to a few rate consultants think otherwise. “There’s a lot of debate surrounding the effectiveness of tiered rates for their conservation purpose, and so I’m not really answering this question other than leaving you with the idea that maybe uniform rates that cover all costs and fines for excessive use might be a more effective strategy for encouraging conservation. I also think that the way the BMP1.4 works where it shifts a lot of fixed costs to the volumetric component is also an effective tool to encourage conservation.”
“I would agree with John on this that there is a legitimate policy debate out there and as lawyers, we can’t dictate policy outcomes to our clients,” said Mr. Colantuono. “But I would also observe though that paragraph A to the governor’s drought order requires water utilities to use either tiered rates or fines, it gives you that choice, and so the debate will continue.”
“I would say that it requires the State Board to develop a requirement that agencies do either rates or fines and it remains to be seen exactly what the State Board’s going to do,” said Mr. Bakker. “Obviously they are dealing with San Juan presently and some of the debates around the ability to use penalties and fines, so we shall see how that turns out.”
Greg Weber, Executive Director of the California Urban Water Conservation Council, then explained what the term BMP 1.4 meant. “For those who don’t know it, BMP 1.4 is the Council’s conservation pricing best management practice, and currently there are two ways of meeting that,” he said. “One is demonstrating that 70% of a utility’s revenue comes from a volumetric portion and no more than 30% comes from a fixed fee. There’s another way that allows an agency to calculate a utility specific allocation of fixed versus volumetric costs. A new approach that the Council has been working for a couple of years … is a much more sophisticated and nuanced approach. It has three separate sections, and the first section does indeed award points based on the rate structure itself.”
“Uniform rates can in fact have a conservation signal to them without a doubt, but the recent studies that have just come out particularly out of the Eastern Municipal Water District is that the very existence of a tier itself can change people’s behavior and cause them to be more efficient in their water use, regardless of where the tier falls, regardless of how high or how low the tier is,” Mr. Weber continued. “The theory behind that is that once people know they are bumping up against a tier and that their additional water use will subject them to a higher rate, they conserve their behavior to avoid that higher rate, and therefore you’ll have a tendency to see less revenue collected through the higher tiers because people have in fact changed their behavior.”
“From the utility’s perspective, one of the least expensive ways of encouraging demand management is through the pricing structure,” Mr. Weber said. “There’s plenty of very expensive ways for a utility to become more efficient – fixing leaks on the utilities side of the meter is often the most expensive although it is totally under the utility’s control. On the other side of the spectrum, much of what utilities do in their conservation programs is dependent upon a third person, that is the customers or ratepayers, over whom the utility has very little control. Pricing seems to be a bit of a sweet spot in the sense that it does not cost the agency much proportionally, and can in fact have a very substantial impact in terms of reducing the volume of water used.”
“This is the former law professor in me that couldn’t resist,” said Mr. Bakker. “I’ve been intrigued by a fee-based model which has been used in some electrical efficiency, electrical power rate circles to encourage efficiency by using a rate structure while still addressing issues about cost and equity. The fee-based model would allow an agency to charge rates higher than costs if it rebated the surplus revenue back to all the ratepayers. David Zetland, whose a fairly provocative economist makes this argument in The End of the Abundance, which is a book that came out a few years ago; there’s now a new edition of it. It seems to me that there are plenty of Prop 218 questions that would need to be addressed, and my hunch after having thought about this for a bit is that it would be extremely challenging to survive a Prop 218 lawsuit using this sort of rate structure, so my guess is until some academic or policy wonk demonstrates that such a rate structure would be in fact consistent with 218, it’s unlikely that we’re going to see much experimentation or pilot programs out in the field.”
“I think conceptually we are already doing this,” he said. “Lots of us have conservation programs that give people a buck a square foot to tear out their turf, that subsidize more efficient appliances, that do free to the consumer water efficiency checks. We have a lot of services that are effectively free to our customers that are paid by other customers via tiered water rates, so we’re effectively doing some of these things now, and I think understood that way, 218 will allow those programs to continue.”
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