Taking Advantage of the Fair Market Value Methodology for Ratemaking Purposes in Water/Sewer System Acquisitions

by David Klein and Chloe Daniels

It is commonplace in Texas for retail water and sewer systems to be bought and sold, and when the parties to such a transaction involve a for-profit utility and/or non-profit water supply corporation, the parties must first secure the approval of the Public Utility Commission (“PUC”) to close on that transaction. To obtain that approval, the parties must file a “Sale, Transfer, Merger” (“STM”) application at PUC under Texas Water Code (“TWC”) § 13.301. In its review of the application, PUC examines whether the purchaser has an adequate financial, managerial, and technical capability to provide the retail service(s). Additionally, PUC also considers whether the facilities conveyed were initially obtained by the seller as a contribution in aid of construction, because such contributed capital may not be included in invested capital or allowed depreciation expense by the buyer in rate-making proceedings. In other words, the buyer cannot recover a rate of return over such improvements. Now, however, PUC has afforded buyers and sellers with an alternate and potentially helpful methodology for valuing water and sewer systems that are the subject of an acquisition, based upon the “fair market value” of those assets.

The Fair Market Valuation (“FMV”) process, established in TWC § 13.305, is not a substitute process for the STM application, but rather is a process that the buyer and seller can undertake before filing the STM application. In short, the use of the FMV process allows the buyer and seller to voluntarily agree to an independently determined transaction price for the selling utility or facilities to be sold, and this transaction price can then be used in the STM application. Within thirty days of initiating the FMV process, PUC will select three qualified utility valuation experts to prepare appraisals of the selling utility or facilities to be sold. The appointed experts then have 120 days to jointly retain an engineer to conduct an assessment of the tangible assets of the utility or facilities to be sold, conduct individual independent appraisals in compliance with TWC § 13.305(c), and provide the buyer and seller with their completed appraisals. The fair market value for the contemplated transaction is calculated by taking the average of the three experts’ appraisals. The utilities then file their STM application that must include each of the three appraisals and the price agreed upon by the parties, among other transaction details. Actual use of the calculated FMV amount is not expressly required by TWC and associated regulations; therefore, the utilities can use a transaction price that differs from that calculated in the FMV process. From start to finish, the process can take approximately 150 days – 30 for staff to appoint experts and an additional 120 for the experts to complete and submit their appraisals. Then, PUC will review the transaction and closing costs, including fees paid to utility valuation experts, in the rate case in which the acquiring utility requests rate recovery of those costs.

The FMV process is not necessarily available to all for-profit utilities. Instead, at this time, the FMV process is only available to buyers that are Class A or B Utilities. But for those utilities that qualify, the FMV process can be a valuable tool for the buyer in establishing an updated rate base, especially considering that the participating utilities are not bound to the determined FMV amount. On the flip side, however, the FMV process can add additional delay and expense to the STM application process. Therefore, in the end, a buyer and seller should evaluate their goals and timing constraints to decide whether to take advantage of PUC’s FMV process.

David Klein is a Principal in the Firm’s Districts and Water Practice Groups. Chloe Daniels is a to-be-licensed Associate in the Firm’s Districts and Water Practice Groups. If you would like additional information or have questions related to this article or other matters, please contact David at 512.322.5818 or dklein@lglawfirm.com, or Chloe at 512.322.5814 or chloe.daniels@lglawfirm.com.