General
The following discussion and analysis provides information on AWR's consolidated
operations and assets and includes specific references to AWR's individual
segments and/or its subsidiaries (GSWC and ASUS and its subsidiaries), and AWR
(parent) where applicable. On
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Overview
Factors affecting our financial performance are summarized under Forward-Looking Information and under "Risk Factors" in our Form 10-K for the period endedDecember 31, 2019 . Water and Electric Segments: GSWC's and BVESI's revenues, operating income and cash flows have been earned primarily through delivering potable water to homes and businesses inCalifornia and the delivery of electricity in the Big Bear area ofSan Bernardino County, California , respectively. Rates charged to GSWC and BVESI customers are determined by the CPUC. These rates are intended to allow recovery of operating costs and a reasonable rate of return on capital. GSWC and BVESI plan to continue to seek additional rate increases in future years from the CPUC to recover operating and supply costs and receive reasonable returns on invested capital. Capital expenditures in future years at GSWC and BVESI are expected to remain at higher levels than depreciation expense. When necessary, GSWC and BVESI are able to obtain funds from external sources in the capital markets and through bank borrowings.General Rate Case ("GRC") Filings and Other Matters: Water Segment GRC: InMay 2019 , the CPUC issued a final decision on GSWC's water general rate case, which determined new rates for the years 2019 - 2021 with rates retroactive toJanuary 1, 2019 . Among other things, the final decision authorized GSWC to invest approximately$334.5 million over the rate cycle. The$334.5 million of infrastructure investment includes$20.4 million of capital projects to be filed for revenue recovery through advice letters when those projects are completed. Due to the delay in receiving a final CPUC decision on the water general rate case, billed water revenues for the first quarter of 2019 were based on 2018 adopted rates, pending a final decision. As a result of theMay 2019 CPUC final decision, GSWC recorded the impact of the final decision in the second quarter of 2019, including earnings of$0.08 per share that related to the first quarter of 2019. The final decision also allowed for a water gross margin increase in 2020 and 2021, subject to an earnings test. EffectiveJanuary 1, 2020 , GSWC received its full second-year step increase, which it achieved because of passing the earnings test at all of its ratemaking areas. The full step increase is expected to generate an additional$10.4 million in water gross margin for 2020. The final decision also allows for a potential additional increase in the water gross margin of approximately$11.4 million in 2021, subject to the results of an earnings test and changes to the forecasted inflationary index values. Electric Segment GRC: InAugust 2019 , the CPUC issued a final decision on the electric general rate case. Among other things, the decision (i) extended the rate cycle by one year (new rates were effective for 2018 - 2022); (ii) increased the electric gross margin for 2018 by approximately$2.3 million compared to the 2017 adopted electric gross margin, adjusted for Tax Act changes; (iii) authorized GSWC's electric division to construct all the capital projects requested in its application, which are dedicated to improving system safety and reliability and total approximately$44 million over the 5-year rate cycle; and (iv) increased the adopted electric gross margin by$1.2 million for each of the years 2019 and 2020, by$1.1 million in 2021, and by$1.0 million in 2022. The rate increases for 2019 - 2022 are not subject to an earnings test. The decision authorized a return on equity for GSWC's electric segment of 9.60% and included a capital structure and debt cost that is consistent with those approved by the CPUC inMarch 2018 in connection with GSWC's water segment cost of capital proceeding. The rate case decision continues to apply for BVESI. Due to the delay in finalizing the electric general rate case, electric revenues recognized during the first six months of 2019 were based on 2017 adopted rates. Because theAugust 2019 CPUC final decision was retroactive toJanuary 1, 2018 , the cumulative retroactive earnings impact of the decision was included in the third quarter results of 2019, including approximately$0.03 per share related to the six months endedJune 30, 2019 , of which$0.01 per share related to the second quarter of 2019, had the new 2018 and 2019 rates been in place at that time. Issuance of Senior Unsecured Notes at GSWC: OnJuly 8, 2020 , GSWC completed the issuance of unsecured private placement notes totaling$160 million . In connection with this financing, GSWC issued$85 million in 2.17% senior notes which mature in 2030, and$75 million in 2.90% senior notes which mature in 2040. GSWC used the proceeds from the notes to pay down a majority of its intercompany borrowings from AWR. AWR used these proceeds from GSWC to pay down amounts outstanding under its credit facility. InMarch 2020 , AWR had amended its credit facility to temporarily increase the borrowing capacity to$260 million . Following the issuance of GSWC's notes, effectiveJuly 15, 2020 AWR reduced the aggregate borrowing capacity back down to$200 million pursuant to the terms of the revolving credit facility agreement. Proposed Decision on Low-Income Affordability Rulemaking: OnJuly 3, 2020 , the CPUC issued a proposed decision related to the low income ratepayer assistance and affordability objectives contained in the CPUC's 2010 Water Action Plan, which also addressed other issues including matters associated with 32
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the continued use of the water revenue adjustment mechanism ("WRAM"). If approved,California water utilities that use full decoupling WRAM accounts, including GSWC, would be required to replace their WRAM accounts with a limited price adjustment mechanism (the Monterey-Style Water Revenue Adjustment Mechanisms) in their next general rate case filing. This proposed decision may be on the Commission's agenda for a vote as early asAugust 6, 2020 . Management believes the proposed decision, if approved, should not have any impact on GSWC's WRAM balances during the current rate cycle (2019 through 2021). Since its implementation in 2008, the WRAM has helped mitigate fluctuations in GSWC's revenues due to changes in water consumption by its customers. Replacing the WRAM with the mechanism recommended in the proposed decision would undo the current decoupling mechanism, which could result in more volatility in GSWC's future revenues and prevent full recovery of its authorized revenues. GSWC filed comments to the proposed decision. At this time, management cannot predict the outcome of this matter including its potential impact to the water general rate case application filed inJuly 2020 , which will set new rates for the years 2022 - 2024. Cost of Capital Proceeding: Investor-owned water utilities servingCalifornia are required to file their cost of capital applications on a triennial basis, with the next scheduled filing required to have taken place onMay 1, 2020 and to be effective for the years 2021 - 2023. InJanuary 2020 , GSWC, along with the three other water utilities, requested an extension of the date by which each of them must file its 2020 cost of capital application. InMarch 2020 , the CPUC approved the request, postponing the filing date by one year untilMay 1, 2021 , with a corresponding effective date ofJanuary 1, 2022 . The CPUC also approved the joint parties' request to leave the current Water Cost of Capital Mechanism in place, but there will be no changes to the companies' rate of return on rate base during the one-year extension, regardless of what the mechanism might otherwise indicate. GSWC's current authorized rate of return on rate base is 7.91%, based on its weighted cost of capital, which will continue in effect throughDecember 31, 2021 . The 7.91% return on rate base includes a return on equity of 8.9%, an embedded cost of debt of 6.6%, and a capital structure with 57% equity and 43% debt. Contracted Services Segment: ASUS's revenues, operating income and cash flows are earned by providing water and/or wastewater services, including operation and maintenance services and construction of facilities at the water and/or wastewater systems at various military installations, pursuant to 50-year firm fixed-price contracts. The contract price for each of these 50-year contracts is subject to annual economic price adjustments. Additional revenues generated by contract operations are primarily dependent on new construction activities under contract modifications with theU.S. government or agreements with other third-party prime contractors. COVID-19: GSWC and BVESI continue to operate as its water and electric utility services are deemed essential services, and continue to monitor the guidance provided by federal, state, and local health authorities and other government officials. GSWC's response to the COVID-19 outbreak has included: (i) suspending throughApril 2021 service disconnections for nonpayments pursuant to CPUC orders, which will remain in effect over other existing requirements governing disconnections; (ii) the temporary closing of customer service offices; (iii) increasing the number of employees telecommuting; and (iv) delaying some capital improvement projects at its water utility services business. At this time, neither GSWC nor BVESI is able to predict the financial impact this situation may have on the remainder of 2020. However, the pandemic has caused significant volatility on financial markets, resulting in significant fluctuations in the fair value of plan assets in GSWC's pension and other retirement plans, which are likely to continue. Furthermore, due to expected future credit losses on utility customer bills, GSWC has increased its allowance for doubtful accounts as ofJune 30, 2020 . However, the CPUC has authorized GSWC and BVESI to track incremental costs, including bad debt expense in excess of what is included in their respective revenue requirements, incurred as a result of the COVID-19 pandemic in a Catastrophic Event Memorandum Account ("CEMA") to be filed with the CPUC for future recovery. ThroughJune 30, 2020 , we have recorded approximately$669,000 in the CEMA regulatory asset account related to bad debt expense in excess of GSWC's revenue requirement, personal protective equipment, printing costs and other incremental miscellaneous costs. By tracking these costs in a CEMA, utilities can later ask for recovery of these costs from the CPUC. Thus far, the COVID-19 pandemic has not had a material impact on ASUS's operations, as the water and wastewater services performed on the military bases are deemed essential services. 33
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Summary of Second Quarter Results by Segment The table below sets forth the second quarter diluted earnings per share by business segment:
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