Two recent decisions of the California Court of Appeal have increased risk for California’s local governments as to utility fees and fees imposed to fund regulation. A new statute provides a means to reduce that risk somewhat.

Coziahr v. Otay Water District is a class-action challenge to tiered water rates imposed by a district which serves territory along the international border south and east of San Diego. Tiered rates make water progressively more expensive as customers use more of it and are intended to encourage conservation. A 2015 decision I handled for the City of San Juan Capistrano established that such rates are lawful, but agencies must “show their math” and make a record justifying the portion of service cost assigned to each rate tier. At one level, Coziahr is just an application of that rule — decided against the District because its tiered rates were not sufficiently justified by its ratemaking record. On another, though, it is very troubling. It rejected the approach to tiered rates recommended by the American Water Works Association’s M-1 Manual — the most-cited authority on ratemaking — that looks to so-called “peaking factors” (ratios of the volume of water a customer or customer class uses in a pear hour, day or month as compared to that customer’s or class’s average use). Although ratemaking is necessarily based on reasonable estimates of future expenses, this Court demanded “actual data” regarding costs the District incurred to provide water in each tier of use. It stated that reasonable estimates will not suffice. That standard will invite litigation and may discourage use of tiered rates even though the Legislature has passed laws in each of the last two years encouraging such rates because conservation is a necessity in our desert state. The Court of Appeal upheld an award of $18 million in refunds against Otay, rejecting its arguments that money awards are not authorized under Proposition 218. The District has petitioned the California Supreme Court to review the case and both the District and our firm have asked the Supreme Court to depublish it. If either is successful, the decision will not be binding authority to be used against ratemakers other than Otay. Decision on those requests is due by late November.

Sutter’s Place, Inc. v. City of San Jose partly invalidated that City’s regulatory fees on licensed poker clubs to fund the cost of regulation. It construed the regulatory fee exception to Proposition 26 narrowly, limiting the fees which can be imposed without voter approval as taxes to those which fund only a local agency’s reasonable costs for issuing licenses and permits; performing investigations, inspections, and audits; and administrative enforcement and adjudication of permits and inspections. Such costs as drafting regulations, responding to public records requests, and defending legal challenges to fees are not necessarily included. This seems to mean that regulation cannot be funded by fees on the regulated parties, but will require at least some funding from other sources, perhaps general fund money, which is typically scarce and spoken for. This is a surprising result. Based on the ballot arguments on Proposition 26, most public lawyers understood that the fees could cover the full cost of regulatory programs, which necessarily require rulemaking, Public Records Act compliance, and litigation because these are costs associated with licensing, permitting, investigations, etc.

There is some good news in the case, as it upheld the trial court’s conclusion that the City appropriately split its regulatory costs 50/50 between its two licensees because each was allowed the same number of card tables. Unlike Proposition 218, construed in the Coziahr case to require a tight fit of cost-generation by a customer class and the fee imposed, Proposition 26’s limit on regulatory and other fees requires only that an allocation of costs among fee payors be “fair or reasonable.”

San Jose has sought review of this case and depublication, too. Review should be granted or denied by early January. CHW will write amicus letters for Cal Cities and the California State Association of Counties if they authorize them, as we expect.

Both these cases are bad news for local agencies, suggesting much more work to be done to impose defensible fees and much greater risk of litigation and large refund awards. But the Governor signed three bills into law in September which will help manage that risk. AB 1827 (Papen, D-San Mateo) states the Legislature’s support for tiered water rates and identifies means to structure them — including reliance on peaking factors rejected in the Coziahr case. It states that it is declaratory of existing law. Environmental groups sponsored the bill.

SB 1072 (Padilla, D-Chula Vista) states that refunds are not available in a Proposition 218 challenge to water rates. Such remedies strip all reserves out of an agency, requiring it to raise rates to reestablish those reserves, which are necessary to ensure reliable service. This means a refund remedy is a very expensive way to give money to ratepayers only to take it back again — and to pay substantial attorney fees to plaintiffs’ counsel and to counsel who defend the agency. It is more efficient to limit relief to an order that rates be made lawful prospectively. The new law also provides that any refund due must be accomplished in the next ratemaking.

Finally, AB 2257 (Wilson, D-Suisun City) makes two changes to the law governing Proposition 218 rate challenges. It limits such lawsuits to the agency’s administrative record and defines what constitutes that record. Public agency lawyers had thought this was the law, but the new statute will curtail litigation of these points. Secondly it allows local agencies to adopt a policy requiring those who would challenge water and sewer rates in court to exhaust administrative remedies by identifying the legal bases of the challenge in writing when a protest to rates is filed. The agency must respond to each such claim in writing before adopting rates. The statute has detailed requirement for a local exhaustion procedure, but most duplicate existing law. The most significant new requirements are duties to respond in writing to objections and to include in a notice of a ratemaking the requirement to exhaust administrative remedies.

AB 2257’s limitations on litigation against utility rates are powerful defenses. Public agencies which provide water or sewer service should make it a priority to adopt the necessary policy by year-end.

Legal developments under 1996’s Proposition 218 and 2010’s Proposition 26 keep coming. There is much hazard out there for revenue sources on which local services depend. Local governments should be alert to new legal developments and work with capable counsel when making and defending rates. And adopt that exhaustion policy pronto!