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March 18, 2010 3. COST -OF- SERVICE ANALYSIS Cost -of- service analysis is a rate making technique that is used to derive reasonable rates. Reasonable rates are defined by the courts as not being capricious, arbitrary, or discriminatory. Rates are not capricious if there is a clear rationale supporting the analysis. Rates are not arbitrary if there is a sound basis for choosing among alternatives. Finally, rates are not discriminatory if they allocate costs proportionately. The City's rates have been designed consistent with cost -of- service principles. The cost -of- service analysis applies to both the City's service and consumption charges. Each of these charges should generate an amount of revenue that is appropriate to the City's rate making objectives. As previously explained, service charges apply to each customer regardless of the customers class. In the case of the consumption charges, however, the rates are different for each customer class. As a result, the cost -of- service analysis is used to determine the amount of revenue that should be generated by each customer class' consumption charges. 3.1. REVENUE COMPONENTS Figure 3 -1 summarizes the major sources of City revenue projected for FY 2010 -11. The cost -of- service analysis is concerned with the operating revenues, which are generated by service and consumption charges. The Water O &M Fund receives about 5% of its revenue from non operating sources (which does not include revenue from connection fees). Most of the revenue comes from operations. 3.2. Revenue From Service charges The City's service charges recover 81% of the current operating revenue from rates. This is an appropriate amount of revenue to be recovered from service charges based on guidelines provided by the California Urban Water Conservation Council. This Council has promulgated a guideline recommending that fixed charges such as the City's service charges should generate no more than 30% of the total rate revenue. Rates that generate at Least 70% of the operating revenue from the consumption charges are deemed to be conservation oriented by the Council, which is regarded in California as an important rate making criterion. We recommend maintaining the current relationship between the City's service and consumption charges whereby service charges continue to generate no more than approximately one -fifth of the operating revenue. City staff concurred and decided not to increase the service charges effective July 1, 2010. 3.3. Revenue From Consumption Charges As a default condition, each customer class should pay the same cost per unit through consumption charges unless conditions warrant otherwise. For example high peak Page 11 HF&H Consultants, LLC