California Water Service Group - Q1 2024

Transcript

Operator (participant)

Good day, ladies and gentlemen. Thank you for standing by, and welcome to the California Water Service Group first quarter 2024 earnings call. During today's presentation, all parties will be in a listen mode only. Following the presentation, the conference will be open for question and answer. This call is being recorded. I'd like to turn the call over to Jim Lynch, Senior Vice President, CFO, and Treasurer. Please go ahead.

James Lynch (CFO)

Thank you, Ellie. Welcome, everyone, to our first quarter 2024 results call for California Water Service Group. With me today is Marty Kropelnicki, our Chairman and CEO, and Greg Milleman, Vice President of Rates and Regulatory Affairs. Replay dial-in information for this call can be found in our quarterly results release, which was issued earlier today. A replay of the call will be available until Monday, 24 June 2024. As a reminder, before we begin, the company has a slide deck to accompany the earnings call today. The slide deck was furnished with an 8-K and is also available at the company's website at www.calwatergroup.com. Before looking at the first quarter 2024 results, I'd like to take a few moments to cover forward-looking statements. During the course of the call, the company may make certain forward-looking statements.

Because these statements deal with future events, they are subject to various risks and uncertainties, and actual results could differ materially from the company's current expectations. Because of this, the company strongly advises all current shareholders as well as interested parties to carefully read and understand the company's disclosures on risks and uncertainties found in our Forms 10-K, 10-Q, press releases, and other reports filed from time to time with the Securities and Exchange Commission. Now I will turn the call over to Marty.

Marty Kropelnicki (Chairman, President, & CEO)

Thank you, Jim. Good morning, everyone. Thanks for joining us today to talk about our Q1 2024 results. We have a number of topics to cover today, starting with our strong operational performance, which is really highlighted by the final resolution of the 2021 General Rate Case. I will say it's after going through the delays which stretched out over 2023, it's nice to see the arrows all going in the right direction. Big kudos to Jim and the team for booking everything and getting it all set up here as we wrap up Q1. In addition, we'll want to talk about the implementation of the Water Cost of Capital Adjustment Mechanism, which sets our return on equity for 2024 at 10.27%.

We were able to secure an additional $83 million of COVID funds from the State of California to help our customers with past-due balances that linger from our COVID times. And then talk about where we are with PFAS and the EPA's new regulation and our plans to be in compliance with that. And then finally wrap up talking about the commitment we made recently to reduce our Scope 1 and Scope 2 emissions. But prior to going into some of these more operational themes, I'm going to turn it back over to Jim to review the financial results for the first quarter of 2024. Jim?

James Lynch (CFO)

Thank you, Marty. As Marty mentioned, our first quarter results benefited from the conclusion of our 2021 General Rate Case. Operating revenue for the quarter increased 106.5% to $270.7 million compared to the prior year first quarter revenue of $131.1 million. The implementation of two regulatory mechanisms authorized by the 2021 GRC decision had a significant impact on revenues, with the Interim Rates Memorandum Account, or IRMA, adding $80.7 million and the Monterey Style Water Revenue Mechanism, or MRAM, adding $31.7 million. Recorded IRMA and MRAM revenue included $70.2 million and $17.6 million, respectively, related to fiscal year 2023. Greg will walk us through the 2021 GRC decision later in the presentation. The revenue increase also included $13.9 million related to the recognition of water revenue adjustment mechanism, or RAM revenue, that was deferred in previous reporting periods.

First quarter 2024 operating expenses increased $192.9 million compared to the first quarter total operating expenses of $148.6 million. The $44.3 million increase was primarily driven by $9.2 million in higher water production costs associated with the company's new incremental costs balancing account, or ICBA, higher other operations expenses primarily due to $11.4 million in deferred costs associated with the recognized deferred WRAM revenue, and a $21.2 million increase in income taxes related to higher pre-tax earnings. Net interest expense increased 25.5% to $15 million during the first quarter as compared to $12 million for the first quarter of 2023. The increase was primarily due to higher short-term borrowing rates and higher balances on our outstanding lines of credit. Reported net income for the first quarter was $69.9 million, up nearly 415% compared to a loss of $22.2 million in the first quarter of 2023.

Turning to the earnings per share, first quarter 2024 diluted earnings per share was $1.21 compared to first quarter 2023 loss of $0.40 per share. The significant increase in EPS was driven by resolution of our 2021 general rate case coupled with rate increases and the reversal of previously deferred RAM revenue. These increases were partially offset by increased expenses, including higher water production expenses related to the new ICBA regulatory mechanism, higher production expenses due to the reversal of RAM-related deferred production costs, and interest expense. Turning to capital, we continue to make significant investments in our water utilities to help ensure the delivery of safe and reliable water service. We invested just under $110 million in capital improvements during the first quarter of 2024. This was an increase of approximately 34% over the first quarter of 2023.

For the year, we anticipate making approximately $380 million in capital investments, which includes an estimated $20 million in developer-funded projects. Depreciation for the first quarter of 2024 was $32.8 million, or approximately 30% of first quarter capital investment expenditures. The success of our capital investment strategy is reflected in our rate base growth. Our overall rate base grew to an estimated $2.2 billion by the end of 2023. This was an increase of 15.4% over 2022. Further, based on our current planned capital expenditures and subject to regulatory approval, we estimate that rate base will grow to $2.36 billion by the end of 2024 and $2.47 billion by the end of 2025. Turning to dividends, at the beginning of the year, we increased the annual dividend 7.7% from $1.04 to $1.12 per share, which marked our 57th consecutive annual dividend increase.

And yesterday, we declared a quarterly dividend of $0.28 per share for shareholders on record as of 6 May 2024. This was our 317th consecutive quarterly dividend. We continue to maintain a strong liquidity position. As of March 31, 2024, the company maintained cash and cash equivalents of $88.3 million, of which $45.4 million was classified as restricted. Further, we had additional short-term borrowing capacity on our lines of credit of $320 million. Lastly, we are pleased to report that subsequent to the end of the quarter, we received approximately $83 million under the state of California Extended Arrearage Program. The program is designed to provide financial assistance to customers with past-due balances that accrued during the COVID-19 pandemic. Marty will provide additional color on the program in a few minutes.

With that, I'll turn the call over to Greg to give an update on our 2021 general rate case decision.

Greg?

Greg Milleman (VP California Rates)

Sure. Thanks, Jim. I'm going to walk through some of the highlights of the decision for our 2021 GRC decision that we received 7 March 2024. Overall, the decision was financially very positive for the company. As Jim indicated, the decision increases adopted revenues after corrections for 2023 by approximately $41.5 million, retroactive back to 1 January 2023. The decision also adopted 95% of the requested operating expenses. It adopted a very favorable water mix of groundwater and purchased water that provides the company financial protection. It authorizes Cal Water to invest $1.2 billion, which is 86% of our request from 2021 through 2024 in our water system infrastructure projects, including approximately $160 million of infrastructure projects that may be submitted for recovery via the PUC's advisory process.

In fact, we've already filed an advice letter for 145 projects capitalized at $39 million for a $5.8 million increase in annual revenues. The decision provides a very progressive rate design that provides financial stability while benefiting low-income, low-water using customers. And finally, and most importantly, when voting out the decision on 7 March, the commissioners all agreed that the process took too long. And so I'm hopeful that the decision on our 2024 case will come out more timely. Back to you, Marty.

Marty Kropelnicki (Chairman, President, & CEO)

Great. Thanks, Greg. Just echoing what you said when we were in the hearing room with the commissioners, every commissioner did comment on that. We think that's a good sign that they recognize the problems this was causing, not only for us but also for our customers. And it's going to have a pancaking effect on the rates. I'm going to be on slide 10. I want to come back to the Extended Arrearage Management Program for the State of California. I think, as many of you know, we have been extremely proactive, our government affairs team in Sacramento, in looking for ways to help our customers who were still suffering kind of the hangover of the pandemic. You recall the State of California had an original arrearage management program that kind of covered half of the COVID time, and then it cut off.

For that first part, the company was able to secure a little over $20 million that was applied to our customer balances during the COVID time. We were able to work with the state to take some of the unspent federal dollars that were allocated to the state and come up with an arrearage management program, kind of number two. We worked with the state to appropriate approximately $300 million-$400 million of unspent federal dollars and reopen up that window to allow utilities and water companies to apply for further funds to offset the past-due balances from 16 June 2021, through 31 December 2022. Very happy to report that our application was accepted, and we received the entirety of our request, which is $83 million that Jim mentioned.

That money has been received, and during the second quarter, we'll be allocating those dollars to those past-due balances, again, from between 16 June 2021, through 31 December 2022. These funds benefit both current and past-due customers because all customers eventually bear the cost of uncollectible accounts. Moving on to slide 11, I want to take a moment to update everyone on where we are with the PFAS regulations that have come out, also known as forever chemicals. We believe we continue to be well-positioned to meet the EPA's new guidelines. Across our portfolio, we have a rigorous and coordinated water quality assurance program with protocols in place to test and monitor the water we deliver to our customers. I think, as any of you know, that investor-owned water utilities, we take public health as one of the most important things we do as a company.

We've had a fair amount of experience with PFOA and PFAS in California and Washington. Our utilities have been compliant with the previously issued PFAS guidelines issued by their state regulators. On 18 April, the California Public Utilities Commission dismissed our application requesting authorization to modify a previously approved PFAS expense balancing account to include capital investments related to the PFAS compliance. CPUC indicated that we would need to file for recovery of the capital components of PFAS treatment later in the process. What that really means is, first of all, I was disappointed they denied it. They dismissed it without prejudice, but it allows us to file a separate application or include it in the 2024 General Rate Case. And I believe, Greg, our plans are to file it as a separate application.

Greg Milleman (VP California Rates)

That is correct.

Marty Kropelnicki (Chairman, President, & CEO)

Outside the rate case. Despite the commission's shortsightedness, recognizing the urgency that you need to get this PFAS treatment in the ground, the company put a press release out reaffirming our commitment to our customers that we'll be investing the $215 million expeditiously to put PFAS treatment in place for approximately 100 wells in all the states that we operate in. Overall, it is a group, meaning at the parent company project. So we have a project director who is managing the implementation in all of our states. In that group, that project director reports to the management committee on a normal basis. We have hit the ground running. We plan to spend probably between $12 and $20 million this year on PFAS treatment, and that'll ramp up as we go out into the implementation period over the next couple of years.

Greg Milleman (VP California Rates)

Marty, before you move on, you mentioned PFAS balancing account. I believe what you mentioned was.

Marty Kropelnicki (Chairman, President, & CEO)

That's a Memo Account.

Greg Milleman (VP California Rates)

Memo account.

Marty Kropelnicki (Chairman, President, & CEO)

Thank you. It is a memo account. So it's outside the rate case. We're incurring the cost. It goes to the P&L, but we're allowed to track those costs. And we asked the commission to allow us to modify that memo account to pick up the capital components, which was denied. However, capital projects in the rate-making world do accrue AFUDC, allowance for funds used during construction, and that'll accrue throughout the process until we put that plant in service. Moving on to Slide 12, where we talk about greenhouse gas and Scope 1 and Scope 2 reduction targets. As we worked on our decarbonization strategy and our ESG strategy overall the last 5 years, we recently made our commitment to reduce absolute Scope 1 and Scope 2 greenhouse gases by 63% by 2023 from our baseline 2021 year.

Our targets are science-aligned, which the team's done a very good job working with a third-party advisor to pull that data together. We expect to achieve these reductions through a multi-prong approach consisting of the electrification of the fleet, water conservation, installing on-site solar where it makes sense, and looking at renewable electricity procurement. In other words, making sure we're tapping into the green side of the grid for the power that we use. As many of you may recall, water production and distribution use a lot of energy. So the more green energy we can use, the more it helps us drive towards that target, as well as the other components here in the multi-prong strategy.

Just as an FYI, the group may evolve its decarbonization strategy if warranted due to changes in industry, working with our regulator business, and other operating things that may happen, including SEC rules, etc. Overall, we're very committed to delivering value to our customers and stockholders while pursuing these reduction targets. We believe it's the right long-term approach as we deal with climate change. Going on to slide 13. So just to kind of recap, very pleased with the start of 2024 and getting the 2021 rate case behind us. Nice to have that done. The numbers will be a little confusing, obviously, when we publish the 10-Q here later on this week. There'll be more information, so you can strip out what was the retroactive piece and what was the actual piece for the quarter itself. We're going to now turn our focus on implementing our infrastructure improvement plans.

As Greg's mentioned, we have a lot of capital to get in the ground in addition to the PFAS. So the guidance that Jim gave everyone earlier does not include the $215 million commitment for PFAS or for the forever chemical treatments that we have made to our customers. So that'll be incremental. And one other thing to put on everyone's calendar, we have our state Supreme Court date on 8 May. And that's our oral arguments on the RAM decision from the commission. So we'll look forward to hopefully having some type of decision by the state Supreme Court, probably three months after the oral argument or so. So we're looking forward to having that day in court because we believe decoupling is absolutely essential to the state of California, its work on climate change, resiliency, and sustainability.

So with that, I want to thank everyone for bearing with us through the delays of the 2021 general rate case. I want to thank the rates and accounting team for their hard work. Not only did we have to close out the year, but right after the year, we got the decision. We had to book everything. So the team did a fantastic job getting that stuff all booked in the general ledger. And now we'll move forward onto our 2024 plans, investing in infrastructure, going after PFAS, and getting the PFAS treatment put in place and getting our rate case filed for the state of California on or around 1 July. So Ellie, with that, let's open it up for questions, please.

Operator (participant)

Thank you. We are now opening the floor for question-and-answer session. If you'd like to ask a question, please press star and number one on your telephone keypad. That's star and number one on your telephone keypad. Our first question comes from Michael Gaugler from Janney Montgomery Scott. Your line is now open.

Michael Gaugler (Managing Director)

Good morning, everyone.

James Lynch (CFO)

Morning, Michael.

Michael Gaugler (Managing Director)

Just wondering if you could update us on water supply and water production costs. I noticed they were rather high in the quarter. I know Jim touched on them a little bit. Maybe how we should think about that for the remainder of the year.

James Lynch (CFO)

Sure, Jim. Yeah, well, from a water supply perspective, Michael, the State of California is doing very well. I believe our snowpack for the second consecutive year was higher than our 20-year average. I think it's the first time in an awful long time that we've had two consecutive years where we've beat the average. So I think we're looking good. There's been a good opportunity also for replenishment of some of our underground aquifers throughout the State of California. I think our other states are also similarly well-positioned in terms of actual water supply. We do have some operations in Texas. Most of our utilities down there are wastewater utilities. And I think that we've not seen the current water situation in Texas put any stress on those operations.

As it relates to expenses and water expenses, we do have in California, with the new rate case, the new ICBA, which provides us some protection in terms of cost increases in our water production. So we will lean on that new mechanism and focus on that as our familiarity with the new mechanism becomes greater. Then I'd also like to point out that we did have an increase in other production expenses. I mentioned it in my comments. Those were primarily related to the recognition of the deferred WRAM revenue. I would view those more as something that will continue to reduce as we kind of unwind those deferred revenue costs.

Marty Kropelnicki (Chairman, President, & CEO)

Yeah, one thing I would add is, as Jim said, the snowpack was very, very good. Water supply within the state of California, I think, is doing great. California is still in a stage two drought. If you remember, we were racing towards a stage three drought, and then the governor has walked that back. We're still in a stage two drought, which I kind of expect the governor to stay in a stage two or maybe drop it down to a stage one, given the longer-term issues of sustainability with the state, climate change, the variations we get in the weather. But overall, for 2024, we think we're in good shape in all of our districts.

All right. Thank you, John. Most helpful.

James Lynch (CFO)

Thanks, Michael.

Marty Kropelnicki (Chairman, President, & CEO)

Thanks, Michael.

Operator (participant)

Next question comes from Jonathan Reeder from Wells Fargo. Your line is now open.

Jonathan Reeder (Equities Research Associate Analyst)

Hey, good morning, team. Got a couple of questions here, if you don't mind. First would be, how should we think about the timing of the cash recovery of the retroactive 2023 GRC revenues?

Greg Milleman (VP California Rates)

Jonathan, this is Greg Milleman. Because of the timing of the 2021 decision and our upcoming filing on 1 July of our 2024 rate case, we have been focused on implementing the new rate, get those into effect first, calculating what the lost revenue or the IRMA amount and the M-WRAM amount will be so that we could book that. We will be filing in the third quarter for recovery of those back monies. We need to go through 31 May when we're planning to have the new rates fully in effect and close out the IRMA account. But then we need some time to put together that filing and start requesting it. So we'll start requesting it in the third quarter. It is based on a per-CCF surcharge.

I would imagine in the summer, it will be a little bit higher, and then obviously, in the winter months, lower and go someplace from 12-24 months.

Jonathan Reeder (Equities Research Associate Analyst)

Okay. So it sounds like, I mean, those revenues aren't going to really come in in 2024. It'll probably be more 2025 and 2026.

Greg Milleman (VP California Rates)

The revenues were booked in the first quarter.

Jonathan Reeder (Equities Research Associate Analyst)

Yeah. Yeah. Sorry. I thought your question was related to cash. No, exactly. You are. Yeah. The cash flows won't come in until 2025 and 2026. I apologize.

James Lynch (CFO)

Yeah. The one thing I would point out, though, with the timing of when the new rates will go into effect, we will at least experience the positive cash uptick related to those new rates as we go into our more traditionally busy season. So we were pleased to be able to get the rates effective as of 1 June.

Jonathan Reeder (Equities Research Associate Analyst)

Gotcha. And then how should we think, I guess, about the $83 million arrearage payment program cash recovery potentially offsetting 2024 external equity needs?

James Lynch (CFO)

Yeah. So if you remember, during COVID, we were decoupled. So the revenue is all accounted for through the decoupling mechanisms for the State of California. So this piece really becomes cash flow. So essentially, customers that have balances that are still past due from the period that I defined 16 June 2021, through the end of 2022 who have balances, those dollars will be applied to their balances. And then we'll also be applying some of those balances to the RAM balances that existed for those customers as well. So that'll all work its way into cash flow, but it won't really have a revenue effect. It'll have an effect on the aged receivables that are still outstanding during COVID, and you'll see a pickup in cash flow. So certainly, that helps the company from going to the market and needing to issue equity right away.

Obviously, water utility stocks over 2023, everyone was down 20%+. We're not racing the market anytime soon to go sell stock. Jim's not throwing any pieces of paper at me for saying that. The reality is, with this rate case and with the step-up in the rate design, the movement from fixed or from variable to being more recovered and fixed, that's all going to help us throughout this year. If you think about our capital needs, we're still investing at 3x our depreciation rate. As Greg mentioned, we got 86% of our ask. It's a $1.2 billion capital program. We do have adequate lines, etc. Jim and I will be evaluating that as we go throughout the year to define what those needs are.

Obviously, with interest-carrying costs being higher, the stock being down, and we still got to get our job done, there's a fine line there that we'll be looking at our capital structure and trying to optimize that on behalf of our stockholders, but also our customers as well because it helps play into affordability.

Jonathan Reeder (Equities Research Associate Analyst)

Okay. So in terms of absolute size of annual equity needs, that's still to be determined at this point?

James Lynch (CFO)

Yeah, I think so, John. The real good news is that from the recognition of the 2023, our ability to recognize the 2023 impact of the 2021 decision has brought us back to where we had hoped we would be at this point in time relative to our cap structure, which is very close to our authorized cap structure. So there's not a need right now in terms of forcing us I wouldn't say forcing us, but directing us into which particular capital we would pursue in the event that we needed to pursue capital. And so I think right now, we've got a lot of availability on our line of credit. We understand that the interest rates are still inverted, so we'll be taking a look at short-term versus long-term debt, amongst other things, as we move forward.

It's only with the booking of the current rate case results, the 2021 rate case results, that we're in the position now to kind of forecast out what we think we might need from a capital perspective for the remaining of the year. Yeah. We're also benefiting from the higher ROE that went into effect on 1 January, the 10.27 ROE. That's also helping us with our cash flows.

Jonathan Reeder (Equities Research Associate Analyst)

Yeah, sure. Glad you brought up the ROE. It kind of leads into the next question because, I guess, just given the GRC final outcome and recovery of some of the CapEx through the advice letter recovery process, where do you expect your earned ROEs in 2024 and 2025 to come in relative to the allowed levels?

James Lynch (CFO)

Oh, that's a very good question. 2025 is certainly a little harder to talk about. But from a budgeting perspective and how we manage the company, right, we try to drive towards hitting that ROE. Obviously, when you have a delayed rate case, it throws everything kind of off balance, significantly off balance. So I think for 2024, we should be at or maybe slightly above that ROE. For 2025, you start to get the period of regulatory lag that starts to seep in. And obviously, inflation is a big deal. Getting back to Michael Gaugler's questions about production cost, in Northern California, for time-of-use rates for electricity, it's now $0.40-$0.50/kWh, highest cost in the U.S. So that's stuff that affects the operating side that will also lag. And hopefully, some of it will get picked up in the rate case.

As inflation stays high, a lot of it gets pushed out into the next rate filing. Certainly, for 2024, I think we're in excellent shape. For 2025, we're going to budget to hit our ROE. And that's kind of our job. I think, as Jim talked about, is there an opportunity with inverted interest rates, short-term versus long-term, how we finance things? We're going to take a look at all that because our job is to operate as efficiently as possible while earning an ROE for our stockholders and keeping rates affordable for our customers. 2025, hard to comment on. 2024, we're going to drive hard to hit the ROE.

Jonathan Reeder (Equities Research Associate Analyst)

Okay. And then lastly, I know you said you filed for $39 million of the advice letter recovery projects already. How much do you expect to file in total in 2024, and then what about in 2025?

James Lynch (CFO)

That's to be determined, Jonathan. If anyone listened into the rate proceeding, I thought it was kind of fascinating because the commission was really kind of focused on these 335 projects the company didn't get done, or they only got done 5 of these 335 projects. But as you know, numbers are relevant, right? And so during this 3-year period, we probably had 5,000, 6,000 total projects that we completed. Those aren't talked about. They were just focused on these 335 projects that didn't get done. There's 2 failures that I see in the rate-making process in the state of California. One is the failure to recognize that projects now go through 1 or 2 and even 3 rate case cycles. So you want to put a well in Southern California.

By the time you procure the land, design the well, get sign-off on the treatment, build the treatment, go through testing, put it in service, it's longer than 3 years. And so the rate-making process in California fails to recognize these projects now are multi-cycle projects. The second thing that the commission fails to recognize in the rate-making process is, as these projects get more complicated and go farther in time, the level of contingency needed for those projects goes up. And if you listen to the hearing, the commission tossed out a lot of the contingencies associated with these projects. So those are the two things that Greg has to work on in the 2024 rate case. Obviously, they're kind of embedded into the process, in the rate-making process within the state of California.

But those are the two of the things we're going to be focusing on in 2024 because both those things help lead to regulatory lag. And the reality is, and you've followed us for a long time, we're very good about hitting our capital commitment numbers and getting that capital in the ground, right? It's really about on the backside, the rate-making process and the efficiency of the rate-making process. So we'll have to see what happens next. But I think we'll keep doing what we're doing, and we're going to keep investing at three times the depreciation rate, which I think benefits our stockholders. We're focusing on affordability.

Jonathan Reeder (Equities Research Associate Analyst)

Okay. But out of those 160 million projects, do you expect to complete them all over the course of 2024 and 2025, or might some of those fall into the next rate case cycle still?

James Lynch (CFO)

Yeah. We have a concerted effort going on right now to reevaluate those projects from two perspectives. One, to confirm that they are still needed. And two, with regards to that first point, to make sure they weren't just projects that we've subsequently found other alternatives for. And two, to really identify what time period we are going to complete the projects and put them in service for those that remain out of the $160 million. So at this point, I think that process is still underway, and we'll have a better sense for the timing of that here in the next couple of weeks.

Jonathan Reeder (Equities Research Associate Analyst)

Okay. Thanks. I appreciate you taking my questions.

James Lynch (CFO)

Thanks, Shannon. Take care, Jonathan.

Operator (participant)

Question comes from Angie Storozynski from Seaport Research Partners. Your line is now open.

Angie Storozynski (Senior Equity Research Analyst/US utilites & power)

Thank you. So first, maybe you alluded to the 10-Q, which will have more information about the retroactive impacts on the first-quarter earnings. But can you just give us a sense, roughly, what it is from an EPS perspective versus $0.21 that you reported?

James Lynch (CFO)

Well, we haven't broken it down from an earnings per share perspective. But relatively speaking, there was approximately $90 million of earnings, of revenue, that was included in the 2024 first quarter that related to the decision. And in addition to that, there was an incremental about $8.5 million of expenses that related to the decision.

Angie Storozynski (Senior Equity Research Analyst/US utilites & power)

Okay. I mean, you don't have guidance, so that's actually pretty important for us to have a basis to extrapolate from, right? So again, we would probably appreciate it going forward. Secondly, on the PFAS spending, so will you be booking AFUDC earnings associated with this CapEx? So will it flow through the income statement?

James Lynch (CFO)

Well, AFUDC, we are eligible to use the AFUDC mechanism as we move forward with those expenditures. So I think the way you're asking the question, we will be able to reduce our interest expense for the AFUDC to the extent that we are making expenditures related to those projects.

Angie Storozynski (Senior Equity Research Analyst/US utilites & power)

Okay. And then just in general on PFAS, so we're starting to see some losses against investor-owned utilities related to PFAS, the fact that you or, in general, utilities were not attempting to remove the forever chemicals from distributed water in the past. And I'm just wondering how you can protect yourself. Is there anything in California that would allow you to limit the litigation risk and, more importantly, limit any earnings impacts?

James Lynch (CFO)

Yeah. I think from a liability standpoint in California, we have a Hartwell decision, which basically set a Hartwell decision, which basically says, "If we're operating in accordance with the rules set forth by our regulator, that we have protection." So I'm not too worried about California compared to some of the stuff that we're seeing on the East Coast in terms of product liability associated with water, etc. From an earnings perspective, as Jim said, we'll accrue AFUDC on those capital projects. Most of the treatment is capital. It's 100 wells out of 1,170 wells total that we have within Group. So we'll accumulate the AFUDC on that, and then those other capital costs get picked up. Any of the operating costs, once we put those vessels into production, we'll track the incremental costs through the memo account and seek recovery of that at a later date.

So I think we got kind of all the pieces in place that we need to have. I was just disappointed in the commission's decision not to recognize the capital now because the EPA put that new standard out there. They did extend the implementation timeline. I think, believe it's over 5 years now versus over 3. But you got customers don't want to hear, "We're going to implement PFAS treatment 4.5 years from now." If Jim's drinking water that has PFAS in it, he wants to know, "We're treating it right away." And so that's why when we put our press release out, we pointed out we were disappointed in the commission's decision. And despite that, we reaffirmed our commitment to getting that capital in the ground as quickly as possible. And so from an operating cost perspective, I'm not too worried about it.

To me, it's about making sure the water's safe for customers and implementing that capital as quickly as possible. And then just one other point on that, Angie. We are pursuing any available grant money that may be out there to assist with the whole PFAS issue, as well as potential third-party liability. Yeah. There's a lot of litigation around PFAS, actually to the polluters. And there's been a ton of press on that. I don't want to get into the particulars of the case because we're a member of the action against the polluters. But we believe we'll get some dollars back from the polluters to offset the implementation costs and the capital costs of putting PFAS treatment in place.

Angie Storozynski (Senior Equity Research Analyst/US utilites & power)

Okay. And then lastly, so you mentioned the weak performance of water utility stocks and the timing of your future equity needs. I'm just wondering, you raised your dividend by, I think, 7%, 7-something%. So do you think that going forward, depending on the stock performance, the growth in dividends is a lever for you to potentially use to adjust downwards if you have higher equity needs? Is this a lever in this high interest rate environment as well? Again, what is this 7%-plus linked to?

James Lynch (CFO)

Sure. Well, if you go back to our, yeah, if you look at our dividend increases over the last 5 years, they've been above inflation. We have a payout ratio target between 55%-65%. We try to manage within that range. I personally believe that the compound annual growth rate of dividends is one of the key drivers to equity valuation in the marketplace. So looking at that CAGR number, as Jim mentioned, we've grown the dividend every year for the last 57 years. So I have no reason to believe we won't continue down that path. Obviously, when the board looks at that, we look at what's the general market conditions? What was the dividend growth rate of other utilities? What are our capital needs? And we try to keep that all in balance.

But obviously, for me personally, I think dividend growth is a key thing that our investors expect, and they like to see, and they like the stability of a water company. So to me, yes, it was a bear year for water utilities in 2023. But I think three most important things we can do: make sure water quality is the most important thing on our operating list, continue investing at that three times the depreciation rate, and keep growing that dividend. And I guess the fourth thing is making sure our customer service stays outstanding, best in class. When you do those things, in the long run, you create value for stockholders.

Angie Storozynski (Senior Equity Research Analyst/US utilites & power)

Very good. Thank you.

James Lynch (CFO)

Thanks, Angie. Have a good day.

Operator (participant)

Comes from Davis Sunderland from Baird. Your line is now open.

Davis Sunderland (Senior Research Associate)

Hey, Jim. Marty, Greg. Good morning. I guess the same questions.

James Lynch (CFO)

Hey, Davis. Good morning. Thanks for joining us.

Davis Sunderland (Senior Research Associate)

I wanted to ask a PFAS question. As it relates to the business development plan, I guess the abrupt question is any updates on that that are noted. But specifically, has the PFAS system created any opportunity for you guys to be more aggressive or more interested or, I guess, take a closer look at any systems who may have difficulty reaching compliance?

James Lynch (CFO)

Davis, we got about every third word there. You were cutting out. One of you guys. I think I'm going to answer a question that I think you asked, or at least I'll rephrase the question for Marty. Davis, it sounded like you said, with PFAS out there, if we took a look at the business opportunities that are also out in the market right now that we may be pursuing, how are we considering the potential PFAS liability? And is that coloring our desire or interest in some of those potential opportunities? Wow. You could hear that in that question? That's incredible. But let's answer that.

Davis Sunderland (Senior Research Associate)

Well, let's ask a better question.

James Lynch (CFO)

Was that the right question, Davis?

Davis Sunderland (Senior Research Associate)

You got great ears. I apologize for that.

Marty Kropelnicki (Chairman, President, & CEO)

I think we said, wait, Jim, I had great ears. So let me answer that question. Yeah. I think, obviously, the cost of capital has gotten a lot more expensive. And from a business development standpoint, we've seen maybe a little bit of a slowdown on things that go into our pipeline from a business development standpoint. But our business development team continues to be very, very busy. As Jim mentioned, the stuff we got going on in Texas and other things we're doing in other states. So I think the PFAS thing, I think the smaller systems are going to struggle to be in compliance. And you think about, for us, there's 100 wells. It's $215 million. And we're fairly good at implementing that type of treatment. We're very fast, and we try to keep our overhead fairly low.

If a smaller system doesn't have access to capital or they don't have the technical resources on site to figure out what the treatment should be, it's going to affect their ability to operate. I think the broader operating issue is for companies like Cal Water or for Essential or Aqua or SGW or Middlesex, any of us that are publicly traded companies, you fall out of compliance, and the regulator fines the hell out of you, or you end up getting sued by somebody, right? So we generally operate to the highest standards possible associated with that. When you're a municipal system, what's the recourse? You think about the 60,000 systems out there that fall under the purview of the EPA, there's no way they can effectively monitor all those systems to make sure they're in compliance with PFOA and PFAS.

And so I give the Biden administration credit for trying to push through the PFAS treatment, get the EPA to move quicker. I think that's really important. But you'll have compliance lags on the municipal side, where I don't think you're going to have that same problem on the investor-owned side. Yeah. And I think, as a result of Marty's observations on that, we do think that, as with any new regulation that comes out, it will put financial stress on some systems, and that may open up the market. And yes, if we believe we could assist the customers in those markets, we would be interested in taking a look at those systems. Right. But even then, Jimmy, one of the things that happens, we take over a system. We got liability day one.

So if you look at some of the work we've done, like in New Mexico, or we've taken over troubled systems, we work very closely with the regulator to get the rates paid upfront before we buy them, that we have an implementation timeline so we don't get pinged on the backside with these penalties and fines. Because I think, in the water world, the investor-owned utilities are the deep pocket for the regulators to fine.

Davis Sunderland (Senior Research Associate)

Perfect. Apologize for the audio at the time, guys. Appreciate it.

Marty Kropelnicki (Chairman, President, & CEO)

All right, Davis. Thank you.

James Lynch (CFO)

Thank you.

Marty Kropelnicki (Chairman, President, & CEO)

Jim, good ears. That was impressive. You could decide for that.

Operator (participant)

Thank you. As of right now, we don't have any raised hands. So I'd like to hand back over to the management for the final remarks.

Marty Kropelnicki (Chairman, President, & CEO)

All right, Ellie, thank you. Well, everyone, thanks for joining us today. Obviously, there's a lot going on. But at least one thing is off the list, the 2021 general rate case. That's in the rearview mirror. Obviously, there's a lot of work to do on the tariffs and filing the required documentation with the commission to start the collection of the retroactive piece. We'll be in a better position on our Q2 earnings call to talk about that. And then, in between now and then, we'll be working on our 2024 general rate case and preparing for the State Supreme Court or arguments on 8 May. So thank you for joining us today, and we look forward to talking to everyone really, really soon. Have a good day.

Operator (participant)

Thank you all for attending today's conference call. We hope you have a wonderful day. You may now all disconnect to the session.