Management’s Discussion and Analysis (continued) RATES AND REGULATION ENVIRONMENTAL MATTERS LIQUIDITY AND CAPITAL RESOURCES WATER SUPPLY After analyzing 17 Cal Water districts that were eligible for general rate filings in 2001, and based on current earnings levels, projected expense increases, including higher electric power costs, and expected capital expen- ditures, applications were filed in July 2001 for 15 districts covering about 65% of Cal Water customers. The applications request an 11.5% return on equity including 75 basis points to reflect the increased risk associ- ated with the CPUC’s changes in recovery of water production expense increases. An application to increase customer rates to cover higher General Office expenses is also being processed by the CPUC. Combined the applications request $19 million in additional annual revenue. A decision from the CPUC on the General Office application is expected in the second quarter of 2002, and a decision on the district GRC applications is expected in 2002’s third quarter. There can be no assurance that the increases will be granted as requested. The CPUC has lengthened the time required to process the 2001 series of GRC applications. The schedule had required approximately 10 months, but for this series, it is expected to exceed one year. The regulatory delays are detri- mental to the Company because rate relief to cover increased costs are not issued on a timely basis, and rev- enue is effectively lost. In October 2001, the CPUC adopted a resolution implementing its staff’s interim recommendation concerning practices and policies that enable water utilities to recover increases in purchased water, purchased power and pump taxes. These expenses are referred to as “offsetable expenses.” The CPUC also directed its staff to open a proceeding to evaluate offsetable expense recovery practices and policies, and recommend per- manent revisions. Historically, offset rate increases have enabled water utilities to recover increases in off- setable expenses that were not anticipated when customer rates were established and are beyond the utility’s control. Future Company requests to recover offsetable expenses will be processed only if a district has filed a GRC application within its three-year rate case cycle and the district is not earning more than its authorized rate of return on a forward-looking, pro-forma basis. Neither of these requirements applied to offset rate increases prior to adoption of the resolution. The Company can continue to track offsetable expenses in regula- tory memorandum accounts for potential recovery subject to the CPUC’s future determination of appropriate practices and policies. During 2001, the rates charged to the Company by electric power suppliers increased almost 50%. In May 2001, immediately after the CPUC authorized substantial electric rate increases for the state’s two largest power companies, the Company requested authorization to recover $5.9 million in higher power costs for 23 of its 24 regulated California districts. Late in 2001, the Company was authorized rate increases in four districts totaling $2.7 million in additional annual revenue. The Company’s requests to recover power cost increases in the other districts will be processed in accordance with the interim policies adopted by the CPUC. Although the Company is hopeful that it will be authorized to recover the additional offsetable expenses, it is unable to predict the timing or amount of such recoveries. During 2002, the Company expects to file GRCs for six of its California operating districts. Those fil- ings will be made in July 2002 with a decision expected from the CPUC about mid-year in 2003. A GRC was filed for Washington Water in February 2002 with a decision expected in April 2002. The Company’s source of supply varies among its operating districts. Certain districts obtain all of their supply from wells, some districts purchase all of the supply from wholesale suppliers and other districts obtain the supply from a combination of well and purchased sources. A small portion of the supply is from surface sources and processed through three Company-owned treatment plants. On average, slightly more than half of the water produced is provided from wells and surface supply with the remainder purchased from wholesale suppliers. California’s normal weather pattern yields little precipitation between mid-spring and mid-fall. The Washington service areas receive precipitation in all seasons with the heaviest amounts during the winter. Water usage is highest during the warm and dry summers and declines in the cool winter months. Rain and snow during the winter months replenish underground water basins and fill reservoirs providing the water supply for subsequent delivery to customers. To date, snow and rainfall accumulation during the 2001-2002 water year has been above average. Precipitation in the prior five years has been near normal levels. Water storage in California’s reservoirs at the end of 2001 was at historic average. The Company believes that its supply from underground aquifers and purchased sources will be adequate to meet customer demand during 2002. The Company also develops long-term water supply plans for each of its districts to help assure an ade- quate water source under various operating and supply conditions. The Company is subject to regulations of the United States Environmental Protection Agency (EPA), state health service departments and various local health departments concerning water quality matters. It is also subject to the jurisdiction of various state and local regulatory agencies relating to environmental matters, including handling and disposal of hazardous materials. The Company strives for complete compliance with all requirements set forth by the various agencies. The Safe Drinking Water Act (SDWA) was amended in 1996 to provide a new process for the EPA to select and regulate waterborne contaminants. The EPA can now regulate only contaminants that are known or likely to occur at levels expected to pose a risk to public health when regulation would provide a meaningful opportunity to reduce a health risk. New drinking water regulations will be based primarily on risk assess- ment and measurement of cost/benefit considerations for minimizing overall health risk. The amended SDWA allows EPA to require monitoring of up to 30 contaminants in any five-year cycle. Also, every five years the EPA must select at least five listed contaminants and determine if they should be regulated. The Company has an established water supply monitoring program to test for contaminants in accor- dance with SDWA requirements. Water pumped from underground sources is treated as necessary or required by regulations. The Company owns and operates three surface water treatment plants. The cost of existing treatment is being recovered in customer rates as authorized by the regulatory authorities. Water purchased from wholesale suppliers is treated before delivery to the Company’s systems. Enforcement of the EPA standards is the responsibility of individual states. The states can impose more stringent regulation than mandated by EPA. In addition to the EPA’s requirements, various regulatory agencies could require increased monitoring and possibly require additional treatment of water supplies. During 2001, EPA released a new, lower Maximum Contaminant Level (MCL) of 10 parts per billion  for arsenic, a naturally-occurring element, that is sometimes present in groundwater. Compliance with the new standard is required by January 2006. Of the Company’s almost 900 wells, 75 will require treatment to comply with the new MCL. The Company estimates the compliance cost at $125 million in capital expenditures over the next five years and $10 million in additional annual operating costs. The State of California could estab- lish a lower arsenic MCL standard. If the state were to set the standard at five parts per billion, the estimated capital expenditures necessary for compliance would be $250 million. At this time, the Company is unable to predict if the state will adopt the EPA standard or require a lower MCL. The Company is participating in test- ing alternate arsenic treatment technologies in order to meet the standard in the most cost efficient manner. It is anticipated that EPA will issue other regulations that will require further monitoring and possi- ble treatment for specific contaminants. Depending on the action levels contained in the regulations, the cost of compliance with the new regulations could be significant in certain Company districts. The Company intends to request recovery for capital investments and additional treatment costs needed to remain in compliance with established health standards through the ratemaking process. Liquidity. The Company’s liquidity is provided by bank lines of credit and internally generated funds. The Company has a $60 million bank line of credit that expires on April 30, 2003. The Company expects the bank lines of credit will be renewed upon expiration. It replaced a previous $50 million credit line. Of the $60 mil- lion total, $10 million is designated for the parent and $50 million is available to Cal Water. The $10 million portion may be drawn on for use by the Company, including funding of its subsidiaries’ operations. Cal Water’s $50 million portion can be used solely for purposes of the regulated utility. The Company has committed $7.6 million of the $10 million credit line to a contractor for construc- tion of a customer/operation center where the Company will consolidate its South Bay Los Angeles operations, including the former Dominguez Water Company operations. At December 31, 2001, $6.3 million had been drawn to acquire land and construct the facility. The amount drawn on the credit line is an obligation of the contractor, but guaranteed by the Company. The new facility is pledged to the Company as security for the guar- antee. The Company occupied the new facility in January 2002 on a month-to-month rent basis. The transac- 21 CALIFORNIA WATER SERVICE GROUP 20 CALIFORNIA WATER SERVICE GROUP