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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-K

Commission file number 0-8176 Southwest Water Company (Exact name of registrant as specified in its charter)

          Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. 

          Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III in this Form 10-K or any amendment to this Form 10-K. o

          Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

          The aggregate market value of the voting common equity held by non-affiliates of the registrant was approximately $120,068,000 based upon the average high and low prices of such common equity as of June 28, 2002.  The registrant is unable to estimate the aggregate market value of its preferred shares held by non-affiliates of the registrant because there is no public market for such shares. On March 26, 2003, there were 9,770,832 common shares outstanding.

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SOUTHWEST WATER COMPANY AND SUBSIDIARIES

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SOUTHWEST WATER COMPANY AND SUBSIDIARIES

FORWARD-LOOKING STATEMENTS

          Certain written and oral statements made by our Company and subsidiaries or with the approval of an authorized executive officer of our Company may constitute “forward looking statements” as defined under the Private Securities Litigation Reform Act of 1995, including statements made in this report and other filings with the Securities and Exchange Commission. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will,” and similar expressions identify forward-looking statements, which generally are not historical in nature. All statements which address operating performance, events or developments that we expect or anticipate will occur in the future are forward-looking statements. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. When made, we believe that these forward-looking statements are reasonable. However, caution should be taken not to place undue reliance on any such forward-looking statements since such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements.

PART I

Item 1. Description of Business

           A.     History

          Southwest Water Company (Southwest Water, the Company, “we,” “ us,” or “our”) was incorporated in California on December 10, 1954. We reincorporated in Delaware on June 30, 1988. We provide a broad range of services including water production and distribution, wastewater collection and treatment, public works services, customer billing and service, and utility submetering. We provide service for more than two million people in 31 states from coast to coast. Our business is operated by our subsidiaries and is segmented into two operating groups: our Utility Group, which owns and operates regulated water and wastewater utilities, and our Services Group, which manages our non-regulated businesses.

          Our Services Group consists of our contract service businesses through which we operate and maintain water supply and wastewater treatment facilities owned by cities, public agencies, municipal utility districts and private entities primarily in Texas, New Mexico, California, Colorado, Mississippi and Georgia. Nationwide, we provide utility submetering and billing and collection services. While state and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations, the pricing of our services within the Services Group is not subject to regulation. Operating margins within our Services Group are generally low because these are service businesses and competition exists within the industry.

          Within our Utility Group, we own and operate rate-regulated public water and wastewater utilities in California, New Mexico and Texas. State and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations, as well as establish the rates that we can charge for our water and wastewater services.

           B.     Acquisitions

          In November 2002, we acquired 100% ownership of certain contract operations of AquaSource, Inc., a provider of contract water and wastewater services in Texas and Colorado. The purchase price consisted of approximately $10,317,000 in cash.  Upon closing of the transaction on November 22, 2002, we began operating a part of this business under the name Aqua Services, LP (Aqua Services) while the remaining part was incorporated into one of our existing subsidiaries, ECO Resources, Inc. (ECO).

          In August 2001, we purchased 90% of the outstanding shares of Operations Technologies, Inc. (OpTech), a provider of contract water and wastewater and public works services in the southeastern United States, for a

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purchase price of $8,248,000. The purchase price consisted of cash payments of $3,530,000 in August 2001 and $418,000 in January 2002, in addition to 96,580 shares (restated for a 5% stock dividend on January 2, 2003) of our common stock with a market value of $1,300,000 at August 31, 2001 and promissory notes in the aggregate amount of $3,000,000. We also entered into an employment agreement and a non-compete agreement with the owner of the remaining 10% of OpTech. Under the terms of our purchase agreement, we have the right to acquire the remaining 10% of OpTech after a period of five years based upon a formula relating to the profitability of OpTech. After two years, the prior owner has the option to sell the remaining 10% of OpTech to us using the same formula.

          In April 2000, we acquired 80% of the outstanding common stock of Master Tek International, Inc. (Master Tek) and entered the utility submetering, billing and collection services market. Master Tek was established in 1975, and incorporated in Colorado in 1985. The purchase price was $4,000,000, consisting of $2,000,000 in cash and a $2,000,000 10-year promissory note. Under the terms of the purchase agreement, the minority owner of Master Tek may require us to purchase his initial 20% minority interest in 5% increments at a price based on a formula but not less than $1,000,000 per year over a four–year period commencing in April 2002. In April 2002, we paid $1,000,000 to the minority owner for an additional 5% interest in Master Tek in accordance with the purchase agreement, thereby increasing our ownership to 85%.  In February 2003, the minority owner exercised his right to require us to purchase an additional 5% interest in Master Tek, which will increase our ownership to 90% in April 2003. We may be required to purchase the remaining 10% minority interest for $2,000,000 over the course of the next two years.  We also entered into an employment agreement, a consulting agreement and a non-compete agreement with the minority owner.

          In 2000, our California utility purchased the city of West Covina’s water distribution system and facilities for a price of approximately $8,500,000. The sale closed February 25, 2000, and we assumed ownership and operation of the water system on that date. The transaction added approximately 7,000 connections to our California utility customer base, an increase of about 11%.

          In 1996, we acquired a 49% interest in Windermere Utility Company (Windermere), a regulated water and wastewater utility located in the Austin, Texas area. In October 2000, we reached an agreement with the majority shareholder and purchased an additional 31% interest from the majority shareholder, thereby increasing our ownership in Windermere to 80%. The former majority shareholder retains a 20% ownership interest in Windermere. As part of this transaction, we also purchased 100% of Hornsby Bend Utility Company (Hornsby), a nearby water and wastewater utility. The purchase price for these two transactions consisted of Southwest Water common stock with a market value of $4,000,000 at October 1, 2000. The purchase agreement provides that we have the right to acquire the remaining 20% ownership in Windermere for a purchase price of $6,000,000 payable in our common stock at any time when the market value of our common stock increases to $18.14 per share (as adjusted for stock splits and dividends). The minority owner of Windermere has the right to sell the remaining 20% after October 1, 2005, for $6,000,000 payable in our common stock, subject to a limitation on the maximum and minimum number of issuable shares. We also entered into a consulting agreement with the minority owner to provide certain services to Southwest Water.

           C.     Operating Segments

          Our operations are organized into two reportable business segments: Services Group and Utility Group. Our Services Group conducts our non-regulated segment operations, while our regulated segment operations are conducted by our Utility Group. Our reportable business segments are strategic business units that offer different services. They are managed separately because each business requires different operating and marketing strategies. A summary of the profit or loss and assets for our business segments is found in Note 13 to the accompanying consolidated financial statements in Item 8.

           1)     Services Group

           a.     Development of Business, Services and Regulation

          Our Services Group provides water and wastewater services primarily in Texas, Mississippi, California, Georgia, New Mexico, and Colorado. These services include water and wastewater facility operations and maintenance services, equipment maintenance and repair, sewer pipeline cleaning, billing and collection services, and state-certified water and wastewater laboratory analysis. Typically, our Services Group does not own the water sources or utility facilities that we operate for our clients. Although not the owner, the Services Group is responsible

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for operating water and wastewater facilities in compliance with all federal, state and local environmental and health standards and regulations. Our Services Group also facilitates the design, construction, project management, and operating aspects of various water and wastewater projects.  During the construction phase of such a project, our Services Group may have an ownership interest in the project.

          Additionally, our Services Group provides utility submetering for multiple family housing units such as apartment buildings. Submetering operations include installation of submeters, billing, collection and customer services.

          In some instances, the companies in our Services Group may be subject to regulatory oversight; however, the pricing of our services is not subject to regulation. See Note 13 to the accompanying consolidated financial statements.

          Our Services Group generally has three distinct types of contractual relationships: (1) time-and-material contracts, primarily with municipal utility districts in Texas, (2) fixed-fee operations and maintenance contracts and (3) hybrid contracts involving fixed fees for defined basic services with additional billings beyond the basic services.

          Most contracts with municipal utility districts are short-term contracts and do not generally include inflation adjustments. Changes in prices are negotiated on a contract-by-contract basis. Our operations and maintenance contracts are generally longer-term water and wastewater service contracts, primarily with cities, and many include inflation adjustments, as measured by a consumer price index. Most contracts with management companies and owners of apartment or condominium communities are short-term contracts and generally do not include inflation adjustments. Changes in prices are negotiated on a contract-by-contract basis.

           b.     Municipal Utility District (MUD) Contracts

          A MUD is created under the rules of the Texas Commission on Environmental Quality (TCEQ), formerly the Texas Natural Resource Conservation Commission, to provide water supply, wastewater treatment and drainage services to areas where existing municipal services are not available. Our Services Group has MUD contracts in the suburbs of Houston, Austin and El Paso, Texas. Under a typical MUD contract, we bill a monthly base fee to provide a specified level of services. Services typically include customer billing and collection, customer service, daily operation and maintenance of water and wastewater facilities and assets, and environmental monitoring and reporting. Our Services Group usually bills for any additional services provided beyond the basic contract on a time-and-materials basis as such services are rendered. Generally, MUD contracts are cancellable on 30 or 60-day notice by either party.  Our experience indicates that, with high-quality service and strong focus on client satisfaction, MUD relationships can last for periods of 10 or more years.  Most MUD contracts provide for an increase in the monthly base fee as the number of customer connections increases.

           c.     Operations and Maintenance (O&M) Contracts

          O&M contracts are agreements with cities and private entities that provide specific services such as facility operation and maintenance, meter reading, customer billing and collection, or management of the entire water or wastewater system. Under a standard O&M contract, our Services Group companies charge a fee that covers a specified level of services. Although in some cases there may be some variation due to weather or seasonality, services are typically provided evenly throughout the contract period and are billed on a monthly basis. Our O&M contracts limit our liability in the event of a major system failure or catastrophic event. When our Services Group provides services beyond the scope of a contract, we bill for the additional services. If a major system failure or catastrophic event occurred as the result of flooding, earthquake, electrical strike or vandalism for example, the facility owner would likely call upon us to provide a variety of additional services on a time-and-materials basis. Such services could include running pumps, resealing manholes or replacing meters. 

          Most O&M contracts provide for annual increases based upon measures of inflation, and we typically have the right to increase our fixed operations fee if the system experiences growth beyond a specified level. Under the O&M contracts, our Services Group may pay certain costs such as chemical or utility expenses. The O&M contracts provide that we are reimbursed for certain of these costs.

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          In most cases, O&M contracts are cancellable only upon a specific breach of the contract by either party.  O&M contracts have terms ranging from month-to-month up to 10 or more years, and our experience has been that approximately 90% of our O&M contracts are renewed upon expiration.

           d.     Construction Management Projects

          In 1999, we agreed to provide the design, building, financing and operation of a $6,500,000 reverse osmosis water treatment plant near El Paso, Texas, for the El Paso County Water Authority (EPCWA). The project included drilling five wells and developing associated water lines and settling ponds. During construction of the treatment plant, we received monthly payments from the EPCWA. In addition, the EPCWA awarded us a 20-year, $22,000,000 extension of the existing operating contract. The construction of the plant was substantially completed in December 2000 and the facility began operating in February 2001, treating an average of 2,600,000 gallons of water per day. Reverse osmosis technology is a process that removes microscopic particles such as minerals and salts from a solution to produce potable water.

          In September 2002, we agreed to facilitate the engineering and construction of a $25,000,000 reverse osmosis water treatment plant in the city of San Juan Capistrano, California, for the Capistrano Valley Water District (CVWD). The project will include the drilling of eight new wells and developing associated water lines. During construction of the treatment plant, we will receive payments upon completion of construction milestones until final completion of the construction. In addition, the CVWD awarded us a 20-year, $20,000,000 contract to operate the treatment plant after completion of construction. The construction of the plant commenced in December 2002, with completion expected in late 2004, at which time we will begin to operate the facility under the 20-year contract.  Upon completion, the plant will have a capacity to treat approximately 5,000,000 gallons of water per day.

          Our Services Group has contracted with our Texas utilities and our New Mexico utility to perform operating services, normal maintenance and construction work and, in addition, to manage capital projects for these utilities. These contracts were established utilizing terms and conditions equivalent to prevailing industry rates for similar work performed by our Services Group for non-affiliated entities. In accordance with Statement of Financial Accounting Standards (SFAS) No. 71, Accounting for the Effects of Certain Types of Regulation, we recognize a profit margin from contract work performed and do not eliminate the intercompany profit on the contract work performed when the contract sales price is reasonable and it is probable that the costs and capital will be recoverable through the rate making process. Accordingly, the intercompany profit on such projects has not been eliminated in the accompanying consolidated financial statements.

           e.     Utility Submetering

          Utility submetering involves the installation of electronic equipment in apartments, condominiums, mobile home parks and other multi-family dwellings to monitor each resident’s usage of utilities, allowing water, gas and electricity usage to be measured and charged to each individual residential unit. By making residents accountable for their own utility consumption, submetering tends to promote conservation of natural resources and allows for landlord utility cost recovery. Our Services Group has designed its own submetering equipment and also installs submetering equipment manufactured by others.

          In addition to the sale and installation of submetering devices, our submetering company provides billing, collection and customer relation services. The billing process for submetered facilities usually involves the transmission of utility usage data via radio frequency and telephone lines to our facility near Denver, Colorado. As of December 31, 2002, our Services Group was providing submetering services to approximately 127,000 dwelling units in 29 states.

           f.     Competition

          Competition in the O&M portion of our business includes a number of significantly larger companies that provide O&M services on a national and international basis, as well as regional competitors. New contracts are awarded based on a combination of customer relationships, service levels, competitive pricing, references and technical expertise. While our Services Group intends to expand its market share within the southwestern and southern United States, there is substantial competition in these markets. Cities themselves are also major competitors, since we must overcome reluctance on the part of city officials to outsource their water and wastewater services. Although industry renewal rates tend to be high, the contract water and wastewater management business is very competitive, and we cannot assure you that our Services Group will be able to increase or sustain its market share.

          The utility submetering, installation, billing and collection business is highly competitive. While industry contract renewal rates are high, management companies and owners of multifamily dwellings periodically change billing and collection companies. In addition, we compete with several larger competitors whose size, customer base and capital resources may restrict our ability to compete successfully for certain contracts. Submetering is a relatively new industry and may attract other large competitors.  We cannot assure you that our efforts in the submetering business will be successful in increasing or sustaining market share.

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           g.     Growth and Backlog

          During the past three years, our Services Group has increased revenues and service area by adding new MUD, O&M and submetering contracts, managing construction projects, aggressively pursuing renewal of its existing contracts and making acquisitions.

          As the major cities in Texas (such as Houston and Austin) expand their boundaries, they periodically acquire MUD-owned facilities through annexation to city-owned facilities; however, during 2002, none of the MUD facilities operated by our Services Group was annexed to city-owned facilities.

          As of December 31, 2002, our Services Group had 263 MUD contracts, an increase of 85 contracts compared to December 31, 2001. As of December 31, 2002, we had 196 O&M contracts compared to 66 contracts as of December 31, 2001.  The acquisition of Aqua Services in November 2002 accounted for most of the increase in MUD and O&M contracts during 2002. 

          The following table indicates the number of Services Group contracts in effect as of the end of each of the three most recent years:

Table 1
Services Group – Number of Contracts

          Our Services Group’s revenue backlog consists of new and existing contracts. We include new contracts in the backlog when both the client and we have signed the contracts. Revenues included in the backlog may be realized over a multi-year period. The O&M contracts signed by our Services Group typically have durations of three to five years, and the uncompleted remaining portion of these existing contracts is reflected in the backlog. MUD and submetering contracts are assumed to have a 36-month term, consistent with our experience, and are included in the backlog computation using an assumed 36-month term. We believe our backlog figures are firm, subject only to the cancellation and modification provisions contained in the contracts.

          As of December 31, 2002 and 2001, our Services Group backlog was approximately $275,000,000 and $144,000,000, respectively. The increase in the backlog was primarily due to 1) the addition of several new O&M and MUD contracts resulting from the acquisition of Aqua Services and 2) the addition of a $25,000,000 construction project of a reverse osmosis water treatment plant in San Juan Capistrano, California.  Of the backlog as of December 31, 2002, we anticipate that approximately $100,000,000 will be realized in revenues during calendar year 2003.

           h.     Seasonality

          Our Services Group operations can be affected by severe weather and rainfall. In general, heavy rainfall or storm conditions may limit our ability to perform certain billable work such as pipeline maintenance, manhole rehabilitation and other outdoor services. Severe weather conditions may also result in additional labor and material costs to us that may not necessarily be recoverable from our various city contracts. However, such severe weather conditions are infrequent, and any additional costs that we incur that cannot be billed under our contracts are not material to our results of operations.

          Revenues and earnings of our utility submetering business are generally not subject to seasonal fluctuations.

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           2)     Utility Group

           a.     Development of Business, Services and Regulation

California

          Our regulated public water utility in California produces and supplies water for residential, business, industrial and public authority use and for private and public fire protection service under the jurisdiction of the California Public Utilities Commission (CPUC). Our California utility service area contains a population of approximately 311,000 people in an area of approximately 43 square miles within Los Angeles and Orange counties, California.

          Our California utility or its predecessor entities have supplied water since approximately 1907. From the mid-1950s to the late 1960s, our operations expanded rapidly as most of our service area was converted from agricultural use to residential, business and industrial use. We have experienced only modest connection growth since the late 1960s, principally due to the population saturation of our service area. In February 2000, our California utility purchased the City of West Covina’s (West Covina) water distribution system and facilities, which added approximately 7,000 connections to our customer base, an increase of approximately 11%.

          The following table indicates by classification the number of water connections that our California utility served as of the end of each of the past three years:

Table 2
California Utility – Number of Water Connections by Classification

          During 2002, our California utility’s annual revenues were approximately 72% from sales to residential connections, approximately 17% from sales to business and industrial connections, and approximately 11% from sales to other connections.

New Mexico

          Our regulated public water utility in New Mexico provides water supply and sewage collection services for residential, commercial and irrigation use and for fire protection service under jurisdiction of the New Mexico Public Regulation Commission (NMPRC). Our New Mexico utility service area is located in the northwest part of the City of Albuquerque and in the northern portion of Bernalillo County, New Mexico, and contains a population of about 36,000 people in an area of approximately 34 square miles, of which an estimated 34% has been developed.

          The following table indicates by classification the number of water connections served by our New Mexico utility as of the end of each of the most recent three years:

Table 3
New Mexico Utility – Number of Water Connections by Classification

          Our New Mexico utility has grown from approximately 800 connections at the time of its acquisition in 1969 to over 11,000 connections. Most of this growth has resulted from the extension of water services and sewage

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collection services into new residential subdivisions and new commercial development. During 2002, we added 1,359 new water connections and 1,317 new wastewater connections in New Mexico. Because of the continuing real estate development in its service area, our New Mexico utility expects continued connection growth in 2003. During 2002 and 2001, our revenues in New Mexico were approximately 61% and 58%, respectively, from sales to residential connections and approximately 39% and 42%, respectively, from sales to commercial and industrial connections.

          Texas

          Our Texas utilities currently provide water supply and sewage collection and treatment services to approximately 5,800 connections for residential, commercial, irrigation and fire protection under the jurisdiction of the Texas Commission on Environmental Quality (TCEQ), formerly the Texas Natural Resource Conservation Commission. Our service areas in Texas are located near the City of Austin, and contain a population of approximately 19,000 people in an area of approximately eight square miles, of which an estimated 46% has been developed. These service areas are experiencing continued real estate development, and we expect the number of connections to continue growing in 2003.

Table 4
Texas Utilities – Number of Water Connections by Classification

           b.     Sources of Water

          The wells owned and operated by our California utility pump water from two of the major groundwater basins in the Southern California coastal watershed: the Main San Gabriel Basin (the Main Basin) and the San Gabriel Central Basin (the Central Basin). Our rights to pump water from the Main and Central Basins are fully adjudicated under California law, and these adjudications establish our right to produce water at levels and at a cost prescribed each year by the Watermaster Boards (the Boards) that manage the Main and Central Basins. Our California utility is also allowed to produce water from the Main and Central Basins in excess of the amount prescribed by the Boards, but when such excess production occurs, an additional payment from our utility is required to provide for the replenishment of the water supply.  As the water levels in the Main and Central Basins increase or decrease, the Boards may adjust the amount of water that we are allowed to pump without paying any additional charges. As discussed in Part D. Environmental Matters, in recent years, the availability of water from the Main Basin has decreased because of groundwater contamination issues. As a result, the amount of water that our California utility has pumped from the Main Basin has declined. During 2002, the Main and Central Basins were the source of approximately 28% of our California water supply, compared to approximately 54% and 60% in 2001 and 2000, respectively.  Generally, purchased water is more expensive than water pumped from our own wells. 

          Our water supply in California is supplemented by water purchased from external sources. We purchase water from the Metropolitan Water District (MWD) of Southern California through member agencies and other customers of member agencies. We also purchase water from two mutual water companies that produce their water from the Main Basin. Our California utility’s ownership of shares in each of these mutual water companies has allowed it to purchase water at a cost that is lower than many other sources. In addition, in the past we have leased Main Basin pumping rights from other parties, which has reduced our cost of water in California. However, we cannot assure you that these sources of water will remain unaffected by the Main Basin groundwater contamination issues or that our California utility will be able to use these water sources indefinitely. 

          In Part D. Environmental Matters, we discuss certain groundwater issues impacting the Main Basin. In 2001 we were required to shut down some of our wells. This resulted in our California utility purchasing approximately 46% of its water supply from the MWD and other sources in 2001, compared to approximately 40% in 2000. During 2002, our California utility shut down additional wells. As a consequence, the Main and Central Basins were the source of approximately

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28% of our California water supplies in 2002, and we were required to purchase approximately 72% of our water supply from the MWD and other water sources. Under an agreement made in early 2002, we have been reimbursed for certain costs of purchasing water needed to replace lost production as a result of the Main Basin contamination issues.  We expect such reimbursement to continue until completion of remediation.

          To date, we have been able to produce and purchase enough water to meet our current customer requirements in California. However, we cannot assure you that we will be able to produce or purchase enough water to fully satisfy future customer demand in our California service area. We are currently examining various options to increase our available water supply in California. These options include drilling new wells, adding connections to our existing MWD supply lines and constructing water treatment facilities. We cannot assure you that the results of drilling the wells will be successful, that we will be able to obtain necessary permits to add new supply lines and connections, or that we will be able to obtain regulatory or legislative approval to operate new water treatment facilities.

          Our New Mexico utility owns five wells and four reservoirs, and we believe that we have adequate water capacity to serve our current customer base as well as new customers over the next decade, based upon the current growth rate. The wells that we own and operate in New Mexico produce water from the Rio Grande Underground Basin.

          As customer growth continues in our New Mexico service area, we may have to increase our water supply capacity through additional well construction to ensure an adequate supply of water. If an interruption were to occur in our New Mexico water supply, our New Mexico utility also has an emergency supply of water available through an interconnection with another water purveyor.

          Our Texas utilities own eight wells and 10 reservoirs in addition to distribution, collection and treatment facilities. Water is pumped out of the Edwards aquifer. We believe that we have adequate capacity to serve our existing customer base in Texas.

          As customer growth continues in our Texas service areas, we may have to increase the water supply capacity of our Texas utilities through a combination of outside water purchases and the construction of additional wells. One of our Texas utilities has a 20-year agreement to purchase water from the City of Austin.

           c.     Water Quality Regulation

          The water supplies available to our utilities in California, New Mexico and Texas are subject to regulation by the United States Environmental Protection Agency (EPA) under the 1996 Federal Safe Drinking Water Act (US Act).  The US Act establishes uniform minimum national water quality standards, as well as specification of the types of treatment processes to be used for public drinking water. The EPA, as mandated under the US Act, issues regulations that require, among other things, disinfection of drinking water, specification of maximum contaminant levels (MCLs) and filtration of surface water supplies.

          Our California water supplies are also subject to regulation by the Office of Drinking Water of the California Department of Health Services (DOHS) under the California Safe Drinking Water Act (Cal Act). The Cal Act and the rules of the DOHS are similar to the US Act and the mandates of the EPA, except that in many instances the requirements of the DOHS are more stringent than those of the EPA.

          In addition to the EPA and the DOHS water quality regulations, our California water utility is also subject to water quality standards that may be set by the CPUC. The California Supreme Court has ruled that the CPUC has the authority to set standards that are more stringent than those set by the EPA and the DOHS.

          The water supplied by our New Mexico utility is subject to regulation by the EPA and by the State of New Mexico Environmental Improvement Division. The water supplied by our Texas utilities is subject to regulation by the EPA and by the TCEQ.

          In June 1998, we detected the substance N-nitrosodimethylamine (NDMA) in one of our California utility’s wells at a level in excess of the EPA reference dosage for health risks. Upon detection, the well was immediately

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removed from service. In 1999, our California utility completed construction of a treatment facility that is intended to reduce NDMA in this well to non-detectable levels. In February 2001, we received final regulatory approval of the facility and in May 2001, our California utility began producing water from this well.

          In January 2002, the DOHS set a more stringent recommended standard for the substance perchlorate, which was subsequently detected in this California well at levels in excess of the revised standard. We immediately removed this well from service. In 2000, in another of our California utility’s well fields, we detected amounts of contaminants in excess of the EPA reference dosage for health risks.  All wells in that well field were immediately removed from service.  The water production from these wells was replaced with purchased water, the excess costs of which were substantially funded by the Cooperating Respondents (CRs).

          In February 2002, the EPA set a more stringent arsenic standard in drinking water from 50 parts per billion to 10 parts per billion, which must be fully met by 2006. At the present time, our water sources in California and Texas are in compliance with the new standards. The DOHS is holding discussions that could result in a more stringent arsenic standard effective in June 2004. We cannot predict the impact that such changes in the arsenic standard would have on our California and Texas water utility operations. If the arsenic standard remains at 10 parts per billion, we do not expect it to have a material adverse impact on our financial position or results of operations in California and Texas.

          Although our New Mexico utility meets the current arsenic standard of 50 parts per billion, it does not meet the newly adopted arsenic standard of 10 parts per billion. To meet this new standard by the required 2006 implementation date, we are considering an option that includes the construction of an arsenic removal treatment plant. We anticipate that significant capital expenditures at our New Mexico facility may be required to comply with the new arsenic standard, and we anticipate that the change in standard may have an impact on our New Mexico water utility operations. However, we cannot determine the impact at this time. We believe that there may be funds available from state or federal agencies that could defray all or a part of the capital expenditures that we believe will be necessary to meet the new arsenic standards. If this new standard has an impact on our New Mexico operations, we will likely present a rate case to the NMPRC to recover these costs. We cannot assure you that funds will be made available to our New Mexico utility or that costs incurred or capital spent will ultimately be recoverable from the ratepayers.

          Costs associated with testing of our water supplies in California have increased and are expected to further increase as regulatory agencies adopt additional monitoring requirements. We believe that costs associated with the additional monitoring and testing of our water supply in California will be recoverable from ratepayers through future rate increases. However, we cannot assure you that water sources currently available to our California utility will meet future EPA or DOHS requirements, that recovery of additional costs will be allowed, or that new or revised monitoring requirements will not necessitate additional capital expenditures by our California utility in the future. We believe that future incremental costs of complying with governmental regulations, including capital expenditures, will be recoverable through increased rates. However, we cannot assure you that recovery of such costs will be allowed.

          Both the EPA and the DOHS have put into effect regulations and other pronouncements that require periodic testing and sampling of water to ensure that only permissible levels of organic and volatile and semi-volatile organic compounds (VOCs), herbicides, radio nuclides, pesticides and inorganic substances are present in water supplied to the public. Our California water quality personnel regularly sample and monitor the quality of water being distributed throug