Document ID: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-caDC-05-01303/USCOURTS-caDC-05-01303-0/pdf.json

Parties Involved:
Association of Oil Pipe Lines
Petitioner
Federal Energy Regulatory Commission
Respondent
United States of America
Respondent

Document Text:

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued December 12, 2006 Decided May 29, 2007

No. 04-1102

EXXONMOBIL OIL CORPORATION,

PETITIONER

v.

FEDERAL ENERGY REGULATORY COMMISSION AND

UNITED STATES OF AMERICA,

RESPONDENTS

WESTERN REFINING COMPANY, L.P., ET AL.,

INTERVENORS

Consolidated with

04-1103, 04-1104, 04-1140, 04-1142, 04-1143, 04-1160,

05-1204, 05-1217, 05-1218, 05-1219, 05-1223, 05-1226,

05-1232, 05-1245, 05-1303

______

On Petitions for Review of Orders of the

Federal Energy Regulatory Commission

Thomas J. Eastment and R. Gordon Gooch argued the cause

for Shipper Petitioners. With them on the briefs were Joshua B.

Frank, Elisabeth R. Myers, George L. Weber, Walter Lowry

Barfield, III., Steven A. Adducci, Richard E. Powers, Jr., Marcus

W. Sisk, Jr., and Frederick G. Jauss IV. 

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Charles F. Caldwell and Christopher J. Barr argued the

cause for petitioners SFPP, L.P. and the Association of Oil Pipe

Lines. With them on the briefs were Albert S. Tabor, Jr.,

Catherine O’Harra, Sabina K. Dugal, Steven H. Brose, Timothy

M. Walsh, Daniel J. Poynor, and Michele F. Joy. Erin M.

Murphy,Neil Patten, Judith M. Andrade, Kevin B. Bedell, Glenn

S. Benson, and Michael J. Manning entered appearances.

Lona T. Perry, Attorney, Federal Energy Regulatory

Commission, argued the cause for respondent. With her on the

brief were R. Hewitt Pate, Assistant Attorney General, U.S.

Department of Justice, John J. Powers, III., and Robert J.

Wiggers, Attorneys, John S. Moot, General Counsel, Federal

Energy Regulatory Commission, and Robert H. Solomon,

Solicitor. Robert B. Nicholson, Attorney, U.S. Department of

Justice, entered an appearance.

Charles F. Caldwell argued the cause for intervenors SFPP,

L.P. and the Association of Oil Pipe Lines in support of

respondent. With him on the brief were Christopher J. Barr,

Albert S. Tabor, Jr., Catherine O’Harra, Steven H. Brose,

Timothy M. Walsh, and Daniel J. Poynor. 

Steven A. Adducci, R.Gordon Gooch, Elisabeth R. Myers,

Marcus W. Sisk, Jr., Frederick G. Jauss IV., and George L.

Weber were on the brief of Shipper Intervenors in support of

respondent with respect to arguments of SFPP, L.P. and the

Association of Oil Pipe Lines.

Before: SENTELLE, GRIFFITH and KAVANAUGH, Circuit

Judges.

Opinion for the Court filed PER CURIAM.

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PER CURIAM: SFPP, L.P., operates pipelines that transport

petroleum products through Arizona, California, Nevada, New

Mexico, Oregon, and Texas. This case is the latest chapter in a

long-running dispute over SFPP’s tariffs.

The consolidated petitions for review challenge three orders

of the Federal Energy Regulatory Commission (“FERC”):

1. ARCO Products Co. v. SFPP, L.P., 92 FERC ¶ 61,244

(2000) (“Order Consolidating Proceedings”);

2. ARCO Products Co. v. SFPP, L.P., 106 FERC ¶ 61,300

(2004) (“Order on Initial Decision”); and

3. SFPP, L.P., 111 FERC ¶ 61,334 (2005) (“Remand

Order”).

Several shippers – i.e., firms that pay to transport petroleum

products over SFPP’s pipelines – seek review of these three

orders. The shipper petitioners are BP West Coast Products,

Chevron Products, ConocoPhillips, ExxonMobil Oil, Navajo

Refining, Ultramar, Valero Marketing and Supply, and Western

Refining. The shippers raise several challenges to the

Commission’s orders. In particular, they argue that: (1) the

Commission unlawfully granted an income tax allowance to

SFPP; (2) the Commission applied the wrong standard and

relied upon faulty data in its analysis of whether SFPP’s rates

should be “de-grandfathered” under the Energy Policy Act of

1992; and (3) the Commission erroneously held that certain

shippers were not entitled to reparations for rates charged on

SFPP’s East Line after August 1, 2000. SFPP and the

Association of Oil Pipe Lines have intervened on behalf of the

Commission with respect to these issues.

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SFPP and the Association of Oil Pipe Lines have also crosspetitioned for review of the three challenged orders. They argue

that the Commission incorrectly interpreted the Energy Policy

Act and made several computational errors in determining

whether SFPP’s rates should be de-grandfathered. The shippers

have intervened on behalf of the Commission regarding these

issues.

We deny the petitions for review with respect to the income

tax allowance issues and the Energy Policy Act issues. We hold

that the Commission’s income tax allowance policy was not

arbitrary or capricious or contrary to law. We also hold that

FERC’s interpretation of the Energy Policy Act was reasonable.

We need not consider several of the arguments raised by SFPP

and the shippers regarding FERC’s calculations because the

parties failed to raise those arguments before the Commission in

the first instance. However, we grant the shippers’ petition for

review with respect to the reparations issue. FERC acted

contrary to law when it held that the Arizona Grocery doctrine

precluded the Commission from awarding reparations to East

Line shippers for rates paid after August 1, 2000.

I. FERC’S INCOME TAX ALLOWANCE POLICY

The first issue in these petitions for review is whether it was

lawful for FERC to grant an income tax allowance to pipelines

operating as limited partnerships. In the Remand Order, FERC

held that SFPP is entitled to an income tax allowance to the

extent that its partners incur “actual or potential income tax

liability” on the income they receive from the partnership.

SFPP, L.P., 111 FERC ¶ 61,334 at 62,456 (2005). The shipper

petitioners contend that this order is arbitrary and capricious and

contrary to our decision in BP West Coast Products, LLC v.

FERC, 374 F.3d 1263 (D.C. Cir. 2004), because it grants a tax

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allowance to entities that do not actually pay income taxes.

While we agree that the orders under review and the policy

statement upon which they are based incorporate some of the

troubling elements of the phantom tax we disallowed in BP West

Coast, FERC has justified its new policy with reasoning

sufficient to survive our review. We therefore deny the petitions

for review with respect to this issue.

A.

FERC’s income tax allowance (“ITA”) policy for pipelines

that operate as limited partnerships has a tortuous history. In

1995, the Commission adopted the “Lakehead policy,” under

which pipelines’ ITA eligibility turned on whether the partners

were corporations or individuals. Lakehead Pipe Line Co., 71

FERC ¶ 61,338 at 62,313-15 (1995). In Lakehead, FERC held

that a pipeline was entitled to an ITA only for income taxes that

were “attributable to its corporate partners.” Id. at 62,314. The

Commission reasoned:

When partnership interests are held by corporations, the

partnership is entitled to a tax allowance in its cost-ofservice for those corporate interests because the tax cost

will be passed on to the corporate owners who must pay

corporate income taxes on their allocated share of income

directly on their tax returns. The partnership is in essence

a division of each of its corporate partners because the

partnership functions as a conduit for income tax purposes.

Id. at 62,314-15. In contrast, FERC held that pipelines were not

entitled to an ITA with respect to income attributable to

partnership interests held by individuals because “those

individuals do not pay a corporate income tax.” Id. at 62,315.

The Commission noted that its holding “comports with the

principle that there should not be an element in the cost-ofUSCA Case #05-1303 Document #1043050 Filed: 05/29/2007 Page 5 of 45
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service to cover costs that are not incurred.” Id.

In the Opinion No. 435 proceedings, FERC applied the

Lakehead policy to SFPP’s rates, holding that SFPP could

include an income tax allowance in its cost-of-service for the

share of the partnership’s income that was attributable to

corporate partners. SFPP, L.P., 86 FERC ¶ 61,022 at 61,102-04

(1999). Several parties petitioned for review of this order. The

shipper petitioners argued – as they do in the instant case – that

SFPP should not be entitled to any income tax allowance

because it is a limited partnership that pays no income tax at the

entity level. In contrast, SFPP argued that it should have been

granted a full income tax allowance, even on the share of

income attributable to non-corporate partners.

In BP West Coast, we granted the shippers’ petition for

review and vacated the income tax allowance provisions of

Opinion No. 435. 374 F.3d at 1285-93. We held that:

[T]he Commission’s opinions in Lakehead do not evidence

reasoned decisionmaking for their inclusion in cost of

service of corporate tax allowances for corporate unit

holders, but denial of individual tax allowances reflecting

the liability of individual unit holders.

Id. at 1290. In other words, the Commission did not reasonably

explain why corporate partners and individual partners were

treated differently under the Lakehead policy. Id. at 1288-90.

We acknowledged that corporate income is taxed twice – while

other income is taxed only once – but we emphasized that this

discrepancy is simply “a product of the corporate form.” Id. at

1290-91. FERC may not attempt to compensate for the double

taxation of corporations by creating a “phantom” tax allowance.

As we explained:

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[W]here there is no tax generated by the regulated entity,

either standing alone or as part of a consolidated corporate

group, the regulator cannot create a phantom tax in order to

create an allowance to pass through to the rate payer.

Id. at 1291. Income tax costs are “no different” than any other

costs, such as bookkeeping expenses. Id. We noted that just as

a pipeline does not receive an allowance for the bookkeeping

costs of its investors, neither may it receive an allowance for

income taxes paid by “corporate unit holders” (i.e., investors).

Id. In sum, our per curiam decision in BP West Coast vacated

FERC’s Lakehead policy because the Commission did not

provide a reasoned explanation for distinguishing between

individual and corporate partners, and because the Commission

appeared to be granting income tax allowances to regulated

entities that did not actually pay income taxes.

In response to our decision in BP West Coast, the

Commission issued a notice of inquiry seeking comments from

interested parties on the question when, if ever, it is appropriate

to provide an income tax allowance for partnerships or similar

pass-through entities that hold interests in a regulated public

utility. Inquiry Regarding Income Tax Allowances; Request for

Comments, 69 Fed. Reg. 72,188 (Dec. 13, 2004). On May 4,

2005, the Commission issued a policy statement that provided

guidance about how it planned to address the ITA issue going

forward. Policy Statement on Income Tax Allowances, 111

FERC ¶ 61,139 (2005) (“Policy Statement”). In the Policy

Statement, the Commission concluded that “such an allowance

should be permitted on all partnership interests, or similar legal

interests, if the owner of that interest has an actual or potential

income tax liability on the public utility income earned through

the interest.” Id. at 61,736. In response to its request for

comments, the Commission received 42 responses. Id. at

61,737. After review of the comments, the Commission

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determined that it should choose one of four possible

approaches:

(1) provide an income tax allowance only to corporations,

but not partnerships; (2) give an income tax allowance to

both corporations and partnerships; (3) permit an allowance

for partnerships owned only by corporations; and (4)

eliminate all income tax allowances and set rates based on

a pre-tax rate of return.

Id. at 61,741. The Commission ultimately selected the second

option, stating that it would “permit an income tax allowance for

all entities or individuals owning public utility assets, provided

that an entity or individual has an actual or potential income tax

liability to be paid on that income from those assets.” Id. After

weighing the relevant policy concerns, FERC concluded that

this policy “serves the public because it allows rate recovery of

the income tax liability attributable to regulated utility income,

facilitates investment in public utility assets, and assures just

and reasonable rates.” Id. at 61,736.

The Commission applied its new policy and reiterated its

reasoning in the Remand Order. 111 FERC at 62,454-56. In

that order, FERC ruled that SFPP was entitled to an ITA to the

extent that the pipeline’s partners – both individual and

corporate – paid taxes on the income they received from the

partnership. Id. at 62,455-56. The Commission acknowledged

that “the pass-through entity does not itself pay income taxes,”

but nonetheless granted the ITA because “the owners of a passthrough entity pay income taxes on the utility income generated

by the assets they own via the device of the pass-through entity.”

Id. at 62,455. FERC reasoned that:

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[J]ust as a corporation has an actual or potential income tax

liability on income from the public utility assets it controls,

so do the owners of a partnership or limited liability

corporation (LLC) on the assets and income that they

control by means of the pass-through entity.

Id. Thus, the Commission concluded that “SFPP, L.P. should be

afforded an income tax allowance on all of its partnership

interests to the extent that the owners of those interests had an

actual or potential income tax liability during the periods at

issue.” Id. at 62,456.

ExxonMobil Oil, BP West Coast Products, Navajo Refining

Company, and other shippers have petitioned for review of the

Remand Order, arguing that FERC’s decision to grant SFPP an

income tax allowance was arbitrary and capricious and contrary

to our decision in BP West Coast. The Policy Statement is not

directly challenged in these petitions for review. However, in

the Remand Order – which is challenged in the instant case – the

Commission expressly relied upon the conclusions and

reasoning of the Policy Statement. See 111 FERC at 62,456

(“Given the Commission’s Policy Statement and the application

of its policy in this opinion, the Commission concludes that

SFPP, L.P. should be afforded an income tax allowance . . . .”).

Thus, in determining whether the Remand Order was arbitrary

and capricious or contrary to BP West Coast, we necessarily

review the Commission’s conclusions and reasoning in the

Policy Statement.

B.

In the Remand Order, FERC resolved the principal defect

of the Lakehead policy, which was the inadequately explained

differential treatment of the tax liability of individual and

corporate partners. The Commission concluded that regulated

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pipelines operating as limited partnerships should be eligible for

income tax allowances to the extent that all partners incur actual

or potential tax liability on the income they receive from the

partnership. FERC’s explanation in support of this policy

choice is reasonable, and the Commission’s Remand Order is

not inconsistent with BP West Coast. Accordingly, we deny the

petitions for review with respect to this issue.

We review the Commission’s ratemaking decisions under

the “arbitrary and capricious” standard. Ass’n of Oil Pipe Lines

v. FERC, 83 F.3d 1424, 1431 (D.C. Cir. 1996) (“AOPL”).

Under this test, FERC’s decisions will be upheld as long as the

Commission has examined the relevant data and articulated a

rational connection between the facts found and the choice

made. Id. (quoting Motor Vehicle Mfrs. Ass’n v. State Farm

Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983)). In other words, the

Commission must “cogently explain why it has exercised its

discretion in [the] given manner.” Exxon Corp. v. FERC, 206

F.3d 47, 54 (D.C. Cir. 2000) (internal quotation marks omitted)

(alteration in original). In reviewing FERC’s orders, we are

“particularly deferential to the Commission’s expertise” with

respect to ratemaking issues. AOPL, 83 F.3d at 1431; see also

FPC v. Hope Natural Gas Co., 320 U.S. 591, 602 (1944) (noting

that a party challenging a natural gas rate order “carries the

heavy burden of making a convincing showing that it is invalid

because it is unjust and unreasonable”).

The Commission must ensure that the rates charged by

jurisdictional pipelines are “just and reasonable.” BP West

Coast, 374 F.3d at 1286 (citation omitted). We have held that

“just and reasonable” rates are “rates yielding sufficient revenue

to cover all proper costs, including federal income taxes, plus a

specified return on invested capital.” City of Charlottesville v.

FERC, 774 F.2d 1205, 1207 (D.C. Cir. 1985). Of course, this

canonical principle of ratemaking begs the question of which

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costs are “proper.” In the challenged Remand Order, FERC

concluded that it was proper to grant SFPP an income tax

allowance to the extent that its partners – both individual and

corporate – incurred actual or potential tax liability on their

distributive share of the partnership income. In light of the

deference we extend to the Commission’s judgments regarding

ratemaking issues, we cannot hold that this conclusion was

arbitrary or capricious.

On remand from BP West Coast, the Commission

considered four different options for its income tax allowance

policy. First, the Commission considered – and rejected – a

proposal to adopt a modified version of the Lakehead policy. As

FERC explained in the Policy Statement, “the Commission

agrees with the court’s conclusion in BP West Coast that . . .

Lakehead did not articulate a rational ground for concluding that

there should be no tax allowance on partnership interests owned

by individuals, but that there should be one for partnership

interests owned by corporations.” 111 FERC at 61,743. Given

our holding in BP West Coast, the Commission was certainly

permitted – if not required – to reject the comments that

proposed a modified Lakehead policy. Second, FERC

considered a proposal that would grant income tax allowances

only to partnerships that are “owned wholly by corporations

filing a consolidated return.” Id. at 61,738. FERC reasonably

rejected this for the same reason it rejected the first alternative

– because it found no rational reason for differentiating between

corporate and non-corporate partnership interests. Id. at 61,744.

The two remaining policy options considered by the

Commission were polar opposites. One proposal would have

categorically prohibited limited partnerships from taking income

tax allowances, while the other would have granted partnerships

a full income tax allowance to the extent that the partners incur

actual or potential tax liability. Id. at 61,739-41. The

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Commission chose to adopt a policy of full income tax

allowances for limited partnerships, and we cannot conclude that

this choice was unreasonable. Most importantly, FERC

determined that income taxes paid by partners on their

distributive share of the pipeline’s income are “just as much a

cost of acquiring and operating the assets of that entity as if the

utility assets were owned by a corporation.” Id. at 61,742. In

other words, the Commission found no good reason to limit the

income tax allowance to corporations, given that “both partners

and Subchapter C corporations pay income taxes on their first

tier income.” Id. at 61,744.

Moreover, the Commission determined that income taxes

paid on the partners’ distributive share of the pipeline’s income

were properly “attributable” to the regulated entity because such

taxes must be paid regardless of whether the partners actually

receive a cash distribution. See United States v. Basye, 410 U.S.

441, 453 (1973) (“[I]t is axiomatic that each partner must pay

taxes on his distributive share of the partnership’s income

without regard to whether that amount is actually distributed to

him.”). Based on this aspect of partnership law, FERC

concluded that income taxes paid by investors in a limited

partnership are “first-tier” taxes that may be allocated to the

regulated entity’s cost-of-service. The shipper petitioners argue

that these taxes are ultimately paid by individual investors – not

the pipeline – and thus it was improper for FERC to grant an

ITA to the regulated entity. However, the Commission

reasonably addressed this concern, explaining:

Because public utility income of pass-through entities is

attributed directly to the owners of such entities and the

owners have an actual or potential income tax liability on

that income, the Commission concludes that its rationale

here does not violate the court’s concern that the

Commission had created a tax allowance to compensate for

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an income tax cost that is not actually paid by the regulated

utility.

Policy Statement, 111 FERC at 61,742.

FERC also emphasized that “the return to the owners of

pass-through entities will be reduced below that of a corporation

investing in the same asset if such entities are not afforded an

income tax allowance on their public utility income.” Id. The

Commission determined that “termination of the allowance

would clearly act as a disincentive for the use of the partnership

format,” because it would lower the returns of partnerships visa-vis corporations, and because it would prevent certain

investors from realizing the benefits of a consolidated income

tax return. Id. We cannot hold that these conclusions were

unreasonable. It has long been established that “the return to the

equity owner should be commensurate with returns on

investments in other enterprises having corresponding risks.”

Hope Natural Gas, 320 U.S. at 603. In the Policy Statement,

FERC concluded that it would be inequitable to grant a full

income tax allowance to corporations while denying a similar

allowance to limited partnerships. 111 FERC at 61,740, 61,742.

For example, if the corporate tax rate is 35%, then a pipeline that

operates as a corporation is permitted to charge a rate of $154 in

order to earn after-tax income of $100. As several commenters

pointed out, “if an income tax allowance is not allowed the

partnership, then the partners must pay a $35 income tax on

$100 of utility income, leaving them with only an after-tax

return of $65.” Id. Based on these comments, the Commission

determined that pipelines operating as limited partnerships

should receive a full income tax allowance in order to maintain

parity with pipelines that operate as corporations. This

conclusion was not unreasonable, and we defer to FERC’s

expert judgment about the best way to equalize after-tax returns

for partnerships and corporations.

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In sum, policy choices about ratemaking are the

responsibility of the Commission – not this Court. See AT&T

Corp. v. FCC, 220 F.3d 607, 631 (D.C. Cir. 2000) (noting that

“policy judgment[s]” are “for the agency – not this court – to

make”). Our role as a reviewing court is limited to ensuring that

“the Commission’s decisionmaking is reasoned, principled, and

based upon the record.” So. Cal. Edison Co. v. FERC, 443 F.3d

94, 98 (D.C. Cir. 2006) (quoting Williston Basin Interstate

Pipeline Co. v. FERC, 165 F.3d 54, 60 (D.C. Cir. 1999)). Here,

the conclusions reached in the Policy Statement and the Remand

Order were within the scope of the Commission’s discretion

with respect to ratemaking issues. We held in City of

Charlottesville that regulated entities are entitled to recover all

“proper” costs from their ratepayers. 774 F.2d at 1207.

Obviously, “proper” is not a self-defining term, and the

Commission thus has broad discretion to determine which costs

may be recovered through a pipeline’s rates. Here, FERC has

reasonably explained why income taxes paid on partnership

income are properly allocated to the regulated entity for

ratemaking purposes, and the shipper petitioners have offered no

compelling reason to second-guess the agency’s policy choices.

* * *

Petitioners argue that regardless of whether FERC’s new

ITA policy is reasonable, the Remand Order must be set aside

because it is inconsistent with our opinion in BP West Coast.

We disagree.

At the outset, we note that BP West Coast did not

categorically prohibit the Commission from granting income tax

allowances to pipelines that operate as limited partnerships. We

granted the shippers’ petition for review in that case primarily

because of the Commission’s inadequately justified differential

treatment of individual partners and corporate partners. As we

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explained, “the Commission’s opinions in Lakehead do not

evidence reasoned decisionmaking for their inclusion in cost of

service of corporate tax allowances for corporate unit holders,

but denial of individual tax allowances reflecting the liability of

individual unit holders.” BP West Coast, 374 F.3d at 1290. The

Commission has now chosen to treat all income taxes alike,

regardless of whether they are incurred by individual partners or

corporate partners. See Remand Order, 111 FERC at 62,455

(conceding that “Lakehead mistakenly focused on who pays the

taxes rather than on the more fundamental cost allocation

principle of what costs, including tax costs, are attributable to

regulated service, and therefore properly included in a regulated

cost of service”). BP West Coast did not pass upon the specific

question at issue in the instant case – whether FERC may grant

an ITA to limited partnerships for the income taxes paid by all

partners on the income they receive from the partnership. It is

a basic tenet of administrative law that when an agency action

is found to be arbitrary and capricious because of a failure to

exercise reasoned decisionmaking, the agency is free to adopt a

new policy on remand, provided it supplies a reasoned

explanation for its actions. See SEC v. Chenery Corp., 332 U.S.

194, 200-01 (1947) (holding that when a court sets aside an

agency order as “unsupportable for the reasons supplied by that

agency,” the agency is “bound to deal with the problem afresh”

on remand).

Petitioners also argue that limited partnerships do not pay

entity-level income taxes, and thus FERC’s new ITA policy

disregards our statement in BP West Coast that “the regulator

cannot create a phantom tax in order to create an allowance to

pass through to the rate payer.” 374 F.3d at 1291. While not

without force, this argument cannot ultimately prevail, for two

reasons. First, as FERC explained in the Policy Statement and

the Remand Order, the income taxes for which SFPP will

receive an income tax allowance are real, albeit indirect. SFPP

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will be eligible for a tax allowance only to the extent it can

demonstrate – in a rate proceeding – that its partners incur

“actual or potential” income tax liability on their respective

shares of the partnership income. Remand Order, 111 FERC at

62,456. Second, when we used the term “phantom tax” in BP

West Coast, we were reviewing a very different set of orders

than the ones at issue here. In BP West Coast, we vacated the

Lakehead policy because the Commission had offered no

reasoning to support its distinction between corporate partners

and individual partners. 374 F.3d at 1290 (“This does not

supply reasoning for differentiating between individual and

corporate tax liability. It is merely restating the proposition that

the Commission is so differentiating.”). However, in the instant

case FERC has gone to great lengths to explain why the taxes in

question are not “phantom” and are properly attributed to the

regulated entity. And there is at least one aspect of partnership

law that supports FERC’s conclusion but was not advanced by

the Commission in BP West Coast – investors in a limited

partnership are required to pay tax on their distributive shares of

the partnership income, even if they do not receive a cash

distribution. See Basye, 410 U.S. at 454. As explained above,

this supports FERC’s determination that taxes on the income

received from a limited partnership should be allocated to the

pipeline and included in the regulated entity’s cost-of-service.

In this sense, petitioners’ likening of partnership tax to

shareholder dividend tax is inapposite because a shareholder of

a corporation is generally taxed on the amount of the cash

dividend actually received. In sum, in the Policy Statement and

the Remand Order, FERC has reasonably explained why its new

ITA policy does not result in the creation of “phantom” tax

liability for regulated pipelines that operate as limited

partnerships. The same cannot be said for the Lakehead policy

that we vacated in BP West Coast.

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Shipper petitioners also emphasize that in BP West Coast

we rejected SFPP’s argument that the Commission should have

adopted a full income tax allowance for limited partnerships.

Petitioners argue that this holding is now the “law of the case,”

because the instant case involves the same issue that was

litigated – and resolved in the shippers’ favor – in the earlier

proceeding. Again, we disagree. In BP West Coast, SFPP

cross-petitioned for review of the Lakehead policy. Like the

shipper petitioners, SFPP argued that the Commission’s

distinction between corporate partners and individual partners

was unsupportable. 374 F.3d at 1291. However, while the

shipper petitioners argued that FERC should not have permitted

any income tax allowance, SFPP argued that FERC should have

granted a full ITA to pipelines operating as limited partnerships.

We rejected SFPP’s argument in BP West Coast, but petitioners

now read too much into our holding with respect to this issue.

All we held in BP West Coast is that the Commission was not

required to grant a full income tax allowance to pipelines that

operate as limited partnerships. Petitioners’ argument assumes

that “not required” is synonymous with “prohibited.” To the

contrary, when an agency has broad discretion to choose among

different policy options, the fact that any one option is not

required certainly does not mean that it is prohibited. Arguably,

a fair return on equity might have been afforded if FERC had

chosen the fourth alternative of computing return on pretax

income and providing no tax allowance at all for the pipeline

owners. This, however, is a policy decision rejected by FERC.

As we noted above, policy decisions are for the Commission and

not the court.

* * *

In conclusion, we deny the petitions for review with respect

to the income tax allowance issue. Under the arbitrary and

capricious test, our standard of review is “only reasonableness,

USCA Case #05-1303 Document #1043050 Filed: 05/29/2007 Page 17 of 45
18

not perfection.” Kennecott Greens Creek Min. Co. v. MSHA,

476 F.3d 946, 954 (D.C. Cir. 2007). We need not decide

whether the Commission has adopted the best possible policy as

long as the agency has acted within the scope of its discretion

and reasonably explained its actions. In the Policy Statement

and the Remand Order, the Commission resolved the principal

defect of the Lakehead policy, which was the unexplained

differential treatment of individual and corporate partners.

FERC then determined that it would be “just and reasonable” to

grant regulated pipelines an income tax allowance to the extent

that all of the pipeline’s partners – whether individual or

corporate – incur actual or potential tax liability. The

Commission reasonably determined that such taxes are

“attributable” to the regulated entity, given that partners must

pay tax on their share of the partnership income regardless of

whether they actually receive a cash distribution. Additionally,

the Commission reasonably relied upon evidence that a full

income tax allowance is necessary to ensure that corporations

and partnerships of like risk will earn comparable after-tax

returns. Lastly, in the income tax allowance Policy Statement,

FERC explained in detail why it chose to reject the other three

policy options proposed by commenters. We cannot hold that

the Commission’s policy choices were arbitrary and capricious.

Accordingly, we deny the petitions for review with respect to

this issue.

II. ENERGY POLICY ACT ISSUES

 Both sets of petitioners argue that FERC misinterpreted §

1803 of the Energy Policy Act of 1992. This provision

grandfathers certain oil pipeline rates as they existed at the time

of the Act’s enactment. Under this statute, shippers can

challenge these grandfathered rates when “a substantial change

has occurred after the date of the enactment of [the EPAct] . . .

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19

1

 As a result, the older version of the ICA was reprinted in the

appendix to Title 49 of the United States Code. Because newer

editions of the Code do not include the ICA, however, all citations to

the ICA in this opinion refer to the 1988 U.S. Code.

in the economic circumstances of the oil pipeline which were a

basis for the rate.” FERC interpreted § 1803 to allow rate

challenges when there has been a substantial change in a

pipeline’s overall rate of return. Shipper petitioners argue that

this interpretation grandfathers too many rates; they contend that

a substantial change in any one cost element, even if offset by

other changes such that the overall rate of return is unaffected,

subjects a rate to challenge under § 1803. From the other

direction, pipeline petitioners contend that FERC’s

interpretation grandfathers too few rates; they argue that the

correct standard should take account of factors in addition to a

pipeline’s costs. FERC has rejected the diametrically opposed

arguments of the petitioners and interpreted the statutory text to

establish a middle ground between those two competing

positions. We hold that FERC’s interpretation is reasonable. 

A.

Federal regulation of oil pipelines began in 1906, when

Congress passed the Hepburn Act. That statute applied the

Interstate Commerce Act (ICA) to oil pipelines and gave the

Interstate Commerce Commission jurisdiction over the

pipelines. Pub. L. No. 59-337, § 1, 34 Stat. 584, 584. In 1977,

Congress transferred responsibility for oil pipeline regulation to

the newly created FERC. Department of Energy Reorganization

Act, Pub. L. No. 95-91, § 402(b), 91 Stat. 565, 584. The

following year, Congress comprehensively revised the ICA but

provided that its 1977 provisions would continue to govern

FERC’s regulation of oil pipelines.1

 Act of Oct. 17, 1978, Pub

L. No. 95-473, § 4(c), 92 Stat. 1337, 1470.

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20

The ICA prohibits pipelines from charging rates that are

“unjust or unreasonable” and permits shippers to challenge both

pre-existing and newly filed rates. 49 U.S.C. app. §§ 13(1),

15(1), (7). FERC has generally approved just and reasonable

rates based primarily on a pipeline’s costs. See Frontier

Pipeline Co. v. FERC, 452 F.3d 774, 776 (D.C. Cir. 2006)

(citing Ass’n of Oil Pipe Lines v. FERC, 83 F.3d 1424, 1428-29

(D.C. Cir. 1996); Farmers Union Cent. Exch. v. FERC, 734 F.2d

1486, 1495-96 (D.C. Cir. 1984); Farmers Union Cent. Exch. v.

FERC, 584 F.2d 408, 412-22 (D.C. Cir. 1978)). In Opinion No.

154-B, issued in 1985, FERC adopted the “trended original cost”

(or “TOC”) method for ratemaking, in which asset depreciation

and equity recovery are smoothed out over the lifetime of a

pipeline in order to avoid excessively high rates at the front end,

thereby encouraging new market entrants. See Williams Pipe

Line Co., 31 FERC ¶ 61,377 at 61,833 (1985); BP West Coast

Prods., LLC v. FERC, 374 F.3d 1263, 1282-83 (D.C. Cir. 2004).

In 1992, Congress enacted the Energy Policy Act (EPAct).

Pub. L. No. 102-486, 106 Stat. 2776. In Title 18 of that Act,

called “Oil Pipeline Regulatory Reform,” Congress sought to

simplify ratemaking procedures for oil pipelines; this would

reduce administrative and litigation costs for pipelines and

shippers. See id. at 3010-12 (codified at 42 U.S.C. § 7172 note);

Ass’n of Oil Pipe Lines v. FERC, 83 F.3d 1424, 1429 (D.C. Cir.

1996). Section 1801 of the EPAct directed FERC to “issue a

final rule which establishes a simplified and generally applicable

ratemaking methodology for oil pipelines” within one year of

the passage of the Act. 106 Stat. at 3010. Section 1802 required

FERC to “issue a final rule to streamline procedures . . . relating

to oil pipeline rates in order to avoid unnecessary regulatory

costs and delays” within 18 months. Id. The goal of these

provisions was to decrease the costs associated with

administrative proceedings and litigation involving oil pipeline

rates. 

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21

FERC implemented those mandates in Order No. 561 by

establishing an indexed cap system, in which the maximum

permissible rates for pipelines are adjusted annually to reflect

predictions of industry-wide changes in costs. See Revisions to

Oil Pipeline Regulations Pursuant to the Energy Policy Act of

1992, Order No. 561, FERC Stats. & Regs. ¶ 30,985, 58 Fed.

Reg. 58,753 (1993); Order No. 561-A, FERC Stats. & Regs. ¶

31,000, 59 Fed. Reg. 40,243 (1994). A pipeline may charge a

rate above the applicable cap only if there is a “substantial

divergence” between the cap and its actual costs, if it shows that

it lacks “significant market power,” or if all of its customers

consent. 18 C.F.R. § 342.4.

We upheld this scheme in Association of Oil Pipe Lines v.

FERC. 83 F.3d at 1428. We have explained that the primary

benefits of the cap system are that it “dispenses with intricate

calculations of specific pipeline costs” and encourages pipelines

to develop “cost-reducing innovations” because any given

pipeline’s cost-cutting is unlikely to affect the industry-wide

cap. Frontier Pipeline Co., 452 F.3d at 777.

 In keeping with its general purpose to reduce costs from

administrative proceedings and litigation associated with the

regulation of oil pipelines, the EPAct also includes a

“grandfathering” provision that insulates certain pre-existing

pipeline rates from challenge even if the rates exceed the

appropriate indexed cap. Section 1803(a) provides that any rate

in effect for the full year ending on the date of the enactment of

the EPAct (October 24, 1992) is just and reasonable unless it

had been subject to protest, investigation, or complaint during

that one-year period. Under § 1803(b), a grandfathered rate can

be challenged as not just and reasonable – “de-grandfathered” –

if “evidence is presented to the Commission which establishes

that a substantial change has occurred after the date of the

enactment of this Act – (A) in the economic circumstances of

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22

the oil pipeline which were a basis for the rate; or (B) in the

nature of the services provided which were a basis for the rate”

(emphasis added). Thus, under § 1803, “the analysis of a

pipeline rate challenge . . . proceeds in two steps: first, FERC

determines whether the rate in question is grandfathered; if it is,

FERC then asks whether the rate falls within either of the

exceptions outlined in Section 1803(b).” BP West Coast, 374

F.3d at 1272. 

The background to this litigation is complex. Since the

EPAct went into effect in 1992, shippers have asked FERC to

declare that SFPP’s lines either did not qualify for

grandfathering or should be de-grandfathered due to

substantially changed circumstances. 

Docket No. OR92-8 (1992-1995). In Docket No. OR92-8,

addressing complaints filed between 1992 and August 1995,

FERC determined that SFPP’s West Line rates were (with one

exception) grandfathered, but that its East Line rates were not.

SFPP, L.P., Opinion No. 435-A, 91 FERC ¶ 61,135 at 61,499

(2000); BP West Coast, 374 F.3d at 1281. We affirmed FERC’s

conclusion with respect to the West Line in BP West Coast

Products, LLC v. FERC (the East Line analysis was not

challenged). 374 F.3d at 1278, 1282. In that same docket,

FERC also determined that the West Line had not experienced

substantially changed circumstances necessary to de-grandfather

its rates, despite the fact that FERC’s new Lakehead policy had

altered the income tax allowances SFPP could include in its

rates. See Lakehead Pipe Line Co., L.P., 71 FERC ¶ 61,338

(1995); Opinion No. 435-A, 91 FERC at 61,499; BP West Coast,

374 F.3d at 1280. In BP West Coast, we did not need to reach

the question of substantially changed circumstances on the West

Line because we held that the Lakehead policy itself was

defective. 374 F.3d at 1280. We therefore remanded the issue

to FERC. 

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23

Docket No. OR96-2 (1995-2000). While the BP West Coast

appeal was pending, FERC consolidated in Docket No. OR96-2

shipper complaints filed between August 1995 and August 2000.

In March 2004, three months before we announced our decision

in BP West Coast, FERC held that the West Line had

experienced substantially changed circumstances and thus its

rates were de-grandfathered. ARCO Prods. Co. v. SFPP, L.P.,

106 FERC ¶ 61,300 at 62,148 (2004) (“Order on Initial

Decision”). In the same order, FERC held that SFPP’s North

and Oregon Lines had not experienced substantially changed

circumstances, reversing an ALJ decision to the contrary. Id. at

62,153. FERC explained that the ALJ had wrongly found

substantially changed circumstances solely because SFPP’s tax

allowance – only one factor in its total costs – had changed due

to the Lakehead policy. Id. at 62,144. Instead, the Commission

explained, the ALJ should have considered whether SFPP’s total

costs on those lines had substantially changed. Id. In other

words, even if SFPP’s tax liability had significantly decreased,

if its overall cost of service remained roughly the same due to

other cost increases, there would not be substantially changed

circumstances. FERC analyzed the change in total costs on the

West, North, and Oregon Lines, and found that only the West

Line had experienced substantially changed circumstances. Id.

at 62,148-50. 

June 2005 Remand Order. In June 2005, eleven months

after our remand order in BP West Coast, FERC issued an order

that served both as a remand order from BP West Coast

(addressing Docket No. OR92-8) and as a decision on appeal in

Docket No. OR96-2. SFPP, L.P., 111 FERC ¶ 61,334 (2005)

(“Remand Order”). In that order, FERC re-calculated whether

there had been substantially changed circumstances on SFPP’s

lines in light of its new adoption of a full income tax allowance

policy (see Part I above). After making these calculations,

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24

FERC reaffirmed its determinations that the West Line was

de-grandfathered but that the North and Oregon Lines were not.

Id. at 62,458-59. 

Both SFPP (with the Association of Oil Pipe Lines) and its

shippers petitioned this Court for review, each believing that the

Commission’s standard for determining substantially changed

circumstances is incorrect. Both sets of petitioners also allege

in their petitions that FERC erred in some of its calculations for

determining whether SFPP’s lines had experienced substantially

changed circumstances. We have jurisdiction under 49 U.S.C.

app. § 17(10) (1988). 

B.

Both sets of petitioners challenge FERC’s interpretation of

the statutory phrase “a substantial change has occurred after the

date of the enactment of this Act . . . in the economic

circumstances of the oil pipeline which were a basis for the

rate.” FERC interpreted that phrase to mean a change in a

pipeline’s total cost of service. Remand Order, 111 FERC at

62,458-59. The shippers believe that the phrase must mean that

any substantial change in one rate element – for example, a

pipeline’s tax allowance – suffices to de-grandfather the rate,

even if that change is offset by another change, such that there

is virtually no change in the pipeline’s overall cost of service.

For their part, SFPP and the Association of Oil Pipe Lines

believe that the phrase must be interpreted to encompass factors

in addition to a pipeline’s cost of service because many pipelines

did not set the rates initially under the current cost-of-service

method. For example, FERC approved some pipeline rates on

the basis that a pipeline faced competition sufficient to allow the

market, rather than a cost-of-service formula, to determine the

rates.

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25

Because Congress authorized FERC to adjudicate

complaints arising out of § 1803, the Commission’s

interpretation of § 1803 in an adjudication is entitled to Chevron

deference. BP West Coast, 374 F.3d at 1272-73.

FERC interprets the phrase “a substantial change has

occurred after the date of the enactment of this Act . . . in the

economic circumstances of the oil pipeline which were a basis

for the rate” as requiring a substantial change in the overall rate

of return of the pipeline, rather than in one cost element, such as

a tax allowance. That is because, as the Commission explained,

“there can be a very large reduction in income tax allowance . . .

even if many of the other principal cost factors, and in fact the

total cost-of-service, increased.” Order on Initial Decision, 106

FERC at 62,144. In other words, it makes little sense to

de-grandfather a rate when the pipeline is no more profitable –

or perhaps even less profitable – than it was when the rate was

grandfathered.

FERC’s interpretation easily fits within the bounds of the

statutory text. The word “circumstances” plausibly invokes a

composite of several variables. One definition of

“circumstances” is “the total complex of essential attributes and

attendant adjuncts of a fact or action: the sum of essential and

environmental characteristics.” WEBSTER’S THIRD NEW

INTERNATIONAL DICTIONARY 410 (1976). Another is “the

logical surroundings or ‘adjuncts’ of an action; the time, place,

manner, cause, occasion, etc., amid which it takes place.” 3

OXFORD ENGLISH DICTIONARY 241 (2d ed. 1989). When

modified by the word “economic,” the word “circumstances”

could reasonably mean the total economic outlook of a pipeline

– its profitability. In that case, it would be a change only in that

overall picture, rather than in any individual part of that picture,

that would constitute a change in “economic circumstances.” A

straightforward reading of the statutory text, therefore,

USCA Case #05-1303 Document #1043050 Filed: 05/29/2007 Page 25 of 45
26

substantially validates FERC’s interpretation.

Moreover, FERC’s reading meshes with the purpose of the

EPAct, as gleaned from its text and structure. The

grandfathering provision of § 1803 is intended to insulate

pre-existing rates from attack by ordaining them to be

necessarily “just and reasonable.” The most natural

understanding of § 1803 is that Congress believed that the

then-existing rates of return were not so large as to justify the

added litigation costs of subjecting the rates to agency

evaluation and judicial review. This inference comports with

the streamlining goals of § 1801 and § 1802. It makes good

sense, then, to de-grandfather rates only when the rate of return

itself has changed. It is unclear why Congress would care if the

underlying composition of a pipeline’s costs has changed so

long as the pipeline’s rate of return has remained constant or

decreased.

The shippers focus on a different word in § 1803: the

indefinite article “a” before the phrases “substantial change” and

“basis for the rate.” They claim that the presence of the singular

indefinite article indicates that any substantial change in a single

cost element must qualify as a substantial change in economic

circumstances, even if that change is offset by other changes

such that the pipeline’s overall return is unaffected. We

disagree that such an interpretation is required by the text.

FERC could reasonably conclude that the phrase “a substantial

change . . . in the economic circumstances” means a change in

the overall economic circumstances, not a change in one

economic circumstance. And the phrase “a basis for the rate”

indicates nothing more than the fact that there are other bases for

a rate besides a pipeline’s economic circumstances. The EPAct

even identifies another basis for a rate: “the nature of services

provided.” EPAct, § 1803(b)(1)(B). Neither use of the

indefinite article undermines the reasonable inference that the

USCA Case #05-1303 Document #1043050 Filed: 05/29/2007 Page 26 of 45
27

term “economic circumstances” refers to a composite of several

variables rather than any individual variable – which might be

the case if, for instance, the statute said “an economic

circumstance.” 

The shippers also contend that the Order on Initial Decision

unreasonably departed from FERC’s precedent in Opinion No.

435. Of course, FERC may not depart from its own precedent

without a reasoned explanation. See Dominion Res., Inc. v.

FERC, 286 F.3d 586, 592 (D.C. Cir. 2002). In Opinion No. 435,

FERC wrote that a substantial change “could be established by

one or a number of rate elements” and that it is unnecessary to

“establish that there has been a substantial change to every rate

design element.” 86 FERC ¶ 61,022 at 61,066 (1999). The

shippers believe this means that FERC concluded that a change

in a single cost element – even absent a change in the overall

rate of return – would qualify as a change in economic

circumstances. It is doubtful, however, that FERC was

considering the possibility that two or more changes could offset

each other, which would explain why FERC discussed changes

in terms of a single rate element. Nowhere in Opinion No. 435

does FERC mention the possibility of offsetting. In the Order

on Initial Decision, in contrast, FERC became aware that using

single cost factors “could lead to anomalous results and result

[in] a threshold that does not adequately discourage challenges

to grandfathered oil pipeline rates.” 106 FERC at 62,151. The

Commission therefore explained that offsetting changes would

not count as changes in economic circumstances. See Remand

Order, 111 FERC at 62,458-59. This decision does not appear

to be a departure from precedent at all, but rather a clarification

of an issue that was not on the Commission’s radar at the time

of Opinion No. 435. 

The shippers also argue that FERC inexplicably ascribes a

different quantitative level to the word “substantial” in

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28

determining substantially changed circumstances under § 1803

than it does in determining whether a pipeline’s costs have

increased so much that the pipeline may charge a rate exceeding

the appropriate index level. In the de-grandfathering context,

the word “substantial” connotes a greater percentage change it

does in the indexing context. See Texaco Refining & Marketing,

Inc., 103 FERC ¶ 63,055 at 65,151 n.29 (2003); FERC

Supplemental Br. at 36-37. Even assuming this argument is not

waived (as it is unclear where in the record the petitioners raised

this point), it has no merit. The two regulatory contexts that the

shippers seek to equate – de-grandfathering and indexing –

implicate different regulatory interests. With indexing, FERC

must ensure that pipelines can survive economically by

recovering their costs. Even a small divergence between the

index level and actual costs might thwart this goal. In contrast,

in fleshing out the de-grandfathering standard under § 1803,

FERC is attempting to determine when a pipeline’s costs

diverge so much from those of the original rates that the benefits

of grandfathering (e.g., less litigation, more certainty) no longer

outweigh the costs to consumers. It is hardly irrational to

ascribe different meanings to the general term “substantial” in

those very different contexts.

Coming from the other direction, SFPP and the Association

of Oil Pipe Lines argue that FERC’s approach does not provide

enough protection to grandfathered rates. They argue that

because many of the grandfathered rates were not established

using a cost-of-service method, that method was not a “basis”

for those rates, and that therefore it is improper to

de-grandfather a rate based simply on a change in its cost of

service. SFPP points out that “[m]any rates were effectively set

according to the informal consent or formal agreement of the

shippers.” SFPP’s Br. at 36. Even rates that were computed

through a cost-of-service method often utilized formulas

different from the current method – for example, without the

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29

income tax allowance. Moreover, beginning in the late 1980’s,

FERC offered pipelines a market-based alternative to the

cost-of-service method if they could demonstrate that they did

not possess significant market power.

A flaw in SFPP’s argument, so FERC could reasonably

conclude, is that § 1803 does not necessarily depend on the

method used to compute the grandfathered rate. Rather, § 1803

assumes that the “economic circumstances” of a pipeline were

a basis for its rate, regardless of how the rate was actually

established. It is certainly reasonable for FERC to use a

cost-of-service computation as an approximation for a pipeline’s

economic circumstances; the purpose of a cost-of-service rate,

after all, is to simulate what a pipeline’s economic behavior

would be in a competitive market. Merely because some

grandfathered rates were set according to non-regulated

agreements with shippers does not mean that the pipeline’s costs

did not indirectly influence the rate. Consequently, FERC’s

choice appears to be a perfectly reasonable means of interpreting

and applying § 1803.

C.

Both the shipper and pipeline petitioners raise a number of

technical challenges to the method by which FERC calculated

whether SFPP’s West, North, and Oregon lines had experienced

substantially changed circumstances: (1) The shippers argue

that FERC erred in using volumes as a proxy for revenues. (2)

The shippers argue that FERC should have apportioned costs

among different delivery points on the West Line. (3) The

shippers argue that FERC incorrectly determined that SFPP’s

North and Oregon Lines had not experienced substantially

changed circumstances because FERC employed an

inappropriate cost-of-service method. (4) SFPP and the

Association of Oil Pipe Lines argue that the figure FERC used

USCA Case #05-1303 Document #1043050 Filed: 05/29/2007 Page 29 of 45
30

for 1992 costs is erroneous. (5) SFPP and the Association of Oil

Pipe Lines argue that FERC made an arithmetic error in

summing percentages of changes in rate elements to compute

the total change in return. Petitioners failed, however, to raise

any of those challenges in the proceedings before the

Commission.

A party must first raise an issue with an agency before

seeking judicial review. United States v. L.A. Tucker Truck

Lines, Inc., 344 U.S. 33, 36-37 (1952). This requirement serves

at least two purposes. It ensures “simple fairness” to the agency

and other affected litigants. It also provides this Court with a

record to evaluate complex regulatory issues; after all, the scope

of judicial review under the APA would be significantly

expanded if courts were to adjudicate administrative action

without the benefit of a full airing of the issues before the

agency. See Advocates for Highway & Auto Safety v. Fed.

Motor Carrier Safety Admin., 429 F.3d 1136, 1150 (D.C. Cir.

2005). 

Petitioners believe that the absence of a rehearing

requirement in the ICA means that they were not required to

raise their complaints with FERC. Compare 49 U.S.C. app. §

17(9)(h) (1988) (Interstate Commerce Act) with 15 U.S.C. §

717r(b) (Natural Gas Act) and 16 U.S.C. § 825l(b) (Federal

Power Act). Petitioners miss the point: Their error was not

failing to seek rehearing, but rather failing to raise the issue at

all. See Sims v. Apfel, 530 U.S. 103, 108-110 (2000); L.A.

Tucker Truck Lines, Inc., 344 U.S. at 36-37; Hormel v.

Helvering, 312 U.S. 552, 556 (1941); Frontier Pipeline Co., 452

F.3d at 793; cf. 47 U.S.C. § 405(a) (“The filing of a petition for

reconsideration shall not be a condition precedent to judicial

review of [an FCC decision] except where the party seeking

such review . . . relies on questions of law or fact upon which

the Commission . . . has been afforded no opportunity to pass.”).

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31

We need not consider the merits of those arguments because

none of them was raised below.

D.

In sum, we hold that FERC’s interpretation of § 1803 as

requiring a substantial change in a pipeline’s cost of service is

a reasonable interpretation of the statute. We need not address

the petitioners’ challenges to FERC’s technical calculations

because those arguments were not raised before the

Commission.

III. REPARATIONS

Shipper petitioners also challenge the Commission’s denial

of their claim for reparations for the service rates they have paid

to use SFPP’s East Line since August 1, 2000. The ICA permits

reparations for successful challenges to the justness and

reasonableness of existing rates, see 49 U.S.C. app. § 16(3)

(1988). If the Commission determines that the pipeline rates are

not “just and reasonable,” shippers who file complaints – and

only those shippers – are entitled to the difference between the

rates they paid and the rates the Commission retrospectively

determines to be just and reasonable. Id. The period for

potential reparations generally includes two years prior to the

filing date of the complaint. See id.; BP West Coast, 374 F.3d

at 1305-06.

In this case, the Commission determined that reparations

were not warranted for the challenged rates that went into effect

on August 1, 2000 because (1) they were proposed by SFPP in

response to a FERC order, (2) FERC had accepted them (albeit

on an interim basis), and (3) at the time the rates were accepted,

FERC explicitly recognized shippers’ right to appropriate

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32

refunds pending the Commission’s finalization of just and

reasonable rates. Because reparations are precluded where the

Commission has “approved or prescribed” a reasonable rate, see

Arizona Grocery Co. v. Atchison, T. & S. F. Ry. Co., 284 U.S.

370 (1932), FERC argued that shippers were not entitled to

reparations for these rates. In challenging the Commission’s

ruling, shippers argue, inter alia, that Arizona Grocery does not

apply because the final rate has not been prescribed even as of

the time briefs were filed and argument was made to this Court.

The Commission and intervenors respond that this Court in BP

West Coast affirmed an earlier Commission ruling that upon

completion of refund calculations, the East Line’s rates are

considered final and effective as of August 1, 2000; therefore,

they argue, BP West Coast essentially permits Arizona Grocery

protection of the final rate once it is determined. 

At the outset, we note that in this case the Commission

accepted SFPP’s proposed rate subject to refund as an interim

rate to compensate pipelines before the final just and reasonable

rate was to be determined. The question before us is whether we

should therefore consider the August 2000 rates minus potential

refunds to be FERC-prescribed and thus immune to reparation

claims. Critical to our analysis is the fact that when FERC

accepted this interim rate, its methodology had not yet been

established for determining the final rate. Because we agree

with petitioners that the Commission could not have “approved

or prescribed” just and reasonable rates as of August 1, 2000, we

conclude that these yet-to-be-finalized rates, which the shippers

paid to use SFPP’s East Line, do not receive Arizona Grocery

protection. The Commission’s ruling in denying these shippers

reparations was thus contrary to law. 

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A.

To determine whether the challenged rates were FERCprescribed, we must review their provenance. SFPP proposed

the August 1, 2000 rates in response to a FERC order, which

was the result of the proceedings now referred to as the OR92-8

proceedings. We briefly describe the relevant portion of those

proceedings. 

As we discussed in Part II, § 1803(a) of the EPAct

grandfathered any rate in effect for the full year ending on the

date of the enactment of the EPAct (October 24, 1992) unless it

had been subject to protest, investigation, or complaint during

that year. SFPP was unable to benefit from this protection for

its East Line rates because one month before passage of the

EPAct, a shipper filed a complaint challenging those rates. See

BP West Coast, 374 F.3d at 1281. Following passage, numerous

shippers filed complaints challenging the East Line rates that

were not protected by the EPAct.

The Commission grouped those complaints into two

dockets: one docket included complaints filed between

November 1992 and August 1995 (Docket No. OR92-8) and

another docket included complaints filed between August 1995

and August 2000 (Docket No. OR96-2). Although the petition

before us challenges only FERC’s determination with respect to

the complaints in the OR96-2 proceedings, because that

determination rested in part on FERC’s action with respect to

the complaints in the OR92-8 proceedings, we describe each

docket in turn. The OR92-8 proceedings involved three steps by

which FERC determined that “the East Line rates between Texas

and Arizona were not just and reasonable and ordered them to

be modified and directed SFPP to make reparations

accordingly.” Opinion No. 435, 86 FERC ¶ 61,022 at 61,055

(1999) (citing SFPP, L.P., 80 FERC ¶ 63,014 (1997)). Once the

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34

2

 The ALJ had determined – and the Commission affirmed –

that 1994 was a representative year “particularly for throughput.” 86

FERC at 61,084-85.

3

 The Commission’s indexing regulation permits pipelines to

adjust their rates each year based on the Producer Price Index. See 18

C.F.R. § 342.3.

4

 Although shippers are entitled to reparations beginning two

years prior to the filing date of their complaints, it is not clear from the

record whether the Commission indexed the 1994 rates to claims for

prior years because the indexing regulations were not in effect prior to

1995. See Opinion No. 435-B, 96 FERC at 62,071.

initial determination of unreasonableness had been made, the

Commission initiated proceedings to calculate the appropriate

modification so that reparations could be paid to East Line

shippers that had filed complaints. To calculate the appropriate

modification, the Commission employed a “test-year”

methodology. See 86 FERC at 61,113-14; see also BP West

Coast, 374 F.3d at 1307 (approving “test-year” methodology).

The test year chosen for the OR92-8 proceedings was 1994.2

The Commission took that rate and, using its indexing

regulation,3

 determined just and reasonable rates for the East

Line from 1994 through August 1, 2000. See Opinion No. 435-

B, 96 FERC ¶ 61,281 at 62,071 (2001). The Commission then

determined the amount of reparations due shippers that had

challenged the East Line rates for these years by calculating the

difference between the rates actually paid and the adjusted rates

based on the test-year methodology. Finally, SFPP was ordered

to pay these reparations to shippers who had filed complaints.4

As indicated in Part I, the Commission’s order requiring

SFPP to pay these reparations did not conclude the OR92-8

proceedings. The shippers that had successfully challenged

SFPP’s East Line rates also challenged the amount of

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35

5

 It is settled that the Commission had authority to direct a

pipeline to file interim rates subject to refunds if there was a

possibility that the final rates would be lower than the interim rates.

See BP West Coast, 374 F.3d at 1305. 

reparations calculated by FERC, arguing that its method of

calculating SFPP’s cost of service for the test year was amiss.

In litigation that came before us in BP West Coast, these

shippers disputed whether SFPP ought to be allowed to recover

(and thus remove from the amount of reparations owed) certain

income tax allowances, litigation costs, and reconditioning costs.

See 374 F.3d at 1285-1302. Because this Court vacated the

Commission’s Lakehead policy and remanded for the

Commission to re-calculate just and reasonable rates in light of

that holding, id. at 1312, FERC had not completed proper

calculations when the instant case was heard. 

Meanwhile, the Commission had never made a final

determination as to SFPP’s East Line rates going forward.

Instead, the Commission directed SFPP to propose a new tariff

for rates beginning on August 1, 2000. See Opinion No. 435-A,

91 FERC ¶ 61,135 at 61,521 (2000); Opinion No. 435-B, 96

FERC at 62,075. SFPP proposed such a tariff (“Tariff No. 60”),

which was based in large measure on the same calculations that

FERC had used to determine just and reasonable rates for 1994

through 2000. 96 FERC at 62,075.

This proposed tariff faced substantial protest from shippers.

The Commission also noted that there were “technical problems

in SFPP’s compliance filings, some of which involved clear

overreaching.” SFPP, L.P., 100 FERC ¶ 61,353 at 62,626

(2002). So the Commission accepted the rate on an interim

basis subject to later refunds if the tariff was subsequently

determined not to be just and reasonable.5 See id. at 62,625.

The Commission did so “out of equitable concern for the East

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36

Line shippers that are not eligible for reparations in this

proceeding” because they “would continue to pay rates higher

than those that might ultimately be determined to be just and

reasonable until such time as a final and definitive prospective

rate was determined.” Id. In other words, because FERC might

later deem SFPP’s proposed August 2000 rates to be not just and

reasonable, the Commission sought to give the benefit of that

subsequent determination to East Line shippers who had not

filed a complaint challenging these rates. The Commission

therefore stressed that SFPP’s interim rate for the East Line

shippers would not receive Arizona Grocery protection because

in this case “the Commission has expressly reserved its authority

in the context of an ongoing proceeding in which the

methodology for determining the rate had not even been

established.” Id. at 62,626 (emphasis added). 

Since submitting Tariff No. 60 in August 2000, SFPP has

changed its rates each year pursuant to the Commission’s

indexing regulations. See Respondent’s Br. at 48-49. That is,

since August 1, 2000, all East Line shippers have been paying

interim rates, and once the final rates are determined all East

Line shippers will be entitled to refunds if the interim rates

exceed the final rates. As of the time briefs in this matter were

filed and argument was presented to this Court, SFPP and the

Commission were still working out the implications of BP West

Coast for the determination of a just and reasonable rate on the

East Line. Whatever rate is eventually determined to be just and

reasonable will be applied retroactively to August 1, 2000. See

BP West Coast, 374 F.3d at 1304; Opinion No. 435-B, 96 FERC

at 62,079. The shippers seek review of FERC’s determination

with respect to these rates. 

The post-August 1, 2000 rates at issue in this case were not

directly challenged in the OR92-8 proceedings. Nevertheless,

insofar as these rates applied to all East Line shippers, and

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37

6

 Other than the time periods in which they were filed, there

is no significant conceptual difference between the complaints in the

OR92-8 proceedings and those in the OR96-2 proceedings. The

complaints in the first docket challenged the East Line’s rates between

November 1990 (two years before the first complaint in the docket

was filed) and August 2000 (the date Tariff No. 60 went into effect).

The complaints in the second docket challenged rates between late

1993 (two years before the first complaint in the docket was filed) and

May 2006 (the effective date of SFPP’s new tariff), see SFPP, L.P.,

114 FERC ¶ 61,136 at 61,463 (2006). 

insofar as the complaints filed after August 1995 had still to be

addressed, the post-August 1, 2000 rates had important

consequences on the calculation of reparations arising from any

rate proceedings that ended after August 1, 2000. This brings us

to the OR96-2 proceedings, which involved complaints filed

between late 1995 and August 2000.6 The OR96-2 proceedings

were initially completed in March 2004, see Order on Initial

Decision, 106 FERC ¶ 61,300 (2004), then in June 2005, see

Remand Order, 111 FERC ¶ 61,334 (2005), and were revisited

again in December 2005, see SFPP, L.P., 113 FERC ¶ 61,277

(2005). This meant that the East Line’s post-August 1, 2000

rates and the Commission’s refund policy came under scrutiny

to the extent that reparations had to be calculated up until 2006

for the OR96-2 complainants. 

In the OR96-2 proceedings, the Commission applied the

same test-year methodology it had applied in the OR92-8

proceedings, see id., but substituted 1999 for 1994 as the test

year. See 113 FERC at 62,096-97. Accordingly, FERC first

established the just and reasonable rates based on the estimated

cost of service in 1999 and then indexed these rates forward to

May 1, 2006. Based on FERC’s calculations of the test-year

rate, SFPP was directed to make compliance filings with the

proposed interim rates by February 15, 2006. Id. at 62,115. The

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38

Commission held that SFPP’s newly proposed tariff would go

into effect as of May 1, 2006. Id. As in the OR92-8

proceedings, the tariff was accepted on an interim basis and was

subject to refund if the rates are later determined to be not just

and reasonable. Id. Reparations due shippers for rates paid

between 1993 and August 1, 2000 – unless shippers have

already received reparations based on the 1994 rates by virtue of

having participated in the OR92-8 proceedings – will also be

based on the 1999 indexed rates. Id. Notably for the current

controversy, however, the Commission does not intend to use

the 1999 rates to determine the just and reasonable rates between

August 1, 2000 and May 1, 2006. 

The Commission argues that as a result of the interim rate

from SFPP’s Tariff No. 60, determined according to the OR92-8

proceedings, all East Line shippers will already receive

appropriate refunds once the initial 1994 test-year analysis is

corrected and appropriate refunds are ordered. The Commission

argues, therefore, that all shippers, including those in the OR96-

2 proceedings, will eventually have paid just and reasonable

rates on the East Line from August 1, 2000 because the refund

will equal the amount between SFPP’s proposed interim rate and

the final rate eventually calculated by the Commission.

Respondent’s Br. at 39. For these reasons, in the orders under

review, the Commission denied East Line shippers reparations

for rates charged for East Line service since August 1, 2000.

See ARCO Prods. Co., 92 FERC ¶ 61,244 at 61,781 (2000);

Order on Initial Decision, 106 FERC at 62,141; Remand Order,

111 FERC at 62,462-63. Instead, shippers will be entitled to

refunds alone. Shippers petition us to vacate FERC’s orders

thereby entitling them to reparations. Before turning to our

analysis of the shippers’ petition, we pause briefly to highlight

the difference between refund and reparation. 

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39

When FERC has accepted interim rates subject to refund,

all shippers – not just those that file complaints – are entitled to

appropriate refunds once the final “just and reasonable” rates are

established. Where the Commission has not prescribed final

“just and reasonable” rates, refunds may be appropriate, e.g.,

where an intervening change in law alters the Commission’s

cost-of-service calculation. The BP West Coast case and the

OR92-8 proceedings are illustrative. The Commission used a

test-year methodology to calculate just and reasonable rates for

a given period, but this Court subsequently held that the

Commission, as a matter of law, erred in its income tax

allowance policy. See 374 F.3d at 1285-93. This Court

therefore remanded the case back to the Commission, and the

Commission was required to recalculate the underlying rate in

light of our holding. Upon completing the calculation, the

Commission would then have to index the new just and

reasonable rate forward, and order SFPP to refund any amount

paid in excess of the new calculations. See, e.g., 113 FERC at

62,115. Reparations, by contrast, correct the errors of rate

calculations when those calculations have never been approved

as just and reasonable, and only shippers that have filed

complaints are entitled to reparations. But under Arizona

Grocery, where the Commission has prescribed a reasonable

rate, it may not then subject a carrier to reparations based on the

Commission’s revised determination of reasonableness. See

Arizona Grocery, 284 U.S. at 390. 

To those who do not specialize in the Commission’s

proceedings, it may not be obvious why an East Line shipper

that is already entitled to refunds at the completion of

compliance proceedings would seek reparations, given that both

refunds and reparations amend unreasonable rates by

compensating those who have been subject to them by

overpayment. The difference to petitioners between refund and

reparation is simple: the two methods may, by circumstance

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40

7

 In a separate order, the Commission illustrates this

possibility:

By way of example only, assume that the new East Line rate

established by this order would be $1.00 on January 1, 1994,

and the indexed rate would be $1.10 on August 1, 2000 and

$1.20 on May 1, 2006 (the target date of new interim rates in

this proceeding). These levels ultimately become the January

1, 1994 indexed final rates adopted by the Commission in this

decision for the [OR92-8 Docket]. The projected final rate[s]

developed from the 1999 cost of service in [the OR96-2

Docket] are $1.05 as of August 1, 2000 and $1.15 as of May

1, 2006. This latter and lower rate of $1.15 would be effective

prospectively on May 1, 2006 because the East Line rates

previously established in [the OR92-8 Docket] are subject to

the Arizona Grocery doctrine.

113 FERC at 62,110.

alone, reflect two different values.7 

B.

The issue before us is whether Arizona Grocery precludes

reparations otherwise due East Line shippers for the rates they

have paid since August 1, 2000. We are asked to consider, in

particular, our holding in BP West Coast, which acknowledged

the Commission’s authority “to direct an oil pipeline to file

interim rates to go into effect, subject to refund, during the

suspension period for the initial rates.” 374 F.3d at 1305. The

limited question before us is whether the final rate, which will

be determined at the completion of compliance proceedings, is

entitled to Arizona Grocery protection. Put differently, the

question is whether East Line shippers can be considered to have

paid FERC–prescribed rates since August 1, 2000 if they receive

refunds at the end of yet-to-be concluded compliance

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41

proceedings. If so, they will not be entitled to reparations. If the

disputed rates paid since August 1, 2000 are not FERCprescribed rates, shippers may seek reparations.

The Arizona Grocery doctrine is essentially a prohibition

against retroactive ratemaking. The key passage from Arizona

Grocery states:

Where the Commission has upon complaint, and after

hearing, declared what is the maximum reasonable rate to

be charged by a carrier, it may not at a later time . . . by

declaring its own finding as to reasonableness erroneous,

subject a carrier which conformed thereto to the payment of

reparation measured by what the Commission now holds it

should have decided in the earlier proceeding to be a

reasonable rate.

284 U.S. at 390; see also Verizon Tel. Cos. v. FCC, 269 F.3d

1098, 1107 (D.C. Cir. 2001) (noting that Arizona Grocery

proscribes “the retroactive revision of established rates through

ex post reparations”). The purpose of the doctrine is to ensure

that when carriers – in this case, pipelines – rely on the

Commission’s determinations regarding just and reasonable

rates, they will not then be forced to pay reparations when the

Commission subsequently reconsiders its prior approval. See

Arizona Grocery, 284 U.S. at 389 (“[T]he carrier is entitled to

rely upon the declaration as to what will be a lawful, that is, a

reasonable rate[.]”). For this reason, in order for the Arizona

Grocery doctrine to apply, the Commission must have

“approved or prescribed” or “declared” a reasonable rate upon

which the carrier has relied. Id. at 381, 390. 

We hold that where, as here, the Commission accepts a

pipeline’s proposed tariff subject to suspension and refund

without even establishing the methodology for determining the

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42

final rate, the Commission cannot properly be considered to

have prescribed a just and reasonable rate until the proposed

tariff is approved at the completion of compliance proceedings.

Consequently, we hold that Arizona Grocery does not preclude

reparations in this case. Our holding today is motivated in large

measure by the Commission’s own acknowledgment that it was

uncertain of the methodology it would use to determine a just

and reasonable rate when it accepted Tariff No. 60. At the time

the shippers moved their gas through the East Line, the

Commission had yet to determine either a just and reasonable

rate or even the methodology of calculating it. The rates the

shippers paid were certainly not settled. The shippers, SFPP,

and FERC all accepted the rates to be interim. More

importantly, the shippers and SFPP knew that FERC had not yet

established the methodology it would use to determine a just and

reasonable rate for shipments after August 1, 2000. In such a

context, the pipeline owner’s reliance interest – which Arizona

Grocery tells us must be protected from retroactive ratemaking

– simply does not exist. The fact that once FERC had

determined how best to calculate a just and reasonable rate it

would apply that methodology retroactively to Tariff No. 60

does not help SFPP. That a rate is ultimately prescribed by

FERC is a necessary but not sufficient condition to invoke

Arizona Grocery protection. To extend Arizona Grocery

protection to such unsettled rates retroactively would itself

amount, potentially, to retroactive ratemaking. Therefore, even

after having received refunds, all East Line shippers remain

entitled to reparations to the extent that the Commission later

determines these rates (less any refunds) to be unjust and

unreasonable. 

Without any approval, prescription, or declaration of (at a

minimum) a definitive methodology by which pipelines are

instructed to compute reasonable rates, it is not at all clear in

what sense the pipelines can be considered to have relied upon

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43

the Commission’s determination. See Arizona Grocery, 284

U.S. at 390 (noting that the Arizona Grocery doctrine only

protects shippers that have “conformed” to FERC-prescribed

rates). Perhaps a reliance argument could be made if the

Commission had established a clear guideline for calculating

reasonable rates and still accepted SFPP’s proposed rates on an

interim basis merely because the calculation of the exact rate

had not been completed. But that is not this case and we need

not address whether this hypothetical would trigger Arizona

Grocery protection. As the record here provides, “it is clear that

the Commission had not reached a final determination on the

methodology to be used to design SFPP’s East Line rates at the

time it accepted Tariff No. 60 subject to refund or on the level

of those rates.” 100 FERC at 62,625.

At oral argument, the Commission argued that the Arizona

Grocery doctrine was “all about whether people are on notice.”

Tr. of Oral Arg. at 81. Thus, the Commission argued that where

shipments move under rates the shippers know to be interim,

these shipments can still be considered to have moved under the

FERC-prescribed just and reasonable rates upon receiving

appropriate refunds. This, we think, is an impermissibly broad

reading of Arizona Grocery that vitiates its purpose, which is to

protect the pipeline’s reasonable reliance interest. We are not

aware of any authority that supports such a sweeping application

of Arizona Grocery urged upon us by the Commission. By

contrast, we have previously cautioned against overly broad

interpretation of Arizona Grocery. See, e.g., Verizon Tel. Cos.,

269 F.3d at 1107 (“Arizona Grocery has been and should be

understood in the terms in which it was decided . . . .”).

In support of the Commission’s ruling, FERC and

intervenors SFPP and the Association of Oil Pipe Lines argue

that this Court in BP West Coast has already held that SFPP’s

post-refund rates would be considered final and prescribed

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44

effective August 1, 2000. But this asks too much of our holding

in BP West Coast. In that case, SFPP challenged the

Commission’s authority to order refunds to East Line shippers

for the interim rates they had been paying since August 1, 2000.

We held as regards pre-refund interim rates that “[t]he

Commission did not establish final lawful rates where it has

expressly reserved authority to make adjustments in the context

of an ongoing proceeding in which the methodology for

determining the rate had not even been established.” 374 F.3d

at 1305 (emphasis added). We never addressed whether the

Commission’s final lawful rates would eventually be considered

to have been prescribed as of August 1, 2000 for purposes of

Arizona Grocery protection. The issue of whether shippers’

claims for reparations would be barred by the Commission’s

inability to establish the proper methodology to calculate just

and reasonable rates until the end of compliance proceedings

was not properly before us until today. 

Nor are we persuaded by intervenors’ argument that

“[w]here, as here, FERC orders a carrier to make a compliance

filing or file a new tariff to be effective prospectively from the

date of the tariff, FERC is prescribing rates.” Final Joint Br. of

Intervenors SFPP, L.P. and Ass’n of Oil Pipe Lines in Support

of Respondent at 14. Such a broad statement is patently

inconsistent with the holding of BP West Coast because in that

case we specifically upheld the Commission’s authority to

accept a tariff on an interim basis. 

In sum, the Commission acted contrary to law when it held

that Arizona Grocery precluded the Commission from awarding

reparations to East Line shippers for rates paid after August 1,

2000. To be sure, for East Line shippers to receive reparations,

they will still need to demonstrate that the rates they paid after

August 1, 2000 were unjust and unreasonable. Nonetheless, the

Commission erred by holding that Arizona Grocery

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45

categorically barred it from granting the reparations sought by

the shippers. For the foregoing reasons, we vacate the portions

of the orders under review in which the Commission disallowed

reparations for East Line rates post-August 1, 2000.

IV.

For the aforementioned reasons, the petitions for review are

granted in part and denied in part. We deny the petitions for

review with respect to the income tax allowance issues and the

Energy Policy Act issues. We grant the petitions for review

with respect to the reparations issue, and we remand to the

Commission for further proceedings consistent with this

opinion.

So ordered.

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